1. BUS 525.2: Managerial Economics Lecture 1 The Fundamentals of Managerial Economics

2. Course Overview Prerequisites –Bus501 and/or Bus511 Requirements and Grading –3 Cases (20%) –Two Midterm Examinations (40%) –Final Exam (40%) Class Materials –Baye, Michael R. Managerial Economics and Business Strategy. Sixth Edition. Boston: McGraw-Hill Irwin, 2009. [MRB]Baye, Michael R. Managerial Economics and Business Strategy. Sixth Edition. Boston: McGraw-Hill Irwin, 2009. [MRB] –Web-page: http://fkk.weebly.comhttp://fkk.weebly.com Office: NAC 751 Office hours: Tuesday, Wednesday and Saturday, 5pm-6:30 pm 2

3. Activity Schedule:BUS525:2 ClassDateExamsCases 128 May 24 June 36 June 411 JuneCase 1 518 JuneMid 1 62 July 79 July 816 JulyCase 2 923 July 1025 JulyMid 2 1130 July (Make up TBA) 1213 AugustCase 3 1316 -27 AugustFinal

4. Activity Schedule:BUS525:3 ClassDateExamsCases 129 May 25 June 312 June 419 JuneCase 1 526 JuneMid 1 63 July 710 July 817 JulyCase 2 924 JulyMid 2 1031 July 111 AugustCase 3 1214 August 1316 -27 AugustFinal

5. Make-up Policy 5 There will be only one make-up for all examinations (mid-terms, final etc.) towards the end of the course to accommodate force majeure. All examination dates are pre- announced/agreed. Please make necessary arrangements with your office. Historically, the performance of students taking make-up examinations were always poorer compared to students taking examinations on schedule. I hope you will appreciate that it is not practical to offer a customized course for any or group of individual student(s).

6. Overview I. Introduction Why should I study Economics? –Understand business behavior, profit/loss making firms, advertising strategy Impart basic tools of pricing and output decisions –Optimize production mix and input mix –Choose product quality –Guide horizontal and vertical merger decisions –Optimal design of internal and external incentives. Not for managers only-any other designation –Private, NGO, Government Headline –loss due to managerial ineptness 1-6

7. Managerial Economics Manager –A person who directs resources to achieve a stated goal. Economics –The science of making decisions in the presence of scarce resources. –Managerial Economics –The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal. Case No. 1, Global Standards for Garment Industry Under Scrutiny After Bangladesh Disaster 1-7

8. Capitalism 101 To identify money-making opportunities, you must first understand how wealth is created (and sometimes destroyed). Definition: Wealth is created when assets are moved from lower to higher-valued uses Definition: Value = willingness to pay Desire + income The chief virtue of a capitalist economy is its ability to create wealth Voluntary transactions, between individuals or firms, create wealth. 8

9. Example: House Sale A house is for sale: The buyer values the house at $130,000 – maximum price The seller values the house at $120,000 – minimum price The buyer and seller must agree to a price that “splits” surplus between buyer and seller. Here, $128,000. The buyer and seller both benefit from this transaction: Buyer surplus = buyer’s value minus the price, $2,000 Seller surplus = the price minus the seller’s value, $8,000 Total surplus = buyer + seller surplus, $10,000 = difference in values 9

10. Wealth-Creating Transactions Which assets do these transactions move to higher-valued uses? Factory Owners Real Estate Agents Investment Bankers Corporate Raiders Insurance Salesman Discussion: How does eBay/Bikroy.com create wealth? Discussion: Which individual has created the most wealth during your lifetime? Discussion: How do you create wealth? 10

11. Do Mergers Create Wealth? The movement of assets to a higher-valued use is the wealth-creating engine of capitalism. Our largest and most valuable assets are corporations Dell-Alienware merger: In 2006, Dell purchased Alienware, a manufacturer of high-end gaming computers. Dell left design, marketing, sales and support in Alienware’s hands; manufacturing, however, was taken over by Dell. With its manufacturing expertise, Dell was able to build Alienware’s computers at a much lower cost Despite this example, many mergers and acquisitions do not create value – and if they do, value creation is rarely so clear. To create value, the assets of the acquired firm must be more valuable to the buyer than to the seller. 11

12. Does Government Create Wealth? Discussion: What’s the government’s role is wealth creation? Enforcing property rights, contracts, to facilitate wealth creating transactions Discussion: Why are some countries so poor? No property rights, no rule of law Discussion: Much of the justification for government intervention comes from the assertion that markets have failed. One money manager scoffed at this idea. “The markets are working fine, but they’re giving people answers that they don’t like, so people cry market failure.” 12

