Managerial Economics &

Business Strategy
Chapter 1
The Fundamentals of Managerial
Economics

McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy

Copyright 2008 by the McGraw-Hill Companies, Inc. All rights reserved.

1-2

Overview
I. Introduction
II. 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 Analysis

1-3

Managerial 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.

1-4

Identify 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.

1-5

Economic vs. Accounting

Profits
Accounting Profits

Total revenue (sales) minus dollar cost of producing

goods or services.
Reported on the firms income statement.

Economic Profits

Total revenue minus total opportunity cost.

Opportunity Cost
Accounting Costs

The explicit costs of the resources needed to produce

goods or services.
Reported on the firms 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.

1-6

1-7

Profits 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.

The Five Forces Framework

Entry Costs
Speed of Adjustment
Sunk Costs
Economies of Scale

Entry

Network Effects
Reputation
Switching Costs
Government Restraints

Power of
Input Suppliers

Power of
Buyers

Supplier Concentration
Price/Productivity of
Alternative Inputs
Relationship-Specific
Investments
Supplier Switching Costs
Government Restraints

Sustainable
Industry
Profits

Industry Rivalry
Concentration
Price, Quantity, Quality, or
Service Competition
Degree of Differentiation

Switching Costs
Timing of Decisions
Information
Government Restraints

Buyer Concentration
Price/Value of Substitute
Products or Services
Relationship-Specific
Investments
Customer Switching Costs
Government Restraints

Substitutes & Complements

Price/Value of Surrogate Products
or Services
Price/Value of Complementary
Products or Services

Network Effects
Government
Restraints

1-8

1-9

Understanding 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.

1-10

Market 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.

1-11

The Time Value of Money

Present value (PV) of a future value (FV) lumpsum amount to be received at the end of n
periods in the future when the per-period
interest rate is i:

PV

FV

1 i

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.

1-12

Present 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.

What does the consumers intertemporal

problem look like?
At the tangency of U1 and the budget
constraint, W, we get equilibrium
consumption of Co, as Co*, and equilibrium
future consumption, C1*

Future Consumption C1

Intertemporal utility or
Indifference curves

W/P1

U2

C1*

The consumer maximizes

intertemporal utility over current
and future consumption given
the budget constraint, which is
the limit on wealth

U1
U3
W = Co + P1C1
Co*

Current Consumption Co

Intertemporal optimization
(optimization over time) -- the problem
Max U(Co) + 1/(1+)U(C1), subject to the
wealth constraint, W = Co + C1/(1+ r), because
P1 = 1/(1 + r), and r = interest rate and is our
time preference rate (or how impatient we are
for returns over time)
We are maximizing intertemporal economic
welfare subject to our wealth constraint
W = Co C1/(1+r)

Suppose a two-period problem

(optimization over time) -- today relative to
tomorrow
Max U(Co) + 1/(1+)U(C1), subject to the
wealth constraint, W = Co + C1/(1+ r)
Lets say U = LN (logarithmic utility), =3%,
and r = 9%, and grandma left you 400,000
We would solve this problem using something
like Excel --- using the solver in Excel would
work --- enter the utility function as the
objective function --- and the wealth
constraint as a constraint --- then solve

Intertemporal optimization
(optimization over time) -- the problem
Max U(Co) + 1/(1+)U(C1), subject to the
wealth constraint, W = Co + C1/(1+ r), because
P1 = 1/(1 + r)
The Lagrangian with the objective function,
Max U(Co) + 1/(1+)U(C1), and constraint, W
= Co + C1/(1+ r) is:
L = U(Co) + 1/(1+)U(C1) + [W Co C1/(1+r)
Well, we would have to use this solution
concept --- but we can use EXCELs Solver
see EXCEL file INTERTEMP U

1-17

Present Value of a Series

Present value of a stream of future amounts
(FVt) received at the end of each period for n
periods:

PV

FV1

1 i

Equivalently,

FV2

1 i
n

...

FVt
PV
t

i
t 1

FVn

1 i

SOME FURTHER EXPLANATION ON PRESENT

VALUE COMPONENTS
PRESENT VALUE OF AN AMOUNT

PV = S[ 1 / (1 + i )t ]
THE BRACKETED TERM
[ 1 / (1 + i )t ]
IS THE PRESENT VALUE OF $1 IN t PERIODS,
WHERE i IS THE INTEREST RATE
THE TERM
[ 1 / (1 + i )t ]
IS CALLED
THE PRESENT VALUE INTEREST FACTOR
OR PVIFi , t

AN EXAMPLE
WHAT IS THE PRESENT VALUE OF $1,080 ?
IN ONE YEAR IF THE INTEREST RATE IS 8 %
PER YEAR?
SO i = 8 % OR 0.08, AND t = 1
PV = $1,080[ 1/(1.08)1] = $1,000
---NOTICE, THAT PV = FV/ (1 + i )t
SO FV = PV(1+ i ) t
THEREFORE NOTE THAT $1,000 IN 1 YEAR
AT 8% WOULD INCREASE TO $1,080

LETS GO A BIT FURTHER ON THIS CONCEPT:

WHAT IS THE PRESENT VALUE OF 100,000 TO BE
RECEIVED AT THE END OF 10 YEARS IF THE
INTEREST RATE, i = 10% ?
PV = 100,000[ 1 / (1.10)10]

SO DO THE MATH, AND WE GET PV = 38,550

HOW DID WE DO THAT? WELL, USE A
CALCULATOR OR, IF YOU ARE GOOD AT
EXPONENTIATION, THEN IT ALL COMES OUT OK

OR, WE COULD USE A PRESENT VALUE TABLE --AN EXAMPLE IS GIVEN BELOW
PVIFi, t = 1/(1+ i )t
0.3855
INTEREST RATE

PERIODS

8%

10%

12%

0.9259

0.9091

0.8929

0.8573

0.8264

0.7972

0.7938

0.7513

0.7118

0.7350

0.6830

0.6355

0.6302

0.5645

0.5066

0.5403

0.4665

0.4039

10

0.4632

0.3855

0.3220

TAKEN FROM: Vichas, Robert P. 1979. Handbook of Financial Mathematics, Formulas and Tables.
Englewood Cliffs, N. J., Prentice Hall.

