PLEASE KNOW HOW TO DO MANAGERIAL ECONOMICS!!

1 Photo of two gear wheels side by side on top of U.S. currency. © Terry Why/Getty Images Foundations of Managerial Economics Learning Objectives After reading this chapter, you should be able to: Explain that the economic way of thinking considers both monetary and nonmonetary variables and is consistent with the "triple bottom line" of contemporary business firms. Discuss the economic principles of relative scarcity, the market mechanism, and opportunity costs and revenues. Discuss how simple models can be used to explain and predict the actions of individuals and business firms who are pursuing their objective functions. Distinguish between the explicit and the implicit costs associated with a decision. Distinguish between accounting costs and profits and economic cost and profit concepts. Explain how costs and revenues that occur in the future must be discounted back to their net present value. Explain how costs and revenues that are uncertain, due to risk, may be quantified in expected net present value terms. 1.1 What Is Managerial Economics About? Managerial economics concerns the application of economic concepts and the economic way of thinking to the decision-making processes of managers. Managers make decisions in both the private and the public sectors at the household (individuals), organization (firms), and society (governments) levels. Managerial economics facilitates better decision making: that is, it helps managers make decisions that best serve the objectives of the individual, the organization, and/or society. In this book our main interest is in decision making by managers of profit-seeking business firms, but you will see that the same principles also apply to decisions made by not-for-profit organizations, households, and governments. The Economic Way of Thinking When we refer to "the economics" of something, such as a new product proposal or a new infrastructure project, we are usually referring to the costs, revenues, and profit characteristics of that something. Costs are the outflow of funds associated with a decision or action; revenues are the inflow of funds associated with a decision or action; and profits are the excess of revenues over costs—if negative, this difference is known as a loss, of course. These monetary issues are the traditional concern of managerial economics, but increasingly we must also take into account the nonmonetary costs and benefits of our decisions. For example, will the decision contribute positively or negatively to individual satisfaction, business reputation, societal welfare, and/or environmental protection? Nonmonetary cost impacts of a decision are also known as psychic costs. That is, the individual, the firm, or society at large suffer a psychological (or emotional) cost because the decision and its consequences cause what psychologists call negative affect, or a loss of psychic satisfaction, which economists have traditionally called disutility. Conversely, the nonmonetary benefits of a decision or its consequences are known as psychic revenues when they generate positive affect or psychic satisfaction (which we call utility). Almost all decisions have both monetary and nonmonetary consequences. To gain better economic outcomes for individuals, firms, and society, we must take into account the monetary and nonmonetary outcomes. Often there is a simple monetary equivalent for these nonmonetary costs and benefits. For example, individuals expect to be paid more for working in a dirty job. Likewise, we pay an insurance premium to avoid not only the financial cost of replacing our car but also to avoid the psychic dissatisfaction that would be associated with losing the services of our car. In business, we accept higher business risk only if the expected return on investment is also higher. In general, people understand these monetary trade-offs: People are prepared to accept less revenue if it comes with psychic benefits, or conversely they will want more revenue if it comes with psychic costs. Photo of a stack of $100 bills with a single die on top. © Spike Mafford/Thinkstock Businesses take on greater risk when the expected return on investment is also greater. The economic way of thinking can best be summarized as thinking at the margin; that is, considering marginal costs, marginal revenues, and marginal profits rather than focusing on average or total costs, revenues, or profits. The marginal unit of something is the last unit that is either consumed or produced. For example, the marginal cost of production is the change in total costs that is incurred when an additional unit of output is produced, as compared to the average cost of production, which is the total cost of production divided by the total number of units produced. By thinking at the margin, economists ask whether an additional unit of output, or consumption of that output, would improve or reduce individual satisfaction, business profits, and/or societal welfare. The presumption is that if an additional unit will improve the situation, then the decision should be made to do it because we assume that individuals want to maximize their satisfaction, firms want to maximize profits, and societies want to maximize social welfare. In this book, we will encounter a variety of economic concepts that allow us to apply the economic way of thinking in our decision making. As these economic concepts are introduced, many of them will be familiar to you because you already have plenty of experience as an "economic actor" in the economy and in society. You make economically based decisions daily and, consciously or subconsciously, apply economic concepts in your personal and professional decision making. So, managerial economics should be an extension of your intuitive way of making decisions in your personal life into the interactions and decisions you make for your business organization. The conceptual heritage of managerial economics can be found in the tenets of microeconomics, which is the study of the behavior of individual people and organizations in a market economy. Macroeconomics, conversely, is the study of the aggregate behavior of consumers, investors, and governments. Macroeconomics generates many of the variables that enter the decision making of individuals and business firms such as unemployment rates, interest rates, inflation rates, and foreign exchange rates. Governments are fundamentally concerned with managing the macroeconomy, of course. In this book, our main concern is the decision making of business firms who take these macroeconomic variables as givens, as these variables are outside firms' control as individual economic entities. Hence, managerial economics examines the decision-making processes of individuals and other economic entities at the microeconomic level that in aggregate determine the levels of important variables in the macroeconomy. The Use of Models in Managerial Economics In managerial economics, we frequently use simplified representations of reality—known as models—to analyze decision-making problems. A model depicts and defines the relationships among the major variables in a decision problem while abstracting away from (i.e., ignoring) minor influences on the outcome. Professionals in other fields also use models: Architects and planners use scale models of buildings; engineers use scale models of automobiles and aircraft; and fashion designers use human models as representation of you and me! In economics we use symbolic models with words and other symbols that have a specialized meaning. You already know that words like costs and profits have special, more precise meanings in managerial economics. Jargon words are verbal models of things or phenomena. They allow us to communicate more efficiently because they offer a concise and precise means of conveying the information we wish to convey. For example, "utility" is much quicker than saying, "the psychic satisfaction that a consumer expects to derive from the consumption of a product or service." Communication between economists, between managers, and between you and me through the medium of the printed word is substantially enhanced by the use of jargon. Diagrams model a situation by the use of lines, shading, and other features, while abstracting from the finer details. Similarly, a mathematical equation simplistically expresses one (dependent) variable as a function of one or more (independent) variables and does not account for the variability that is likely to occur due to the minor and perhaps random variables that also impact the dependent variable. In this book, we will use a lot of diagrams and a few equations as a quick and effective means of demonstrating the main variables in particular decision problems and the assumed relationship between and among these variables. Our models incorporate assumed relationships among the variables and assumed motivations of the economic actors. For example, we assume that firms want to maximize their profits and that consumers want to maximize their utility. If these assumed relationships are inaccurate, or we have overlooked important variables, these inaccuracies will be revealed by information search and empirical testing—by gathering data to test the model against reality. If our models are found to be excessively inaccurate or misleading, these models may consequently be modified to become more realistic for future applications. There are three main purposes of models. First, models are useful for teaching purposes. They are a useful device for teaching individuals about the operation of complex systems because they allow the complexity of reality to be reduced by abstracting from (i.e., ignoring) variables that have a minor effect on the outcome of a decision. A simple model allows us to deal with the central issues of a decision problem without the added complexity of relatively minor influences. As noted above, models can always be made more complex (and more accurate depictions of reality) by adding the minor variables into the model. Second, models are used for explanatory purposes. They allow us to discover the causal relationships between and among variables. Using prior information and logic we can hypothesize, for example, that sales will increase by 40% if we set up a Facebook page for our business and reward individuals with discount coupons if they recruit their friends to "like" our Facebook page. We would then conduct an empirical test of that hypothesis to confirm (or reject) the hypothesis. If supported by the data, we can then claim to explain the increase in sales as being the result of having a Facebook page and issuing discount coupons to those who recommend our page to their friends. Third, models are used for predictive purposes. We might predict that fuel economy is a negative function of both vehicle weight and engine capacity and develop a simple formula that reasonably predicts the actual fuel consumption of any particular vehicle. This