Managerial Economics & Business Strategy Chapter 1 The Fundamentals of Managerial Economics

Managerial Economics Economics –The study of how individuals, firms, organizations, etc., make choices about the allocation of scarce resources to achieve a stated goal. Manager –A person who directs resources to achieve a stated goal. Managerial Economics –The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.

Managerial Economics You are a consultant to Acme Mugs that produces coffee mugs for restaurants. You notice that sales are lagging behind production by 20%. As a consultant you must find a way to cut production by 20%. Acme Mugs is considering cutting the workweek from 5 to 4 days. Will this plan achieve the goal? Keep in mind that Acme Mugs is the major employer in a very small community, and that the company pays its employees based on the number of mugs produced.

Managerial Economics If you cut the workweek, production probably won’t change; workers will produce just as much. Set a quota, but employee morale may decline. Decrease commission and increase fixed hourly wage. Loss of morale may be offset by the fixed hourly wage.

Problem Under flat hourly wage, employees (EEs) have little incentive to work hard as working hard will not directly benefit them: –EEs make $144 per day regardless of effort. This adversely affects the firm, b/c its profits will be lower than the $40,000, which is obtainable each day when employees perform at their peak. Under the proposed pay structure, employees have a strong incentive to increase effort, and this will benefit the firm. –An EE receives $264 (=0.005*$40,000 + $8*8) per day if the store achieves its maximum possible daily profit and only $64 if the store’s daily profit is zero. –This provides employees an incentive: to work hard to exert peer pressure on employees who might otherwise goof off. STOP TO DO VOTING GAME

# of zerosYou vote zeroYou vote one 008,000 12,00010,000 24,00012,000 36,00014,000 48,00016, ,00018, ,00020, ,00022, ,00024, ,00026, ,00028, ,00030, ,00032, ,00034, ,00036, ,00038, ,00040, ,00042,000

# of zerosYou vote zeroYou vote one 1836,00044, ,00046, ,00048, ,00050, ,00052, ,00054, ,00056, ,00058, ,00060, ,00062, ,00064, ,00066, ,00068, ,00070, ,00072, ,00074, ,00076, ,00078,000

Economic vs. Accounting Profits Accounting Profits –Total revenue (sales) minus dollar cost of producing goods or services –Reported on the firm’s income statement Economic Profits –Total revenue minus total opportunity cost

Opportunity Cost Accounting Costs –The explicit costs of the resources needed to produce produce goods or services –Reported on the firm’s income statement Opportunity Cost –Explicit and implicit costs –“full cost” of a choice In this class, we will be using opportunity costs and economic profits.

Problem Accounting costs = $3,160,000 per year (overhead and operating expenses). Implicit costs = $56,000 (salary that must be given up to start the new business). Opportunity cost includes both implicit and explicit costs = $3,160,000 + $56,000 = $3,216,000.

Problem continued To earn positive accounting profits, the revenues per year should greater than $3,160,000. To earn positive economic profits, the revenues per year must be greater than $3,216,000.

The Role of Profits & 5 Forces Framework By maximizing profits, firm meets needs of society (sometimes, more later). Profits, and prices, are incentives. They provide information on how to direct resources. If consumers demand for a product increases, then price will increase and firms direct resources accordingly to maximize their profits.

The 5 Forces Framework There are many interrelated forces that affect profitability (level, growth and sustainability), and Porter’s 5 Forces Framework demonstrates this. 1)Entry 2)Power of Input Suppliers 3)Power of Buyers 4)Industry Rivalry 5)Substitutes and Complements

Market Interactions: Understanding the Degree of Rivalry & Government Intervention Consumer-Producer Rivalry –Consumers want to buy low, and producers want to sell high 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

Net Benefits = Total Benefits – Total Costs Basic Managerial Question: How much of the control variable should be used to maximize net benefits (profits)? Control Variables: –Output, Price, Quality, Advertising, R&D Benefit-Cost Analysis (BCA)

The Goal of the Firm Net Benefits = Total Benefits - Total Costs Profits = Revenue - Costs

The Time Value of Money Present value (PV) of an amount to be received at the end of n periods (FV) when the per-period interest rate is i: The higher the interest rate, the larger the opportunity cost of waiting to receive the payment, and the lower the PV.

Present Value of a Series Present value of a stream of future amounts (FV t ) received at the end of each period for n periods: Today, PV1 year from today2 years from today3 years from today PVFV 1 FV 2 FV 3 n = 3 n = 2 n = 1

Net Present Value (BCA over time) Suppose a manager can purchase a stream of future receipts (FV t ) by spending C 0 dollars today. The NPV of such a decision is NPV < 0: Reject NPV > 0: Accept Note: if comparing alternative ways to spend C 0, then do NPV calculation for all. Alternatively, could include the “full cost” in calculation.

Question The maximum you would be willing to pay for this asset is the present value, which is

Marginal Analysis Looking at benefits and costs for incremental changes in a control variable.

Marginal Benefit (MB) Change in total benefits arising from a change in the control variable, Q: MB =  B /  Q Slope (calculus derivative) of the total benefit curve

Marginal Cost (MC) Change in total costs arising from a change in the control variable, Q: MC =  C /  Q Slope (calculus derivative) of the total cost curve

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 STOP DO DOLLAR-BILL AUCTION

P roblem MR = $9,807,700 if you adopt the project. MC = $2,945,700 (in TV airtime) + $1,179,100 (for additional ad development labor) + $6,000,000 (in implicit costs) $10,124,800 Thus, MC>MR, you should not proceed with the new advertising campaign. Going forward with the plan would reduce the firm’s bottom line by $317,100. Expressed differently, the extra accounting profits earned in the U. S. would not offset the accounting profits lost from foreign operations.

The Geometry of Optimization Q Benefits & Costs Benefits Costs Q* B C Slope = MC Slope =MB

Calculus Optimization Problem Goal: Choose the output level that maximizes profits. TR = PQ, where P = $20 TC = Q 2, $60 is a monthly equip. rental fee (you pay regardless if you use). Differentiate TR and TC wrt Q, set MR=MC and solve for Q. Profits = $20(5) – 60 – 2(5 2 ) = $100 – 110 = ($10). Should they produce 5 or produce nothing at all?

Summary 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)