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Chapter 1
The Fundamentals of
Managerial Economics

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 Learning Objectives

Summarize Summarize how goals, constraints, incentives, and market rivalry affect economic decisions.

Distinguish Distinguish economic versus accounting profits and costs.

Explain Explain the role of profits in a market economy.

Apply Apply the five forces framework to analyze the sustainability of an industry’s profits.

Apply Apply present value analysis to make decisions and value assets.

Apply Apply marginal analysis to determine the optimal level of a managerial control variable.

Identify Identify and apply seven principles of effective managerial decision making.

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 The Manager

A person who directs resources to achieve a stated goal.

• Directs the efforts of others.
• Purchases inputs used in the production of the firm’s output.
• Directs other decisions, such as, the product price and quality.

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 Economics

The science of making decisions in the presence of scarce

resources.
• Resources are anything used to produce a good or service or achieve a goal.
• Decisions are important because scarcity implies trade-offs.

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 Managerial Economics Defined

The study of how to direct scarce resources in the way that most
efficiently achieves a managerial goal.
• Should a firm purchase components – like disk drives and chips – from other
manufacturers or produce them within the firm?
• Should the firm specialize in making one type of computer or produce several
different types?
• How many computers should the firm produce, and at what price should you
sell them?
• How many employees should the firm hire and how should they be
compensated?

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 Economics of Effective Management

7 Principles of Effective Managerial Decision Making

1. Identify goals and constraints.
2. Recognize the nature and importance of profits.
3. Understand incentives.
4. Understand markets.
5. Recognize the time value of money.
6. Use marginal analysis.
7. Make data driven decisions.

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 Identify Goals and Constraints

Goals must be well-defined.

Firm’s overall goal is to maximize profits.
Constraints make it difficult to achieve goals.
• Available technology.
• Prices of inputs used in production.

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 Recognize the Nature and Importance of Profits 1

Accounting profit
• Total amount of money taken in from sales (total revenue) minus the dollar cost of
producing goods or services.
Economic profit
The difference between total revenue and total opportunity cost.
Opportunity cost
• The explicit cost of a resource plus the implicit cost of giving up its best alternative.

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 Recognize the Nature and Importance of Profits 2

The role of profits

• Profits are a signal to resource holders where resources are most highly valued by
society.

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 Five Forces and Industry Profitability (Figure 1-1)

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 Understand Incentives

Changes in profits provide an incentive to resource holders to alter

their use of resources.
Within a firm, incentives impact how resources are used and how
hard workers work.
• One role of a manager is to construct incentives to induce maximal effort
from employees.

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 Understand Markets

Two sides to every market transaction: buyer and seller.

Bargaining position of consumers and producers is limited by three
rivalries in economic transactions:
• Consumer-producer rivalry.
• Consumer-consumer rivalry.
• Producer-producer rivalry.
Government and the market.

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 Recognize the Time Value of Money

Often a gap exists between the time when costs are borne, and when
benefits are received.
• Managers can use present value analysis to properly account for the timing of
receipts and expenditures.

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 Present Value Analysis 1

Present value of a single future value.

• The amount that would have to be invested today at the prevailing interest rate to
generate the given future value:
FV
PV 
1  i 
n

• Present value reflects the difference between the future value and the opportunity
cost of waiting:
PV  FV  OCW

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 Present Value Analysis II

Present value of a stream of future values.

FV1 FV2 FVn

PV   L 
1  i  1  i  1  i 
1 2 n

or,
n
FVt
PV  
1  i 
t
t 1

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 The Time Value of Money in Action

Consider a project that returns the following income stream:

• Year 1, $10,000; Year 2, $50,000; and Year 3, $100,000.
• At an annual interest rate of 3 percent, what is the present value of this income
stream?
$10, 000 $50, 000 $100, 000
PV     $148,352.70
1  0.03 1  0.03 1  0.03
1 2 3

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 Net Present Value

The present value of the income stream generated by a project

minus the current cost of the project:
FV1 FV2 FVn
NPV   L   C0
1  i  1  i  1  i 
1 2 n

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 Present Value of Indefinitely Lived Asset

Present value of decisions that indefinitely generate cash flows:

CF1 CF2 CF3

PVAsset  CF0    L
1  i  1  i  1  i 
1 2 3

Present value of this perpetual income stream when the same cash flow is
generated  CF1  CF2  L  CF  :
CF
PV perpetuity 
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 Present Value and Profit Maximization

Profit maximization
• Maximizing profits means maximizing the value of the firm, which is the
present value of current and future profits.

