Unit 1 Fundamentals of Managerial Economics Chapter 1

Unit 1. Fundamentals of Managerial Economics (Chapter 1)

“Hindsight is 20 -20” “It’s easy to identify successful strategies (and the reasons for their success) or failed strategies (and the reasons for their failures) in retrospect. It’s much more difficult to identify successful or failed strategies before they succeed or fail. ” Luke Frueb and Brian Mc. Cann Managerial Economics (2008)

Lucky or Good? While there is no doubt that luck, both good and bad, plays a role in determining the success of firms, we believe that success is often no accident. We believe that we can better understand why firms succeed or fail when we analyze decision making in terms of consistent principles of market economics and strategic action. Besanko, et. Al Economics of Strategy (2 nd)

Common Causes of Failed Strategies 1. Relevant information a. Not enough b. Enough BUT either ignored or used/analyzed incorrectly 2. Irrelevant information used

Microeconomics is the study of how individual firms or consumers do and/or should make economic decisions taking into account such things as: 1. 2. 3. 4. 5. Their goals, incentives, objectives. Their choices, alternatives, problems. Constraints such as inputs, resources, money, time, technology, competition, supply & demand factors. All (cash & noncash) incremental or marginal benefits and costs. The time value of money.

Managerial Economics is microeconomics applied to decisions made by business managers.

Goals, Incentives, Objectives A fundamental economic truth is that individual firms or decision makers respond to economic incentives. What these incentives are (i. e. money, profits, utility, etc. ) and how they influence economic decision making are key topics for study and analysis in business (or managerial) economics.

Managerial Goals (examples) $ sales, total revenue, gross income, market share Q sales, Q of output, output per unit of input (production efficiency) $ costs, total costs, cost per unit of output (cost efficiency) $ profits, total profits, profit per unit of output

Managerial Choices (examples) Output quantity Output quality Output mix Output price Marketing and advertising Production processes (input mix) Input quantity Production location Production incentives Input procurement

Michael Porter’s “Five Competitive Forces” = Decision-making constraints = Factors that influence the sustainability of firm profits 1. Market entry conditions for new firms 2. Market power of input suppliers 3. Market power of product buyers 4. Market rivalry amongst current firms 5. Price and availability of related products including both ‘substitutes’ and ‘complements’

Drive Rental Car or Co. Car? Sue has been asked by her boss to attend a business meeting 125 miles away. She has two alternatives for getting to the meeting and back: 1) rent a car for $50 plus fuel costs or 2) drive a company-owned car. Her boss has asked her to choose the cheapest form of transportation for the company. What should Sue do?

Buy New Book or Used Book? Joe has signed up to take an Econ class which is about to begin. His instructor expects him to read material from the textbook and to access/use on-line supplements. Joe has two alternatives: 1) buy a new book for $120 which gives him the supplements at no additional charge or 2) buy a used book for $70 which does not include the supplements so they would have to be purchased separately for $35. What should Joe do?

Fuel Once or Twice? Suppose an airline company has a round trip flight from Houston to Cancun to Houston. Soaring oil prices have airlines scrambling to save money on fuel. The company has noticed fuel prices are 17 cents per gallon less in Houston vs Cancun. Rather than refueling in Cancun, the airline is thinking about buying enough fuel for the whole trip in Houston before departure. What are the ‘marginal’ analysis considerations in this case?

How Much to Spend on TV and Radio Advertising? Total Spent New Beer Sales Generated (in barrels per year) TV Radio 0 0 $100, 000 4, 750 950 $200, 000 9, 000 1, 800 $300, 000 12, 750 2, 550 $400, 000 16, 000 3, 200 $500, 000 18, 750 3, 750 $600, 000 21, 000 4, 200 $700, 000 22, 750 4, 550 $800, 000 24, 000 4, 800 $900, 000 24, 750 4, 950 $1, 000 25, 000 $0 Max B(T, R) Subject to: T + R = 1, 000

What Is the Additional Revenue? Suppose a statistician in your firm’s research department has given you his/her mathematical estimate of your company’s sales (total revenue = TR and Q = quantity of output) as follows: TR = 7 Q -. 01 Q 2 What will be the added revenue of selling another unit of output? If the added cost of producing another unit of output is constant at $2. 00, at what level of output is the additional revenue generated from that output just equal to the added cost?

