CHAPTER 1

THE FUNDAMENTALS OF MANAGERIAL

ECONOMICS
Managerial Economics &
Business Strategy
McGraw-Hill/Irwin
Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
What are the roles of a manager?
What managerial economic
decisions does a manager make??
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
PURPOSE OF USING MANAGERIAL
ECONOMICS TOOLS:
Shape pricing and output decisions
Optimize production process and input mix
Choose product quality
Guide horizontal and vertical merger decisions
Optimally design internal and external incentives
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
REMINDER
Managerial economics are useful for both

profit making companies
and
Not-for profit organization
(coordinate shelter for homeless, decide best
means for distributing food to the needy)
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
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.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
MANAGER
A person who directs resources to achieve stated
goal. Includes those who:
Direct effort of others-delegate tasks
Purchase inputs to be used in production
In charge of making other decision such as product price
and quality
Responsible for his/her own actions and actions of
other individuals, machines, other inputs under
his/her control
Maximises profit and value of firms
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
Managerial economics
Study of how to direct scarce resources in a way that
most efficiently achieves managerial goal.
Example- managers in computer making company
would decide on :
Whether to purchase or produce intermediate input (disk
drive/ computer chips
How many computers to produce and what is the selling price
How many employees to hire
How should the employees be compensated
What incentive to be given to ensure quality
How would rival company affect the organization?
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
Solution:
To make a sound decision, manager would need
To identify information needed
Account dept- tax advice or cost data
Legal dept- legal ramification of alternative decisions
Marketing dept- data on product market
characteristic
Finance dept- data on alternative method to obtain
financial capital
To collect and process data

MANAGER INTEGRATE ALL INFORMATION TO
ARRIVE AT A DECISION
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
The Economics of Effective Management

AN EFFECTIVE MANAGER MUST:

Identify Goals and Constraints
Recognize the Role of Profits
Understand Incentives
Five Forces Model
Understand Markets
Recognize the Time Value of Money
Use Marginal Analysis
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
Identify Goals and Constraints

Well defined goals
Different goals entails different decisions
Decision maker faces constraints that affect
the ability to achieve goal

EXAMPLES:
marketing dept -maximise sales and market
share , finance dept- isk reduction strategies
Constraints- available technology, input
prices
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
Recognize nature and
importance of profits
Overall goal- maximise profit of firms value
Difference between economics and
accounting profits
Implicit costs very hard to measure

Example hairstyling salon vs restaurant
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.

Sustainable
Industry
Profits
Power of
Input Suppliers
-Supplier Concentration
-Price/Productivity of
Alternative Inputs
-Relationship-Specific
Investments
-Supplier Switching Costs
-Government Restraints
Power of
Buyers
-Buyer Concentration
-Price/Value of Substitute
Products or Services
-Relationship-Specific
Investments
-Customer Switching Costs
-Government Restraints
Entry

-Entry Costs
-Speed of Adjustment
-Sunk Costs
-Economies of Scale
-Network Effects
-Reputation
-Switching Costs
-Government Restraints
Substitutes & Complements
-Price/Value of Surrogate
Products or Services
-Price/Value of Complementary
Products or Services
-Network Effects
-Government
Restraints
Industry Rivalry
-Switching Costs
-Timing of Decisions
-Information
-Government Restraints
-Concentration
-Price, Quantity, Quality, or
Service Competition
-Degree of Differentiation
The Five Forces Framework
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
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.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
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.

Accounting profits overstate your economics profits

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
Understanding incentives
Profits
signal to holders of resources to enter or exit industry
Incentive to resource holders to alter/change use of
resources

Managers should understand the role of incentive
Induce workers to work harder/maximising effort
Reward vs penalty
Incentive plan directly proportionate to firms
profitability
Commission based remuneration
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
Understanding markets
Relative outcome of markets :
Power of buyers vs power of sellers
bargaining position of consumers and producers

3 sources of rivalry in economic transaction:
Consumer producer rivalry
Consumer-consumer rivalry
Producer-producer rivalry

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
Market Interactions
Consumer-Producer Rivalry
Consumers attempt to locate low prices, while producers
attempt to charge high prices.
Risk- producer refuse to sell, consumer refuse to purchase

Consumer-Consumer Rivalry
Scarcity of goods reduces the negotiating power of
consumers as they compete for the right to those goods.
Consumer willing to pay highest price to outbid others.
eg-auction

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
Market Interactions
Producer-Producer Rivalry
Multiple sellers of a product competing ; customers are
scarce
Scarcity of consumers causes producers to compete with
one another for the right to service customers.
Producer with best-quality product t lowest price wins
The Role of Government
Losing/disadvantage parties in the market seek for govt
intervention-monopoly market
Seeking aids from govt to compete with foreign
counterparts
Disciplines the market process.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
The Time Value of Money
Timing in making decision-gap between
time when cost of project is borne and
time when benefits of project is received
Is $1 today going to worth more than $1 received
in future?
Opportunity cost of $1 in future = interest forgone
Its the time value of money

