1. Contact Information Dr. Daniel Simons Vancouver Island University Faculty of Management Building 250 - Room 416 Office Hours: MTW: 11:30 – 12:30 Email: simonsd@viu.ca

2. Suggestions for Best Individual Performance Attend all classes Take notes. Course covers a lot of material and your notes are essential Complete all assignments (not for grade) Read the book Participate, enrich class discussion, provide feedback and ask questions Revise materials between classes, integrate concepts, make sure you understand the tools and their application Don’t hesitate to contact me if necessary

3. Evaluation Method Tests have a mix of problems that evaluate Concepts Problem sets (assignments) Class applications Readings New applications 3 closed book time constrained tests to reward knowledge and speed Each test covers slides, assignments, and required readings. Evaluation system may not be perfect but it works

4. Main Course Objectives 1.Present relevant tools for effective management of organizational processes and resources 2.Show the application of core concepts to typical business problems and management decisions 3.Provide the foundation for late in-depth coverage of business issues in Economics 4.Present a general framework to better understand and meet the challenges faced by organizations 5.Contribute to the generation and implementation of strategies to create economic value and sustain competitive advantage in organizations

5. Introduction, Basic Principles and Methodology The central themes of Managerial Economics: 1.Identify problems and opportunities 2.Analyzing alternatives from which choices can be made 3.Making choices that are best from the standpoint of the firm or organization

6. Not true that all managers must be managerial economists But managers who understand the economic dimensions of business problems and apply economic analysis to specific problems often choose more wisely than those who do not.

7. Some Economic Principles of Managers 1.Role of manager is to make decisions. Firms come in all sizes but no firm has unlimited resources so managers must decide how resources are employed

8. 2.Decisions are always among alternatives. 3.Decision alternatives always have costs and benefits Opportunity cost = next best alternative foregone. Marginal or incremental approach 4.Anticipated objective of management is to increase the firm’s value

9. Maximize shareholder’s wealth Negative impact = principal-agent problem 5.Firm’s value is measured by its expected profits Time value of money, discount rates 6.The firm must minimize cost for each level of production

10. 7.The firm’s growth depends on rational investment decisions Capital budgeting decisions 8.Successful firms deal rationally and ethically with laws and regulations

11. Macroeconomics & Microeconomics Economists generally divide their discipline into two main branches: Macroeconomics is the study of the aggregate economy. –National Income Analysis (GDP) –Unemployment –Inflation –Fiscal and Monetary policy –Trade and Financial relationships among nations

12. Microeconomics is the study of individual consumers and producers in specific markets. –Supply and demand –Pricing of output –Production processes –Cost structure –Distribution of income and output Microeconomics is the basis of managerial economics

13. Methodology, data and application Methodology- is a branch of philosophy that deals with how knowledge is obtained. How can you know that you are managing efficiently and effectively? You need some theory to do some analysis. Without theory, there can be no good analysis

14. Microeconomics (probably more than other disciplines) provides the methodology for managerial economics Managerial Economics is about both methodology and data You need data to plug into some model to do some analysis. This gives you the information to manage Managerial Economics lends empirical content to the study of effective management

15. Review of Economic Terms Resources are factors of production or inputs. –Examples: Land Labor Capital Entrepreneurship

16. Managerial Economics –The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.

17. Managerial economics is the use of economic analysis to make business decisions involving the best use (allocation) of an organization’s scarce resources.

18. Relationship to other business disciplines –Marketing: Demand, Price Elasticity –Finance: Capital Budgeting, Break-Even Analysis, Opportunity Cost, Economic Value Added –Management Science: Linear Programming, Regression Analysis, Forecasting –Strategy: Types of Competition, Structure- Conduct-Performance Analysis –Managerial Accounting: Relevant Cost, Break- Even Analysis, Incremental Cost Analysis, Opportunity Cost

19. Questions that managers must answer: –What are the economic conditions in a particular market? Market Structure? Supply and Demand Conditions? Technology? Government Regulations? International Dimensions? Future Conditions? Macroeconomic Factors?

20. Questions that managers must answer: –Should our firm be in this business? –If so, what price and output levels achieve our goals?

