EC 500

Chapter 1
The Fundamentals of Managerial
Economics

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 Headline

Amcott Loses $3.5 Million; Manager Fired.

On Tuesday software giant Amcott posted a year-end operating
loss of $3.5 million. Reportedly, $1.7 million of the loss stemmed
from its foreign language division.

With short-term interest rates at 7 percent, Amcott decided to use

$20 million of its retained earnings to purchase three-year rights to
Magicword, a software package that converts generic word
processor files saved as French text into English. First year sales
revenue from the software was $7 million, but thereafter sales were
halted pending a copyright infringement suit filed by Foreign, Inc.

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 Amcott lost the suit and paid damages of $1.7 million. Industry
insiders say that the copyright violation pertained to a very small
component of Magicword.

Ralph, the Amcott manager who was fired over the incident, was
quoted as saying, “I’m a scapegoat for the attorneys [at Amcott] who
didn’t do their homework before buying the rights to Magicword. I
projected annual sales of $7 million per year for three years. My
sales forecasts were right on target.”
Do you know why Ralph was fired?

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 1. 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.
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 2. Economic vs. Accounting
Profits

• Goal = Profit Maximization (among others)

• Accounting Profits
– Total revenue (sales) minus dollar cost of
producing goods or services.
– Reported on the firm’s income statement.

• Economic Profits
– Total revenue minus total opportunity cost.
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 Opportunity Cost
• Accounting Costs
– The explicit costs of the resources needed to
produce produce goods or services.
– Reported on the firm’s 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.

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 [Example]
• Pizza House in NY
– Revenue = $100,000
– Cost = $20,000
– Profit =

• Opportunity Cost
– Can work for $30,000
– Rental revenue = $70,000

• Total Economic Cost = Cost + Opportunity Cost

=

• Economic Profit = Revenue – Total Economic Cost = $100,000 -

$120,000 =

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 3. The Five Forces Framework
Entry Costs
Entry Network Effects
Speed of Adjustment Reputation
Sunk Costs Switching Costs
Economies of Scale Government Restraints

Sustainable Industry
Power of Profits Power of
Input Suppliers Buyers
Supplier Concentration Buyer Concentration
Price/Productivity of Price/Value of Substitute
Alternative Inputs Products or Services
Relationship-Specific Relationship-Specific
Investments 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, or Timing of Decisions or Services Government
Service Competition Information Price/Value of Complementary Restraints
Degree of Differentiation Government Restraints Products or Services
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 4. 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. 9
 5. The Time Value of Money
• Present value (PV) of a lump-sum amount (FV)
to be received at the end of “n” periods when the
per-period interest rate is “i”:

FV
PV 
1  i  n

• 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. 10
 Present Value of a Series
• Present value of a stream of future
amounts (FVt) received at the end of each
period for “n” periods:

F V1 FV2 FVn
PV    ...
1  i  1
1  i  2
1  i  n

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 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
F V1 FV2 FVn
NPV    ...  C0
1  i  1
1  i  2
1  i  n

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

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 [example]
• A new machine costs $300,000 and has a life of
5 years.
• Cost reductions will be $50,000, $60,000,
$75,000, $90,000 and $90,000 in year 1,2,..,5,
respectively.
• If the interest rate is 8 percent, should the
manager purchase the machine?

• PV = $284,679
• NPV = PV – C = -$15,321.
• Thus,
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 Present Value of a Perpetuity
• An asset that perpetually (endlessly) generates a
stream of cash flows (CF) at the end of each period is
called a perpetuity.
• The present value (PV) of a perpetuity of cash flows
paying the same amount at the end of each period is

CF CF CF
PVPerpetuity     ...
1  i  1  i  1  i 
2 3

CF

i

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• How?

• Example: What is the value of a perpetual bond that

pays the owner $100 at the end of each year when i =
0.05?

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 Firm Valuation
• The value of a firm equals the present value of current and
future profits.
– PV = t / (1 + i)t

Note: If the profits are expected to grow at a constant rate of g

percent,
t = 0 (1 + g)
t

Then,
PV = 0 (1 + g)t / (1 + i)t gives (HOW?):
1 i
PVFirm   0
ig
.. before current profits have been paid out as dividends.

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 If profits grow at a constant rate (g < i):
Ex  Dividend 1 g
PVFirm  0
ig
.. immediately after current profits are paid out as dividends
(How?)

Point: If the growth rate in profits < interest rate, i.e., g < i, and
both remain constant, maximizing the present value of all
future profits is the same as maximizing current profits.

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 [Example]
Suppose that i = 10% and g = 5%. The firm’s current profits
are $100 million.
(a) What is PV?

(b) What is PV after paying a dividend of the current

profit?

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 Related concept: Tobin’s q
• Tobin's q, is the ratio of the market value of a firm's
assets (as measured by the market value of its
outstanding stock and debt) to the replacement cost of
the firm's assets (Tobin 1969).

• This concept is frequently used in finance analysis.

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 6. Marginal (Incremental)
Analysis
• Basic Managerial Question: How much of the
control variable should be used to maximize
net benefits?
– Control Variables = Output, Price, Product Quality,
Advertising, R&D, etc.

• When to stop working?

– Study plan?
– Retirement plan?

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

• Point:
– Benefit keeps increasing before calling down.
– Cost keeps increasing at an increasing rate.

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 Key points
• The optimal point is at the level of input (Q)
– Where two slopes are the same.
That is, MB = MC.
– Where the slope of the Net Benefit is zero.
That is, the Net benefit is maximized.

• Should explain WHY this occurs.

– If MB < MC?
– If MB > MC?

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 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.

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 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

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 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.
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 The Geometry of
Optimization
Total Benefits Costs
& Total Costs
Benefits
Slope =MB

B
Slope = MC
C

Q* Q 28
 [Example]
• Suppose
– Benefit = 300Q – 6Q2
– Cost = 4Q2

– MB = 300 – 12Q
– MC = 8Q
– MB = MC implies 300 – 12Q = 8Q
Q* = 15
NB = 300*15 – 6*152 - 4*152 = 2,250

Exercise: Suppose
– Benefit = 150 +28Q – 5Q2
– Cost = 100 + 8Q
– What is Q*?

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 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).

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 Back to Headline
• NPV
= 7,000,000/(1+0.07)1 + 7,000,000/(1+0.07)2 +
7,000,000/(1+0.07)3 - 20,000,000
= -$1,629,788

LOSS!
; Not fired because of the mistakes of his legal
department.

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 Exercises and Homework
• Chapter 1
– In-Class
• Q. 4, Q. 5, Q. 9

– Homework
• Q. 3, Q. 10, Q. 13, Q. 18

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