Managerial Economics

Presenter: Dr. Yan-Fu Li

Institute of Quality and Reliability
Department of Industrial Engineering
Tsinghua University
Beijing, China
liyanfu@tsinghua.edu.cn
Course Introduction

• Lecture 1: Introduction
• Lecture 2: Demand
• Lecture 3: Forecasting
• Lecture 4: Production
• Lecture 5: Cost
Methods of reliability
• assessment
Lecture 6: Pricing and optimization
and Output Decision of
• components
Lecture 7: Pricing and Decision
and Output systems for
energy applications
• Lecture 8: Organizational Architecture and Regulation
Text book
• Economics for Managers, international student edition, McGuigan/
Moyar/ Harris, eleventh edition

Methods of reliability
assessment and optimization of
components and systems for
energy applications
Grade
• 60% Final Exam
• 30% Project
• 10% Presence

Methods of reliability
assessment and optimization of
components and systems for
energy applications
Course Introduction
• Introduction and Goals of the Firm
 What is Managerial Economics?
 The Decision-Making Model
 The Role of Profits
 Objective of the Firm
 Principle-Agent Problem
 Implications of Shareholder Wealth Maximization
• Fundamental Economic Concepts
 Demand and Supply
 Marginal Analysis
 The Net Present Value Concept
 Meaning and Measurement of Risk
 The Relationship between Risk and Return

5
Chapter 1 Introduction and
Goals of the Firm
What is Managerial Economics?
 Honda and Toyota case
• Honda and Toyota are attempting to expand their already substantial
assembly operations in North America.
• Two strategies: S1. Increase production of existing plants
S2. Purchase and upgrade GM plants

Objective function: Maximize the present value (PV) of strategies

Methods of reliability
(S1,S2)
assessment and optimization of
Decision rule: components
Choose S1:and
if PVsystems
(Profit S1)
for > PV (Profit S2)
energy applications
Choose S2: if PV (Profit S1) < PV (Profit S2)
What is Managerial Economics?
• Managerial economics extracts from microeconomic theory
those concepts and techniques that enable managers to select
strategic direction, to allocate efficiently the resources
available, and to respond effectively to tactical issues.

Methods of reliability
• Decision making:
To identifyassessment and
the alternative optimization
means of given
of achieving
components and systems for
objective(s)
energy applications
To select an alternative that accomplishes the objective(s) in
the most resource-efficient manner, taking into account the
constraints and the likely actions and reactions of rival
decision makers.
 Methods of reliability
The Decision-Making Model
assessment and optimization of
components and systems for
energy applications
 Market
The Decision-Making Model characteristics,
economic situation,
Pricing errors, government
declining labor relations, natural
environment…
productivity, the
Consider
The profit use of outdated societal
margin on sales retailing concepts constraints
is decreasing

MethodsExamine
of reliabilityAnalyze
Perform a Implement
Establish Identify the possible alternatives
objectives
assessment
problem
and optimization
alternative and select the of
sensitivity and monitor

components
solutions
and systems
best
for analysis the decision

energy applications
Market Consider Measure the
segmenting, scale organizational influence of the
and input variation of each key
production, constraints
technical upgrade factor on the value
of the company
Maximize ……
the PV Scale of the
company, Standardization,
organizational improve the
structure, human regulations,
resource, IT appropriate grading,
infrastructure,… training,…
The Role of Profits
Methods of reliability
assessment and optimization of
components and systems for
energy applications
The Role of Profits
• Economic profit = total revenue - total economic cost.
• Total revenue = price × quantity sold.
• The economic cost (i.e. opportunity cost), the cost of attracting
a resource from its next best alternative.
• labor, capital, intellectual property, land, and materials.
Methods of reliability
assessment and optimization of
Tires Management, environment and taxes
components and systems for
Operation
energy applications
Fuel
Labor

Repair
Tolls
The factors to profit: theories
• Risk-bearing theory of profit
• Compensated for the risk in the form of a higher rate of return.
• Normal profits (the relative risk of alternative investments)

Methods of reliability
assessment and optimization of
components and systems for
energy applications

22.9%→8.4% 11.2%→14.8%
Theories of Profit
• Temporary disequilibrium theory of profit
• Objective: a long-run equilibrium normal rate of profit
(adjusted for risk).
• Higher and lower returns (compared to the long-run normal
return level) can occur because of temporary dislocations
Methods
(shocks) in various of reliability
sectors of the economy.
assessment and optimization of
components and systems for
energy applications
The invasion of Kuwait in Iraq in 1990

The general strike in Venezuela in 2002

Theories of Profit
• Monopoly theory of profit
• In some industries, one firm is effectively able to dominate the
market and potentially earn above-normal rates of return for a
long period of time.
• economies of scale, control of essential natural resources, control
of essentialMethods of reliability
natural resources, control of critical patents, or
assessment
governmental restrictionsand optimization
that prohibit of
competition.
components and systems for
energy applications
Theories of Profit
• Innovation theory of profit
• Above-normal profits are the reward for successful innovations.
• High-quality products or unique market opportunities

Methods of reliability
assessment and optimization of
components and systems for
energy applications
Theories of Profit
• Managerial efficiency theory of profit
• Above-normal profits can arise because of the exceptional
managerial skills of well-managed firms.

