Transcript document

Managerial Economics:
Introduction
Donald J. Harmatuck
UW-Madison School of Business
What is Managerial
Economics?

Managerial Economics
The application of the principles and techniques of
economic analysis to managerial problems.
•Microeconomics
– demand
– production and cost
– market structure
•Management Science
– Marginal Analysis and Calculus
•Econometrics
– Regression Analysis
Relationship of Managerial Economics
to Business School Curriculum

Integrating Course that treats the firm as a
whole rather than as individual functional
areas
• operations
• finance
• marketing

Technique Course
What do you get out of the course?

Better
• Decisionmaking skills
• Understanding of the role of business
• Understanding of economic analysis
Course Outline

Introduction
• Organizational Goals
– Profit Maximization
• Principal Agent Problems
• Supply and Demand Analysis

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
Demand
Production and Cost
Markets
• Market Structure
• Pricing Practices
• Regulation
Requirements and Preparation for
Course
Some calculus
 Text and class discussion will present
alternative treatments of most course
material.
 Exams will use some calculus.

What is Economics?


Firms exist to allocate society’s resources
efficiently and equitably
The study of resource allocation
1.
What goods will be produced
–
–
–
what market to serve
how differentiated should the products be
what price to charge
2. How goods will be produced
–
what mix of inputs to use in production
3. Who gets the goods that are produced
Common framework for analyzing these issues is called
the economic problem.
What is the ‘Economic Problem’?
 The ECONOMIC PROBLEM is the problem of
allocating resources
• to achieve objectives
• while satisfying constraints:
– scarcity
– requirement
– feasibility
What is the ‘Economic Problem’?

Different groups have different objectives
• Firms maximize profits constrained by
– demand (consumer preferences),
– production (technological production possibilities),
– competition (competitive responses),
– government (regulatory or fiscal measures)
• Consumers maximize utility
– prices and other characteristics of goods
– income
• Governments maximize social welfare
Framework for Managerial
Economics
Firm Objectives
 Firm Constraints
 Decision Rule Generalizations

Firm Objectives
1. Profit Maximization:
the difference between revenues and costs over a
multiperiod planning horizon
n
V = S (TRt-TCt)/(1+i)t
t=0
where V = long term profits or the value of the firm
TRt = total revenues in year t,
TCt = total costs in year t, and
i = the discount rate, and
n = the number of periods.
Discounting Example
n
V = S (TRt-TCt)/(1+i)t
t=0
Discount rate (i) = 0.06
Two courses of action: A and B
• If A is chosen, outflow of $1 million this year (t=0) and inflows
of $300,000 for each of next 5 years.
V = -1,000,000 + 300,000 + 300,000 + 300,000 + 300,000 + 300,000 = $263,709
1.060
1.06
1.062
1.063
1.064
1.065
• If B is chosen, outflow of $1 million this year (t=0) and inflows
of $260,000 for each of next 6 years.
V = -1,000,000 + 260,000 + 260,000 + 260,000 + 260,000 + 260,000 + 260,000 =$278,504
1.060
1.06
1.062
1.063
1.064
1.065
1.066
Gaming: Profits depend on your decision and
your competitor’s decision






