Contact Information Details Dr. Daniel Simons Building 250 - Room 416 Lectures: W: 8:30 – 11:30 Building 250 – Room 205 Office Hours: T Thu : 11:45 – 12:45 W: 11:30 – 12:30 Or By appointment Email: simonsd@viu.ca Dr. Rosmy Jean Louis Building 250 – Room 464 Lectures: W: 9:00 – 12:00 Building 200 – Room 238

Suggestions for Best Individual Performance Attend all classes Take notes. Course covers a lot of material and your notes are essential Complete all assignments (not for grade) Read the book Participate, enrich class discussion, provide feedback and ask questions Revise materials between classes, integrate concepts, make sure you understand the tools and their application Don’t hesitate to contact me if necessary

Evaluation Method Tests have a mix of problems that evaluate Concepts Problem sets (assignments) Class applications Readings New applications 3 closed book time constrained tests to reward knowledge and speed Each test covers slides, assignments, and required readings. Evaluation system may not be perfect but it works

Main Course Objectives Present relevant tools for effective management of organizational processes and resources Show the application of core concepts to typical business problems and management decisions Provide the foundation for late in-depth coverage of business issues in Economics Present a general framework to better understand and meet the challenges faced by organizations Contribute to the generation and implementation of strategies to create economic value and sustain competitive advantage in organizations

Introduction, Basic Principles and Methodology The central themes of Managerial Economics: Identify problems and opportunities Analyzing alternatives from which choices can be made Making choices that are best from the standpoint of the firm or organization

Not true that all managers must be managerial economists But managers who understand the economic dimensions of business problems and apply economic analysis to specific problems often choose more wisely than those who do not.

Manager-: A person who directs resources to achieve a stated goal Economics-: Study of making decisions in the presence of scarce resources

Managerial Economics Defined Is the study of how to direct scarce resources in the way that most efficiently achieves a managerial goal Main thrust of Managerial Economics is to provide you with a vast pool of skills that will allow you to make sound decisions and to determine the right incentives within your company

Methodology, data and application Methodology- is a branch of philosophy that deals with how knowledge is obtained. How can you know that you are managing efficiently and effectively? You need some theory to do some analysis. Without theory, there can be no good analysis

Microeconomics (probably more than other disciplines) provides the methodology for managerial economics Managerial Economics is about both methodology and data You need data to plug into some model to do some analysis. This gives you the information to manage Managerial Economics lends empirical content to the study of effective management

Decisions are always among alternatives Decisions are always among alternatives. Decision alternatives always have costs and benefits Opportunity cost = next best alternative foregone. Marginal or incremental approach

Review of Economic Terms Resources are factors of production or inputs. Examples: Land Labor Capital Entrepreneurship

Relationship to other business disciplines Marketing: Demand, Price Elasticity Finance: Capital Budgeting, Break-Even Analysis, Opportunity Cost, Economic Value Added Management Science: Linear Programming, Regression Analysis, Forecasting Strategy: Types of Competition, Structure-Conduct-Performance Analysis Managerial Accounting: Relevant Cost, Break-Even Analysis, Incremental Cost Analysis, Opportunity Cost

The Economics of Effective Management An effective manager must Identify goals and constraints Recognize the nature and importance of profits Understand incentives Understand markets Recognize the time value of money Use Marginal Analysis

Identify Goals and constraints Well-defined goals and recognize constraints such as available technology, prices of inputs used in production, decisions made by competitors etc.

Because of scarcity, an allocation decision must be made Because of scarcity, an allocation decision must be made. The allocation decision is comprised of three separate choices: What and how many goods and services should be produced? How should these goods and services be produced? For whom should these goods and services be produced?

What: The product decision – begin or stop providing goods and/or services. How: The hiring, staffing, procurement, and capital budgeting decisions. For whom: The market segmentation decision – targeting the customers most likely to purchase.

Three processes to answer what, how, and for whom Market Process: use of supply, demand, and material incentives Command Process: use of government or central authority, usually indirect Traditional Process: use of customs and traditions

Profits are a signal to resource holders where resources are most valued by society So what factors impact sustainability of industry profitability? Porter’s 5-forces framework discusses 5 categories of forces that impacts profitability

Entry Power of input sellers Power of buyers Industry rivalry Substitutes and Complements

Entry: Heightens competition Reduces margin of existing firms Ability to sustain profits depends on the barriers to entry: cost, regulations, networking, etc. Profits are higher where entry is low

Power of input suppliers: Do input suppliers have power to negotiate favorable input prices? Less power if inputs are standardized, not highly concentrated alternative inputs available Profits are high when suppliers power is low

Power of buyers: High buyer power if buyers can negotiate favorable terms for the good/service Buyer concentration is high Cost of switching to other products is low perfect information leading to less costly buyer search

Industry rivalry: Rivalry tends to be less intense in concentrated industries high product differentiation high consumer switching cost Profits are low where industry rivalry is intense

Substitutes and complements: Profitability is eroded when there are close substitutes Government policies (restrictions e.g. import restriction on drugs from Canada to US) can affect the availability of substitutes.

Understand Markets Power or bargaining position of consumers and producers in the market is limited by 3 sources of rivalry: Consumer – consumer rivalry Because of scarcity, consumers compete with each other for the right to purchase the available goods Those willing to pay higher prices will outbid others for the right to consume the product

Consumer-Producer Rivalry Consumers attempt to locate low prices, while producers attempt to charge high prices. The ability of each party to achieve its goal is limited. Offer too low a price and producer will refuse to sell the product Charge to high a price and consumers will refuse to buy the product

Producer-Producer Rivalry Scarcity of consumers causes producers to compete with one another for the right to service customers. The Role of Government When agents on either side of the market feel aggrieved in the market process, they attempt to induce government to intervene on their behalf, Disciplines the market process.

