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Foundations of Managerial Economics
Learning Objectives
A�er reading this chapter, you should be able to:
Explain that the economic way of thinking considers both
monetary and nonmonetary variables and is
consistent with the "triple bo�om line" of contemporary
business firms.
Discuss the economic principles of rela�ve scarcity, the market
mechanism, and opportunity costs and
revenues.
Discuss how simple models can be used to explain and predict

the ac�ons of individuals and business
firms who are pursuing their objec�ve func�ons.
Dis�nguish between the explicit and the implicit costs
associated with a decision.
Dis�nguish between accoun�ng costs and profits and economic
cost and profit concepts.
Explain how costs and revenues that occur in the future must be
discounted back to their net present
value.
Explain how costs and revenues that are uncertain, due to risk,
may be quan�fied in expected net
present value terms.
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Businesses take on greater risk when the
expected return on investment is also
greater.
© Spike Mafford/Thinkstock
1.1 What Is Managerial Economics About?
Managerial economics concerns the applica�on of
economic concepts and the economic way of thinking to
the decision-making processes of managers.
Managers make decisions in both the private and the
public sectors at the household (individuals), organiza�on
(firms), and society (governments) levels.
Managerial economics facilitates be�er decision making:

that is, it helps managers make decisions that best serve
the objec�ves of the individual, the
organiza�on, and/or society. In this book our main
interest is in decision making by managers of profit-
seeking business firms, but you will see that the same
principles also apply to decisions made by not-for-profit
organiza�ons, households, and governments.
The Economic Way of Thinking
When we refer to "the economics" of something, such as
a new product proposal or a new infrastructure project,
we are usually referring to the costs,
revenues, and profit characteris�cs of that something. Costs
are the ou�low of funds associated with a decision or
ac�on; revenues are the inflow of funds
associated with a decision or ac�on; and profits are the
excess of revenues over costs—if nega�ve, this difference
is known as a loss, of course. These
monetary issues are the tradi�onal concern of managerial
economics, but increasingly we must also take into
account the nonmonetary costs and benefits of
our decisions. For example, will the decision contribute
posi�vely or nega�vely to individual sa�sfac�on, business
reputa�on, societal welfare, and/or
environmental protec�on? Nonmonetary cost impacts of a
decision are also known as psychic costs. That is, the
individual, the firm, or society at large suffer
a psychological (or emo�onal) cost because the decision
and its consequences cause what psychologists call nega�ve
affect, or a loss of psychic sa�sfac�on,
which economists have tradi�onally called disu�lity.
Conversely, the nonmonetary benefits of a decision or its
consequences are known as psychic revenues
when they generate posi�ve affect or psychic sa�sfac�on
(which we call u�lity).

Almost all decisions have both monetary and nonmonetary
consequences. To gain be�er economic outcomes for
individuals, firms, and society, we must
take into account the monetary and nonmonetary outcomes.
O�en there is a simple monetary equivalent for these
nonmonetary costs and benefits. For
example, individuals expect to be paid more for working
in a dirty job. Likewise, we pay an insurance premium to
avoid not only the financial cost of
replacing our car but also to avoid the psychic
dissa�sfac�on that would be associated with losing the
services of our car. In business, we accept higher
business risk only if the expected return on investment is
also higher. In general, people understand these monetary
trade-offs: People are prepared to
accept less revenue if it comes with psychic benefits, or
conversely they will want more revenue if it comes with
psychic costs.
The economic way of thinking can best be summarized as
thinking at the margin; that is, considering marginal costs,
marginal revenues, and marginal profits rather than
focusing on average or total costs, revenues, or profits.
The
marginal unit of something is the last unit that is either
consumed or produced. For example, the marginal cost of
produc�on is the change in total costs that is incurred
when an addi�onal unit of output is produced, as
compared
to the average cost of produc�on, which is the total cost
of produc�on divided by the total number of units
produced. By thinking at the margin, economists ask
whether an addi�onal unit of output, or consump�on of
that
output, would improve or reduce individual sa�sfac�on,

business profits, and/or societal welfare. The presump�on
is
that if an addi�onal unit will improve the situa�on, then
the decision should be made to do it because we assume
that individuals want to maximize their sa�sfac�on, firms
want to maximize profits, and socie�es want to maximize
social welfare.
In this book, we will encounter a variety of economic
concepts that allow us to apply the economic way of
thinking
in our decision making. As these economic concepts are
introduced, many of them will be familiar to you because
you already have plenty of experience as an "economic
actor" in the economy and in society. You make
economically
based decisions daily and, consciously or subconsciously,
apply economic concepts in your personal and professional
decision making. So, managerial economics should be an
extension of your intui�ve way of making decisions in
your
personal life into the interac�ons and decisions you make
for your business organiza�on.
The conceptual heritage of managerial economics can be
found in the tenets of microeconomics, which is the study
of the behavior of individual people and
organiza�ons in a market economy. Macroeconomics,
conversely, is the study of the aggregate behavior of
consumers, investors, and governments.
Macroeconomics generates many of the variables that enter
the decision making of individuals and business firms such
as unemployment rates, interest
rates, infla�on rates, and foreign exchange rates.
Governments are fundamentally concerned with managing
the macroeconomy, of course. In this book, our

main concern is the decision making of business firms
who take these macroeconomic variables as givens, as
these variables are outside firms' control as
individual economic en��es. Hence, managerial economics
examines the decision-making processes of individuals and
other economic en��es at the
microeconomic level that in aggregate determine the levels
of important variables in the macroeconomy.
The Use of Models in Managerial Economics
In managerial economics, we frequently use simplified
representa�ons of reality—known as models—to analyze
decision-making problems. A model depicts
and defines the rela�onships among the major variables in
a decision problem while abstrac�ng away from (i.e.,
ignoring) minor influences on the outcome.
Professionals in other fields also use models: Architects
and planners use scale models of buildings; engineers use
scale models of automobiles and aircra�;
and fashion designers use human models as representa�on
of you and me!
In economics we use symbolic models with words and
other symbols that have a specialized meaning. You
already know that words like costs and profits
have special, more precise meanings in managerial
economics. Jargon words are verbal models of things or
phenomena. They allow us to communicate
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Revenues > Costs =
Profit (called "surplus"
in non-profit firms)
more efficiently because they offer a concise and precise
means of conveying the informa�on we wish to convey.
For example, "u�lity" is much quicker than
saying, "the psychic sa�sfac�on that a consumer expects
to derive from the consump�on of a product or service."
Communica�on between economists,
between managers, and between you and me through the
medium of the printed word is substan�ally enhanced by
the use of jargon. Diagrams model a
situa�on by the use of lines, shading, and other features,
while abstrac�ng from the finer details. Similarly, a
mathema�cal equa�on simplis�cally expresses
one (dependent) variable as a func�on of one or more
(independent) variables and does not account for the
variability that is likely to occur due to the
minor and perhaps random variables that also impact the
dependent variable.
In this book, we will use a lot of diagrams and a few
equa�ons as a quick and effec�ve means of
demonstra�ng the main variables in par�cular decision
problems and the assumed rela�onship between and among
these variables. Our models incorporate assumed
rela�onships among the variables and
assumed mo�va�ons of the economic actors. For example,
we assume that firms want to maximize their profits and
that consumers want to maximize their
u�lity. If these assumed rela�onships are inaccurate, or
we have overlooked important variables, these inaccuracies
will be revealed by informa�on search

