Managerial Economics:

Economic Tools for

Todays Decision
Makers, 5/e By Paul
Keat and Philip Young
Introductory Lecture
VIU- MBA 504

Question

Have you taken an economics course in

the past five years?
a)

Yes

b)

No

Economics- the science of

scarcity

How do you make efficient choices given limited resources?

How do you maximize happiness with a certain level of

income?

How do you maximize profits given limited resources?

Can be applied to many different fields and actors

Consumers

Managers

Central Planners

Public Policy

Sociology

Political Science

Macroeconomics &
Microeconomics

Economists generally divide their

discipline into two main branches:

Microeconomics

Macroeconomics

Macroeconomics

Macroeconomics is the study of the

aggregate economy

National Income Analysis (GDP)

Unemployment

Inflation

Fiscal and Monetary policy

Trade and Financial relationships among

nations

Macroeconomics

Is important in understanding trends in the

world economy and how it may relate to your
business

A good understanding will help with strategic

decisions and investment

This wing of economics will not be focused on in

this class

Courses such as global context will tackle this in

more depth

Microeconomics

Is the study of individual consumers and producers

in specific markets

How do individuals, mangers, and consumers make

decisions?

Supply and demand

Pricing of output

Production processes

Cost structure

Distribution of income and output

Information

Microeconomics is the basis of managerial economics

Managerial Economics & This

Class

The goal is for you to solve your future

problems as managers

With given resources (employees, available

capital & credit, goodwill, etc.) how can
you maximize profits?

The theories and ideas discussed in this

class should help you make more reasoned
and efficient decisions

Relationship to other business

disciplines

Marketing: Demand, Price Elasticity

Finance: Capital Budgeting, Break-Even

Analysis, Opportunity Cost, Economic Value
Added

Management Science: Linear Programming,

Regression Analysis, Forecasting

Strategy: Types of Competition, StructureConduct-Performance Analysis, Game Theory

Managerial Accounting: Relevant Cost,

Break-Even Analysis, Incremental Cost
Analysis, Opportunity Cost

Fundamental Problem of
Economics

There is a basic confrontation in human

nature that necessitates the field of
economics

Unlimited Wants vs. Scarce Resources

The Rolling Stones:

You cant always get what you want

Scarcity

There is a limited amount of capital and

resources available to a firm

How do we most efficiently allocate our

resources

Time, capital, labour, etc.

How do people make

decisions?

People face tradeoffs

Must balance the benefits & costs of your actions

No free lunch

Same is true for firms

If make an investment in a new facility or piece of equipment it

reduces your ability to invest in other resources

If you increase spending on marketing you may not have as much

to spend on R&D

Must decide what investments and projects will be best at

maximizing shareholder value

The Allocation Decision

Economic Decisions for the Firm

What: The product decision begin or stop

providing goods and/or services.

How: The hiring, staffing, procurement, and

capital budgeting decisions.

For whom: The market segmentation decision

targeting the customers most likely to purchase.

Question

Have you ever worked for a firm that tried

to produce too much for too many
people?

Which problems did this create for the

business?

Decision Making Processes

Three processes to answer what, how, and

for whom

Market Process: use of supply, demand,

and material incentives

Command Process: use of government or

central authority, usually indirect

Traditional Process: use of customs and

traditions

Short-run vs. Long-run

Nothing to do directly with calendar time

Short-run: firm can vary amount of some resources

but not others

Long-run: firm can vary amount of all resources to

improve profits

At times short-run profitability will be sacrificed for

long-run purposes

Amazon , Tesla, etc.

However, this can still be consistent with

maximizing longer term profits

Economic Goal of the Firm

Primary objective of the firm (to

economists) is to maximize profits.

Profit maximization hypothesis

Other goals include market share, revenue

growth, and shareholder value

Optimal decision is the one that brings

the firm closest to its goal

Drivers of Profit Maximization

Large number of shares are owned by

institutions (mutual funds, banks, etc.)
utilizing analysts to judge the prospects of a
company.

Stock prices are a reflection of a companys

profitability. If managers do not seek to
maximize profits, stock prices fall and firms
are subject to takeover bids and proxy
fights.

The compensation of many executives is

tied to stock price through stock options

Metrics Other Than Profit

Market share maximization (as measured by sales revenue

or proportion of quantity sold to total market)

Growth rate maximization (increasing size of the firm over

time. Higher rates of growth in other variables than profit)

Profit margin

Return on investment, Return on assets

Goals Other Than Profit

Shareholder value

Technological advancement

Customer satisfaction

Maximization of managerial returns (managers own

interest subject to generating sufficient profits to keep their
jobs)

Other Metrics

Many of these metrics are associated with

profit maximization

May be associated with longer-term

profits

Do Companies Maximize Profit?

