Contact Information

1
Contact Information

• Dr. Daniel Simons
• Building 250 - Room 416
• Office Hours
• M 1000 1100
• W 1030 1300
• Or
• By appointment
• Email simonsd_at_viu.ca

2
Suggestions for Best Individual Performance

• Attend all classes
• Take notes. Course covers a lot of material and
  your notes are essential
• Complete all assignments (not for grade)
• Read the book
• Participate, enrich class discussion, provide
  feedback and ask questions
• Revise materials between classes, integrate
  concepts, make sure you understand the tools and
  their application
• Dont hesitate to contact me if necessary

3
Evaluation Method

• Tests have a mix of problems that evaluate
• Concepts
• Problem sets (assignments)
• Class applications
• Readings
• New applications
• 3 closed book time constrained tests to reward
  knowledge and speed
• Each test covers slides, assignments, and
  required readings.
• Evaluation system may not be perfect but it works

4
Main Course Objectives

1. Present relevant tools for effective management
   of organizational processes and resources
2. Show the application of core concepts to typical
   business problems and management decisions
3. Provide the foundation for late in-depth coverage
   of business issues in Economics
4. Present a general framework to better understand
   and meet the challenges faced by organizations
5. Contribute to the generation and implementation
   of strategies to create economic value and
   sustain competitive advantage in organizations

5
Introduction, Basic Principles and Methodology

• The central themes of Managerial Economics
• Identify problems and opportunities
• Analyzing alternatives from which choices can be
  made
• Making choices that are best from the standpoint
  of the firm or organization

6

• Not true that all managers must be managerial
  economists
• But managers who understand the economic
  dimensions of business problems and apply
  economic analysis to specific problems often
  choose more wisely than those who do not.

7

• Manager-
• A person who directs resources to achieve a
  stated goal
• Economics-
• Study of making decisions in the presence of
  scarce resources

8
Managerial Economics Defined

• Is the study of how to direct scarce resources
  in the way that most efficiently achieves a
  managerial goal
• Main thrust of Managerial Economics is to provide
  you with a vast pool of skills that will allow
  you to make sound decisions and to determine the
  right incentives within your company

9

• Methodology, data and application
• Methodology- is a branch of philosophy that deals
  with how knowledge is obtained.
• How can you know that you are managing
  efficiently and effectively?
• You need some theory to do some analysis.
• Without theory, there can be no good analysis

10

• Microeconomics (probably more than other
  disciplines) provides the methodology for
  managerial economics
• Managerial Economics is about both methodology
  and data
• You need data to plug into some model to do some
  analysis.
• This gives you the information to manage
• Managerial Economics lends empirical content to
  the study of effective management

11

• Decisions are always among alternatives.
• Decision alternatives always have costs and
  benefits
• Opportunity cost next best alternative
  foregone.
• Marginal or incremental approach

12
Review of Economic Terms

• Resources are factors of production or inputs.
• Examples
• Land
• Labor
• Capital
• Entrepreneurship

13

• Relationship to other business disciplines
• Marketing Demand, Price Elasticity
• Finance Capital Budgeting, Break-Even Analysis,
  Opportunity Cost, Economic Value Added
• Management Science Linear Programming,
  Regression Analysis, Forecasting
• Strategy Types of Competition,
  Structure-Conduct-Performance Analysis
• Managerial Accounting Relevant Cost, Break-Even
  Analysis, Incremental Cost Analysis, Opportunity
  Cost

14

• The Economics of Effective Management
• An effective manager must
• Identify goals and constraints
• Recognize the nature and importance of profits
• Understand incentives
• Understand markets
• Recognize the time value of money
• Use Marginal Analysis

15
Identify Goals and constraints

• Well-defined goals and recognize constraints such
  as available technology, prices of inputs used in
  production, decisions made by competitors etc.

16

• Because of scarcity, an allocation decision must
  be made. The allocation decision is comprised of
  three separate choices
• What and how many goods and services should be
  produced?
• How should these goods and services be produced?
• For whom should these goods and services be
  produced?

17

• What The product decision begin or stop
  providing goods and/or services.
• How The hiring, staffing, procurement, and
  capital budgeting decisions.
• For whom The market segmentation decision
  targeting the customers most likely to purchase.

