Managerial Economics: Introduction Donald J. Harmatuck UW-Madison School of Business

What is Managerial Economics? n Managerial Economics The application of the principles and techniques of economic analysis to managerial problems. Microeconomics –demand –production and cost –market structure Management Science –Marginal Analysis and Calculus Econometrics –Regression Analysis

Relationship of Managerial Economics to Business School Curriculum n Integrating Course that treats the firm as a whole rather than as individual functional areas operations finance marketing n Technique Course

What do you get out of the course? n Better Decisionmaking skills Understanding of the role of business Understanding of economic analysis

Course Outline n Introduction Organizational Goals –Profit Maximization Principal Agent Problems Supply and Demand Analysis n Demand n Production and Cost n Markets Market Structure Pricing Practices Regulation

Requirements and Preparation for Course n Some calculus n Text and class discussion will present alternative treatments of most course material. n Exams will use some calculus.

What is Economics ? n Firms exist to allocate society’s resources efficiently and equitably n The study of resource allocation 1.What goods will be produced –what market to serve –how differentiated should the products be –what price to charge 2. How goods will be produced –what mix of inputs to use in production 3. Who gets the goods that are produced Common framework for analyzing these issues is called the economic problem.

What is the ‘Economic Problem’? n The ECONOMIC PROBLEM is the problem of allocating resources to achieve objectives while satisfying constraints: –scarcity –requirement –feasibility

What is the ‘Economic Problem’? n Different groups have different objectives Firms maximize profits constrained by –demand (consumer preferences), –production (technological production possibilities), –competition (competitive responses), –government (regulatory or fiscal measures) Consumers maximize utility –prices and other characteristics of goods –income Governments maximize social welfare

Framework for Managerial Economics n Firm Objectives n Firm Constraints n Decision Rule Generalizations

Firm Objectives 1. Profit Maximization: the difference between revenues and costs over a multiperiod planning horizon n V =  (TR t -TC t )/(1+i) t t=0 where V = long term profits or the value of the firm TR t = total revenues in year t, TC t = total costs in year t, and i = the discount rate, and n = the number of periods.

Discounting Example n V =  (TR t -TC t )/(1+i) t t=0 Discount rate (i) = 0.06 Two courses of action: A and B If A is chosen, outflow of $1 million this year (t=0) and inflows of $300,000 for each of next 5 years. V = -1,000, , , , , ,000 = $263, If B is chosen, outflow of $1 million this year (t=0) and inflows of $260,000 for each of next 6 years. V = -1,000, , , , , , ,000 =$278,

Solving Using an Excel Worksheet n Enter annual revenues (TR) and costs (TC) as columns n Create profits column (TR-TC) by subtracting costs (TC) from revenues (TR) n Create discounted profits column by dividing (TR- TC) by (1.06) raised to the year n Sum discounted profits to get value (V)

Gaming: Profits depend on your decision and your competitor’s decision n Profits depends on your choices A or B as well as choices of competitor choices C or D n First, assume decisions are made simultaneously n Do you have a dominant strategy? Play it. n Does your competitor have a dominant strategy? Assume s/he will use. n Prisoners’ dilemma n What if you can lead?

Example in which your leadership can increase your (and competitor) profits n Assume You or Competitor will become leader (who goes first) n If competitor leads, they choose D If they choose D, you choose B, their payoff is 200 and yours is 225 If they choose C, you choose A, their payoff is 175 and yours is 300 n If you lead, you choose B If you choose A, they choose D, your payoff is 200 and theirs is 250 If you choose B, they choose C, your payoff is 250, and theirs is 250 n We’re better off leading and their better off following n More in McGuigan, Moyer, and Harris, Chapter 14 (which, unfortunately, we cannot cover in detail in our class)

A twist on a current Madison issue: setting transit fares Wisconsin State Journal 1/12/2000: Bus Fare increase to $1.50 Proposed Suppose our objective is to minimize the transit deficit in Madison.  =Total Revenues (TR) - Total Cost (TC) ExistingProposed Total Cost ($ mil./yr.) TC Fare ($/passenger) P Ridership (mil./yr.) Q 10 9

P – 1.50 = ( )(Q - 9) (9 – 10) (9 – 10) TC – 23 = (23 – 25) (Q – 9) (9 – 10) (9 – 10) n n Price v. Ridership: P = Q Total Revenue TR = P  Q = 3.75Q -.25 Q 2 n n Total Cost v. Ridership:TC = Q n n Profit or Deficit = Total Revenue – Total Cost = (P  Q - TC) = 3.75Q -.25 Q Q n n Two approaches: 1. For various prices and quantities, pick Q to minimize deficit 2. Find Q where marginal profits equal 0 marginal revenue equals to marginal cost P = $2.875 and Q = 3.5

