ch1 intro me sem2
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CHAPTER 1
THE FUNDAMENTALS OF MANAGERIAL ECONOMICS
Managerial Economics &
Business Strategy
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
What are the roles of a manager?
yWhat managerial economic d ecisions d oes a manager make??
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
PURPOSE OF USING MANAGERIALPURPOSE OF USING MANAGERIAL
ECONOMICS TOOLS:ECONOMICS TOOLS:
y Shape pricing and output decisions
y Optimize production process and input mix
y Choose product quality
y Guide horizontal and vertical merger decisions
y Optimally design internal and external incentives
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
Managerial economics are useful for both
profit making companies
and
Not-for ±profit organization
(coordinate shelter for homeless, decide best
means for distributing food to the needy)
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
Managerial EconomicsManagerial Economics
y
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y
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y
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
MANAGER
y A person who directs resources to achieve
stated goal. Includes those who:
Direct effort of others-delegate tasks
Purchase inputs to be used in production In charge of making other decision such as product
price and quality
y Responsible for his/her own actions and actions
of other individuals, machines, other inputsunder his/her control
y Maximises profit and value of firms
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
M anagerial economics
y Study of how to direct scarce resources in a way
that most efficiently achieves managerial goal.
y Example- managers in computer making company
would decide on : W hether to purchase or produce intermediate input (disk
drive/ computer chips
How many computers to produce and what is the selling
price How many employees to hire
How should the employees be compensated
W hat incentive to be given to ensure quality
How would rival company affect the organization?
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
Solution:Solution:
y To make a sound decision, manager would need
To identify information needed
Ù Account dept- tax advice or cost data
ÙLegal dept- legal ramification of alternativedecisions
ÙMarketing dept- data on product market
characteristic
Ù
Finance dept- data on alternative method to obtainfinancial capital
To collect and process data
MANAGER INTEGRATE ALL INFORMATION TO
ARRIVE AT A DECISION
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
The Economics of Eff ective Management
AN EFFECTIVE MANAGER MUST:
Identify Goals and Constraints
Recognize the Role of Profits Understand Incentives
Five Forces Model
Understand Markets
Recognize the Time Value of Money Use Marginal Analysis
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
Id entify Goals and C onstraints
y W ell defined goals
y Different goals entails different decisions
y Decision maker faces constraints that
affect the ability to achieve goal
EXAMPLES:
y marketing dept -maximise sales and market
share , finance dept- isk reduction
strategies
y Constraints- available technology, input
prices
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
Recogniz e nature and
importance of profits
y Overall goal- maximise profit of firm¶s value
y Difference between economics and
accounting profitsy Implicit costs ± very hard to measure
Example ± hairstyling salon vs restaurant
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
Economic vs. Accounting P rofits
yy Accounting Profits Accounting Profits
Total revenue (sales) minus dollar cost of
producing goods or services.
Reported on the firm¶s income statement.
yyEconomic ProfitsEconomic ProfitsTotal revenue minus total opportunity
cost.
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
y Accounting Costs
The explicit costs of the resources needed to produce
goods or services.
Reported on the firm¶s income statement.
y Opportunity Cost
The cost of the explicit and implicit resources that are
foregone when a decision is made.
y Economic Profits
Total revenue minus total opportunity cost.
Accounting profits overstate your economics
profits
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
Understanding incentivesUnderstanding incentives
y Profits
signal to holders of resources to enter or exit industry
Incentive to resource holders to alter/change use of
resources
y Managers should understand the role of incentive
Induce workers to work harder/maximising effort
Reward vs penalty
Incentive plan ± directly proportionate to firms profitability
Commission based remuneration
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
Understanding marketsUnderstanding markets
y Relative outcome of markets :
Power of buyers vs power of sellers
bargaining position of consumers and producers
y 3 sources of rivalry in economic transaction:
Consumer producer rivalry
Consumer-consumer rivalry
Producer-producer rivalry
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
Market Interactions Market Interactions
yy Consumer Consumer- -Producer Rivalry Producer Rivalry
Consumers attempt to locate low prices, while
producers attempt to charge high prices.
Risk- producer refuse to sell, consumer refuse to
purchase
yy Consumer Consumer- -Consumer Rivalry Consumer Rivalry
Scarcity of goods reduces the negotiating power of
consumers as they compete for the right to thosegoods.
Consumer willing to pay highest price to outbid others.
eg-auction
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
Market Interactions Market Interactions
Producer Producer- -Producer Rivalry Producer Rivalry
Multiple sellers of a product competing ; customers
are scarce
Scarcity of consumers causes producers to compete
with one another for the right to service customers.
Producer with best-quality product t lowest price wins
The Role of Government The Role of Government
Losing/disadvantage parties in the market seek for
govt intervention-monopoly market
Seeking aids from govt to compete with foreign
counterparts
Disciplines the market process.
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
The Time Value of MoneyThe Time Value of Money
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
The Time Value of Money The Time Value of Money
y Timing in making decision-gap between time when cost of project is borne and
time when benefits of project is received
y Is $1 today going to worth more than $1 received infuture? Opportunity cost of $1 in future = interest forgone
Its the time value of money
y PV of an amount received in future = amount that would
be invested today at prevailing interest rate to generate
given future value
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
The T ime Value of MoneyThe T ime Value of Money
y Present value ( PV ) of a lump-sum amount ( FV ) to
be received at the end of ´ nµ periods when the
per-period interest rate is ´ iµ:
PV
FV
in!
