Post on 23-Dec-2015
BUS 525.2: Managerial Economics
Lecture 1
The Fundamentals of Managerial Economics
Course OverviewCourse Overview• Prerequisites
– Bus501 and/or Bus511• Requirements and Grading
– 3 Cases (20%)– Two Midterm Examinations (40%)– Final Exam (40%)
• Class Materials– Baye
, Michael R. Managerial Economics and Business Strategy. Sixth Edition. Boston: McGraw-Hill Irwin, 2009. [MRB]
– Web-page: http://fkk.weebly.com
• Office: NAC 751• Office hours: Tuesday and Thursday 5pm-6:30 pm
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Activity Schedule:BUS525Activity Schedule:BUS525Class Date Exams Cases
1 26 Jan
2 2 Feb
3 9 Feb Case 1
4 16 Feb
5 23 Feb Mid 1
6 2 Mar Case 2
7 9 Mar
8 16 Mar
9 23 Mar Mid 2
10 30 Mar Case 3
11 6 Apr
12 9 Apr
13 15 Apr-24 Apr Final
OverviewOverview
I. Introduction• Why should I study Economics?
– Understand business behavior, profit/loss making firms, advertising strategy
• Impart basic tools of pricing and output decisions– Optimize production mix and input mix– Choose product quality – Guide horizontal and vertical merger decisions– Optimal design of internal and external incentives.
• Not for managers only-any other designation– Private, NGO, Government
• Headline –loss due to managerial ineptness
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Managerial EconomicsManagerial Economics• Manager
– A person who directs resources to achieve a stated goal.
• Economics– The science of making decisions in the
presence of scarce resources.– Case No. 1, Load shedding in DESCO area
• Managerial Economics– The study of how to direct scarce resources in
the way that most efficiently achieves a managerial goal.
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Managerial Managerial Economics Economics is a Tool for is a Tool for Improving Improving
Management Management Decision MakingDecision Making
Figure 1.1Figure 1.1
The Economics of Effective The Economics of Effective ManagementManagement
• Identify goals and constraints• Recognize the nature and importance of
profits– Five forces framework and industry
profitability
• Understand incentives • Understand markets• Recognize the time value of money• Use marginal analysis
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Identify Goals and Identify Goals and ConstraintsConstraints
• Sound decision making involves having well-defined goals.– Leads to making the “right” decisions.
• In striving to achieve a goal, we often face constraints.– Constraints are an artifact of scarcity.
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Economic vs. Accounting Economic vs. Accounting ProfitsProfits
• Accounting Profits– Total revenue (sales) minus cost of
producing goods or services.– Reported on the firm’s income
statement.
• Economic Profits– Total revenue minus total opportunity
cost.
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Opportunity CostOpportunity 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.
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Significance of the Significance of the Opportunity Cost ConceptOpportunity Cost Concept
• Accounting profits = Net revenue – Accounting costs (dollar costs of goods and services)
• Reported on the firms income statement
• Economic profits = Net revenue – Opportunities Costs
• Economic profits and opportunity costs are critical to decision making
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The principle of relevant The principle of relevant costcost
• Sound decision-making requires that only costs caused by a decision--the relevant costs--be considered. In contrast, the costs of some other decision not impacted by the choice being considered--the irrelevant costs--should be ignored.
• Not all accounting costs are relevant and many need adjustments to become relevant
Profits as a SignalProfits 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.
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Theories of ProfitsTheories of Profits(Why are profits necessary? Why do profits
vary across industries and across firms?)• Risk-Bearing Theory of Profit - Profits are
necessary to compensate for the risk that entrepreneurs take with their capital and efforts
• Dynamic Equilibrium (Frictional) Theory - Profits, especially extraordinary profits, are the result of our economic system’s inability to adjust instantaneously to unanticipated changes in market conditions.
• Case No. 3: Square Backtracks on PSTN Plan
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Theories of ProfitsTheories of Profits• Monopoly Theory - Profits are the result
of some firm’s ability to dominate the market
• Innovation Theory - Extraordinary profits are the rewards for successful innovations
• Managerial Efficiency Theory - Extraordinary profits can result from exceptionally managerial skills of well-managed firms.
