BUS 525.2: Managerial
Economics
Lecture 1
The Fundamentals of Managerial
Economics
Course 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
2
Activity Schedule:BUS525
Class
Date
Exams
1
26 Jan
2
2 Feb
3
9 Feb
4
16 Feb
5
23 Feb
6
2 Mar
7
9 Mar
8
16 Mar
9
23 Mar
10
30 Mar
11
6 Apr
12
9 Apr
13
15 Apr-24 Apr Final
Cases
Case 1
Mid 1
Case 2
Mid 2
Case 3
Overview
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
1-4
1-5
Managerial 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.
Managerial
Economics
is a Tool for
Improving
Management
Decision Making
Figure 1.1
The Economics of Effective
Management
• 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
1-7
Identify Goals and
Constraints
• 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.
1-8
Economic vs. Accounting
Profits
• 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.
1-9
Opportunity 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.
1-10
Significance of the
Opportunity 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
11
The principle of relevant
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
12
1-13
Profits 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.
Theories 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
14
Theories 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.
15
The Five Forces Framework
Entry Costs
Speed of Adjustment
Sunk Costs
Economies of Scale
Entry
Power of
Input Suppliers
Power of
Buyers
Supplier Concentration
Price/Productivity of
Alternative Inputs
Relationship-Specific
Investments
Supplier Switching Costs
Government Restraints
Sustainabl
e Industry
Profits
Industry Rivalry
Concentration
Price, Quantity, Quality, or
Service Competition
Degree of Differentiation
Network Effects
Reputation
Switching Costs
Government Restraints
Switching Costs
Timing of Decisions
Information
Government Restraints
Buyer Concentration
Price/Value of Substitute
Products or Services
Relationship-Specific
Investments
Customer Switching Costs
Government Restraints
Substitutes & Complements
Price/Value of Surrogate Products
or Services
Price/Value of Complementary
Products or Services
Network Effects
Government
Restraints
1-16
Understanding Firms’
Incentives
• 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.
1-17
Agency 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.
The Principal-Agent Problem
• 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
Solutions 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
1-21
Market 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
Market
• 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 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 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 Market
Definition: where
– one party directly conveys a benefit or
cost to others
– externalities
or
– one party has better information than
others
1-26
The Time Value of Money
• Present value (PV) of a future value (FV) lumpsum amount to be received at the end of “n”
periods in the future when the per-period interest
rate is “i”:
PV 
FV
1  i 
n
• 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.
Present Value vs. Future
Value
• 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.
1-27
1-28
Present Value of a Series
• Present value of a stream of future
amounts (FVt) received at the end of
each period for “n” periods:
PV 
FV1
1  i 
1

FV2
1  i 
• Equivalently, PV 
n
2
 ...
FVt

t
t 1 1  i 
FVn
1  i 
n
1-29
Net 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
FV1
FV2
FVn
NPV 
1 
2  ...
n  C0
 1  i  1  i 
1  i 
If
Decision Rule:
NPV < 0: Reject project
NPV > 0: Accept project
Present Value of a
Perpetuity
• 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
CF
CF
CF
PVPerpetuity 


 ...
2
3
1  i  1  i  1  i 
CF

i
1-30
Objective of the Firm
• Not
• Not
• Not
• Not
• Not
• Not
• Not
market share
growth
revenue
empire building
net profit margin
name recognition
state-of-the-art technology
31
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?
32
Value
Maximization
Is
a Complex
Process
Figure 1.3
Definition and Measurement of
“Value of the Firm”
“The present value of the firm’s
future net earnings.”
1
2
n
V = [--------] + [ --------] + . . . + [ -------- ]
(1+r)1
(1+r)2
(1+r)n
t
V =  [ ------- ] , t = 1, 2, ... , N
t = 1 (1+r)t
N
34
Adding Value to the Firm
Profit = Total Rev - Total Cost
 = P . Qd - VC . Qs - F
where   profit, P = price,
Qd
VC
Qs
F
=
=
=
=
quantity demanded,
variable cost per unit,
quantity supplied,
total fixed costs
35
Determinants of Value of the
Firm
N
t
N
P . Qd - VC . Qs - F
V =  [ ------- ] =  [---------------------- ]
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
Maximization
• The value of a firm equals the present
value of current and future profits (cash
flows).
PVFirm   0 
1

2
1  i  1  i 

 ...  
t 1
t
1  i 
t
• 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.
1-37
Firm Valuation With Profit
Growth
1-38
• If profits grow at a constant rate (g < i)
and current period profits are o, before
and after dividends are:
1 i
before current profits have been paid out as dividends;
ig
1 g
Ex  Dividend
PVFirm
 0
immediately after current profits are paid out as dividends.
ig
PVFirm   0
• Provided that g < i.
– That is, the growth rate in profits is less than
the interest rate and both remain constant.
Marginal (Incremental)
Analysis
• 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?
1-39
1-40
Net Benefits
• Net Benefits = Total Benefits - Total
Costs
• Profits = Revenue - Costs
1-41
Marginal Benefit (MB)
• Change in total benefits arising from
a change in the control variable, Q:
B
MB 
Q
• Slope (calculus derivative) of the
total benefit curve.
1-42
Marginal Cost (MC)
• Change in total costs arising from a
change in the control variable, Q:
C
MC 
Q
• Slope (calculus derivative) of the
total cost curve
1-43
Marginal 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.
The Geometry of Optimization:
Total Benefit and Cost
Total Benefits
& Total Costs
Costs
Slope =MB
Benefits
B
Slope = MC
C
Q*
Q
1-44
The Geometry of
Optimization: Net Benefits
Net Benefits
Maximum net benefits
Slope = MNB
Q*
Q
1-45
Myths 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.
46
Myths and
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
47
Myths and Misconceptions
(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.
48
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.
49
1-50
Conclusion
• 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).