MANAGERIAL ECONOMICS

14th Edition

BY
MARK HIRSCHEY AND ERIC BENTZEN
 Nature and
Scope of
Managerial
Economics
CHAPTER 1
Chapter 1 3
OVERVIEW
 How Is Managerial Economics Useful?
 Theory of the Firm
 Profit Measurement
 Why Do Profits Vary among Firms?
 Role of Business in Society
 Structure of this Text
Chapter 1 4
KEY CONCEPTS
 managerial  normal rate of return
economics  economic profit
 theory of the firm  profit margin
 expected value  return on stockholders'
maximization equity
 value of the firm  frictional profit theory
 present value  monopoly profit
 optimize theory
 satisfice  innovation profit
theory
 business profit
 compensatory profit
theory
Managerial Economics Defined 5

 The application of economic

theory and
 the tools of decision science
 to examine how an organization
can achieve its aims or
objectives most efficiently.
Figure 1.1 Managerial Decision Problem
6
Managerial Decision Problems

Economic theory Decision Sciences

Microeconomics Mathematical Economics
Macroeconomics Econometrics

MANAGERIAL ECONOMICS
Application of economic theory
and decision science tools to solve
managerial decision problems

OPTIMAL SOLUTIONS TO
MANAGERIAL DECISION PROBLEMS
How Is Managerial 7
Economics Useful?
 Evaluating Choice Alternatives
 Identify ways to efficiently achieve goals.
 Specify pricing and production strategies.
 Spell out production and marketing rules to maximize
profits.
 Making the Best Decision
 Managerial economics helps meet management
objectives efficiently.
 Managerial economics shows the logic of consumer,
and government decisions.
8
 Theory of the Firm 9

 Expected Value Maximization

 Owner-managers maximize short-run profits.
 Primary goal is long-term expected value
maximization.
 Constraints and the Theory of the Firm
 Resource constraints.
 Social constraints.
 Limitations of the Theory of the Firm
 Alternative theory adds perspective.
 Competition forces efficiency.
 Hostile takeovers threaten inefficient managers.
Theory of the Firm 10
 At its simplest level, a business enterprise represents a series of
contractual relationships that specify the rights and
responsibilities of various parties (see Figure 1.2).
 People directly involved include customers, stockholders,
management, employees, and suppliers. Society is also involved
because businesses use scarce resources, pay taxes, provide
employment opportunities, and produce much of society’s
material and services output.
 The model of business is called the theory of the firm. In its
simplest version, the firm is thought to have profit maximization
as its primary goal. The firm’s owner-manager is assumed to be
working to maximize the firm’s short-run profits.
 Today, the emphasis on profits has been broadened to
encompass uncertainty and the time value of money. In this
more complete model, the primary goal of the firm is long-term
expected value maximization.
11
Long-term expected 12
value maximization
 The value of the firm is the present value of the firm’s expected
future net cash flows. If cash flows are equated to profits for
simplicity, the value of the firm today, or its present value, is the
value of expected profits, discounted back to the present at an
appropriate interest rate.
 This model can be expressed as follows:

 Because profits () are equal to total revenues (TR) minus total
costs (TC), Equation (1.1) can be rewritten as
Why is discounting required? 13

 Discounting is required because profits obtained in

the future are less valuable than profits earned
presently.
 One dollar today is worth more than $1 to be
received a year from now because $1 today can be
invested and, with interest, grow to a larger amount
by the end of the year.
 One dollar invested at 10 percent interest would
grow to $1.10 in one year.
 Thus, $1 is defined as the present value of $1.10 due
in 1 year when the appropriate interest rate is 10
percent.
Determinants of Firm Value
The discount rate, i, depends on:
1. Perceived risk of the firm
(Chapters 16-18)
2. Capital market conditions.
14
Future stream of profits depends on:
1. Revenues generated
- Demand theory and
Forecasting (Chapters 3-6)
- Pricing (Chapters 10-15)
2. Costs
- Production methods used (Chapter 7)
- Nature of cost function (Chapter 8)
The Rationale for the Firm 15

