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
• Sound decision making involves having
well-defined goals.

Leads to making the “right” decisions.
• In striking to achieve a goal, we often
face constraints.

Constraints are an artifact of scarcity.
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
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
Entry
Network Effects
Reputation
Switching Costs
Government Restraints
Power of
Input Suppliers
Power of
Buyers
Supplier Concentration
Price/Productivity of
Alternative Inputs
Relationship-Specific
Investments
Supplier Switching Costs
Government Restraints
Sustainable
Industry
Profits
Industry Rivalry
Concentration
Price, Quantity, Quality, or
Service Competition
Degree of Differentiation
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
1-8
1-9
Understanding Firms’ Incentives
• 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.
1-10
Market Interactions
• Consumer-Producer Rivalry

Consumers attempt to locate low prices, while
producers attempt to charge high prices.
• 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.
• The Role of Government

Disciplines the market process.
1-11
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
• Examples:


Lotto winner choosing between a single lump-sum payout of
$104 million or $198 million over 25 years.
Determining damages in a patent infringement case.
1-12
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.
What does the consumer’s intertemporal
problem look like?
At the tangency of U1 and the budget
constraint, W, we get equilibrium
consumption of Co, as Co*, and equilibrium
future consumption, C1*
Future Consumption C1
Intertemporal utility or
Indifference curves
W/P1
U2
C1*
The consumer maximizes
intertemporal utility over current
and future consumption given
the budget constraint, which is
the limit on wealth
U1
U3
W = Co + P1C1
Co*
W
Current Consumption Co
Intertemporal optimization
(optimization over time) -- the problem
• Max U(Co) + 1/(1+)U(C1), subject to the
wealth constraint, W = Co + C1/(1+ r), because
P1 = 1/(1 + r), and r = interest rate and  is our
time preference rate (or how impatient we are
for returns over time)
• We are maximizing intertemporal economic
welfare subject to our wealth constraint
• W = Co – C1/(1+r)
Suppose a two-period problem
(optimization over time) -- today relative to
tomorrow
• Max U(Co) + 1/(1+)U(C1), subject to the
wealth constraint, W = Co + C1/(1+ r)
• Let’s say U = LN (logarithmic utility),  =3%,
and r = 9%, and grandma left you ￥400,000
• We would solve this problem using something
like Excel --- using the solver in Excel would
work --- enter the utility function as the
objective function --- and the wealth
constraint as a constraint --- then solve
Intertemporal optimization
(optimization over time) -- the problem
• Max U(Co) + 1/(1+)U(C1), subject to the
wealth constraint, W = Co + C1/(1+ r), because
P1 = 1/(1 + r)
• The Lagrangian with the objective function,
Max U(Co) + 1/(1+)U(C1), and constraint, W
= Co + C1/(1+ r) is:
• L = U(Co) + 1/(1+)U(C1) + λ[W – Co – C1/(1+r)
• Well, we would have to use this solution
concept --- but we can use EXCEL’s Solver
see EXCEL file INTERTEMP U
1-17
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 
• Equivalently,
1

