CHAPTER 1

INTRODUCTI
ON & GOALS
OF THE FIRM

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whole or in part.

 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
2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in
whole or in part.

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.
2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in
whole or in part.

RESPONSIBILITIES 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.
2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in
whole or in part.

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 (S1NEW, S2USED)
where S1NEW is expand capacity with new
facilities and S2USED to purchase used facilities
from GM.
Decision Rule:
Choose S1NEW if PV (Profits S1NEW) > PV
(Profits S2USED)
Choose S2USED if PV (Profits of S1NEW) < PV
(Profits of S2USED)

2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in
whole or in part.

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.
Sales later slumped in the late 1990s
through 2009.
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whole or in part.

MORAL HAZARD IN TEAMS

Teamwork skills and the ability to motivate teams is
the most critical trait of effective managers.
Attaining full commitment from a team becomes
difficult when individuals in the team shirk; this
constitutes the moral hazard problem in team-making.
If penalties and sanctions are few and far between,
team effort reduces due to the free-riding problem.
Managers are motivated to monitor teamwork because
of economic 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 firms partners.
Economic costs should always be thought of as
opportunity costs.
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whole or in part.

PRODUCTION WITH AND WITHOUT A

SUPERVISOR

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whole or in part.

MORAL HAZARD IN TEAMS

FIGURE 1.2
Without supervision, {Shirk, Shirk}
appears to be the dominant strategy
Hiring a supervisor reduces gross profit
to $40; supervisors imposes a penalty
of $15 to the teammate who shirks.
With supervision, {Pull Hard, Pull
Hard}becomes the dominant strategy.

2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in
whole or in part.

THE ROLE OF PROFITS?

Wed expect high profit areas to
attract investment.
Wed expect low profit areas to
lose investment.

Shouldnt then all industries

earn the same profit
eventually?

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whole or in part.

10

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

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whole or in part.

11

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.
2014
Learning.
Rights Reserved.value
May not be scanned,
or duplicated,
or posted to a publicly accessible website, in
V0 is
theAllcurrent
of acopied
share
of stock.
Cengage
whole or in part.

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SEPARATION OF OWNERSHIP AND

CONTROL: THE PRINCIPAL-AGENT
PROBLEM
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?)
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whole or in part.

13

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

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AGENCY COSTS
1. 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. Internal audits and accounting

oversight boards to monitor the firm
3. Bonding expenditures and fraud
liability insurance
4. Costs of complex internal approval
processes to avoid adverse
managerial discretion
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whole or in part.

15

FIGURE 1.3 CEO PAY TRENDS,

1999-2011

Across 350 companies, CEO compensation

has mirrored corporate profitability.
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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 Lillys 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 Prozacs
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.
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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.
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whole or in part.

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RESIDUAL CLAIMANTS
Shareholders have a residual claim on
the firms net cash flows.
All other stakeholders have contractual
expected returns.
When a CEO is hired by a shareholder
owners, they create fiduciary duty to
allocate resources in a way to maximize
the NPV of residual claims.

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whole or in part.

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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).
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whole or in part.

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