Methods of reliability
assessment and optimization of
components and systems for
Staff training
energy applications

Golden Day Club

 Methods of reliability
Objective of the Firm
assessment and optimization of
components and systems for
energy applications
Objective of the Firm

• Conventional assumption: maximizing profits of business firms.

• Advantages:
• Simplicity;
• Usefulness to guide research allocation decision-making
Methods of reliability
assessment and optimization of
components and systems for
energy applications
• Limitations:
• no time dimension;
• no risk consideration.
The Shareholder Wealth-Maximization Model of the Firm

• Shareholder wealth maximization as an objective of the firm

overcomes above limitations.
• Shareholder wealth definition

𝑉0 ∙ 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
Methods
𝜋1 𝜋of
2 reliability
𝜋3 𝜋∞
= + + + ⋯ +
1+ 𝑘𝑒 1 1 + 𝑘𝑒 2and1 optimization
assessment + 𝑘𝑒 3 1+
of𝑘𝑒 ∞
∞
components and= systems 𝜋𝑖 for
1 + 𝑘𝑒 𝑖
energy applications
𝑖=1

where 𝑉0 is the current value of a share of stock, 𝜋𝑡 represents the economic

profits expected in each of the future periods, and 𝑘𝑒 equals the required rate
of return.
• A dollar received in the future is worth less than a dollar
received at present: INFLATION.
1
Future 1 + 𝑘𝑒 𝑛 <1 Present
The Shareholder Wealth-Maximization Model of the Firm

• Profit in period 𝑡, 𝜋𝑡 , is equal to total revenue (𝑇𝑅𝑡 ) minus

total costs (𝑇𝐶𝑡 ),or

𝜋𝑡 = 𝑇𝑅𝑡 − 𝑇𝐶𝑡

Methods
• Similarly, total revenueofinreliability
period 𝑡 equals price per unit (𝑃𝑡 )
assessment
times quantity sold (𝑄𝑡 ), orand optimization of
components and systems for
𝑇𝑅𝑡 = 𝑃𝑡 ∙ 𝑄𝑡
energy applications

• Total cost in period 𝑡 equals variable cost per unit (𝑉𝑡 ) times
the number of units of output (𝑄𝑡 ) plus fixed costs in period 𝑡,
𝐹𝑡 , or

𝑇𝐶𝑡 = 𝑉𝑡 ∙ 𝑄𝑡 + 𝐹𝑡
The Shareholder Wealth-Maximization Model of the Firm

• So the shareholder wealth-maximization model could be

expressed as
∞
𝑃𝑡 ∙ 𝑄𝑡 − 𝑉𝑡 ∙ 𝑄𝑡 − 𝐹𝑡
𝑉0 ∙ 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 =
(1 + 𝑘𝑒 )𝑡
Methods of reliability
𝑡=1

assessment and optimization of

Example: components and systems for
energy applications
t 1 2 3
P 20 25 20
3
Q 75 60 80 𝑃𝑡 ∙ 𝑄𝑡 − 𝑉𝑡 ∙ 𝑄𝑡 − 𝐹𝑡
𝑉0 = = 1244.79
V 12 15 10 (1 + 𝑘𝑒 )𝑡
𝑡=1
F 200 200 220
𝑘𝑒 5%
The Shareholder Wealth-Maximization Model of the Firm

• The integrative nature of the shareholder wealth-maximization

model

Limited by
Value of a firm Internal (resource) and
external regulatory
Methods of reliability
constraints
assessment and optimization of
∞
components and
𝑃𝑡 ∙ 𝑄𝑡 − 𝑉𝑡 ∙ 𝑄𝑡 − 𝐹𝑡 systems for
energy (1 + 𝑘𝑒 )𝑡
applications
𝑡=1

The discount rate, 𝑘𝑒 , depends on Future stream of profits depends on

1. Perceived risk of the firm 1. Revenues generated
2. Capital market conditions -demand theory and forecasting
-pricing and output
-export/import considerations
2. Costs
-production and output
-nature of cost function
Apple case
Apple considered three distribution channels:
 Direct-to-the-consumer approach
 Distribution agreements with electronics retailers
 Retail its own products in Apple Stores

Methods of reliability
assessment and optimization of
components and systems for
energy applications
Apple’s 147th retail store
on Fifth Avenue in New
York City
 Methods of reliability
Principle-Agent Problem
assessment and optimization of
components and systems for
energy applications
Principal-agent Problem
• As business grows, the owners (the principals) frequently
delegate decision-making authority to professional managers
(the agents).
• The agents often seek acceptable levels (rather than a
maximum) of profit and shareholder wealth while pursuing
Methods of reliability
their own self-interests.
• This issue is assessment and optimization
known as a principal-agent of or “agency
problem
conflict”. components and systems for
energy applications

