1. BUS 525.2: Managerial Economics
Lecture 1
The Fundamentals of Managerial Economics
Webpage: fkk.weebly.com
Tel: /1713
Office:NAC 751

2. Course Overview Prerequisites Bus501 and/or Bus511
Requirements and Grading
3 Cases (20%)
Two Midterm Examinations (40%)
Final Exam (40%)
Class Materials
Baye, Michael R. Managerial Economics and Business Strategy. Sixth Edition. Boston: McGraw-Hill Irwin, [MRB]
Web-page:
Office: NAC 751
Office hours: Tuesday and Thursday 5pm-6:30 pm 2

3. Activity Schedule:BUS525
Class
Date
Exams
Cases 1
26 Jan 2
2 Feb 3
9 Feb
Case 1 4
16 Feb 5
23 Feb
Mid 1 6
2 Mar
Case 2 7
9 Mar 8
16 Mar 9
23 Mar
Mid 2 10
30 Mar
Case 3 11
6 Apr 12
9 Apr 13
15 Apr-24 Apr
Final

4. Overview I. Introduction Why should I study Economics?
1-4
I. Introduction
Why should I study Economics?
Understand business behavior, profit/loss making firms, advertising strategy
Impart basic tools of pricing and output decisions
Optimize production mix and input mix
Choose product quality
Guide horizontal and vertical merger decisions
Optimal design of internal and external incentives.
Not for managers only-any other designation
Private, NGO, Government
Headline –loss due to managerial ineptness
Why mobile phone operators advertise so much but rice sellers do not advertise at all?
Why pizza hut offers buy one get one free deals?
Why A4 size papers are sold in a package of 500 sheets?
Why clubs charge an annual/yearly fee as well as small user fee for their services?

5. Managerial Economics Manager Economics Managerial Economics
1-5
Manager
A person who directs resources to achieve a stated goal.
Economics
The science of making decisions in the presence of scarce resources.
Case No. 1, Load shedding in DESCO area
Managerial Economics
The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.
Manager has the responsibility of his/her own actions as well as for the actions of other individuals, machines, and other inputs under his/her control
Purchase inputs, decides product quality and/ or price
Goal: maximize profit, increase shareholders wealth
Economics-scarcity- by making one choice, you give up another-advertising vs R&D; missing a great show on TV right now, could have watched slumdog millionaire

6. Internet strategy: broadband or dial up. Which company. Wi Fi
Internet strategy: broadband or dial up? Which company? Wi Fi? Should you give it to all employees? Chat during office hours? Disturb staff with internet facilities. Staff without internet facilities go out office to use internet.
Managerial Economics is a Tool for Improving Management Decision Making
Figure 1.1

7. The Economics of Effective Management
1-7
The Economics of Effective Management
Identify goals and constraints
Recognize the nature and importance of profits
Five forces framework and industry profitability
Understand incentives
Understand markets
Recognize the time value of money
Use marginal analysis

8. Identify Goals and Constraints
1-8
Sound decision making involves having well-defined goals.
Leads to making the “right” decisions.
In striving to achieve a goal, we often face constraints.
Constraints are an artifact of scarcity.
Supplying fertilizer during Boro season
Price, subsidy, smuggling, overuse
Distribution outlets, farmers’ time: fewer outlets longer queue, travel time
Marketing-increase sales
Finance-earnings growth
Maximize profit or increasing market share
Constraints-available technology, prices of inputs, optimal price, how much to produce? which technology to use? how much inputs to use? how to react to competitors behavior?
You will be able to answer such questions

9. Economic vs. Accounting Profits
1-9
Economic vs. Accounting Profits
Accounting Profits
Total revenue (sales) minus cost of producing goods or services.
Reported on the firm’s income statement.
Economic Profits
Total revenue minus total opportunity cost.
Nature and importance of profits

