CHAPTER 1

The Fundamentals of Managerial Economics

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 Learning Objectives
1. Summarize how goals, constraints, incentives, and market
rivalry affect economic decisions.
2. Distinguish economic versus accounting profits and costs.
3. Explain the role of profits in a market economy.
4. Apply the five forces framework to analyze the sustainability of
an industry’s profits.
5. Apply present value analysis to make decisions and value
assets.
6. Apply marginal analysis to determine the optimal level of a
managerial control variable.
7. Identify and apply six principles of effective managerial
decision making.
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 Introduction

The Manager
• A person who directs resources to achieve a
stated goal.
– Directs the efforts of others.
– Purchases inputs used in the production of the
firm’s output.
– Directs the product price or quality decisions.

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 Introduction

Economics
• The science of making decisions in the
presence of scarce resources.
– Resources are anything used to produce a good or
service, or achieve a goal.
– Decisions are important because scarcity implies
trade-offs.

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 Introduction

Managerial Economics Defined

• The study of how to direct scarce resources in
the way that most efficiently achieves a
managerial goal.
– Should a firm purchase components – like disk
drives and chips – from other manufacturers or
produce them within the firm?
– Should the firm specialize in making one type of
computer or produce several different types?
– How many computers should the firm produce,
and at what price should you sell them?

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 The Economics of Effective Management

Economics of Effective Management

• Basic principles comprising effective
management:
– Identify goals and constraints
– Recognize the nature and importance of profits
– Understand incentives
– Understand markets
– Recognize the time value of money
– Use marginal analysis

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 The Economics of Effective Management

Identify Goals and Constraints

• Well-defined goals
• Firm’s overall goal is to maximize profits
• Constraints make it difficult to achieve goals
– Available technology
– Prices of inputs used in production

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 The Economics of Effective Management

Recognize the Nature and

Importance of Profits
• Accounting profit
– Total amount of money taken in from sales (total
revenue) minus the dollar cost of producing goods
or services.
• Economic profit
– The difference between total revenue and cost
opportunity cost.
– Opportunity cost
• The explicit cost of a resource plus the implicit cost of
giving up its best alternative.
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 Why use opportunity cost?
• Situation: You are able to open a pizza shop in a
building that you own. During the year Uncle Vinnie
offers you a job with his pizza shop (he wants to
eliminate the competition) which will pay $30,000 and
Aunt Judy offers you $100,000 to rent the building for a
year for her new hair salon. You decide to continue
with your pizza shop. At the end of the year you
calculate the following on your income statement.
– Revenue = $100,000
– Cost of Supplies = $20,000
• Did you make a good decision???
 Did you???
• Accounting profit
– 100,000 - 20,000 = 80,000
– Looks like you did!!!

• Economic profit
– 100,000 – 20,000 – 30,000 – 100,000 = -$50,000
– You could have done better by taking them up on
their offers
 The Economics of Effective Management

Recognize the Nature and

Importance of Profits
• The role of profits
– Profits are a signal to resource holders where
resources are most highly valued by society.

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 The Economics of Effective Management

Five Forces and Industry Profitability

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 The Economics of Effective Management

Understand Incentives
• Changes in profits provide an incentive to how
resource holders use their resources.
• Within a firm, incentives impact how
resources are used and how hard workers
work.
– One role of a manager is to construct incentives to
induce maximal effort from employees.

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 The Economics of Effective Management

Understand Markets
• Two sides to every market transaction: buyer
and seller
• Bargaining position of consumers and
producers is limited by three rivalries in
economic transactions:
– Consumer-producer rivalry
– Consumer-consumer rivalry
– Producer-producer rivalry
• Government and the market

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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.
• Out-bid or under-bid
• Producer-Producer Rivalry
– Scarcity of consumers causes producers to compete with one
another for the right to service customers.
• Better customer service, higher quality, perks…
• The Role of Government
– Disciplines the market process.
– Firms “tell on each other” to try to get the government to intervene
 The Economics of Effective Management

Recognize the Time Value of Money

• Often a gap exists between the time when
costs are borne and benefits received.
– Managers can use present value analysis to
properly account for the timing of receipts and
expenditures.

