A: INTRODUCTION TO MANAGERIAL

ECONOMICS AND UNDERSTANDING SIMPLE

MARKETS
INTRODUCTION
To begin, lets address a simple (but important) questionwhy should we study managerial
economics? The reasons include:

--Although managers have job specific tasks, they all involve making decisions.
Managerial economics is the application of economic theory to managerial decision
making. Its study enables managers to make better decisions.

--Corporations are formed because they efficiently produce and distribute goods and
services. A firm is basically an economic entity. As such, many of its activities can be
analyzed via an economic model.

--Managerial economics can prescribe rules which can help managers efficiently achieve
corporate objectives. It does so by helping managers recognize the effects of various
factors (both economic and non-economic) and then predicts economic consequences.

--Managerial economics is integrative and is used in both inter-firm (market) and intra-firm
situations. For example, the theories of marketing (e.g., pricing, advertising, and product
attribute decisions), production (e.g., cost control, plant layout, inventory policies),
finance/accounting (e.g., transfer pricing policies, compensation schemes, equity
pricing), and strategic planning (e.g., market entry deterrence, mergers and acquisitions,
organizational structure) all use economic principles to identify optimal strategies.

Managerial economics is a relatively new discipline and it helped bridge the gap between formal
economic theory and actual managerial practices. The theory therefore can be viewed from two
dimensions. One dimension is prescriptive. This involves the developing of normative models
which tell managers how they should act if they want to obtain optimal results. The second
dimension is descriptive. These models are based on empirical observation and they attempt
to explain managerial behavior in the real world. We will focus on the former.

THE 10 PRINCIPLES OF ECONOMICS (attributed to Greg Mankiw)

A. Individual Decision Making

1. People face tradeoffs
2. The cost of something is what you give up to get itopportunity cost
3. Rational people think at the margin
4. People respond to incentives

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B. Interaction Among Individual Decisionmakers
5. Trade can make everyone better off
6. Markets are usually a good way to organize economic activity
7. Governments can sometimes improve market outcomes

C. A More Macro View of the Economy

8. A countrys standard of living depends on its ability to produce goods and services
9. Prices rise when the government prints too much money
10. Society faces a short run tradeoff between inflation and unemployment

THEORY
Market Exchange

In our society, social and economic institutions arise to solve recurrent economic problems faced
by individuals. One problem faced by individuals long ago was how to facilitate economic
exchange. Lets assume we have two individuals: one grows apples, the other grows pears. Either
party could simply stick to eating the fruit she grows, but most of us would soon get bored with
eating one type of fruit. Since there are only two individuals, they might enter into what is called
bilateral negotiation and exchange some pears for some apples. But what happens when the
number of individuals grows? What if they number in the hundreds, thousands, or even millions?
Now we need an economic institution that can accommodate such a large number of transactions.
This institution is called a market. Markets facilitate the process of multilateral bargaining.

So a market occurs when the potential for economic exchange takes placethat is, when two or
more parties can enter into binding contracts for economic exchange. For reasons that will
subsequently become obvious in the course, we need to examine (and understand) the underlying
motivations of all parties that enter into this economic exchange. To simplify matters, we
designate parties as either sellers or buyers. Sellers supply the commodity that is being sold and
buyers purchase the commodity.

All corporations engage in economic exchange. Managers must understand factors that affect
exchange patterns, because, as we will see later, they can manipulate these factors thereby
strategically altering exchange patterns and improving firm performance.

Before we get into a more extensive discussion of markets, lets get some basic concepts down
that will serve us throughout EFM.

Lesson 1: Beware of quick fixes and buzz words versus long run human capital stock investment

We will talk about what's used but also about what is useful

Managerial (micro) Economics is a way of setting up and analyzing problems

It's a logical perspective based on rational assumptions

It's intuitive--we'll show the intuition, show that the intuition is correct, and then work problems
demonstrating the concept
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It involves the scientific method--we'll hypothesis test

Your task is to think of managerial applications of the micro theory

We'll do some in class--but every situation is idiosyncratic

So you have to think about how to apply these general concepts and rules to situations which you
have faced (and later on, to situations you will face)

ENDOGENOUS AND EXOGENOUS VARIABLES

You must think about endogenous variables (ones you control as a manager) and exogenous
variables (ones you don't control but which influence your business). Also think about how to
make exogenous variables endogenous

Exogenous variables: income, tastes, prices of other goods, strategic actions of competitors,
regulations, etc., are likely to influence customers' demands for your product--but you can't do
anything about them--or can you??

Lets look at some exogenous variables that may become more endogenous

a.new tax policies or minimum wages could influence consumers' incomes

b. advertising could influence peoples' tastes
c. as we'll see later, in markets with limited competition, you may be able to influence prices
of goods which are substitutes for your product
d. through bundling deals across companies, you may be able to influence the prices of
goods which are complements to your products (e.g., computers and software)
e. you can lobby to propose or oppose legislation

But you can also do market research to determine how your good is likely to do as income
changes. Then by using forecasts of income change, you can predict changes in your markets.

A good manager can't say that they won't worry about a variable because they can't control it.

A good manager will develop strategies (pricing, quality, investment, etc.) based on expected
changes in variables he/she can't control--but whose changes will influence the demand for
his/her product

A manager certainly needs to know endogenous variables because managers directly control
these variables and these variables influence the demand for their product (e.g., quantity and/or
price, advertising, quality, etc.)

