Managerial Economics & Business Strategy

Chapter 1The Fundamentals of Managerial

Economics

McGraw-Hill/IrwinMichael R. Baye, Managerial Economics and Business Strategy Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.

Overview

I. IntroductionII. The Economics of Effective Management

Identify Goals and Constraints Recognize the Role of Profits Five Forces Model Understand Incentives Understand Markets Recognize the Time Value of Money Use Marginal Analysis

1-2

Managerial Economics

• Manager A person who directs resources to achieve a stated goal.

• Economics The science of making decisions in the presence of

scare resources.

• Managerial Economics The study of how to direct scarce resources in the way

that most efficiently achieves a managerial goal.

1-3

Identify Goals and Constraints• Effective management• Sound decision making involves having well-defined

goals. Leads to making the “right” decisions. Maximizing profits or the value of the firm.

• In striving to achieve a goal, we often face constraints. Constraints are an artifact of scarcity. Various parts of the firm may seek to achieve differing

goals. The manager unifies disparate goals into a corporate

goal.

1-4

Economic vs. Accounting Profits

• Accounting Profits Total revenue (sales) minus dollar cost of producing

goods or services. Reported on the firm’s income statement.

• Economic Profits Total revenue minus total opportunity cost.

1-5

Opportunity Cost

• Accounting Costs The explicit costs of the resources needed to produce

produce goods or services. Reported on the firm’s income statement.

• Opportunity Cost The cost of the explicit and implicit resources that are

foregone when a decision is made.

• Economic Profits Total revenue minus total opportunity cost.

1-6

Profits as a Signal

• Profits signal to resource holders where resources are most highly valued by society. Resources will flow into industries that are most highly

valued by society.

1-7

Sustainable IndustryProfits

Power of Input Suppliers

· Supplier Concentration· Price/Productivity of

Alternative Inputs· Relationship-Specific

Investments· Supplier Switching Costs· Government Restraints

Power ofBuyers

· Buyer Concentration· Price/Value of Substitute

Products or Services· Relationship-Specific

Investments· Customer Switching Costs· Government Restraints

Entry· Entry Costs· Speed of Adjustment· Sunk Costs· Economies of Scale

· Network Effects· Reputation· Switching Costs· Government Restraints

Substitutes & Complements· Price/Value of Surrogate

Products or Services· Price/Value of Complementary

Products or Services

· Network Effects

· Government Restraints

Industry Rivalry· Switching Costs· Timing of Decisions· Information· Government Restraints

· Concentration· Price, Quantity, Quality, or

Service Competition· Degree of Differentiation

The Five Forces Framework 1-8

Understanding Firms’ Incentives

• Profits are the ultimate incentive.• Incentives play an important role within the firm.• Incentives determine:

How resources are utilized. How hard individuals work.

• Managers must understand the role incentives play in the organization.

• Constructing proper incentives will enhance productivity and profitability.

1-9

Understanding Firms’ Incentives

• Agent versus principal problem• Incentive plans – profit sharing,

commissions• How to structure appropriate incentives?• Assume self-interested employees

Understanding Markets• Final outcome of the market process depends on

the relative power (bargaining position) of buyers and sellers.

• Three sources of rivalry in economic transactions each serving as a disciplinary device to guide the market process:

• Consumer-producer• Consumer-consumer• Producer-producer

Market Interactions• Consumer-Producer Rivalry

Consumers attempt to locate low prices, while producers attempt to charge high prices. Demand function serves as a guide

• Consumer-Consumer Rivalry Scarcity of goods reduces the negotiating power of

consumers as they compete for the right to those goods.• Producer-Producer Rivalry

Scarcity of consumers causes producers to compete with one another for the right to service customers. Best quality at lowest price wins.

• The Role of Government Disciplines the market process.

1-12

The Time Value of Money

• Present value (PV) of a future value (FV) lump-sum amount to be received at the end of “n” periods in the future when the per-period interest rate is “i”:

P V

F V

i n1

• Example: What is the maximum you would pay for an asset that generates an

income of $150,000 at the end of each of five years given the opportunity cost of using funds is 9 percent?

The higher the interest rate the lower the PV.

1-13

Present Value vs. Future Value

• The present value (PV) reflects the difference between the future value and the opportunity cost of waiting (OCW).

• Succinctly,PV = FV – OCW

• If i = 0, note PV = FV.• As i increases, the higher is the OCW and

the lower the PV.

