4 - KY - Introduction

Chapter 1
Introduction
Chapter One Copyright 2009 Pearson Education, Inc. 1

Publishing as Prentice Hall.
Economics and managerial decision
making
 Economics
The study of the behavior of human

beings in producing, distributing and
consuming material goods and
services in a world of scarce
resources

making
 Management
The science of organizing and allocating a

firm’s scarce resources to achieve its
desired objectives

making
Managerial economics
The use of economic analysis to make

business decisions involving the best
use (allocation) of an organization’s
scarce resources.

making
 Relationship to other business
disciplines
Marketing: demand, price elasticity

Finance: capital budgeting, breakeven
analysis, opportunity cost, value added
Management science: linear

programming, regression analysis,
forecasting
making
 Relationship to other business disciplines
Strategy: types of competition,

structure-conduct-performance
analysis
Managerial accounting: relevant

cost, breakeven analysis, incremental
cost analysis, opportunity cost
making
 Questions that managers must
answer:
 What are the economic conditions in

our particular market?
 market structure?
 supply and demand?
 technology?

making
 Questions that managers must answer:
 What are the economic conditions in our

particular market?
 government regulations?
 international dimensions?
 future conditions?
 macroeconomic factors?

making
 Should our firm be in this business?

 if so, at what price?
 and at what output level?

making
 How can we maintain a competitive

advantage over other firms?
 cost-leader?
 product differentiation?
 market niche?
 outsourcing, alliances, mergers?
 international perspective?

making
 What are the risks involved?

 shifts in demand/supply
conditions?
 technological changes?
 the effect of competition?
 changing interest rates and
inflation rates, exchange rates ?

making
 What are the risks involved?

 exchange rates (for companies in
international trade)?
 political risk (for firms with foreign
operations)?
Risk is the chance that actual future

outcomes will differ from those
expected
Economics of a business
 The economics of a business refers to
the key factors that affect the firm’s
ability to earn an acceptable rate of
return on its owners’ investment
The most important of these factors are

 competition
 technology
 customers

 Change: the four-stage model
 Stage I (the ‘good old days’)

 market dominance
 high profit margin
 cost plus pricing
… changes in technology, competition,

customers force firm into Stage II ..

 Stage II (crisis)
 cost management
 downsizing
 restructuring
… ‘re-engineering’ to deal with changes

and move firm into Stage III ..

 Stage III (reform)

 revenue management
 cost cutting has limited benefit
… focus on ‘top-line’ growth ..

 Stage IV (recovery)
 revenue plus
… revenue grows profitably

Review of economic terms
 Microeconomics is the study of individual
consumers and producers in specific
markets, especially:
 supply and demand
 pricing of output
 production process
 cost structure
 distribution of income

 Macroeconomics is the study of the
aggregate economy, especially:
 national output (GDP)
 unemployment
 inflation
 fiscal and monetary policies
 trade and finance among nations

 Resources are inputs (factors of
production), notably:
 Land  Return : rent
 Labor  Wage/Salary
 Capital  Interest
 Entrepreneurship  Profit

 Scarcity is the condition in which
resources are not available to satisfy
all the needs and wants of a specified
group of people
 Opportunity cost is the amount (or

subjective value) that must be
sacrificed in choosing one activity
over the next best alternative

 Allocation decisions must be made
because of scarcity. Three choices:
What should be produced?
How should it be produced?
For whom should be produced?

 Economic decisions of the Firm
What - begin or stop providing

goods/services (production)
How - hiring, staffing, capital budgeting
(resourcing)
For whom – target the customers most
likely to purchase (marketing)

 Entrepreneurship is the willingness to

take certain risks in the pursuit of
goals
 Management is the ability to organize

resources and administer tasks to
achieve objectives

Chapter 2
The Firm and its Goals
Chapter Two Copyright 2009 Pearson Education, Inc. 25

The Firm
 A firm is a collection of resources that is

transformed into products demanded by
consumers
 Profit is the difference between revenue

received and costs incurred

The Firm
 Transaction costs are incurred when

entering into a contract
 types of transaction costs

 investigation
 negotiation
 enforcing contracts

The Firm
 Transaction costs are incurred when

entering into a contract
 influences
 uncertainty
 frequency of recurrence
 asset specificity

