Unit 1.
Fundamentals of Managerial
Economics (Chapter 1)
While there is no doubt that luck, both good
and bad, plays a role in determining the
success of firms, we believe that success is
often no accident. We believe that we can
better understand why firms succeed or fail
when we analyze decision making in terms of
consistent principles of market economics and
strategic action.
Besanko, et. Al
Economics of Strategy (2nd)
Microeconomics is the study of how individual
firms or consumers do and/or should make
economic decisions taking into account such
things as:
1.
2.
3.
4.
5.
Their goals, incentives, objectives.
Their choices, alternatives, problems.
Constraints such as inputs, resources, money, time,
technology, competition.
All (cash & noncash) incremental or marginal
benefits and costs.
The time value of money.
Goals, Incentives, Objectives
A fundamental economic truth is that
individual firms or decision makers
respond to economic incentives. What
these incentives are (i.e. money, profits,
utility, etc.) and how they influence
economic decision making are key
topics for study and analysis in business
(or managerial) economics.
Managerial Choices
(examples)
Output quantity
Output quality
Output mix
Output price
Marketing and
advertising
Production processes
(input mix)
Input quantity
Production location
Production incentives
Input procurement
Michael Porter’s “Five Competitive
Forces”
= Decision-making constraints
= Factors that influence the sustainability of
firm profits
1. market entry conditions for new firms
2. Market power of input suppliers
3. Market power of product buyers
4. Market rivalry amongst current firms
5. Price and availability of related products
including both ‘substitutes’ and ‘complements’
Marginal Analysis
Analysis of ‘marginal’ costs and
‘marginal’ benefits due to a change
Marginal = additional or incremental
Costs and benefits that are constant
(i.e. fixed, don’t change) are excluded
from the analysis
Changes occurring at ‘the margin’ are
all that matter
Marginal Analysis
(Examples)
Y
Incremental Y/
Incremental X
MR
TR
X
Units of output
TC
Units of output
MC
TP
Units of input
MP
TRP
Units of input
MRP
TC
Units of input
MFC
TU
Units of good
MU
Profit
Units of output
MP
New Beer Sales Resulting from Amounts
Spent on TV and Radio Advertising
Total Spent
New Beer Sales Generated
(in barrels per year)
TV
Radio
0
0
$100,000
4,750
950
$200,000
9,000
1,800
$300,000
12,750
2,550
$400,000
16,000
3,200
$500,000
18,750
3,750
$600,000
21,000
4,200
$700,000
22,750
4,550
$800,000
24,000
4,800
$900,000
24,750
4,950
$1,000,000
25,000
5,000
$0
Max B(T,R)
Subject to: T + R = 1,000,000
Example of a Business (Economic)
Decision Resolved with ‘Marginal’ Analysis
Goal: max dollar sales of a product
Constraint: advertising budget
‘Marginal’ decision rule: incremental
dollar sales generated per incremental
dollar spent should be the same for
each alternative type of advertising
Assume you are a member of your company’s
Marketing Dept. You believe, and correctly so,
1) the market demand for your firm’s product is
linear,
2) if your company charges $5.00 for its product,
quantity sold would be 200 units and
3) if your company set price = $3.00, the number of
units sold would be 400.
Develop alternative ways of explaining to upper-level
management more fully the relationship between the
company’s price and the resulting number of units of
product sold.
Variable Relationships
Example of Alternative Ways of Depicting
Tabular
P
Q
$7
0
6
100
5
200
4
300
3
400
2
500
1
600
0
700
Variable Relationships
Example of Alternative Ways of Depicting
Graphical
Variable Relationships
Example of Alternative Ways of Depicting
Mathematical
Q = 700 – 100P
P = 7 – 0.01Q
Common Math Terms Used in
Economic Analysis
Term
Definition
Variable
Something whose value or magnitude (often Q or $
in Econ) may change (or vary); usually denoted by
letter ‘labels’ such as Y, X, TR, TC
Parameter or
Constant
Something whose value does NOT change
General
equation or
function
A mathematical expression that suggests the value
of one variable relates to or depends on the value of
another variable (or set of variables) without
showing the precise nature of that relationship [e.g.
y = f(x)].
