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

– Web-page: http://fkk.weebly.com

• Office: NAC 751• Office hours: Tuesday and Thursday 5pm-6:30 pm

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Activity Schedule:BUS525Activity Schedule:BUS525Class Date Exams Cases

1 26 Jan

2 2 Feb

3 9 Feb Case 1

4 16 Feb

5 23 Feb Mid 1

6 2 Mar Case 2

7 9 Mar

8 16 Mar

9 23 Mar Mid 2

10 30 Mar Case 3

11 6 Apr

12 9 Apr

13 15 Apr-24 Apr Final

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.– Case No. 1, Load shedding in DESCO area

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

the way that most efficiently achieves a managerial goal.

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

Management Management Decision MakingDecision Making

Figure 1.1Figure 1.1

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 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 relevant The principle of relevant costcost

• 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.

• Case No. 3: Square Backtracks on PSTN Plan

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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.

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

The Five Forces FrameworkThe Five Forces Framework 1-16

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.– Case No. 4– Professor Yunus blasts Telenor ethics in Bangladesh– 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, ERC

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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, Ship breakers to Shipbuilders

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

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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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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• 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

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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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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.

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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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