Note: Anyone who is suffering under the delusion that neoclassical economics or marginal analysis is in any way a valid reflection of reality should watch this great interview explaining why everything we learn in classes like this is basically superstitious ideological nonsense. And yet, here we are.
Class Notes
- Watch
- Discussion: Introduce yourself
- Two powerpoints
- Chapter 1
- Introduction
- Economic Analysis and Decisions
- Demand Analysis
- Production and Cost Analysis
- Product, Pricing, and Output Decisions
- Capital Expenditure Analysis
- Economic, Political And Social Environment
- Business Conditions
- Trends, Cycles, and Seasonal Effects
- Factor Market Conditions
- Capital, Labor, and Raw Materials
- Competitors’ Reactions and Tactical Response
- Organizational Architecture and Regulatory Constraints
- Business Conditions
- These categories interact with each other and with Cash Flow and Risk
- Cash Flow and Risk determine Firm Value
- Economic Analysis and Decisions
- What is Managerial Economics
- The decision-making model
- The role of profits
- Objective of the firm
- Separation of ownership and control: the principal-agent problem
- Implications of shareholder wealth maximization
- Strategy
- Managerial economics enables managers to select strategic direction, allocate efficiently, and respond effectively to tactical issues
- Managerial economic decision-making seeks to
- Identify the alternatives
- Select the choice that accomplishes the objective(s) in the most efficient manner
- Taking into account the constraints
- And the likely actions and reactions of rival decision-makers.
- Decision Making
- Making good decisions is key to successful managerial performance and includes several elements
- Establish the objective
- Identify the problem
- Examine potential solutions
- Analyze the relative costs and benefits
- Analyze the best available alternative under a variety of assumptions (Sensitivity analysis)
- Implement the decision
- Making good decisions is key to successful managerial performance and includes several elements
- Challenges
- Responsibilities of Management
- Managers are responsible for many goals
- They must proactively solve problems before they become crises
- Moral Hazard in Teams
- The single most critical trait of effective managers is the ability to motivate teams to perform to their best
- To encourage team members to avoid the moral hazards of free riding and shirking of duties
- Without penalties and sanctions, only moral duty induces full effort teamwork
- The single most critical trait of effective managers is the ability to motivate teams to perform to their best
- Responsibilities of Management
- Capitalist economy
- Managers in a capitalist economy are motivated to monitor teamwork because of their overarching goal to maximize returns to owners of the business.
- Economic profits: the difference between total revenue and total economic cost
- Includes a “normal” rate of return on the capital contributions of the firm’s partners
- Managers in a capitalist economy are motivated to monitor teamwork because of their overarching goal to maximize returns to owners of the business.
- Introduction
- Continued
- Continued
- Role of profit
- Risk-bearing theory of profit
- Risk-bearing should lead to higher profits
- Temporary disequilibrium theory of profit
- Firms may earn a return above or below the long-run normal return level
- Monopoly theory of profit
- A firm which dominates the market can consistently earn above-normal returns
- Innovation theory of profit
- These are the rewards for successful innovations
- Managerial efficiency theory of profit
- Exceptional managerial skills may lead to higher profits
- Risk-bearing theory of profit
- Eli Lily, a Pharmaceutical company
- It takes 12.3 years on average to get a new drug approved.
- Patents on Lilly’s Prozac created monopoly power and profits for a widely used medication for depression
- As the patent began to expire, Lilly requested a patent “extension” because of some alterations in Prozac’s formula
- But when the patent extension was overturned, generic drug manufacturers took 70% of the share of the market for antidepressants
- Lilly missed the chance of finding a replacement in time for its blockbuster Prozac
- This is an example of having and losing monopoly power
- The shareholder wealth-maximization model
- Shareholder wealth is measured by the market value of a firm’s common stock, which is equal to the present value of all expected future cash flows to equity owners discounted at the shareholders’ required rate of return plus a value for the firm’s embedded real options
- Agency problem
- Divergent objectives and agency conflict
- Growth results in owners (principals) delegating decision-making authority to professional managers (agents)
- Because manager-agents have much less to lose, agents may seek acceptable (not maximum) profit levels, pursuing their own self-interests; agency conflict
- Agency problem
- problems arise from inherent unobservability of managerial effort and random disturbances in team production
- Separation of ownership (shareholders) and control (management) in large corporations permits managers to pursue goals that are not always in the long-term interests of shareholders
- Divergent objectives and agency conflict
- Role of profit
- Continued
- Continued
- Continued
- Agency problem continued
- In attempts to mitigate agency problems, firms incur agency costs
- Grants of stock options or restricted stock from treasury stock so executive compensation aligns the incentives for management with shareholder interests; also, many monitor financial ratios and investment decisions of large debtor companies; strengthens firm’s corporate governance
- Internal audits and accounting oversight boards to monitor actions of management
- Bonding expenditures and fraud liability insurance to protect shareholders
- Complex internal approval processes to limit discretion, but which prevent timely responses to business opportunities
- Shareholder wealth maximization
- Critics of those who seek to align interests of managers with equity owners allege that maximizing shareholder wealth focuses on short-term payoffs, sometimes to detriment of long-term profits
- Evidence suggests just the opposite
- Short-term cash flows reflect only a small fraction of the firm’s share price
- In general, only about 85% of shareholder value can be explained by even 30 years of cash flows
- Managers’ value-maximizing behavior distinguishable from satisficing behavior
- Caveats to maximizing shareholder value
- Complete markets: to directly influence a company’s cash flows, forward or futures markets, and spot markets must be available for firms’ inputs, outputs, and by-products
- No asymmetric information: problems often arise because of asymmetric information; Line managers and employees can misunderstand what senior executives want when they challenge employees to find a thousand different ways to save 1%.
