CHAPTER The Fundamentals of Managerial Economics Contents I II Introduction The Economics of Effective Management I Identify Goals and Constraints II Recognize the Role of Profits III Five Forces Model IV Understand Incentives V Understand Markets VI Recognize the Time Value of Money VII Use Marginal Analysis Copyright © 2014 by the McGraw-Hill Companies, Inc All rights reserved 2-2 Chapter One Chapter Overview Learning objectives • Summarize how goals, constraints, incentives, and market rivalry affect economic decisions • Distinguish economic versus accounting profits and costs • Explain the role of profits in a market economy • Apply the five forces framework to analyze the sustainability of an industry’s profits • Apply present value analysis to make decisions and value assets • Apply marginal analysis to determine the optimal level of a managerial control variable • Identify and apply six principles of effective managerial decision making 1-3 Introduction Chapter Overview Chapter focuses on defining managerial economics, and illustrating how it is a valuable tool for analyzing many business situations => Billions of dollars are lost each year because many existing managers fail to use basic tools from managerial economics to: • shape pricing and output decisions • optimize the production process and input mix • choose product quality • guide horizontal and vertical merger decisions • optimally design internal and external incentives => Managerial economics is not only valuable to managers of Fortune 500 companies; it is also valuable to managers of not-forprofit organizations => In fact, managerial economics provides useful insights into every facet of the business and nonbusiness world in which we live— including house- hold decision making 1-4 Introduction • This chapter provides managerial economics an Chapter Overview overview of – How accounting profits and economic profits differ? • Why is the difference important? – How managers account for time gaps between costs and revenues? – What guiding principle can managers use to maximize profits? 1-5 The Manager Introduction • A person who directs resources to achieve a stated goal – Directs the efforts of others – Purchases inputs used in the production of the firm’s output – Directs the product price or quality decisions 1-6 Introduction Economics • The science of making decisions in the presence of scarce resources – Resources are anything used to produce a good or service, or achieve a goal – Decisions are important because scarcity implies trade-offs – Time is one of the scarcest resources 1-7 Introduction Managerial Economics Defined • The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal – Should a firm purchase components – like disk drives and chips – from other manufacturers or produce them within the firm? – Should the firm specialize in making one type of computer or produce several different types? – How many computers should the firm produce, and at what price should you sell them? – How you ensure employees work hard and produce quality products? – How will the actions of rival computer firms affect your decisions? The key to making sound decisions is to know what information is needed to make an informed decision and then to collect and process the data 1-8 Economics of Effective Management Economics of Effective Management • Basic principles comprising effective management: – Identify goals and constraints – Recognize the nature and importance of profits – Understand incentives – Understand markets – Recognize the time value of money – Use marginal analysis 1-9 Economics of Effective Management Identify goals and constraints • Knowing your goals allows you to identify which decisions you need to make • Contraints make it difficult for managers to achieve goals 1-10 Economics of Effective Management Determining the Optimal Level of a Control Variable Total benefits Total costs Maximum total benefits 𝐶 𝑄 pe Slo = 𝑄 𝐵 𝑀 𝐵 𝑄 Maximum net benefits p Slo e 𝐶 =𝑀 𝑄 Quantity (Control Variable) 1-43 Economics of Effective Management Determining the Optimal Level of a Control Variable II Net benefits Maximum net benefits Slope =𝑀𝑁𝐵(𝑄) Quantity 𝑁 𝑄 =𝐵 𝑄 −𝐶 𝑄 =0 (Control Variable) 1-44 Economics of Effective Management Determining the Optimal Level of a Control Variable III Marginal benefits, costs and net benefits Maximum net benefits 𝑀𝐶 𝑄 𝑀𝑁𝐵 𝑄 𝑀𝐵 𝑄 Quantity (Control Variable) 1-45 Economics of Effective Management Incremental Decisions • Incremental revenues – The additional revenues that stem from a yes-or-no decision • Incremental costs – The additional costs that stem from a yes-or-no decision • To maximize net benefits, the managerial control variable should be increased up to the point where MB = MC • MB > MC means the last unit of the control variable increased benefits more than it increased costs • MB < MC means the last unit of