Managerial Economics & Business Strategy
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Transcript Managerial Economics & Business Strategy
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.
1-2
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
1-3
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.
1-4
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.
1-5
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.
Opportunity Cost
• 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.
1-6
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.
The Five Forces Framework
Entry Costs
Speed of Adjustment
Sunk Costs
Economies of Scale
Power of
Input Suppliers
Entry
Sustainable
Industry
Profits
Supplier Concentration
Price/Productivity of
Alternative Inputs
Relationship-Specific
Investments
Supplier Switching Costs
Government Restraints
Industry Rivalry
Concentration
Price, Quantity, Quality, or
Service Competition
Degree of Differentiation
Network Effects
Reputation
Switching Costs
Government Restraints
Switching Costs
Timing of Decisions
Information
Government Restraints
Power of
Buyers
Buyer Concentration
Price/Value of Substitute
Products or Services
Relationship-Specific
Investments
Customer Switching Costs
Government Restraints
Substitutes & Complements
Price/Value of Surrogate Products
or Services
Price/Value of Complementary
Products or Services
Network Effects
Government
Restraints
1-8
1-9
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.
Understanding Firms’ Incentives
• Agent versus principal problem
• Incentive plans – profit sharing,
commissions
• How to structure appropriate incentives?
• Assume self-interested employees
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
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.
1-12
1-13
The Time Value of Money
• Present value (PV) of a future value (FV) lumpsum amount to be received at the end of “n”
periods in the future when the per-period interest
rate is “i”:
PV
FV
1 i
n
• 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.
1-14
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.
1-15
Present Value of a Series
• Present value of a stream of future amounts (FVt)
received at the end of each period for “n” periods:
PV
FV 1
1 i
1
FV 2
1 i
2
...
• Equivalently,
n
PV
FV t
1 i
t 1
t
FV n
1 i
n
1-16
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
N PV
F V1
1 i
If
1
FV2
1 i
2
...
FVn
1 i
Decision Rule:
NPV < 0: Reject project
NPV > 0: Accept project
n
C0
1-17
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
PV Perpetuity
CF
1 i
CF
i
CF
1 i
2
CF
1 i
3
...
1-18
Firm Valuation and Profit
Maximization
• The value of a firm equals the present value of
current and future profits (cash flows).
PV Firm 0
1
2
1 i 1 i
...
t
1 i
t
t 1
• 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.
1-19
Firm Valuation With Profit Growth
• If profits grow at a constant rate (g < i) and current
period profits are o, before and after dividends are:
P V F irm 0
E x D ividend
P V F irm
1 i
i g
0
before current profits have been paid out as dividends;
1 g
i g
im m ediately after current profits are paid out as dividends.
• 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.
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.
1-21
Marginal (Incremental) Analysis
• 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?
1-22
Net Benefits
• Net Benefits = Total Benefits - Total Costs
• Profits = Revenue - Costs
1-23
Marginal Benefit (MB)
• Change in total benefits arising from a change
in the control variable, Q:
MB
B
Q
• Slope (calculus derivative) of the total benefit
curve.
1-24
Marginal Cost (MC)
• Change in total costs arising from a change in
the control variable, Q:
MC
C
Q
• Slope (calculus derivative) of the total cost
curve
1-25
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.
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.
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 = 300-12Y
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
The Geometry of Optimization:
Total Benefit and Cost
Total Benefits
& Total Costs
Costs
Slope =MB
Benefits
B
Slope = MC
C
Q*
Q
1-28
The Geometry of Optimization:
Net Benefits
Net Benefits
Maximum net benefits
Slope = MNB
Q*
Q
1-29
1-30
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).