Managerial Economics &

Business Strategy
Chapter 1
The Fundamentals of Managerial
Economics

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Overview
I. Introduction
II. The Economics of Effective Management
Q Identify Goals and Constraints
Q Recognize the Role of Profits
Q Understand Incentives
Q Five Forces Model
Q Understand Markets
Q Recognize the Time Value of Money
Q Use Marginal Analysis

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Managerial Economics
• Manager
Q A person who directs resources to achieve a stated goal.
• Economics
Q The science of making decisions in the presence of
scare resources.
• Managerial Economics
Q The study of how to direct scarce resources in the way
that most efficiently achieves a managerial goal.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Economic vs. Accounting
Profits
• Accounting Profits
Q Total revenue (sales) minus dollar cost of producing
goods or services.
Q Reported on the firm’s income statement.
• Economic Profits
Q Total revenue minus total opportunity cost.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Opportunity Cost
• Accounting Costs
Q The explicit costs of the resources needed to produce
produce goods or services.
Q Reported on the firm’s income statement.
• Opportunity Cost
Q The cost of the explicit and implicit resources that are
foregone when a decision is made.
• Economic Profits
Q Total revenue minus total opportunity cost.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 The Five Forces Framework
•Entry Costs
Entry •Network Effects
•Speed of Adjustment •Reputation
•Sunk Costs •Switching Costs
•Economies of Scale •Government Restraints

Power of Power of
Input Suppliers Buyers
•Supplier Concentration •Buyer Concentration
•Price/Productivity of Sustainable •Price/Value of Substitute
Alternative Inputs Products or Services
•Relationship-Specific
Industry •Relationship-Specific
Investments Profits Investments
•Supplier Switching Costs •Customer Switching Costs
•Government Restraints •Government Restraints

Industry Rivalry Substitutes & Complements

•Concentration •Switching Costs •Price/Value of Surrogate Products •Network Effects
•Price, Quantity, Quality, or •Timing of Decisions or Services •Government
Service Competition •Information •Price/Value of Complementary Restraints
•Degree of Differentiation •Government Restraints Products or Services

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Market Interactions
• Consumer-Producer Rivalry
Q Consumers attempt to locate low prices, while producers
attempt to charge high prices.
• Consumer-Consumer Rivalry
Q Scarcity of goods reduces the negotiating power of
consumers as they compete for the right to those goods.
• Producer-Producer Rivalry
Q Scarcity of consumers causes producers to compete with
one another for the right to service customers.
• The Role of Government
Q Disciplines the market process.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 The Time Value of Money
• Present value (PV) of a lump-sum amount
(FV) to be received at the end of “n” periods
when the per-period interest rate is “i”:
FV
PV =
(1 + i ) n

• Examples:
Q Lotto winner choosing between a single lump-sum payout of $104
million or $198 million over 25 years.
Q Determining damages in a patent infringement case.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Present Value of a Series
• Present value of a stream of future amounts
(FVt) received at the end of each period for
“n” periods:

FV1 FV2 FVn

PV = + + ...+
(1 + i ) 1
(1 + i ) 2
(1 + i ) n

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Net Present Value
• Suppose a manager can purchase a stream of
future receipts (FVt ) by spending “C0” dollars
today. The NPV of such a decision is

FV1 FV2 FVn

NPV = + + ...+ − C0
(1 + i ) 1
(1 + i ) 2
(1 + i ) n

Decision Rule:
If NPV < 0: Reject project
NPV > 0: Accept project

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Present Value of a Perpetuity
• An asset that perpetually generates a stream of cash flows
(CF) at the end of each period is called a perpetuity.
• The present value (PV) of a perpetuity of cash flows paying
the same amount at the end of each period is

CF CF CF
PV Perpetuity = + + + ...
(1 + i ) (1 + i ) (1 + i )
2 3

CF
=
i

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Firm Valuation
• The value of a firm equals the present value of current and
future profits.
Q PV = Σ πt / (1 + i)t
• If profits grow at a constant rate (g < i) and current period
profits are πο:
1+ i
PVFirm = π 0 before current profits have been paid out as dividends;
i−g
1+ g
Ex − Dividend
PVFirm = π0 immediately after current profits are paid out as dividends.
i−g

• If the growth rate in profits < interest rate and both remain
constant, maximizing the present value of all future profits
is the same as maximizing current profits.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Marginal (Incremental)
Analysis
• Control Variables
Q Output
Q Price
Q Product Quality
Q Advertising
Q R&D
• Basic Managerial Question: How much of
the control variable should be used to
maximize net benefits?
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Net Benefits
• Net Benefits = Total Benefits - Total Costs
• Profits = Revenue - Costs

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Marginal Benefit (MB)
• Change in total benefits arising from a change
in the control variable, Q:
∆B
MB =
∆Q
• Slope (calculus derivative) of the total benefit
curve.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Marginal Cost (MC)
• Change in total costs arising from a change in
the control variable, Q:
∆C
MC =
∆Q
• Slope (calculus derivative) of the total cost
curve

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Marginal Principle
• 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.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 The Geometry of Optimization
Total Benefits Costs
& Total Costs
Benefits
Slope =MB

B
Slope = MC
C

Q* Q
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Conclusion
• Make sure you include all costs and benefits
when making decisions (opportunity cost).
• When decisions span time, make sure you
are comparing apples to apples (PV
analysis).
• Optimal economic decisions are made at the
margin (marginal analysis).

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006