13. The One Lesson of Economics Definition: an economy is efficient if all wealth- creating transactions have been consummated. This is an unattainable, but useful benchmark The One Lesson of Economics: the art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups. Policies should then be judged by whether they move us towards or away from efficiency. The economist’s solution to inefficient outcomes is to argue for a change in public policy. 13

14. One Lesson of Economics (cont.) Taxes Destroy Wealth: By deterring wealth-creating transactions – when the tax is larger than the surplus for a transaction. Which assets end up in lower-valued uses? Subsidies Destroy Wealth: Example: flood insurance – encourages people to build in areas that they otherwise wouldn’t Which assets end up in lower-valued uses? Price Controls Destroy Wealth: Example: rent control (price ceiling) in New York City - deters transactions between owners and renters Which assets end up in lower-valued uses? 14

15. The one Lesson of Business Definition: Inefficiency implies the existence of unconsummated, wealth-creating transactions The One Lesson of Business: the art of business consists of identifying assets in lower valued uses, and profitably moving them to higher valued uses. In other words, make money by identifying unconsummated wealth-creating transactions and devise ways to profitably consummate them. 15

16. Companies Create Wealth Companies are collections of transactions: They go from buying raw materials, capital, and labor (lower value) To selling finished goods & services (higher value) Why do some companies have difficulty creating wealth? They have trouble moving assets to higher-valued uses Analogy to taxes, subsidies, price controls on internal transactions 16

17. Government Destroys Wealth Zimbabwe experienced economic contraction of approximately 30 percent per year from 1999 to 2003 Unemployment rates have been as high as 80 percent and life expectancy has fallen over 20 years during the reign of Robert Mugabe Why has economic growth been so low? 17

18. Government Destroys Wealth One main problem occurred in 2000 Mugabe backed his supporters takeover of commercial farms, essentially revoking property rights of these farmers The state resettled the confiscated lands with subsistence producers - many with no previous farming experience. Agricultural production plummeted. Farm debacle had economic ripple effects through the banking and manufacturing sectors Declining production deprived the country of ability to earn foreign currency and buy food overseas Widespread famine ensued The government's initial attack on private property eventually led to more direct intervention in the economy and the destruction of political freedom in Zimbabwe. 18

19. Problem Solving Two distinct steps: Figure out what’s wrong, i.e., why the bad decision was made Figure out how to fix it Both steps require a model of behavior Why are people making mistakes? What can we do to make them change? Economists use the rational actor paradigm to model behavior. The rational actor paradigm states: People act rationally, optimally, self- interestedly i.e., they respond to incentives – to change behavior you must change incentives. 19

20. How to Figure Out What is Wrong Under the rational actor paradigm, mistakes are made for one of two reasons: lack of information or bad incentives. To diagnose a problem, ask 3 questions: 1. Who is making bad decision? 2. Do they have enough info to make a good decision? 3. Do they have the incentive to do so? 20

21. How to Fix It The answers will suggest one or more solutions: 1. Let someone else make the decision, someone with better information or incentives. 2. Change the information flow. 3. Change incentives Change performance evaluation metric Change reward scheme Use benefit-cost analysis to choose the best (most profitable?) solution 21

22. Keep the Ultimate Goal in Mind For a business or organization to operate profitably and efficiently the incentives of individuals need to be aligned with the goals of the company. How do we make sure employees have the information necessary to make good decisions? And the incentive to do so? 22

23. Manager Bonuses for Increasing Reserves The bonus system created incentives to over- bid. Senior managers were rewarded for acquiring reserves regardless of their profitability Bonuses also created incentive to manipulate the reserve estimate. Now that we know what is wrong, how do we fix it? Let someone else decide? Change information flow? Change incentives? Performance evaluation metric Reward scheme 23

24. Ethics Does the rational-actor paradigm encourage self- interested, selfish behavior? NO! Opportunistic behavior is a fact of life. You need to understand it in order to control it. The rational-actor paradigm is a tool for analyzing behavior, not a prescription for how to live your life. 24

25. Why Else this Material is Important Employers expect that you will know these concepts Further, employers will expect that you are able to apply them. 25

26. How Do Firms Behave Economists often assume the goal of the firm is profit maximization. Opinions do differ, however. Discussion: pricing of hotel rooms during tourist season Traditional economic view – level pricing leads to excess demand; how are rooms allocated then (rationing, arbitrageurs,...) Contrasting view – businesses should not raise prices during times of shortage; businesses have a responsibility to consumers and society Your view? Text view: firms serve consumers and society best by engaging in free and open competition within legal limits while attempting to maximize profits. Not a license to engage in illegal behavior No denying that concerns exist about the ethical dimension of business Reasonable people have disagreed for millennia on what constitutes “ethical” behavior 26

27. The Economics of Effective Management Identify goals and constraints Recognize the nature and importance of profits –Five forces framework and industry profitability Understand incentives Understand markets Recognize the time value of money Use marginal analysis 1-27

