Slide 1 © 2008 Cengage Learning South-Western Managerial Economics Applications, Strategy, and Tactics, 11 th Edition by McGuigan, Moyer, & Harris PowerPoint Lecture Slides prepared by Richard D. Marcus University of Wisconsin - Milwaukee

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

Slide 3 What is 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, and making efficient choices.

Slide 4 To Expand Capacity or Not? Should Toyota expand its capacity? In part, it must consider current and future demand and what other firms are likely to do. Capacity for making cars is a long term project, so Toyota should think in terms of the present value (PV) of future profits. Objective Function: »Max PV of profits {S1, S2} »S1 could be expand capacity and S2 not to expand yet capacity at this time. Decision Rule: »Choose S1 if PV {Profits of S1 } > PV { Profits of S2 } »Choose S2 if PV { Profits of S1 } < PV { Profits of S2 } »If equal profits, then flip a coin

Slide 5 The Decision-Making Process (Figure 1.2) 1. Establish Objectives 2. Identify the Problem 3. Examine Alternative Solutions 4. Analyze Alternatives and Select the Best! 5.Perform Sensitivity Analysis 6. Implement and Monitor the Decision Consider Societal Constraints Consider Organizational & Input Constraints

Slide 6 The Role of Profits 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). We’d expect high profit areas to attract investment We’d expect low profit areas to lose investment »Shouldn’t then all industries earn the same profit eventually?

Slide 7 Theories of Why Profit Varies Across Industries 1.RISK-BEARING THEORY 2.TEMPORARY DISQUILIBRIUM THEORY OF PROFIT 3.MONOPOLY THEORY OF PROFIT 4.INNOVATION THEORY OF PROFIT 5.MANAGERIAL EFFICIENCY THEORY OF PROFIT

Slide 8 What Went Right? What Went Wrong? Eli Lilly (p. 16) a Pharmaceutical company »12.3 on average to get a new drug approved »Patents on Lilly’s Prozac created monopoly power and profits for a widely used medication for depression. »As the patent began to expire, Lilly requested s patent “extension” because of some alterations in Prozac’s formula »But when the patent extension was overturned, generic drug manufactures took 70% of the share of the market for anti- depressants. »Lilly missed the chance of finding a replacement in time for its blockbuster Prozac

Slide 9 Objectives of the Firm Profit maximization Shareholder wealth = value of each share (V 0 ) times the number of shares outstanding, or V 0 · (# shares outstanding). This is the present value of expected future profits  or cash flows, discounted at the shareholders required rate of return, k e, ignoring taxes.  V 0 (shares outstanding) =   t /(1+k e ) t t=1

Slide 10 Determinants of Firm Value (Figure 1.3)  t = REVENUE – COST = TR t – TC t = P t Q t – V t Q t - F t Value of the Firm = the present value of discounted cash flows N  (  t ) / (1+k e ) t = t=1 N  (P t Q t – V t Q t – F t ) / (1+k e ) t t =1 Whatever lowers the perceived risk of the firm (k e ) will also raise firm value. Whatever raises the price of the product (P t ) or the quantity sold (Q t ) will raise firm value. Whatever raises variable cost (V t )or fixed cost ( F t ) will reduce firm value.

Slide 11 To make good economic decisions, managers need to be able to forecast & estimate relationships Will be forecasting demand (both P t & Q t ) »applies to for-profit corporations »non-profit organizations Hospital Administrators forecast patients University Administrator forecast enrollment Regression analysis, time series methods, and qualitative forecasting methods used for forecasting

Slide 12 Agency Problems Modern corporations allow firm managers to have no ownership participation, or only limited 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.

Slide 13 The Principal-Agent Problem »Shareholders (principals) want profit »Managers (agents) want leisure & security »Conflicting motivations between these groups are called agency problems. Examples (page 13) »KKR’s takeover of RJR Nabisco to refocus on wealth-maximization »The LBO by O.M. Scott (a lawn fertilizer company) from ITT (a conglomerate) improved Scott’s performance

Slide 14 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.

Slide 15 What Went Right? What Went Wrong? Saturn Corporation (p. 15) »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. »Must continuously keep up with global competitors.

Slide 16 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.

Slide 17 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.

Slide 18 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.