chap 001 economic
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chapter one notesTRANSCRIPT
CHAPTER 1
The Fundamentals of
Managerial Economics
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
• Introduction– The manager– Economics– Managerial economics defined
• Economics of Effective Management– Identifying goals and constraints– Recognize the nature and importance of profits– Understand incentives– Understand markets– Recognize the time value of money– Use marginal analysis
• Learning managerial economics
Chapter Overview
Chapter One
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Introduction
• Chapter 1 focuses on defining managerialeconomics, and illustrating how it is a valuabletool for analyzing many business situations.
• This chapter provides an overview of managerialeconomics.– How do accounting profits and economic profits
differ?• Why is the difference important?
– How do managers account for time gaps betweencosts and revenues?
– What guiding principle can managers use to maximizeprofits?
Chapter Overview
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The Manager
• A person who directs resources to achieve astated goal.
– Directs the efforts of others.
– Purchases inputs used in the production of thefirm’s output.
– Directs the product price or quality decisions.
Introduction
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Economics
• The science of making decisions in thepresence of scarce resources.
– Resources are anything used to produce a good orservice, or achieve a goal.
– Decisions are important because scarcity impliestrade-offs.
Introduction
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• The study of how to direct scarce resources inthe way that most efficiently achieves amanagerial goal.
– Should a firm purchase components – like diskdrives and chips – from other manufacturers orproduce them within the firm?
– Should the firm specialize in making one type ofcomputer or produce several different types?
– How many computers should the firm produce,and at what price should you sell them?
Introduction
Managerial Economics Defined
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• Basic principles comprising effectivemanagement:
– Identify goals and constraints.
– Recognize the nature and importance of profits.
– Understand incentives.
– Understand markets.
– Recognize the time value of money.
– Use marginal analysis.
Economics of Effective ManagementEconomics of Effective Management
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The Nature and Importance of Profits
• A typical firm’s objective is to maximize profits.
• Accounting profit
– Total amount of money taken in from sales (totalrevenue) minus the dollar cost of producing goods orservices.
• Economic profit
– The difference between total revenue and the totalopportunity cost of producing goods or services.
– Opportunity cost
• The explicit cost of a resource plus the implicit cost of givingup its best alternative.
Economics of Effective Management
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The Role of Profits
• Profit Principle:
– Profits are a signal to resource holders where resources are most highly valued by society.
– Resources will flow into industries that are mosthighly valued by society.
– Similarly, the profits of business signal wheresociety’s scarce resources are best allocated.
Economics of Effective Management
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Power of
Input SuppliersSupplier Concentration
Price/Productivity of
Alternative Inputs
Relationship-Specific
Investments
Supplier Switching Costs
Government Restraints
Power of
BuyersBuyer Concentration
Price/Value of Substitute
Products or Services
Relationship-Specific
Investments
Customer Switching Costs
Government Restraints
Entry
Substitutes & ComplementsIndustry Rivalry
Concentration
Price, Quantity, Quality,
or Service Competition
Degree of Differentiation
Level, Growth, and Sustainabilityof Industry Profits
Entry Costs
Speed of Adjustment
Sunk Costs
Economies of Scale
Network Effects
Reputation
Switching Costs
Government Restraints
Price/Value of Surrogate Products
or Services
Price/Value of Complementary
Products or Services
Network Effects
Government
Restraints
Switching Costs
Timing of Decisions
Information
Government
Restraints
Economics of Effective Management
Five Forces and Industry Profitability
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Understand Incentives
• Changes in profits provide an incentive toresource holders to change their use ofresources.
• Within a firm, incentives impact howresources are used and how hard workerswork.
– One role of a manager is to construct incentives toinduce maximal effort from employees.
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Economics of Effective Management
• Two sides to every market transaction:– Buyer (consumer).
– Seller (producer).
• Bargaining position of consumers and producers islimited by three rivalries in economic transactions:– Consumer-producer rivalry potential car buyer and
salesperson).
– Consumer-consumer rivalry (a good example is anauction-Ch.12).
– Producer-producer rivalry (For example, when 2 gasstations located across the street from one anothercompete on price).
• Government and the market.
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Economics of Effective ManagementUnderstand Markets
The Time Value of Money
• Often a gap exists between the time whencosts are borne and benefits received.
– $1 today is worth more than $1 received in thefuture.
• The opportunity cost of receiving the $1 in the future isthe forgone interest that could be earned were $1received today
– Managers can use present value analysis toproperly account for the timing of receipts andexpenditures.
