Managerial Economics

MANAGERIAL ECONOMICS

DR. NOR’AZNIN ABU BAKAR

Chapter 1Introduction & Goals of the Firm

» What is Managerial Economics?» The Decision-Making Model and the

Responsibilities of Management» The Role of Profits?» The Principal-Agent Problem» Shareholder Wealth Maximization and the

Real Option Value» Objectives in the Public Sector and Not-for-

Profit Organizations

What is Managerial Economics?

The application of microeconomics to problems faced by decision makers in the private, public, and not-for-profit sectors.» Even questions of how best to abate nitrous oxide by coal-

fired Power Plants involves economic issues of finding efficient, least cost solutions.

Managerial economics deals with microeconomic reasoning on real world problems such as pricing decisions, selecting the best strategy in different competitive environments, and making efficient choices.

Responsibility of Management• Managers solve problems before they become a crisis

• Managers select strategies to try to assure the success of the firm

• Managers create an organizational culture attune to the mission of the organization

• Senior management establish a vision for the firm

• Managers motivate and promote teamwork

• Managers promote the profitability of the firm

• And 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 be mangers of

BP, Enron, or Bernie Madoff

To Expand Capacity or Not?An example of a simplified decision problem

• Should Honda or Toyota expand its capacity in North America? 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 these firms should think in terms of the present value (PV) of future profits.

• Objective Function: » Max PV of profits {S1(New), S2(Used)}» where S1(New) is expand capacity with new facilities and

S2(Used) to purchase used facilities from GM. • 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» If negative profits for both, then don’t expand at all

The Role of Profits?• Economic Profit is the difference between total

revenues and total economic cost (Economic cost includes the “normal” rate of return on capital contributions by the firm’s partners).

• We’d expect high profit areas to attract investment• We’d expect low profit areas to lose investment

» Shouldn’t then all industries earn the same profit eventually?

Theories of Why Profit Varies Across Industries

1. RISK-BEARING Theory of Profit

2. TEMPORARY DISQUILIBRIUM Theory of Profit

3. MONOPOLY Theory of Profit

4. INNOVATION Theory of Profit

5. MANAGERIAL EFFICIENCY Theory of Profit

What Went Right? ● What Went Wrong? Eli Lilly, a Pharmaceutical company

» It takes12.3 years on average to get a new drug approved

» Patents on Lilly’s Prozac created monopoly power and profits for a widely used medication for depression.

» As the patent began to expire, Lilly requested a patent “extension” because of some alterations in Prozac’s formula

» But when the patent extension was overturned, generic drug manufactures took 70% of the share of the market for anti-depressants.

» Lilly missed the chance of finding a replacement in time for its blockbuster Prozac

» This is an example of having and losing monopoly power.

Shareholder Wealth Maximization [1.1]

t = REVENUE – COST = TRt – TCt = PtQt – VtQt - Ft

• Value of the Firm = the present value of discounted future cash flows, both from current operations but also those that might be.

V0∙(shares outstanding) = 1/(1+ke)1 +2/(1+ke)2 + … + Real Option Value

or

V0∙(shares outstanding) = (t ) / (1+ke)t + Real Option Value t=1

• The real option value of the firm comes from the flexibility that the firm has to find added cost savings or new revenue possibilities that have not yet come to pass, but could in the future because of following their current business plans.

• V0 is the current value of a share of stock.• Whatever lowers perceived risk of the firm (ke) will raise firm value.• Whatever raises the profits of the firm, raises firm value

Agency ProblemsAgency Problems• Modern corporations allow firm managers to

have no participation (or only limited ownership participation) in the profitability of the firm.

• Shareholders are principals, managers are agents.

• Two common problems: (1) often hard to observe managerial effort and (2) random disturbances in team performance (luck versus effort?)

• The Principal-Agent Problem» Shareholders (principals) want profit

» Managers (agents) want leisure & security

» Divergent objectives between these groups are called agency problems.

• Diversification by Exxon executives was designed to help smooth their bonuses, but led to worse stock performance

• KKR’s takeover of RJR Nabisco to refocus on wealth-maximization

• The LBO by O.M. Scott & Sons (a lawn fertilizer company) from ITT (a conglomerate) improved Scott’s performance

Agency Costs1. Extending grants of stock or deferred stock

options• It helps to make workers act more like owners of firm

to try to raise the price of the stock, but is a cost

2. Bonuses or other compensation can be an incentive, but clearly is also a “cost” of solving agency problems

3. Internal audits and accounting oversight boards to monitor the firm

4. Bonding expenditures and fraud liability insurance

5. Costs of complex internal approval processes to avoid adverse managerial discretion

What Went Right? ● What Went Wrong?Saturn Corporation

» Different kind of car company in 1991, but permanently closed in 2009.

» It used no-haggle pricing and designed cars to compete with Asian imports

» Sales were above expectations at first because of tiny margin of only $400 per car to GM, so that GM earned only 3% on capital

» Saturn customers wanted bigger Saturn cars rather than trade up to Buick, as GM hoped. Saturn was unable to adopt a change-management view to get customers to trade up to other GM products.

» Sales later slumped in the late 1990s through 2009.

Caveats to

Shareholder Wealth Maximization

1. COMPLETE MARKETS - liquid markets for firm's inputs and by-products (including polluting by-products).

2. NO ASYMMETRIC INFORMATION - buyers and sellers all know the same things.

3. KNOWN RECONTRACTING COSTS - future input costs are part of the present value of expected cash flows.

Goals in the Public Sector and the Not-For-Profit (NFP) Enterprise

Instead of profit, NFP organizations may have as their goals:1. Maximizing the quantity and quality of output, subject to a

breakeven constraint.

2. Maximizing the outcomes preferred by the NFP contributors.

3. Maximizing the longevity of the NFP administrators.

Knowing their goals, helps to understand their behavior. » Using cost-benefit analysis, we can evaluate their efficiency in

terms of maximizing benefits for a given cost; or minimizing costs for a given benefit; or maximizing net benefits (Benefits – Costs).

Managerial Economics

Documents

Transcript of Managerial Economics