Common Math Terms Used in
Economic Analysis
Term
Definition
Specific
equation or
function
A mathematical expression that shows precisely how
the value of one variable is related to the value of
another variable (or set of variables) [e.g. y = 10 +
2x].
Inverse
equation or
function
A mathematical expression rewritten so that the
variable previously on the right-hand side of the
equal sign now becomes the variable solved for on
the left-hand side of the equal sign [e.g. y = 2x and
x = 1/2 y are each an inverse equation of the
other].
Common Math Functions Used in
Economics
Function Form
Y = a0
Y = a 0 + a 1x
(or y = mx + b)
Name of
Function
Constant
Linear
Graph of Function
Horizontal straight line with
slope = 0
Straight line with slope = a1 (or
= m)
Y=a0+a1x+a2x2
Quadratic
Parabola (u-shaped curve) with
either minimum or maximum
value
Y=a0+a1x+a2x2+a3x3
Cubic
Curved line (e.g. slope changes
from getting flatter to steeper
Y=a0x-n
Hyperbola
Curved line (u-shaped) bowed
towards origin
EXPONENT RULES
1.
xn = x multiplied by itself n times
2.
x0 = 1
3.
x-a =
EXAMPLES
x3 = x x x
x1 = x
1
xa
xa xb = xa+b
x-2 = 1/x2
5.
x a = xa-b
xb
x2/x3 = x2 x-3 = x-1 = 1/x
6.
x1/a = the ath root of x
4.
= what number multiplied by
itself "a" times = x
x2 x3 = x5
x2 x-1 = x2-1 = x
x 1/2 
x
81/3 = 2 (because 2 2 2 = 8)
7.
xa ya = (xy)a
x2y2 = (xy)2
8.
(xa)b = xab
(x2) 3 = x6
9.
(xy)1/a = x1/a y1/a
(xy)1/2 = x . y
Y = a + b1X1 + …bnXn=> the value of Y
depends on the values of n different
other variables; a ‘ceteris paribus’
assumption => we assume that all X
variable values except one are held
constant so we can look at how the
value of Y depends on the value of the
one X variable that is allowed to change
Given 2 pts on a straight line, how to solve for the
specific equation of that line?
Recall, in general, the equation of a straight line is Y
= a + bX, where b = the slope, and a = the vertical
axis intercept. The specific equation has the values of
‘a’ and ‘b’ specified.
Solution procedure:
1. Solve for b = Y/X = (Y2-Y1)/(X2-X1)
2. Given values at one pt for Y, X, and b, solve for a
(e.g. a = Y1 – bX1)
Graphical Concepts (Variable Relationships)
Y axis:
a vertical line in a graph along which the
units of measurement represent different
values of, normally, the Y or dependent
variable.
Y axis intercept:
the value of Y when the value of X = 0, or
the value of Y where a line or curve
intersects the Y axis; = ‘a’ in Y = a + bX
Graphical Concepts (Variable Relationships)
X axis:
a horizontal line in a graph along which
the units of measurement represent
different values of, normally, the X or
independent variable
X axis intercept:
the value of X when the value of Y = 0, or
the value of X where a line or curve
intersects the X axis
Graphical Concepts (Variable Relationships)
Slope:
= the steepness of a line or curve; a +(-) slope =>
the line or curve slopes upward (downward) to the
right
= the change in the value of Y divided by the
change in the value of X (between 2 pts on a line
or a curve)
= Y/X = 1st derivative (in calculus)
= Y/ X using algebraic notation
= the ‘marginal’ effect, or the change in Y brought
about by a 1 unit change in X
= b if Y = a + bX
‘Slope’ Graphically
 y rise y2  y1



 x run x2  x1
Slope Calculation Rules
(slope = Y/ X = dy / dx)
Rule
Example
1. Slope of a constant = 0
If y=6, slope = 0
2. ‘power rule’ => slope of a
function y = axn is (n)(a)xn-1
If y=3x2, slope = (2)(3)x2-1=6x
If y=x, slope = (1)x1-1=1
3. ‘Sum of functions rule’ = slope If y = x + 3x2, slope = 1 + 6x
of the sum of two functions is the
sum of the two functions’ slopes
Mathematics of ‘Optimization’
‘Optimization’  a decision maker wishes
to either MAXimize or MINimize a goal
(i.e. objective function)
For a function to have a maximum or
minimum value, the corresponding
graph will reveal a nonlinear curve that
has either a ‘peak’ or a ‘valley’
Mathematics of ‘Optimization’
The mathematical equation of the function to be optimized will
have THE VERTICAL AXIS VARIABLE ON THE LEFT-HAND SIDE
OF THE EQUATION (e.g. Y = f(x)  Y is the vertical axis
variable)
the slope of a curve at either a peak or a valley will = 0; in math
terms, the slope is the first derivative (I.e. dY/dX = 0)
‘Constrained optimization’  do the best job of maximizing (or
minimizing) a function given constraints; the ‘Lagrangian
Multiplier Method’ is a mathematical procedure for solving these
kinds of problems
Typical ‘Time Value of Money’
Problems in Business
How to compare or evaluate two
different dollar amounts at two different
time periods?
