BUS 525.

2: Managerial
Economics
Lecture 1
The Fundamentals of Managerial
Economics

Course Overview
Prerequisites
Bus501 and/or Bus511
Requirements and Grading
3 Cases (20%)
Two Midterm Examinations (40%)
Final Exam (40%)
Class Materials
Baye, Michael R. Managerial Economics and Business Str
ategy. Sixth Edition. Boston: McGraw-Hill Irwin, 2009.
[MRB]
Web-page: http://fkk.weebly.com

Office: NAC 751

Office hours: Tuesday, Wednesday and Saturday,
5pm-6:30 pm

Activity Schedule:BUS525:2
Class

Date

28 May

4 June

6 June

11 June

18 June

2 July

9 July

16 July

23 July

10

25 July

11

30 July (Make up
TBA)

12

13 August

13

16 -27 August

Exams

Cases

Case 1
Mid 1

Case 2
Mid 2

Case 3
Final

Activity Schedule:BUS525:3
Class

Date

29 May

5 June

12 June

19 June

26 June

3 July

10 July

17 July

24 July

10

31 July

11

1 August

12

14 August

13

16 -27 August

Exams

Cases

Case 1
Mid 1

Case 2
Mid 2
Case 3
Final

Make-up Policy
There will be only one make-up for all
examinations (mid-terms, final etc.) towards
the end of the course to accommodate force
majeure. All examination dates are preannounced/agreed. Please make necessary
arrangements with your office.
Historically, the performance of students taking
make-up examinations were always poorer
compared to students taking examinations on
schedule.
I hope you will appreciate that it is not practical
to offer a customized course for any or group of
individual student(s).

Overview
I. Introduction
Why should I study Economics?
Understand business behavior, profit/loss making
firms, advertising strategy

Impart basic tools of pricing and output

decisions

Optimize production mix and input mix

Choose product quality
Guide horizontal and vertical merger decisions
Optimal design of internal and external incentives.

Not for managers only-any other designation

Private, NGO, Government

Headline loss due to managerial ineptness

1-6

1-7

Managerial Economics
Manager
A person who directs resources to achieve a
stated goal.

Economics
The science of making decisions in the presence
of scarce resources.

Managerial Economics
The study of how to direct scarce resources in the
way that most efficiently achieves a managerial
goal.
Case No. 1, Global Standards for Garment
Industry Under Scrutiny After Bangladesh
Disaster

Capitalism 101
To identify money-making opportunities, you
must first understand how wealth is created
(and sometimes destroyed).
Definition: Wealth is created when assets
are moved from lower to higher-valued uses
Definition: Value = willingness to pay
Desire + income

The chief virtue of a capitalist economy is

its ability to create wealth
Voluntary transactions, between individuals
or firms, create wealth.
8

Example: House Sale

A house is for sale:

The buyer values the house at $130,000

maximum price
The seller values the house at $120,000
minimum price
The buyer and seller must agree to a price that splits surplus
between buyer and seller. Here, $128,000.
The buyer and seller both benefit from this transaction:
Buyer surplus = buyers value minus the price, $2,000
Seller surplus = the price minus the sellers value, $8,000
Total surplus = buyer + seller surplus, $10,000 = difference
in values
9

Wealth-Creating Transactions
Which assets do these transactions move to highervalued uses?
Factory Owners
Real Estate Agents
Investment Bankers
Corporate Raiders
Insurance Salesman

Discussion: How does eBay/Bikroy.com create

wealth?
Discussion: Which individual has created the most
wealth during your lifetime?
Discussion: How do you create wealth?

10

Do Mergers Create Wealth?

The movement of assets to a higher-valued use is the
wealth-creating engine of capitalism.

Our largest and most valuable assets are corporations

Dell-Alienware merger:

In 2006, Dell purchased Alienware, a manufacturer of high-end

gaming computers.

Dell left design, marketing, sales and support in Alienwares

hands; manufacturing, however, was taken over by Dell.

With its manufacturing expertise, Dell was able to build

Alienwares computers at a much lower cost

Despite this example, many mergers and acquisitions do not

create value and if they do, value creation is rarely so clear.
To create value, the assets of the acquired firm must be
more valuable to the buyer than to the seller .
11

Does Government Create Wealth?