Price v. Ridership P – 1.50 = ( )(Q - 9) (9 – 10) (9 – 10) P = Q Total Revenue TR = P  Q = 3.75Q -.25 Q 2 Total Cost v. Ridership: TC – 20 = (20 – 22) (Q – 9) (9 – 10) (9 – 10) TC = Q Profit or Deficit = Total Revenue – Total Cost  = (P  Q - TC)  = 3.75Q -.25 Q Q Two approaches: 1. Enumeration a. Select various prices (P’s) b. Determine corresponding quantities (Q’s) and Profits (  ’s) c. Pick price (P*) that minimizes deficit 2. Find Q and P such that Marginal Profits = 0 marginal revenue = marginal cost  TR/  Q = Q =  TC/  Q = 2 P = $2.875 and Q = 3.5 $ P Q Q TC 5 2

P (Price) = Q TR = P  Q = 3.75Q -.25 Q 2 TC = Q

Calculus of Profit Maximization: Marginal Profits = 0

Calculus of Profit Maximization: Marginal Revenue=Marginal Cost

Marginal Cost Marginal Revenue Total Cost TotalRevenue Total Profits

What’s wrong with our solution? n We may be pursuing the wrong objective n Our cost and demand estimates may be incorrect n Look at alternative pricing structures n Look at quality variations of the service n Change the technology n...

Why do profits vary across firms and industries? 1. RISK 2. FRICTION 3. MONOPOLY 4. INNOVATION 5. MANAGERIAL EFFICIENCY

2. Alternatives to Profit Maximization a. Management Utility Maximization b. Growth c. Long Run Survival d. Revenue Maximization e. Satisficing

Agency Costs n Stockholder and managers may have different objectives job security or personal wealth may be pursued by managers rather than pursuing stockholder wealth maximization Stockholder lack knowledge of managers Random events may obscure managerial effectiveness and results n Agency costs costs to provide incentive for managers to pursue stockholder goals monitoring cost

CEO Incentives- It’s Not How Much You Pay, But How Michael C. Jensen and Kevin J. Murphy Harvard Business Review Article

Agency Theory n Compensation policy ties the agent’s (CEO’s) expected utility to the principal’s (Shareholders’) objective CEO objective is to maximize his/her expected utility Shareholder’s objective is to maximize the long term profits of the firm n In the early ‘80s, Jensen found the CEO pay- performance relationship is weak a project that reduces the firm’s value (by $10 million) would be adopted if CEO’s pay increases (by $32,000).

Three policies that create the right monetary incentives for CEO’s to maximize the value of their companies: n Boards can require that CEOs become substantial owners of company stock n Salaries, bonuses, and stock options can be structured so as to provide big rewards for superior performance n The threat of dismissal for poor performance can be made real

Salomon Brothers CEO Compensation Plan ANNUAL BONUS, IN MILLIONS OF DOLLARS Salomon Brothers’ return on equity 5% 10% 15% 20% 25% 30% +10 $1 $2.5 $7 $12 $17 $ $0.5 $2 $6 $ 9 $12 $17 0 $0 $1.5 $5 $ 7 $ 9 $ $0 $1 $4 $ 6 $ 8 $ $0 $0.5 $3 $ 4 $ 5 $ 7 Salomon Brothers' return on equity vs. competition

Michael Eisner and Disney n Old Structure Salary of $750,000 plus $750,000 signing bonus 2% of the dollar amount by which net income exceeds a return of 9% on shareholder equity Option on 2 million shares of Disney stock purchase within 5 years at $14 n Eisner’s compensation over time: $2.6 million in 1986 $41 million in 1988 $202 million in 1993 $565 million in 1997 –5.5 million shares at $17.14 –1.8 million shares at $19.64 Disney closed at $95.19

Eisner’s Newer Compensation Package (1997): Three Elements n Annual base salary $750,000 n Cash bonus based on growth in earning per share EPS ‘Base eps’ based on the average of ’97 and ’98 eps –required to be in range of $2.75 to $3.25 –Target for ’99 is base eps x and increase 7.5 % annually –Bonus Percentage offsets anticipated compound growth in earnings % % % % % % % % –Bonus = (Actual EPS-Target EPS)(No. of shares)(Bonus Percentage) n Option on 8 million shares on 9/30/96 5 million expire on 9/30/2008 and carry exercise price of $63.31 and 3 million on 9/30/2011 –one million have exercise price of $ x $63.31 –one million have exercise price of $ x $63.31 –one million have exercise price of $ x $63.31

This Is Not Michael Eisner's Pay Stub…, Fortune; Jun 8, 1998; n Between arrival in 1984 and 1998 company's share price outperformed the S&P 500, and the wealth of Disney shareholders increased more than $80 billion. n His options (exercised and unexercised) are valued $1.43 billion.