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Fundamentals of Managerial

Economics (Chapter 1)

“It‟s easy to identify successful

strategies (and the reasons for their

success) or failed strategies (and the

reasons for their failures) in retrospect.

It‟s much more difficult to identify

successful or failed strategies before

they succeed or fail.”

Luke Frueb and Brian McCann

Managerial Economics (2008)

“Hindsight is 20-20”

While there is no doubt that luck, both good

and bad, plays a role in determining the

success of firms, we believe that success is

often no accident. We believe that we can

better understand why firms succeed or fail

when we analyze decision making in terms of

consistent principles of market economics and

strategic action.

Besanko, et. Al

Economics of Strategy (2

nd

)

Lucky or Good?

Common Causes of Failed

Strategies

1. Relevant information

a. Not enough

b. Enough BUT either ignored or

used/analyzed incorrectly

2. Irrelevant information used

Microeconomics is the study of how individual

firms or consumers do and/or should make

economic decisions taking into account such

things as:

1. Their goals, incentives, objectives.

2. Their choices, alternatives, problems.

3. Constraints such as inputs, resources, money, time,

technology, competition, supply & demand factors.

4. All (cash & noncash) incremental or marginal

benefits and costs.

5. The time value of money.

Managerial Economics

Managerial Economics is

microeconomics applied to decisions

made by business managers.

Goals, Incentives, Objectives

A fundamental economic truth is that

individual firms or decision makers

respond to economic incentives. What

these incentives are (i.e. money,

profits, utility, etc.) and how they

influence economic decision making are

key topics for study and analysis in

business (or managerial) economics.

Managerial Goals (examples)

$ sales, total revenue, gross income,

market share

Q sales, Q of output, output per unit of

input (production efficiency)

$ costs, total costs, cost per unit of

output (cost efficiency)

$ profits, total profits, profit per unit of

output

Managerial Choices

(examples)

Output quantity

Output quality

Output mix

Output price

Marketing and

advertising

Production processes

(input mix)

Input quantity

Production location

Production incentives

Input procurement

Michael Porter‟s “Five

Competitive Forces”

= Decision-making constraints

= Factors that influence the sustainability of

firm profits

1. Market entry conditions for new firms

2. Market power of input suppliers

3. Market power of product buyers

4. Market rivalry amongst current firms

5. Price and availability of related products

including both „substitutes‟ and „complements‟

Drive Rental Car or Co. Car?

Sue has been asked by her boss to

attend a business meeting 125 miles

away. She has two alternatives for

getting to the meeting and back: 1)

rent a car for $50 plus fuel costs or 2)

drive a company-owned car. Her boss

has asked her to choose the cheapest

form of transportation for the company.

What should Sue do?

Buy New Book or Used Book?

Joe has signed up to take an Econ class

which is about to begin. His instructor

expects him to read material from the

textbook and to access/use on-line

supplements. Joe has two alternatives: 1)

buy a new book for $120 which gives him the

supplements at no additional charge or 2)

buy a used book for $70 which does not

include the supplements so they would have

to be purchased separately for $35. What

should Joe do?

Fuel Once or Twice?

Suppose an airline company has a round trip

flight from Houston to Cancun to Houston.

Soaring oil prices have airlines scrambling to

save money on fuel. The company has

noticed fuel prices are 17 cents per gallon

less in Houston vs Cancun. Rather than

refueling in Cancun, the airline is thinking

about buying enough fuel for the whole trip

in Houston before departure. What are the

„marginal‟ analysis considerations in this case?

How Much to Spend on TV and Radio

Advertising?

Total Spent

New Beer Sales Generated

(in barrels per year)

TV Radio

$0 0 0

$100,000 4,750 950

$200,000 9,000 1,800

$300,000 12,750 2,550

$400,000 16,000 3,200

$500,000 18,750 3,750

$600,000 21,000 4,200

$700,000 22,750 4,550

$800,000 24,000 4,800

$900,000 24,750 4,950

$1,000,000 25,000 5,000

Max B(T,R)

Subject to: T + R = 1,000,000

What Is the Additional Revenue?

Suppose a statistician in your firm‟s research

department has given you his/her

mathematical estimate of your company‟s

sales (total revenue = TR and Q = quantity of

output) as follows:

TR = 7Q - .01Q

2

What will be the added revenue of selling

another unit of output? If the added cost of

producing another unit of output is constant

at $2.00, at what level of output is the

additional revenue generated from that

output just equal to the added cost?

