Lecture one © copyright ： qinwang 2013 Qinwang@mail.shufe.edu.cn SHUFE school of international...

Lecture one

© copyright ： qinwang 2013

Qinwang@mail.shufe.edu.cn  

SHUFE  school of international business

Outline

What is managerial economics Objectives of the firm Analysis methods Risk and uncertainty Agency Problems & Solutions

Resource allocation Organization activity

The nature of managerial economics

Economics Management

Economic Theory

Economic theory helps managers understand real-world business problems Uses simplifying assumptions to turn

complexity into relative simplicity

The Main Problem in Economy Limited resources Unlimited wants

Limit personal wants ? Get more resources?

Resource allocation: How to use limited resources to satisfy

unlimited wants.

What would you do?

Economics

What ？How much ？

For who ？

When Where

How

Resource scarcity---Economic-cost and revenue ---Decision

What Does “Managerial Economics” Do?

Help manager to make business decision on the economic perspective and use micro-economic theory to make your decision effectively.

Managerial Economics

Integrates the use of economics, math, and financial analysis to make good business decisions

Managerial economics

EconomicManagement

Decision technique

Business decision

Objectives of the firm

The Nature of the Firm Division of labor advantage theory Transaction cost theory

The boundary of the firm Case: GM and Fisher (auto-parts producer )

Knowledge theory

Objectives of the firm Profit maximization:

Short-term profit? Long-term profit?

1 22

11 1 1 1( ) ( ) ( ) ( )

TT T

T tt

...r r r r

Shareholder wealth maximizationThe value of the firm =V0 (shares outstanding), is the present value of expected future profits or cash flows, discounted at the shareholders required rate of return, Ke, ignoring taxes.

V0 (shares outstanding) = t /(1+Ke) t

t=1

Profit: = TR - TC = P•Q - TC

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.

Why Profit Varies Across Industries?Why Profit Varies Across Industries?

Risk-bearing theory Dynamics equilibrium (or frictional, temporary

disequilibrium) theory of profit Monopoly theory of profit Innovation theory of profit Managerial efficiency theory of profit

Analysis methods

1.Marginal perspective : :“It is valuable？”

The flight is traveling from city A to city B, Total cost of every seat is $250. When there are still some seats available (vacancies)，would you like sell them to students for $150？

2. Maximum perspective: The more the better?

Wheat plant and fertilizer: PPfertilizerfertilizer==30, Pwheatwheat=15,

How much fertilizer per Mu to get profit maximum for the farmer？

Quantity of fertilizer/mu

Production

(unit)

Marginal production

0 20 --

1 30 10

2 38 8

3 43 5

4 46 3

5 48 2

6 49 1

7 49 0

Marginal Revenue = Marginal Cost

profit=TR-TC=15×48-30 ×5=570

Quantity of fertilizer

Marginal revenue ( ￥ )

Marginal cost Marginal profit

0 --

1 150 30 120

2 120 30 80

3 75 30 45

4 45 30 15

5 30 30 0

6 15 30 -15

7 0 30 -30

3. Game Analysis

Prisoner dilemma

Prisoner B

honest Not honest

honest - 5 ， - 5 - 1 ， - 10 Prisoner A Not honest - 10 ， - 1 - 2 ， - 2

Two Auto’s Price Decision

Products of Auto Firm I and Firm II have no difference， Price is the main factor in competition

Profit ： Million

Firm II

High price Low price

Firm

I

High price

500 ， 500 100 ， 700

Low

price

700 ， 100 300 ， 300

Risk, uncertainty and information

Risk and uncertainty Risk reference Information asymmetry and decision

Economic Decisions

CONSTRAINTS

INFORMATION

GOALS & OBJECTIVES

Risk vs. Uncertainty Risk

Must make a decision for which the outcome is not known with certainty

Can list all possible outcomes & assign probabilities to the outcomes

Uncertainty Cannot list all possible outcomes Cannot assign probabilities to the

outcomes

Expected Value Expected value (or mean) of a

probability distribution is:

1

n

i ii

E( X ) Expected value of X p X

Where Xi is the ith outcome of a decision,

pi is the probability of the ith outcome, and

n is the total number of possible outcomes

Economic situation

Probability ROI: rate of return on investment(%)

Case one（ Treasury bonds ）

Case two（ Corporate bond )

Case three(Stock market)

Depression 0.2 8.0 10.0 -2.0

Normal 0.5 8.0 9.0 11.0

Prosperous 0.3 8.0 8.0 19.0

Expected value

1 8.0 8.9 10.8

The person has one million to invest for one year.