and empirical tes�ng—by gathering data to test the model
against reality. If our models are found to be excessively
inaccurate or misleading, these models
may consequently be modified to become more realis�c
for future applica�ons.
There are three main purposes of models. First, models
are useful for teaching purposes. They are a useful device
for teaching individuals about the
opera�on of complex systems because they allow the
complexity of reality to be reduced by abstrac�ng from
(i.e., ignoring) variables that have a minor
effect on the outcome of a decision. A simple model
allows us to deal with the central issues of a decision
problem without the added complexity of
rela�vely minor influences. As noted above, models can
always be made more complex (and more accurate
depic�ons of reality) by adding the minor
variables into the model. Second, models are used for
explanatory purposes. They allow us to discover the causal
rela�onships between and among
variables. Using prior informa�on and logic we can
hypothesize, for example, that sales will increase by 40%
if we set up a Facebook page for our business
and reward individuals with discount coupons if they
recruit their friends to "like" our Facebook page. We
would then conduct an empirical test of that
hypothesis to confirm (or reject) the hypothesis. If
supported by the data, we can then claim to explain the
increase in sales as being the result of having a
Facebook page and issuing discount coupons to those who
recommend our page to their friends.
Third, models are used for predic�ve purposes. We might
predict that fuel economy is a nega�ve func�on of both
vehicle weight and engine capacity and

develop a simple formula that reasonably predicts the
actual fuel consump�on of any par�cular vehicle. This
kind of predic�ve model is typically based on
prior empirical studies, and would be periodically adjusted
as engine efficiency con�nues to improve, for example.
Another class of predic�ve model might
predict behavior using a model that is completely
unrealis�c but nonetheless is able to predict outcomes
reasonably accurately. An example is the u�lity-
maximizing model of consumer behavior (see Chapter 3)
that assumes individuals choose among different items to
buy a�er carefully calcula�ng the u�lity
they will derive from consuming specific goods and
services. No consumer actually calculates expected u�lity,
but virtually all consumers act as if they do.
Through a complex intui�ve reasoning process they decide
which products to buy, and typically, these choices are
accurately predicted by a simple model
that assumes individuals will buy those goods that are
expected to give them the most u�lity (psychic
sa�sfac�on) per dollar. So business decision makers
are able to focus on what aspects of the product or
service will give the customer greater sa�sfac�on and
how to reduce costs so that their price can be
more compe��ve.
Integrated Managerial Economics
Managerial economics is usually taught in the context of a
business or MBA degree program alongside other business
courses such as accoun�ng, finance,
human resource management, marke�ng, and business
strategy. Students may think that these are separate silos
of informa�on but in reality economics is
the glue that binds them. Any business decision—whether
a marke�ng, financial, accoun�ng, human resource, or a

strategic decision—must take the
economics of that decision into account. It makes no
sense to make decisions in these other business areas
without regard to the impact of that decision on
cost, revenues, and profits. It is also poten�ally
detrimental to one's objec�ves to make decisions without
regard to the nonmonetary psychic costs and
revenues and the monetary trade-offs that are involved.
Accordingly, in this book we will integrate examples
rela�ng to marke�ng, finance, accoun�ng, human resource
management, marke�ng, and strategy into
our discussion of managerial economics. We shall also
u�lize some rela�vely simple quan�ta�ve methods (also
studied by business students), since we will
need to use data to make es�mates of demand and costs
in later chapters.
The Profit Concept
The profit concept is central to the pursuit of business
and is thus central to the study of managerial economics.
As discussed previously, profit is defined as
the excess of revenues over costs. For not-for-profit and
public-sector organiza�ons, an excess of revenues over
costs is called a "surplus." Conversely, if
costs exceed revenues, there is a loss, which is known as
a "deficit." Regardless of the terms used, no firm or
organiza�on can sustain losses or deficits
forever. The decision-making problems facing managers of
for-profit firms and not-for-profit organiza�ons are
essen�ally similar, involving revenue
enhancement if possible and cost control wherever
possible. The a�ainment of profit/surplus and the
avoidance of loss/deficit are generally seen as
measures of managerial effec�veness, and the market for

managers generally rewards (with higher salaries) those
who are be�er at making decisions that
raise profit or surplus.
It follows that decision making in the areas of revenue
enhancement and cost reduc�on are major themes in
managerial
economics. Concerning the revenue side, we will study
consumer decision making and how we can increase
demand for
the goods and services provided by firms and other
organiza�ons. On the cost side, we consider the
produc�on process
and the costs associated with producing a product or
service for sale. Se�ng price levels in different market
situa�ons is
an important decision related to revenue enhancement, and
our study of the pricing decision will extend to four
chapters.
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Costs > Revenues = Loss
(called "deficit" in non-
profit firms)
But revenues can also be augmented by improving product
design and by be�er marke�ng of the firm's products, so
we
also examine these sources of revenue enhancements,

which of course also cause the firm or organiza�on to
incur costs.
Finally, we bring it all together in the final chapter,
which considers the economics of compe��ve strategy for
the business
firm. But first we will consider some fundamental
concepts of economics that pervade the economic way of
thinking and
underpin the opera�on of the na�onal economy and the
global economic system.
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With the current push towards social and
environmental responsibility, more
companies are working to achieve the
triple bo�om line, which is concerned
with people, planet, and profit.
© Boris Lyubner/Ge�y Images
1.2 Fundamental Concepts of Economics
Underlying the economic way of thinking are several
concepts that form the founda�on on which economic
thinking rests. First, we note that economists
explain the behavior of economic en��es by assuming
that they are ac�ng to pursue a par�cular objec�ve,
rather than ac�ng in a random or irregular
manner. Second, the principle of rela�ve scarcity—meaning

