Managerial Economics &
Business Strategy
CHAPTER 1
THE FUNDAMENTALS OF MANAGERIAL
ECONOMICS
Overview
I. Introduction
II. The Economics of Effective Management

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

Problem-Solving Method
Managerial Economics

Manager


Economics


A person who directs resources to achieve a stated
goal.
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.
Genesis 3:19
19 By
the sweat of your brow
you will eat your food
until you return to the ground,
since from it you were taken;
for dust you are
and to dust you will return.”
Relevance of Managerial Economics
for Non-Profit Organization Managers

A relief agency receives a grant to plan a
program to help refugees. Should it add
a staff member or buy a computer
system with this funds?

A private university wishes to raise money
to build a new wing on its library. Should
it undertake a direct-mail campaign or
seek funds through personal solicitations,
or both? How much should the university
invest in these fund-raising efforts?
Relevance of Managerial Economics
for Non-Profit Organization Managers

A church runs a popular adult-education
program that is losing money. Should the
church expand or contract the program?

A community agency for the elderly runs
a day-care program and a Meals on
Wheel program. How should it allocate its
limited staff and budget between these
two programs?
Identify Goals and
Constraints

Achieving different goals entails making
different decisions.

The constrains include such things as the
available technology and prices of inputs
used in production.
Recognize the nature and
importance of Profit

Accounting Profits
 Total
revenue (sales) minus dollar cost of
producing goods or services.
 Reported

on the firm’s income statement.
Economic Profits
 Total
revenue minus total opportunity cost.
Opportunity 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.
Profit is a Signal

Profit signal to resource holders where
resources are most highly valued by
society.
 By
moving scarce resources toward
the production of goods most valued
by society, the total welfare of society
is improved.
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
Interview with Michael
Porter
https://www.youtube.com/watch?v=mYF2_FBCvXw
Understand Incentives

Managerial economics would
enable you to structure incentives
within your organization.
Understand Markets

Consumer-Producer Rivalry


Consumer-Consumer Rivalry


Scarcity of goods reduces the negotiating power of
consumers as they compete for the right to those goods.
Producer-Producer Rivalry


Consumers attempt to locate low prices, while producers
attempt to charge high prices.
Scarcity of consumers causes producers to compete with
one another for the right to service customers.
The Role of Government

Disciplines the market process.
Recognize the Time Value of
Money

Present value (PV) of a lump-sum amount (FV)
to be received at the end of “n” periods when
the per-period interest rate is “i”:
PV 
.
FV
1  i 
n
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 
2
 ...
FVn
1  i 
n
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
NPV 
FV1
1  i 
If
1

FV2
1  i 
2
 ...
FVn
1  i 
Decision Rule:
NPV < 0: Reject project
NPV > 0: Accept project
n
 C0
Present Value of a Perpetuity

An asset that perpetually generates a stream of
cash flows (CF) at the end of each period is
called a perpetuity.

The present value (PV) of a perpetuity of cash
flows paying the same amount at the end of
each period is
CF
CF
CF


 ...
2
3
1  i  1  i  1  i 
CF

i
PVPerpetuity 
Use Marginal Analysis

Control Variables
 Output
 Price
 Product
Quality
 Advertising
 R&D

Basic Managerial Question: How much of the
control variable should be used to maximize net
benefits?
Net Benefits

Net Benefits = Total Benefits - Total Costs

Profits = Revenue - Costs
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.
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
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.
Marginal decision making
example
•
Discussion: How much advertising?
•
A $50,000 increase in the TV ad budget brings in 1,000
new customers
•
Estimated MCTV is $50 (the cost to get one more
customer)
•
•
$50,000 / 1,000 = $50
If the marginal revenue generated by this customer is
greater than $50, do more advertising.
Marginal decision making
example (cont.)
•
Even if we do not know the marginal revenue, we
can still use marginal analysis to make extent
decisions
•
Compare TV advertising to telephone solicitation
•
Say you recently cut telephone budget by $10,000
and lost 100 customers
•
•
Estimated MCPH = $100= ($10,000 / 100)
So, to get one more customer costs $50 for TV and
$100 for phone
•
MCPH > MCTV so shift ad dollars from phone to TV
Problem-Solving Method
Example: Over-bidding OVI gas tract
26

A young geologist was preparing a bid
recommendation for an oil tract in the Gulf of
Mexico.

With knowledge of the productivity of
neighboring tracts also owned by company, the
geologist recommended a bid of $5 million.

Senior management, though, bid $20 million - far
over the next highest-bid of $750,000.

What, if anything, is wrong?
ANSWER:
Manager bonuses for increasing reserves
27

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.
Problem Solving Method


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?
28
Problem Solving Method

Economists use the rational actor
paradigm to model behavior. The
rational actor paradigm states:
•
People act rationally, optimally, selfinterestedly, i.e., they respond to
incentives – to change behavior you
must change incentives.
Problem Solving Method

How do we fix problem?
 Let
someone else decide?
 Change
information flow?
 Change
incentives?
 Performance
 Reward
evaluation metric
scheme
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).