Managerial Economics & Business Strategy

Chapter 1
The Fundamentals of Managerial Economics

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999

Overview
I. Introduction II. The Economics of Effective Management

Identify Goals and Constraints Recognize the Role of Profits Understand Incentives Understand Markets Recognize the Time Value of Money Use Marginal Analysis

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999

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

Managerial Economics

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999

Economic vs. Accounting Profits

Accounting Profits

Total revenue (sales) minus dollar cost of producing goods or services Reported on the firms income statement Total revenue minus total opportunity cost

Economic Profits

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999

Opportunity Cost
Accounting Costs

The explicit costs of the resources needed to produce produce goods or services Reported on the firms income statement The cost of the explicit and implicit resources that are foregone when a decision is made Total revenue minus total opportunity cost

Opportunity Cost

Economic Profits

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999

Market Interactions
Consumer-Producer Rivalry

Consumers attempt to locate low prices, while producers attempt to charge high prices Scarcity of goods reduces the negotiating power of consumers as they compete for the right to those goods Scarcity of consumers causes producers to compete with one another for the right to service customers Disciplines the market process
Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999

Consumer-Consumer Rivalry

Producer-Producer Rivalry

The Role of Government

The Time Value of Money

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

FV PV n 1 i
Examples?
Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999

Present Value of a Series

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

FV1 FV2 FVn PV 1 2 ... n 1 i 1 i 1 i

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999

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

FV1 FV2 FVn NPV C0 1 2 ... n 1 i 1 i 1 i

NPV < 0: Reject NPV > 0: Accept

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999

Firm Valuation
The value of a firm equals the present value of all its future profits

PV = S pt / (1 + i)t PV = po 1i) / ( i - g), po current profit level.

If profits grow at a constant rate, g < i, then:

Maximizing Short-Term Profits

If the growth rate in profits < interest rate and both remain constant, maximizing the present value of all future profits is the same as maximizing current profits.
Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999

Marginal (Incremental) Analysis

Control Variables

Output Price Product Quality Advertising R&D

Basic Managerial Question: How much of the control variable should be used to maximize net benefits?
Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999

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

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999

Maximizing Net Benefit

(1) Control Variable Z 0 1 2 3 4 5 6 7 8 9 10 (2) Total Benefits B(Z) 0 200 380 540 680 800 900 980 1,040 1,080 1,100 (3) Total Costs C(Z) 0 10 30 60 100 150 210 280 360 450 550 190 350 480 580 650 690 700 680 630 550 (4) Net Benefits N(Z) 0 (5) Marginal Benefit MB(Z) (6) Marginal Cost MC(Z) (7) Marginal Net Benefit MNB(Z)

-200 180 160 140 120 100 80 60 40 20

-10 20 30 40 50 60 70 80 90 100

-190 160 130 100 70 40 10 -20 -50 -80

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999

Marginal Benefit (MB)

Change in total benefits arising from a change in the control variable, Q:
MB = DB / DQ

Slope (calculus derivative) of the total benefit curve

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999

Marginal Cost (MC)

Change in total costs arising from a change in the control variable, Q:
MC = DC / DQ

Slope (calculus derivative) of the total cost curve

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999

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
Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999

The Geometry of Optimization

Benefits & Costs Slope =MB Costs Benefits

B C Slope = MC

Q*

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999

Summary
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)

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999