Discussion: Whats the governments role is
wealth creation?
Enforcing property rights, contracts, to
facilitate wealth creating transactions

Discussion: Why are some countries so

poor?
No property rights, no rule of law
Discussion: Much of the justification for government
intervention comes from the assertion that markets
have failed. One money manager scoffed at this idea.
The markets are working fine, but theyre giving people
answers that they dont like, so people cry market
failure.
12

The One Lesson of Economics

Definition: an economy is efficient if all wealthcreating transactions have been consummated.

This is an unattainable, but useful

benchmark
The One Lesson of Economics: the art of
economics consists in looking not merely at the
immediate but at the longer effects of any act or
policy; it consists in tracing the consequences of that
policy not merely for one group but for all groups.
Policies should then be judged by whether they
move us towards or away from efficiency.
The economists solution to inefficient outcomes is to argue
for a change in public policy.
13

One Lesson of Economics (cont.)

Taxes Destroy Wealth:

By deterring wealth-creating transactions

when the tax is larger than the surplus for a
transaction.
Which assets end up in lower-valued uses?
Subsidies Destroy Wealth:

Example: flood insurance encourages people

to build in areas that they otherwise wouldnt
Which assets end up in lower-valued uses?
Price Controls Destroy Wealth:
Example: rent control (price ceiling) in New York City deters transactions between owners and renters
Which assets end up in lower-valued uses?

14

The one Lesson of Business

Definition: Inefficiency implies the existence of
unconsummated, wealth-creating transactions
The One Lesson of Business: the art of
business consists of identifying assets in lower
valued uses, and profitably moving them to
higher valued uses.
In other words, make money by identifying
unconsummated wealth-creating transactions and
devise ways to profitably consummate them.

15

Companies Create Wealth

Companies are collections of transactions:

They go from buying raw materials, capital,

and labor (lower value)
To selling finished goods & services (higher
value)
Why do some companies have difficulty creating wealth?

They have trouble moving assets to highervalued uses

Analogy to taxes, subsidies, price controls on internal transactions

16

Government Destroys Wealth

Zimbabwe experienced economic
contraction of approximately 30
percent per year from 1999 to 2003
Unemployment rates have been as
high as 80 percent and life
expectancy has fallen over 20 years
during the reign of Robert Mugabe
Why has economic growth been so
low?
17

Government Destroys Wealth

One main problem occurred in 2000
Mugabe backed his supporters takeover of commercial
farms, essentially revoking property rights of these
farmers
The state resettled the confiscated lands with
subsistence producers - many with no previous farming
experience. Agricultural production plummeted.
Farm debacle had economic ripple effects through the
banking and manufacturing sectors
Declining production deprived the country of ability to
earn foreign currency and buy food overseas
Widespread famine ensued
The government's initial attack on private property eventually led
to more direct intervention in the economy and the destruction of
political freedom in Zimbabwe.
18

Problem Solving
Two distinct steps:
Figure out whats wrong, i.e., why the bad
decision was made
Figure out how to fix it

Both steps require a model of behavior

Why are people making mistakes?
What can we do to make them change?

Economists use the rational actor

paradigm to model behavior. The rational
actor paradigm states:
People act rationally, optimally, self-interestedly
i.e., they respond to incentives to change behavior
you must change incentives.
19

How to Figure Out What is Wrong

Under the rational actor paradigm, mistakes are
made for one of two reasons:
lack of information or
bad incentives.

To diagnose a problem, ask 3 questions:

1. Who is making bad decision?
2. Do they have enough info to make a good
decision?
3. Do they have the incentive to do so?

20

How to Fix It
The answers will suggest one or more solutions:
1. Let someone else make the decision, someone
with better information or incentives.
2. Change the information flow.
3. Change incentives
Change performance evaluation metric
Change reward scheme

Use benefit-cost analysis to choose the best

(most profitable?) solution

21

Keep the Ultimate Goal in

Mind
For a business or organization to operate profitably
and efficiently the incentives of individuals need
to be aligned with the goals of the company.
How do we make sure employees have the
information necessary to make good decisions?
And the incentive to do so?