Purchase Agreement – Good or

Bad?

With short-term interest rates at 7%, Amcott‟s CEO

(Ralph) decided to use $20 million of the company‟s most

recent annual retained earnings to purchase the rights to

Magicword, a software package that converts French text

word files into English. The purchase agreement is for the

next three years. Ralph has projected Amcott will earn an

additional $7 million net profits annually for each of the

next three years as a result of the agreement. After

learning of Ralph‟s decision, some members of Amcott‟s

board have been critical of Ralph‟s decision and are

considering firing Ralph. Is the board‟s criticism of Ralph‟s

decision justified?

Marginal Analysis

Analysis of „marginal‟ costs and „marginal‟

benefits due to a change

Marginal = additional or incremental

Costs and benefits that are constant (i.e.

fixed, don‟t change) are excluded from the

analysis

Changes occurring at „the margin‟ are all that

matter

Two important dimensions of change:

direction, magnitude

“Good” Economic Decisions

¬Marginal benefits > marginal costs

¬Examples of marginal benefits:

↑ profit

↑ revenue

↓ cost

↑ safety

↓ risk

Marginal costs = opposite of above examples

Marginal Analysis

(Examples)

Y

X

Incremental Y/

Incremental X

TR Units of output MR

TC Units of output MC

TP Units of input MP

TRP Units of input MRP

TC Units of input MFC

TU Units of good MU

Profit Units of output MP

Assume you are a member of your company‟s

Marketing Dept. You believe, and correctly so,

1) the market demand for your firm‟s product is

linear,

2) if your company charges $5.00 for its product,

quantity sold would be 200 units and

3) if your company set price = $3.00, the number of

units sold would be 400.

Develop alternative ways of explaining to upper-level

management more fully the relationship between the

company‟s price and the resulting number of units of

product sold.

P&Q Relationship?

Variable Relationships

Example of Alternative Ways of Depicting

Tabular

P Q

$7 0

6 100

5 200

4 300

3 400

2 500

1 600

0 700

Variable Relationships

Example of Alternative Ways of Depicting

Graphical

Variable Relationships

Example of Alternative Ways of Depicting

Mathematical

Q = 700 – 100P

P = 7 – 0.01Q

Common Math Terms Used in

Economic Analysis

Term Definition

Variable Something whose value or magnitude (often Q or $

in Econ) may change (or vary); usually denoted by

letter „labels‟ such as Y, X, TR, TC

Parameter or

Constant

Something whose value does NOT change

General

equation or

function

A mathematical expression that suggests the value

of one variable relates to or depends on the value of

another variable (or set of variables) without

showing the precise nature of that relationship [e.g.

y = f(x)].

Common Math Terms Used in

Economic Analysis

Term Definition

Specific

equation or

function

A mathematical expression that shows precisely how

the value of one variable is related to the value of

another variable (or set of variables) [e.g. y = 10 +

2x].

Inverse

equation or

function

A mathematical expression rewritten so that the

variable previously on the right-hand side of the

equal sign now becomes the variable solved for on

the left-hand side of the equal sign [e.g. y = 2x and

x = 1/2 y are each an inverse equation of the

other].

Common Math Functions Used in

Economics

Function Form

Name of

Function

Graph of Function

Y = a

0

Constant Horizontal straight line with

slope = 0

Y = a

0

+ a

1

x

(or y = mx + b)

Linear Straight line with slope = a

1

(or

= m)

Y=a

0

+a

1

x+a

2

x

2

Quadratic Parabola (u-shaped curve) with

either minimum or maximum

value

Y=a

0

+a

1

x+a

2

x

2

+a

3

x

3

Cubic Curved line (e.g. slope changes

from getting flatter to steeper

Y=a

0

x

-n

Hyperbola Curved line (u-shaped) bowed

towards origin

EXPONENT RULES EXAMPLES

1. x

n

= x multiplied by itself n times x

3

= x x x

x

1

= x

2. x

0

= 1

3. x

-a

=

1

x

a

x

-2

= 1/x

2

4. x

a

x

b

= x

a+b

x

2

x

3

= x

5

x

2

x

-1

= x

2-1

= x

5.