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In order to make decisions in the
future you need to know what the
future holds….

Is a dollar today worth the same as a

dollar in three years??
 The Economics of Effective Management

Present Value Analysis 1

•  Present value of a single future value
– The amount that would have to be invested today
at the prevailing interest rate to generate the
given future value:

* The present value (PV) of future value (FV)

received n years in the future, where i is the rate of
interest

– Present value reflects the difference between the

future value and the opportunity cost of waiting:
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Sample Problem 1

Solve for the present value of $100.00

in 10 years if the interest rate is 7
percent

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 The Economics of Effective Management

Present Value Analysis II

•  Present value of a stream of future values

or,

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 The Economics of Effective Management

The Time Value of Money in Action

• Consider
  a project that returns the following
income stream:
– Year 1, $10,000; Year 2, $50,000; and Year 3,
$100,000.
– At an annual interest rate of 3 percent, what is the
present value of this income stream?

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 The Economics of Effective Management

Net Present Value

• The
  present value of the income stream
generated by a project minus the current cost
of the project:

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 Sample Problem 2
The manager of Automated Products is contemplating
the purchase of a new machine that will cost $300,000
and has a useful life of five years. The machine will yield
(year-end) cost reductions to Automated Products of
$50,000 in year 1, $60,000 in year 2, $75,000 in year 3,
and $90,000 in year 4 & 5. What is the present value of
the cost of savings of the machine if the interest rate is 8
percent? Should the manager purchase the machine?

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 Economics of Effective Management

Present Value of Indefinitely Lived

Assets
• Present
  value of decisions that indefinitely
generate cash flows:

• Present value of this perpetual income stream

when the same cash flow is generated :

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Examples of Assets with Perpetual Stream
of Identical Cash flows

1. perpetual bonds and

2. preferred stocks.

Each of these assets pay the owner a fixed

amount at the end of each period, indefinitely.

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 Sample Problem
A perpetual bond pays the owner $100 at the
end of each year with the interest rate is fixed at
5%. Solve for Present Value of the perpetual
bond.

PV perpetual bond = CF
= $100
= $2,000
i .05

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 Economics of Effective Management

Present Value and Profit

Maximization
• Profit maximization
– Maximizing profits means maximizing the value of
the firm, which is the present value of current and
future profits.

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 Economics of Effective Management

Present Value and Estimating Values

of Firms I
• The
  value of a firm with current profits , with
no dividends paid out and expected, constant
profit growth rate of (assuming ) is:

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 Economics of Effective Management

Present Value and Estimating

Values of Firms II
• When
  dividends are immediately paid out of
current profits, the present value of the firm is
(at ex-dividend date):

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 Economics of Effective Management
Short-Term versus Long-Term
Profits
• Short-term and long-term profits
– If the growth rate in profits is less than the
interest rate and both are constant, maximizing
current (short-term) profits is the same as
maximizing long-term profits.

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 Sample Problem
Suppose the interest rate is 10% and the firm is
expected to grow at a rate of 5 percent for the
foreseeable future. The firm’s current profits are
$100 million.

a.) What is the value of the firm (the present value of

its current and future earnings)?

b.) What is the value of the firm immediately after it

pays dividend equal to its current profits?

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Solution to Demo Problem PV and
Estimating Values of the Firm

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 Economics of Effective Management

Use Marginal Analysis

marginal analysis
- states that optimal managerial decisions
involve comparing the marginal (or incremental)
benefits of a decision with the marginal (or
incremental) costs.

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 Example
For example, the optimal amount of studying for this course
is determined by comparing

(1) the improvement in your grade that will result from an

additional hour of studying and

(2) the additional costs of studying an additional hour.

