Finance 30210: Managerial Economics

Finance 30210: Managerial Economics

Introduction

“Economics deals with the allocation of scarce resources to satisfy unlimited wants”

“You can’t always get what you want…”

- Mick Jagger

We have limited incomes to spend on a wide variety of goods and services (both now and in the future)

We have a finite number of hours in the day to work, relax, go to school, etc

Firms have finite capacity and limited financial resources, to produce goods and services

The economy as a whole has a finite number of resources trying to satisfy a population with unlimited wants! We need to make choices!!

What’s the difference between Macroeconomics and Microeconomics?

Nothing!!!Both are interested in allocations of resources….

MacroMicro

•We allocate our time towards either leisure or labor•We allocate our available resources towards either consumption ,investment, or government

Macroeconomic allocations determine the size of the pie

•We allocate our time towards a variety of different activities•We allocate consumption/investment goods across a range of uses

Microeconomic allocations determine who gets what slice

Macro Example: The US Economy

•Consumption (64%)•Investment (17%)•Government(15%)•Net Exports (4%)

1950 1960 2016200019901970 1980

•Consumption (67%)•Investment (17%)•Government(21%)•Net Exports (-5%)

Consumption

Business Investment

Government

GDP

Micro Example: Uses of corn

•Fed to livestock (75%)•Exported (13%)•Food and Industrial Products (12%)

•Fed to livestock (60%)•Exported (22%)•High Fructose corn syrup (6%)•Ethanol Production (6%)•Food and Industrial Products (6%)

1950 1960 2016200019901970 1980

Efficiency vs. Equity

An allocation of resources that maximize total welfare

An allocation of resources provides a “fair” distribution of welfare

How do we rank various allocations?

VS.

Suppose that Exxon acquires drilling rights within a remote area where there will be negligible environmental damage in the traditional sense

The Sierra club files a lawsuit to block the drilling (Their personal serenity has been threatened by the knowledge that the oil is being removed from it’s natural habitat)

If you are the judge, who should prevail?

If Exxon Wins:• Exxon stockholders

gain• Workers gain from

added jobs• Motorists see falling

gasoline prices

If Exxon Wins:• Sierra club members

lay awake at night screaming

$10M

$5M

VS.

A ruling against Exxon in this example would be inefficient – a missed opportunity to make everyone better off.

If you are interested in efficiency you are trying to allocate resources to their highest value

Introducing homo economicus….also known as “Economic Man”

Economic man is a RATIONAL being

The Fundamental Rule of Economics: Individuals are rational beings and therefore respond to incentives – i.e. they respond to opportunities with Economic Profit

Economic Profit = Benefit – Opportunity Cost

Opportunity cost = Direct (Money) Costs + Implicit Costs

In other words, think about opportunity cost as the value of ALL the resources that are being used

Example: What would be the opportunity cost of attending Notre Dame as an undergraduate? Do students have an incentive to go to Notre Dame?

Item Average 2015/2016 Expenses

Tuition and Fees $47,929

Room & Board $13,846

Books & Supplies $1,050

Personal Expenses $1,200

Transportation (to/from ND) $750

Total $64,775

$64,775 x 4 = $259,100

Is this right?

So if you wanted a 10% return on your college education, you would need to earn $22,000 a year more per year after college

Major Median Starting Salary (2014)

Accounting $57,000Finance $62,000Management $60,000Marketing $52,000Management - Consulting $60,000Management - Entrepreneurship $40,000Mendoza Median $59,000Notre Dame Median $58,000

Median Salary (25 and Older) High School Degree: $28,763Median Salary (16 and older): $17,900

Item Average 2015/2016 Expenses

Tuition and Fees $47,929

Room & Board $13,846

Books & Supplies $1,050

Personal Expenses $1,200

Transportation (to/from ND) $750

Opportunity Cost of Your Time $17,900

Total Opportunity Cost $67,629

$15,046 (8 mo.)

$22,569 (12 mo.)

