Hirschey_ Mark - Fundamentals of Managerial Economics 8e

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investment partnership with $100 in 1956 and has gone on to accumulate a

personal net worth in excess of $30 billion. As both a manager and an investo r ,

Buffett is renowned for focusing on the economic s of businesses.

Berkshires collection of operating businesses, including the GEICO

Insuranc e Compan y, Internationa l Dairy Queen , Inc., the Nebrask a Furniture

Mart, and See s Candies, commonl y earn 30 percent to 50 percent per year on

invested capital . This is astonishingly good performance in light of the 10

percent to 12 percent return typical of industry in general . A second and

equally important contributor to Berkshires outstanding performance is a

handful of substantial holdings in publicly traded common stocks, such as

The American Express Company, The Coca-Cola Company, and The

Washington Post Company , amon g others . As both manager and investor,

Buffett looks for wonderfu l businesses with outstandin g economi c charac -

teristics : high rates of return on investe d capital , subs tantial profit margins on

sales, and consistent earnings growth . Complicated businesses that face

fierce competition or require large capital investment are shunned .1

Buffetts success is powerfu l testimon y to the practica l usefulnes s of man-

agerial economics. Manage rial economics answers fundamental questions.

When is the market for a product so attractive that entry or expansion

become s appealing? When is exit preferable to continue d operation ? Why do

some professions pay well, while others offer only meager pay? Successful

managers make good decisions, and one of their most useful tools is the

methodolog y of manageria l economics.

1 Information about Warren Buffett's investment philosophy and Berkshire Hathawa y , Inc.,can be found on the Internet (http://www.berkshi rehathawa y .com).

CHAPTE R ON E

Introduction

2

1

arren E. Buffett, the celebrated chairman and chief executive officer of Omaha, Nebraska based Berkshire Hathaway, Inc., started anW

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Chapter One Introduction 3

H O W IS MANAGERIAL ECONOMICS USEFUL?

Managerial economics applies economi c theory and methods to busines s and administrative

decisio n making. Managerial economic s prescribes rules for improving manageria l decisions.

Manageria l economic s also helps manager s recogniz e how economi c forces affect organiza -tions and describes the economic consequences of managerial behavior . It links economic

concepts with quantitative methods to develop vital tools for managerial decision making.

This process is illustrated in Figure 1.1.

Evaluating Choice Alternatives

Managerial economics identifies ways to efficiently achieve goals . For example, suppose a

small business seeks rapid growth to reach a size that permits efficient use of national media

advert ising . Manageria l economic s can be used to identif y pricing and production strategies

to help meet this short-run objectiv e quickly and effectivel y. Similarl y, managerial economics

provides production and marketing rules that permit the company to maximiz e net profits

once it has achieved growth or marke t share objec tives.

FIGURE 1.1

Managerial Economics Is a Tool for Improving Management Decision Making

Managerial eco nomics uses economic concepts and quantitative methods to solve managerial problems.

Management Decision Pr oblems

Economic Concepts Quantitative Methods

Managerial Economics

2 Introduction

managerial

economics

Applies economi c toolsand technique s to

busines s and adminis -

trative decision making

Managerial Economics



Managerial economics has applications in both profit and not-for-profit sectors . For

example, an administrator of a nonprofit hospital strives to provide the best medical care possible given limited medical staff, equipment, and relate d resources. Using the tools and

concepts of managerial economics, the administrator can determine the optimal allocation

of these limited resources . In short, manageria l economic s helps manager s arrive at a set of

operating rules that aid in the efficient use of scarce human and capital resources . By fol-

lowing these rules, businesses, nonprofi t organizations, and government agencies are ableto meet object ives ef ficientl y.

Making the Best Decision

To establish appropriate decision rules, managers must understan d the economi c envi ron-

ment in which they operate . For example, a grocery retailer may offer consumers a highly

price-sensitiv e product , such as milk , at an extremely low marku p over cost say, 1 percent

to 2 percent whil e offerin g less price -sensitiv e products , such as nonprescriptio n drugs, atmarkups of as high as 40 percent over cos t. Manageria l economic s describe s the logic of this

pricing practice with respect to the goal of profit maximization . Similarl y, manageria l eco-

nomic s reveal s that auto import quota s reduce the availabilit y of substitutes for domestically

produce d cars , raise auto prices , and create the possibilit y of monopoly profits for domestic

manufactu rers. It does not explain whether imposing quotas is good public policy ; that is a

decisio n involvin g broader politica l considerations . Manageria l economi cs only describes the

predictabl e economi c consequence s of such actions.

