1. Managerial Economics Applications, Strategy, and Tactics, 10th Edition
by McGuigan, Moyer, & Harris
PowerPoint Lecture Slides
prepared by
Richard D. Marcus
University of Wisconsin - Milwaukee
2005 South-Western Publishing 1

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

3. 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. 3

4. MAJOR TOPICS Demand and Supply Analysis Production and Cost Analysis
and how to estimate price elasticities with regressions
Production and Cost Analysis
and how managers can estimate these relationships
Monopoly, Competition, and Oligopolies
and how to make good pricing decisions in the real world
Organization Architecture
and the economic problem of motivating agents
Risk in Economic Decisions
and ways to modify or compare risks 4

5. The Decision-Making Process (Figure 1.1)
1. Establish and Identify Objectives
2. Define the Problem
3. Identify Alternative Solutions
4. Evaluate the Alternatives
and Select the Best!
5. Implement and Monitor
the Decision
Consider
Organizational
& Input
Constraints
Consider
Societal
Constraints

6. Theories of Why Profit Varies Across Industries
RISK-BEARING THEORY
DYNAMIC EQUILIBRIUM (or FRICTIONAL) THEORY OF PROFIT
MONOPOLY THEORY OF PROFIT
INNOVATION THEORY OF PROFIT
MANAGERIAL EFFICIENCY THEORY OF PROFIT 11

7. Objectives of the Firm Profit maximization
Shareholder wealth = value of each share (V0) times the number of shares outstanding, or
V0 · (shares outstanding). This is the present value of expected future profits or cash flows, discounted at the shareholders required rate of return, ke, ignoring taxes 
V0 (shares outstanding) =  t /(1+ke) t
t=1 6

8. Firm Value (Figure 1.2)
t = REVENUE – COST = TRt – TCt = PtQt – VtQt - Ft
Value of the Firm = the present value of discounted cash flows N
(t ) / (1+ke)t =
t=1
(PtQt – VtQt – Ft) / (1+ke)t
t =1
Whatever lowers the perceived risk of the firm (ke) will also raise firm value.
Whatever raises the price of the product (Pt) or the quantity sold (Qt ) will raise firm value.
Whatever raises variable cost (Vt )or fixed cost ( Ft ) will reduce firm value. 7

9. Will be forecasting demand (both Pt & Qt)
To make good economic decisions, managers need to be able to forecast & estimate relationships
Will be forecasting demand (both Pt & Qt)
applies to for-profit corporations
non-profit organizations
Hospital Administrators -- # patients
University Administrator -- enrollment
Regression analysis, time series methods, and qualitative forecasting methods used for forecasting 9

10. The Role of Profits
Economic Cost (or opportunity cost) is the highest valued benefit that must be sacrificed as a result of choosing an alternative.
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. 10

11. Factors Affecting Stock Prices
(Figure 1.3)
Factors Affecting Stock Prices
Economic Environment Factors
Economic Activity
Tax Rates & Regulations
Competition
Laws and Governmental Regulation
Unionization
International Conditions & Exchange Rates
Major Policy Decisions Under Management Control
Products or Services Offered
Production Technology
Marketing and Distribution Network Used
Investment Strategies
Employment & Compensation Policies
Ownership Form
Capital Structure Used
Working Capital Management Policies
Dividend Policies
Alliances, mergers, spin-offs
Amount, Timing, and Risk of Expected Profits
Shareholder Wealth (The Market Price of the Stock)
Conditions in
Financial Markets
Interest Rates
Investor Sentiment
Expected Inflation

12. Agency Problems
Modern corporations allow managers to have no, or limited, ownership 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.
Conflicting motivations between these groups are called agency problems. 12

13. The Principal-Agent Problem
Shareholders (principals) want profit
Managers (agents) want leisure & security
Examples
KKR’s takeover of RJR Nabisco to refocus on wealth-maximization
The LBO by O.M. Scott (a lawn fertilizer company) from ITT improved Scott’s performance 13

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. 14

15. What Went Right? What Went Wrong?
Saturn Corporation
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.

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. 15

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. 16

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. 17