18

• Three processes to answer what, how, and for whom
• Market Process use of supply, demand, and
  material incentives
• Command Process use of government or central
  authority, usually indirect
• Traditional Process use of customs and traditions

19

• Profits are a signal to resource holders where
  resources are most valued by society
• So what factors impact sustainability of industry
  profitability?
• Porters 5-forces framework discusses 5
  categories of forces that impacts profitability

20

1. Entry
2. Power of input sellers
3. Power of buyers
4. Industry rivalry
5. Substitutes and Complements

21

• Entry
• Heightens competition
• Reduces margin of existing firms
• Ability to sustain profits depends on the
  barriers to entry cost, regulations, networking,
  etc.
• Profits are higher where entry is low

22

• Power of input suppliers
• Do input suppliers have power to negotiate
  favorable input prices?
• Less power if
• inputs are standardized,
• not highly concentrated
• alternative inputs available
• Profits are high when suppliers power is low

23

• Power of buyers
• High buyer power if
• buyers can negotiate favorable terms for the
  good/service
• Buyer concentration is high
• Cost of switching to other products is low
• perfect information leading to less costly buyer
  search

24

• Industry rivalry
• Rivalry tends to be less intense
• in concentrated industries
• high product differentiation
• high consumer switching cost
• Profits are low where industry rivalry is intense

25

• Substitutes and complements
• Profitability is eroded when there are close
  substitutes
• Government policies (restrictions e.g. import
  restriction on drugs from Canada to US) can
  affect the availability of substitutes.

26
Understand Markets

• Power or bargaining position of consumers and
  producers in the market is limited by 3 sources
  of rivalry
• Consumer consumer rivalry
• Because of scarcity, consumers compete with each
  other for the right to purchase the available
  goods
• Those willing to pay higher prices will outbid
  others for the right to consume the product

27

• Consumer-Producer Rivalry
• Consumers attempt to locate low prices, while
  producers attempt to charge high prices.
• The ability of each party to achieve its goal is
  limited.
• Offer too low a price and producer will refuse to
  sell the product
• Charge to high a price and consumers will refuse
  to buy the product

28

• Producer-Producer Rivalry
• Scarcity of consumers causes producers to compete
  with one another for the right to service
  customers.
• The Role of Government
• When agents on either side of the market feel
  aggrieved in the market process, they attempt to
  induce government to intervene on their behalf,
• Disciplines the market process.

29
The Firm and Its Goals

• The Firm
• Economic Goal of the Firm
• Goals Other Than Profit
• Do Companies Maximize Profits?
• Maximizing the Wealth of Stockholders
• Economic Profits

30
Profits

• Profit is the difference between revenue received
  and costs incurred.

31
Economic vs. Accounting Profits

• Accounting Profits
• Total revenue (sales) minus dollar cost of
  producing goods or services.
• Reported on the firms income statement.
• Economic Profits
• Total revenue minus total opportunity cost.

32
Cost

• Accounting Costs
• The explicit costs of the resources needed to
  produce produce goods or services.
• Reported on the firms income statement.

33

• 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.

34
Economic Goal of the Firm

• Primary objective of the firm (to economists) is
  to maximize profits.
• Profit maximization hypothesis
• Other goals include market share, revenue growth,
  and shareholder value
• Optimal decision is the one that brings the firm
  closest to its goal.

35
Goals Other Than Profit

• Market share maximization (as measured by sales
  revenue or proportion of quantity sold to total
  market
• Growth rate maximization (increasing size of the
  firm over time. Higher rates of growth in other
  variables than profit)
• Profit margin
• Return on investment, Return on assets

36

• Shareholder value
• Technological advancement
• Customer satisfaction
• Maximization of managerial returns (managers own
  interest subject to generating sufficient profits
  to keep their jobs)

37

• Non-economic Objectives
• Good work environment
• Quality products and services
• Corporate citizenship, social responsibility

38
Do Companies Maximize Profit?

• Criticism Companies do not maximize profits but
  instead their aim is to satisfice.
• Satisfice is to achieve a set goal, even though
  that goal may not require the firm to do its
  best.

39

• Two components to satisficing
• Position and power of stockholders
• Position and power of professional management

40

• Position and power of stockholders
• Medium-sized or large corporations are owned by
  thousands of shareholders
• Shareholders own only minute interests in the
  firm
• Shareholders diversify holdings in many firms
• Shareholders are concerned with performance of
  entire portfolio and not individual stocks.

41

• Most stockholders are not well informed on how
  well a corporation can do and thus are not
  capable of determining the effectiveness of
  management.
• Not likely to take any action as long as they are
  earning a satisfactory return on their
  investment.

42

• Position and power of professional management
• High-level managers who are responsible for major
  decision making may own very little of the
  companys stock.
• Managers tend to be more conservative because
  jobs will likely be safe if performance is
  steady, not spectacular.