Managerial economic s of fers a comp r ehensive application of economic theory and method-

olog y to managemen t decisi on making. It is as relevant to the management of government

agencies , cooperatives, schools, hospitals, museums, and similar not-for -profit institutions as it

Introduction

Stick by your principles. Principles ar e not for sale at

any price.

Does the high road lead to corporate success? Consider

the experience of one of Americas most famous winners

Omaha billionair e War r en E. Buf fett, chairman of

Berkshir e Hathaway, Inc. Buffett and Charlie Munger, the

number-two man at Berkshir e, ar e famous for doing

multimillion -dollar deals on the basis of a simple hand -

shake. At Berkshi r e, managemen t relies upon the charac -

ter of the people that they are dealing with rather than

expensive accountin g audits, detailed legal opinions , or

liability insurance coverage. Buf fett says that after some

early mistakes , he learned to go into business only with

people whom he likes, tr usts, and admires. Although a

compan y will not necessarily pr osper because its man-

agers display admirable qualities, Buffett says he has

never made a good deal with a bad person.

Doing the right thing not only makes sense from an

ethical perspective, but it makes busines s $ense , too!

See: Emelie Rutherfo r d, Lawmaker s Involve d with Enron Probe Had

Personal Stake in the Compan y , The W all St r eet Journal Online, March 4,2002 (http://online.wsj.com).

4 Part One Overview of Managerial Economics

MA NAG ERIAL APP LICATION 1 . 1

Managerial Ethics

In T he W al l Str eet Journal , it is not hard to find evidence

of unsc rupulou s busines s behavio r . However , unethical

conduc t is neithe r consisten t with value maximiz ation

nor with the enlightene d self -inter est of management

and othe r employ ees. If honest y did not pervad e corpo -

rate Americ a, the ability to conduc t business would col-

lapse . Eventuall y, the truth always come s out, and when

it does the unscrupulous lose out. For better or worse,

we ar e know n by the standa r ds we adopt.

To become successful in business, everyon e must

adopt a set of principles. Ethical rules to keep in mind

when conducting business include the following:

Above all else, keep your wor d. Say what you mea n,

and mean what you say .

Do the right thing. A handsh ake with an honorable

person is worth mo r e than a ton of legal documents

from a corrupt individual.

Accept responsibilit y for your mistakes, and fix

them. Be quick to shar e cr edit for success.

Leave something on the table. Pr ofit wit h your cus-

tome r, not of f your custo mer .




is to the managemen t of profit-orient ed business es. Althou gh this text focus es primarily on

business applications , it also includes example s and problems from the governmen t and non-

profit sectors to illustrate the broad r elevance of managerial economics.

THEORY OF THE F I RM

At its simples t level, a business enterpris e represents a series of contractua l relationship s that

specify the rights and r esponsibilities of various parties (see Figur e 1.2). People dir ectly involved

include customers, stockholders, management, employees, and suppliers . Society is also

involved because businesses use scar ce r esour ces, pay taxes, pr ovide employmen t opportunities,

and produce much of societys material and services output . Firms ar e a useful device for pr o-

ducing and distributing goods and services. They ar e economic entities and ar e best analyzed inthe context of an economic model.

Expected Value Maximization

The model of business is called the theory of the firm. In its simplest version, the firm isthought to have profit maximizatio n as its primary goal. The firms owner -manager is assumed

to be working to maximiz e the firms short-run profits. Today , the emphasi s on profits has been

broadened to encompas s uncertainty and the time value of mone y . In this mor e complete model,

the primary goal of the firm is long-term expected value maximization .

The value of the f irm is the present value of the firms expected future net cash flows. If cash flows are equated to profits for simplicit y, the value of the firm today, or its present value,

FIGURE 1.2

The Corporation Is a Legal Device

The firm can be viewed as a confluence of contractual relationships that connect suppliers, investors,

workers, and management in a joint effort to serve customers.

