Finance 30210: Managerial Economics

1. Finance 30210: Managerial Economics Introduction

2. “Economics deals with the Allocation of scarce resources to satisfy unlimited wants”

3. “You can’t always get what you want…” - Mick Jagger Consumers have limited incomes to spend on a wide variety of goods and services (both now and in the future) Workers have a finite number of hours in the day to work, relax, go to school, etc Firms have finite capacity and limited financial resources, to produce goods and services Microeconomics is all about making the most of these limits

4. If we can’t have everything we want, so we need to decide what to do with the limited resources we do have. Efficiency vs. Equity An allocation of resources that maximum total welfare An allocation of resources provides a “fair” distribution of welfare Under certain circumstances, the market process guarantees this Can we trust markets to produce a desirable outcome?

5. When thinking about efficiency, think about the impact on individuals! Suppose that Exxon acquires drilling rights within a remote area where there will be negligible environmental damage in the traditional sense VS. The Sierra club files a lawsuit to block the drilling (Their personal serenity has been threatened by the knowledge that the oil is being removed from it’s natural habitat) If you are the judge, who should prevail?

6. VS. • If Exxon Wins: • Exxon stockholders gain • Workers gain from added jobs • Motorists see falling gasoline prices • If Exxon Wins: • Sierra club members lay awake at night screaming -$5M $10M A ruling against Exxon in this example would be inefficient – a missed opportunity to make everyone better off.

7. Charles Darwin vs. Adam Smith: Efficiency and the Competitive Marketplace "Greed captures the essence of the evolutionary spirit." -Gordon Gekko

8. Introducing homo economicus….also known as “Economic Man” Economic man is a RATIONAL being

9. The Fundamental Rule of Economics: Individuals are rational beings and therefore respond to incentives Economic Incentive = (Expected) Benefit – Opportunity Cost Opportunity cost = Direct (Money) Costs + Indirect Costs In other words, think about opportunity cost as the value of ALL the resources that have been consumed

10. Example: Do you have an incentive to be here? Costs Benefits (Mendoza Grads) Tuition & Fees: $39,920 Median Salary: $56,000 Room & Board: $10,870 - HS Grad Salary: $26,000 Books/Supplies: $1,000 Difference: $30,000/yr Other Expenses: $900 Transportation: $500 Think of the salary differential as interest being collected from an initial investment Lost Salary: $26,000 Total: $67,820 X 4 = $271,280 $30,000/yr = .011 (11.0%) $271,280

11. Competitive markets will yield efficient outcomes (that is, maximize total gains), but not necessarily equitable outcomes. • Many producers/consumers • Homogeneous product • No taxes, subsidies, tariffs, quotas, etc. • Perfect information • No externalities Producers with the lowest costs stand to gain the most The average consumer/producer stands to gain very little Consumers with the highest values stand to gain the most This is where the equity issues arise!

12. Markets are all about taking advantage of differences in opportunity cost. Consider the following example. Two countries (the US and Mexico) producing two different goods (Agriculture and Manufacturing). Mexico USA Note: Assume that wages are equal across sectors

13. Everything we do involves a cost (Time, money, or both). Opportunity cost measures all the costs involved with an activity. In this example, the cost of manufacturing in Mexico is the time spent. We need to value that time. 1 Unit of manufactured goods 5/4 units of agriculture lost ¼ hour of time spent 5 units of agriculture per hour Mexico 1.25 units of agriculture per unit of manufacturing 4 units of manufacturing per hour

14. We could work this the other way and figure the opportunity cost for Mexico of producing agriculture. 1 Unit of agriculture 4/5 units of manufacturing lost 1/5 hour of time spent 4 units of manufacturing per hour Mexico .80 units of manufacturing per unit of agriculture 5 units of agriculture per hour

15. In terms of opportunity cost, Mexico has the lower cost of agriculture (in terms of lost manufacturing) and the US has a lower cost of Manufacturing (in terms of lost agriculture). We would say that Mexico has a comparative advantage in agriculture while the US has a comparative advantage in manufacturing Mexico USA

16. Suppose that both the US and Mexico had 40 hrs per week available to produce both goods: For every unit of agriculture produced, the US gives up 1.25 units of manufactured products For every unit of agriculture produced, Mexico gives up .80 units of manufactured products 200 Slope = 1.25 Slope = .80 160 100 80 80 160 100 200 If the US devoted half its resources to each sector, it could have 80 units of agriculture and 100 units of manufacturing If Mexico devoted half its resources to each sector, it could have 100 units of agriculture and 80 units of manufacturing

17. Prices will determine what actually gets produced in each country: Suppose that the wage rate in the US is $10/hr USA $2 unit cost 1 unit = 1/5 hr $2.50 unit cost 1 unit = 1/4 hr Lets look at the profitability of each industry in the US With a wage of $10/hr, the price of agriculture has to be at least $2.50/unit while manufacturing has to be at least $2 to be profitable

18. How do markets provide efficient outcomes? PRICES!! A unit of manufacturing sells for $2.00 A unit of agriculture sells for $2.50 The relative price of agriculture (in terms of manufacturing) is $2.50 = 1.25 (Units of manufacturing per unit of agriculture) $2.00 Why should we only be interested in relative prices?