0
$X
$Y
t1
t2
t3
Time Value of Money
(Basic Concept)
A dollar is worth more (or less) the sooner (later) it is
received or paid due to the ability of money to earn
interest.

present value
+ interest earned
= future value
Or

future value
- interest lost
= present value
Time Value of Money
(Applications/Uses)
1. To evaluate business decisions where
at least some of the cash flows occur
in the future
2. To project future dollar amounts such
as cash flows, incomes, prices
3. To estimate equivalent current-period
values based on projected future
values
Time Value of Money Concepts
PV = present value
=
the number of $ you will be able to
borrow [or have to save] presently in
order to payback [or collect] a given
number of $ in the future
FV = future value
=
the number of $ you will have to pay back
[or be able to collect] in the future as a
result of having borrowed [or saved] a
given number of $ presently
FV1
FV2
•
•
•
•
FVn
=
=
=
=
=
=
PV + PV(r)
PV(1+r)
FV1+FV1(r)
FV1(1+r)
PV(1+r)(1+r)
PV(1+r)2
=
PV(1+r)n
Time Value Problems
Given
FVn = PV(1+r)n
Solve For
PV,r,n
FVn = PV(1+r)n
FVn,r,n PV=FVn[1/(1+r)n]
= ‘compounding’
= ‘discounting’
FVn,PV,n
r  (1+r)n=FVn/PV ( find in ‘n’ row)
FVn,PV,r
n  (1+r)n=FVn/PV ( find in ‘r’ column)
Borrow or save
today (= PV)
Pay back or collect
in 1 yr (= FV)
$ interest
8
1.00
_____
_____
8
_____
1.00
_____
9
1.00
_____
_____
9
_____
1.00
_____
r
PV
_____
_____
r
_____
FV
_____
r(%)
Net Present Value (NPV)
= an investment analysis concept
= PV of future net cash flows – initial
cost
= PV of MR’s – PV of MC’s
= invest if NPV > 0
= invest if PV of MR’s > PV of MC’s
Internal Rate of Return
= an investment analysis
alternative
= value of ‘r’ that results
in a NPV = 0
Payback Period
= an investment analysis alternative
= period of time required for the sum
of net cash flows to equal the initial
cost
= value of n such that
n
 NCF  C
i 1
i
Firm Valuation
The value of a firm equals the present value of all its
future profits
PV    t / (1  i )
t
If profits grow at a constant rate, g<I, then:
PV   0 (1  i ) / (i  g ).  0 
current profit level.
Maximizing Short-Term Profits
If the growth rate in profits < interest rate and both
remain constant, maximizing the present value of all
future profits is the same as maximizing current profits.
Time Value of Money
(Applied to Inflation)
 Can be used to estimate or forecast
future prices, revenues, costs, etc.
 FVn = PV (1+r)n where
PV = present value of price, cost, etc.
r = estimated annual rate of increase
n = number of years
FV = future value of price, cost, etc.