Society

Supplier s Investor s

Firm

Management Employees

Customer s

4 Introduction

theory of the firm

Basic mode l of business

expected value

maxi mization

Optimizatio n of pr ofits

in light of uncertainty

and the time valu e of

money

value of the firm

Present value of the

firms expected

futu re net cash flows

present value

Worth in currentdollars



This expanded equation can be used to examine how the expected value maximization

model relates to a firms various functional departments . The marketing department often

has primar y responsibilit y for product promotio n and sales (TR); the produ ction department

has primar y respon sibilit y for produc t developmen t costs (TC ); and the finance department

has primary responsibility for acquirin g capita l and, hence , for the discoun t facto r (i) in the

deno minato r . Important overlaps exist among these functional areas. The marketing

department can help reduce costs associated with a given level of output by influencing

customer order size and timing . The production departme nt can stimulat e sale s by improv-

ing quality . Other departments , for example , accountin g, human resources, transportation , and

engine ering, provide information and services vital to sales growth and cost control . The

determination of TR and T C is a complex task that requires r ecognizin g important interrelationsamong the various areas of firm activit y. An important concep t in manageria l economic s is

that manageria l decision s should be analyze d in terms of their effects on value, as expressedin Equations 1.1 and 1.2.

2 Discounting is requi red because pr ofits obtained in the future are less valuabl e tha n profits earne d presentl y.To understand this concept, one needs to recognize that $1 in hand today is worth more than $1 to be receiveda year from now, because $1 today can be invested and, with interest, grow to a larger amount by the end of the yea r. If we had $1 and invested it at 10 percent interest, it would grow to $1.10 in one year . Thus, $1 isdefined as the present value of $1.10 due in 1 year when the appropriate interest rate is 10 percent.

Introduction


is the value of expecte d profits or cash flows, discounte d back to the present at an appropriate

interest rate.2

This model can be expressed as follows:

Value of the Firm = Present Value of Expected Future Profits

n=

1 2

(1 + i) 1 + (1 + i)2 + + (1 +

(1. 1)

(1. 2)

Here, 1, 2, . . . n represent expecte d profits in each yea r , t , and i is the appropriat e interest,

or discount , rate . The final form for Equatio n 1.1 is simply a shorthan d expression in which

sigma () stands for sum up or add togethe r . The term

n

t =1

means , Add togethe r as t goes from 1 to n the values of the term on the right. For Equation

1.1, the process is as follows: Let t = 1 and find the value of the term 1/(1 + i)1, the present

value of year 1 profit; then let t = 2 and calculate 2/(1 + i)2, the present value of year 2 profit;

continue until t = n, the last year included in the analysis; then add up these present -value

equivalent s of yearly profits to find the current or present value of the firm.

Because profits () are equal to total revenues (TR) minus total costs (TC ), Equation 1.1can be rewritte n as

n

= t = 1

t (1 + i)t

n

t = 1

TR t TC t

(1 + i) t Value =




Constraints and the Theory of the Firm

Manageria l deci sions are often made in ligh t of constraint s impose d by technolog y, resource

scarcity, contractual obligations, laws, and regulations . To make decisions that maximize

value , manager s must conside r how externa l constraint s affect their ability to achieve organ-ization objectives.

Organizations frequentl y face limited availabilit y of essentia l inputs, such as skilled labor ,

raw materials, energy, specialized machiner y, and warehouse space. Manager s often face lim-

itations on the amount of investment funds available for a particular project or activity.

Decision s can also be constraine d by contractua l requi rements . For example , labor contracts

limit flexibilit y in worker schedulin g and job assignments . Contract s sometime s require that

a minimum level of outpu t be produced to meet delivery requirements . In most instances,

outpu t mus t also mee t qualit y requirements . Some commo n example s of outpu t quality con-

straints are nutritional requirement s for feed mixtu res, audienc e exposu re requirement s for

marketin g promotions , reliabilit y requirement s for electronic products, and custome r service

requ irement s for minimu m satisfactio n levels.

Lega l restrictions , which affect both productio n and marketing activities , can also play an

importan t role in managerial decisions. Laws that define minimum wages, health and safetystanda rds, pollution emission standards, fuel efficien cy requi rements , and fair pricin g and

marketin g practice s all limit manageria l flexibility .

The role that constraint s play in manageria l decision s makes the topic of constraine d opti-

mization a basic element of managerial economics. Later chapters consider important eco-

nomic implication s of self-impose d and social constraints . This analysi s is importan t because

value maximizatio n and allocative efficiency in society depend on the efficient use of scarce

economic resources.