Diversification Digital photography products

Agency Problems
• Two common factors to principal-agent problem
 inherent unobservable nature of managerial effort
 presence of random disturbances in team production
• In explaining fluctuations in company performance, the
manager’s creative ingenuity is often inseparable from good
and bad luck.Methods of reliability
• It is difficultassessment
to know whenand optimization
to reward of for upturns and
managers
when to blame components and systems for
for poor performance.
energy applications
• In an attempt to mitigate these agency problems, firms incur
several agency costs.
Agency Costs
• Grants of restricted stock or deferred stock options.
• Payroll expenditures in a way that aligns the incentives for management
with shareholder interests
• Internal audits and accounting oversight boards to monitor
management’s actions.
• Bonding expenditures
Methods and
of reliability
fraud liability insurance to protect
assessment
the shareholders and optimization
from managerial dishonesty.of
components
• Complex organizational and systems
structures designedforto limit managerial
energy
discretion, but whichapplications
prevent timely responses to opportunities.
Implications of Shareholder
Methods of reliability
Wealth Maximization
assessment and optimization of
components and systems for
energy applications
Implications of Shareholder Wealth Maximization
• Short-term payoffs of managers do not maximize shareholder
wealth.
• Short-term cash flows reflect only a small fraction of the firm’s
share price.
• The first five years of expected dividend payouts explain only 18% and the first
ten years only 35% of the of
Methods share prices of NYSE stocks.
reliability
• The goal of shareholder
assessment wealth maximizationof
and optimization requires a long-
term focus. components and systems for
energy applications
Caveats to Maximizing Shareholder Value
• Managers should concentrate on maximizing shareholder value
alone only if three conditions are met.

Complete markets.
Methods of reliability
assessment and optimization of
components and systems for
energy applications
No significant asymmetric
information.

Known recontracting costs.

Goals in the Public Sector and Not-for-Profit Enterprises

• The public sector or not-for-profit (NFP) organizations pursue

a set of objectives different to the value-maximization
objective
• Public sector (government) agencies tend to provide services
that have significant
Methodspublic-good characteristics.
of reliability
assessment and optimization of
components and systems for
energy applications
Not-for-Profit Objectives
• Maximizing the quantity and quality of output subject to a
break-even budget constraint.
• Maximizing the utility of the NFP’s administrators.
• Maximizing cash flows.
• Maximizing the utility (satisfaction) of contributors.
Methods of reliability
assessment and optimization of
components and systems for
energy applications
Achievement of NFP Objectives
• Efficiently manage its resources.
• Increase its capacity to supply high-quality goods and services.
• Provide a rewarding work environment for its administrators.

Methods of reliability
assessment and optimization of
components and systems for
energy applications
The Efficiency Objective in NFP Organizations
• By cost-benefit analysis, the goals used to evaluate
expenditures for any public purpose can be any one of the
following:
• Maximize the benefits for given costs.
• Maximize the costs while achieving a fixed level of benefits.
• Maximize theMethods of reliability
net benefits (benefits minus costs).
assessment and optimization of
components and systems for
energy applications
Exercise
• Specific Electric Co. asks you to implement a pay-for-performance
incentive contract for its new CEO. The CEO can either work hard
with a personal opportunity cost $200,000 or reduce her effort, there
by avoiding the personal cost. The shareholder value under different
CEO efforts and conditions is listed in the table. The initial
shareholder value of the company is $650 million.
Methods of reliability
assessment and optimization of
components and systems for
Shareholder Value (in $millions)
energy applications
Good luck (30%) Medium luck (40%) Bad luck (30%)

High CEO Effort 1,000 800 500

Low CEO Effort 800 500 300
Exercise
• What is the maximum amount it would be worth to shareholders to
elicit high CEO effort all the time rather than low CEO effort all the
time?

Shareholder Value (in $millions)

Methods of reliability
assessment and Medium
Good luck (30%) optimization
luck (40%)of Bad luck (30%)
components
High CEO Effort 1,000
and systems
800
for 500
Low CEO Effort
energy applications
800 500 300
Difference 200 300 200

$300 million
Exercise
• If you decide to pay 1% of this amount as a cash bonus, what
performance level in the table (what shareholder value) should
trigger the bonus?