kind of predictive model is typically based on prior empirical studies, and would be periodically adjusted as engine efficiency continues to improve, for example. Another class of predictive model might predict behavior using a model that is completely unrealistic but nonetheless is able to predict outcomes reasonably accurately. An example is the utility-maximizing model of consumer behavior (see Chapter 3) that assumes individuals choose among different items to buy after carefully calculating the utility they will derive from consuming specific goods and services. No consumer actually calculates expected utility, but virtually all consumers act as if they do. Through a complex intuitive reasoning process they decide which products to buy, and typically, these choices are accurately predicted by a simple model that assumes individuals will buy those goods that are expected to give them the most utility (psychic satisfaction) per dollar. So business decision makers are able to focus on what aspects of the product or service will give the customer greater satisfaction and how to reduce costs so that their price can be more competitive. Integrated Managerial Economics Managerial economics is usually taught in the context of a business or MBA degree program alongside other business courses such as accounting, finance, human resource management, marketing, and business strategy. Students may think that these are separate silos of information but in reality economics is the glue that binds them. Any business decision—whether a marketing, financial, accounting, human resource, or a strategic decision—must take the economics of that decision into account. It makes no sense to make decisions in these other business areas without regard to the impact of that decision on cost, revenues, and profits. It is also potentially detrimental to one's objectives to make decisions without regard to the nonmonetary psychic costs and revenues and the monetary trade-offs that are involved. Accordingly, in this book we will integrate examples relating to marketing, finance, accounting, human resource management, marketing, and strategy into our discussion of managerial economics. We shall also utilize some relatively simple quantitative methods (also studied by business students), since we will need to use data to make estimates of demand and costs in later chapters. The Profit Concept The profit concept is central to the pursuit of business and is thus central to the study of managerial economics. As discussed previously, profit is defined as the excess of revenues over costs. For not-for-profit and public-sector organizations, an excess of revenues over costs is called a "surplus." Conversely, if costs exceed revenues, there is a loss, which is known as a "deficit." Regardless of the terms used, no firm or organization can sustain losses or deficits forever. The decision-making problems facing managers of for-profit firms and not-for-profit organizations are essentially similar, involving revenue enhancement if possible and cost control wherever possible. The attainment of profit/surplus and the avoidance of loss/deficit are generally seen as measures of managerial effectiveness, and the market for managers generally rewards (with higher salaries) those who are better at making decisions that raise profit or surplus. Revenues > Costs = Profit (called "surplus" in non-profit firms) Costs > Revenues = Loss (called "deficit" in non-profit firms) It follows that decision making in the areas of revenue enhancement and cost reduction are major themes in managerial economics. Concerning the revenue side, we will study consumer decision making and how we can increase demand for the goods and services provided by firms and other organizations. On the cost side, we consider the production process and the costs associated with producing a product or service for sale. Setting price levels in different market situations is an important decision related to revenue enhancement, and our study of the pricing decision will extend to four chapters. But revenues can also be augmented by improving product design and by better marketing of the firm's products, so we also examine these sources of revenue enhancements, which of course also cause the firm or organization to incur costs. Finally, we bring it all together in the final chapter, which considers the economics of competitive strategy for the business firm. But first we will consider some fundamental concepts of economics that pervade the economic way of thinking and underpin the operation of the national economy and the global economic system. 1.2 Fundamental Concepts of Economics Underlying the economic way of thinking are several concepts that form the foundation on which economic thinking rests. First, we note that economists explain the behavior of economic entities by assuming that they are acting to pursue a particular objective, rather than acting in a random or irregular manner. Second, the principle of relative scarcity—meaning that money, time, and all other resources are in limited supply—underlies all economic analysis. Third, and because resources are in limited supply, the value of those resources in an alternative use (i.e., their opportunity cost) must always be considered. We now consider these in more detail. Economic Entities Have Objective Functions Economists assume that consumers, organizations, and society make decisions purposefully to achieve their specific objectives, which are target outcomes that the decision maker wants to attain. We often talk of the consumer's objective function, the organization's objective function, or society's objective function. We use the word function in the mathematical sense, that is, the level or magnitude of the outcome is a function of the level of the determining variables that the decision maker decides to use. Illustration of a globe with a pie graph, two arrows pointing upward to the right, silhouettes of five business professionals, and four U.S. bills of various monetary values. © Boris Lyubner/Getty Images With the current push towards social and environmental responsibility, more companies are working to achieve the triple bottom line, which is concerned with people, planet, and profit. What is the objective of consumers? Economists view consumers as hedonists who act to best serve their own well-being or psychic satisfaction, which is called "utility." Thus, we assume that consumers decide which goods and services to purchase (the inputs to their objective function) such that they maximize their expected utility. They decide to buy particular goods and services depending on how much satisfaction they expect to gain by consuming each one of those goods and services. As a consumer, you make decisions like this all the time, whether consciously or subconsciously. Think about it: Would you rather spend $500 for a larger TV or for a new rug for your living room? Your answer will depend on how much you think you would enjoy either the new TV or the new rug. If you already have a large TV, or a perfectly good rug, your enjoyment (i.e., your psychic satisfaction) from having a new one would be relatively small because your perceived need for the item would be relatively low. Conversely, if your old TV has a bad picture, or your rug has worn thin, those issues would factor into your purchasing decision. So we proceed on the assumption that consumers make decisions (among alternative combinations of goods and services) to maximize their utility. What is the objective of an organization? Traditionally economists have assumed that the owners or shareholders of the business firm will want to maximize the firm's monetary profit. Shareholders1 want the firm to make a profit to pay out dividends and capital gains so that the shareholders can buy the things they want. But, more recently economists have recognized the triple bottom line concept that says environmentally conscious and socially responsible firms will want to achieve a balance between profits, avoidance of damage to the environment, and achieving social benefits. However, note that firms will pursue the triple bottom line only if their owners and managers want them to, and thus it comes back to the objective function of individuals. Economists incorporate the triple bottom line into their models of business decision making by assuming that many individuals will buy shares in companies that achieve the triple bottom line outcomes they want and will sell shares in companies that do not. Thus, these individuals drive up the stock prices of firms that are environmentally and socially conscious while driving down the stock price of firms that are not.2 Many not-for-profit organizations exist to do good things for society and/or the natural environment. Examples include organizations that want to help disadvantaged individuals, families or groups; organizations that want to save endangered species; and organizations that want to stop the degradation of the natural environment. Again, these organizations operate to achieve what their owners and other stakeholders want them to achieve, so again, it comes back to individual hedonism. Individuals who gain utility from helping others, from saving endangered species, and/or from reducing environment degradation will operate and support such organizations, and the managers of these organizations will need to make decisions that deliver what the owners and stakeholders want.3 At the societal level, governments exist to serve the wants and needs of the people, and accordingly argue about and make decisions that are intended to improve the psychic satisfaction of individuals, the profitability of firms, the welfare of society, and the health of the natural environment. Political differences underlie the arguments about which groups should be the major beneficiaries of policy changes, of course, and there are always winners and losers. For example, passing a new law to restrict pollution will increase the costs and thereby reduce firms' profits (and reduce the utility of shareholders who care only about profits) while increasing the utility of individuals who are more environmentally conscious. Laws that apply domestically but not in foreign countries will also affect the balance of competition between domestic firms and international firms, and thus impose further costs on profit-seeking shareholders while conferring psychic benefits on other stakeholders. Relative Scarcity If everything that people wanted was plentiful, there would be no economic problem. The economic problem is that resources are relatively scarce and must be allocated to best serve the wants and needs of individuals, which are effectively unlimited. Put another way, individuals, organizations, and societies must make allocation decisions because their wants and needs are effectively infinite, whereas the resources to produce and serve those wants and needs are available only in finite quantities. For individuals, except perhaps for the