1. Unit 1. Fundamentals of Managerial Economics (Chapter 1)

2. While there is no doubt that luck, both good and bad, plays a role in determining the success of firms, we believe that success is often no accident. We believe that we can better understand why firms succeed or fail when we analyze decision making in terms of consistent principles of market economics and strategic action. Besanko, et. Al Economics of Strategy (2 nd )

3. Microeconomics is the study of how individual firms or consumers do and/or should make economic decisions taking into account such things as: 1. Their goals, incentives, objectives. 2. Their choices, alternatives, problems. 3. Constraints such as inputs, resources, money, time, technology, competition. 4. All (cash & noncash) incremental or marginal benefits and costs. 5. The time value of money.

4. Goals, Incentives, Objectives A fundamental economic truth is that individual firms or decision makers respond to economic incentives. What these incentives are (i.e. money, profits, utility, etc.) and how they influence economic decision making are key topics for study and analysis in business (or managerial) economics.

5. Managerial Choices (examples) Output quantity Output quality Output mix Output price Marketing and advertising Production processes (input mix) Input quantity Production location Production incentives Input procurement

6. Michael Porter’s “Five Competitive Forces” =Decision-making constraints =Factors that influence the sustainability of firm profits 1. market entry conditions for new firms 2. Market power of input suppliers 3. Market power of product buyers 4. Market rivalry amongst current firms 5. Price and availability of related products including both ‘substitutes’ and ‘complements’

7. Marginal Analysis Analysis of ‘marginal’ costs and ‘marginal’ benefits due to a change Marginal = additional or incremental Costs and benefits that are constant (i.e. fixed, don’t change) are excluded from the analysis Changes occurring at ‘the margin’ are all that matter

8. Marginal Analysis (Examples) YX Incremental Y/ Incremental X TRUnits of outputMR TCUnits of outputMC TPUnits of inputMP TRPUnits of inputMRP TCUnits of inputMFC TUUnits of goodMU ProfitUnits of outputMP

9. New Beer Sales Resulting from Amounts Spent on TV and Radio Advertising Total Spent New Beer Sales Generated (in barrels per year) TVRadio $000 $100,0004,750950 $200,0009,0001,800 $300,00012,7502,550 $400,00016,0003,200 $500,00018,7503,750 $600,00021,0004,200 $700,00022,7504,550 $800,00024,0004,800 $900,00024,7504,950 $1,000,00025,0005,000 Max B(T,R) Subject to: T + R = 1,000,000

10. Example of a Business (Economic) Decision Resolved with ‘Marginal’ Analysis Goal: max dollar sales of a product Constraint: advertising budget ‘Marginal’ decision rule: incremental dollar sales generated per incremental dollar spent should be the same for each alternative type of advertising

11. Assume you are a member of your company’s Marketing Dept. You believe, and correctly so, 1) the market demand for your firm’s product is linear, 2) if your company charges $5.00 for its product, quantity sold would be 200 units and 3) if your company set price = $3.00, the number of units sold would be 400. Develop alternative ways of explaining to upper-level management more fully the relationship between the company’s price and the resulting number of units of product sold.

12. Variable Relationships Example of Alternative Ways of Depicting Tabular PQ $70 6100 5200 4300 3400 2500 1600 0700

13. Variable Relationships Example of Alternative Ways of Depicting Graphical

14. Variable Relationships Example of Alternative Ways of Depicting Mathematical Q = 700 – 100P P = 7 – 0.01Q

15. Common Math Terms Used in Economic Analysis TermDefinition VariableSomething whose value or magnitude (often Q or $ in Econ) may change (or vary); usually denoted by letter ‘labels’ such as Y, X, TR, TC Parameter or Constant Something whose value does NOT change General equation or function A mathematical expression that suggests the value of one variable relates to or depends on the value of another variable (or set of variables) without showing the precise nature of that relationship [e.g. y = f(x)].

16. Common Math Terms Used in Economic Analysis TermDefinition Specific equation or function A mathematical expression that shows precisely how the value of one variable is related to the value of another variable (or set of variables) [e.g. y = 10 + 2x]. Inverse equation or function A mathematical expression rewritten so that the variable previously on the right-hand side of the equal sign now becomes the variable solved for on the left-hand side of the equal sign [e.g. y = 2x and x = 1/2 y are each an inverse equation of the other].

17. Common Math Functions Used in Economics Function Form Name of Function Graph of Function Y = a 0 ConstantHorizontal straight line with slope = 0 Y = a 0 + a 1 x (or y = mx + b) LinearStraight line with slope = a 1 (or = m) Y=a 0 +a 1 x+a 2 x 2 QuadraticParabola (u-shaped curve) with either minimum or maximum value Y=a 0 +a 1 x+a 2 x 2 +a 3 x 3 CubicCurved line (e.g. slope changes from getting flatter to steeper Y=a 0 x -n HyperbolaCurved line (u-shaped) bowed towards origin

19. Y = a + b 1 X 1 + …b n X n => the value of Y depends on the values of n different other variables; a ‘ceteris paribus’ assumption => we assume that all X variable values except one are held constant so we can look at how the value of Y depends on the value of the one X variable that is allowed to change