10. Opportunity Cost Accounting Costs Opportunity Cost Economic Profits
1-10
Accounting Costs
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.
Opportunity cost =explicit costs (accounting) + implicit costs (giving up the best alternative use of the resource)
Opportunity cost is generally higher than accounting costs
Implicit costs- Run business using own premise, own time, rentals foregone
Restaurant: Sales: 100,000
Costs of sales: 20,000
Accounting profit ,000
Own time ,000
Rentals forgone -100,000
Costs of sales: ,000
Economic cost ,000
Economic Loss ,000

11. Significance of the Opportunity Cost Concept
Accounting profits = Net revenue – Accounting costs (dollar costs of goods and services)
Reported on the firms income statement
Economic profits = Net revenue – Opportunities Costs
Economic profits and opportunity costs are critical to decision making
Particularly in making investment decisions. Many accounting items are irrelevant, depreciation, financing costs
Other items receive different treatment
Working capital, current assets, current liabilities-treated as outflow 11

12. The principle of relevant cost
Sound decision-making requires that only costs caused by a decision--the relevant costs--be considered. In contrast, the costs of some other decision not impacted by the choice being considered--the irrelevant costs--should be ignored.
Not all accounting costs are relevant and many need adjustments to become relevant
Incremental costs
Sunk costs
Costs that have already been incurred. They do not affect any future cost and cannot be changed by any current or future action.
Sunk costs are investment costs incurred before a certain activity takes place which cannot be recovered by the possible sale of the asset they produced.
Highly specific investment (e.g. R&D) are usually sunk costs.
Sunk costs represent barriers to exit. A firm which has incurred in high sunk costs will have difficulties in deciding to exit the market even if it sees good opportunities outside.
Conversely, a firm that is deciding whether to enter into a certain business will have to consider with a particular attention the sunk costs and the risk that during the operations period they might not be recovered. Sunk costs, in this perspective, represent barriers to entry.
In the case of an exporter, an example of sunk costs could be the costs of analysing the market and of exploring opportunities and seeking commercial partners.
"The more the setting up of an activity is innovative, the more is it likely to involve long periods of gestation, and thus higher sunk costs" states Prof. Sergio Bruno in "The economics of ex-ante coordination".
High sunk costs makes an investment irreversible, what, couple with uncertainty about the future, impacts the level of investment by industry, as this empirical analysis points out. 12

13. Profits as a Signal
1-13
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.
Profit versus profiteering
Profit is not bad
Adam Smith
Wealth of the Nations
“It is not out of the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.”

14. Theories of Profits
(Why are profits necessary? Why do profits vary across industries and across firms?)
Risk-Bearing Theory of Profit - Profits are necessary to compensate for the risk that entrepreneurs take with their capital and efforts
Dynamic Equilibrium (Frictional) Theory - Profits, especially extraordinary profits, are the result of our economic system’s inability to adjust instantaneously to unanticipated changes in market conditions.
Case No. 3: Square Backtracks on PSTN Plan
Since shareholders are residual claimants, they need to be compensated for risk in the form of a higher return. Exposure to downside
There exists a long-run equilibrium normal rate of profit that all firms should tend to earn.
At any point in time, however, firms may earn returns above or below this normal level. 14

15. Theories of Profits
Monopoly Theory - Profits are the result of some firm’s ability to dominate the market
Innovation Theory - Extraordinary profits are the rewards for successful innovations
Managerial Efficiency Theory - Extraordinary profits can result from exceptionally managerial skills of well-managed firms.
In some industries, one firm is effectively able to dominant the market and earn above-normal rates of return for a long time.
Ability to dominate market may arise from
Economies of scale
Control of essential natural resources
Control of critical patents
Government restrictions
Patent system is designed to ensure these above normal returns serve as a strong incentive to innovate 15

16. The Five Forces Framework
1-16
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
Michael porter:
Forces that impact sustainability of industry profits: (i) entry; (2) power of input suppliers;(3) power of buyers; (4) industry rivalry; (5) substitute and complements
Entry: promotes competition, barriers to entry, OPEC: sent the world economy in a tailspin, rice cartel, higher barrier-sustained profits, trade policies
Power of input suppliers: lower profits when suppliers have power to negotiate favorable terms for their inputs, Low power when standardized inputs, level of concentration in the market, role of government
Power of buyers: Buyers are usually fragmented, imperfect information, CAB, Consumer protection law
Industry rivalry, concentration, product differentiation
Substitutes: Close substitutes erode profitability, and Complementarities affect industry profitability: Microsoft Windows and compatible software such as MS Office, Linux, Open system
Five forces gives you the big picture, there are many other determinants, not a comprehensive list