super-rich, needs and wants are typically greater than the income available to purchase goods and services to satisfy those needs and wants. Thus, individuals must make decisions to allocate their limited incomes among a wide variety of goods and services such that their utility is maximized. But even the super-rich have to make allocation decisions. For example, should a billionaire buy a new private jet (for $2.5 million) or fund a charity for homeless people, starving children, threatened species, or the like? It is useful to distinguish between needs and wants. Needs are goods and services that individuals find necessary to survive and to conduct their daily lives. Wants are goods and services that are nice to have but are not necessary to have; individuals gain utility from the consumption of wants but could do without them. Economists like to illustrate the concept of scarcity, and the difference between wants and needs, with the diamond–water paradox. Diamonds are relatively scarce, while water is relatively abundant. Accordingly, water is relatively cheap to buy and diamonds are relatively expensive. The price of diamonds (per carat) is much higher than the price of water (per gallon) because of relative scarcity, not because of necessity. For business firms, managers have to make allocation decisions, such as whether to use $1 million to buy more machines (for a more capital-intensive manufacturing process) or pay more wages (for a more labor-intensive process) in determining the least cost of producing a given output level (so as to maximize the firm's profits). Managers also have to allocate the limited production capacity of their production processes to different products or services to meet the increasing market demand for one product and the decreasing demand for another. For example, should Toyota produce more cars and fewer trucks, or more of one model car and less of another model? Should a hairdresser allocate less floor space to hairdressing chairs and more floor space to places for filing and painting fingernails? Managers of not-for-profit organizations also must decide whether to allocate their scarce funds among competing social and environmental needs. For example, managers of the Save the Children international charity must decide whether to save the children in Eritrea, Somalia, or the jungles of the Amazon. Their limited resources mean they cannot possibly save all the children in all the places where their health and welfare is threatened, so they must make allocation decisions. At the societal level, governments must similarly make allocation decisions. For example, in which region should they spend scarce public funds to reduce poverty, or upgrade the transportation infrastructure, or relocate a government office so as to provide local employment? Should they increase public spending on education or on military preparedness? On the revenue side, should they raise profit taxes or raise individual income taxes? The latter is also an allocation decision because it involves a trade-off of votes (at the next election) from those who earn most of their income from wages or salaries compared to those who earn most of their income from dividends and capital gains. Politicians know that voters who suffer from a government decision like this are likely to vote against the party in power at the next election while those who gain are likely to support that party in a subsequent election. Thus, they effectively trade-off the interests of one group against those of the other and suffer the political consequences of their decisions. Opportunity Costs, Economic Costs, and Accounting Costs Photo of the produce section is a grocery store. The prices of each of the fruits and vegetables are written on black chalkboards. © Stockbyte/Thinkstock Economists are concerned with the explicit and implicit costs. The explicit cost is the sticker price of an item, whereas the implicit cost is the opportunity cost or trade-off associated with buying that item. Scarcity of time and of resources gives rise to what are called opportunity costs. The opportunity cost of something is what you have to give up in order to have that thing. As you know, an opportunity is something that you could do if you had the time and the resources to do it. Because there are only 24 hours in the day and an infinite variety of things you could do with that time, you have to give up one activity (use of the time) to spend time doing an alternative activity. Similarly, to utilize part of your money buying one thing you have to forego the opportunity of spending that money on another thing. For example, if I want to spend $20,000 on a long holiday, then I will have to forego buying a new car. But note that opportunity costs are not simply monetary costs. Economists are concerned not only with the explicit cost of an item (its sticker price) but also want to factor in the implicit cost (other expenses also incurred) associated with buying that item. For example, suppose you took time off from work to drive to a store to buy something on sale for $50, and your tank was empty so you had to buy $10 worth of fuel—just enough to get you there and back. Your explicit costs would be $60. But in addition, you would have an opportunity cost associated with using your owned resources in this way. Owned resources are things that you already own, such as your time, your car, and your other possessions, so they do not directly cost you money to use. Suppose it took an hour to drive to the store and back. First, your time has an opportunity cost when you consider you could have earned $20 had you worked that hour. Second, suppose that the additional wear-and-tear on your car would cause its value to decline by $5. Thus, your implicit costs are $25. The economic cost of the item to you is $85—the sum of the explicit cost ($60) plus the implicit costs ($25) due to spending your time and other owned resources to buy that item. In summary, the economic cost is equal to the opportunity cost of all resources involved in the decision, including both explicit and implicit costs. Similarly, a business firm has to consider both explicit and implicit costs. A firm will pay explicit costs for labor and materials, which should be equal the opportunity costs of those items because, for example, a worker or supplier of materials would refuse to sell labor or materials for a lower price than he could get from another firm. We must also consider the implicit costs of the owned resources of the firm, such as management time, real estate, machinery and equipment, and other items that the firm already owns. If these physical resources were rented or leased, their explicit cost would equal their opportunity cost, but if they are owned resources, they might alternatively be used to produce a more profitable product or be sold for a higher value than they contribute in their current production process. For example, a furniture maker's equipment and skilled labor might be more profitable making custom-designed kitchen units, or the firm's land might be sold to a real estate developer for more than it is worth underneath a factory that makes furniture or kitchen units. Thus, firms must also consider the economic costs of the resources they use if they are to maximize profits for their shareholders. It is important to understand that accounting costs may differ from economic costs. Accounting costs are the costs that firms must use to report their costs and consequent profits to the public. Accountants are constrained by the Generally Accepted Accounting Principles (GAAP) laid down by the Financial Accounting Standards Board (FASB) and the Securities Exchange Commission (SEC). Accountants must follow specific rules so that customers, suppliers, and people who buy and sell shares on stock exchanges can be assured that the costs, revenues, and profits announced to the public have been calculated using accepted accounting principles and procedures. Thus, for financial accounting purposes, the cost of an hour's labor is the explicit cost of the salary paid to the worker plus superannuation payments and labor taxes, if any, and ignores any implicit costs (which might have made the economic cost to the firm higher). Similarly, the accounting cost of a machine will be recorded as the depreciation charge (e.g., 20% of the machine's historical cost rather than the actual cash outflow for the purchase of that machine in the accounting period) plus the costs of repairs and maintenance (which are explicit costs captured in a separate cost category)4 The opportunity cost of the equipment is what it could earn in a different production process, or its resale value, or its scrap value, whichever is the highest. For financial reporting purposes, (financial) accountants ignore these opportunity costs, but for decision-making purposes (managerial) accountants will incorporate the opportunity costs of owned resources into their calculations. Economic cost = explicit cost + implicit cost Accounting cost = explicit cost only Profits are equal to revenues minus costs, but economic costs include both explicit and implicit costs while accounting profits are constrained by the GAAP to include only explicit costs. It follows that if economic costs are likely to exceed accountings costs, then accounting profit may overstate economic profit to the extent that implicit costs are not accounted for. Henceforth in this book when we use the term profit we will mean economic profit, which is a concept that both managerial economists and managerial accountants accept as the appropriate measure of profit for decision-making purposes. The Market Mechanism Economists place great faith in the market mechanism to ensure that buyers can trade money for goods and services, and sellers can trade goods and services for money. The term market mechanism refers to the process by which when demand exceeds supply, prices will rise, and conversely when supply exceeds demand, prices will fall. The market mechanism works because, when demand exceeds supply at any price level, some potential buyers will miss out and will offer slightly higher prices to buy the product or service, which will soon induce suppliers to set price at a higher level. Conversely, when supply exceeds demand at any given price level, some suppliers will be unable to sell their goods or services and will offer to sell at a slightly reduced price, which will soon bring the prices of other suppliers to a lower level (or they would not be able to sell their goods or services). If prices rise when demand exceeds supply, and fall when supply exceeds demand, it follows that when supply and demand are equal the price will be the market equilibrium price. There will be neither seller pressure to reduce prices nor buyer pressure to raise prices, such that the price will remain constant until either the demand or the supply situation changes. The equilibrium price is also known as the market-clearing price because at that price