Economics

What’s Economics about?

♦ Science of making decisions to allocate scarce resources to alternative uses.

♦ Three fundamental questions: – What? – How? – To whom?

♦ Microeconomics vs Macroeconomics.

Managerial Economics vs Micro Economics

A market economy

• Microeconomics vs Macroeconomics

♦ Microeconomics: – Studies decision making and interactions of individual

agents; – Concentrates on Demand, Supply and Markets.

♦ Macroeconomics: – Studies the evolution of the aggregate economy, as a

result of individual decisions and interactions; – Concentrates on Product, Unemployment and Inflation. • Managerial Economics vs Micro economics

• Managerial economics applies microeconomic theory to business problems– How to use economic analysis to make

decisions to achieve firm’s goal of profit maximization

• Microeconomics– Study of behavior of individual economic

agents

• Why Managerial Economics?

The Fundamentals of Managerial Economics

• Use economic profits;

• Identify objectives and constraints;

• Understand markets;

• Conduct marginal analysis;

• Consider incentives and signaling;

• Recognize time value of money

Economic Cost of Resources

• Opportunity cost of using any resource is:– What firm owners must give up to use the

resource

• Market-supplied resources– Owned by others & hired, rented, or leased

• Owner-supplied resources– Owned & used by the firm

Total Economic Cost

• Total Economic Cost– Sum of opportunity costs of both market-

supplied resources & owner-supplied resources

• Explicit Costs– Monetary payments to owners of market-

supplied resources

• Implicit Costs– Nonmonetary opportunity costs of using

owner-supplied resources

Economic Cost of Using Resources

Im plic it Costsof

O w ner-S upp lied R esourcesThe re tu rns fo rgone by n o t takingthe ow ners ’ res ources to m arke t

Explicit Costso f

M arket-S u p p lied R eso u rce sT he m oneta ry paym ents to

resource o wners

Total Econom ic CostT he to ta l opportun ity cos ts o f

bo th k inds o f res ources

+

=

Types of Implicit Costs

• Opportunity cost of cash provided by owners– Equity capital

• Opportunity cost of using land or capital owned by the firm

• Opportunity cost of owner’s time spent managing or working for the firm

Economic Profit versus Accounting Profit

• Economic profit = Total revenue – Total economic cost

= Total revenue – Explicit costs – Implicit costs

• Accounting profit = Total revenue – Explicit costs

• Accounting profit does not subtract implicit costs from total revenue

• Firm owners must cover all costs of all resources used by the firm

– Objective is to maximize economic profit

3. Use economic profits

♦ Accounting profits

♦ Economic profits: – Oportunity costs.

♦ Example: Operation of a small pizzeria.

♦ Objective: maximize shareholders value.

Operation of a small pizzeria (I)

♦ Mike runs a small pizzeria in his hometown.

♦ He owns the building.

♦ Annual revenues are €100000 euros.

♦ Annual costs are €20000.

♦ Annual profit is €80000 euros.

♦ This is not the economic profit!

Operation of a small pizzeria (II)

♦ Mike could have a job earning €30000.

♦ Mike could have rented the space for €100000.

♦ The economic profit is just:

∏ = 80000-30000-100000= -50000

♦ CONCLUSION: Mike should close the pizzeria, rent the space and get the alternative job.

2. Identify objectives and constraints

♦ The role of objectives:

– Choices are made to achieve objectives;

– Objectives of the unit and objectives of the sub-units.

♦ Resources are scarce:

– Impose constraints;

– Limit possibilities.

Maximizing the Value of a Firm

• Value of a firm– Price for which it can be sold– Equal to net present value of expected future

profit

• Risk premium– Accounts for risk of not knowing future profits– The larger the rise, the higher the risk

premium, & the lower the firm’s value

Maximizing the Value of a Firm

• Maximize firm’s value by maximizing profit in each time period– Cost & revenue conditions must be

independent across time periods

• Value of a firm =

1 22

1

...(1 ) (1 ) (1 ) (1 )

TtT

T ttr r r r

3. What is a Market?

• A market is any arrangement through which buyers & sellers exchange goods & services

• Markets reduce transaction costs– Costs of making a transaction other than the

price of the good or service

Price-Takers vs. Price-Setters

• Price-taking firm– Cannot set price of its product – Price is determined strictly by market forces of

demand & supply

• Price-setting firm– Can set price of its product– Has a degree of market power, which is ability

to raise price without losing all sales

Market Structures

• Market characteristics that determine the economic environment in which a firm operates– Number & size of firms in market– Degree of product differentiation– Likelihood of new firms entering market

Perfect Competition

• Large number of relatively small firms

• Undifferentiated product

• No barriers to entry

Monopoly

• Single firm

• Produces product with no close substitutes

• Protected by a barrier to entry

Monopolistic Competition

• Large number of relatively small firms

• Differentiated products

• No barriers to entry

Oligopoly

• Few firms produce all or most of market

output

• Profits are interdependent

– Actions by any one firm will affect sales &

profits of the other firms

Globalization of Markets

• Economic integration of markets located in

nations around the world

– Provides opportunity to sell more goods &

services to foreign buyers

– Presents threat of increased competition from

foreign producers

Recognize the time value of money ♦ Many decisions have monetary implications

throughout a long period of time (R&D is a typical example). This raises specific problems.

♦ 1€ today is worth more that 1€ one year from now.

– Opportunity cost of capital; – Use present values. ♦ Example: R&D of new drugs. •

4. Conduct marginal analysis

♦ Why and how marginal analysis:

– Decide on the basis of marginal benefits and marginal costs.

♦ Examples:

– Discrete decisions: How many machines (Labor) to buy?

3. Use economic profits

♦ Accounting profits

♦ Economic profits:

– Oportunity costs.