Shareholder Value (in $millions)

Methods of reliability
assessment and Medium
Good luck (30%) optimization
luck (40%)of Bad luck (30%)
components
High CEO Effort 1,000
and systems
800
for 500
Low CEO Effort
energy applications
800 500 300
Difference 200 300 200

$1,000 and $800 millions

Chapter 2 Fundamental
Economic Concepts
 Methods of reliability
Demand and Supply
assessment and optimization of
components and systems for
energy applications
Individual and Market Demand Curves

• A simplified demand schedule of Pizza Hut restaurant

Price of pizza Quantity of pizzas sold

($/Unit) (Units per time period)
10 50
Methods of reliability
9 60
assessment and optimization of
8 70
components and systems for
7 80
energy
6
applications 90
5 100
Individual and Market Demand Curves

• The demand curve of Pizza Hut

Price (𝑃)
($/unit)
10

Methods
8 of reliability
assessment
6 and optimization of
components and systems for
4
energy applications
2

0 20 40 60 80 100 120 140

Quantity (𝑄)
(units)
Individual and Market Demand Curves

• The individual and market demand curve

Methods of reliability
assessment and optimization of
components and systems for
energy applications
The Demand Function

𝑄𝐷 = 𝑓(𝑃, 𝑃𝑆 , 𝑃𝐶 , 𝑌, 𝐴, 𝐴𝐶 , 𝑁, 𝐶𝑃 , 𝑃𝐸 , 𝑇𝐴 , 𝑇 𝑆 ⋯ )

𝑄𝐷 = quantity demanded of
𝑃 = price of the good or service
𝑁 = size of the potential target marker
Methods
𝑃𝑆 = price of substitute goods of reliability
or services
𝐶𝑃 = consumer tastes and preferences for the
assessment andgood
𝑃𝐶 = price of complementry goods or optimization
or service of
services
𝑌 = income of consumers
components and𝑃𝐸 systems forprice appreciation or
= expected future
depreciation
energy
𝐴 = advertising and promotion applications
expenditures
𝑇𝐴 = adjustment time period
𝐴𝐶 = competitors’ advertising and promotion
expenditures 𝑇 𝑆 = taxes or subsidies
The Demand Function

• Changes in the price (P) of 𝐷1

Price 𝐷
the good or service will ($/unit)
result only in movement 𝐷2
𝑃1
along the demand curve,
whereas changes in any ofof reliability
Methods 𝑃2
the other demandassessment and optimization of
determinants incomponents
the demand and systems for
𝐷′1
function will shift the curve.
energy applications 𝐷′
𝐷′2
0 𝑄4 𝑄1 𝑄2 𝑄3
Quantity (units)
 The Supply Function

𝑄𝑆 = 𝑓(𝑃, 𝑃𝐼 , 𝑃𝑈𝐼 , 𝑇, 𝐸𝐸, 𝐹, 𝑅𝐶, 𝑃𝐸 , 𝑇𝐴 , 𝑇 𝑆 ⋯ )

𝑄𝑠 = quantity supplied
𝑃 = price of autos
Methods of reliabilityF= accidental supply interruptions from fires,
𝑃𝐼 = price of inputs floods, etc.
assessment
𝑃𝑈𝐼 = price of unused substitute inputs and optimization of
𝑅𝐶 = costs of regulatory compliance
components and
𝑇 = technological improvements systems for
𝑃𝐸 = expected future changes in price
𝐸𝐸 = entry or exist of otherenergy
auto sellers applications
𝑇𝐴 = adjustment time period
𝑇 𝑆 = taxes or subsidies
The Supply Function

• Changes in the price (P) of the good or service will result only in
movement along the given supply curve, whereas changes in any of
the other independent variables in the function shift the supply curve.
• A movement along a supply curve is referred to as a change in the
quantity supplied, while holding constant other determinants of
supply. A shiftMethods of reliability
of the entire supply curve is often referred to as a
assessment
change in supply and is alwaysand optimization
caused of determinant
by some supply
components and systems for
other than price.
energy applications
 Equilibrium Market Price

• The equilibrium market

Equilibrium
price price
• Demand and supply ($/unit) Planned rate
simultaneously determine of purchase
𝑆𝑡
the equilibrium market price
Methods
(𝑃𝑒𝑞 ). That is, 𝑃𝑒𝑞 sets the of reliability
𝑃𝑒𝑞
assessment and optimization of
desired rate of purchase
(𝑄𝑑 𝑡) equal to thecomponents
planned and systemsPlanned
for rate
rate of sale (𝑄𝑠 𝑡). 𝐷𝑡
of sale
energy applications

0
𝑄𝑡𝑑 = 𝑄𝑡𝑠
Quantity (units/time)
The Diamond-Water Paradox and the Marginal Revolution
• The diamond-water paradox
“Why should consumers bid low offer prices for something as
essential as water while bidding high offer prices for something
as frivolous as diamonds?”
• Marginal use value vs. total use value.
Methods of reliability
assessment and optimization of
• Marginal utility: the maximum offer price consumers are
components and systems for
willing to pay for each additional unit of consumption on the
energy applications
demand side of the market.