19. Relative price of agriculture (in terms of manufactured goods) Profit from producing agriculture (in terms of manufactured goods) Relative cost of agriculture (in terms of manufactured goods) (equals 1.25) If the relative price of agriculture is below 1.25, labor in the US is dedicated to manufacturing 200 If the relative price of agriculture is above 1.25, labor in the US is dedicated to agriculture 160

20. We get similar results in Mexico In Mexico, the relative cost of agriculture is .80 If the relative price of agriculture is below .80, labor in Mexico is dedicated to manufacturing 160 If the relative price of agriculture is above .80, labor in Mexico is dedicated to agriculture 200

21. For any relative price of agriculture between .80 and 1.25, Mexico will specialize in agriculture and the US will specialize in manufacturing. Suppose the price of agriculture is one (each agricultural item is traded for one manufactured item) With trade, The US specializes in manufacturing (produces 200 units) and then sells 100 units of them for 100 units of agriculture With trade, Mexico specializes in agriculture (produces 200 units) and then sells 100 units of them for 100 units of manufacturing Production point 200 160 Consumption point Consumption point 100 100 80 Production point 100 200 80 100 160 Gain = 20 Manufactured Goods Gain = 20 Agricultural Goods

22. Suppose the agreed upon price of agriculture is .80 (each agricultural item is traded for .80 manufactured items With trade, The US specializes in manufacturing (produces 200 units) and then sells 100 units of them for 125 units of agriculture With trade, Mexico specializes in agriculture (produces 200 units) and then sells 125 units of them for 100 units of manufacturing 200 160 100 100 80 125 160 75 200 Gain = 45 Agricultural Goods Gain = 0

23. Suppose the agreed upon price of agriculture is 1.25 (each agricultural item is traded for 1.25 manufactured items With trade, The US specializes in manufacturing (produces 200 units) and then sells 100 units of them for 80 units of agriculture With trade, Mexico specializes in agriculture (produces 200 units) and then sells 80 units of them for 100 units of manufacturing 200 160 100 100 80 160 120 200 Gain = 0 Gain = 20 Agriculture, 20 Manufacturing

24. How do we know what price will actually be? For prices above 1.25, both countries specialize in agriculture 1.25 For prices between .80 and 1.25, both countries are completely specialized (US in manufacturing, Mexico in Agriculture) .80 200 360 For prices below .80, neither country produces agriculture But supply is only half the story!!

25. The location of the demand curve will determine the price!! In equilibrium, demand must equal supply. In this case, 200 units of agriculture are produces (all in Mexico) and are sold at a relative price of 1.15 1.25 1.15 .80 Note: We would get a similar picture for Manufacturing 200

26. Suppose we change this example slightly. Now, the US has an absolute advantage in everything. However, Mexico still has a comparative advantage in agriculture. Mexico USA 1 Unit of agriculture 10/8 = 1.25 units of manufacturing lost 1/8 hour of time spent 1 Unit of agriculture 4/5 = .80 units of manufacturing lost 1/5 hour of time spent

27. Multiple Producers/Consumers Suppose that you have been elected president of the US. Your job is to find the most efficient production/consumption pattern for wheat. You know that different consumers/producers have different values/costs Producers Consumers However, you can’t tell them apart! What do you do? Note: All values are relative to some general price index

28. Competitive markets provide the efficient solution The Supply curve sorts potential producers by cost The Demand curve sorts potential buyers by value 6 6 5 5 4 4 3 3 400 500 800 1000 200 300 700 900 What should the equilibrium price be?

29. Competitive markets provide the efficient solution Note that the gains are not distributed equally!! 6 #4 5 #2 4 #3 3 200 400 500 Total “Profit” = 900

30. The Average Shopping cart in the US today is approximately three times as big as its 1975 counterpart Ralph Nader has argued that this is a prime example of consumers being manipulated by unscrupulous capitalists – bigger carts shame consumers into bigger purchases. What’s wrong with this argument?

31. Microsoft’s new Xbox 360 gaming console was released in North America on November 22, 2005 at a retail price of $299.99. Available supply sold out almost immediately as Christmas shoppers stood in line for this year’s hot item. (Microsoft has increased its sales target from 3M units to 6M units). What’s odd about this??

32. In the years following a divorce, statistics show that the woman’s living standard falls 27% while the man’s living standard rises by 10% Feminists such as Patricia Ireland (NOW) would argue that this proves divorce is unfair to women Couldn’t you just as easily argue that marriage is unfair to men?

33. On December 22, 2001, Richard Reid was arrested trying to blow up an American Airlines flight from Paris to Miami with a bomb hidden in his shoes. Many human rights groups have fought heavily against the practice of racial profiling by airline security Isn’t there a better way to secure the safety of our airplanes? (Hint: could we create a marketplace?)

34. Paul “Freck” Morgan started a website in 2001 offering a $20 Pay Per View event…..to watch him cut off his feet with a homemade guillotine. Note: The site turned out to be a hoax…Paul never actually went through with it! How should we feel about this entrepreneurial effort? (i.e. could we/should we repress this market?)