x

a

x

b

= x

a-b

x

2

/x

3

= x

2

x

-3

= x

-1

= 1/x

6. x

1/a

= the a

th

root of x x

1/2

x

= what number multiplied by

itself "a" times = x 8

1/3

= 2 (because 2 2 2 = 8)

7. x

a

y

a

= (xy)

a

x

2

y

2

= (xy)

2

8. (x

a

)

b

= x

ab

(x

2

)

3

= x

6

9. (xy)

1/a

= x

1/a

y

1/a

(xy)

1/2

= x . y

3. x

-a

=

1

x

a

x

-2

= 1/x

2

4. x

a

x

b

= x

a+b

x

2

x

3

= x

5

5.

x

a

x

b

= x

a-b

x

2

/x

3

= x

2

x

-3

= x

-1

= 1/x

6. x

1/a

= the a

th

root of x x

1/2

x

9. (xy)

1/a

= x

1/a

y

1/a

(xy)

1/2

= x . y

Y = a + b

1

X

1

+ …b

n

X

n

=> the value of Y

depends on the values of n different

other variables; a „ceteris paribus‟

assumption => we assume that all X

variable values except one are held

constant so we can look at how the

value of Y depends on the value of the

one X variable that is allowed to change

“Ceteris Paribus”

Given 2 pts on a straight line, how to solve for the

specific equation of that line?

Recall, in general, the equation of a straight line is Y

= a + bX, where b = the slope, and a = the vertical

axis intercept. The specific equation has the values of

„a‟ and „b‟ specified.

Solution procedure:

1. Solve for b = AY/AX = (Y

2

-Y

1

)/(X

2

-X

1

)

2. Given values at one pt for Y, X, and b, solve for a

(e.g. a = Y

1

– bX

1

)

Straight Line Equation

Graphical Concepts (Variable Relationships)

Y axis: a vertical line in a graph along which the

units of measurement represent different

values of, normally, the Y or dependent

variable.

Y axis intercept:

the value of Y when the value of X = 0, or

the value of Y where a line or curve

intersects the Y axis; = „a‟ in Y = a + bX

Graphical Concepts (Variable Relationships)

X axis: a horizontal line in a graph along which

the units of measurement represent

different values of, normally, the X or

independent variable

X axis intercept:

the value of X when the value of Y = 0, or

the value of X where a line or curve

intersects the X axis

Graphical Concepts (Variable Relationships)

Slope:

= the steepness of a line or curve; a +(-) slope =>

the line or curve slopes upward (downward) to the

right

= the change in the value of Y divided by the

change in the value of X (between 2 pts on a line

or a curve)

= cY/ cX = 1

st

derivative (in calculus)

= AY/ AX using algebraic notation

= the „marginal‟ effect, or the change in Y brought

about by a 1 unit change in X

= b if Y = a + bX

„Slope‟ Graphically

¬ = =

÷

÷

A

A

y

x

rise

run

y y

x x

2 1

2 1

Slope Calculation Rules

(slope = AY/ AX = dy / dx)

Rule Example

1. Slope of a constant = 0 If y=6, slope = 0

2. „power rule‟ => slope of a

function y = ax

n

is (n)(a)x

n-1

If y=3x

2

, slope = (2)(3)x

2-1

=6x

If y=x, slope = (1)x

1-1

=1

3. „Sum of functions rule‟ = slope

of the sum of two functions is the

sum of the two functions‟ slopes

If y = x + 3x

2

, slope = 1 + 6x

Mathematics of „Optimization‟

„Optimization‟ ¬ a decision maker wishes

to either MAXimize or MINimize a goal

(i.e. objective function)

For a function to have a maximum or

minimum value, the corresponding

graph will reveal a nonlinear curve that

has either a „peak‟ or a „valley‟

Mathematics of „Optimization‟

The mathematical equation of the function to be optimized will

have THE VERTICAL AXIS VARIABLE ON THE LEFT-HAND SIDE

OF THE EQUATION (e.g. Y = f(x) ¬ Y is the vertical axis

variable)

the slope of a curve at either a peak or a valley will = 0; in math

terms, the slope is the first derivative (I.e. dY/dX = 0)

„Constrained optimization‟ ¬ do the best job of maximizing (or

minimizing) a function given constraints; the „Lagrangian

Multiplier Method‟ is a mathematical procedure for solving these

kinds of problems

Typical „Time Value of Money‟

Problems in Business

How to compare or evaluate two

different dollar amounts at two different

time periods?