• Marginal cost: the minimum asking price producers are willing

to accept for each additional unit supplied.
Marginal Utility and Marginal Cost Simultaneously Determine Equilibrium Market Price

Equilibrium price 𝑆 𝑑𝑖𝑠𝑚𝑜𝑛𝑑𝑠

($/unit)
𝑒𝑞
𝑃𝑑
𝐷𝑑𝑖𝑠𝑚𝑜𝑛𝑑𝑠
Asking
• Water is both cheaper
Methods to of reliability 𝑝𝑟𝑖𝑐𝑒𝑑 = 𝑔(𝑀. 𝐶.𝑑 )
assessment
produce and more trivial and optimization of
than diamonds components
at the and systems for
Offer 𝑆 𝑤𝑎𝑡𝑒𝑟
relevant margin.
energy applications 𝑝𝑟𝑖𝑐𝑒 = 𝑓(𝑀. 𝑈. )
𝑤 𝑤

𝑒𝑞
𝑃𝑤
𝐷𝑤𝑎𝑡𝑒𝑟
2 carats 90 gallons

Quantity
(gallons/day)
(carats/lifetime)
Methods of reliability
Marginal Analysis
assessment and optimization of
components and systems for
energy applications
Marginal Analysis
• One most useful concept in microeconomics
• Marginal equilibrium condition

• Profit-maximization rule:
Methods of reliability
assessment and optimization of
marginal cost =
components andmarginal
systems forrevenue
energy applications
Example

• Marginal analysis for Sara Lee Corporation.

Potential investment projects

Cost of acquiring the funds to finance
Project Investment Expected Cumulative
these investment projects
Required Methods of reliability
Rate of Investment
($ millions) Return ($ millions)
assessment and Block pf Funds
optimization
($ millions)
Cost of Capital
of Cumulative
Funds Raised
A 25.0 components
27.0% 25.0 and systems for ($ millions)
B 15.0 24.0% 40.0 First $50.0 10.0% 50.0
C 40.0
energy
21.0%
applications
80.0 Next $25.0 10.5% 75.0
D 35.0 18.0% 115.0 Next $40.0 11.0% 115.0
E 12.0 15.0% 127.0 Next $50.0 12.2% 165.0
F 20.0 14.0% 147.0 Next $20.0 14.5% 185.0
G 18.0 13.0% 165.0
H 13.0 11.0% 178.0
I 7.0 8.0% 185.0
Example

Project Marginal Return Marginal Cost Marginal profit Invest or

($ million) ($ million) not
A 25.0 × 27.0% = 6.75 50.0 × 10.0% = 5 6.75-5=1.75 Acceptable
B 15.0 × 24.0% = 3.6 6.75+3.6-5=5.35 Acceptable
C 40.0 × 21.0% = 8.4 25.0 × 10.5% + 40.0 × 11.0% = 7.025 8.4-7.025=1.375 Acceptable
D 35.0 × 18.0% = 6.3 8.4+6.3-7.025=7.675 Acceptable
E Methods of
12.0 × 15.0% = 1.8 50.0reliability
× 12.2% = 6.1 1.8-6.1=-4.3 Acceptable
F 20.0 × 14.0% =assessment
2.8 and optimization 1.8+2.8-6.1=-1.5
of Acceptable
G 18.0 × 13.0% = 2.34 1.8+2.8+2.34-6.1=0.84 Acceptable
components and systems for
H 13.0 × 11.0% = 1.43 20.0 × 14.5% = 2.9 1.43-2.9=-1.47 Undertaken
I
energy applications
7.0 × 8.0% = 0.56 1.43+0.56-2.9=-0.91 Undertaken
Total, Marginal and Average Relationships

Number of Units of Total Marginal Profit Average Profit

Output Per Unit of Profit ∆𝝅 𝑸 = 𝝅𝑻 𝑸 − 𝝅𝑻 𝑸 − 𝟏 𝝅𝑨 𝑸 = 𝝅𝑻 (𝑸) 𝑸
Time 𝝅𝑻 (𝑸) ($/Unit) ($/Unit)
𝑸 ($)
0 -200 0 −
The marginal
profit is greater
1 -150 50 -150.00
than the
2 -25 125 -12.50
average profit.
Methods of reliability
3 200 225 66.67 The average
4 475
assessment and optimization of 275 118.75 profit function
5 775 300 155.00 values are
components and systems for
6 1075 300 179.17 increasing.
energy applications
7 1325 250 189.29

8 1475 150 184.38 The marginal

9 1500 25 166.67
profit is less
10 1350 -150 135.00
than the average
profit.
The average
profit function
values are
The net marginal return is switching to negative value. decreasing.
The total profit is maximized.
Total, Marginal and Average Relationships
Total profit Maximum total profit
($) (𝜋 𝑇 (𝑄))
Inflection
point Total profit 𝜋 𝑇 (𝑄)

Break-even
point

Methods of reliability
assessment and optimization Unitsof
of output (𝑄)
components and systems for
Average profit
(𝜋𝐴 (𝑄)) energy applications
Maximum marginal profit point
Marginal profit
(∆𝜋(𝑄)) Maximum average profit point
($/unit)

Average profit 𝜋𝐴 (𝑄)

𝑄1 𝑄2 𝑄3 𝑄4 Units of output (𝑄)

Marginal profit ∆𝜋(𝑄)