there are no goods and services left in the market unable to be sold, and no buyer left unable to buy. Stock prices on the stock exchange are the best example of a competitive market at work: Stock prices for any particular company rise and fall on a daily basis reflecting the balance of stock supplied for sale and bids made to purchase that stock. Potential buyers (or sellers) of that stock bid to buy (or sell) stock at the price at which they are willing to buy (or sell) and the stock exchange matches people willing to buy at a particular price with sellers willing to sell at that price. Because the matching process starts from the highest bid to buy and proceeds to lower bids, trading continues until there is no seller left who is willing to sell at the highest bid to buy, and thus there is neither excess demand nor excess supply remaining at the equilibrium price. Photo of a smoke stack. © Mike Kirk/LOOP IMAGES/Loop Images/Corbis Untaxed carbon emissions produced as a byproduct of manufacturing is an example of market failure because neither the seller nor the buyer repays the economic value. The stock exchange is an example of a purely competitive market, or a price-takers market, in which sellers have to accept the market price even though they may wish for a higher price, and buyers have to pay the market prices even though they might wish for a lower price. The market mechanism ensures that the combined forces of supply and demand determine the equilibrium market price level and this price must be accepted by both buyers and sellers (but they do not have to buy or sell at that price unless they want to). In other market forms, the sellers are pricemakers; that is, they set the price and the buyers must take it or leave it. In Chapter 7, we examine market structure, which is defined in terms of the relative number of buyers and sellers and the degree of product differentiation. We will see that monopolies (single sellers, such as the electricity company) and oligopolies (relatively few sellers, such as the passenger airplane makers), in both cases facing many buyers, have the market power to raise their prices and make extraordinary profits. Monopolistic competitors (many sellers facing many buyers, such as restaurants in a big city) are also price makers but can only make excess profits in the short term until others copy their point of differentiation. Pure competition features many sellers each selling an undifferentiated product (like people selling stock in a particular company) to many buyers. Because each seller is selling an identical item, price competition prevents one seller from gaining a higher price than others (at any point of time in that market; subsequently excess demand might push prices up or excess supply might press prices down). In some markets there will be market failure, meaning that the market price does not repay the seller for the full economic value of the item being produced and sold. For example, as a byproduct of manufacturing, firms produce carbon, which (in the absence of a tax on carbon production or a carbon-trading system) is not paid for by either the seller or the buyer. Similarly, individuals who drive cars, or use electricity for household appliances, cause carbon to be produced but do not pay a tax on this carbon. Because carbon is effectively free to produce and consume, society consequently gets too much carbon (and this accelerates global warming). To rectify the failure of the market system to put an appropriate price on carbon, governments need to implement a tax on the production and consumption of items that produce carbon. Other instances of market failure include the market for the protection of the environment, endangered species, and human beings who are disadvantaged in some way. Governments and/or socially conscious and environmentally concerned individuals are needed to set up and operate charitable and not-for-profit organizations to rectify such market failures. All of the decisions made by individuals, organizations, and societies are made with an expectation of achieving a particular outcome that will best serve the objective function of the individual, the organization, or society, respectively. Arguably, organizational and societal objectives will reflect the objectives of the relevant stakeholders. But good decisions are not always followed by good outcomes. For many decisions, we cannot be certain that the desired outcome will follow the decision we make because most decision making takes place in an environment of risk and uncertainty. It is useful to distinguish "shareholders" from "stakeholders." A stakeholder is anyone who has an interest in the operations of the firm, and thereby incurs or receives either monetary or nonmonetary costs or benefits as a result of the firm's operations. Thus, shareholders are stakeholders, but so too are non-shareholders who incur monetary or psychic costs, or who gain monetary or nonmonetary benefits, as a result of the firm's operations. Thus, stakeholders include suppliers and buyers and governments (e.g., tax collectors) and anyone else in society whose well-being is reduced or improved because of the firm's operations. [return] This is a simplistic treatment of a complex issue. The monetary trade-off between profits and nonmonetary concerns for particular business firms might be quite high, such that paying attention to the latter might reduce profits substantially and thus reduce the stock price of the firm. Proponents of the triple bottom line argue that socially and environmentally conscious customers will choose to buy (and even pay more for) products and services from firms that pursue the triple bottom line and thus those firms will earn higher profits. Others argue that due to "market failure" the adverse social and environmental effects will not be priced appropriately such that firms will not be adequately compensated (by customers) for paying attention to the social and environmental "externalities" of their production processes, and so will make lower profits unless governments or not-for-profit organizations step in to fix the market failure. [return] The shareholders and supporters of organizations can exert pressure on the managers of those organizations to pay more or less attention to social and environmental outcomes, and typically do this via the Board of Directors (who monitor management decisions on behalf of all the shareholders) or by transferring their investment to organizations that more closely reflect their preferences. [return] Accountants make a depreciation charge against revenue earned in the current period to reflect the portion of the asset's life represented by the present period. For example, if the asset's usable life is five years, the depreciation charge would be 20% of the asset's initial purchase price per year for five years. Note that the explicit cost of the asset is equal to the purchase price in the first year and is zero in the next four years, while the depreciation charge spreads that purchase cost over the expected life of the asset. [return] 1.3 Certainty Versus Uncertainty Certainty means that we know what the outcome of a decision will be before we make it. For example, if I drop a ball, I know the outcome is that it will hit the floor (because I know about gravity). Indeed, I could calculate exactly how many milliseconds it would take for it to hit the floor if I also know the weight of the ball and the resistance to gravity that would be due to wind resistance as the ball fell. But most economic decisions are not this simple—instead they are complicated by the fact that we do not know the outcome in advance. Instead, a range of unknown factors— known but immeasurable factors—and/or potential interventions to the decision outcome (such as the actions of rival firms) cannot be accurately predicted. Managerial decision making takes place in an environment of risk and uncertainty, requiring a manager to apply economic concepts in the context of risk and uncertainty. An early economic theorist, Frank H. Knight (Knight, 1921), made the technical distinction between risk and uncertainty. Risk is involved when the potential outcomes and the probability of each outcome are known in advance of a decision. In the simplest case of dropping a ball, I know the outcome will be that it will hit the floor, and the probability of that happening is 100%. Or, when tossing a coin I know the outcomes are either heads or tails and that there is a 50% probability for heads and 50% for tails (on average, if the coin is tossed many times). Uncertainty, on the other hand, is involved when the potential outcomes are not entirely predictable and/or the probabilities of these are not estimable in advance. Suppose I need to decide whether to drive to work or to take the train. The train runs on a relatively reliable schedule, and I estimate it will take me between 40 and 42 minutes to get to work (door to door). Alternatively, driving my car in city traffic could take as little as 20 minutes or as long as 60 minutes, depending on the (basically unpredictable) degree of traffic congestion due to accidents or street repairs. I need to get to work by 9:00 a.m. for an important meeting. It is already 8:05 a.m., and the train leaves at 8:10 a.m. The potential outcomes of my decision (train or car) are the possible times of arrival at work. The train costs $5 while the economic cost of driving my car would be only $2. What should my decision be? As we shall see, managerial economics provides the tools to make this decision. Business firms face much more complex decisions and must make these in an environment that usually includes both risk and uncertainty. To solve these managerial decision problems, we often "model" the problem and let the economic principles suggest the best decision. For example, an insurance company wants to answer the question: "What premium will allow the company to make a satisfactory rate of return on our business?" The insurance industry sets premiums for particular risks insured on the basis of estimated risk because they take the same risk many times. For example, consider an 18-year-old man seeking accident insurance for his turbocharged sports car. The insurance companies know that the potential outcomes are "no accidents" or "accidents" and from their prior experience insuring 18-year-old males driving sports cars they know the probability of an accident happening within a year is (let's say) 60%. The insurance company models its decision problem by assuming that all 18-year-old males driving a turbocharged sports car are equally liable to crash. Past data also shows that the average cost of repairing these cars is $10,000. This model delivers the answer required: There is a 60% probability of a $10,000 cost of repair (and associated overhead costs including a margin for profit), so the insurer will want to charge an insurance premium of $6,000 to cover the young man's sports car for one year. The Expected Value of