1. Managerial Economics & Business Strategy
Chapter 1
The Fundamentals of Managerial Economics
McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and Business Strategy
Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.

2. Overview I. Introduction II. The Economics of Effective Management
1-2
Overview
I. Introduction
II. The Economics of Effective Management
Identify Goals and Constraints
Recognize the Role of Profits
Five Forces Model
Understand Incentives
Understand Markets
Recognize the Time Value of Money
Use Marginal Analysis

3. Managerial Economics Manager Economics Managerial Economics
1-3
Managerial Economics
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.

4. Identify Goals and Constraints
1-4
Identify Goals and Constraints
Sound decision making involves having well-defined goals.
Leads to making the “right” decisions.
In striking to achieve a goal, we often face constraints.
Constraints are an artifact of scarcity.

5. Economic vs. Accounting Profits
1-5
Economic vs. Accounting Profits
Accounting 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.

6. Opportunity Cost Accounting Costs Opportunity Cost Economic Profits
1-6
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.

7. 1-7
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.

8. The Five Forces Framework
1-8
Sustainable Industry
Profits
Power of
Input Suppliers
Supplier Concentration
Price/Productivity of Alternative Inputs
Relationship-Specific Investments
Supplier Switching Costs
Government Restraints
Buyers
Buyer Concentration
Price/Value of Substitute Products or Services
Customer Switching Costs
Entry
Entry Costs
Speed of Adjustment
Sunk Costs
Economies of Scale
Network Effects
Reputation
Switching Costs
Substitutes & Complements
Price/Value of Surrogate Products or Services
Price/Value of Complementary Products or Services
Industry Rivalry
Timing of Decisions
Information
Concentration
Price, Quantity, Quality, or Service Competition
Degree of Differentiation

9. Understanding Firms’ Incentives
1-9
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.

10. Market Interactions Consumer-Producer Rivalry
1-10
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.

11. 1-11
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:
Lotto winner choosing between a single lump-sum payout of $104 million or $198 million over 25 years.
Determining damages in a patent infringement case.

12. Present Value vs. Future Value
1-12
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.

13. What does the consumer’s intertemporal problem look like?
At the tangency of U1 and the budget constraint, W, we get equilibrium consumption of Co, as Co*, and equilibrium future consumption, C1*
Future Consumption C1
Intertemporal utility or Indifference curves
W/P1 U2
C1*
The consumer maximizes intertemporal utility over current and future consumption given the budget constraint, which is the limit on wealth U1 U3
W = Co + P1C1 W
Co*
Current Consumption Co

14. Intertemporal optimization (optimization over time) -- the problem
Max U(Co) + 1/(1+)U(C1), subject to the wealth constraint, W = Co + C1/(1+ r), because P1 = 1/(1 + r), and r = interest rate and  is our time preference rate (or how impatient we are for returns over time)
We are maximizing intertemporal economic welfare subject to our wealth constraint
W = Co – C1/(1+r)

15. Suppose a two-period problem (optimization over time) -- today relative to tomorrow
Max U(Co) + 1/(1+)U(C1), subject to the wealth constraint, W = Co + C1/(1+ r)
Let’s say U = LN (logarithmic utility),  =3%, and r = 9%, and grandma left you ￥400,000
We would solve this problem using something like Excel --- using the solver in Excel would work --- enter the utility function as the objective function --- and the wealth constraint as a constraint --- then solve

16. Intertemporal optimization (optimization over time) -- the problem
Max U(Co) + 1/(1+)U(C1), subject to the wealth constraint, W = Co + C1/(1+ r), because P1 = 1/(1 + r)
The Lagrangian with the objective function, Max U(Co) + 1/(1+)U(C1), and constraint, W = Co + C1/(1+ r) is:
L = U(Co) + 1/(1+)U(C1) + λ[W – Co – C1/(1+r)
Well, we would have to use this solution concept --- but we can use EXCEL’s Solver
see EXCEL file INTERTEMP U

17. Present Value of a Series
1-17
Present Value of a Series
Present value of a stream of future amounts (FVt) received at the end of each period for “n” periods:
Equivalently,

18. SOME FURTHER EXPLANATION ON PRESENT VALUE COMPONENTS
PRESENT VALUE OF AN AMOUNT
PV = S[ 1 / (1 + i )t ]
THE BRACKETED TERM
[ 1 / (1 + i )t ]
IS THE PRESENT VALUE OF $1 IN t PERIODS,
WHERE i IS THE INTEREST RATE
THE TERM [ 1 / (1 + i )t ]
IS CALLED
THE PRESENT –VALUE INTEREST FACTOR
OR PVIFi , t

19. WHAT IS THE PRESENT VALUE OF $1,080 ?
AN EXAMPLE
WHAT IS THE PRESENT VALUE OF $1,080 ?
IN ONE YEAR IF THE INTEREST RATE IS 8 % PER YEAR?
SO i = 8 % OR 0.08, AND t = 1
PV = $1,080[ 1/(1.08)1] = $1,000
----
NOTICE, THAT PV = FV/ (1 + i )t
SO FV = PV(1+ i ) t
THEREFORE NOTE THAT $1,000 IN 1 YEAR
AT 8% WOULD INCREASE TO $1,080

20. LET’S GO A BIT FURTHER ON THIS CONCEPT:
WHAT IS THE PRESENT VALUE OF €100,000 TO BE RECEIVED AT THE END OF 10 YEARS IF THE INTEREST RATE, i = 10% ?
PV = €100,000[ 1 / (1.10)10]
SO DO THE MATH, AND WE GET PV = €38,550
HOW DID WE DO THAT? WELL, USE A CALCULATOR OR, IF YOU ARE GOOD AT EXPONENTIATION, THEN IT ALL COMES OUT OK