 Methods of reliability
The Net Present Value Concept
assessment and optimization of
components and systems for
energy applications
The Net Present Value Concept
• The net present value (NPV) rule provides appropriate guidance for
decision makers.
• The NPV of an investment made by a firm represents the
contribution of that investment to the value of the firm and to the
wealth of shareholders.
Methods of reliability
assessment and optimization
$180of
components
$120
and systems for
energy applications
$100 $100
$70

0 1 2 3 4 5 t

$300
Determine the Net Present Value of an Investment
• A present value interest factor (PVIF)
1
𝑃𝑉𝐼𝐹 =
1+𝑖
where 𝑖 is the compensation for postponing receipt of a cash return
for one year.
Methods of reliability
assessment
• The present value andreceived
of an amount optimization
one yearof
in the future is
components and systems for
𝑃𝑉0 = 𝐹𝑉1 × (𝑃𝑉𝐼𝐹)
energy applications
The NPV of an investment is equal to

NPV = Present value of future returns − Initial outlay

Example
• You just inherited $1 million. If you use these funds to purchase a
piece of land, in one year the value of this land will increase to $1.2
million. You could also invest in a one-year U.S. government bond
that currently offers a return of 5 percent. What is the NPV of the
investment of the land?

Methods of reliability
assessment and optimization of
1
𝑃𝑉0 = 𝐹𝑉1 ×components
𝑃𝑉𝐼𝐹 = $1.2and systems for = $1,142,857
𝑚𝑖𝑙𝑙𝑖𝑜𝑛
energy applications 1 + 0.05
NPV = Present value of future returns − Initial outlay
= $1,142,857 − $1,000,000 = $142,857
Meaning and Measurement
Methods of reliability
of
Risk
assessment and optimization of
components and systems for
energy applications
Meaning and Measurement of Risk
• Risk refers to the chance that you will encounter an outcome that
differs from the expected outcome.
• Risk refers to the potential variability of outcomes from a decision.

Methods of reliability
assessment andriskoptimization of
components and systems for
energy applications Forecasted
Actual cash flow
cash flow
Probability Distributions
• Probability is the percentage chance that a particular outcome will
occur.
• An example of probability distributions of the annual net cash flows
(NCF) from two investments

Methods
Investmentof reliability
1 Investment 2
assessment
Possible NCF Probabilityand optimization
Possible NCF ofProbability
$200 components0.2 and systems
$100 for 0.2
300 energy applications
0.6 300 0.6
400 0.2 500 0.2
1.0 1.0
Expected Value and Standard Deviation

• The expected value

𝑛

𝑟= 𝑟𝑗 𝑝𝑗
𝑗=1

where 𝑟 is the Methods of reliability

expected value, 𝑟𝑗 is the outcome of the 𝑗th case,
assessment
among 𝑛 possible and𝑝𝑗optimization
outcomes, and of that the 𝑗th
is the probability
components and systems for
outcome will occur.
energy applications
• The standard deviation

𝜎= (𝑟𝑗 − 𝑟)2 𝑝𝑗
𝑗=1
Expected Value and Standard Deviation

Possible NCF Probability 𝑟 𝜎

Investment 1 $200 0.2

300 0.6 300 63.25
Methods
400 of reliability
0.2
assessment
Possible NCF and optimization
Probability 𝑟 of 𝜎
components and systems for
Investment 2 energy
$100 applications
0.2
300 0.6 300 126.49
500 0.2
The continuous probability distribution

Investment Ⅰ
𝜎 = $63.25
Probability of occurrence

Methods of reliability
assessment and optimization of
components and systems forInvestment Ⅱ
energy applications 𝜎′ = $126.49

−2𝜎′ −2𝜎 𝑟 +2𝜎 +2𝜎′

𝑟 (annual net cash flow $)

Normal Probability Distribution

A probability of 0.1587
Probability of occurrence of a value occurs that is
greater than +1𝜎 from
the mean.

Methods of reliability
68.26%

assessment and optimization of

15.87%
components and systems for
energy applications
95.44%

99.74%

Standard deviations

The expected price is $4.25, and the most

z value: the number of standard optimistic price is $5.00, if the price follows the
deviations a point from the mean normal distribution, and the z-value is 1.645, then
𝑟−𝑟 ($5.00 − $4.25)
𝑧= 𝜎= = $0.46
𝜎 1.645
The Coefficient of Variation: A Relative Measure of Risk
• The coefficient of variation

𝜎
𝑣=
𝑟

Example: Methods of reliability

assessment
Arrow Tool Company and
is considering twooptimization
investments, T of
and S. Investment T
has expected annual net cash flowsand
components of $100,000
systemsandfor
a standard deviation of
$20,000. Investment S has expected annual net cash flows of $4,000 and a
energy applications
standard deviation of $2,000. The coefficient of variation for investment T
and S are computed as
𝜎 $20,000
Investment T: 𝑣 = = = 0.2
𝑟 $100,000
𝜎 $2,000
Investment S: 𝑣 = = = 0.5
𝑟 $4,000
Investment S is more risky, although it as a smaller standard deviation.
The Relationship between
Methods of reliability
Risk
and Return
assessment and optimization of
components and systems for
energy applications
The Relationship between Risk and Return
• Risk-free return equals to the real rate of interest plus the expected
rate of inflations.
• A risk premium is a potential “reward” that an investor can expect to
receive from making a risky investment.

