BUS 525.2: Managerial Economics Lecture 1 The Fundamentals of Managerial Economics

1. BUS 525.2: Managerial Economics Lecture 1 The Fundamentals of Managerial Economics

2. Course Overview 2 • 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 Strategy. Sixth Edition. Boston: McGraw-Hill Irwin, 2009. [MRB] • Web-page: http://fkk.weebly.com • Office: NAC 751 • Office hours: Tuesday, 5pm-6:30 pm

3. Activity Schedule:BUS525

4. 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 pre-announced. 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).

5. Overview 1-5 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

6. Managerial Economics 1-6 • Manager • A person who directs resources to achieve a stated goal. • Economics • The science of making decisions in the presence of scarce resources. • Case No. 1, Load shedding in DESCO area • Managerial Economics • The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.

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

8. The Economics of Effective Management 1-8 • 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

9. Identify Goals and Constraints 1-9 • 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.

10. Economic vs. Accounting Profits 1-10 • Accounting profits • Total revenue (sales) minus cost of producing goods or services. • Reported on the firm’s income statement. • Economic profits • Total revenue minus total opportunity cost.

11. Opportunity Cost 1-11 • Accounting costs • The explicit costs of the resources needed to produce goods or services. • Reported on the firm’s 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.

12. 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 12

13. 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 13

14. Profits as a Signal 1-14 • 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.

15. 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 system’s inability to adjust instantaneously to unanticipated changes in market conditions. Case No. 3: Eastman Kodak Files for Bankruptcy Protection 15

16. Theories of Profits Monopoly theory - Profits are the result of some firm’s 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 well-managed firms. 16

17. Entry • Entry Costs • Speed of Adjustment • Sunk Costs • Economies of Scale • Network Effects • Reputation • Switching Costs • Government Restraints 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 Substitutes & Complements • Concentration • Price, Quantity, Quality, or Service Competition • Degree of Differentiation • Price/Value of Surrogate Products or Services • Price/Value of Complementary Products or Services • Network Effects • Government Restraints • Switching Costs • Timing of Decisions • Information • Government Restraints The Five Forces Framework 1-17

18. Understanding Firms’ Incentives 1-18 • 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.

19. 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.

20. Shareholders (principals) want profit Managers (agents) want leisure & security Conflicting motivations between these groups are called agency problems. Case No. 4 Professor Yunus blasts Telenor ethics in Bangladesh Stock brokers and investors Physicians and patients Auto mechanics and car owners The Principal-Agent Problem

21. Solutions to Agency Problems Compensationas 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

22. Market Interactions 1-22 • 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

23. 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

24. 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

25. 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

26. 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

27. The Time Value of Money 1-27 • Present value (PV) of a future value (FV) lump-sum amount to be received at the end of “n” periods in the future when the per-period interest rate is “i”: • Examples: • 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.

28. Present Value vs. Future Value 1-28 • 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.

29. Present Value of a Series 1-29 • Present value of a stream of future amounts (FVt) received at the end of each period for “n” periods: • Equivalently,

30. Net Present Value 1-30 • Suppose a manager can purchase a stream of future receipts (FVt) by spending “C0” dollars today. The NPV of such a decision is Decision Rule: If NPV < 0: Reject project NPV > 0: Accept project

31. Present Value of a Perpetuity 1-31 • 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

32. Objective of the Firm Not market share Not growth Not revenue Not empire building Not net profit margin Not name recognition Not state-of-the-art technology 32

33. What’s 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 for-profit 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? 33

34. Value Maximization Isa Complex Process Figure 1.3

35. Definition and Measurement of “Value of the Firm” “The present value of the firm’s future net earnings.” 12n V = [--------] + [ --------] + . . . + [ -------- ] (1+r)1 (1+r)2 (1+r)n N t V =  [ ------- ] , t = 1, 2, ... , N t = 1 (1+r)t 35

36. Adding Value to the Firm Profit = Total Rev - Total Cost  = P . Qd - VC . Qs - F where  = profit, P = price, Qd = quantity demanded, VC = variable cost per unit, Qs = quantity supplied, F = total fixed costs 36

37. Determinants of Value of the Firm N t 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)

38. Firm Valuation and Profit Maximization 1-38 • The value of a firm equals the present value of current and future profits (cash flows). • A common assumption among economist is that it is the firm’s goal to maximization profits. • This means the present value of current and future profits, so the firm is maximizing its value.

39. Firm Valuation With Profit Growth 1-39 • If profits grow at a constant rate (g < i) and current period profits are po, before and after dividends are: • Provided that g < i. • That is, the growth rate in profits is less than the interest rate and both remain constant.

40. 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 firm’s current profits are $100 million. • 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?

41. 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? Marginal (Incremental) Analysis 1-41

42. Net Benefits 1-42 • Net Benefits = Total Benefits - Total Costs • Profits = Revenue - Costs

43. Marginal Benefit (MB) 1-43 • Change in total benefits arising from a change in the control variable, Q: • Slope (calculus derivative) of the total benefit curve.

44. Marginal Cost (MC) 1-44 • Change in total costs arising from a change in the control variable, Q: • Slope (calculus derivative) of the total cost curve

45. Marginal Principle 1-45 • To maximize net benefits, the managerial control variable should be increased up to the point where MB = MC. • MB > MCmeans the last unit of the control variable increased benefits more than it increased costs. • MB < MCmeans the last unit of the control variable increased costs more than it increased benefits.

46. Q The Geometry of Optimization: Total Benefit and Cost 1-46 Total Benefits & Total Costs Costs Benefits Slope =MB B Slope = MC C Q*

47. Q The Geometry of Optimization: Net Benefits 1-47 Net Benefits Maximum net benefits Slope = MNB Q*

48. Myths and Misconceptions Economics is about money only Economics assumes that everyone is selfish A company’s value is measured by the company’s assets Costs are measured appropriately by accountants. 48

49. 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 it’s cost-effective Our price should be based on our costs 49

50. 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. 50