Topic 1

The Nature & Scope

of Economics

What is the ‘Economic Problem’?

• The ECONOMIC PROBLEM is the problem of allocating resources efficiently– to achieve objectives – while satisfying constraints, such

as

•scarcity

•requirement

•feasibility

• Economics – analyses and provides answers to basic fundamental question of scarcity

• Scarcity arises out of two basic fundamental facts of life

a) Wants unlimited b) Economic Resources limited

• Three questions

A) What to produceB) How to produceC) For whom to produce

‘Objectives of Economic Agents’

• Different groups have different objectives – Firms maximize profits constrained by

• demand (consumer preferences), • production (technological production

possibilities), • competition (competitive responses), • government (regulatory or fiscal measures)

– Consumers maximize utility• prices and other characteristics of goods• income

– Governments maximize social welfare

Managerial Economics:

Introduction

Definition of Economics• ECONOMICS IS THE ART OF MAKING THE

MOST OF LIFE……..GB Shaw

• “……….THE STUDY OF MANKIND IN THE EVERYDAY BUSINESS OF LIFE”…..A Marshall

• “THE SCIENCE WHICH STUDIES HUMAN BEHAVIOR AS A RELATIONSHIP BETWEEN ENDS AND SCAECE MEANS WHICH HAVE ALTERNATIVE USES”.. L Robbins

Managerial Economics Defined

The application of economic theory and the tools of decision

science to examine how an organization can achieve its

aims or objectives most efficiently.

Managerial Decision Problems

Economic theoryMicroeconomicsMacroeconomics

Decision SciencesMathematical Economics

Econometrics

MANAGERIAL ECONOMICSApplication of economic theory

and decision science tools to solvemanagerial decision problems

OPTIMAL SOLUTION TOMANAGERIAL DECISION PROBLEMS

Relationship of Managerial Economics to Business School Curriculum

• Integrating Course that treats the firm as one unit rather than as individual functional areas such as – Operations

– Finance

– Marketing etc

• Technique Course

What do you get out of the course?

•Better – Decision-making skills

– Understanding of the role of business

– Understanding of economic analysis

Basic Assumptions in Economics

• Ceteris Paribus– A Latin Phrase which means “with other things

being the same”– Used in isolating description of a particular event

from other potential variables– Ex: price-demand relationship

• Rationality– People act rationality (??!!)– Consumers and producers measure and compare

the costs and benefits of a decision before going ahead

Basic Assumptions in Economics

• People Respond to Economic Incentives– Diesel & petrol cars

• Optimal Decision is Made at the Margin– Most decision in life involve doing a little

more or little less– Economists use the word marginal to mean

an extra or additional benefit or cost of a decision

– Economists reason that the optimal is to continue any activity up to the point where marginal benefit is equal to marginal cost; MR=MC

THEORY OF THE FIRM

-What is a firm-Types of Firms-Reasons for Existence of a firm-Value of the firm-Constraints under which the firm operates-Limitations of the theory of the firm

What is a FIRM:

Definition

FIRM is an organisation that combines and organizes resources for the purpose of producing goods and/or services for selling in the market

Types of Firms

-Proprietorships

-Partnerships

-Corporations

In India the firms produce more than 70% of all goods and services. Rest by GOs and NGOs

Forms of Ownership

• Private Sector– Wholly owned by people, individually

or as a group

• Public Sector– Owned, managed and controlled by

government

• Joint Sector– Owned and managed jointly by

individuals and government

Private Sector• Sole Proprietorship: Ancient form of ownership in

which an individual invests own or borrowed capital and solely responsible for the results of operations

• Partnership: Two or more individuals decide to start a common business

• Joint Stock Company: Most important type of business organization. Owners capital here is invested in the form of shares. The liability of each shareholders is limited to the proportion of share held by him(er)

• Cooperative: A non-profit, non-political, non-religious voluntary organization formed with an economic objective

Public Sector• Public Sector Units (PSUs):

– Here, just like private sector, government invests in production activities and enters the market.

– These units play very significant role in aspects like employment generation, equitable distribution of national wealth and where private sector doesn’t want to enter

• Corporation or Board– Does not aim for revenue generation but equitable

distribution of resources through government intervention (FCI, KVIC etc)

• Department– Run for a specific purpose like education, health,

civil administration etc

Theory of the FirmWhat will be the consequences for the society if the firm did not exist?