43

• Management incentives may be misaligned
• E.g. incentive for revenue growth, not profits
• Managers may be more interested in maximizing own
  income and perks
• Divergence of objectives is known as
  principal-agent problem or agency problem

44

• Counter-arguments which support the profit
  maximization hypothesis.
• Large number of shares is owned by institutions
  (mutual funds, banks, etc.) utilizing analysts to
  judge the prospects of a company.
• Stock prices are a reflection of a companys
  profitability. If managers do not seek to
  maximize profits, stock prices fall and firms are
  subject to takeover bids and proxy fights.
• The compensation of many executives is tied to
  stock price.

45

• Company tries to manage its business in such a
  way that the dividends over time paid from its
  earnings and the risk incurred to bring about the
  stream of dividends always create the highest
  price for the companys stock.
• When stock options are substantial part of
  executive compensation, management objectives
  tend to be more aligned with stockholder
  objectives.

46
Maximizing the Wealth of Stockholders

• Views the firm from the perspective of a stream
  of earnings over time, i.e., a cash flow.
• Must include the concept of the time value of
  money.
• Dollars earned in the future are worth less than
  dollars earned today.

47

• Future cash flows must be discounted to the
  present.
• The discount rate is affected by risk.
• Two major types of risk

• Business Risk up and down of the economy
• Financial Risk due to a leverage

48
Maximization of stockholders wealthvsMaximizati
on of profits

• MSW seems to be a more comprehensive goal because
• It is a long-run concept
• It considers the timing of benefits
• It incorporates the concept of risk

49
The Time Value of Money

• Present value (PV) of a lump-sum amount (FV) to
  be received at the end of n periods when the
  per-period interest rate is i

• .

50

• Examples
• Lotto winner choosing between a single lump-sum
  payout of 104 million or 198 million over 25
  years.
• Determining damages in a patent infringement case

51
Present Value of a Series

• Present value of a stream of future amounts (FVt)
  received at the end of each period for n
  periods

52
Net Present Value

• Suppose a manager can purchase a stream of future
  receipts (FVt ) by spending C0 dollars today.
  The NPV of such a decision
• Is

Decision Rule If NPV lt 0 Reject
project NPV gt 0 Accept project
53
Present Value of a Perpetuity

• An asset that perpetually generates a stream of
  cash flows (CF) at the end of each period is
  called a perpetuity.
• The present value (PV) of a perpetuity of cash
  flows paying the same amount at the end of each
  period is

54
Firm Valuation

• The value of a firm equals the present value of
  current and future profits.
• PV S pt / (1 i)t

55

• If profits grow at a constant rate (g lt i) and
  current period profits are po

56

• If the growth rate in profits lt interest rate and
  both remain constant, maximizing the present
  value of all future profits is the same as
  maximizing current profits.

57
Marginal (Incremental) Analysis

• Control Variables
• Output
• Price
• Product Quality
• Advertising
• RD

58
Net Benefits

• Basic Managerial Question How much of the
  control variable should be used to maximize net
  benefits?
• Net Benefits Total Benefits - Total Costs
• Profits Revenue - Costs

59
Marginal Benefit (MB)

• Change in total benefits arising from a change in
  the control variable, Q
• Slope (calculus derivative) of the total benefit
  curve.

60
Marginal Cost (MC)

• Change in total costs arising from a change in
  the control variable, Q
• Slope (calculus derivative) of the total cost
  curve

61
Marginal Principle

• To maximize net benefits, the managerial control
  variable should be increased up to the point
  where MB MC.
• MB gt MC means the last unit of the control
  variable increased benefits more than it
  increased costs.
• MB lt MC means the last unit of the control
  variable increased costs more than it increased
  benefits.

62
The Geometry of Optimization
Total Benefits Total Costs
Costs
Benefits
Slope MB
B
Slope MC
C
Q
63
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).

64
Maximizing the Wealth of Stockholders

• Another measure of the wealth of stockholders is
  called Market Value Added (MVA).
• MVA represents the difference between the market
  value of the company and the capital that the
  investors have paid into the company.

65
Maximizing the Wealth of Stockholders

• Market value includes value of both equity and
  debt.
• Capital includes book value of equity and debt as
  well as certain adjustments.
• E.g. Accumulated RD and goodwill.
• While the market value of the company will always
  be positive, MVA may be positive or negative.

66
Maximizing the Wealth of Stockholders

• Another measure of the wealth of stockholders is
  called Economic Value Added (EVA).
• EVA(Return on Total Capital Cost of Capital) x
  Total Capital
• If EVA is positive then shareholder wealth is
  increasing. If EVA is negative, then shareholder
  wealth is being destroyed.