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Chapter 1

Introduction to Managerial
Economics
What are managers doing?

• Decisions, Decisions, Decisions!!!


• What price to charge?
• What customers to target?
• What markets to enter?
• Where to produce?
• How intense to advertise?
What is Managerial
Economics?
• Guidelines for decision-making!
– It involves the study of analytical tools
and methods to determine the optimal
courses of action for decision-makers to
achieve their managerial goals
Managerial Economics
• By applying economic theory to
business problems, managerial
economics develops general principles
that can be applied to business
decision-making and strategy
How useful is Managerial
Economics?
• In a survey of a random sample of 500
executives drawn from the 1500 largest
U.S. companies, Guiseppe Forgionne found
that fully 70 percent of the executives
said that they make use of most of the
basic economic concepts of cost(e.g.
economies of scale,cost functions,learning
curves, etc.), price(MC pricing,
supply&demand, etc.), and value in decision
and strategy making
Application of Managerial
Economics: The Disney Corporation
• High brand recognition ≠ Sales
• Michael Eisner, the new CEO in 1980s
– used analyses based on managerial economics principles
– launched a series of advertising campaigns
– lowered the price of videocassette so that sales soared
– “Bundle pricing”: Disney cruise, Theme park ticket, Kid’s
meal with action figures from Disney’s movies
• As a result, Disney have given its shareholders
20% annual earnings growth for 14 years.
Application of Managerial
Economics: The Toyota Motor
Company
• Multiple products
– Camry, Corolla, Prius, Tundra, Scion, Rev4, etc.
• How much of a given product should they
produce in a production run?
– Long production run lowers costs associated with
changing over the production line to produce a
different product
– Short production cost lowers the costs associated
with raw material and final product inventory
• Economic order quantity model
Application of Managerial
Economics: Incentive Problems

• R&D and Executive Turnover


– Suppose a R&D-intensive firm links the
CEO's bonus to earnings and the CEO
plans to retire in two years.

What do you think would happen??


Application of Managerial
Economics: Incentive Problems
• The CEO might reduce the firm's
research and development budget to
boost earnings this year and next.
• Five years down the road, earnings
will suffer with no new products
coming on stream. By then, however,
this CEO will be long gone.
Application of Managerial
Economics: Incentive Problems
• Creative Responses to a Poorly Designed
Incentive System
– A manager at a software company wanted
to find and fix software bugs more
quickly. He devised an incentive plan that
paid $20 for each bug the Quality
Assurance people found and $20 for each
bug the programmers fixed.

What do you think would happen??


Application of Managerial
Economics: Incentive Problems
• Since the programmers who created the
bugs were also in charge of fixing them,
they responded to the plan by creating
bugs in software programs.
• This action increased their payoffs under
the plan-there were more bugs to detect
and fix.
• The plan was canceled within a single week
after one employee netted $1,700 under
the new program.
What is the goal of
firms?
• To maximize the value of the firm!
– Old-Fashioned: Current profit
– Current consensus: Expected profit
How to express
“Expected Profits”?
• Time preference
– people prefer their needs being met today
rather than tomorrow
• Future value (FV) & present value (PV)
– The value of a dollar received today in ten
years: 1 ⋅ (1 + 5%)10
– The value today of a dollar received in ten
years: 1
(1 + 5%)10
Expected Profits
• Present value of expected future profits
π1 π2 πn
= + +  +
1 + i (1 + i )2 (1 + i )n
n
πt
=∑
t =1 (1 + i )t

n
TRt − TCt
=∑
t =1 (1 + i )t