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EC 500
Chapter 1The Fundamentals of Managerial
Economics
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Headline
Amcott Loses $3.5 Million; Manager Fired.
On Tuesday software giant Amcott posted a year-end operating loss of $3.5 million. Reportedly, $1.7 million of the loss stemmed from its foreign language division.
With short-term interest rates at 7 percent, Amcott decided to use $20 million of its retained earnings to purchase three-year rights to Magicword, a software package that converts generic word processor files saved as French text into English. First year sales revenue from the software was $7 million, but thereafter sales were halted pending a copyright infringement suit filed by Foreign, Inc.
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Amcott lost the suit and paid damages of $1.7 million. Industry insiders say that the copyright violation pertained to a very small component of Magicword.
Ralph, the Amcott manager who was fired over the incident, was quoted as saying, “I’m a scapegoat for the attorneys [at Amcott] who didn’t do their homework before buying the rights to Magicword. I projected annual sales of $7 million per year for three years. My sales forecasts were right on target.”
Do you know why Ralph was fired?
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1. Managerial Economics
• Manager– A person who directs resources to achieve a stated
goal.
• Economics– The science of making decisions in the presence of
scare resources.
• Managerial Economics– The study of how to direct scarce resources in the
way that most efficiently achieves a managerial goal.
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2. Economic vs. Accounting Profits
• Goal = Profit Maximization (among others)
• 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.
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Opportunity Cost• Accounting Costs
– The explicit costs of the resources needed to produce 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.
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[Example]• Pizza House in NY
– Revenue = $100,000– Cost = $20,000– Profit =
• Opportunity Cost– Can work for $30,000– Rental revenue = $70,000
• Total Economic Cost = Cost + Opportunity Cost =
• Economic Profit = Revenue – Total Economic Cost = $100,000 - $120,000 =
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Sustainable Industry
Profits
Power of Input Suppliers
Supplier ConcentrationPrice/Productivity of Alternative InputsRelationship-Specific InvestmentsSupplier Switching CostsGovernment Restraints
Power ofBuyers
Buyer ConcentrationPrice/Value of Substitute Products or ServicesRelationship-Specific InvestmentsCustomer Switching CostsGovernment Restraints
EntryEntry CostsSpeed of AdjustmentSunk CostsEconomies of Scale
Network EffectsReputationSwitching CostsGovernment Restraints
Substitutes & ComplementsPrice/Value of Surrogate Products or ServicesPrice/Value of Complementary Products or Services
Network EffectsGovernment Restraints
Industry RivalrySwitching CostsTiming of DecisionsInformationGovernment Restraints
ConcentrationPrice, Quantity, Quality, or Service CompetitionDegree of Differentiation
3. The Five Forces Framework
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4. Market Interactions• 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.
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5. The Time Value of Money
• Present value (PV) of a lump-sum amount (FV) to be received at the end of “n” periods when the per-period interest rate is “i”:
PV
FV
i n1
• Examples:– Lotto winner choosing between a single lump-sum
payout of $104 million or $198 million over 25 years.
– Determining damages in a patent infringement case.
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Present Value of a Series
• Present value of a stream of future amounts (FVt) received at the end of each period for “n” periods:
PV
FV
i
FV
i
FV
inn
1
12
21 1 1. . .
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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
FV
i
FV
i
FV
iCn
n
11
22 01 1 1
. . .
Decision Rule:If NPV < 0: Reject project
NPV > 0: Accept project
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[example]
• A new machine costs $300,000 and has a life of 5 years.
• Cost reductions will be $50,000, $60,000, $75,000, $90,000 and $90,000 in year 1,2,..,5, respectively.
• If the interest rate is 8 percent, should the manager purchase the machine?
• PV = $284,679• NPV = PV – C = -$15,321. • Thus,
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Present Value of a Perpetuity
• An asset that perpetually (endlessly) generates a stream of cash flows (CF) at the end of each period is called a perpetuity.
• The present value (PV) of a perpetuity of cash flows paying the same amount at the end of each period is
i
CF
i
CF
i
CF
i
CFPVPerpetuity
...111 32
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• How?
• Example: What is the value of a perpetual bond that pays the owner $100 at the end of each year when i = 0.05?
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Firm Valuation• The value of a firm equals the present value of current and
future profits.
– PV = t / (1 + i)t
Note: If the profits are expected to grow at a constant rate of g percent,
t = 0 (1 + g)t
Then,
PV = 0 (1 + g)t / (1 + i)t gives (HOW?):
0
1
.. before current profits have been paid out as dividends.
Firm
iPV
i g
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0
1
.. immediately after current profits are paid out as dividends
Ex DividendFirm
gPV
i g
If profits grow at a constant rate (g < i):
(How?)
Point: If the growth rate in profits < interest rate, i.e., g < i, and both remain constant, maximizing the present value of all future profits is the same as maximizing current profits.
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[Example]
Suppose that i = 10% and g = 5%. The firm’s current profits are $100 million.
(a) What is PV?
(b) What is PV after paying a dividend of the current profit?
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Related concept: Tobin’s q
• Tobin's q, is the ratio of the market value of a firm's assets (as measured by the market value of its outstanding stock and debt) to the replacement cost of the firm's assets (Tobin 1969).
• This concept is frequently used in finance analysis.
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• Basic Managerial Question: How much of the control variable should be used to maximize net benefits?– Control Variables = Output, Price, Product Quality,
Advertising, R&D, etc.
• When to stop working? – Study plan?– Retirement plan?
6. Marginal (Incremental) Analysis
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Net Benefits
• Net Benefits = Total Benefits - Total Costs
• Profits = Revenue – Costs
• Point: – Benefit keeps increasing before calling down.– Cost keeps increasing at an increasing rate.
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Key points
• The optimal point is at the level of input (Q) – Where two slopes are the same.
That is, MB = MC.– Where the slope of the Net Benefit is zero.
That is, the Net benefit is maximized.
• Should explain WHY this occurs.– If MB < MC?– If MB > MC?
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Marginal Benefit (MB)
• Change in total benefits arising from a change in the control variable, Q:
• Slope (calculus derivative) of the total benefit curve.
Q
BMB
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Marginal Cost (MC)
• Change in total costs arising from a change in the control variable, Q:
• Slope (calculus derivative) of the total cost curve
Q
CMC
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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.
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The Geometry of Optimization
Q
Total Benefits & Total Costs
Benefits
Costs
Q*
B
CSlope = MC
Slope =MB
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[Example]• Suppose
– Benefit = 300Q – 6Q2
– Cost = 4Q2
– MB = 300 – 12Q– MC = 8Q– MB = MC implies 300 – 12Q = 8Q
Q* = 15NB = 300*15 – 6*152 - 4*152 = 2,250
Exercise: Suppose – Benefit = 150 +28Q – 5Q2
– Cost = 100 + 8Q– What is Q*?
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Conclusion
• 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).
• Optimal economic decisions are made at the margin (marginal analysis).
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Back to Headline
• NPV
= 7,000,000/(1+0.07)1 + 7,000,000/(1+0.07)2 +
7,000,000/(1+0.07)3 - 20,000,000
= -$1,629,788
LOSS!
; Not fired because of the mistakes of his legal department.
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Exercises and Homework
• Chapter 1– In-Class
• Q. 4, Q. 5, Q. 9
– Homework• Q. 3, Q. 10, Q. 13, Q. 18