Managerial Economics & Business Strategy

Chapter 1

The Fundamentals of Managerial Economics

McGraw-Hill/Irwin

Michael R. Baye, Managerial Economics and

Business Strategy

Overview

I. Introduction II. 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

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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.

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Definition of Economics

Economics is the social science that studies the choices that individuals, businesses, governments, and entire societies make as they cope with scarcity and the incentives that influence and reconcile those choices.

Economics divides in two main parts:

Microeconomics

Macroeconomics

Puerto Rico Prices Last Previous Highest Lowest Unit Inflation Rate 0.1 0.4 8.8 -1.2 percent

Food Inflation 2.8 2.6 9.69 -0.09 percent

Inflation Rate Reference Previous Highest Lowest Argentina 16 15-Jan 23.9 20262.8 -7

Aruba 1 15-Jan 2.2 12.66 -4.68

Bahamas 2.2 15-Jan 0.25 14.24 -0.19

Barbados 1.89 14-Dec 1.79 9.6 1.67

Belize -1.1 15-Jan -0.4 9.6 -12.7

Bolivia 5.49 15-Feb 5.94 23464.36 -1.27

Brazil 7.7 15-Feb 7.14 6821.31 1.65

Canada 1 15-Jan 1.5 21.6 -17.8

Cayman Islands 1.5 14-Aug 0.7 11.4 -3.1

Chile 4.4 15-Feb 4.5 746.3 -3.4

Colombia 4.36 15-Feb 3.82 41.65 -0.87

Costa Rica 3.53 15-Feb 4.37 108.89 2.57

Cuba 5.5 12-Dec 3.5 5.7 0.8

Dominican Republic

1.16 15-Jan 1.58 82.49 -1.57

Ecuador 4.05 15-Feb 3.53 107.87 -2.67

El Salvador -1.06 15-Feb -0.74 12.2 -1.6

Guatemala 2.32 15-Jan 2.95 60.71 -11.94

Guyana 0.27 14-Sep 0.62 16.04 -1.46

Haiti 6.6 15-Jan 6.4 42.46 -4.7

Honduras 3.83 15-Jan 5.82 40.2 2.66

Jamaica 5.3 15-Jan 6.4 26.49 5.29

Mexico 3 15-Feb 3.07 179.73 2.91

Nicaragua 5.51 15-Feb 5.45 23.99 -0.12

Panama 2.3 15-Jan 2.6 10.04 0.49

Paraguay 3.2 15-Feb 3.4 13.4 0.9

Peru 2.77 15-Feb 3.07 12377.32 -1.11

Puerto Rico 0.1 14-Dec 0.4 8.8 -1.2

Suriname 2.3 15-Jan 3.9 586.48 -11.68

Trinidad and Tobago

8.47 14-Dec 9.02 24.52 -2.61

United States -0.1 15-Jan 0.8 23.7 -15.8

Uruguay 7.43 15-Feb 8.02 182.86 -7.12

Venezuela 68.5 14-Dec 63.61 115.18 3.22

http://www.tradingeconomics.com/puerto-rico/inflation-cpihttp://www.tradingeconomics.com/puerto-rico/food-inflationhttp://www.tradingeconomics.com/argentina/inflation-cpihttp://www.tradingeconomics.com/aruba/inflation-ratehttp://www.tradingeconomics.com/bahamas/inflation-cpihttp://www.tradingeconomics.com/barbados/inflation-ratehttp://www.tradingeconomics.com/belize/inflation-ratehttp://www.tradingeconomics.com/bolivia/inflation-cpihttp://www.tradingeconomics.com/brazil/inflation-cpihttp://www.tradingeconomics.com/canada/inflation-cpihttp://www.tradingeconomics.com/cayman-islands/inflation-cpihttp://www.tradingeconomics.com/chile/inflation-cpihttp://www.tradingeconomics.com/colombia/inflation-cpihttp://www.tradingeconomics.com/costa-rica/inflation-cpihttp://www.tradingeconomics.com/cuba/inflation-cpihttp://www.tradingeconomics.com/dominican-republic/inflation-cpihttp://www.tradingeconomics.com/dominican-republic/inflation-cpihttp://www.tradingeconomics.com/ecuador/inflation-cpihttp://www.tradingeconomics.com/el-salvador/inflation-cpihttp://www.tradingeconomics.com/guatemala/inflation-cpihttp://www.tradingeconomics.com/guyana/inflation-cpihttp://www.tradingeconomics.com/haiti/inflation-cpihttp://www.tradingeconomics.com/honduras/inflation-cpihttp://www.tradingeconomics.com/jamaica/inflation-cpihttp://www.tradingeconomics.com/mexico/inflation-cpihttp://www.tradingeconomics.com/nicaragua/inflation-cpihttp://www.tradingeconomics.com/panama/inflation-cpihttp://www.tradingeconomics.com/paraguay/inflation-cpihttp://www.tradingeconomics.com/peru/inflation-cpihttp://www.tradingeconomics.com/puerto-rico/inflation-cpihttp://www.tradingeconomics.com/suriname/inflation-cpihttp://www.tradingeconomics.com/trinidad-and-tobago/inflation-cpihttp://www.tradingeconomics.com/trinidad-and-tobago/inflation-cpihttp://www.tradingeconomics.com/united-states/inflation-cpihttp://www.tradingeconomics.com/uruguay/inflation-cpihttp://www.tradingeconomics.com/venezuela/inflation-cpi

