Managerial Economics & Business Strategy Chapter 1 The Fundamentals of Managerial Economics McGraw-Hill/Irwin Michael R. Baye, Managerial Economics and Business Strategy Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved. 1-2 Overview I. Introduction II. The Economics of Effective Management Identify Goals and Constraints Recognize the Role of Profits Five Forces Model Understand Incentives Understand Markets Recognize the Time Value of Money Use Marginal Analysis 1-3 Managerial Economics • Manager A person who directs resources to achieve a stated goal. • Economics The science of making decisions in the presence of scare resources. • Managerial Economics The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal. 1-4 Identify Goals and Constraints • Effective management • Sound decision making involves having well-defined goals. Leads to making the “right” decisions. Maximizing profits or the value of the firm. • In striving to achieve a goal, we often face constraints. Constraints are an artifact of scarcity. Various parts of the firm may seek to achieve differing goals. The manager unifies disparate goals into a corporate goal. 1-5 Economic vs. Accounting Profits • 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 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. 1-6 1-7 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. The Five Forces Framework Entry Costs Speed of Adjustment Sunk Costs Economies of Scale Power of Input Suppliers Entry Sustainable Industry Profits Supplier Concentration Price/Productivity of Alternative Inputs Relationship-Specific Investments Supplier Switching Costs Government Restraints 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 Power of Buyers 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 1-8 1-9 Understanding Firms’ Incentives • Profits are the ultimate incentive. • 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. Understanding Firms’ Incentives • Agent versus principal problem • Incentive plans – profit sharing, commissions • How to structure appropriate incentives? • Assume self-interested employees Understanding Markets • Final outcome of the market process depends on the relative power (bargaining position) of buyers and sellers. • Three sources of rivalry in economic transactions each serving as a disciplinary device to guide the market process: • Consumer-producer • Consumer-consumer • Producer-producer Market Interactions • Consumer-Producer Rivalry Consumers attempt to locate low prices, while producers attempt to charge high prices. Demand function serves as a guide • 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. Best quality at lowest price wins. • The Role of Government Disciplines the market process. 1-12 1-13 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 • Example: What is the maximum you would pay for an asset that generates an income of $150,000 at the end of each of five years given the opportunity cost of using funds is 9 percent? The higher the interest rate the lower the PV. 1-14 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. 1-15 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 FV 1 1 i 1 FV 2 1 i 2 ... • Equivalently, n PV FV t 1 i t 1 t FV n 1 i n 1-16 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 N PV F V1 1 i If 1 FV2 1 i 2 ... FVn 1 i Decision Rule: NPV < 0: Reject project NPV > 0: Accept project n C0 1-17 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. E.g. Perpetual bonds, preferred stocks. • The present value (PV) of a perpetuity of cash flows paying the same amount (CF = CF1 = CF2 = …) at the end of each period is PV Perpetuity CF 1 i CF i CF 1 i 2 CF 1 i 3 ... 1-18 Firm Valuation and Profit Maximization • The value of a firm equals the present value of current and future profits (cash flows). PV Firm 0 1 2 1 i 1 i ... t 1 i t t 1 • 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. 1-19 Firm Valuation With Profit Growth • If profits grow at a constant rate (g < i) and current period profits are o, before and after dividends are: P V F irm 0 E x D ividend P V F irm 1 i i g 0 before current profits have been paid out as dividends; 1 g i g im m ediately after current profits are paid out as dividends. • Provided that g < i. That is, the growth rate in profits is less than the interest rate and both remain constant. Example Baye 7th page 18. Firm Valuation With Profit Growth • The previous assumes that growth rate is constant. • More realistically investment and marketing strategies will affect growth rate. • Market actions of competitors will also affect the growth rate of the firm. 1-21 Marginal (Incremental) Analysis • Optimal managerial decisions involve comparing the marginal benefits vs marginal costs. • Control Variable Examples: Output Product Quality Advertising R&D • Basic Managerial Question: How much of the control variable should be used to maximize net benefits? 1-22 Net Benefits • Net Benefits = Total Benefits - Total Costs • Profits = Revenue - Costs 1-23 Marginal Benefit (MB) • Change in total benefits arising from a change in the control variable, Q: MB B Q • Slope (calculus derivative) of the total benefit curve. 1-24 Marginal Cost (MC) • Change in total costs arising from a change in the control variable, Q: MC C Q • Slope (calculus derivative) of the total cost curve 1-25 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 Principle • The goal of maximizing net benefits takes costs into account. • The goal of maximizing total benefits does not. • Maximizing total benefits w/o regard to costs is not a goal of the firm. Differentiating a Function • • • • • • • • • • An engineering firm conducted a study to determine its benefit and cost structure. The results of the study were: B(Y) = 300Y – 6Y2 C(Y) = 4Y2 The manager has been asked to determine the maximum level of net benefits and the level of Y that will yield that result. Solution: MB = 300-12Y MC = 8Y Equating MB and MC yields 300 – 12Y = 8Y. Solving the equation for Y reveals that the optimum level of Y is Y* = 15. Plugging Y* = 15 into the net benefit relation yields the maximum level of net benefits: NB = 300(15) – 6(152) – 4(152) = 2250 The Geometry of Optimization: Total Benefit and Cost Total Benefits & Total Costs Costs Slope =MB Benefits B Slope = MC C Q* Q 1-28 The Geometry of Optimization: Net Benefits Net Benefits Maximum net benefits Slope = MNB Q* Q 1-29 1-30 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).