The Fundamentals of Managerial Economics

The Fundamentals of Managerial Economics

CHAPTER 1

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Learning Objectives

1. Summarize how goals, constraints, incentives, and

market rivalry affect economic decisions.

2. Distinguish economic versus accounting profits and

costs.

3. Explain the role of profits in a market economy.
4. Apply the five forces framework to analyze the

sustainability of an industry’s profits.

5. Apply present value analysis to make decisions and

value assets.

6. Apply marginal analysis to determine the optimal level

of a managerial control variable.

7. Identify and apply six principles of effective managerial

decision making.

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2

The Manager

• A person who directs resources to achieve a

stated goal.
– Directs the efforts of others.
– Purchases inputs used in the production of the

firm’s 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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1-4

Introduction

• 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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Introduction

Managerial Economics Defined

• 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 Economics of Effective Management

Identify Goals and Constraints

• Well-defined goals
• Firm’s overall goal is to maximize profits
• Constraints make it difficult to achieve goals

– Available technology
– Prices of inputs used in production

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7

The Economics of Effective Management

Recognize the Nature and

Importance of 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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1-8

The Economics of Effective Management

• The role of profits

– Profits are a signal to resource holders where

resources are most highly valued by society.

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1-9

The Economics of Effective Management

Recognize the Nature and

Importance of Profits

Five Forces and Industry Profitability

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10

The 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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1-11

The Economics of Effective Management

• Two sides to every market transaction: buyer

and 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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1-12

The Economics of Effective Management

Understand Markets

Recognize 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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1-13

The 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:

𝑃𝑉 =
𝐹𝑉

1 + 𝑖𝑛

– Present value reflects the difference between the

future value and the opportunity cost of waiting:

𝑃𝑉 = 𝐹𝑉 − 𝑂𝐶𝑊

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The Economics of Effective Management

Present Value Analysis II

• Present value of a stream of future values

𝑃𝑉 =
𝐹𝑉1
1 + 𝑖1 +
𝐹𝑉2
1 + 𝑖2 + ⋯ +
𝐹𝑉𝑛

1 + 𝑖𝑛

or,

𝑃𝑉 = ෍

𝑡=1

𝑛
𝐹𝑉𝑡
1 + 𝑖𝑡

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1-15

The Economics of Effective Management

• 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?

𝑃𝑉 =
$10,000
1 + 0.031 +
$50,000
1 + 0.032 + $100,000

1 + 0.033

= $148,352.70

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The Economics of Effective Management

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
of the project:

𝑁𝑃𝑉 =
𝐹𝑉1
1 + 𝑖1 +
𝐹𝑉2
1 + 𝑖2 + ⋯ +
𝐹𝑉𝑛

1 + 𝑖𝑛 − 𝐶0

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1-17

The Economics of Effective Management

• Present value of decisions that indefinitely

generate cash flows:

𝑃𝑉𝐴𝑠𝑠𝑒𝑡 = 𝐶𝐹0 +
𝐶𝐹1
1 + 𝑖1 +
𝐶𝐹2
1 + 𝑖2 +
𝐶𝐹3
1 + 𝑖3 + ⋯

• Present value of this perpetual income stream

when the same cash flow is generated (𝐶𝐹1=
𝐶𝐹2 = ⋯ = 𝐶𝐹):

𝑃𝑉𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 =𝐶𝐹

𝑖

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Economics of Effective Management

Present Value of Indefinitely Lived

Assets

• Profit maximization

– 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 Profit

Maximization

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 +𝜋0 1 + 𝑔

1 + 𝑖1 + 𝜋0 1 + 𝑔 2

1 + 𝑖2
+𝜋0 1 + 𝑔 3

1 + 𝑖3
+ ⋯

= 𝜋0

1 + 𝑖
𝑖 − 𝑔

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1-20

Economics of Effective Management

• 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

= 𝜋0

1 + 𝑔
𝑖 − 𝑔

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Economics of Effective Management

Present Value and Estimating

Values of Firms II

• Short-term and long-term profits

– 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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1-22

Economics of Effective Management
Short-Term versus Long-Term

Profits

• 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

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1-23

Economics of Effective Management

Use 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

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1-24

Economics of Effective Management

Use Marginal Analysis

• 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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1-25

Economics of Effective Management

Use Marginal Analysis

Marginal Analysis In Action

• It is estimated that the benefit and cost

structure of a firm is:

𝐵 𝑄 = 250𝑄 − 4𝑄2

𝐶 𝑄 = 𝑄2

• Find the 𝑀𝐵 𝑄 and 𝑀𝐶 𝑄 functions.

𝑀𝐵 𝑄 = 250 − 8𝑄

𝑀𝐶 𝑄 = 2𝑄

• What value of 𝑄 makes 𝑁𝑀𝐵 𝑄 zero?

250 − 8𝑄 = 2𝑄 ⇒ 𝑄 = 25

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Economics of Effective Management

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1-27

Quantity
(Control Variable)

Total benefits
Total costs

0

𝐵 𝑄

𝐶 𝑄

Maximum total benefits

Maximum net
benefits

Economics of Effective Management

Determining the Optimal Level of a

Control Variable

Determining the Optimal Level of a

Control Variable II

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1-28

Quantity
(Control Variable)

Net benefits

0

Maximum
net benefits

Slope =𝑀𝑁𝐵(𝑄)

𝑁 𝑄 = 𝐵 𝑄 − 𝐶 𝑄 = 0

Economics of Effective Management

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1-29

Quantity
(Control Variable)

Marginal
benefits, costs
and net benefits

0

𝑀𝐶 𝑄

𝑀𝐵 𝑄
𝑀𝑁𝐵 𝑄

Maximum net
benefits

Economics of Effective Management

Determining the Optimal Level of a

Control Variable III

Marginal Value Curves Are the Slopes of

Total Value Curves

– When the control variable is infinitely divisible,

the slope of a total value curve at a given point is
the marginal value at that point.

– The slope of the total benefit curve at a given Q is

the marginal benefit of that level of Q.

– The slope of the total cost curve at a given Q is the

marginal cost of that level of Q.

– The slope of the net benefit curve at given Q is the

marginal net benefit of that level of Q.

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Economics of Effective Management

Marginal Value Curves Are the Slopes of

Total Value Curves

• A calculus alternative

– Slope of a continuous function is the derivative

/marginal value of that function:

𝑀𝐵 =𝑑𝐵 𝑄

𝑑𝑄

𝑀𝐶 = 𝑑𝐶 𝑄

𝑑𝑄

𝑀𝑁𝐵 =𝑑𝑁 𝑄

𝑑𝑄

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Economics of Effective Management

• 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.

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Economics of Effective Management

Incremental Decisions

Learning Managerial Economics

• Practice, practice, practice …
• Learn terminology

– Break down complex issues into manageable

components.

– Helps economics practitioners communicate

efficiently.

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1-33

Learning Managerial Economics