Managerial economics and business strategy chap 1

Present Value Analysis 1• Present value of a single future value at the prevailing interest rate to generate the given future value: future value and the opportunity cost of waiting: ??

CHAPTER 1

The Fundamentals of Managerial Economics

I Introduction

II The Economics of Effective Management

Learning objectives

market rivalry affect economic decisions.

costs.

sustainability of an industry’s profits.

value assets.

of a managerial control variable.

decision making.

Chapter One

Chapter 1 focuses on defining managerial economics, and

illustrating how it is a valuable tool for analyzing many business

situations.

=> Billions of dollars are lost each year because many existing

managers fail to use basic tools from managerial economics to:

• shape pricing and output decisions

• optimize the production process and input mix

• choose product quality

• guide horizontal and vertical merger decisions

• optimally design internal and external incentives

=> Managerial economics is not only valuable to managers of

Fortune 500 companies; it is also valuable to managers of

not-for-profit organizations.

=> In fact, managerial economics provides useful insights into every

facet of the business and nonbusiness world in which we live—

Chapter Overview

costs and revenues?

maximize profits?

The Manager

• A person who directs resources to achieve a

stated goal

firm’s output.

Introduction

• The science of making decisions in the

presence of scarce resources.

– Resources are anything used to produce a good or

service, or achieve a goal.

– Decisions are important because scarcity implies

trade-offs.

• The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.

chips – from other manufacturers or produce them within

the firm?

or produce several different types?

price should you sell them?

products?

decisions?

The key to making sound decisions is to know what

information is needed to make an informed decision and then

to collect and process the data

Introduction

Managerial Economics Defined

• Basic principles comprising effective

management:

Economics of Effective Management

• Knowing your goals allows you to identify

which decisions you need to make

• Contraints make it difficult for managers to

achieve goals

Identify goals and constraints

Economics of Effective Management

The Nature and Importance of Profits

– Total amount of money taken in from sales (total

revenue) minus the dollar cost of producing goods or

services.

– The difference between total revenue and the total

opportunity cost of producing goods or services.

– Opportunity cost

• The explicit cost of a resource plus the implicit cost of giving

up its best alternative use of the resource

The Nature and Importance of Profits

therefore managers often overlook them

other sources to identify and quantify implicit

costs

Economics of Effective Management

The Nature and Importance of Profits

use to run a small pizzeria Food supplies are your

only accounting costs

you that these costs were $20,000 and that your

revenues were $100,000

Þyour accounting profits =?

ÞHowever, these accounting profits overstate your

economic profits because the costs include only

accounting costs

The Nature and Importance of Profits

1 The costs do not include the time you spent

running the business

Þsuppose you could have worked for someone

else for $30,000 Your opportunity cost of time would have been $30,000 for the year

Þ$30,000 of your accounting profits are not

profits at all but one of the implicit costs of

running the pizzeria

Economics of Effective Management

The Nature and Importance of Profits

2 Accounting costs do not account for the fact

that, had you not run the pizzeria, you could have rented the building to someone else

If the rental value of the building is $100,000 per year, you gave up this amount to run your own

business

=> Economic profits = Revenue –Opportunity

cost?

The Nature and Importance of Profits

• Joe faced the following options: (a) pay $5,000

in tuition to attend classes at Econ Tech; (b)

work as a fry cook for $4,000; or (c) work as a

waiter at an elite restaurant and earn $10,000 What is Joe's opportunity cost of attending

classes at Econ Tech?

The Role of Profits

• Profit Principle:

resources are most highly valued by society.

profits, the opportunity cost to resource holders

out- side the industry increases Owners of other

resources soon recognize that, by continuing to

operate their existing businesses, they are giving

up profits.

which economic profits are available As more

firms enter the industry, the market price falls,

and economic profits decline.