The Firm and Its Goals The Firm Economic Goal of the Firm Goals Other Than Profit Do Companies Maximize Profits? Maximizing the Wealth of Stockholders Economic Profits

Profits Profit is the difference between revenue received and costs incurred.

Economic vs. 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.

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 Economic Profits The cost of the explicit and implicit resources that are foregone when a decision is made. Economic Profits Total revenue minus total opportunity cost.

Economic Goal of the Firm Primary objective of the firm (to economists) is to maximize profits. Profit maximization hypothesis Other goals include market share, revenue growth, and shareholder value Optimal decision is the one that brings the firm closest to its goal.

Goals Other Than Profit Market share maximization (as measured by sales revenue or proportion of quantity sold to total market Growth rate maximization (increasing size of the firm over time. Higher rates of growth in other variables than profit) Profit margin Return on investment, Return on assets

Shareholder value Technological advancement Customer satisfaction Maximization of managerial returns (manager’s own interest subject to generating sufficient profits to keep their jobs)

Non-economic Objectives Good work environment Quality products and services Corporate citizenship, social responsibility

Do Companies Maximize Profit? Criticism: Companies do not maximize profits but instead their aim is to “satisfice.” “Satisfice” is to achieve a set goal, even though that goal may not require the firm to “do its best.”

Two components to “satisficing”: Position and power of stockholders Position and power of professional management

Position and power of stockholders Medium-sized or large corporations are owned by thousands of shareholders Shareholders own only minute interests in the firm Shareholders diversify holdings in many firms Shareholders are concerned with performance of entire portfolio and not individual stocks.

Most stockholders are not well informed on how well a corporation can do and thus are not capable of determining the effectiveness of management. Not likely to take any action as long as they are earning a “satisfactory” return on their investment.

Position and power of professional management High-level managers who are responsible for major decision making may own very little of the company’s stock. Managers tend to be more conservative because jobs will likely be safe if performance is steady, not spectacular.

Management incentives may be misaligned E.g. incentive for revenue growth, not profits Managers may be more interested in maximizing own income and perks Divergence of objectives is known as “principal-agent” problem or “agency problem”

Counter-arguments which support the profit maximization hypothesis. Large number of shares is owned by institutions (mutual funds, banks, etc.) utilizing analysts to judge the prospects of a company. Stock prices are a reflection of a company’s profitability. If managers do not seek to maximize profits, stock prices fall and firms are subject to takeover bids and proxy fights. The compensation of many executives is tied to stock price.

Company tries to manage its business in such a way that the dividends over time paid from its earnings and the risk incurred to bring about the stream of dividends always create the highest price for the company’s stock. When stock options are substantial part of executive compensation, management objectives tend to be more aligned with stockholder objectives.

Maximizing the Wealth of Stockholders Views the firm from the perspective of a stream of earnings over time, i.e., a cash flow. Must include the concept of the time value of money. Dollars earned in the future are worth less than dollars earned today.

Future cash flows must be discounted to the present. The discount rate is affected by risk. Two major types of risk: Business Risk – up and down of the economy Financial Risk – due to a leverage

Maximization of stockholder’s wealth vs Maximization of profits MSW seems to be a more comprehensive goal because It is a long-run concept It considers the timing of benefits It incorporates the concept of risk

The Time Value of Money Present value (PV) of a lump-sum amount (FV) to be received at the end of “n” periods when the per-period interest rate is “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

Present Value of a Series Present value of a stream of future amounts (FVt) received at the end of each period for “n” periods:

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 Decision Rule: If NPV < 0: Reject project NPV > 0: Accept project

Present Value of a Perpetuity An asset that perpetually generates a stream of cash flows (CF) at the end of each period is called a perpetuity. The present value (PV) of a perpetuity of cash flows paying the same amount at the end of each period is

Firm Valuation The value of a firm equals the present value of current and future profits. PV = S pt / (1 + i)t

If profits grow at a constant rate (g < i) and current period profits are po:

If the growth rate in profits < interest rate and both remain constant, maximizing the present value of all future profits is the same as maximizing current profits.

Marginal (Incremental) Analysis Control Variables Output Price Product Quality Advertising R&D

Net Benefits Basic Managerial Question: How much of the control variable should be used to maximize net benefits? Net Benefits = Total Benefits - Total Costs Profits = Revenue - Costs

Marginal Benefit (MB) Change in total benefits arising from a change in the control variable, 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: 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.

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

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).

Maximizing the Wealth of Stockholders Another measure of the wealth of stockholders is called Market Value Added (MVA)®. MVA represents the difference between the market value of the company and the capital that the investors have paid into the company.

Maximizing the Wealth of Stockholders Market value includes value of both equity and debt. Capital includes book value of equity and debt as well as certain adjustments. E.g. Accumulated R&D and goodwill. While the market value of the company will always be positive, MVA may be positive or negative.

Maximizing the Wealth of Stockholders Another measure of the wealth of stockholders is called Economic Value Added (EVA)®. EVA=(Return on Total Capital – Cost of Capital) x Total Capital If EVA is positive then shareholder wealth is increasing. If EVA is negative, then shareholder wealth is being destroyed.

Lessons There is no free lunch The cost of an action is the alternative that is sacrificed The relevant costs and benefits are the marginal ones People respond to incentive Things aren’t always what they seem