the fundamentals of managerial economics

7/22/2019 The Fundamentals of Managerial Economics

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CHAPTER 1THE 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 rights

What are the roles of a manager?

What managerial economicdecisions does a manager make??


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PURPOSE OF USING MANAGERIALECONOMICS TOOLS: Shape pricing and output decisions

Optimize production process and input mix

Choose product quality

Guide horizontal and vertical merger decisions

Optimally design internal and external incentives


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REMINDER

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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Managerial Economics

ManagerA person who directs resources to achieve a

stated goal. EconomicsThe science of making decisions in the presence

of scare resources.Managerial EconomicsThe study of how to direct scarce resources in

the way that m ost efficiently achieves amanagerial goal.


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MANAGER

A person who directs resources to achieve statedgoal. 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

Responsible for his/her own actions and actions of

other individuals, machines, other inputs underhis/her control

Maximises profit and value of firms


7/38Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights

Managerial economics

Study of how to direct scarce resources in a way thatmost efficiently achieves managerial goal.

Example- managers in computer making company

would decide on : Whether 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

What incentive to be given to ensure quality

How would rival company affect the organization?



Solution:

To make a sound decision, manager would need

To identify information needed

Account dept- tax advice or cost data

Legal dept- legal ramification of alternative decisionsMarketing dept- data on product market

characteristic

Finance dept- data on alternative method to obtain

financial capital To collect and process data

MANAGER INTEGRATE ALL INFORMATION TO

ARRIVE AT A DECISION



The Economics of Effective 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



Identify Goals and Constraints

Well defined goals Different goals entails different decisions Decision maker faces constraints that affect

the ability to achieve goal

EXAMPLES: marketing dept -maximise sales and market

share , finance dept- isk reduction strategies Constraints- available technology, inputprices



Recognize nature andimportance of profits

Overall goal- maximise profit of firms value

Difference between economics andaccounting profits

Implicit costs very hard to measure

Example hairstyling salon vs restaurant



SustainableIndustryProfits

Power of

Input SuppliersSupplier ConcentrationPrice/Productivity ofAlternative InputsRelationship-SpecificInvestmentsSupplier Switching CostsGovernment Restraints

Power of

BuyersBuyer ConcentrationPrice/Value of SubstituteProducts or ServicesRelationship-SpecificInvestmentsCustomer Switching CostsGovernment Restraints

EntryEntry CostsSpeed of Adjustment

Sunk CostsEconomies of Scale

Network EffectsReputation

Switching CostsGovernment Restraints

Substitutes & ComplementsPrice/Value of SurrogateProducts or ServicesPrice/Value of ComplementaryProducts or Services

Network EffectsGovernmentRestraints

Industry RivalrySwitching CostsTiming of DecisionsInformationGovernment Restraints

ConcentrationPrice, Quantity, Quality, orService CompetitionDegree of Differentiation

The Five Forces Framework



Economic vs. Accounting Profits

Accounting Profits

Total revenue (sales) minus dollar cost of

producing goods or services.Reported on the firms income statement.

Economic ProfitsTotal revenue minus total opportunity cost.



Opportunity Cost Accounting Costs The explicit costs of the resources needed to produce

goods or services.

Reported on the firms income statement.

Opportunity Cost The cost of the explicit andimplicit resources that are

foregone when a decision is made.

Economic Profits

Total revenue minus total opportunity cost.

Accounting profits overstate your economics profits



Understanding incentives

Profits

signal to holders of resources to enter or exit industry

Incentive to resource holders to alter/change use ofresources

Managers should understand the role of incentive

Induce workers to work harder/maximising effort

Reward vs penalty

Incentive plan directly proportionate to firmsprofitability

Commission based remuneration


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Understanding markets

Relative outcome of markets : Power of buyers vs power of sellers

bargaining position of consumers and producers

3 sources of rivalry in economic transaction: Consumer producer rivalry

Consumer-consumer rivalry

Producer-producer rivalry


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Market Interactions

Consumer-Producer Rivalry Consumers attempt to locate low prices, while producers

attempt to charge high prices.

Risk- producer refuse to sell, consumer refuse to purchase

Consumer-Consumer Rivalry

Scarcity of goods reduces the negotiating power ofconsumers as they compete for the right to those goods.