• Combines and organizes resources for the purpose of producing goods and/or services for sale.

• Internalizes transactions, reducing transactions costs.

• Primary goal is to maximize the wealth or value of the firm.

Why FIRM exists?

Social role

Firms exist to allocate society’s resources efficiently and

equitably

- Case Application 1-2 – p 12-3: The Objective and Strategy of Firms in Cigarette Industry

Why FIRM exists?

•Firms exist becoz otherwise it’ll be very inefficient & costly for entrepreneurs to enter into & enforce contracts with workers, owners of capital, land & other resources for separate step of production & distribution process. e.g. Car, PC.

•Firms do not continue to grow larger and larger indefinitely because of limitations on management ability to effectively control and direct the operation of the firm as it becomes larger and larger. •Interesting book on this issue by John Kennith Galbraith ‘The New Industrial Estate’

Present Value Analysis

• Many transactions involve making or receiving cash payments at future dates

• Here concepts related to time value of money are required to take sound business decision

• TVM refers to the fact that a rupee to be received in the future is not worth a rupee today

• Hence measuring present value of rupees is important

Value of the FirmThe present value of all expected future profits

1 21 2

1(1 ) (1 ) (1 ) (1 )

nn t

n tt

PVr r r r

1 1(1 ) (1 )

n nt t t

t tt t

TR TCValueof Firm

r r

where: TRt = Total Revenue TCt = Total cost year

r = the interest rate, t goes from 1 (next year) to n (the last year) in

the planning horizon

Present value (PV) of expected future profits

where: TRt = the firm’s TR in year t

TCt = the firm’s TC in year t

r = the interest rate

and t goes from 1 (next year) to n (the last year in the planning horizon)

1 1(1 ) (1 )

n nt t t

t tt t

TR TCValueof Firm

r r

Hershey Foods – an example

Year Cash Flow

Present Value of

$1 at 15%

Present Value

0 (2,500,000) 1.000 (2,500,000)1 600,000 0.870 521,739 2 800,000 0.756 604,915 3 800,000 0.658 526,013 4 600,000 0.572 343,052 5 250,000 0.497 124,294

(379,987)

Because the project has a negative net present value, it does not contribute to the goal of maximizing shareholder value. Therefore, it should be rejected.

Present Value of Re 1

at

1. # years Profit 1 Present

in the future (Rs. crores) (1 + r)t value (PV)

1 8 .90909 7.27272

2 10 .82645 8.26450

3 12 .75131 9.01572

4 14 .68301 9.56214

5 15 .62092 9.31380

6 16 .56447 9.03152

7 17 .51316 8.72372

8 15 .46651 6.99765

9 13 .42410 5.51330

10 10 .38554 3.85540

Total 77.55047

Thus, the answer is Rs.77.55047 crores.

Problem 1Cost 30 crores

Problem 11. # years Profit 1 Present

in the future (Rs. crores) (1 + r)t value (PV)

1 8 .90909 7.27272

2 10 .82645 8.26450

3 12 .75131 9.01572

4 14 .68301 9.56214

5 15 .62092 9.31380

6 16 .56447 9.03152

7 17 .51316 8.72372

8 15 .46651 6.99765

9 13 .42410 5.51330

10 10 .38554 3.85540

Total 77.55047

Thus, the answer is Rs.77.55047-30 = 47.55047 crores.

Cost of the 30 crores

Discounting Examples n

V = (TRt-TCt)/(1+i)t Discount rate (i) = 0.06 t=0

Two courses of action: A and B– If A is chosen, outflow of Rs. 1 million this year (t=0) and

inflows of Rs300,000 for each of next 5 years. V = -1,000,000 + 300,000 + 300,000 + 300,000 + 300,000 + 300,000 =

Rs263,709 1.060 1.06 1.062 1.063 1.064 1.065

– If B is chosen, outflow of Rs 1 million this year (t=0) and inflows of Rs. 260,000 for each of next 6 years.