Limitations of the Theory of the Firm

Some critics questio n why the value maximiza tion criterion is used as a foundatio n for study-

ing firm behavior . Do managers try to optimize (seek the best result) or merely satisfice(seek satisfactory rather than optimal results)? Do managers seek the sharpest needle in a

haystack (optimize), or do they stop after finding one sharp enough for sewing (satisfice)?

How can one tell whether compan y suppor t of the United Way , for example, leads to long-run

value maximization ? Are generous salarie s and stock options necessar y to attract and retain

managers who can keep the firm ahea d of the competition ? Whe n a risky ventu re is turned

down, is this inefficient risk avoidance? Or does it reflec t an appropriat e decisio n from the

standpoin t of value maximization?

It is impossible to give definitive answers to questions lik e these, and this dilemma has led to

the development of alternative theories of firm behavior . Some of the mor e prominent alterna-

tives are models in which size or growth maximization is the assumed primary objective of man-

agemen t, models that argue that manager s ar e most concerned with their own personal utility

or welfare maximizatio n, and models that tr eat the firm as a collection of individuals with wide-

ly divergent goals rather than as a single, identifiable unit. These alternative theories, or models,of manageria l behavior have added to our understandin g of the firm. Still, none can supplant the

basic value maximizatio n model as a foundation for analyzing managerial decisions. Examining

why provides additional insight into the value of studying managerial economics.

Research shows that vigorous competitio n in markets for most goods and services typical-

ly forces manager s to seek value maximizatio n in their operating decisions. Competitio n in the

capi tal market s forces manager s to seek value maximizatio n in their financin g decision s as

well. Stockholder s are, of course, interested in value maximizati on because it af fects their rates

of return on common stock investments . Manager s who pursue their own interests instead of

stockhol ders interests run the risk of losing their job. Buyo ut pressure from unfriendl y firms

6 Introduction

optimizeSeek the best solution

satisfice

Seek satisfactory rather

than optimal results



(raiders ) has been considerabl e during recent years. Unfriendl y takeover s are especial ly hos-

tile to inefficient manageme nt that is replaced . Furthe r , becaus e recent studies show a strongcorrelation between firm profits and managerial compensation, managers have strong eco-

nomic incentive s to pursue value maximizatio n through their decisions.

It is also sometimes overlooke d that manager s must fully conside r costs and benefits befor e

they can make reas oned decisio ns. Would it be wise to seek the best technical solution to a

problem if the costs of findin g this solution greatl y excee d resulting benefits? Of course not.

What often appear s to be satisficin g on the part of managemen t can be interpreted as value-

maximi zing behavior once the costs of information gathering and analysis are considered.

Similarl y, short- run growth maximizatio n strategie s are often consis tent with long-run value

maximization when the production, distribution, or promotional advantages of large firm

size are better understood.

Finall y, the value maximizatio n model also offers insight into a firms voluntary socially

responsible behav ior . The criticis m that the traditional theory of the firm emphasize s profits

and value maximizatio n while ignoring the issue of socia l responsibilit y is importan t and will be discusse d later in the chapter . For now, it will prove useful to examin e the concep t of prof-

its, whic h is centra l to the theory of the firm.

PROFIT MEASUREMENT

The free enterpris e syste m would fail withou t profits and the profit motive . Even in planned

economies , where state ownershi p rathe r than privat e enterpris e is typical , the profit motive

is increasingl y used to spur efficien t resource use. In the former Eastern Bloc countries, the

Introduction


MA NAG ERIAL APP LICATION 1 . 2

The World Is Turning to Capitalism and Democracy

Capitalism and democracy are mutually reinforcing.

Some philosophers have gone so far as to say that capi -

talism and democracy are intertwined . Without capital-

ism, democrac y may be impossib le. Without demo cracy,

capitalism may fail. At a minimum, freely competitive

markets give consumers broad choices and r einfo r ce the

individual freedoms pr otected in a democratic society .

In democracy, government does not grant individual

freedom . Instead, the political power of government

emanates from the people . Similarly, the flow of eco-

nomic resources originates with the individual cus-

tomer in a capitalistic system. It is not centrally dir ected

by government.

Capitalism is socially desirable because of its decen-tralized and customer-oriente d natu r e. The menu of

products to be produced is derived from market price

and output signals originating in competitive markets,

not from the output schedules of a centralized planning

agency. Resour ces and products ar e also allocated thr ough

market for ces. They ar e not earmarked on the basis of

favoritism or social status. Through their pur chas e deci -

sions, customers dictate the quantit y and qualit y of

products brought to market.

