Managerial Economics &

Business Strategy

CHAPTER 1
THE FUNDAMENTALS OF MANAGERIAL
ECONOMICS
Overview
I. Introduction
II. The Economics of Effective Management
 Identify Goals and Constraints
 Recognize the Role of Profits
 Understand Incentives
 Five Forces Model
 Understand Markets
 Recognize the Time Value of Money
 Use Marginal Analysis
 Problem-Solving Method
Managerial Economics
 Manager
 A person who directs resources to achieve a stated goal.
 Economics
 The science of making decisions in the presence of scarce
resources.
 Managerial Economics
 The study of how to direct scarce resources in the way that
most efficiently achieves a managerial goal.
Genesis 3:19

19 
By the sweat of your brow
    you will eat your food
until you return to the ground,
    since from it you were taken;
for dust you are
    and to dust you will return.”
Relevance of Managerial Economics for Non-
Profit Organization Managers

 A relief agency receives a grant to plan a program

to help refugees. Should it add a staff member or
buy a computer system with this funds?
 A private university wishes to raise money to
build a new wing on its library. Should it
undertake a direct-mail campaign or seek funds
through personal solicitations, or both? How
much should the university invest in these fund-
raising efforts?
Relevance of Managerial Economics for
Non-Profit Organization Managers

 A church runs a popular adult-education program

that is losing money. Should the church expand or
contract the program?
 A community agency for the elderly runs a day-
care program and a Meals on Wheel program.
How should it allocate its limited staff and budget
between these two programs?
Identify Goals and Constraints

 Achieving different goals entails making different

decisions.
 The constrains include such things as the available
technology and prices of inputs used in
production.
Recognize the nature and importance
of Profit
 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. (Implicit
cost ) like equity
Opportunity Cost
 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.
Profit is a Signal
 Profit signal to resource holders where resources
are most highly valued by society.
 By moving scarce resources toward the
production of goods most valued by society,
the total welfare of society is improved.
The Five Forces Framework
· Entry Costs
Entry · Network Effects
· Speed of Adjustment · Reputation
· Sunk Costs · Switching Costs
· Economies of Scale · Government Restraints

Power of Power of
Input Suppliers Buyers
· Supplier Concentration · Buyer Concentration
· Price/Productivity of Sustainabl · Price/Value of Substitute
Alternative Inputs Products or Services
· Relationship-Specific
e Industry · Relationship-Specific
Investments Profits Investments
· Supplier Switching Costs · Customer Switching Costs
· Government Restraints · Government Restraints

Industry Rivalry Substitutes & Complements

· Concentration · Switching Costs · Price/Value of Surrogate · Network
· Price, Quantity, Quality, or · Timing of Decisions Products or Services Effects
Service Competition · Information · Price/Value of Complementary · Government
· Degree of Differentiation · Government Restraints Products or Services Restraints
Interview with Michael Porter

https://www.youtube.com/watch?v=mYF2_FBCvXw
Understand Incentives

 Managerial economics would enable you

to structure incentives within your
organization.
Understand Markets
 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.
Recognize 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”:

.
Present Value of a Series

 Present value of a stream of future amounts (FVt) received

at the end of each period for “n” periods:
 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

Decision Rule:
If NPV < 0: Reject project
NPV > 0: Accept project
Present Value of a Perpetuity
 An asset that perpetually 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
Use Marginal Analysis
 Control Variables
 Output

 Price

 Product Quality
 Advertising

 R&D

 Basic Managerial Question: How much of the control

variable should be used to maximize net benefits?
Net Benefits

 Net Benefits = Total Benefits - Total Costs

 Profits = Revenue - Costs
Marginal Benefit (MB)
 Change in total benefits arising from a change in the control
variable, Q:

 Slope (calculus derivative) of the total benefit curve.

Marginal Cost (MC)

 Change in total costs arising from a change in the control

variable, Q:

 Slope (calculus derivative) of the total cost curve

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.
 Marginal decision making
example
• Discussion: How much advertising?
• A $50,000 increase in the TV ad budget brings in 1,000 new
customers
• Estimated MCTV is $50 (the cost to get one more customer)
• $50,000 / 1,000 = $50
• If the marginal revenue generated by this customer is greater
than $50, do more advertising.
Marginal decision making
example (cont.)
• Even if we do not know the marginal revenue, we can still use
marginal analysis to make extent decisions
• Compare TV advertising to telephone solicitation
• Say you recently cut telephone budget by $10,000 and lost
100 customers
• Estimated MCPH = $100= ($10,000 / 100)
• So, to get one more customer costs $50 for TV and $100 for
phone
• MCPH > MCTV so shift ad dollars from phone to TV
Problem-Solving Method 26

Example: Over-bidding OVI gas tract

 A young geologist was preparing a bid recommendation
for an oil tract in the Gulf of Mexico.
 With knowledge of the productivity of neighboring tracts
also owned by company, the geologist recommended a bid
of $5 million.
 Senior management, though, bid $20 million - far over the
next highest-bid of $750,000.
 What, if anything, is wrong?
 27
ANSWER:
Manager bonuses for increasing reserves
 The bonus system created incentives to over-bid.
 Senior managers were rewarded for acquiring reserves
regardless of their profitability
 Bonuses also created incentive to manipulate the reserve
estimate.
Problem Solving Method 28

 Two distinct steps:

• Figure out what’s wrong, i.e., why the
bad decision was made
• Figure out how to fix it
 Both steps require a model of behavior
• Why are people making mistakes?
• What can we do to make them change?
Problem Solving Method
 Economists use the rational actor
paradigm to model behavior. The rational
actor paradigm states:
• People act rationally, optimally, self-
interestedly, i.e., they respond to incentives –
to change behavior you must change
incentives.
Problem Solving Method

 How do we fix problem?

 Let someone else decide?
 Change information flow?
 Change incentives?
Performance evaluation metric
Reward scheme
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).