Managerial Economics

Applications, Strategy, and Tactics, 10th Edition

by McGuigan, Moyer, & Harris

PowerPoint Lecture Slides

prepared by

Richard D. Marcus
University of Wisconsin - Milwaukee
2005 South-Western Publishing

Slide 1

Chapter 1
Introduction

Structure of Decision Models

Profits Role
Agency Problems & Solutions
Not-for-Profit Organizations
Why Corporations Have Succeeded
Over Other Organizational Forms

Slide 2

Managerial Economics
Integrates and applies microeconomic theory and
methods to decision making problems faced by
private, public, and not-for-profit organizations.
Managerial economics deals with microeconomic
reasoning on real world problems such as pricing
decisions selecting the best strategy in different
competitive environments.

Slide 3

MAJOR TOPICS
Demand and Supply Analysis
and how to estimate price elasticities with regressions

Production and Cost Analysis

and how managers can estimate these relationships

Monopoly, Competition, and Oligopolies

and how to make good pricing decisions in the real world

Organization Architecture
and the economic problem of motivating agents

Risk in Economic Decisions

and ways to modify or compare risks
Slide 4

The Decision-Making Process

(Figure 1.1)
1. Establish and Identify Objectives
2. Define the Problem
3. Identify Alternative Solutions
Consider
Societal
Constraints

4. Evaluate the Alternatives

and Select the Best!

5. Implement and Monitor

the Decision

Consider
Organizational
& Input
Constraints

Slide 5

Theories of Why Profit Varies

Across Industries
1. RISK-BEARING THEORY
2. DYNAMIC EQUILIBRIUM (or
FRICTIONAL) THEORY OF PROFIT
3. MONOPOLY THEORY OF PROFIT
4. INNOVATION THEORY OF PROFIT
5. MANAGERIAL EFFICIENCY THEORY
OF PROFIT
Slide 6

Objectives of the Firm

Profit maximization
Shareholder wealth = value of each share (V 0)
times the number of shares outstanding, or
V0 (shares outstanding). This is the present
value of expected future profits or cash flows,
discounted at the shareholders required rate of
return, ke, ignoring taxes.

t
V0 (shares
outstanding)
=

/(1+k
e)
t
t=1

Slide 7

Firm Value

(Figure 1.2)

t = REVENUE COST = TRt TCt = PtQt VtQt - Ft

Value of the Firm = the present value of discounted cash flows
N

(t ) / (1+ke)t =
t=1

(PtQt VtQt Ft) / (1+ke)t

t =1

Whatever lowers the perceived risk of the firm (k e) will also raise firm
value.
Whatever raises the price of the product (P t) or the quantity sold (Qt ) will
raise firm value.
Whatever raises variable cost (Vt )or fixed cost ( Ft ) will reduce firm value.

Slide 8

 To make good economic decisions, managers

need to be able to forecast & estimate relationships

Will be forecasting demand (both Pt & Qt)

applies to for-profit corporations
non-profit organizations
Hospital Administrators -- # patients
University Administrator -- enrollment

Regression analysis, time series methods, and

qualitative forecasting methods used for
forecasting

Slide 9

The Role of Profits

Economic Cost (or opportunity cost) is
the highest valued benefit that must be
sacrificed as a result of choosing an
alternative.

Economic Profit is the difference

between revenues and total economic
cost (including the economic or
opportunity cost of owner supplied
resources such as time and capital.
Slide 10

(Figure 1.3)

Factors Affecting Stock Prices

Economic Environment Factors
1.
2.
3.
4.
5.
6.

Economic Activity
Tax Rates & Regulations
Competition
Laws and Governmental Regulation
Unionization
International Conditions & Exchange Rates

Major Policy Decisions Under Management Control

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.

Products or Services Offered

Production Technology
Marketing and Distribution Network Used
Investment Strategies
Employment & Compensation Policies
Ownership Form
Capital Structure Used
Working Capital Management Policies
Dividend Policies
Alliances, mergers, spin-offs

Amount, Timing, and Risk of Expected Profits

Shareholder Wealth (The Market Price of the Stock)

Conditions in
Financial Markets
1.

Interest Rates

2.

Investor
Sentiment

3.

Expected Inflation
Slide 11

Agency Problems
Modern corporations allow managers to have
no, or limited, ownership participation in the
profitability of the firm.
Shareholders may want profits, but managers
may wish to relax.
The shareholders are principals, whereas the
managers are agents.
Conflicting motivations between these
groups are called agency problems.
Slide 12

 The Principal-Agent Problem

Shareholders (principals) want profit
Managers (agents) want leisure & security

Examples
KKRs takeover of RJR Nabisco to refocus on
wealth-maximization
The LBO by O.M. Scott (a lawn fertilizer
company) from ITT improved Scotts
performance

Slide 13

Solutions to Agency Problems

Compensation as incentive
Extending to all workers stock options,
bonuses, and grants of stock
It helps to make workers act more like owners of
firm

Incentives to help the company, because that

improves the value of stock options and
bonuses.
Slide 14

What Went Right?

What Went Wrong?

Saturn Corporation
Different kind of
car company in 1991
No-haggle pricing
Sales were above expectations

But, margin of only $400 per car to GM

GM earned only 3% on capital
Saturn customers wanted bigger Saturns rather than trade up to
Buick, as GM hoped.
When the dollar appreciated, Japanese firms could price their cars
more competitively.

Slide 15

Shareholder Wealth Maximization:

Necessary Conditions
COMPLETE MARKETS - liquid markets for
firm's inputs and by-products (including polluting byproducts).

NO SIGNIFICANT ASYMMETRIC
INFORMATION - buyers and sellers all know the
same things.

KNOWN RECONTRACTING COSTS future

input costs are part of the present value of expected cash
flows.

Slide 16

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 17

 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 18