22

Manager Bonuses for

Increasing Reserves
The bonus system created incentives to overbid.
Senior managers were rewarded for acquiring
reserves regardless of their profitability

Bonuses also created incentive to manipulate

the reserve estimate.
Now that we know what is wrong, how do we
fix it?
Let someone else decide?
Change information flow?
Change incentives?
Performance evaluation metric
Reward scheme

23

Ethics
Does the rational-actor paradigm encourage selfinterested, selfish behavior?
NO!
Opportunistic behavior is a fact of life.
You need to understand it in order to control it.
The rational-actor paradigm is a tool for analyzing
behavior, not a prescription for how to live your life.

24

Why Else this Material is Important

Employers expect that you will know these
concepts
Further, employers will expect that you are able
to apply them.

25

How Do Firms Behave

Economists often assume the goal of the firm is profit
maximization. Opinions do differ, however.

Discussion: pricing of hotel rooms during tourist season

Traditional economic view level pricing leads to excess
demand; how are rooms allocated then (rationing,
arbitrageurs, . . .)
Contrasting view businesses should not raise prices
during times of shortage; businesses have a responsibility
to consumers and society
Your view?
Text view: firms serve consumers and society best by engaging
in free and open competition within legal limits while
attempting to maximize profits.
Not a license to engage in illegal behavior
No denying that concerns exist about the ethical dimension
of business
Reasonable people have disagreed for millennia on what
constitutes ethical behavior
26

The Economics of Effective

Management
Identify goals and constraints
Recognize the nature and importance of
profits
Five forces framework and industry
profitability

Understand incentives
Understand markets
Recognize the time value of money
Use marginal analysis

1-27

Identify Goals and

Constraints
Sound decision making involves
having well-defined goals.
Leads to making the right decisions.

In striving to achieve a goal, we

often face constraints.
Constraints are an artifact of scarcity.

1-28

Economic vs. Accounting

Profits
Accounting profits
Total revenue (sales) minus cost of
producing goods or services.
Reported on the firms income
statement.

Economic profits
Total revenue minus total opportunity
cost.

1-29

Opportunity Cost
Accounting costs
The explicit costs of the resources needed
to produce goods or services.
Reported on the firms income statement.

Opportunity cost
The cost of the explicit and implicit
resources that are foregone when a decision
is made.

Economic profits
Total revenue minus total opportunity cost.

1-30

Significance of the
Opportunity Cost Concept
Accounting profits = Net revenue
Accounting costs (dollar costs of goods
and services)
Reported on the firms income
statement
Economic profits = Net revenue
Opportunities Costs
Economic profits and opportunity costs
are critical to decision making
31

The Principle of Relevant

Cost
Sound decision-making requires that
only costs caused by a decision--the
relevant costs--be considered. In
contrast, the costs of some other
decision not impacted by the choice
being considered--the irrelevant costs-should be ignored.
Not all accounting costs are relevant and
many need adjustments to become
relevant
32

1-33

Profits as a Signal
Profits signal to resource holders
where resources are most highly
valued by society.
Resources will flow into industries that
are most highly valued by society.

Theories of Profits
(Why are profits necessary? Why do profits
vary across industries and across firms?)
Risk-bearing theory of profit - Profits are
necessary to compensate for the risk that
entrepreneurs take with their capital and efforts
Dynamic equilibrium (frictional) theory Profits, especially extraordinary profits, are the
result of our economic systems inability to adjust
instantaneously to unanticipated changes in
market conditions.

34

Theories of Profits
Monopoly theory - Profits are the result of
some firms ability to dominate the market
Innovation theory - Extraordinary profits
are the rewards for successful innovations
Managerial efficiency theory Extraordinary profits can result from
exceptionally managerial skills of wellmanaged firms.

35

Understanding Firms
Incentives
Incentives play an important role within
the firm.
Incentives determine:
How resources are utilized.
How hard individuals work.

Managers must understand the role

incentives play in the organization.
Constructing proper incentives will
enhance productivity and profitability.

1-36

Agency Problems
Modern corporations allow firm
managers to have no ownership
participation, or only limited
participation in the profitability of the
firm.
Shareholders may want profits, but
hired managers may wish to relax or
pursue self interest.
The shareholders are principals,
whereas the managers are agents.

