January 14 -16, 2002



January 13, 2002 Reading Baye, Ch. 1 pp 1-25

Lecture 1 Ch 2 pp. 33-57 (for next class)

Problems: Ch. 1 1, 2, 3, 4, 5, 6 ,7, 8, 9, 10, 11, 12, 13, 14, 15, plus the extra review of derivatives.

Bolded problems will be collected.

I. Chapter 1. The Fundamentals of Managerial Economics

Preview:

A. Definition of Topic.

1. Economics

2. Managerial Decisions

B. Components of Effective Decision Making

1. Identify Goals and Constraints:

2. Recognize the Nature and Importance of Profits: Economic profits differ from Accounting profits. . Good decision-making involves the maximization of economic profits.

3. Understanding Incentives. .Compensation and the structure of organizations affects importantly organizations.

4. Understand Markets. Market forces represent a series of rivalries. In any problem, you must appreciate your position relative to other agents.

5. Recognize the Time Value of Money

6. Appreciate Marginal Analysis Marginal decisions are an easy way to optimize totals. Calculus is just a formal expression of marginal analysis.

Lecture

A. Definition of Topic.

A first topic involves defining the scope of the course:

1. Economics: The study of how societies and individuals allocate scarce resources among competing ends.

Observation: This is a study of allocations. It applies widely to an immense variety of topics. It is not, for example, particularly focused on the decisions of businesses. It applies to profit as well as to non profit institutions.

2. The Manager. A person who directs resources to achieve a stated goal.

Observation: Again, this is a very broad definition. Clearly, you manage your own lives. In business or organizational contexts, managers control resources other than their own time and energy such as

a. The efforts of others

b. Input acquisition and use

c. Output/Pricing decisions

3. Managerial Economics: The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.

Observation: The difference between this course and a graduate economics course it that it is policy oriented. That is, we focus on giving you tools to make decisions, rather than describing how a market or an economy as a whole works.

B. Effective Management from an Economic Perspective. Economic “tools” are guides to good allocative decision-making. Elements of good decision-making can be divided into six categories

1. Identify Goals and Constraints: This is critical for defining the dimension of the problem.

Objectives are simply what you would like to accomplish. Constraints are the natural (and perhaps unfortunate) consequence of scarcity.

a. Having a well-defined objective in mind when making an allocative decision is critical. (Very concretely, imagine how one might decide to allocate time to this course if it were uncertain whether the intention was either to get a good grade or to merely pass)

b. Also, it is necessary to evaluate the constraints available in the decision process. (For example, time is typically the constraint in making personal allocative decisions. Most of our applications will focus on the decisions of a profit-maximizing firm. Here the objective is typically profits. Constraints arise in the form of pricing limitations, and production considerations.)

2. Recognize the Nature and Importance of Profits: When discussing the firm, profits take on a special role. However, when making allocative decisions you must have the correct definition of profits in mind.

a. Accounting Profits

(A = TR - TCA

b. Economic Profits

(E = TR - (TCA +TCI)

The difference in the definitions is implicit costs. Implicit costs are measured in terms of foregone alternatives. Economic costs are the sum of implicit and implicit costs. Economic costs can be measured in terms of choices foregone, or opportunity costs.

Observations

a) The function of economic profits. Accounting profits are not an incorrect definition of profits, just inappropriate for the purpose of making allocative decisions.

Example: Suppose you consider opening a T.J. Cinnamon Franchise in a storefront you own in the VA Center Commons, North of Richmond. Suppose the franchise fee is $20,000 per year, and you must pay $80,000 per year for materials and help. How much must you earn to realize an accounting profit?

Suppose that you must work in the store (and quit your job paying $25,000 per year). Also you could rent the store slot for $1000 per month. If you expected revenues of $120,000 per year, would this be a good allocation of resources?

b) The difficulty of collecting implicit cost information. In fact, it is relatively difficult get good information pertaining to opportunity costs. A legitimate (and important) function of the manager is to do as good a job as possible in collecting this information.

c) The social role of profits. The 1980’s are popularly called “the decade of greed.” A popular depiction of attitudes in the 80’s was the film “Wall Street” where Michael Douglas gives a lecture to shareholders extolling the virtues of selfishness. This is passe, of course, but, even at its height, it was a caricature of the role of profits in society.

Given that the assumptions underlying competitive performance are satisfied. Assumptions include:

-many buyers and sellers. This is referred to as the structural assumption. Violations cause problems of monopoly or oligopoly.

-perfect information about both product quality and price. The informational assumption: Violations are of the form of “lemon’s markets” problems, as well as “Diamond Paradox”

-pure privacy in consumption and production. The privacy assumption. Violations cause “free-riding” and “externalities.

Suppose that these assumptions are met. Then the signals sent by profits channel resources into their most efficient use. To quote Smith (1776)

“It is not out of the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.”

Profits send signals about entry, exit, expansion and innovation.

Example: The computer industry in the 1980s was very dynamic. The number of firms increased substantially. As a consequence, prices fell, and also the quality of computers increased. More recently, computers have become a more commodity-like product. The number of firms has decreased, and production runs have increased.