FV2
1  i 
n
2
 ...
FVt
PV  
t
t 1 1  i 
FVn
1  i 
n
SOME FURTHER EXPLANATION ON PRESENT
VALUE COMPONENTS
PRESENT VALUE OF AN AMOUNT
PV = S[ 1 / (1 + i )t ]
THE BRACKETED TERM
[ 1 / (1 + i )t ]
IS THE PRESENT VALUE OF $1 IN t PERIODS,
WHERE i IS THE INTEREST RATE
THE TERM
[ 1 / (1 + i )t ]
IS CALLED
THE PRESENT –VALUE INTEREST FACTOR
OR PVIFi , t
AN EXAMPLE
WHAT IS THE PRESENT VALUE OF $1,080 ?
IN ONE YEAR IF THE INTEREST RATE IS 8 %
PER YEAR?
SO i = 8 % OR 0.08, AND t = 1
PV = $1,080[ 1/(1.08)1] = $1,000
---NOTICE, THAT PV = FV/ (1 + i )t
SO FV = PV(1+ i ) t
THEREFORE NOTE THAT $1,000 IN 1 YEAR
AT 8% WOULD INCREASE TO $1,080
LET’S GO A BIT FURTHER ON THIS CONCEPT:
WHAT IS THE PRESENT VALUE OF €100,000 TO BE
RECEIVED AT THE END OF 10 YEARS IF THE
INTEREST RATE, i = 10% ?
PV = €100,000[ 1 / (1.10)10]
SO DO THE MATH, AND WE GET PV = €38,550
HOW DID WE DO THAT? WELL, USE A
CALCULATOR OR, IF YOU ARE GOOD AT
EXPONENTIATION, THEN IT ALL COMES OUT OK
OR, WE COULD USE A PRESENT VALUE TABLE --AN EXAMPLE IS GIVEN BELOW
PVIFi, t = 1/(1+ i )t
0.3855
INTEREST RATE
PERIODS
8%
10%
12%
1
0.9259
0.9091
0.8929
2
0.8573
0.8264
0.7972
3
0.7938
0.7513
0.7118
4
0.7350
0.6830
0.6355
6
0.6302
0.5645
0.5066
8
0.5403
0.4665
0.4039
10
0.4632
0.3855
0.3220
TAKEN FROM: Vichas, Robert P. 1979. Handbook of Financial Mathematics, Formulas and Tables.
Englewood Cliffs, N. J., Prentice Hall.
THEN, PICKING THE VALUE FOR 10% AND 10
PERIODS, WE GET 0.3855
SO PV = €100,000(0.3855) = €38,550
-------------------------------------------------------------OF COURSE WE COULD SOLVE THIS PRESENT
VALUE USING EXCEL
= 100000*(1/(1.1)^10), WHICH WOULD GIVE US THE
VALUE OF 38554.33 TO BE EXACT!! WHY THE
DIFFERENCE? THE TABLE ABOVE GIVES US
“ROUNDED” FACTORS, SUCH AS 0.3855 THAT WE
USED ---- WE COULD ALSO USE
=100000*(1.10^-10) TO ALSO GET THE 38554.33
VALUE
PRESENT VALUE OF AN ANNUITY
THE PRESENT VALUE OF AN ANNUITY CAN BE
THOUGHT OF AS THE SUM OF THE PRESENT VALUES
OF EACH OF SEVERAL AMOUNTS
PVA = 100(1/1.10), PVB = 100(1/1.102), PVC = 100(1/1.103, ETC.
SO SUM THESE UP AS,
PV = 100(1/1.10) + 100(1/1.102) + 100(1/1.103)
OR PV = 100 [1/1.10 + 1/1.102 + 1/1.103 ]
SUBSTITUTE THE APPROPRIATE PVIF FACTORS FROM
THE TABLE ABOVE TO GET
PV =100(0.9091 + 0.8264 + 0.7513) = 100(2.4868)  248.68
USING EXCEL,
= PV(RATE, NPER, PV,(FV),TYPE), WHICH FOR OUR
EXAMPLE WOULD BE:
=PV(0.10,3,-100) SKIPPING (FV), TYPE
WHICH GIVES 248.69, AGAIN DIFFERENT BECAUSE
OF ROUNDING OF THE FACTORS IN THE TABLE
OF COURSE THIS CAN BE DONE VIA CALCULATOR
SO THE PRESENT VALUE OF AN ANNUITY IS GIVEN
BY PV = (AMOUNT)t[1/(1+ i )t ]
THE TERM t MEAN SUM OVER VALUES OF t, WHICH
IS THE SUM OVER ALL THE PERIODS INVOLVED
THE TERM t [1 / (1 + i ) t ] IS CALLED THE PRESENTVALUE ANNUITY FACTOR, OR PVAFi , t
SOME SELECTED PRESENT VALUE ANNUITY
FACTORS ARE:
INTEREST RATE
PERIODS
1%
2%
3%
12
11.2551
10.5753
9.9540
24
21.2434
18.9139
16.9355
30
25.8077
22.3965
19.6004
SO, IF WE DESIRED TO FIND THE PRESENT VALUE
OF £150 PAYMENTS OVER 30 MONTHS AT 24%,
THEN WE GET
PV = £150[ t = 130 (1/1.02)t] = 150(22.3965) = £3,359
WHY? INTEREST IS ANNUAL, BUT THE PAYMENTS
ARE MONTHLY ---- SO WE NEED A MONTHLY
INTEREST RATE ---- OR 24%/12 = 2%, AND IN THE
TABLE AT 30 PERIODS THE PVAF IS 22.3965
BY USING EXCEL WE GET
=PV(0.02,30,-150) = £3,359.47 TO BE EXACT
1-27
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
1-28
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.
• The present value (PV) of a perpetuity of cash flows
paying the same amount (CF = CF1 = CF2 = …) at the
end of each period is
CF
CF
CF
PVPerpetuity 


 ...
2
3
1  i  1  i  1  i 
CF

i
1-29
Firm Valuation and Profit
Maximization
• The value of a firm equals the present value of
current and future profits (cash flows).

t
1
2
PVFirm   0 

 ...  
t
1  i  1  i 
t 1
1  i 
• 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.
1-30
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:
1 i
PVFirm   0
before current profits have been paid out as dividends;
ig
1 g
Ex  Dividend
PVFirm
 0
immediately after current profits are paid out as dividends.
ig
• Provided that g < i.

That is, the growth rate in profits is less than the interest rate and both
remain constant.
Marginal (Incremental)
Analysis
• Control Variable Examples:





Output
Price
Product Quality
Advertising
R&D
• Basic Managerial Question: How much
of the control variable should be used to
maximize net benefits?
1-31
1-32
Net Benefits
• Net Benefits = Total Benefits - Total
Costs
• Profits = Revenue - Costs
1-33
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.
1-34
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
1-35
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.
The Geometry of Optimization:
Total Benefit and Cost
Total Benefits
& Total Costs
Costs
Slope =MB
Benefits
B
Slope = MC
C
Q*
Q
1-36
The Geometry of Optimization:
Net Benefits
Net Benefits
Maximum net benefits
Slope = MNB
Q*
Q
1-37
1-38
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).