The Fundamentals of Managerial Economics

CHAPTER 1
The Fundamentals of
Managerial Economics
© 2014 by McGraw-Hill Education. All Rights Reserved.

Chapter Overview
Introduction
• 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?
Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved. 1-2
Who is the “Manager”?
Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights

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What is Economics?
Photo Credit: Wikipedia Commons

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Introduction
Managerial Economics
• The study of how to direct scarce resources in
the way that most efficiently achieves a
managerial goal.
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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Opportunity Cost
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Understanding Incentives
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Understand Markets
• Two sides to every market transaction:
– Buyer (consumer).
– Seller (producer).
• 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.
The Time Value of Money

• Often a gap exists between the time when
costs are borne and benefits received.
– $1 today is worth more than $1 received in the
future.
• The opportunity cost of receiving the $1 in the future is
the forgone interest that could be earned were $1
received today
– Managers can use present value analysis to
properly account for the timing of receipts and
expenditures.
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:
𝐹𝑉
𝑃𝑉 =
1+𝑖 𝑛
– Present value reflects the difference between the
future value and the opportunity cost of waiting:
𝑃𝑉 = 𝐹𝑉 − 𝑂𝐶𝑊
Practice with PV
• If the interest rate is 5 percent, $100 received at
the end of 7 years is worth how much today?

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Present Value Analysis II

• Present value of a stream of future values
𝐹𝑉1 𝐹𝑉2 𝐹𝑉𝑛
𝑃𝑉 = 1
+ 2
+ ⋯+ 𝑛
1+𝑖 1+𝑖 1+𝑖
or,
𝑛
𝐹𝑉𝑡
𝑃𝑉 = ෍ 𝑡
1+𝑖
𝑡=1
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?
Practice with Present Value
• What is the maximum amount you would pay
for an asset that generates an income of
$200,000 at the end of each of four years if the
opportunity cost of using the funds is 6 percent?
Michael R. Baye, Managerial Economics and Business Strategy, 6e. ©The McGraw-Hill Companies, Inc., 2008
Practice
A bond pays $100 at the end of each year for five
years, plus an additional $1,000 when the bond
matures at the end of five years. What is the most
you would be willing to pay for this bond if your
opportunity cost of funds is 6 percent?

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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  i  1
1  i  2
1  i  n
Decision Rule:
If NPV < 0: Reject project
NPV > 0: Accept project
Practice
• Tom of CastAways Inc. make volleyballs. His
employee, Hank, comes to him with a business
idea. If they invest $300,000 in a new machine,
they can generate an extra $100,000 a year for
the next 3 years by making volleyball nets, too.
Is this a wise business decision? What is the net
present value of their decision? The interest rate
is 7 percent.
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.
Present Value and Estimating Values of Firms I

• The value of a firm with current profits 𝜋0 ,
with no dividends paid out and expected,
constant profit growth rate of 𝑔 (assuming
𝑔 < 𝑖) is:
𝑃𝑉𝐹𝑖𝑟𝑚
𝜋0 1 + 𝑔 𝜋0 1 + 𝑔 2 𝜋0 1 + 𝑔 3
= 𝜋0 + 1
+ 2
+ 3
+⋯
1+𝑖 1+𝑖 1+𝑖
1+𝑖
= 𝜋0
𝑖−𝑔
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 ex-dividend date):
𝑃𝑉𝐹𝑖𝑟𝑚 𝐸𝑥−𝑑𝑖𝑣 = 𝑃𝑉𝐹𝑖𝑟𝑚 − 𝜋0
1+𝑔
= 𝜋0
𝑖−𝑔
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.
Practice with PV
• In 2012, a group of investors bought the LA
Dodgers for 2.15 billion dollars (2,150 million).
If the interest rate is 10 percent and the
expected growth rate of profits is 5 percent,
how much are they anticipating initial profits?
Assume no payouts in dividends and that they
value the firm at 2.15 billion (what they paid for
it).
Why did the ECONOMIST cross the road?
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Marginal Analysis
• Given a control variable, 𝑄, of a managerial
objective, denote the
– total benefit as 𝐵 𝑄 .
– total cost as 𝐶 𝑄 .
• Manager’s objective is to maximize net
benefits:
𝑁 𝑄 =𝐵 𝑄 −𝐶 𝑄
Using Marginal Analysis

