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Managerial Economics & Business

Strategy

Chapter 1
The Fundamentals of Managerial Economics

McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy

1-2

Overview
I. Introduction
II. The Economics of Effective Management
Identify Goals and Constraints
Recognize the Role of Profits
Five Forces Model
Understand Incentives
Understand Markets
Recognize the Time Value of Money
Use Marginal Analysis

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Managerial Economics
Manager
A person who directs resources to achieve a stated
goal.

Economics
The science of making decisions in the presence of
scare resources.

Managerial Economics
The study of how to direct scarce resources in the
way that most efficiently achieves a managerial goal.

Definition of Economics
Economics is the social science that studies the
choices that individuals, businesses, governments, and
entire societies make as they cope with scarcity and
the incentives that influence and reconcile those
choices.
Economics divides in two main parts:
Microeconomics
Macroeconomics

Puerto Rico
Prices
Inflation Rate
Food Inflation

Argentina
Aruba
Bahamas
Barbados
Belize
Bolivia
Brazil
Canada
Cayman Islands
Chile
Colombia
Costa Rica
Cuba
Dominican
Republic
Ecuador
El Salvador
Guatemala
Guyana
Haiti
Honduras
Jamaica
Mexico
Nicaragua
Panama
Paraguay
Peru
Puerto Rico
Suriname
Trinidad and
Tobago
United States
Uruguay
Venezuela

Last

Previous
0.1

0.4

2.8

2.6

Inflation Rate
16
1
2.2
1.89
-1.1
5.49
7.7
1
1.5

Highest Lowest
8.8

Unit
-1.2

percent

9.69

-0.09

percent

Reference Previous
15-Jan
23.9
15-Jan
2.2
15-Jan
0.25
14-Dec
1.79
15-Jan
-0.4
15-Feb
5.94
15-Feb
7.14
15-Jan
1.5
14-Aug
0.7

Highest
20262.8
12.66
14.24
9.6
9.6
23464.36
6821.31
21.6
11.4

Lowest
-7
-4.68
-0.19
1.67
-12.7
-1.27
1.65
-17.8
-3.1

4.4
4.36
3.53
5.5
1.16

15-Feb
15-Feb
15-Feb
12-Dec
15-Jan

4.5
3.82
4.37
3.5
1.58

746.3
41.65
108.89
5.7
82.49

-3.4
-0.87
2.57
0.8
-1.57

4.05
-1.06
2.32
0.27
6.6
3.83
5.3
3
5.51
2.3
3.2
2.77
0.1
2.3
8.47

15-Feb
15-Feb
15-Jan
14-Sep
15-Jan
15-Jan
15-Jan
15-Feb
15-Feb
15-Jan
15-Feb
15-Feb
14-Dec
15-Jan
14-Dec

3.53
-0.74
2.95
0.62
6.4
5.82
6.4
3.07
5.45
2.6
3.4
3.07
0.4
3.9
9.02

107.87
12.2
60.71
16.04
42.46
40.2
26.49
179.73
23.99
10.04
13.4
12377.32
8.8
586.48
24.52

-2.67
-1.6
-11.94
-1.46
-4.7
2.66
5.29
2.91
-0.12
0.49
0.9
-1.11
-1.2
-11.68
-2.61

-0.1

15-Jan

0.8

23.7

-15.8

7.43
68.5

15-Feb
14-Dec

8.02
63.61

182.86
115.18

-7.12
3.22

Two Big Economic Questions


Goods and services are produced by using
productive resources that economists call factors
of production.
Factors of production are grouped into four
categories:
Land
Labor
Capital
Entrepreneurship

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Identify Goals and Constraints


Sound decision making involves having welldefined goals.
Leads to making the right decisions.

In striking to achieve a goal, we often face


constraints.
Constraints are an artifact of scarcity.

1-9

Economic vs. Accounting Profits


Accounting Profits
Total revenue (sales) minus dollar cost of
producing goods or services.
Reported on the firms income statement.

Economic Profits
Total revenue minus total opportunity cost.

Opportunity Cost
Accounting Costs
The explicit costs of the resources needed to
produce goods or services.
Reported on the firms 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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1-11

Profits 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.

