The Course Lectures Hirschey

Lecture 1
The Nature and Scope of Managerial Economics
Getting Started with Economics Managerial Economics September 23, 2010

Thomas F. Rutherford
Center for Energy Policy and Economics Department of Management, Technology and Economics ETH Zrich

The Course Lectures Hirschey

Introduction to Ideas

Let us begin with the ideas of economics in general and then link in managerial economics.

The Course Lectures Hirschey

Introduction to Ideas

Let us begin with the ideas of economics in general and then link in managerial economics. Economics is: the study of how people allocate scarce resources.

The Course Lectures Hirschey

Introduction to Ideas

Let us begin with the ideas of economics in general and then link in managerial economics. Economics is: the study of how people allocate scarce resources. Managerial economics focuses on how managers allocate their scarce resources:

The Course Lectures Hirschey

Introduction to Ideas

Let us begin with the ideas of economics in general and then link in managerial economics. Economics is: the study of how people allocate scarce resources. Managerial economics focuses on how managers allocate their scarce resources:
People Skills Ofce equipment Warehouses Machinery Raw materials

The Course Lectures Hirschey

Subjects in Business Administration

Courses dealing with the functions of a business:

Production (operations) Human resources management Marketing Finance

The Course Lectures Hirschey

Subjects in Business Administration

Courses dealing with the functions of a business:

Production (operations) Human resources management Marketing Finance

There are separate courses for each of these areas, but managerial economics is not in this list.

The Course Lectures Hirschey

Courses Dealing with the Business Environment

Ethics Legal issues International business Information technology

The Course Lectures Hirschey

Courses Dealing with the Business Environment

Ethics Legal issues International business Information technology

There are separate courses for each of these areas, but managerial economics is not in this list.

The Course Lectures Hirschey

Courses Dealing with Methodology

Quantitative methods Decision theory and management science Game theory

The Course Lectures Hirschey

Courses Dealing with Methodology

Quantitative methods Decision theory and management science Game theory Managerial economics

The Course Lectures Hirschey

What is the idea of managerial economics

Use economic princples to solve the problems which managers encounter when running their businesses:
Tend to be more technical Involves more mathematics and statistics than other courses.

The Course Lectures Hirschey

Scope of Managerial Economics

What are the elements of managerial economics and how are these inter-related?
The core focus of ME is pricing (price theory), But this view can be misleading (too narrow) ME is generally

concerned with all aspects of rm operation which affect prot.

The Course Lectures Hirschey

A Taxonomy

Joint dependence of demand and supply:

PRICING / \ DEMAND SUPPLY

Basic ideas here:

Supply is cost theory Demand is theory of the consumer.

The Course Lectures Hirschey

Other Ideas

Supply is also affected by behavior of producers including

competing rms (production theory and strategy).

Theory of the rm (nature, objectives) interrelates game theory

and business strategy. Theory of markets concerns the nature of competition (how are prices and prots determined in different types of competitive situations?

The Course Lectures Hirschey

Diagrammatic Perspective

Government | ---------------------------------------| | Theory --------- Pricing ------------ Competitionn Firm / \ Theory / \ Demand Supply | | Consumer Production Theory Theory

The Course Lectures Hirschey

Lecture Sequence

Introductory concepts: scope and context, demand, supply and market equilibrium. Demand theory and estimation (marketing) Cost and market structure (strategic decisions) Decision making with risk (investment under uncertainty)

2 3 4

The Course Lectures Hirschey

Outline of Lectures
9/23 The nature and scope of managerial economics (MH 1,2) 9/30 Demand, supply and market equilibrium (MH 3, HW #1) 10/7 Budget constraints, preferences and consumer choice (MH 4) 10/14 Demand functions price and income elasticities (HW # 2) 10/21 Demand estimation and forecasting (MH 5 and 6) 10/28 Case study: marketing (Professor Hoffman) 11/4 Firm level cost minimization (MH: 7 and 8) 11/11 Competitive markets (MH: 10 and 11; HW # 3) 11/18 Case study: rm-level decisions (Professor Hoffman) 11/25 Imperfectly competitive markets (MH 12 and 13) 12/2 Game theory and pricing (MH 14 and 15, HW # 4) 12/9 Risk and uncertainty (MH 16) 12/16 Case study: investment under uncertainty (Professor Hoffman) 12/23 Final Examination Review

The Course Lectures Hirschey

Assessment

Homeworks (40%) Final examination in early January, 2011 (60%).

The Course Lectures Hirschey

Other information

Instructors: Email: Ofce: Phone: Ofce Hours:

Thomas F. Rutherford and Volker Hoffman trutherford@ethz.ch ZUE (E7) 044 632 6359 Wednesday mornings and by appointment.

Course Web Page: http://ethz.ch/cepe/education/managerialeconomics

The Course Lectures Hirschey

Textbook

The course will be based on the textbook Managerial Economics

(12th edition) by Mark Hirschey (MH).

Additional readings will be periodically assigned from Managerial

Economics: A Problem-Solving Approach (2nd edition) by Froeb and McCann, South-Western.

Copies of these texts are available for short-term loan from my

secretary Rina Fichtl, ZUE E8 (rfichtl@ethz.ch).

The Course Lectures Hirschey

Objectives of the Course

Learn foundations of economics Appreciate the role of economic ideas in managerial decisions. Learn some formal models and methods of analysis in

economics and management science.

The Course Lectures Hirschey

Key Ideas from Herschey Chapter 1

How Is Managerial Economics Useful? Theory of the Firm Prot Measurement Why Do Prots Vary among Firms? Role of Business in Society

The Course Lectures Hirschey

Key Concepts

managerial economics theory of the firm expected value maximization value of the firm present value optimize satisfice business profit normal rate of return economic profit profit margin return on stockholders equity frictional profit theory monopoly profit theory innovation profit theory compensatory profit theory

The Course Lectures Hirschey

How is Managerial Economics Useful?

