BUS 525.2: Managerial Economics

Lecture 1

The Fundamentals of Managerial Economics

Course OverviewCourse Overview

• Prerequisites– Bus501 and/or Bus511

• Requirements and Grading– 3 Cases (20%)– Two Midterm Examinations (40%)– Final Exam (40%)

• Class Materials– Baye, Michael R. Managerial Economics and Business St

rategy. Sixth Edition. Boston: McGraw-Hill Irwin, 2009. [MRB]

– Web-page: http://fkk.weebly.com

• Office: NAC 751• Office hours: Tuesday, Wednesday and Saturday, 5pm-6:30 pm

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Activity Schedule:BUS525:2Activity Schedule:BUS525:2Class Date Exams Cases

1 28 May

2 4 June

3 6 June

4 11 June Case 1

5 18 June Mid 1

6 2 July

7 9 July

8 16 July Case 2

9 23 July

10 25 July Mid 2

11 30 July (Make up TBA)

12 13 August Case 3

13 16 -27 August Final

Activity Schedule:BUS525:3Activity Schedule:BUS525:3Class Date Exams Cases

1 29 May

2 5 June

3 12 June

4 19 June Case 1

5 26 June Mid 1

6 3 July

7 10 July

8 17 July Case 2

9 24 July Mid 2

10 31 July

11 1 August Case 3

12 14 August

13 16 -27 August Final

Make-up PolicyMake-up Policy

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• There will be only one make-up for all examinations (mid-terms, final etc.) towards the end of the course to accommodate force majeure. All examination dates are pre-announced/agreed. Please make necessary arrangements with your office.

• Historically, the performance of students taking make-up examinations were always poorer compared to students taking examinations on schedule.

• I hope you will appreciate that it is not practical to offer a customized course for any or group of individual student(s).

OverviewOverview I. Introduction• Why should I study Economics?

– Understand business behavior, profit/loss making firms, advertising strategy

• Impart basic tools of pricing and output decisions– Optimize production mix and input mix– Choose product quality – Guide horizontal and vertical merger decisions– Optimal design of internal and external incentives.

• Not for managers only-any other designation– Private, NGO, Government

• Headline –loss due to managerial ineptness

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Managerial EconomicsManagerial Economics• Manager

– A person who directs resources to achieve a stated goal.

• Economics– The science of making decisions in the presence

of scarce resources.

– Managerial Economics– The study of how to direct scarce resources in

the way that most efficiently achieves a managerial goal.

• Case No. 1, Global Standards for Garment Industry Under Scrutiny After Bangladesh Disaster

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Capitalism 101Capitalism 101To identify money-making opportunities,

you must first understand how wealth is created (and sometimes destroyed).

• Definition: Wealth is created when assets are moved from lower to higher-valued uses

• Definition: Value = willingness to pay

• Desire + income

• The chief virtue of a capitalist economy is its ability to create wealth

• Voluntary transactions, between individuals or firms, create wealth.

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Example: House SaleExample: House Sale• A house is for sale:

• The buyer values the house at $130,000 – maximum price

• The seller values the house at $120,000 – minimum price

• The buyer and seller must agree to a price that “splits” surplus between buyer and seller. Here, $128,000.

• The buyer and seller both benefit from this transaction:

• Buyer surplus = buyer’s value minus the price, $2,000

• Seller surplus = the price minus the seller’s value, $8,000

• Total surplus = buyer + seller surplus, $10,000 = difference in values 9

Wealth-Creating TransactionsWealth-Creating Transactions• Which assets do these transactions move to higher-

valued uses?

• Factory Owners    

• Real Estate Agents

• Investment Bankers        

• Corporate Raiders     

• Insurance Salesman

• Discussion: How does eBay/Bikroy.com create wealth?

• Discussion: Which individual has created the most wealth during your lifetime?

• Discussion: How do you create wealth? 10

Do Mergers Create Wealth?Do Mergers Create Wealth?• The movement of assets to a higher-valued use is the

wealth-creating engine of capitalism.

• Our largest and most valuable assets are corporations

• Dell-Alienware merger:

• In 2006, Dell purchased Alienware, a manufacturer of high-end gaming computers.