The Firm
 Examples
 Kodak – uses offshoring to source

cameras
 IBM – manufacturing computers
overseas
 Exult – third party services used in
human resources

The Firm
 Limits to firm size
 tradeoff between
external transactions
and the cost of internal
operations
 company chooses to
allocate resources so
total cost is minimum
 outsourcing of
peripheral, non-core
activities
The Firm
 Illustration: Coase and the Internet
 Ronald Coase wrote in 1937, pre-

internet
 but his ideas are still relevant today
 tradeoff between internal costs and
external transactions
 search costs

Economic goal of the firm
 Profit maximization hypothesis: the
primary objective of the firm (to
economists) is to maximize profits
Other goals include market share, revenue

growth, and shareholder value
 Optimal decision is the one that brings

the firm closest to its goal

Economic goal of the firm
 Short-run versus Long-run
 nothing to do directly with calendar time

 short-run: firm can vary amount of
some resources but not others
 long-run: firm can vary amount of all
resources
 at times short-run profitability will be
sacrificed for long-run purposes

Goals other than profit
 Economic goals
 market share, growth rate

 profit margin
 return on investment, Return on assets
 technological advancement
 customer satisfaction
 shareholder value

Goals other than profit
 Non-economic objectives
 good work environment
 quality products and services
 corporate citizenship, social

responsibility

Do companies maximize profit?
 Criticism: companies do not maximize
profits but instead merely aim to
satisfice, which means to achieve a
satisfactory goal, one that may not require
the firm to ‘do its best’
 two forces affect satisficing:

 position and power of stockholders
 position and power of management

 Position and power of stockholders
 larger firms are owned by thousands of

shareholders
 shareholders own only minute interests
in the firm ... and hold diversified
holdings in many other firms

 Position and power of stockholders
 shareholders are concerned with

performance of entire portfolio and not
individual stocks
 less informed about the firm than
management
 stockholders not likely to take any

action if earning a ‘satisfactory’ return
 Position and power of management
 high-level managers may own very little

of the firm’s stock
 managers tend to be more conservative
because jobs will likely be safe if
performance is steady, not spectacular

 Position and power of management
 managers may be more interested in

maximizing own income and perks
 management incentives may be
misaligned (eg. revenue not profits)
 divergence of objectives is known as

‘principal-agent’ problem
 Counter-arguments which support the
profit maximization hypothesis
 large stockholdings held by institutions

(mutual funds, banks, etc.)  scrutiny
by professional analysts
 stockmarket discipline  if managers do
not seek to maximize profits, firms face
threat of takeover
 incentive effect  the compensation of
many executives is tied to stock price

Maximizing the wealth
of stockholders
 Views the firm from the perspective of a
stream of profits (cash flows) over time
 the value of the stream depends on
when cash flows occur
 Requires the concept of the time value of

money: says a dollar earned in the future
is worth less than a dollar earned today

of stockholders
 Future cash flows (Di) must be
‘discounted’ to find their present
equivalent value
The discount rate (k) is affected by risk
 Two major types of risk:

business risk
financial risk
of stockholders
 Business risk involves variation in

returns due to the ups and downs of the
economy, the industry, and the firm
All firms face business risk to varying

degrees

of stockholders
 Financial risk concerns the variation in

returns that is induced by ‘leverage’
Leverage is the proportion of a company

financed by debt
 the higher the leverage, the greater
the potential fluctuations in stockholder
earnings
 financial risk is directly related to the
degree of leverage
of stockholders
 The present price of a firm’s stock should
reflect the discounted value of the expected
future cash flows to shareholders (dividends)
D1 D2 D3 Dn
P (1 k )  (1 k ) 2  (1 k )3    (1 k ) n
P = present price of the stock

