Managerial Economics

1. Managerial Economics İlker Daştan, PhD Department of Economics Izmir University of Economics

2. Introduction & Goals of the Firm • Introduction • Structure of Decision Models • Profit’s Role • Agency Problems & Solutions • Not-for-Profit Organizations • Why Corporations Have Succeeded Over Other Organizational Forms

3. What is Managerial Economics • Managerial economics integrates and applies microeconomic theory and methods to decision making problems faced by private, public, and not-for-profit organizations. • Managerial economics deals with microeconomic reasoning on real world problems such as pricing decisions, selecting the best strategy in different competitive environments, and making efficient choices.

4. Should we expand capacity? (example) • Should Toyota expand its capacity? In part, it must consider current and future demand and what other firms are likely to do. • Capacity for making cars is a long term project, so Toyota should think in terms of the present value (PV) of future profits. • Objective Function: Max PV of profits depending on {S1, S2} • S1 is strategy to expand capacity; S2 is strategy to not to expand capacity at this time. • Decision Rule: Choose S1 if PV {Profits of S1 } > PV {Profits of S2} Choose S2 if PV { Profits of S1 } < PV { Profits of S2 } If equal profits, flip a coin (indifferent between S1 and S2)

5. The Decision-making Process 1. Establish objectives 2. Problem identification 3. Examine alternative solutions Societal constraints 4. ANALYSIS & CHOICE Organizational & Input constraints 5. Sensitivity analysis 6. Implementation and monitoring

6. The Role of Profit • Economic profit is the difference between total revenue and total (economic) cost. • Economic cost includes the opportunity cost of owner like time and capital spent. • High profit ventures should attract investment, while low profit businesses would lose investment. • Then shouldn’t all industries earn the same profit eventually?

7. Why Profits Vary Across Industries • Risk-bearing theory • Temporary disequilibrium • Monopoly • Innovation • Managerial efficiency

8. Eli Lilly (example) • 12.3 yrs on average to get a new drug approved. • Patents on Lilly’s Prozac created monopoly power and profits for a widely used medication for depression. • As the patent began to expire, Lilly requested patent “extension” citing some alterations in Prozac’s formula. • But when the patent extension was overturned, generic drug manufactures took 70% of the share of the market for anti-depressants. • Lilly missed the chance of finding a replacement in time for its blockbuster Prozac.

9. The Firm’s Objective • Profit maximization • Shareholder wealth = value of each share (V0) times the number of shares outstanding • That is V0× # shares outstanding • This is the present value of expected future profits or cash flows discounted at the shareholders required rate of return, ke, ignoring taxes.  V0 × # shares outstanding =  t /(1+ke) t t=1

10. Determinants of Firm Value t = REVENUE – COST =TRt – TCt = PtQt – (VtQt + Ft) • Firm Value is the present value of discounted cash flows: N N (t ) / (1+ke)t = (PtQt – VtQt – Ft) / (1+ke)t t =1 t =1 • Whatever lowers the perceived risk of the firm (ke) will also raise firm value. • Whatever raises the price of the product (Pt) or the quantity sold (Qt) will raise firm value. • Whatever raises variable cost (Vt) or fixed cost (Ft) will reduce firm value.

11. To make good economic decisions, managers need to be able to forecast & estimate relationships. • Will be forecasting demand (both Pt & Qt) • applies to for-profit corporations • non-profit organizations • Hospital Administrators forecast patients • University Administrator forecast enrollment • Regression analysis, time series methods, and qualitative forecasting methods are used for forecasting.

12. Agency Problems • Modern corporations allow firm managers to have no ownership participation, or only limited participation in the profitability of the firm. • Shareholders (owners) may want profits, but managers may wish to relax. • The shareholders are principals, whereas the managers are agents.

13. The Principal-Agent Problem • Shareholders (principals) want profit • Managers (agents) want leisure & security • Conflicting motivations between these groups are called agency problems. • Examples (page 13) • KKR’s takeover of RJR Nabisco to refocus on wealth-maximization. • The LBO by O.M. Scott (a lawn fertilizer company) from ITT (a conglomerate) improved Scott’s performance.

14. 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. • Develop incentives to help the company, because that improves the value of stock options and bonuses.

15. Saturn Corporation (example) • Company restructuring in 1991. • No-haggle pricing. • Sales above expectations. • But, margin of only $400 per car to GM. • GM earned only 3% on capital. • Saturn customers wanted bigger Saturns rather than trade up to Buick, as GM hoped. • When dollar appreciated, Japanese firms could price their cars more competitively. • Lesson: Must continuously keep up with global competitors.

16. Shareholder Wealth Maximization:Necessary Conditions • Complete Markets: liquid markets for firm’s inputs and by-products (including polluting by-products). • No Significant Asymmetric Information: buyers and sellers all know the same things. • Known Re-contracting Costs: future input costs should be part of the present value of expected cash flows.

17. Goals in the Public Sector and the NFP Enterprises • Public goods are goods that can be consumed or used by more than one person at the same time with no extra cost (like a flood control, national defense). • Often governments produce public goods, which are usually non-rival and non-excludable. • Instead of profit, NFP organizations may have as their goals: • Maximization of the quantity of output, subject to a breakeven constraint. • Maximization of the utility (happiness). • Maximization of cash flows. • Maximization of the utility of contributors to the NFP organization.

18. Which goal a NFP manager selects affects decisions made. • A food shelter manager may decide to maximize the utility of contributors by selecting only “healthy foods.” • Public sector managers are performance monitored. • V.A. hospital administrators are rewarded by reducing the cost per bed over a year. Hence, they become efficient with respect to costs. • The “friendliness” of the hospital staff is harder to measure, so friendliness will tend not be a high priority of the public sector manager.