Two Big Economic Questions

Goods and services are produced by using productive resources that economists call factors of production.

Factors of production are grouped into four categories:

Land

Labor

Capital

Entrepreneurship

Identify Goals and Constraints

Sound decision making involves having well-defined goals.

Leads to making the right decisions.

In striking to achieve a goal, we often face constraints.

Constraints are an artifact of scarcity.

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Economic vs. Accounting Profits

Accounting Profits

Total revenue (sales) minus dollar cost of producing goods or services.

Reported on the firms income statement.

Economic Profits

Total revenue minus total opportunity cost.

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Opportunity Cost

Accounting Costs

The explicit costs of the resources needed to produce goods or services.

Reported on the firms 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.

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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.

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Sustainable Industry Profits

Power of

Input Suppliers Supplier Concentration

Price/Productivity of

Alternative Inputs

Relationship-Specific

Investments

Supplier Switching Costs

Government Restraints

Power of

Buyers 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 1-12

Understanding Firms Incentives

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.

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Market Interactions Consumer-Producer Rivalry

Consumers attempt to locate low prices, while producers attempt to charge high prices.

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.

The Role of Government Disciplines the market process.

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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:

PV

FV

in

1 Examples:

Lotto winner choosing between a single lump-sum payout of

$104 million or $198 million over 25 years.

Determining damages in a patent infringement case.

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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.

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What does the consumers intertemporal problem look like?

U1

U2

U3

Future Consumption C1

Current Consumption Co

W/P1

W

C1*

Co*

W = Co + P1C1

Intertemporal utility or Indifference curves

At the tangency of U1 and the budget constraint, W, we get equilibrium consumption of Co, as Co*, and equilibrium future consumption, C1*

The consumer maximizes intertemporal utility over current and future consumption given the budget constraint, which is the limit on wealth

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,

PV

FV

i

FV

i

FV

i

n

n

1

1

2

21 1 1

...

n

tt

t

i

FVPV

1 1

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AN EXAMPLE

WHAT IS THE PRESENT VALUE OF $1,080 ?

IN ONE YEAR IF THE INTEREST RATE IS 8 % PER

YEAR?

SO i = 8 % OR 0.08, AND t = 1

PV = $1,080[ 1/(1.08)1] = $1,000

----

NOTICE, THAT PV = FV/ (1 + i )t

SO FV = PV(1+ i ) t

THEREFORE NOTE THAT $1,000 IN 1 YEAR

AT 8% WOULD INCREASE TO $1,080

LETS GO A BIT FURTHER ON THIS CONCEPT:

WHAT IS THE PRESENT VALUE OF 100,000 TO BE

RECEIVED AT THE END OF 10 YEARS IF THE

INTEREST RATE, i = 10% ?

PV = 100,000[ 1 / (1.10)10]

SO DO THE MATH, AND WE GET PV = 38,550

HOW DID WE DO THAT? WELL, USE A

CALCULATOR OR, IF YOU ARE GOOD AT

EXPONENTIATION, THEN IT ALL COMES OUT OK

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

NPV

FV

i

FV

i

FV

iC

n

n

1

1

2

2 01 1 1

...

Decision Rule:

If NPV < 0: Reject project

NPV > 0: Accept project

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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.

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

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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 firms 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

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Firm Valuation With Profit Growth

If profits grow at a constant rate (g < i) and current period profits are 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.

0

0

1 before current profits have been paid out as dividends;

1 immediately after current profits are paid out as dividends.

Firm

Ex Dividend

Firm

iPV

i g

gPV

i g

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Control Variable Examples: Output

Price

Product Quality

Advertising

R&D

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

Marginal (Incremental) Analysis 1-26

Net Benefits

Net Benefits = Total Benefits - Total Costs

Profits = Revenue - Costs

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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

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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

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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.

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The Geometry of Optimization: Total Benefit and Cost

Q

Total Benefits

& Total Costs Benefits

Costs

Q*

B

C Slope = MC

Slope =MB

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The Geometry of Optimization: Net Benefits

Q

Net Benefits

Maximum net benefits

Q*

Slope = MNB

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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).

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