THEN, PICKING THE VALUE FOR 10% AND 10

PERIODS, WE GET 0.3855
SO PV = 100,000(0.3855) = 38,550
-------------------------------------------------------------OF COURSE WE COULD SOLVE THIS PRESENT
VALUE USING EXCEL
= 100000*(1/(1.1)^10), WHICH WOULD GIVE US THE
VALUE OF 38554.33 TO BE EXACT!! WHY THE
DIFFERENCE? THE TABLE ABOVE GIVES US
ROUNDED FACTORS, SUCH AS 0.3855 THAT WE
USED ---- WE COULD ALSO USE
=100000*(1.10^-10) TO ALSO GET THE 38554.33
VALUE

PRESENT VALUE OF AN ANNUITY

THE PRESENT VALUE OF AN ANNUITY CAN BE
THOUGHT OF AS THE SUM OF THE PRESENT VALUES
OF EACH OF SEVERAL AMOUNTS
PVA = 100(1/1.10), PVB = 100(1/1.102), PVC = 100(1/1.103, ETC.
SO SUM THESE UP AS,
PV = 100(1/1.10) + 100(1/1.102) + 100(1/1.103)
OR PV = 100 [1/1.10 + 1/1.102 + 1/1.103 ]
SUBSTITUTE THE APPROPRIATE PVIF FACTORS FROM
THE TABLE ABOVE TO GET
PV =100(0.9091 + 0.8264 + 0.7513) = 100(2.4868) 248.68

USING EXCEL,
= PV(RATE, NPER, PV,(FV),TYPE), WHICH FOR OUR
EXAMPLE WOULD BE:
=PV(0.10,3,-100) SKIPPING (FV), TYPE
WHICH GIVES 248.69, AGAIN DIFFERENT BECAUSE
OF ROUNDING OF THE FACTORS IN THE TABLE

OF COURSE THIS CAN BE DONE VIA CALCULATOR

SO THE PRESENT VALUE OF AN ANNUITY IS GIVEN

BY PV = (AMOUNT)t[1/(1+ i )t ]
THE TERM t MEAN SUM OVER VALUES OF t, WHICH
IS THE SUM OVER ALL THE PERIODS INVOLVED
THE TERM t [1 / (1 + i ) t ] IS CALLED THE PRESENTVALUE ANNUITY FACTOR, OR PVAFi , t
SOME SELECTED PRESENT VALUE ANNUITY
FACTORS ARE:
INTEREST RATE
PERIODS

1%

2%

3%

12

11.2551

10.5753

9.9540

24

21.2434

18.9139

16.9355

30

25.8077

22.3965

19.6004

SO, IF WE DESIRED TO FIND THE PRESENT VALUE

OF 150 PAYMENTS OVER 30 MONTHS AT 24%,
THEN WE GET
PV = 150[ t = 130 (1/1.02)t] = 150(22.3965) = 3,359
WHY? INTEREST IS ANNUAL, BUT THE PAYMENTS
ARE MONTHLY ---- SO WE NEED A MONTHLY
INTEREST RATE ---- OR 24%/12 = 2%, AND IN THE
TABLE AT 30 PERIODS THE PVAF IS 22.3965
BY USING EXCEL WE GET
=PV(0.02,30,-150) = 3,359.47 TO BE EXACT

1-27

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
NPV

FV1

1 i
If

FV2

1 i

...

FVn

1 i

Decision Rule:
NPV < 0: Reject project
NPV > 0: Accept project

C0

1-28

Present 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

PVPerpetuity

CF
CF
CF

...
2
3
1 i 1 i 1 i
CF

1-29

Firm Valuation and Profit

Maximization
The value of a firm equals the present value of
current and future profits (cash flows).

t
1
2
PVFirm 0

...
t

1 i 1 i

t 1

1 i

A common assumption among economist is that

it is the firms goal to maximization profits.

This means the present value of current and future profits, so the
firm is maximizing its value.

1-30

Firm Valuation With Profit

Growth
If profits grow at a constant rate (g < i) and current
period profits are o, before and after dividends are:
1 i
PVFirm 0
before current profits have been paid out as dividends;
ig
1 g
Ex Dividend
PVFirm
0
immediately after current profits are paid out as dividends.
ig

Provided that g < i.

That is, the growth rate in profits is less than the interest rate and both
remain constant.

Marginal (Incremental)
Analysis
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?

1-31

1-32

Net Benefits
Net Benefits = Total Benefits - Total
Costs
Profits = Revenue - Costs

1-33

Marginal Benefit (MB)

Change in total benefits arising from a
change in the control variable, Q:

B
MB
Q
Slope (calculus derivative) of the total
benefit curve.

1-34

Marginal Cost (MC)

Change in total costs arising from a
change in the control variable, Q:

C
MC
Q
Slope (calculus derivative) of the total cost
curve

1-35

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.

The Geometry of Optimization:

Total Benefit and Cost
Total Benefits
& Total Costs

Costs
Slope =MB

Benefits

B
Slope = MC

Q*

1-36

The Geometry of Optimization:

Net Benefits
Net Benefits

Maximum net benefits

Slope = MNB

Q*

1-37

1-38

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).