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Introduction
ECONOMICS FOR MANAGEMENT The Manager
CODE DEC 5013 • A person who directs resources to achieve a
stated goal.
The Fundamentals of – Directs the efforts of others.
Managerial Economics – Purchases inputs used in the production of the
firm’s output.
– Directs the product price or quality decisions.

McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. 1-2

Introduction Introduction

Economics Managerial Economics Defined

• The science of making decisions in the • The study of how to direct scarce resources in
presence of scarce resources. the way that most efficiently achieves a
– Resources are anything used to produce a good or managerial goal.
service, or achieve a goal. – Should a firm purchase components – like disk
– Decisions are important because scarcity implies drives and chips – from other manufacturers or
trade-offs. 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

Economics of Effective Management The Nature and Importance of Profits

• Basic principles comprising effective • A typical firm’s objective is to maximize
management: profits.
– Identify goals and constraints. • Accounting profit
– Recognize the nature and importance of profits. – Total amount of money taken in from sales (total
revenue) minus the dollar cost of producing goods
– Understand incentives. or services.
– Understand markets. • Economic profit
– Recognize the time value of money. – The difference between total revenue and cost
– Use marginal analysis. opportunity cost.
– 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 Economics of Effective Management

The Role of Profits Five Forces and Industry Profitability

• Profit Principle: Entry Costs
Speed of Adjustment
Entry Network Effects
Reputation
Sunk Costs Switching Costs
– Profits are a signal to resource holders where Economies of Scale Government Restraints

resources are most highly valued by society. 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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Understand Incentives Understand Markets

• Changes in profits provide an incentive to how • Two sides to every market transaction:
resource holders use their resources. – Buyer.
• Within a firm, incentives impact how – Seller.
resources are used and how hard workers • Bargaining position of consumers and
work. producers is limited by three rivalries in
– One role of a manager is to construct incentives to economic transactions:
induce maximal effort from employees. – Consumer-producer rivalry.
– Consumer-consumer rivalry.
– Producer-producer rivalry.
• Government and the market.
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Economics of Effective Management Economics of Effective Management

The Time Value of Money Present Value Analysis 1

• Often a gap exists between the time when • Present value of a single future value
costs are borne and benefits received. – The amount that would have to be invested today
– Managers can use present value analysis to at the prevailing interest rate to generate the
properly account for the timing of receipts and given future value:
expenditures. 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 Economics of Effective Management

Present Value Analysis II The Time Value of Money in Action

• Present value of a stream of future values • Consider a project that returns the following
𝐹𝑉1 𝐹𝑉2 𝐹𝑉𝑛 income stream:
𝑃𝑉 = 1+ 2 + ⋯+ 𝑛
1+𝑖 1+𝑖 1+𝑖 – Year 1, $10,000; Year 2, $50,000; and Year 3,
or, $100,000.
𝑛
𝐹𝑉𝑡 – At an annual interest rate of 3 percent, what is the
𝑃𝑉 = 𝑡
1+𝑖 present value of this income stream?
𝑡=1

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

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

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Net Present Value Present Value of Indefinitely Lived Assets

• The present value of the income stream • Present value of decisions that indefinitely
generated by a project minus the current cost generate cash flows:
of the project:
𝐶𝐹1 𝐶𝐹2 𝐶𝐹3
𝑃𝑉𝐴𝑠𝑠𝑒𝑡 = 𝐶𝐹0 + + + +⋯
𝐹𝑉1 𝐹𝑉2 𝐹𝑉𝑛 1+𝑖 1 1+𝑖 2 1+𝑖 3
𝑁𝑃𝑉 = 1+ 1+𝑖 2 + ⋯+ 1 +𝑖 𝑛 − 𝐶0
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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Present Value and Profit Maximization Short-Term versus Long-term Profits

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

• Given a control variable, 𝑄, of a managerial • How can the manager maximize net benefits?
objective, denote the • Use marginal analysis
– total benefit as 𝐵 𝑄 . – Marginal benefit: 𝑀𝐵 𝑄
– total cost as 𝐶 𝑄 . • The change in total benefits arising from a change in
the managerial control variable, 𝑄.
• Manager’s objective is to maximize net
benefits: – Marginal cost: 𝑀𝐶 𝑄
𝑁 𝑄 =𝐵 𝑄 −𝐶 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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Marginal Analysis Principle I Determining the Optimal Level of a Control Variable

• Marginal principle Total benefits
Total costs Maximum total benefits

– To maximize net benefits, the manager should 𝐶 𝑄

increase the managerial control variable up to
the point where marginal benefits equal marginal
costs. 𝐵 𝑄
– This level of the managerial control variable Maximum net
benefits
corresponds to the level at which marginal net
benefits are zero; nothing more can be gained by
further changes in that variable.

0 Quantity
(Control Variable)

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Determining the Optimal Level of a Control Variable II Incremental Decisions

Net benefits • Incremental revenues
Maximum
– The additional revenues that stem from a yes-or-
net benefits no decision.
• Incremental costs
Slope =𝑀𝑁𝐵(𝑄)
– The additional costs that stem from a yes-or-no
decision.
• “Thumbs up” decision
– 𝑀𝐵 > 𝑀𝐶.

0
• “Thumbs down” decision
Quantity
𝑁 𝑄 =𝐵 𝑄 −𝐶 𝑄 =0 (Control Variable)
– 𝑀𝐵 < 𝑀𝐶.
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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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