17. Understanding Firms’ Incentives
1-17
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.
Incentive plan, profit and bonus relationship, everyone is greedy !
Satyam, Corporate governance
Staff turnover

18. Agency Problems
Modern corporations allow firm managers to have no ownership participation, or only limited participation in the profitability of the firm.
Shareholders may want profits, but hired managers may wish to relax or pursue self interest.
The shareholders are principals, whereas the managers are agents. 12

19. The Principal-Agent Problem
Shareholders (principals) want profit
Managers (agents) want leisure & security
Conflicting motivations between these groups are called agency problems.
Case No. 4
Professor Yunus blasts Telenor ethics in Bangladesh
Stock brokers and investors
Physicians and patients
Auto mechanics and car owners 13

20. 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 (but not always – Citibank and Managers)
Incentives to help the company, because that improves the value of stock options and bonuses
Good legal contracts that can be effectively enforced 14

21. Market Interactions Consumer-Producer Rivalry
1-21
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
BTRC, ERC
Rickshaw puller on a rainy day versus normal day, buying sacrificial animal
Buying big Hilsha fish
Grameen bought all the Banglalink free SIMs
Price monitoring

22. Market
Definition: Buyers and sellers communicate with one another for voluntary exchange
market need not be physical
Bookstore, Internet bookstore Amazon.com
Outsourcing
industry – businesses engaged in the production or delivery of the same or similar items
Clothing and textile industry,
Clothing industry is a buyer in the textile market and a seller in the clothing market
Market need not be physical or organized
oil market extends from organized exchange (wholesale level) to corner gasoline station (retail level)
Various markets
markets for consumer products, buyers are households and sellers are businesses.
markets for industrial products, both buyers and sellers are businesses.
markets for human resources, buyers are businesses and sellers are households.
E-commerce :In the US, e-commerce accounted for 55.3% of total book and magazine sales, 50.2% of music and video sales, 35% of computer and hardware and software sales

23. Competitive Market Benchmark for managerial economics
Purely competitive market
The global cotton market
many buyers and many sellers
no room for managerial strategizing
Achieves economic efficiency
Entry of firms
Case No.2, Ship breakers to Shipbuilders
Competitive market is the basic starting point of managerial economics -- where capitalist system performs best
demand
supply
market equilibrium
Model analyzes and explains
systematic effect of prices and other economic variables on household choice and business decisions
interaction of households and businesses

24. Market Power
Definition – ability of a buyer or seller to influence market conditions
Seller with market power must manage
costs
price
advertising expenditure
policy toward competitors
Non-competitive market -- in which market power exists.
market power --
in addition to managing costs,

25. Imperfect Market Definition: where
one party directly conveys a benefit or cost to others
externalities or
one party has better information than others
Lack of competition, Barriers to entry

26. The Time Value of Money
1-26
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”:
For example, the present value of Tk. 100 in 10 years, if the interest rate is 7 percent is Tk
If you invested Tk today at 7 percent interest rate, in 10 years your investment would be worth Tk.100
Interest rate appears in the denominator. Higher the interest rate the lower the present value and conversely
Examples:
Lottery winner choosing between a single lump-sum payout of Tk.104 million or Tk.198 million over 25 years.
Determining damages in a patent infringement case.

