Managerial Economics & Business

Strategy

Chapter 1:
The Fundamentals of
Managerial
Economics

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
 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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 Economics
 is the science of making decisions in the
presence of scarce resources.
 Resources are simply anything used to
produce a good or service or, more
generally, to achieve a goal.
 Decisions are important because scarcity
implies that by making one choice, you
give up another.

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 Managerial economics
 the study of how to direct scarce
resources in the way that most efficiently
achieves a managerial goal.
 It is a very broad discipline in that it
describes methods useful for directing
everything from the resources of a
household to maximize household welfare to
the resources of a firm to maximize profits.

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 Economic profits
 are the difference between the total revenue and the
total opportunity cost of producing the firm’s goods or
services.
 The opportunity cost of using a resource
includes both the explicit (or accounting) cost of the
resource and the implicit cost of giving
up the best alternative use of the resource.
 The opportunity cost of producing a good or service
generally is higher than accounting costs because it
includes both the dollar value of
costs (explicit, or accounting, costs) and any implicit costs

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 Studying Economics
 In studying microeconomics in general, and managerial economics
in particular, it is important to bear in mind that there are two sides to
every transaction in a market :
 For every buyer of a good there is a corresponding seller.
 The final outcome of the market process, then, depends on the relative
power of buyers and sellers in the marketplace.
 The power, or bargaining position, of consumers and producers in the
market is limited by three sources of rivalry that exist in economic
transactions: consumer–producer rivalry, consumer–consumer rivalry,
and producer–producer rivalry.
 Each form of rivalry serves as a disciplining device to guide the market
process, and each affects different markets to a different extent.
 Thus, your ability as a manager to meet performance objectives will
depend on the extent to which your product is affected by these
sources of rivalry.

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 Recognize the Time Value of Money
 The timing of many decisions involves a gap between
the time when the costs of a project are borne and
the time when the benefits of the project are
received.
 In these instances it is important to recognize that $1
today is worth more than $1 received in the future.
 The reason is simple : The opportunity cost of receiving
the $1 in the future is the forgone interest that could be
earned were $1 received today.
 This opportunity cost reflects the time value of
money. To properly account for the timing of receipts and
expenditures, the manager must understand present
value 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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 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 firm’s 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 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.
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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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 The Five Forces Framework
Entry Costs Entry Network Effects
Speed of Adjustment Reputation
Sunk Costs Switching Costs
Economies of Scale Government Restraints

Sustainable Industry
Power of Profits Power of
Input Suppliers Buyers
Supplier Concentration Buyer Concentration
Price/Productivity of Price/Value of Substitute
Alternative Inputs Products or Services
Relationship-Specific Relationship-Specific
Investments Investments
Supplier Switching Costs Customer Switching Costs
Government Restraints Government Restraints

Industry Rivalry Substitutes & Complements

Concentration Switching Costs Price/Value of Surrogate Products or Network Effects
Price, Quantity, Quality, or Timing of Decisions Services Government
Service Competition Information Price/Value of Complementary Restraints
Degree of Differentiation Government Restraints Products or Services

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 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 consumers’ negotiating
power 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”:

FV
PV 
1  i  n

• 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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 Present Value of a Series
 Present value of a stream of future amounts
(FVt) received at the end of each period for
“n” periods:
F V1 FV2 FVn
PV    ...
1  i  1
1  i  2
1  i  n

 Equivalently,
n
FVt
PV  
t 1 1  i t

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 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

F V1 FV2 FVn
NPV    ...  C0
1  i  1
1  i  2
1  i  n

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
CF CF CF
PVPerpetuity     ...
1  i  1  i  1  i 
2 3

CF

i
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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).
1 2 
t
PVFirm  0    ...  
1  i  1  i  t 1 1  i t

 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.

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 Firm Valuation With Profit Growth
 If profits grow at a constant rate (g < i) and
current period profits are before and after
dividends are:
1 i
PVFirm   0 before current profits have been paid out as dividends;
ig
Ex  Dividend 1 g
PVFirm  0 immediately after current profits are paid out as dividends.
ig

 Provided that g < i.

– That is, the growth rate in profits is less than
the interest rate and both remain constant.
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Marginal (Incremental) Analysis
 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?

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 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:
B
MB 
Q
 Slope (calculus derivative) of the total benefit
curve.

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 Marginal Cost (MC)
 Change in total costs arising from a change
in the control variable, Q:

C
MC 
Q
 Slope (calculus derivative) of the total cost
curve.

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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
Total Benefits Costs
& Total Costs
Benefits
Slope =MB

B
Slope = MC
C

Q* Q
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 The Geometry of Optimization:
Net Benefits
Net Benefits

Maximum net benefits

Slope = MNB

Q
Q*
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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 (Present
Value Analysis).
 Optimal economic decisions are made at the
margin (marginal analysis).

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