Uncertain Events In the previous example above we have calculated the expected value of the possible outcome (that a young male will crash his sports car). The expected value of an outcome is the value of the outcome multiplied by the probability that the outcome will occur. Note that not all young males will crash their sports cars—the probability is that 6 out of 10 actually will crash in any year. Moreover, some will barely scratch their cars while others will absolutely trash their cars, such that the repair cost might vary from nearly nothing to the cost of a new car replacement. The insurance company cannot predict which young males will actually crash, or the extent of the damage in each case (due to limited prior data on individuals coupled with the seemingly random occurrence and severity of car crashes). Thus, the company shares the cost of repairs over all those who take out an insurance policy and sets the premium just high enough to earn a satisfactory profit. In any given year, fewer or more than 60% of these drivers might crash and their repair bill might average more or less than $10,000, but over many cases the best price decision is provided by using the expected value model of the decision problem. As an example of a decision-making problem under conditions of uncertainty, let's consider the pricing decision of a storekeeper who is contemplating the purchase of 200 mangos at the fruit market for $1 each and wants to sell them at a profit before they become over-ripe and thus unsalable. She expects them to last for only three days before they are too ripe to sell, so she has to decide on a price that is sufficiently attractive to her customers so they will buy the mangos within three days. The storekeeper faces several unknown variables. How many customers will actually come into the store in the next three days? Will they be cashed-up or buying only the essentials while waiting for their next paycheck? At what prices are other stores selling their mangos, if they indeed have any to sell? What is the relative quality of these other available mangos? What other foodstuffs will be put on sale in the next few days to tempt customers to spend their money elsewhere? Thus, there are many unknown variables that cannot easily be given a probability of happening. To model this pricing decision we adopt a simplified model that combines all these factors into a single probability—namely, what is the probability that all 200 mangos will be sold at several alternative prices? Table 1.1 shows the data we need to solve this pricing problem. Note that because all other costs of the storekeeper are constant, regardless of this pricing decision, we consider only the incremental costs of the decision. Table 1.1: Expected value of profit contribution at alternative price levels Alternative possible price levels Contribution to profit per mango (cost was $1 ea.) Probability of selling all 200 mangos Expected value of contribution to profit per mango Expected value of total contribution to profit $1.50 $0.50 100% $0.50 $100 $1.75 $0.75 80% $0.60 $120 $2.00 $1.00 70% $0.70 $140 $2.25 $1.25 50% $0.625 $125 $2.50 $1.50 30% $0.45 $90 From the table it is clear that the price that is expected to maximize profit contribution (at $140) is $2.00 per mango. The only difficult part of this pricing decision is estimating the probabilities of selling all the mangos at each price. This estimate has to be provided by the storekeeper, who should be able to make an informed guess about these probabilities from her prior experience with mangos and other food items and the prior behavior of her regular customers and rival stores. These examples demonstrate that the expected value model is a simplified version of a complex situation. In general, models abstract from reality by ignoring the finer details that are not essential to the decision at hand. They concentrate on the major variables and relationships without obscuring the picture with the less important details that vary across individuals and/or are unknowable. Risk Analysis Photo of Euros, two dice with the sixes face up and four aces from a deck of cards. © iStockphoto/Thinkstock Some outcomes (such as four aces when playing cards or double sixes when rolling dice) have very low probabilities, and are thus very risky to gamble on. Individuals who are less risk-averse may be willing to make such gambles, while other more riskaverse individuals may not. Where a decision might be followed by one of several outcomes, the decision maker faces the risk that the expected outcome might not be the one that actually happens. For example, in the above illustration, when price was set at $2.00 each, there was only a 70% probability that all the mangos would be sold, so there is a 30% probability that all the mangos would not be sold. Thus, although the storekeeper's expected value is $140, the actual outcome might be as high as $200 (if all 100 mangos are sold) or as low as, say, $50 (if only 25 mangos are sold). The actual outcome depends on how many mangos actually are sold. If the storekeeper had set the price at $1.50 per mango the probability of selling all was 100%, the mango pricing decision would be risk free, with a certain payoff of $100. By choosing a higher price (to make more profit) the storekeeper took the risk that not all mangos would be sold. Apparently our storekeeper is relatively risk tolerant—she was willing to take the gamble of pricing at $2 per mango, which could pay off a maximum of $200 (with probability 70%) or some lesser sum, rather than taking the certain bet of setting price at $1.50 with payoff $100 (with probability of 100%). In Chapter 2 we will consider the individual's degree of risk aversion and see that some less-risk-averse individuals will prefer the gamble (to make more or less money at the higher price) while other more-risk-averse individuals would prefer the risk-free alternative. Information Search Costs Notice that risk and uncertainty is fundamentally due to the absence of knowledge. We do not know which of the possible outcomes will happen, or what the exact probabilities are that the alternatives will happen, because we do not know enough about the "system" that causes the outcome to occur after a decision has been made. We learn about a system by collecting and making sense of information to better understand the mechanisms within the system that form the linkage between the decision that is made and the outcome that is observed. Collecting and interpreting information typically costs money, and this expense is called information search cost. Decision makers should incur information search costs if they expect the increased revenue (from making a better decision) to exceed the search costs that allow that better decision to be made. As a simple example, a quick phone call to see if the store has a desired item in stock would save the consumer from wasting time and fuel on a fruitless drive across the city to buy that item if it is already out of stock. Similarly, the storekeeper with the mangos might conduct a simple market survey of customers to ascertain what price would be high enough to maximize profit while not so high as to leave her with a pile of over-ripe mangos. 1.4 Multiyear Scenarios Future cash flows must be discounted by a factor (known as the discount rate) that is dependent on the available interest rate if they are to be compared with current cash flows. The opportunity discount rate is equal to the rate of interest that cash held today could earn if invested elsewhere at the same risk. In many managerial decision problems the revenues and costs will be received and incurred over a time interval of more than one year, so it is necessary to discount future-period cash flows to make them comparable (and thus additive) to present-period cash flows. By reducing future cash flows to their present value equivalent, we are able to compare like with like, rather than trying to add or compare cash flows from different time periods, which is like comparing apples and oranges. Net Present Value Analysis A dollar received in the present period is worth more than a dollar received in a future period because an amount less than a dollar received today could be put into a bank and grow to equal one dollar by earning interest before the end of the future period. For example, if I had 91 cents today, and I could earn 10% interest per annum on my 91 cents, it would grow to about $1 in a year (i.e., 91 + 9.1 = 100.1). Thus, if I can earn 10% on any funds that I hold today, a dollar to be received in a year's time should be valued at no more than 91 cents in present value terms. Conversely, if I expect to receive $1.10 in a year's time, it would be worth only $1 in present value terms if I could earn 10% on funds put in a bank today. Cash flows from years 2, 3, 4, 5, and further into the future must be discounted progressively more heavily since even smaller sums held presently would grow to a dollar if allowed to earn interest for more years (i.e., the interest compounds) from the present period out to year 2, 3, 4, or 5 and beyond. Note that discounting back to find the present value of a future period's dollar is the converse process of compounding a present period's dollar up to find its value in a future period. Let us look into the relationship between present value and future value in more detail, using a little symbolic notation. The future value at a point one year hence (FV1) of a present value (PV) is FV1 = PV(1+r) where r represents the rate of interest. Thus, the FV1 of $1 is equal to $1(1.1) = $1.10 in one year (when r = 10%). If that future value were to be re-invested for another year, it would earn 10% on the principal and the interest already earned. That is: FV2 = PV(1+r)(1+r) which is equal to PV(1+r)2. If we were to re-invest the money for a third year we would find FV3 = PV(1+r)(1+r)(1+r) which is equal to PV(1+r)3. More generally, the future value of a dollar to be invested for n years (where n might be 1, 2, 3, 4, 5, etc.) at r percent interest is FVn = PV(1+r)n. Conversely, the present value of a dollar to be received n years into the future is PV = FVn/(1+r)n. Note that the latter element in this expression, 1/(1+r)n, is the discount factor, which is the fraction by which the future value must be multiplied to find the present value of the future sum. As you can see, the discount factor depends on the specific discount rate (r) and the specific period (n) in which the future funds are received or disbursed. For example, when n = 1 (i.e., the next period) and r =10%, the discount factor is equal to 1/(1.1)1 = 0.9091, consistent with the 91-cent example used above. Note further that the discount factor is 1/(1.1)2 = 0.8232 when n = 2, and 1/(1.1)3 = 0.7566 when n = 3, and so on. Thus, amounts to be received further into the future are multiplied by progressively smaller discount factors. Let us illustrate present value analysis with a business example. Suppose a firm has asked