Required
Methods = Risk-free
returnof return + Risk premium
reliability
assessment and optimization of
components and systems for
Relationship Between Default Risk and Required Returns
energy applications
Security Yield
U.S. Treasury bonds (25-year+) 5.06%
Aaa-rated corporate bonds 6.49
Aa-rated bonds 6.93
A-rated bonds 7.18
Baa-rated corporate bonds 7.80
Exercise 1

The demand for MICHTEC’s products is related to the state of the economy. If
the economy is expanding next year, the company expects sales to be $90
million. If a recession occurs next year, the company expects sales to be $75
million. If next year is normal, the company expects sales to be $85 million.
The probability estimated that the economy will be either expanding, normal,
or in a recession is 0.2,0.5,and 0.3 respectively.
Methods of reliability
Questions: assessment and optimization of
• Compute expected
components
annual sales. and systems for
• Compute the standard
energy applications
deviation of annual sales.
• Compute the coefficient of variation of annual sales.
Exercise 1
Solutions:
The expected annual sales is
𝑟 = 90 × 0.2 + 85 × 0.5 + 75 × 0.3 = 83

The standard deviation is

𝜎 = (90 −Methods
83)2 × 0.2of
+ reliability
(85 − 83)2 × 0.5 + (75 − 83)2 × 0.3
= 5.568 assessment and optimization of
components and systems for
The coefficient ofenergy applications
variation of annual sales is
𝜎 5.568
𝑣= = = 0.0671
𝑟 83
Differential Calculus Techniques in Management

