Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
Managerial Economics & Business Strategy
Chapter 1: The Fundamentals of
Managerial Economics
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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
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Managerial Economics § Manager
– A person who directs resources to achieve a stated goal.
§ Economics – The science of making decisions in the presence of
scarce resources.
§ Managerial Economics – The study of how to direct scarce resources in the
way that most efficiently achieves a managerial goal.
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Identify Goals and Constraints § Constrained Optimization
Analytical tool for making the best (optimal) choice taking into account any possible limitations or restrictions on the choice.
§ Sound decision making involves having well-defined goals. – Leads to making the “right” decisions.
§ In striking to achieve a goal, we often face constraints. – Constraints are an artifact of scarcity.
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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.
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Opportunity Cost § Accounting Costs
– The explicit costs of the resources needed to 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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Example: Mary’s Bike Shop § Total Revenue = $200,000 § Bikes costs = $100, 000 § Utilities, taxes and other expenses = $ 20,000 § Yearly salary for Mary if she were an accountant = $
40,000 § A large clothing retail chain wants to expand and
offers to rent the store from Mary for $50,000 per year.
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Example: Mary’s Bike Shop
§ Explicit costs: $120,000 (bikes costs and utility expenses)
§ Implicit costs: $90,000 (potential salary and potential rent)
§ Opportunity costs: $210,000
§ Accounting profit = $80,000 § Economic profit = – $10,000 (Economic loss)
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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.
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The Five Forces Framework
Sustainable Industry Profits
Power of Input Suppliers
· Supplier Concentration · Price/Productivity of Alternative Inputs · Relationship-Specific Investments · Supplier Switching Costs · Government Restraints
Power of Buyers
· Buyer Concentration · Price/Value of Substitute Products or Services · Relationship-Specific Investments · Customer Switching Costs · Government Restraints
Entry
· Entry Costs · Speed of Adjustment · Sunk Costs · Economies of Scale
· Network Effects · Reputation · Switching Costs · Government Restraints
Substitutes & Complements · Price/Value of Surrogate Products or Services · Price/Value of Complementary Products or Services
· Network Effects · Government Restraints
Industry Rivalry · Switching Costs · Timing of Decisions · Information · Government Restraints
· Concentration · Price, Quantity, Quality, or Service Competition · Degree of Differentiation
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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 consumers’ negotiating power 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”:
( )PVFVi n
=+1
• 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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Example: Microsoft “Bing” Project § Microsoft is thinking of investing $100
millions today to the development of Bing to rival Google, and estimates that the yield of the project in 5 years is $140 millions.
• If the interest rate is 4%, the present value of $140 millions 5 years from now would be
PV = FV/ (1 + i)n = 140 / (1 + 0.04)5 = 115.1 in million
• If the interest rate is 7%, the present value of $140 millions 5 years from now would be
PV = FV / (1 + i)n = 140 / (1 + 0.07)5 = 99.8 in million
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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.
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Example: Microsoft “Bing” Project § Microsoft is thinking of investing $100
millions today to the development of Bing to rival Google, and estimates that the yield of the project in 5 years is $140 millions.
• If the interest rate is 4%, the present value of $140 millions 5 years from now would be 115.1 millions.
• So, OCW = FV – PV = 140 – 115.1 = 24.9 in million
• If the interest rate is 7%, the present value of $140 millions 5 years from now would be 99.8 millions.
• So, OCW = FV – PV = 140 – 99.8 = 40.2 in million
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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:
§ Equivalently,
( )∑= +
=n
ttt
iFVPV
1 1
( ) ( ) ( )PVFVi
FVi
FVinn=
++
++ +
+11
221 1 1...
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Example: Microsoft “Bing” Project § Microsoft is thinking of investing $100 millions today
to the development of Bing to rival Google, and estimates that the yield of the project in 5 years is $24 millions each year.
