1. 1 © 2006 by Nelson, a division of Thomson Canada Limited Slides developed by: William Rentz & Al Kahl University of Ottawa Chapter 1 Introduction and Goals of the Firm

2. 2 © 2006 by Nelson, a division of Thomson Canada Limited Topics What is Managerial Economics Decision-Making Process Objectives of the Firm Role of Profits Agency Problems & Solutions Vision, Mission, and Strategy Porter’s Five Forces Not-for-Profit Organizations

3. 3 © 2006 by Nelson, a division of Thomson Canada Limited 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.

4. 4 © 2006 by Nelson, a division of Thomson Canada Limited 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 Major Topics

5. 5 © 2006 by Nelson, a division of Thomson Canada Limited

6. 6 Objectives of the Firm Profit maximization Market Value Added = market value of all shares minus the book value of all shares. This is the present value of expected future profits  or cash flows, discounted at the shareholders required rate of return, k e, ignoring taxes.  Market Value Added =   t /(1+k e ) t t=1

7. 7 © 2006 by Nelson, a division of Thomson Canada Limited Market Value Added = the present value of expected economic profits discounted at shareholders’ required rate of return n  (  t ) / (1+k e ) t = t=1 n  (P t Q t – V t Q t – F t ) / (1+k e ) t t =1 Whatever lowers the perceived risk of the firm (k e ) will also raise firm value. Whatever raises the price of the product (P t ) or the quantity sold (Q t ) will raise firm value. Whatever raises variable cost (V t ) or fixed cost (F t ) will reduce firm value. Firm Value

8. 8 © 2006 by Nelson, a division of Thomson Canada Limited To make good economic decisions, managers need to be able to forecast & estimate relationships Forecasting demand (both P t & Q t ) »applies to for-profit corporations »non-profit organizations Hospital Administrators -- # patients University Administrator -- enrolment Regression analysis, time series methods, and qualitative forecasting methods used for forecasting

9. 9 © 2006 by Nelson, a division of Thomson Canada Limited 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).

10. 10 © 2006 by Nelson, a division of Thomson Canada Limited Factors Affecting Stock Prices Economic Environment Factors 1.Economic Activity 2.Tax Rates & Regulations 3.Competition 4.Laws and Governmental Regulation 5.Unionization 6.International Conditions & Exchange Rates Major Policy Decisions Under Management Control 1.Products or Services Offered 2.Production Technology 3.Marketing and Distribution Network Used 4.Investment Strategies 5.Employment & Compensation Policies 6.Ownership Form 7.Capital Structure Used 8.Working Capital Management Policies 9.Dividend Policies 10.Alliances, mergers, spin-offs Amount, Timing, and Risk of Expected Profits Shareholder Wealth (The Market Price of the Share) Conditions in Financial Markets 1.Interest Rates 2.Investor Sentiment 3.Expected Inflation

11. 11 © 2006 by Nelson, a division of Thomson Canada Limited 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. Agency Problems

12. 12 © 2006 by Nelson, a division of Thomson Canada Limited Shareholders (principals) want profit Managers (agents) want leisure & security »Examples KKR’s takeover of RJR Nabisco to refocus on wealth-maximization The LBO by O.M. Scott (a lawn fertilizer company) from ITT improved Scott’s performance Principal-Agent Problem

13. 13 © 2006 by Nelson, a division of Thomson Canada Limited Solutions to Agency Problems Compensation as incentive Extending to all workers stock options, bonuses, and grants of shares 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.

14. 14 © 2006 by Nelson, a division of Thomson Canada Limited Vision, Mission, and Strategy Vision statement indicates what the firm strives to achieve in the long term – what it wants to become. Mission statement indicates what business the firm is in now – what it is. Strategy is the firm’s plan for getting from where it is now to where it wants to be in the future – how it will compete.

15. 15 © 2006 by Nelson, a division of Thomson Canada Limited The 5 forces that determine competitive advantage are: 1.Substitutes 2.Potential Entrants 3.Buyer Power 4.Supplier Power 5.Intensity of Rivalry Michael Porter’s Five Forces of Competitive Advantage

16. 16 © 2006 by Nelson, a division of Thomson Canada Limited Substitutes Value-price gap Branded vs. generic Intensity of rivalry Industrial concentration Pricing tactics Switching costs Exit barriers Cost fixity Industrial growth rates Supplier power Unique suppliers Number of suppliers Supply shortages or surplus Degree of vertical integration Buyer power Buyer concentration Overcapacity Homogeneity of buyers Potential of integration Outside alternatives Potential entrants High capital requirements Economies of scale Absolute cost advantages High switching costs Lack of access to distribution channels Product differentiation Public policy constraints Sustainable industry profitability Five Forces Framework

17. 17 © 2006 by Nelson, a division of Thomson Canada Limited 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.  Instead of profit, NFP organizations may have as their goals: 1.Maximization of output, subject to a budget constraint. 2.Maximization of the utility of NFP administrators. 3. Maximization of cash flows. 4. Maximization of the utility of contributors to the NFP organization.

18. 18 © 2006 by Nelson, a division of Thomson Canada Limited Which goal a NFP manager selects affects decisions made. »A food bank manager may maximize the utility of clients by selecting only "healthy foods" Public sector managers are performance monitored. »Hospital administrators are rewarded for 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.