Managerial Economics & Business Strategy Chapter 1 The Fundamentals of Managerial Economics McGraw-Hill/Irwin Michael R. Baye, Managerial Economics and Business Strategy Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.

Overview I. Introduction II. The Economics of Effective Management 1-2 Overview I. Introduction II. The Economics of Effective Management Identify Goals and Constraints Recognize the Role of Profits Five Forces Model Understand Incentives Understand Markets Recognize the Time Value of Money Use Marginal Analysis

Managerial Economics Manager Economics Managerial Economics 1-3 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. Managerial Economics The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.

Identify Goals and Constraints 1-4 Identify Goals and Constraints Sound decision making involves having well-defined goals. Leads to making the “right” decisions. In striking to achieve a goal, we often face constraints. Constraints are an artifact of scarcity.

Economic vs. Accounting Profits 1-5 Economic vs. Accounting Profits Accounting Profits Total revenue (sales) minus dollar cost of producing goods or services. Reported on the firm’s income statement. Economic Profits Total revenue minus total opportunity cost.

Opportunity Cost Accounting Costs Opportunity Cost Economic Profits 1-6 Accounting Costs The explicit costs of the resources needed to produce goods or services. Reported on the firm’s income statement. Opportunity Cost The cost of the explicit and implicit resources that are foregone when a decision is made. Economic Profits Total revenue minus total opportunity cost.

1-7 Profits as a Signal Profits signal to resource holders where resources are most highly valued by society. Resources will flow into industries that are most highly valued by society.

The Five Forces Framework 1-8 Sustainable Industry Profits Power of Input Suppliers Supplier Concentration Price/Productivity of Alternative Inputs Relationship-Specific Investments Supplier Switching Costs Government Restraints Buyers Buyer Concentration Price/Value of Substitute Products or Services Customer Switching Costs Entry Entry Costs Speed of Adjustment Sunk Costs Economies of Scale Network Effects Reputation Switching Costs Substitutes & Complements Price/Value of Surrogate Products or Services Price/Value of Complementary Products or Services Industry Rivalry Timing of Decisions Information Concentration Price, Quantity, Quality, or Service Competition Degree of Differentiation

Understanding Firms’ Incentives 1-9 Understanding Firms’ Incentives Incentives play an important role within the firm. Incentives determine: How resources are utilized. How hard individuals work. Managers must understand the role incentives play in the organization. Constructing proper incentives will enhance productivity and profitability.

Market Interactions Consumer-Producer Rivalry 1-10 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. Producer-Producer Rivalry Scarcity of consumers causes producers to compete with one another for the right to service customers. The Role of Government Disciplines the market process.

1-11 The Time Value of Money Present value (PV) of a future value (FV) lump-sum amount to be received at the end of “n” periods in the future when the per-period interest rate is “i”: Examples: Lotto winner choosing between a single lump-sum payout of $104 million or $198 million over 25 years. Determining damages in a patent infringement case.

Present Value vs. Future Value 1-12 Present Value vs. Future Value The present value (PV) reflects the difference between the future value and the opportunity cost of waiting (OCW). Succinctly, PV = FV – OCW If i = 0, note PV = FV. As i increases, the higher is the OCW and the lower the PV.

What does the consumer’s intertemporal problem look like? At the tangency of U1 and the budget constraint, W, we get equilibrium consumption of Co, as Co*, and equilibrium future consumption, C1* Future Consumption C1 Intertemporal utility or Indifference curves W/P1 U2 C1* The consumer maximizes intertemporal utility over current and future consumption given the budget constraint, which is the limit on wealth U1 U3 W = Co + P1C1 W Co* Current Consumption Co

Intertemporal optimization (optimization over time) -- the problem Max U(Co) + 1/(1+)U(C1), subject to the wealth constraint, W = Co + C1/(1+ r), because P1 = 1/(1 + r), and r = interest rate and  is our time preference rate (or how impatient we are for returns over time) We are maximizing intertemporal economic welfare subject to our wealth constraint W = Co – C1/(1+r)

Suppose a two-period problem (optimization over time) -- today relative to tomorrow Max U(Co) + 1/(1+)U(C1), subject to the wealth constraint, W = Co + C1/(1+ r) Let’s say U = LN (logarithmic utility),  =3%, and r = 9%, and grandma left you ￥400,000 We would solve this problem using something like Excel --- using the solver in Excel would work --- enter the utility function as the objective function --- and the wealth constraint as a constraint --- then solve