Power of

Input Suppliers

•Industry profits tend to

be lower when suppliers

have the power to

or services produced in the industry

Entry

Substitutes & Complements

Industry Rivalry

•Rivalry tends to be less intense (and

hence the likelihood of sustaining

profits is higher) in concentrated

industries—that is, those with

relatively few firms

Level, Growth, and Sustainability

Economics of Effective Management

Five Forces and Industry Profitability

•Buyer Concentration

•Price/Value of Substitute Products or Services

•Relationship-Specific Investments

•Customer Switching Costs

•Network Effects

•Government Restraints

•Switching Costs

•Timing of Decisions

•Information

•Government Restraints

Five Forces and Industry Profitability

Understand Incentives

• Changes in profits provide an incentive to

resource holders to change their use of

resources

• Within a firm, incentives impact how

resources are used and how hard workers

work

induce maximal effort from employees.

Economics of Effective Management

• Two sides to every market transaction:

• Bargaining position of consumers and

producers is limited by three rivalries in

Economics of Effective Management

Consumer-Scarcity of goods reduces the

negotiating power of consumers as they compete for the right to

purchase those goods.

Producer Rival

Producer-Scarcity of consumers causes producers

to compete with one another for the right to serve customers.

Government the Market Disciplines the market process.

-Understand Markets

Southwest Airlines begins a “Bags Fly Free” campaign, charging no fees for the first and second checked bags Does this situation best

consumer–consumer rivalry, or consumer– producer rivalry?

Explain.

The Time Value of Money

• a gap exists between the time when costs are

borne and benefits received

future

the forgone interest that could be earned were $1 received today

properly account for the timing of receipts and

expenditures.

Economics of Effective Management

Present Value Analysis 1

• Present value of a single future value

at the prevailing interest rate to generate the

given future value:

future value and the opportunity cost of waiting:

𝑃𝑉 = 𝐹𝑉 − 𝑂𝐶𝑊

Present Value Analysis II

• Present value of a stream of future values

• Consider a project that returns the following

income stream:

$100,000

present value of this income stream?

The Time Value of Money in Action

Net Present Value

• The present value of the income stream

generated by a project minus the current cost

contemplating the purchase of a new copier, which will cost $50,000 and has a useful life of 3 years

The copier will save the firm $20,000 in year one,

$20,000 in the second year, and $10,000 in the

third year The machine can be re-sold at the end of three years to a junk dealer for $5,000

Alternatively, the manager can invest the $50,000

at a guaranteed interest rate of 5% To maximize

profits, should the manager purchase the copier or invest the money at 5%?

• Approximately 14 million Americans are addicted to drugs and alcohol The federal government estimates that these addicts cost the U.S

economy $300 billion in medical expenses and lost productivity

Despite the enormous potential market, many biotech companies

have shied away from funding R&D initiatives to find a cure for drug

and alcohol addiction Your firm—Drug Abuse Sciences (DAS)— is a

notable exception It has spent $200 million to date working on a cure, but is now at a crossroads It can either abandon its program or invest another $60 million today Unfortunately, the firm’s opportunity cost

of funds is 5 percent, and it will take another five years before final

approval from the Food and Drug Administration is achieved and the

product is actually sold Expected (year-end) profits from selling the

drug are pre- sented in the accompanying table Should DAS continue with its plan to bring the drug to market, or should it abandon the

project? Explain

• Present value of decisions that indefinitely

generate cash flows:

𝑃𝑉'(()$ = 𝐶𝐹& + 𝐶𝐹"

• Present value of this perpetual income stream

when the same cash flow is generated (𝐶𝐹!=

• Profit maximization principle

the firm, which is the present value of current and

future profits.

Economics of Effective Management

Present Value and Profit Maximization

Present Value and Estimating Values of Firms I

• The value of a firm with current profits 𝜋#,

with no dividends paid out and expected,

constant profit growth rate of 𝑔 (assuming

• When dividends are immediately paid out of

current profits, the present value of the firm is (at ex-dividend date):

𝑃𝑉+,-./012,3 = 𝑃𝑉+,-. − 𝜋&

= 𝜋& 1 + 𝑔

𝑖 − 𝑔

Economics of Effective Management

Present Value and Estimating Values of Firms II

• Short-term and long-term profits principle

interest rate and both are constant, maximizing

current (short-term) profits is the same as

maximizing long-term profits.

Short-Term versus Long-term Profits

• A firm’s current profits are $400,000 These

profits are expected to grow indefinitely at a

constant annual rate of 4 percent If the firm’s

opportunity cost of funds is

6 percent, determine the value of the firm:

• a The instant before it pays out current profits

as dividends

• b The instant after it pays out current profits as

dividends

• Given a control variable, 𝑄, of a managerial

objective, denote the

• How can the manager maximize net benefits?

