Managerial Economics: Applications, Strategy, and Tactics, 12 Edition

Managerial Economics
Applications, Strategy, and Tactics, 12h Edition

by McGuigan, Moyer, & Harris
PowerPoint Lecture Slides

prepared by
Richard D. Marcus
University of Wisconsin - Milwaukee
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part. Slide 1
Chapter 1
Introduction & Goals of the Firm
» What is Managerial Economics?
» The Decision-Making Model and the
Responsibilities of Management
» The Role of Profits?
» The Principal-Agent Problem
» Shareholder Wealth Maximization and the Real
Option Value
» Objectives in the Public Sector and Not-for-
Profit Organizations
Slide 2
What is Managerial Economics?
Managerial Economics is the application of
microeconomics to problems faced by decision makers in
the private, public, and not-for-profit sectors.
» Even questions of how best to abate nitrous oxide by coal-fired
Power Plants involves economic issues of finding efficient, least
cost solutions.
Managerial economics deals with microeconomic
reasoning on real world problems such as pricing
decisions, selecting the best strategy in different
competitive environments, and making efficient choices.
Slide 3
The Decision-Making Process
(Figure 1.2)
1. Establish Objectives
2. Identify the Problem
3. Examine Alternative Solutions
Consider 4. Analyze Alternatives Consider
Organizational
Societal and Select the Best! & Input
Constraints Constraints
5.Perform Sensitivity Analysis

6. Implement and
Monitor the Decision Slide 4
Responsibility of Management
• Managers solve problems before they become a crisis
• Managers select strategies to try to assure the success of the
firm
• Managers create an organizational culture attune to the
mission of the organization
• Senior management establish a vision for the firm
• Managers motivate and promote teamwork
• Managers promote the profitability of the firm
• And many managers see it in their long-run interest to
promote sustainability of their enterprise in their environment.
» Managers who fail at these responsibilities are reviled, be they be mangers of BP, Enron, or
Bernie Madoff
Slide 5
To Expand Capacity or Not?
An example of a simplified decision problem
• Should Honda or Toyota expand its capacity in North