Intertemporal optimization (optimization over time) -- the problem Max U(Co) + 1/(1+)U(C1), subject to the wealth constraint, W = Co + C1/(1+ r), because P1 = 1/(1 + r) The Lagrangian with the objective function, Max U(Co) + 1/(1+)U(C1), and constraint, W = Co + C1/(1+ r) is: L = U(Co) + 1/(1+)U(C1) + λ[W – Co – C1/(1+r) Well, we would have to use this solution concept --- but we can use EXCEL’s Solver see EXCEL file INTERTEMP U

Present Value of a Series 1-17 Present Value of a Series Present value of a stream of future amounts (FVt) received at the end of each period for “n” periods: Equivalently,

SOME FURTHER EXPLANATION ON PRESENT VALUE COMPONENTS PRESENT VALUE OF AN AMOUNT PV = S[ 1 / (1 + i )t ] THE BRACKETED TERM [ 1 / (1 + i )t ] IS THE PRESENT VALUE OF $1 IN t PERIODS, WHERE i IS THE INTEREST RATE THE TERM [ 1 / (1 + i )t ] IS CALLED THE PRESENT –VALUE INTEREST FACTOR OR PVIFi , t

WHAT IS THE PRESENT VALUE OF $1,080 ? AN EXAMPLE WHAT IS THE PRESENT VALUE OF $1,080 ? IN ONE YEAR IF THE INTEREST RATE IS 8 % PER YEAR? SO i = 8 % OR 0.08, AND t = 1 PV = $1,080[ 1/(1.08)1] = $1,000 ---- NOTICE, THAT PV = FV/ (1 + i )t SO FV = PV(1+ i ) t THEREFORE NOTE THAT $1,000 IN 1 YEAR AT 8% WOULD INCREASE TO $1,080

LET’S GO A BIT FURTHER ON THIS CONCEPT: WHAT IS THE PRESENT VALUE OF €100,000 TO BE RECEIVED AT THE END OF 10 YEARS IF THE INTEREST RATE, i = 10% ? PV = €100,000[ 1 / (1.10)10] SO DO THE MATH, AND WE GET PV = €38,550 HOW DID WE DO THAT? WELL, USE A CALCULATOR OR, IF YOU ARE GOOD AT EXPONENTIATION, THEN IT ALL COMES OUT OK

OR, WE COULD USE A PRESENT VALUE TABLE --- AN EXAMPLE IS GIVEN BELOW PVIFi, t = 1/(1+ i )t 0.3855 INTEREST RATE PERIODS 8% 10% 12% 1 0.9259 0.9091 0.8929 2 0.8573 0.8264 0.7972 3 0.7938 0.7513 0.7118 4 0.7350 0.6830 0.6355 6 0.6302 0.5645 0.5066 8 0.5403 0.4665 0.4039 10 0.4632 0.3855 0.3220 TAKEN FROM: Vichas, Robert P. 1979. Handbook of Financial Mathematics, Formulas and Tables. Englewood Cliffs, N. J., Prentice Hall.

THEN, PICKING THE VALUE FOR 10% AND 10 PERIODS, WE GET 0.3855 SO PV = €100,000(0.3855) = €38,550 -------------------------------------------------------------- OF COURSE WE COULD SOLVE THIS PRESENT VALUE USING EXCEL = 100000*(1/(1.1)^10), WHICH WOULD GIVE US THE VALUE OF 38554.33 TO BE EXACT!! WHY THE DIFFERENCE? THE TABLE ABOVE GIVES US “ROUNDED” FACTORS, SUCH AS 0.3855 THAT WE USED ---- WE COULD ALSO USE =100000*(1.10^-10) TO ALSO GET THE 38554.33 VALUE

