New Works 01/12
Managerial Economics Applications, Strategies and Tactics, 14e
James R. McGuigan
R. Charles Moyer
Frederick H. deB. Harris
© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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PART I – INTRODUCTION
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Chapter 1 – Introductions and Goals of the Firm Overview
WHAT IS MANAGERIAL ECONOMICS?
THE DECISION-MAKING MODEL
THE ROLE OF PROFITS
OBJECTIVE OF THE FIRM
SEPARATION OF OWNERSHIP AND CONTROL: THE PRINCIPAL-AGENT PROBLEM
IMPLICATIONS OF SHAREHOLDER WEALTH MAXIMIZATION
© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Figure 1.1 – Nitrous Oxide from Coal-Fired Power Plants, pre Clean Air Act
© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Chapter 1 – Introductions and Goals of the Firm What is Managerial Economics? (1 of 1)
Managerial economics enables managers to select strategic direction, allocate efficiently, and respond effectively to tactical issues
Managerial economic decision-making seeks to:
Identify the alternatives,
Select the choice that accomplishes the objective(s) in the most efficient manner,
Taking into account the constraints,
And the likely actions and reactions of rival decision-makers.
© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Chapter 1 – Introductions and Goals of the Firm The Decision-Making Model (1 of 3)
Making good decisions is key to successful managerial performance, and includes several elements:
Establish the objectives
Identify the problem
Examine potential solutions
Analyze the relative costs and benefits
Analyze the best available alternative under a variety of assumptions (sensitivity analysis)
Implement the decision
© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Chapter 1 – Introductions and Goals of the Firm The Decision-Making Model (2 of 3)
The Responsibilities of Management
Managers are responsible for many goals
They must proactively solve problems before they become crises
Moral Hazard in Teams
The single most critical trait of effective managers is the ability to motivate teams to perform to their best
To encourage team members to avoid the moral hazards of free riding and shirking of duties;
Without penalties and sanctions, only moral duty induces full effort teamwork
© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Chapter 1 – Introductions and Goals of the Firm The Decision-Making Model (3 of 3)
Managers in a capitalist economy are motivated to monitor teamwork because of their overarching goal to maximize returns to owners of the business:
Economic profits: the difference between total revenue and total economic cost
Includes a “normal” rate of return on the capital contributions of the firm’s partners
© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Figure 1.2 – Payoffs from Team Production with and without a Supervisor
© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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What Went Right? ● What Went Wrong?
Saturn Corporation
Different kind of car company in 1991, but permanently closed in 2009
It used no-haggle pricing and designed cars to compete with Asian imports
Sales were above expectations at first because of tiny margin of only $400 per car to GM, so that GM earned only 3% on capital
Saturn customers wanted bigger Saturn cars rather than trade up to Buick, as GM hoped
Sales later slumped in the late 1990s through 2009
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© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Chapter 1 – Introductions and Goals of the Firm The Role of Profits (1 of 1)
Risk-Bearing Theory of Profit
Risk-bearing should lead to higher profits
Temporary Disequilibrium Theory of Profit
Firms may earn a return above or below the long-run normal return level
Monopoly Theory of Profit
A firm which dominates the market can persistently earn above-normal returns
Innovation Theory of Profit
These are the reward for successful innovations
Managerial Efficiency Theory of Profit
Exceptional managerial skills may lead to higher profits
© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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What Went Right? ● What Went Wrong?
Eli Lilly, a Pharmaceutical Company
It takes12.3 years on average to get a new drug approved.
