SEEG5013 MANAGERIAL ECONOMICS

SEEG5013 MANAGERIAL ECONOMICS

UNIVESITI UTARA MALAYSIASCHOOL OF ECONOMICS, FINANCE

AND BANKING, UUM COB

MASTER OF BUSINESS ADMINISTRATION

Chapter 1Introduction & 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

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.

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

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 don’t expand at all

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 firm’s partners).

We’d expect high profit areas to attract investment

We’d expect low profit areas to lose investmentShouldn’t then all industries

earn the same profit eventually?

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

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Douglas - “Managerial economics is .. the application of economic principles and methodologies to the decision-making process within the firm or organization.”

Pappas & Hirschey - “Managerial economics applies economic theory and methods to business and administrative decision-making.”

Salvatore - “Managerial economics refers to the application of economic theory and the tools of analysis of decision science to examine how an organisation can achieve its objectives most effectively.”

What is Managerial Economics?

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Howard Davies and Pun-Lee Lam -

“It is the application of economic analysis to business problems; it has its origin in theoretical microeconomics.”

What is Managerial Economics?

Managerial Economics Defined

The application of economic theory (eg. demand theory, production theory, cost theory, market structure) and the tools of decision science (eg. mathematics and regression analysis) to examine how an organization can achieve its aims or objectives most efficiently.

How Is Managerial Economics Useful?

Evaluating Choice Alternatives Identify ways to efficiently achieve goals. Specify pricing and production strategies. Provide production and marketing rules to help

maximize net profits. Making the Best Decision

Managerial economics can be used to efficiently meet management objectives.

Managerial economics can be used to understand logic of company, consumer, and government decisions.

Evaluating Choice Alternatives

Managerial Economics identifies ways to efficiently achieve goals. For example,

To identify pricing and production strategies to help small business meet short run objective such as rapid growth.

Provides production and marketing rules that permit the company to maximize net profits once it has achieve growth or market share objectives.

Evaluating Choice Alternatives

Managerial economics has applications in both profit and not-for-profit sectors

For example, an administrator of a nonprofit hospital strives to provide the best medical care possible given limited staff, equipment, and related resources. Using the tools and concepts of managerial economics, the administrator can determine the optimal allocation of these limited resources.

Making the best decision

To make a good decision, managers must understand the economic environment in which they operate. For example,

A grocery retailer may offer consumers a highly price-sensitive product, such as rice, at an extremely low markup over cost – say, 1 percent to 2 percent – while offering less price-sensitive products, such nonprescription drugs, at markups of as high as 40 percent over cost. (Discuss : HYPERMARKET VS SUPERMARKET; MAS VS AIR ASIA; PASARAYA PELADANG VS PACIFIC etc.)

Similarly, managerial economics reveals that car import quotas reduce the availability of substitutes for domestically produced cars, and create the possibility of monopoly profits for domestic manufacturers.

It does not explain whether imposing quotas is good public policy (benefits for consumers, lower income group, environment etc.); that is a decision involving broader political considerations. Managerial economics only describes the predictable economic consequences of such actions. (draw diagram govt. intervention - QUOTAS; impact of changes in EXCHANGE RATE).

Theory of the Firm Expected Value Maximization

Owner-managers maximize short-run profits. Primary goal is long-term expected value

maximization. Constraints and the Theory of the Firm

Resource constraints. Social constraints

Limitations of the Theory of the Firm Alternative theory adds perspective. Competition forces efficiency. Hostile takeovers threaten inefficient managers.

The firm connect suppliers, investors, workers, and management in a joint effort to serve customers.

Value of the Firm

The value of the firm is the present value of the firm’s expected future net cash flows.

If cash flows are equated to profits for simplicity, the value of the firm today, or its present value, is the value of expected profits , discounted back to the present at an appropriate interest rate. (?? Why we have to do discounting?).

Value of the Firm

The present value of all expected future profits

1 21 2

1(1 ) (1 ) (1 ) (1 )

nn tn t

t

PVr r r r

1 1(1 ) (1 )

n nt t tt t

t t

TR TCValueof Firm

r r

Shareholder Wealth Maximization [1.1]

t = REVENUE – COST = TRt – TCt = PtQt – VtQt - Ft

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

V0∙(shares outstanding) = 1/(1+ke)1 +2/(1+ke)2 + … + Real Option Valueor

V0∙(shares outstanding) = (t ) / (1+ke)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.

V0 is the current value of a share of stock. Whatever lowers perceived risk of the firm (ke) will raise firm value. Whatever raises the profits of the firm, raises firm value

Profit MeasurementBusiness Versus Economic Profit

Business (accounting) profit reflects explicit costs and revenues.

Economic profit. Profit above a risk-adjusted normal

return. Considers cash and noncash items.

Variability of Business ProfitsBusiness profits vary widely.

Relationship between profits, total revenues and total costs.

The ‘value of firms’ equation can be used to examine how the expected value maximization model relates to a firm’s various functional department.

The marketing department often has primary responsibility for product promotion and sales (TR);

The production department has primary responsibility for product development costs (TC); and

The finance department has primary responsibility for acquiring capital and, hence, for the discount factor (r) in the denominator.

