Managerial Economics & Business Strategy

1. Managerial Economics & Business Strategy Chapter 1 The Fundamentals of Managerial Economics

2. Overview I. Introduction II. The Economics of Effective Management

3. Overview I. Introduction • Models • Simplifications - reality is a complex set of interactions • Essential factors - which parts of this complex environment are most important? • Narrow focus - questions and answers are concerned with only those factors and relationships we are interested in

4. Overview I. Introduction • Models • Theory • Basic assumptions about behaviors/relationships • assumptions are 1st principle • everyone uses them, few state them • Stereotypes • Hypothesis - specific relationships • Hypothesis testing - do our hypotheses work on a regular basis, not insisting on 100% reliability

5. Overview I. Introduction • Models • Theory • Math • Clarity of thought - • definitions are precise, not loose • train of thought stays on track • brainstorming is out • Internally consistent reasoning • given basic assumptions, what is true?

6. Overview I. Introduction • Models • Theory • Math • Managerial applications • Firm specific - your company • Product specific - your product • Industry specific - your product’s competitors • What’s your interest? • Who’s paying?

7. Overview I. Introduction II. The Economics of Effective Management • Identify Goals and Constraints • Recognize the Role of Profits • Understand Incentives • human race is the subject • You get what you ask for: • (Bausch and Lomb: Blind Ambition) • Understand Markets • Recognize the Time Value of Money • Use Marginal Analysis

8. Managerial Economics • Manager • A person who directs resources to achieve a stated goal. • Economics • The study of the allocation of scarce resources to competing uses • Managerial Economics • The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.

9. Opportunity Cost • Accounting Costs • The explicit costs of the resources needed to produce produce goods or services • Reported on the firm’s income statement • Implicit Costs • Expenses incurred for which there is no directly attributed price. • Entrepreneur's efforts, return to shareholders • Opportunity Cost • The cost of the explicit and implicit resources that are foregone when a decision is made

10. Economic vs. Accounting Profits • Accounting Profits • Total revenue (sales) minus dollar cost of producing goods or services • Reported on the firm’s income statement • Economic Profits • Total revenue minus total opportunity cost • Income statements over estimate profits • Acct.  = $3 mil., Assets = $100 mil.

11. Economic vs. Accounting Profits in the Decision Process • Consider the following 1 period decision • Individual with $1,000,000 in the bank earning 5% • Job prospects: • Old firm - salary of $55,000 • Start sole proprietorship: • salary of $40,000 • accounting profit = $60,000 • Find profits and personal values

12. Market Interactions • Consumer-Producer Rivalry • Consumers attempt to locate low prices, while producers attempt to charge high prices • car dealers, real estate, most personal sales and retail sales • Internet sales? • Consumer-Consumer Rivalry • Producer-Producer Rivalry • The Role of Government

13. Market Interactions • Consumer-Producer Rivalry • Consumer-Consumer Rivalry • Scarcity of goods reduces the negotiating power of consumers as they compete for the right to those goods • Tickle-me-Elmo, Dodge Viper, e-bay • Producer-Producer Rivalry • The Role of Government

14. Market Interactions • Consumer-Producer Rivalry • Consumer-Consumer Rivalry • Producer-Producer Rivalry • Scarcity of consumers causes producers to compete with one another for the right to service customers • Nuclear generators, steel industry (dumping complaints) now, airplane manufacturers (Airbus, Boeing and, uh…) • Contracts, bidding and vendor choice (Coke vs. Pepsi) • The Role of Government

15. Market Interactions • Consumer-Producer Rivalry • Consumer-Consumer Rivalry • Producer-Producer Rivalry • The Role of Government • Disciplines the market process (crime and punishment) • Provides for rules of the game • Private property rights • Dispute resolution • Allowable behavior • Establishes environment • Work force abilities • Available infrastructure

16. The Time Value of Money • Present value (PV) of an amount (FV) to be received at the end of “n” periods when the per-period interest rate is “i”: Examples?

