Introduction To Managerial Economics

Introduction to Managerial Economics
Managerial economics
Science of directing scarce resources

resources
financial, human, physical management of customers, suppliers, competitors, internal organization setting business, nonprofit, household
(c) 1999-2007, I.P.L. Png & D.E. Lehman
Preliminaries: Scope
Managerial

economics based on microeconomics

micro individual economic behavior macro aggregate economic behavior
Managerial Economics and Relationship to Other Business Disciplines

Marketing: Demand, Price Elasticity Finance: Capital Budgeting, Break-Even Analysis, Opportunity Cost, Economic Value Added Management Science: Linear Programming, Regression Analysis, Forecasting Strategy: Types of Competition, Structure-ConductPerformance Analysis Managerial Accounting: Relevant Cost, Break-Even Analysis, Incremental Cost Analysis, Opportunity Cost
Economics and Managerial Decision Making
Questions that managers must answer:
What are the economic conditions in a particular market? Market Structure? Supply and Demand Conditions? Technology? Government Regulations? International Dimensions? Future Conditions? Macroeconomic Factors? Should our firm be in this business? If so, what price and output levels achieve our goals? How can we maintain a competitive advantage over our competitors? Cost-leader? Product Differentiation? Outsourcing, alliances, mergers, acquisitions?
Questions that managers must answer: What are the risks involved?
Risk
is the chance or possibility that actual future outcomes will differ from those expected today.
Types of risk
Changes in demand and supply conditions Technological changes and the effect of competition Changes in interest rates and inflation rates Exchange rates for companies engaged in international trade Political risk for companies with foreign operations
Market
Definition: Buyers and sellers communicate with one another for voluntary exchange Market need not be physical Industry businesses engaged in the production or delivery of the same or similar items
Competitive market
Benchmark for managerial economics

Extremely
many
competitive market
buyers and many sellers no room for managerial strategizing

Achieves
economic efficiency
Model:
demand
supply market
equilibrium
(c) 1999-2007, I.P.L. Png & D.E. Lehman 9
Market power
Definition ability of a buyer or seller to influence market conditions Seller with market power must manage
costs
pricing advertising
expenditure R&D expenditure strategy toward competitors

Imperfect market
Definition: where
one
party directly conveys a benefit or cost to others, or one party has better information than others
11
Pindyck & Rubinfeld Microeconomics
Choice Under Uncertainty

Describing Risk
Expected Value
The
weighted average of the payoffs or values resulting from all possible outcomes.
The
probabilities of each outcome are used as weights Expected value measures the central tendency; the payoff or value expected on average
13
Describing Risk
Given:
Two
possible outcomes having payoffs X1 and X2
Probabilities
of each outcome is given by Pr1 & Pr2
14
Describing Risk
Generally, expected value is written as:
E(X) Pr1X1 Pr2 X 2 ... Prn X n
15
Describing Risk
Variability
The
extent to which possible outcomes of an uncertain even may differ
16
Describing Risk Example 1

Income from Sales Jobs
Outcome 1
Probability Income ($)
Outcome 2
Probability
Expected Income ($) Income
Job 1: Commission Job 2: Fixed salary
.5 .99
2000 1510
.5 .01
1000 510
1500 1500
17
Describing Risk
Variability
The standard deviation is written:
Pr1 ( X 1 E ( X ))
Pr ( X
2
E ( X ))
18
Describing Risk
Calculating Variance ($)
Average
Outcome 1 Deviation Squared Outcome 2 Deviation Squared Deviation Squared Standard Deviation
Job 1 Job 2
$2,000 $250,000 1,510 100
$1,000 510
$250,000 $250,000 980,100 9,900
$500.00 99.50
19
Outcome Probabilities for Two Jobs example 2

Probability
Job 1 has greater spread, greater standard deviation, and greater risk than Job 2.
0.2
Job 2
0.1
Job 1
$1000
$1500
$2000
Income
20
Unequal Probability Outcomes example 3

Probability
The distribution of payoffs associated with Job 1 has a greater spread and standard deviation than those with Job 2.
0.2
Job 2
0.1
Job 1
$1000
$1500
$2000
Income
21
Preferences Toward Risk

Example
A person is earning $15,000 and receiving 13 units of utility from the job. She is considering a new, but risky job.
She will earn either $10,000 with a probability 50% or + earn $30,000 with a probability 50%.
22

Example
The expected utility of the new position is the sum of the utilities associated with all her possible incomes weighted by the probability that each income will occur.
23

