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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??