28. Identify Goals and Constraints Sound decision making involves having well-defined goals. –Leads to making the “right” decisions. In striving to achieve a goal, we often face constraints. –Constraints are an artifact of scarcity. 1-28

29. Economic vs. Accounting Profits Accounting profits –Total revenue (sales) minus cost of producing goods or services. –Reported on the firm’s income statement. Economic profits –Total revenue minus total opportunity cost. 1-29

30. Opportunity Cost Accounting costs –The explicit costs of the resources needed to 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. 1-30

31. 31 Significance of the Opportunity Cost Concept Accounting profits = Net revenue – Accounting costs (dollar costs of goods and services) Reported on the firms income statement Economic profits = Net revenue – Opportunities Costs Economic profits and opportunity costs are critical to decision making

32. 32 The Principle of Relevant Cost Sound decision-making requires that only costs caused by a decision--the relevant costs--be considered. In contrast, the costs of some other decision not impacted by the choice being considered--the irrelevant costs-- should be ignored. Not all accounting costs are relevant and many need adjustments to become relevant

33. Profits as a Signal Profits signal to resource holders where resources are most highly valued by society. –Resources will flow into industries that are most highly valued by society. 1-33

34. 34 Theories of Profits (Why are profits necessary? Why do profits vary across industries and across firms?) Risk-bearing theory of profit - Profits are necessary to compensate for the risk that entrepreneurs take with their capital and efforts Dynamic equilibrium (frictional) theory - Profits, especially extraordinary profits, are the result of our economic system’s inability to adjust instantaneously to unanticipated changes in market conditions.

35. 35 Theories of Profits Monopoly theory - Profits are the result of some firm’s ability to dominate the market Innovation theory - Extraordinary profits are the rewards for successful innovations Managerial efficiency theory - Extraordinary profits can result from exceptionally managerial skills of well-managed firms.

36. Understanding Firms’ Incentives Incentives play an important role within the firm. Incentives determine: –How resources are utilized. –How hard individuals work. Managers must understand the role incentives play in the organization. Constructing proper incentives will enhance productivity and profitability. 1-36

37. 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 hired managers may wish to relax or pursue self interest. The shareholders are principals, whereas the managers are agents.

38. Shareholders (principals) want profit Managers (agents) want leisure & security Conflicting motivations between these groups are called agency problems. –Stock brokers and investors –Physicians and patients –Auto mechanics and car owners The Principal-Agent Problem

39. 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 (but not always – Citibank and Managers) Incentives to help the company, because that improves the value of stock options and bonuses Good legal contracts that can be effectively enforced

40. 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 –BTRC, BERC, SECs failure brought debacle 1-40

41. Market Definition: Buyers and sellers communicate with one another for voluntary exchange market need not be physical –Bookstore, Internet bookstore Amazon.com –Outsourcing industry – businesses engaged in the production or delivery of the same or similar items –Clothing and textile industry, –Clothing industry is a buyer in the textile market and a seller in the clothing market

42. Competitive Market Benchmark for managerial economics Purely competitive market –The global cotton market –many buyers and many sellers –no room for managerial strategizing Achieves economic efficiency Entry of firms –Case No.2, Textile millers hit rough patch

43. Market Power Definition – ability of a buyer or seller to influence market conditions Seller with market power must manage –costs –price –advertising expenditure –policy toward competitors

44. Imperfect Market Definition: where –one party directly conveys a benefit or cost to others – externalities or –one party has better information than others –Lack of competition, barriers to entry

45. The Time Value of Money Present value (PV) of a future value (FV) lump- sum amount to be received at the end of “n” periods in the future when the per-period interest rate is “i”: Examples: –Lottery winner choosing between a single lump-sum payout of Tk.104 million or Tk.198 million over 25 years. –Determining damages in a patent infringement case. 1-45

46. Present Value vs. Future Value The present value (PV) reflects the difference between the future value and the opportunity cost of waiting (OCW). Succinctly, PV = FV – OCW If i = 0, note PV = FV. As i increases, the higher is the OCW and the lower the PV. 1-46

47. 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: Equivalently, 1-47

48. Net Present Value 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 Decision Rule: If NPV < 0: Reject project NPV > 0: Accept project 1-48

49. Present Value of a Perpetuity An asset that perpetually generates a stream of cash flows (CF i ) at the end of each period is called a perpetuity. The present value (PV) of a perpetuity of cash flows paying the same amount (CF = CF 1 = CF 2 = …) at the end of each period is 1-49

50. 50 Objective of the Firm Not market share Not growth Not revenue Not empire building Not net profit margin Not name recognition Not state-of-the-art technology

51. 51 What’s the Objective of the Firm? The objective of the firm is to maximize the value of the firm. Value of the firm is the true measure of business success (of course, from a for-profit perspective.) Two questions: 1. How is the “value of the firm” defined and measured? 2. How do managers go about adding value to the firm?

