Chapter 1

The Fundamentals of Managerial

Economics
 Learning Objectives

Summarize Summarize how goals, constraints, incentives, and market rivalry affect economic decisions.

Distinguish Distinguish economic versus accounting profits and costs.

Explain Explain the role of profits in a market economy.

Apply Apply the five forces framework to analyze the sustainability of an industry’s profits.

Apply Apply present value analysis to make decisions and value assets.

Apply marginal analysis to determine the optimal level of a managerial control variable.
Apply

Identify Identify and apply seven principles of effective managerial decision making.

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 The Manager

A person who directs resources to achieve a stated goal.

– Directs the efforts of others.
– Purchases inputs used in the production of the firm’s output.
– Directs other decisions, such as, the product price and quality.

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 Economics

The science of making decisions in the presence of scarce resources.

– Resources are anything used to produce a good or service or achieve a goal.
– Decisions are important because scarcity implies trade-offs.

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 Managerial Economics Defined

The study of how to direct scarce resources in the way that most efficiently
achieves a managerial goal.
– Should a firm purchase components – like disk drives and chips – from other
manufacturers or produce them within the firm?
– Should the firm specialize in making one type of computer or produce several
different types?
– How many computers should the firm produce, and at what price should you sell
them?
– How many employees should the firm hire and how should they be compensated?

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 Economics of Effective Management

7 Principles of Effective Managerial Decision Making

1. Identify 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
7. Make data driven decisions

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 Identify Goals and Constraints

• Goals must be well-defined

• Firm’s overall goal is to maximize profits

• Constraints make it difficult to achieve goals

– Available technology
– Prices of inputs used in production

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 Recognize the Nature and Importance of Profits

Accounting profit
– Total amount of money taken in from sales (total revenue) minus the dollar cost of
producing goods or services.
Economic profit
– The difference between total revenue and total opportunity cost.
– Opportunity cost
• The explicit cost of a resource plus the implicit cost of giving up its best alternative.

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 Recognize the Nature and Importance of Profits

The role of profits

– Profits are a signal to resource holders where resources are most highly valued by
society.

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Five Forces and Industry Profitability (Figure 1-1)

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 Understand Incentives

• Changes in profits provide an incentive to resource holders to alter their

use of resources.
• Within a firm, incentives impact how resources are used and how hard
workers work.
—One role of a manager is to construct incentives to induce maximal effort from
employees.

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 Understand Markets

• Two sides to every market transaction: buyer and seller

• Bargaining position of consumers and producers is limited by three
rivalries in economic transactions:
⁻ Consumer-producer rivalry
⁻ Consumer-consumer rivalry
⁻ Producer-producer rivalry
• Government and the market

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 Recognize the Time Value of Money

Often a gap exists between the time when costs are borne, and when
benefits are received.
– Managers can use present value analysis to properly account for the timing of
receipts and expenditures.

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 Present Value Analysis 1

Present value of a single future value

– 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

– Present value reflects the difference between the future value and the opportunity
cost of waiting:
𝑃𝑉 = 𝐹𝑉 − 𝑂𝐶𝑊

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 Present Value Analysis II

Present value of a stream of future values

𝐹𝑉1 𝐹𝑉2 𝐹𝑉𝑛

𝑃𝑉 = 1
+ 2
+ ⋯+ 𝑛
1+𝑖 1+𝑖 1+𝑖
or,
𝑛
𝐹𝑉𝑡
𝑃𝑉 = ෍ 𝑡
1+𝑖
𝑡=1

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 The Time Value of Money in Action

Consider a project that returns the following income stream:

– Year 1, $10,000; Year 2, $50,000; and Year 3, $100,000.
– At an annual interest rate of 3 percent, what is the present value of this income
stream?

