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Fundamentals of Managerial Economics

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I. Marginal Analysis - Definitions

Marginal Benefit – the change in total benefits arising from a change in the managerial control variable, Q (OR the change in total benefits arising from a given choice).

Marginal Cost – the change in total costs arising from a change in the managerial control variable, Q (OR the change in total costs arising from a given choice).

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Marginal Analysis for Profit Maximizing Firm Note first that firms maximize Economic Profits

not Accounting Profits

Accounting Profits= Total Revenue-Accounting Costs

Economic Profits= Total Revenue-Economic Costs

where Economic Costs include opportunity costs

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Opportunity Cost - Definition

The cost of the explicit and implicit resources that are foregone when a decision is made OR the cost of using resources for a certain purpose in terms of the benefit given up by using them in their best alternative way.

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Marginal Analysis for Profit Maximizing Firm Marginal Benefit of a firm’s decision is the

change in Total Revenue attributable to that decision.

Marginal Cost of a firm’s decision is the change in Economic Costs attributable to that decision.

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Example 1: Coffee Shop

Steve Mason works as a lawyer in Chicago and owns a two-story Brownstone. He currently lives on the second story of his Brownstone and leases the first floor out to a travel agency. Steve makes $60,000 per year as a lawyer, pays $80,000 per year in mortgage payments on the Brownstone and leases the first floor for $100,000 per year.

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Example 1 (cont.): Coffee Shop Steve is deciding whether to quit is job and open

a coffee shop on the first floor of his Brownstone (instead of leasing the space to the travel agency). Steve expects the coffee shop’s labor costs to be $40,000 per year and supplies to cost $50,000 per year. What is the minimum expected revenue the coffee shop must generate in order for Steve to quit his job as a lawyer? What assumptions do you need to make?

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Example 2: 2015 Cotton Bowl Suppose you attended the Cotton Bowl at AT&T

Stadium in Dallas Texas – MSU versus Baylor. You purchased a plane ticket for $600, bought a ticket for $300 and booked a hotel room for $500. You are standing in the parking lot of the Cotton Bowl right before kickoff and a scalper offers you $1200 for your ticket. Do you take it? What does it depend on?

COTTON BOWL

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Scalper Here you are.

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Time Value of Money

Generally, what is the PV of $100 in T years if the interest rate is i?

PV=100/(1+i)T

What is the PV of $100 in T years and $150 in Z years if the interest rate is i?

PV=100/(1+i)T+150/(1+i)Z

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Example 3: Skaneateles Bar Sherwood Inn is a bar on Skaneateles Lake (one of the

Finger Lakes in Upstate New York). The manager of Sherwood is deciding whether to buy a large tent for the 4th of July (when the town has fireworks over the lake). The manager would use the tent each 4th of July for a beer garden and expects the tent to last three years. The manager also expects that he would be able to increase the number of drinks sold each July 4th by 2,000. Suppose the price of a drink is $3, the cost of the ingredients in each drink is $1 and that the manager would have $1,000 more in labor costs if he has the beer garden. If the annual interest rate is 10%, what is the maximum the manager is willing to pay for the tent?

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Example 4: My Mom My mom owns a house in the Chicago suburbs which is

currently worth $200,000. If she sells the house, she would rent another place in the suburbs for $15,000 a year which she has to pay at the beginning of the year. Suppose that the expected appreciation on the house is 5% annually. Let the interest rate be 10% annually and assume my mom is indifferent between living in her current house or renting (except for the cost issue). What is the maximum annual maintenance cost on the house my mom should be willing to pay? If the annual maintenance cost is greater than this amount, my mom would choose to rent. Assume the maintenance cost is paid at the end of the year.

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Example 5: When to retire?

What if Social Security is Optional?

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What does Social Security have to do with the annuities market?

Is Adverse Selection in the Annuity Market a Big Problem?

by Anthony Webb – Center for Retirement Research  Introduction

An annuity provides an individual or a household with insurance against living too long. In exchange for a one-time premium payment, the insurer agrees to make periodic payments to the insured for life. In theory, annuities seem like a valuable product for many retirees given an uncertain date of death. However, in practice, few people purchase annuities. Researchers who have studied this puzzle have concluded that annuities are not "actuarially fair," that is, for someone with average life expectancy they provide only about 74 to 85 cents in income for every dollar in premium payments...