Profits depends on your
choices A or B as well as
choices of competitor
choices C or D
First, assume decisions are
made simultaneously
Do you have a dominant
strategy? Play it.
Does your competitor have
a dominant strategy?
Assume s/he will use.
Prisoners’ dilemma
What if you can lead?
PROFITS
YOU
COMPETITOR
C
250
A
250
D
200
400
400
B
200
PROFITS
YOU
0
0
COMPETITOR
C
250
A
200
D
200
400
400
B
250
PROFITS
YOU
0
0
COMPETITOR
C
500
A
500
D
150
600
600
B
150
PROFITS
YOU
200
200
COMPETITOR
C
250
A
200
D
200
400
400
B
250
0
0
Example in which your leadership can
increase your (and competitor) profits
PROFITS
YOU
COMPETITOR
C
175
A
300
D
250
200
250
B
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
250
200
225
Assume You or Competitor will become leader (who goes first)
If competitor leads, they choose D
• If they choose D, you choose B, their payoff is 200 and yours is 225
• If they choose C, you choose A, their payoff is 175 and yours is 300
If you lead, you choose B
• If you choose A, they choose D, your payoff is 200 and theirs is 250
• If you choose B, they choose C, your payoff is 250, and theirs is 250
We’re better off leading and their better off following
More in McGuigan, Moyer, and Harris, Chapter 14 (which, unfortunately,
we cannot cover in detail in our class)
A twist on a current Madison
issue: setting transit fares
Wisconsin State Journal 1/12/2000:
Bus Fare increase to $1.50 Proposed
Suppose our objective is to minimize the transit
deficit in Madison.
p =Total Revenues (TR) - Total Cost (TC)
Existing Proposed
Total Cost ($ mil./yr.) TC
12
10
Fare ($/passenger)
P 1.25
1.50
Ridership (mil./yr.)
Q
10
9
Total Cost, Total Revenue, and Total Profit
35
30
25
$ per Year
20
15
TR
TC
Profit
10
5
0
-5
0
2
4
6
8
10
12
14
16
-10
Quantity in Millions
Price and Average Cost
5
4.5
4
$ per Unit
3.5
3
P
2.5
AC
2
1.5
1
0.5
0
0
2
4
6
8
Quantity in Millions
10
12
14
16
Price v. Ridership
P – 1.50 = (1.50-1.25)(Q - 9)
(9 – 10) P
P = 3.75 - .25 Q
$3.75
Total Revenue
TR = P  Q = 3.75Q - .25 Q2
Q
15
Total Cost v. Ridership:
TC – 20 = (20 – 22) (Q – 9)
(9 – 10) TC
2
TC = 2 + 2 Q
P
Q
Profit
$3.50
1
-0.5
$3.25
2
0.5
5
$3.00
3
1
Q
$2.75
4
1
Profit or Deficit =
Total Revenue – Total Cost
p = (PQ - TC)
p = 3.75Q - .25 Q2 - 2 - 2 Q
Two approaches:
1. Enumeration
a. Select various prices (P’s)
b. Determine corresponding
quantities (Q’s) and Profits (p’s)
c. Pick price (P*) that minimizes deficit
2. Find Q and P such that
Marginal Profits = 0
marginal revenue = marginal cost
DTR/DQ = 3.75 - .5 Q = DTC/DQ = 2
P = $2.875 and Q = 3.5
$2.50
5
0.5
$2.25
6
-0.5
$2.00
7
-2
$1.75
8
-4
$1.50
9
-6.5
$1.25
10
-9.5
P (Price) = 3.75 - .25 Q
TR = P  Q = 3.75Q - .25 Q2
TC = 2 + 2 Q
Q
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
Price
TR
3.625
1.8125
3.5
3.5
3.375
5.0625
3.25
6.5
3.125
7.8125
3
9
2.875 10.0625
2.75
11
2.625 11.8125
2.5
12.5
TC
3
4
5
6
7
8
9
10
11
12
Profit
-1.1875
-0.5
0.0625
0.5
0.8125
1
1.0625
1
0.8125
0.5
Calculus of Profit Maximization:
Marginal Profits = 0
Profits ( p )  TR  TC
 (3.75Q  0.25Q 2 )  (2  2Q)
dp
 Mp  3.75  (2)(0.25)Q  2  0
dQ
Q  3.5 million riders
P  3.75 - 0.25Q  3.75 - 0.25(3.5)  $2.875/tri p
p  $1.0625 million
Calculus of Profit Maximization:
Marginal Revenue=Marginal Cost
TR  $3.75Q  0.25Q 2
dTR
 MR  3.75  (2)(0.25)Q  3.75  0.5Q
dQ
TC  2  2Q
dTC
 MC  2
dQ
Setting MR  MC
3.75  0.5Q  2
1.75  0.5Q  0
Q  3.5
P  $3.75  0.25(3.5)  $2.875
What’s wrong with our solution?
We may be pursuing the wrong objective
 Our cost and demand estimates may be
incorrect
 Look at alternative pricing structures
 Look at quality variations of the service
 Change the technology
 ...