Patents on Lilly’s Prozac created monopoly power and profits for a widely used medication for depression
As the patent began to expire, Lilly requested a patent “extension” because of some alterations in Prozac’s formula
But when the patent extension was overturned, generic drug manufactures took 70% of the share of the market for anti-depressants
Lilly missed the chance of finding a replacement in time for its blockbuster Prozac
This is an example of having and losing monopoly power
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© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Chapter 1 – Introductions and Goals of the Firm Objective of the Firm (1 of 1)
The Shareholder Wealth-Maximization Model
Shareholder wealth is measured by the market value of a firm’s common stock, which is equal to the present value of all expected future cash flows to equity owners discounted at the shareholders’ required rate of return, plus a value for the firm’s embedded real options:
© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Chapter 1 – Introductions and Goals of the Firm Separation of Ownership & Control: Principal-Agent… (1 of 2)
Divergent Objectives and Agency Conflict
Growth results in owners (principals) delegating decision-making authority to professional managers (agents)
Because manager-agents have much less to lose, agents may seek acceptable (not maximum) profit levels, pursuing their own self-interests; Agency Conflict
Agency Problem
Problems arise from inherent unobservability of managerial effort and random disturbances in team production
Separation of ownership (shareholders) and control (management) in large corporations permits managers to pursue goals that are not always in the long-term interests of shareholders
© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Comparison slide; see Figure 1.3, next slide
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Figure 1.3 – CEO Pay Trends Reflect Corporate Performance
© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Chapter 1 – Introductions and Goals of the Firm Separation of Ownership & Control: Principal-Agent… (2 of 2)
Agency Problem (cont’d)
In attempt to mitigate agency problems, firms incur agency costs:
1. Grants of stock options or restricted stock from Treasury stock so executive compensation aligns the incentives for management with shareholder interests; also, many monitor financial ratios and investment decisions of large debtor companies; strengthens firm’s corporate governance
2. Internal audits and accounting oversight boards to monitor actions of management
3. Bonding expenditures and fraud liability insurance to protect shareholders
4. Complex internal approval processes to limit discretion, but which prevent timely responses to business opportunities
© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Chapter 1 – Introductions and Goals of the Firm Implications of Shareholder Wealth Maximization (1 of 4)
Critics of those who seek to align interests of managers with equity owners allege that maximizing shareholder wealth focuses on short-term payoffs, sometimes to detriment of long-term profits
But evidence suggests just the opposite:
Short-term cash flows reflect only a small fraction of the firm’s share price
In general, only about 85% of shareholder value can be explained by even 30 years of cash flows
Managers’ value-maximizing behavior distinguishable from satisficing behavior (hitting their targets)
© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Chapter 1 – Introductions and Goals of the Firm Implications of Shareholder Wealth Maximization (2 of 4)
Caveats to Maximizing Shareholder Value
Complete Markets – to directly influence a company’s cash flows, forward or futures markets, and spot markets must be available for firm’s inputs, outputs and by-products
No Asymmetric Information - Problems often arise because of asymmetric information; Line managers and employees can misunderstand what senior executives want when they challenge employees to find a thousand different ways to save 1 percent
Known Recontracting Costs – Focusing exclusively on discounted present value of future cash flows requires managers to forecast future recontracting costs for pivotal inputs
© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Chapter 1 – Introductions and Goals of the Firm Implications of Shareholder Wealth Maximization (3 of 4)
Residual Claimants
Shareholders have only a residual claim on the firm’s net cash flows after all expected contractual returns have been paid
Goals in the Public Sector and Not-for-Profit Enterprises
Profit maximization not appropriate for public sector of NFP firms
Public goods are consumed by more than one person at a time with little or no extra cost; expensive or impossible to exclude those who do not pay
Not-for-Profit Objectives
Maximize: 1) quantity and equality of output subject to break-even budget constraint; 2) outcomes preferred by NFP’s contributors; 3) longevity of NFP’s contributors
© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Chapter 1 – Introductions and Goals of the Firm Implications of Shareholder Wealth Maximization (4 of 4)
The Efficiency Objective in Not-for-Profit Organizations
Cost-benefit analysis is a resource-allocation model that can be used by public sector and NFP firms to evaluate programs or investments on the basis of the magnitude of the discounted costs and benefits
Because such spending is constrained by a budget ceiling, goals can be any one of these:
1. Maximize benefits for given costs
2. Minimize the costs while achieving a fixed level of benefits
3. Maximize the net benefits (benefits minus costs)
But cost-benefit analysis is only one factor in the final decision
It does not incorporate subjective considerations or less quantifiable attributes such as fairness
© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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