Chap 001 economic

CHAPTER 1

The Fundamentals of

Managerial Economics

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

• Introduction– The manager– Economics– Managerial economics defined

• Economics of Effective Management– Identifying goals and constraints– Recognize the nature and importance of profits– Understand incentives– Understand markets– Recognize the time value of money– Use marginal analysis

• Learning managerial economics

Chapter Overview

Chapter One

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Introduction

• Chapter 1 focuses on defining managerialeconomics, and illustrating how it is a valuabletool for analyzing many business situations.

• This chapter provides an overview of managerialeconomics.– How do accounting profits and economic profits

differ?• Why is the difference important?

– How do managers account for time gaps betweencosts and revenues?

– What guiding principle can managers use to maximizeprofits?

Chapter Overview

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The Manager

• A person who directs resources to achieve astated goal.

– Directs the efforts of others.

– Purchases inputs used in the production of thefirm’s output.

– Directs the product price or quality decisions.

Introduction

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Economics

• The science of making decisions in thepresence of scarce resources.

– Resources are anything used to produce a good orservice, or achieve a goal.

– Decisions are important because scarcity impliestrade-offs.

Introduction

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• The study of how to direct scarce resources inthe way that most efficiently achieves amanagerial goal.

– Should a firm purchase components – like diskdrives and chips – from other manufacturers orproduce them within the firm?

– Should the firm specialize in making one type ofcomputer or produce several different types?

– How many computers should the firm produce,and at what price should you sell them?

Introduction

Managerial Economics Defined

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• Basic principles comprising effectivemanagement:

– Identify goals and constraints.

– Recognize the nature and importance of profits.

– Understand incentives.

– Understand markets.

– Recognize the time value of money.

– Use marginal analysis.

Economics of Effective ManagementEconomics of Effective Management

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The Nature and Importance of Profits

• A typical firm’s objective is to maximize profits.

• Accounting profit

– Total amount of money taken in from sales (totalrevenue) minus the dollar cost of producing goods orservices.

• Economic profit

– The difference between total revenue and the totalopportunity cost of producing goods or services.

– Opportunity cost

• The explicit cost of a resource plus the implicit cost of givingup its best alternative.

Economics of Effective Management

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The Role of Profits

• Profit Principle:

– Profits are a signal to resource holders where resources are most highly valued by society.

– Resources will flow into industries that are mosthighly valued by society.

– Similarly, the profits of business signal wheresociety’s scarce resources are best allocated.


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Power of

Input SuppliersSupplier Concentration

Price/Productivity of

Alternative Inputs

Relationship-Specific

Investments

Supplier Switching Costs

Government Restraints

Power of

BuyersBuyer Concentration

Price/Value of Substitute

Products or Services

Relationship-Specific

Investments

Customer Switching Costs


Entry

Substitutes & ComplementsIndustry Rivalry

Concentration

Price, Quantity, Quality,

or Service Competition

Degree of Differentiation

Level, Growth, and Sustainabilityof Industry Profits

Entry Costs

Speed of Adjustment

Sunk Costs

Economies of Scale

Network Effects

Reputation

Switching Costs


Price/Value of Surrogate Products

or Services

Price/Value of Complementary

Products or Services

Network Effects

Government

Restraints

Switching Costs

Timing of Decisions

Information

Government

Restraints


Five Forces and Industry Profitability

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Understand Incentives

• Changes in profits provide an incentive toresource holders to change their use ofresources.

• Within a firm, incentives impact howresources are used and how hard workerswork.

– One role of a manager is to construct incentives toinduce maximal effort from employees.

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• Two sides to every market transaction:– Buyer (consumer).

– Seller (producer).

• Bargaining position of consumers and producers islimited by three rivalries in economic transactions:– Consumer-producer rivalry potential car buyer and

salesperson).

– Consumer-consumer rivalry (a good example is anauction-Ch.12).

– Producer-producer rivalry (For example, when 2 gasstations located across the street from one anothercompete on price).

• Government and the market.

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Economics of Effective ManagementUnderstand Markets

The Time Value of Money

• Often a gap exists between the time whencosts are borne and benefits received.

– $1 today is worth more than $1 received in thefuture.