Consumer willing to pay highest price to outbid others.

eg-auction


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Market Interactions

Producer-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

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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The Time Value of oney


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The Time Value of Money

Timing in making decision-gap between time when cost of project is borne and

time when benefits of project is received

Is $1 today going to worth more than $1 receivedin future? Opportunity cost of $1 in future = interest forgone

Its the time value of money

PV of an amount received in future = amount that wouldbe invested today at prevailing interest rate to generategiven future value


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Present Value Analysis Present value (PV) o f a fu ture value (FV) o f a

lump-sum amoun t to be received at the end

of n periods when the per-period interest

rate is i:

PV

FV

in

1

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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(1) Present Value Analysis

Eg calculate PV of $100 in 10 years if the interestrate is 7 percent

PV=$50.83

i.e if you invested $50.83 today at a 7% interest rate, in 10 years yourinvestment is worth $100.

Interest rate is inversely related to the PV

Higher interest rate-lower PV

PV of future payment = FV - opportunity costswaiting (OCW)

If interest rate is zero, OCW is zero then PV=FV


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2) Present Value of a Series Present value of a stream of future amounts

t received at the end of each period for nperiods:

Given PV of income stream from a project, wecan compute the net PV of the projectNPV=PV-C0 current cost)

PV

FV

i

FV

i i

1

1

2

2

1 1 1...


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3) NET PRESENT VALUE Suppose a manager can purchase a stream of

future receipts (FVt) by spending C0 dollarstoday. The NPVof such a decision is

PVFV

i

FV

i

F

i

n

n

1

1

2

2

1 1 1...

Decision Rule:If NPV < 0: Reject project

NPV > 0: Accept projecdemo problem 1-1


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4) Present Value of indefinitely Lived AssetsSome decisions generates cash flows thatcontinue indefinitely. The PV of such cash flowsis

PV assets = CF0 + CF1 + CF2 1+i) 1+i)2If all future cash flows are identical CF1=CF2=then

PV perpetuity= CF/ i


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(5) FIRM VALUATION

The value of a firm equals the present value of currentand future profits.

PV firm = 0 + 1 + 2 1+i) 1+i)2PV firm= t/ 1 + i)t

Profit maximising goal also means firms want tomaximise its value which is PV of current andfuture profits


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(5) FIRM VALUATION

If profits is expected to grow at a constant rate ofg percent each year which is less than the interestrate, i ;(g < i) and current period profits are o:then the PV of the firms is

0

0

1 before current profits have been paid out as dividends;

1 immediately after current profits are paid out as div

Firm

Ex Dividend

Firm

iPV

i g

gPV

i g


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Firm Valuation

If the growth rate in profits < interest rateand both remain constant, maximizing the

present value of all future profits is the sameas maximizing current short term profits.

Eg demo problem 1-2


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Marginal (Incremental) Analysis


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Control Variables

Output

Price

Product Quality Advertising

R&D

Basic Managerial Question: How much of

the control variable should be used tomaximize net benefits?

Marginal (Incremental) Analysis


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MARGINAL ANALYSIS

OPTIMAL MANAGERIAL DECISIONS INVOLVESComparing the marginal incremental) benefitswith the marginal incremental ) costsNote:B Q)-total benefits derived from Q units of variableC Q)- total costs corresponding level of QManagers objective: maximise net benefits Net Benefits = Total Benefits - Total Cost

= B Q)-C Q) Profits = Revenue - Costs


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MARGINAL defined

MB additional benefit arise by using an additionalunit of managerial control variable MC additional costs incurred by using an additionalunit of the managerial control variable MNB Q) the change in net benefits that arise froma one unit change in Q OR

MNB Q) = MB Q)-MC Q)Refer table 1-1 p20Note When net benefit is maximised,

MNB Q)=0 since MB Q)=MC Q)


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Marginal Benefit (MB)

Change in total benefits arising from a changein the control variable, Q:

Slope calculus derivative) of the total benefitcurve.

QBMB


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Marginal Cost (MC)

Change in total costs arising from a changein the control variable, Q:

Slope calculus derivative) of the total costTC) curve

QCMC


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Marginal Principle

To maximize net benefits, the managerialcontrol variable should be increased up to thepoint where M = MC. M > MC means the last unit of the controlvariable increased benefits more than itincreased costs. M < MC means the last unit of the controlvariable increased costs more than itincreased benefits.


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The Geometry of Optimization

Refer fig 1-2Q

Total Benefits& Total Costs

Benefits B(Q)

Costs C(Q)

Q*

B

CSlope = MC

Slope =MB


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The Geometry of Optimization

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 ofa given function

MB= dB(Q)

dQ

MC= dC(Q)

dQ

MNB= dN(Q)dQ


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CONCLUSION

Make sure you include all costs and benefitswhen making decisions opportunity cost). When decisions span time, make sure you arecomparing apples to apples PV analysis).

Optimal economic decisions are made at themargin marginal analysis).

the fundamentals of managerial economics

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