Ch1 Intro Me Sem2

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CHAPTER 1

THE FUNDAMENTALS OF MANAGERIAL ECONOMICS

Managerial Economics &

Business Strategy

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.



Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsr rv d.

What are the roles of a manager?

yWhat managerial economic d ecisions d oes a manager make??




PURPOSE OF USING MANAGERIALPURPOSE OF USING MANAGERIAL

ECONOMICS TOOLS:ECONOMICS TOOLS:

y Shape pricing and output decisions

y Optimize production process and input mix

y Choose product quality

y Guide horizontal and vertical merger decisions

y Optimally design internal and external incentives




Managerial economics are useful for both

profit making companies

and

Not-for ±profit organization

(coordinate shelter for homeless, decide best

means for distributing food to the needy)




Managerial EconomicsManagerial Economics

y

.

y

.

y

.




MANAGER

y A person who directs resources to achieve

stated goal. Includes those who:

Direct effort of others-delegate tasks

Purchase inputs to be used in production In charge of making other decision such as product

price and quality

y Responsible for his/her own actions and actions

of other individuals, machines, other inputsunder his/her control

y Maximises profit and value of firms




M anagerial economics

y Study of how to direct scarce resources in a way

that most efficiently achieves managerial goal.

y Example- managers in computer making company

would decide on : W hether to purchase or produce intermediate input (disk

drive/ computer chips

How many computers to produce and what is the selling

price How many employees to hire

How should the employees be compensated

W hat incentive to be given to ensure quality

How would rival company affect the organization?




Solution:Solution:

y To make a sound decision, manager would need

To identify information needed

Ù Account dept- tax advice or cost data

ÙLegal dept- legal ramification of alternativedecisions

ÙMarketing dept- data on product market

characteristic

Ù

Finance dept- data on alternative method to obtainfinancial capital

To collect and process data

MANAGER INTEGRATE ALL INFORMATION TO

ARRIVE AT A DECISION




The Economics of Eff ective Management

AN EFFECTIVE MANAGER MUST:

Identify Goals and Constraints

Recognize the Role of Profits Understand Incentives

Five Forces Model

Understand Markets

Recognize the Time Value of Money Use Marginal Analysis




Id entify Goals and C onstraints

y W ell defined goals

y Different goals entails different decisions

y Decision maker faces constraints that

affect the ability to achieve goal

EXAMPLES:

y marketing dept -maximise sales and market

share , finance dept- isk reduction

strategies

y Constraints- available technology, input

prices




Recogniz e nature and

importance of profits

y Overall goal- maximise profit of firm¶s value

y Difference between economics and

accounting profitsy Implicit costs ± very hard to measure

Example ± hairstyling salon vs restaurant






Economic vs. Accounting P rofits

yy Accounting Profits Accounting Profits

Total revenue (sales) minus dollar cost of

producing goods or services.

Reported on the firm¶s income statement.

yyEconomic ProfitsEconomic ProfitsTotal revenue minus total opportunity

cost.




y Accounting Costs

The explicit costs of the resources needed to produce

goods or services.

Reported on the firm¶s income statement.

y Opportunity Cost

The cost of the explicit and implicit resources that are

foregone when a decision is made.

y Economic Profits

Total revenue minus total opportunity cost.

Accounting profits overstate your economics

profits




Understanding incentivesUnderstanding incentives

y Profits

signal to holders of resources to enter or exit industry

Incentive to resource holders to alter/change use of

resources

y Managers should understand the role of incentive

Induce workers to work harder/maximising effort

Reward vs penalty

Incentive plan ± directly proportionate to firms profitability

Commission based remuneration




Understanding marketsUnderstanding markets

y Relative outcome of markets :

Power of buyers vs power of sellers

bargaining position of consumers and producers

y 3 sources of rivalry in economic transaction:

Consumer producer rivalry

Consumer-consumer rivalry

Producer-producer rivalry




Market Interactions Market Interactions

yy Consumer Consumer- -Producer Rivalry Producer Rivalry

Consumers attempt to locate low prices, while

producers attempt to charge high prices.

Risk- producer refuse to sell, consumer refuse to

purchase

yy Consumer Consumer- -Consumer Rivalry Consumer Rivalry

Scarcity of goods reduces the negotiating power of

consumers as they compete for the right to thosegoods.

Consumer willing to pay highest price to outbid others.

eg-auction




Market Interactions Market Interactions

Producer Producer- -Producer Rivalry Producer Rivalry

Multiple sellers of a product competing ; customers

are scarce

Scarcity of consumers causes producers to compete

with one another for the right to service customers.

Producer with best-quality product t lowest price wins

The Role of Government The Role of Government

Losing/disadvantage parties in the market seek for

govt intervention-monopoly market

Seeking aids from govt to compete with foreign

counterparts

Disciplines the market process.




The Time Value of MoneyThe Time Value of Money




The Time Value of Money The Time Value of Money

y Timing in making decision-gap between time when cost of project is borne and

time when benefits of project is received

y Is $1 today going to worth more than $1 received infuture? Opportunity cost of $1 in future = interest forgone

Its the time value of money

y PV of an amount received in future = amount that would

be invested today at prevailing interest rate to generate

given future value




The T ime Value of MoneyThe T ime Value of Money

y Present value ( PV ) of a lump-sum amount ( FV ) to

be received at the end of ´ nµ periods when the

per-period interest rate is ´ iµ:

PV

FV

in!

