Managerial Economics Applications, Strategy, and Tactics, 10th Edition by McGuigan, Moyer, & Harris PowerPoint Lecture Slides prepared by Richard D. Marcus University of Wisconsin - Milwaukee 2005 South-Western Publishing 1

Chapter 1 Structure of Decision Models Profit’s Role Introduction Structure of Decision Models Profit’s Role Agency Problems & Solutions Not-for-Profit Organizations Why Corporations Have Succeeded Over Other Organizational Forms 2

Managerial Economics Integrates and applies microeconomic theory and methods to decision making problems faced by private, public, and not-for-profit organizations. Managerial economics deals with microeconomic reasoning on real world problems such as pricing decisions selecting the best strategy in different competitive environments. 3

MAJOR TOPICS Demand and Supply Analysis Production and Cost Analysis and how to estimate price elasticities with regressions Production and Cost Analysis and how managers can estimate these relationships Monopoly, Competition, and Oligopolies and how to make good pricing decisions in the real world Organization Architecture and the economic problem of motivating agents Risk in Economic Decisions and ways to modify or compare risks 4

The Decision-Making Process (Figure 1.1) 1. Establish and Identify Objectives 2. Define the Problem 3. Identify Alternative Solutions 4. Evaluate the Alternatives and Select the Best! 5. Implement and Monitor the Decision Consider Organizational & Input Constraints Consider Societal Constraints

Theories of Why Profit Varies Across Industries RISK-BEARING THEORY DYNAMIC EQUILIBRIUM (or FRICTIONAL) THEORY OF PROFIT MONOPOLY THEORY OF PROFIT INNOVATION THEORY OF PROFIT MANAGERIAL EFFICIENCY THEORY OF PROFIT 11

Objectives of the Firm Profit maximization Shareholder wealth = value of each share (V0) times the number of shares outstanding, or V0 · (shares outstanding). This is the present value of expected future profits or cash flows, discounted at the shareholders required rate of return, ke, ignoring taxes.  V0 (shares outstanding) =  t /(1+ke) t t=1 6

Firm Value (Figure 1.2) t = REVENUE – COST = TRt – TCt = PtQt – VtQt - Ft Value of the Firm = the present value of discounted cash flows N (t ) / (1+ke)t = t=1 (PtQt – VtQt – Ft) / (1+ke)t t =1 Whatever lowers the perceived risk of the firm (ke) will also raise firm value. Whatever raises the price of the product (Pt) or the quantity sold (Qt ) will raise firm value. Whatever raises variable cost (Vt )or fixed cost ( Ft ) will reduce firm value. 7

Will be forecasting demand (both Pt & Qt) To make good economic decisions, managers need to be able to forecast & estimate relationships Will be forecasting demand (both Pt & Qt) applies to for-profit corporations non-profit organizations Hospital Administrators -- # patients University Administrator -- enrollment Regression analysis, time series methods, and qualitative forecasting methods used for forecasting 9

The Role of Profits Economic Cost (or opportunity cost) is the highest valued benefit that must be sacrificed as a result of choosing an alternative. Economic Profit is the difference between revenues and total economic cost (including the economic or opportunity cost of owner supplied resources such as time and capital. 10

Factors Affecting Stock Prices (Figure 1.3) Factors Affecting Stock Prices Economic Environment Factors Economic Activity Tax Rates & Regulations Competition Laws and Governmental Regulation Unionization International Conditions & Exchange Rates Major Policy Decisions Under Management Control Products or Services Offered Production Technology Marketing and Distribution Network Used Investment Strategies Employment & Compensation Policies Ownership Form Capital Structure Used Working Capital Management Policies Dividend Policies Alliances, mergers, spin-offs Amount, Timing, and Risk of Expected Profits Shareholder Wealth (The Market Price of the Stock) Conditions in Financial Markets Interest Rates Investor Sentiment Expected Inflation

Agency Problems Modern corporations allow managers to have no, or limited, ownership participation in the profitability of the firm. Shareholders may want profits, but managers may wish to relax. The shareholders are principals, whereas the managers are agents. Conflicting motivations between these groups are called agency problems. 12

The Principal-Agent Problem Shareholders (principals) want profit Managers (agents) want leisure & security Examples KKR’s takeover of RJR Nabisco to refocus on wealth-maximization The LBO by O.M. Scott (a lawn fertilizer company) from ITT improved Scott’s performance 13

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 Incentives to help the company, because that improves the value of stock options and bonuses. 14

What Went Right? What Went Wrong? Saturn Corporation Different kind of car company in 1991 No-haggle pricing Sales were above expectations But, margin of only $400 per car to GM GM earned only 3% on capital Saturn customers wanted bigger Saturns rather than trade up to Buick, as GM hoped. When the dollar appreciated, Japanese firms could price their cars more competitively.

Shareholder Wealth Maximization: Necessary Conditions COMPLETE MARKETS - liquid markets for firm's inputs and by-products (including polluting by-products). NO SIGNIFICANT ASYMMETRIC INFORMATION - buyers and sellers all know the same things. KNOWN RECONTRACTING COSTS future input costs are part of the present value of expected cash flows. 15

Goals in the Public Sector and the Not-For-Profit (NFP) Enterprise Public Goods are goods that can be consumed or used by more than one person at the same time with no extra cost (like a flood control or national defense). Sometimes governments produce public goods. Other times, they are exclusive to one person (like a free meal). Instead of profit, NFP organizations may have as their goals: 1. Maximization of the quantity of output, subject to a breakeven constraint. 2. Maximization of the utility (happiness) of NFP administrators. 3. Maximization of cash flows. 4. Maximization of the utility of contributors to the NFP organization. 16

Which goal a NFP manager selects affects decisions made. A food shelter manager may decide to maximize the utility of contributors by selecting only "healthy foods" Public sector managers are performance monitored. V.A. hospital administrators are rewarded by reducing the cost per bed over a year. Hence, they become efficient with respect to costs. The "friendliness" of the hospital staff is harder to measure, so friendliness will tend not be a high priority of the public sector manager. 17