Transcript The Fundamentals of Managerial Economics [ MRB Ch. 1]

BUS 525.2: Managerial
Economics
Lecture 1
The Fundamentals of Managerial
Economics
Course Overview
• Prerequisites
– Bus501 and/or Bus511
• Requirements and Grading
– 3 Cases (20%)
– Two Midterm Examinations (40%)
– Final Exam (40%)
• Class Materials
– Baye, Michael R. Managerial Economics and Business
Strategy. Sixth Edition. Boston: McGraw-Hill Irwin,
2009. [MRB]
– Web-page: http://fkk.weebly.com
2
• Office: NAC 751
• Office hours: Tuesday, Wednesday and Saturday,
5pm-6:30 pm
Activity Schedule:BUS525:2
Class
Date
1
28 May
2
4 June
3
6 June
4
11 June
5
18 June
6
2 July
7
9 July
8
16 July
9
23 July
10
25 July
11
30 July (Make up
TBA)
12
13 August
13
16 -27 August
Exams
Cases
Case 1
Mid 1
Case 2
Mid 2
Case 3
Final
Activity Schedule:BUS525:3
Class
Date
1
29 May
2
5 June
3
12 June
4
19 June
5
26 June
6
3 July
7
10 July
8
17 July
9
24 July
10
31 July
11
1 August
12
14 August
13
16 -27 August
Exams
Cases
Case 1
Mid 1
Case 2
Mid 2
Case 3
Final
Make-up Policy
• There will be only one make-up for all
examinations (mid-terms, final etc.) towards
the end of the course to accommodate force
majeure. All examination dates are preannounced/agreed. Please make necessary
arrangements with your office.
• Historically, the performance of students taking
make-up examinations were always poorer
compared to students taking examinations on
schedule.
• I hope you will appreciate that it is not practical
to offer a customized course for any or group of
individual student(s).
5
Overview
I. Introduction
• Why should I study Economics?
– Understand business behavior, profit/loss making
firms, advertising strategy
• Impart basic tools of pricing and output
decisions
–
–
–
–
Optimize production mix and input mix
Choose product quality
Guide horizontal and vertical merger decisions
Optimal design of internal and external incentives.
• Not for managers only-any other designation
– Private, NGO, Government
• Headline –loss due to managerial ineptness
1-6
1-7
Managerial Economics
• Manager
– A person who directs resources to achieve a
stated goal.
• Economics
– The science of making decisions in the presence
of scarce resources.
– Managerial Economics
– The study of how to direct scarce resources in
the way that most efficiently achieves a
managerial goal.
• Case No. 1, Global Standards for Garment
Industry Under Scrutiny After Bangladesh
Disaster
Capitalism 101
To identify money-making opportunities,
you must first understand how wealth is
created (and sometimes destroyed).
• Definition: Wealth is created when assets
are moved from lower to higher-valued
uses
• Definition: Value = willingness to pay
• Desire + income
• The chief virtue of a capitalist economy is
its ability to create wealth
• Voluntary transactions, between
individuals or firms, create wealth.
8
Example: House Sale
• A house is for sale:
• The buyer values the house at $130,000 –
maximum price
• The seller values the house at $120,000 –
minimum price
• The buyer and seller must agree to a price that “splits” surplus
between buyer and seller. Here, $128,000.
• The buyer and seller both benefit from this transaction:
• Buyer surplus = buyer’s value minus the price, $2,000
• Seller surplus = the price minus the seller’s value, $8,000
• Total surplus = buyer + seller surplus, $10,000 = difference
in values
9
Wealth-Creating Transactions
• Which assets do these transactions move to
higher-valued uses?
• Factory Owners
• Real Estate Agents
• Investment Bankers
• Corporate Raiders
• Insurance Salesman
• Discussion: How does eBay/Bikroy.com create
wealth?
• Discussion: Which individual has created the
most wealth during your lifetime?
• Discussion: How do you create wealth?
10
Do Mergers Create Wealth?
• The movement of assets to a higher-valued use is the
wealth-creating engine of capitalism.
•
Our largest and most valuable assets are corporations
• Dell-Alienware merger:
•
In 2006, Dell purchased Alienware, a manufacturer of high-end
gaming computers.
