BUS7500
Managerial Economics
Week 2
Dr. Jenne Meyer
Class Activity
The owners of a small manufacturing concern have
hired a manager to run the company with the
expectation that he will buy the company after five
years. Compensation of the new vice president is a flat
salary plus 75% of first $150,000 of profit, and then 10%
of profit over $150,000. Purchase price for the company
is set as 4½ times earnings (profit), computed as
average annual profitability over the next five years.
Does this contract align the incentives of the new vice
president with the goals of the owners?
Class Activity Answer
No. Both the purchase price and the profit sharing
create perverse incentives. The VP keeps $0.75 of each
dollar earned up to $150,000, but only $0.10 of each
dollar earned after $150K. Since earning more requires
more effort (increasing marginal effort), the VP has
little incentive to earn more than $150,000. And every
dollar the VP earns raises the price that he will
eventually pay for the company by $4.50, effectively
penalizing him for increasing company profitability.
Capitalism 101
 To identify money-making opportunities, you must first
understand how wealth is created (and sometimes destroyed).
 Definition: Wealth is created when assets are moved from
lower to higher-valued uses
 Definition: Value = willingness to pay
 Desire + income
 The chief virtue of a capitalist economy is its ability to create
wealth
 Voluntary transactions, between individuals or firms, create
wealth.
4
Example: Robinson Crusoe economy
 A house is for sale:
 The buyer values the house at $130,000 – top dollar
 The seller values the house at $120,000 – bottom line
 The buyer and seller must agree to a price that “splits”
surplus between buyer and seller. Here, $128,000.
 The buyer and seller both benefit from this transaction:
 Buyer surplus = buyer’s value minus the price, $2,000
 Seller surplus = the price minus the seller’s value, $8,000
Total surplus = buyer + seller surplus, $10,000 = difference in values
5
Wealth-Creating transactions
 Which assets do these transactions move to highervalued uses?
 Factory Owners
 Real Estate Agents
 Investment Bankers
 Corporate Raiders
 Insurance Salesman
 Discussion: How does eBay create wealth?
 Discussion: How do you create wealth?
6
Do mergers create wealth?
 Dell-Alienware merger:
 In 2006, Dell purchased Alienware, a manufacturer of high-end gaming
computers.
 Dell left design, marketing, sales and support in Alienware’s hands;
manufacturing, however, was taken over by Dell.
 With its manufacturing expertise, Dell was able to build Alienware’s
computers at a much lower cost
 Despite this example, many mergers and acquisitions do
not create value – and if they do, value creation is rarely so
clear.
 To create value, the assets of the acquired firm must be
more valuable to the buyer than to the seller.
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Does government create wealth?
 What’s the government’s role is wealth creation?
 Why are some countries so poor?
 Much of the justification for government intervention comes from the
assertion that markets have failed. One money manager scoffed at this idea.
“The markets are working fine, but they’re giving people answers that they
don’t like, so people cry market failure.”
 What does Wheelan (Naked Economics) say about government?
8
The one lesson of economics
 Definition: an economy is efficient if all wealth-creating transactions have
been consummated.
 This is an unattainable, but useful benchmark
 The economist’s solution to inefficient outcomes is to argue for a change in
public policy.
 The One Lesson of Economics: the art of economics consists in looking not
merely at the immediate but at the longer effects of any act or policy; it
consists in tracing the consequences of that policy not merely for one group
but for all groups.
 Policies should then be judged by whether they move us towards or away from efficiency.
9
One lesson of economics (cont.)
 Taxes Destroy Wealth:
 By deterring wealth-creating transactions – when the tax is larger
than the surplus for a transaction.
 Which assets end up in lower-valued uses?
 Subsidies Destroy Wealth:
 flood insurance – encourages people to build in areas that they
otherwise wouldn’t
 Which assets end up in lower-valued uses?
 Price Controls Destroy Wealth:
 rent control (price ceiling) in New York City - deters transactions
between owners and renters
 Which assets end up in lower-valued uses?
10
Companies create wealth
 Companies are collections of transactions:
 They go from buying raw materials, capital, and labor (lower value)
 To selling finished goods & services (higher value)
 Why do some companies have difficulty creating wealth?
 They have trouble moving assets to higher-valued uses
Analogy to taxes, subsidies, price controls on internal transactions
 Can you think of an example of a price control, tax, or
subsidy?
11
Extra Discussion:
Darwinian Evolution of Organizations
 Pressure to evolve from two sources
 Product market competition
 Financial market: threat of takeover
 Discussion: extinct forms, Phycor
12
Introductory anecdote: Armadillo
Appliances
 Armadillo Appliances switched steel suppliers because a new manufacturer offered a price
$0.01/lb less than the old purchasing price.
