Slide 1

MANAGERIAL ECONOMICS
DR. NORAZNIN ABU BAKAR
Slide 2
Chapter 1
Introduction & Goals of the Firm
What is Managerial Economics?
The Decision-Making Model and the
Responsibilities of Management
The Role of Profits?
The Principal-Agent Problem
Shareholder Wealth Maximization and the
Real Option Value
Objectives in the Public Sector and Not-for-
Profit Organizations

Slide 3
What is Managerial Economics?
The application of microeconomics to problems
faced by decision makers in the private, public, and
not-for-profit sectors.
Even questions of how best to abate nitrous
oxide by coal-fired Power Plants involves
economic issues of finding efficient, least cost
solutions.
Managerial economics deals with microeconomic
reasoning on real world problems such as pricing
decisions, selecting the best strategy in different
competitive environments, and making efficient
choices.

Slide 4
Slide 5
Responsibility of Management
Managers solve problems before they become a crisis
Managers select strategies to try to assure the success of the
firm
Managers create an organizational culture attune to the mission
of the organization
Senior management establish a vision for the firm
Managers motivate and promote teamwork
Managers promote the profitability of the firm
And many managers see it in their long-run interest to promote
sustainability of their enterprise in their environment.
Managers who fail at these responsibilities are reviled, be they be mangers of
BP, Enron, or Bernie Madoff

Slide 6
To Expand Capacity or Not?
An example of a simplified decision problem

Should Honda or Toyota expand its capacity in North America?
In part, it must consider current and future demand and what other
firms are likely to do.
Capacity for making cars is a long term project, so these firms
should think in terms of the present value (PV) of future profits.
Objective Function:
Max PV of profits {S1(New), S2(Used)}
where S1(New) is expand capacity with new facilities and
S2(Used) to purchase used facilities from GM.
Decision Rule:
Choose S1 if PV {Profits of S1 } > PV { Profits of S2 }
Choose S2 if PV { Profits of S1 } < PV { Profits of S2 }
If equal profits, then flip a coin
If negative profits for both, then dont expand at all
Slide 7
The Role of Profits?
Economic Profit is the difference between total
revenues and total economic cost (Economic cost
includes the normal rate of return on capital
contributions by the firms partners).
Wed expect high profit areas to attract investment
Wed expect low profit areas to lose investment
Shouldnt then all industries
earn the same profit eventually?
Slide 8
Theories of Why Profit Varies
Across Industries
1. RISK-BEARING Theory of Profit
2. TEMPORARY DISQUILIBRIUM Theory
of Profit
3. MONOPOLY Theory of Profit
4. INNOVATION Theory of Profit
5. MANAGERIAL EFFICIENCY Theory of
Profit
Slide 9
What Went Right?
What Went Wrong?
Eli Lilly, a Pharmaceutical company
It takes12.3 years on average to get a new drug approved
Patents on Lillys Prozac created monopoly power and
profits for a widely used medication for depression.
As the patent began to expire, Lilly requested a patent
extension because of some alterations in Prozacs formula
But when the patent extension was overturned, generic drug
manufactures took 70% of the share of the market for anti-
depressants.
Lilly missed the chance of finding a replacement in time for
its blockbuster Prozac
This is an example of having and losing monopoly power.
Slide 10
Shareholder Wealth Maximization [1.1]

t
= REVENUE COST = TR
t
TC
t
= P
t
Q
t
V
t
Q
t
- F
t

Value of the Firm = the present value of discounted future cash
flows, both from current operations but also those that might be.

V
0
(shares outstanding) =
1
/(1+k
e
)
1
+
2
/(1+k
e
)
2
+ + Real Option Value
or
V
0
(shares outstanding) = (
t
) / (1+k
e
)
t
+ Real Option Value
t=1
The real option value of the firm comes from the flexibility that the
firm has to find added cost savings or new revenue possibilities that
have not yet come to pass, but could in the future because of following
their current business plans.
V
0
is the current value of a share of stock.
Whatever lowers perceived risk of the firm (k
e
) will raise firm value.
Whatever raises the profits of the firm, raises firm value

Slide 11
Agency Problems
Modern corporations allow firm managers to
have no participation (or only limited
ownership participation) in the profitability of
the firm.
Shareholders are principals, managers are
agents.
Two common problems: (1) often hard to observe
managerial effort and (2) random disturbances in
team performance (luck versus effort?)
Slide 12
The Principal-Agent Problem
Shareholders (principals) want profit
Managers (agents) want leisure & security
Divergent objectives between these groups
are called agency problems.
Diversification by Exxon executives was designed to
help smooth their bonuses, but led to worse stock
performance
KKRs takeover of RJR Nabisco to refocus on wealth-
maximization
The LBO by O.M. Scott & Sons (a lawn fertilizer
company) from ITT (a conglomerate) improved Scotts
performance
Slide 13
Agency Costs
1. Extending grants of stock or deferred stock
options
It helps to make workers act more like owners of firm
to try to raise the price of the stock, but is a cost
2. Bonuses or other compensation can be an
incentive, but clearly is also a cost of solving
agency problems
3. Internal audits and accounting oversight boards
to monitor the firm
4. Bonding expenditures and fraud liability
insurance
5. Costs of complex internal approval processes to
avoid adverse managerial discretion
Slide 14
What Went Right? What Went Wrong?
Saturn Corporation
Different kind of car company in 1991, but
permanently closed in 2009.
It used no-haggle pricing and designed cars to
compete with Asian imports
Sales were above expectations at first because of
tiny margin of only $400 per car to GM, so that
GM earned only 3% on capital
Saturn customers wanted bigger Saturn cars rather than
trade up to Buick, as GM hoped. Saturn was unable to
adopt a change-management view to get customers to
trade up to other GM products.
Sales later slumped in the late 1990s through 2009.
Slide 15
Caveats to
Shareholder Wealth Maximization
1. COMPLETE MARKETS - liquid markets for
firm's inputs and by-products (including polluting by-
products).
2. NO ASYMMETRIC INFORMATION -
buyers and sellers all know the same things.
3. KNOWN RECONTRACTING COSTS -
future input costs are part of the present value of expected
cash flows.
Slide 16
Goals in the Public Sector and the
Not-For-Profit (NFP) Enterprise
Instead of profit, NFP organizations may have as their
goals:
1. Maximizing the quantity and quality of output, subject to a
breakeven constraint.
2. Maximizing the outcomes preferred by the NFP
contributors.
3. Maximizing the longevity of the NFP administrators.
Knowing their goals, helps to understand their behavior.
Using cost-benefit analysis, we can evaluate their efficiency
in terms of maximizing benefits for a given cost; or
minimizing costs for a given benefit; or maximizing net
benefits (Benefits Costs).