0

t

1

t

2

t

3

$Y

$X

Assume x = $900, y = $1000, r = 6%, t

1

= 3, t

2

= 5

Time Value of Money

(Basic Concept)

A dollar is worth more (or less) the sooner (later) it is

received or paid due to the ability of money to earn

interest.

¬ present value

+ interest earned

= future value

Or

¬ future value

- interest lost

= present value

Time Value of Money

(Applications/Uses)

1. To evaluate business decisions where

at least some of the cash flows occur

in the future

2. To project future dollar amounts such

as cash flows, incomes, prices

3. To estimate equivalent current-period

values based on projected future

values

Time Value of Money Concepts

PV = present value

= the number of $ you will be able to

borrow [or have to save] presently in

order to payback [or collect] a given

number of $ in the future

FV = future value

= the number of $ you will have to pay back

[or be able to collect] in the future as a

result of having borrowed [or saved] a

given number of $ presently

FV

1

= PV + PV(r)

= PV(1+r)

FV

2

= FV

1

+FV

1

(r)

= FV

1

(1+r)

= PV(1+r)(1+r)

= PV(1+r)

2

•

•

•

•

FV

n

= PV(1+r)

n

Time Value Equation

Time Value Problems

FV

n

= PV(1+r)

n

Given Solve For

PV,r,n FV

n

= PV(1+r)

n

= „compounding‟

FV

n

,r,n PV=FV

n

[1/(1+r)

n

] = „discounting‟

FV

n

,PV,n r ¬ (1+r)

n

=FV

n

/PV (¬ find in „n‟ row)

FV

n

,PV,r n ¬ (1+r)

n

=FV

n

/PV (¬ find in „r‟ column)

Net Present Value (NPV)

= an investment analysis concept

= PV of future net cash flows – initial

cost

= PV of MR‟s – PV of MC‟s

= invest if NPV > 0

= invest if PV of MR‟s > PV of MC‟s

Internal Rate of Return

= an investment analysis

alternative

= value of ‘r’ that results

in a NPV = 0

Payback Period

= an investment analysis alternative

= period of time required for the sum

of net cash flows to equal the initial

cost

= value of n such that

i

n

i

NCF C

=

¿

=

1

Firm Valuation

The value of a firm equals the present value of all its

future profits

PV i

t

t

= ¿ + t / ( ) 1

If profits grow at a constant rate, g<I, then:

PV i i g = + ÷ = t t

0 0

1 ( ) / ( ).

current profit level.

Maximizing Short-Term Profits

If the growth rate in profits < interest rate and both

remain constant, maximizing the present value of all

future profits is the same as maximizing current profits.

Time Value of Money

(Applied to Inflation)

¬Can be used to estimate or forecast

future prices, revenues, costs, etc.

¬FV

n

= PV (1+r)

n

where

PV = present value of price, cost, etc.

r = estimated annual rate of increase

n = number of years

FV = future value of price, cost, etc.

“Hindsight is 20-20”

“It‟s easy to identify successful strategies (and the reasons for their success) or failed strategies (and the reasons for their failures) in retrospect. It‟s much more difficult to identify successful or failed strategies before they succeed or fail.”

Luke Frueb and Brian McCann Managerial Economics (2008)

Lucky or Good?

While there is no doubt that luck, both good and bad, plays a role in determining the success of firms, we believe that success is often no accident. We believe that we can better understand why firms succeed or fail when we analyze decision making in terms of consistent principles of market economics and strategic action.

Besanko, et. Al

Economics of Strategy (2nd)

**Common Causes of Failed Strategies
**

1. Relevant information a. Not enough b. Enough BUT either ignored or used/analyzed incorrectly

2. Irrelevant information used

Microeconomics is the study of how individual firms or consumers do and/or should make economic decisions taking into account such things as:

1. 2. 3. 4.

5.

Their goals, incentives, objectives. Their choices, alternatives, problems. Constraints such as inputs, resources, money, time, technology, competition, supply & demand factors. All (cash & noncash) incremental or marginal benefits and costs. The time value of money.