• Dell left design, marketing, sales and support in Alienware’s hands; manufacturing, however, was taken over by Dell.

• With its manufacturing expertise, Dell was able to build Alienware’s computers at a much lower cost

• Despite this example, many mergers and acquisitions do not create value – and if they do, value creation is rarely so clear.

• To create value, the assets of the acquired firm must be more valuable to the buyer than to the seller.

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Does Government Create Wealth?Does Government Create Wealth?• Discussion: What’s the government’s role

is wealth creation?

• Enforcing property rights, contracts, to facilitate wealth creating transactions

• Discussion: Why are some countries so poor?

• No property rights, no rule of law

• Discussion: Much of the justification for government intervention comes from the assertion that markets have failed. One money manager scoffed at this idea. “The markets are working fine, but they’re giving people answers that they don’t like, so people cry market failure.” 12

The One Lesson of EconomicsThe One Lesson of Economics• Definition: an economy is efficient if all wealth-

creating transactions have been consummated.

• This is an unattainable, but useful benchmark

• The One Lesson of Economics: the art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.

• Policies should then be judged by whether they move us towards or away from efficiency.

• The economist’s solution to inefficient outcomes is to argue for a change in public policy.

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One Lesson of Economics (cont.)One Lesson of Economics (cont.)• Taxes Destroy Wealth:

• By deterring wealth-creating transactions – when the tax is larger than the surplus for a transaction.

• Which assets end up in lower-valued uses?

• Subsidies Destroy Wealth:

• Example: flood insurance – encourages people to build in areas that they otherwise wouldn’t

• Which assets end up in lower-valued uses?

• Price Controls Destroy Wealth:

• Example: rent control (price ceiling) in New York City - deters transactions between owners and renters

• Which assets end up in lower-valued uses? 14

The one Lesson of BusinessThe one Lesson of Business• Definition: Inefficiency implies the existence of

unconsummated, wealth-creating transactions

• The One Lesson of Business: the art of business consists of identifying assets in lower valued uses, and profitably moving them to higher valued uses.

• In other words, make money by identifying unconsummated wealth-creating transactions and devise ways to profitably consummate them.

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Companies Create WealthCompanies Create Wealth• Companies are collections of transactions:

• They go from buying raw materials, capital, and labor (lower value)

• To selling finished goods & services (higher value)

• Why do some companies have difficulty creating wealth?

• They have trouble moving assets to higher-valued uses

• Analogy to taxes, subsidies, price controls on internal transactions

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Government Destroys WealthGovernment Destroys Wealth

• Zimbabwe experienced economic contraction of approximately 30 percent per year from 1999 to 2003

• Unemployment rates have been as high as 80 percent and life expectancy has fallen over 20 years during the reign of Robert Mugabe

• Why has economic growth been so low?

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Government Destroys WealthGovernment Destroys Wealth• One main problem occurred in 2000

• Mugabe backed his supporters takeover of commercial farms, essentially revoking property rights of these farmers

• The state resettled the confiscated lands with subsistence producers - many with no previous farming experience. Agricultural production plummeted.

• Farm debacle had economic ripple effects through the banking and manufacturing sectors

• Declining production deprived the country of ability to earn foreign currency and buy food overseas

• Widespread famine ensued• The government's initial attack on private property eventually led

to more direct intervention in the economy and the destruction of political freedom in Zimbabwe.

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Problem SolvingProblem Solving• Two distinct steps:

• Figure out what’s wrong, i.e., why the bad decision was made

• Figure out how to fix it

• Both steps require a model of behavior• Why are people making mistakes?• What can we do to make them change?

• Economists use the rational actor paradigm to model behavior. The rational actor paradigm states:• People act rationally, optimally, self-interestedly

• i.e., they respond to incentives – to change behavior you must change incentives.

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How to Figure Out What is WrongHow to Figure Out What is Wrong

• Under the rational actor paradigm, mistakes are made for one of two reasons: • lack of information or• bad incentives.

• To diagnose a problem, ask 3 questions:1. Who is making bad decision?2. Do they have enough info to make a good

decision?3. Do they have the incentive to do so?