Purchase Agreement – Good or Bad? With short-term interest rates at 7%, Amcott’s CEO (Ralph) decided to use $20 million of the company’s most recent annual retained earnings to purchase the rights to Magicword, a software package that converts French text word files into English. The purchase agreement is for the next three years. Ralph has projected Amcott will earn an additional $7 million net profits annually for each of the next three years as a result of the agreement. After learning of Ralph’s decision, some members of Amcott’s board have been critical of Ralph’s decision and are considering firing Ralph. Is the board’s criticism of Ralph’s decision justified?

Marginal Analysis of ‘marginal’ costs and ‘marginal’ benefits due to a change Marginal = additional or incremental Costs and benefits that are constant (i. e. fixed, don’t change) are excluded from the analysis Changes occurring at ‘the margin’ are all that matter Two important dimensions of change: direction, magnitude

“Good” Economic Decisions Marginal benefits > marginal costs Examples of marginal benefits: ↑ profit ↑ revenue ↓ cost ↑ safety ↓ risk Marginal costs = opposite of above examples

Marginal Analysis (Examples) Y Incremental Y/ Incremental X MR TR X Units of output TC Units of output MC TP Units of input MP TRP Units of input MRP TC Units of input MFC TU Units of good MU Profit Units of output MP

P&Q Relationship? Assume you are a member of your company’s Marketing Dept. You believe, and correctly so, 1) the market demand for your firm’s product is linear, 2) if your company charges $5. 00 for its product, quantity sold would be 200 units and 3) if your company set price = $3. 00, the number of units sold would be 400. Develop alternative ways of explaining to upper-level management more fully the relationship between the company’s price and the resulting number of units of product sold.

Variable Relationships Example of Alternative Ways of Depicting Tabular P Q $7 0 6 100 5 200 4 300 3 400 2 500 1 600 0 700

Variable Relationships Example of Alternative Ways of Depicting Graphical

Variable Relationships Example of Alternative Ways of Depicting Mathematical Q = 700 – 100 P P = 7 – 0. 01 Q

Common Math Terms Used in Economic Analysis Term Definition Variable Something whose value or magnitude (often Q or $ in Econ) may change (or vary); usually denoted by letter ‘labels’ such as Y, X, TR, TC Parameter or Constant Something whose value does NOT change General equation or function A mathematical expression that suggests the value of one variable relates to or depends on the value of another variable (or set of variables) without showing the precise nature of that relationship [e. g. y = f(x)].

Common Math Terms Used in Economic Analysis Term Definition Specific equation or function A mathematical expression that shows precisely how the value of one variable is related to the value of another variable (or set of variables) [e. g. y = 10 + 2 x]. Inverse equation or function A mathematical expression rewritten so that the variable previously on the right-hand side of the equal sign now becomes the variable solved for on the left-hand side of the equal sign [e. g. y = 2 x and x = 1/2 y are each an inverse equation of the other].

Common Math Functions Used in Economics Function Form Name of Function Graph of Function Y = a 0 Constant Horizontal straight line with slope = 0 Y = a 0 + a 1 x (or y = mx + b) Linear Straight line with slope = a 1 (or = m) Y=a 0+a 1 x+a 2 x 2 Quadratic Parabola (u-shaped curve) with either minimum or maximum value Y=a 0+a 1 x+a 2 x 2+a 3 x 3 Cubic Curved line (e. g. slope changes from getting flatter to steeper Y=a 0 x-n Hyperbola Curved line (u-shaped) bowed towards origin

“Ceteris Paribus” Y = a + b 1 X 1 + …bn. Xn=> the value of Y depends on the values of n different other variables; a ‘ceteris paribus’ assumption => we assume that all X variable values except one are held constant so we can look at how the value of Y depends on the value of the one X variable that is allowed to change

Straight Line Equation Given 2 pts on a straight line, how to solve for the specific equation of that line? Recall, in general, the equation of a straight line is Y = a + b. X, where b = the slope, and a = the vertical axis intercept. The specific equation has the values of ‘a’ and ‘b’ specified. Solution procedure: 1. Solve for b = Y/ X = (Y 2 -Y 1)/(X 2 -X 1) 2. Given values at one pt for Y, X, and b, solve for a (e. g. a = Y 1 – b. X 1)

Graphical Concepts (Variable Relationships) Y axis: a vertical line in a graph along which the units of measurement represent different values of, normally, the Y or dependent variable. Y axis intercept: the value of Y when the value of X = 0, or the value of Y where a line or curve intersects the Y axis; = ‘a’ in Y = a + b. X