3. Understanding Incentives. If profits restrict the behavior of firms via incentives, in the market, it is also important to understand the effects of incentives within the firm. a. Institutional organization affects performance. The way an institution is organized often puts incredible limitations on the power of personalities to exert influence. Sometimes this is healthy (e.g., in the U.S. government, laws severely restrict the power of the presidency.) In other environments institutional restrictions are an important handicap. For example, the recent scandals at Enron and WorldCom are not a consequence of “bad guys”. Rather the institutional structure of these firms, and the oversight process for these firms, not only allowed, but encouraged illegal behavior.

Reorganizing the structure of an institution, as well as the laws regulating the oversight process, can make firms more reliable and more efficient.

b. The way people are rewarded can influence their incentive to work

Example: Suppose you pay someone $75,000 to manage your restaurant. Would this person do better than someone paid $50,000? There is no particular reason to suppose that the answer should be in the affirmative. A compensation package that more nearly aligns the interests of the owner and the manager would be one that provided incentives to the manager that paralleled the interests of the owner. (e.g., a profit-sharing arrangement.)

This type of problem is called a principle-agent problem. It is a common problem in many firms. Particularly in publicly-held firms, where the stockholders have only limited control over the decisions of the CEO.

4. Understand Markets. Markets are the regulating force for firms, and the source of incentives for their activities. These incentives arise via transactions, and are the consequence of competing interests. For every transaction, there are two parties.

a. Consumer-Producer Rivalry: Consumers and producers are simultaneously trying to take advantage of each other. They are limited by reputation and bargaining skills. As a consequence of bargaining, each gets less than they want, but not more than it is worth, or less than it costs.

b. Consumer-Consumer Rivalry: Consumers compete with each other for products. In the process, the purchasing consumer pays more than (s)he wants, but not more than it is worth to him or her. (Example: This is most clearly seen in auctions for specialized consumer goods, such as antiques. Bidding by rival potential purchasers drives up the price.)

c. Producer-Producer Rivalry: Producers compete with each other, and as a consequence, offer better quality, and higher quantities at a lower price than they would like. (Again, this is most directly seen in a procurement auction)

d. The Role of Government: Provided that the conditions that I mentioned above are satisfied, there is no need for the government to intervene. However, when one or more of these assumptions fails, the Government frequently intervenes to restore the balance.

5. Recognize the Time Value of Money. It is important to realize that money earned in the future is not valued the same as money earned today. Allocative decisions should be adjusted accordingly.

a. Present Value Analysis.

Suppose that the interest rate is 10%. Then it would take $1.10 next year to equal $1 today. In general

PV(1+i) = FV

Similarly, for two years hence

PV(1+i)2 = FV

and in general

PV = FV

(1+i)n

Often times we are interested in a stream of earnings.

PV = ( FVt

(1+i)t

In valuing a stream of earnings relative to a cost. (As is typical for any investment decision) It is important to consider the net present value

NPV = ( FVt - Co

(1+i)t

Example: Suppose you are given the opportunity to purchase a new high-speed lathe that will reduce the costs of producing cedar wooden eggs by $2 per egg. At current prices, you sell 10,000 per year for each of the next 4 years. If the interest rate is 10%, and the machine costs $65,000 is it a good purchase?

20,000/(1.1) + 20,000/(1.1)2 + 20,000/(1.1)3 + 2 0,000/(1.1)4

= 18,182 + 16258 + 15026+ 13660 = 63,397

No. The NPV is -$1,603.

b. The present value of the firm: This same equation can be generalized to value the profitability of a firm, simply by substituting ( for FV

PV = ( (t

(1+i)t

Accounting for indefinite life. There is, however, one important complication. Unlike a piece of equipment, firms are not expected to be finitely lived. In this case, the summation in the present value formula becomes infinite, e.g.,

PV = (0 + (1 + (2 + (3 + …

(1+i)1 (1+i)2 (1+i)3

We can still come up with a finite present value if we assume that the stream of revenues each period is fixed. That is, consider a “perpetuity” e.g,. a constant cash flow (“CF”) that, starting one year from today, will be paid to you the first day of each year, forever. The present value of that flow is

PV = CF + CF + CF + …

(1+i)1 (1+i)2 (1+i)3

Notice, that as long as i > 0, terms get smaller as we get further into the future. It is well known that the present value of a such perpetuity can be expressed simply as

PV = CF/i

Similarly, for a firm generating a constant profit

PV = (/i

Notice that the above PV formula excludes a payment received now (e.g., at time 0).The PV of a stream of returns starting today is

PV = (/i + ( = (1+i) (/i

You must always be careful to stipulate the timing of the first payment when doing PV calculations.

Allowing for Growth. Of course, it is more interesting to consider the possibility that profits will grow somewhat overtime. Again, making some simplifications, we can generate an expression for present value. Suppose that profits grow at the same rate g each year. Then

(

PV = ( (0 (1+g)t

t=0 (1+i)t

PV = (0 (1 + i)

(i - g)

Notice: The above calculation includes an immediate payment (at time 0)

Analytically, the discount term becomes (1+g)/(1+i) rather than 1/(1+i) . This will be convergent as long as (1+g)/(1+i) ................
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