Introduction

1. Introduction

2. Introduction What is managerial economics going to do for you? Among other things, by studying this course you will gain insight into pricing and output decisions by firms, input mix and production choices by firms, and government intervention in markets. Note economics is a science where decisions in the presence of scarce resources are studied.

3. Assume In economics it is assumed that individuals have objectives and goals in mind that guide their actions. For example, businesses attempt to maximize profit and consumers attempt to maximize utility. What would a manager of a social service agency have as an objective?

4. Economic Profit When the term profit is used in economics it is usually a short way of saying economic profit. Let’s see what this means.

5. Example Say I am planning to open my own entertainment establishment, called Parker’s Pool Hall. I will have explicit costs for the pool tables, pinball machines, labor and electric I use. Say these explicit costs add up to $10,000 a year. If the revenue to the firm is $60,000 a year, the accounting profit (revenue – explicit costs) is $50,000. How do you think I would feel if I gave up a job where I made $40,000 a year and I could have rented out the building where the pool hall is located for $15,000?

6. Implicit costs Notice the $60,000 in revenue pays the explicit costs of $10,000, pays me the $40,000 I gave up in a job, and only pays $10,000 of the $15,000 in forgone rent. I end up short $5,000 (I always end up short – slow too!) in the entertainment business, compared to what I was doing before. The forgone income and rent are examples of implicit costs that economists incorporate into the analysis of profit.

7. Profit Economic profit = accounting profit – implicit costs = total revenue – explicit costs – implicit costs = total revenue – total costs = profit. Costs mean all explicit and implicit costs and in economics the term cost really means opportunity cost, or what is given up in a course of action.

8. Profits can be a guiding light! Resource owners (those having land, labor, capital or entrepreneurial ability) like to make money. When an industry is earning profits (economic profits), resource owners get the message that maybe they should move resources to the industry. In this sense profits are seen as a mechanism that moves resources to areas that have higher value than where resources are currently being used. As a manager of business you may get criticized that profits are ugly and outrageous, but profits serve the role of allocating resources to the highest valued use. This is a good thing if you want the world’s resources to go to the place where they are valued most (in terms of willingness to pay).

9. Industry Profit and Five Forces • Michael Porter, a writer of business topics, has put down on paper some ideas about what factors influence the profit an industry can sustain. The following is a listing and brief summary of those ideas. • Entry – the ability of others to get into an industry will impact the overall level of profit. If barriers to entry can be erected than perhaps profits can be maintained. • Power of input suppliers – unique inputs tend to be able to get more out of firms and thus influence the level of profits. • Power of Buyers (of the output) – If there are a few “high-volume” customers they may be able to get low prices and thus drive profits down. • Industry rivalry – rivalry pertains to influences that exists among the firms within the industry. The greater the rivalry, the lower the profits.

10. -Substitutes and Compliments – The relationship products have with other products can also influence profit levels. The author points out that Microsoft makes more on operating systems (because it sells more units) when hardware is cheaper and thus more folks can buy computers.

11. Understanding Markets Who are the players in the market system and what influence do they have on price?

12. Transactions – two sides Every transaction has two sides – the buying side and the selling side. Other names used are the consumer and producer sides. A market is where the consumer and the producer interact. The consumer would like to PAY LOW PRICES (given all else the same). The producer would like to RECEIVE HIGH PRICES. In every transaction there is a struggle between the desires of producers and consumers in terms of the market price. The market is a mechanism that balances out the two desires.

13. Bargaining Power The power that consumers and producers have over the price is influenced by relationships that exist between consumer and producer consumers and other consumers, and producer and other producers. Let’s explore these ideas on the next few screens, OK?

14. Consumer-Producer Rivalry Consumers like to pay low prices, but consumers can not offer too low of prices because eventually producers would not make the good available. Producers like high prices, but producers can not require too high of prices because eventually consumers would not purchase the good. The market price is the price that balances out the opposing forces.

15. Consumer-Consumer Rivalry Consumers like to pay low prices. But in a world of scarcity (wants being greater than resources available to satisfy all those wants) consumers are pitted against each other in an attempt to capture the goods and services they want. This leads consumers to BID-UP prices in the presence of a relatively large amount of consumers. Think about professional sports. Owners are the frontline consumers of the athletes. Years ago when one owner had the right to resign the player forever the player received much less than occurs in a world a free agency.

16. Producer-Producer Rivalry Producers like high prices. But, if there are many producers of a product then each, in an attempt to gain buyers, will tend to lower the price to attract those consumers from other producers. Think about fast-food establishments in an area. As a casual observation, it seems to me the more producers you have in an area, the lower the prices. This may take affect by using coupons or other special deals, but the producers try to get your business.

17. Prices Later in the course we will think about why prices turn out the way they do, and the rivalry among producers and consumers and among themselves will play a key role. A topic like this is often called price theory within the economics community because a primary concept of study is the price of products.

18. Time Value of Money Decisions made today have consequences today and in the future. The time value of money concept is an aid in evaluating the future in terms of today’s value.

19. Time line Now 1 2 3 4 5 n Now is time zero, or when the decision is made. Each following number is an “end of period” concept. We have the end of the first period, end of the second period and so on until the end of the nth period.

