Transcript Managerial Economics & Business Strategy

Chapter
1
The Fundamentals of
Managerial Economics
Sar Sopheap
Cambodian Mekong University
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
Managerial Economics

1-3
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.
Identify Goals and Constraints

Sound decision making involves having well-defined
goals.
 Leads

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to making the “right” decisions.
In striking to achieve a goal, we often face
constraints.
 Constraints
are an artifact of scarcity.
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.
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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.
1-7
The Five Forces Framework
Entry Costs
Speed of Adjustment
Sunk Costs
Economies of Scale
Entry
Power of
Input Suppliers
Network Effects
Reputation
Switching Costs
Government Restraints
Power of
Buyers
Supplier Concentration
Price/Productivity of
Alternative Inputs
Relationship-Specific
Investments
Supplier Switching Costs
Government Restraints
Sustainable
Industry
Profits
Industry Rivalry
Concentration
Price, Quantity, Quality, or
Service Competition
Degree of Differentiation
1-8
Switching Costs
Timing of Decisions
Information
Government Restraints
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
Understanding Firms’ Incentives


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.
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Market Interactions

Consumer-Producer Rivalry
 Consumers
attempt to locate low prices, while
producers attempt to charge high prices.

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.

The Role of Government
 Disciplines
the market process.
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The Time Value of Money

Present value (PV) of a future value (FV) lump-sum
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
• Examples:


Lotto winner choosing between a single lump-sum payout of $104
million or $198 million over 25 years.
Determining damages in a patent infringement case.
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Present Value vs. Future Value




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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.
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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 

FV1
1  i 
1

FV2
1  i 
2
 ...
Equivalently,
n
FVt
PV  
t
t 1 1  i 
FVn
1  i 
n
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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
NPV 
FV1
1  i 
If
1

FV2
1  i 
2
 ...
FVn
1  i 
Decision Rule:
NPV < 0: Reject project
NPV > 0: Accept project
n
 C0
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.
The present value (PV) of a perpetuity of cash flows paying
the same amount (CF = CF1 = CF2 = …) at the end of each
period is
CF
CF
CF
PVPerpetuity 


 ...
2
3
1  i  1  i  1  i 
CF

i
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1-16
Firm Valuation and Profit Maximization

The value of a firm equals the present value of
current and future profits (cash flows).

t
1
2
PVFirm   0 

 ...  
t
1  i  1  i 

t 1
1  i 
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.
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:
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1 i
before current profits have been paid out as dividends;
ig
1 g
Ex  Dividend
PVFirm
 0
immediately after current profits are paid out as dividends.
ig
PVFirm   0

Provided that g < i.

That is, the growth rate in profits is less than the interest rate and both
remain constant.
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Marginal (Incremental) Analysis

Control Variable Examples:
 Output
 Price
 Product
Quality
 Advertising
 R&D

Basic Managerial Question: How much of the
control variable should be used to maximize net
benefits?
Net Benefits


Net Benefits = Total Benefits - Total Costs
Profits = Revenue - Costs
Table 1-1 Determining the Optimal Level of a Control Variable: The Discrete Case
(2)
(1)
(3)
(4)=(2)-(3)
(5)
(6)
(7) )=(5)-(6)
Control
Total
Marginal
Marginal Marginal Net
Total Costs Net Benefits
Variable
Benefits
Benefit
Cost
Benefit
Q
B(Q)
C(Q)
N(Q)
MB(Q)
MC(Q)
MNB(Q)
0
0
0
0
---1
90
10
80
90
10
80
2
170
30
140
80
20
60
3
240
60
180
70
30
40
4
300
100
200
60
40
20
5
350
150
200
50
50
0
6
390
210
180
40
60
-20
7
420
280
140
30
70
-40
8
440
360
80
20
80
-60
9
450
450
0
10
90
-80
10
450
550
-100
0
100
-100
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Marginal Benefit (MB)

Change in total benefits arising from a change in the
control variable, Q:
B
MB 
Q

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Slope (calculus derivative) of the total benefit curve.
1-21
Marginal Cost (MC)

Change in total costs arising from a change in the
control variable, Q:
C
MC 
Q

Slope (calculus derivative) of the total cost curve
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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.
The Geometry of Optimization: Total
Benefit and Cost
Total Benefits
& Total Costs
Costs
Slope =MB
Benefits
B
Slope = MC
C
Q*
Q
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The Geometry of Optimization: Net
Benefits
Net Benefits
Maximum net benefits
Slope = MNB
Q*
Q
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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).
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