 The interaction of individuals and firms in a market economy

can be described as a circular flow of money, goods and
resources through product and factor markets.
 Firms exist because the costs of production are lower and
returns to the owners of labor and capital are higher than if
the firm did not exist.
 The firm combines and organizes resources for the purpose of
producing goods and/or services for sale.
 Internalizes transactions, reducing transactions costs.
 Primary goal is to maximize the wealth or value of the firm.
 Example: KKR’s takeover of RJR Nabisco to refocus on wealth-
maximization
The Rationale for the Firm: 16
Reasons for lower costs:
 (1) there is a cost of using the price system to
organize production: costs of information,
negotiating and concluding several
contracts, for each step of the production
process would be very burdensome.
 (2) (secondary explanation) some
government intervention in the marketplace
applies to transactions among firms rather
than within firms.
The Rationale for the Firm: 17
Diminishing Returns to Management
 Limits are imposed on the size of firms because:
 (1) Transaction Costs (TC): the cost of organizing
transactions rises as the firm becomes larger (i.e. first
internalize the lower TC and then the higher ones. At
some point, these TC=costs of transacting in the
market and the firm ceases to grow.
 (2) Limited Managerial Ability.
 To overcome this problem, many large firms are
organized into groups of decisions referred to as
profit centers (PC). The management of each PC is
to maximize that division’s profit.
Objective of the Firm 18

 A management decision can only be

evaluated against the goal that the firm is
attempting to achieve.
 It is assumed that that the objective of the
firm is to maximize the present value of all
future profits, subject to various legal. moral,
contractual, financial, and technological
constraints.
 The principles of managerial economics
allow accurate predictions of decision
making in business and other organizations.
 Functions of Profit 19

 Profit is a signal that guides the allocation of society’s

resources.
 Profit provides incentive for firms to increase their
efficiency: profit is a reward to entrepreneurs for taking
risks, being especially innovative in developing new
products and reducing production costs.
 High profits in an industry are a signal that buyers want
more of what the industry produces (increase output rate
in the short run and expand in the long run).
 Low (or negative) profits in an industry are a signal that
buyers want less of what the industry produces (reduce
output rate in the short run or even shut down, and exist
the industry in the long run).
Maximizing Versus Satisficing 20

 Profit maximization for some critics is unrealistic

because managers must function in an environment
characterized by inadequate information and
uncertainty about the outcome of any strategy.
 Machlup contends that managers are seeking to
maximize profits and simply react intuitively to a set
of conditions characterized by incomplete
information and uncertainty as an automobile driver.
 Most of the criticism leveled at the PM is irrelevant. It
is not our concern about how real-world managers
really behave and what their goals are.
 The essential question is: If we assume PM, will the
principles of economics derived from that objective
function explain the behavior of real-world firms?
 Profit Measurement 21

 Business Versus Economic Profit

 Business (accounting) profit reflects
explicit costs and revenues.
 Economic profit
Profit
above a risk-adjusted normal return.
Considers cash and noncash items.
Opportunity cost: Implicit value of a
resource in its best alternative use.
 Variability of Business Profits
 Business profits vary widely.
 Why Do Profits Vary 22

Among Firms?
Disequilibrium Profit Theories
Unexpected revenue growth.
Unexpected cost savings.
Compensatory Profit Theories
Profits accrue to firms that are
better, faster, or cheaper
than the competition.
Theories of Why Profit Varies 23
Across Industries
 RISK-BEARING THEORY
 DYNAMIC EQUILIBRIUM (or
FRICTIONAL) THEORY OF PROFIT
 MONOPOLY THEORY OF PROFIT
 INNOVATION THEORY OF PROFIT
 MANAGERIAL EFFICIENCY THEORY
OF PROFIT
 Theories of Profit 24
 (1) Risk-Bearing Theories of Profit:
 Above normal returns (Econ.) are required by firms to enter
and remain in such fields as petroleum exploration with above
average risk.
 Similarly, the expected return on stocks has to be higher than
on bonds because of the greater risk of the former.
 (2) Frictional Theory of Profit:
 Stresses that profits arise as a result of friction or disturbances
from long-run equilibrium: perfectly competitive firms in the long run tend to earn zero
econ. profit (a normal return adjusted to risk) on their investment.