PRESENT VALUE OF AN ANNUITY THE PRESENT VALUE OF AN ANNUITY CAN BE THOUGHT OF AS THE SUM OF THE PRESENT VALUES OF EACH OF SEVERAL AMOUNTS PVA = 100(1/1.10), PVB = 100(1/1.102), PVC = 100(1/1.103, ETC. SO SUM THESE UP AS, PV = 100(1/1.10) + 100(1/1.102) + 100(1/1.103) OR PV = 100 [1/1.10 + 1/1.102 + 1/1.103 ] SUBSTITUTE THE APPROPRIATE PVIF FACTORS FROM THE TABLE ABOVE TO GET PV =100(0.9091 + 0.8264 + 0.7513) = 100(2.4868)  248.68

USING EXCEL, = PV(RATE, NPER, PV,(FV),TYPE), WHICH FOR OUR EXAMPLE WOULD BE: =PV(0.10,3,-100) SKIPPING (FV), TYPE WHICH GIVES 248.69, AGAIN DIFFERENT BECAUSE OF ROUNDING OF THE FACTORS IN THE TABLE OF COURSE THIS CAN BE DONE VIA CALCULATOR

SOME SELECTED PRESENT VALUE ANNUITY FACTORS ARE: SO THE PRESENT VALUE OF AN ANNUITY IS GIVEN BY PV = (AMOUNT)t[1/(1+ i )t ] THE TERM t MEAN SUM OVER VALUES OF t, WHICH IS THE SUM OVER ALL THE PERIODS INVOLVED THE TERM t [1 / (1 + i ) t ] IS CALLED THE PRESENT-VALUE ANNUITY FACTOR, OR PVAFi , t SOME SELECTED PRESENT VALUE ANNUITY FACTORS ARE: INTEREST RATE PERIODS 1% 2% 3% 12 11.2551 10.5753 9.9540 24 21.2434 18.9139 16.9355 30 25.8077 22.3965 19.6004

SO, IF WE DESIRED TO FIND THE PRESENT VALUE OF £150 PAYMENTS OVER 30 MONTHS AT 24%, THEN WE GET PV = £150[ t = 130 (1/1.02)t] = 150(22.3965) = £3,359 WHY? INTEREST IS ANNUAL, BUT THE PAYMENTS ARE MONTHLY ---- SO WE NEED A MONTHLY INTEREST RATE ---- OR 24%/12 = 2%, AND IN THE TABLE AT 30 PERIODS THE PVAF IS 22.3965 BY USING EXCEL WE GET =PV(0.02,30,-150) = £3,359.47 TO BE EXACT

NPV > 0: Accept project 1-27 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 Decision Rule: If NPV < 0: Reject project NPV > 0: Accept project

Present Value of a Perpetuity 1-28 Present Value of a Perpetuity An asset that perpetually generates a stream of cash flows (CFi) at the end of each period is called a perpetuity. The present value (PV) of a perpetuity of cash flows paying the same amount (CF = CF1 = CF2 = …) at the end of each period is

Firm Valuation and Profit Maximization 1-29 Firm Valuation and Profit Maximization The value of a firm equals the present value of current and future profits (cash flows). A common assumption among economist is that it is the firm’s goal to maximization profits. This means the present value of current and future profits, so the firm is maximizing its value.

Firm Valuation With Profit Growth 1-30 Firm Valuation With Profit Growth If profits grow at a constant rate (g < i) and current period profits are po, before and after dividends are: Provided that g < i. That is, the growth rate in profits is less than the interest rate and both remain constant.

Marginal (Incremental) Analysis 1-31 Control Variable Examples: Output Price Product Quality Advertising R&D Basic Managerial Question: How much of the control variable should be used to maximize net benefits?

Net Benefits Net Benefits = Total Benefits - Total Costs 1-32 Net Benefits Net Benefits = Total Benefits - Total Costs Profits = Revenue - Costs

1-33 Marginal Benefit (MB) Change in total benefits arising from a change in the control variable, Q: Slope (calculus derivative) of the total benefit curve.

1-34 Marginal Cost (MC) Change in total costs arising from a change in the control variable, Q: Slope (calculus derivative) of the total cost curve

1-35 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.

The Geometry of Optimization: Total Benefit and Cost 1-36 The Geometry of Optimization: Total Benefit and Cost Total Benefits & Total Costs Costs Benefits Q Slope =MB B Slope = MC C Q*

The Geometry of Optimization: Net Benefits 1-37 The Geometry of Optimization: Net Benefits Net Benefits Q Maximum net benefits Slope = MNB Q*

1-38 Conclusion 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).