Criticism: Managers may not

maximize profits but instead
aim to satisfice.

Satisfice is to achieve a set

goal, even though that goal may
not require the firm to do its
best.

Goals Other Than Profits

Non-economic Objectives

Good work environment

Quality products and services

Corporate citizenship, social responsibility

Job Stability

Constraints on Profit
Maximization

Public or stock owners

Activist Shareholders

Lawsuits and Legal Remedies

Position & Power of Stockholders

While stockholders should constrain the

action of managers, many stockholders are
not well informed on how well a corporation
can do and thus are not capable of
determining the effectiveness of
management

Not likely to take any action as long as they

are earning a satisfactory return on their
investment.

Position & Power of Professional

Management

High-level managers who are responsible

for major decision making may own very
little of the companys stock.

Managers tend to be more conservative

because jobs will likely be safe if
performance is steady, not spectacular.

Management Incentives

May be misaligned

E.g. incentive for revenue growth, not

profits

Managers may be more interested in

maximizing own income and perks

Divergence of objectives is known as

principal-agent problem or agency
problem

Recent Changes

A recent trend in corporate ownership is for

founders to own a controlling interest

Most famously Mark Zuckerburg retained voting

control of Facebook (28% value & 55% voting)

Allows decision-making to be more nimble

However, this ownership structure removes

public accountability and doesnt allow
shareholders to constrain the behaviour of
managers

Breaktime!!!!!!!!!!!!!!!!!!

The Firm

A firm is a collection of resources that is

transformed into products demanded by
consumers

Profit is the difference between revenue

received and costs incurred

Accounting Profits

Accounting Profits

Total revenue (sales) minus dollar cost of producing goods or

services.

Reported on the firms income statement

Accounting Costs

The explicit costs of the resources needed to produce goods

or services

Reported on the firms income statement.

Question

Would you give me $1000 in exchange for

a certificate that entitles you to $1010
one year from today?

a)

Yes

b)

No

Answer

This investment would yield an accounting profit of

$10

However the rate of return is only 1%

There are alternatives that would pay better than 1%

May be safer storage options than giving your money to

your new Professor

Could earn a much higher return by putting $100 into

another investment

May not have $1000

May not be able to pay bills

May have to borrow at prohibitively high rates via

credit card to afford expensive textbooks

Normal & Economic Profit

Economic Profits

Total revenue minus total opportunity cost

This is the more important number for

shareholders & managers

Opportunity Cost

The cost of the explicit and implicit resources

that are foregone when a decision is made

Maximizing the Wealth

of Stockholders

Views the firm from the perspective of a stream of

earnings over time, i.e., a cash flow.

Must include the concept of risk and the time value

of money

Dollars earned in the future are worth less than dollars

earned today

Denotes the opportunity cost of money

Could earn a given return at another investment

Business Risk

Business risk involves variation in

returns due to the ups and downs of the
economy, the industry, and the firm.

All firms face business risk to varying

degrees.

Some face higher risks and investors will

demand higher returns to reflect this

Financial Risk

Financial Risk concerns the variation in

returns that is induced by leverage.

Leverage is the proportion of a company

financed by debt.

The higher the leverage, the greater the

potential fluctuations in stockholder earnings.

Financial risk is directly related to the degree

of leverage.

Discount Value

Future cash flows must be discounted to

the present.

The discount rate is affected by the going

interest rate and risk

Time Discounting
Two types of models

1.

Static model: describe the behavior at a

single point in time. Disregards differences
in the sequence of actions and payments

2.

Dynamic models:- focus on the timing and

sequence of actions and payments

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:

PV

FV

1 i

Examples

Lotto winner choosing between a

single lump-sum payout of $104
million or $198 million split into
25 equal payments spread over
25 years

Determining past damages in a

lawsuit

Present Value of a Series

Present value of a stream of future amounts (FVt)

received at the end of each period for n periods:

PV

FV

1 i

FV

1 i

. . .

FV

1 i

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:

NPV

FV

1 i
If

FV

1 i

. . .

FV

1 i

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

Present Value of a Perpetuity

An asset that perpetually 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

...
2
3
1 i 1 i 1 i
CF

Firm Valuation

The value of a firm equals the present

value of current and future profits.
PV = t / (1 + i)t

If profits grow at a constant rate (g < i)

and current period profits are :

1 i
before current profits have been paid out as dividends;
ig
1 g
Ex Dividend
PVFirm
0
immediately after current profits are paid out as dividends.
ig
PVFirm 0

Next Class

The Economic Way of Thinking (Marginal Analysis)

Supply & Demand

Mathematical Review

Do Homework Assignment #1

Read Ch. 3