•
Dell left design, marketing, sales and support in Alienware’s
hands; manufacturing, however, was taken over by Dell.
•
With its manufacturing expertise, Dell was able to build
Alienware’s computers at a much lower cost
• Despite this example, many mergers and acquisitions do not
create value – and if they do, value creation is rarely so
clear.
• To create value, the assets of the acquired firm must be
more valuable to the buyer than to the seller.
11
Does Government Create Wealth?
• Discussion: What’s the government’s role
is wealth creation?
• Enforcing property rights, contracts, to
facilitate wealth creating transactions
• Discussion: Why are some countries so
poor?
• No property rights, no rule of law
• Discussion: Much of the justification for government
intervention comes from the assertion that markets
have failed. One money manager scoffed at this idea.
“The markets are working fine, but they’re giving
people answers that they don’t like, so people cry
market failure.”
12
The One Lesson of Economics
• Definition: an economy is efficient if all wealthcreating transactions have been consummated.
• This is an unattainable, but useful
benchmark
• The One Lesson of Economics: the art of
economics consists in looking not merely at the
immediate but at the longer effects of any act or
policy; it consists in tracing the consequences of
that policy not merely for one group but for all
groups.
• Policies should then be judged by whether they
move us towards or away from efficiency.
• The economist’s solution to inefficient outcomes is to argue
for a change in public policy.
13
One Lesson of Economics (cont.)
• Taxes Destroy Wealth:
• By deterring wealth-creating transactions –
when the tax is larger than the surplus for a
transaction.
• Which assets end up in lower-valued uses?
• Subsidies Destroy Wealth:
• Example: flood insurance – encourages
people to build in areas that they otherwise
wouldn’t
• Which assets end up in lower-valued uses?
• Price Controls Destroy Wealth:
• Example: rent control (price ceiling) in New York City deters transactions between owners and renters
14
• Which assets end up in lower-valued uses?
The one Lesson of Business
• Definition: Inefficiency implies the existence of
unconsummated, wealth-creating transactions
• The One Lesson of Business: the art of
business consists of identifying assets in lower
valued uses, and profitably moving them to
higher valued uses.
• In other words, make money by identifying
unconsummated wealth-creating transactions and
devise ways to profitably consummate them.
15
Companies Create Wealth
• Companies are collections of transactions:
• They go from buying raw materials,
capital, and labor (lower value)
• To selling finished goods & services
(higher value)
• Why do some companies have difficulty
creating wealth?
• They have trouble moving assets to
higher-valued uses
• Analogy to taxes, subsidies, price controls on internal
transactions
16
Government Destroys Wealth
• Zimbabwe experienced economic
contraction of approximately 30
percent per year from 1999 to 2003
• Unemployment rates have been as
high as 80 percent and life
expectancy has fallen over 20 years
during the reign of Robert Mugabe
• Why has economic growth been so
low?
17
Government Destroys Wealth
• One main problem occurred in 2000
• Mugabe backed his supporters takeover of commercial
farms, essentially revoking property rights of these
farmers
• The state resettled the confiscated lands with
subsistence producers - many with no previous farming
experience. Agricultural production plummeted.
• Farm debacle had economic ripple effects through the
banking and manufacturing sectors
• Declining production deprived the country of ability to
earn foreign currency and buy food overseas
• Widespread famine ensued
• The government's initial attack on private property eventually led
to more direct intervention in the economy and the destruction of
political freedom in Zimbabwe.
18
Problem Solving
• Two distinct steps:
• Figure out what’s wrong, i.e., why the bad
decision was made
• Figure out how to fix it
• Both steps require a model of behavior
• Why are people making mistakes?
• What can we do to make them change?
• Economists use the rational actor
paradigm to model behavior. The rational
actor paradigm states:
• People act rationally, optimally, selfinterestedly
• i.e., they respond to incentives – to change behavior 19
you must change incentives.
How to Figure Out What is Wrong
• Under the rational actor paradigm, mistakes are
made for one of two reasons:
• lack of information or
• bad incentives.
• To diagnose a problem, ask 3 questions:
1. Who is making bad decision?
2. Do they have enough info to make a good
decision?
3. Do they have the incentive to do so?
20
How to Fix It
• The answers will suggest one or more solutions:
1. Let someone else make the decision, someone
with better information or incentives.
