Managerial Economics Chapter One Introduction.ppt

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

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
Effective manager must:
 Identify goals and constraints;
 Recognize the nature and importance of profits;
 Understand incentives;
 Understand markets;
 Recognize the time value of money;
 And use managerial analysis.

1-5
Identify Goals and Constraints
 Sound decision making involves having well-
defined goals because achieving different
goals entails making different decisions.
– Leads to making the “right” decisions.
 In striking to achieve a goal, we often face
constraints.
– Constraints are an artifact of scarcity.

1-6
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(OC).
– The OC includes explicit (or accounting) cost of
the resources and the implicit cost of give up the
best alternative use of the resource.

1-7
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.

1-8
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.
– Similarly, the profits of business signal where
society’s scarce resources are best allocated.

1-9
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
Entry
Entry Costs
Speed of Adjustment
Sunk Costs
Economies of Scale
Network Effects
Reputation
Switching Costs
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
Concentration
Price, Quantity, Quality, or
Service Competition
Degree of Differentiation

1-10
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.

1-11
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
– In modern economics government plays a role in discipline
the market process.

1-12
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”:
 
P V
F V
i
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.
Then, the opportunity cost reflects the time value of money.

1-13
Present Value (PV) vs. Future Value (FV)
 PV: The amount that would have to be invested today
at prevailing interest rate to generate the given future
value.
 The 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.

1-14
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
t
t
t
i
FV
PV
1 1
     
PV
FV
i
FV
i
FV
i
n
n




 

1
1
2
2
1 1 1
...

1-15
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
FV
i
FV
i
FV
i
C
n
n




 


1
1
2
2 0
1 1 1
...
Decision Rule:
If NPV < 0: Reject project
NPV > 0: Accept project

1-16
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
     
i
CF
i
CF
i
CF
i
CF
PVPerpetuity







 ...
1
1
1 3
2

1-17
Firm Valuation and Profit Maximization
 The value of a firm (physical, human, and intangible)
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.
– Maximizing profits means maximizing PV and FV.
     


 







1
2
1
0
1
...
1
1 t
t
t
Firm
i
i
i
PV





1-18
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.
0
0
1
before current profits have been paid out as dividends;
1
immediately after current profits are paid out as dividends.
Firm
Ex Dividend
Firm
i
PV
i g
g
PV
i g









0



PV
PV Firm
divident
Ex
Firm

1-19
 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

1-21
Marginal Benefit (MB)
 Change in total benefits arising from a change in the
control variable, Q:
 Slope (calculus derivative) of the total benefit curve.
Q
B
MB



Q
Q
dB
MB


)
(

1-22
Marginal Cost (MC)
 Change in total costs arising from a change in the
control variable, Q:
 Slope (calculus derivative) of the total cost curve.
Q
C
MC



dQ
Q
dC
MC
)
(


1-23
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.

1-24
The Geometry of Optimization:
Total Benefit and Cost
Q
Total Benefits
& Total Costs
Benefits
Costs
Q*
B
C
Slope = MC
Slope =MB

1-25
The Geometry of Optimization:
Net Benefits
Q
Net Benefits
Maximum net benefits
Q*
Slope = MNB

1-26
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).

1-27
Learning Managerial Economics
 Becoming proficient in economics is like learning to
play music or ride a bicycle.
 The best way to learn economics is to practice,
practice, and practice some more.
 Practicing managerial economics means practicing
making decisions.
 The best way to do this is to work and rework the
problems presented in the text and at the end of each
chapter.
 Before you can be effective at practicing, however,
you must understand the language of economics.

1-28
Solve Problems
Next meeting, we will solve the following problems:
A. Conceptual and Computational Questions:
Solve: 2, 3, 4, 5, 6,9, and 10.
B. Problems and Applications: solve 12 and 14.
C. Consider problem 15, 16, 17, 19 as case study.
D. Read carefully Demonstration Problems, 1-1, p.15; 1-2, p.18,
and 1-3, p. 24. Also, read the Appendix in pp.33-34.

Managerial Economics Chapter One Introduction.ppt

More Related Content

Similar to Managerial Economics Chapter One Introduction.ppt (20)

Recently uploaded (20)

Managerial Economics Chapter One Introduction.ppt