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Economics of Effective Management
Present Value Analysis 1
• Present value of a single future value– The amount that would have to be invested today at
the prevailing interest rate to generate the given futurevalue:
𝑃𝑉 =𝐹𝑉
1 + 𝑖 𝑛
– Present value reflects the difference between thefuture value and the opportunity cost of waiting:
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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Economics of Effective Management
Present Value Analysis II
• Present value of a stream of future values
𝑃𝑉 =𝐹𝑉11 + 𝑖 1
+𝐹𝑉21 + 𝑖 2
+⋯+𝐹𝑉𝑛1 + 𝑖 𝑛
or,
𝑃𝑉 =
𝑡=1
𝑛𝐹𝑉𝑡1 + 𝑖 𝑡
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Economics of Effective Management
• Consider a project that returns the following income stream:
– Year 1, $10,000; Year 2, $50,000; and Year 3, $100,000.
– At an annual interest rate of 3 percent, what is the present value of this income stream?
𝑃𝑉 =$10,000
1 + 0.03 1+$50,000
1 + 0.03 2+$100,000
1 + 0.03 3
= $148,352.70
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Economics of Effective Management
The Time Value of Money in Action
Net Present Value
• The present value of the income streamgenerated by a project minus the current costof the project:
𝑁𝑃𝑉 =𝐹𝑉11 + 𝑖 1
+𝐹𝑉21 + 𝑖 2
+⋯+𝐹𝑉𝑛1 + 𝑖 𝑛
− 𝐶0
• Decision Rule:
• If NPV < 0: Reject project
NPV > 0: Accept project
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Economics of Effective Management
• Present value of decisions that indefinitelygenerate cash flows:
𝑃𝑉𝐴𝑠𝑠𝑒𝑡 = 𝐶𝐹0 +𝐶𝐹11 + 𝑖 1
+𝐶𝐹21 + 𝑖 2
+𝐶𝐹31 + 𝑖 3
+⋯
• Present value of this perpetual income streamwhen the same cash flow is generated (𝐶𝐹1=𝐶𝐹2 = ⋯ = 𝐶𝐹):
𝑃𝑉𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 =𝐶𝐹
𝑖
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Economics of Effective Management
Present Value of Indefinitely Lived Assets
• Profit maximization principle
– Maximizing profits means maximizing the value ofthe firm, which is the present value of current andfuture profits.
– Maximizing profits means maximizing PV and FV.
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Economics of Effective Management
Present Value and Profit Maximization
Present Value and Estimating Values of Firms I
• The value of a firm with current profits 𝜋0,with no dividends paid out and expected,constant profit growth rate of 𝑔 (assuming𝑔 < 𝑖) is:𝑃𝑉𝐹𝑖𝑟𝑚
= 𝜋0 +𝜋0 1 + 𝑔
1 + 𝑖 1+𝜋0 1 + 𝑔
2
1 + 𝑖 2+𝜋0 1 + 𝑔
3
1 + 𝑖 3+⋯
= 𝜋01 + 𝑖
𝑖 − 𝑔
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Economics of Effective Management
• When dividends are immediately paid out of
current profits, the present value of the firm is
(at ex-dividend date):
𝑃𝑉𝐹𝑖𝑟𝑚𝐸𝑥−𝑑𝑖𝑣 = 𝑃𝑉𝐹𝑖𝑟𝑚 − 𝜋0
= 𝜋01 + 𝑔
𝑖 − 𝑔
Provided that g < i.
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Economics of Effective Management
Present Value and Estimating Values of Firms II
• Short-term and long-term profits principle
– If the growth rate in profits is less than the
interest rate and both are constant, maximizing
current (short-term) profits is the same as
maximizing long-term profits.
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Economics of Effective Management
Short-Term versus Long-term Profits
• Given a control variable, 𝑄, of a managerialobjective, denote the
– total benefit as 𝐵 𝑄 .
– total cost as 𝐶 𝑄 .
• Manager’s objective is to maximize netbenefits:
𝑁 𝑄 = 𝐵 𝑄 − 𝐶 𝑄
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Economics of Effective Management
Marginal Analysis
• How can the manager maximize net benefits?
• Use marginal analysis
– Marginal benefit: 𝑀𝐵 𝑄
• The change in total benefits arising from a change in the managerial control variable, 𝑄.