2. Alternatives to Profit
Maximization
a. Management Utility Maximization
b. Growth
c. Long Run Survival
d. Revenue Maximization
e. Satisficing
Agency Costs

Stockholder and managers may have different
objectives
• job security or personal wealth may be pursued by
managers rather than pursuing stockholder wealth
maximization
• Stockholder lack knowledge of managers
• Random events may obscure managerial effectiveness
and results

Agency costs
• costs to provide incentive for managers to pursue
stockholder goals
• monitoring cost
CEO Incentives- It’s Not How
Much You Pay, But How
Michael C. Jensen and Kevin J. Murphy
Harvard Business Review Article
Agency Theory

Compensation policy ties the agent’s (CEO’s)
expected utility to the principal’s (Shareholders’)
objective
• CEO objective is to maximize his/her expected utility
• Shareholder’s objective is to maximize the long term
profits of the firm

In the early ‘80s, Jensen found the CEO payperformance relationship is weak
• a project that reduces the firm’s value (by $10
million) would be adopted if CEO’s pay increases
(by $32,000).
Three policies that create the right monetary
incentives for CEO’s to maximize the value
of their companies:
Boards can require that CEOs become
substantial owners of company stock
 Salaries, bonuses, and stock options can be
structured so as to provide big rewards for
superior performance
 The threat of dismissal for poor performance
can be made real

Salomon Brothers CEO
Compensation Plan
ANNUAL BONUS, IN MILLIONS OF DOLLARS
Salomon Brothers’ return on equity
+10
+ 5
0
- 5
-10
5%
$1
$0.5
$0
$0
$0
10%
$2.5
$2
$1.5
$1
$0.5
15%
$7
$6
$5
$4
$3
20%
$12
$ 9
$ 7
$ 6
$ 4
25%
$17
$12
$ 9
$ 8
$ 5
30%
$24
$17
$12
$10
$ 7
Salomon Brothers' return on equity vs. competition
Michael Eisner and Disney

Old Structure
• Salary of $750,000 plus $750,000 signing bonus
• 2% of the dollar amount by which net income exceeds a
return of 9% on shareholder equity
• Option on 2 million shares of Disney stock purchase
within 5 years at $14

Eisner’s compensation over time:
•
•
•
•
$2.6 million in 1986
$41 million in 1988
$202 million in 1993
$565 million in 1997
– 5.5 million shares at $17.14
– 1.8 million shares at $19.64 Disney closed at $95.19
Eisner’s Newer Compensation
Package (1997): Three Elements


Annual base salary $750,000
Cash bonus based on growth in earning per share EPS
• ‘Base eps’ based on the average of ’97 and ’98 eps
– required to be in range of $2.75 to $3.25
– Target for ’99 is base eps x 1.075 and increase 7.5 % annually
– Bonus Percentage offsets anticipated compound growth in earnings
• 1999 5.75%
• 2003 0.75 %
2000 2.75 %
2004 0.55 %
2001 1.6 %
2005 0.45 %
2002 1.1 %
2006 0.4 %
– Bonus = (Actual EPS-Target EPS)(No. of shares)(Bonus Percentage)

Option on 8 million shares on 9/30/96
• 5 million expire on 9/30/2008 and carry exercise price of $63.31
• and 3 million on 9/30/2011
– one million have exercise price of $79.14
– one million have exercise price of $94.97
– one million have exercise price of $126.62
1.25 x $63.31
1.50 x $63.31
2.00 x $63.31
This Is Not Michael Eisner's Pay
Stub…, Fortune; Jun 8, 1998;
Between arrival in 1984 and 1998
company's share price outperformed the
S&P 500, and the wealth of Disney
shareholders increased more than $80
billion.
 His options (exercised and unexercised) are
valued $1.43 billion.
