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EC 500

Chapter 1The Fundamentals of Managerial

Economics

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Headline

Amcott Loses $3.5 Million; Manager Fired.

On Tuesday software giant Amcott posted a year-end operating loss of $3.5 million. Reportedly, $1.7 million of the loss stemmed from its foreign language division.

With short-term interest rates at 7 percent, Amcott decided to use $20 million of its retained earnings to purchase three-year rights to Magicword, a software package that converts generic word processor files saved as French text into English. First year sales revenue from the software was $7 million, but thereafter sales were halted pending a copyright infringement suit filed by Foreign, Inc.

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Amcott lost the suit and paid damages of $1.7 million. Industry insiders say that the copyright violation pertained to a very small component of Magicword.

Ralph, the Amcott manager who was fired over the incident, was quoted as saying, “I’m a scapegoat for the attorneys [at Amcott] who didn’t do their homework before buying the rights to Magicword. I projected annual sales of $7 million per year for three years. My sales forecasts were right on target.”

Do you know why Ralph was fired?

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1. 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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2. Economic vs. Accounting Profits

• Goal = Profit Maximization (among others)

• 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 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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[Example]• Pizza House in NY

– Revenue = $100,000– Cost = $20,000– Profit =

• Opportunity Cost– Can work for $30,000– Rental revenue = $70,000

• Total Economic Cost = Cost + Opportunity Cost =

• Economic Profit = Revenue – Total Economic Cost = $100,000 - $120,000 =

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Sustainable Industry

Profits

Power of Input Suppliers

Supplier ConcentrationPrice/Productivity of Alternative InputsRelationship-Specific InvestmentsSupplier Switching CostsGovernment Restraints

Power ofBuyers

Buyer ConcentrationPrice/Value of Substitute Products or ServicesRelationship-Specific InvestmentsCustomer Switching CostsGovernment Restraints

EntryEntry CostsSpeed of AdjustmentSunk CostsEconomies of Scale

Network EffectsReputationSwitching CostsGovernment Restraints

Substitutes & ComplementsPrice/Value of Surrogate Products or ServicesPrice/Value of Complementary Products or Services

Network EffectsGovernment Restraints

Industry RivalrySwitching CostsTiming of DecisionsInformationGovernment Restraints

ConcentrationPrice, Quantity, Quality, or Service CompetitionDegree of Differentiation

3. The Five Forces Framework

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4. 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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5. The Time Value of Money

• Present value (PV) of a lump-sum amount (FV) to be received at the end of “n” periods when the per-period interest rate is “i”:

PV

FV

i n1

• 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 of a Series

• Present value of a stream of future amounts (FVt) received at the end of each period for “n” periods:

PV

FV

i

FV

i

FV

inn

1

12

21 1 1. . .

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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

NPV

FV

i

FV

i

FV

iCn

n

11

22 01 1 1

. . .

Decision Rule:If NPV < 0: Reject project

NPV > 0: Accept project

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[example]

• A new machine costs $300,000 and has a life of 5 years.

• Cost reductions will be $50,000, $60,000, $75,000, $90,000 and $90,000 in year 1,2,..,5, respectively.

• If the interest rate is 8 percent, should the manager purchase the machine?

• PV = $284,679• NPV = PV – C = -$15,321. • Thus,

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Present Value of a Perpetuity

• An asset that perpetually (endlessly) generates a stream of cash flows (CF) at the end of each period is called a perpetuity.

• The present value (PV) of a perpetuity of cash flows paying the same amount at the end of each period is

i

CF

i

CF

i

CF

i

CFPVPerpetuity

...111 32

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• How?

• Example: What is the value of a perpetual bond that pays the owner $100 at the end of each year when i = 0.05?

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Firm Valuation• The value of a firm equals the present value of current and

future profits.

– PV = t / (1 + i)t

Note: If the profits are expected to grow at a constant rate of g percent,

t = 0 (1 + g)t

Then,

PV = 0 (1 + g)t / (1 + i)t gives (HOW?):

0

1

.. before current profits have been paid out as dividends.

Firm

iPV

i g

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0

1

.. immediately after current profits are paid out as dividends

Ex DividendFirm

gPV

i g

If profits grow at a constant rate (g < i):

(How?)

Point: If the growth rate in profits < interest rate, i.e., g < i, and both remain constant, maximizing the present value of all future profits is the same as maximizing current profits.

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[Example]

Suppose that i = 10% and g = 5%. The firm’s current profits are $100 million.

(a) What is PV?

(b) What is PV after paying a dividend of the current profit?

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Related concept: Tobin’s q

• Tobin's q, is the ratio of the market value of a firm's assets (as measured by the market value of its outstanding stock and debt) to the replacement cost of the firm's assets (Tobin 1969).

• This concept is frequently used in finance analysis.

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• Basic Managerial Question: How much of the control variable should be used to maximize net benefits?– Control Variables = Output, Price, Product Quality,

Advertising, R&D, etc.

• When to stop working? – Study plan?– Retirement plan?

6. Marginal (Incremental) Analysis

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Net Benefits

• Net Benefits = Total Benefits - Total Costs

• Profits = Revenue – Costs

• Point: – Benefit keeps increasing before calling down.– Cost keeps increasing at an increasing rate.

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Key points

• The optimal point is at the level of input (Q) – Where two slopes are the same.

That is, MB = MC.– Where the slope of the Net Benefit is zero.

That is, the Net benefit is maximized.

• Should explain WHY this occurs.– If MB < MC?– If MB > MC?

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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

Q

Total Benefits & Total Costs

Benefits

Costs

Q*

B

CSlope = MC

Slope =MB

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[Example]• Suppose

– Benefit = 300Q – 6Q2

– Cost = 4Q2

– MB = 300 – 12Q– MC = 8Q– MB = MC implies 300 – 12Q = 8Q

Q* = 15NB = 300*15 – 6*152 - 4*152 = 2,250

Exercise: Suppose – Benefit = 150 +28Q – 5Q2

– Cost = 100 + 8Q– What is 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 (PV analysis).

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

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Back to Headline

• NPV

= 7,000,000/(1+0.07)1 + 7,000,000/(1+0.07)2 +

7,000,000/(1+0.07)3 - 20,000,000

= -$1,629,788

LOSS!

; Not fired because of the mistakes of his legal department.

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Exercises and Homework

• Chapter 1– In-Class

• Q. 4, Q. 5, Q. 9

– Homework• Q. 3, Q. 10, Q. 13, Q. 18