that money, �me, and all other resources are in limited
supply—underlies all economic analysis.
Third, and because resources are in limited supply, the
value of those resources in an alterna�ve use (i.e., their
opportunity cost) must always be
considered. We now consider these in more detail.
Economic Entities Have Objective Functions
Economists assume that consumers, organiza�ons, and
society make decisions purposefully to achieve their
specific objec�ves, which are target outcomes
that the decision maker wants to a�ain. We o�en talk of
the consumer's objec�ve func�on, the organiza�on's
objec�ve func�on, or society's objec�ve
func�on. We use the word func�on in the mathema�cal
sense, that is, the level or magnitude of the outcome is a
func�on of the level of the determining
variables that the decision maker decides to use.
What is the objec�ve of consumers? Economists view
consumers as hedonists who act to best serve their own
well-being or psychic sa�sfac�on, which is called
"u�lity." Thus, we assume that consumers decide which
goods
and services to purchase (the inputs to their objec�ve
func�on) such that they maximize their expected u�lity.
They decide to buy par�cular goods and services
depending on how much sa�sfac�on they expect to gain
by
consuming each one of those goods and services. As a
consumer, you make decisions like this all the �me,
whether consciously or subconsciously. Think about it:
Would you rather spend $500 for a larger TV or for a
new
rug for your living room? Your answer will depend on

how much you think you would enjoy either the new TV
or
the new rug. If you already have a large TV, or a
perfectly good rug, your enjoyment (i.e., your psychic
sa�sfac�on) from having a new one would be rela�vely
small because your perceived need for the item would be
rela�vely low. Conversely, if your old TV has a bad
picture, or your rug has worn thin, those issues would
factor
into your purchasing decision. So we proceed on the
assump�on that consumers make decisions (among
alterna�ve combina�ons of goods and services) to
maximize their u�lity.
What is the objec�ve of an organiza�on? Tradi�onally
economists have assumed that the owners or shareholders
of the business firm will want to maximize the firm's
monetary profit. Shareholders1
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�o
ns/sec1.2#Ch1footNote1) want the firm to make a profit to
pay out
dividends and capital gains so that the shareholders can
buy the things they want. But, more recently economists
have recognized the triple bo�om line concept that says
environmentally conscious and socially responsible firms
will want to achieve a balance between profits, avoidance
of damage to the environment, and achieving social
benefits. However, note that firms will pursue
the triple bo�om line only if their owners and managers
want them to, and thus it comes back to the objec�ve
func�on of individuals. Economists
incorporate the triple bo�om line into their models of
business decision making by assuming that many

individuals will buy shares in companies that
achieve the triple bo�om line outcomes they want and
will sell shares in companies that do not. Thus, these
individuals drive up the stock prices of firms
that are environmentally and socially conscious while
driving down the stock price of firms that are not.2
ns/sec1.2#Ch1footNote2)
Many not-for-profit organiza�ons exist to do good things
for society and/or the natural environment. Examples
include organiza�ons that want to help
disadvantaged individuals, families or groups; organiza�ons
that want to save endangered species; and organiza�ons
that want to stop the degrada�on of
the natural environment. Again, these organiza�ons operate
to achieve what their owners and other stakeholders want
them to achieve, so again, it comes
back to individual hedonism. Individuals who gain u�lity
from helping others, from saving endangered species,
and/or from reducing environment
degrada�on will operate and support such organiza�ons,
and the managers of these organiza�ons will need to
make decisions that deliver what the owners
and stakeholders want.3
At the societal level, governments exist to serve the wants
and needs of the people, and accordingly argue about and
make decisions that are intended to
improve the psychic sa�sfac�on of individuals, the
profitability of firms, the welfare of society, and the

health of the natural environment. Poli�cal
differences underlie the arguments about which groups
should be the major beneficiaries of policy changes, of
course, and there are always winners and
losers. For example, passing a new law to restrict
pollu�on will increase the costs and thereby reduce firms'
profits (and reduce the u�lity of shareholders
who care only about profits) while increasing the u�lity
of individuals who are more environmentally conscious.
Laws that apply domes�cally but not in
foreign countries will also affect the balance of
compe��on between domes�c firms and interna�onal
firms, and thus impose further costs on profit-seeking
shareholders while conferring psychic benefits on other
stakeholders.
Relative Scarcity
If everything that people wanted was plen�ful, there
would be no economic problem. The economic problem is
that resources are rela�vely scarce and
must be allocated to best serve the wants and needs of
individuals, which are effec�vely unlimited. Put another
way, individuals, organiza�ons, and socie�es
must make alloca�on decisions because their wants and
needs are effec�vely infinite, whereas the resources to
produce and serve those wants and needs
are available only in finite quan��es. For individuals,
except perhaps for the super-rich, needs and wants are
typically greater than the income available to
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1.2#Ch1footNote1
1.2#Ch1footNote2

1.2#Ch1footNote3
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Economists are concerned with the explicit and implicit
costs. The
explicit cost is the s�cker price of an item, whereas the
implicit
cost is the opportunity cost or trade-off associated with
buying that
item.
© Stockbyte/Thinkstock
purchase goods and services to sa�sfy those needs and
wants. Thus, individuals must make decisions to allocate
their limited incomes among a wide variety
of goods and services such that their u�lity is maximized.
But even the super-rich have to make alloca�on decisions.
For example, should a billionaire buy a new private jet
(for $2.5 million) or fund a charity for
homeless people, starving children, threatened species, or
the like? It is useful to dis�nguish between needs and
wants. Needs are goods and services that
individuals find necessary to survive and to conduct their
daily lives. Wants are goods and services that are nice to
have but are not necessary to have;
individuals gain u�lity from the consump�on of wants but
could do without them. Economists like to illustrate the
concept of scarcity, and the difference

between wants and needs, with the diamond–water paradox.
Diamonds are rela�vely scarce, while water is rela�vely
abundant. Accordingly, water is
rela�vely cheap to buy and diamonds are rela�vely
expensive. The price of diamonds (per carat) is much
higher than the price of water (per gallon) because
of rela�ve scarcity, not because of necessity.
For business firms, managers have to make alloca�on
decisions, such as whether to use $1 million to buy more
machines (for a more capital-intensive
manufacturing process) or pay more wages (for a more
labor-intensive process) in determining the least cost of
producing a given output level (so as to
maximize the firm's profits). Managers also have to
allocate the limited produc�on capacity of their
produc�on processes to different products or services to
meet the increasing market demand for one product and
the decreasing demand for another. For example, should
Toyota produce more cars and fewer
trucks, or more of one model car and less of another
model? Should a hairdresser allocate less floor space to
hairdressing chairs and more floor space to
places for filing and pain�ng fingernails? Managers of
not-for-profit organiza�ons also must decide whether to
allocate their scarce funds among compe�ng
social and environmental needs. For example, managers of
the Save the Children interna�onal charity must decide
whether to save the children in Eritrea,
Somalia, or the jungles of the Amazon. Their limited
resources mean they cannot possibly save all the children
in all the places where their health and
welfare is threatened, so they must make alloca�on
decisions.
At the societal level, governments must similarly make

