Fundamentals of Managerial Economics  Managers can use present value

analysis to properly account for the

Module 1B
timing of receipts and expenditures.

Time Value of Money

Managerial Economics
- economics applied in decision making.
Is a branch of economics that applies:
- Economic theory and decision science
methodology.
6 Basics Principles Comprising the Effective
Management:
1. Identify the Goals and Constraints
2. Recognize the Nature and Importance
of Profits.
3. Understand Incentives
4. Understand Markets
5. Recognize the Time Value of Money
6. Use Marginal Analysis
Economic Profit
1. Present value of a single future value;
2. Present value of a stream of future
values;
3. Future value and the opportunity cost
of waiting
4. Present Value of Indefinitely Lived
Assets
5. Present value and Profit Maximization
The Present Value of a Single Future Money
The amount that would have to be invested
today at the prevailing interest rate to generate
the given future value:
FV
PV =
( 1+ i )n
Where:

PV = present value

FV = future value

i = interest rate

N = nos. of years

Economic Profit V.S Accounting Profit PV of a Single Future Value

Economic profit is equal to total revenue less FV
economic costs. Economic costs are the sum of 1. PV =
( 1+ i )n
explicit and implicit costs and includes a normal
profit to the entrepreneur. Accounting profit is Example:
equal to total revenue less accounting (explicit)
The Present Value of receiving Php
costs.
100.00 ten years from now at 7%
The Time Value of Money interest rate.

- The timing of decision involves a gap Php100

PV = =Php 50.83
between the time when costs are borne ( 1. 07 )10
and benefits received.
 2. If the interest rate is 5 percent, what is
the present value of $10 received one
year from now?
$ 10.00 3. The Net Present Value of a Project
PV = =$ 9.52
( 1. 05 )1 - Is simply the present value (PV) of
3. What is the PV of receiving Php1,000, the income stream generated by
two years from now given that the the project minus the current cost
interest rate is 8% ? of the project:
1,000
PV = =Php 857.33 Formula:
( 1.08 )2
4. If the interest rate is 10% the PV of NPV = PV – OCW
Php2,000 received one year from now
Net Present Value is (+)
will be?
2,000 - the Project is Profitable
PV = =Php 1,818.18
( 1.10 )1 Net Present Value is (-)
- should reject a project that has a
2. Present Value of a Stream of Future Value negative NPV since the cost of such a
project exceeds the PV of the income
 The cumulative present value of future
stream that project generates.
cash flows can be calculated by
summing the contributions of FVt, the
value of cash flow at time t:
Present value reflects the difference between
FV 1 FV 2 FV n the future value and the opportunity cost of
PV = 1
+ 2
+ …+ waiting:
( 1+ i ) ( 1+i ) ( 1+i )n

Example:
Consider a project that returns the following
income stream: The manager of an office supply company is
contemplating the purchase of a new copier,
 Year 1, Php 10,000
which will cost P50,000 and has a useful life
 Year 2, Php 50,000; and
of 3 years. The copier will save the firm
 Year 3, Php 100,000
P20,000 in year one, P20,000 in  year 2, and
At an annual interest rate of 3%, What is the P15,000 in year 3. 
Present Value of this income stream from
 The machine can be re-sold at the
year 1 to year 3?
end of three years to a junk dealer for
P 10,000 P 50,000 P 100,000 P5,000. Alternatively, the manager
PV = + + can invest the P50,000 at a
( 1+ 0.03 )1 ( 1+0.03 )2 ( 1+0.03 )3
guaranteed interest rate of 5%. 
= 9,708.73 = 47,129.79 = 91,514.16  To maximize profits, should the
manager purchase the copier? or
= Php 148,352.68
invest the money at 5%?
Formula:
 PV =FV −OCW
First: Calculate the PV of a Stream of future
cash flows
By purchasing the copier the firm effectively
earns 20,000 in 1yr., 20,000 in 2 yr. and
15,000 in year 3. Thus, the PV of benefits of
buying the copier at 5% is:
20,000 20,000 15,000
Year 1 Year 2 Year 3
19,047.61 18,140.58 12,957.56
The Present Value of Buying the Copier is
= Php 50,145.75
Second: Calculate the Net Present Value
Given:
Present Value (PV) = 50,145.75
Opportunity Cost of Waiting (OCW) = 50,000
Formula: NPV = PV –OCW
NPV = 50,145.75 – 50,000 = 145.75
The PV exceeds the cost of the copier
(50,000) the manager maximize profits by
purchasing the copier instead of investing the
50,000 at 5%.
4. Present Value of Indefinitely lived Assets
 Some decisions generate cash flows
that continue indefinitely.
 Consider an asset that generates a
cash flow from one to three years for
an indefinite period of time.
 The asset generates a perpetual
stream of identical cash flows at the
end of each period.
Formula:
CF = Cash Flow
I = interest rate
CF
PVPerpetuity = i
Example:
What is the present value of a preferred stock
(entitles the holder to a fixed dividend) that
pays a perpetual dividend of P150 at the end
of each year when the interest rate is 5%?
PV perpetuity = 150 = Php3,000
5%
The value of a preferred stock that pays the
owner 150 at the end of each year when the
interest rate is fixed at 5%.
5. Present Value of a Firm
- Present value analysis is also useful in
determining the value of a firm since
the value of a firm is the PV of the
stream of profits (cash flow)
generated by the firm’s physical,
human and intangible asset;
- In other words, the value of the firm
today is the present value of its
current and future profits.
- The PV of the firm takes the long-term
impact of managerial decisions on
profits.
Present Value and Estimating Values of
Firms I
Formula:
PV = Present Value
i – Interest Rate
g = Growth Rate
 1+i - States optimal managerial decisions
PV = Value of the Firm ( )
i−g involve comparing the marginal
benefits and marginal costs
The formula explains that the profits of the - One of the most important managerial
firm have not yet been paid out to tools.
stockholders as dividends.