• How can the manager maximize net benefits?
• Use marginal analysis
– Marginal benefit: 𝑀𝐵 𝑄
• The change in total benefits arising from a change in
the managerial control variable, 𝑄.
– Marginal cost: 𝑀𝐶 𝑄
• The change in the total costs arising from a change in
the managerial control variable, 𝑄.
– Marginal net benefits: 𝑀𝑁𝐵 𝑄
𝑀𝑁𝐵 𝑄 = 𝑀𝐵 𝑄 − 𝑀𝐶 𝑄
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.
Marginal Principle II
• Marginal principle (calculus alternative)
– Slope of a continuous function is the derivative, or
marginal value, of that function:
𝑑𝐵 𝑄
𝑀𝐵 =
𝑑𝑄
𝑑𝐶 𝑄
𝑀𝐶 =
𝑑𝑄
𝑑𝑁 𝑄
𝑀𝑁𝐵 =
𝑑𝑄
Marginal Analysis In Action

• It is estimated that the benefit and cost
structure of a firm is:
𝐵 𝑄 = 250𝑄 − 4𝑄 2
𝐶 𝑄 = 𝑄2
• Find the 𝑀𝐵 𝑄 and 𝑀𝐶 𝑄 functions.
• What value of 𝑄 makes 𝑁𝑀𝐵 𝑄 zero?
Determining the Optimal Level of a Control Variable

Total benefits
Total costs Maximum total benefits
𝐶 𝑄
𝐵 𝑄
Maximum net
benefits
0 Quantity
(Control Variable)
Determining the Optimal Level of a Control Variable II

Net benefits
Maximum
net benefits
Slope =𝑀𝑁𝐵(𝑄)
0 Quantity
𝑁 𝑄 =𝐵 𝑄 −𝐶 𝑄 =0 (Control Variable)
Determining the Optimal Level of a Control Variable III

Marginal
benefits, costs
and net benefits
Maximum net
benefits 𝑀𝐶 𝑄
0 Quantity
𝑀𝑁𝐵 𝑄 𝑀𝐵 𝑄 (Control Variable)
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
– 𝑀𝐵 > 𝑀𝐶.
• “Thumbs down” decision
– 𝑀𝐵 < 𝑀𝐶.
Practice
• Suppose:
B(Q) = 150 + 28Q – 5Q2
C(Q) = 100 + 8Q
• Find MB and MC
• Write equation for Net Benefits
• Write equation for Marginal Net Benefits
• What are MNB when Q=1? Q=5?
• What level Q Maximizes NB?
• What is value of MNB at that value of Q?
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).
Why management matters
• What was the experiment?
• How were firms selected?
– Role of selection bias
• What did the management consultants do?
• What were the main results of the experiment?
– Table II handout

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CHAPTER 1

© 2014 by McGraw-Hill Education. All Rights Reserved.

Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights

Photo Credit: Wikipedia Commons

Economics of Effective Management

Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights

The Time Value of Money

Present Value Analysis 1

Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights

Present Value Analysis II

The Time Value of Money in Action

Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights

FV1 FV2 FVn

Present Value and Profit Maximization

Present Value and Estimating Values of Firms I

Present Value and Estimating Values of Firms II

Short-Term versus Long-term Profits

Using Marginal Analysis

Marginal Analysis Principle I

Marginal Analysis In Action

Determining the Optimal Level of a Control Variable

Determining the Optimal Level of a Control Variable II

Determining the Optimal Level of a Control Variable III

Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights

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