.Managerial Economics Managerial Economics is microeconomics applied to decisions made by business managers.

money. Incentives.e. What these incentives are (i. . Objectives A fundamental economic truth is that individual firms or decision makers respond to economic incentives. etc.Goals. profits. utility.) and how they influence economic decision making are key topics for study and analysis in business (or managerial) economics.

cost per unit of output (cost efficiency) $ profits. total profits.Managerial Goals (examples) $ sales. total costs. profit per unit of output . Q of output. output per unit of input (production efficiency) $ costs. gross income. total revenue. market share Q sales.

Managerial Choices (examples) Output quantity Output quality Output mix Output price Marketing and advertising Production processes (input mix) Input quantity Production location Production incentives Input procurement .

Price and availability of related products including both „substitutes‟ and „complements‟ . Market power of input suppliers 3. Market power of product buyers 4. Market entry conditions for new firms 2. Market rivalry amongst current firms 5.Michael Porter‟s “Five Competitive Forces” = Decision-making constraints = Factors that influence the sustainability of firm profits 1.

What should Sue do? . Car? Sue has been asked by her boss to attend a business meeting 125 miles away. Her boss has asked her to choose the cheapest form of transportation for the company. She has two alternatives for getting to the meeting and back: 1) rent a car for $50 plus fuel costs or 2) drive a company-owned car.Drive Rental Car or Co.

His instructor expects him to read material from the textbook and to access/use on-line supplements. Joe has two alternatives: 1) buy a new book for $120 which gives him the supplements at no additional charge or 2) buy a used book for $70 which does not include the supplements so they would have to be purchased separately for $35. What should Joe do? .Buy New Book or Used Book? Joe has signed up to take an Econ class which is about to begin.

Rather than refueling in Cancun. What are the „marginal‟ analysis considerations in this case? . The company has noticed fuel prices are 17 cents per gallon less in Houston vs Cancun. the airline is thinking about buying enough fuel for the whole trip in Houston before departure.Fuel Once or Twice? Suppose an airline company has a round trip flight from Houston to Cancun to Houston. Soaring oil prices have airlines scrambling to save money on fuel.

How Much to Spend on TV and Radio Advertising? Total Spent $0 $100.000 $200.800 2.000 $600.000 $1.000 24.750 4.000 12.000 $400.000.750 21.750 24.000 $700.550 3.200 3.000 Max B(T.000 $900.000 $500.750 16.000 $300.200 4.750 25.R) Subject to: T + R = 1.000 Radio 0 950 1.550 4.750 9.000 New Beer Sales Generated (in barrels per year) TV 0 4.000 22.000 $800.800 4.000 18.950 5.000.000 .

at what level of output is the additional revenue generated from that output just equal to the added cost? ..00.What Is the Additional Revenue? Suppose a statistician in your firm‟s research department has given you his/her mathematical estimate of your company‟s sales (total revenue = TR and Q = quantity of output) as follows: TR = 7Q .01Q2 What will be the added revenue of selling another unit of output? If the added cost of producing another unit of output is constant at $2.

The purchase agreement is for the next three years. Ralph has projected Amcott will earn an additional $7 million net profits annually for each of the next three years as a result of the agreement. After learning of Ralph‟s decision. Amcott‟s CEO (Ralph) decided to use $20 million of the company‟s most recent annual retained earnings to purchase the rights to Magicword. Is the board‟s criticism of Ralph‟s decision justified? .Purchase Agreement – Good or Bad? With short-term interest rates at 7%. a software package that converts French text word files into English. some members of Amcott‟s board have been critical of Ralph‟s decision and are considering firing Ralph.

don‟t change) are excluded from the analysis Changes occurring at „the margin‟ are all that matter Two important dimensions of change: direction. magnitude . fixed.Marginal Analysis Analysis of „marginal‟ costs and „marginal‟ benefits due to a change Marginal = additional or incremental Costs and benefits that are constant (i.e.

“Good” Economic Decisions Marginal benefits > marginal costs Examples of marginal benefits: ↑ profit ↑ revenue ↓ cost ↑ safety ↓ risk Marginal costs = opposite of above examples .

Marginal Analysis (Examples) Y TR TC TP X Units of output Units of output Units of input Incremental Y/ Incremental X MR MC MP TRP TC TU Profit Units of input Units of input Units of good Units of output MRP MFC MU MP .