The Principal-Agent Problem

Shareholders (principals) want profit
Managers (agents) want leisure & security
Conflicting motivations between these
groups are called agency problems.
Stock brokers and investors
Physicians and patients
Auto mechanics and car owners

Solutions to Agency Problems

Compensation as incentive
Extending to all workers stock options,
bonuses, and grants of stock
It helps to make workers act more like
owners of firm (but not always Citibank
and Managers)
Incentives to help the company, because that
improves the value of stock options and
bonuses
Good legal contracts that can be effectively
enforced

1-40

Market Interactions
Consumer-Producer rivalry
Consumers attempt to locate low prices, while
producers attempt to charge high prices.

Consumer-Consumer rivalry
Scarcity of goods reduces the negotiating power of
consumers as they compete for the right to those
goods.

Producer-Producer rivalry
Scarcity of consumers causes producers to compete
with one another for the right to service customers.

The Role of government

Disciplines the market process
BTRC, BERC, SECs failure brought debacle

Market
Definition: Buyers and sellers communicate
with one another for voluntary exchange
market need not be physical
Bookstore, Internet bookstore Amazon.com
Outsourcing

industry businesses engaged in the

production or delivery of the same or
similar items

Clothing and textile industry,

Clothing industry is a buyer in the textile
market and a seller in the clothing market

Competitive Market
Benchmark for managerial economics
Purely competitive market
The global cotton market
many buyers and many sellers
no room for managerial strategizing

Achieves economic efficiency

Entry of firms
Case No.2, Textile millers hit rough
patch

Market Power
Definition ability of a buyer or
seller to influence market conditions
Seller with market power must
manage
costs
price
advertising expenditure
policy toward competitors

Imperfect Market
Definition: where
one party directly conveys a benefit or
cost to others
externalities
or
one party has better information than
others
Lack of competition, barriers to entry

1-45

The Time Value of Money

Present value (PV) of a future value (FV) lumpsum amount to be received at the end of n
periods in the future when the per-period interest
rate is i:

PV
Examples:

FV

1 i

Lottery winner choosing between a single lump-sum

payout of Tk.104 million or Tk.198 million over 25
years.
Determining damages in a patent infringement case.

Present Value vs. Future

Value
The present value (PV) reflects the
difference between the future value
and the opportunity cost of waiting
(OCW).
Succinctly,
PV = FV OCW
If i = 0, note PV = FV.
As i increases, the higher is the OCW
and the lower the PV.

1-46

1-47

Present Value of a Series

Present value of a stream of future
amounts (FVt) received at the end of
each period for n periods:

PV

FV

1 i

FV

1 i
n

. . .

FV
t
Equivalently, PV
t

i
t 1

FV

1 i n

1-48

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
1
2 . . .
n C 0
1 i 1 i
1 i
If

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

Present Value of a
Perpetuity
An asset that perpetually generates a stream of cash
flows (CFi) at the end of each period is called a
perpetuity.
The present value (PV) of a perpetuity of cash flows
paying the same amount (CF = CF1 = CF2 = ) at the
end of each period is

PVPerpetuity

CF
CF
CF

...
2
3
1 i 1 i 1 i
CF

1-49

Objective of the Firm

Not
Not
Not
Not
Not
Not
Not

market share
growth
revenue
empire building
net profit margin
name recognition
state-of-the-art technology
50

Whats the Objective of the Firm?

The objective of the firm is to maximize
the value of the firm.
Value of the firm is the true measure of
business success (of course, from a forprofit perspective.)
Two questions:
1. How is the value of the firm defined
and measured?
2. How do managers go about adding
value to the firm?
51

Value
Maximization
Is
a Complex
Process

Figure 1.3

Definition and Measurement of Value

of the Firm

The present value of the firms

future net earnings.
1

V = [--------] + [ --------] + . . . + [ -------- ]

(1+r)1
(1+r)2
(1+r)n
t
V = [ ------- ] , t = 1, 2, ... , N
t = 1 (1+r)t
N

53

Adding Value to the Firm

Profit = Total Rev - Total Cost
= P . Qd - VC . Qs - F
where profit, P = price,
Qd

