Lecture 1 – Scope And Nature Of Managerial Economics

Economics 340H - Managerial Economics

Lecture 1 – Scope and Nature of Managerial Economics

1.1 - Defining Managerial Economics

Refers to the use of economic theory (micro and macro) and the tools of analysis of decision science (mathematical economics and econometrics) to examine how an organization can achieve its aims and objectives most efficiently. Microeconomics – Is the study of decisions of individual people and businesses and the interaction of these decisions: • Price & quantities of individual goods and services. • Effects of government regulation & taxation on prices and quantities of goods and services produced. Macroeconomics - Is the study of the national economy and the global economy. • Effects of taxation and government spending on the economy and is measured through jobs, labour, output, income etc… • Effects of money and interest rates. Mathematical Economics – Is used to formalize the economic models postulated by economic theory. Econometrics – applies statistical tools (regression analysis) to real world data to estimate models postulated by economic theory and forecasting. Managerial economics combines or applies economic tools and techniques to business and administrative decision making using micro, macro, mathematical and econometric models. Prescribes rules for improving managerial decisions and public policy. Integrates and applies microeconomic theory and methods to decision making problems faced by private, public, and not-for-profit organizations. Managerial economics deals with microeconomic reasoning on real world problems such as pricing decisions selecting the best strategy in different competitive environments.

Christopher Michael, Department of Economics - Trent University 1 Economics 340H - Managerial Economics

1.2 - Relationship of Managerial Economics to other fields of study .

Managerial economics uses concepts and quantitative methods to solve managerial problems.

Management Decision Problems - Product selection, output and pricing - Internet strategy - Organizational design - Product development and promotion - HR – hiring and training - Investment and financing

Economic Concepts Quantitative Methods - Marginal analysis - Numerical analysis - Theory of consumer demand - Statistical estimation - Theory of the firm - Forecasting procedures - Industrial organization - Game theory and firm behaviour - Optimization techniques - Public choice theory - Information systems

Managerial Economics = Optimal Solutions to Management Decisions

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

Seven steps in the decision making process.

1.3 - Theory of the firm

A firm may seek to maximize profits subject to limitations on the availability of essential inputs (skilled labour, land, capital and raw materials) and legal constraints (minimum wage laws, health and safety, and pollution).

Value of the firm = Present value of expected future profits

1 2 3 PV  1 /(1 r)   2 /(1 r)  ....3 /(1 r) or Such that: n PV   /(1 r)t i1 t

PV = Present value of all expected future profits of the firm.   Expected profits in each of the n years considered. r = discount rate.

Example 1:

The owner of a small business expects to generate a profit of $100,000 per year for 2 years and is going to sell the firm at the end of the second year for $800,000. The owner believes that the appropriate discount rate for the firm is 10 percent per year. What is the value of the small business based on the assumptions that the owner has set?

PV  $100,000 /(1 .1)1  $100,000 /(1 .1)2  $800,000 /(1 .1) 2 PV  $100,000 /(1.1)  $100,000 /(1.21)  $800,000 /(1.21)

PV  $90909.1 $82,644.6  $661,157.0 PV  $834,710.7

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

1. Maximization of output, subject to a budget constraint. 2. Maximization of the utility 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 bank manager may maximize the utility of clients by selecting only "healthy foods" • Public sector managers are performance monitored. » Hospital administrators are rewarded for 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.

Examples of NFPs

Not for profit organizations (NFP) . Hospitals . Universities / Colleges . Museums NFPs seek to reach some goal or objective subject to a constraint. What are the objectives of NFPs? . Hospital – objective (patients) . University / college (students) . Museum (customers) What are the constraints NPOs face? . Hospital (doctors, nurses, beds, facilities, equipment etc…) . University / college (Faculty, staff, funding sources, facilities, etc….) . Museum (funding, space etc…)

1.4 – Nature and Function of Profits

Economic Profit

Economic profit = Total Revenue – Economic Costs Total Revenue = Price * Quantity Economic costs include: o Explicit costs . Are the actual out-of-pocket expenditures of the firm to hire labour, borrow capital, rent land and buildings and purchase raw materials. o Implicit costs . Are the money value of inputs owned and used by the firm in its own production processes. Economic profit = Total Revenue – explicit costs - implicit costs Accounting profit = Total Revenue – explicit costs Economic profit = Accounting profit – implicit costs Normal profit = implicit costs = opportunity cost of owner-supplied resources

Economic profit = Accounting profit – normal profit

Example 2:

The costs for a typical full-time student attending Trent University for their first yr of study in 2006-07 is $4,372 for tuition fees, $1,184 for compulsory and student fees, $8,500 for a residence room and a meal plan, and $650 for textbooks. As an alternative to attending University that same student could have earned $28,000 by getting a job in the labour market. In addition, they could have earned 4.5% interest by investing the money not spent on attending Trent University.

Calculate explicit costs, implicit costs and economic costs. a) Explicit costs

EC = $4,372 + $1,184 + $8,500 + $650 EC = $14,706 b) Implicit costs

IC = Income Earned + Investing University Costs @ rate of return of 4.5% IC = $28,000 + ($14,706 * .045) IC = $28,000 + $661.77 IC = $28,661.77 c) Total economic cost that the student faces for that one year?

Economic Costs = Explicit costs + Implicit Costs Economic Costs = $14,706 + $28,661.77 Economic Costs = $43,367.77

Profit Maximization

Profit maximization and value maximization are equivalent in the long run If costs and revenue are independent of decisions made in other periods, short-run profit-maximization is equivalent to value maximization

Incentives

Separation of ownership and control Principal-agent problem – Shareholders (principals) want profit – Managers (agents) want leisure & security Moral hazard problem Incentive compatibility – Equity ownership – Outside directors Tie CEO pay to value of the firm Debt finance  Adds risk of bankruptcy and loss of job for managers  Loans must be repaid  Lenders provide monitoring

Market structure and decisions

Economic theory postulates that the quantity demanded of a product (Q) is a function of, or depends upon, the price (P), the income of consumers (Y), and the prices of related commodities (complementary and substitutes).

Such that: Q  f (P,Y, Pc , Ps )

Control over price varies by market structure o Price-setting firms o Price-taking firms Market = any arrangement through which buyers and sellers exchange goods or services

Transactions costs affect market outcomes and price dispersion

Alternative market structures

# of and size of firms Degree of product differentiation Likelihood of entry of new firms in response to economic profits

Perfect competition

Large number of firms Homogeneous product No barriers to either entry or exit

Monopoly

Single seller No close substitutes Barriers to entry – Economies of scale – Exclusive ownership of raw material – Licensing, patents, copyrights, legal franchise Local monopolies may exist

Monopolistic competition

Many firms Differentiated product Free entry and exit

Oligopoly

Few firms produce most output Homogeneous or differentiated product Barriers to entry Recognized mutual interdependence

Globalization Increased global integration Growth of imports and exports in all industrialized economies Reduction in trade barriers Internet and reduced transaction costs NAFTA, FTAA, EU, EMU

Michael Porter - The 5 forces that determine competitive advantage are:

. Substitutes . Potential Entrants . Buyer Power . Supplier Power . Intensity of Rivalry

Christopher Michael, Department of Economics - Trent University 9