Develop alternative ways of explaining to upper-level management more fully the relationship between the company‟s price and the resulting number of units of product sold.00. the number of units sold would be 400. You believe. 2) if your company charges $5.00 for its product. quantity sold would be 200 units and 3) if your company set price = $3. 1) the market demand for your firm‟s product is linear. and correctly so. .P&Q Relationship? Assume you are a member of your company‟s Marketing Dept.

Variable Relationships Example of Alternative Ways of Depicting Tabular P $7 6 5 4 3 2 Q 0 100 200 300 400 500 1 0 600 700 .

Variable Relationships Example of Alternative Ways of Depicting Graphical .

Variable Relationships Example of Alternative Ways of Depicting Mathematical Q = 700 – 100P P = 7 – 0.01Q .

. usually denoted by letter „labels‟ such as Y. TR.g. y = f(x)]. X. TC Parameter or Constant General equation or function Something whose value does NOT change A mathematical expression that suggests the value of one variable relates to or depends on the value of another variable (or set of variables) without showing the precise nature of that relationship [e.Common Math Terms Used in Economic Analysis Term Variable Definition Something whose value or magnitude (often Q or $ in Econ) may change (or vary).

Common Math Terms Used in Economic Analysis Term Specific equation or function Inverse equation or function Definition A mathematical expression that shows precisely how the value of one variable is related to the value of another variable (or set of variables) [e. y = 10 + 2x].g. y = 2x and x = 1/2 y are each an inverse equation of the other]. .g. A mathematical expression rewritten so that the variable previously on the right-hand side of the equal sign now becomes the variable solved for on the left-hand side of the equal sign [e.

slope changes from getting flatter to steeper Curved line (u-shaped) bowed towards origin Constant Linear Quadratic Y=a0+a1x+a2x2+a3x3 Y=a0x-n Cubic Hyperbola .g.Common Math Functions Used in Economics Function Form Y = a0 Y = a 0 + a 1x (or y = mx + b) Y=a0+a1x+a2x2 Name of Function Graph of Function Horizontal straight line with slope = 0 Straight line with slope = a1 (or = m) Parabola (u-shaped curve) with either minimum or maximum value Curved line (e.

8. xn = x multiplied by itself n times x0 = 1 1 xa xa b = xa+b x x-a = xa xb = xa-b EXAMPLES x3 = x x x 1 x =x x-2 = 1/x2 x2 3 = x5 x 2 x -1 = x2-1 = x x x2/x3 = x2 -3 = x-1 = 1/x x x 1/2 6. x1/a = the ath root of x = what number multiplied by itself "a" times = x x 81/3 = 2 (because 2 = 8) 2 2 x2y2 = (xy)2 (x2) 3 = x6 (xy)1/2 = . 3. 4.EXPONENT RULES 1. x y 7. xa a = (xy)a y (xa)b = xab (xy)1/a = x1/a 1/a y . 9. 2. 5.

“Ceteris Paribus” Y = a + b1X1 + …bnXn=> the value of Y depends on the values of n different other variables. a „ceteris paribus‟ assumption => we assume that all X variable values except one are held constant so we can look at how the value of Y depends on the value of the one X variable that is allowed to change .

in general. a = Y1 – bX1) . X. and a = the vertical axis intercept. The specific equation has the values of „a‟ and „b‟ specified. and b. Solution procedure: 1. solve for a (e.g. the equation of a straight line is Y = a + bX.Straight Line Equation Given 2 pts on a straight line. Solve for b = Y/X = (Y2-Y1)/(X2-X1) 2. how to solve for the specific equation of that line? Recall. where b = the slope. Given values at one pt for Y.

or the value of Y where a line or curve intersects the Y axis.Graphical Concepts (Variable Relationships) Y axis: a vertical line in a graph along which the units of measurement represent different values of. the Y or dependent variable. Y axis intercept: the value of Y when the value of X = 0. normally. = „a‟ in Y = a + bX .

normally.Graphical Concepts (Variable Relationships) X axis: a horizontal line in a graph along which the units of measurement represent different values of. or the value of X where a line or curve intersects the X axis . the X or independent variable X axis intercept: the value of X when the value of Y = 0.

a +(-) slope => the line or curve slopes upward (downward) to the right = the change in the value of Y divided by the change in the value of X (between 2 pts on a line or a curve) = Y/X = 1st derivative (in calculus) = Y/ X using algebraic notation = the „marginal‟ effect. or the change in Y brought about by a 1 unit change in X = b if Y = a + bX .Graphical Concepts (Variable Relationships) Slope: = the steepness of a line or curve.

