MECO

Due Date Assign Tag

Objectives
Summarize how goals, constraints, incentives, and market rivalry affect economic decisions.
Distinguish economic versus accounting profits and costs.
Explain the role of profits in a market economy.
Apply the five forces framework to analyse the sustainability of an industry’s profits.
Apply present value analysis to make decisions and value assets.
Apply marginal analysis to determine the optimal level of a managerial control variable.
Identify and apply six principles of effective managerial decision making.

Fundametals of Managerial Economics

Managerial economics
is not only valuable to managers of Fortune 500 companies
is also valuable to managers of not-for-profit organizations
provides useful insights into every facet of the business and nonbusiness world in which we live—including
household decision making.
the definitions and formulas economists use are needed for precision. Economics deals with very complex
issues, and much confusion can be avoided by using the language economists have designed to break
down complex issues into manageable components
precise terminology helps practitioners of economics communicate more efficiently
The Manager
is a person who directs resources to achieve a stated goal.
 direct the efforts of others, including those who delegate tasks within an organization such as a firm, a family,
or a club
purchase inputs to be used in the production of goods and services such as the output of a firm, food for the
needy, or shelter for the homeless
are in charge of making other decisions, such as product price or quality
has responsibility for his or her own actions as well as for the actions of individuals, machines, and other
inputs under the manager’s control
This control may involve responsibilities for the resources of a multinational corporation or for those of a
single household
a manager must direct resources and the behavior of individuals for the purpose of accomplishing some task.
manager’s task is to maximize the profits of the firm that employs the manager, the underlying principles are
valid for virtually any decision process.
Economics
is the science of making decisions in the presence of scarce resources
Resources are simply anything used to produce a good or service or, more generally, to achieve a goal.
Decisions are important because scarcity implies that by making one choice, you give up another.
Economic decisions thus involve the allocation of scarce resources, and a manager’s task is to allocate
resources so as to best meet the manager’s goals\
It is a very broad discipline in that it describes methods useful for directing everything from the resources of a
household to maximize household welfare to the resources of a firm to maximize profits.
The key to making sound decisions is to know what information is needed to make an informed decision and
then to collect and process the data.
Economics of Effective Management
1. Identify goals and constraints

The first step in making sound decisions is to have well-defined goals because achieving different goals
entails making different decisions.
The decision maker faces constraints that affect the ability to achieve a goal.
 Constraints make it difficult for managers to achieve goals such as maximizing profits or increasing market
share. These constraints include such things as the available technology and the prices of inputs used in
production
2. Recognize the nature and importance of profits

Economic versus Accounting Profits

Accounting profit is the total amount of money taken in from sales (total revenue, or price times
quantity sold) minus the dollar cost of producing goods or services.
Accounting profits are what show up on the firm’s income statement and are typically reported to
the manager by the firm’s accounting department
Economic profits are the difference between the total revenue and the total opportunity cost of
producing the firm’s goods or services.
The opportunity cost of using a resource includes both the explicit (or accounting) cost of the
resource and the implicit cost of giving up the best alternative use of the resource.
The opportunity cost of producing a good or service generally is higher than accounting costs
because it includes both the dollar value of costs (explicit, or accounting, costs) and any implicit
costs.
Implicit costs are very hard to measure and therefore managers often overlook them.
Effective managers, however, continually seek out data from other sources to identify and
quantify implicit costs. Managers of large firms can use sources within the company,
including the firm’s finance, marketing, and/or legal departments, to obtain data about the
implicit costs of decisions. In other instances managers must collect data on their own
Economic costs are opportunity costs and include not only the explicit (accounting) costs but
also the implicit costs of the resources used in production.
The Role of Profits
A common misconception is that the firm’s goal of maximizing profits is necessarily bad for society
Individuals who want to maximize profits often are considered self-interested, a quality that many
people view as undesirable.
the profits of businesses signal where society’s scarce resources are best allocated.
 profits signal the owners of resources where the 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 and Industry Profitability
“five forces” framework pioneered by Michael Porter
It is also important to stress that the five forces framework is primarily a tool for helping managers see
the “big picture”; it is a schematic you can use to organize various industry conditions that affect
industry profitability and assess the efficacy of alternative business strategies.
The five force
1. Entry

the ability of existing firms to sustain profits depends on how barriers to entry affect the ease
with which other firms can enter the industry.
Entry can come from a number of directions, including the formation of new companies;
globalization strategies by foreign companies and the introduction of new product lines by
existing firms
2. Power of Input Suppliers

