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PART I - INTRODUCTION

Chapter 1

Introduction and Goals of the Firm

Managerial economics is that part of economics applied to the decisions that managers must make. When managers make decisions that maximize firm profits, they simultaneously maximize shareholder wealth and promote efficient allocation of resources. Managers drift away from this objective when they concentrate on their own security.

Managerial Challenge

1. Southern Company, an electric utility, aligned its goals of sustainable use of its own resources and the government’s pollution abatement requirements by engaging in a least-cost cash flow basis.

2. A move toward low-sulfur coal maximized shareholder value because it was based on sound decision-making principles.

What is Managerial Economics?

1. Managerial Economics deals with applications of microeconomics. It is useful for making business decisions concerning pricing, production, cost analysis, market structure, and strategy.

2. Honda and Toyota both expanded capacity to produce cars in the US. The decision is either to expand internally (S1) or to purchase assembly plants currently owned by General Motors (S2). Both firms believe that the capacity expansion was profitable.

3. Steps in decision making include: Establish and identify objectives, define the problem, find possible alternative solutions, select the best solution, and implement that choice.

The Decision-Making Model

1. The decision maker must establish the objectives, identify the problem, examine potential solutions, analyze the relative costs and benefits of each, and then engage in a sensitivity analysis.

2. Managers are responsible for proactively solving problems before they become crises.

3. Economic profit is the difference between total sales revenue (identified as price times units sold) and total economic cost. The economic cost of an activity is similar to opportunity cost, the highest value opportunity foregone.

The Role of Profits

1. Theories of why profit varies across industries:

a. Risk-bearing theory of profit. Higher profit is compensation for investing in riskier endeavors. Example: investing in the stock of Circus Circus.

b. temporary disequilibrium theory of profit. Industries earning above normal profits (economic profits) will eventually find more competition. Added competition will bring profits back to normal (zero economic profits) over time. Competition directs resources to industries with the greatest profit. Example: petroleum industry profits rise when there are international wars in oil producing countries.

c. Monopoly theory of profit. Barriers, such as governmental regulations, are the source of higher than normal profits.

d. Innovation theory of profit. There is a reward for developing new ideas, new construction technologies, and for finding new markets.

e. Managerial efficiency theory of profit. Exceptional managerial skills can produce superior profits.

Objective of the Firm

1. Profit maximization as a goal implies that decisions that raise revenues more than costs or lower costs more than reduce revenues should be selected. This is a short term objective.

2. Shareholder wealth maximization as a goal implies that decisions that increase the present value of expected future profits should be selected. Even decisions that reduce today's profits, yet substantially raise future profits, may be appropriate decisions. This is a long-term business goal.

3. The price of a share of stock can be thought of as the present value of expected future cash flows per share. Cash flows are discounted at the shareholders required rate of return, ke.

4. The value of the firm, VALUE, is the price per share, V0, times the number of shares outstanding. VALUE = V0•Shares Outstanding. The price per share, V0, is the present value of future profit per share, where (t is cash flow per share in each period and ke is the investor’s required rate of return.

(

VALUE = V0•Shares Outstanding = { ( (t /(1+ke) t } + Real Option Value

t=1

5. Business decisions affect the amount and timing of the discount rate used by investors.

6. If firm is perceived as less risky, then a reduction in required rate of return, ke, raises the value of the firm.

7. Shareholder wealth maximization is the primary goal of William Buffett, CEO of Berkshire Hathaway, who has produced higher profits and higher share values than market averages over time.

Separation of Ownership and Control: The Principal-Agent Problem

1. In many corporations, the managers own very few shares. Shareholders may want profits, but managers may wish to relax. The shareholders are principals, whereas the managers are agents. Divergent objectives between these groups are called agency problems.

2. Solutions to agency problems involve compensation that is based on the performance of agents. Some firms have compensation plans that extend stock options, bonuses, and grants of stock to workers, so that employees have added incentives to increase their company's value.

3. RJR Nabisco was mismanaged. An unfriendly takeover of the firm was successful, and they sold the bad performing businesses. Also, O.M. Scott, a fertilizer company, was part of the ITT conglomerate. Once Scott Fertilizer was taken private in a leverage buyout, performance improved in inventory levels and other areas.

Implications of Shareholder Wealth Maximization

1. Critics claim that aligning compensation with shareholder interests leads to short run objectives.

2. Patents for Eli Lilly’s profitable drug Prozac were running out. Lilly hoped to find ways to extend the patents. When a federal judge blocked the extension in 2000, competitors came in with generic versions of Prozac. Lilly used short run crisis management. Longer run thinking, such as ‘scenario planning’ would have led them to bring out new generation anti-depressants before the patent terminated.

3. Net present value analysis adjusts for timing and risk but ignores the value of flexibility present in some capital budgeting projects but not in others. These embedded options present an opportunity to maximize the value of a capital investment.

4. Maximization of the present value of expected cash flows works well if the following conditions are met:

a. Complete Markets -- there are liquid markets to buy and sell the firm's inputs, contaminants (including polluting by-products), and common property resources.

b. No Asymmetric Information -- buyers and sellers all know the same things.

c. Known Recontracting Costs -- future input costs are part of the present value of expected cash flows. The existence of future and forward markets in inputs can help lock-in future input costs.

5. The focus on shareholder wealth maximization is appropriate because shareholders have a residual claim on the firm’s net cash flows after all expected contractual returns have been paid.

6. The value maximization approach may not be appropriate in the public sector, or for Not-For-Profit (NFP) Enterprises.

a. NFP organizations such as performing arts groups, most hospitals, universities, and volunteer organizations receive a substantial portion of their financial support from contributions, and some support from "clients" who use their services.

b. NFP organizations seek goals such as increased contributions. They may achieve their goals by being efficient in the services they offer or by providing meritorious services.

c. several objectives have been suggested for NFP enterprises, including maximizing the quality and quantity of output subject to a break-even constraint; maximizing the outcomes preferred by the NFP’s contributors; and maximizing the longevity of the NFP’s administrators.

7. Cost-benefit analysis has been developed to allocate pubic and NFP resources. In practice these may take the form of maximizing benefits for given costs; minimizing the costs for a fixed level of benefits; or maximizing net benefits (benefits minus costs).

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