27. Present Value vs. Future Value
1-27
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.

28. Present Value of a Series
1-28
Present value of a stream of future amounts (FVt) received at the end of each period for “n” periods:
Equivalently,

29. Net Present Value
1-29
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

30. Present Value of a Perpetuity
1-30
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
The value of a perpetual bond that pays the owner Tk 100 at the end of each year when the interest rate is 5 percent is Tk. 2000

31. Objective of the Firm Not market share Not growth Not revenue
Not empire building
Not net profit margin
Not name recognition
Not state-of-the-art technology
These are the right answer to the wrong question. If the question was: What are the means effective in achieving the objective of the firm, then these are the correct answers. But the question is not about the means but rather about the fundamental objective of the firm. Do not make Type III error – asking the wrong question. Type I error – wrongly convict an innocent person; Type II error – failure to convict a guilty person 31

32. What’s the Objective of the Firm?
The objective of the firm is to maximize the value of the firm.
Value of the firm is the true measure of business success (of course, from a for-profit perspective.)
Two questions:
1. How is the “value of the firm” defined and measured?
2. How do managers go about adding value to the firm?
Stakeholders value 32

33. Value Maximization Is a Complex Process
Stakeholders value
Figure 1.3

34. Definition and Measurement of “Value of the Firm”
“The present value of the firm’s future net earnings.”
  n
V = [ ] + [ ] [ ]
(1+r) (1+r) (1+r)n
N t
V =  [ ] , t = 1, 2, ... , N
t = 1 (1+r)t 34

35. Adding Value to the Firm
Profit = Total Rev - Total Cost
 = P . Qd - VC . Qs - F
where  = profit, P = price,
Qd = quantity demanded,
VC = variable cost per unit,
Qs = quantity supplied,
F = total fixed costs 35

36. Determinants of Value of the Firm
N t N P . Qd - VC . Qs - F
V =  [ ] =  [ ]
t=1 (1+r)t t= (1+r)t
Whatever that raises the price of the product and/or the quantity of the product sold
Whatever that lowers the variable and fixed costs
Whatever that lower the “r” (discount rate or the perceived “risk” of investment)

37. Firm Valuation and Profit Maximization
1-37
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.

38. Firm Valuation With Profit Growth
1-38
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.
i = 10 percent
g = 5 percent
Current profit Tk. 100 million
Find value of the firm
Value of the firm immediately after it pays a dividend equal to its current profits
Tk million 100x(1.1/.05)
Tk million 100x(1.05/.05)

39. Marginal (Incremental) Analysis
1-39
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?

40. Net Benefits Net Benefits = Total Benefits - Total Costs
1-40
Net Benefits = Total Benefits - Total Costs
Profits = Revenue - Costs

41. Marginal Benefit (MB)
1-41
Change in total benefits arising from a change in the control variable, Q:
Slope (calculus derivative) of the total benefit curve.

42. Marginal Cost (MC)
1-42
Change in total costs arising from a change in the control variable, Q:
Slope (calculus derivative) of the total cost curve

43. 1-43
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.

44. The Geometry of Optimization: Total Benefit and Cost
1-44
The Geometry of Optimization: Total Benefit and Cost
Total Benefits
& Total Costs
Costs
Benefits Q
Slope =MB B
Slope = MC C Q*

45. The Geometry of Optimization: Net Benefits
1-45
The Geometry of Optimization: Net Benefits
Net Benefits Q
Maximum net benefits
Slope = MNB Q*

46. Myths and Misconceptions
Economics is about money only
Economics assumes that everyone is selfish
A company’s value is measured by the company’s assets
Costs are measured appropriately by accountants. 46

47. Myths and Misconceptions (cont.)
We must cover our fixed costs in the decisions we make as managers
Our firm must create the best quality product
We should do more advertising, because it’s cost-effective
Our price should be based on our costs 47

48. Myths and Misconceptions (cont.)
Unit or average cost provides useful management information
Wider profit margins are desirable
A price increase reduces demand
High research and development expense results in high prices. 48

49. What Will We Learn?
Useful economic principles for sound economic decision-making in a management context.
The basics of the demand side of the market and which factors influence the buyers’ behavior.
The fundamentals of the market’s supply side -laws of production and how these laws impact a firm’s costs.
How firms’ costs and buyers’ demand together determine the firm’s price and net profit. 49

50. Conclusion
1-50
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).