1. Chapter 1 Managers, Profits, and Markets

2. Learning Objectives
Understand why managerial economics relies on microeconomics and industrial organization to analyze business practices and design business strategies
Explain the difference between economic and accounting profit and relate economic profit to the value of the firm
Discuss problems arising from separation of ownership and control in businesses and suggest some corporate control mechanisms to address these problems
Explain the difference between price-taking and price-setting firms and discuss the characteristics of the four market structures

3. Managerial Economics & Theory
Managerial economics applies microeconomic theory to business problems
How to use economic analysis to make decisions to achieve firm’s goal of profit maximization
Economic theory helps managers understand real-world business problems
Uses simplifying assumptions to turn complexity into relative simplicity

4. Microeconomics Microeconomics Business practices or tactics
Study of behavior of individual consumers, business firms, and markets
Business practices or tactics
Routine business decisions managers must make to earn the greatest profit under prevailing market conditions
Using marginal analysis, microeconomics provides the foundation for understanding everyday business decisions

5. Managerial Economics
The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.
Should a firm purchase components – like disk drives and chips – from other manufacturers or produce them within the firm?
Should the firm specialize in making one type of computer or produce several different types?
How many computers should the firm produce, and at what price should you sell them?

6. Strategic Decisions
Business actions taken to alter market conditions and behavior of rivals
Increase/protect strategic firm’s profit
While common business practices are necessary for the goal of profit-maximization, strategic decisions are generally optimal actions managers can take as circumstances permit

7. Economics of Effective Management
Identifying goals and constraints
Recognize the nature and importance of profits
Understand incentives
Understand markets
Recognize the time value of money
Use marginal analysis
The science of making decisions in the presence of scarce resources.
Resources are anything used to produce a good or service, or achieve a goal.
Decisions are important because scarcity implies trade-offs.
Changes in profits provide an incentive to resource holders to change their use of resources.
Within a firm, incentives impact how resources are used and how hard workers work.
One role of a manager is to construct incentives to induce maximal effort from employees.
Understand markets
Two sides to every market transaction:
Buyer (consumer).
Seller (producer).
Bargaining position of consumers and producers is limited by three rivalries in economic transactions:
Consumer-producer rivalry.
Consumer-consumer rivalry.
Producer-producer rivalry.
Government and the market.
How can the manager maximize net benefits?
Use marginal analysis
Marginal benefit: 𝑀𝐵 𝑄
The change in total benefits arising from a change in the managerial control variable, 𝑄.
Marginal cost: 𝑀𝐶 𝑄
The change in the total costs arising from a change in the managerial control variable, 𝑄.
Marginal net benefits: 𝑀𝑁𝐵 𝑄
𝑀𝑁𝐵 𝑄 =𝑀𝐵 𝑄 −𝑀𝐶 𝑄
Marginal principle
To maximize net benefits, the manager should increase the managerial control variable up to the point where marginal benefits equal marginal costs. This level of the managerial control variable corresponds to the level at which marginal net benefits are zero; nothing more can be gained by further changes in that variable.
Incremental decisions
Incremental revenues
The additional revenues that stem from a yes-or-no decision.
Incremental costs
The additional costs that stem from a yes-or-no decision.
“Thumbs up” decision
𝑀𝐵>𝑀𝐶.
“Thumbs down” decision
𝑀𝐵<𝑀𝐶.

8. Economic Forces that Promote Long-Run Profitability (Figure 1.1)

9. Five Forces and Industry Profitability Substitutes & Complements
Entry
Entry Costs
Speed of Adjustment
Sunk Costs
Economies of Scale
Network Effects
Reputation
Switching Costs
Government Restraints
Level, Growth,
and Sustainability
of 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
Industry Rivalry
Substitutes & Complements
Concentration
Price, Quantity, Quality,
or Service Competition
Degree of Differentiation
Switching Costs
Timing of Decisions
Information
Government Restraints
Price/Value of Surrogate Products or Services
Price/Value of Complementary Products or Services
Network Effects
Government Restraints

10. Economic Cost of Resources
Opportunity cost is:
What firm owners must give up to use resources to produce goods & services
Market-supplied resources
Owned by others & hired, rented, or leased
Owner-supplied resources
Owned & used by the firm

