Chapter 1 The Fundamentals of Managerial Economics

Headline Amcott Loses $3.5 Million; Manager Fired. On Tuesday software giant Amcott posted a year-end operating loss of $3.5 million. Reportedly, $1.7 million of the loss stemmed from its foreign language division. With short-term interest rates at 7 percent, Amcott decided to use $20 million of its retained earnings to purchase three-year rights to Magicword, a software package that converts generic word processor files saved as French text into English. First year sales revenue from the software was $7 million, but thereafter sales were halted pending a copyright infringement suit filed by Foreign, Inc.

Amcott lost the suit and paid damages of $1. 7 million Amcott lost the suit and paid damages of $1.7 million. Industry insiders say that the copyright violation pertained to a very small component of Magicword. Ralph, the Amcott manager who was fired over the incident, was quoted as saying, “I’m a scapegoat for the attorneys [at Amcott] who didn’t do their homework before buying the rights to Magicword. I projected annual sales of $7 million per year for three years. My sales forecasts were right on target.” Do you know why Ralph was fired?

1. Managerial Economics Manager Economics Managerial Economics A person who directs resources to achieve a stated goal. Economics The science of making decisions in the presence of scare resources. Managerial Economics The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.

2. Economic vs. Accounting Profits Goal = Profit Maximization (among others) 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 Opportunity Cost Economic Profits The explicit costs of the resources needed to produce produce goods or services. Reported on the firm’s income statement. Opportunity Cost The cost of the explicit and implicit resources that are foregone when a decision is made. Economic Profits Total revenue minus total opportunity cost.

[Example] Pizza House in NY Opportunity Cost Revenue = $100,000 Cost = $20,000 Profit = Opportunity Cost Can work for $30,000 Rental revenue = $70,000 Total Economic Cost = Cost + Opportunity Cost = Economic Profit = Revenue – Total Economic Cost = $100,000 - $120,000 =

3. The Five Forces Framework Sustainable Industry Profits Power of Input Suppliers Supplier Concentration Price/Productivity of Alternative Inputs Relationship-Specific Investments Supplier Switching Costs Government Restraints Buyers Buyer Concentration Price/Value of Substitute Products or Services Customer Switching Costs Entry Entry Costs Speed of Adjustment Sunk Costs Economies of Scale Network Effects Reputation Switching Costs Substitutes & Complements Price/Value of Surrogate Products or Services Price/Value of Complementary Products or Services Industry Rivalry Timing of Decisions Information Concentration Price, Quantity, Quality, or Service Competition Degree of Differentiation

4. Market Interactions Consumer-Producer Rivalry Consumers attempt to locate low prices, while producers attempt to charge high prices. 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.

5. 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

[example] A new machine costs $300,000 and has a life of 5 years. Cost reductions will be $50,000, $60,000, $75,000, $90,000 and $90,000 in year 1,2,..,5, respectively. If the interest rate is 8 percent, should the manager purchase the machine? PV = $284,679 NPV = PV – C = -$15,321. Thus,

Present Value of a Perpetuity An asset that perpetually (endlessly) 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

How? Example: What is the value of a perpetual bond that pays the owner $100 at the end of each year when i = 0.05?

Firm Valuation The value of a firm equals the present value of current and future profits. PV = S pt / (1 + i)t Note: If the profits are expected to grow at a constant rate of g percent, pt = p0 (1 + g)t Then, PV = S p0 (1 + g)t / (1 + i)t gives (HOW?):

If profits grow at a constant rate (g < i): (How?) Point: If the growth rate in profits < interest rate, i.e., g < i, and both remain constant, maximizing the present value of all future profits is the same as maximizing current profits.

[Example] Suppose that i = 10% and g = 5%. The firm’s current profits are $100 million. What is PV? What is PV after paying a dividend of the current profit?

Related concept: Tobin’s q Tobin's q, is the ratio of the market value of a firm's assets (as measured by the market value of its outstanding stock and debt) to the replacement cost of the firm's assets (Tobin 1969). This concept is frequently used in finance analysis.

6. Marginal (Incremental) Analysis Basic Managerial Question: How much of the control variable should be used to maximize net benefits? Control Variables = Output, Price, Product Quality, Advertising, R&D, etc. When to stop working? Study plan? Retirement plan?

Net Benefits Net Benefits = Total Benefits - Total Costs Profits = Revenue – Costs Point: Benefit keeps increasing before calling down. Cost keeps increasing at an increasing rate.

Key points The optimal point is at the level of input (Q) Where two slopes are the same. That is, MB = MC. Where the slope of the Net Benefit is zero. That is, the Net benefit is maximized. Should explain WHY this occurs. If MB < MC? If MB > MC?

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*

[Example] Exercise: Suppose Suppose MB = 300 – 12Q Benefit = 300Q – 6Q2 Cost = 4Q2 MB = 300 – 12Q MC = 8Q MB = MC implies 300 – 12Q = 8Q Q* = 15 NB = 300*15 – 6*152 - 4*152 = 2,250 Exercise: Suppose Benefit = 150 +28Q – 5Q2 Cost = 100 + 8Q What is 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).

Back to Headline NPV = 7,000,000/(1+0.07)1 + 7,000,000/(1+0.07)2 + 7,000,000/(1+0.07)3 - 20,000,000 = -$1,629,788 LOSS! ; Not fired because of the mistakes of his legal department.

Exercises and Homework Chapter 1 In-Class Q. 4, Q. 5, Q. 9 Homework Q. 3, Q. 10, Q. 13, Q. 18