20. Interest Rate Growth If you have $1 today and can earn an interest rate of 10% by the end of the first year then you will have $1.10. The$1.10 is calculated as the amount you start the period with plus the product of what you start the period with times the rate of interest that period. If F is the amount at the end of the period, P is the amount at the beginning of the period and i is the rate of interest during the period, then in general we have F = P + Pi = P(1 + i).

21. Growth in general If you start out with P and wait one period at rate i we just saw you have F = P(1 + i). Now, if you again earn i, by the end of the second period you would have F = P(1 + i) + P(1 + i )i (start period with + start period with times i) = P(1 + i)(1 + i) = P(1 + i)2. In general, at the end of n periods, you have F = P(1 + i)n.

22. Present Value The present value concept uses the growth process we just studied, but the focal point is the present. As an example, what amount do you need today if you want $1.10 at the end of the period and you can earn 10% during the period. You need P = F / (1 + i) = 1.10 / (1 + .1) = $1.00 In general if you want to have F n periods from now and you can earn i each period , then today you need P = F / (1 + i)n. Note, the present value of an amount today would mean n = 0 and so P = F because anything raised to the power zero equals 1.

23. Discount Rate The present value P of a future amount F n periods from now at interest rate i is P = F / (1 + i)n. The interest rate i in this context is often called the discount rate. It is the rate at which we “discount” future values to place them in terms of today’s value. Do not confuse this with the discount rate in the context of monetary policy. The Federal Reserve charges banks the “discount rate” when those banks borrow from the Fed.

24. Example say you are offered the opportunity to get paid $1 at the end of the first period and another $1 at the end of the second period. You know you can earn 10% over the next two years. The catch is that to get the pay-outs you have to give up $1.50. Should you do it? The present value of the future payments is {1 / (1 + .1)} + {1 / (1 + i)2} = {1/1.1} + {1/1.21} = .91 + .83 (rounding to two digits) =1.74. Since the future stream of payments has a present value of $1.74 you should do it. You basically trade $1.50 for $1.74. What a deal!

25. Net Present Value The net present value of an opportunity is the present value of all the benefits of the opportunity minus the present value of all the costs of the opportunity. On the last screen, the NPV of the opportunity was $1.74 - $1.50 = $0.24.

26. Apply NPV • Rules for behavior • Take an opportunity if the NPV > 0. • Choose the opportunity among competing choices that has the highest NPV (firms maximize profit). • The value of the firm is the net present value of the future profit stream.

27. Caution Much of what we will do in this course is think about what to do in one period and we will think about the rules of behavior in that context. It seems we will ignore the time value of money. We are not ignoring the concept. As an example, we will think about how much a firm should produce this period. Should it make 1, 2, 3, or more units this period? This period it should make the profit maximizing amount. The rules we come up with for this type of decision can be used in any time period. There is no time dimension in much of what we do. BUT, if there is a time dimension, use the time value of money!

28. Marginal Analysis A major tool or way of thinking in economics is marginal analysis. Basically, the tool says to get to the “optimal” position think about the next move.

29. Driving Analogy Did you drive 100 mph today? When you think about driving there are benefits and costs. Benefits: it can be exhilarating, you get there quicker so you can stay where you are longer and enjoy that situation, and there are probably more. Costs: risk of injury, penalties for driving over speed limit, and there are probably more. Many choose to drive instead of walk because the benefits of driving outweigh the costs. But how fast should we drive?

30. Driving Analogy Now think about increasing the speed at which you drive 1 mph at a time, please (). We usually don’t even think about it out of the driveway until we hit the speed limit. Then we start to think about cops in the area giving tickets, how fun it is to push the exhilarator (accelerator), the injuries that might happen, etc… As we push our total speed higher and higher, the economic way of thinking would have use write down the marginal benefit and marginal cost of each mile per hour faster. Drive a mile per hour faster if the marginal benefit is at least as great as the marginal cost.

31. General Analysis We will see more later, but essentially it is thought that the marginal benefits of an activity decline the more we do of the activity and the marginal costs of an activity rise the more we do of an activity. With this in mind, on the next screen I will have a graph with MB and MC on the vertical axis, while on the horizontal axis I will have the TOTAL amount of the activity. So, while we increase the total activity on the horizontal axis, on the vertical axis we measure the marginal benefit and cost of the additional unit.

32. Graphical Interpretation MB, MC MC MB go don’t amount or Q Q*

33. Activity Rule Engage in an activity up to the point where the marginal benefit equals the marginal cost. The logic here is that people are maximizers – they want the most benefit net of costs. Q* is the optimal amount in the graph. Before this point each unit added has a MB > MC and so adding these units adds more to benefit than cost and makes the total net higher. Always add a unit if MB > MC on that unit. If more than Q* is done then on those units the MB < MC and thus the net amount is lowered. We do not want that. You will notice that when the Q* unit was added MB = MC. Nothing on the net was added or lost. But our rule is go to point where MB = MC.

34. Calculations of marginal amounts Total Revenue is price times quantity. Marginal revenue is the typical benefit we have for firms in a market. MR is the change in total revenue when we change output, usually by one unit. MR = Change TR divided by change in output. Marginal cost is the change in total cost divided by the change in output.