PV of an amount received in future = amount that would
be invested today at prevailing interest rate to generate
given future value

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
Present Value Analysis
Present value (PV) of a future value (FV) of a
lump-sum amount to be received at the end
of n periods when the per-period interest
rate is i:
( )
PV
FV
i
n
=
+ 1
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.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
(1) Present Value Analysis
Eg calculate PV of $100 in 10 years if the interest
rate is 7 percent
PV=$50.83
i.e if you invested $50.83 today at a 7% interest rate, in 10 years your
investment is worth $100.
Interest rate is inversely related to the PV
Higher interest rate-lower PV

PV of future payment = FV - opportunity costs
waiting (OCW)
If interest rate is zero, OCW is zero then PV=FV
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
(2) Present Value of a Series
Present value of a stream of future amounts
(FV
t
) received at the end of each period for n
periods:



Given PV of income stream from a project, we
can compute the net PV of the project
NPV=PV-C0 (current cost)
( ) ( ) ( )
PV
FV
i
FV
i
FV
i
n
n
=
+
+
+
++
+
1
1
2
2
1 1 1
...
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
(3) NET PRESENT VALUE
Suppose a manager can purchase a stream of
future receipts (FV
t
) by spending C
0
dollars
today. The NPV of such a decision is
( )( ) ( )
NPV
FV
i
FV
i
FV
i
C
n
n
=
+
+
+
++
+

1
1
2
2 0
1 1 1
...
Decision Rule:
If NPV < 0: Reject project
NPV > 0: Accept projec
demo problem 1-1
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
(4) Present Value of indefinitely Lived Assets
Some decisions generates cash flows that
continue indefinitely. The PV of such cash flows
is

PV assets = CF0 + CF
1
+ CF
2 +

(1+i) (1+i)
2


If all future cash flows are identical CF1=CF2=
then
PV
perpetuity
= CF/ i
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
(5) FIRM VALUATION
The value of a firm equals the present value of current
and future profits.

PV
firm
= t
0 +


t
1
+ t
2 +

(1+i) (1+i)
2

PV
firm
= E

t
t
/ (1 + i)
t


Profit maximising goal also means firms want to
maximise its value which is PV of current and
future profits






Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
(5) FIRM VALUATION

If profits is expected to grow at a constant rate of
g percent each year which is less than the interest
rate, i ;(g < i) and current period profits are

t
o
:
then the PV of the firms is
0
0
1
before current profits have been paid out as dividends;
1
immediately after current profits are paid out as dividends.
Firm
Ex Dividend
Firm
i
PV
i g
g
PV
i g
t
t

+
=

+
=

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
Firm Valuation


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

Eg demo problem 1-2
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
Marginal (Incremental) Analysis
Control Variables
Output
Price
Product Quality
Advertising
R&D
Basic Managerial Question: How much of
the control variable should be used to
maximize net benefits?
Marginal (Incremental) Analysis
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
MARGINAL ANALYSIS
OPTIMAL MANAGERIAL DECISIONS INVOLVES
Comparing the marginal (incremental) benefits
with the marginal (incremental ) costs

Note:
B(Q)-total benefits derived from Q units of variable
C(Q)- total costs corresponding level of Q
Managers objective: maximise net benefits
Net Benefits = Total Benefits - Total Cost
= B(Q)-C(Q)
Profits = Revenue - Costs
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
MARGINAL defined
MB additional benefit arise by using an additional
unit of managerial control variable
MC additional costs incurred by using an additional
unit of the managerial control variable
MNB(Q) the change in net benefits that arise from
a one unit change in Q OR
MNB(Q) = MB(Q)-MC(Q)

Refer table 1-1 p20
Note When net benefit is maximised,
MNB(Q)=0 since MB(Q)=MC(Q)
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
Marginal Benefit (MB)
Change in total benefits arising from a change
in the control variable, Q:



Slope (calculus derivative) of the total benefit
curve.
Q
B
MB
A
A
=
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
Marginal Cost (MC)
Change in total costs arising from a change
in the control variable, Q:




Slope (calculus derivative) of the total cost
(TC) curve
Q
C
MC
A
A
=
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
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.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
The Geometry of Optimization








Refer fig 1-2
Q
Total Benefits
& Total Costs
Benefits B(Q)
Costs C(Q)
Q*
B
C
Slope = MC
Slope =MB
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
The Geometry of Optimization
MB,MC
& NB
NB
Q
N(Q)=B(Q)-C(Q)
NB
MB(Q)
MC(Q)
MNB(Q)
Q)
Maximum
NB
At level of Q where the MB curve
intersect the MC curve, MNB is
zero, that Q maximises NB
Q*
Q*
Slope of a function
is the derivative of
a given function

MB= dB(Q)
dQ

MC= dC(Q)
dQ

MNB= dN(Q)
dQ



Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
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).