Read and respond

ECO 518

Unit 1 Lecture This lecture will function as a guide to assist you in studying. It contains questions that you

should be able to answer after you read the chapters. As you read the text book think about the

questions posed below. The answers comprise the main topics and concepts that you should

know and understand after you have finished your readings. There are no quiz or test activities

associated with this lecture content.

Unit Learning Outcomes

Unit 1

ULO 1. Articulate the important types of decisions that managers must make concerning the

allocation of a company's scarce resources

ULO 2. Explain the economic goals of the firm and optimal decision making

ULO 3. Differentiate the usefulness of Market Value Added and Economic Value Added.

KEY LEARNING POINTS Managerial economics is a discipline that combines microeconomic theory with management

practice. Microeconomics is the study of how choices are made to allocate scarce resources

with competing uses. An important function of a manager is to decide how to allocate a

firm’s scarce resources. Examples of such decisions are the selection of a firm’s products or

services, the hiring of personnel, the assigning of personnel to particular functions or tasks, the

purchase of materials and equipment, and the pricing of products and services.

Managerial economics shows how the application of economic theory and concepts helps

managers make allocation decisions that are in the best economic interests of their firms.

Throughout the text, numerous examples are cited to illustrate how economic theory and

concepts can be applied to management decision making. References are also made to

business cases and economic events that have been reported in the popular press.

Important Concepts and Meanings This section provides definitions of important concepts

Command process - The use of central planning and the directives of government authorities

to answer the questions of what, how, and for whom.

Economic decisions for the firm - “What goods and services should be produced?”—the

product decision. “How should these goods and services be produced?”—the hiring, staffing,

and capital-budgeting decision. “For whom should these goods and services be produced?”—

the market segmentation decision.

Economics - The study of how choices are made under conditions of scarcity. The basic

economic problem can be defined as: “What goods and services should be produced and in

what quantities?” “How should these goods and services be produced?” “For whom should

these goods and services be produced?”

Economics of a business - The key factors that affect the ability of a firm to earn an

acceptable rate of return on its owners’ investment. The most important of these factors are

competition, technology, and customers.

Managerial economics - The use of economic analysis to make business decisions involving

the best use of a firm’s scarce resources.

Market process - The use of supply, demand, and material incentives to answer the questions

of what, how, and for whom.

Opportunity cost - The amount or subjective value forgone in choosing one activity over the

next best alternative. This cost must be considered whenever decisions are made under

conditions of scarcity.

Resources - Also referred to as factors of production or inputs, economic analysis usually

includes four basic types: land, labor, capital, and entrepreneurship. This chapter also includes

managerial safe skills and entrepreneurship.

Scarcity - A condition that exists when resources are limited relative to the demand for their

use. In the market process, the extent of this condition is reflected in the price of resources or

the goods and services they produce.

Traditional process - The use of customs and traditions to answer the questions of what, how,

and for whom.

Ask yourself: How do the three basic economic questions relate to the firm?

The Firm and Its Goal

KEY LEARNING POINTS Chapter 2 elaborates on the process of making decisions under conditions of scarcity by

discussing the goals of a firm and the economic significance of the optimal decision while

illustrating key economic concepts and methods of analysis.

The Firm Here are some very important definitions which are discussed at length on page 25. A firm is a

collection of resources that is transformed into products demanded by consumers.

The Profit is the difference between revenue received and costs incurred.

Transaction costs are incurred when entering into a contract.

Types of transaction costs:

a. investigation

b. negotiation

c. enforcing contracts

Examples of Firms are:

a. Kodak – uses off-shoring to source cameras

b. IBM – manufacturing computers overseas

c. exult – third party services used in human resources

d. investigation

e. negotiation

f. enforcing contracts

Economic Goal of the Firm Profit maximization hypothesis: the primary objective of the firm (to economists) is to maximize

profits:

• Other goals include market share, revenue growth, and shareholder value

• Optimal decision is the one that brings the firm closest to its goal

Short-run versus 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

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

Ask yourself: What is the best example of an economic goal of a firm?

Do Companies Maximize Profits? Criticism: companies do not maximize profits but instead merely aim to satisfy, which means to

achieve a satisfactory goal, one that may not require the firm to ‘do its best’ two forces affect

satisfying:

Position and power of stockholders:

▪ Shareholders are concerned with performance of entire portfolio and not individual

stocks

▪ Less informed about the firm than management

▪ Stockholders 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

▪ Managers may be more interested in maximizing own income and perks

▪ Management incentives may be misaligned (eg. revenue not profits)

Divergence of objectives is known as ‘principal-agent’ problem

Counter-arguments which support the profit maximization hypothesis:

▪ Large stockholdings held by institutions (mutual funds, banks, etc.)  scrutiny by

professional analysts

▪ Stockmarket 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

▪ Views the firm from the perspective of a 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: says a dollar earned in the future

is worth less than a dollar earned today

Ask yourself: What is one of the weaknesses you have noticed in your company in pursuing

the objective of profit maximization?

Maximizing the Wealth of Stockholders ▪ Views the firm from the perspective of a 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: says a dollar earned in the future

is worth less than a dollar earned today

▪ Future cash flows (Di) must be ‘discounted’ to find their present equivalent value

o The discount rate (k) is affected by risk

▪ Two major types of risk:

o Business risk

o Financial risk

▪ Business risk involves variation in returns due to the ups and downs of the

economy, the industry, and the firm

o All firms face business risk to varying degrees

▪ Financial risk concerns the variation in returns that is induced by ‘leverage’

o 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

The present price of a firm’s stock should reflect the discounted value of the expected future

cash flows to shareholders (dividends)

Where P = present price of the stock

D = dividends received per year

k = discount rate

n = life of firm in years

If the firm is assumed to have an infinitely long life, the price of a unit of stock which earns a

dividend D per year is given by the equation:

n

n

k

D

k

D

k

D

k

D P

)1()1()1()1( 3

3

2

21

  

P = D/k

Given an infinitely lived firm whose dividends grow at a constant rate (g) each year, the equation

for the stock price becomes:

P = D1/(k-g)

where D1 is the dividend to be paid during the coming year

Multiplying P by the number of shares outstanding gives total value of firm’s common equity

(‘market capitalization’)

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 objective.

Market Value Added (MVA) Another measure of the wealth of stockholders is called Market Value Added (MVA)®

MVA = difference between the market value of the company and the capital that the

investors have paid into the company 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

Economic Value Added (EVA) 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 > 0 shareholder wealth rising

if EVA < 0 shareholder wealth falling

Ask yourself: What are the typical types of risk faced by a firm?

Economic Profits Economic profits and accounting profits are typically different. For instance, Accountants

measure explicit incurred costs, as allowed by GAAP and uses historical cost of machines.

Economists are concerned with implicit costs, called opportunity costs. Accordingly, economists

use replacement cost of machines:

 economic costs include historical and explicit (accounting) costs as well as

replacement and implicit (economic) costs

 economic profit is total revenue minus all economic costs

Global Application: Other Countries and Other Cultures It is important to recognize that multinational firms (e.g., a U.S. parent corporation operating in

many different countries through subsidiaries or branches) will encounter restrictions and

complications, which they must consider in doing business abroad. Some of these are as

follows:

• Foreign currencies

• Legal differences

• Language

• Attitudes

• Role of government