The Fundamentals of
Managerial Economics
Chapter One
Chapter
Overview
Introduction
The manager
Economics
Managerial economics defined
Economics of Effective Management
Identifying goals and constraints
Recognize the nature and importance of profits
Understand incentives
Understand markets
Recognize the time value of money
Use marginal analysis
Learning managerial economics
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Introduction
Chapter
Overview
Chapter 1 focuses on defining managerial
economics, and illustrating how it is a
valuable tool for analyzing many business
situations.
This chapter provides an overview of
managerial economics.
How do accounting profits and economic profits
differ?
Why is the difference important?
How do managers account for time gaps
between costs and revenues?
What guiding principle can managers use to
maximize profits?
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The Manager
Introduction
A person who directs resources to
achieve a stated goal.
Directs the efforts of others.
Purchases inputs used in the production
of the firms output.
Directs the product price or quality
decisions.
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Introduction
Economics
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.
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Introduction
Managerial Economics Defined
The study of how to direct scarce
resources in the way that most efficiently
achieves a managerial goal.
Should a firm purchase components like disk
drives and chips from other manufacturers
or produce them within the firm?
Should the firm specialize in making one type
of computer or produce several different
types?
How many computers should the firm
produce, and at what price should you sell
them?
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Economics of Effective
Management
Economics of Effective
Management
Basic principles comprising effective
management:
Identify goals and constraints.
Recognize the nature and importance of
profits.
Understand incentives.
Understand markets.
Recognize the time value of money.
Use marginal analysis.
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Economics of Effective
Management
The Nature and Importance of
Profits
A typical firms objective is to maximize
profits.
Accounting profit
Total amount of money taken in from sales
(total revenue) minus the dollar cost of
producing goods or services.
Economic profit
The difference between total revenue and
cost opportunity cost.
Opportunity cost
The explicit cost of a resource plus the implicit
cost of giving up its best alternative.
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Economics of Effective
Management
The Role of Profits
Profit Principle:
Profits are a signal to resource holders
where resources are most highly valued
by society.
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Economics of Effective
Management
Five Forces and Industry
Profitability
Entry
Entry Costs
Speed of Adjustment
Sunk Costs
Economies of Scale
Network Effects
Reputation
Switching Costs
Government Restraints
Power of
Input Suppliers
Power of
Buyers
Supplier Concentration
Price/Productivity of
Alternative Inputs
Relationship-Specific
Investments
Supplier Switching Costs
Government Restraints
Level, Growth,
and Sustainability
of Industry Profits
Industry Rivalry
Concentration
Price, Quantity, Quality,
or Service Competition
Degree of Differentiation
Switching Costs
Timing of Decisions
Information
Government Restraints
Buyer Concentration
Price/Value of Substitute
Products or Services
Relationship-Specific
Investments
Customer Switching Costs
Government Restraints
Substitutes & Complements
Price/Value of Surrogate Products Network Effects
Government
or Services
Price/Value of Complementary
Restraints
Products or Services
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Economics of Effective
Management
Understand Incentives
Changes in profits provide an
incentive to how resource holders
use their resources.
Within a firm, incentives impact how
resources are used and how hard
workers work.
One role of a manager is to construct
incentives to induce maximal effort from
employees.
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Economics of Effective
Management
Understand Markets
Two sides to every market transaction:
Buyer.
Seller.
Bargaining position of consumers and
producers is limited by three rivalries
in economic transactions:
Consumer-producer rivalry.
Consumer-consumer rivalry.
Producer-producer rivalry.
Government and the market.
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Economics of Effective
Management
The Time Value of Money
Often a gap exists between the time
when costs are borne and benefits
received.
Managers can use present value
analysis to properly account for the
timing of receipts and expenditures.
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Economics of Effective
Management
Present Value Analysis 1
Present value of a single future value
The amount that would have to be
invested today at the prevailing interest
rate to generate the given future value:
Present value reflects the difference
between the future value and the
opportunity cost of waiting:
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Economics of Effective
Management
Present Value Analysis II
Present value of a stream of future
values
or,
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Economics of Effective
Management
The Time Value of Money in
Action
Consider a project that returns the
following income stream:
Year 1, $10,000; Year 2, $50,000; and
Year 3, $100,000.
At an annual interest rate of 3 percent,
what is the present value of this income
stream?
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Economics of Effective
Management
Net Present Value
The present value of the income
stream generated by a project minus
the current cost of the project:
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Economics of Effective
Management
Present Value of Indefinitely
Lived Assets
Present value of decisions that
indefinitely generate cash flows:
Present value of this perpetual
income stream when the same cash
flow is generated :
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Economics of Effective
Management
Present Value and Profit
Maximization
Profit maximization principle
Maximizing profits means maximizing
the value of the firm, which is the
present value of current and future
profits.
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Economics of Effective
Management
Present Value and Estimating Values
of Firms I
The value of a firm with current
profits , with no dividends paid out
and expected, constant profit growth
rate of (assuming ) is:
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Economics of Effective
Management
Present Value and Estimating
Values of Firms II
When dividends are immediately
paid out of current profits, the
present value of the firm is (at exdividend date):
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Economics of Effective
Management
Short-Term versus Long-term
Profits
Short-term and long-term profits
principle
If the growth rate in profits is less than
the interest rate and both are constant,
maximizing current (short-term) profits
is the same as maximizing long-term
profits.
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Economics of Effective
Management
Marginal Analysis
Given a control variable, , of a
managerial objective, denote the
total benefit as .
total cost as .
Managers objective is to maximize
net benefits:
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Economics of Effective
Management
Using Marginal Analysis
How can the manager maximize net
benefits?
Use marginal analysis
Marginal benefit:
The change in total benefits arising from a
change in the managerial control variable, .
Marginal cost:
The change in the total costs arising from a
change in the managerial control variable, .
Marginal net benefits:
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Economics of Effective
Management
Marginal Analysis Principle I
Marginal principle
To maximize net benefits, the manager
should 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.
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Economics of Effective
Management
Marginal Principle II
Marginal principle (calculus
alternative)
Slope of a continuous function is the
derivative /marginal value of that
function:
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Economics of Effective
Management
Marginal Analysis In Action
It is estimated that the benefit and
cost structure of a firm is:
Find the and functions.
What value of makes zero?
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Economics of Effective
Management
Determining the Optimal Level of a
Control Variable
Total benefits
Total costs
Maximum total benefits
pe
o
l
S
Maximum net
benefits
pe
o
l
S
Quantity
(Control Variable)
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Economics of Effective
Management
Determining the Optimal Level of a
Control Variable II
Net benefits
Maximum
net benefits
Slope =
Quantity
(Control Variable)
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Economics of Effective
Management
Determining the Optimal Level of a
Control Variable III
Marginal
benefits, costs
and net benefits
Maximum net
benefits
Quantity
(Control Variable)
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Economics of Effective
Management
Incremental Decisions
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.
Thumbs up decision
.
Thumbs down decision
.
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Learning Managerial
Economics
Learning Managerial Economics
Practice, practice, practice
Learn terminology
Break down complex issues into
manageable components.
Helps economics practitioners
communicate efficiently.
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Conclusion
Conclusion
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).
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