$20,194 (National Average)

Mendoza Median: $59,000 – Median (No College) $28,763 = $30,237

$67,629*4 = $270,516 Total 4 Year Cost

$30,237 / *100 11.2%$270,516

yr

High School Graduate Unemployment Rate: 7.5%

Mendoza Grads Unemployment Rate: 2%

.02 $0 .98 $59,000 $57,820

.075 $0 .925 $28,763 $26,605

$31,215 / *100 11.5%$270,516

yr

Example: What is IBM’s opportunity cost? Is IBM earning economic profit?

Item 2010*

Net Sales 99,870

Cost of Goods Sold (49,358)

Depreciation (4,831)

Gross Income 45,681

Selling, General, and Adm. Expense (27,025)

Operating Income 18,656

Interest Income/Expense 1,067

Pretax Income 19,723

Income Taxes (4,890)

Net Income 14,833* In Millions

Current Stock Price: $166Shares Outstanding: 1,287M

$166 * 1,287M = $213.6B

Is 5% a reasonable rate of return?

$213.6B * .05 = $213.6B = $10.7B

Economic Profit = $14.8B - $10.7B = $4.1B

Efficiency vs. Equity

An allocation of resources that maximum total welfare

An allocation of resources provides a “fair” distribution of welfare

What does this mean from a business perspective? That is, why should we care?

If we have an efficient outcome, there are no opportunities to create wealth.

With inefficient outcomes, there are wealth creating opportunities.

An inefficiency offers an opportunity to create wealth by moving resources to higher value uses! This is done through voluntary transactions.

From a business standpoint, an inefficiency offers an opportunity to create wealth by moving resources to higher value uses! This is done through voluntary transactions.

Suppose that you own a Porsche that you value at $65,000, but I value at $80,000

My Value - $80,000

Your Value - $65,000

The sale of your car creates $15,000 of new wealth. The sale price determines how that wealth is allocated between us

Example: Sale Price = $75,000

Consumer Surplus = $5,000

Producer Surplus = $10,000

Exxon- $10M

Sierra Club- $5M

Example: Sale Price = $8M

Consumer Surplus = $2M

Producer Surplus = $3M

The sale creates $5M of new wealth. The sale price determines how that wealth is allocated

Rather than bringing a judge into the Exxon/Sierra Club problem, we could let the free market solve the problem

“A subtle but damaging factor in this is the dominance of economists at business schools. Although there is no evidence that economists are less ethical than members of other discipline, approaching the world through the dollar sign does make people more cynical”*

Amitai Etzioni, “When it comes to Ethics, B-Schools Get an F”, Washington Post, August 4, 2002

“In 2006, when Notre Dame played Michigan, the south bend Marriott charged $649 per night - $500 above its usual rate of $149”*

* Ilan Brat, “Notre Dame Football introduces its Fans to Inflationary Spiral”, Wall Street Journal, September 6, 2006

Ethicist Joe Holt responds…

“It is an act of moral abdication for businesses to pretend that they have no choice but to charge as much as they can based on supply and demand”

Cost = $100/Night

ALL voluntary transactions create wealth!!

Value = $700/Night

Price = $150

Consumer Surplus = $550

Producer Surplus = $50

Price = $650

Consumer Surplus = $50

Producer Surplus = $550

Either way, $600 of wealth is created!

Cost = $100/Night

Cost = $100/Night

Cost = $100/Night

Value = $1000/Night Value = $800/Night

Value = $600/Night

Value = $200/Night

Value = $400/Night

You have three rooms to rent. How do you set the price to create the most wealth?

Cost = $100/Night

Cost = $100/Night

Cost = $100/Night

Value = $600/Night

Value = $1000/Night

Value = $800/Night

CS = $400

CS = $200

PS = $500

PS = $500

PS = $500

CS = $600PS = $1500

At a $600 per night price we create $2100 of wealth

Cost = $100/Night

Cost = $100/Night

Cost = $100/Night

Value = $600/Night

Value = $1000/Night

Value = $800/Night

CS = $850

CS = $650

PS = $50

PS = $50

PS = $50

At a $150 per night price we could create $2100 of wealth

CS = $1950PS = $150

CS = $450

Cost = $100/Night

Cost = $100/Night

Cost = $100/Night

Value = $600/Night

Value = $200/Night

Value = $400/Night

CS = $50

CS = $250

PS = $50

PS = $50

PS = $50

At a $150 per night price we could create $900 of wealth

CS = $750PS = $150

CS = $450

If Marriott charged $150 per night, what should happen?