Why every department important? The marketing department can help reduce costs

associated with a given level of output by influencing customer order size and timing (TR = p x q).

The production department can stimulate sales by improving quality (discuss ISO and quality control).

Other departments, for example – accounting, human resources, and transportation, provide information that are useful for sales growth (TR) and cost control (TC).

Constraints and the Theory of the Firm

Managerial decisions are often made in light of constraints imposed by technology, resource scarcity, contractual obligations, and regulations.

Managers often face limitations on the amount of investment funds available for a particular project or activity.

Decisions can also be constrained by contractual requirements. For example, contracts sometimes require that a minimum level of output be produced to meet delivery requirements.

In most situation, output must also meet quality requirements.

Definitions of Profit

Business Profit: Total revenue minus the explicit or accounting costs of production.

Economic Profit: Total revenue minus the explicit and implicit costs of production (i.e. the implicit (non-cash) costs of capital and other owner provided inputs, used by the firm).

Opportunity Cost: Implicit value of a resource in its best alternative use.

Role of Profits in the Economy

Economic profits play an important role in a market-based economy.

Above-normal profits serve as valuable signal that firm or industry output should be increased.

Entry by new competitors often occurs quickly during high profit periods.

Just as above-normal profits provide a signal for expansion and entry, below-normal profits provide a signal for contraction and exit.

Above-normal profits can also constitute an important reward for innovation and efficiency, just as below-normal profits can serve as a penalty for stagnation and inefficiency.

Function of Profit

Profit is a signal that guides the allocation of society’s resources.

High profits in an industry are a signal that buyers want more of what the industry produces.

Low (or negative) profits in an industry are a signal that buyers want less of what the industry produces.

Why Firms Exist?

Firms exist by public consent to serve social needs.

Maximization of sosial welfare requires answering the following important questions:

What combination of goods and services should be produced?

How to produce? How to distribute goods and services?

Why Do Profits Vary Among Firms?Disequilibrium Profit Theories

Rapid growth in revenues.Rapid decline in costs.

Compensatory Profit TheoriesBetter, faster, or cheaper than

the competition is profitable.

Role of Business in SocietyWhy Firms Exist

Business is useful in satisfying consumer wants.

Business contributes to social welfareSocial Responsibility of Business

Serve customers.Provide employment opportunities.Obey laws and regulations.

To make good economic decisions, managers need to be able to forecast & estimate relationships

Will be forecasting demand (both Pt & Qt) applies to for-profit corporations non-profit organizations

Hospital Administrators forecast patients University Administrator forecast

enrollment Regression analysis, time series methods, and

qualitative forecasting methods used for forecasting

Agency ProblemsAgency ProblemsModern corporations allow firm

managers to have no ownership participation, or only limited participation in the profitability of the firm.

Shareholders may want profits, but managers may wish to relax.

The shareholders are principals, whereas the managers are agents.

The Principal-Agent Problem Shareholders (principals) want profit Managers (agents) want leisure & security Conflicting motivations between these groups

are called agency problems. Examples

KKR’s takeover of RJR Nabisco to refocus on wealth-maximization

The LBO by O.M. Scott (a lawn fertilizer company) from ITT (a conglomerate) improved Scott’s performance

Goals in the Public Sector and the Not-For-Profit (NFP) Enterprise

Public Goods are goods that can be consumed or used by more than one person at the same time with no extra cost (like a flood control or national defense).

Sometimes governments produce public goods. Other times, they are exclusive to one person (like a free meal).

Instead of profit, NFP organizations may have as their goals:

1. Maximization of the quantity of output, subject to a breakeven constraint.

2. Maximization of the utility (happiness) of NFP administrators.

3. Maximization of cash flows.4. Maximization of the utility of contributors to the NFP

organization.

Which goal a NFP manager selects affects decisions made. A food shelter manager may decide to

maximize the utility of contributors by selecting only "healthy foods"

Public sector managers are performance

monitored. V.A. hospital administrators are rewarded by

reducing the cost per bed over a year. Hence, they become efficient with respect to costs.

The "friendliness" of the hospital staff is harder to measure, so friendliness will tend not be a high priority of the public sector manager.

The Changing Environment of Managerial Economics Globalization of Economic Activity

Goods and Services Capital Technology Skilled Labor

Technological Change Telecommunications Advances The Internet and the World Wide Web

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These Definitions Cover a Number of Different Approaches

1. Analysis based on the theory of the firm

2. Analysis based upon management sciences

3. Analysis based upon industrial economics

Related to, but not the same as management science and industrial economics.

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The Process of Model-building

The economics ‘method’ ‘illicit relationships with beautiful models’

The steps: the hypothetical-deductive approach make assumptions about behaviour work out the consequences of those assumptions make predictions test the predictions against the evidence PREDICTIONS SUPPORTED? The model is accepted as a

good explanation (for the moment) PREDICTIONS REFUTED? Go back and re-work the whole

process

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Definitions&

assumptions

Predictions

If predictionsnot supported by

data, model isamended ordiscarded

If predictions borne out by

data, the model is valid, for the moment

Theoreticalanalysis

Predictionstested

against data

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Should Assumptions be Realistic?

