Introduction and

Goals of the Firm

Lesson 1
 What is
Managerial
Economics?
Section 1

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Managerial Economics: Definition
• Managerial economics extracts from
microeconomic theory those concepts and
techniques that enable managers to select 2. select the
strategic direction, to allocate efficiently the choice that
resources available to the organization, and 1. identify the accomplishes
alternatives the objective(s)
to respond effectively to tactical issues. in the most
efficient manner
• All such managerial decision making seeks
to do the following:
4. and the likely
3. taking into actions and
account the reactions of
constraints rival decision
makers.

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The Decision-
Making Model
Section 2

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Decision making process

Good decisions = better performance

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Decision making process: The responsibilities of Management

• Managers should proactively solve business problems.

Productivity Risk
Mismanagement Defeatism Overplanning Under planning
shortfall Mismanagement

Change
Defense of the Perverse
management Failure to lead Lack of control Authoritarianism
status quo Incentives
failure

Neglect of Optimization Corporate

Rent seeking Bozo explosion
culture Myopia Narcissism

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Decision making process: Moral Hazard in Teams

• Managers should focus on teamwork and motivation

• Moral hazard occurs when an entity has an incentive to increase its exposure to
risk because it does not bear the full costs of that risk. For example, when a
corporation is insured, it may take on higher risk knowing that its insurance will
pay the associated costs.

• Economic profit is the difference between total sales revenue (price times units
sold) and total economic cost. The economic cost of any activity may be thought
of as the highest valued alternative opportunity that is forgone.

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The Role of
Profits
Section 3

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The Role of Profits
Temporary
Risk-Bearing Monopoly
Disequilibrium
Theory of Theory of
Theory of
Profit Profit
Profit
Managerial
Innovation
Efficiency
Theory of
Theory of
Profit
Profit
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Industry Life Cycles

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Abnormal profits and Unicorns
• Unicorn is the term used in the venture capital industry to describe a start-up company with a value of over
$1 billion. The term was first coined by venture capitalist Aileen Lee.

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Hyperdisruptive Business Models

The
The Freemium
Subscription The Free Model
Model
Model

The Access- The

The Digital
Over-Ownership Hypermarket
Platform Model
Model Model

The Service
The Experience
Ecosystem
Model
Model

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Objective of the
Firm/Theory of
the Firm
Section 4

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The Shareholder Wealth-Maximization Model of the Firm
• To maximize the value of the firm, managers should maximize shareholder wealth. 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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Constrains on the Operations of the Firm
• There are many factors which affect the working of a firm and many of them also acts as the
constraints, due to their limited availability and other reasons.
• Limited availability of inputs
• Amount of investments
• Contractual agreements
• Level of output
• Legal restrictions
• Governmental rules
• Technological issues
• Financial issues

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Some criticisms:
• Firms are not a homogenous unit. Owners may want profit maximization, but managers and workers may
have different objectives.
• Other objectives to profit maximization. Profit maximization is not the only goal of a firm, it could include
maximizing sales, maximizing market share, social responsibility (e.g. looking after the environment) and
co-operatives which seek to improve the welfare of all society.
• Marginal approach to firms is not replicated in the real world. Businessmen do not have time or the ability
to work out the marginal cost and marginal revenues. They tend to use a rough ‘rule of thumbs’ such as
average cost + profit margin. Prices may also be sticky (not change) even if marginal cost and marginal
revenue changes.
• Imperfect information. Firms have imperfect information about prices, costs and competitors. Also, workers
are not like a typical factor of production. They may become demotivated or discouraged if work appears
boring or lacking in interest. This can affect the objectives of firms.
• Behavioral economics. Recent behavioral economists, Thaler and Aversky state the importance of human
psychology in determining the behavior of firms – a much more complex set of circumstances than simple
profit maximization.

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 Separation of
Ownership and
Control: The
Principal-Agent
Problem
Section 5

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Divergent Objectives and Agency Conflict
Two key assumptions underlie agency theory.
1. All individuals will act in their own self-
interest. Therefore, where a potential conflict
of interest exists between principals and
agents, agents will tend to act first in ways
that will maximise their own personal
circumstances.
2. Agents are in a position of power as they
have better access to, and control of,
information (information asymmetry) and the
ability to make decisions. This allows them
to further their own interests.

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Further on the Agency Theory
• Agency theory identifies three types of agency costs: monitoring costs, bonding costs
and costs relating to residual loss. These costs can arise as a result of:
 information asymmetry (where the agent has more information than the principal)
 poor communication
 poor understanding
 innocent and unintended self-interested behaviour by agents
 deliberate legal self-interested behaviour
 illegal self-interested behaviour by agents (e.g. fraud).

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Agency Issues and Costs
Monitoring Costs
• Monitoring costs are incurred
by principals because an
agency relationship exists.
Some monitoring costs are
compulsory, such as costs
relating to annual reporting
and external auditing. Other
monitoring costs are
discretionary, such as the
work required to construct
and analyse activities
according to a strategic or
balanced scorecard.
Bonding Costs
• Bonding costs are costs
incurred by the agent to
demonstrate to the principal
that they are goal congruent.
This may include voluntary
restrictions on the agent’s
behaviour or benefits to
demonstrate goal
congruence, and are part of
the explanation for the
development of executive
stock options and other
benefits that have significantly
increased executive rewards
in recent decades.
Residual Loss
• Residual loss is a cost
incurred by the principal.
Residual loss arises because,
no matter how good the
monitoring and bonding
efforts, the agent will
inevitably make decisions that
are not consistent with the
principal’s interests. Any loss,
cost or underperformance
arising from these decisions
or actions by the agent
represents a residual loss of
value to the principals.
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Examples of residual loss
Excessive Non-financial Benefits
• The over-consumption of perquisites (perks) relates to obtaining an excessive level of incidental benefits in addition to income.