Charles Darwin vs. Adam Smith: Efficiency and the Competitive Marketplace

"Greed captures the essence of the evolutionary spirit."

-Gordon Gekko

Manufacturing 4 units/hr 10 units/hr

Agriculture 5 units/hr 8 units/hr

Mexico USA

Markets and prices allow resources to be distributed in a way to take advantage of differences. Consider the following example. Two countries (the US and Mexico) producing two different goods (Agriculture and Manufacturing).

The United States has an Absolute advantage in both goods (we require less labor for everything we produce)

Opportunity cost measures all the costs involved with an activity. In this example, the cost of agriculture in the USA is the time spent. We need to value that time.

Manufacturing 10 units/hr

Agriculture 8 units/hr

USA

1 Unit of agricultural goods

1/8 hour of time spent10/8 = 5/4 units of agriculture lost

AM

hrAhr

MOCA 25.1

8

10

10 units of manufacturing per hour

8 units of agriculture per hour

1.25 units of manufacturing per unit of agriculture

Now, lets figure out the opportunity cost for Mexico of producing agriculture.



Mexico

1 Unit of agriculture 1/5 hour of time spent

4/5 units of manufacturing lost

AM

hrAhr

MOCA 80.

5

4

4 units of manufacturing per hour

5 units of agriculture per hour

.80 units of manufacturing per unit of agriculture

Manufacturing 1.25 Units of Agriculture

.80 Units of Agriculture

Agriculture .80 Units of Manufacturing

1.25 Units of Manufacturing

Mexico USA

In terms of opportunity cost, Mexico has the lower cost of agriculture (in terms of lost manufacturing) . Likewise, US has a lower cost of Manufacturing (in terms of lost agriculture). We would say that Mexico has a comparative advantage in agriculture while the US has a comparative advantage in manufacturing

Suppose that both the US and Mexico had 40 hrs per week available to produce both goods:

A

M

320

400

A

160

M

200

Slope = 1.25 Slope = .80

For every unit of agriculture produced, the US gives up 1.25 units of manufactured products

For every unit of agriculture produced, Mexico gives up .80 units of manufactured products

80

300

80

100

If the US devotes 10 hours to agriculture and 30 hours to manufacturing, we could have 80 units of agriculture and 300 units of manufacturing

If Mexico devoted half its resources to each sector, it could have 100 units of agriculture and 80 units of manufacturing

Suppose that, rather than producing both goods, the US specialized in Manufacturing and Mexico specialized in Agriculture…we could both be better off!

With trade, The US could specialize in manufacturing (produce 400 units) and then trade 100 units of them for 100 units of agriculture

A

M

320

400

80

200

100

Gain = 20 Agricultural Goods

A

M

200

160

80

100

100

With trade, Mexico could specialize in agriculture (produces 200 units) and then trade 100 units of them for 100 units of manufacturing

Gain = 20 Manufactured Goods

Production point

Consumption point

Production point

Consumption point300

Prices will determine what actually gets produced in each country:



USA

Suppose that the wage rate in the US is $10/hr

1 unit = 1/10 hr $1 unit cost

1 unit = 1/8 hr $1.25 unit cost

Cost)Q-(PriceProfit

Lets look at the profitability of each industry in the US

With a wage of $10/hr, the price of agriculture has to be at least $1.25/unit while manufacturing has to be at least $1 to be profitable

Suppose that manufactured goods sell for $4, while agricultural goods sell for $5



USA




Manufacturing Agriculture

$3Q$1)Q-($4Profit Q75.3$$1.25)Q-($5Profit Every hour of labor generates $30 of profit

Every hour of labor generates $30 of profit

A unit of manufacturing sells for $4.00

A unit of agriculture sells for $5.00

The relative price of agriculture (in terms of manufacturing) is

$5.00$4.00

= 1.25 (Units of manufacturing per unit of agriculture)

Let’s look at these prices in relative terms…

When the relative price of agriculture equals 1.25 (the relative cost), both industries are equally profitable!

