CHAPTER 1

The Fundamentals of
Managerial Economics

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 Chapter Overview

Chapter One
• Introduction
– The manager
– Economics
– Managerial economics defined
• Economics of Effective Management
– Identifying goals and constraints
– Recognize the nature and importance of profits
– Understand incentives
– Understand markets
– Recognize the time value of money
– Use marginal analysis
• Learning managerial economics

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 Chapter Overview

Introduction
• Chapter 1 focuses on defining managerial
economics, and illustrating how it is a valuable
tool for analyzing many business situations.
• This chapter provides an overview of managerial
economics.
– How do accounting profits and economic profits
differ?
• Why is the difference important?
– How do managers account for time gaps between
costs and revenues?
– What guiding principle can managers use to maximize
profits?

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 Introduction

The Manager
• A person who directs resources to achieve a
stated goal.
– Directs the efforts of others.
– Purchases inputs used in the production of the
firm’s output.
– Directs the product price or quality decisions.

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 Introduction

Economics
• The science of making decisions in the
presence of scarce resources.
– Resources are anything used to produce a good or
service, or achieve a goal.
– Decisions are important because scarcity implies
trade-offs.

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 Introduction

Managerial Economics Defined

• The study of how to direct scarce resources in
the way that most efficiently achieves a
managerial goal.
– Should a firm purchase components – like disk
drives and chips – from other manufacturers or
produce them within the firm?
– Should the firm specialize in making one type of
computer or produce several different types?
– How many computers should the firm produce,
and at what price should you sell them?

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 Economics of Effective Management

Economics of Effective Management

• Basic principles comprising effective
management:
– Identify goals and constraints.
– Recognize the nature and importance of profits.
– Understand incentives.
– Understand markets.
– Recognize the time value of money.
– Use marginal analysis.

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 Economics of Effective Management

The Nature and Importance of Profits

• A typical firm’s objective is to maximize profits.
• Accounting profit
– Total amount of money taken in from sales (total
revenue) minus the dollar cost of producing goods or
services.
• Economic profit
– The difference between total revenue and the total
opportunity cost of producing goods or services.
– Opportunity cost
• The explicit cost of a resource plus the implicit cost of giving
up its best alternative.

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 Economics of Effective Management

The Role of Profits

• Profit Principle:
– Profits are a signal to resource holders where
resources are most highly valued by society.

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 Economics of Effective Management

Five Forces and Industry Profitability

Entry
Entry Costs Network Effects
Speed of Adjustment Reputation
Sunk Costs Switching Costs
Economies of Scale Government Restraints

Power of Power of
Input Suppliers Buyers
Supplier Concentration Buyer Concentration
Price/Productivity of Level, Growth, Price/Value of Substitute
Alternative Inputs
and Sustainability Products or Services
Relationship-Specific Relationship-Specific
Investments of Industry Profits Investments
Supplier Switching Costs Customer Switching Costs
Government Restraints
Government Restraints

Industry Rivalry Substitutes & Complements

Concentration Switching Costs Price/Value of Surrogate Products Network Effects
Price, Quantity, Quality, Timing of Decisions or Services Government
or Service Competition Information Price/Value of Complementary Restraints
Degree of Differentiation Government Products or Services
Restraints

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 Economics of Effective Management

Understand Incentives
• Changes in profits provide an incentive to
resource holders to change their use of
resources.
• Within a firm, incentives impact how
resources are used and how hard workers
work.
– One role of a manager is to construct incentives to
induce maximal effort from employees.

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 Economics of Effective Management

Understand Markets
• Two sides to every market transaction:
– Buyer (consumer).
– Seller (producer).
• Bargaining position of consumers and
producers is limited by three rivalries in
economic transactions:
– Consumer-producer rivalry.
– Consumer-consumer rivalry.
– Producer-producer rivalry.
• Government and the market.
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 Economics of Effective Management

The Time Value of Money

• Often a gap exists between the time when
costs are borne and benefits received.
– $1 today is worth more than $1 received in the
future.
• The opportunity cost of receiving the $1 in the future is
the forgone interest that could be earned were $1
received today
– Managers can use present value analysis to
properly account for the timing of receipts and
expenditures.