So long as the benefits of studying an additional hour exceed

the costs of studying an additional hour, it is profitable to
continue to study. However, once an additional hour of
studying adds more to costs than it does to benefits, you
should stop studying.
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 Economics of Effective Management

Use Marginal Analysis

• How
  can the manager maximize net benefits?
• Use marginal analysis
– Marginal benefit:
• The change in total benefits arising from a change in
the managerial control variable, .
– Marginal cost:
• The change in the total costs arising from a change in
the managerial control variable, .
– Marginal net benefits:

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• Given
  a control variable, , of a managerial
objective, denote the
– total benefit as .
– total cost as .
• Manager’s objective is to maximize net benefits:

– units of some variable that is within the manager’s

control

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 Example
 Forexample, the optimal amount of studying for this course
is determined by comparing

(1) the improvement in your grade that will result from an

additional hour of studying and

(2) the additional costs of studying an additional hour.

So long as the benefits of studying an additional hour (B(Q))

exceed the costs of studying an additional hour (), it is
profitable to continue to study. However, once an additional
hour of studying adds more to costs than it does to benefits,
you should stop studying.
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 Economics of Effective Management

Use Marginal Analysis

• Marginal principle
– To maximize net benefits, the manager should
increase the managerial control variable up to
the point where marginal benefits equal marginal
costs. This level of the managerial control
variable corresponds to the level at which
marginal net benefits are zero; nothing more can
be gained by further changes in that variable.

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 Determining the Optimal Level of a Control
Variable : The Discrete Case

In the context of a production decision, Q may be the

number of gallons of soft drink produced. The manager
must decide how many gallons of soft drink to produce
(0,1, 2, and so on), but cannot choose to produce
fractional units (for example, one pint). Column 2 of
Table 1–1 provides hypothetical data for total benefits;
column3 gives hypothetical data for total costs.
Suppose the objective of the manager is to maximize
the net benefits which represent the premium of total
benefits over total costs of using Q units of the
managerial control variable, Q.
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 Illustration

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 Economics of Effective Management

Incremental Decisions
•  Incremental revenues
– The additional revenues that stem from a yes-or-
no decision.
• Incremental costs
– The additional costs that stem from a yes-or-no
decision.
• “Thumbs up” decision
–.
• “Thumbs down” decision
–.
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 Incremental Decisions Illustration
Imagine that you are the CEO of Slick Drilling Inc.
and you must decide whether or not to drill for
crude oil around the Twin Lakes area in Michigan.
You are relatively certain there are 10,000 barrels
of crude oil at this location.

An accountant working for you prepared the

information in Table 1–2 to help you decide
whether or not to adopt the new project.

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 Group work 1

Amcott Loses $3.5 Million; Manager Fired

On Tuesday software giant Amcott posted a year-end operating loss of $3.5 million.
Reportedly, $1.7 million of the loss stemmed from its foreign language division.

With short-term interest rates at 7 percent, Amcott decided to use $20 million of its
retained earnings to purchase three-year rights to Magicword, a software package that
converts generic word processor files saved as French text into English. First-year
sales revenue from the software was $7 million, but thereafter sales were halted pending
a copyright infringement suit filed by Foreign, Inc. Amcott lost the suit and paid
damages of $1.7 million. Industry insiders say that the copyright violation pertained to “a
very small component of Magicword.” Ralph, the Amcott manager who was fired over
the
incident, was quoted as saying, “I’m a scapegoat for the attorneys [at Amcott] who didn’t
do their homework before buying the rights to Magicword. I projected annual sales of $7
million per year for three years. My sales forecasts were right on target.”

Why Ralph was fired?

Show the basis for your answer.
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 Learning Managerial Economics

Learning Managerial Economics

• Practice, practice, practice …
• Learn terminology
– Break down complex issues into manageable
components.
– Helps economics practitioners communicate
efficiently.

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