2. Change the information flow.
3. Change incentives
• Change performance evaluation metric
• Change reward scheme
• Use benefit-cost analysis to choose the best
(most profitable?) solution
21
Keep the Ultimate Goal in
Mind
For a business or organization to operate profitably
and efficiently the incentives of individuals need
to be aligned with the goals of the company.
• How do we make sure employees have the
information necessary to make good decisions?
• And the incentive to do so?
22
Manager Bonuses for
Increasing Reserves
• The bonus system created incentives to overbid.
• Senior managers were rewarded for acquiring
reserves regardless of their profitability
• Bonuses also created incentive to manipulate
the reserve estimate.
• Now that we know what is wrong, how do we
fix it?
• Let someone else decide?
• Change information flow?
• Change incentives?
• Performance evaluation metric
• Reward scheme
23
Ethics
• Does the rational-actor paradigm encourage selfinterested, selfish behavior?
• NO!
• Opportunistic behavior is a fact of life.
• You need to understand it in order to control it.
• The rational-actor paradigm is a tool for analyzing
behavior, not a prescription for how to live your
life.
24
Why Else this Material is Important
• Employers expect that you will know these
concepts
• Further, employers will expect that you are able
to apply them.
25
How Do Firms Behave
• Economists often assume the goal of the firm is profit
maximization. Opinions do differ, however.
• Discussion: pricing of hotel rooms during tourist season
• Traditional economic view – level pricing leads to excess
demand; how are rooms allocated then (rationing,
arbitrageurs, . . .)
• Contrasting view – businesses should not raise prices
during times of shortage; businesses have a responsibility
to consumers and society
• Your view?
• Text view: firms serve consumers and society best by
engaging in free and open competition within legal limits while
attempting to maximize profits.
• Not a license to engage in illegal behavior
• No denying that concerns exist about the ethical dimension
of business
• Reasonable people have disagreed for millennia on what
constitutes “ethical” behavior
26
The Economics of Effective
Management
• Identify goals and constraints
• Recognize the nature and importance of
profits
– Five forces framework and industry
profitability
•
•
•
•
Understand incentives
Understand markets
Recognize the time value of money
Use marginal analysis
1-27
Identify Goals and
Constraints
• Sound decision making involves
having well-defined goals.
– Leads to making the “right” decisions.
• In striving to achieve a goal, we
often face constraints.
– Constraints are an artifact of scarcity.
1-28
Economic vs. Accounting
Profits
• Accounting profits
– Total revenue (sales) minus cost of
producing goods or services.
– Reported on the firm’s income
statement.
• Economic profits
– Total revenue minus total opportunity
cost.
1-29
Opportunity Cost
• Accounting costs
– The explicit costs of the resources needed
to produce goods or services.
– Reported on the firm’s income statement.
• Opportunity cost
– The cost of the explicit and implicit
resources that are foregone when a decision
is made.
• Economic profits
– Total revenue minus total opportunity cost.
1-30
Significance of the
Opportunity Cost Concept
• Accounting profits = Net revenue –
Accounting costs (dollar costs of
goods and services)
• Reported on the firms income
statement
• Economic profits = Net revenue –
Opportunities Costs
• Economic profits and opportunity
costs are critical to decision making
31
The Principle of
Relevant Cost
• Sound decision-making requires that
only costs caused by a decision--the
relevant costs--be considered. In
contrast, the costs of some other
decision not impacted by the choice
being considered--the irrelevant costs-should be ignored.
• Not all accounting costs are relevant
and many need adjustments to become
relevant
32
1-33
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.
Theories of Profits
(Why are profits necessary? Why do profits
vary across industries and across firms?)
• Risk-bearing theory of profit - Profits are
necessary to compensate for the risk that
entrepreneurs take with their capital and efforts
• Dynamic equilibrium (frictional) theory Profits, especially extraordinary profits, are the
result of our economic system’s inability to adjust
instantaneously to unanticipated changes in
market conditions.
34
Theories of Profits
• Monopoly theory - Profits are the
result of some firm’s ability to
dominate the market
• Innovation theory - Extraordinary
profits are the rewards for
successful innovations
• Managerial efficiency theory Extraordinary profits can result
from exceptionally managerial skills
of well-managed firms.
