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Managerial Economics & Business Strategy

CHAPTER 1
THE FUNDAMENTALS OF MANAGERIAL ECONOMICS

McGraw-Hill/Irwin

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

‡What are the roles of a manager?
y What managerial economic

decisions does a manager make??

Michael R. Baye, Managerial Economics and Business Strategy, 5e. reserved.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights

PURPOSE OF USING MANAGERIAL ECONOMICS TOOLS:
y Shape pricing and output decisions y Optimize production process and input mix y Choose product quality y Guide horizontal and vertical merger decisions y Optimally design internal and external incentives

Michael R. Baye, Managerial Economics and Business Strategy, 5e. reserved.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights

5e. Managerial Economics and Business Strategy. All rights .Managerial economics are useful for both profit making companies and Not-for ±profit organization (coordinate shelter for homeless. decide best means for distributing food to the needy) Michael R. Inc. Copyright © 2006 by The McGraw-Hill Companies. reserved. Baye.

Copyright © 2006 by The McGraw-Hill Companies.Managerial Economics y  . . All rights . Inc. y  . 5e. reserved. y  Michael R. Managerial Economics and Business Strategy. Baye.

reserved.MANAGER y A person who directs resources to achieve stated goal. Managerial Economics and Business Strategy. Inc. machines. Copyright © 2006 by The McGraw-Hill Companies. Baye. 5e. Includes those who:    Direct effort of others-delegate tasks Purchase inputs to be used in production In charge of making other decision such as product price and quality y Responsible for his/her own actions and actions of other individuals. All rights . other inputs under his/her control y Maximises profit and value of firms Michael R.

Inc.Managerial economics y Study of how to direct scarce resources in a way that most efficiently achieves managerial goal.managers in computer making company would decide on :       Whether to purchase or produce intermediate input (disk drive/ computer chips How many computers to produce and what is the selling price How many employees to hire How should the employees be compensated What incentive to be given to ensure quality How would rival company affect the organization? Copyright © 2006 by The McGraw-Hill Companies. Managerial Economics and Business Strategy. y Example. 5e. All rights Michael R. Baye. . reserved.

Inc. Copyright © 2006 by The reserved.data on alternative method to obtain financial capital  To collect and process data  MANAGER INTEGRATE ALL INFORMATION TO ARRIVE AT A DECISION McGraw-Hill Companies.Solution: y To make a sound decision.data on product market characteristic Ù Finance dept. Baye.tax advice or cost data Ù Legal dept. . manager would need To identify information needed Ù Account dept. All rights Michael R. Managerial Economics and Business Strategy.legal ramification of alternative decisions Ù Marketing dept. 5e.

The Economics of Effective Management AN EFFECTIVE MANAGER MUST: Identify Goals and Constraints  Recognize the Role of Profits  Understand Incentives  Five Forces Model  Understand Markets  Recognize the Time Value of Money  Use Marginal Analysis  Michael R. Inc. All rights . Copyright © 2006 by The McGraw-Hill Companies. 5e. Baye. reserved. Managerial Economics and Business Strategy.

available technology.Identify Goals and Constraints y Well defined goals y Different goals entails different decisions y Decision maker faces constraints that affect the ability to achieve goal EXAMPLES: y marketing dept -maximise sales and market share . reserved. Inc. input prices Michael R. 5e. Baye. Copyright © 2006 by The McGraw-Hill Companies. finance dept. Managerial Economics and Business Strategy. All rights .isk reduction strategies y Constraints.

Baye. 5e. Copyright © 2006 by The McGraw-Hill Companies.maximise profit of firm¶s value y Difference between economics and accounting profits y Implicit costs ± very hard to measure Example ± hairstyling salon vs restaurant Michael R. Inc. reserved. All rights . Managerial Economics and Business Strategy.Recognize nature and importance of profits y Overall goal.

Baye. Copyright © 2006 by The McGraw-Hill Companies. reserved. Managerial Economics and Business Strategy. Quality.The Five Forces Framework yEntry Costs ySpeed of Adjustment ySunk Costs yEconomies of Scale Entry yNetwork Effects yReputation ySwitching Costs yGovernment Restraints Power of Input Suppliers ySupplier Concentration yPrice/Productivity of Alternative Inputs yRelationship-Specific Investments ySupplier Switching Costs yGovernment Restraints Power of Buyers Sustainabl e Industry Profits yBuyer Concentration yPrice/Value of Substitute Products or Services yRelationship-Specific Investments yCustomer Switching Costs yGovernment Restraints Industry Rivalry yConcentration yPrice. All rights . or Service Competition yDegree of Differentiation ySwitching Costs yTiming of Decisions yInformation yGovernment Restraints Substitutes & Complements yPrice/Value of Surrogate Products or Services yPrice/Value of Complementary Products or Services yNetwork Effects yGovernment Restraints Michael R. 5e. Quantity. Inc.