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How to Fix ItHow to Fix It• The answers will suggest one or more solutions:

1. Let someone else make the decision, someone with better information or incentives.

2. Change the information flow.3. Change incentives

• Change performance evaluation metric• Change reward scheme

• Use benefit-cost analysis to choose the best (most profitable?) solution

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Keep the Ultimate Goal in Keep the Ultimate Goal in MindMind

For a business or organization to operate profitably and efficiently the incentives of individuals need to be aligned with the goals of the company.

• How do we make sure employees have the information necessary to make good decisions?

• And the incentive to do so?

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Manager Bonuses for Manager Bonuses for Increasing ReservesIncreasing Reserves

• The bonus system created incentives to over-bid. • Senior managers were rewarded for acquiring

reserves regardless of their profitability

• Bonuses also created incentive to manipulate the reserve estimate.

• Now that we know what is wrong, how do we fix it?• Let someone else decide?• Change information flow?• Change incentives?

• Performance evaluation metric• Reward scheme 23

EthicsEthics• Does the rational-actor paradigm encourage self-

interested, selfish behavior?• NO!

• Opportunistic behavior is a fact of life.• You need to understand it in order to control it.• The rational-actor paradigm is a tool for analyzing

behavior, not a prescription for how to live your life.

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Why Else this Material is ImportantWhy Else this Material is Important

• Employers expect that you will know these concepts

• Further, employers will expect that you are able to apply them.

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How Do Firms BehaveHow Do Firms Behave• Economists often assume the goal of the firm is profit

maximization. Opinions do differ, however.• Discussion: pricing of hotel rooms during tourist season

• Traditional economic view – level pricing leads to excess demand; how are rooms allocated then (rationing, arbitrageurs, . . .)

• Contrasting view – businesses should not raise prices during times of shortage; businesses have a responsibility to consumers and society

• Your view?• Text view: firms serve consumers and society best by engaging

in free and open competition within legal limits while attempting to maximize profits. • Not a license to engage in illegal behavior• No denying that concerns exist about the ethical dimension

of business• Reasonable people have disagreed for millennia on what

constitutes “ethical” behavior26

The Economics of Effective The Economics of Effective ManagementManagement

• Identify goals and constraints• Recognize the nature and importance of

profits– Five forces framework and industry

profitability

• Understand incentives • Understand markets• Recognize the time value of money• Use marginal analysis

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Identify Goals and Identify Goals and ConstraintsConstraints

• Sound decision making involves having well-defined goals.– Leads to making the “right” decisions.

• In striving to achieve a goal, we often face constraints.– Constraints are an artifact of scarcity.

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Economic vs. Accounting Economic vs. Accounting ProfitsProfits

• Accounting profits– Total revenue (sales) minus 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 CostOpportunity Cost• Accounting costs

– The explicit costs of the resources needed to 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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Significance of the Significance of the Opportunity Cost ConceptOpportunity Cost Concept

• Accounting profits = Net revenue – Accounting costs (dollar costs of goods and services)

• Reported on the firms income statement

• Economic profits = Net revenue – Opportunities Costs

• Economic profits and opportunity costs are critical to decision making

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The Principle of The Principle of Relevant CostRelevant Cost

• Sound decision-making requires that only costs caused by a decision--the relevant costs--be considered. In contrast, the costs of some other decision not impacted by the choice being considered--the irrelevant costs--should be ignored.

• Not all accounting costs are relevant and many need adjustments to become relevant

Profits as a SignalProfits as a Signal• Profits signal to resource holders

where resources are most highly valued by society.– Resources will flow into industries that

are most highly valued by society.

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Theories of ProfitsTheories of Profits(Why are profits necessary? Why do profits

vary across industries and across firms?)• Risk-bearing theory of profit - Profits are

necessary to compensate for the risk that entrepreneurs take with their capital and efforts

• Dynamic equilibrium (frictional) theory - Profits, especially extraordinary profits, are the result of our economic system’s inability to adjust instantaneously to unanticipated changes in market conditions.

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Theories of ProfitsTheories of Profits• Monopoly theory - Profits are the result

of some firm’s ability to dominate the market

• Innovation theory - Extraordinary profits are the rewards for successful innovations

• Managerial efficiency theory - Extraordinary profits can result from exceptionally managerial skills of well-managed firms.