„Slope‟ Graphically y rise y2 y1 x run x2 x1 .

slope = (2)(3)x2-1=6x If y=x. slope = 0 If y=3x2. „power rule‟ => slope of a function y = axn is (n)(a)xn-1 Example If y=6. „Sum of functions rule‟ = slope If y = x + 3x2.Slope Calculation Rules (slope = Y/ X = dy / dx) Rule 1. slope = (1)x1-1=1 3. Slope of a constant = 0 2. slope = 1 + 6x of the sum of two functions is the sum of the two functions‟ slopes .

e. objective function) For a function to have a maximum or minimum value. the corresponding graph will reveal a nonlinear curve that has either a „peak‟ or a „valley‟ .Mathematics of „Optimization‟ „Optimization‟ a decision maker wishes to either MAXimize or MINimize a goal (i.

Mathematics of „Optimization‟ The mathematical equation of the function to be optimized will have THE VERTICAL AXIS VARIABLE ON THE LEFT-HAND SIDE OF THE EQUATION (e. Y = f(x) Y is the vertical axis variable) the slope of a curve at either a peak or a valley will = 0. the „Lagrangian Multiplier Method‟ is a mathematical procedure for solving these kinds of problems .e. in math terms. the slope is the first derivative (I. dY/dX = 0) „Constrained optimization‟ do the best job of maximizing (or minimizing) a function given constraints.g.

.

y = $1000. t2 = 5 .Typical „Time Value of Money‟ Problems in Business How to compare or evaluate two different dollar amounts at two different time periods? $X 0 $Y t1 t2 t3 Assume x = $900. t1 = 3. r = 6%.

present value + interest earned = future value Or future value .interest lost = present value .Time Value of Money (Basic Concept) A dollar is worth more (or less) the sooner (later) it is received or paid due to the ability of money to earn interest.

To project future dollar amounts such as cash flows. To evaluate business decisions where at least some of the cash flows occur in the future 2. prices 3. To estimate equivalent current-period values based on projected future values .Time Value of Money (Applications/Uses) 1. incomes.

Time Value of Money Concepts PV = present value = the number of $ you will be able to borrow [or have to save] presently in order to payback [or collect] a given number of $ in the future FV = future value = the number of $ you will have to pay back [or be able to collect] in the future as a result of having borrowed [or saved] a given number of $ presently .

Time Value Equation FV1 FV2 = = = = = = PV + PV(r) PV(1+r) FV1+FV1(r) FV1(1+r) PV(1+r)(1+r) PV(1+r)2 • • • • FVn = PV(1+r)n .

n FVn.n FVn.Time Value Problems Given PV.r FVn = PV(1+r)n Solve For FVn = PV(1+r)n PV=FVn[1/(1+r)n] = „compounding‟ = „discounting‟ r (1+r)n=FVn/PV ( find in „n‟ row) n (1+r)n=FVn/PV ( find in „r‟ column) .n FVn.r.PV.PV.r.

.

.

Net Present Value (NPV) = an investment analysis concept = PV of future net cash flows – initial cost = PV of MR‟s – PV of MC‟s = invest if NPV > 0 = invest if PV of MR‟s > PV of MC‟s .

Internal Rate of Return = an investment analysis alternative = value of ‘r’ that results in a NPV = 0 .

Payback Period = an investment analysis alternative = period of time required for the sum of net cash flows to equal the initial cost = value of n such that NCF C i 1 i n .

.Firm Valuation The value of a firm equals the present value of all its future profits PV t / (1 i ) t If profits grow at a constant rate. Maximizing Short-Term Profits If the growth rate in profits < interest rate and both remain constant. maximizing the present value of all future profits is the same as maximizing current profits. 0 current profit level. g<I. then: PV 0 (1 i ) / (i g).

cost. etc. revenues. . etc. FVn = PV (1+r)n where PV = present value of price. r = estimated annual rate of increase n = number of years FV = future value of price. costs. cost. etc.Time Value of Money (Applied to Inflation) Can be used to estimate or forecast future prices.

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