FMG 22 Managerial Economics

Introduction
Dr. Subhasis Bera
 The Average Shopping cart in the US today is
approximately three times as big as its 1975
counterpart

Ralph Nader has argued that this is a prime example of

consumers being manipulated by unscrupulous
capitalists – bigger carts shame consumers into bigger
purchases.

What’s wrong with this argument?

Microsoft’s new Xbox 360 gaming console was released in North America on November
22 at a retail price of $299.99. Available supply sold out almost immediately as
Christmas shoppers stood in line for this year’s hot item. (Microsoft has increased its
sales target from 3M units to 6M units).

What’s odd about this?

 In the years following a divorce, statistics show that the
woman’s living standard falls 27% while the man’s
living standard rises by 10%

Feminists such as Patricia Ireland (NOW) would argue that

this proves divorce is unfair to women

Couldn’t you just as easily argue that marriage is unfair to men?

 Paul “Freck” Morgan started a website in 2001 offering a $20 Pay
Per View event…..to watch him cut off his feet with a homemade
guillotine.

How should we feel about this entrepreneurial effort? (i.e. could we/should we repress this market?)

Note: this was a hoax….

What is your incentive to join in FSM?

?
Submit your cost and benefit analysis using Claroline

But before submitting the analysis we need to have clear idea regarding few concepts
The Fundamental Rule of Economics: each individual look for an incentive for their action.
Each action is backed by an objective.

Example/Case Study-1

What is the objective of a manager? who are managers?

A manager is a person who directs resources to achieve a stated goal. This definition includes all
individuals who
1) direct the efforts of others
2) purchase inputs to be used in the production of goods and services such as output of the firm
3) are in charge of making other decisions, such as product price and quality.

Primary objective is to earn profit.

Profit Signal
Profit signals where society’s scarce resources are best allocated

What is profit?
a) Accounting Profits
A = Total Revenue - Total Cost = TR - TCA

b) Economic Profits
E = Total Revenue - Total Cost = TR - (TCA +TCI)

The difference in the definitions is implicit costs. Implicit costs are measured in terms of foregone
alternatives. Economic costs are the sum of explicit and implicit costs. Economic costs can be
measured in terms of choices foregone, or opportunity costs.

Although accounting profits are not an incorrect definition of profits but this is inappropriate for the
purpose of making decisions regarding allocation.
Accounting Profit and Economic Profit

franchise fee $20,000 per year

Cost of materials and help $80,000 per year
Rent the shop $1,000 per month

How much must you earn to realize an accounting profit?

Quit your present job worth $25,000 per year

If you expected revenues of $120,000 per year, would

this be a good allocation of resources?
Time Value of Money

It is important to realize that money earned in the future is not valued the same as money earned
today.

Present Value Analysis

Suppose that the interest rate is 10%. Then it would take $1.10 next year to equal $1 today. In
general
PV(1+i) = FV
Similarly, for two years hence
PV(1+i)2 = FV
and in general
PV = FV
(1+i)n
We are mainly interested in a stream of earnings.
Time Value of Money

Example: the present value of Rs. 100.00 in 10 years if the interest rate is at 7 percent is
Rs.100 Rs.100
PV    Rs. 50.83
1  0.07 
10
1.9672

This essentially means that if you invest Rs. 50.83 today at a 7 percent interest rate,
in 10 years your investment would be worth Rs. 100.

The basic idea of the present value of a future amount can be extended to a series of future payments.
For example, if you are promised FV1 one year in the future, FV2 two years in the future, and so on for
n years, the present value of this sum of future payments is
FV1 FV2 FV3 FVn
PV     ........ 
1  i  1  i  1  i  1  i 
1 2 3 n

n
FVt
or, PV  
1  i 
t
t 1
Time Value of Money

The net present value (NPV) of a project is simply the present value (PV) of the income stream generated
by the project minus the current cost (C0) of the project: NPV= PV - C0.
n
FVt
NPV    C0
1  i 
t
t 1

If we have a varying rate for different years then we can use the formula
FV1 FV2 FV3 FVn
PV     ........ 
 1   1  2   1  2  3 
1  i 1  i 1  i 1  i 1  i 1  i 1  i1 1  i2  ....... 1  in 
Example/Case Study-2
Example/Case study-3

