The Fundamentals of Managerial Economics: Overview Basic premise of this course: Study managerial decisions as they relate to maximizing profits, or more generally, the value of the firm. Fundamental principles for effective management: 1. Identify goals and constraints 2. Recognize the role of profits 3. Understand incentives 4. Understand markets 5. Recognize the time value of money 6. Use marginal analysis Managerial Economics I Manager - A person who directs resources to achieve a stated goal. I Economics - The science of making decisions in the presence of scarce resources. I Managerial Economics - The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal. 14/38
Identify Goals and Constraints I Sound decision making involves having well-defined goals. - Leads to making the right decisions. I For example, goal of maximizing profits requires manager to: - decide on optimal price of product - how much to produce - which technology to use - how much of each input to use - how to react to decisions made by competitors -... I In striking to achieve a goal, we often face constraints. - Constraints are an artifact of scarcity. 15/38 Economic vs. Accounting Profits I Accounting Profits - Total revenue (sales) minus dollar cost of producing goods or services. - Reported on the firm s income statement. I Economic Profits - Total revenue minus total opportunity cost. 16/38
Opportunity Cost I Accounting Costs - The explicit costs of the resources needed to produce goods or services. - Reported on the firm s income statement. I Opportunity Cost - The cost of the explicit and implicit resources that are foregone when a decision is made. - Implicit cost: the cost of giving up the best alternative use of the resource I Economic Profits - Total revenue minus total opportunity cost. Example I Suppose you own a building to run a restaurant and food supplies are the only accounting costs. - At the end of the year, costs for food $20k and revenues $100k - Hence accounting profits are $80k but these overstate your economic profits. I Here opportunity cost is - Cost of your time (you could have worked for somebody else, earning, say $30k) - Cost of capital (you could have rented the building, earning, say $100k) I Economic profits are then negative, i.e. you should not run the business - $50 = $100k $20k $30k $100k 18/38
Profits as a Signal Profits signal to resource holders where resources are most highly valued by society. - Resources will flow into industries that are most highly valued by society. A common misperception is that the firm s goal of maximizing profits is necessarily bad for profits - Adam Smith, The Wealth of Nations: It is not out of the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. - Individuals (firms and households) pursuing their self-interest, maximizes total welfare of society (very influential paradigm in economics, in reality unclear whether it holds or not) 8 Understanding Firms Incentives Changes in profits provide incentives to alter use of resources. Incentives play an important role within the firm. Incentives determine: - How resources are utilized. - How hard individuals work. Managers must understand the role incentives play in the organization. Constructing proper incentives will enhance productivity and profitability. 21/38 22/38
Market Interactions Consumer-Producer Rivalry - Consumers attempt to locate low prices, while producers attempt to charge high prices. Consumer-Consumer Rivalry - Scarcity of goods reduces consumers negotiating power as they compete for the right to those goods. Producer-Producer Rivalry - Scarcity of consumers causes producers to compete with one another for the right to service customers. The Role of Government - Disciplines the market process. 22/38
The Time Value of Money Timing of many decisions involves a gap between the time when costs of a project are borne and the time when benefits are received. $1 today is worth more than $1 tomorrow. Present value (PV ) of a future value (FV ) lump-sum amount to be received at the end of n periods in the future when the per-period interest rate is i : PV = FV (1 + i ) n Examples: - Lotto winner choosing between a single lump-sum payout of $104 million or $198 million over 25 years. - Determining damages in a patent infringement case. 23/38 Present Value vs. Future Value The present value (PV) reflects the difference between the future value and the opportunity cost of waiting (OCW). Succinctly, If i = 0, note that PV = FV. PV = FV OCW As i increases, the higher is the OCW and the lower the PV. 24/38
Present Value of a Series I Present value of a stream of future amounts (FV t ) received at the end of each period for n periods: I Equivalently PV = FV 1 (1 + i ) 1 + FV 2 (1 + i ) 2 + + FV n (1 + i ) n n PV = X t =1 FV t (1 + i ) t 25/38 Net Present Value Suppose a manager can purchase a stream of future receipts (FV t ) by spending C 0 dollars today. The NPV of such a decision is FV NPV = 1 (1 + i ) 1 + FV 2 (1 + i ) + + FV n 2 (1 + i ) C n 0 Decision rule: - If NPV < 0 then reject the proposal - If NPV > 0 then accept the proposal 26/38
Present Value of a Perpetuity An asset that perpetually generates a stream of cash flows (CF i ) at the end of each period is called a perpetuity. The present value (PV) of a perpetuity of cash flows paying the same amount (CF = CF 1 = CF 2 =...) at the end of each period is CF CF PV perpetuity = + + (1+i) 1 (1+i) 2 = CF i CF +... (1+i) 3 27/38 Firm Valuation and Profit Maximization The value of a firm equals the present value of current and future profits (cash flows). PV firm = π 0 + π 1 (1 + i ) + π 2 1 (1 + i ) +... = X 2 t =0 π t (1 + i ) t A common assumption among economist is that it is the firm s goal to maximization profits. - This means the present value of current and future profits, so the firm is maximizing its value. 28/38
Firm Valuation with Profit Growth If profits grow at a constant rate (g < i ) and current period profits are before and after dividends are: 1 + i PV firm = π 0 i g before current profits have been paid out as dividends PV ex div 1 firm + g = π 0 i g immediately after current profits are paid out as dividends Provided that g < i. - That is, the growth rate in profits is less than the interest rate and both remain constant. Optimization 29/38 Marginal (Incremental) Analysis I Marginal analysis states that optimal managerial decisions involve comparing the marginal (or incremental) benefits of a decisions with the marginal (or incremental) costs. I Control Variable Examples: - Output - Price - Product Quality - Advertising - R&D I Basic Managerial Question: How much of the control variable should be used to maximize net benefits? 30/38
Net Benefits I Net Benefits = Total Benefits - Total Costs I Profits = Revenue - Costs Optimization 31/38 Marginal Benefit (MB) I Change in total benefits arising from a change in the control variable, Q: MB = B Q I Slope (calculus derivative) of the total benefit curve. 32/38
Marginal Cost (MC) I Change in total costs arising from a change in the control variable, Q: MC = C Q I Slope (calculus derivative) of the total cost curve. Optimization 33/38 Marginal Principle I To maximize net benefits, the managerial control variable should be increased up to the point where MB = MC. I MB > MC, the last unit of the control variable increased benefits more than it increased costs. I MB < MC means the last unit of the control variable increased costs more than it increased benefits. 34/38
I Make sure you include all costs and benefits when making decisions (opportunity cost). I When decisions span time, make sure you are comparing apples to apples (PV analysis). I Optimal economic decisions are made at the margin (marginal analysis). 38/38