Graphical Concepts (Variable Relationships) X axis: a horizontal line in a graph along which the units of measurement represent different values of, normally, the X or independent variable X axis intercept: the value of X when the value of Y = 0, or the value of X where a line or curve intersects the X axis

Graphical Concepts (Variable Relationships) Slope: = the steepness of a line or curve; a +(-) slope => the line or curve slopes upward (downward) to the right = the change in the value of Y divided by the change in the value of X (between 2 pts on a line or a curve) = Y/ X = 1 st derivative (in calculus) = Y/ X using algebraic notation = the ‘marginal’ effect, or the change in Y brought about by a 1 unit change in X = b if Y = a + b. X

‘Slope’ Graphically

Slope Calculation Rules (slope = Y/ X = dy / dx) Rule Example 1. Slope of a constant = 0 If y=6, slope = 0 2. ‘power rule’ => slope of a function y = axn is (n)(a)xn-1 If y=3 x 2, slope = (2)(3)x 2 -1=6 x If y=x, slope = (1)x 1 -1=1 3. ‘Sum of functions rule’ = slope If y = x + 3 x 2, slope = 1 + 6 x of the sum of two functions is the sum of the two functions’ slopes

Mathematics of ‘Optimization’ a decision maker wishes to either MAXimize or MINimize a goal (i. e. objective function) For a function to have a maximum or minimum value, the corresponding graph will reveal a nonlinear curve that has either a ‘peak’ or a ‘valley’

Mathematics of ‘Optimization’ The mathematical equation of the function to be optimized will have THE VERTICAL AXIS VARIABLE ON THE LEFT-HAND SIDE OF THE EQUATION (e. g. Y = f(x) Y is the vertical axis variable) the slope of a curve at either a peak or a valley will = 0; in math terms, the slope is the first derivative (I. e. d. Y/d. X = 0) ‘Constrained optimization’ do the best job of maximizing (or minimizing) a function given constraints; the ‘Lagrangian Multiplier Method’ is a mathematical procedure for solving these kinds of problems

Typical ‘Time Value of Money’ Problems in Business How to compare or evaluate two different dollar amounts at two different time periods? $X 0 $Y t 1 t 2 t 3 Assume x = $900, y = $1000, r = 6%, t 1 = 3, t 2 = 5

Time Value of Money (Basic Concept) A dollar is worth more (or less) the sooner (later) it is received or paid due to the ability of money to earn interest. present value + interest earned = future value Or future value - interest lost = present value

Time Value of Money (Applications/Uses) 1. To evaluate business decisions where at least some of the cash flows occur in the future 2. To project future dollar amounts such as cash flows, incomes, prices 3. To estimate equivalent current-period values based on projected future values

Time Value of Money Concepts PV = present value = the number of $ you will be able to borrow [or have to save] presently in order to payback [or collect] a given number of $ in the future FV = future value = the number of $ you will have to pay back [or be able to collect] in the future as a result of having borrowed [or saved] a given number of $ presently

Time Value Equation FV 1 FV 2 • • FVn = = = PV + PV(r) PV(1+r) FV 1+FV 1(r) FV 1(1+r) PV(1+r)2 = PV(1+r)n

Time Value Problems Given FVn = PV(1+r)n Solve For PV, r, n FVn = PV(1+r)n = ‘compounding’ FVn, r, n PV=FVn[1/(1+r)n] = ‘discounting’ FVn, PV, n r (1+r)n=FVn/PV ( find in ‘n’ row) FVn, PV, r n (1+r)n=FVn/PV ( find in ‘r’ column)

Net Present Value (NPV) = an investment analysis concept = PV of future net cash flows – initial cost = PV of MR’s – PV of MC’s = invest if NPV > 0 = invest if PV of MR’s > PV of MC’s

Internal Rate of Return = an investment analysis alternative = value of ‘r’ that results in a NPV = 0

Payback Period = an investment analysis alternative = period of time required for the sum of net cash flows to equal the initial cost = value of n such that

Firm Valuation The value of a firm equals the present value of all its future profits If profits grow at a constant rate, g

Time Value of Money (Applied to Inflation) Can be used to estimate or forecast future prices, revenues, costs, etc. FVn = PV (1+r)n where PV = present value of price, cost, etc. r = estimated annual rate of increase n = number of years FV = future value of price, cost, etc.