Managerial Economics

Applications, Strategy, and Tactics, 10th Edition by McGuigan, Moyer, & Harris

PowerPoint Lecture Slides

prepared by

Richard D. Marcus
2005 South-Western Publishing

University of Wisconsin - Milwaukee

Slide 1

Chapter 1
Introduction

Structure of Decision Models Profits Role Agency Problems & Solutions Not-for-Profit Organizations Why Corporations Have Succeeded Over Other Organizational Forms
Slide 2

Managerial Economics
Integrates and applies microeconomic theory and methods to decision making problems faced by private, public, and not-for-profit organizations. Managerial economics deals with microeconomic reasoning on real world problems such as pricing decisions selecting the best strategy in different competitive environments.
Slide 3

MAJOR TOPICS
Demand and Supply Analysis
and how to estimate price elasticities with regressions

Production and Cost Analysis

and how managers can estimate these relationships

Monopoly, Competition, and Oligopolies

and how to make good pricing decisions in the real world

Organization Architecture
and the economic problem of motivating agents

Risk in Economic Decisions

and ways to modify or compare risks
Slide 4

The Decision-Making Process

(Figure 1.1) 1. Establish and Identify Objectives 2. Define the Problem 3. Identify Alternative Solutions
Consider Societal Constraints

4. Evaluate the Alternatives and Select the Best!

Consider Organizational & Input Constraints

5. Implement and Monitor the Decision

Slide 5

Theories of Why Profit Varies Across Industries

1. RISK-BEARING THEORY 2. DYNAMIC EQUILIBRIUM (or FRICTIONAL) THEORY OF PROFIT 3. MONOPOLY THEORY OF PROFIT 4. INNOVATION THEORY OF PROFIT 5. MANAGERIAL EFFICIENCY THEORY OF PROFIT
Slide 6

Objectives of the Firm

Profit maximization Shareholder wealth = value of each share (V0) times the number of shares outstanding, or V0 (shares outstanding). This is the present value of expected future profits or cash flows, discounted at the shareholders required rate of return, ke, ignoring taxes. V0 (shares outstanding) = t /(1+ke) t
t=1
Slide 7

Firm Value

(Figure 1.2)

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

Value of the Firm = the present value of discounted cash flows
N

(t ) / (1+ke)t =
t=1

(PtQt VtQt Ft) / (1+ke)t

t =1

Whatever lowers the perceived risk of the firm (ke) will also raise firm value. Whatever raises the price of the product (Pt) or the quantity sold (Qt ) will raise firm value. Whatever raises variable cost (Vt )or fixed cost ( Ft ) will reduce firm value. Slide 8

 To make good economic decisions,

managers need to be able to forecast & estimate relationships

Will be forecasting demand (both Pt & Qt)

applies to for-profit corporations non-profit organizations
Hospital Administrators -- # patients University Administrator -- enrollment

Regression analysis, time series methods, and qualitative forecasting methods used for forecasting
Slide 9

The Role of Profits

Economic Cost (or opportunity cost) is
the highest valued benefit that must be sacrificed as a result of choosing an alternative.

Economic Profit is the difference

between revenues and total economic cost (including the economic or opportunity cost of owner supplied resources such as time and capital.
Slide 10

(Figure 1.3)

Factors Affecting Stock Prices

Economic Environment Factors
1. 2. 3. 4. 5. 6. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Economic Activity Tax Rates & Regulations Competition Laws and Governmental Regulation Unionization International Conditions & Exchange Rates Products or Services Offered Production Technology Marketing and Distribution Network Used Investment Strategies Employment & Compensation Policies Ownership Form Capital Structure Used Working Capital Management Policies Dividend Policies Alliances, mergers, spin-offs

Major Policy Decisions Under Management Control

Conditions in Financial Markets

1. Interest Rates

2.
3.

Investor Sentiment
Expected Inflation

Amount, Timing, and Risk of Expected Profits Shareholder Wealth (The Market Price of the Stock)

Slide 11

Agency Problems
Modern corporations allow managers to have no, or limited, ownership participation in the profitability of the firm. Shareholders may want profits, but managers may wish to relax. The shareholders are principals, whereas the managers are agents. Conflicting motivations between these groups are called agency problems.
Slide 12

 The Principal-Agent Problem

Shareholders (principals) want profit Managers (agents) want leisure & security

Examples
KKRs takeover of RJR Nabisco to refocus on wealth-maximization The LBO by O.M. Scott (a lawn fertilizer company) from ITT improved Scotts performance
Slide 13

Solutions 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

Incentives to help the company, because that improves the value of stock options and bonuses.
Slide 14

What Went Right? What Went Wrong?

Saturn Corporation
Different kind of car company in 1991 No-haggle pricing Sales were above expectations

But, margin of only $400 per car to GM

GM earned only 3% on capital Saturn customers wanted bigger Saturns rather than trade up to Buick, as GM hoped. When the dollar appreciated, Japanese firms could price their cars more competitively.
Slide 15

Shareholder Wealth Maximization:

Necessary Conditions

COMPLETE MARKETS - liquid markets

for firm's inputs and by-products (including polluting by-products).

NO SIGNIFICANT ASYMMETRIC INFORMATION - buyers and sellers all

know the same things.

KNOWN RECONTRACTING COSTS

future input costs are part of the present value of expected cash flows.
Slide 16

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

Public Goods are goods that can be consumed or used by
more than one person at the same time with no extra cost (like a flood control or national defense). Sometimes governments produce public goods. Other times, they are exclusive to one person (like a free meal). Instead of profit, NFP organizations may have as their goals: 1. Maximization of the quantity of output, subject to a breakeven constraint. 2. Maximization of the utility (happiness) of NFP administrators. 3. Maximization of cash flows. 4. Maximization of the utility of contributors to the NFP organization.

Slide 17

 Which goal a NFP manager selects affects decisions made. A food shelter manager may decide to maximize the utility of contributors by selecting only "healthy foods" Public sector managers are performance monitored.
V.A. hospital administrators are rewarded by reducing the cost per bed over a year. Hence, they become efficient with respect to costs. The "friendliness" of the hospital staff is harder to measure, so friendliness will tend not be a high priority of the public sector manager.
Slide 18