Given a Control Variable, Q, of a managerial

Profit Maximization object denote the
Suppose the interest rate is 10% and the firm - total benefit as B (Q).
is expected to grow at 5% for the foreseeable
future The firms current profits are 100M. - Total Cost as C (Q)

a. What is the value of the firm with no Manger’s Objective is to maxximize net
dividends paid out (the present value benefits:
of its current future earnings)?
Formula:
1+.1
PV =100 M ( ) N (Q) = B(Q) – C(Q)
.1−0.5

PV =100 M ( .0.0
1.10
5)
=2.2 B Marginal Principle

- To maximize net benefits, the

b. What is the value of the firm immediately
after it pays to stockholders as dividend equal
to its current profits.
Use Marginal Analysis
PV firm ex div. = Value of the firm – Dividend
PV = 2.2B – 100M = 2.1B
manager should increase the
managerial control variable up to the
point where marginal benefits equal
marginal costs.
 Marginal Benefit: MB (Q)
- The change in total benefits
arising from a change in the
managerial control variable, Q.
 Marginal Cost: MC (Q)
- The change in the total cost
arising from a change in the
managerial control variable, Q.
 Marginal Net Benefits: MNB (Q)
MNB(Q) = MB(Q) – MC (Q)

Marginal Analysis
Marginal Value Curves are the Slopes of Total
Value of Curves

 A Calculus Alternative
- Slope of a continuous function is
the derivative/marginal value of
that function.
dB(Q)
MB=
dQ
- Slope (first derivative) of the
total benefit curve
MC

dC (Q)
MC=
dQ
- Slope (first derivative) of
the total cost curve

dN (Q)
MNB=
dQ

Example 1

 It is estimated that the benefit and

cost structure of a firm is:
B(Q) = 250Q – 4Q2
C(Q) = Q2

 Find the MB(Q) and MC(Q)

functions.
MB(Q) = 250 – 8Q
MC(Q) = 2Q
 What value of Q makes NMB(Q)
zero?
250 – 8Q = 2Q
Q = 25
(when Q=25 the manager
ensures that NMB are
maximized. This is where
MB=MC at the level of Q that
maximizes net benefits.)
Example 2
An engineering firm conducted a study to
determine the benefits and cost structures:
B(Q) = 300Q – 6Q C(Q) = 4Q
1. Determine the MB and MC functions?
Therefore:
*MB = 300 – 12Q; MC = 8Q
2. What level of Q maximizes net benefits?
Equating MB and MC yields
300 – 12Q = 8Q
300 = 20Q
*The optimal level of Q is = 15
3. What is marginal benefit and marginal cost
at this level of Q?
MB = 300 – 12 (15) = 120
MC = 8 (15) = 120
An engineering firm conducted a study to
determine the benefits and cost structures:
B(Q) = 300Q – 6Q C(Q) = 4Q
Therefore:
*MB = 300 – 12Q; MC = 8Q
*The optimal level of Q is = 15
4. Determine the maximum level of net
benefits at this level of Q?
*MNB = 300 (15) – 6(15 2) – 4 (15 2)
= 4,500 – 1,350 – 900 = 2,250
2,250 is the amount at which the engineering
firm maximizes profits.

