1. Managerial Economics

Managerial Economics

Applies economic tools and techniques to business and administrative decision making [Hirshey, 2009]

Uses decision sciences to solve managerial problems faced by private, public, and not-for-profit organizations.

Q=f(Price, Income, AD)

2. Some Examples Management Decision Problems

Demand Analysis & Forecasting Product pricing and output decision Buy or lease decisions [vehicles] Production techniques [capital vs. labor] Inventory levels – JITAdvertising media [ TV, newspaper, radio]Labor hiring and trainingInvestment and Financing

3. Managerial Economics Managerial economics deals with

microeconomic reasoning on real world problems such as selecting the best strategy in different competitive environments, and making efficient choices.

Should Toyota expand its capacity (S1)? In part, it must consider current and future demand and what other firms are likely to do.

Capacity for making cars is a long term project, so Toyota should think in terms of the present value (PV) of future profits (S2).

Managerial EconomicsObjective Function:

Max PV of profits {S1, S2}where S1 is to expand capacity and S2 is not to

expand capacity yet at this time. Decision Rule:

Choose S1 if PV {Profits of S1 } > PV { Profits of S2 }

Choose S2 if PV { Profits of S1 } < PV { Profits of S2 }

If equal profits, then flip a coin

4. Basic Decision Making Model

Statement of the problem => [ International competition threatens Black and Decker’s profits]

Identification of objectives => [ Maintain, or gain market share ]

Identify possible solutions => [ Changing production techniques, market strategies, etc. ]

4. Basic Decision Making Model

Select the best solution from an array of alternative solutions.

Implement the decision.

Evaluate performance (Sensitivity analysis)e.g. property income forecasting with varying

vacancy rates (VR).

When vacancy rate is 15%=> ROI= 16%; for VR =18% => expected ROI= 5%

5. Common Managerial QuestionsWhat to produce?=> Consumers-Typically, the

answer depends on what the consumers want

Determine what price to charge. => Market forces determine the price in a market economy

Determine the optimal resource use=> Firms

Choice of feasible investment projects.

6. Management Theories of the Firm.Value or profit maximization model-primary goal of

managers (popular theory)- Road MapSales maximization model [ Baumol, 1959 ]-

managers seek to maximize sales after an adequate profit is achieved to satisfy shareholders (salaries and sales)

Management Utility maximization model (Williamson, 1963) - managers may seek to maximize their compensation [salaries, fringe benefits, stock options], the size of their staff, extent of their control over the corporation =>(principal-agent problem).

Management satisficing behavior (Cyert,1963; Herbert Simon, 1949)- Because of the complexity of modern corporation, managers seek to achieve satisfactory results in terms of growth in sales, profits, and market share.

Responsibility of Management

Managers solve problems before they become a crisisManagers select strategies to try to assure the success of

the firmManagers create an organizational culture attune to the

mission of the organization Senior management establishes a vision for the firmManagers motivate and promote teamworkManagers promote the profitability of the firmAnd many managers see it in their long-run interest to

promote sustainability of their enterprise in their environment. Managers who fail at these responsibilities are reviled, be they mangers

of BP, Enron, or Bernie Medoff

7a. The present value of the firm’s future net earnings.

•The objective of the firm is to maximize the value of the firm, the true measure of business success.

•Two key questions are the measure of value and how managers add value to the firm

1 2 nV = [--------] + [ --------] + . . . + [ -------- ]

(1+r)1 (1+r)2 (1+r)n

N t

V = [ ------- ], t = 1, 2, ... , N t = 1 (1+r)t

Value = [(TRt - TCt)/(1+r)t], t = 1, 2, ... , N

Broad Definition of ValueProfit = 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 Firm N t N P . Qd - VC . Qs - F

V = [ ------- ] = [---------------------- ] t=1 (1+r)t t=1 (1+r)t

Whatever raises the price of the product and/or the quantity of the product sold

Whatever lowers the variable and fixed costsWhatever lowers the “r” (discount rate or the

perceived “risk” of investment) will maximize the value of the firm.

Do Class Exercise # 1 and 2 in the handout

7b. Value maximization as a Team Effort

The marketing department has the responsibility for increasing sales by using the most effective promotional strategy [radio, TV, Newspaper ads]

The production department has the responsibility for minimizing costs by using new methods of production.

The finance department has a major responsibility of acquiring capital for the firm when the cost capital is low (retiring debt and expanding investment).

8. Major Constraints to value maximization a. Resource scarcity or constraints i.e. limited availability of essential input such as

skilled labor, raw material, energy, machinery warehouse, etc.

b. Contractual Obligations

Meeting nutritional requirements for feed mixture, reliability requirements.

c. Legal restrictions Minimum wage laws, health and safety

standards, pollution emission standards, fuel efficiency requirements, fair pricing, etc.

Profits (Accounting vs Economic)9a. Business or accounting profits refer to the

difference between total revenue and explicit costs. Accounting (Business) Profit = TR-Explicit costs

Profit(Econ) = Total revenue - Total costs

=Total Revenue - [Explicit costs +

Implicit costs]Examples: Exercise #1 Problems 3 & 4 page 2 handout

Theories of Why Profits Exist RISK-BEARING THEORY (Oil exploration; Investing

in Stocks)

TEMPORARY DISQUILIBRIUM THEORY OF PROFIT (Windfall Gains)

MONOPOLY THEORY OF PROFIT

INNOVATION THEORY OF PROFIT (Gates, Job, Schmidt-Page- billionaires)

MANAGERIAL EFFICIENCY THEORY OF PROFIT (a reward for organizational efficiency)

10. ExamplesMultinational Production & PricingEuro DisneyMarket Entry Building an AirportA Regulatory ProblemAn R&D Decision Canon Texaco VS. Pennzoil11. In a global economy, what happens in one

country has a direct bearing on the economies other countries

(The 2011 Flooding in Thiland and production disruption at Toyota, Honda Plants in the US; Ford Escort parts coming from global manufacturing sources)

Term Paper Title

I. Introduction - Statement of issue(s) to be addressed - Importance of the study - Objective of the paperII. A Review of Selected Literature -Recognize previous studies related to topic -Find a niche where you make some

contribution to the literature

III. Data and Analytical Framework Develop a theoretical model

underlying the issueIV. Analyses and Interpretations of Empirical Results Statistical test results of the

theoretical modelV. Summary and Conclusion References