• If the interest rate is 4%, the present value would be PV = 24 / (1 + 0.04)1 + 24 / (1 + 0.04)2 + 24 / (1 + 0.04)3 + 24 / (1 + 0.04)4 + 24 / (1 + 0.04)5 = 106.8 in million
• If the interest rate is 7%, the present value would be PV = 24 / (1 + 0.07)1 + 24 / (1 + 0.07)2 + 24 / (1 + 0.07)3 + 24 / (1 + 0.07)4 + 24 / (1 + 0.07)5 = 98.4 in million
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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
( ) ( ) ( )NPVFVi
FVi
FVi
Cnn=
++
++ +
+−1
122 01 1 1...
Decision Rule:
If NPV < 0: Reject project NPV > 0: Accept project
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Example: Microsoft “Bing” Project § Microsoft is thinking of investing $100 millions today
to the development of Bing to rival Google, and estimates that the yield of the project in 5 years is $24 millions each year.
• If the interest rate is 4%, the present value would be 106.8 millions. (Accept Project)
• So, NPV = PV – C0 = 106.8 – 100 = 6.8 in million
• If the interest rate is 7%, the present value would be 98.4 millions. (Reject Project)
• So, NPV = PV – C0 = 98.4 – 100 = – 1.6 in million
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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
( ) ( ) ( )
iCF
iCF
iCF
iCFPVPerpetuity
=
++
++
++
= ...111 32
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Example: Microsoft “Bing” Project § Microsoft is thinking of investing $100 millions today
to the development of Bing to rival Google, and estimates this project could perpetually generates a stream of cash flows $10 millions at the end of each period.
• If the interest rate is 4%, the present value would be PVperpetuity = CF/i = $10/ 0.04 = $ 250 in million
• If the interest rate is 7%, the present value would be PVperpetuity = CF/i = $10/ 0.07 = $ 142.9 in million
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Firm Valuation and Profit Maximization
§ The value of a firm equals the present value of current and future profits (cash flows).
§ 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.
PVFirm = π 0 +π11+ i( ) +
π 21+ i( )2
+ ... = π t
1+ i( )tt=0
∞
∑
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Firm Valuation With Profit Growth § If profits grow at a constant rate (g < i) and
current period profits are , before and after dividends are:
§ Provided that g < i. – That is, the growth rate in profits is less than the
interest rate and both remain constant.
PVFirm = π0
1+ ii − g
before current profits have been paid out as dividends;
PVFirmEx−Dividend = π0
1+ gi − g
immediately after current profits are paid out as dividends.
π0
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Example: Microsoft “Bing” Project § Microsoft is investing in the development of Bing to
rival Google, the current period profit is $1 million, and the profit is estimated to grow at a constant rate 3%.
• If the interest rate is 4%, the present value of profit before and after dividends would be
PVFirm = π0
1+ ii − g
=1× 1+ 0.040.04− 0.03
=104 in million
PVFirmEx−Dividend = π0
1+ gi − g
=1× 1+ 0.030.04− 0.03
=103 in million
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§ 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?
Marginal (Incremental) Analysis
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Marginal Benefit (MB)
§ Change in total benefits arising from a change in the control variable, Q:
§ Slope (calculus derivative) of the total benefit curve.
MB = ΔBΔQ
= dB(Q)dQ
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Marginal Cost (MC)
§ Change in total costs arising from a change in the control variable, Q:
§ Slope (calculus derivative) of the total cost curve.
MC = ΔCΔQ
= dC(Q)dQ
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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.
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The Geometry of Optimization: Total Benefit and Cost
Q
Total Benefits & Total Costs
Benefits Costs
Q*
B
C Slope = MC
Slope =MB
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Example: MB and MC § Suppose the total benefit and total cost of an
economic project are given by the following equations:
– a. Net benefit?
B(Q) =150+ 28Q −5Q2
C(Q) =100+8Q
NB(Q) = B(Q) −C(Q) = 50+ 20Q −5Q2
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Example: MB and MC
– a. Marginal benefit?
– b. Marginal cost?
– c. Marginal net benefit?
– d. Maximized net benefit Q?
MB = dB(Q)dQ
= 28−10Q
MC = dC(Q)dQ
= 8
MNB = dNB(Q)dQ
= 20 −10Q = MB −MC
MNB = 0⇒ 20 −10Q = 0⇒Q* = 2