Think strategically about how to price and vary quality and how your competitors are likely to react
to your decisions

Think strategically about how to produce your product--technologies, factor intensities, make
versus buy, locations

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Our watchword will be: Always think strategically

ROLE OF PROFIT MAXIMIZATION IN OUR THEORY

We will assume that firms wish to maximize profit and will look to rules which will lead them to
profit maximization.

But how is this consistent with Texaco sponsoring the opera or McDonald's sponsoring Ronald
McDonald houses or Bono red products?

It's a metric for putting a price on managerial behavior

1. suppose that the profit maximizing profit = 100

2. suppose that the firm decides to maximize market share instead and gets profit of 85
3. then the cost of maximizing market share is 15
4. management involves a lot of tradeoffs and we need a metric to measure those tradeoffs

Value of a firm = the present value of the future stream of expected profits of the firm (as
opposed to its book value)

1. t = TRt - TCt

i.e., the profit (t) at time t is the total revenues (TRt) at time t minus the total costs (TCt) at time t
(expected value concepts will be developed later)

2. Present value = t e-rt ,
t=0

where r is the discount rate and e-rt is the discount factor for continuous discounting

or 3. Present value = t /(1 + r)t
t=0

where r is the discount rate and (1/[1 + r]t) is the discount factor for discrete discounting.

Well use the latter in the following explanation

Suppose that Uncle Ned passes away and you are the only living relative. His will says you get
either $1 million today OR $1.1 million a year from today. How do you decide (well assume away
taxes and inflation)?

1. if r = 10%, then you're indifferent because $1 million today invested at 10% would yield
$1.1 million a year from now (discrete case entails non-compounding of interest)

2. if r = 20%, then you'd take the $1 million today because you could invest it and have $1.2
million in a year

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 3. if r = 8%, then you'd take the $1.1 million in a year because if you invest $1 million at 8%,
you'd have $1.08 million in a year

Reverse the process: Look for the present value (x) of $1.1 million next year if the interest rate
was 20%, i.e., what amount x would you have to have today that when invested at 20%/year
would give you the $1.1 million you could get if you showed up in the lawyers office in a year?
1
x(1 + 0.2) = $1.1 Million (note r = 0.2 and t = 1)
x = $1.1 Million/ (1 + 0.2)1
x = $1.1 Million/1.2
x = $0.91667 Million

Clearly, $1 million today is better than a present value of $0.91667 million today. So at 20%, youd
take $1 million today (same result as above).

MARKETS
Markets can be physical-like the bazaar in Hyderabad

But we define them as a collection of buyers and sellers that interact resulting in the
possibility of exchange

An industry is a collection of firms that sell the same or related products

Markets have spatial, product, intramodal, intermodal, and temporal dimensions

Spatiala Mercedes dealer in Mohali vs. Mercedes dealer in Hyderabad

Consider a transportation of coal example:

Power Plant A .__________________. Coal Mine A

Railroad A

You could define the market as rail transportation of coal from Coal Mine A to Power Plant A. If
another railroad went from Coal Mine A to Power Plant A, then we'd have intramodal competition.
If a navigable waterway ran from Coal Mine A to Power Plant A, we'd have intermodal
competition by barge. If Power Plant A could buy coal from Coal Mine B and Coal Mine C (served
by other railroads than the ones running from Coal Mine A to Power Plant A), then the railroads
running from Coal Mine A to Power Plant A would be facing competition from another location
(coal from Mines B and C). This is spatial competition. Likewise, Coal Mine A might be able to sell
coal to Power Plant B served by different carriers. Or Power Conglomerate A might build a new
facility to serve its customers at a different location. Finally, Power Plant A (over time) might be
able to convert to oil, nuclear, windmills, mice on a treadmill, etc. This is product competition.

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 CONCEPT OF OPPORTUNITY COST
Opportunity Costs Example (per day basis)

Total Revenue of street vendor = $115

- Cost of goods sold = $ 40
_____________________________________________
= $ 75 What's this?

It might be her/his accounting profit for income tax purposes but it's not her/his economic profit.
We must consider the opportunity costs of her/his time and the opportunity costs on the capital
she/he has invested in her/his cart.

Suppose that shes/he's a minimum wage kind of guy and that the minimum wage is $7/hour and
that the work day is set at 8 hours. Assuming that minimum wage jobs are available, the
opportunity costs of her/his time spent vending is

8 * $7 = $56

Assume that her/his cart is worth $1,000, that there's an active resale market in vending carts and
that the interest rate per day is 0.1%. Then the opportunity cost of her/his capital is

$1,000 * 0.001 = $1.

Thus, from an opportunity cost perspective, her/his profits are

Total Revenue of street vendor = $115

- Cost of goods sold = $ 40
- Opportunity cost of labor = $ 56
- Opportunity cost of capital =$ 1
_____________________________________________
Economic Profit = $ 18

What if the city where the vendor is located puts an $18.50/day vending fee in?

Consider a student with a job contemplating going to graduate school full time:

Being in school has an opportunity cost (lost wages in your current job)

Why do you choose to go to school? Youre a long run utility (profit) maximizer! (See Figure 1)

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 B
$ Present value of
income stream B (with
graduate degree) >
present value of
BENEFIT income stream A
(without graduate
A degree), i.e. net
present value of
BENEFIT > net present
value of COST

t S t+2 Time

FIGURE 1

STUDENT OPPORTUNITY COST

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