Competitio n is a fundamentall y attractiv e feature of

the capitalisti c system because it keeps costs and prices

as low as possible . By operating ef ficiently, firms ar e able

to p r oduce the maximu m quantit y and quality of goods

and services possible . Mass pr oduct ion is, by definition,

productio n for the masses . Competitio n also limits con-

centration of economic and politica l power . Similarly,

the democrati c form of governmen t is inconsisten t with

consolidate d economi c influence and decisio n making.

Totalitarian forms of government ar e in r etr eat. China

has experienced violent upheaval as the country embarks

on much-needed economic and political r eforms. In the

former Soviet Union, Eastern Europe, India, and Latin

America, years of economic failur e forced governments to dismantle entrenched bureaucracy and install economic

incentives. Rising living standards and political f r eedom

have made life in the West the envy of the world.

Agains t this backdrop, the future is bright for capitalism

and dem ocracy!

See: Karen Richar dson , Chin a and India Coul d Lead Asia in

Technology Spending, The W al l St r eet Journal Online, Mar ch 4, 2002(http://onl ine.wsj .com).

http://onl/

http://onl/




former Soviet Union, China, and other nations, new profit incentives for manager s and employ-

ees have led to higher product quality and cost efficienc y . Thus, profits and the profit motive

play a growing role in the ef ficient allocation of economic r esour ces worldwide.

Business Versus Economic Profit

The genera l public and the busines s community typically define profit as the residua l of sales

revenue minus the explicit costs of doing business . It is the amoun t availabl e to fund equity

capital after payment for all other resources used by the firm. This definition of profit isaccountin g profit, or business profit .

The economist also defines profit as the excess of revenue s over costs. Howeve r , inputs

provide d by owners , includin g entrepreneuria l effort and capital , are resources that mus t be

com pensated . The economis t include s a norma l rate of return on equit y capital plus an oppor-

tunity cost for the effort of the owner -entrepreneur as costs of doing business, just as the

interest paid on debt and the wages are costs in calculatin g business profit. The risk-adjustednormal rate of return on capital is the minimum return necessary to attract and retain

investment . Similarly, the opportunity cost of owner effort is determined by the value thatcould be received in alternative employment . In economic terms, profit is business profit

minus the implicit (noncash) costs of capita l and other owne r-provide d input s used by thefirm . This profit concep t is frequentl y referred to as economic profit .

The concepts of business profit and economic profit can be used to explain the role of

profits in a free enterpris e econom y. A norma l rate of return , or profit, is necessar y to induce

individual s to inves t fund s rathe r than spen d them for current consumption . Norma l profit

is simply a cost for capital; it is no different from the cost of other resources, such as labo r ,

mate rials , and energy. A similar price exists for the entrepreneuria l effort of a firm s owner-

manager and for other resources that owner s bring to the firm. These opportunity costs for

owne r-provided inputs offer a primar y explanatio n for the existenc e of busines s profits, espe-

cially amon g small businesses.

Variability of Business Profits

In practice , reporte d profits fluctuate widely. Table 1.1 shows business profits for a well-known

sample of 30 industrial giants: those companies that comprise the Dow Jones Industrial

Average. Busines s profit is often measu r ed in dollar terms or as a percentage of sales revenue,

called profit margin, as in Table 1.1 . The economist s concept of a normal rate of profit is typ-ically assessed in terms of the realized rate of return on stockholders equity (ROE). Return

on stockholders equity is defined as accounting net income divided by the book value of the

firm . As seen in Table 1.1, the average ROE for industrial giants found in the Dow Jones

Industria l Average falls in a broad range of around 15 percent to 25 percent per year . Altho ugh

an average annual RO E of roughl y 10 percent can be regarded as a typical or normal rate of

return in the United States and Canada , this standard is routinel y exceede d by companie s such

as Coca-Cola, which has consistently earned a ROE in excess of 35 percent per year . It is a stan-

dard seldom met by International Pape r , a company that has suffered massiv e losse s in an

attempt to cut costs and incr ease product quality in the face of tough environmenta l r egulations

and foreign competi tion.