alloca�on decisions. For example, in which region should
they spend scarce public funds to reduce
poverty, or upgrade the transporta�on infrastructure, or
relocate a government office so as to provide local
employment? Should they increase public
spending on educa�on or on military preparedness? On
the revenue side, should they raise profit taxes or raise
individual income taxes? The la�er is also an
alloca�on decision because it involves a trade-off of votes
(at the next elec�on) from those who earn most of their
income from wages or salaries compared
to those who earn most of their income from dividends
and capital gains. Poli�cians know that voters who suffer
from a government decision like this are
likely to vote against the party in power at the next
elec�on while those who gain are likely to support that
party in a subsequent elec�on. Thus, they
effec�vely trade-off the interests of one group against
those of the other and suffer the poli�cal consequences of
their decisions.
Opportunity Costs, Economic Costs, and Accounting Costs
Scarcity of �me and of resources gives rise to what are
called opportunity costs. The
opportunity cost of something is what you have to give
up in order to have that thing. As you
know, an opportunity is something that you could do if
you had the �me and the resources to
do it. Because there are only 24 hours in the day and an
infinite variety of things you could
do with that �me, you have to give up one ac�vity (use
of the �me) to spend �me doing an
alterna�ve ac�vity. Similarly, to u�lize part of your
money buying one thing you have to
forego the opportunity of spending that money on another

thing. For example, if I want to
spend $20,000 on a long holiday, then I will have to
forego buying a new car.
But note that opportunity costs are not simply monetary
costs. Economists are concerned not
only with the explicit cost of an item (its s�cker price)
but also want to factor in the implicit
cost (other expenses also incurred) associated with buying
that item. For example, suppose
you took �me off from work to drive to a store to buy
something on sale for $50, and your
tank was empty so you had to buy $10 worth of fuel—
just enough to get you there and back.
Your explicit costs would be $60. But in addi�on, you
would have an opportunity cost
associated with using your owned resources in this way.
Owned resources are things that you
already own, such as your �me, your car, and your other
possessions, so they do not directly
cost you money to use. Suppose it took an hour to drive
to the store and back. First, your
�me has an opportunity cost when you consider you
could have earned $20 had you worked that hour. Second,
suppose that the addi�onal wear-and-tear
on your car would cause its value to decline by $5. Thus,
your implicit costs are $25. The economic cost of the item
to you is $85—the sum of the explicit
cost ($60) plus the implicit costs ($25) due to spending
your �me and other owned resources to buy that item. In
summary, the economic cost is equal to
the opportunity cost of all resources involved in the
decision, including both explicit and implicit costs.
Similarly, a business firm has to consider both explicit
and implicit costs. A firm will pay explicit costs for

labor and materials, which should be equal the
opportunity costs of those items because, for example, a
worker or supplier of materials would refuse to sell labor
or materials for a lower price than he
could get from another firm. We must also consider the
implicit costs of the owned resources of the firm, such as
management �me, real estate, machinery
and equipment, and other items that the firm already
owns. If these physical resources were rented or leased,
their explicit cost would equal their
opportunity cost, but if they are owned resources, they
might alterna�vely be used to produce a more profitable
product or be sold for a higher value than
they contribute in their current produc�on process. For
example, a furniture maker's equipment and skilled labor
might be more profitable making custom-
designed kitchen units, or the firm's land might be sold to
a real estate developer for more than it is worth
underneath a factory that makes furniture or
kitchen units. Thus, firms must also consider the economic
costs of the resources they use if they are to maximize
profits for their shareholders.
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Economic cost = explicit
cost + implicit cost
Accoun�ng cost =
explicit cost only

Untaxed carbon emissions produced as a
byproduct of manufacturing is an example
of market failure because neither the
seller nor the buyer repays the economic
value.
© Mike Kirk/LOOP IMAGES/Loop Images/Corbis
It is important to understand that accoun�ng costs may
differ from economic costs. Accoun�ng costs are the costs
that firms must use to report their costs
and consequent profits to the public. Accountants are
constrained by the Generally Accepted Accoun�ng
Principles (GAAP) laid down by the Financial
Accoun�ng Standards Board (FASB) and the Securi�es
Exchange Commission (SEC). Accountants must follow
specific rules so that customers, suppliers, and
people who buy and sell shares on stock exchanges can
be assured that the costs, revenues, and profits announced
to the public have been calculated using
accepted accoun�ng principles and procedures. Thus, for
financial accoun�ng purposes, the cost of an hour's labor
is the explicit cost of the salary paid to
the worker plus superannua�on payments and labor taxes,
if any, and ignores any implicit costs (which might have
made the economic cost to the firm
higher). Similarly, the accoun�ng cost of a machine will
be recorded as the deprecia�on charge (e.g., 20% of the
machine's historical cost rather than the
actual cash ou�low for the purchase of that machine in
the accoun�ng period) plus the costs of repairs and
maintenance (which are explicit costs captured
in a separate cost category)4

ns/sec1.2#Ch1footNote4) The opportunity cost of the
equipment is what it could earn in
a different produc�on process, or its resale value, or its
scrap value, whichever is the highest. For financial
repor�ng purposes, (financial) accountants ignore
these opportunity costs, but for decision-making purposes
(managerial) accountants will incorporate the opportunity
costs of owned resources into their
calcula�ons.
Profits are equal to revenues minus costs, but economic
costs include both explicit and implicit costs while
accoun�ng
profits are constrained by the GAAP to include only
explicit costs. It follows that if economic costs are likely
to exceed
accoun�ngs costs, then accoun�ng profit may overstate
economic profit to the extent that implicit costs are not
accounted for. Henceforth in this book when we use the
term profit we will mean economic profit, which is a
concept
that both managerial economists and managerial
accountants accept as the appropriate measure of profit for
decision-
making purposes.
The Market Mechanism
Economists place great faith in the market mechanism to
ensure that buyers can trade money for goods and
services, and sellers can trade goods and
services for money. The term market mechanism refers to
the process by which when demand exceeds supply, prices
will rise, and conversely when supply
exceeds demand, prices will fall. The market mechanism
works because, when demand exceeds supply at any price

level, some poten�al buyers will miss
out and will offer slightly higher prices to buy the
product or service, which will soon induce suppliers to set
price at a higher level. Conversely, when supply
exceeds demand at any given price level, some suppliers
will be unable to sell their goods or services and will
offer to sell at a slightly reduced price, which
will soon bring the prices of other suppliers to a lower
level (or they would not be able to sell their goods or
services). If prices rise when demand exceeds
supply, and fall when supply exceeds demand, it follows
that when supply and demand are equal the price will be
the market equilibrium price. There will
be neither seller pressure to reduce prices nor buyer
pressure to raise prices, such that the price will remain
constant un�l either the demand or the supply
situa�on changes. The equilibrium price is also known as
the market-clearing price because at that price there are no
goods and services le� in the market
unable to be sold, and no buyer le� unable to buy.
Stock prices on the stock exchange are the best example
of a compe��ve market at work: Stock prices for any
par�cular company rise and fall on a daily
basis reflec�ng the balance of stock supplied for sale and
bids made to purchase that stock. Poten�al buyers (or
sellers) of that stock bid to buy (or sell)
stock at the price at which they are willing to buy (or
sell) and the stock exchange matches people willing to
buy at a par�cular price with sellers willing to
sell at that price. Because the matching process starts
from the highest bid to buy and proceeds to lower bids,
trading con�nues un�l there is no seller le�
who is willing to sell at the highest bid to buy, and thus
there is neither excess demand nor excess supply
remaining at the equilibrium price.