Understanding Firms’ Understanding Firms’ IncentivesIncentives

• Incentives play an important role within the firm.

• Incentives determine:– How resources are utilized.– How hard individuals work.

• Managers must understand the role incentives play in the organization.

• Constructing proper incentives will enhance productivity and profitability.

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Agency ProblemsAgency ProblemsAgency ProblemsAgency Problems

• Modern corporations allow firm managers to have no ownership participation, or only limited participation in the profitability of the firm.

• Shareholders may want profits, but hired managers may wish to relax or pursue self interest.

• The shareholders are principals, whereas the managers are agents.

• Shareholders (principals) want profit• Managers (agents) want leisure & security• Conflicting motivations between these

groups are called agency problems.– Stock brokers and investors– Physicians and patients– Auto mechanics and car owners

The Principal-Agent ProblemThe Principal-Agent ProblemThe Principal-Agent ProblemThe Principal-Agent Problem

Solutions to Agency ProblemsSolutions to Agency Problems• Compensation as incentive• Extending to all workers stock options,

bonuses, and grants of stock– It helps to make workers act more like

owners of firm (but not always – Citibank and Managers)

• Incentives to help the company, because that improves the value of stock options and bonuses

• Good legal contracts that can be effectively enforced

Market InteractionsMarket 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– BTRC, BERC, SECs failure brought debacle

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MarketMarket• Definition: Buyers and sellers

communicate with one another for voluntary exchange

• market need not be physical– Bookstore, Internet bookstore Amazon.com– Outsourcing

• industry – businesses engaged in the production or delivery of the same or similar items– Clothing and textile industry, – Clothing industry is a buyer in the textile

market and a seller in the clothing market

Competitive MarketCompetitive Market• Benchmark for managerial economics• Purely competitive market

– The global cotton market– many buyers and many sellers – no room for managerial strategizing

• Achieves economic efficiency• Entry of firms

– Case No.2, Textile millers hit rough patch

Market PowerMarket Power• Definition – ability of a buyer or seller

to influence market conditions• Seller with market power must

manage – costs– price – advertising expenditure – policy toward competitors

Imperfect MarketImperfect MarketDefinition: where

– one party directly conveys a benefit or cost to others

– externalitiesor – one party has better information than

others– Lack of competition, barriers to entry

The Time Value of MoneyThe Time Value of Money• Present value (PV) of a future value (FV) lump-

sum amount to be received at the end of “n” periods in the future when the per-period interest rate is “i”:

PV

FV

i n1

• Examples:– Lottery winner choosing between a single lump-sum

payout of Tk.104 million or Tk.198 million over 25 years.

– Determining damages in a patent infringement case.

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Present Value vs. Future Present Value vs. Future ValueValue

• The present value (PV) reflects the difference between the future value and the opportunity cost of waiting (OCW).

• Succinctly,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 of a SeriesPresent Value of a Series

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

• Equivalently,

PV

FV

i

FV

i

FV

inn

1

12

21 1 1. . .

n

ttt

i

FVPV

1 1

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Net Present ValueNet 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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Present Value of a Present Value of a PerpetuityPerpetuity

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

• The present value (PV) of a perpetuity of cash flows paying the same amount (CF = CF1 = CF2 = …) at the end of each period is

i

CF

i

CF

i

CF

i

CFPVPerpetuity

...111 32

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Objective of the FirmObjective of the Firm• Not market share• Not growth• Not revenue• Not empire building• Not net profit margin• Not name recognition• Not state-of-the-art technology

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What’s the Objective of the Firm?What’s the Objective of the Firm?• The objective of the firm is to maximize

the value of the firm.• Value of the firm is the true measure of

business success (of course, from a for-profit perspective.)

• Two questions:1. How is the “value of the firm” defined

and measured?2. How do managers go about adding

value to the firm?

Value Value Maximization IsMaximization Is

a Complex a Complex ProcessProcess

Figure 1.3Figure 1.3

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Definition and Measurement of Definition and Measurement of “Value of the Firm”“Value of the Firm”

“The present value of the firm’s future net earnings.”