Some of the variatio n in ROE depicted in Table 1.1 represents the influence of differential

risk premiums . In the pharmaceutical s industr y, for example , hoped -for discoverie s of effec-

tive therapies for importan t disease s are often a long shot at best. Thus , profit rate s reported

by Merck and othe r leadin g pharmaceutic al companie s oversta te the relative profitabilit y of

the drug industry ; it could be cut by one-half with proper risk adjustment . Similarly , reported

profit rates can overstate differences in economic profits if accounting error or bias causes

8 Introduction

business profit

Residual of sales r ev-

enue minus the explicit

accountin g costs of

doing business

normal rate of

returnAverage prof it necessary

to attract and retain

investment

econom ic profit

Busin ess profit minus

the implicit costs of

capital and any other

owner-provide d inputs

profit margin

Accountin g net income

divided by sales

return on stock-

holders equity

Accountin g net income

divided by the book

value of total assets

minus total liabilities



Introduction


TABLE 1.1

The Profitability of Industrial Giants Included in the Dow Jones Industrial Average

Return Return

Net Income Sales Net Worth on Sales on Equity Company Name Industry ($ Millions) ($ Millions) ($ Millions) (Margin) (R OE)

Alcoa Inc.

American Express

AT&T Corp.

Boeing

Caterpillar Inc.

Citigrou p Inc.

Coca-Cola

Disney (Walt)

DuPont

Eastman Kodak

Exxon Mobil Corp.

General Electric

General Motor s

Hewlett-Packard

Home Depot Honeywell International

Intel Corp.

International Business

Machine

International Paper

Johnson & Johnson

McDonalds Corp.

Merck & Co. Microsof t Corp.

Minnesota Mining

Mor gan (J.P .) Chase

Phili p Morris

Procter & Gamble

SBC Communications

United Technologies

Wal-Mar t Stores

Metals and Mining (Div .)

Financial Services (Div .)

Telecom. Ser vices

Aerospace/Defense

Machiner y

Financial Services (Div .)

Beverage (Sof t Drink)

Entertainment

Chemical (Basic)

Precision Instrument

Petroleum (Integrated)

Electrical Equipment

Auto and Truck

Computer and Peripherals

Retail Building Supply

Diver sified Co.

1,489 22,936 11,422 6.5% 13.0%

2,810 23,675 11,684 11.9% 24.0%

6,630 65,981 107,908 10.0% 6.1%

2,511 51,321 11,020 4.9% 22.8%

1,053 20,175 5,600 5.2% 18.8%

13,519 n.a. 66,206 n.a. 20.4%

3,669 20,458 9,316 17.9% 39.4%

1,892 25,020 24,100 7.6% 7.8%

2,884 28,268 13,299 10.2% 21.7%

1,441 13,994 3,428 10.3% 42.0%

16,910 206,083 70,757 8.2% 23.9%

12,735 63,807 50,492 20.0% 25.2%

5,472 184,632 30,175 3.0% 18.1%

3,561 48,782 14,209 7.3% 25.1%

2,581 45,738 15,004 5.6% 17.2% 2,293 25,023 9,707 9.2% 23.6%

28.6% Semiconductor 10 ,669 33,726 37,322 31.6%

Computer and Peripherals 8,093 88,396 20,624 9.2% 39.2%

Paper and Forest Products

Medical Supplies

Restaurant

Dr ug Computer Softwar e and Services

Chemical (Diversified)

Bank

To bacco

Household Products

Telecom. Services

Diversified Co.

Retail Stor e

969 28,180 12,034 3.4% 8.1%

4,800 29,139 18,808 16.5%

1,977 14,243 9,204 13.9%

6,822 40,363 14,832 16.9% 10,003 25,296 47,289 39.5%

1,857 16,724 6,531 11.1%

25.5%

21.5%

46.0% 21.2%

28.4% 5,727 n.a. 42,338 n.a. 13.5%

8,510 80,356 15,005 10.6% 56.7%

4,397 39,244 12,010 11.2% 36.6%

7,746 53,313 31,463 14.5% 24.6%

1,808 26,583 8,094 6.8% 22.3%

6,295 191,329 31,343 3.3% 20.1% Averages 5,371 54,028 25,374 9.9% 21.2%

.a . means no t applicable.

Data source: V alue Line Investmen t Survey, March 4, 2002 (http://www.valueline.com).

