Managerial Economics

Applications, Strategies and Tactics, 14e

James R. McGuigan
R. Charles Moyer
Frederick H. deB. Harris

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 PART I – INTRODUCTION

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 Chapter 1 – Introductions and Goals of the Firm
Overview
• WHAT IS MANAGERIAL ECONOMICS?
• THE DECISION-MAKING MODEL
• THE ROLE OF PROFITS
• OBJECTIVE OF THE FIRM
• SEPARATION OF OWNERSHIP AND CONTROL: THE
PRINCIPAL-AGENT PROBLEM
• IMPLICATIONS OF SHAREHOLDER WEALTH
MAXIMIZATION
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 Figure 1.1 – Nitrous Oxide from Coal-Fired
Power Plants, pre Clean Air Act

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 Chapter 1 – Introductions and Goals of the Firm
What is Managerial Economics? (1 of 1)
• Managerial economics enables managers to select
strategic direction, allocate efficiently, and respond
effectively to tactical issues
• Managerial economic decision-making seeks to:
1. Identify the alternatives,
2. Select the choice that accomplishes the objective(s) in the
most efficient manner,
3. Taking into account the constraints,
4. And the likely actions and reactions of rival decision-makers.
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 Chapter 1 – Introductions and Goals of the Firm
The Decision-Making Model (1 of 3)
• Making good decisions is key to successful managerial
performance, and includes several elements:
• Establish the objectives
• Identify the problem
• Examine potential solutions
• Analyze the relative costs and benefits
• Analyze the best available alternative under a variety of
assumptions (sensitivity analysis)
• Implement the decision
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 Chapter 1 – Introductions and Goals of the Firm
The Decision-Making Model (2 of 3)
• The Responsibilities of Management
• Managers are responsible for many goals
• They must proactively solve problems before they become crises
• Moral Hazard in Teams
• The single most critical trait of effective managers is the ability to
motivate teams to perform to their best
• To encourage team members to avoid the moral hazards of free
riding and shirking of duties;
• Without penalties and sanctions, only moral duty induces full effort
teamwork
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 Chapter 1 – Introductions and Goals of the Firm
The Decision-Making Model (3 of 3)

• Managers in a capitalist economy are motivated to

monitor teamwork because of their overarching goal
to maximize returns to owners of the business:
• Economic profits: the difference between total revenue and total
economic cost
• Includes a “normal” rate of return on the capital contributions of
the firm’s partners

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 Figure 1.2 – Payoffs from Team Production
with and without a Supervisor

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 What Went Right? ● What Went Wrong?
Saturn Corporation
• Different kind of car company in 1991, but permanently closed
in 2009
• It used no-haggle pricing and designed cars to compete with
Asian imports
• Sales were above expectations at first because of tiny margin of
only $400 per car to GM, so that GM earned only 3% on capital
• Saturn customers wanted bigger Saturn cars rather than trade
up to Buick, as GM hoped
• Sales later slumped in the late 1990s through 2009
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 Chapter 1 – Introductions and Goals of the Firm
The Role of Profits (1 of 1)
• Risk-Bearing Theory of Profit
• Risk-bearing should lead to higher profits
• Temporary Disequilibrium Theory of Profit
• Firms may earn a return above or below the long-run normal return level
• Monopoly Theory of Profit
• A firm which dominates the market can persistently earn above-normal returns
• Innovation Theory of Profit
• These are the reward for successful innovations
• Managerial Efficiency Theory of Profit
• Exceptional managerial skills may lead to higher profits
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 What Went Right? ● What Went Wrong?
Eli Lilly, a Pharmaceutical Company
• It takes12.3 years on average to get a new drug approved.
• Patents on Lilly’s Prozac created monopoly power and profits for a
widely used medication for depression
• As the patent began to expire, Lilly requested a patent “extension”
because of some alterations in Prozac’s formula
• But when the patent extension was overturned, generic drug
manufactures took 70% of the share of the market for anti-depressants
• Lilly missed the chance of finding a replacement in time for its
blockbuster Prozac
• This is an example of having and losing monopoly power
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 Chapter 1 – Introductions and Goals of the Firm
Objective of the Firm (1 of 1)
• The Shareholder Wealth-Maximization Model
• Shareholder wealth is measured by the market value of a firm’s common
stock, which is equal to the present value of all expected future cash flows to
equity owners discounted at the shareholders’ required rate of return, plus a
value for the firm’s embedded real options:

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 Chapter 1 – Introductions and Goals of the Firm
Separation of Ownership & Control: Principal-Agent…
(1 of 2)

• Divergent Objectives and Agency Conflict

• Growth results in owners (principals) delegating decision-making authority to
professional managers (agents)
• Because manager-agents have much less to lose, agents may seek acceptable
(not maximum) profit levels, pursuing their own self-interests; Agency
Conflict
• Agency Problem
• Problems arise from inherent unobservability of managerial effort and
random disturbances in team production
• Separation of ownership (shareholders) and control (management) in large
corporations permits managers to pursue goals that are not always in the
long-term interests of shareholders
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 Comparison slide; see Figure 1.3, next slide

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 Figure 1.3 –
CEO Pay Trends Reflect Corporate Performance

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 Chapter 1 – Introductions and Goals of the Firm
Separation of Ownership & Control: Principal-Agent…
(2 of 2)

• Agency Problem (cont’d)

• In attempt to mitigate agency problems, firms incur agency costs:
• 1. Grants of stock options or restricted stock from Treasury stock so executive
compensation aligns the incentives for management with shareholder
interests; also, many monitor financial ratios and investment decisions of large
debtor companies; strengthens firm’s corporate governance
• 2. Internal audits and accounting oversight boards to monitor actions of
management
• 3. Bonding expenditures and fraud liability insurance to protect shareholders
• 4. Complex internal approval processes to limit discretion, but which prevent
timely responses to business opportunities

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 Chapter 1 – Introductions and Goals of the Firm
Implications of Shareholder Wealth Maximization (1 of 4)
• Critics of those who seek to align interests of managers with
equity owners allege that maximizing shareholder wealth
focuses on short-term payoffs, sometimes to detriment of
long-term profits
• But evidence suggests just the opposite:
• Short-term cash flows reflect only a small fraction of the firm’s share price
• In general, only about 85% of shareholder value can be explained by even 30
years of cash flows
• Managers’ value-maximizing behavior distinguishable from satisficing
behavior (hitting their targets)
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 Chapter 1 – Introductions and Goals of the Firm
Implications of Shareholder Wealth Maximization (2 of 4)
• Caveats to Maximizing Shareholder Value
• Complete Markets – to directly influence a company’s cash flows, forward or
futures markets, and spot markets must be available for firm’s inputs, outputs
and by-products
• No Asymmetric Information - Problems often arise because of asymmetric
information; Line managers and employees can misunderstand what senior
executives want when they challenge employees to find a thousand different
ways to save 1 percent
• Known Recontracting Costs – Focusing exclusively on discounted present
value of future cash flows requires managers to forecast future recontracting
costs for pivotal inputs

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 Chapter 1 – Introductions and Goals of the Firm
Implications of Shareholder Wealth Maximization (3 of 4)
• Residual Claimants
• Shareholders have only a residual claim on the firm’s net cash flows after all
expected contractual returns have been paid
• Goals in the Public Sector and Not-for-Profit Enterprises
• Profit maximization not appropriate for public sector of NFP firms
• Public goods are consumed by more than one person at a time with little or no
extra cost; expensive or impossible to exclude those who do not pay
• Not-for-Profit Objectives
• Maximize: 1) quantity and equality of output subject to break-even budget
constraint; 2) outcomes preferred by NFP’s contributors; 3) longevity of NFP’s
contributors
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 Chapter 1 – Introductions and Goals of the Firm
Implications of Shareholder Wealth Maximization (4 of 4)
• The Efficiency Objective in Not-for-Profit Organizations
• Cost-benefit analysis is a resource-allocation model that can be used by public
sector and NFP firms to evaluate programs or investments on the basis of the
magnitude of the discounted costs and benefits
• Because such spending is constrained by a budget ceiling, goals can be any one of
these:
• 1. Maximize benefits for given costs
• 2. Minimize the costs while achieving a fixed level of benefits
• 3. Maximize the net benefits (benefits minus costs)
• But cost-benefit analysis is only one factor in the final decision
• It does not incorporate subjective considerations or less quantifiable attributes
such as fairness
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