Download Chapter 1: Introduction - Vancouver Island University

Contact Information
Dr. Daniel Simons
Vancouver Island University
Faculty of Management
Building 250 - Room 416
Office Hours:
MTW: 11:30 – 12:30
Email: [email protected]
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
• Don’t hesitate to contact me if necessary
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
Main Course Objectives
1.
2.
3.
4.
5.
Present relevant tools for effective management of
organizational processes and resources
Show the application of core concepts to typical business
problems and management decisions
Provide the foundation for late in-depth coverage of
business issues in Economics
Present a general framework to better understand and
meet the challenges faced by organizations
Contribute to the generation and implementation of
strategies to create economic value and sustain
competitive advantage in organizations
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:
•
•
•
•
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.
The Firm and Its Goals
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The Firm
Economic Goal of the Firm
Goals Other Than Profit
Do Companies Maximize Profits?
Maximizing the Wealth of
Stockholders
• Economic Profits
The Firm
• A firm is a collection of resources
that is transformed into products
demanded by consumers.
• Profit is the difference between
revenue received and costs incurred.
Economic vs. Accounting
Profits
• Accounting Profits
– Total revenue (sales) minus dollar cost of
producing goods or services.
– Reported on the firm’s income
statement.
• Economic Profits
– Total revenue minus total opportunity
cost.
Cost
• Accounting Costs
– The explicit costs of the resources
needed to produce produce goods or
services.
– Reported on the firm’s 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.
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.
• Short-run vs. Long-run
– Nothing to do directly with calendar
time
– Short-run: firm can vary amount of
some resources but not others
– Long-run: firm can vary amount of all
resources
At times short-run profitability will be
sacrificed for long-run purposes
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
– Shareholder value
– Technological advancement
– Customer satisfaction
– Maximization of managerial returns
(manager’s own interest subject to
generating sufficient profits to keep
their jobs)
• Non-economic Objectives
– Good work environment
– Quality products and services
– Corporate citizenship, social
responsibility
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.”
– Two components to “satisficing”:
• Position and power of stockholders
• Position and power of professional
management
• 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.
– 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.
• Position and power of professional
management
– High-level managers who are responsible
for major decision making may own very
little of the company’s stock.
– Managers tend to be more conservative
because jobs will likely be safe if
performance is steady, not spectacular.
– 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”
• 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 company’s
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.
• 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 company’s stock.
• When stock options are substantial part of
executive compensation, management
objectives tend to be more aligned with
stockholder objectives.
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.
• Future cash flows must be
discounted to the present.
• The discount rate is affected by
risk.
• Two major types of risk:
•Business Risk
•Financial Risk
• Business risk involves variation in
returns due to the ups and downs of
the economy, the industry, and the
firm.
• All firms face business risk to
varying degrees.
• Financial Risk concerns the variation in
returns that is induced by leverage.
• Leverage is the proportion of a company
financed by debt.
• The higher the leverage, the greater the
potential fluctuations in stockholder
earnings.
• Financial risk is directly related to the
degree of leverage.
Timing
2 types of models
1. Static model:– describe the
behaviour at a single point in time.
Disregards differences in the
sequence of actions and payments
2. Dynamic models:- focus on the
timing and sequence of actions and
payments
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 perperiod interest rate is “i”:
PV 
• .
FV
1  i 
n
• Examples:
– Lotto winner choosing between a single lumpsum payout of $104 million or $198 million over
25 years.
– Determining damages in a patent infringement
case
Present Value of a Series
• Present value of a stream of future
amounts (FVt) received at the end of
each period for “n” periods:
PV 
FV1
1  i 
1

FV2
1  i 
2
 ...
FVn
1  i 
n
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
NPV 
FV1
1  i 
If
1

FV2
1  i 
2
 ...
FVn
1  i 
Decision Rule:
NPV < 0: Reject project
NPV > 0: Accept project
n
 C0
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
CF
CF
CF
PVPerpetuity 


 ...
2
3
1  i  1  i  1  i 
CF

i
Firm Valuation
• The value of a firm equals the
present value of current and future
profits.
– PV = S pt / (1 + i)t
• If profits grow at a constant rate (g < i)
and current period profits are po:
1 i
PVFirm  p 0
before current profits have been paid out as dividends;
ig
1 g
Ex  Dividend
PVFirm
 p0
immediately after current profits are paid out as dividends.
ig
• 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 profits.
Marginal (Incremental)
Analysis
• Control Variables
–
–
–
–
–
Output
Price
Product Quality
Advertising
R&D
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
Marginal Benefit (MB)
• Change in total benefits arising from a
change in the control variable, Q:
B
MB 
Q
• Slope (calculus derivative) of the total
benefit curve.
Marginal Cost (MC)
• Change in total costs arising from a
change in the control variable, Q:
C
MC 
Q
• Slope (calculus derivative) of the total
cost curve
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.
The Geometry of
Optimization
Total Benefits
& Total Costs
Costs
Slope =MB
Benefits
B
Slope = MC
C
Q*
Q
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).
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.
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 R&D and goodwill.
• While the market value of the company will
always be positive, MVA may be positive or
negative.
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.