Economics for Managers, 11th Edition
by McGuigan, Moyer, & Harris
PowerPoint Lecture Slides
prepared by
Richard D. Marcus
University of Wisconsin - Milwaukee
2008 Thomson * South-Western
Slide 1
Chapter 1
Introduction & Goals of the Firm
» Introduction
»
»
»
»
»
Structure of Decision Models
Profit’s Role
Agency Problems & Solutions
Not-for-Profit Organizations
Why Corporations Have Succeeded
Over Other Organizational Forms
Slide 2
What is Managerial Economics?
Integrates and applies microeconomic
theory and methods to decision making
problems faced by private, public, and
not-for-profit organizations.
Managerial economics deals with
microeconomic reasoning on real world
problems such as pricing decisions,
selecting the best strategy in different
competitive environments, and making
efficient choices.
Slide 3
To Expand Capacity or Not?
• Should Toyota expand its capacity? In part, it must
consider current and future demand and what other
firms are likely to do.
• Capacity for making cars is a long term project, so
Toyota should think in terms of the present value (PV)
of future profits.
• Objective Function:
» Max PV of profits {S1, S2}
» S1 could be expand capacity and S2 not to expand yet
capacity at this time.
• Decision Rule:
» Choose S1 if PV {Profits of S1 } > PV { Profits of S2 }
» Choose S2 if PV { Profits of S1 } < PV { Profits of S2 }
» If equal profits, then flip a coin
Slide 4
The Decision-Making Process
(Figure 1.2)
1. Establish Objectives
2. Identify the Problem
3. Examine Alternative Solutions
Consider
Societal
Constraints
4. Analyze Alternatives
and Select the Best!
5.Perform Sensitivity Analysis
6. Implement and
Monitor the Decision
Consider
Organizational
& Input
Constraints
Slide 5
The Role of Profits
• Economic Profit is the difference between
revenues and total economic cost (including
the economic or opportunity cost of owner
supplied resources such as time and capital).
• We’d expect high profit areas to attract
investment
• We’d expect low profit areas to lose
investment
» Shouldn’t then all industries
earn the same profit eventually?
Slide 6
Theories of Why Profit Varies
Across Industries
1. RISK-BEARING THEORY
2. TEMPORARY DISQUILIBRIUM
THEORY OF PROFIT
3. MONOPOLY THEORY OF PROFIT
4. INNOVATION THEORY OF PROFIT
5. MANAGERIAL EFFICIENCY
THEORY OF PROFIT
Slide 7
What Went Right?
What Went Wrong?
• Eli Lilly (p. 16) a Pharmaceutical company
» 12.3 on average to get a new drug approved
» Patents on Lilly’s Prozac created monopoly power and
profits for a widely used medication for depression.
» As the patent began to expire, Lilly requested s patent
“extension” because of some alterations in Prozac’s formula
» But when the patent extension was overturned, generic drug
manufactures took 70% of the share of the market for antidepressants.
» Lilly missed the chance of finding a replacement in time for
its blockbuster Prozac
Slide 8
Objectives of the Firm
• Profit maximization
• Shareholder wealth = value of each share (V0)
times the number of shares outstanding, or
V0 · (# shares outstanding). This is the present
value of expected future profits or cash
flows, discounted at the shareholders required
rate of return, ke, ignoring taxes.

V0 (shares outstanding) =   t /(1+ke) t
t=1
Slide 9
Determinants of Firm Value
(Figure 1.3)
t = REVENUE – COST = TRt – TCt = PtQt – VtQt - Ft
• Value of the Firm = the present value of discounted cash flows
N
(t ) / (1+ke)t =
t=1
N
(PtQt – VtQt – Ft) / (1+ke)t
t =1
• Whatever lowers the perceived risk of the firm (ke) will also
raise firm value.
• Whatever raises the price of the product (Pt) or the quantity
sold (Qt ) will raise firm value.
• Whatever raises variable cost (Vt )or fixed cost ( Ft ) will
reduce firm value.
Slide 10
• To make good economic decisions,
managers need to be able to forecast &
estimate relationships
• Will be forecasting demand (both Pt & Qt)
» applies to for-profit corporations
» non-profit organizations
• Hospital Administrators forecast patients
• University Administrator forecast enrollment
• Regression analysis, time series
methods, and qualitative forecasting
methods used for forecasting
Slide 11
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
managers may wish to relax.
• The shareholders are principals, whereas
the managers are agents.
Slide 12
• The Principal-Agent Problem
» Shareholders (principals) want profit
» Managers (agents) want leisure & security
» Conflicting motivations between these
groups are called agency problems.
• Examples (page 13)
» KKR’s takeover of RJR Nabisco to
refocus on wealth-maximization
» The LBO by O.M. Scott (a lawn fertilizer
company) from ITT (a conglomerate)
improved Scott’s performance
Slide 13
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
• Incentives to help the company,
because that improves the value of
stock options and bonuses.
Slide 14
What Went Right?
• Saturn Corporation (p. 15)
What Went Wrong?
» Different kind of car company in 1991
» No-haggle pricing
» Sales were above expectations
• But, margin of only $400 per car to GM
» GM earned only 3% on capital
» Saturn customers wanted bigger Saturns rather than
trade up to Buick, as GM hoped.
» When the dollar appreciated, Japanese firms could
price their cars more competitively.
» Must continuously keep up with global
competitors.
Slide 15
Shareholder Wealth Maximization:
Necessary Conditions
• COMPLETE MARKETS - liquid markets
for firm's inputs and by-products (including polluting
by-products).
• NO SIGNIFICANT ASYMMETRIC
INFORMATION - buyers and sellers all
know the same things.
• KNOWN RECONTRACTING COSTS
future input costs are part of the present value of
expected cash flows.
Slide 16
Goals in the Public Sector and the
Not-For-Profit (NFP) Enterprise
 Public Goods are goods that can be consumed or used by
more than one person at the same time with no extra cost
(like a flood control or national defense).
 Sometimes governments produce public goods. Other times,
they are exclusive to one person (like a free meal).
 Instead of profit, NFP organizations may have as their goals:
1. Maximization of the quantity of output, subject to a
breakeven constraint.
2. Maximization of the utility (happiness) of NFP
administrators.
3. Maximization of cash flows.
4. Maximization of the utility of contributors to the NFP
organization.
Slide 17
• Which goal a NFP manager selects affects
decisions made.
» A food shelter manager may decide to maximize
the utility of contributors by selecting only
"healthy foods"
• Public sector managers are performance
monitored.
» V.A. hospital administrators are rewarded by reducing
the cost per bed over a year. Hence, they become
efficient with respect to costs.
» The "friendliness" of the hospital staff is harder to
measure, so friendliness will tend not be a high priority
of the public sector manager.
Slide 18