Industry profits tend to be lower when suppliers have the power to negotiate favorable terms
for their inputs.
Supplier power tends to be low when inputs are relatively standardized and relationship-
specific investments are minimal, input markets are not highly concentrated , or alternative
inputs are available with similar marginal productivities per dollar spent.
In many countries, the government constrains the prices of inputs through price ceilings and
other controls, which limits to some extent the ability of suppliers to expropriate profits from
firms in the industry.
3. Power of Buyers

industry profits tend to be lower when customers or buyers have the power to negotiate
favorable terms for the products or services produced in the industry.
In most consumer markets, buyers are fragmented and thus buyer concentration is low.
 Buyer concentration and hence customer power tend to be higher in industries that serve
relatively few “high-volume” customers.
Buyer power tends to be lower in industries where the cost to customers of switching to other
products is high—as is often the case when there are relationship-specific investments and
hold-up problems, imperfect information that leads to costly consumer search, or few close
substitutes for the product.
Government regulations can also impact the ability of buyers to obtain more favorable terms.
4. Industry Rivalry

The sustainability of industry profits also depends on the nature and intensity of rivalry
among firms competing in the industry
Rivalry tends to be less intense (and hence the likelihood of sustaining profits is higher) in
concentrated industries—that is, those with relatively few firms.
The level of product differentiation and the nature of the game being played— whether firms’
strategies involve prices, quantities, capacity, or quality/service attributes
5. Substitutes and Complements

The level and sustainability of industry profits also depend on the price and value of
interrelated products and services.
More recent work by economists and business strategists emphasizes that
complementarities also affect industry profitability
it is important to recognize that the many forces that impact the level and sustainability of
industry profits are interrelated.
3. Understand incentives

changes in profits provide an incentive to resource holders to alter their use of resources.
Within a firm, incentives affect how resources are used and how hard workers work
To succeed as a manager, you must have a clear grasp of the role of incentives within an organization
such as a firm and how to construct incentives to induce maximal effort from those you manage.
The first step in constructing incentives within a firm is to distinguish between the world, or the business
place, as it is and the way you wish it were.
4. Understand markets

The final outcome of the market process depends on the relative power of buyers and sellers in the
marketplace.
The power, or bargaining position, of consumers and producers in the market is limited by three sources
of rivalry that exist in economic transactions:
1. Consumer–producer rivalry

occurs because of the competing interests of consumers and producers

Consumers attempt to negotiate or locate low prices, while producers attempt to negotiate high
prices.
These two forces provide a natural check and balance on the market process even in markets in
which the product is offered by a single firm (a monopolist).
2. Consumer–consumer rivalry

guides the market process occurs among consumers.

reduces the negotiating power of consumers in the marketplace.
It arises because of the economic doctrine of scarcity.
When limited quantities of goods are available, consumers will compete with one another for the
right to purchase the available goods
present even in markets in which a single firm is selling a product
3. Producer–producer

this disciplining device functions only when multiple sellers of a product compete in the
marketplace
Given that customers are scarce, producers compete with one another for the right to service the
customers available.
4. Government and the Market

When agents on either side of the market find themselves disadvantaged in the market process,
they frequently attempt to induce government to intervene on their behalf.
Consumer groups may initiate action by a public utility commission to limit the power of utilities in
setting prices. Similarly, producers may lobby for government assistance to place them in a better
 bargaining position relative to consumers and foreign producers.
In modern economies government also plays a role in disciplining the market process
5. Recognize the time value of money

The timing of many decisions involves a gap between the time when the costs of a project are borne and
the time when the benefits of the project are received.
To properly account for the timing of receipts and expenditures, the manager must understand present
value analysis.
Present Value Analysis
The present value (PV) of an amount received in the future is the amount that would have to be
invested today at the prevailing interest rate to generate the given future value
Formula (Present Value). The present value (PV) of a future value (FV) received n years in the
future is

the interest rate appears in the denominator of the expression in Equation 1–1. This means that
the higher the interest rate, the lower the present value of a future amount, and conversely
The present value of a future payment reflects the difference between the future value (FV) and
the opportunity cost of waiting (OCW): PV = FV - OCW
the higher the interest rate, the higher the opportunity cost of waiting to receive a future
amount and thus the lower the present value of the future amount
The basic idea of the present value of a future amount can be extended to a series of future
payments.