V = -1,000,000 + 260,000 + 260,000 + 260,000 + 260,000 + 260,000 + 260,000 1.060 1.06 1.062 1.063 1.064 1.065 1.066

=Rs. 278,504

Case Study of

- Indian Oil buying IB Petroleum- Jet –Sahara Deal – Some Details of Case- TATA - Jaguar Land Rover Deal- TATA –CORUS Deal- TATA Tetley Tea- Buying Equity Shares from Market- M & A Deals- Google – Motorola buying & Selling it later to Lenovo- Microsoft buying Skype & earlier Hotmail- Vodafone buying Hutch – The Tax controversy apart

Jet –Sahara Deal

Some Details of Case – Jetlite Brand now

Kingfisher was ready to pay 500 crores but Jet paid 1500 crores why?

1.Capital Cost2.Interest Rate on capital cost3.Staff cost4.Type of Aircraft 5.International Rights – what are the rules?6.Parking slots – Regulatory domain

1. # years Profit 1 Present

in the future (Rs. crores) (1 + r)t value (PV)

1 18

2 15

3 12.9

4 14.5

5 15.5

6 11.6

7 19.7

8 18.5

9 15.3

10 100

Find the PV 4, 5, 8 and 10 years

The discount rate is 5, 10, 15, 20 and 25 percentThe answer is Rs.__________ crores.

Home Assignment 1 Cost 100 crores

1. A firm is expected to earn Rs100,000 per year forever. If the annual discount rate is 10%, what is the present value of the firm?

2. The owner of a firm has decided that he wants to sell it for Rs5,000,000 and he sets out to increase annual profits up to the level required to attain this value. If the annual discount rate is 10% and the level of profit can be expected to continue indefinitely, how much annual profit must the firm earn to attain the value that the owner seeks?

3. Phil is considering the purchase of a 10-year lease that will allow him to operate a concession stand at a local sports stadium. If the lease will cost Rs100,000 and the relevant discount rate is 15%, what is the minimum annual profit necessary to justify the purchase?

Alternative Theories• Sales/Revenue maximization (W.Baumol, 1959)

– Adequate rate of profit

• Management utility maximization (Williamson, 1963)– Principle-agent problem - e.g. ESOPs

• Satisficing behavior (Cyert & March)• Growth

• Long Run Survival

Management utility maximization Agency Costs

•Stockholder and managers may have different objectives– job security or personal wealth may be pursued by

managers rather than pursuing stockholder wealth maximization

– Stockholder lack knowledge of managers– Random events may obscure managerial effectiveness

and results

•Agency costs– costs to provide incentive for managers to pursue

stockholder goals– monitoring cost

3 policies that create the right monetary incentives for CEO’s to

maximize the value of their companies:

• Boards can require that CEOs become substantial owners of company stock - ESOPs

• Salaries, bonuses, and stock options can be structured so as to provide big rewards for superior performance

• The threat of dismissal for poor performance can be made real

Ha-Joon Chang Thing 14 : US Managers are Overpriced

Executive payJan 19th 2006 The Economist

America's chief executives earn almost twice as much as their European counterparts thanks mainly to the greater use of incentive schemes, such as stock options. The typical chief executive of a $500m company in America earned $2.2m in 2005. Of this total, only $600,000, or less than 30%, came from a basic salary, according to the latest study of global executive pay by Towers Perrin, a consultancy.

Opportunity Cost• When an activity is

chosen, the opportunity cost is the benefit expected from the best alternative forgone–Example: If you choose to attend B-School this year, your opportunity cost is the salary you would have received from the best available full-time job.

“I hunt and she gathers—otherwise we couldn’t make ends meet.”

Opportunity Cost

Example: Neanderthals and Homo Sapiens

Source: Discovery Channel Documentary

Diamond – water paradox

Definitions of Profit

•Business Profit:

Total revenue minus the explicit (or accounting) costs of production[1].

[1] also called out-of-pocket expenses

Definitions of Profit• Business (or Accounting) Profit:

Total revenue minus the explicit (or accounting) costs of production.

Mainly a concern of an Accountant• Controlling day to day operations• Detecting frauds/embezzlement• Satisfy tax and other laws• Produce records for various interest

groups - e.g. shareholders, tax authority, regulators etc.

Economic Profit:

•Total revenue minus the explicit and implicit costs* of production.*refers to the value of the inputs owned and used by the firm in its own production process e.g salary that entrepreneur could have earned for someone else in a similar capacity, return the firm could have earned from investing its capital, renting its land & other inputs to others .