$10,000 $50,000 $100,000

𝑃𝑉 = 1
+ 2
+ 3
= $148,352.70
1 + 0.03 1 + 0.03 1 + 0.03

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 Net Present Value

The present value of the income stream generated by a project minus the
current cost of the project:
𝐹𝑉1 𝐹𝑉2 𝐹𝑉𝑛
𝑁𝑃𝑉 = 1
+ 2
+⋯+ 𝑛
− 𝐶0
1+𝑖 1+𝑖 1+𝑖

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 Present Value of Indefinitely Lived Asset

Present value of decisions that indefinitely generate cash flows:

𝐶𝐹1 𝐶𝐹2 𝐶𝐹3
𝑃𝑉𝐴𝑠𝑠𝑒𝑡 = 𝐶𝐹0 + 1
+ 2
+ 3
+⋯
1+𝑖 1+𝑖 1+𝑖
Present value of this perpetual income stream when the same cash flow is
generated (𝐶𝐹1 = 𝐶𝐹2 = ⋯ = 𝐶𝐹):

𝐶𝐹
𝑃𝑉𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 =
𝑖

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 Present Value and Profit Maximization

Profit maximization
–Maximizing profits means maximizing the value of the firm, which is
the present value of current and future profits.

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 Present Value and Estimating Values of Firms I

The value of a firm with current profits 𝜋0 , with no dividends paid out and
expected, constant profit growth rate of 𝑔 (assuming 𝑔 < 𝑖) is:

𝜋0 1 + 𝑔 𝜋0 1 + 𝑔 2 𝜋0 1 + 𝑔 3
𝑃𝑉𝐹𝑖𝑟𝑚 = 𝜋0 + 1
+ 2
+ 3
+⋯
1+𝑖 1+𝑖 1+𝑖

1+𝑖
= 𝜋0
𝑖−𝑔

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 Present Value and Estimating Values of Firms II

When dividends are immediately paid out of current profits, the present
value of the firm is (at ex-dividend date):

𝑃𝑉𝐹𝑖𝑟𝑚 𝐸𝑥−𝑑𝑖𝑣 = 𝑃𝑉𝐹𝑖𝑟𝑚 − 𝜋0

1+𝑔
= 𝜋0
𝑖−𝑔

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 Short-Term versus Long-Term Profits

Short-term and long-term profits

– If the growth rate in profits is less than the interest rate and both are constant,
maximizing current (short-term) profits is the same as maximizing long-term
profits.

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 Use Marginal Analysis

Given a control variable, 𝑄, of a managerial objective, denote the

– total benefit as 𝐵 𝑄 .
– total cost as 𝐶 𝑄 .

Manager’s objective is to maximize net benefits:

𝑁 𝑄 =𝐵 𝑄 −𝐶 𝑄

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 Use Marginal Analysis

How can the manager maximize net benefits?

Use marginal analysis
– 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 costs arising from a change in the managerial control variable, 𝑄.
– Marginal net benefits: 𝑀𝑁𝐵 𝑄
𝑀𝑁𝐵 𝑄 = 𝑀𝐵 𝑄 − 𝑀𝐶 𝑄

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 Use Marginal Analysis

Marginal principle
– To maximize net benefits, the manager should increase the managerial control
variable up to the point where marginal benefits equal marginal costs. This level of
the managerial control variable corresponds to the level at which marginal net
benefits are zero; nothing more can be gained by further changes in that variable.

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 Marginal Analysis In Action

It is estimated that the benefit and cost structure of a firm is:

𝐵 𝑄 = 250𝑄 − 4𝑄 2
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

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 Determining the Optimal Level of a
Control Variable (Figure 1-2)
Total benefits
Total costs
Maximum total benefits
𝐶 𝑄

𝐵 𝑄
Maximum net
benefits

0 Quantity
(Control Variable)

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Determining the Optimal Level of a Control
Variable II (Figure 1-2)
Net benefits

Maximum
net benefits

Slope =𝑀𝑁𝐵(𝑄)

0 Quantity
𝑁 𝑄 =𝐵 𝑄 −𝐶 𝑄 =0 (Control Variable)

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 Determining the Optimal Level of a
Control Variable III (Figure 1-2)
Marginal
benefits, costs
and net benefits

Maximum net
benefits 𝑀𝐶 𝑄

0 Quantity
𝑀𝑁𝐵 𝑄 𝑀𝐵 𝑄 (Control Variable)

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Determining the Optimal Level of a Control Variable II (Figure 1-2)

1-30
 Marginal Value Curves Are the Slopes of Total
Value Curves
– When the control variable is infinitely divisible, the slope of a total value curve at a
given point is the marginal value at that point.