17. Present Value of a Series • Present value of a stream of future amounts (FVt) received at the end of each period for “n” periods:

18. 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 NPV < 0: Reject NPV > 0: Accept

19. The Wisdom of the 80s:Japanese managers are better long-term thinkers • Two firms: US and Japanese • Same project, same profit potential • Invest now, get 3 years of profits, i = $100 • Different interest rates: • iUS = 7% • iJap = 3%

20. The Wisdom of the 80s:Japanese managers are better long-term thinkers • Find PV of the project for each firm

21. The Wisdom of the 80s:Japanese managers are better long-term thinkers • Find PV of the project for each firm

22. The Wisdom of the 80s:Japanese managers are better long-term thinkers • Invest only if NPV is positive (we assume profit maximization as the objective of the firm) • Consider profit possibilities for various cost levels • If TC < $262.43, both profit • If $262.43 < TC < $282.96, only Japanese can profit • If TC > $282.96, no one can profit

23. The Wisdom of the 80s:Japanese managers are better long-term thinkers • Results: • Japanese may have invested more because their borrowing rates were lower • More investment is not necessarily a good idea • What is a firm’s objective? • Implications: • Government influence on interest rates is important • Access to financial capital markets is critical for investment purposes

24. Factors in PV • Higher interest rates mean lower PV • More periods mean higher PV • Higher FV means higher PV • Lower PV means less investment • FV is uncertain

25. Firm Valuation • Why buy stock? • Ownership implies (40% of on-line traders don’t know these): • Voting • Claim on profits • Ability to resell ownership • What stock is worth: • Resale price? • Dividends? • Combination of the 2

26. Firm Valuation • The value of a firm (V) equals the present value of all its future profits • Profits (t) = TRt - TCt and we assume this is economic profit • If we start counting this period and assume constant profits (t = t+1= t+2= t+n= ) • Assume infinite life for the firm (consider the alternative)

27. Firm Valuation • If  = $100, and • If i = 5%, then V = $100(1.05)/0.05 = $2,100 • If i = 10%, then V = $100(1. 10)/0.10 = $1,100 • If there are 50 shares of stock then each share is worth:V/# shares • If i = 5%, then each share is worth $2,100/50 = $42 • If i = 10%, then each share is worth $1,100/50 = $22 • Convert this to P/E (price-earnings ratio) • If share price is $50 and per share earnings are $5, then P/E is 50/5 = 10

28. Firm Valuation • Find the share price (try http://quote.yahoo.com/) • Find the earnings per share (try http://biz.yahoo.com/z/a/b/ba.html) • We started with V = (1+i)/i • If (1+i)/i is taken as a constant mark-up called  we get that V = • Rearranging we get  = V/ • P/E is basically the market opinion of V/ • The U.S. historical average P/E is about 17-19 • We expect to pay 17 to 19 times this year’s earnings for a share of stock.

29. Firm Valuation • Now suppose profits grow at a constant rate, g < i

30. Firm Valuation • If  = $100, g = 3% and • If i = 5%, then V = $100(1.05)/0.02 = $5,250 • If i = 10%, then V = $100(1. 10)/0.07 = $1,375 • Note the basic P/Es in this case: • Without growth at i = 5% the expected P/E is 21, with 3% growth it is 52.5 • Without growth at i = 10% the expected P/E is 11, with 3% growth it is 13.75

31. Firm Valuation - a case • In 1996 Softbank’s market value was 160 times its annual profits. • Profits were ¥25 billion • Japanese interest rates were about 5% • Find these: • What is the market value? • If g = 0 what is the expected P/E? • If the company grows at the historic average of world GDP (2%) what is the expected P/E? • What g is consistent with a P/E of 160? • Is this likely to happen? • Profits grew by 210% the previous year. What does this suggest?