Rep roduced with the permissio n of Value Line Publishing , Inc.

investment s with long-term benefits to be omitted from the balance sheet. For example , cur r ent

accountin g practice often fails to conside r advertising or research and developmen t expendi-

tures as intangible investment s with long-term benefits. Becaus e advertising and research and

developmen t expenditu res are imm ediatel y expense d rathe r than capitalize d and written off

over their useful lives, intangible assets can be grossly understated for certain companies . The

balance sheet of Coca-Cola does not reflect the hundreds of millions of dollars spent to estab-

lish and maintain the brand-name recognitio n of Coca-Cola , just as Merck s balance sheet fails to r eflect research dollars spent to develop importan t produc t names like V asotec (for the treat-

http://ww/

http://ww/




ment of high blood pressure), Zocor (an antiarthriti c drug), and Sin gulair (asthma medication).

As a result, busines s profit rates for both Coca-Cola and Merck overstate each company s trueeconomi c performance.

WHY DO PROFITS VARY AMONG FIRMS?

Even after risk adjustment and modification to account for the ef fects of accountin g error and

bias, ROE numbers r eflect significant variation in economic pr ofits. Many firms earn significant

economic profits or experience meaningfu l economic losses at any given point. To better under-

stand real-world differences in profit rates, it is necessary to examine theories used to explain profit variations.

Frictional Theory of Economic Profits

One explanation of economic profits or losses is frictional profit theory . It states that markets

are sometime s in disequilibriu m becaus e of unanticipate d change s in demand or cost condi -

tions. Unanticipate d shocks produce positive or negative economic profits for some firms.For example, automated teller machines (ATMs) make it possible for customers of financial

institutions to easily obtain cash, enter deposits, and make loan payments. ATM s r ender obsolete

many of the functions that used to be carried out at branch of fices and foster ongoing consoli-

dation in the industr y. Similarly, new user -friendly software incr eases demand for high-powe r ed

personal computer s (PCs) and boosts r eturns for ef ficient PC manufactur ers. Alternatively , a rise

in the use of plastics and aluminum in automobiles drives down the pr ofits of steel manufactur-

ers. Over time, barring impassable barriers to entry and exit, r esources flow into or out of finan-

cial institutions, compute r manufactu r ers, and steel manufac tur ers, thus driving rates of r eturn

back to normal levels. During interim periods, profits might be above or below normal becauseof frictional factors that pr event instantaneous adjustmen t to new market conditions.

Monopoly Theory of Economic Profits

A further explanation of above-normal profits, monopoly profit theory, is an extension of fric-

tional profit theor y . This theory asserts that some firms are shelter ed from competition by high

barriers to entr y. Econom ies of scale, high capital requirements , patents, or import protection

enable some firms to build monopol y position s that allow above-norma l profits for extended

periods . Monopol y profits can even arise because of luck or happenstanc e (being in the right

industr y at the right time) or from anticompetitiv e behavior . Unlike other potentia l sour ces of

above-normal profits, monopoly profits are often seen as unwarranted. Thus, monopoly pr ofits

are usually taxed or otherwis e r egulated. Chapters 10, 11, and 13 consider the causes and con-sequences of monopoly and how society attempts to mitigate its potential costs.

Innovation Theory of Economic Profits

An additional theory of economic pr ofits, innovation profit theory, describes the above-normal profi ts that arise followin g successfu l inventi on or modernization . For example , innovation

profit theory suggests that Microsoft Corporatio n has earned superior rates of return because it

successfully developed, intr oduced, and marketed the Graphical User Interface, a superior image-

based rather than command -based approach to compute r software instructions . Microsoft has

continue d to earn above-normal returns as other firms scramble to offer a wide variety of user

friendly software for persona l and business applications . Only afte r competi tors have intro-

duced and successfull y saturat ed the marke t for user-friendly software will Microsoft profits

be driven down to normal levels. Similarly, McDonald s Corporation earned above-normal

rates of return as an early innovato r in the fast-food business. With increased competitio n from

Burger King, Wendys, and a host of national and regional competitors, McDonalds, like

10 Introduction

frictional profit

theory

Abnor mal profits

observed following

unanti cipate d changes

in demand or cost

conditions

monopoly profit

theory

Abov e-norm al pr ofits

caused by barrier s to

entry that limit

competition

innov ation profittheory

Above -norm al pr ofits

that follow successful

inventio n or modern -

ization

Documents

Hirschey_ Mark - Fundamentals of Managerial Economics 8e