The stock exchange is an example of a purely
compe��ve market, or a price-takers market, in which
sellers have
to accept the market price even though they may wish for
a higher price, and buyers have to pay the market
prices even though they might wish for a lower price.
The market mechanism ensures that the combined forces
of
supply and demand determine the equilibrium market price
level and this price must be accepted by both buyers
and sellers (but they do not have to buy or sell at that
price unless they want to). In other market forms, the
sellers are pricemakers; that is, they set the price and the
buyers must take it or leave it. In Chapter 7, we
examine market structure, which is defined in terms of the
rela�ve number of buyers and sellers and the degree
of product differen�a�on. We will see that monopolies
(single sellers, such as the electricity company) and
oligopolies (rela�vely few sellers, such as the passenger
airplane makers), in both cases facing many buyers, have
the market power to raise their prices and make
extraordinary profits. Monopolis�c compe�tors (many
sellers
facing many buyers, such as restaurants in a big city) are
also price makers but can only make excess profits in the
short term un�l others copy their point of differen�a�on.
Pure compe��on features many sellers each selling an
undifferen�ated product (like people selling stock in a
par�cular company) to many buyers. Because each seller
is
selling an iden�cal item, price compe��on prevents one
seller from gaining a higher price than others (at any
point of �me in that market; subsequently excess demand
might push prices up or excess supply might press
prices down).

In some markets there will be market failure, meaning that
the market price does not repay the seller for the full
economic value of the item being produced and sold. For
example, as a byproduct of manufacturing, firms produce
carbon, which (in the absence of a tax
on carbon produc�on or a carbon-trading system) is not
paid for by either the seller or the buyer. Similarly,
individuals who drive cars, or use electricity for
household appliances, cause carbon to be produced but do
not pay a tax on this carbon. Because carbon is
effec�vely free to produce and consume, society
consequently gets too much carbon (and this accelerates
global warming). To rec�fy the failure of the market
system to put an appropriate price on carbon,
governments need to implement a tax on the produc�on
and consump�on of items that produce carbon. Other
instances of market failure include the
1.2#Ch1footNote4
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market for the protec�on of the environment, endangered
species, and human beings who are disadvantaged in some
way. Governments and/or socially
conscious and environmentally concerned individuals are
needed to set up and operate charitable and not-for-profit
organiza�ons to rec�fy such market
failures.

All of the decisions made by individuals, organiza�ons,
and socie�es are made with an expecta�on of achieving a
par�cular outcome that will best serve the
objec�ve func�on of the individual, the organiza�on, or
society, respec�vely. Arguably, organiza�onal and societal
objec�ves will reflect the objec�ves of the
relevant stakeholders. But good decisions are not always
followed by good outcomes. For many decisions, we
cannot be certain that the desired outcome
will follow the decision we make because most decision
making takes place in an environment of risk and
uncertainty.
1. It is useful to dis�nguish "shareholders" from "stakeholders."
A stakeholder is anyone who has an interest in the opera�ons of
the firm, and thereby incurs or receives either monetary
or nonmonetary costs or benefits as a result of the firm's
opera�ons. Thus, shareholders are stakeholders, but so too are
non-shareholders who incur monetary or psychic costs, or
who gain monetary or nonmonetary benefits, as a result of the
firm's opera�ons. Thus, stakeholders include suppliers and
buyers and governments (e.g., tax collectors) and anyone
else in society whose well-being is reduced or improved
because of the firm's opera�ons. [return
ns/sec1.2#return1) ]
2. This is a simplis�c treatment of a complex issue. The
monetary trade-off between profits and nonmonetary concerns
for par�cular business firms might be quite high, such that
paying
a�en�on to the la�er might reduce profits substan�ally and
thus reduce the stock price of the firm. Proponents of the triple
bo�om line argue that socially and environmentally

conscious customers will choose to buy (and even pay more for)
products and services from firms that pursue the triple bo�om
line and thus those firms will earn higher profits.
Others argue that due to "market failure" the adverse social and
environmental effects will not be priced appropriately such that
firms will not be adequately compensated (by
customers) for paying a�en�on to the social and environmental
"externali�es" of their produc�on processes, and so will make
lower profits unless governments or not-for-profit
organiza�ons step in to fix the market failure. [return
3. The shareholders and supporters of organiza�ons can exert
pressure on the managers of those organiza�ons to pay more or
less a�en�on to social and environmental outcomes, and
typically do this via the Board of Directors (who monitor
management decisions on behalf of all the shareholders) or by
transferring their investment to organiza�ons that more closely
reflect their preferences. [return
4. Accountants make a deprecia�on charge against revenue
earned in the current period to reflect the por�on of the asset's
life represented by the present period. For example, if the
asset's usable life is five years, the deprecia�on charge would
be 20% of the asset's ini�al purchase price per year for five
years. Note that the explicit cost of the asset is equal to the
purchase price in the first year and is zero in the next four
years, while the deprecia�on charge spreads that purchase cost
over the expected life of the asset. [return

1.2#return1
1.2#return1
1.2#return3
1.2#return4
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uction,sec2.1,sec2.… 10/43
1.3 Certainty Versus Uncertainty
Certainty means that we know what the outcome of a
decision will be before we make it. For example, if I
drop a ball, I know the outcome is that it will hit
the floor (because I know about gravity). Indeed, I could
calculate exactly how many milliseconds it would take for
it to hit the floor if I also know the
weight of the ball and the resistance to gravity that
would be due to wind resistance as the ball fell.
But most economic decisions are not this simple—instead
they are complicated by the fact that we do not know the
outcome in advance. Instead, a range
of unknown factors— known but immeasurable factors—
and/or poten�al interven�ons to the decision outcome
(such as the ac�ons of rival firms) cannot
be accurately predicted. Managerial decision making takes
place in an environment of risk and uncertainty, requiring
a manager to apply economic concepts
in the context of risk and uncertainty.