• The opportunity cost of receiving the $1 in the future isthe forgone interest that could be earned were $1received today

– Managers can use present value analysis toproperly account for the timing of receipts andexpenditures.

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Present Value Analysis 1

• Present value of a single future value– The amount that would have to be invested today at

the prevailing interest rate to generate the given futurevalue:

𝑃𝑉 =𝐹𝑉

1 + 𝑖 𝑛

– Present value reflects the difference between thefuture value and the opportunity cost of waiting:

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 Analysis II

• Present value of a stream of future values

𝑃𝑉 =𝐹𝑉11 + 𝑖 1

+𝐹𝑉21 + 𝑖 2

+⋯+𝐹𝑉𝑛1 + 𝑖 𝑛

or,

𝑃𝑉 =

𝑡=1

𝑛𝐹𝑉𝑡1 + 𝑖 𝑡

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• Consider a project that returns the following income stream:

– Year 1, $10,000; Year 2, $50,000; and Year 3, $100,000.

– At an annual interest rate of 3 percent, what is the present value of this income stream?

𝑃𝑉 =$10,000

1 + 0.03 1+$50,000

1 + 0.03 2+$100,000

1 + 0.03 3

= $148,352.70

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The Time Value of Money in Action

Net Present Value

• The present value of the income streamgenerated by a project minus the current costof the project:

𝑁𝑃𝑉 =𝐹𝑉11 + 𝑖 1

+𝐹𝑉21 + 𝑖 2

+⋯+𝐹𝑉𝑛1 + 𝑖 𝑛

− 𝐶0

• Decision Rule:

• If NPV < 0: Reject project

NPV > 0: Accept project

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• Present value of decisions that indefinitelygenerate cash flows:

𝑃𝑉𝐴𝑠𝑠𝑒𝑡 = 𝐶𝐹0 +𝐶𝐹11 + 𝑖 1

+𝐶𝐹21 + 𝑖 2

+𝐶𝐹31 + 𝑖 3

+⋯

• Present value of this perpetual income streamwhen the same cash flow is generated (𝐶𝐹1=𝐶𝐹2 = ⋯ = 𝐶𝐹):

𝑃𝑉𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 =𝐶𝐹

𝑖

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Present Value of Indefinitely Lived Assets

• Profit maximization principle

– Maximizing profits means maximizing the value ofthe firm, which is the present value of current andfuture profits.

– Maximizing profits means maximizing PV and FV.

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Present Value and Profit Maximization

Present Value and Estimating Values of Firms I

• The value of a firm with current profits 𝜋0,with no dividends paid out and expected,constant profit growth rate of 𝑔 (assuming𝑔 < 𝑖) is:𝑃𝑉𝐹𝑖𝑟𝑚

= 𝜋0 +𝜋0 1 + 𝑔

1 + 𝑖 1+𝜋0 1 + 𝑔

2

1 + 𝑖 2+𝜋0 1 + 𝑔

3

1 + 𝑖 3+⋯

= 𝜋01 + 𝑖

𝑖 − 𝑔

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• When dividends are immediately paid out of

current profits, the present value of the firm is

(at ex-dividend date):

𝑃𝑉𝐹𝑖𝑟𝑚𝐸𝑥−𝑑𝑖𝑣 = 𝑃𝑉𝐹𝑖𝑟𝑚 − 𝜋0

= 𝜋01 + 𝑔

𝑖 − 𝑔

Provided that g < i.

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Present Value and Estimating Values of Firms II

• Short-term and long-term profits principle

– If the growth rate in profits is less than the

interest rate and both are constant, maximizing

current (short-term) profits is the same as

maximizing long-term profits.

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Short-Term versus Long-term Profits

• Given a control variable, 𝑄, of a managerialobjective, denote the

– total benefit as 𝐵 𝑄 .

– total cost as 𝐶 𝑄 .

• Manager’s objective is to maximize netbenefits:

𝑁 𝑄 = 𝐵 𝑄 − 𝐶 𝑄

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Marginal Analysis

• How can the manager maximize net benefits?

• Use marginal analysis

– Marginal benefit: 𝑀𝐵 𝑄

• The change in total benefits arising from a change in the managerial control variable, 𝑄.