Managerial Economics and Business Strategy. 5e. All rights .  Reported on the firm¶s income statement. Accounting Profits y Accounting Profits  Total revenue (sales) minus dollar cost of producing goods or services. reserved. Michael R. Baye. Inc. y Economic Profits  Total revenue minus total opportunity cost. Copyright © 2006 by The McGraw-Hill Companies.Economic vs.

Accounting profits overstate your economics profits Michael R. Managerial Economics and Business Strategy. y Opportunity Cost  The cost of the explicit and implicit resources that are foregone when a decision is made.y Accounting Costs  The explicit costs of the resources needed to produce goods or services. 5e. y Economic Profits  Total revenue minus total opportunity cost. Baye.  Reported on the firm¶s income statement. Copyright © 2006 by The McGraw-Hill Companies. All rights . reserved. Inc.

Baye. All rights .Understanding incentives y Profits signal to holders of resources to enter or exit industry  Incentive to resource holders to alter/change use of resources  y Managers should understand the role of incentive Induce workers to work harder/maximising effort  Reward vs penalty  Incentive plan ± directly proportionate to firms profitability  Commission based remuneration  Michael R. Copyright © 2006 by The McGraw-Hill Companies. reserved. Managerial Economics and Business Strategy. 5e. Inc.

Baye. Managerial Economics and Business Strategy.Understanding markets y Relative outcome of markets :  Power of buyers vs power of sellers  bargaining position of consumers and producers y 3 sources of rivalry in economic transaction: Consumer producer rivalry  Consumer-consumer rivalry  Producer-producer rivalry  Michael R. Copyright © 2006 by The McGraw-Hill Companies. reserved. Inc. 5e. All rights .

 Risk.  Consumer willing to pay highest price to outbid others. reserved. Copyright © 2006 by The McGraw-Hill Companies.Market Interactions y Consumer-Producer Rivalry Consumer Consumers attempt to locate low prices. 5e. Baye. Managerial Economics and Business Strategy.producer refuse to sell. Inc. All rights . consumer refuse to purchase y Consumer-Consumer Rivalry Consumer Scarcity of goods reduces the negotiating power of consumers as they compete for the right to those goods. while producers attempt to charge high prices.  eg-auction Michael R.

5e. All rights The Role of Government    Michael R. Inc. . Producer with best-quality product t lowest price wins Losing/disadvantage parties in the market seek for govt intervention-monopoly market Seeking aids from govt to compete with foreign counterparts Disciplines the market process. Copyright © 2006 by The McGraw-Hill Companies. customers are scarce Scarcity of consumers causes producers to compete with one another for the right to service customers. Baye. reserved. Managerial Economics and Business Strategy.Market Interactions ProducerProducer-Producer Rivalry    Multiple sellers of a product competing .

Inc. Copyright © 2006 by The McGraw-Hill Companies. Managerial Economics and Business Strategy. All rights . reserved. 5e.The Time Value of Money Michael R. Baye.

Copyright © 2006 by The McGraw-Hill Companies. Baye.The Time Value of Money y Timing in making decision-gap between  time when cost of project is borne and  time when benefits of project is received y Is $1 today going to worth more than $1 received in future?   Opportunity cost of $1 in future = interest forgone Its the time value of money y PV of an amount received in future = amount that would be invested today at prevailing interest rate to generate given future value Michael R. Inc. All rights . 5e. Managerial Economics and Business Strategy. reserved.

The Time Value of Money y Present value (PV) of a lump-sum amount (FV) to be received at the end of ´nµ periods when the per-period interest rate is ´iµ: FV PV ! n .

Baye. Managerial Economics and Business Strategy. Copyright © 2006 by The McGraw-Hill Companies. . 5e. Inc. reserved. All rights Michael R. Determining damages in a patent infringement case.1  i ‡ Examples:   Lotto winner choosing between a single lump-sum payout of lump$104 million or $198 million over 25 years.

opportunity costs waiting OCW  If interest rate is zero. Baye. Managerial Economics and Business Strategy. Copyright © 2006 by The McGraw-Hill Companies. reserved. Inc. OCW is zero the PV=FV  Michael R.(1) The Time Value of Money y Eg calculate PV of $100 in 10 years if the interest rate is 7 percent PV=$50. 5e. All rights .83 y Interest rate is inversely related to the PV  Higher interest rate-lower PV y PV of future payment = FV .

(2) Present Value of a Series y Present value of a stream of future amounts (FVt) received at the end of each period for ³n´ periods: PV ! FV1 .

1  i 1  FV2 .

 FVn ...1  i 2 .

Inc. 5e. Managerial Economics and Business Strategy.1  i n y Given PV of income stream from a project. Baye. reserved. we can compute the net PV of the project  NPV=PV-C0 (current cost) NPV=PVMichael R. All rights . Copyright © 2006 by The McGraw-Hill Companies.

(3) y Suppose a manager can purchase a stream of future receipts (FVt ) by spending ³C0´ dollars today. The NPV of such a decision is NPV ! FV1 .

1  i 1  FV2 .

