Fundamentals of
Managerial
Economics
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I. Marginal Analysis - Definitions


Marginal Benefit – the change in total
benefits arising from a change in the
managerial control variable, Q (OR the
change in total benefits arising from a given
choice).
Marginal Cost – the change in total costs
arising from a change in the managerial
control variable, Q (OR the change in total
costs arising from a given choice).
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Marginal Analysis for Profit
Maximizing Firm

Note first that firms maximize Economic Profits
not Accounting Profits
Accounting Profits= Total RevenueAccounting Costs
Economic Profits= Total RevenueEconomic Costs
where Economic Costs include opportunity costs
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Opportunity Cost - Definition
The cost of the explicit and implicit
resources that are foregone when a
decision is made OR the cost of
using resources for a certain
purpose in terms of the benefit given
up by using them in their best
alternative way.
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Marginal Analysis for Profit
Maximizing Firm
Marginal Benefit of a firm’s decision is the
change in Total Revenue attributable to
that decision.
 Marginal Cost of a firm’s decision is the
change in Economic Costs attributable to
that decision.

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Example 1: Coffee Shop

Steve Mason works as a lawyer in Chicago and
owns a two-story Brownstone. He currently lives
on the second story of his Brownstone and
leases the first floor out to a travel agency.
Steve makes $60,000 per year as a lawyer, pays
$80,000 per year in mortgage payments on the
Brownstone and leases the first floor for
$100,000 per year.
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Example 1 (cont.): Coffee Shop

Steve is deciding whether to quit is job and open
a coffee shop on the first floor of his Brownstone
(instead of leasing the space to the travel
agency). Steve expects the coffee shop’s labor
costs to be $40,000 per year and supplies to
cost $50,000 per year. What is the minimum
expected revenue the coffee shop must
generate in order for Steve to quit his job as a
lawyer? What assumptions do you need to
make?
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Example 2: 2016 Cotton Bowl

Suppose you attended the Cotton Bowl at AT&T
Stadium in Arlington Texas – MSU versus
Alabama. You purchased a plane ticket for $600,
bought a ticket for $300 and booked a hotel
room for $500. You are standing in the parking
lot of the Cotton Bowl right before kickoff and a
scalper offers you $1200 for your ticket. Do you
take it? What does it depend on?
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COTTON BOWL
Scalper
Here you are.
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Time Value of Money

Generally, what is the PV of $100 in T
years if the interest rate is i?
PV=100/(1+i)T

What is the PV of $100 in T years and
$150 in Z years if the interest rate is i?
PV=100/(1+i)T+150/(1+i)Z
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Example 3: Skaneateles Bar

Sherwood Inn is a bar on Skaneateles Lake (one of the
Finger Lakes in Upstate New York). The manager of
Sherwood is deciding whether to buy a large tent for the
4th of July (when the town has fireworks over the lake).
The manager would use the tent each 4th of July for a
beer garden and expects the tent to last three years.
The manager also expects that he would be able to
increase the number of drinks sold each July 4th by
2,000. Suppose the price of a drink is $3, the cost of the
ingredients in each drink is $1 and that the manager
would have $1,000 more in labor costs if he has the beer
garden. If the annual interest rate is 10%, what is the
maximum the manager is willing to pay for the tent?
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Example 4: My Mom

My mom owns a house in the Chicago suburbs which is
currently worth $200,000. If she sells the house, she
would rent another place in the suburbs for $15,000 a
year which she has to pay at the beginning of the year.
Suppose that the expected appreciation on the house is
5% annually. Let the interest rate be 10% annually and
assume my mom is indifferent between living in her
current house or renting (except for the cost issue).
What is the maximum annual maintenance cost on the
house my mom should be willing to pay? If the annual
maintenance cost is greater than this amount, my mom
would choose to rent. Assume the maintenance cost is
paid at the end of the year.
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Example 5: When to retire?
What if Social Security is Optional?
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What does Social Security have to do
with the annuities market?
Is Adverse Selection in the Annuity Market a Big
Problem?
by Anthony Webb – Center for Retirement Research
Introduction
An annuity provides an individual or a household with
insurance against living too long. In exchange for a onetime premium payment, the insurer agrees to make
periodic payments to the insured for life. In theory,
annuities seem like a valuable product for many retirees
given an uncertain date of death. However, in practice,
few people purchase annuities. Researchers who have
studied this puzzle have concluded that annuities are not
"actuarially fair," that is, for someone with average life
expectancy they provide only about 74 to 85 cents in
income for every dollar in premium payments...
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