Download Chapter 1: Introduction

Introduction, Basic Principles and
Methodology
The central themes of Managerial
Economics:
1. Identify problems and opportunities
2. Analyzing alternatives from which
choices can be made
3. Making choices that are best from
the standpoint of the firm or
organization
• 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.
Some Economic Principles
of Managers
1. Role of manager is to make decisions.
Firms come in all sizes but no firm
has unlimited resources so managers
must decide how resources are
employed
2. Decisions are always among
alternatives.
3. Decision alternatives always have
costs and benefits
Opportunity cost = next best
alternative foregone.
Marginal or incremental approach
4. Anticipated objective of
management is to increase the firm’s
value
• Maximize shareholder’s wealth
• Negative impact = principal-agent
problem
5. Firm’s value is measured by its
expected profits
Time value of money, discount rates
6. The firm must minimize cost for
each level of production
7. The firm’s growth depends on
rational investment decisions
Capital budgeting decisions
8. Successful firms deal rationally and
ethically with laws and regulations
Macroeconomics &
Microeconomics
• Economists generally divide their discipline
into two main branches:
• Macroeconomics is the study of the
aggregate economy.
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National Income Analysis (GDP)
Unemployment
Inflation
Fiscal and Monetary policy
Trade and Financial relationships among nations
• Microeconomics is the study of individual
consumers and producers in specific
markets.
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Supply and demand
Pricing of output
Production processes
Cost structure
Distribution of income and output
Microeconomics is the basis of managerial
economics
• 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
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
Review of Economic
Terms
• Resources are factors of production
or inputs.
– Examples:
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Land
Labor
Capital
Entrepreneurship
• Managerial Economics
– The study of how to direct scarce
resources in the way that most
efficiently achieves a managerial goal.
• Managerial economics is the use of
economic analysis to make business
decisions involving the best use
(allocation) of an organization’s
scarce resources.
• 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, StructureConduct-Performance Analysis
– Managerial Accounting: Relevant Cost, BreakEven Analysis, Incremental Cost Analysis,
Opportunity Cost
• Questions that managers must answer:
– What are the economic conditions in a
particular market?
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Market Structure?
Supply and Demand Conditions?
Technology?
Government Regulations?
International Dimensions?
Future Conditions?
Macroeconomic Factors?
• Questions that managers must
answer:
– Should our firm be in this business?
– If so, what price and output levels
achieve our goals?
• Questions that managers must answer:
– How can we maintain a competitive advantage
over our competitors?
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Cost-leader?
Product Differentiation?
Market Niche?
Outsourcing, alliances, mergers,
acquisitions?
International Dimensions?
• Questions that managers must
answer:
– What are the risks involved?
• Risk is the chance or possibility that
actual future outcomes will differ
from those expected today.
• Types of risk
– Changes in demand and supply conditions
– Technological changes and the effect of
competition
– Changes in interest rates and inflation
rates
– Exchange rates for companies engaged
in international trade
– Political risk for companies with foreign
operations
• 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?
• Economic Decisions for the Firm
– 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.
• 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
• Profits are a signal to resource
holders where resources are most
valued by society
• So what factors impact sustainability
of industry profitability?
• Porter’s 5-forces framework
discusses 5 categories of forces that
impacts profitability
1. Entry
2. Power of input sellers
3. Power of buyers
4. Industry rivalry
5. Substitutes and Complements
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
Power of input suppliers:
Do input suppliers have power to
negotiate favorable input prices?
Less power if
a. inputs are standardized,
b. not highly concentrated
c. alternative inputs available
Profits are high when suppliers power
is low
Power of buyers:
High buyer power if
a. buyers can negotiate favorable
terms for the good/service
b. Buyer concentration is high
c. Cost of switching to other products
is low
d. perfect information leading to less
costly buyer search
Industry rivalry:
Rivalry tends to be less intense
a. in concentrated industries
b. high product differentiation
c. high consumer switching cost
Profits are low where industry rivalry
is intense
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.
The Five Forces Framework
Entry Costs
Speed of Adjustment
Sunk Costs
Economies of Scale
Entry
Power of
Input Suppliers
Power of
Buyers
Supplier Concentration
Price/Productivity of
Alternative Inputs
Relationship-Specific
Investments
Supplier Switching Costs
Government Restraints
Sustainabl
e Industry
Profits
Industry Rivalry
Concentration
Price, Quantity, Quality, or
Service Competition
Degree of Differentiation
Network Effects
Reputation
Switching Costs
Government Restraints
Switching Costs
Timing of Decisions
Information
Government Restraints
Buyer Concentration
Price/Value of Substitute
Products or Services
Relationship-Specific
Investments
Customer Switching Costs
Government Restraints
Substitutes & Complements
Price/Value of Surrogate Products
or Services
Price/Value of Complementary
Products or Services
Network Effects
Government
Restraints
Market Interactions
• Consumer-Producer Rivalry
– Consumers attempt to locate low prices,
while producers attempt to charge high
prices.
• Consumer-Consumer Rivalry
– Scarcity of goods reduces the
negotiating power of consumers as they
compete for the right to those goods.
• Producer-Producer Rivalry
– Scarcity of consumers causes producers
to compete with one another for the
right to service customers.
• The Role of Government
– Disciplines the market process.