1  i 2 .. FVn ..

reserved. Baye. 5e. Managerial Economics and Business Strategy.1  i n  C0 Decision Rule: If NPV < 0: Reject project NPV > 0: Accept projec demo problem 1-1 Michael R. All rights . Inc. Copyright © 2006 by The McGraw-Hill Companies.

Managerial Economics and Business Strategy. reserved.(5) FIRM VALUATION The value of a firm equals the present value of current and future profits. All rights . PV = S pt / (1 + i)t If profits grow at a constant rate (g < i) and current period profits are po: PVFirm ! T 0 1 i before current profits have been paid out as dividends. Inc. Baye. 5e. Copyright © 2006 by The McGraw-Hill Companies. ig 1 g Ex  PVFirm Dividend ! T 0 immediately after current profits are paid out as dividen ig Michael R.

All rights . reserved. Inc. Baye.Firm Valuation y If the growth rate in profits < interest rate and both remain constant. Copyright © 2006 by The McGraw-Hill Companies. maximizing the present value of all future profits is the same as maximizing current short term profits y Eg ± demo problem 1-2 Michael R. Managerial Economics and Business Strategy. 5e.

Marginal (Incremental) Analysis Michael R. Baye. reserved. Inc. Managerial Economics and Business Strategy. Copyright © 2006 by The McGraw-Hill Companies. All rights . 5e.

Marginal (Incremental) Analysis y Control Variables Output  Price  Product Quality  Advertising  R&D  y Basic Managerial Question: How much of the control variable should be used to maximize net benefits? .

Baye. Inc.total costs corresponding level of Q ‡ Managers objective: maximise net benefits y Net Benefits = Total Benefits .Costs Michael R. Copyright © 2006 by The McGraw-Hill Companies. Managerial Economics and Business Strategy.Total Cost = B(Q)-C(Q) y Profits = Revenue . 5e. reserved. All rights .MARGINAL ANALYSIS y OPTIMAL MANAGERIAL DECISIONS INVOLVES Comparing the marginal (incremental) benefits With the marginal (incremental ) costs ‡ B(Q)-total benefits derived from Q units of variable ‡ C(Q).

5e. Baye. Copyright © 2006 by The McGraw-Hill Companies. Inc.MARGINAL defined ‡ MB ±additional benefit arise by using an additional unit of managerial control variable ‡ MC ± additional costs incurred by using an additional unit of the managerial control variable ‡ MNB(Q) ± the change in net benefits that arise from a one unit change in Q OR MNB(Q) = MB(Q)-MC(Q) MB(Q)Refer table 1-1 p20 Note ‡ When net benefit is maximised. All rights . reserved. MNB(Q)=0 since MB(Q)=MC(Q) Michael R. Managerial Economics and Business Strategy.

Managerial Economics and Business Strategy. Q: (B MB ! (Q ‡Slope (calculus derivative) of the total benefit curve. Baye. Michael R. Inc. Copyright © 2006 by The McGraw-Hill Companies. reserved. 5e.Marginal Benefit (MB) ‡Change in total benefits arising from a change in the control variable. All rights .

Copyright © 2006 by The McGraw-Hill Companies. reserved.Marginal Cost (MC) ‡Change in total costs arising from a change in the control variable. Baye. Q: (C MC ! (Q ‡Slope (calculus derivative) of the total cost curve Michael R. Managerial Economics and Business Strategy. All rights . 5e. Inc.

Managerial Economics and Business Strategy. Copyright © 2006 by The McGraw-Hill Companies. Michael R. the managerial control variable should be increased up to the point where MB = MC. y MB < MC means the last unit of the control variable increased costs more than it increased benefits. y MB > MC means the last unit of the control variable increased benefits more than it increased costs. Inc. All rights .Marginal Principle y To maximize net benefits. reserved. 5e. Baye.

Inc. Managerial Economics and Business Strategy. Q Copyright © 2006 by The McGraw-Hill Companies. All rights . 5e. reserved.The Geometry of Optimization Total Benefits & Total Costs Slope =MB Costs C(Q) Benefits B(Q) B C Slope = MC Refer fig 1-2 Q* Michael R. Baye.

reserved. 5e.NB Maximum NB NB N(Q)=B(Q)-C(Q) Q MB. Managerial Economics and Business Strategy.MC & NB Slope of a function is the derivative of a given function MB= dB(Q) dQ MC= dC(Q) dQ MNB= dN(Q) dQ Q* At level of Q where the MB curve intersect the MC curve. Baye. . MNB is zero. that Q maximises NB MC(Q) Q) Q* MNB(Q) MB(Q) Copyright © 2006 by The McGraw-Hill Companies. All rights Michael R. Inc.

Michael R. Managerial Economics and Business Strategy. Inc. All rights . y Optimal economic decisions are made at the margin (marginal analysis). 5e.y Make sure you include all costs and benefits when making decisions (opportunity cost). y When decisions span time. Baye. make sure you are comparing apples to apples (PV analysis). reserved. Copyright © 2006 by The McGraw-Hill Companies.