America? In part, it must consider current and future
demand and what other firms are likely to do.
• Capacity for making cars is a long term project, so
these firms should think in terms of the present value
(PV) of future profits.
• Objective Function:
» Max PV of profits {S1(New), S2(Used)}
» where S1(New) is expand capacity with new facilities and
S2(Used) to purchase used facilities from GM.
• Decision Rule:
» Choose S1 if PV {Profits of S1 } > PV { Profits of S2 }
» Choose S2 if PV { Profits of S1 } < PV { Profits of S2 }
» If equal profits, then flip a coin
» If negative profits for both, then don’t expand at all Slide 6
The Role of Profits?
• Economic Profit is the difference between
total revenues and total economic cost
(Economic cost includes the “normal” rate of
return on capital contributions by the firm’s
partners).
• We’d expect high profit areas to attract
investment
• We’d expect low profit areas to lose investment
» Shouldn’t then all industries earn the
same profit eventually?
Slide 7
Theories of Why Profit Varies
Across Industries
1. RISK-BEARING Theory of Profit
2. TEMPORARY DISQUILIBRIUM Theory
of Profit
3. MONOPOLY Theory of Profit
4. INNOVATION Theory of Profit
5. MANAGERIAL EFFICIENCY Theory of
Profit
Slide 8
Theories of Why Profit Varies
Across Industries: Example
• Apple
» An example of Innovation and Managerial
Efficiency
• Watch Apple Think Different video
Slide 9
What Went Right?
● What Went Wrong?
• Eli Lilly a Pharmaceutical company
» It take12.3 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 s patent “extension” because
of some alterations in Prozac’s formula
» But when the patent extension was overturned, generic drug manufactures
took 70% of the share of the market for anti-depressants.
» Lilly missed the chance of finding a replacement in time for its blockbuster
Prozac
» This is an example of having and losing monopoly power.
Slide 10
Shareholder Wealth
Slide 11
Shareholder Wealth Maximization
[1.1}
•Value of the Firm = to maximize the value of the firm, managers must
maximize shareholder wealth
•The real option value of the firm comes from the flexibility that the
firm has to find added cost savings or new revenue possibilities that have
not yet come to pass, but could in the future because of following their
current business plans.
•Whatever lowers the perceived risk of the firm (ke) will raise firm
value.
•Whatever raises the profits of the firm, raises firm value
Slide 12
• To make good economic decisions, managers need
to be able to forecast & estimate relationships
• In this class, we will discussing how to forecast
demand (both Pt & Qt)
» This applies both to for-profit corporations &
» Public & not-for-profit organizations
• Hospital Administrators forecast patients
• University Administrators forecast enrollment
• Regression analysis, time series methods, and
qualitative forecasting methods used for
forecasting
Slide 13
Resource Allocation and Shareholder Wealth
Maximization:
Apple Store Fifth Avenue NYC
Slide 14
Apple Store Fifth Avenue NYC
Slide 15
Agency Problems
• Modern corporations allow firm
managers to have no participation (or
only limited ownership participation) in
the profitability of the firm.
• The shareholders are principals, whereas
the managers are agents.
(1) its often hard to observe
• Two common problems:
managerial effort and (2) random disturbances
in team performance (luck versus effort?)
Slide 16
• The Principal-Agent Problem
» Shareholders (principals) want profit
» Managers (agents) want leisure & security
» Divergent objectives between these groups are
called agency problems.
Examples
» Diversification by Exxon executives was designed to help
smooth their bonuses, but led to worse stock performance
» Kodak in the early 2000s did not want to risk developing
digital photography products
Slide 17
The Principal-Agent Problem
• Kodak Misses the Moment
Slide 18
Agency Costs
1. Extending grants of stock or deferred stock options
• It helps to make workers act more like owners of firm to try
to raise the price of the stock, but is a cost
2. Bonuses or other compensation can be an incentive,
but clearly is also a “cost” of solving agency problems
3. Internal audits and accounting oversight boards to
monitor the firm
4. Bonding expenditures and fraud liability insurance
5. Costs of complex internal approval processes to avoid
adverse managerial discretion
Slide 19
What Went Right? ● What Went Wrong?
• Saturn Corporation
» Different kind of car company in 1991, but sadly permanently
closed in 2009.
» It used no-haggle pricing and designed cars to compete with Asian
imports
» Sales were above expectations at first because of tiny margin of
only $400 per car to GM, so that GM earned only 3% on capital
» Saturn customers wanted bigger Saturn cars rather than trade up to
Buick, as GM hoped. Saturn was unable to adopt a change-
management view to get customers to trade up to other GM products.
» Sales later slumped in the late 1990s through 2009.
Slide 20
Caveats to
Shareholder Wealth Maximization
1. COMPLETE MARKETS - liquid markets
for firm's inputs and by-products (including polluting
by-products).
2. NO ASYMMETRIC INFORMATION
- buyers and sellers all know the same things.
3. KNOWN RECONTRACTING COSTS
- future input costs are part of the present value of
expected cash flows.
Slide 21
Goals in the Public Sector and the
Not-For-Profit (NFP) Enterprise
 Public Goods are goods that can be consumed or used by more than one
person at the same time with no extra cost (like a flood control or
national defense).
 Sometimes governments produce public goods. Other times, they are
exclusive to one person (like a free meal).
 Instead of profit, NFP organizations may have as their goals:
1. Maximization of the quantity of output, subject to a breakeven
constraint.
2. Maximization of the utility (happiness) of NFP administrators.
3. Maximization of cash flows.
4. Maximization of the utility of contributors to the NFP organization.
Slide 22
• Which goal a NFP manager selects affects decisions
made.
» A food shelter manager may decide to maximize the
utility of contributors by selecting only "healthy foods"
• Public sector managers are performance monitored .
» V.A. hospital administrators are rewarded by reducing the cost
per bed over a year. Hence, they become efficient with respect to
costs.
» The "friendliness" of the hospital staff is harder to measure, so
friendliness will tend not be a high priority of the public sector
manager.
Slide 23
Seatwork
If you were the chairman of the board of a
multi-national company, what would you do
differently to address and prevent principal-
agent or agency problems in the company?
Slide 24

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Managerial Economics

Applications, Strategy, and Tactics, 12h Edition

PowerPoint Lecture Slides

5.Perform Sensitivity Analysis

• Should Honda or Toyota expand its capacity in North

• Watch Apple Think Different video

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