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 Economics of Effective Management

Present Value Analysis 1

• Present value of a single future value
– The amount that would have to be invested today
at the prevailing interest rate to generate the
given future value:
𝐹𝑉
𝑃𝑉 =
1+𝑖 𝑛
– Present value reflects the difference between the
future value and the opportunity cost of waiting:
𝑃𝑉 = 𝐹𝑉 − 𝑂𝐶𝑊

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 Economics of Effective Management

Present Value Analysis II

• Present value of a stream of future values
𝐹𝑉1 𝐹𝑉2 𝐹𝑉𝑛
𝑃𝑉 = 1
+ 2
+ ⋯+ 𝑛
1+𝑖 1+𝑖 1+𝑖
or,
𝑛
𝐹𝑉𝑡
𝑃𝑉 = ෍ 𝑡
1+𝑖
𝑡=1

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 Economics of Effective Management

The Time Value of Money in Action

• Consider a project that returns the following
income stream:
– Year 1, $10,000; Year 2, $50,000; and Year 3,
$100,000.
– At an annual interest rate of 3 percent, what is the
present value of this income stream?

$10,000 $50,000 $100,000

𝑃𝑉 = 1
+ 2
+
1 + 0.03 1 + 0.03 1 + 0.03 3
= $148,352.70

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 Economics of Effective Management

Net Present Value

• The present value of the income stream
generated by a project minus the current cost
of the project:
𝐹𝑉1 𝐹𝑉2 𝐹𝑉𝑛
𝑁𝑃𝑉 = 1
+ 2
+⋯+ 𝑛
− 𝐶0
1+𝑖 1+𝑖 1+𝑖

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 Economics of Effective Management

Present Value of Indefinitely Lived Assets

• Present value of decisions that indefinitely
generate cash flows:
𝐶𝐹1 𝐶𝐹2 𝐶𝐹3
𝑃𝑉𝐴𝑠𝑠𝑒𝑡 = 𝐶𝐹0 + 1
+ 2
+ 3
+⋯
1+𝑖 1+𝑖 1+𝑖
• Present value of this perpetual income stream
when the same cash flow is generated (𝐶𝐹1
= 𝐶𝐹2 = ⋯ = 𝐶𝐹):
𝐶𝐹
𝑃𝑉𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 =
𝑖
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 Economics of Effective Management

Present Value and Profit Maximization

• Profit maximization principle
– Maximizing profits means maximizing the value of
the firm, which is the present value of current and
future profits.

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 Economics of Effective Management

Present Value and Estimating Values of Firms I

• The value of a firm with current profits 𝜋0 ,
with no dividends paid out and expected,
constant profit growth rate of 𝑔 (assuming 𝑔
< 𝑖) is:
𝑃𝑉𝐹𝑖𝑟𝑚
𝜋0 1 + 𝑔 𝜋0 1 + 𝑔 2 𝜋0 1 + 𝑔 3
= 𝜋0 + 1
+ 2
+ 3
+⋯
1+𝑖 1+𝑖 1+𝑖
1+𝑖
= 𝜋0
𝑖−𝑔

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 Economics of Effective Management

Present Value and Estimating Values of Firms II

• When dividends are immediately paid out of
current profits, the present value of the firm is
(at ex-dividend date):
𝑃𝑉𝐹𝑖𝑟𝑚 𝐸𝑥−𝑑𝑖𝑣 = 𝑃𝑉𝐹𝑖𝑟𝑚 − 𝜋0
1+𝑔
= 𝜋0
𝑖−𝑔

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 Economics of Effective Management

Short-Term versus Long-term Profits

• Short-term and long-term profits principle
– If the growth rate in profits is less than the
interest rate and both are constant, maximizing
current (short-term) profits is the same as
maximizing long-term profits.