21. OR, WE COULD USE A PRESENT VALUE TABLE --- AN EXAMPLE IS GIVEN BELOW
PVIFi, t = 1/(1+ i )t
0.3855
INTEREST RATE
PERIODS 8%
10%
12% 1
0.9259
0.9091
0.8929 2
0.8573
0.8264
0.7972 3
0.7938
0.7513
0.7118 4
0.7350
0.6830
0.6355 6
0.6302
0.5645
0.5066 8
0.5403
0.4665
0.4039 10
0.4632
0.3855
0.3220
TAKEN FROM: Vichas, Robert P Handbook of Financial Mathematics, Formulas and Tables. Englewood Cliffs, N. J., Prentice Hall.

22. THEN, PICKING THE VALUE FOR 10% AND 10 PERIODS, WE GET 0.3855
SO PV = €100,000(0.3855) = €38,550
OF COURSE WE COULD SOLVE THIS PRESENT VALUE USING EXCEL
= *(1/(1.1)^10), WHICH WOULD GIVE US THE VALUE OF TO BE EXACT!! WHY THE DIFFERENCE? THE TABLE ABOVE GIVES US “ROUNDED” FACTORS, SUCH AS THAT WE USED WE COULD ALSO USE
=100000*(1.10^-10) TO ALSO GET THE VALUE

23. PRESENT VALUE OF AN ANNUITY
THE PRESENT VALUE OF AN ANNUITY CAN BE THOUGHT OF AS THE SUM OF THE PRESENT VALUES OF EACH OF SEVERAL AMOUNTS
PVA = 100(1/1.10), PVB = 100(1/1.102), PVC = 100(1/1.103, ETC.
SO SUM THESE UP AS,
PV = 100(1/1.10) + 100(1/1.102) + 100(1/1.103)
OR PV = 100 [1/ / /1.103 ]
SUBSTITUTE THE APPROPRIATE PVIF FACTORS FROM THE TABLE ABOVE TO GET
PV =100( ) = 100(2.4868) 

24. USING EXCEL,
= PV(RATE, NPER, PV,(FV),TYPE), WHICH FOR OUR EXAMPLE WOULD BE:
=PV(0.10,3,-100) SKIPPING (FV), TYPE
WHICH GIVES , AGAIN DIFFERENT BECAUSE OF ROUNDING OF THE FACTORS IN THE TABLE
OF COURSE THIS CAN BE DONE VIA CALCULATOR

25. SOME SELECTED PRESENT VALUE ANNUITY FACTORS ARE:
SO THE PRESENT VALUE OF AN ANNUITY IS GIVEN BY PV = (AMOUNT)t[1/(1+ i )t ]
THE TERM t MEAN SUM OVER VALUES OF t, WHICH IS THE SUM OVER ALL THE PERIODS INVOLVED
THE TERM t [1 / (1 + i ) t ] IS CALLED THE PRESENT-VALUE ANNUITY FACTOR, OR PVAFi , t
SOME SELECTED PRESENT VALUE ANNUITY FACTORS ARE:
INTEREST RATE
PERIODS 1% 2% 3% 12
9.9540 24 30

26. SO, IF WE DESIRED TO FIND THE PRESENT VALUE OF £150 PAYMENTS OVER 30 MONTHS AT 24%, THEN WE GET
PV = £150[ t = 130 (1/1.02)t] = 150( ) = £3,359
WHY? INTEREST IS ANNUAL, BUT THE PAYMENTS ARE MONTHLY SO WE NEED A MONTHLY INTEREST RATE ---- OR 24%/12 = 2%, AND IN THE TABLE AT 30 PERIODS THE PVAF IS
BY USING EXCEL WE GET
=PV(0.02,30,-150) = £3, TO BE EXACT

27. NPV > 0: Accept project
1-27
Net Present Value
Suppose a manager can purchase a stream of future receipts (FVt ) by spending “C0” dollars today. The NPV of such a decision is
Decision Rule:
If NPV < 0: Reject project
NPV > 0: Accept project

28. Present Value of a Perpetuity
1-28
Present Value of a Perpetuity
An asset that perpetually generates a stream of cash flows (CFi) 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 = CF1 = CF2 = …) at the end of each period is

29. Firm Valuation and Profit Maximization
1-29
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.

30. Firm Valuation With Profit Growth
1-30
Firm Valuation With Profit Growth
If profits grow at a constant rate (g < i) and current period profits are po, 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.

31. Marginal (Incremental) Analysis
1-31
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?

32. Net Benefits Net Benefits = Total Benefits - Total Costs
1-32
Net Benefits
Net Benefits = Total Benefits - Total Costs
Profits = Revenue - Costs

33. 1-33
Marginal Benefit (MB)
Change in total benefits arising from a change in the control variable, Q:
Slope (calculus derivative) of the total benefit curve.

34. 1-34
Marginal Cost (MC)
Change in total costs arising from a change in the control variable, Q:
Slope (calculus derivative) of the total cost curve

35. 1-35
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.

36. The Geometry of Optimization: Total Benefit and Cost
1-36
The Geometry of Optimization: Total Benefit and Cost
Total Benefits
& Total Costs
Costs
Benefits Q
Slope =MB B
Slope = MC C Q*

37. The Geometry of Optimization: Net Benefits
1-37
The Geometry of Optimization: Net Benefits
Net Benefits Q
Maximum net benefits
Slope = MNB Q*

38. 1-38
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).