Thomas12e_Chapter1_12e.pptx

1-1
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Chapter 1
Managers, Profits, & Markets

1-2
Learning Objectives
 Understand why managerial economics relies on microeconomics
and industrial organization to analyze business practices and
design business strategies.
 Explain the difference between economic and accounting profit and
relate economic profit to the value of the firm.
 Describe how separation of ownership and management can lead
to a principal-agent problem when goals of owners and managers
are not aligned and monitoring managers is costly or impossible for
owners.
 Explain the difference between price-taking and price-setting firms
and discuss the characteristics of the four market structures.
 Discuss the primary opportunities and threats presented by the
globalization of markets in business.

1-3
Managerial Economics & Theory
 Managerial economics applies microeconomic
theory to business problems
~ How to use economic analysis to make decisions to
achieve firm’s goal of profit maximization
 Economic theory helps managers understand
real-world business problems
~ Uses simplifying assumptions to turn complexity into
relative simplicity

1-4
Microeconomics
 Microeconomics
~ Study of behavior of individual consumers, business
firms, and markets
 Business practices or tactics
~ Routine business decisions managers must make to
earn the greatest profit under prevailing market
conditions
~ Using marginal analysis, microeconomics provides
the foundation for understanding everyday business
decisions

1-5
Microeconomics
 Industrial organization
~ Specialized branch of microeconomics
focusing on behavior and structure of firms
and industries
~ Provides foundation for understanding
strategic decisions through application of
game theory

1-6
Strategic Decisions
 Business actions taken to alter market
conditions and behavior of rivals
~ Increase/protect strategic firm’s profit
 While common business practices are
necessary for the goal of profit-
maximization, strategic decisions are
generally optimal actions managers can
take as circumstances permit

1-7
Economic Forces that Promote
Long-Run Profitability (Figure 1.1)

1-8
Economic Cost of Resources
 Opportunity cost is:
~ What firm owners must give up to use
resources to produce goods and services
 Market-supplied resources
~ Owned by others and hired, rented, or leased
 Owner-supplied resources
~ Owned and used by the firm

1-9
Total Economic Cost
 Total Economic Cost
~ Sum of opportunity costs of both market-
supplied resources and owner-supplied
resources
 Explicit Costs
~ Monetary opportunity costs of using market-
supplied resources
 Implicit Costs
~ Nonmonetary opportunity costs of using
owner-supplied resources

1-10
Types of Implicit Costs
 Opportunity cost of cash provided by
owners
~ Equity capital (money provided to businesses
by the owners)
 Opportunity cost of using land or capital
owned by the firm
 Opportunity cost of owner’s time spent
managing or working for the firm

1-11
Economic Cost of Using Resources
(Figure 1.2)
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1-12
Economic Profit vs. Accounting
Profit
Economic profit = Total revenue – Total economic cost
= Total revenue – Explicit costs – Implicit costs
Accounting profit = Total revenue – Explicit costs
 Accounting profit does not subtract implicit
costs from total revenue
 Firm owners must cover all costs of all
resources used by the firm
~ Objective is to maximize profit

1-13
Maximizing the Value of a Firm
 Value of a firm
~ Price for which it can be sold
~ Equal to the present value of expected future
profits
 Risk premium
~ An increase in the discount rate to
compensate investors for uncertainty about
future profits
~ The larger the risk, the higher the risk
premium, and the lower the firm’s value

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Maximizing the Value of a Firm
 Maximize firm’s value by maximizing profit
in each time period
~ Cost & revenue conditions must be
independent across time periods
 Value of a firm =
𝜋1
(1 + 𝑟)
+
𝜋2
(1 + 𝑟)2
+ ⋯ +
𝜋𝑇
(1 + 𝑟)𝑇
=
𝑡=1
𝑇
𝜋𝑇
(1 + 𝑟)𝑡

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Some Common Mistakes
Managers Make
 Never increase output simply to reduce
average costs
 Pursuit of market share usually reduces
profit
 Focusing on profit margin won’t maximize
total profit
 Maximizing total revenue reduces profit
 Cost-plus pricing formulas don’t produce
profit-maximizing prices

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Principal-Agent Relationship
 Relationship formed when a business
owner (the principal) enters an agreement
with an executive manager (the agent)
whose job is to formulate and implement
tactical and strategic business decisions
that will further the objectives of the
business owner (the principal).

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Separation of Ownership & Control
 Principal-agent problem
~ A manager takes an action or makes a
decision that advances the interests of the
manager but reduces the value of the firm.
 Complete contract
~ An employment contract that protects owners
from every possible deviation by managers
from value-maximizing decisions.

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Separation of Ownership & Control
 Hidden actions
~ Actions or decisions taken by managers that
cannot be observed by owners for any
feasible amount of monitoring effort.
 Moral Hazard
~ A situation in which managers take hidden
actions that harm the owners of the firm but
further the interests of the managers.

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Corporate Control Mechanisms
 Internal control mechanisms
~ Require managers to hold stipulated amount
of firm’s equity
~ Increase percentage of outsiders serving on
board of directors
~ Finance corporate investments with debt
instead of equity
 External mechanism
~ Corporate takeovers

1-20
Price-Takers vs. Price-Setters
 Price-taking firm
~ Cannot set price of its product
~ Price is determined strictly by market forces of
demand & supply
 Price-setting firm
~ Can set price of its product
~ Has a degree of market power, which is the
ability to raise price without losing all sales

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What is a Market?
 A market is any arrangement through
which buyers & sellers exchange anything
of value
 Markets reduce transaction costs
~ Costs of making a transaction happen, other
than the price of the good or service itself

1-22
Market Structures
 Market characteristics that determine the
economic environment in which a firm
operates
~ Number and size of firms in market
~ Degree of product differentiation among
competing firms
~ Likelihood of new firms entering market when
incumbent firms are earning economic profits

1-23
Perfect Competition
 Large number of relatively small firms
 Undifferentiated product
 Price takers with no market power
 No barriers to entry
~ Any economic profit earned will vanish as new
firms enter

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Monopoly
 Single firm
 Produces product with no close
substitutes
 Protected by a barrier to entry
~ Allows the monopolist to raise its price without
concern that economic profits will attract new
firms

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Monopolistic Competition
 Large number of relatively small firms
 Differentiated products
~ Gives the monopolistic competitor some
degree of market power
 Price setters
 No barriers to entry
~ Ensures any economic profits will be bid away
by new entrants

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Oligopoly
 Few firms produce all or most of market
output
 Profits are interdependent
~ Actions by any one firm will affect sales and
profits of the other firms

1-27
Globalization of Markets
 Economic integration of markets located
in nations around the world
~ Provides opportunity to sell more goods &
services to foreign buyers
~ Presents threat of increased competition from
foreign producers

1-28
Summary
 Managerial economics applies concepts/theories from
microeconomics and industrial organization
~ Marginal analysis provides the foundation for everyday business
practices or tactics
 Opportunity cost of using any resource is what the firm owners
must give up to use the resource
~ Unlike economic profit, accounting profit does not subtract
implicit (opportunity) costs from total revenue
 With the separation of ownership and management, a principal-
agent problem can arise because owners cannot be certain that
managers are making decisions to maximize the value of the firm
 For price-taking firms, price is determined solely by market forces
of supply and demand, while price-setters have some degree of
market power to set price

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