– The slope of the total benefit curve at a given Q is the marginal benefit of that
level of Q.

– The slope of the total cost curve at a given Q is the marginal cost of that level of Q.

– The slope of the net benefit curve at given Q is the marginal net benefit of that
level of Q.

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 Incremental Decisions
Incremental revenues
– The additional revenues that stem from a yes-or-no decision.
Incremental costs
– The additional costs that stem from a yes-or-no decision.
“Thumbs up” decision
– 𝑀𝐵 > 𝑀𝐶.
“Thumbs down” decision
– 𝑀𝐵 < 𝑀𝐶.

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 Make Data-Driven Decisions

How does one obtain information on the demand function?

– Published studies
– Hire a consultant
– Econometric models
– Statistical technique called regression analysis using data on quantity, price,
income and other important variables.

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 Regression Line and Least Squares Regression
• True (or population) regression model
𝑌 = 𝑎 + 𝑏𝑋 + 𝑒
– 𝑎 unknown population intercept parameter.
– 𝑏 unknown population slope parameter.
– 𝑒 random error term with mean zero and standard deviation 𝜎.
• Least squares regression line
෠
𝑌 = 𝑎ො + 𝑏𝑋
– 𝑎ො least squares estimate of the unknown parameter 𝑎.
– 𝑏෠ least squares estimate of the unknown parameter 𝑏.
• The parameter estimates 𝑎ො and 𝑏, ෠ represent the values of 𝑎 and 𝑏 that result in
the smallest sum of squared errors between a line and the actual data.

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 Obtaining Estimates Using Regression (Figure 1-3)
• Find the line that minimizes the sum of
squared deviations between the line
and the actual data points.
• The least squares regression line for
the equation
𝑌 = 𝑎 + 𝑏𝑋 + 𝑒
Where a and b are unknown parameters and e is a random
variable
• Is given by
෠
Y= 𝑎ො + 𝑏𝑋
Parameter estimates 𝑎ො and 𝑏෠ represent
the values of a and b that result in the
smallest sum of squared errors between a
line and the actual data.
35
Using a Spreadsheet to Perform a Regression (Table 1-3)
The Data

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 Excel and Least Squares Estimates (Table 1-3)
SUMMARY OUTPUT
Estimated Demand:
Regression Statistics
𝑄 = 1631.47 − 2.60𝑃𝑅𝐼𝐶𝐸
Multiple R 0.87
R Square 0.75 𝑎ො = 1631.47
Adjusted R Square 0.72 𝑏෠ = −2.60
Standard Error 112.22
Observations 10.00

Analysis of Variance
Df SS MS F Significance F
Regression 1 301470.89 301470.89 23.94 0.0012
Residual 8 100751.61 12593.95
Total 9 402222.50

Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

Intercept 1631.47 243.97 6.69 0.0002 1068.87 2194.07
Price -2.60 0.53 -4.89 0.0012 -3.82 -1.37

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 Excel and Least Squares Estimates (Table 1-3)
SUMMARY OUTPUT

Regression Statistics ෢ = 243.97

𝑠𝑒 (𝑎)
Multiple R 0.87 ෢ = 0.53
𝑠𝑒(𝑏)
R Square 0.75
Adjusted R Square 0.72 𝑡𝑎ො = 6.69 > 2, the intercept is different
Standard Error 112.22 from zero.
Observations 10.00 𝑡𝑏෠ = −4.89 < 2, the intercept is different
from zero.
Analysis of Variance
Df SS MS F Significance F
Regression 1 301470.89 301470.89 23.94 0.0012
Residual 8 100751.61 12593.95
Total 9 402222.50

Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

Intercept 1631.47 243.97 6.69 0.0002 1068.87 2194.07
Price -2.60 0.53 -4.89 0.0012 -3.82 -1.37

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 Evaluating Statistical Significance
Confidence Intervals
• Standard error
–Measure of how much each estimated coefficient would vary in
regressions based on the same underlying true relationships with
different observations.

