Introduction to Managerial Economics

Managerial economics Science of directing scarce resources resources – financial, human, physical management of customers, suppliers, competitors, internal organization setting – business, nonprofit, household Aim: cost-effective management, best value for money; not just effective, must be cost-effective; technical people often don’t appreciate the distinction – go for the biggest engine, most powerful server, but at what cost? Managerial economics principles are universal Airbus vs Boeing – Airbus was not commercial entity GM vs Toyota University: Should it expand into distance education? Should it open a medical school? Should it shut down PhD program? Household – Should we engage maid service (out-sourcing)? Should we buy a bigger car and incur higher fuel consumption?

Shell’s ads strategy

Shell Gains by Giving Safe-Driving Advice Shell Oil created TV ads notifying people that the company will send them a free booklet on safe- driving and how to cope with problems on the road. All of this occurs without mentioning Shell’s products. Why? Survey based on a poll covering 2000 households shows 80% of the households have a more positive image of companies who are more willing to take social responsibilities; and 67% would probably switch to the brands of those companies.

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Preliminaries: Scope Managerial economics based on microeconomics micro – individual economic behavior macro – aggregate economic behavior Example: China’s economic stimulation policies micro effects – lower interest rate (mortage rate), investment decision (buy stock vs. buy house) macro effects – increase domestic demand, lower unemployment, keep economic growth; INFLATION Typical macro issues – depreciation of US dollar, interest rates, unemployment; doesn’t directly consider economic decisions at individual business or consumer level uses a different set of economic models

Individual behavior Bounded rationality: individuals have limited cognitive abilities and cannot fully exercise self-control Separate accounting for different categories of benefits and costs Lack self-control: addictive behavior and difficulty postponing immediate gratification for longer-term benefits More sensitive to losses than to gains Decisions may depend on how choices are “framed”

Preliminaries: Methodology Economic model – concise abstraction of behavior and outcomes Marginal vis-à-vis average example: your wage rate is 100 yuan per hour for an eight-hour working day; if you work overtime, then the wage rate per additional hour is 150 yuan. Now you work 10 hours a day, what is your marginal wage and your average wage respectively? Stock vis-à-vis flow example: annual income is flow variable; total assets is a stock variable. Other things equal Models are deliberately unrealistic – like maps; imagine a completely realistic map?? marginal vis-à-vis average earnings – overtime wage rate is higher than standard wage rate, so marginal return to labor is higher than average stock at some time is cumulation of flows over preceding periods, eg, inventory of automobiles “holding other things equal" is an abstraction -- so that changes due to the factor being studied may be examined independently of those other factors.

Preliminaries: Methodology Timing static model – single point in time dynamic model – focus on sequence of actions and payments Example: life cycle model, smoothing consumption Will mainly present static models Some dynamic models – experience curve, games in extensive form, oligopoly

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Timing Discount future values to be comparable with present values If discount rate = 10%, $1 next year worth 1/1.10 = 91 cents now $1 two years later worth about 83 cents now

Timing Net present value: sum of discounted values of inflows and outflows over time Example: Month 1: gain of $3 million Months 2 and 3: loss of $2 million Net present value: Math. Appendix: Introduce another analytical method – internal rate of return

Internal rate of return (IRR): discount rate that would make the net present value of a series of inflows and outflows equal to zero.

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Organization Vertical boundaries – closer to or further from end user Samsung Electronics – vertical boundaries (components such as hard drive, flash memory, system LSI, fiber optics) longer than Intel – specializes in semiconductors (upstream) Motorola – specializes in mobile phones (downstream) Samsung Electronics is vertically integrated electronics manufacturer manufactures and markets semiconductors, LCDs, mobile phones, computers, TVs

Organization Horizontal boundaries – scale and scope of activities --Example: scale: Samsung operates at a larger scale than ASUS --Example: scope: Samsung Electronics – horizontal boundaries (mobile phone, CD, lpatop computer, digital camera) broader than LG.Philips LCD – specializes in LCD Motorola – specializes in mobile phones

Why is organization architecture important? Scale economy Risk, uncertainty and incomplete information Incomplete contract Hold up problems Principle-agent problem Organization design helps reduce the cost and inefficiency caused by the above problems.

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Market Definition: Buyers and sellers communicate with one another for voluntary exchange Market need not be physical Market need not be physical or organized oil market extends from organized exchange (wholesale level) to corner gasoline station (retail level) Various markets markets for consumer products, buyers are households and sellers are businesses. markets for industrial products, both buyers and sellers are businesses. markets for human resources, buyers are businesses and sellers are households.

Comment: newspaper classified advertisements are part of human resource market

Competitive market Benchmark for managerial economics Extremely competitive market many buyers and many sellers no room for managerial strategizing Achieves economic efficiency Competitive market is the basic starting point of managerial economics -- where capitalist system performs best demand supply market equilibrium

Competitive market Model: demand supply market equilibrium Model analyzes and explains systematic effect of prices and other economic variables on household choice and business decisions interaction of households and businesses

Market power Definition – ability of a buyer or seller to influence market conditions Seller with market power must manage costs pricing advertising expenditure R&D expenditure strategy toward competitors

Market power: Prozac August 2001: US Court of Appeals limited Prozac patent Lilly market value dropped $36 billion Barr market value rose $1.1 billion Huge discrepancy in impact – why? This is example of market power analysis Lilly’s loss > Barr’s gain gain to consumers (lower price) gain to other generic manufacturers

Imperfect market Definition: where one party directly conveys a benefit or cost to others, or one party has better information than others

Imperfect market: Disneyland Hong Kong Disney insisted on rights to adjoining property before commencing new investment. Why? Disney wanted to capture the externalities generated by new theme park investments; discuss in Chapter 11: Externalities Disney wanted to capture the externalities generated by new theme park investments; discuss in Chapter 11: Externalities

Imperfect Market: Asymmetric information and Adverse Selection problem: health insurance

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Globalization: Why? Growth of cross-border trade and investment falling trade barriers falling financial barriers falling communications costs European monetary integration – Euro Easier for people in one country to buy from other Euro country  more trade and investment

Globalization: Outsourcing tele-radiology transcription increasing bandwith outgoing call center, eg, telemarketing record-keeping Medicine -- tele-radiology Background: 15% annual increase in radiology procedures while only 2% annual increase in raidologiest in the U.S. incoming call center, eg, customer service

Globalization: e-commerce Extends geographical reach –Google, eBay, Yahoo, Amazon Limitations payments system trade barriers shipment costs eBay: the “World’s Online Marketplace” enormously successful worldwide except Japan, where Yahoo started earlier, and China

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