Sustainable Industry
Profits
Power of Input Suppliers
Supplier ConcentrationPrice/Productivity of Alternative InputsRelationship-Specific InvestmentsSupplier Switching CostsGovernment Restraints
Power ofBuyers
Buyer ConcentrationPrice/Value of Substitute Products or ServicesRelationship-Specific InvestmentsCustomer Switching CostsGovernment Restraints
EntryEntry CostsSpeed of AdjustmentSunk CostsEconomies of Scale
Network EffectsReputationSwitching CostsGovernment Restraints
Substitutes & ComplementsPrice/Value of Surrogate Products or ServicesPrice/Value of Complementary Products or Services
Network EffectsGovernment Restraints
Industry RivalrySwitching CostsTiming of DecisionsInformationGovernment Restraints
ConcentrationPrice, Quantity, Quality, or Service CompetitionDegree of Differentiation
The Five Forces FrameworkThe Five Forces Framework 1-16
Understanding Firms’ Understanding Firms’ IncentivesIncentives
• 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.
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Agency ProblemsAgency ProblemsAgency ProblemsAgency Problems
• Modern corporations allow firm managers to have no ownership participation, or only limited participation in the profitability of the firm.
• Shareholders may want profits, but hired managers may wish to relax or pursue self interest.
• The shareholders are principals, whereas the managers are agents.
• Shareholders (principals) want profit• Managers (agents) want leisure & security• Conflicting motivations between these
groups are called agency problems.– Case No. 4– Professor Yunus blasts Telenor ethics in Bangladesh– Stock brokers and investors– Physicians and patients– Auto mechanics and car owners
The Principal-Agent ProblemThe Principal-Agent ProblemThe Principal-Agent ProblemThe Principal-Agent Problem
Solutions to Agency ProblemsSolutions to Agency Problems• Compensation as incentive• Extending to all workers stock options,
bonuses, and grants of stock– It helps to make workers act more like
owners of firm (but not always – Citibank and Managers)
• Incentives to help the company, because that improves the value of stock options and bonuses
• Good legal contracts that can be effectively enforced
Market InteractionsMarket 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– BTRC, ERC
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MarketMarket• Definition: Buyers and sellers
communicate with one another for voluntary exchange
• market need not be physical– Bookstore, Internet bookstore Amazon.com– Outsourcing
• industry – businesses engaged in the production or delivery of the same or similar items– Clothing and textile industry, – Clothing industry is a buyer in the textile
market and a seller in the clothing market
Competitive MarketCompetitive Market• Benchmark for managerial
economics• Purely competitive market
– The global cotton market– many buyers and many sellers – no room for managerial strategizing
• Achieves economic efficiency• Entry of firms
– Case No.2, Ship breakers to Shipbuilders
Market PowerMarket Power• Definition – ability of a buyer or seller
to influence market conditions• Seller with market power must
manage – costs– price – advertising expenditure – policy toward competitors
Imperfect MarketImperfect MarketDefinition: where
– one party directly conveys a benefit or cost to others
– externalitiesor – one party has better information than
others
The Time Value of MoneyThe Time Value of Money• Present value (PV) of a future value (FV) lump-
sum amount to be received at the end of “n” periods in the future when the per-period interest rate is “i”:
PV
FV
i n1
• Examples:– Lottery winner choosing between a single lump-sum
payout of Tk.104 million or Tk.198 million over 25 years.– Determining damages in a patent infringement case.
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Present Value vs. Future Present Value vs. Future ValueValue
• 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.
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Present Value of a SeriesPresent Value of a Series
• Present value of a stream of future amounts (FVt) received at the end of each period for “n” periods:
• Equivalently,
PV
FV
i
FV
i
FV
inn
1
12
21 1 1. . .
n
ttt
i
FVPV
1 1
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Net Present ValueNet 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
FV
i
FV
i
FV
iCn
n
11
22 01 1 1
. . .
Decision Rule:If NPV < 0: Reject project
NPV > 0: Accept project
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Present Value of a Present Value of a PerpetuityPerpetuity
• 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
i
CF
i
CF
i
CF
i
CFPVPerpetuity
...111 32
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Objective of the FirmObjective of the Firm• Not market share• Not growth• Not revenue• Not empire building• Not net profit margin• Not name recognition• Not state-of-the-art technology
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What’s the Objective of the Firm?What’s the Objective of the Firm?• The objective of the firm is to maximize
the value of the firm.• Value of the firm is the true measure of
business success (of course, from a for-profit perspective.)