Market Equilibrium
 • Competitive Market Equilibrium
- Determined by the intersection of the
market demand and market supply
curves.
- A price and quantity such that there
is no shortage or surplus in the
market.
- Forces that drive market demand
and market supply are balanced, and
there is no pressure on prices or
quantities to change.
- The equilibrium price is the price
that equates quantity demanded with
quantity supplied
- Determined by the intersection of the
market demand and market supply
curves.
- A price and quantity such that there
is no shortage or surplus in the
market.
- Forces that drive market demand
and market supply are balanced, and
there is no pressure on prices or
quantities to change.
- The equilibrium price is the price
that equates quantity demanded with
quantity supplied
Market Equilibrium in Action
 Consider a market with demand and
supply functions, respectively, as
d S
Q =10−2 P∧Q =2+2 P
 A competitive market equilibrium
exists at a price, Pe , such that
Q ( P ) =Q ( P ) . That is,
d e s e
10−2 P=2+ 2 P
8=4 P Pe =$ 2Q e =10−2 ( $ 2 )=6
¿ Q e =2+2 ( $ 2 )=6
Qe =6 units
Market Equilibrium, Excess Demand, Excess
Supply
 Market Equilibrium
- When the supply of an item os
exactly identical to its
demand. Since there is neithe
a surplus nor shortage in this
situation the price tends to
stay stable.
 Excess Supply
- If the price is set too high (P1)
and the demand is expected to
be a Q2, but is actually lower
than expected (Q1); excess
supply ( or surplus) is created.
  In a competitive market equilibrium,
price and quantity freely adjust to the
forces of demand and supply.

 Sometime government restricts how

much prices are permitted to rise or
fall.
• Price ceiling

 Excess Demand
- If the price is set relatively low
(P1) and the demand for a
product are higher than
expected (q2) but the firm
only supplies Q1; Excess
demand (or shortage) is
created.
• Price floor

Price Ceiling in Action

 Consider a market with demand and

supply functions respectively, as
d s
Q =10−2 P∧Q =2+2 P

 Suppose a $1.50 price ceiling is

imposed on the market.
Qd =10−2 ( $ 1.50 )=7 units
s
Q =2+2 ( $ 1.50 ) =5units
 Since Qd > Qs a shortage of 7 – 5 = 2
Price Restriction and Market Equilbrium units exists
 Full economics price of 5th unit is 5 =
10 – 2Pfull , or Pfull = $2.50.
• $1.50 is the dollar price
 • $1 is the nonpecuniary price. - Increase equilibrium price

- Increase equilibrium quantity

Price Floor in Action
• Decrease in demand only
 Consider a market with demand and
supply functions respectively, as - Decrease equilibrium price

- Decrease equilibrium quantity

Qd =10−2 P∧Q s=2+2 P

 Suppose a $3.50 price ceiling is

imposed on the market.
d
Q =10−2 ( $ 3 .50 )=3 units
s
Q =2+2 ( $ 3 .50 )=9units
 Since Q d > Qs a shortage of 9 – 3 = 6
units exists
 Th ecost to the government of
purchasing the surplus is $3.50 x 6 = Example:
$21.
Suppose that consumer incomes are
projected to increase 2.5% and the number of
individuals over 25 years of age will reach an
Comparative Statics
all time high by the end of next year. What is
 Comparative static analysis the impact on the rental car market?

- The study of the movement

from one equilibrium to
another.

 Competitive markets, operating free

of price restraints, will be analyzed
when:

- Demand changes

- Supply changes

- Demand and supply

simultaneously change

Changes in Supply
Changes in Demand
• Increase in supply only
• Increase in demand only
- Decrease equilibrium price
 - Increase equilibrium quantity

• Decrease in supply only

- Increase equilibrium price

- Decrease equilibrium quantity

Simultaneous Shifts in Supply and Demand

 Suppose that simultaneously the

following events occur:

- An earthquake hit Kobe, Japan and

decreased the supply of fermented
rice used to make sake wine.

- The stress caused by the

earthquake led many to increase
their demand for sake, and other
alcoholic beverages.

 What is the combined impact on

Japan’s sake market?

Example:

Suppose that a bill before Congress would

require all employers to provide health care to
their workers. What is the impact on retail
markets?
Changes in Supply

• Increase in supply only

- Decrease equilibrium price

- Increase equilibrium quantity

• Decrease in supply only

- Increase equilibrium price

- Decrease equilibrium quantity

Example:

Suppose that a bill before Congress would

require all employers to provide health care to
their workers. What is the impact on retail
markets?
Demand

Graphically, the new demand curve lies

either to the right (an increase) or to the
left (a decrease) of the original demand
curve.

Supply Curve

Moves to the right increases supply, to the left  Demand Shifter

decreases supply

 Market Demand Curve

 Law of Demand

 Shift in Quantity Demand VS Shift in

Demand Changes in Quantity Demanded VS Shift in
Demand
Formula:
Profit = Revenue – Cost