21. Questions that managers must answer: –How can we maintain a competitive advantage over our competitors? Cost-leader? Product Differentiation? Market Niche? Outsourcing, alliances, mergers, acquisitions? International Dimensions?

22. Questions that managers must answer: –What are the risks involved? Risk is the chance or possibility that actual future outcomes will differ from those expected today.

23. Types of risk –Changes in demand and supply conditions –Technological changes and the effect of competition –Changes in interest rates and inflation rates –Exchange rates for companies engaged in international trade –Political risk for companies with foreign operations

24. Because of scarcity, an allocation decision must be made. The allocation decision is comprised of three separate choices: –What and how many goods and services should be produced? –How should these goods and services be produced? –For whom should these goods and services be produced?

25. Economic Decisions for the Firm –What: The product decision – begin or stop providing goods and/or services. –How: The hiring, staffing, procurement, and capital budgeting decisions. –For whom: The market segmentation decision – targeting the customers most likely to purchase.

26. Three processes to answer what, how, and for whom –Market Process: use of supply, demand, and material incentives –Command Process: use of government or central authority, usually indirect –Traditional Process: use of customs and traditions

27. Profits are a signal to resource holders where resources are most valued by society So what factors impact sustainability of industry profitability? Porter’s 5-forces framework discusses 5 categories of forces that impacts profitability

28. 1.Entry 2.Power of input sellers 3.Power of buyers 4.Industry rivalry 5.Substitutes and Complements

29. Entry: Heightens competition Reduces margin of existing firms Ability to sustain profits depends on the barriers to entry: cost, regulations, networking, etc. Profits are higher where entry is low

30. Power of input suppliers: Do input suppliers have power to negotiate favorable input prices? Less power if a.inputs are standardized, b.not highly concentrated c.alternative inputs available Profits are high when suppliers power is low

31. Power of buyers: High buyer power if a.buyers can negotiate favorable terms for the good/service b.Buyer concentration is high c.Cost of switching to other products is low d.perfect information leading to less costly buyer search

32. Industry rivalry: Rivalry tends to be less intense a.in concentrated industries b.high product differentiation c.high consumer switching cost Profits are low where industry rivalry is intense

33. Substitutes and complements: Profitability is eroded when there are close substitutes Government policies (restrictions e.g. import restriction on drugs from Canada to US) can affect the availability of substitutes.

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

35. 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.

36. 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.

37. The Firm and Its Goals The Firm Economic Goal of the Firm Goals Other Than Profit Do Companies Maximize Profits? Maximizing the Wealth of Stockholders Economic Profits

38. The Firm A firm is a collection of resources that is transformed into products demanded by consumers. Profit is the difference between revenue received and costs incurred.

39. 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.

40. Cost Accounting Costs –The explicit costs of the resources needed to produce produce goods or services. –Reported on the firm’s income statement.

41. 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.

42. Economic Goal of the Firm Primary objective of the firm (to economists) is to maximize profits. –Profit maximization hypothesis –Other goals include market share, revenue growth, and shareholder value Optimal decision is the one that brings the firm closest to its goal.

43. Short-run vs. Long-run –Nothing to do directly with calendar time –Short-run: firm can vary amount of some resources but not others –Long-run: firm can vary amount of all resources At times short-run profitability will be sacrificed for long-run purposes

44. Goals Other Than Profit –Market share maximization (as measured by sales revenue or proportion of quantity sold to total market –Growth rate maximization (increasing size of the firm over time. Higher rates of growth in other variables than profit) –Profit margin –Return on investment, Return on assets

45. –Shareholder value –Technological advancement –Customer satisfaction –Maximization of managerial returns (manager’s own interest subject to generating sufficient profits to keep their jobs)

46. Non-economic Objectives –Good work environment –Quality products and services –Corporate citizenship, social responsibility

47. Do Companies Maximize Profit? Criticism: Companies do not maximize profits but instead their aim is to “satisfice.” –“Satisfice” is to achieve a set goal, even though that goal may not require the firm to “do its best.”