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 Economics of Effective Management

Marginal Analysis
• Given a control variable, 𝑄, of a managerial
objective, denote the
– total benefit as 𝐵 𝑄 .
– total cost as 𝐶 𝑄 .
• Manager’s objective is to maximize net
benefits:
𝑁 𝑄 =𝐵 𝑄 −𝐶 𝑄

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 Economics of Effective Management

Using Marginal Analysis

• How can the manager maximize net benefits?
• Use marginal analysis
– Marginal benefit: 𝑀𝐵 𝑄
• The change in total benefits arising from a change in
the managerial control variable, 𝑄.
– Marginal cost: 𝑀𝐶 𝑄
• The change in the total costs arising from a change in
the managerial control variable, 𝑄.
– Marginal net benefits: 𝑀𝑁𝐵 𝑄
𝑀𝑁𝐵 𝑄 = 𝑀𝐵 𝑄 − 𝑀𝐶 𝑄

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 Economics of Effective Management

Marginal Analysis Principle I

• Marginal principle
– To maximize net benefits, the manager should
increase the managerial control variable up 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.

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 Economics of Effective Management

Marginal Principle II
• Marginal principle (calculus alternative)
– Slope of a continuous function is the derivative, or
marginal value, of that function:
𝑑𝐵 𝑄
𝑀𝐵 =
𝑑𝑄
𝑑𝐶 𝑄
𝑀𝐶 =
𝑑𝑄
𝑑𝑁 𝑄
𝑀𝑁𝐵 =
𝑑𝑄

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 Economics of Effective Management

Marginal Analysis In Action

• It is estimated that the benefit and cost
structure of a firm is:
𝐵 𝑄 = 250𝑄 − 4𝑄 2
𝐶 𝑄 = 𝑄2
• Find the 𝑀𝐵 𝑄 and 𝑀𝐶 𝑄 functions.
𝑀𝐵 𝑄 = 250 − 8𝑄
𝑀𝐶 𝑄 = 2𝑄
• What value of 𝑄 makes 𝑁𝑀𝐵 𝑄 zero?
250 − 8𝑄 = 2𝑄 ⇒ 𝑄 = 25

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 Economics of Effective Management

Determining the Optimal Level of a Control Variable

Total benefits
Total costs Maximum total benefits

𝐶 𝑄

𝐵 𝑄
Maximum net
benefits

0 Quantity
(Control Variable)

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 Economics of Effective Management

Determining the Optimal Level of a Control Variable II

Net benefits

Maximum
net benefits

Slope =𝑀𝑁𝐵(𝑄)

0 Quantity
𝑁 𝑄 =𝐵 𝑄 −𝐶 𝑄 =0 (Control Variable)

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 Economics of Effective Management

Determining the Optimal Level of a Control Variable III

Marginal
benefits, costs
and net benefits

Maximum net
benefits 𝑀𝐶 𝑄

0 Quantity
𝑀𝑁𝐵 𝑄 𝑀𝐵 𝑄 (Control Variable)

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 Economics of Effective Management

Incremental Decisions
• Incremental revenues
– The additional revenues that stem from a yes-or-
no decision.
• Incremental costs
– The additional costs that stem from a yes-or-no
decision.
• “Thumbs up” decision
– 𝑀𝐵 > 𝑀𝐶.
• “Thumbs down” decision
– 𝑀𝐵 < 𝑀𝐶.
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 Learning Managerial Economics

Learning Managerial Economics

• Practice, practice, practice …
• Learn terminology
– Break down complex issues into manageable
components.
– Helps economics practitioners communicate
efficiently.

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 Conclusion
Conclusion
• Make sure you include all costs and benefits
when making decisions (opportunity costs).
• When decisions span time, make sure you are
comparing apples to apples (present value
analysis).
• Optimal economic decisions are made at the
margin (marginal analysis).

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