1. 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.

2. Overview I. Introduction II. The Economics of Effective Management
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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

3. Managerial Economics Manager Economics Managerial Economics
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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.

4. Identify Goals and Constraints
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Identify Goals and Constraints
Effective management
Sound decision making involves having well-defined goals.
Leads to making the “right” decisions.
Maximizing profits or the value of the firm.
In striving to achieve a goal, we often face constraints.
Constraints are an artifact of scarcity.
Various parts of the firm may seek to achieve differing goals.
The manager unifies disparate goals into a corporate goal.

5. Economic vs. Accounting Profits
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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.

6. Opportunity Cost Accounting Costs Opportunity Cost Economic Profits
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Accounting Costs
The explicit costs of the resources needed to produce 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.

7. 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.

8. The Five Forces Framework
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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

9. Understanding Firms’ Incentives
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Understanding Firms’ Incentives
Profits are the ultimate incentive.
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.

10. Understanding Firms’ Incentives
Agent versus principal problem
Incentive plans – profit sharing, commissions
How to structure appropriate incentives?
Assume self-interested employees

11. Understanding Markets
Final outcome of the market process depends on the relative power (bargaining position) of buyers and sellers.
Three sources of rivalry in economic transactions each serving as a disciplinary device to guide the market process:
Consumer-producer
Consumer-consumer
Producer-producer

12. Market Interactions Consumer-Producer Rivalry
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Market Interactions
Consumer-Producer Rivalry
Consumers attempt to locate low prices, while producers attempt to charge high prices. Demand function serves as a guide
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. Best quality at lowest price wins.
The Role of Government
Disciplines the market process.

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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”:
Example:
What is the maximum you would pay for an asset that generates an income of $150,000 at the end of each of five years given the opportunity cost of using funds is 9 percent?
The higher the interest rate the lower the PV.

14. Present Value vs. Future Value
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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.

15. Present Value of a Series
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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,

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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

17. Present Value of a Perpetuity
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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. E.g. Perpetual bonds, preferred stocks.
The present value (PV) of a perpetuity of cash flows paying the same amount (CF = CF1 = CF2 = …) at the end of each period is

18. Firm Valuation and Profit Maximization
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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.

19. Firm Valuation With Profit Growth
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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.
Example Baye 7th page 18.

20. Firm Valuation With Profit Growth
The previous assumes that growth rate is constant.
More realistically investment and marketing strategies will affect growth rate.
Market actions of competitors will also affect the growth rate of the firm.

21. Marginal (Incremental) Analysis
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Optimal managerial decisions involve comparing the marginal benefits vs marginal costs.
Control Variable Examples:
Output
Product Quality
Advertising
R&D
Basic Managerial Question: How much of the control variable should be used to maximize net benefits?

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

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

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

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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.

26. Marginal Principle
The goal of maximizing net benefits takes costs into account.
The goal of maximizing total benefits does not.
Maximizing total benefits w/o regard to costs is not a goal of the firm.

27. Differentiating a Function
An engineering firm conducted a study to determine its benefit and cost structure. The results of the study were:
B(Y) = 300Y – 6Y2
C(Y) = 4Y2
 The manager has been asked to determine the maximum level of net benefits and the level of Y that will yield that result.
Solution:
MB = Y
MC = 8Y
Equating MB and MC yields 300 – 12Y = 8Y. Solving the equation for Y reveals that the optimum level of Y is Y* = 15. Plugging Y* = 15 into the net benefit relation yields the maximum level of net benefits:
NB = 300(15) – 6(152) – 4(152) = 2250

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

29. The Geometry of Optimization: Net Benefits
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The Geometry of Optimization: Net Benefits
Net Benefits Q
Maximum net benefits
Slope = MNB Q*

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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).