Managerial Economics &
Business Strategy
Chapter 1
The Fundamentals of Managerial
Economics
McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy
Copyright 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
1-2
Overview
I. Introduction
II. The Economics of Effective Management
Identify Goals and Constraints
Recognize the Role of Profits
Five Forces Model
Understand Incentives
Understand Markets
Recognize the Time Value of Money
Use Marginal Analysis
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Managerial Economics
Manager
A person who directs resources to achieve a stated goal.
Economics
The science of making decisions in the presence of
scare resources.
Managerial Economics
The study of how to direct scarce resources in the way
that most efficiently achieves a managerial goal.
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Identify Goals and Constraints
Sound decision making involves having
well-defined goals.
Leads to making the right decisions.
In striking to achieve a goal, we often face
constraints.
Constraints are an artifact of scarcity.
Economic vs. Accounting
Profits
Accounting Profits
Total revenue (sales) minus dollar cost of producing
goods or services.
Reported on the firms income statement.
Economic Profits
Total revenue minus total opportunity cost.
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Opportunity Cost
Accounting Costs
The explicit costs of the resources needed to produce
produce goods or services.
Reported on the firms 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.
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1-7
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.
1-8
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.
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.
1-9
1-10
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
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.
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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.
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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
FV
1 i
Equivalently,
FV
1 i
n
. . .
FVt
PV
t
t 1 1 i
FV
1 i
1-13
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
NPV
FV
FV
1 i
. . .
FV
1 i
If
Decision Rule:
NPV < 0: Reject project
NPV > 0: Accept project
1 i
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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
PVPerpetuity
CF
CF
CF
...
2
3
1 i 1 i 1 i
CF
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Firm Valuation and Profit
Maximization
The value of a firm equals the present value of
current and future profits (cash flows).
t
1
2
PVFirm 0
...
t
1 i 1 i
t 1
1 i
A common assumption among economist is that it is
the firms goal to maximization profits.
This means the present value of current and future profits, so the
firm is maximizing its value.
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?
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1-17
Net Benefits
Net Benefits = Total Benefits - Total Costs
Profits = Revenue - Costs
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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.
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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
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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
Q*
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The Geometry of Optimization:
Net Benefits
Net Benefits
Maximum net benefits
Slope = MNB
Q*
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1-23
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).