The Five Forces Framework


Entry Costs
Speed of Adjustment
Sunk Costs
Economies of Scale

Entry

Network Effects
Reputation
Switching Costs
Government Restraints

Power of
Input Suppliers

Power of
Buyers

Supplier Concentration
Price/Productivity of
Alternative Inputs
Relationship-Specific
Investments
Supplier Switching Costs
Government Restraints

Sustainable
Industry
Profits

Industry Rivalry
Concentration
Price, Quantity, Quality, or
Service Competition
Degree of Differentiation

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Switching Costs
Timing of Decisions
Information
Government Restraints

Buyer Concentration
Price/Value of Substitute
Products or Services
Relationship-Specific
Investments
Customer Switching Costs
Government Restraints

Substitutes & Complements


Price/Value of Surrogate Products
or Services
Price/Value of Complementary
Products or Services

Network Effects
Government
Restraints

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Understanding Firms Incentives


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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Market 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.

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The Time Value of Money


Present value (PV) of a future value (FV) lumpsum amount to be received at the end of n
periods in the future when the per-period
interest rate is i:

PV

FV

1 i

Examples:

Lotto winner choosing between a single lump-sum payout of


$104 million or $198 million over 25 years.
Determining damages in a patent infringement case.

1-16

Present Value vs. Future Value


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.

What does the consumers intertemporal


problem look like?
At the tangency of U1 and the budget
constraint, W, we get equilibrium
consumption of Co, as Co*, and equilibrium
future consumption, C1*

Future Consumption C1

Intertemporal utility or
Indifference curves

W/P1

U2

C1*

The consumer maximizes


intertemporal utility over current
and future consumption given
the budget constraint, which is
the limit on wealth

U1
U3
W = Co + P1C1
Co*

Current Consumption Co

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Present Value of a Series


Present value of a stream of future amounts (FVt)
received at the end of each period for n periods:

PV

FV1

1 i

FV2

1 i

...

Equivalently,
n

FVt
PV
t
t 1 1 i

FVn

1 i

AN EXAMPLE
WHAT IS THE PRESENT VALUE OF $1,080 ?
IN ONE YEAR IF THE INTEREST RATE IS 8 % PER
YEAR?
SO i = 8 % OR 0.08, AND t = 1
PV = $1,080[ 1/(1.08)1] = $1,000

---NOTICE, THAT PV = FV/ (1 + i )t


SO FV = PV(1+ i ) t
THEREFORE NOTE THAT $1,000 IN 1 YEAR
AT 8% WOULD INCREASE TO $1,080

LETS GO A BIT FURTHER ON THIS CONCEPT:


WHAT IS THE PRESENT VALUE OF 100,000 TO BE
RECEIVED AT THE END OF 10 YEARS IF THE
INTEREST RATE, i = 10% ?
PV = 100,000[ 1 / (1.10)10]
SO DO THE MATH, AND WE GET PV = 38,550
HOW DID WE DO THAT? WELL, USE A
CALCULATOR OR, IF YOU ARE GOOD AT
EXPONENTIATION, THEN IT ALL COMES OUT OK

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Net 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

FV1

1 i
If

FV2

1 i

...

FVn

1 i

Decision Rule:
NPV < 0: Reject project
NPV > 0: Accept project

C0

1-23

Present Value of a Perpetuity


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

CF
CF
CF
PVPerpetuity

...
2
3
1 i 1 i 1 i
CF

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Firm Valuation and Profit Maximization


The value of a firm equals the present value of
current and future profits (cash flows).

t
1
2
PVFirm 0

...
t

1 i 1 i

t 1

1 i

A common assumption among economist is that it


is the firms goal to maximization profits.
This means the present value of current and future profits, so the
firm is maximizing its value.

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Firm Valuation With Profit Growth


If profits grow at a constant rate (g < i) and current
period profits are o, before and after dividends are:
1 i
PVFirm 0
before current profits have been paid out as dividends;
ig
1 g
Ex Dividend
PVFirm
0
immediately after current profits are paid out as dividends.
ig

Provided that g < i.

That is, the growth rate in profits is less than the interest rate and both
remain constant.

1-26

Marginal (Incremental) Analysis


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?

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Net Benefits
Net Benefits = Total Benefits - Total Costs
Profits = Revenue - Costs

1-28

Marginal Benefit (MB)


Change in total benefits arising from a
change in the control variable, Q:

B
MB
Q
Slope (calculus derivative) of the total benefit
curve.

1-29

Marginal Cost (MC)


Change in total costs arising from a change
in the control variable, Q:

C
MC
Q
Slope (calculus derivative) of the total cost
curve

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Marginal 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.

The Geometry of Optimization: Total


Benefit and Cost
Total Benefits
& Total Costs

Costs
Slope =MB

Benefits

B
Slope = MC

Q*

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The Geometry of Optimization: Net


Benefits
Net Benefits

Maximum net benefits

Slope = MNB

Q*

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1-33

Conclusion
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).