- Known recontracting costs: focusing exclusively on discounted present value of future cash flows requires managers to forecast future recontracting costs for pivotal inputs.
- Shareholder wealth maximization
- Residual claimants
- Shareholders have only a residual claim on the firm’s net cash flows after all expected contractual returns have been paid
- Goals in the public sector and not-for-profit enterprises
- Profit maximization not appropriate for public sector of nfp firms
- public goods are consumed by more than one person at a time with little or no extra cost; expensive or impossible to exclude those who do not pay
- Not-for-profit objectives
- Maximize
- Quantity and equality of output subject to break-even budget constraint
- Outcomes preferred by NFP’s contributors
- Longevity of NFP’s contributors
- Maximize
- Residual claimants
- The efficiency objective in nonprofits
- Cost-benefit analysis is a resourse-allocation model that can be used by public sector and NFP firms to evaluate programs or investments on the basis of the magnitude of the discounted costs and benefits
- Because spending is constrained by a budget ceiling, goals can be any one of these
- Maximize the benefits for given costs
- Minimize the costs while achieving a fixed level of benefits
- Maximize net benefits (benefits minus costs)
- Cost-benefit analysis is only one factor in the final decision
- It does not incorporate subjective considerations or less quantifiable attributes such as fairness
- Agency problem continued
- Chapter 2: Microecon review
- Overview
- Review supply and demand
- Marginal analysis
- Net present value concept
- Meaning and measurement of risk
- Risk and required return
- Supply and Demand
- Supply and demand simultaneously determine equilibrium market price. Market price equates the desired rate of purchase with the planned rate of sale. Both concepts address intentions — that is, purchase intentions and supply intentions.
- In addition, supply and demand are explicitly rates per unit time period (eg autos per week at a Chevy dealership and the aggregate purchase intentions of the households in the surrounding target market). Hence, market price is a projected market-clearing equilibrium concept, a price that equates the flow rates of intended purchase and planned sale.
- Equilibrium market price results from the interaction of suppliers and demanders involved in an exchange. In addition to the use value demanders anticipate from a product, a supplier’s variable cost will also influence the market price observed.
- Responsibilities of a manager
- Diminishing marginal utility: marginal use value declines as the rate of consumption increases
- Diminishing marginal return: marginal cost in production increases as more quantity is being produced
- Demand Schedule
- The demand schedule (Sometimes called the demand curve) is the simplest form of the demand relationship. It is merely a list of prices and corresponding quantities of a commodity that would be demanded by some individual or group of individuals at uniform prices.
- Overview
- Continued
| Price of a piece of pizza | Quantity of pizzas sold |
| 10 | 50 |
| 9 | 60 |
| 8 | 70 |
| 7 | 80 |
| 6 | 90 |
- Cont
- Cont
- Demand Function
- The demand schedule (or curve) specifies the relationship between prices and quantity demanded, holding constant the influence of all other factors. A demand function specified all these other factors that management will often consider, including the design and packaging of products, the amount and distribution of the firm’s advertising budget, the size of the sales force, promotional expenditures, the time period of adjustment for any price changes, and taxes and subsidies.
- Demand Function
- Cont
- Cont
- Cont
- Change in demand
- Movement along a demand curve is often referred to as a a change in the quantity demanded, while holding constant the effects of factors other than price that determine demand.
- In contrast, a shift of the entire demand curve is often referred to as a change in demand in is always caused by some demand determinant other than price.