48. –Two components to “satisficing”: Position and power of stockholders Position and power of professional management

49. Position and power of stockholders –Medium-sized or large corporations are owned by thousands of shareholders –Shareholders own only minute interests in the firm –Shareholders diversify holdings in many firms –Shareholders are concerned with performance of entire portfolio and not individual stocks.

50. –Most stockholders are not well informed on how well a corporation can do and thus are not capable of determining the effectiveness of management. –Not likely to take any action as long as they are earning a “satisfactory” return on their investment.

51. Position and power of professional management –High-level managers who are responsible for major decision making may own very little of the company’s stock. –Managers tend to be more conservative because jobs will likely be safe if performance is steady, not spectacular.

52. –Management incentives may be misaligned E.g. incentive for revenue growth, not profits Managers may be more interested in maximizing own income and perks –Divergence of objectives is known as “principal-agent” problem or “agency problem”

53. Counter-arguments which support the profit maximization hypothesis. –Large number of shares is owned by institutions (mutual funds, banks, etc.) utilizing analysts to judge the prospects of a company. –Stock prices are a reflection of a company’s profitability. If managers do not seek to maximize profits, stock prices fall and firms are subject to takeover bids and proxy fights. –The compensation of many executives is tied to stock price.

54. Company tries to manage its business in such a way that the dividends over time paid from its earnings and the risk incurred to bring about the stream of dividends always create the highest price for the company’s stock. When stock options are substantial part of executive compensation, management objectives tend to be more aligned with stockholder objectives.

55. Maximizing the Wealth of Stockholders Views the firm from the perspective of a stream of earnings over time, i.e., a cash flow. Must include the concept of the time value of money. –Dollars earned in the future are worth less than dollars earned today.

56. Future cash flows must be discounted to the present. The discount rate is affected by risk. Two major types of risk: Business Risk Financial Risk

57. Business risk involves variation in returns due to the ups and downs of the economy, the industry, and the firm. All firms face business risk to varying degrees.

58. Financial Risk concerns the variation in returns that is induced by leverage. Leverage is the proportion of a company financed by debt. The higher the leverage, the greater the potential fluctuations in stockholder earnings. Financial risk is directly related to the degree of leverage.

59. Timing 2 types of models 1.Static model:– describe the behaviour at a single point in time. Disregards differences in the sequence of actions and payments 2.Dynamic models:- focus on the timing and sequence of actions and payments

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

61. 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

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

63. Net Present Value Suppose a manager can purchase a stream of future receipts (FV t ) by spending “C 0 ” dollars today. The NPV of such a decision Is Decision Rule: If NPV < 0: Reject project NPV > 0: Accept project

64. Present Value of a Perpetuity An asset that perpetually generates a stream of cash flows (CF) at the end of each period is called a perpetuity. The present value (PV) of a perpetuity of cash flows paying the same amount at the end of each period is

65. Firm Valuation The value of a firm equals the present value of current and future profits. –PV =    t / (1 + i) t

66. If profits grow at a constant rate (g < i) and current period profits are   :

67. 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.

68. Control Variables –Output –Price –Product Quality –Advertising –R&D Marginal (Incremental) Analysis

69. Net Benefits Basic Managerial Question: How much of the control variable should be used to maximize net benefits? Net Benefits = Total Benefits - Total Costs Profits = Revenue - Costs

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

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

72. 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.

73. The Geometry of Optimization Q Total Benefits & Total Costs Benefits Costs Q* B C Slope = MC Slope =MB

74. 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).

75. Maximizing the Wealth of Stockholders Another measure of the wealth of stockholders is called Market Value Added (MVA)®. MVA represents the difference between the market value of the company and the capital that the investors have paid into the company.

76. Maximizing the Wealth of Stockholders Market value includes value of both equity and debt. Capital includes book value of equity and debt as well as certain adjustments. –E.g. Accumulated R&D and goodwill. While the market value of the company will always be positive, MVA may be positive or negative.

77. Maximizing the Wealth of Stockholders Another measure of the wealth of stockholders is called Economic Value Added (EVA)®. –EVA=(Return on Total Capital – Cost of Capital) x Total Capital If EVA is positive then shareholder wealth is increasing. If EVA is negative, then shareholder wealth is being destroyed.