Managerial Economics

Managerial Economics – Study Guide: Chapters 1-7

CHAPTER 1:

• Cost-Benefit Principle

• An economic agent should undertake an action if and only if the marginal benefit is greater than the marginal cost

• Ignore sunk costs
• Consider your next best options

• Opportunity Cost (Marginal Thinking)
• Compare Marginal Benefit to Marginal Cost

• Ex:  MBA Program – Benefits

• Learning
• Entertaining
• Checking out the professor
• Paid tuition (SUNK COST)

• Allocation Decisions

• Illustrate how economic changes affect a firm’s ability to earn an acceptable return
• Apply to an individual firm the three basic questions faced by a country

• Economics

• The study of the behavior of human beings in producing, distributing and consuming material goods and services in a world of scarce resources

• Management

• The science of organizing and allocating a firm’s scarce resources to achieve its desired objective

• Managerial Economics

• The use of economic analysis (i.e. statistics and math) to make business decisions involving the best use (allocation) of an organization’s scarce resources

• Relationship to other business disciplines

• Marketing

• Demand, price elasticity

• Finance

• Capital budgeting, breakeven analysis, opportunity cost, value added

• Management science

• Linear programming, regression analysis, forecasting

• Strategy

• Types of competition, structure-conduct-performance analysis

• Managerial accounting

• Relevant cost, breakeven analysis, incremental cost analysis, opportunity cost

• Questions that managers must answer:

• What are the economic conditions in our particular market?

• National market?
• Global market?
• Market structure?
• Supply and demand?
• Technology?

• What are economic conditions in our particular market?

• Government regulations?
• International dimensions?
• Future conditions?
• Macroeconomic factors?

• Should our firm be in this business?

• If so, at what price?
• …and at what output level?

• How can we maintain a competitive advantage over other firms?

• Cost-leader?
• Product differentiation?
• Market niche?
• Outsourcing, alliances, mergers?
• International perspective?

(Risk is the chance that actual future outcomes will differ from those expected)

• What are the risks involved?

• Exchange rates (for companies in international trade)?
• Political risk (for firms with foreign operations)?

• Economics of a business

• Refers to the key factors that affect the firm’s ability to earn an acceptable rate of return on its owners’ investment

• Competition
• Technology
• Customers

• Change:  the four-stage model

• STAGE I (the ‘good old days’)

• Market dominance
• High profit margin
• Cost plus pricing

…changes in technology, competition, customers force firm into Stage II

• STAGE II (crisis)

• Cost management
• Downsizing
• Restructuring

…’re-engineering’ to deal with change sand move firm into Stage III

• STAGE III (reform)

• Revenue management
• Cost cutting has limited benefit

...focus on ‘top-line’ growth

• Stage IV (recovery)

• Revenue plus

…revenue grows profitably

• Microeconomics

• The study of individual consumers and producers in specific markets:

• Supply and demand
• Pricing of output
• Production process
• Cost structure
• Distribution of income

• Macroeconomics

• The study of the aggregate economy, especially:

• National output (GDP)
• Unemployment
• Inflation
• Fiscal and monetary policies
• Trade and finance among nations

• Resources

• Inputs (factors) of production, notably:

• Land
• Labor
• Capitol
• Entrepreneurship

• Also referred to as the technology constant in the AK model

• Allocation decisions must be made because of scarcity.  Three choices:

• What should be produced?

• Begin or stop providing
• Goods / services (production

• How should it be produced?

• Hiring, staffing, capital budgeting
• Resourcing

• For whom should it be produced?

• Target the customers most likely to purchase (marketing)

• Entrepreneurship

• The willingness to take certain risks in the pursuit of goals

• Management

• The ability to organize resources and administer tasks to achieve objectives

CHAPTER 2 – The Firm and its Goals:

• Learning Objectives

• Understand the rationale for existence of firms
• Explain economic goals and optimal decision making
• Describe the ‘principal-agent’ problem
• Distinguish between profit maximization and shareholder wealth maximization
• Apply market value Added and Economic Value Added

• The Firm

• A collection of resources that is transformed into products demanded by consumers
• Profit is the difference between revenue received and costs incurred

• Accounting v. Economic

• Transaction Costs

• Incurred when entering into a contract

• Investigation
• Negotiation
• Enforcing Contracts

• Transportation costs

• Influences

• Uncertainty
• Frequency of recurrence
• Asset specificity

• Limits to Firm Size

• Economies of Scale

• CRS
• DRS
• IRS

• Economics of Agglomeration
• Legal / Market Share
• Additional Limits:

• Tradeoff between extrernal transactions and the cost of internal operations
• Company chooses to allocate resources so total cost is minimum
• Outsourcing of peripheral, non-core activities

[pic 1]

Coase & the Internet

• Ronald Coase
• 1937 tradeoff between internal costs and external transactions
• Coase Theorem
• Search costs (Search Theory in labor Markets)

• Profit maximization hypothesis

• The primary objective of the firm (to economists) is to maximize profits
• Other goals:

• Market share
• Revenue Growth
• Shareholder Value

• Short-run v. Long-run

• Nothing to do directly with calendar time
• Short-run

• Firm can vary amount of some resources but not others
• Generally capital is fixed

• Long-run

• Firm can vary amount of all resources

• At times, short-run profitability will be sacrificed for long-run purposes

• Economic goals

• Market share / growth rate
• Profit margin
• Return on investment / return on assets
• Technological advancement
• Customer satisfaction
• Shareholder Value

• Non-economic objectives

• Good work environment
• Quality products and services
• Corporate citizenship / social responsibility

• Do companies maximize profit?

• Criticism:  companies do not maximize profits but instead merely aim to satisfice, which means to achieve a satisfactory goal, one that may not require the firm to ‘do its best’

• Two forces affect satisficing:

• Position and power of stockholders

• Shareholders are concerned with performance of entire portfolio and not individual stocks
• Less informed about the firm than management
• Institutional shareholders monitor
• Stockholders are not likely to take any action if earning a ‘satisfactory return’

• Position and power of management

• High-level managers may own very little of the firm’s stock
• Managers tend to be more conservative because jobs will likely be safe if performance is steady, not spectacular

• Can be fired for reversal

• Managers may be more interested in maximizing own income and perks
• Management incentives may be misaligned (ie.e revenue not profits)

• Principal-Agent Problem

• Divergence of objectives
• There is no perfect solution (Holmstrom)
• Incentive schemes / rules
• Efficiency wages (Stiglitz)
• Observation

• Counter-arguments which support the profit maximization hypothesis

• Large stockholdings held by institutions (mutual funds, banks, etc.)

• scrutiny by professional analysts

• Stock market discipline

• if managers do not seek to maximize profits, firms face threat of takeover

• Incentive effect

• The compensation of many executives is tied to stock price

• Stream of Profits (cash flows) over time

• The value of the stream depends on when cash flows occur
• Requires the concept of the time value of money

• A dollar earned in the future is worth less than a dollar earned today

• Future cash flows must be ‘discounted’ to find present equivalent value

• The discount rate (k) is affected by risk

• Two major types of risk

• Business Risk

• Involves variation in returns due to the ups and downs of the economy, the industry and the firm

• Financial Risk

• Concerns the variation in returns that is induced by ‘leverage’

• Leverage

• 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

The present price of a firm’s stock should reflect the discounted value of the expected future cash flows to shareholders (dividends)