1-14

Present Value of a Series

• Present value of a stream of future amounts (FVt) received at the end of each period for “n” periods:

• Equivalently,

P V

F V

i

F V

i

F V

in

n

11

221 1 1

. . .

n

tt

t

i

FVPV

1 1

1-15

Net Present Value

• Suppose a manager can purchase a stream of future receipts (FVt ) by spending “C0” dollars today. The NPV of such a decision is

N P V

F V

i

F V

i

F V

iCn

n

11

22 01 1 1

. . .

Decision Rule:If NPV < 0: Reject project

NPV > 0: Accept project

1-16

Present Value of a Perpetuity• An asset that perpetually generates a stream of cash flows

(CFi) at the end of each period is called a perpetuity. E.g. Perpetual bonds, preferred stocks.

• The present value (PV) of a perpetuity of cash flows paying the same amount (CF = CF1 = CF2 = …) at the end of each period is

i

CF

i

CF

i

CF

i

CFPVPerpetuity

...111 32

1-17

Firm Valuation and Profit Maximization

• The value of a firm equals the present value of current and future profits (cash flows).

• A common assumption among economist is that it is the firm’s goal to maximization profits. This means the present value of current and future profits, so the

firm is maximizing its value.

1

210

1...

11 tt

tFirm

iiiPV

1-18

Firm Valuation With Profit Growth

• If profits grow at a constant rate (g < i) and current period profits are p , o before and after dividends are:

• Provided that g < i. That is, the growth rate in profits is less than the interest rate and

both remain constant. Example Baye 7th page 18.

0

0

1 before current profits have been paid out as dividends;

1 immediately after current profits are paid out as dividends.

Firm

Ex DividendFirm

iPV

i g

gPV

i g

1-19

Firm Valuation With Profit Growth

• The previous assumes that growth rate is constant.

• More realistically investment and marketing strategies will affect growth rate.

• Market actions of competitors will also affect the growth rate of the firm.

• Optimal managerial decisions involve comparing the marginal benefits vs marginal costs.

• Control Variable Examples: Output Product Quality Advertising R&D

• Basic Managerial Question: How much of the control variable should be used to maximize net benefits?

Marginal (Incremental) Analysis1-21

Net Benefits

• Net Benefits = Total Benefits - Total Costs• Profits = Revenue - Costs

1-22

Marginal Benefit (MB)

• Change in total benefits arising from a change in the control variable, Q:

• Slope (calculus derivative) of the total benefit curve.

Q

BMB

1-23

Marginal Cost (MC)

• Change in total costs arising from a change in the control variable, Q:

• Slope (calculus derivative) of the total cost curve

Q

CMC

1-24

Marginal Principle

• To maximize net benefits, the managerial control variable should be increased up to the point where MB = MC.

• MB > MC means the last unit of the control variable increased benefits more than it increased costs.

• MB < MC means the last unit of the control variable increased costs more than it increased benefits.

1-25

Marginal Principle

• The goal of maximizing net benefits takes costs into account.

• The goal of maximizing total benefits does not.

• Maximizing total benefits w/o regard to costs is not a goal of the firm.

Differentiating a Function• An engineering firm conducted a study to determine its benefit and cost

structure. The results of the study were:• B(Y) = 300Y – 6Y2

• C(Y) = 4Y2

•  The manager has been asked to determine the maximum level of net benefits and the level of Y that will yield that result.

•  • Solution:• MB = 300-12Y• MC = 8Y• Equating MB and MC yields 300 – 12Y = 8Y. Solving the equation for Y

reveals that the optimum level of Y is Y* = 15. Plugging Y* = 15 into the net benefit relation yields the maximum level of net benefits:

• NB = 300(15) – 6(152) – 4(152) = 2250

The Geometry of Optimization: Total Benefit and Cost

Q

Total Benefits & Total Costs

Benefits

Costs

Q*

B

CSlope = MC

Slope =MB

1-28

The Geometry of Optimization: Net Benefits

Q

Net Benefits

Maximum net benefits

Q*

Slope = MNB

1-29

Conclusion• Make sure you include all costs and benefits

when making decisions (opportunity cost).• When decisions span time, make sure you

are comparing apples to apples (PV analysis).

• Optimal economic decisions are made at the margin (marginal analysis).

1-30