1
Ex amples:Ex amples: Lotto w inner choosing bet w een a single lumpLotto w inner choosing bet w een a single lump--sum payout of sum payout of
$104 million or $198 million over 25 years.$104 million or $198 million over 25 years.
Deter mining d amages in a patent infringement case.Deter mining d amages in a patent infringement case.
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
(1) The Time Value of Money(1) The Time Value of Money
y Eg calculate PV of $100 in 10 years if the interestrate is 7 percent
PV=$50.83
y Interest rate is inversely related to the PV
Higher interest rate-lower PV
y PV of future payment = FV - opportunity costs waiting OCW
If interest rate is zero, OCW is zero the PV=FV
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
(2) Present Value of a Series(2) Present Value of a Series
yy Present value of a stream of future amountsPresent value of a stream of future amounts
( ( FVFVtt ) received at the end of each period for ) received at the end of each period for
³ ³ nn´ periods:´ periods:
yy
Given PV of income stream from a project,Given PV of income stream from a project,we can compute the net PV of the project we can compute the net PV of the project
NPV=PV NPV=PV- -C C 0 0 (current cost)(current cost)
PV
FV
i
FV
i
FV
i
n
n!
1
1
2
21 1 1
...
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
(3) (3)
y Suppose a manager can purchase a stream
of future receipts ( FVt ) by spending ³ C0´
dollars today. The NPV of such a decision is
N PV
FV
i
FV
i
FV
iC
n
n!
1
1
2
2 0
1 1 1...
Decision Rule:
If NPV < 0: Reject project
NPV > 0: Accept projec demo problem 1-1
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
(5) FIRM VALUATION(5) FIRM VALUATION
The value of a firm equals the present value of currentand future profits.
PV = S pt / (1 + i)t
If profits grow at a constant rate (g < i ) and currentperiod profits are po:
0
0
1
before current profits have been paid out as dividends;
1immediately after current profits are paid out as divide
Firm
Ex Dividend
Firm
i
PV i g
g PV
i g
T
T
!
!
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
Firm ValuationFirm Valuation
y If the growth rate in profits < interest rate
and both remain constant, maximizing the
present value of all future profits is thesame as maximizing current short term
profits
y Eg ± demo problem 1-2
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
Marginal (Incremental) AnalysisMarginal (Incremental) Analysis
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y Control Variables
Output
Price
Product Quality Advertising
R&D
y Basic Managerial Question: How much of
the control variable should be used tomaximize net benefits?
Marginal (Incremental) AnalysisMarginal (Incremental) Analysis
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
MARGINAL ANALYSIS MARGINAL ANALYSIS
y OPTIMAL MANAGERIAL DECISIONS INVOLVES
Comparing the marginal (incremental) benefits
W ith the marginal (incremental ) costs
B(Q)-total benefits derived from Q units of variable
C(Q)- total costs corresponding level of Q
Managers objective: maximise net benefits
y Net Benefits = Total Benefits - Total Cost
= B(Q)-C(Q)
y Profits = Revenue - Costs
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
MARGINAL definedMARGINAL defined
M B ±additional benefit arise by using an additional unit
of managerial control variable
MC ± additional costs incurred by using an additional
unit of the managerial control variable
MN B(Q) ± the change in net benefits that arise from a
one unit change in Q OR
MN B(Q) = M B(Q)MN B(Q) = M B(Q)- -MC(Q)MC(Q)
Refer table 1-1 p20
Note
W hen net benefit is maximised, MN B(Q)=0 since
M B(Q)=MC(Q)
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
Marginal Benefit (MB)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
B MB
(
(!
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
Marginal Cost (MC)Marginal Cost (MC)
Change in total costs arising from a change in
the control variable, Q:
Slope (calculus derivative) of the total cost curve
QC M C (
(!
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
Marginal P rincipl e Marginal P rincipl e
y To maximize net benefits, the managerial
control variable should be increased up to
the point where MB = MC.
yy MBMB >> MCMC means the last unit of the control variable increased benefits more than it
increased costs.
yy MBMB << MCMC means the last unit of the control
variable increased costs more than it increased benefits.
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
The Geometry of OptimizationThe Geometry of Optimization
Refer fig 1-2
Q
Total Benefits
& Total CostsBenefits B(Q)
Costs C(Q)
Q*
B
CSlope = MC
Slope =MB
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.
MB,MC
& NB
NB
Q
N(Q)=B(Q)-C(Q)
NB
MB(Q)
MC(Q)
MNB(Q)
Q)
Maximum
NB
At level of Q where the MB curveintersect the MC curve, MNB iszero, that Q maximises NB
Q*
Q*
Slope of a functionis the derivative of a given function
MB= dB(Q)dQ
MC= dC(Q)dQ
MNB= dN(Q)dQ
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Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsd
y Make sure you include all costs and benefits
when making decisions (opportunity cost).
y W hen decisions span time, make sure you
are comparing apples to apples (PV
analysis).
y Optimal economic decisions are made at the
margin (marginal analysis).
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