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.
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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.
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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.
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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?
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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
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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).