Managerial Economics & Business StrategyOverviewManagerial EconomicsIdentify Goals and ConstraintsEconomic vs. Accounting ProfitsOpportunity CostProfits as a SignalUnderstanding Firms’ IncentivesMarket InteractionsThe Time Value of MoneyPresent Value vs. Future ValuePresent Value of a SeriesNet Present ValuePresent Value of a PerpetuityFirm Valuation and Profit MaximizationMarginal (Incremental) AnalysisNet BenefitsMarginal Benefit (MB)Marginal Cost (MC)Marginal PrincipleThe Geometry of Optimization: Total Benefit and CostThe Geometry of Optimization: Net BenefitsConclusionManagerial Economics & Business StrategyChapter 1The Fundamentals of Managerial EconomicsMcGraw-Hill/IrwinMichael R. Baye, Managerial Economics and Business StrategyCopyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.OverviewI. IntroductionII. The Economics of Effective ManagementIdentify Goals and ConstraintsRecognize the Role of ProfitsFive Forces ModelUnderstand Incentives Understand MarketsRecognize the Time Value of MoneyUse Marginal Analysis1-2Managerial 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.1-3Identify Goals and Constraints•Sound decision making involves having well-defined goals.Leads to making the “right” decisions.•In striking to achieve a goal, we often face constraints.Constraints are an artifact of scarcity.1-4Economic vs. Accounting Profits•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.1-5Opportunity 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.1-6Profits as a Signal•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.1-7Understanding Firms’ Incentives•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.1-8Market 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.1-9The Time Value of Money•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”:  P VF Vin1•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.1-10Present Value vs. Future Value•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.1-11Present Value of a Series•Present value of a stream of future amounts (FVt) received at the end of each period for “n” periods:•Equivalently,      P VF ViF ViF Vinn 11221 1 1. . . ntttiFVPV111-12Net 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     N P VF ViF ViF ViCnn 1122 01 1 1. . .Decision Rule:If NPV < 0: Reject projectNPV > 0: Accept project1-13Present Value of a Perpetuity•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    iCFiCFiCFiCFPVPerpetuity ...111321-14Firm Valuation and Profit Maximization•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.    12101...11tttFirmiiiPV1-15•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) Analysis1-16Net Benefits•Net Benefits = Total Benefits - Total Costs•Profits = Revenue - Costs1-17Marginal Benefit (MB)•Change in total benefits arising from a change in the control variable, Q:•Slope (calculus derivative) of the total benefit curve.QBMB1-18Marginal Cost (MC)•Change in total costs arising from a change in the control variable, Q:•Slope (calculus derivative) of the total cost curveQCMC1-19Marginal 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.1-20The Geometry of Optimization: Total Benefit and CostQTotal Benefits & Total CostsBenefitsCostsQ*BCSlope = MCSlope =MB1-21The Geometry of Optimization: Net BenefitsQNet BenefitsMaximum net benefitsQ*Slope = MNB1-22Conclusion•Make sure you include all costs and benefits when making decisions (opportunity cost).•When