1

Ex amples:Ex amples: Lotto w inner choosing bet w een a single lumpLotto w inner choosing bet w een a single lump--sum payout of sum payout of

$104 million or $198 million over 25 years.$104 million or $198 million over 25 years.

Deter mining d amages in a patent infringement case.Deter mining d amages in a patent infringement case.




(1) The Time Value of Money(1) The Time Value of Money

y Eg calculate PV of $100 in 10 years if the interestrate is 7 percent

PV=$50.83

y Interest rate is inversely related to the PV

Higher interest rate-lower PV

y PV of future payment = FV - opportunity costs waiting OCW

If interest rate is zero, OCW is zero the PV=FV




(2) Present Value of a Series(2) Present Value of a Series

yy Present value of a stream of future amountsPresent value of a stream of future amounts

( ( FVFVtt ) received at the end of each period for ) received at the end of each period for

³ ³ nn´ periods:´ periods:

yy

Given PV of income stream from a project,Given PV of income stream from a project,we can compute the net PV of the project we can compute the net PV of the project

NPV=PV NPV=PV- -C C 0 0 (current cost)(current cost)

PV

FV

i

FV

i

FV

i

n

n!

1

1

2

21 1 1

...




(3) (3)

y Suppose a manager can purchase a stream

of future receipts ( FVt ) by spending ³ C0´

dollars today. The NPV of such a decision is

N PV

FV

i

FV

i

FV

iC

n

n!

1

1

2

2 0

1 1 1...

Decision Rule:

If NPV < 0: Reject project

NPV > 0: Accept projec demo problem 1-1




(5) FIRM VALUATION(5) FIRM VALUATION

The value of a firm equals the present value of currentand future profits.

PV = S pt / (1 + i)t

If profits grow at a constant rate (g < i ) and currentperiod profits are po:

0

0

1

before current profits have been paid out as dividends;

1immediately after current profits are paid out as divide

Firm

Ex Dividend

Firm

i

PV i g

g PV

i g

T

T

!

!




Firm ValuationFirm Valuation

y If the growth rate in profits < interest rate

and both remain constant, maximizing the

present value of all future profits is thesame as maximizing current short term

profits

y Eg ± demo problem 1-2




Marginal (Incremental) AnalysisMarginal (Incremental) Analysis



y Control Variables

Output

Price

Product Quality Advertising

R&D

y Basic Managerial Question: How much of

the control variable should be used tomaximize net benefits?

Marginal (Incremental) AnalysisMarginal (Incremental) Analysis




MARGINAL ANALYSIS MARGINAL ANALYSIS

y OPTIMAL MANAGERIAL DECISIONS INVOLVES

Comparing the marginal (incremental) benefits

W ith the marginal (incremental ) costs

B(Q)-total benefits derived from Q units of variable

C(Q)- total costs corresponding level of Q

Managers objective: maximise net benefits

y Net Benefits = Total Benefits - Total Cost

= B(Q)-C(Q)

y Profits = Revenue - Costs




MARGINAL definedMARGINAL defined

M B ±additional benefit arise by using an additional unit

of managerial control variable

MC ± additional costs incurred by using an additional

unit of the managerial control variable

MN B(Q) ± the change in net benefits that arise from a

one unit change in Q OR

MN B(Q) = M B(Q)MN B(Q) = M B(Q)- -MC(Q)MC(Q)

Refer table 1-1 p20

Note

W hen net benefit is maximised, MN B(Q)=0 since

M B(Q)=MC(Q)




Marginal Benefit (MB)Marginal Benefit (MB)

Change in total benefits arising from a change

in the control variable, Q:

Slope (calculus derivative) of the total benefit

curve.

Q

B MB

(

(!




Marginal Cost (MC)Marginal Cost (MC)

Change in total costs arising from a change in

the control variable, Q:

Slope (calculus derivative) of the total cost curve

QC M C (

(!




Marginal P rincipl e Marginal P rincipl e

y To maximize net benefits, the managerial

control variable should be increased up to

the point where MB = MC.

yy MBMB >> MCMC means the last unit of the control variable increased benefits more than it

increased costs.

yy MBMB << MCMC means the last unit of the control

variable increased costs more than it increased benefits.




The Geometry of OptimizationThe Geometry of Optimization

Refer fig 1-2

Q

Total Benefits

& Total CostsBenefits B(Q)

Costs C(Q)

Q*

B

CSlope = MC

Slope =MB




MB,MC

& NB

NB

Q

N(Q)=B(Q)-C(Q)

NB

MB(Q)

MC(Q)

MNB(Q)

Q)

Maximum

NB

At level of Q where the MB curveintersect the MC curve, MNB iszero, that Q maximises NB

Q*

Q*

Slope of a functionis the derivative of a given function

MB= dB(Q)dQ

MC= dC(Q)dQ

MNB= dN(Q)dQ



Michael R. Baye, Managerial Economics and Business Strategy , 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rightsd

y Make sure you include all costs and benefits

when making decisions (opportunity cost).

y W hen decisions span time, make sure you

are comparing apples to apples (PV

analysis).

y Optimal economic decisions are made at the

margin (marginal analysis).

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Ch1 Intro Me Sem2