Suppose that manufactured goods sell for $4.50, while agricultural goods sell for $5



USA





$3.50Q$1)Q-($4.50Profit Q75.3$$1.25)Q-($5Profit Every hour of labor generates $35 of profit





$5.00$4.50



When the relative price of agriculture is less than 1.25 (the relative cost), manufacturing is more profitable!

Suppose that manufactured goods sell for $4.00, while agricultural goods sell for $5.50



USA





$3Q$1)Q-($4Profit Q25.4$$1.25)Q-($5.50Profit






$5.50$4.00



When the relative price of agriculture is more than 1.25 agriculture is more profitable!

A

M

320

400

Example #2: manufactured goods sell for $4.50, while agricultural goods sell for $5

Example #1: manufactured goods sell for $4.50, while agricultural goods sell for $5

Example #3: manufactured goods sell for $4.00, while agricultural goods sell for $5.50

So relative prices are driving production patterns…

Relative price of agriculture is less than 1.25

Relative price of agriculture is greater than 1.25

Relative price of agriculture is equal to 1.25

Note that, keeping relative prices constant, changing absolute prices and wages has no affect on production, but alters the distribution of gains between workers and factory owners.




Suppose that manufactured goods sell for $4, while agricultural goods sell for $5, the wage rate is $10/hr

1 Hour of Labor 1 Hour of Labor

$40 of Output$10 of Wages$30 of Profits


A

M

200

160

We get similar results in Mexico

Relative price of agriculture is less than .80

Relative price of agriculture is equal to .80

Relative price of agriculture is greater than .80

A

M

320

400

A200

160

M

Slope = 1.25

Slope = .80

This leaves us with three possibilities…

#1: The relative price of agriculture is below .80 – both countries specialize in manufacturing (no trade)

#2: The relative price of agriculture is between .80 and 1.25 – US produces manufactured goods, Mexico produces agriculture countries specialize in manufacturing (trade)

#3: The relative price of agriculture is above 1.25 – both countries specialize in agriculture (no trade)

Suppose that the relative price of agriculture is 1

With trade, The US specializes in manufacturing (produces 400 units) and then trades 100 units of them for 100 units of agriculture

A

M

320

400

80

200

100


A

M

200

160

80

100

100

With trade, Mexico specializes in agriculture (produces 200 units) and then sells 100 units of them for 100 units of manufacturing


Production point

Consumption point

Production point


Price of manufacturing equals $8Price of agriculture equals $8Wages equal $10/hr

Suppose that the relative price of agriculture is 1

A

M

320

400

80

200

100

300


A

M

320

400

80

300

Manufacturing (30 hours):• Output: $2400• Wages Paid: $300• Profits: $2100

Agriculture (10 Hours):• Output: $640• Wages Paid: $100• Profits: $540



Net gain is $160 in extra profits (i.e. 20 agricultural goods)

Suppose the agreed upon relative price of agriculture is .80

With trade, The US specializes in manufacturing (produces 400 units) and then sells 100 units of them for 125 units of agriculture

A

M

200

160

100

75


Gain = 0

A

M

320

400

80

200

125


Production point



Suppose the agreed upon price of agriculture is .80 (each agricultural item is traded for .80 manufactured items

A

M

320

400

80

200

125

300


A

M

320

400

80

300





Net gain is $360 in extra profits (i.e. 45 agricultural goods)

Suppose the agreed upon relative price of agriculture is 1.25

With trade, The US specializes in manufacturing (produces 400 units) and then sells 125 units of them for 100 units of agriculture

A

M

200

160

125



A

M

320

400

100

200

Gain = 0

Production point


Price of manufacturing equals $10Price of agriculture equals $12.50Wages equal $10/hr

100

80

Suppose the agreed upon price of agriculture is 1.25

Price of manufacturing equals $10Price of agriculture equals $12.50Wages equal $10/hr

A

M

320

400

80

200

300

A

M

320

400

80

300





Net gain is $0 in extra profits

We can actually sketch out the world supply curve for agriculture…

A

.80

AP

200 520

1.25

For prices below .80, neither country produces agriculture

For prices between .80 and 1.25, both countries are completely specialized (US in manufacturing, Mexico in Agriculture)

For prices above 1.25, both countries specialize in agricultureS

Producer surplus measures he difference between price and cost for every good sold…

A

.80

AP

200 520

1.25

S

A

M

200

160

250Gain = 90 Manufactured foods

Gain = 90 Manufactured foodsA

M45.