• Two questions:1. How is the “value of the firm” defined
and measured?2. How do managers go about adding
value to the firm?
Value Value Maximization IsMaximization Is
a Complex a Complex ProcessProcess
Figure 1.3Figure 1.3
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Definition and Measurement of Definition and Measurement of “Value of the Firm”“Value of the Firm”
“The present value of the firm’s future net earnings.”
1 2 nV = [--------] + [ --------] + . . . + [ -------- ]
(1+r)1 (1+r)2 (1+r)n
N t V = [ ------- ] , t = 1, 2, ... , N
t = 1 (1+r)t
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Adding Value to the FirmAdding Value to the FirmProfit = Total Rev - Total Cost = P . Qd - VC . Qs - F
where profit, P = price,
Qd = quantity demanded,
VC = variable cost per unit, Qs = quantity supplied,
F = total fixed costs
Determinants of Value of the Determinants of Value of the FirmFirm
N t N P . Qd - VC . Qs - FV = [ ------- ] = [---------------------- ]
t=1 (1+r)t t=1 (1+r)t
• Whatever that raises the price of the product and/or the quantity of the product sold
• Whatever that lowers the variable and fixed costs
• Whatever that lower the “r” (discount rate or the perceived “risk” of investment)
Firm Valuation and Profit Firm Valuation and Profit MaximizationMaximization
• The value of a firm equals the present value of current and future profits (cash flows).
• 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
210
1...
11 tt
tFirm
iiiPV
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Firm Valuation With Profit Firm Valuation With Profit GrowthGrowth
• If profits grow at a constant rate (g < i) and current period profits are before and after dividends are:
• Provided that g < i.– That is, the growth rate in profits is less than the
interest rate and both remain constant.
0
0
1 before current profits have been paid out as dividends;
1 immediately after current profits are paid out as dividends.
Firm
Ex DividendFirm
iPV
i g
gPV
i g
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• 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?
Marginal (Incremental) Marginal (Incremental) AnalysisAnalysis
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Net BenefitsNet Benefits• Net Benefits = Total Benefits - Total
Costs• Profits = Revenue - Costs
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Marginal Benefit (MB)Marginal Benefit (MB)
• Change in total benefits arising from a change in the control variable, Q:
• Slope (calculus derivative) of the total benefit curve.
Q
BMB
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Marginal Cost (MC)Marginal Cost (MC)
• Change in total costs arising from a change in the control variable, Q:
• Slope (calculus derivative) of the total cost curve
Q
CMC
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Marginal PrincipleMarginal 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.
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The Geometry of Optimization: The Geometry of Optimization: Total Benefit and CostTotal Benefit and Cost
Q
Total Benefits & Total Costs
Benefits
Costs
Q*
B
CSlope = MC
Slope =MB
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The Geometry of The Geometry of Optimization: Net BenefitsOptimization: Net Benefits
Q
Net Benefits
Maximum net benefits
Q*
Slope = MNB
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Myths and MisconceptionsMyths and Misconceptions
• Economics is about money only• Economics assumes that everyone
is selfish• A company’s value is measured by
the company’s assets• Costs are measured appropriately
by accountants.
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Myths and Myths and Misconceptions (cont.)Misconceptions (cont.)
• We must cover our fixed costs in the decisions we make as managers
• Our firm must create the best quality product
• We should do more advertising, because it’s cost-effective
• Our price should be based on our costs
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Myths and Misconceptions Myths and Misconceptions (cont.)(cont.)
• Unit or average cost provides useful management information
• Wider profit margins are desirable• A price increase reduces demand• High research and development
expense results in high prices.
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What Will We Learn?What Will We Learn? Useful economic principles for sound
economic decision-making in a management context.
The basics of the demand side of the market and which factors influence the buyers’ behavior.
The fundamentals of the market’s supply side -laws of production and how these laws impact a firm’s costs.
How firms’ costs and buyers’ demand together determine the firm’s price and net profit.
ConclusionConclusion
• 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).
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