 At any time, however, firms are not likely to be in their long-run

equilibrium and may earn a profit or make a loss.
 For example, at the time of the energy crisis in the early 1970s,
firms producing insulating materials enjoyed a sharp increase
in demand, which led to large profits. With sharp decline in
petroleum prices in the mid-1980s, many of these firms began
to incur losses.
 Theories of Profit 25
 (3) Monopoly Theory of Profit
 Some firms have monopoly powers: they can restrict output and
charge higher prices and therefore can make monopoly profits.
 Monopoly power may arise from the firm’s (a) owning and
controlling the entire supply of a raw material required for the
production of the commodity,
 (b) from EOS,
 (c) from ownership of patents,
 (d) or from government restrictions that prohibit competition.
 (4) Innovation Theory of Profit
 It postulates that profits is the reward for the introduction of a
successful innovation.
 Example: Steven Jobs, the founder of the Apple Computer
Company, became a millionaire in the course of a few years by
introducing his company in 1977.
 Patent system is designed to protect the profits of a successful
innovator in order to encourage the flow of innovations. Remember
that inevitably other firms imitate and your profits will be brought
down and maybe eliminated.
Theories of Profit 26

 (5) Managerial Efficiency Theory of Profit

 It rests on the observation that if the
average firm tends to earn only a normal
return on its investment in the long run,
firms that are more efficient than the
average would earn above-normal
returns and economic profits.
 Example: the case of the Dell company.
Alternative Theories: Limitations of the
Theory of the Firm 27
 (1) Sales maximization (William Baumol et al Model)
 Managers of modern corporations seek to maximize sales
after an Adequate Rate of Profit has been earned to satisfy
stockholders.
 Empirically, a strong correlation has been found between
executives’ salaries and sales but not profit. More recent
studies have found the opposite.
 (2) Management utility maximization (Oliver Williamson et al
Model)
 It postulates that with the advent of the modern corporation
and the resulting separation of management from ownership,
 managers are more interested in maximizing their utility,
measured in terms of their compensation (salaries, fringe
benefits, stock option ..etc.), the size of their staff, extent of
control over the corporation, lavish offices …than maximizing
corporate profits.
The Principal-Agent Problem 28

 The P-A problem refers to the possibility that owners and their
managers may have different objectives. This is because of
the difficulty in monitoring the managers on a continual basis.
 These interests can be aligned through the use of managerial
compensation arrangements that tie individual compensation
to the overall performance of the firm.
 Compensation as incentive
 Extending to all workers stock options, bonuses, and grants of
stock
 Help make workers act as owners of firm
 Incentives to help the company, because that improves the
value of stock options and bonuses.
Alternative Theories: Limitations of
the Theory of the Firm 29
 (3) Satisficing behavior (Richard Cyert and
James March based on the Work of Herbert
Simon)
 Because of the great complexity of running the
large modern corporation (complicated by
uncertainty and lack of adequate data)
managers are not able to maximize profits
 but can only strive for some satisfactory goal in
terms of sales, profits, growth, market share …
 Simon called this satisficing behavior.
 This is not necessarily inconsistent with profit or
value maximization. With more and better data
and search procedures, the modern corporation
could conceivably approach profit or value
maximization.
Role of Business in Society 30

 Why Firms Exist

Businesses help satisfy consumer
wants.
Businesses contributes to social
welfare
 Social Responsibility of Business
Serve customers
Provide employment opportunities
Obey laws and regulations
31
Structure of this Text 32

 Objectives
Learn usefulness of economics in
describing managerial behavior.
Appreciate how economics can be
used to improve managerial
decisions.
Understand vital role of business in
society.