 Multiplied by the nine million pounds of steel used annually, AA anticipated $90,000 in
savings
 Instead – acquisitions costs increased by $75,000
 Why? What happened?
 Discussion: Diagnose the problem.
 Discussion: Come up with a proposal to fix it.
Armadillo’s freight costs went up
 Coil Steel Procurement
 Original Supplier
$0.50/lb.
 Old Supplier
$0.50/lb
 New Supplier
$0.49/lb
 Material Cost Savings: $93,000/yr
Armadillo
 HOWEVER, Transportation Cost Increase:
$170,000/yr
$77,000 Total Cost Increase
Background: Types of costs
 Definition: Fixed costs do not vary with the amount of output.
 Definition: Variable costs change as output changes.
 For Example: A Candy Factory
 The cost of the factory is fixed.
 Employee pay and cost of ingredients are variable costs.
Total, Fixed, and Variable Costs
Your turn
 Are these costs fixed or variable?
 Payments to your accountants to prepare your tax returns.
 Electricity to run the candy making machines.
 Fees to design the packaging of your candy bar.
 Costs of material for packaging.
 Work in pairs or teams to review your organizations.
 What are the fixed and variable costs?
 How does your organization move low-value assets to high-value assets?
 What gets in the way of this process?
Background: Accounting vs. Economic cost
 Typical income statements include explicit costs:
 Costs paid to its suppliers for product ingredients
 General operating expenses, like salaries to factory managers and marketing expenses
 Depreciation expenses related to investments in buildings and equipment
 Interest payments on borrowed funds
 What’s missing from these statements are implicit costs:
 Payments to other capital suppliers (stockholders)
 Stockholders expect a certain return on their money (they could have invested elsewhere)
 “Profit” should recognize whether firm is generating a return beyond shareholders
expected return
 Economic profit recognizes these implicit costs; accounting profit recognizes
only explicit costs
Example: Cadbury (Bombay)
 Beginning in 1978, Cadbury offered managers free housing in company
owned flats to offset the high cost of living.
 In 1991, Cadbury added low-interest housing loans to its benefits package.
Managers moved out of the company housing and purchased houses. The
empty company flats remained on Cadbury’s balance sheet for 6 years.
 1997 Cadbury adopted Economic Value Added (EVA)®
 A capital charge appeared on division income statements
 Senior managers then decided to sell the unused apartments after seeing
the implicit cost of capital.
 Discussion: How did this action increase profitability?
Accounting costs for Cadbury
Opportunity costs & decisions
 Definition: the opportunity cost of an action is what you give up (forgone
profit) to pursue it.
 Costs imply decision-making rules and vice-versa
 The goal is to make decisions that increase profit
 If the profit of an action is greater than the alternative, pursue it.
 Discussion: What was cost of capital
 To Bombay division?; to company?
 How do we get GOAL ALIGNMENT?
 What are your opportunity costs of sitting in class to get your degree?
Fixed-cost fallacy
 Definition: letting irrelevant costs influence a decision
 Football game example – how does ticket price affect your decision to stay or leave at
halftime? Should it?
 Launching a new product – what if overhead deters a profitable product launch
 Discussion: does your company include “overhead” in transfer prices?
 Discussion: outsourcing agitator production
 Diagnose problem using Decisions rights; evaluation metric; compensation scheme,
Try to fix it: how do you better align the incentives of the plant managers with the profitability goals
of the company?
Discussion: Outsourcing
Hidden-cost fallacy
 Definition: ignoring relevant costs when making a decision
 Example: another football game p30 – what is the opportunity cost
 Discussion: should you fire an employee?
 The revenue he provides to the company is $2,500 per month
 His wages are $1,900 per month
 His office could be rented out $800 per month
 Discussion: Come up with examples of the hidden-cost fallacy.
Hidden cost of capital
 Recall that accounting profit does not necessarily correspond to economic
profit.
 Discussion: Economic Value Added
 EVA®= net operating profit after taxes minus the cost of capital times the amount of capital
utilized
 Makes visible the hidden cost of capital
 The major benefit of EVA is identifying costs. If you cannot measure
something, you cannot control it.
 Those who control costs should be responsible for them.
Coca-Cola EVA
 As an example of a company that did not ignore its cost of capital, consider
Coca-Cola in the 1980s. It had very little debt because it preferred to raise
equity capital from its stockholders. It also had a diversified product line,
including products like aquaculture and wine. But none of these activities
earned as much as its soft drink division. The opportunity cost of investing
in these unrelated businesses was the forgone opportunity to expand the
soft drink division, which at the time was earning a 16 percent return on
capital. Although these other businesses were earning a positive 10 percent
rate of return on capital, the opportunity cost of that capital was 16 percent.
CEO Robert Goizueta correctly decided to sell off these under-performing
divisions and invest the capital in its soft drink division. By making decisions
whose benefits were greater than their costs, the topic of this chapter, CocaCola increased its profitability.