– Marginal cost: 𝑀𝐶 𝑄

• The change in the total costs arising from a change in the managerial control variable, 𝑄.

– Marginal net benefits: 𝑀𝑁𝐵 𝑄𝑀𝑁𝐵 𝑄 = 𝑀𝐵 𝑄 −𝑀𝐶 𝑄

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Using Marginal Analysis

• Marginal principle

–To maximize net benefits, the managershould increase the managerial controlvariable up to the point where marginalbenefits equal marginal costs. This level ofthe managerial control variablecorresponds to the level at which marginalnet benefits are zero; nothing more can begained by further changes in that variable.

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Marginal Analysis Principle I

Marginal Principle II

• Marginal principle (calculus alternative)

– Slope of a continuous function is the derivative, ormarginal value, of that function:

𝑀𝐵 =𝑑𝐵 𝑄

𝑑𝑄

𝑀𝐶 =𝑑𝐶 𝑄

𝑑𝑄

𝑀𝑁𝐵 =𝑑𝑁 𝑄

𝑑𝑄

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Marginal Principle

• To maximize net benefits, the managerialcontrol variable should be increased up to thepoint where MB = MC.

• MB > MC means the last unit of the controlvariable increased benefits more than itincreased costs.

• MB < MC means the last unit of the controlvariable increased costs more than it increasedbenefits.

Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.

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Marginal Analysis In Action

• It is estimated that the benefit and cost structure of a firm is:

𝐵 𝑄 = 250𝑄 − 4𝑄2

𝐶 𝑄 = 𝑄2

• Find the 𝑀𝐵 𝑄 and 𝑀𝐶 𝑄 functions.𝑀𝐵 𝑄 = 250 − 8𝑄𝑀𝐶 𝑄 = 2𝑄

• What value of 𝑄 makes 𝑁𝑀𝐵 𝑄 zero?250 − 8𝑄 = 2𝑄 ⇒ 𝑄 = 25

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Quantity(Control Variable)

Total benefitsTotal costs

0

𝐵 𝑄

𝐶 𝑄

Maximum total benefits

Maximum net benefits


Determining the Optimal Level of a Control Variable

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Net benefits

0


Slope =𝑀𝑁𝐵(𝑄)

𝑁 𝑄 = 𝐵 𝑄 − 𝐶 𝑄 = 0


Determining the Optimal Level of a Control Variable II

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Marginal benefits, costsand net benefits

0

𝑀𝐶 𝑄

𝑀𝐵 𝑄𝑀𝑁𝐵 𝑄



Determining the Optimal Level of a Control Variable III

• Incremental revenues

– The additional revenues that stem from a yes-or-no decision.

• Incremental costs

– The additional costs that stem from a yes-or-no decision.

• “Thumbs up” decision

–𝑀𝐵 > 𝑀𝐶.

• “Thumbs down” decision

–𝑀𝐵 < 𝑀𝐶.

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Incremental Decisions

Learning Managerial Economics

• Practice, practice, practice …

• Learn terminology

– Break down complex issues into manageablecomponents.

– Helps economics practitioners communicateefficiently.

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Conclusion

• Make sure you include all costs and benefitswhen making decisions (opportunity costs).

• When decisions span time, make sure you arecomparing apples to apples (present valueanalysis).

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

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Conclusion


• Becoming proficient in economics is like learningto play music or ride a bicycle.

• The best way to learn economics is to practice,practice, and practice some more.

• Practicing managerial economics means practicingmaking decisions.

• The best way to do this is to work and rework theproblems presented in the text and at the end ofeach chapter.

• Before you can be effective at practicing, however,you must understand the language of economics.


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Solve problems

Next meeting, we will solve the following problems:

A. Conceptual and Computational Questions:

Solve: 2, 3, 4, 5, 6,9, and 10.

B. Problems and Applications: solve 12 and 14.

C. Consider problem 15, 16, 17, 19 as case study.

D. Read carefully Demonstration Problems, 1-1, p.15; 1-2,

p.18, and 1-3, p. 24. Also, read the Appendix in pp.34-36.


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Chap 001 economic

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