1. INTRODUCTION TO CORPORATE STRATEGY
MANAGERIAL ECONOMICS
INTRODUCTION TO CORPORATE STRATEGY
Michael R. Baye
Managerial Economics & Business Strategy

2. Managerial Economics Objectives: Introduction to economic concepts
Apply economic method to understand the business environment
Introduction to economic methods
Statistical methods
Relationship of costs, demand, and profits

3. STRATEGY  Competitive Strategy
WHAT IS IT ALL ABOUT?
STRATEGY  Competitive Strategy

4. FORCES DRIVING INDUSTRY COMPETITION
SUBSTITUTES (Threat of substitute products or services)
BUYERS (Bargaining power of buyers)
INDUSTRY COMPETITORS (Rivalry among Existing Firms)
SUPPLIERS (Bargaining power of suppliers)
POTENTIAL ENTRANTS (Threat of New Entrants)

5. FORCES DRIVING INDUSTRY COMPETITION
New Entrants
Industry
Competitors
Rivalry among
industry
Buyers
Suppliers
Substitutes

6. Substitutes General Question:
Do other firms produce substitutes for our product?
Economic Tools Needed:
Demand elasticities, consumer preferences, consumer demand, regression analysis, product differentiation, consumer search.

7. Buyers General Question:
How much power do we have over consumers, and how does this affect our pricing and output decisions?
Economic Tools Needed:
Market structure (competition, monopoly, mon.compet), pricing strategies, reputation, regulation

8. Rivalry General Question:
How are rival firms likely to respond to our strategies?
Economic Tools Needed:
Concentration, oligopoly, game theory, commitment, reputation, collusion, antitrust

9. Suppliers General Question:
From whom we should acquire inputs? Howmuch and at what price?
Economic Tools Needed:
Markets, productivity analysis, cost analysis, vertical integration, contracts, antitrust, auctions

10. New Entrants General Question:
Is our position sustainable, or is entry into market likely?
Economic Tools Needed:
Economies of scale, entry bariers, contestable markets, patents, product differentiation, commitment, government policy

11. Managerial Decision Problems
Salvatore
Managerial Decision Problems
Economic Theory:
Macro & Micro
Decision Sciences:
Mathematical Econ,
Econometrics
Managerial Economics:
Application of Econ Theory
And Dec.Science Tools
To Solve Manag Dec Problems
Optimal Solution of Managerial
Decision Problems

12. The Fundamentals of Managerial Economics
2. BASIC CONCEPTS and TOOLS
(Baye Chapter 1)

13. MANAGERIAL ECONOMICS MICROECONOMICS ACCOUNTING MARKETING STATISTICS
COMPETITIVE
STRATEGY

15. Managerial Economics 2. BASIC CONCEPTS and TOOLS (Baye Chapter 1)
Identification of Goals and Constraints
Recognition of the Role of Profits
Understanding of Incentives
Understanding of Markets
Recognition the Time Value of Money
Use Marginal Analysis

16. Goals and Constraints Manager
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.

17. Profit
A signal that society wants resources to be shifted (socially desirable).
A signal that a firm is able to abuse market power (not socially desirable). Microsoft?
An incentive for savings and investment

18. Profit Accounting Profits Economic 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

19. 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

20. Opportunity Cost
Example: $100,000 invested in your cousin’s internet vulture company will earn 8%. The bond market pays 10%.
The foregone income is the 10% you can earn on bonds.
The economic profit, net the opportunity cost of investing in bonds, is -2%.

21. 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

22. The production decision
For any output level, the firm attempts to mimimize costs
Assume the firm aims to maximize profits
Profits depend on both COSTS and REVENUE
each of which varies with the level of output
Marginal cost (MC) is the rise in total cost if output increases by 1 unit.
Marginal revenue (MR) is the rise in total revenue if output increases by 1 unit
See Sections 7-4 and 7-5 in the main text.

23. Will firms try to maximize profits?
Large firms are not run by their owners
there is separation of ownership and control
Managers may pursue different objectives
e.g. size, growth
But firms not maximizing profits may be vulnerable to takeover
or managers may be given share options to influence their incentive to maximize profits
See Section 7-3 in the main text.

24. The Time Value of Money
Present value (PV) of an amount (FV) to be received at the end of “n” periods when the per-period interest rate is “i”:

25. Present Value of a Series
Present value of a stream of future amounts (FVt) received at the end of each period for “n” periods:

26. Use of NPV in Management
Suppose a manager can purchase a stream of future receipts (FVt ) by spending “C0” dollars today. The NPV of such a decision is
NPV < 0: Reject
NPV > 0: Accept

27. NPV and Firm Valuation
The value of a firm equals the present value of all its future profits
PV = S pt / (1 + i)t
If profits grow at a constant rate, g < i, then:
PV = po ( 1+i) / ( i - g), po = current profit level.
Maximizing Short-Term Profits
If the growth rate in profits < interest rate and both remain constant, maximizing the present value of all future profits is the same as maximizing current profits.

28. Marginal (incremental) analysis
Control Variables
Output
Price
Product Quality
Advertising
R&D
Basic Managerial Question: How much of the control variable should be used to maximize net benefits?

29. Net Benefits Net Benefits = Total Benefits - Total Costs
Profits = Revenue - Costs

30. Marginal Benefits and CostsMC
Change in total costs arising from a change in the control variable, Q:
MC = DC / DQ
Slope (calculus derivative) of the total cost curve MB
Change in total benefits arising from a change in the control variable, Q:
MB = DB / DQ
Slope (calculus derivative) of the total benefit curve

31. Marginal Benefits and Costs
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

32. An Example:
The profit contribution is the difference between price and average variable cost.
Non-linear break-even analysis
Assumptions: (1) Price may vary with output; (2) We have fixed costs; (3) We have constant variable cost. We might have other cost functions.
Total cost
C = FC + VC*Q
R,C
Total revenue
R = P*Q
Break-even
output
Profit maximizing
output
Break-even
output Q

34. Summary
Make sure you include all costs and benefits when making decisions (opportunity cost)
When decisions span time, make sure you are using PV analysis
Optimal economic decisions are made at the margin (marginal analysis)

35. Optimizing rules:
Choose value for decision variable that equates (to the extent possible) MB & MC
If MB > MC, increase level of decision variable
If MC > MB, decrease level of decision variable

36. Constrained Optimization
Still use marginal analysis, but instead of focusing on MB = MC, we focus on ratio of MB to MC
Optimizing rule:
Choose levels of decision variables so that ratio of MB to MC is equal for all decision variables, i.e.
MBa/MCa = MBb/MCb = ……. = MBn/MCn

37. Constrained Optimization Rule
When choosing between two goods (or two activities)
MBA/ PA = MBB/ PB
Ratio indicates that marginal benefit per dollar spend on each good or activity should be equal.
If MBA/ PA > MBB/ PB increase A, decrease B
If MBA/ PA < MBB/ PB decrease A, increase B

38. Summary There is no such thing as a free lunch!
To optimize, use marginal analysis
If unconstrained, set MB = MC
If constrained, equalize MB/P of the activities chosen
Think Marginal, marginal, marginal!