D = dividends received per year
k = discount rate
n = life of firm in years
of stockholders
 If the firm is assumed to have an infinitely

long life, the price of a unit of stock which
earns a dividend D per year is given by
the equation:
P = D/k

of stockholders
 Given an infinitely lived firm whose
dividends grow at a constant rate (g) each
year, the equation for the stock price
becomes:
P = D1/(k-g)
where D1 is the dividend to be paid during
the coming year
Multiplying P by the number of shares outstanding

gives total value of firm’s common equity (‘market
capitalization’)
of stockholders
 Company tries to manage its business in
such a way that the dividends over time
paid from its earnings and the risk
incurred to bring about the stream of
dividends always create the highest price
for the company’s stock
When stock options are substantial part of

executive compensation, management
objectives tend to be more aligned with
stockholder objective

of stockholders
 Another measure of the wealth of

stockholders is called Market Value
Added (MVA)®
MVA = difference between the market

value of the company and the capital that
the investors have paid into the company

of stockholders
 Market value includes value of both
equity and debt
‘Capital’ includes book value of equity and

debt as well as certain adjustments
e.g. accumulated R&D and goodwill
While the market value of the company

will always be positive, MVA may be
positive or negative
of stockholders
 Another measure of the wealth of
stockholders is called Economic Value
Added (EVA)®
EVA=(Return on total capital – Cost of

capital) x Total capital
if EVA > 0 shareholder wealth rising

if EVA < 0 shareholder wealth falling
Economic profits
 Economic profits and accounting profits
are typically different
 accountants measure explicit incurred

costs, as allowed by GAAP
 accountants use historical cost of

machines

Economic profits
 Economists are concerned with implicit
costs, called opportunity costs
Accordingly, economists use replacement

cost of machines
 economic costs include historical and
explicit (accounting) costs as well as
replacement and implicit (economic) costs
 economic profit is total revenue
minus all economic costs


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Chapter 1

Chapter One Copyright 2009 Pearson Education, Inc. 1

The study of the behavior of human

Chapter One Copyright 2009 Pearson Education, Inc. 2

The science of organizing and allocating a

Chapter One Copyright 2009 Pearson Education, Inc. 3

The use of economic analysis to make

Chapter One Copyright 2009 Pearson Education, Inc. 4

Marketing: demand, price elasticity

Management science: linear

Strategy: types of competition,

Managerial accounting: relevant

 What are the economic conditions in

 supply and demand?

Chapter One Copyright 2009 Pearson Education, Inc. 7

 What are the economic conditions in our

Chapter One Copyright 2009 Pearson Education, Inc. 8

 Should our firm be in this business?

 and at what output level?

Chapter One Copyright 2009 Pearson Education, Inc. 9

 How can we maintain a competitive

 outsourcing, alliances, mergers?

Chapter One Copyright 2009 Pearson Education, Inc. 10

 What are the risks involved?

 the effect of competition?

 changing interest rates and

inflation rates, exchange rates ?

 Questions that managers must answer:

 What are the risks involved?

Risk is the chance that actual future

The most important of these factors are

Chapter One Copyright 2009 Pearson Education, Inc. 13

 Stage I (the ‘good old days’)

 high profit margin

 cost plus pricing

… changes in technology, competition,

Chapter One Copyright 2009 Pearson Education, Inc. 14

… ‘re-engineering’ to deal with changes

Chapter One Copyright 2009 Pearson Education, Inc. 15

 Stage III (reform)

 cost cutting has limited benefit

… focus on ‘top-line’ growth ..

Chapter One Copyright 2009 Pearson Education, Inc. 16

… revenue grows profitably

Chapter One Copyright 2009 Pearson Education, Inc. 17

Chapter One Copyright 2009 Pearson Education, Inc. 18

 fiscal and monetary policies

 trade and finance among nations

Chapter One Copyright 2009 Pearson Education, Inc. 19

Chapter One Copyright 2009 Pearson Education, Inc. 20

 Opportunity cost is the amount (or

Chapter One Copyright 2009 Pearson Education, Inc. 21

What should be produced?

How should it be produced?

For whom should be produced?

Chapter One Copyright 2009 Pearson Education, Inc. 22

What - begin or stop providing

Chapter One Copyright 2009 Pearson Education, Inc. 23

 Entrepreneurship is the willingness to

 Management is the ability to organize

Chapter One Copyright 2009 Pearson Education, Inc. 24

The Firm and its Goals

Chapter Two Copyright 2009 Pearson Education, Inc. 25

 A firm is a collection of resources that is