Empire Building
• Empire building refers to acts by management to increase their power and influence in a company for reasons associated with
personal satisfaction. Such personal aggrandisement or excess may have little or no congruence with company profitability or
success.

Risk Avoidance
• Depending on how managers are remunerated, there may be little incentive for them to engage in risky investments. The higher
returns associated with risk might be actively sought by some shareholders who have the ability to diversify their own risk through
their portfolio of investments.

Differing Time Horizons

• Managers often only have an interest in the firm for the duration of their employment. If managers are to be rewarded on current-
year profits alone, then those managers may only consider the current year as being the relevant time frame. If managers anticipate
leaving the firm or are approaching retirement, they may seek to maximise gains based on those time frames.

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Agency costs and ethics: Short case example
Robert was the CEO of a large listed corporation. He had been in the position for many years. During his
tenure, a branch had opened near a popular seaside resort in Thailand. It was not profitable, but Robert argued
it was important and visited it several times each year. He would commonly take a holiday at the same time at
a nearby resort. The corporation would pay his hotel bills and travel costs.
Robert later retired and his position was advertised. Susan was interviewed by the board for the position.
Susan had sought extensive information about the corporation and had learned about Robert’s regular travel
and holidays. At the interview, without inappropriately referring to Robert, Susan advised the board that:
 she would only travel with permission from the corporation chair
 if urgent travel was required without permission from the chair, she would provide a written report to the
board following the travel
 if the report was not accepted immediately, she would pay the travel costs personally without further
request to the corporation
 she would undertake a review of the efficiency of all overseas branches with a view to closing those that
were not profitable.

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Monetary and Non-monetary benefits

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Monetary and Non-monetary benefits

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Agency costs: Ways to mitigate the Agency problem

Grants of restricted stock or deferred stock options to structure executive compensation

in such a way as to align the incentives for management with shareholder interests.

Internal audits and accounting oversight boards to monitor management’s actions.

Bonding expenditures and fraud liability insurance to protect the shareholders from
managerial dishonesty.

Lost profits arising from complex internal approval processes designed to limit
managerial discretion, but which prevent timely responses to opportunities.

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Implications of
Shareholder
Wealth
Maximization
Section 6

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Shareholder Wealth Maximization
• The goal of shareholder wealth maximization requires a long-term focus.

• Shareholder wealth maximization also reflects dynamic changes in the information

available to the public about a company’s expected future cash flows and foreseeable
risks.

• In general, only about 85 percent of shareholder value can be explained by even 30

years of cash flows. The remainder reflects the capitalized value of strategic flexibility
to expand some profitable lines of business, to abandon others, and to retain but delay
investment in still others until more information becomes available. These additional
sources of equity value are referred to as “embedded real options.”

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What are real options?

facilitating follow-on projects through exiting early without penalty through

growth options abandonment options

staging investment over a learning

period until better information is
available through deferral options

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Factors affecting Share Price
THE MARKET DEMAND AND INTEREST POLITICAL
DIVIDENDS MANAGEMENT ECONOMY
PLACE SUPPLY RATES CLIMATE
• The marketplace • Demand and • In case of lower • Dividends • Management • Fluctuations in • Political factors
determines share supply in the interest rates, indicate the profile has a the economy that range from
prices. While market affect the demand for funds movement of significant effect feature what are relations with
seller supply and prices of shares. is higher and the share prices. on company commonly other nations to
buyer demand When demand subsequent When companies success and referred to as government
meet in the for shares demand for make dividend stock prices. If booms and policies can
market, there is exceeds supply, shares rises. On announcements, management depressions. affect share
no perfect which means the the other hand, the share prices consists of Under favorable prices.
equation that lets buyers are more high interest of such experienced conditions share
investors know than sellers, the lowers the companies are professionals prices are at their
exactly how prices increase. demand for funds likely to increase. with a proven peak and their
share prices will When demand is and the demand It is important to track record, lowest point is
behave. less than supply, for shares is note that if the share prices are experienced
However, there a meaning that lower. dividend rate likely to be during
number of factors buyers are less announced is higher. If the depressions.
that can move than sellers, the lower than the management that Share prices
stocks up and prices decrease. investors’ takes over a gradually rise
down. expectations, company lacks during recovery
share prices integrity, share and fall during
decline while if prices tend to recessions
they are up to fall.
more than
expected, share
prices increase.

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Caveats to Maximizing Shareholder Value

No
Complete
Asymmetric
Markets
Information

Known
Recontracting
Costs

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Residual Claimants
• Why is it that the primary duty of management and the board of directors of a
company is to the shareholders themselves?

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Goals in the Public Sector and Not-for-Profit Enterprise

1. Maximizing the quantity and quality of output

subject to a break-even budget constraint.

2. Maximizing the outcomes preferred by the

NFP’s contributors.

3. Maximizing the longevity of the NFP’s

administrators.

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The Efficiency Objective in Not-for-Profit Organizations
• Cost-benefit analysis has been developed to more efficiently allocate public and NFP resources
among competing uses. Because government and NFP spending is normally constrained by a
budget ceiling, the goals actually used in practice can be any one of the following:

1. Maximize the benefits for given costs.

2. Minimize the costs while achieving a fixed level of
benefits.
3. Maximize the net benefits (benefits minus costs).

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 International
Framework of
Managerial
Economics

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International Framework of Managerial Economics

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Framework for strategy analysis

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