for tenders to build a new factory and receives two quotes. Supplier A would charge a total of $3.8 million, payable $1.8 million immediately, $1 million in one year, and $1 million at the end of two years when the project will be finished. Supplier B would charge $4 million, payable $500,000 immediately, $1.5 million in one year and $2 million at the end of two years when the project would be finished. Suppose the firm has sufficient cash to pay for either deal, but has an opportunity cost of 12%, which is the rate of interest it could earn on its cash balances if loaned out at equal risk. Which supplier is offering the better deal? To answer this we must calculate the present value (PV) of each offer, as in Table 1.2. Table 1.2: Present value calculation for cost of new factory Year Tender A cash flows Discount factors* (12%) PVA Tender B cash flows Discount factors* (12%) PVB 0 $1,800,000 1.000 $1,800,000 $500,000 1.000 $500,000 1 $1,000,000 0.8929 $892,857 $1,500,000 0.8929 $1,339,286 2 $1,000,000 0.7972 $797,719 $2,000,000 0.7972 $1,594,388 Totals $3,800,000 $3,490,051 $4,000,000 $3,433,673 *Discount factors are rounded to four decimal places. Using the equation PV = FVn/(1+r)n for each payment, we first calculate the discount factors, which are equal to 1/(1+r)n, where r is the opportunity discount rate (in this case 12%) and n = 0, 1, and 2 in turn. These are shown in the third column for Supplier A and repeated in the sixth column for Supplier B. Multiplying the future value (FV) by the discount factor we find the present value (PV) for each payment, and summing these present values we find that Supplier B actually offers the better deal, being $56,378 cheaper in present value terms, despite having a larger total cost of the project in undiscounted terms. More generally, the present value calculation will involve both revenues and costs, and we will want to net (or subtract) the costs from the revenues in each period to find the net present value (NPV) of each decision alternative. Thus the formula for net present value becomes NPV = FVn/(1+r)n – Cn /(1+r)n , which simplifies to NPV = NCFn/(1+ r)n where NCFn signifies net cash flow in year n. Usually multiyear streams of revenue will require an initial investment cost at the beginning (year 0) with revenues occurring in subsequent years, in which case NCF will be negative in year 1 and positive subsequently.5 We illustrate the calculation of net present value in Table 1.3. Suppose that a new housing development is planned that would cost $15 million in the first year to set up the necessary infrastructure (roads, drainage, electricity supply) and the developer would then build and sell houses over the following five years until the development is complete. As you can see in Table 1.3, there is cash outflow of $10 million in year 1 with zero cash inflows—thus net cash flow (NCF) is –$10 million in year 1. In year 2 the developer spends $3 million building houses and sells those that are completed for a total of $5 million, so the NCF = $2 million in year 2. Similarly, we can verify the NCF values for years 2, 3, 4, and 5. The developer's discount rate is 15% per annum because this is the rate of interest the developer could earn by lending the funds to another developer who wants to build a similar new housing development in another city. To calculate the discount factor for year 1 we set DF = 1/(1+0.15)1 to find DF = 1/1.15 = 0.8696. For year 2 we find DF = 1/(1.15)2 = 0.7561, and so on for years 3, 4 and 5 to arrive at the values shown in the DF column. Multiplying the NCF by the DF for each year we find the NPV of each year's NCF in the final column, and summing these at the bottom of the table we find that the NPV for the housing development project is $4.355 million. Table 1.3: Net present value analysis of the housing development project Year Cash outflow ($m) Cash inflow ($m) NCF ($m) DF @ 15% NPV ($m) 0 10 0 −10 1.0000 –10.000 1 3 5 2 0.8696 1.739 2 5 8 3 0.7561 2.268 3 8 13 5 0.6575 3.288 4 12 20 8 0.5718 4.574 5 5 10 5 0.4972 2.486 Total 43 56 13 4.355 Photo of a chessboard with three pieces: two with dollar signs and one with a clock on top. © Peter Crowther/Getty Images The expected value of a decision is used when more than one possible outcome exists. Expected value is calculated by multiplying the value of the outcome by the probability of its occurrence. Note that we have totaled the cash flow columns in Table 1.3 to show the difference between nominal net cash flows ($13 million) over the five years and discounted net present value of those cash flows ($4.355 million). I hope you can see that it would be managerial folly to make decisions based on nominal dollars rather than net-present-value dollars—cash inflows that are received several years away are worth a lot less (e.g., 49.72 cents in the dollar in year 5 when the discount rate is 15%). If the net cash flows (or the profit rate) had not been as high as those shown in Table 1.3 in the latter few years, this project could have lost money in NPV terms even if the nominal net cash flows remained positive. For example, if the cash outflows remain the same in years 3–5 but the cash inflows fell to $12 million, $15 million, and $8 million (due to a global financial crisis, for example), the nominal net cash flows would be only $5 million over the five-year period and the NPV would fall to −$155,580 representing a loss on the entire project compared with the next best opportunity (i.e., investing the funds elsewhere at 15% per annum). A second important thing to notice from the above examples is that as the opportunity discount rate (ODR) increases, the discount factors become increasingly smaller. From the above examples you will see that the discount factor for cash received in one year is 0.9090 when the ODR is 10%; 0.8929 when the ODR is 12%; and 0.8696 when the ODR is 15%. We know that the ODR is based on the rate of interest that could be earned if the funds were invested at equal risk, so these differences in ODR are due to differences in the risk associated with investment projects—more risky projects should be discounted using higher ODRs. We will return to the issue of differing degrees of investment risk in Chapter 2. Measuring Profit in Different Scenarios Since managers might face either certainty or uncertainty, and profit may occur either only in the present period or in both the present and future periods, managers might be operating in one of four different scenarios as shown in Table 1.4. First, if there are only present period cash flows and these are certain, the managers' decision rule is simply to maximize profit. Second, if they face only present period cash flows but these are subject to uncertainty, they need to maximize expected value (EV) of profits. Third, if they face both present and future period cash flows and these are certain, they need to calculate the net present value (NPV) of profits. And, fourth, finally if they face future period cash flows and these are subject to uncertainty, they need to calculate the expected net present value (ENPV) of profits. In managerial decision making the final scenario is the most common situation. Table 1.4: The decision criterion for profit maximization under different decision scenarios Present period Future periods Certainty Maximize Profit Maximize NPV of Profit Uncertainty Maximize EV of Profit Maximize ENPV of Profit To calculate the ENPV of uncertain future revenues and costs we would first calculate the EV for each future period and then use the appropriate discount factor to calculate the present value of each expected value. Subtracting costs from revenues in each year would then give us the ENPV of future profits. This is best demonstrated using a decision tree format. Decision Trees A decision tree is useful to depict decisions that involve multiyear net profits with potential variability of the outcomes in each year. A decision tree shows the potential outcomes of a decision like branches on a tree (that is, lying sideways!), as shown in Table 1.5. This example relates to a young entrepreneur who is considering establishing a microbusiness to print and sell souvenir T-shirts in the two years prior to the Olympic Games. Depending on the success of his designs and the quality of rival designs, he expects that demand will be high, medium, or low in each year, with probabilities 0.2, 0.3, and 0.5 in the first year and probabilities 0.4, 0.4, and 0.2 in the second year, respectively. He will need to invest $2,000 in the necessary equipment right now, and his opportunity cost of the funds involved is 10%. Table 1.5: Decision tree analysis to calculate ENPV of profits (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) Year 0 Year 1 Year 1 Year 1 Year 2 Year 2 Year 2 Cost ($) Demand probability Profit ($) PV (DF = 0.909) Demand probability Profit ($) PV (DF = 0.826) NPV of Profit ($) Joint probability ENPV of branches ($) High (P = 0.4) $12,500 $10,325 $17,415 0.08 $1,393 High (P = 0.2) $10,000 $9,090 Medium (P = 0.4) $5,000 $4,130 $11,220 0.08 $898 Low (P = 0.2) $1,000 $826 $7,916 0.04 $317 High (P = 0.4) $12,500 $10,325 $11,961 0.12 $1,435 −$2,000 Medium (P = 0.3) $4,000 $3,636 Medium (P = 0.4) $5,000 $4,130 $5,766 0.12 $692 Low (P = 0.2) $1,000 $826 $2,462 0.06 $148 High (P = 0.4) $12,500 $10,325 $7,416 0.20 $1,483 Low (P = 0.5) −$1,000 −$909 Medium (P = 0.4) $5,000 $4,130 $1,221 0.20 $244 Low (P = 0.2) $1,000 $826 −$2,083 0.10 −$208 ENPV = $6,402 Photo of a person wearing a suite holding a crystal ball containing the financial section of a newspaper. © Fredrik Skold/Getty Images Using models for predictive purposes enables business decision makers to focus on what aspects of a product or service will provide the customer greater satisfaction and how to reduce costs to maintain competitive prices. You can see that the table looks something like a tree lying on its side—the trunk of the tree in year 0 (column 1) splits into three branches in year 1 and each of these branches splits into three more branches in year 2 (column 5), making nine possible outcomes at the end of year 2 (column 8). These terminal branches each have a joint probability of occurring, equal to the joint probability of demand being high, medium, or low in the first year in combination with being either high, medium, or low in the second year.6 Weighting the NPV (in column 10, which is the sum of columns 1, 4, and 7) by the joint probabilities gives us the ENPV for each terminal branch, and summing these vertically in column 10 gives us the ENPV of the entrepreneur's project.7 Because the ENPV is positive and of significant magnitude, we conclude that the young entrepreneur should certainly invest in this project, unless he could utilize his time and money in an even more lucrative project (i.e., one with a higher ENPV). We should make it perfectly clear that the expected value analysis presumes that the individual makes many similar decisions, such that over all these decisions the total outcome would