Example
The expected utility can be written: E(u) = (1/2)u($10,000) + (1/2)u($30,000)

= 0.5(10) + 0.5(18) = 14 E(u) of new job is 14 which is greater than the current utility of 13 and therefore preferred.
24
Different Preferences Toward Risk People can be risk averse, risk neutral, or risk loving.
25
Different Preferences Toward Risk

Risk
Averse: A person who prefers a certain given income to a risky income with the same expected value. A person is considered risk averse if they have a diminishing marginal utility of income
The
use of insurance demonstrates risk aversive behavior.
26

Risk Averse
A Scenario
A
person can have a $20,000 job with 100% probability and receive a utility level of 16. The person could have a job with a .5 chance of earning $30,000 and a .5 chance of earning $10,000.
27

Utility
Risk Averse
E
D C B A
18
16 14 13
The consumer is risk averse because she would prefer a certain income of $20,000 to a gamble with a .5 probability of $10,000 and a .5 probability of $30,000.
10
10
15 16
20
30
Income ($1,000)
28

Risk Neutral
A person is said to be risk neutral if they show no preference between a certain income, and an uncertain one with the same expected value.
29

Risk Neutral
Utility 18
E
12
The consumer is risk neutral and is indifferent between certain events and uncertain events with the same expected income.
10
20
30
Income ($1,000)
30

Risk Loving
A person is said to be risk loving if they show a preference toward an uncertain income over a certain income with the same expected value.
Examples:
Gambling, some criminal activity
Chapter 5
31

Risk Loving
Utility 18 E
The consumer is risk loving because she would prefer the gamble to a certain income.
8 A 3 0 10
20
30
Income ($1,000)
32

Risk Premium
The risk premium is the amount of money that a risk-averse person would pay to avoid taking a risk.
33

Risk Premium
A Scenario
The
person has a .5 probability of earning $30,000 and a .5 probability of earning $10,000 (expected income = $20,000). The expected utility of these two outcomes can be found: E(u) = .5(18) + .5(10) = 14
34

Risk Premium
Utility
Risk Premium
Here , the risk premium is $4,000 because a certain income of $16,000 gives the person the same expected utility as the uncertain income that has an expected value of $20,000.
G
20 18 14
E C A F
10
10
16
20
30
40
Income ($1,000)
35

Risk Aversion and Income
Variability in potential payoffs increase the risk premium. Example:

A
job has a .5 probability of paying $40,000 (utility of 20) and a .5 chance of paying 0 (utility of 0).
36

Example:
The
16. If the person is required to take the new position, their utility will fall by 6.
certain income of $20,000 has a utility of
37

Therefore, it can be said that the greater the
variability, the greater the risk premium.
38
Reducing Risk
Three ways consumers attempt to reduce risk are:

1) Diversification 2) Insurance 3) Obtaining more information
39
Reducing Risk
Diversification
Firms can reduce risk by diversifying among a variety of activities that are not closely related.
40
Reducing Risk
Insurance
Risk averse people are willing to pay to avoid risk. If the cost of insurance equals the expected loss, risk averse people will buy enough insurance to recover fully from a potential financial loss.
41
The Decision to Insure
Insurance
Burglary (Pr = .1)
No Burglary (Pr = .9)
Expected Wealth
Standard Deviation
No Yes
$40,000 $50,000 $49,000 49,000 49,000 49,000
$3,000 0
42
The Value of Information
The value of complete information

The
difference between the expected value of a choice with complete information and the expected value when information is incomplete
43
The Value of Information
Profits from the Sales of Suits Sale price:$300 Sales of 50 (Pr:0.5) Buy 50 (cost:$200) 5000 Buy 100 (cost:$180) 1500 Sales of 100 (Pr:0.5) 5000 12000 Expected Profit 5000 6750
Expected value with complete information 8500 Expected value with uncertaity(buy 100) -6750 Value of complete information 1750
Decision Trees
Decision tree: a method for evaluating project risk used with sequential decision making in which a diagram points out graphically the order in which decisions must be made and compares the value of the various actions that can be undertaken. Decision points are designated with squares on a decision tree. Chance events are designated with circles and are assigned certain probabilities.
Decision Trees
Set up all the branches of the decision tree. Move back from right to left, calculating the expected value of each branch. Where appropriate, combine or eliminate branches. Eliminate branches corresponding to poor decisions. Compare the net expected value of the final remaining alternatives to arrive at a solution.
Mind Tools Ltd., 1995-8