An early economic theorist, Frank H. Knight (Knight,
1921), made the technical dis�nc�on between risk and
uncertainty. Risk is involved when the poten�al
outcomes and the probability of each outcome are known
in advance of a decision. In the simplest case of dropping
a ball, I know the outcome will be that
it will hit the floor, and the probability of that happening
is 100%. Or, when tossing a coin I know the outcomes
are either heads or tails and that there is a
50% probability for heads and 50% for tails (on average,
if the coin is tossed many �mes). Uncertainty, on the
other hand, is involved when the poten�al
outcomes are not en�rely predictable and/or the
probabili�es of these are not es�mable in advance.
Suppose I need to decide whether to drive to work or
to take the train. The train runs on a rela�vely reliable
schedule, and I es�mate it will take me between 40 and
42 minutes to get to work (door to door).
Alterna�vely, driving my car in city traffic could take as
li�le as 20 minutes or as long as 60 minutes, depending
on the (basically unpredictable) degree of
traffic conges�on due to accidents or street repairs. I
need to get to work by 9:00 a.m. for an important
mee�ng. It is already 8:05 a.m., and the train leaves
at 8:10 a.m. The poten�al outcomes of my decision (train
or car) are the possible �mes of arrival at work. The
train costs $5 while the economic cost of
driving my car would be only $2. What should my
decision be? As we shall see, managerial economics
provides the tools to make this decision.
Business firms face much more complex decisions and
must make these in an environment that usually includes
both risk and uncertainty. To solve these
managerial decision problems, we o�en "model" the

problem and let the economic principles suggest the best
decision. For example, an insurance company
wants to answer the ques�on: "What premium will allow
the company to make a sa�sfactory rate of return on our
business?" The insurance industry sets
premiums for par�cular risks insured on the basis of
es�mated risk because they take the same risk many
�mes. For example, consider an 18-year-old man
seeking accident insurance for his turbocharged sports car.
The insurance companies know that the poten�al outcomes
are "no accidents" or "accidents"
and from their prior experience insuring 18-year-old males
driving sports cars they know the probability of an
accident happening within a year is (let's say)
60%. The insurance company models its decision problem
by assuming that all 18-year-old males driving a
turbocharged sports car are equally liable to
crash. Past data also shows that the average cost of
repairing these cars is $10,000. This model delivers the
answer required: There is a 60% probability of a
$10,000 cost of repair (and associated overhead costs
including a margin for profit), so the insurer will want to
charge an insurance premium of $6,000 to
cover the young man's sports car for one year.
The Expected Value of Uncertain Events
In the previous example above we have calculated the
expected value of the possible outcome (that a young
male will crash his sports car). The expected
value of an outcome is the value of the outcome
mul�plied by the probability that the outcome will occur.
Note that not all young males will crash their
sports cars—the probability is that 6 out of 10 actually
will crash in any year. Moreover, some will barely scratch
their cars while others will absolutely trash

their cars, such that the repair cost might vary from
nearly nothing to the cost of a new car replacement. The
insurance company cannot predict which
young males will actually crash, or the extent of the
damage in each case (due to limited prior data on
individuals coupled with the seemingly random
occurrence and severity of car crashes). Thus, the
company shares the cost of repairs over all those who
take out an insurance policy and sets the premium
just high enough to earn a sa�sfactory profit. In any
given year, fewer or more than 60% of these drivers
might crash and their repair bill might average
more or less than $10,000, but over many cases the best
price decision is provided by using the expected value
model of the decision problem.
As an example of a decision-making problem under
condi�ons of uncertainty, let's consider the pricing
decision of a storekeeper who is contempla�ng the
purchase of 200 mangos at the fruit market for $1 each
and wants to sell them at a profit before they become
over-ripe and thus unsalable. She expects
them to last for only three days before they are too ripe
to sell, so she has to decide on a price that is
sufficiently a�rac�ve to her customers so they will
buy the mangos within three days. The storekeeper faces
several unknown variables. How many customers will
actually come into the store in the next
three days? Will they be cashed-up or buying only the
essen�als while wai�ng for their next paycheck? At what
prices are other stores selling their mangos,
if they indeed have any to sell? What is the rela�ve
quality of these other available mangos? What other
foodstuffs will be put on sale in the next few days
to tempt customers to spend their money elsewhere? Thus,
there are many unknown variables that cannot easily be

given a probability of happening. To
model this pricing decision we adopt a simplified model
that combines all these factors into a single probability—
namely, what is the probability that all 200
mangos will be sold at several alterna�ve prices? Table
1.1 shows the data we need to solve this pricing problem.
Note that because all other costs of the
storekeeper are constant, regardless of this pricing
decision, we consider only the incremental costs of the
decision.
Table 1.1: Expected value of profit contribu�on at
alterna�ve price levels
Alterna�ve
possible price
levels
Contribu�on to profit per
mango (cost was $1 ea.)
Probability of selling
all 200 mangos
Expected value of contribu�on
to profit per mango
Expected value of total
contribu�on to profit
$1.50 $0.50 100% $0.50 $100
$1.75 $0.75 80% $0.60 $120
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Some outcomes (such as four aces when
playing cards or double sixes when rolling
dice) have very low probabili�es, and are
thus very risky to gamble on. Individuals
who are less risk-averse may be willing to
make such gambles, while other more
riskaverse individuals may not.
© iStockphoto/Thinkstock
$2.00 $1.00 70% $0.70 $140
$2.25 $1.25 50% $0.625 $125
$2.50 $1.50 30% $0.45 $90
From the table it is clear that the price that is expected
to maximize profit contribu�on (at $140) is $2.00 per
mango. The only difficult part of this pricing
decision is es�ma�ng the probabili�es of selling all the
mangos at each price. This es�mate has to be provided
by the storekeeper, who should be able to
make an informed guess about these probabili�es from her
prior experience with mangos and other food items and
the prior behavior of her regular
customers and rival stores.
These examples demonstrate that the expected value model
is a simplified version of a complex situa�on. In general,
models abstract from reality by
ignoring the finer details that are not essen�al to the

decision at hand. They concentrate on the major variables
and rela�onships without obscuring the
picture with the less important details that vary across
individuals and/or are unknowable.
Risk Analysis
Where a decision might be followed by one of several
outcomes, the decision maker faces the risk that the
expected
outcome might not be the one that actually happens. For
example, in the above illustra�on, when price was set at
$2.00 each, there was only a 70% probability that all the
mangos would be sold, so there is a 30% probability that
all the mangos would not be sold. Thus, although the
storekeeper's expected value is $140, the actual outcome
might be as high as $200 (if all 100 mangos are sold) or
as low as, say, $50 (if only 25 mangos are sold). The
actual
outcome depends on how many mangos actually are sold.
If the storekeeper had set the price at $1.50 per mango
the probability of selling all was 100%, the mango pricing
decision would be risk free, with a certain payoff of
$100. By choosing a higher price (to make more profit)
the
storekeeper took the risk that not all mangos would be
sold.
Apparently our storekeeper is rela�vely risk tolerant—she
was willing to take the gamble of pricing at $2 per
mango,
which could pay off a maximum of $200 (with probability
70%) or some lesser sum, rather than taking the certain
bet of se�ng price at $1.50 with payoff $100 (with
probability of 100%). In Chapter 2 we will consider the