Summary of Rules for Differentiating Functions

Function Derivative
1. Constant Function 𝑑𝑌
=0
𝑌=𝑎 𝑑𝑋
2. Power Function 𝑑𝑌
𝑌 =Methods
𝑎𝑋 𝑏 of reliability𝑑𝑋 = 𝑏 ∙ 𝑎 ∙ 𝑋 𝑏−1
assessment and optimization
3. Sums of Functions 𝑑𝑌 𝑑𝑓1 𝑋 of2 𝑋
𝑑𝑓
= +
𝑌 = 𝑓1 𝑋components
+ 𝑓2 (𝑋) and systems
𝑑𝑋 𝑑𝑋for 𝑑𝑋
energy
4. Product of Two applications
Functions 𝑑𝑌 𝑑𝑓2 𝑋 𝑑𝑓1 𝑋
= 𝑓1 𝑋 ∙ + 𝑓2 𝑋 ∙
𝑌 = 𝑓1 𝑋 ∙ 𝑓2 (𝑋) 𝑑𝑋 𝑑𝑋 𝑑𝑋
3. Quotient of Two Functions 𝑑𝑓1 𝑋 𝑑𝑓2 𝑋
𝑑𝑌 𝑓2 𝑋 ∙ − 𝑓1 𝑋 ∙
𝑓1 𝑋 = 𝑑𝑋 𝑑𝑋
𝑌= 𝑑𝑋 [𝑓2 𝑋 ]2
𝑓2 (𝑋)
6. Functions of a Function 𝑑𝑌 𝑑𝑌 𝑑𝑍
= ∙
𝑌 = 𝑓1 (𝑍), where 𝑍 = 𝑓2 (𝑋) 𝑑𝑋 𝑑𝑍 𝑑𝑋
Example 1
Suppose we are interested in determining the output level that
minimizes average total costs for KeySpan Energy, where the average
total cost function might be approximated by the following relationship
(𝑄 represents output):
𝐶 = 15 − 0.040𝑄 + 0.000080𝑄2
Differentiating 𝐶 with respect to 𝑄 gives
Methods
𝑑𝐶 of reliability
= −0.040
assessment and +optimization
0.000160𝑄 of
𝑑𝑄
components
Setting this derivative andand
equal to zero systems for 𝑄 yields
solving for
energy 0=applications
0.040 + 0.000160𝑄
𝑄∗ = 250
Taking the second derivative, we obtain
𝑑2𝐶
= +0.000160
𝑑𝑄2
Because the second derivative is positive, the output level of 𝑄 = 250 is
indeed the value that maximizes average total costs.
Example 2
The profit variable, 𝜋, is a function of the output level of two products
(heating oil and gasoline) 𝑄1 and 𝑄2 :
𝜋 = −60 + 140𝑄1 + 100𝑄2 − 10𝑄12 − 8𝑄22 − 6𝑄1 𝑄2
To maximize the company’s profits, each of the partial derivative
function would be set equal to zero:
𝑑𝜋
Methods = 140
of − 20𝑄1 − 6𝑄2 = 0
reliability
𝑑𝑄1
assessment
𝑑𝜋 and optimization of
components= 100 and
− 16𝑄 2 − 6𝑄1 =
systems for0
𝑑𝑄2
energy can
This system of equations applications
be solved for the profit-maximizing values
of 𝑄1 and 𝑄2 . The optimal values are 𝑄1∗ = 5.77 units and 𝑄2∗ = 4.08
units. The optimal total profit is
𝜋∗
= −60 + 140 5.77 + 100 4.08 + 10 5.77 2 − 8 4.08 2
− 6 5.77 4.08 = 548.45
Exercise 2
Bound Inc. determined through regression analysis that its sales (𝑆) are
a function of the amount of advertising in two different media. (𝑋 =
newspapers, 𝑌 = magazines):
𝑆 𝑋, 𝑌 = 200𝑋 + 100𝑌 − 10𝑋 2 − 20𝑌 2 + 20𝑋𝑌
Questions:
• Find the levelMethods
of newspaper and magazine advertising that
of reliability
firm’s sales. and optimization of
maximizes theassessment
• Calculate the components
firm’s sales at the
andoptimal values
systems forof newspaper and
magazine. energy applications
Exercise 2
Solutions:
The sales are optimized when the derivatives are equal to zero:
𝜕𝑆(𝑋, 𝑌)
= 200 − 20𝑋 + 20𝑌 = 0
𝜕𝑋
𝜕𝑆(𝑋, 𝑌)
= 100 − 40𝑌 + 20𝑋 = 0
𝜕𝑌
Methods 𝑋of∗ reliability
= 25, 𝑌 ∗ = 15
assessment
The optimal values are 𝑋 ∗ = 25and
unitsoptimization of
and 𝑌 ∗ = 15 units.
components and systems for
The optimal firm’s sales are
energy applications
𝑆 ∗ = 200 × 25 + 100 × 15 − 10 × 252 − 20 × 152 + 20 × 25 × 15
= 3250
Exercise 3
Define 𝑄 to be the level of output produced and sold, and assume that
the firm’s cost function is given by the relationship
TC = 20 + 5𝑄 + 𝑄2
Furthermore, assume that the demand for the output of the firm is a
function of price 𝑃 given by the relationship
Methods of reliability
assessment𝑄 and = 25optimization
−𝑃 of
Questions: components and systems for
• Determine the output level where total profits are maximized.
energy applications
• Calculate total profits and selling price at the profit-maximizing output level.
• If fixed cost increase from $20 to $25 in the total revenue and total cost relationship,
determine the effects of such an increase on the profit-maximizing output level and
total profits.
• Determine the marginal revenue and marginal cost functions.
• Show that, at the profit-maximizing output level, marginal revenue equals marginal
cost and illustrates the economic principle that profits are maximized at the output
level where marginal revenue equals marginal cost.
Exercise 3
Solutions:
The total profits are
𝜋 = 𝑇𝑅 − 𝑇𝐶 = 𝑃 ∙ 𝑄 − 𝑇𝐶 = 25 − 𝑄 ∙ 𝑄 − 20 + 5𝑄 + 𝑄 2
= 5 + 20𝑄 − 2𝑄 2
The total profit is maximized when the derivative is equal to zero
𝑑𝜋
Methods𝑑𝑄 of = 20 − 4𝑄 = 0
reliability
The optimal outputassessment
level is 𝑄 ∗ = 5.and optimization of
components
The optimal total profits are 𝜋 ∗ = 55 and
andsystems for is 𝑃∗ = 20.
the selling price
energytheapplications
If the fixed costs increase, total profits are
𝜋 = 𝑇𝑅 − 𝑇𝐶 = 𝑃 ∙ 𝑄 − 𝑇𝐶 = 25 − 𝑄 ∙ 𝑄 − 25 + 5𝑄 + 𝑄 2
= 20𝑄 − 2𝑄 2
𝑑𝜋
= 20 − 4𝑄 = 0
𝑑𝑄
The optimal output level is 𝑄 ∗ = 5, the optimal total profits are 𝜋 ∗ = 50 and
the selling price is 𝑃∗ = 20. The change of fixed costs has decreased the
optimal total profits, but have no effect on the output level and the price.
Exercise 3
Solutions:
The marginal revenue function is
𝑑𝑇𝑅 𝑑
𝑀𝑅 = = 25 − 𝑄 ∙ 𝑄 = 25 − 2𝑄
𝑑𝑄 𝑑𝑄
The marginal cost function is
𝑑𝑇𝐶 𝑑
𝑀𝐶 =
Methods 20 + 5𝑄 + 𝑄 2 = 5 + 2𝑄
=of reliability
𝑑𝑄 𝑑𝑄
assessment
At the profit-maximizing and
output level 𝑄 ∗ optimization
= 5, of
components and
25 − 2𝑄 ∗ systems
= 5 + 2𝑄 ∗ for
𝑀𝑅 = 𝑀𝐶
energy applications
The profits are maximized when marginal revenue equals marginal cost.
Methods of reliability
assessment and optimization of
The end
components and systems for
energy applications