The NPV calculation is very sensitive to the discount rate: a small change in the discount rates causes a
large change in the NPV.
All other things being equal, using internal rate of return (IRR) and net present value (NPV)
measurements to evaluate projects often results in the same findings. IRR uses one single discount rate to
evaluate every investment.
Now you can submit your cost benefit analysis
You can submit following the format suggested here
Maximizing Net Benefit

To maximize net benefits a manager can use calculus-based derivation method. According to this
method a manager must equate marginal benefits and marginal costs.
Let B(Q) denote the benefits of using Q units of the managerial control variable, and let C(Q) denote
the corresponding costs. The net benefits are N(Q) = B(Q) - C(Q).
The objective is to choose Q so as to maximize N(Q) = B(Q) - C(Q).

dN dB dC
The first-order condition for a maximum is   0
dQ dQ dQ

dB dC
or , 
dQ dQ

or, MB  MC
dB dC
Where  MB (Marginal Benefits) and  MC(Marginal Cost)
dQ dQ
d 2 N d 2 B d 2C
Second order condition for maximum is   0
dQ 2 dQ 2 dQ 2
i.e., the slope of the marginal benefit curve must be less than the slope of the marginal cost curve.
Demonstration Problems

1) An engineering firm recently conducted a study to determine its benefit and cost structure. The
results of the study are as follows:
B(Y)= 300Y - 6Y2 and C(Y)= 4Y2
so that MB = 300 – 12Y and MC= 8Y. The manager has been asked to determine the maximum level
of net benefits and the level of Y that will yield that result.

Answer: Equating MB and MC yields 300 – 12Y = 8Y. Solving this equation for Y reveals that the
optimal level of Y is Y* = 15. into the net benefit relation yields the maximum level of net benefit
NB=300(15) – (6)(15) 2 – (4)(15) 2 = 2,250

2) Suppose B(Q)= 10Q – 2Q2 and C(Q)= 2+ Q2.

What value of the managerial control variable, Q, maximizes net benefits?

Answer: Do it yourself (Hints-use method of optimization. Calculate MB and MC and equate)

What next?

There is no doubt that there are many interrelated issues / factors that influences level (volume), growth
and sustainability of the profit. Therefore, one cannot guarantee/ assure to earn same or higher level of
profit in the coming quarters. One can consider this profit as a market signal. If you earn superior, your
competitors will take a piece of your action (e.g., Computer Industry).

Changes in the profit of a firm changes the sources of incentives for their activities. These incentives arise
via transactions, and are the consequence of competing interests. For every transaction, there are two parties.
There are three types of bargaining position/rivalry in the market
1) Consumer-producer
2) Consumer-consumer- it arises when consumers compete with each other mainly because of the scarcity.
3) Producer-producer- when there are multiple sellers in the market
4) Government intervention in the market – when agents on the either side of the market find
themselves disadvantaged in the market process, they frequently attempt to induce government to
intervene on their behalf.
Therefore as a manager, you need to design your strategy to earn superior profit and sustain the level of
the profit. Before we jump into the formulation of strategies, we need to have the conceptual framework of
the market, especially the behavior of firm and individuals who are considered as clients or customers.
Thank You!
Example/Case Study-1

During the recession managers are asked to increase the sell while customers are loosing their jobs.
loss of job have a negative impact on the total revenue earned by the company.
To avoid risk company wants to get back the return of its huge investment and push for increased sale
of their products.
What a manager will do?
Example/Case Study-2 : Demonstration Problem

The manager of Automated Products is contemplating the purchase of a new machine that will cost $300,000 and has a
useful life of five years. The machine will yield (year-end) cost reductions to Automated Products of $50,000 in year 1,
$60,000 in year 2, $75,000 in year 3, and $90,000 in years 4 and 5. What is the present value of the cost savings of the
machine if the interest rate is 8 percent? Should the manager purchase the machine?