• 95 Percent Confidence interval rule of thumb

– 𝑎ො ± 2𝜎𝑎ො
– 𝑏෠ ± 2𝜎𝑏෠

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 Evaluating Statistical Significance
The t-statistic
• t-statistic – the ratio of the value of a parameter estimate to the standard
error of the parameter estimate.
𝑎ො
• The t-statistic for 𝑎ො 𝑖𝑠 𝑡𝑎 Ƹ =
𝜎 Ƹ
𝑎

𝑏෠
• The t-statistic for 𝑏෠ 𝑖𝑠 𝑡𝑏 Ƹ =
𝜎𝑏෡

• t-statistics rule of thumb

–When 𝑡 > 2, we are 95 percent confident the true value of the underlying
parameter in the regression is not zero.
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Regression for Nonlinear Functions (Figure 1-4)

1-41
 Regression for Nonlinear Functions
and Multiple Regression
Regression techniques can also be applied to the following settings:
– Log-Linear Regression Line
ln 𝑌 = 𝑎 + 𝑏 ln 𝑋 + 𝑒,
by using a spreadsheet to compute Y’ = ln Y and X’ = ln X, this can
be viewed
Equivalently as Y’ = a + bX’ + e

– Multiple regression:
𝑌 = 𝑎 + 𝑏𝑋1 + 𝑏2 𝑋2 + ⋯ + 𝑏𝑘 𝑋𝑘 + 𝑒

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 Learning Managerial Economics

• Practice, practice, practice …

• Make data-driven decisions

• Learn terminology
– Break down complex issues into manageable components.

– Helps economics practitioners communicate efficiently.

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 Appendix A: The Calculus of Maximizing Net Benefits
To maximize net benefits, a manager must equate marginal benefits and
marginal costs. The objective is to choose Q so as to maximize
N(Q) = B(Q) – C(Q);

𝑑𝐵 𝑄 𝑑𝐶 𝑄 𝒅𝑩 𝒅𝑪
= 𝑀𝐵 and = 𝑀𝐶; so = ; or MB=MC
𝑑𝑄 𝑑𝑄 𝒅𝑸 𝒅𝑸

The second-order condition requires the function N(Q) be concave in Q;

d2 𝑁 d2 𝐵 d2 𝐶
2
= 2
− 2<0
d𝑄 d𝑄 d𝑄
*the slope of the marginal benefit curve must be less than the slope of the
marginal cost curve.
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 Appendix B: Evaluating the Overall Fit
of the Regression Line
R-Square
– Also called the coefficient of determination.
– Fraction of the total variation in the dependent variable that is explained by the
regression.

2
𝐸𝑥𝑝𝑙𝑎𝑖𝑛𝑒𝑑 𝑉𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 𝑆𝑆𝑅𝑒𝑔𝑟𝑒𝑠𝑠𝑖𝑜𝑛
𝑅 = =
𝑇𝑜𝑡𝑎𝑙 𝑉𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 𝑆𝑆𝑇𝑜𝑡𝑎𝑙

– Ranges between 0 and 1.

• Values closer to 1 indicate “better” fit.

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 Evaluating the Overall Fit of the Regression Line

Adjusted R-Square
– A version of the R-square that penalize researchers for having few degrees of
freedom.
2 2
(𝑛 − 1)
𝑅 =1− 1−𝑅
(𝑛 − 𝑘)
– 𝑛 is total observations.
– 𝑘 is the number of estimated coefficients.
– 𝑛 − 𝑘 is the degrees of freedom for the regression.

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 Evaluating the Overall Fit of the Regression Line

The F- Statistic
A measure of the total variation explained by the regression relative to the
total unexplained variation.

–The greater the F-statistic, the better the overall regression fit.

–Equivalently, the P-value is another measure of the F-statistic.

• Lower P-values are associated with better overall regression fit.

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 Excel and Least Squares Estimates – F-Statistic
SUMMARY OUTPUT

Regression Statistics
Multiple R 0.87
R Square 0.75
Adjusted R Square 0.72
Standard Error 112.22
Observations 10.00

ANOVA
Df SS MS F Significance F
Regression 1 301470.89 301470.89 23.94 0.0012
Residual 8 100751.61 12593.95
Total 9 402222.50

Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

Intercept 1631.47 243.97 6.69 0.0002 1068.87 2194.07
Price -2.60 0.53 -4.89 0.0012 -3.82 -1.37

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