35
Understanding Firms’
Incentives
• 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.
1-36
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
hired managers may wish to relax or
pursue self interest.
• The shareholders are principals,
whereas the managers are agents.
The Principal-Agent Problem
• Shareholders (principals) want profit
• Managers (agents) want leisure & security
• Conflicting motivations between these
groups are called agency problems.
– Stock brokers and investors
– Physicians and patients
– Auto mechanics and car owners
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 (but not always – Citibank
and Managers)
• Incentives to help the company, because that
improves the value of stock options and
bonuses
• Good legal contracts that can be effectively
enforced
1-40
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 the negotiating power of
consumers 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
– BTRC, BERC, SECs failure brought debacle
Market
• Definition: Buyers and sellers
communicate with one another for
voluntary exchange
• market need not be physical
– Bookstore, Internet bookstore Amazon.com
– Outsourcing
• industry – businesses engaged in the
production or delivery of the same or
similar items
– Clothing and textile industry,
– Clothing industry is a buyer in the textile
market and a seller in the clothing market
Competitive Market
• Benchmark for managerial economics
• Purely competitive market
– The global cotton market
– many buyers and many sellers
– no room for managerial strategizing
• Achieves economic efficiency
• Entry of firms
– Case No.2, Textile millers hit rough
patch
Market Power
• Definition – ability of a buyer or
seller to influence market conditions
• Seller with market power must
manage
– costs
– price
– advertising expenditure
– policy toward competitors
Imperfect Market
Definition: where
– one party directly conveys a benefit or
cost to others
– externalities
or
– one party has better information than
others
– Lack of competition, barriers to entry
1-45
The Time Value of Money
• Present value (PV) of a future value (FV) lumpsum 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:
– Lottery winner choosing between a single lump-sum
payout of Tk.104 million or Tk.198 million over 25
years.
– Determining damages in a patent infringement case.
Present Value vs. Future
Value
• The present value (PV) reflects the
difference between the future value
and the opportunity cost of waiting
(OCW).
• Succinctly,
PV = FV – OCW
• If i = 0, note PV = FV.
• As i increases, the higher is the OCW
and the lower the PV.
1-46
1-47
Present Value of a Series
• Present value of a stream of future
amounts (FVt) received at the end of
each period for “n” periods:
PV 
FV1
1  i 
1

FV2
1  i 
• Equivalently, PV 
n
2
 ...
FVt

t
t 1 1  i 
FVn
1  i 
n
1-48
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 
1 
2  ...
n  C0
 1  i  1  i 
1  i 
If
Decision Rule:
NPV < 0: Reject project
NPV > 0: Accept project
Present Value of a
Perpetuity
• An asset that perpetually generates a stream of
cash flows (CFi) 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 = CF1 = CF2
= …) at the end of each period is
CF
CF
CF
PVPerpetuity 


 ...
2
3
1  i  1  i  1  i 
CF

i
1-49
Objective of the Firm
• Not
• Not
• Not
• Not
• Not
• Not
• Not
market share
growth
revenue
empire building
net profit margin
name recognition
state-of-the-art technology
50
What’s the Objective of the Firm?
• The objective of the firm is to
maximize the value of the firm.
• Value of the firm is the true measure
of business success (of course, from a
for-profit perspective.)
• Two questions:
1. How is the “value of the firm”
defined and measured?
2. How do managers go about adding
value to the firm?
51
Value
Maximization
Is
a Complex
Process
Figure 1.3
Definition and Measurement of
“Value of the Firm”
“The present value of the firm’s
future net earnings.”
1
2
n
V = [--------] + [ --------] + . . . + [ -------- ]
(1+r)1
(1+r)2
(1+r)n
t
V =  [ ------- ] , t = 1, 2, ... , N
t = 1 (1+r)t
N
53
Adding Value to the Firm
Profit = Total Rev - Total Cost
 = P . Qd - VC . Qs - F
where   profit, P = price,
Qd
VC
Qs
F
=
=
=
=
quantity demanded,
variable cost per unit,
quantity supplied,
total fixed costs
54
Determinants of Value of the
Firm
N
t
N
P . Qd - VC . Qs - F
V =  [ ------- ] =  [---------------------- ]
t=1
(1+r)t
t=1
(1+r)t
• Whatever that raises the price of the
product and/or the quantity of the product
sold
• Whatever that lowers the variable and
fixed costs
• Whatever that lower the “r” (discount rate
or the perceived “risk” of investment)
Firm Valuation and Profit
Maximization
• The value of a firm equals the present
value of current and future profits (cash
flows).