32. Firm Valuation • If profits grow at a 0 rate, then: • V =  (1+i)/i • If profits grow at a constant rate, g < i, then: • V =  (1+i)/(i-g) • Maximizing Short-Term Profits • Managers do not control interest rates (Fed, M1, bond market) • A good deal of economic growth is unrelated to management decisions (GDP, legal structures, taxes, etc.) • 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.

33. Control Variables Output (this choice frequently effects price) Price (this choice frequently effects quantity sold) Product Quality Advertising R&D Basic Managerial Question: How much of which control variable should be used to maximize net benefits? Marginal (Incremental) Analysis

34. Net Benefits • Net Benefits = Total Benefits - Total Costs • Profits = Total Revenue - Total Costs or  = TR - TC or  = PxQ - FC - VC(Q) or  = P(Q)xQ - FC - VC(Q)

35. Optimization in parts • Consider a revenue stream that can be described by: • TR = 100Q - Q2 • Consider a cost stream that can be described by: • TC = 30 + Q

36. Marginal Benefit (MB) • Change in total benefits arising from a change in the control variable, Q: MB = DTB / DQ Where D = change • Slope (derivative) of the total benefit curve MB = TB / Q

37. Marginal Cost (MC) • Change in total costs arising from a change in the control variable, Q: MC = DC / DQ • Slope (calculus derivative) of the total cost curve MC = TC / Q

38. 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

39. Optimizing in steps • Suppose we start with MR • If Q = 5, then TR = 100x5 - 52 = 500 - 25 = 475 • If Q = 10, then TR = 100x10 - 102 = 1,000 - 100 = 900 • If Q = 15, then TR = 100x15 - 152 = 1,500 - 225 = 1275 • Between Q = 5 and Q = 10, MR = (900-475)/(10-5) = 425/5 = 85 • Between Q = 10 and Q = 15, MR = (1275-900)/(15-10) = 375/5 = 75 • Apparently MR is decreasing as we increase production • Now look at MC

40. Optimizing in steps • Now look at MC • At Q = 5, TC = 30 + 5 = 35 • At Q = 10, TC = 30 + 10 = 40 • At Q = 15, TC = 30 + 15 = 45 • Between Q = 5 and Q = 10, MC = (40-35)/(10-5) = 5/5 = 1 • Between Q = 10 and Q = 15, MC = (45-40)/(15-10) = 5/5 = 1 • Apparently MC is constant as we increase production

41. Optimizing in steps • All we need to do now is find out what level of production leads to MR = 1 • Suppose we increase production by 1 unit from q1 to q2, so that q2 = q1 + 1,then: MR = TR2-TR1 = (100q2 - q22) - (100q1 - q12) = 100(q2-q1) + (q12 - q22) = 100(q2-q1) + (q1- q2)(q1 + q2) = 100(q1+1- q1) + (q1- q1-1)(q1 + q1+1) = 100 - 2q1-1 Set this equal to 1 and solve for q1

42. Optimizing in steps Set this equal to 1: 1 = 100 - 2q1-1 2q1 = 100 - 1 - 1 2q1 = 98 q1 = 49 • Profit maximization occurs where production is between 49 and 50. • Try finding a higher profit.

43. Optimizing using calculus • Marginal Revenue is the change in revenue that results from a change in production. • TR = 100q - q2 • MR = the slope of the total revenue curve • Slope is the first derivative: • TR/ q • TR/ q = 100 - 2q

44. Optimizing using calculus • Marginal Cost is the change in Total Cost that results from a change in production • TC = 30 + q • MC = the slope of the total cost curve • Slope is the first derivative: • TC/ q • TC/ q = 1

45. Optimizing using calculus • Setting MR = MC • 100 - 2q = 1 • 99 = 2q • q = 49.5

46. Optimizing targets • Breakeven • Revenue maximization • Market share maximization • Cost minimization • Constrained maximization: • Market share subject to no losses • Revenue maximization subject to no losses

47. The Geometry of Optimization

48. Summary • 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) • Lottery payouts • Athletic contracts. • Optimal economic decisions are made at the margin (marginal analysis)