11. Total Economic Cost Total Economic Cost Explicit Costs Implicit Costs
Sum of opportunity costs of both market-supplied resources & owner-supplied resources
Explicit Costs
Monetary opportunity costs of using market-supplied resources
Implicit Costs
Nonmonetary opportunity costs of using owner-supplied resources

12. Types of Implicit Costs
Opportunity cost of cash provided by owners
Equity capital (money provided to businesses by the owners)
Opportunity cost of using land or capital owned by the firm
Opportunity cost of owner’s time spent managing or working for the firm

13. Economic Cost of Using Resources (Figure 1.2)+ =

14. Economic Profit vs. Accounting Profit
Economic profit = Total revenue – Total economic cost
= Total revenue – Explicit costs – Implicit costs
Accounting profit = Total revenue – Explicit costs
Accounting profit does not subtract implicit costs from total revenue
Firm owners must cover all costs of all resources used by the firm
Objective is to maximize profit

15. Maximizing the Value of a Firm
Price for which it can be sold
Equal to the present value of expected future profits
Risk premium
An increase in the discount rate to compensate investors for uncertainty about future profits
The larger the risk, the higher the risk premium, & the lower the firm’s value

16. Maximizing the Value of a Firm
Maximize firm’s value by maximizing profit in each time period
Cost & revenue conditions must be independent across time periods
Value of a firm =

17. Some Common Mistakes Managers Make
Never increase output simply to reduce average costs
Pursuit of market share usually reduces profit
Focusing on profit margin won’t maximize total profit
Maximizing total revenue reduces profit
Cost-plus pricing formulas don’t produce profit-maximizing prices

18. Separation of Ownership & Control
Principal-agent problem
Conflict that arises when goals of management (agent) do not match goals of owner (principal)
Moral Hazard
When either party to an agreement has incentive not to abide by all its provisions & one party cannot cost effectively monitor the agreement

19. Corporate Control Mechanisms
Require managers to hold stipulated amount of firm’s equity
Increase percentage of outsiders serving on board of directors
Finance corporate investments with debt instead of equity

20. Price-Takers vs. Price-Setters
Price-taking firm
Cannot set price of its product
Price is determined strictly by market forces of demand & supply
Price-setting firm
Can set price of its product
Has a degree of market power, which is the ability to raise price without losing all sales

21. What is a Market?
A market is any arrangement through which buyers & sellers exchange anything of value
Markets reduce transaction costs
Costs of making a transaction happen, other than the price of the good or service itself

22. Market Structures
Market characteristics that determine the economic environment in which a firm operates
Number & size of firms in market
Degree of product differentiation among competing firms
Likelihood of new firms entering market when incumbent firms are earning economic profits

23. Perfect Competition Large number of relatively small firms
Undifferentiated product
Price takers with no market power
No barriers to entry
Any economic profit earned will vanish as new firms enter

24. Monopoly Single firm Produces product with no close substitutes
Protected by a barrier to entry
Allows the monopolist to raise its price without concern that economic profits will attract new firms

25. Monopolistic Competition
Large number of relatively small firms
Differentiated products
Gives the monopolistic competitor some degree of market power
Price setters
No barriers to entry
Ensures any economic profits will be bid away by new entrants

26. Oligopoly Few firms produce all or most of market output
Profits are interdependent
Actions by any one firm will affect sales & profits of the other firms

27. Globalization of Markets
Economic integration of markets located in nations around the world
Provides opportunity to sell more goods & services to foreign buyers
Presents threat of increased competition from foreign producers

28. Summary
Managerial economics applies concepts/theories from microeconomics and industrial organization
Marginal analysis provides the foundation for everyday business practices or tactics
Opportunity cost of using any resource is what the firm owners must give up to use the resource
Unlike economic profit, accounting profit does not subtract implicit (opportunity) costs from total revenue
A principal-agent problem exists when agents have different objectives than the principal, and the principal has difficulty monitoring the agent
For price-taking firms, price is determined solely by market forces of supply and demand, while price-setters have some degree of market power to set price