20. Given 2 pts on a straight line, how to solve for the specific equation of that line? Recall, in general, the equation of a straight line is Y = a + bX, where b = the slope, and a = the vertical axis intercept. The specific equation has the values of ‘a’ and ‘b’ specified. Solution procedure: 1.Solve for b =  Y/  X = (Y 2 -Y 1 )/(X 2 -X 1 ) 2.Given values at one pt for Y, X, and b, solve for a (e.g. a = Y 1 – bX 1 )

21. Graphical Concepts (Variable Relationships) Y axis:a vertical line in a graph along which the units of measurement represent different values of, normally, the Y or dependent variable. Y axis intercept: the value of Y when the value of X = 0, or the value of Y where a line or curve intersects the Y axis; = ‘a’ in Y = a + bX

22. Graphical Concepts (Variable Relationships) X axis:a horizontal line in a graph along which the units of measurement represent different values of, normally, the X or independent variable X axis intercept: the value of X when the value of Y = 0, or the value of X where a line or curve intersects the X axis

23. Graphical Concepts (Variable Relationships) Slope: = the steepness of a line or curve; a +(-) slope => the line or curve slopes upward (downward) to the right = the change in the value of Y divided by the change in the value of X (between 2 pts on a line or a curve) =  Y/  X = 1 st derivative (in calculus) =  Y/  X using algebraic notation = the ‘marginal’ effect, or the change in Y brought about by a 1 unit change in X = b if Y = a + bX

24. ‘Slope’ Graphically

25. Slope Calculation Rules (slope =  Y/  X = dy / dx) RuleExample 1. Slope of a constant = 0If y=6, slope = 0 2. ‘power rule’ => slope of a function y = ax n is (n)(a)x n-1 If y=3x 2, slope = (2)(3)x 2-1 =6x If y=x, slope = (1)x 1-1 =1 3. ‘Sum of functions rule’ = slope of the sum of two functions is the sum of the two functions’ slopes If y = x + 3x 2, slope = 1 + 6x

26. Mathematics of ‘Optimization’ ‘Optimization’  a decision maker wishes to either MAXimize or MINimize a goal (i.e. objective function) For a function to have a maximum or minimum value, the corresponding graph will reveal a nonlinear curve that has either a ‘peak’ or a ‘valley’

27. Mathematics of ‘Optimization’ The mathematical equation of the function to be optimized will have THE VERTICAL AXIS VARIABLE ON THE LEFT-HAND SIDE OF THE EQUATION (e.g. Y = f(x)  Y is the vertical axis variable) the slope of a curve at either a peak or a valley will = 0; in math terms, the slope is the first derivative (I.e. dY/dX = 0) ‘Constrained optimization’  do the best job of maximizing (or minimizing) a function given constraints; the ‘Lagrangian Multiplier Method’ is a mathematical procedure for solving these kinds of problems

29. Typical ‘Time Value of Money’ Problems in Business How to compare or evaluate two different dollar amounts at two different time periods? 0 t1t1 t2t2 t3t3 $Y $X

30. Time Value of Money (Basic Concept) A dollar is worth more (or less) the sooner (later) it is received or paid due to the ability of money to earn interest.  present value + interest earned = future value Or  future value - interest lost = present value

31. Time Value of Money (Applications/Uses) 1. To evaluate business decisions where at least some of the cash flows occur in the future 2. To project future dollar amounts such as cash flows, incomes, prices 3. To estimate equivalent current-period values based on projected future values

32. Time Value of Money Concepts PV = present value =the number of $ you will be able to borrow [or have to save] presently in order to payback [or collect] a given number of $ in the future FV = future value =the number of $ you will have to pay back [or be able to collect] in the future as a result of having borrowed [or saved] a given number of $ presently

33. FV 1 =PV + PV(r) =PV(1+r) FV 2 =FV 1 +FV 1 (r) =FV 1 (1+r) =PV(1+r)(1+r) =PV(1+r) 2 FV n =PV(1+r) n

34. Time Value Problems FV n = PV(1+r) n GivenSolve For PV,r,nFV n = PV(1+r) n = ‘compounding’ FV n,r,nPV=FV n [1/(1+r) n ] = ‘discounting’ FV n,PV,nr  (1+r) n =FV n /PV (  find in ‘n’ row) FV n,PV,rn  (1+r) n =FV n /PV (  find in ‘r’ column)

35. r(%) Borrow or save today (= PV) Pay back or collect in 1 yr (= FV) $ interest 81.00_____ 8 1.00_____ 91.00_____ 9 1.00_____ rPV_____ r FV_____

38. Net Present Value (NPV) =an investment analysis concept =PV of future net cash flows – initial cost =PV of MR’s – PV of MC’s =invest if NPV > 0 =invest if PV of MR’s > PV of MC’s

39. Internal Rate of Return =an investment analysis alternative =value of ‘r’ that results in a NPV = 0

40. Payback Period =an investment analysis alternative =period of time required for the sum of net cash flows to equal the initial cost =value of n such that

41. Firm Valuation The value of a firm equals the present value of all its future profits If profits grow at a constant rate, g<I, then: 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.

42. Time Value of Money (Applied to Inflation)  Can be used to estimate or forecast future prices, revenues, costs, etc.  FV n = PV (1+r) n where PV = present value of price, cost, etc. r = estimated annual rate of increase n = number of years FV = future value of price, cost, etc.