– Marginal cost: 𝑀𝐶 𝑄
• The change in the total costs arising from a change in the managerial control variable, 𝑄.
– Marginal net benefits: 𝑀𝑁𝐵 𝑄𝑀𝑁𝐵 𝑄 = 𝑀𝐵 𝑄 −𝑀𝐶 𝑄
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Economics of Effective Management
Using Marginal Analysis
• Marginal principle
–To maximize net benefits, the managershould increase the managerial controlvariable up to the point where marginalbenefits equal marginal costs. This level ofthe managerial control variablecorresponds to the level at which marginalnet benefits are zero; nothing more can begained by further changes in that variable.
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Economics of Effective Management
Marginal Analysis Principle I
Marginal Principle II
• Marginal principle (calculus alternative)
– Slope of a continuous function is the derivative, ormarginal value, of that function:
𝑀𝐵 =𝑑𝐵 𝑄
𝑑𝑄
𝑀𝐶 =𝑑𝐶 𝑄
𝑑𝑄
𝑀𝑁𝐵 =𝑑𝑁 𝑄
𝑑𝑄
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Economics of Effective Management
Marginal Principle
• To maximize net benefits, the managerialcontrol variable should be increased up to thepoint where MB = MC.
• MB > MC means the last unit of the controlvariable increased benefits more than itincreased costs.
• MB < MC means the last unit of the controlvariable increased costs more than it increasedbenefits.
Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.
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Marginal Analysis In Action
• It is estimated that the benefit and cost structure of a firm is:
𝐵 𝑄 = 250𝑄 − 4𝑄2
𝐶 𝑄 = 𝑄2
• Find the 𝑀𝐵 𝑄 and 𝑀𝐶 𝑄 functions.𝑀𝐵 𝑄 = 250 − 8𝑄𝑀𝐶 𝑄 = 2𝑄
• What value of 𝑄 makes 𝑁𝑀𝐵 𝑄 zero?250 − 8𝑄 = 2𝑄 ⇒ 𝑄 = 25
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Economics of Effective Management
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Quantity(Control Variable)
Total benefitsTotal costs
0
𝐵 𝑄
𝐶 𝑄
Maximum total benefits
Maximum net benefits
Economics of Effective Management
Determining the Optimal Level of a Control Variable
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Quantity(Control Variable)
Net benefits
0
Maximum net benefits
Slope =𝑀𝑁𝐵(𝑄)
𝑁 𝑄 = 𝐵 𝑄 − 𝐶 𝑄 = 0
Economics of Effective Management
Determining the Optimal Level of a Control Variable II
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Quantity(Control Variable)
Marginal benefits, costsand net benefits
0
𝑀𝐶 𝑄
𝑀𝐵 𝑄𝑀𝑁𝐵 𝑄
Maximum net benefits
Economics of Effective Management
Determining the Optimal Level of a Control Variable III
• Incremental revenues
– The additional revenues that stem from a yes-or-no decision.
• Incremental costs
– The additional costs that stem from a yes-or-no decision.
• “Thumbs up” decision
–𝑀𝐵 > 𝑀𝐶.
• “Thumbs down” decision
–𝑀𝐵 < 𝑀𝐶.
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Economics of Effective Management
Incremental Decisions
Learning Managerial Economics
• Practice, practice, practice …
• Learn terminology
– Break down complex issues into manageablecomponents.
– Helps economics practitioners communicateefficiently.
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Learning Managerial Economics
Conclusion
• Make sure you include all costs and benefitswhen making decisions (opportunity costs).
• When decisions span time, make sure you arecomparing apples to apples (present valueanalysis).
• Optimal economic decisions are made at themargin (marginal analysis).
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Conclusion
Learning Managerial Economics
• Becoming proficient in economics is like learningto play music or ride a bicycle.
• The best way to learn economics is to practice,practice, and practice some more.
• Practicing managerial economics means practicingmaking decisions.
• The best way to do this is to work and rework theproblems presented in the text and at the end ofeach chapter.
• Before you can be effective at practicing, however,you must understand the language of economics.
Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.
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Solve problems
Next meeting, we will solve the following problems:
A. Conceptual and Computational Questions:
Solve: 2, 3, 4, 5, 6,9, and 10.
B. Problems and Applications: solve 12 and 14.
C. Consider problem 15, 16, 17, 19 as case study.
D. Read carefully Demonstration Problems, 1-1, p.15; 1-2,
p.18, and 1-3, p. 24. Also, read the Appendix in pp.34-36.
Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.
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