the control variable increased costs more than it increased benefits 1-46 practice Suppose that the total benefit and total cost from a continuous activity are, respectively, given by the following equations: B(Q) = 100 + 36Q − 4Q2 and C(Q) = 80 + 12Q Write out the equation for the net benefits What are the net benefits when Q = 1? Q = 5? Write out the equation for the marginal net benefits What are the marginal net benefits when Q = 1? Q = 5? What level of Q maximizes net benefits? At the value of Q that maximizes net benefits, what is the value of marginal net benefits? Copyright © 2014 by the McGraw-Hill Companies, Inc All rights reserved 2-47 Exercise • The manager of a software company seeks to maximize profits by producing the profitmaximizing level of output (Q) The total benefits (revenues) and costs for various levels of output are summarized below, and are given in millions of dollars Complete the table, and answer the accompanying questions Copyright © 2014 by the McGraw-Hill Companies, Inc All rights reserved 2-48 Exercise Copyright © 2014 by the McGraw-Hill Companies, Inc All rights reserved 2-49 Exercise • What level of output maximizes net benefits? • What is the relation between marginal benefits and marginal cost at this level of output? • What would happen if the manager attempted to maximize total benefits? • Are marginal benefits zero when total benefits are maximized? Why or why not? Copyright © 2014 by the McGraw-Hill Companies, Inc All rights reserved 2-50 Exercise • An owner can lease her building for $120,000 per year for three years The explicit cost of maintaining the building is $40,000, and the implicit cost is $55,000 All revenues are received, and costs borne, at the end of each year If the interest rate is percent, deter- mine the present value of the stream of: • a Accounting profits ã b Economic profits Copyright â 2014 by the McGraw-Hill Companies, Inc All rights reserved 2-51 Exercise • You are the human resources manager for a famous retailer and are trying to convince the president of the company to change the structure of employee compensation Currently, the company’s retail sales staff is paid a flat hourly wage of $20 per hour for each eight-hour shift worked You propose a new pay structure whereby each sales- person in a store would be compensated $10 per hour, plus percent of that store’s daily profits Assume that, when run efficiently, each store’s maximum daily profits are $25,000 Outline the arguments that support your proposed plan Copyright © 2014 by the McGraw-Hill Companies, Inc All rights reserved 2-52 Exercise • You are the manager of Local Electronics Shop (LES), a small brick-and-mortar retail camera and electronics store One of your employees proposed a new online strategy whereby LES lists its products at Pricesearch.com—a price comparison Web site that allows consumers to view the prices of dozens of retailers selling the same items Would you expect this strategy to enable LES to achieve sustainable economic profits? Explain Copyright © 2014 by the McGraw-Hill Companies, Inc All rights reserved 2-53 Exercise • You are the manager in charge of global operations at Bank Global—a large com- mercial bank that operates in a number of countries around the world You must decide whether or not to launch a new advertising campaign in the U.S market Your accounting department has provided the accompanying statement, which summarizes the financial impact of the advertising campaign on U.S operations In addition, you recently received a call from a colleague in charge of foreign operations, and she • indicated that her unit would lose $8 million if the U.S advertising campaign were launched Your goal is to maximize BankGlobal’s value Should you launch the new campaign? Explain Copyright © 2014 by the McGraw-Hill Companies, Inc All rights reserved 2-54 Copyright © 2014 by the McGraw-Hill Companies, Inc All rights reserved 2-55 Learning Managerial Economics Learning Managerial Economics • Practice, practice, practice … • Learn terminology – Break down complex issues into manageable components – Helps economics practitioners communicate efficiently 1-56 Conclusion Conclusion • Make sure you include all costs and benefits when making decisions (opportunity costs) • When decisions span time, make sure you are comparing apples to apples (present value analysis) • Optimal economic decisions are made at the margin (marginal analysis) 1-57 ... managerial economics provides useful insights into every facet of the business and nonbusiness world in which we live— including house- hold decision making 1- 4 Introduction • This chapter provides managerial. .. Complements •The level and sustainability of industry profits also depend on the price and value of interrelated products and services 1- 18 Economics of Effective Management Five Forces and Industry Profitability...