• Important for decision making

•To choose rationally among the alternative projects for investment/expansion

•Opportunity Cost: Implicit value of a resource in its best alternative use.

Definitions of Profit

Jane has compiled the following list of expenses after completing 1 year of college. Assume that Jane would be living with her parents and working if she weren't attending college. Use this information to calculate Jane's economic cost of attending college for one year.Tuition Rs 8,000Dormitory room 4,000Books and supplies 1,000Food plan 3,000Foregone income 19,000Entertainment expenses 1,000Clothing 2,000Health insurance 1,000

Sol: Economic cost = 8,000 + 4,000 +1,000 + 3,000 + 19,000 = Rs35,000

EXAMPLEViolet purchased a tract of land for Rs1000,000. She quit her Rs300,000 a year job as a postal employee and opened a skeet shooting range on her land. The range generates Rs300,000 in net revenue after all day-to-day expenses have been covered. Assume that the relevant discount rate is 10%. What is Violet's business profit? What is her economic profit?

Solution: Business profit is Rs 300,000.Economic Profit = Business Profit – Economic CostEconomic cost = 300,000 + (0.10)(1000,000) = Rs 400,000 so she has an economic loss of Rs100,000.

Theories of Profit

• Risk-Bearing Theories of Profit• Frictional Theory of Profit• Monopoly Theory of Profit• Innovation Theory of Profit• Managerial Efficiency Theory of

Profit

Function of Profit• Profit is a signal that guides the

allocation of society’s resources.• High profits in an industry are a signal

that buyers want more of what the industry produces.

• Low (or negative) profits in an industry are a signal that buyers want less of what the industry produces.

- Case Application 1-3 – p 17: Profits in Personal Computer Industry

• Other Example: Biotechnology, Auto Components, BPO etc.

NORMAL PROFIT

Normal profit or normal rate of return, is the level of profit required to keep a firm engaged in a particular activity.

Alternatively, normal profit represents the rate of return on the next best alternative investment of equivalent risk. It is the level of profit necessary to keep people from pulling their investments in search of higher rates of return.

Resources should be used as efficiently as possible to achieve society’s goals

An economy is efficient if it takes all opportunities to make some people better off without making other people worse off

Should economic policy makers always strive to achieve economic efficiency?

Equity means that everyone gets his or her fair share. Since people can disagree about what’s “fair,” equity isn’t as well-defined a concept as efficiency.

Efficiency vs. Equity

Ex.: Handicapped-designated parking spaces in a busy parking lotA conflict between:

• equity, making life “fairer” for handicapped people, and • efficiency, making sure that all opportunities to make people better off have been fully exploited by never letting parking spaces go unused.

How far should policy makers go in promoting equity over efficiency?

Depend upon the state of economy

Markets usually lead to efficiency

The incentives built into a market economy already ensure that resources are usually put to good use

Opportunities to make people better off are not wasted

Exceptions: market failure, the individual pursuit of self-interest found in markets makes society worse off

the market outcome is inefficient.

Business Ethics

• Identifies types of behavior that businesses and their employees should not engage in.

• Source of guidance that goes beyond enforceable laws.

• Case Application: Business Ethics at Boeing• Case Application: Enron-Anderson & Other Financial

Disasters, Present financial crisis, Credit Rating Agencies – Watch Movie Inside Jobs – SONY Pictures

Constraints on Operations of the FIRM

Availability of essential input/s a) Skilled labourb) Specific raw materialc) Credit availability etc. d) Factory and warehouse

space

Constraints on Operations of the FIRM (contd.)

• Legal constraints: to ensure that the firm behaviour is consistent with social welfare objectives

• Wage/labour laws• Health and safety standards• Pollutions emission norms• Unfair business practices etc.

Diamond Water Paradox

The International Framework of Managerial

Economics• Globalization of Economic Activity – Goods and Services (e.g. BPO, auto

components, electricity etc.)

– Capital (FDI, FII)

– Technology (Biotechnology, Computer Software)

– Skilled Labor (software professionals, scientists, teachers)

• Technological Change– Telecommunications Advances– The Internet and the World Wide Web

• Walmart, Lafarge

Any Questions ???

All the best