approximate the sum of the expected values for all the decisions. So, for a construction manager who continually tenders quotes for building new buildings, she can win some and lose some and expect to be better off at the end of the year by using the expected value approach. But for a one-shot deal, such as the T-shirt project, the actual outcome might be as high as $17,415 or as low as −$2,083 in NPV terms, and there are no other similar ventures the entrepreneur could use to "average out" the profit outcomes. But, if this entrepreneur did continue to undertake similar projects he would, in effect, be conducting many trials of this gamble and should expect to earn the sum of the ENPV of those many projects. The ENPV analysis we have conducted here essentially assumes the decision maker is risk neutral with respect to any one project, which may not be true, of course. In Chapter 2, we will consider different attitudes to risk and risk-adjusted decision making, and you will be equipped to advise the entrepreneur whether or not he should undertake this project. Note that because we are talking about economic profits, these costs in each period must be economic costs (i.e., both explicit and implicit costs) rather than simply the actual (explicit) costs. [return] The joint probabilities in column 9 are found by multiplying the probability in column 2 by the probability in column 5. The joint probability of an event is the probability of two events occurring together, and is found by multiplying the probability of one event by the probability of the second event. For example, the probability of demand being high in the first year (0.2, or 20%) is multiplied by probability of demand also being high in the second year (0.4, or 40%) to find the joint probability of demand being high in both years to be 0.2 x 0.4 = 0.08. [return] The ENPV is effectively a weighted average of the NPVs, where the weights attached to each branch of the decision tree is the joint probability of being on that branch. [return] Summary In this chapter we have introduced and considered the nature of, and the fundamental building blocks of, managerial economics. Managerial economics is based on microeconomics, the study of individual economic entities, such as consumers and business firms. The economic way of thinking is to consider changes at the margin and to incorporate monetary trade-offs for nonmonetary costs and benefits. The study of economics makes liberal use of models, or simplified depiction of reality, to explain, predict, and teach people about complex systems. We have argued that managerial economics should be integrated into the accounting, financial, human resource, marketing, and strategic decisions that managers make, since in all cases managers are trying to increase the profitability of the firm, or are considering monetary trade-offs to achieve the nonmonetary objectives of the firm (when pursuing the triple bottom line outcome of a suitable balance between economic, social, and environmental net benefits). We noted that economic actors each pursue their objective function and must make allocation decisions because of relative scarcity. Consumers have limited means (income and/or assets to sell) but have effectively unlimited appetites for utility. Firms have limited funds to allocate amongst different resource combinations but must choose the combination that maximizes their profits. If firms observe the triple bottom line objective function, they will seek a balance between profits and benefits to society and to the natural environment. The extent of this balance, which typically involves a trade-off between profit and the other nonmonetary benefits, will be driven by shareholders who push the firms to pay more (or less) attention to the social and environmental outcomes. Other organizations, such as charities and not-for-profit organizations, typically seek to maximize the social and/or environmental benefits while earning enough revenue to avoid a deficit. Economic costs are defined to include both explicit and implicit costs, both of which should be valued at their opportunity costs. These often differ from accounting costs, which typically neglect the implicit costs in order to adhere to the "generally accepted accounting principles" required by the Securities and Exchange Commission (in the United States, or equivalent body in other nations). It follows that the economic profits of firms may differ from the accounting profits, since costs may be measured differently. Understanding the market mechanism is fundamental to an understanding of managerial economics. While different market forms will be discussed in Chapters 7 and 8, we introduced the notion of competitive markets, like the stock exchange, where the forces of demand and supply combine to determine the equilibrium market price, where buyers and sellers have to be price takers. In other market forms, with fewer sellers and/or differentiated products, sellers can be price makers. The price chosen in these markets is important because the price charged for goods and services (the explicit cost) should be equal to its opportunity cost, since this underlies the calculation of economic profit. Next we defined certainty, risk, and uncertainty. Business managers typically must make their decisions in a context of risk and uncertainty. Risk can be narrowly defined as the situation where alternative outcomes are known, with known probabilities, whereas in uncertainty, all outcomes may not be foreseen and probabilities cannot be reliably estimated. We commonly treat risk and uncertainty as a composite concept, often simply referring to it as "risk." Information search cost can be incurred to obtain more information, which will usually allow more reliable estimates of the outcome magnitudes and of the probabilities. When there is more than one possible outcome to a decision, we need to calculate the expected value (EV) of the decision, which is the value of the outcome multiplied by the probability of its occurring. Where the financial outcomes of a decision are spread over more than one year, we need to calculate the present value (PV) of the decision, which is the sum of the products of the cash flows in any year multiplied by the appropriate discount factor. The appropriate discount factor is the opportunity cost of the funds involved, at equal risk. When there are both multiple possible outcomes and these occur over multiple years we need to calculate the expected net present value (ENPV) of the decision. We calculate the ENPV by first summing the present values of the net cash flows for each terminal branch on the decision tree, then multiplying this by the joint probability of its occurring, and finally summing these ENPVs of the terminal branches to find the overall ENPV of the decision. The ENPV approach will be appropriate for most real-world business decision problems because revenues and costs are received to be incurred into the future, and the values of these cash flows are not known with certainty. Questions for Review and Discussion Click on each question to reveal the answer. Why do some business firms pursue a triple bottom line outcome while others focus only on profit maximization? In what ways can customers influence a firm to pay more attention to the preservation of the natural environment? What do we mean when we say that consumer needs and wants are unlimited? Do we mean they are greedy and would not give part of their income to charities? Why are the explicit costs of an item that you could purchase usually equal to the opportunity cost of that item? Can you envision a situation where the explicit cost of an owned resource would be less than its opportunity cost? When will economic profits be less than accounting profits and why? What would be the result, in a price-maker market, if a decision was made to price an item (its explicit cost) at a level higher than its opportunity cost? Distinguish among certainty, risk, and uncertainty, and explain how information search could reduce uncertainty or even change uncertainty to certainty. What is the profit-maximizing decision criterion when there is uncertainty and the costs and revenue outcomes are spread over several years? Why? Using the concept of a decision tree, explain what we mean by the "path-dependency" of outcomes. Why is the joint probability of two uncertain events always smaller than the individual probabilities of those events occurring separately? Decision Problems A global soft drink company has announced it will establish a foundation to provide scholarships to students at a local university. It proposes two alternative timelines, due to a current cash-flow problem: Either it will provide an immediate $10m fund, or it will provide $11.5m over two years, payable $2.5m immediately, $4m next year, and $5m in two years. The university president announces to the faculty that he will accept the $11.5m alternative. As a managerial economics student you are concerned that he has not made the best decision. Assuming the opportunity interest rate is 14%, what is the present value of the $11.5m alternative? Would your decision change if the opportunity interest rate was 16% or 12% instead of 14%? Explain to the president, in a memo of 200 words or less, which alternative should be accepted. The Pulitzer Publishing Company is considering offering a contract to an author who has written a book on the European Debt Crisis. This project would involve reviewing, editing, designing artwork, and layout of the book at an estimated cost of $160,000, payable at the end of year 1 before a single book is printed or sold. The publisher expects to sell 40,000 copies by the end of year in year 2, 35,000 copies in year 3, 25,000 copies in year 4, and 5,000 copies in year 5. It plans to sell the rights to an Internet bookseller at the end of year 5 for $20,000. Its production, distribution and royalty costs are expected to be constant at $3 per book and it will receive $7 per book (wholesale price to booksellers). These prices are expected to stay the same over the five-year period. The funds could alternatively be invested in a Greek Government bond issue of similar risk that would pay 18% per annum. Calculate the NPV of the book project, assuming that all cash flows are spent or received at the end of the year nominated. How would the NPV vary if the opportunity discount rate was much higher, say 25%? Advise the publisher whether it should proceed to offer the author a contract on the proposed terms. The owner of a restaurant approaches you and offers you the following deal. You would give up your current $55,000 per annum job to manage his restaurant while he returns home to his country for two years to complete his compulsory military service. He shows you all his records and you see that the restaurant had total sales of $200,000 last year with costs of only $120,000. You expect the revenue and cost situations to remain stable for the next two years. The restaurant