PVFirm   0 
1

2
1  i  1  i 

 ...  
t 1
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.
1-56
Class Exercise
•
Suppose the interest rate is 10% and the firm is expected
to grow at a rate of 5% for the foreseeable future. The
firm’s current profits are $100 million.
a)
What is the value of the firm (the present value of its
current and future earnings)?
What is the value of the firm immediately after it pays a
dividend equal to its current profits?
b)
Marginal (Incremental)
Analysis
• Control variable, examples:
–
–
–
–
–
Output
Price
Product Quality
Advertising
R&D
• Basic managerial question: How much
of the control variable should be used
to maximize net benefits?
1-58
1-59
Net Benefits
• Net Benefits = Total Benefits - Total
Costs
• Profits = Revenue – Costs
• Case No. 3: Outsourcing and
offshoring
1-60
Marginal Benefit (MB)
• Change in total benefits arising from
a change in the control variable, Q:
B
MB 
Q
• Slope (calculus derivative) of the
total benefit curve.
1-61
Marginal Cost (MC)
• Change in total costs arising from a
change in the control variable, Q:
C
MC 
Q
• Slope (calculus derivative) of the
total cost curve
1-62
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.
The Geometry of Optimization:
Total Benefit and Cost
Total Benefits
& Total Costs
Costs
Slope =MB
Benefits
B
Slope = MC
C
Q*
Q
1-63
The Geometry of
Optimization: Net Benefits
Net Benefits
Maximum net benefits
Slope = MNB
Q*
Q
1-64
What Will We Learn?
 Useful economic principles for sound
economic decision-making in a
management context.
 The basics of the demand side of the
market and which factors influence
the buyers’ behavior.
 The fundamentals of the market’s
supply side -laws of production and
how these laws impact a firm’s costs.
 How firms’ costs and buyers’ demand
together determine the firm’s price
and net profit.
65
1-66
Conclusion
• 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).
Myths and Misconceptions
• Economics is about money only
• Economics assumes that everyone
is selfish
• A company’s value is measured by
the company’s assets
• Costs are measured appropriately
by accountants.
67
Myths and
Misconceptions (cont.)
• We must cover our fixed costs in
the decisions we make as
managers
• Our firm must create the best
quality product
• We should do more advertising,
because it’s cost-effective
• Our price should be based on our
costs
68
Myths and Misconceptions
(cont.)
• Unit or average cost provides useful
management information
• Wider profit margins are desirable
• A price increase reduces demand
• High research and development
expense results in high prices.
69
Managerial
Economics
is a Tool for
Improving
Management
Decision Making
Figure 1.1
The Five Forces Framework
Entry Costs
Speed of Adjustment
Sunk Costs
Economies of Scale
Entry
Power of
Input Suppliers
Power of
Buyers
Supplier Concentration
Price/Productivity of
Alternative Inputs
Relationship-Specific
Investments
Supplier Switching Costs
Government Restraints
Sustainabl
e Industry
Profits
Industry Rivalry
Concentration
Price, Quantity, Quality, or
Service Competition
Degree of Differentiation
Network Effects
Reputation
Switching Costs
Government Restraints
Switching Costs
Timing of Decisions
Information
Government Restraints
Buyer Concentration
Price/Value of Substitute
Products or Services
Relationship-Specific
Investments
Customer Switching Costs
Government Restraints
Substitutes & Complements
Price/Value of Surrogate Products
or Services
Price/Value of Complementary
Products or Services
Network Effects
Government
Restraints
1-71
Firm Valuation With Profit
Growth
1-72
• If profits grow at a constant rate (g < i)
and current period profits are o, before
and after dividends are:
1 i
before current profits have been paid out as dividends;
ig
1 g
Ex  Dividend
PVFirm
 0
immediately after current profits are paid out as dividends.
ig
PVFirm   0
• Provided that g < i.
– That is, the growth rate in profits is less than
the interest rate and both remain constant.