Unit 1. Fundamentals of Managerial Economics (Chapter 1)

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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 McCann
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 (2nd)
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
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
$1,000,000
25,000
5,000
$0
Max B(T,R)
Subject to: T + R = 1,000,000
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 = 7Q - .01Q2
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
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 – 100P
P = 7 – 0.01Q
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 +
2x].
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 = 2x and
x = 1/2 y are each an inverse equation of the
other].
Common Math Functions Used in
Economics
Function Form
Y = a0
Y = a 0 + a 1x
(or y = mx + b)
Name of
Function
Constant
Linear
Graph of Function
Horizontal straight line with
slope = 0
Straight line with slope = a1 (or
= m)
Y=a0+a1x+a2x2
Quadratic
Parabola (u-shaped curve) with
either minimum or maximum
value
Y=a0+a1x+a2x2+a3x3
Cubic
Curved line (e.g. slope changes
from getting flatter to steeper
Y=a0x-n
Hyperbola
Curved line (u-shaped) bowed
towards origin
EXPONENT RULES
1.
xn = x multiplied by itself n times
2.
x0 = 1
3.
x-a =
4.
5.
6.
EXAMPLES
x3 = x x x
x1 = x
1
xa
xa xb = xa+b
x-2 = 1/x2
xa
x2/x3 = x2 x-3 = x-1 = 1/x
xb
= xa-b
x1/a = the ath root of x
= what number multiplied by
itself "a" times = x
x2 x3 = x5
x2 x-1 = x2-1 = x
x 1/2 
x
81/3 = 2 (because 2 2 2 = 8)
7.
xa ya = (xy)a
x2y2 = (xy)2
8.
(xa)b = xab
(x2) 3 = x6
9.
(xy)1/a = x1/a y1/a
(xy)1/2 = x . y
“Ceteris Paribus”
Y = a + b1X1 + …bnXn=> 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 + bX, 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 = (Y2-Y1)/(X2-X1)
2. Given values at one pt for Y, X, and b, solve for a
(e.g. a = Y1 – bX1)
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 + bX
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 = 1st 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 + bX
‘Slope’ Graphically
 y rise y2  y1



 x run x2  x1
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=3x2, slope = (2)(3)x2-1=6x
If y=x, slope = (1)x1-1=1
3. ‘Sum of functions rule’ = slope If y = x + 3x2, slope = 1 + 6x
of the sum of two functions is the
sum of the two functions’ slopes
Mathematics of ‘Optimization’
‘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. dY/dX = 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?
0
$X
$Y
t1
t2
t3
Assume x = $900, y = $1000, r = 6%, t1 = 3, t2 = 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
FV1
FV2
•
•
•
•
FVn
=
=
=
=
=
=
PV + PV(r)
PV(1+r)
FV1+FV1(r)
FV1(1+r)
PV(1+r)(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
FVn,r,n PV=FVn[1/(1+r)n]
= ‘compounding’
= ‘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
n
 NCF  C
i 1
i
Firm Valuation
The value of a firm equals the present value of all its
future profits
PV    t / (1  i)
t
If profits grow at a constant rate, g<I, then:
PV   0 (1  i ) / (i  g).  0 
current profit level.
Maximizing Short-Term Profits
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.
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.

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