Psychological biases
 Not enough information or bad incentives are not the only causes for
business mistakes. Often psychological biases get in the way of rational
decision making.
 Definition: the endowment effect means that taking ownership of item
causes owner to increase value she places on the item.
 Definition: loss aversion – individuals would pay more to avoid loss than to
realize gains.
 Definition: confirmation bias – a tendency to gather information that
confirms your prior beliefs, and to ignore information that contradicts them.
 Definition: anchoring bias – relates the effects of how information is
presented or “framed”
 Definition: overconfidence bias – the tendency to place too much
confidence in the accuracy of your analysis
http://www.youtube.com/watch?v=Du07z79T-Js
Chapter 4
Background: Average cost
 Definition: Average cost is simply the total cost of production divided by the
number of units produced. AC = TC/Q
 Average costs often decrease as quantity increases due to presence of fixed costs
AC = (VC + FC)/Q
FC does not change as Q increases
 Average costs are not relevant to extent decisions
Background: Marginal cost
 Marginal cost is the cost to make and sell one additional unit of output.
MC = TCQ+1 – TCQ.
 Marginal cost is often lower than average cost (due to falling average costs)
but not always.
 Marginal costs are what matter in extent decisions
Extent (how much?) decisions
 Definition: Marginal cost (MC) is the additional cost required to produce
and sell one more unit.
 Definition: Marginal revenue (MR) is the additional revenue gained from
producing and selling one more unit.
 If the benefits of selling another unit (MR) are bigger than the costs (MC),
then sell another unit.
 So, produce more when MR>MC; less when MR<MC. Profits are maximized
when MR=MC.
Extent decision 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.
Average/Marginal Costs Exercises
 http://hspm.sph.sc.edu/COURSES/ECON/ACost/ACost.html
 http://hspm.sph.sc.edu/COURSES/ECON/MCost/MCost.html
Effort is an extent decision
 Discussion: Royalty rates vs. fixed fee contracts
 You receive two bids to harvest 100 trees on your land
$150/tree or $15,000 for the right to harvest all the trees.
On your tract there are pines (worth $200) and fir (worth $100)
Which offer should you accept?
 Discussion: Sales Commissions
 Expected sales level: 100 units @ $10,000/unit=$1M
Option 1: 10% commission
Option 2: 5% commission + $50,000 salary
 Discussion: give example of royalty rate or fixed fee contracts in your firm
Tie pay to performance
 A consulting firm COO received a flat salary of $75,000
 After learning about the benefits of incentive pay in class, the CEO changed COO
compensation to $50K + (1/3)* (Profits-$150K)
 Profits increased 74% to $1.2 M
 Compensation increased $75K  $177K
 Discussion: what are the disadvantages to incentive pay?
Class exercise
 List 3 different businesses
 Work as a team to come up with an incentive plan
Class exercise
 List 3 different businesses
 Work as a team to come up with an incentive plan
 Pass plan to the right, your job is now to poke hole in their incentive plan
Chapter 5
Introductory anecdote
 In summer 2007, Bert Matthews was contemplating purchasing a 48-unit
apartment building.
 The building was 95% occupied and generated $550,000 in annual profit.
 Investors expected a 15% return on their capital
 The bank offered to loan Mr. Matthews 80% of the purchase price at a rate of 5.5%
 Mr. Matthews computed the cost of capital as a weighted average of equity
and debt.

.2*(15%) + .8*(5.5%) = 7.4%
 Mr. Matthews could pay no more than $550,000/7.4% = $7.4 million and still break even.
 Mr. Matthews decided not to buy the building. A good decision – one year
later, the cost of capital was 10.125% and Mr. Matthews could offer only
$5.4 million for the building.
 This story illustrates both the effect of the bursting credit bubble on real
estate valuations and, more importantly, the relevant costs and benefits of
investment decisions.
Background: Investment profitability
 All investments represent a trade-off between possible future gain and
current sacrifice.
 Willingness to invest in projects with a low rate of return, indicates a
willingness to trade current dollars for future dollars at a relatively low rate.
 This is also known as having a low discount rate (r).
 Individuals with low discount rates would willingly lend to those with higher discount
rates.
Determining investment profitability
 The current/future trade-off can be calculated by,
 Compounding
Xt+1=(1+r) Xt
Xt+s=(1+r)s Xt
 Discounting (the opposite of compounding)
Xt+1/(1+r)= Xt
Xt+s/(1+r)s= Xt
 Discussion: If my discount rate is 10%, would I lend to or borrow from
someone with a discount rate of 15%?
 What does this say about behavior?
Present value and investment decisions
 Companies also have discount rates, which are determined by cost of
capital.