owner wants you to pay him $50,000 up front but would allow you to keep all the profits you earn over the next two years (before handing the restaurant back to him upon his return). You know that you could alternatively loan your $50,000 to another restaurant business for a 20% annual rate of return. But this opportunity does appeal to you, since you would gain experience operating a restaurant without incurring the full cost of buying one. What is the net present value of this opportunity based on the figures provided? What other implicit costs or revenues might you consider before making your decision? What would be your response to the restaurant owner? The University of Dingbat is considering whether to buy an "off-the-shelf" student management system or have its IT people build a similar system in-house. There are several such systems on the market and the one that is most like what the university wants is priced at $200,000. The IT manager says she can replicate that system using current employees for as little as $50,000, but admits there might be cost and delivery-time variations due to unexpected problems that might arise. She provides a probability distribution of cost levels and delivery times as follows. Possible cost for in-house delivery of new system ($) Month of delivery Probability 50,000 12 0.25 100,000 24 0.50 150,000 36 0.25 This kind of student management system is expected to save the university about $125,000 per year in labor costs, as well as deliver increased student satisfaction with beneficial impact on future revenues. The off-the-shelf system could be operational within 12 months, whereas the in-house alternative might take anywhere from 12 to 36 months to become operational, as indicated in the table. The university considers that its opportunity discount rate is 8%. Calculate and compare the expected value of the "off-the-shelf" system with the expected value of the "in-house" alternative system (in undiscounted dollars). Calculate and compare the expected present value of the two alternatives— ignoring the future revenue impact of a better student management system. By how much would future revenues need to increase (due to this system) to make the two alternatives equal in EPV terms? Advise the university president which option should be adopted, with your reasoning. Home Goods Stores operates a chain of retail supermarkets across the state. The chief executive officer (CEO) wants to open a new store in your area, but seeks guidance as to whether it should be a regular-sized store or a super-sized store. The initial costs, expected demand scenarios, associated profit data, and the probabilities are shown in the table below. The CEO is considering only a two-year horizon, since he expects to be retired by then. He feels that the opportunity discount rate should be 10%. Note that demand conditions could vary from year to year—demand could be high in the first year and low in the second year, due to conditions outside the firm's control. Store size Initial cost ($m) Demand situation Year 1 profit ($m) Probability Year 2 profit ($m) Probability Low 30 0.2 50 0.2 Regular 85 Medium 50 0.5 80 0.4 High 80 0.3 100 0.4 Low 20 0.4 60 0.3 Super 100 Medium 80 0.4 90 0.5 High 100 0.2 120 0.2 Which store promises the larger expected net present value? What is your advice to the CEO of Home Goods Stores? Key Terms Click on each key term to see the definition. accounting costs The debits or subtractions recorded in an accounting book, including taxes, interests on loans, depreciation, and other business-related expenses. accounting profit The profit that remains after the explicit costs of production and selling have been subtracted from the revenues earned from the firm’s production and sale of goods or services. average cost of production The total cost of production divided by the total number of units produced. costs Expenses incurred by the firm when procuring resources, maintaining debt, paying for property, and so on. decision tree Helps a manager make a business decision by showing the outcomes of a given choice. It is a diagram with branches, like a tree lying sideways, which can include statistical probability values for each of the possible branches occurring. diamond–water paradox Illustrates the concept of scarcity and the difference between wants and needs. Diamonds are relatively scarce, while water is relatively abundant. The price of diamonds (per carat) is much higher than the price of water (per gallon) because of relative scarcity, not because of necessity. discount factor The fraction by which the future value must be multiplied to find the present value of the future sum. disutility The negative utility, or loss of psychic satisfaction, derived from an unpleasant outcome. economic cost The sum of the opportunity costs of all resources involved in a decision, including both explicit and implicit costs associated with that decision. economic problem Occurs when all needs and wants cannot be satisfied simultaneously because resources are relatively scarce and must be allocated to best serve the wants and needs of individuals, which are effectively unlimited. economic profit Is different from the accounting profit because it is not calculated simply by looking at explicit revenues and costs recorded in the accounting books, but also takes into account the implicit opportunity costs associated with conducting the business. expected net present value (ENPV) Before a business decision maker can make a significant investment, he or she has to calculate the ENPV of this investment decision by converting uncertain future revenues and profits into expected net present value to determine if the resulting figure is positive or negative, and thereby if the decision is beneficial or not. expected value The predicted worth of an investment or other action, computed by multiplying the possible outcome by the probability of that outcome. Where there are multiple possible outcomes, the expected value is sum of the outcomes each multiplied by its probability of occurring. explicit cost Actual “out-of-pocket” payments made by a person or organization to another party for products or resources provided. implicit cost An expense that reflects the lost opportunity of utilizing particular resources for some other purpose. For example, money that is left in a savings account can make a small amount of interest income, which would be lost if that money is invested into buying a new piece of machinery. information search cost An expense suffered by a consumer or manager in spending energy, money, or time searching for information about products or resources. macroeconomics The study of broad economic problems, such as monetary inflation, national unemployment, and economic growth, which informs governments to determine the best economic policies for their countries. marginal cost of production The cost of producing one more unit of a particular product. This cost calculation helps businesses to make profit-maximizing decisions by calculating the change in the total cost of production due to generating one more item. market equilibrium price The price at which the supply of goods or services to a market equals the demand for these same goods or services. You can visualize a store where a farmer ships nine boxes of tomatoes on a given day, and each day consumers come in and buy exactly nine boxes of tomatoes in total, without anybody wanting more tomatoes to buy, and without the farmer wishing to sell more tomatoes. market failure Occurs when a market system is unable to properly account for the external costs of production (e.g., pollution) such that the market price of the firm’s output is too low and thus too much is demanded relative to the amount that would be socially optimal (if firms were forced to internalize their external costs of production). market mechanism Refers to a system in which when demand exceeds supply, prices will rise, and conversely, if supply exceeds demand, prices will fall. market-clearing price The market price that leaves no buyer wanting to pay any more and no seller wanting to pay any less, otherwise known as the market equilibrium price. microeconomics The economics of individual consumers and producers within the larger economy. model A simplified representation of reality used to analyze decision-making problems. net present value (NPV) Is calculated by first subtracting the costs from the revenues in each period to find the net cash flow, then multiplying this value by a discount factor reflecting the appropriate opportunity discount rate and the number of periods into the future that the net cash flow occurs. If net cash flows occur in multiple future periods (to constitute a stream of cash flows), the present values of the net cash flows (i.e., their NPVs) are added together to find the NPV of the stream of net cash flows. If the NPV value is negative, the manager is facing an unprofitable investment decision. opportunity costs The implicit costs associated with choosing to do something, and as a result foregoing the opportunity to do something else that would be the next-best usage of one’s time or resources. opportunity discount rate The rate of interest that cash held today could earn if invested elsewhere at the same risk. price-makers Firms that can set their price independently because they have the economic power due to the differentiation of their product relative to other suppliers’ products in the same product category. price-takers Firms that sell undifferentiated products and are forced to trade their goods or services at the equilibrium price set by the market because they hold an insignificant share of the market and cannot directly influence the market price. probabilities The percentage chance that a particular outcome or event will happen. Probabilities may be estimated by calculating how frequently the event has happened before relative to the times it could have occurred. profits Are calculated by subtracting the total costs of a business (including salaries, furniture, buildings, loan payments, etc.) from the total revenues (sales of goods and services) made by a given company. revenues The amount of money a company makes from the sale of its goods or services, minus the refunded value of any returns in a given period. risk The variability of outcomes that may follow an action or decision. Risk means the results may not be what one anticipates when one makes a decision or starts a new project. triple bottom line An economic impact calculation that takes into account not only financial costs and benefits of running a business, but also the environmental and social impacts a company makes. uncertainty The doubts associated with predicting the outcome of a decision, in terms of unpredictable costs, benefits, and effects. utility The psychological satisfaction people expect to receive from doing something. People are motivated to increase their utility and their actions and decisions are driven by this need.