Variance Variance is a measure of absolute risk

Measures dispersion of the outcomes about the mean or expected outcome

• The higher the variance, the greater the risk associated with a probability distribution

2 2

1

n

X i ii

Variance(X) = p ( X E( X ))

Identical Means but Different Variances

Decisions Under Risk No single decision rule guarantees

profits will actually be maximized Decision rules do not eliminate risk

Provide a method to systematically include risk in the decision making process

Expected value rule

Mean-variance rules

Coefficient of variation rule

Summary of Decision Rules Under Conditions of Risk

Choose decision with highest expected value

Given two risky decisions A & B:• If A has higher expected outcome & lower variance than B, choose decision A• If A & B have identical variances (or standard deviations), choose decision with higher expected value• If A & B have identical expected values, choose decision with lower variance (standard deviation)

Choose decision with smallest coefficient of variation

Which Rule is Best? For a repeated decision, with identical probabilities

each time Expected value rule is most reliable to maximizing

(expected) profit Average return of a given risky course of action

repeated many times approaches the expected value of that action

For a one-time decision under risk No repetitions to “average out” a bad outcome No best rule to follow

Rules should be used to help analyze & guide decision making process As much art as science

Decisions Under Uncertainty

With uncertainty, decision science provides little guidance Four basic decision rules are provided to

aid managers in analysis of uncertain situations

Maximax rule

Maximin rule

Minimax regret rule

Equal probability rule

Summary of Decision Rules Under Conditions of Uncertainty

Identify best outcome for each possible decision & choose decision with maximum payoff.

Determine worst potential regret associated with each decision, where potential regret with any decision & state of nature is the improvement in payoff the manager could have received had the decision been the best one when the state of nature actually occurred. Manager chooses decision with minimum worst potential regret.

Assume each state of nature is equally likely to occur & compute average payoff for each. Choose decision with highest average payoff.

Identify worst outcome for each decision & choose decision with maximum worst payoff.

Risk averse If faced with two risky decisions with

equal expected profits, the less risky decision is chosen

Risk loving Expected profits are equal & the more

risky decision is chosen Risk neutral

Indifferent between risky decisions that have equal expected profit

Manager’s Attitude Toward Risk

Thrown a coin for one time, the flower is upward, you get 1000 ， the flower is downward,

you loss 1000.

Coin game

How to reduce risk or shift risk? Search for more

Information diversification Insurance

Information asymmetry and decision

The type of information asymmetry：

Asymmetry before contract: adverse selection

Asymmetry after contract: moral hazard

Adverse Selection

You spent 200000 RMB in buying a car 3 months ago. Now you want to sell the car. (the mileage of the car is 7500 km. The car is good in quality.

How much is the car worth of? (value) How much can it be sold in second-

hand market? (price)

Lemon market In markets where it is

impossible to asses the quality of a product/service, where, so to say the seller of the product has more information than the buyer, the market will gradually deteriorate and maybe even eventually disappear altogether

George Akerlof 2001 Nobel Memorial Prize in Economic Sciences

Second-hand car

The insurance market An person's demand for insurance is positively corr

elated with his risk of loss, the insurer is unable to allow for this correlation in the price of insurance. This may be because of private information known only to the person himself。

Signaling model

Labor-market Product–market ……

What would you do when faced adverse selection

Michael Spence 2001 Nobel Memorial Prize in Economic Sciences

What would you do when faced with adverse selection

Screening model,

A technique used by one economic agent to extract otherwise private information from another.

Joseph E. Stiglitz2001 Nobel Memorial Prize in Economic Sciences

Principal-agent theory

Agent ： have more information Principal ： have less information

Example: Corporate governance: shareholder and m

anagers Insurance market: insurer and insured

The Principal-Agent Problem Shareholders (principals) want profit Managers (agents) want leisure & security

Shareholder Wealth Maximization: Conditions COMPLETE MARKETS - liquid markets for firm's inputs and by-

products (including polluting by-products). NO SIGNIFICANT ASYMMETRIC INFORMATION - buyers and

sellers all know the same things. KNOWN RECONTRACTING COSTS future input costs are part of

the present value of expected cash flows.

Solutions to Agency Problems

Incentive (wages and stock option） Extending to all workers stock options, bonuses, and grants of st

ock. Help make workers act as owners of firm Residual claimants: shareholder have a residual claims on the fir

m’s net cash flows after all expected contractual returns have been paid.

Detailed contract Reputation (professional manager market)

Goals in the Public Sector and the Not-For-Profit (NFP) Enterprise

Instead of profit, NFP organizations may have as their goals:1. Maximization of the quantity of output,

subject to a breakeven constraint.2. Maximization of the utility (happiness) of

NFP administrators.3. Maximization of cash flows.4. Maximization of the utility of contributors to the NFP

organization.

Questions??