52. Value Maximization Is a Complex Process Figure 1.3

53. 53 Definition and Measurement of “Value of the Firm” “The present value of the firm’s future net earnings.”  1  2  n V = [--------] + [ --------] +... + [ -------- ] (1+r) 1 (1+r) 2 (1+r) n N  t V =  [ ------- ], t = 1, 2,..., N t = 1 (1+r) t

54. 54 Adding Value to the Firm Profit = Total Rev - Total Cost  = P. Q d - VC. Q s - F where profit, P = price, Q d = quantity demanded, VC = variable cost per unit, Q s = quantity supplied, F = total fixed costs

55. Determinants of Value of the Firm N  t N P. Q d - VC. Q s - F V =  [ ------- ] =  [---------------------- ] t=1 (1+r) t t=1 (1+r) t Whatever that raises the price of the product and/or the quantity of the product sold Whatever that lowers the variable and fixed costs Whatever that lower the “r” (discount rate or the perceived “risk” of investment)

56. Firm Valuation and Profit Maximization The value of a firm equals the present value of current and future profits (cash flows). A common assumption among economist is that it is the firm’s goal to maximization profits. –This means the present value of current and future profits, so the firm is maximizing its value. 1-56

57. Class Exercise Suppose the interest rate is 10% and the firm is expected to grow at a rate of 5% for the foreseeable future. The firm’s current profits are $100 million. a)What is the value of the firm (the present value of its current and future earnings)? b)What is the value of the firm immediately after it pays a dividend equal to its current profits?

58. Control variable, examples: –Output –Price –Product Quality –Advertising –R&D Basic managerial question: How much of the control variable should be used to maximize net benefits? Marginal (Incremental) Analysis 1-58

59. Net Benefits Net Benefits = Total Benefits - Total Costs Profits = Revenue – Costs Case No. 3: Outsourcing and offshoring 1-59

60. Marginal Benefit (MB) Change in total benefits arising from a change in the control variable, Q: Slope (calculus derivative) of the total benefit curve. 1-60

61. Marginal Cost (MC) Change in total costs arising from a change in the control variable, Q: Slope (calculus derivative) of the total cost curve 1-61

62. 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. 1-62

63. The Geometry of Optimization: Total Benefit and Cost Q Total Benefits & Total Costs Benefits Costs Q* B C Slope = MC Slope =MB 1-63

64. The Geometry of Optimization: Net Benefits Q Net Benefits Maximum net benefits Q* Slope = MNB 1-64

65. 65 What Will We Learn?  Useful economic principles for sound economic decision-making in a management context.  The basics of the demand side of the market and which factors influence the buyers’ behavior.  The fundamentals of the market’s supply side -laws of production and how these laws impact a firm’s costs.  How firms’ costs and buyers’ demand together determine the firm’s price and net profit.

66. 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). 1-66

67. 67 Myths and Misconceptions Economics is about money only Economics assumes that everyone is selfish A company’s value is measured by the company’s assets Costs are measured appropriately by accountants.

68. 68 Myths and Misconceptions (cont.) We must cover our fixed costs in the decisions we make as managers Our firm must create the best quality product We should do more advertising, because it’s cost-effective Our price should be based on our costs

69. 69 Myths and Misconceptions (cont.) Unit or average cost provides useful management information Wider profit margins are desirable A price increase reduces demand High research and development expense results in high prices.

70. Managerial Economics is a Tool for Improving Management Decision Making Figure 1.1

71. Sustainabl e Industry Profits Power of Input Suppliers  Supplier Concentration  Price/Productivity of Alternative Inputs  Relationship-Specific Investments  Supplier Switching Costs  Government Restraints Power of Buyers  Buyer Concentration  Price/Value of Substitute Products or Services  Relationship-Specific Investments  Customer Switching Costs  Government Restraints Entry  Entry Costs  Speed of Adjustment  Sunk Costs  Economies of Scale  Network Effects  Reputation  Switching Costs  Government Restraints Substitutes & Complements  Price/Value of Surrogate Products or Services  Price/Value of Complementary Products or Services  Network Effects  Government Restraints Industry Rivalry  Switching Costs  Timing of Decisions  Information  Government Restraints  Concentration  Price, Quantity, Quality, or Service Competition  Degree of Differentiation The Five Forces Framework 1-71

72. Firm Valuation With Profit Growth If profits grow at a constant rate (g < i) and current period profits are   before and after dividends are: Provided that g < i. –That is, the growth rate in profits is less than the interest rate and both remain constant. 1-72