- Supply function
- The supply schedule is a list of prices and corresponding quantities that an individual or group of sellers desires to sell at uniform prices, holding constant the influence of all other factors.
- Change in demand
- Cont
- Cont
- Cont
- Marginal Analysis
- Marginal analysis is one of the most useful concepts in microeconomics. Resource allocation decisions typically are expressed in terms of the marginal equilibrium conditions that must be satisfied to attain an optimal solution. The familiar profit-maximization rule for the firm of setting output at the point where “marginal cost equals marginal revenue” is one example.
- Long-term investment decisions (capital expenditures) also are made using marginal analysis decision rules. Only if the expected return from an investment project (ie. the marginal return to the firm) exceeds the cost of funds that must be acquired to finance the project (the marginal cost of capital), should the project be undertaken.
- Marginal Analysis
- Cont
- Cont
- Cont
- Total, Marginal, and Average
- The relationships among the total, marginal, and average profit functions and the optimal output decisions also can be represented graphically. A set of continuous profit functions for discrete integer values of output Q is shown. At the break-even output level Q1, both total profits and average profits are zero. The marginal profit function which equals the slope of the total marginal profit function, takes on its maximum value at an output of Q2 units.This point corresponds to the inflection point.
- Net present value concept
- Wehn costs and benefits occur at approximately the same time, the marginal decision rule (proceed with the action if marginal benefit exceeds marginal cost) applies. But, many economic decisions require that costs be incurred immediately to capture a stream of benefits over several future time periods. In these cases, the net present value (NPV) rule replaces the marginal decision rule and provides appropriate guidance for longer-term decision markers.
- Present value: the value today of a future amount of money or a series of future payments evaluated at the appropriate discount rate.
- Net present value of an investment
- Example:
- Purchase a piece of land near a proposed new highway interchange (1 year investment)
- Current value $1m
- Expected future value: $1.2m
- Expected future profit: $0.2m
- Alternative investment return: 3%
- Discount factor / Present value interest factor (PVIF) = 1 / (1+i)
- Present value calculation
- PV = FV * PVIF
- $1.2m * (1/(1+0.03)) = $1,165,049
- Net present value
- NPV = PV of future returns – Initial Outlay
- $1.2m * (1/(1+0.03)) – $1m = $165,049
- Example:
- Sources of Positive NPV Projects
- What causes some projects to have a positive NPV and others to have a negative NPV? When product and factor markets are other than perfectly competetive, it is possible for a firm to earn above-normal profits (economic rents) that result in positive net present value projects. The sources of a positive NPV project include the following barriers to entry and other factors:
- Buyer preferences for established brand names
- Ownership or control of favored distribution systems (Exclusive auto dealerships or airline hubs)
- Patent control of superior product designs or production techniques
- Exclusive ownership pf superior natural resource deposits
- Inability of new firms to acquire necessary factors of production (management, labor, equipment)
- Superior access to financial resources at lower costs (economies of scale in attracting capital)
- Capital-intensive production processes
- High initial start-up costs
- What causes some projects to have a positive NPV and others to have a negative NPV? When product and factor markets are other than perfectly competetive, it is possible for a firm to earn above-normal profits (economic rents) that result in positive net present value projects. The sources of a positive NPV project include the following barriers to entry and other factors:
- Meaning and measurement of risk
- Risk: a decision-making situation in which there is variability in the possible outcomes, and the probabilities of these outcomes can be specified by the decision maker. The more variable these outcomes are, the greater the risk.
- A primary problem facing managers is the difficulty of evaluating the risk associated with investments and then translating that risk into a discount rate that reflects an adequate level of risk compensation.
- The most effective way to demonstrate risk is using probability distributions
- Objective determination
- Subjective determination
- Probability distribution
- A probability distribution can be interpreted in three different measures
- Expected value: the weighted average of the possible outcomes
- Standard deviation: a statistical measure of the dispersion of a variable about its mean
- Symmetry of the distribution, normal distribution, skewed leftward, skewed rightward, double peaks, etc.
- A probability distribution can be interpreted in three different measures
- Risk and required return
- The relationship between risk and required return on an investment can be defined as
- required return = risk free return – risk premium
- The risk-free rate of return refers to the return available on an investment with no risk of default. The best example of risk-free debt securities are short-term government securities such as US treasury bills.
- Note: a positive relationship exists between risk and required rates of return. Investments involving greater risks must offer higher expected returns.
- The relationship between risk and required return on an investment can be defined as
- Total, Marginal, and Average
- Cont
- Quiz