• Use marginal analysis

the managerial control variable, 𝑄.

the managerial control variable, 𝑄.

𝑀𝑁𝐵 𝑄 = 𝑀𝐵 𝑄 − 𝑀𝐶 𝑄

Economics of Effective Management

Using Marginal Analysis

• Marginal principle

increase the managerial control variable up to

the point where marginal benefits equal marginal

costs This level of the managerial control

variable corresponds to the level at which

marginal net benefits are zero; nothing more can

be gained by further changes in that variable.

Marginal Analysis Principle I

Marginal Principle II

• Marginal principle (calculus alternative)

marginal value, of that function:

Marginal Analysis In Action

• It is estimated that the benefit and cost

structure of a firm is:

Determining the Optimal Level of a Control Variable

Slope =𝑀𝑁𝐵(𝑄)

𝑁 𝑄 = 𝐵 𝑄 − 𝐶 𝑄 = 0

Economics of Effective Management

Determining the Optimal Level of a Control Variable II

Maximum net benefits

Determining the Optimal Level of a Control Variable III

• Incremental revenues

– The additional revenues that stem from a yes-or-no decision.

• Incremental costs

– The additional costs that stem from a yes-or-no decision.

• To maximize net benefits, the managerial control variable

should be increased up to the point where MB = MC.

• MB > MC means the last unit of the control variable

increased benefits more than it increased costs.

• MB < MC means the last unit of the control variable

increased costs more than it increased benefits

Economics of Effective Management

Incremental Decisions

1 Suppose that the total benefit and total cost from a continuous activity are, respectively, given by the

following equations: B(Q) = 100 + 36Q − 4Q2 and

C(Q) = 80 + 12Q Write out the equation for the net benefits

1.What are the net benefits when Q = 1? Q = 5?

2.Write out the equation for the marginal net benefits

3.What are the marginal net benefits when Q = 1? Q = 5? 4.What level of Q maximizes net benefits?

5.At the value of Q that maximizes net benefits, what is

the value of marginal net benefits?

Exercise 1

• The manager of a software company seeks to

maximize profits by producing the

profit-maximizing level of output (Q) The total

benefits (revenues) and costs for various levels

of output are summarized below, and are given

in millions of dollars Complete the table, and

answer the accompanying questions

Exercise 1

Exercise 1

• What level of output maximizes net benefits?

• What is the relation between marginal benefits and marginal cost at this level of output?

• What would happen if the manager attempted

to maximize total benefits?

• Are marginal benefits zero when total benefits are maximized? Why or why not?

Exercise 2

• An owner can lease her building for $120,000

per year for three years The explicit cost of

maintaining the building is $40,000, and the

implicit cost is $55,000 All revenues are

received, and costs borne, at the end of each

year If the interest rate is 5 percent, deter- mine the present value of the stream of:

• a Accounting profits

• b Economic profits

Exercise 3

retailer and are trying to convince the president of the company to change the structure of employee compensation Currently, the company’s retail sales staff is paid a flat hourly wage of $20 per hour for each eight-hour shift worked You propose a new pay structure whereby each sales- person in a store would be compensated $10 per hour, plus 1 percent of that store’s daily profits Assume that, when run efficiently, each store’s maximum daily profits are $25,000 Outline the arguments that support your proposed plan.

Exercise 4

small brick-and-mortar retail camera and electronics

store One of your employees proposed a new online

Pricesearch.com—a price comparison Web site that

allows consumers to view the prices of dozens of

retailers selling the same items Would you expect this

strategy to enable LES to achieve sustainable economic

profits? Explain.

• indicated that her unit would lose $8 million if the U.S advertising campaign were launched Your goal is to maximize BankGlobal’s value Should you launch the new campaign? Explain.

Learning Managerial Economics

• Practice, practice, practice …

• Make sure you include all costs and benefits

when making decisions (opportunity costs)

• When decisions span time, make sure you are

comparing apples to apples (present value

analysis)

• Optimal economic decisions are made at the

margin (marginal analysis)