READ BEFORE YOU APPLY - 3 Short Papers 3 pages each ----- DUE in 12hours

Instructor – Dr. Gabriel Axarlian

• Chapter 1 – The Fundamentals of Managerial Economics

o The Economics of Effective Management

o Learning Managerial Economics

Introduction

• Managerial economics is a valuable tool for analyzing business situations

o Billions are lost each year because many existing managers fail to use basic tools from managerial economics to:

o shape pricing and output decisions

o optimize the production process and input mix

o choose product quality

o guide horizontal and vertical merger decisions

o optimally design internal and external incentives

• Managerial economics is useful for both fortune 500 type companies as well as for non-profit organizations

• Managerial economics provides useful insights into every facet of the business and nonbusiness world, including household decision making

Manager: A person who directs resources to achieve a stated goal

Economics: The science of making decisions in the presence of scarce resources

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

The Economics of Effective Management

• This course focuses on managerial decisions as they relate to maximizing profits, or more generally, the value of a firm

• There are six basic principles that comprise effective management

1. Indentify Goals and Constraints

• Knowing your goals allows you to identify which decisions you need to make

• Constraints make it difficult for managers to achieve goals

2. Recognize the Nature and Importance of Profits

Economic vs. Accounting Profits

Accounting Profit: The total amount of money taken in from sales (total revenue; price times quantity sold) minus the dollar cost of producing goods or services

Economic Profit: The difference between the total revenue and the total opportunity cost of producing the firm’s goods or services

Opportunity Cost: Costs that include both explicit (accounting) costs of resources and the implicit cost of giving up the best alternative use of the resource

• Implicit costs are hard to measure so managers often overlook them

o Effective managers continually seek out data from other sources to identify and quantify implicit costs

• Suppose you own a building in New York that you use to run a small pizzeria

o Food suppliers are your only accounting costs

o At the end of the year, your accountant informs you that these costs were $20,000 and that your revenues were $100,000

❑ Your accounting profits are $80,000

Example

______________________________________

• These accounting profits overstate your economic profits

o The costs do not include the time you spent running the business

▪ If you worked for someone else for $30,000 for the year your opportunity cost of time is $30,000 for the year

▪ This is one of your implicit costs of running the pizzeria

o The accounting costs also do not take into consideration that if you not run the pizzeria you could have rented the building out

▪ If the rental value is $100,000 a year, you gave up this amount to run your business (another implicit costs)

Economic Profits: Revenue – Opportunity Costs

Revenue $100,000 Explicit cost $ 20,000 Implicit costs $30,000 + $100,000 = $130,000

_ _

_ _

_ _

_ _

Opportunity Costs(explicit+implicit) =$150,000

Economic Profits = $100,000 – $150,000 Economic Profits = -$50,000

• Throughout this course when we refer to costs we mean opportunity costs

The Role of Profits

• Profits of businesses signal where society’s scarce resources are best allocated

The Five Forces Framework and Industry Profitability

• Many interrelated forces and decisions influence the level, growth and sustainability of profits

1-12

Entry

Level, Growth, and Sustainability of Industry Profits

Entry: The ease of entering or exiting a market

1-13

Entry

Level, Growth, and Sustainability of Industry Profits

Power of

Input

Suppliers

Power of

Buyers

Industry Rivalry

• Industries with high concentration (few firms) tend to have more sustainable profits

Level, Growth, and Sustainability of Industry Profits

Substitutes &

Complements

• The level of sustainability of industry profits also depend on the price and value of interrelated products and services

Industry Rivalry

Entry

Power of

Input

Suppliers

Power of

Buyers

3. Understand Incentives

• Changes in profit provide an incentive to resource holders to alter their use of resources

o Within a firm incentives affect how resources are used and how hard workers work

▪ Developing a mechanism such that if the employee does what is in her own interest, she will then do what is in the interest of the manager

4. Understand Markets

• The power or bargaining position, of consumers and producers in a market is limited by three sources of rivalry that exist in economic transactions

1. Consumer-Producer Rivalry

2. Consumer-Consumer Rivalry

3. Producer-Producer Rivalry

• When agents in either side of a market find themselves disadvantaged in the market process, they frequently attempt to induce government to intervene on their behalf