Should Assumptions be Realistic?

The assumption of profit-maximising may be unrealistic or inaccurate

However, what matters is the explanatory or predictive power of a theory (or model), not the descriptive realism of its assumptions.

A model built on unrealistic assumptions may give good predictions.

Assumptions are a necessary simplifying device

Example: Overtaking

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What Is A “Good” Model?

It allows us to make predictions and set hypotheses

The predictions can be tested against the empirical evidence

The predictions are supported by the empirical evidence

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The Use of Economic Models

Positive Economics:-

Derives useful theories with testable propositions about WHAT IS.

Normative Economics:-

Provides the basis for value judgements on economic outcomes.WHAT SHOULD BE

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Managerial Economics

Economics in general takes a ‘positive’ and predictive approach not prescriptive or ‘normative’ trying to explain “what is” not what “should be” the main objective is to understand how a market economy

works

Not very concerned about the descriptive realism of assumptions: “I assume X” does not mean “I believe X to be true”

Some real tension if the models are used for prescription assume “perfect knowledge”: OK for model-building cannot say to a manager: “behave AS IF you had perfect

knowledge”

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Economic Analysis

Comparative Statics begin with an initial equilibrium position - the starting point change something identify the new equilibrium, e.g:in neo-classical model of the firm

When demand increases? When costs rise? When a fixed cost increases?

This is the main purpose of the model -what it was designed to do Normative prescriptions

it will cost me $30 per unit to supply something which will give me $20 per unit in revenue- should I do it?

I must pay $20 billion to set up in my industry. Should I charge higher prices to get that money back?

Positive and Normative are linked by “if?” IF the aim of the firm is to maximise profit what will it do/what should it do?

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What is the purpose of economic analysis?

Why do we want to apply economic analysis to business problems?

What is the purpose of economic analysis?

Why do we want to apply economic analysis to business problems?

For the academic economist: to understand, to make predictions about firm’s behavior The “positive” approach to theory: What is?

For the businessperson: “to assist decision-making”, to provide decision-rules which can be applied The “normative” approach to theory: What should be?

These purposes are different, they can lead to misunderstanding, and economists are not always honest about the limitations of their approach for practical purposes.

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What are these limitations?What are these limitations?

If the aim is prediction, unrealistic assumptions are acceptable and may be needed;for instance, the firm may be assumed to behave “as if” its managers had perfect knowledge of its environment

If the aim is to produce decision-rules which can be applied by practising managers, unrealistic assumptions will produce decision-rules which are not operationalfor instance, set output and price by MC=MR

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How Can Managerial Economics Assist Decision-Making?

How Can Managerial Economics Assist Decision-Making?

1. Adopt a general perspective, not a sample of one

2. Simple models provide stepping stone to more complexity and realism

3. Thinking logically has value itself and can expose sloppy thinking

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Why Managerial Economics?

A powerful “analytical engine”. A broader perspective on the firm.

what is a firm? what are the firm’s overall objectives? what pressures drive the firm towards profit and

away from profit

The basis for some of the more rigourous analysis of issues in Marketing and Strategic Management.

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In industrial economics (or industrial organization), the emphasis is (or was) upon the behavior of the whole industry, in which the firm is simply a component.

In managerial economics, the emphasis is upon the firm, the environment in which the firm finds itself, and the decisions which individual firms have to take.

Links between Managerial Economics and Industrial Economics

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What is Industrial Organization?What is Industrial Organization?

It studies how the performance of an industry is related to its structure, that is, to the number and size of firms it contains.

It is the study of markets for goods and of the firms which produce them. It is the study of industry. It is more concerned with why markets are structured the way they are and behave the way they do.

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Questions Asked in Industrial Organization: Why are some markets monopoly-like while others are competitive?

How can industry performance and structure be measured or analyzed?

How does the performance of individual firms affect the structure and performance of the industry in which they operate?

If industry performance seems deficient but remediable, which government policies are likely to help more than they cost?

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The Structure-Conduct-Performance Paradigm:The Structure-Conduct-Performance Paradigm:

Basic Conditions: factors which shape the market of the industry, e.g. demand, supply, political factors

Structure: attributes which give definition to the supply-side of the market, e.g. economies of scale, barriers to entry, industry concentration, product differentiation, vertical integration.

Conduct: the behavior of firms in the market, e.g. pricing behavior advertising, innovation.

Performance: a judgement about the results of market behaviour, e.g. efficiency, profitability, fairness/income distribution, economic growth.

How can the government improve the performance in an industry?

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Basic Conditions

Structure

Conduct

Performance

Government

Policy

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Management science: is essentially concerned with techniques for the improvement of decision-making and hence it is essentially normative;firms are not assumed to find the optimal solutions for themselves. They are found by the researchers who then present them as

prescriptions for what the firm should do.

Managerial economics: is often concerned with finding optimal solutions to decision problems.However, the primary purpose of using models is to predict how firms will behave, not to advise them what ought to do. Managers are assumed to find the optimal solutions for themselves and that is how predictions are made.

Links between Managerial Economics and Management Science