1 2 nV = [--------] + [ --------] + . . . + [ -------- ]

(1+r)1 (1+r)2 (1+r)n

N t V = [ ------- ] , t = 1, 2, ... , N

t = 1 (1+r)t

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Adding Value to the FirmAdding Value to the FirmProfit = Total Rev - Total Cost = P . Qd - VC . Qs - F

where profit, P = price,

Qd = quantity demanded,

VC = variable cost per unit, Qs = quantity supplied,

F = total fixed costs

Determinants of Value of the Determinants of Value of the FirmFirm

N t N P . Qd - VC . Qs - FV = [ ------- ] = [---------------------- ]

t=1 (1+r)t t=1 (1+r)t

• Whatever that raises the price of the product and/or the quantity of the product sold

• Whatever that lowers the variable and fixed costs

• Whatever that lower the “r” (discount rate or the perceived “risk” of investment)

Firm Valuation and Profit Firm Valuation and Profit MaximizationMaximization

• The value of a firm equals the present value of current and future profits (cash flows).

• A common assumption among economist is that it is the firm’s goal to maximization profits.– This means the present value of current and

future profits, so the firm is maximizing its value.

1

210

1...

11 tt

tFirm

iiiPV

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Class Exercise• Suppose the interest rate is 10% and the firm is expected

to grow at a rate of 5% for the foreseeable future. The firm’s current profits are $100 million.

a) What is the value of the firm (the present value of its current and future earnings)?

b) What is the value of the firm immediately after it pays a dividend equal to its current profits?

• Control variable, examples:– Output– Price– Product Quality– Advertising– R&D

• Basic managerial question: How much of the control variable should be used to maximize net benefits?

Marginal (Incremental) Marginal (Incremental) AnalysisAnalysis

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Net BenefitsNet Benefits• Net Benefits = Total Benefits - Total

Costs• Profits = Revenue – Costs• Case No. 3: Outsourcing and

offshoring

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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

BMB

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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

Q

CMC

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Marginal PrincipleMarginal 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: The Geometry of Optimization: Total Benefit and CostTotal Benefit and Cost

Q

Total Benefits & Total Costs

Benefits

Costs

Q*

B

CSlope = MC

Slope =MB

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The Geometry of The Geometry of Optimization: Net BenefitsOptimization: Net Benefits

Q

Net Benefits

Maximum net benefits

Q*

Slope = MNB

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What Will We Learn?What Will We Learn? Useful economic principles for sound

economic decision-making in a management context.

The basics of the demand side of the market and which factors influence the buyers’ behavior.

The fundamentals of the market’s supply side -laws of production and how these laws impact a firm’s costs.

How firms’ costs and buyers’ demand together determine the firm’s price and net profit.

ConclusionConclusion

• 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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Myths and MisconceptionsMyths and Misconceptions

• Economics is about money only• Economics assumes that everyone

is selfish• A company’s value is measured by

the company’s assets• Costs are measured appropriately

by accountants.

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Myths and Myths and Misconceptions (cont.)Misconceptions (cont.)

• We must cover our fixed costs in the decisions we make as managers

• Our firm must create the best quality product

• We should do more advertising, because it’s cost-effective

• Our price should be based on our costs

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Myths and Misconceptions Myths and Misconceptions (cont.)(cont.)

• Unit or average cost provides useful management information

• Wider profit margins are desirable• A price increase reduces demand• High research and development

expense results in high prices.

Managerial Managerial Economics Economics is a Tool for is a Tool for Improving Improving

Management Management Decision MakingDecision Making

Figure 1.1Figure 1.1

Sustainable IndustryProfitsPower of

Input SuppliersSupplier 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

The Five Forces FrameworkThe Five Forces Framework 1-71

Firm Valuation With Profit Firm Valuation With Profit GrowthGrowth

• If profits grow at a constant rate (g < i) and current period profits are before and after dividends are:

• Provided that g < i.– That is, the growth rate in profits is less than the

interest rate and both remain constant.

0

0

1 before current profits have been paid out as dividends;

1 immediately after current profits are paid out as dividends.

Firm

Ex DividendFirm

iPV

i g

gPV

i g

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