individual's degree of risk aversion and see that some less-
risk-averse individuals will prefer the gamble (to make
more or less money at the higher price) while other more-
risk-averse individuals would prefer the risk-free
alterna�ve.
Information Search Costs
No�ce that risk and uncertainty is fundamentally due to
the absence of knowledge. We do not know which of the
possible outcomes will happen, or what the exact
probabili�es are that the alterna�ves will happen, because
we do
not know enough about the "system" that causes the
outcome to occur a�er a decision has been made. We
learn
about a system by collec�ng and making sense of
informa�on to be�er understand the mechanisms within
the
system that form the linkage between the decision that is
made and the outcome that is observed. Collec�ng and
interpre�ng informa�on typically costs money, and this
expense is called informa�on search cost.
Decision makers should incur informa�on search costs if
they expect the increased revenue (from making a be�er
decision) to exceed the search costs that
allow that be�er decision to be made. As a simple
example, a quick phone call to see if the store has a
desired item in stock would save the consumer from
was�ng �me and fuel on a fruitless drive across the city
to buy that item if it is already out of stock. Similarly,
the storekeeper with the mangos might
conduct a simple market survey of customers to ascertain
what price would be high enough to maximize profit
while not so high as to leave her with a pile

of over-ripe mangos.
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1.4 Multiyear Scenarios
Future cash flows must be discounted by a factor (known
as the discount rate) that is dependent on the available
interest rate if they are to be compared
with current cash flows. The opportunity discount rate is
equal to the rate of interest that cash held today could
earn if invested elsewhere at the same
risk. In many managerial decision problems the revenues
and costs will be received and incurred over a �me
interval of more than one year, so it is
necessary to discount future-period cash flows to make
them comparable (and thus addi�ve) to present-period cash
flows. By reducing future cash flows to
their present value equivalent, we are able to compare
like with like, rather than trying to add or compare cash
flows from different �me periods, which is
like comparing apples and oranges.
Net Present Value Analysis
A dollar received in the present period is worth more
than a dollar received in a future period because an
amount less than a dollar received today could be
put into a bank and grow to equal one dollar by earning
interest before the end of the future period. For example,

if I had 91 cents today, and I could earn
10% interest per annum on my 91 cents, it would grow
to about $1 in a year (i.e., 91 + 9.1 = 100.1). Thus, if I
can earn 10% on any funds that I hold today,
a dollar to be received in a year's �me should be valued
at no more than 91 cents in present value terms.
Conversely, if I expect to receive $1.10 in a year's
�me, it would be worth only $1 in present value terms if
I could earn 10% on funds put in a bank today. Cash
flows from years 2, 3, 4, 5, and further into
the future must be discounted progressively more heavily
since even smaller sums held presently would grow to a
dollar if allowed to earn interest for more
years (i.e., the interest compounds) from the present
period out to year 2, 3, 4, or 5 and beyond. Note that
discoun�ng back to find the present value of a
future period's dollar is the converse process of
compounding a present period's dollar up to find its value
in a future period.
Let us look into the rela�onship between present value
and future value in more detail, using a li�le symbolic
nota�on. The future value at a point one year
hence (FV1) of a present value (PV) is FV1 = PV(1+r)
where r represents the rate of interest. Thus, the FV1 of
$1 is equal to $1(1.1) = $1.10 in one year
(when r = 10%). If that future value were to be re-
invested for another year, it would earn 10% on the
principal and the interest already earned. That is: FV2
= PV(1+r)(1+r) which is equal to PV(1+r)2. If we were to
re-invest the money for a third year we would find FV3
= PV(1+r)(1+r)(1+r) which is equal to
PV(1+r)3. More generally, the future value of a dollar to

be invested for n years (where n might be 1, 2, 3, 4, 5,
etc.) at r percent interest is FVn = PV(1+r)
n.
Conversely, the present value of a dollar to be received n
years into the future is PV = FVn/(1+r)
n. Note that the la�er element in this expression,
1/(1+r)n, is
the discount factor, which is the frac�on by which the
future value must be mul�plied to find the present value
of the future sum. As you can see, the
discount factor depends on the specific discount rate (r)
and the specific period (n) in which the future funds are
received or disbursed. For example, when
n = 1 (i.e., the next period) and r =10%, the discount
factor is equal to 1/(1.1)1 = 0.9091, consistent with the
91-cent example used above. Note further that
the discount factor is 1/(1.1)2 = 0.8232 when n = 2, and
1/(1.1)3 = 0.7566 when n = 3, and so on. Thus, amounts
to be received further into the future are
mul�plied by progressively smaller discount factors.
Let us illustrate present value analysis with a business
example. Suppose a firm has asked for tenders to build a
new factory and receives two quotes.
Supplier A would charge a total of $3.8 million, payable
$1.8 million immediately, $1 million in one year, and $1
million at the end of two years when the
project will be finished. Supplier B would charge $4
million, payable $500,000 immediately, $1.5 million in one
year and $2 million at the end of two years
when the project would be finished. Suppose the firm has
sufficient cash to pay for either deal, but has an

opportunity cost of 12%, which is the rate of
interest it could earn on its cash balances if loaned out
at equal risk. Which supplier is offering the be�er deal?
To answer this we must calculate the
present value (PV) of each offer, as in Table 1.2.
Table 1.2: Present value calcula�on for cost of new
factory
Year Tender A
cash flows
Discount factors* (12%) PVA Tender B cash flows Discount
factors* (12%) PVB
0 $1,800,000 1.000 $1,800,000 $500,000 1.000 $500,000
1 $1,000,000 0.8929 $892,857 $1,500,000 0.8929 $1,339,286
2 $1,000,000 0.7972 $797,719 $2,000,000 0.7972 $1,594,388
Totals $3,800,000 $3,490,051 $4,000,000 $3,433,673
*Discount factors are rounded to four decimal places.
Using the equa�on PV = FVn/(1+r)
n for each payment, we first calculate the discount
factors, which are equal to 1/(1+r)n, where r is the
opportunity
discount rate (in this case 12%) and n = 0, 1, and 2 in
turn. These are shown in the third column for Supplier A
and repeated in the sixth column for
Supplier B. Mul�plying the future value (FV) by the
discount factor we find the present value (PV) for each
payment, and summing these present values we

