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Strategy
Chapter 1
The Fundamentals of Managerial Economics
McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy
1-2
Overview
I. Introduction
II. The Economics of Effective Management
Identify Goals and Constraints
Recognize the Role of Profits
Five Forces Model
Understand Incentives
Understand Markets
Recognize the Time Value of Money
Use Marginal Analysis
1-3
Managerial Economics
Manager
A person who directs resources to achieve a stated
goal.
Economics
The science of making decisions in the presence of
scare resources.
Managerial Economics
The study of how to direct scarce resources in the
way that most efficiently achieves a managerial goal.
Definition of Economics
Economics is the social science that studies the
choices that individuals, businesses, governments, and
entire societies make as they cope with scarcity and
the incentives that influence and reconcile those
choices.
Economics divides in two main parts:
Microeconomics
Macroeconomics
Puerto Rico
Prices
Inflation Rate
Food Inflation
Argentina
Aruba
Bahamas
Barbados
Belize
Bolivia
Brazil
Canada
Cayman Islands
Chile
Colombia
Costa Rica
Cuba
Dominican
Republic
Ecuador
El Salvador
Guatemala
Guyana
Haiti
Honduras
Jamaica
Mexico
Nicaragua
Panama
Paraguay
Peru
Puerto Rico
Suriname
Trinidad and
Tobago
United States
Uruguay
Venezuela
Last
Previous
0.1
0.4
2.8
2.6
Inflation Rate
16
1
2.2
1.89
-1.1
5.49
7.7
1
1.5
Highest Lowest
8.8
Unit
-1.2
percent
9.69
-0.09
percent
Reference Previous
15-Jan
23.9
15-Jan
2.2
15-Jan
0.25
14-Dec
1.79
15-Jan
-0.4
15-Feb
5.94
15-Feb
7.14
15-Jan
1.5
14-Aug
0.7
Highest
20262.8
12.66
14.24
9.6
9.6
23464.36
6821.31
21.6
11.4
Lowest
-7
-4.68
-0.19
1.67
-12.7
-1.27
1.65
-17.8
-3.1
4.4
4.36
3.53
5.5
1.16
15-Feb
15-Feb
15-Feb
12-Dec
15-Jan
4.5
3.82
4.37
3.5
1.58
746.3
41.65
108.89
5.7
82.49
-3.4
-0.87
2.57
0.8
-1.57
4.05
-1.06
2.32
0.27
6.6
3.83
5.3
3
5.51
2.3
3.2
2.77
0.1
2.3
8.47
15-Feb
15-Feb
15-Jan
14-Sep
15-Jan
15-Jan
15-Jan
15-Feb
15-Feb
15-Jan
15-Feb
15-Feb
14-Dec
15-Jan
14-Dec
3.53
-0.74
2.95
0.62
6.4
5.82
6.4
3.07
5.45
2.6
3.4
3.07
0.4
3.9
9.02
107.87
12.2
60.71
16.04
42.46
40.2
26.49
179.73
23.99
10.04
13.4
12377.32
8.8
586.48
24.52
-2.67
-1.6
-11.94
-1.46
-4.7
2.66
5.29
2.91
-0.12
0.49
0.9
-1.11
-1.2
-11.68
-2.61
-0.1
15-Jan
0.8
23.7
-15.8
7.43
68.5
15-Feb
14-Dec
8.02
63.61
182.86
115.18
-7.12
3.22
1-8
1-9
Economic Profits
Total revenue minus total opportunity cost.
Opportunity Cost
Accounting Costs
The explicit costs of the resources needed to
produce goods or services.
Reported on the firms income statement.
Opportunity Cost
The cost of the explicit and implicit resources
that are foregone when a decision is made.
Economic Profits
Total revenue minus total opportunity cost.
1-10
1-11
Profits as a Signal
Profits signal to resource holders where
resources are most highly valued by society.
Resources will flow into industries that are most
highly valued by society.
Entry
Network Effects
Reputation
Switching Costs
Government Restraints
Power of
Input Suppliers
Power of
Buyers
Supplier Concentration
Price/Productivity of
Alternative Inputs
Relationship-Specific
Investments
Supplier Switching Costs
Government Restraints
Sustainable
Industry
Profits
Industry Rivalry
Concentration
Price, Quantity, Quality, or
Service Competition
Degree of Differentiation
1-12
Switching Costs
Timing of Decisions
Information
Government Restraints
Buyer Concentration
Price/Value of Substitute
Products or Services
Relationship-Specific
Investments
Customer Switching Costs
Government Restraints
Network Effects
Government
Restraints
1-13
1-14
Market Interactions
Consumer-Producer Rivalry
Consumers attempt to locate low prices, while
producers attempt to charge high prices.
Consumer-Consumer Rivalry
Scarcity of goods reduces the negotiating power
of consumers as they compete for the right to
those goods.
Producer-Producer Rivalry
Scarcity of consumers causes producers to
compete with one another for the right to service
customers.
1-15
PV
FV
1 i
Examples:
1-16
Future Consumption C1
Intertemporal utility or
Indifference curves
W/P1
U2
C1*
U1
U3
W = Co + P1C1
Co*
Current Consumption Co
1-18
PV
FV1
1 i
FV2
1 i
...
Equivalently,
n
FVt
PV
t
t 1 1 i
FVn
1 i
AN EXAMPLE
WHAT IS THE PRESENT VALUE OF $1,080 ?
IN ONE YEAR IF THE INTEREST RATE IS 8 % PER
YEAR?
SO i = 8 % OR 0.08, AND t = 1
PV = $1,080[ 1/(1.08)1] = $1,000
1-21
NPV
FV1
1 i
If
FV2
1 i
...
FVn
1 i
Decision Rule:
NPV < 0: Reject project
NPV > 0: Accept project
C0
1-23
CF
CF
CF
PVPerpetuity
...
2
3
1 i 1 i 1 i
CF
1-24
t
1
2
PVFirm 0
...
t
1 i 1 i
t 1
1 i
1-25
That is, the growth rate in profits is less than the interest rate and both
remain constant.
1-26
1-27
Net Benefits
Net Benefits = Total Benefits - Total Costs
Profits = Revenue - Costs
1-28
B
MB
Q
Slope (calculus derivative) of the total benefit
curve.
1-29
C
MC
Q
Slope (calculus derivative) of the total cost
curve
1-30
Marginal Principle
To maximize net benefits, the managerial
control variable should be increased up to
the point where MB = MC.
MB > MC means the last unit of the
control variable increased benefits more
than it increased costs.
MB < MC means the last unit of the
control variable increased costs more than
it increased benefits.
Costs
Slope =MB
Benefits
B
Slope = MC
Q*
1-31
Slope = MNB
Q*
1-32
1-33
Conclusion
Make sure you include all costs and
benefits when making decisions
(opportunity cost).
When decisions span time, make sure you
are comparing apples to apples (PV
analysis).
Optimal economic decisions are made at
the margin (marginal analysis).