Overview

I. Introduction
II. The Economics of Effective Management
n Identify Goals and Constraints
n Recognize the Role of Profits
n Understand Incentives
n Understand Markets
n Recognize the Time Value of Money
n Use Marginal Analysis

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999
 Managerial Economics
Manager
n A person who directs resources to achieve a stated goal.
Economics
n The science of making decisions in the presence of
scare resources.
Managerial Economics
n The study of how to direct scarce resources in the way
that most efficiently achieves a managerial goal.

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999
 Economic vs. Accounting
Profits
Accounting Profits
n Total revenue (sales) minus dollar cost of producing
goods or services
n Reported on the firms income statement
Economic Profits
n Total revenue minus total opportunity cost

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999
 Opportunity Cost
Accounting Costs
n The explicit costs of the resources needed to produce
produce goods or services
n Reported on the firms income statement
Opportunity Cost
n The cost of the explicit and implicit resources that are
foregone when a decision is made
Economic Profits
n Total revenue minus total opportunity cost

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999
 Market Interactions
Consumer-Producer Rivalry
n Consumers attempt to locate low prices, while producers
attempt to charge high prices
Consumer-Consumer Rivalry
n Scarcity of goods reduces the negotiating power of
consumers as they compete for the right to those goods
Producer-Producer Rivalry
n Scarcity of consumers causes producers to compete with
one another for the right to service customers
The Role of Government
n Disciplines the market process
Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999
 The Time Value of Money
Present value (PV) of an amount (FV) to be
received at the end of n periods when the
per-period interest rate is i:

FV
PV
1 i n

Examples?

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999
 Present Value of a Series
Present value of a stream of future amounts
(FVt) received at the end of each period for
n periods:

FV1 FV2 FVn

PV 1 2 ...
1 i 1 i 1 i n

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999
 Net Present Value
Suppose a manager can purchase a stream of
future receipts (FVt ) by spending C0 dollars
today. The NPV of such a decision is

FV1 FV2 FVn

NPV C0 1 2 ...
1 i 1 i 1 i n

NPV < 0: Reject

NPV > 0: Accept

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999
 Firm Valuation
The value of a firm equals the present value
of all its future profits
n PV = S pt / (1 + i)t

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

n PV = po 1i) / ( i - g), po current profit level.
Maximizing Short-Term Profits
n 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.

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999
 Marginal (Incremental)
Analysis
Control Variables
n Output
n Price
n Product Quality
n Advertising
n R&D
Basic Managerial Question: How much of
the control variable should be used to
maximize net benefits?
Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999
 Net Benefits
Net Benefits = Total Benefits - Total Costs
Profits = Revenue - Costs

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999
 Marginal Benefit (MB)
Change in total benefits arising from a
change in the control variable, Q:
MB = DB / DQ
Slope (calculus derivative) of the total
benefit curve

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999
 Marginal Cost (MC)
Change in total costs arising from a change
in the control variable, Q:
MC = DC / DQ
Slope (calculus derivative) of the total cost
curve

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999
 Marginal Principle
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
Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999
 The Geometry of Optimization
Costs
Benefits & Costs
Benefits
Slope =MB

B
Slope = MC
C

Q* Q
Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999
 Summary
Make sure you include all costs and benefits
when making decisions (opportunity cost)
When decisions span time, make sure you
are comparing apples to apples (PV
analysis)
Optimal economic decisions are made at the
margin (marginal analysis)

Michael R. Baye, Managerial Economics and Business Strategy, 3e. The McGraw-Hill Companies, Inc. , 1999