CHAPTER 1:
MANAGERS, PROFITS, AND MARKETS
I. INTRODUCTION
A. Definitions:
a) Economics: Concerned with the allocation
of scarce resources among alternative uses
to satisfy unlimited human wants.
b) Opportunity Cost: The highest valued
alternative that must be forgone when a
choice is made.
B. Macroeconomics vs. Microeconomics.
1) Macroeconomics: Involves the study of the
workings of the entire economy.
2) Microeconomics: Involves the study of
the behavior of individual economic units
such as consumers, business, firms, and
resources owners, as well as that of
individual markets.
C. Managerial Economics Involves Applied
Micro Theory.
1) Objective: To provide a framework for
analyzing business decision making, both
day to day (short-run), and long-run
planning.
2) Theory allows business managers to
understand real world problems by using
simplifying assumptions to reduce these
problems to their essential components. The
process is termed abstraction.
D. Managerial Economics Involves statistical
analyses (Econometrics).
1) Primary tool will be regression analysis.
2) Objective is to examine and interpret the
output of a regression model.
II. Some Basics.
A. In Economic Theory it is assumed that the
primary objective of the firm is to maximize
profits.
B. Accounting Profit vs. Economic Profit.
1) Accounting Profit = Total Revenue –
Explicit Costs.
2) Economic Profit ( П )
a) П = Total Revenue – Explicit Costs –
Implicit Costs.
b) Normal Rate of Return: The rate of
return earned by a firm when economic
profit is 0.
c) Normal Profit is zero economic profit.
3) Examples of Implicit Costs
a) Equity Capital: The opportunity cost of
cash provided to a firm by its owners.
b) The opportunity cost of using land or
capital owned by the firm.
c) The opportunity cost of the owner’s time
spent managing or working for the firm.
4) Example: Technical problem 2
 Firm earns $175,000 in revenue.
 Firm spends $80,000 on raw materials,
labor expense, utilities and rent.
 Owner’s invested $500,000 of their own
money in the firm instead of investing
the money elsewhere where they could
have earned 14% annual rate of return.
a) Explicit Costs =
Implicit Costs =
Total Economic Cost =
b) Economic Profit =
c) Accounting Profit =
d) If the owners could have earned 20%
annually on their money
П=
C. Maximizing the Value of the Firm.
1) Value of the firm
a) Defined: the price for which the firm
can be sold, which equals the present
value of expected future profits.
T
πt
π1
π2
πT


 

2
T
t
b) V (1  r) (1  r)
(1  r)
(1

r)
t 1
2) Risk free discount rate.
3) Risk premium: An increase in the discount
rate to compensate investors for uncertainty
about future profits.
4) Example of discounting: Technical prob. #3
D. Equivalence of profit maximization and
maximizing the value of the firm.
1. We will concentrate on single period profit
maximization rather than maximizing the value of
the firm because the two are closely related.
III. Corporate Form of Business
A. Separation of Ownership and Control
1. Owners
Stockholders
2. Management CEO and Board of Directors
B. Principal-Agent Problem
A conflict that arises when the goals of
Management (the agents) does not match the
goals of the owners (principals).
C. Moral Hazard
Exists when either party to an agreement has
an incentive not to abide by all provisions of
the agreement and one party cannot cost effectively
monitor the agreement.
D. Best Solution: Equity ownership by
management.
IV. MARKET STRUCTURES AND
MANAGERIAL DECISION MAKING.
A. Definitions
1) Price taker: A firm that cannot set the price
of its product because price is determined
strictly by market forces.
2) Price setting firm: A firm that can raise its
price without losing all of its sales.
3) Market power: A firm’s ability to raise price
without losing all of its sales.
B. Market Structures
1. Vary on the basis of the following
characteristics:
a. Number and size of firms operating in the
market.
b. Degree of product differentiation among
producer.
c. Likelihood of Entry when existing firms are
earning economic profit.
2. The Market Structures
a. Perfect Competition (price taker).
1. A large number of relatively small firms.
2. Undifferentiated products.
3. No barriers to entry.
[Agriculture]
b. Monopolistic Competition (price setter).
1. Large number of small firms.
2. Differentiated products.
3. No barriers to entry.
[Retail Trade]
c. Monopoly (price setter).
1. Single firm.
2. Produces a product for which there are no
close substitutes.
3. Barriers to entry exist.
[Utilities]
d. Oligopoly (price setter).
1. Few firms
2. Differentiated or identical products are
produced.
3. Barriers to entry exist.
4. Mutual interdependence: Conditions in
which an individual firm has to take into
account how its competitors might react to
its price/output decisions.
[Automobiles/Aluminum]
Chapter 1 Assignment
Technical Problems: 1, 2, 3
Applied Problems: 1, 3, 4