Evaluating Choice Alternatives Identify ways to efciently achieve goals. Specify pricing and production strategies. Spell out production and marketing rules to maximize prots. Making the Best Decision Managerial economics helps meet management objectives efciently. Managerial economics shows the logic of consumer, and government decisions

The Course Lectures Hirschey

The Course Lectures Hirschey

Theory of the Firm

Expected Value Maximization Owner-managers maximize short-run prots. 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 efciency. Hostile takeovers threaten inefcient managers.

The Course Lectures Hirschey

Measuring Prot

Business Versus Economic Prot Business (accounting) prot reects explicit costs and revenues. Economic prot.
Prot above a risk-adjusted normal return. Considers cash and noncash items.

Variability of Business Prots Business prots vary widely

The Course Lectures Hirschey

Why Do Prots Vary Among Firms?

Disequilibrium Prot Theories Unexpected revenue growth. Unexpected cost savings. Compensatory Prot Theories
Prots accrue to rms that are better, faster, or cheaper than the

competition.

The Course Lectures Hirschey

Role of Business in Society

Why Firms Exist Businesses help satisfy consumer wants. Businesses contributes to social welfare Social Responsibility of Business Serve customers. Provide employment opportunities. Play by the rules (laws and regulations)

The Course Lectures Hirschey

Froeb and McCann: Managerial Economics and Problem Solving

Problemsolvingrequirestwosteps:First,figureoutwhymistakesare beingmade;andthenfigureouthowtomakethemstop. Therationalactorparadigmassumesthatpeopleactrationally,optimally, andselfinterestedly.Tochangebehavior,youhavetochangeincentives. Goodincentivesarecreatedbyrewardinggoodperformance. Awelldesignedorganizationisoneinwhichemployeeincentivesare alignedwithorganizationalgoals.Bythiswemeanthatemployeeshave enoughinformationtomakegooddecisions,andtheincentivetodoso. Youcananalyzeanyproblembyaskingthreequestions:(1)Whoismaking thebaddecision?;(2)Doesthedecisionmakerhaveenoughinformation tomakeagooddecision?;and(3)theincentivetodoso? Answerstothesequestionswillsuggestsolutionscenteredon(1)letting someoneelsemakethedecision,someonewithbetterinformationor incentives;(2)givingthedecisionmakermoreinformation;or(3)changing thedecisionmakersincentives.

Problem:OverbiddingOVIgastract
Ayounggeologistwaspreparingabidrecommendationforanoiltractin theGulfofMexico. Withknowledgeoftheproductivityofneighboringtractsalsoownedby company,thegeologistrecommendedabidof$5million. Seniormanagement,though,bid$20million faroverthenexthighest bidof$750,000.

What,ifanything,iswrong? Thegoalofthistextistoprovidetoolstohelpdiagnoseandsolve problemslikethis.

Problemsolving
Twodistinctsteps:
Figureoutwhatswrong,i.e.,whythebaddecisionwas made Figureouthowtofixit

Bothstepsrequireamodelofbehavior
Whyarepeoplemakingmistakes? Whatcanwedotomakethemchange?

Economistsusetherationalactorparadigmtomodel behavior.Therationalactorparadigmstates:
Peopleactrationally,optimally,selfinterestedly
i.e.,theyrespondtoincentives tochangebehavioryoumust changeincentives.

Howtofigureoutwhatiswrong
Undertherationalactorparadigm,mistakesaremadeforone oftworeasons:
lackofinformationor badincentives.

Todiagnoseaproblem,ask3questions:
1.Whoismakingbaddecision? 2.Dotheyhaveenoughinfotomakeagooddecision? 3.Dotheyhavetheincentivetodoso?

Howtofixit
Theanswerswillsuggestoneormoresolutions:
1.Letsomeoneelsemakethedecision,someonewithbetter informationorincentives. 2.Changetheinformationflow. 3.Changeincentives
Changeperformanceevaluationmetric Changerewardscheme

Usebenefitcostanalysistochoosethebest(most profitable?)solution

Keeptheultimategoalinmind
Forabusinessororganizationtooperateprofitablyand efficientlytheincentivesofindividualsneedtobealigned withthegoalsofthecompany. Howdowemakesureemployeeshavetheinformation necessarytomakegooddecisions? Andtheincentive todoso?

Analyzetheoverbiddingmistake
Anotherclue:
Afterwinningthebid,thegeologistincreasedtheestimated reservesofthecompany. But,afteradrywellwasdrilled,thereserveestimateswere decreased. SeniorManagementsteppedinandorderedanincreaseinthe reserveestimate.

Lastclue:
Seniormanagementresignedseveralmonthslater.

ANSWER:Managerbonusesfor increasingreserves
Thebonussystemcreatedincentivestooverbid.
Seniormanagerswererewardedforacquiringreserves regardlessoftheirprofitability

Bonusesalsocreatedincentivetomanipulatethe reserveestimate. Nowthatweknowwhatiswrong,howdowefixit?

Letsomeoneelsedecide? Changeinformationflow? Changeincentives?
Performanceevaluationmetric Rewardscheme
8

Ethics
Doestherationalactorparadigmencourageselfinterested, selfishbehavior? NO!
Opportunisticbehaviorisafactoflife. Youneedtounderstanditinordertocontrolit. Therationalactorparadigmisatoolforanalyzingbehavior,not aprescriptionforhowtoliveyourlife.