 A company’s cost of capital is a blend of debt and equity, its “weighted average cost of
capital” or WACC
 Time is a critical element in investment decisions
 cash flows to be received in the future need to be discounted to present value using the
cost of capital
 The NPV Rule: if the present value of the net cash flows is larger than zero,
the project if profitable.
The NPV rule in action
• For this example the company’s cost of capital is 14%
• To determine profitability, discount future inflows and outflows
to compare with the initial investment – here $100
NPV and economic profit
 Projects with a positive NPV create economic profit.
 Only positive NPV projects earn a return higher than the company’s cost of
capital.
 Projects with negative NPV may create accounting profits, but not economic
profit.
 In making investment decisions, choose only projects with a positive NPV.
Background: break-even quantities
 The break-even quantity is the amount you need to sell to just cover your
costs
 At this sales level, profit is zero.
 The break-even quantity is Q=FC/(P-MC), where FC are fixed costs, P is price,
and MC is marginal cost
 (P-MC) is the “contribution margin” – what’s left after marginal cost to “contribute” to
covering fixed costs
Decision making example: Nissan truck
 Nissan’s popular truck model, the Titan, had only two years remaining on its
production cycle. Redesigning the “Titan” would cost $400M.
 Cost of capital was 12%, implying annual fixed cost of $48M
 Contribution margin on each truck is $1,500
 Break-even quantity is 32,000 trucks
 The decision to redesign or not came down to a break-even analysis
 Nissan had a 3% share of the market, implying only 12,000 Titan sales per
year – not enough to break even.
 Instead they decided to license the Dodge Ram Truck, which would reduce
the fixed cost of redesign, and a lower break-even point.
 After the Government took over Chrysler, Nissan reconsidered
Deciding between two technologies
 In 1983, John Deere was in the midst of building a Henry-Ford-style
production line factory for large 4WD tractors
 Unexpectedly, wheat prices fell dramatically reducing demand for large tractors
 Deere decided to abandon the new factory and instead purchased Versatile,
a company that assembled tractors in a garage using off-the-shelf
components
 A discrete investment decision – the factory had big FC and small MC, Versatile had small
FC but bigger MC
 Remember this advice: Do not invoke break-even analysis to justify higher
prices or greater output.
The decision to shut-down
 Shut-down decisions are made using break-even prices rather than
quantities.
 The break-even price is the average avoidable cost per unit
 Profit = Rev-Cost= (P-AC)(Q)
 If you shut down, you lose your revenue, but you get back your avoidable
cost.
 If average avoidable cost is less than price, shut down.
 Determining avoidable costs can be difficult.
 To identify avoidable costs firms use Cost Taxonomy
Cost Taxonomy
Using the cost taxonomy
 Example problem:
 Fixed cost (FC)=$100/year
 Marginal costs (MC)=$5/unit
 Quantity (Q)=100/year
 What is the break-even price for this scenario?
 How low can prices go before shut down is profitable?
Sunk costs and post-investment hold up
 National Geographic can reduce shipping costs by printing with regional
printers.
 To print a high quality magazine, the printer must buy a $12 million printing press.
 Each magazine has a MC of $1 and the printer would print 12 million copies over two
years.
 The break-even cost/average cost is $7 = ($12M / 2M copies) + $1/copy
 BUT once the press is purchased, the cost is sunk and the break-even price changes.
 Because of this the magazine can hold up the printer by renegotiating the terms of the
deal – because the price of the press is unavoidable, and sunk, the break-even price falls to
$1, the marginal cost.
Sunk costs and post-investment hold up
(cont.)
 Always remember the business maxim “look ahead and reason back.” This
can help you avoid potential hold up.
 Before making a sunk cost investment, ask what you will do if you are held
up.
 What would you do to address hold up?
 One possible solution to post-investment hold-up is vertical integration.
Vertical integration
 Example: Bauxite mine and alumina refinery
 Refineries are tailored to specific qualities of ore
 The transaction options are:
Spot-market transactions
Long-term contracts
Vertical integration
Vertical integration refers to the common ownership of two firms in separate stages of the
vertical supply chain that connects raw materials to finished goods
Discussion: How is vertical integration a solution to hold up?
 Contractual view of marriage
 What is the hold-up problem?
Class Exercises
 QUESTION 1: With fixed costs of $100/year, expected production of
100/year, and MC of $5. What is shut down price?
 QUESTION 2: Your firm received an RFP (request for proposal) on a wire
harness from GM with fixed costs of $1 million and MC of $1 with expected
sales of 1 million units. What is break-even price?
 QUESTION 3: GM agrees to the price, and then hands you with a PO
(purchase order) for .5 million units, what do you say?
Supporting videos
 Chapter 3
http://managerialecon.blogspot.com/search/label/03.%20Benefits%3B%20c
osts%20and%20decisions
Discussion
 Key learnings?
 Next weeks assignments.