1. Chapter 1 The Fundamentals of Managerial Economics

2. Headline Amcott Loses $3.5 Million; Manager Fired.
On Tuesday software giant Amcott posted a year-end operating loss of $3.5 million. Reportedly, $1.7 million of the loss stemmed from its foreign language division.
With short-term interest rates at 7 percent, Amcott decided to use $20 million of its retained earnings to purchase three-year rights to Magicword, a software package that converts generic word processor files saved as French text into English. First year sales revenue from the software was $7 million, but thereafter sales were halted pending a copyright infringement suit filed by Foreign, Inc.

3. Amcott lost the suit and paid damages of $1. 7 million
Amcott lost the suit and paid damages of $1.7 million. Industry insiders say that the copyright violation pertained to a very small component of Magicword.
Ralph, the Amcott manager who was fired over the incident, was quoted as saying, “I’m a scapegoat for the attorneys [at Amcott] who didn’t do their homework before buying the rights to Magicword. I projected annual sales of $7 million per year for three years. My sales forecasts were right on target.”
Do you know why Ralph was fired?

4. 1. Managerial Economics Manager Economics Managerial Economics
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.

5. 2. Economic vs. Accounting Profits
Goal = Profit Maximization (among others)
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
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.

7. [Example] Pizza House in NY Opportunity Cost
Revenue = $100,000
Cost = $20,000
Profit =
Opportunity Cost
Can work for $30,000
Rental revenue = $70,000
Total Economic Cost = Cost + Opportunity Cost =
Economic Profit = Revenue – Total Economic Cost = $100,000 - $120,000 =

8. 3. The Five Forces Framework
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. 4. 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.

10. 5. 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”:
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.

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

12. 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

13. [example] A new machine costs $300,000 and has a life of 5 years.
Cost reductions will be $50,000, $60,000, $75,000, $90,000 and $90,000 in year 1,2,..,5, respectively.
If the interest rate is 8 percent, should the manager purchase the machine?
PV = $284,679
NPV = PV – C = -$15,321.
Thus,

14. Present Value of a Perpetuity
An asset that perpetually (endlessly) 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

15. How?
Example: What is the value of a perpetual bond that pays the owner $100 at the end of each year when i = 0.05?

16. Firm Valuation
The value of a firm equals the present value of current and future profits.
PV = S pt / (1 + i)t
Note: If the profits are expected to grow at a constant rate of g percent,
pt = p0 (1 + g)t
Then,
PV = S p0 (1 + g)t / (1 + i)t gives (HOW?):

17. If profits grow at a constant rate (g < i):
(How?)
Point: If the growth rate in profits < interest rate, i.e., g < i, and both remain constant, maximizing the present value of all future profits is the same as maximizing current profits.

18. [Example]
Suppose that i = 10% and g = 5%. The firm’s current profits are $100 million.
What is PV?
What is PV after paying a dividend of the current profit?

19. Related concept: Tobin’s q
Tobin's q, is the ratio of the market value of a firm's assets (as measured by the market value of its outstanding stock and debt) to the replacement cost of the firm's assets (Tobin 1969).
This concept is frequently used in finance analysis.

20. 6. Marginal (Incremental) Analysis
Basic Managerial Question: How much of the control variable should be used to maximize net benefits?
Control Variables = Output, Price, Product Quality, Advertising, R&D, etc.
When to stop working?
Study plan?
Retirement plan?

21. Net Benefits Net Benefits = Total Benefits - Total Costs
Profits = Revenue – Costs
Point:
Benefit keeps increasing before calling down.
Cost keeps increasing at an increasing rate.

24. Key points The optimal point is at the level of input (Q)
Where two slopes are the same.
That is, MB = MC.
Where the slope of the Net Benefit is zero.
That is, the Net benefit is maximized.
Should explain WHY this occurs.
If MB < MC?
If MB > MC?

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

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

27. 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.

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

29. [Example] Exercise: Suppose Suppose MB = 300 – 12Q
Benefit = 300Q – 6Q2
Cost = 4Q2
MB = 300 – 12Q
MC = 8Q
MB = MC implies 300 – 12Q = 8Q
Q* = 15
NB = 300*15 – 6* *152 = 2,250
Exercise: Suppose
Benefit = Q – 5Q2
Cost = Q
What is Q*?

30. 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).

31. Back to Headline NPV = 7,000,000/(1+0.07)1 + 7,000,000/(1+0.07)2 +
7,000,000/(1+0.07)3 - 20,000,000
= -$1,629,788
LOSS!
; Not fired because of the mistakes of his legal department.

32. Exercises and Homework
Chapter 1
In-Class
Q. 4, Q. 5, Q. 9
Homework
Q. 3, Q. 10, Q. 13, Q. 18