A200

MAMAPS 9045.200

At a relative price of agriculture equal to 1.25, Mexico’s potential producer surplus would be 90 Manufactured goods if they traded everything. Note that US gains are zero

We could also sketch out the world supply curve for manufacturing…

M

.80

MP

400 520

1.25

For prices below .80, neither country produces manufacturing

For prices between .80 and 1.25, both countries are completely specialized (US in manufacturing, Mexico in Agriculture)

For prices above 1.25, both countries specialize in ,manufacturingS

Producer surplus measures he difference between price and cost for every good sold…

A

.80

MP

400 560

1.25

S

Gain = 180 Manufactured foodsM

A45.

M400

AMAMPS 18045.400

At a relative price of manufacturing equal to 1.25, USA’s potential producer surplus would be 180 agricultural goods if they traded everything. Note that Mexico’s gains are zero

A

M

320

400

500

Gain = 180 Manufactured foods

Suppose we add another country…

Manufacturing 4 units/hr 10 units/hr 7 units/hr

Agriculture 5 units/hr 8 units/hr 7 units/hr

.80 units of manufacturing per unit of agriculture

1.25 units of manufacturing per unit of agriculture

1units of manufacturing per unit of agriculture

Again, assume each country has 40 hrs available…

A

.80

AP

800

1.00

S

1.25

200 480

Suppose we add another country…

No Trade

No Trade

Mexico Exports Agriculture to USA and Canada

Mexico and Canada Exports Agriculture to USA

Just as with the previous example, relative prices determine trading patterns and gains to each country.

So, the moral of this story is…

Free markets with prices that reflect the proper information creates allocations of resources that are efficient (i.e. wealth maximizing). With an efficient allocation, no more wealth creating transactions are possible.

However, an efficient allocation of resources makes no guarantees of equity…we will have winners and losers in a market system. Are we willing to sacrifice efficiency to improve equity?

The Average Shopping cart in the US today is approximately three times as big as its 1975 counterpart

Ralph Nader has argued that this is a prime example of consumers being manipulated by unscrupulous capitalists – bigger carts shame consumers into bigger purchases.

What’s wrong with this argument?

Microsoft’s new Xbox 360 gaming console was released in North America on November 22, 2005 at a retail price of $299.99. Available supply sold out almost immediately as Christmas shoppers stood in line for this year’s hot item. (Microsoft has increased its sales target from 3M units to 6M units).

What’s odd about this??

http://live.xbox.com/en-us/profile/profile.aspx

In the years following a divorce, statistics show that the woman’s living standard falls 27% while the man’s living standard rises by 10%

Feminists such as Patricia Ireland (NOW) would argue that this proves divorce is unfair to women

Couldn’t you just as easily argue that marriage is unfair to men?

On December 22, 2001, Richard Reid was arrested trying to blow up an American Airlines flight from Paris to Miami with a bomb hidden in his shoes.

Many human rights groups have fought heavily against the practice of racial profiling by airline security

Isn’t there a better way to secure the safety of our airplanes? (Hint: could we create a marketplace?)

http://images.google.com/imgres?imgurl=http://www.spiegel.de/img/0,1020,154046,00.jpg&imgrefurl=http://www.military-info.de/Spezial/terrorismus.htm&h=420&w=336&sz=16&hl=en&start=2&tbnid=OFEsKdmjz_gBIM:&tbnh=122&tbnw=97&prev=/images?q=richard+reid&svnum=10&hl=en&lr=&rls=GGLG,GGLG:2005-30,GGLG:en&sa=N

http://www.adl.org/default.htm

http://www.amnesty.org/

Paul “Freck” Morgan started a website in 2001 offering a $20 Pay Per View event…..to watch him cut off his feet with a homemade guillotine.

Note: The site turned out to be a hoax…Paul never actually went through with it!

How should we feel about this entrepreneurial effort? (i.e. could we/should we repress this market?)

Finance 30210: Managerial Economics

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