Formula (Present Value of a Stream). When the interest rate is i, the present value of a stream of
future payments of
 The net present value (NPV) of a project is simply the present value (PV) of the income stream
generated by the project minus the current cost (C0) of the project:

Formula (Net Present Value)

Present Value of Indefinitely Lived Assets

Some decisions generate cash flows that continue indefinitely.
If the interest rate is i, the value of the asset is given by the present value of these cash flows:

If each of these future cash flows is CF, the value of the asset is the present value of the
perpetuity:

Present value analysis is also useful in determining the value of a firm, since the value of a firm is the
present value of the stream of profits (cash flows) generated by the firm’s physical, human, and
intangible assets.

Therefore, the value of the firm is:

 the value of the firm today is the present value of its current and future profits. To the
extent that the firm is a “going concern” that lives on forever even after its founder dies,
firm ownership represents a claim to assets with an indefinite profit stream.
6. Use marginal analysis

Marginal analysis is one of the most important managerial tools

marginal analysis states that optimal managerial decisions involve comparing the marginal (or
incremental) benefits of a decision with the marginal (or incremental) costs.
Discrete Decisions
We first consider the situation where the managerial control variable is discrete.
Suppose the objective of the manager is to maximize the net benefits N(Q) = B(Q) - C(Q), which
represent the premium of total benefits over total costs of using Q units of the managerial control
variable, Q.
Marginal benefit refers to the additional benefits that arise by using an additional unit of the
managerial control variable.
Marginal cost is the additional cost incurred by using an additional unit of the managerial control
variable.
Marginal net benefits of Q—MNB(Q)—are the change in net benefits that arise from a one-unit
change in Q.
marginal net benefits may also be obtained as the difference between marginal benefits and
marginal costs: MNB(Q) = MB(Q) - MC(Q)
There is an important reason why MB MC at the level of Q that maximizes net benefits: So long as
marginal benefits exceed marginal costs, an increase in Q adds more to total benefits than it does to
total costs. In this instance, it is profitable for the manager to increase the use of the managerial
control variable.
Marginal Principle - To maximize net benefits, the manager should increase the managerial control
variable to the point where marginal benefits equal marginal costs. This level of the managerial
control variable corresponds to the level at which marginal net benefits are zero; nothing more can be
gained by further changes in that variable.
 The goal of maximizing net benefits takes costs into account, while the goal of maximizing total
benefits does not.
maximizing total benefits is equivalent to maximizing revenues without regard for costs.
Continuous Decisions
The basic principles for making decisions when the control variable is discrete also apply to the case
of a continuous control variable.
net benefits are maximized at the point where the difference between B(Q) and C(Q) is the greatest in
the top panel.
The slopes of the total benefits curve and the total cost curve are equal when net benefits are
maximized
Marginal Value Curves Are the Slopes of Total Value Curves When the control variable is infinitely
divisible, the slope of a total value curve at a given point is the marginal value at that point. In
particular, the slope of the total benefit curve at a given Q is the marginal benefit of that level of Q.
The slope of the total cost curve at a given Q is the marginal cost of that level of Q. The slope of the
net benefit curve at a given Q is the marginal net benefit of that level of Q
Since the slope of a function is the derivative of that function, the preceding principle means that
the derivative of a given function is the marginal value of that function.
Incremental Decisions
Sometimes managers are faced with proposals that require a simple thumbs up or thumbs down
decision.
Marginal analysis is the appropriate tool to use for such decisions; the manager should adopt a
project if the additional revenues that will be earned if the project is adopted exceed the additional
costs required to implement the project. In the case of yes-or-no decisions, the additional revenues
derived from a decision are called incremental revenues
The additional costs that stem from the decision are called incremental costs.