Solution: By spending $300,000 today on a new machine, the firm will reduce costs by $365,000
(=$50,000+$60,000+$75,000+$90,000+$90,000) over five years. However, the present value of the cost savings is only

50,000 60,000 75,000 90,000 90,000

PV       $284,679
1.08 1.08 1.08 1.08 1.08
2 3 4 5

Consequently, the net present value of the new machine is

NPV=PV- C0
=$284,679 - $300,000
= -$15,321

Since the net present value of the machine is negative, the manager should not purchase the machine. In other words, the
manager could earn more by investing the $300,000 at 8 percent than by spending the money on the cost-saving
technology.
Cost and Benefit of joining FSM

Name Role Tuition Room Other Transportation Lost Salary Median Salary Total Total
Number and and Expenses Salary Prior to Cost Benefit
Fees Board for joining
education FSM

Think of the salary differential as interest being collected from an initial investment

Information regarding the median salary for the current year may be available from secondary sources.

Level of Education Median Salary

HS
College Graduate ( Arts/Science/Humanities)
MA/MSc/MTech
M Phil/PhD

Now we need to know how to maximize benefit?

Example/case study-3: Joining the jet set

Recently, a major airline offered a one-year membership in its Air Club for $125. Alternatively, one could purchase a three-year
membership for $360. Many managers and executives join air clubs because they offer a quiet place to work or relax while on
the road; thus, productivity is enhanced.

Let’s assume you wish to join the club for three years. Should you pay the up-front $300 fee for a three-year membership or pay
$125 per year for three years for total payments of $375? For simplicity, let’s suppose the airline will not change the annual fee
of $125 over the next three years.

On the surface it appears that you save $75 by paying for three years in advance. But this approach ignores the time value of
money. Is paying for all three years in advance profitable when you take the time value of money into account?

The present value of the cost of membership if you pay for three years in advance is $300, since all of that money is paid
today. If you pay annually, you pay $125 today, $125 one year from today, and $125 two years from today. Given an interest rate
of 5 percent, the present value of these payments is
$125 $125
PV  $125  
1.05 1.052

Or, PV  125  119.05  113.38  $357.43

Thus, in present value terms, you save $2.7 ( i.e., $360 - $357.3) if you pay for three years in advance. If you wish to join for
three years and expect annual fees to either remain constant or rise over the next three years, it is better not to pay in
advance. Given the current interest rate, the airline is offering a good deal, but the present value of the savings is $2.7, not
$75.00.
Example/Case Study-4:Computer Industry

The computer industry in the 1980s was very dynamic. The number of firms increased substantially.
As a consequence, prices fell, and also the quality of computers increased. More recently, computers
have become a more commodity-like product. The number of firms has decreased, and production runs
have increased.

If competitive assumptions are satisfied, economic profits are a temporary phenomenon, attributable to
a new idea, product develop or change in consumer tastes. Entry will dissipate these profits. On the
other hand, if competitive assumptions are not satisfied (because, a firm has a patent, or unique
license) then they are permanent, and not socially beneficial.
Profit Maximization ( for those who are interested to know little more)

As a manager maximizing profits means to you will be the maximizing the value of the firm, which is the present value of
current and future profits.
Suppose a firm’s current profits are p0, and that these profits have not yet been paid out to stockholders as dividends. Imagine
that these profits are expected to grow at a constant rate of g percent each year, and that profit growth is less than the interest
rate (g < i). In this case, profits one year from today will be (1 + g)1 p0, profits two years from today will be (1 + g) 2 p0, and
so on. The value of the firm, under these assumptions, is
 0 1  g   0 1  g   0 1  g   1 i 
2 3

PV firm   0     ......  0  
(1  i) (1  i) 2
(1  i) 3
 i  g 
For a given interest rate and growth rate of the firm, it follows that maximizing the lifetime value of the firm (long-term profits)
is equivalent to maximizing the firm’s current (short-term) profits of p0.

You may wonder how this formula changes if current profits have already been paid out as dividends. In this case, the present
value of the firm is the present value of future profits (since current profits have already been paid out). The value of the firm
immediately after its current profits have been paid out as dividends (called the ex-dividend date) may be obtained by simply
subtracting p0 from the above equation: PVEx dividend Firm  PVFirm   0
This may be simplified to yield the following formula:  1 g 
PVExdividend Firm   0  
 i  g 
Thus, so long as the interest rate and growth rate are constant, the strategy of maximizing current profits also maximizes the
value of the firm on the ex-dividend date.