Economics for Managers, 11th Edition
by McGuigan, Moyer, & Harris
PowerPoint Lecture Slides
prepared by
Richard D. Marcus
University of Wisconsin - Milwaukee
2008 Thomson * South-Western Slide 1
Chapter 1
Introduction & Goals of the Firm
» Introduction
» Structure of Decision Models
» Profit’s Role
» Agency Problems & Solutions
» Not-for-Profit Organizations
» Why Corporations Have Succeeded
Over Other Organizational Forms
Slide 2
What is Managerial Economics?
Integrates and applies microeconomic
theory and methods to decision making
problems faced by private, public, and
not-for-profit organizations.
Managerial economics deals with
microeconomic reasoning on real world
problems such as pricing decisions,
selecting the best strategy in different
competitive environments, and making
efficient choices.
Slide 3
To Expand Capacity or Not?
• Should Toyota expand its capacity? In part, it must
consider current and future demand and what other
firms are likely to do.
• Capacity for making cars is a long term project, so
Toyota should think in terms of the present value (PV)
of future profits.
• Objective Function:
» Max PV of profits {S1, S2}
» S1 could be expand capacity and S2 not to expand yet
capacity at this time.
• Decision Rule:
» Choose S1 if PV {Profits of S1 } > PV { Profits of S2 }
» Choose S2 if PV { Profits of S1 } < PV { Profits of S2 }
» If equal profits, then flip a coin
Slide 4
The Decision-Making Process
(Figure 1.2)
1. Establish Objectives
2. Identify the Problem
3. Examine Alternative Solutions
Consider 4. Analyze Alternatives Consider
Organizational
Societal and Select the Best! & Input
Constraints Constraints
5.Perform Sensitivity Analysis
6. Implement and
Monitor the Decision Slide 5
The Role of Profits
• Economic Profit is the difference between
revenues and total economic cost (including
the economic or opportunity cost of owner
supplied resources such as time and capital).
• We’d expect high profit areas to attract
investment
• We’d expect low profit areas to lose
investment
» Shouldn’t then all industries earn
the same profit eventually?
Slide 6
Theories of Why Profit Varies
Across Industries
1. RISK-BEARING THEORY
2. TEMPORARY DISQUILIBRIUM
THEORY OF PROFIT
3. MONOPOLY THEORY OF PROFIT
4. INNOVATION THEORY OF PROFIT
5. MANAGERIAL EFFICIENCY
THEORY OF PROFIT
Slide 7
What Went Right?
What Went Wrong?
• Eli Lilly (p. 16) a Pharmaceutical company
» 12.3 on average to get a new drug approved
» Patents on Lilly’s Prozac created monopoly power and
profits for a widely used medication for depression.
» As the patent began to expire, Lilly requested s patent
“extension” because of some alterations in Prozac’s formula
» But when the patent extension was overturned, generic drug
manufactures took 70% of the share of the market for anti-
depressants.
» Lilly missed the chance of finding a replacement in time for
its blockbuster Prozac
Slide 8
Objectives of the Firm
• Profit maximization
• Shareholder wealth = value of each share (V0)
times the number of shares outstanding, or
V0 · (# shares outstanding). This is the present
value of expected future profits or cash
flows, discounted at the shareholders required
rate of return, ke, ignoring taxes.
V0 (shares outstanding) = t /(1+ke) t
t=1
Slide 9
Determinants of Firm Value (Figure
1.3)
t = REVENUE – COST = TRt – TCt = PtQt – VtQt - Ft
• Value of the Firm = the present value of discounted cash flows
N
(t ) / (1+ke)t =
t=1
N
(PtQt – VtQt – Ft) / (1+ke)t
t =1
• Whatever lowers the perceived risk of the firm (ke) will also
raise firm value.
• Whatever raises the price of the product (Pt) or the quantity
sold (Qt ) will raise firm value.
• Whatever raises variable cost (Vt )or fixed cost ( Ft ) will
reduce firm value. Slide 10
• To make good economic decisions,
managers need to be able to forecast &
estimate relationships
• Will be forecasting demand (both Pt & Qt)
» applies to for-profit corporations
» non-profit organizations
• Hospital Administrators forecast patients
• University Administrator forecast enrollment
• Regression analysis, time series
methods, and qualitative forecasting
methods used for forecasting
Slide 11
Agency Problems
• Modern corporations allow firm
managers to have no ownership
participation, or only limited
participation in the profitability of the
firm.
• Shareholders may want profits, but
managers may wish to relax.
• The shareholders are principals, whereas
the managers are agents.
Slide 12
• The Principal-Agent Problem
» Shareholders (principals) want profit
» Managers (agents) want leisure & security
» Conflicting motivations between these
groups are called agency problems.
• Examples (page 13)
» KKR’s takeover of RJR Nabisco to
refocus on wealth-maximization
» The LBO by O.M. Scott (a lawn fertilizer
company) from ITT (a conglomerate)
improved Scott’s performance Slide 13
Solutions to Agency Problems
• Compensation as incentive
• Extending to all workers stock options,
bonuses, and grants of stock
» It helps to make workers act more like
owners of firm
• Incentives to help the company, because
that improves the value of stock options
and bonuses.
Slide 14
What Went Right? What Went Wrong?
• Saturn Corporation (p. 15)
» Different kind of car company in 1991
» No-haggle pricing
» Sales were above expectations
• But, margin of only $400 per car to GM
» GM earned only 3% on capital
» Saturn customers wanted bigger Saturns rather than
trade up to Buick, as GM hoped.
» When the dollar appreciated, Japanese firms could
price their cars more competitively.
» Must continuously keep up with global
competitors. Slide 15
Shareholder Wealth Maximization:
Necessary Conditions
• COMPLETE MARKETS - liquid markets
for firm's inputs and by-products (including polluting
by-products).
• NO SIGNIFICANT ASYMMETRIC
INFORMATION - buyers and sellers all know
the same things.
• KNOWN RECONTRACTING COSTS
future input costs are part of the present value of
expected cash flows.
Slide 16
Goals in the Public Sector and the
Not-For-Profit (NFP) Enterprise
Public Goods are goods that can be consumed or used by
more than one person at the same time with no extra cost (like
a flood control or national defense).
Sometimes governments produce public goods. Other times,
they are exclusive to one person (like a free meal).
Instead of profit, NFP organizations may have as their goals:
1. Maximization of the quantity of output, subject to a
breakeven constraint.
2. Maximization of the utility (happiness) of NFP
administrators.
3. Maximization of cash flows.
4. Maximization of the utility of contributors to the NFP
organization. Slide 17
• Which goal a NFP manager selects affects
decisions made.
» A food shelter manager may decide to maximize
the utility of contributors by selecting only
"healthy foods"
• Public sector managers are performance
monitored.
» V.A. hospital administrators are rewarded by reducing
the cost per bed over a year. Hence, they become
efficient with respect to costs.
» The "friendliness" of the hospital staff is harder to
measure, so friendliness will tend not be a high priority
of the public sector manager.
Slide 18