Government and the Market

5. Recognize the Time Value of Money

• The time of many decisions involves a gap between the time when the costs of a project are borne and the time when the benefits of the project are received

o $1 today is worth more than $1 received in the future

▪ The reason is the opportunity cost

▪ The opportunity cost reflects the time value of money

• To properly account for the timing of receipt and expenditures, the manager must understand present value analysis

Present Value Analysis

Present Value: The amount that would have to be invested today at the prevailing interest rate to generate the given future value

• If somebody offered you $1.10 a year from today, what is its present value today?

o $1.00 today at a guaranteed interest rate of 10%, one year from now would be worth

$1.00 X (1+.10) =$1.10

o Over the course of a year, your $1.00 would earn $.10 in interest

o When the interest rate is 10 percent, the present value of receiving $1.10 one year in the future is $1.00

(Formula) Present Value: The present value (PV) of a future value (FV) received t years in the future is

𝑷𝑽 = 𝑭𝑽

𝟏 + 𝒊 𝒕

where i is the rate of interest, the opportunity cost of the funds

=$1.00 +$0.10

+ 𝑭𝑽𝟑 𝟏 + 𝒊 𝟑

𝑷𝑽 + 𝑭𝑽𝟐 𝟏 + 𝒊 𝟐

+⋯= 𝑭𝑽𝟏 𝟏 + 𝒊 𝟏

+ 𝑭𝑽𝒏 𝟏 + 𝒊 𝒏

• Example: The present value of $100 in 10 years, if the interest rate is at 7%, is $50.76

𝑷𝑽 = $𝟏𝟎𝟎

𝟏+.𝟎𝟕 𝟏𝟎 =

$𝟏𝟎𝟎

𝟏.𝟎𝟕 𝟏𝟎 = $𝟏𝟎𝟎

𝟏.𝟗𝟕 = $𝟓𝟎.𝟕𝟔

o This means that if you invest $50.76 today at a 7% interest rate, in 10 years your investment would be worth $100

o Since the interest rate is on the denominator of the equation, the larger it is, the smaller the present value of a future payment

• The basic idea of PV of a FV can be extended to a series of future payments

o If you are promised 𝐅𝐕𝟏 one year in the future and 𝐅𝐕𝟐 in two years in the future, and so on for n years, the present value of this sum of future payments is

This is the Formula for a Present Value of a Stream

= ෍

𝒕=𝟏

𝒏 𝑭𝑽𝒕 𝟏 + 𝒊 𝒕

Net Present Value: The present value of the income stream generated by a project minus the current cost (𝐂𝟎)of the project 𝑵𝑷𝑽 = 𝑷𝑽 − 𝑪𝟎 • If the net present value is positive then a project is profitable because the present value of

the earnings from the project exceeds the current cost of the project

(Formula)Net Present Value: Suppose that by sinking 𝐂𝟎 dollars into a project today, a firm will generate income of 𝐅𝐕𝟏 one year in the future, 𝐅𝐕𝟐 two years in the future, and so on for 𝐧 years. If the interest rate is 𝑖 the net present value of the project is

+ 𝑭𝑽𝟑 𝟏 + 𝒊 𝟑

+ 𝑭𝑽𝟐 𝟏 + 𝒊 𝟐

+⋯ + 𝑭𝑽𝒕 𝟏 + 𝒊 𝒕

− 𝑪𝟎 𝑭𝑽𝟏 𝟏 + 𝒊 𝟏

Present Value of Infinitely Lived Assets

• Some decisions generate cash flows that continue indefinitely

• Supppose every period’s cash flow (ie 𝑭𝑽𝟏, 𝑭𝑽𝟐,𝒆𝒕𝒄) is the same (labeled CF), then

𝑷𝑽 𝒑𝒆𝒓𝒑𝒆𝒕𝒖𝒊𝒕𝒚 = 𝑪𝑭

𝒊

• Present value analysis is also useful in determining the value of a firm

• If 𝝅𝟎 is the firm’s current level of profits, and 𝝅𝟏is next year’s profit and so on then the value of the firm is

𝑷𝑽 𝒇𝒊𝒓𝒎 = + 𝝅𝟐

𝟏 + 𝒊 𝟐 +⋯+

𝝅𝟏 𝟏 + 𝒊 𝟏

𝝅𝟎 + 𝝅𝟑

𝟏 + 𝒊 𝟑

• The value of a firm today is the present value of its current and future profits