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 Present Value and Estimating Values of Firms I

The value of a firm with current profits  0 , with no dividends paid out and
expected, constant profit growth rate of g (assuming g  i ) is:

 0 1  g   0 1  g   0 1  g 
2 3

PVFirm   0    L
1  i  1  i  1  i 
1 2 3

 1 i 
 0  
ig 

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 Present Value and Estimating Values of Firms II

When dividends are immediately paid out of current profits, the present
value of the firm is (at ex-dividend date):

PVFirm Ex  div  PVFirm   0

 1 g 
 0  
ig 

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 Short-Term versus Long-Term Profits

Short-term and long-term profits

• If the growth rate in profits is less than the interest rate and both are constant,
maximizing current (short-term) profits is the same as maximizing long-term profits.

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 Use Marginal Analysis 1

Given a control variable, Q, of a managerial objective, denote the

• total benefit as B(Q).
• total cost as C(Q).

Manager’s objective is to maximize net benefits:

N(Q) = B(Q)  C(Q).

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 Use Marginal Analysis 2

How can the manager maximize net benefits?

Use marginal analysis
Marginal benefit: MB(Q)
• The change in total benefits arising from a change in the managerial control variable, Q.
Marginal cost: MC(Q)
• The change in the total costs arising from a change in the managerial control variable, Q.
Marginal net benefits:MNB(Q)
MNB(Q) = MB(Q)  MC(Q)

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 Use Marginal Analysis 3

Marginal principle
• To maximize net benefits, the manager should increase the managerial control
variable up to the point where marginal benefits equal marginal costs. This level of
the managerial control variable corresponds to the level at which marginal net
benefits are zero; nothing more can be gained by further changes in that variable.

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 Marginal Analysis In Action
It is estimated that the benefit and cost structure of a firm is:
B  Q   250Q  4Q 2

C Q   Q 2

Find the MB(Q) and MC(Q) functions.

MB  Q   250  8Q
MC  Q   2Q
What value of Q makes NMB(Q) zero?
250  8Q  2Q  Q  25

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 Determining the Optimal Level of a
Control Variable I (Figure 1-2)

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 Determining the Optimal Level of a
Control Variable II (Figure 1-2) 1

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 Determining the Optimal Level of a
Control Variable III (Figure 1-2)

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 Determining the Optimal Level of a
Control Variable II (Figure 1-2) 2

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 Marginal Value Curves Are the Slopes of Total
Value Curves
• When the control variable is infinitely divisible, the slope of a total value
curve at a given point is the marginal value at that point.
• The slope of the total benefit curve at a given Q is the marginal benefit of
that level of Q.
• The slope of the total cost curve at a given Q is the marginal cost of that
level of Q.
• The slope of the net benefit curve at given Q is the marginal net benefit of
that level of Q.

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 Incremental Decisions

Incremental revenues
• The additional revenues that stem from a yes-or-no decision.
Incremental costs
• The additional costs that stem from a yes-or-no decision.
“Thumbs up” decision
• MB  MC.

“Thumbs down” decision

• MB  MC.

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 Make Data-Driven Decisions

How does one obtain information on the demand function?

• Published studies.
• Hire a consultant.
• Econometric models.
• Statistical technique called regression analysis using data on quantity, price,
income and other important variables.