= quantity demanded,

VC
Qs

= variable cost per unit,

= quantity supplied,

= total fixed costs

54

Determinants of Value of the

Firm
N

P . Qd - VC . Qs - F

V = [ ------- ] = [---------------------- ]
t=1

(1+r)t

t=1

(1+r)t

Whatever that raises the price of the

product and/or the quantity of the product
sold
Whatever that lowers the variable and
fixed costs
Whatever that lower the r (discount rate
or the perceived risk of investment)

Firm Valuation and Profit

Maximization

1-56

The value of a firm equals the present value

of current and future profits (cash flows).

1
2
t
PVFirm 0

...
t

i
1

i
t 1 1 i
A common assumption among economist
is

that it is the firms goal to maximization

profits.

This means the present value of current and

future profits, so the firm is maximizing its value.

Class Exercise

Suppose the interest rate is 10% and the firm is expected

to grow at a rate of 5% for the foreseeable future. The
firms current profits are $100 million.

a)

What is the value of the firm (the present value of its

current and future earnings)?
What is the value of the firm immediately after it pays a
dividend equal to its current profits?

b)

Marginal (Incremental)
Analysis
Control variable, examples:

Output
Price
Product Quality
Advertising
R&D

Basic managerial question: How much

of the control variable should be used to
maximize net benefits?

1-58

1-59

Net Benefits
Net Benefits = Total Benefits - Total
Costs
Profits = Revenue Costs
Case No. 3: Outsourcing and
offshoring

1-60

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.

1-61

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

1-62

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.

The Geometry of Optimization:

Total Benefit and Cost
Total Benefits
& Total Costs

Costs
Slope =MB

Benefits

B
Slope = MC

Q*

1-63

The Geometry of
Optimization: Net Benefits
Net Benefits

Maximum net benefits

Slope = MNB

Q*

1-64

What Will We Learn?

Useful economic principles for sound
economic decision-making in a
management context.
The basics of the demand side of the
market and which factors influence the
buyers behavior.
The fundamentals of the markets supply
side -laws of production and how these
laws impact a firms costs.
How firms costs and buyers demand
together determine the firms
price and net profit.
65

1-66

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).

Myths and Misconceptions

Economics is about money only
Economics assumes that everyone
is selfish
A companys value is measured by
the companys assets
Costs are measured appropriately
by accountants.

67

Myths and
Misconceptions (cont.)
We must cover our fixed costs in
the decisions we make as
managers
Our firm must create the best
quality product
We should do more advertising,
because its cost-effective
Our price should be based on our
costs
68

Myths and Misconceptions

(cont.)
Unit or average cost provides useful
management information
Wider profit margins are desirable
A price increase reduces demand
High research and development
expense results in high prices.

69

Managerial
Economics
is a Tool for
Improving
Management
Decision Making
Figure 1.1

The Five Forces Framework

Entry Costs
Speed of Adjustment
Sunk Costs
Economies of Scale

Entry

Sustainable Industry
Profits

Power of
Input Suppliers

Supplier Concentration
Price/Productivity of
Alternative Inputs
Relationship-Specific
Investments
Supplier Switching Costs
Government Restraints

Power of
Buyers

Buyer Concentration
Price/Value of Substitute
Products or Services
Relationship-Specific
Investments
Customer Switching Costs
Government Restraints

Industry Rivalry
Concentration
Price, Quantity, Quality, or
Service Competition
Degree of Differentiation

Network Effects
Reputation
Switching Costs
Government Restraints

Switching Costs
Timing of Decisions
Information
Government Restraints

Substitutes & Complements

Price/Value of Surrogate Products
or Services
Price/Value of Complementary
Products or Services

Network Effects
Government
Restraints

1-71

Firm Valuation With Profit

Growth

1-72

If profits grow at a constant rate (g < i) and

current period profits are before and after
dividends are:
1 i
before current profits have been paid out as dividends;
ig
1 g
Ex Dividend
PVFirm
0
immediately after current profits are paid out as dividends.
ig
PVFirm 0

Provided that g < i.

That is, the growth rate in profits is less than the
interest rate and both remain constant.