Calculation
0.4 x $500,000 = $200,000

0.4 x $25,000 0.2 x $1,000 = $10,000 = $200
____________
$210,200
49
50

Decision Tree:Example 2
A
company has an opportunity to purchase a patent for the manufacture of a new product. It has three possible choices: 1) It does not purchase the patent 2) It purchases the patent for $200,000 3)It spends an additional $50,000 on a feasibility study before purchasing the patent.
Decision Tree:Example 2
Probability that additional research will find the product to have good potential is 60%. If the research results are favorable, there is an 80% probability that the product will net the company $1 million;a 20% probability that income will be only $150,000. If the research results are unfavorable, there is a 90% probability that income will be $100,000 and a 10% probability that it will be $800,000. If the company purchases the patent without further research, the income estimates are as follows: $1 million with 30% probability, $500,000 with 40% probability, and $150,000 with 30% probability.
Decision Tree: Solution

NPV 750 150 -50 -80 No Go -200 Go -50
345
580 -200 Go 328

-50 Research
1000
80 %
20%
-100 -50
800
10%
550
-150 -50 800
100 No Go -200 Go
90%
345
500 40 %
300 -50 0
No Go
54

Introduction To Managerial Economics

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Introduction to Managerial Economics

Science of directing scarce resources

(c) 1999-2007, I.P.L. Png & D.E. Lehman

economics based on microeconomics

(c) 1999-2007, I.P.L. Png & D.E. Lehman

Managerial Economics and Relationship to Other Business Disciplines

(c) 1999-2007, I.P.L. Png & D.E. Lehman

Economics and Managerial Decision Making

Questions that managers must answer:

(c) 1999-2007, I.P.L. Png & D.E. Lehman

(c) 1999-2007, I.P.L. Png & D.E. Lehman

(c) 1999-2007, I.P.L. Png & D.E. Lehman

Benchmark for managerial economics

buyers and many sellers no room for managerial strategizing

expenditure R&D expenditure strategy toward competitors

(c) 1999-2007, I.P.L. Png & D.E. Lehman

Pindyck & Rubinfeld Microeconomics

Choice Under Uncertainty

(c) 1999-2007, I.P.L. Png & D.E. Lehman

possible outcomes having payoffs X1 and X2

of each outcome is given by Pr1 & Pr2

(c) 1999-2007, I.P.L. Png & D.E. Lehman

Generally, expected value is written as:

E(X) Pr1X1 Pr2 X 2 ... Prn X n

(c) 1999-2007, I.P.L. Png & D.E. Lehman

extent to which possible outcomes of an uncertain even may differ

(c) 1999-2007, I.P.L. Png & D.E. Lehman

Describing Risk Example 1

Expected Income ($) Income

Job 1: Commission Job 2: Fixed salary

(c) 1999-2007, I.P.L. Png & D.E. Lehman

The standard deviation is written:

(c) 1999-2007, I.P.L. Png & D.E. Lehman

$2,000 $250,000 1,510 100

$250,000 $250,000 980,100 9,900

(c) 1999-2007, I.P.L. Png & D.E. Lehman

Outcome Probabilities for Two Jobs example 2

(c) 1999-2007, I.P.L. Png & D.E. Lehman

Unequal Probability Outcomes example 3

(c) 1999-2007, I.P.L. Png & D.E. Lehman

Preferences Toward Risk

(c) 1999-2007, I.P.L. Png & D.E. Lehman

Preferences Toward Risk

(c) 1999-2007, I.P.L. Png & D.E. Lehman

Preferences Toward Risk

The expected utility can be written: E(u) = (1/2)u($10,000) + (1/2)u($30,000)

(c) 1999-2007, I.P.L. Png & D.E. Lehman

Preferences Toward Risk

(c) 1999-2007, I.P.L. Png & D.E. Lehman

Preferences Toward Risk

Different Preferences Toward Risk

use of insurance demonstrates risk aversive behavior.

(c) 1999-2007, I.P.L. Png & D.E. Lehman

Preferences Toward Risk

(c) 1999-2007, I.P.L. Png & D.E. Lehman

Preferences Toward Risk

(c) 1999-2007, I.P.L. Png & D.E. Lehman

Preferences Toward Risk

(c) 1999-2007, I.P.L. Png & D.E. Lehman

Preferences Toward Risk

(c) 1999-2007, I.P.L. Png & D.E. Lehman

Preferences Toward Risk