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 Regression Line and Least Squares Regression
True (or population) regression model.
Y  a  bX  e
 a unknown population intercept parameter.
• b unknown population slope parameter.
• e random error term with mean zero and standard deviation σ.
Least squares regression line.
ˆ
Y  aˆ  bX
• â least squares estimate of the unknown parameter a.
• b̂ least squares estimate of the unknown parameter b.
The parameter estimates â and b̂ , represent the values of a and b that
the smallest sum of squared errors result in
between a line and the actual
data.
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 Obtaining Estimates Using Regression (Figure 1-3)
• Find the line that minimizes the sum of
squared deviations between the line
and the actual data points.
• The least squares regression line for the
equation.
Y  a  bX  e
Where a and b are unknown parameters and e is a random
variable.
• Is given by
ˆ
Y  aˆ  bX
Parameter estimates â and b̂ represent
the values of a and b that result in the
smallest sum of squared errors between a
line and the actual data.
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 Using a Spreadsheet to Perform a Regression (Table 1-3)
The Data
A B C
1 Observation Quality Price
2 1 180 475
3 2 590 400
4 3 430 450
5 4 250 550
6 5 275 575
7 6 720 375
8 7 660 375
9 8 490 450
10 9 700 400
11 10 210 500
12 Average 450.50 455.00
13
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 Excel and Least Squares Estimates (Table 1-3) 1

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 Excel and Least Squares Estimates (Table 1-3) 2

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 Evaluating Statistical Significance
Confidence Intervals
Standard error
• Measure of how much each estimated coefficient would vary in
regressions based on the same underlying true relationships with
different observations.

95 Percent Confidence interval rule of thumb

• aˆ  2 aˆ
• bˆ  2 bˆ

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 Evaluating Statistical Significance
The t-statistic
t-statistic – the ratio of the value of a parameter estimate to the standard
error of the parameter estimate.
aˆ
The t-statistic for â is taˆ 
 aˆ
bˆ
The t-statistic for b̂ is tbˆ 
 bˆ

t-statistics rule of thumb

• When t  2 , we are 95 percent confident the true value of the underlying
parameter in the regression is not zero.
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 Regression for Nonlinear Functions (Figure 1-4)

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 Regression for Nonlinear Functions
and Multiple Regression
Regression techniques can also be applied to the following settings:
• Log-Linear Regression Line.
In Y  a  b In X  e,
by using a spreadsheet to compute Y′ = In Y and X′ = In X, this can
be viewed.
Equivalently as Y′ = a + bX′ + e

• Multiple regression:

Y  a  bX 1  b2 X 2 L  bk X k  e

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 Learning Managerial Economics

Practice, practice, practice …

Make data-driven decisions.
Learn terminology.
• Break down complex issues into manageable components.
• Helps economics practitioners communicate efficiently.

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 Appendix A: The Calculus of Maximizing Net Benefits
To maximize net benefits, a manager must equate marginal benefits and
marginal costs. The objective is to choose Q so as to maximize.
N Q   B Q   C Q ;

dB  Q  dC  Q  dB dC
 MB and  MC ; so  ; or MB  MC
dQ dQ dQ dQ

The second-order condition requires the function N(Q) be concave in Q;

d 2 N d 2 B d 2C
2
 2
 2
0
dQ dQ dQ
*the slope of the marginal benefit curve must be less than the slope of the
marginal cost curve.
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 Appendix B: Evaluating the Overall Fit
of the Regression Line
R-Square
Also called the coefficient of determination.
Fraction of the total variation in the dependent variable that is explained by the
regression.
Explained Variation SS Regression
R 
2

TotalVariation SSTotal
Ranges between 0 and 1.
• Values closer to 1 indicate “better” fit.

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 Evaluating the Overall Fit of the Regression Line 1

Adjusted R-Square
• A version of the R-square that penalize researchers for having few degrees of
freedom.

R  1  1  R
 n  1
2 2
 n  k 
• n is total observations.
• k is the number of estimated coefficients.
• n  k is the degrees of freedom for the regression.

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 Table 1-3

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 Evaluating the Overall Fit of the Regression Line 2

The F- Statistic
A measure of the total variation explained by the regression relative to the
total unexplained variation.

The greater the F-statistic, the better the overall regression fit.

Equivalently, the P-value is another measure of the F-statistic.

• Lower P-values are associated with better overall regression fit.

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 Excel and Least Squares Estimates – F-Statistic

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