• Firm ownership represents a claim to assets with an indefinite profit stream

(Principle) Profit Maximization When economists say that the goal of a firm is to maximize profits, we mean that the firm’s goal is to maximize its value, which is the present value of current and future profits

1-22

6. Use Marginal Analysis

• Marginal analysis is one of the most important managerial tools

• Marginal analysis states that optimal managerial decisions involve comparing the marginal (or incremental) benefits of a decision with the marginal (or incremental) costs

o Let 𝑩(𝑸) denote the total benefits derived from 𝑸 units of output

o Let 𝑪(𝑸) denote the total cost to a firm of producing 𝑸 units of output

Discrete Decisions

• We first consider the case where the managerial control variable is discrete

• The manager cannot use fractional values of 𝑸 , only integer values

1-23

• Suppose the objective of the manager is to maximize net benefit 𝐍(𝑸)

𝐍 𝐐 = 𝐁 𝐐 − 𝐂(𝐐)

• Notice that the net benefit in the example is maximized when net benefit equals 200

Marginal Benefit: The change in total benefits arising from a change in the managerial control variable 𝑸

Marginal Cost: The change in total costs arising from a change in the managerial control variable 𝑸 • The marginal net benefits 𝑴𝐍𝐁(𝑸) of 𝑸 are the change in net benefits that arise from a one

unit change in 𝑸 • 𝐌𝑵𝑩(𝑸) is also the difference between marginal benefit 𝑴𝑩(𝑸) and marginal cost 𝑴𝐂(𝑸)

• The table reveals that by using 5 units the manager ensures that net benefit is maximized

• At that level marginal net benefits are 0

(Principle) Marginal Principle To maximize total benefits, the manager should increase the

managerial control variable up to the point where marginal benefits equal marginal costs

This level of the managerial control variable corresponds to the level at which marginal net benefits are zero

Continuous Decisions

• The basic principles for making decisions when the control variable is discrete also apply to the case of a continuous control variable

𝐵 𝑄

𝐶 𝑄

Maximum net benefits

Quantity (Control Variable)

Total benefits Total costs

• The slope of 𝐁(𝑸) is ∆𝐁

∆𝐐

• The slope of 𝐂(𝑸) is

marginal benefit

∆𝑪

∆𝑸 marginal cost

• The slopes are equal when net benefits are maximized

• This is just another way of saying that when net benefit is maximized mb=mc

1-26

Maximum net benefits

Quantity (Control Variable)

Net benefits

0

Slope =𝑀𝑁𝐵 𝑄 = 0

𝑁 𝑄 = 𝐵 𝑄 − 𝐶 𝑄 = 0

• Again, the net benefit is maximized when the distance is greatest

• The slope of N(Q) is ∆𝐍

∆𝐐 marginal net benefit MNB(Q)

• As you’ll remember from Calculus, when a curve is maximized the slope is equal to zero

1-27

Quantity (Control Variable)

Marginal benefits, costs and net benefits

0

𝑀𝐶 𝑄

𝑀𝐵 𝑄𝑀𝑁𝐵 𝑄

Maximum net benefits

• This last figure depicts MC, MB and MNB

• At the level of Q where the marginal benefit curve intersects the marginal cost curve, marginal net benefits are zero

• That level of Q maximizes net benefits

1-28

(Principle)Marginal Value Curves Are the Slopes of the Total Value Curves When the control variable is infinitely divisible, the slope of a total value curve at a given point is the marginal value at that point.

• Sometimes managers are faced with proposals that require a simple thumbs up or thumbs down decision

Incremental Decisions

o Marginal analysis is the appropriate tool to use for such decisions

• In the case of yes-or-no decisions, the additional revenues derived from a decision are called incremental revenues

• The additional costs that stem from the decision are called incremental costs.

o A manager should give a “thumbs up” only if the incremental revenue exceeds or is equal to the incremental cost

Learning Managerial Economics

• Becoming proficient in economics is like learning to play music or ride a bicycle

o Practicing managerial economics means practicing making decisions, and the best way to do this is to work and rework the problems

• Before you can be effective at practicing, you must understand the language of economics

• Anyone who is willing to learn the language of economics and take the time to practice making decisions can learn to be an effective manager

o The best way to learn economics is to practice, practice, and practice some more