find that Supplier B actually offers the be�er deal, being
$56,378 cheaper in present value terms, despite having a
larger total cost of the project in
undiscounted terms.
More generally, the present value calcula�on will involve
both revenues and costs, and we will want to net (or
subtract) the costs from the revenues in each
period to find the net present value (NPV) of each
decision alterna�ve. Thus the formula for net present
value becomes NPV = FVn/(1+r)
n – Cn /(1+r)
n ,
which simplifies to NPV = NCFn/(1+ r)
n where NCFn signifies net cash flow in year n. Usually
mul�year streams of revenue will require an ini�al
investment
9/12/2019 Print
The expected value of a decision is used
when more than one possible outcome
exists. Expected value is calculated by
mul�plying the value of the outcome by
the probability of its occurrence.
© Peter Crowther/Ge�y Images

cost at the beginning (year 0) with revenues occurring in
subsequent years, in which case NCF will be nega�ve in
year 1 and posi�ve subsequently.5
We illustrate the calcula�on of net present value in Table
1.3. Suppose that a new housing development is planned
that would cost $15 million in the first
year to set up the necessary infrastructure (roads,
drainage, electricity supply) and the developer would then
build and sell houses over the following five
years un�l the development is complete. As you can see
in Table 1.3, there is cash ou�low of $10 million in year
1 with zero cash inflows—thus net cash
flow (NCF) is –$10 million in year 1. In year 2 the
developer spends $3 million building houses and sells
those that are completed for a total of $5 million,
so the NCF = $2 million in year 2. Similarly, we can
verify the NCF values for years 2, 3, 4, and 5. The
developer's discount rate is 15% per annum because
this is the rate of interest the developer could earn by
lending the funds to another developer who wants to build
a similar new housing development in
another city. To calculate the discount factor for year 1
we set DF = 1/(1+0.15)1 to find DF = 1/1.15 = 0.8696.
For year 2 we find DF = 1/(1.15)2 = 0.7561,
and so on for years 3, 4 and 5 to arrive at the values
shown in the DF column. Mul�plying the NCF by the DF
for each year we find the NPV of each year's
NCF in the final column, and summing these at the
bo�om of the table we find that the NPV for the housing
development project is $4.355 million.

Table 1.3: Net present value analysis of the housing
development project
Year Cash ou�low ($m) Cash inflow ($m) NCF ($m) DF @
15% NPV ($m)
0 10 0 −10 1.0000 –10.000
1 3 5 2 0.8696 1.739
2 5 8 3 0.7561 2.268
3 8 13 5 0.6575 3.288
4 12 20 8 0.5718 4.574
5 5 10 5 0.4972 2.486
Total 43 56 13 4.355
Note that we have totaled the cash flow columns in Table
1.3 to show the difference between nominal net cash
flows ($13 million) over the five years and discounted net
present value of those cash flows ($4.355 million). I
hope you can see that it would be managerial folly to
make decisions based on nominal dollars rather than net-
present-value dollars—cash inflows that are received
several years away are worth a lot less (e.g., 49.72 cents
in
the dollar in year 5 when the discount rate is 15%). If
the net cash flows (or the profit rate) had not been as
high
as those shown in Table 1.3 in the la�er few years, this
project could have lost money in NPV terms even if the
nominal net cash flows remained posi�ve. For example, if
the cash ou�lows remain the same in years 3–5 but the

cash inflows fell to $12 million, $15 million, and $8
million (due to a global financial crisis, for example), the
nominal net cash flows would be only $5 million over the
five-year period and the NPV would fall to −$155,580
represen�ng a loss on the en�re project compared with
the next best opportunity (i.e., inves�ng the funds
elsewhere at 15% per annum).
A second important thing to no�ce from the above
examples is that as the opportunity discount rate (ODR)
increases, the discount factors become increasingly smaller.
From the above examples you will see that the
discount factor for cash received in one year is 0.9090
when the ODR is 10%; 0.8929 when the ODR is 12%;
and
0.8696 when the ODR is 15%. We know that the ODR is
based on the rate of interest that could be earned if the
funds were invested at equal risk, so these differences in
ODR are due to differences in the risk associated with
investment projects—more risky projects should be
discounted using higher ODRs. We will return to the issue
of
differing degrees of investment risk in Chapter 2.
Measuring Profit in Different Scenarios
Since managers might face either certainty or uncertainty,
and profit may occur either only in the present period or
in both the present and future periods,
managers might be opera�ng in one of four different
scenarios as shown in Table 1.4. First, if there are only
present period cash flows and these are certain,
the managers' decision rule is simply to maximize profit.
Second, if they face only present period cash flows but
these are subject to uncertainty, they need
to maximize expected value (EV) of profits. Third, if they

face both present and future period cash flows and these
are certain, they need to calculate the
net present value (NPV) of profits. And, fourth, finally if
they face future period cash flows and these are subject
to uncertainty, they need to calculate the
expected net present value (ENPV) of profits. In
managerial decision making the final scenario is the most
common situa�on.
Table 1.4: The decision criterion for profit maximiza�on
under different decision scenarios
Present period Future periods
Certainty Maximize Profit Maximize NPV of Profit
Uncertainty Maximize EV of Profit Maximize ENPV of
Profit
1.4#Ch1footNote5
9/12/2019 Print
Using models for predic�ve purposes
enables business decision makers to focus
on what aspects of a product or service
will provide the customer greater
sa�sfac�on and how to reduce costs to
maintain compe��ve prices.
© Fredrik Skold/Ge�y Images

To calculate the ENPV of uncertain future revenues and
costs we would first calculate the EV for each future
period and then use the appropriate discount
factor to calculate the present value of each expected
value. Subtrac�ng costs from revenues in each year would
then give us the ENPV of future profits.
This is best demonstrated using a decision tree format.
Decision Trees
A decision tree is useful to depict decisions that involve
mul�year net profits with poten�al variability of the
outcomes in each year. A decision tree shows
the poten�al outcomes of a decision like branches on a
tree (that is, lying sideways!), as shown in Table 1.5.
This example relates to a young entrepreneur
who is considering establishing a microbusiness to print
and sell souvenir T-shirts in the two years prior to the
Olympic Games. Depending on the success of
his designs and the quality of rival designs, he expects
that demand will be high, medium, or low in each year,
with probabili�es 0.2, 0.3, and 0.5 in the first
year and probabili�es 0.4, 0.4, and 0.2 in the second
year, respec�vely. He will need to invest $2,000 in the
necessary equipment right now, and his
opportunity cost of the funds involved is 10%.
Table 1.5: Decision tree analysis to calculate ENPV of
profits
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
Year 0 Year 1 Year 1 Year 1 Year 2 Year 2 Year 2
Cost
($)

Demand
probability
Profit
($)
PV (DF =
0.909)
Demand
probability
Profit
($)
PV (DF =
0.826)
NPV of Profit
($)
Joint
probability
ENPV of
branches ($)
High (P = 0.4) $12,500 $10,325 $17,415 0.08 $1,393
High (P = 0.2) $10,000 $9,090 Medium (P =
0.4)
$5,000 $4,130 $11,220 0.08 $898
Low (P = 0.2) $1,000 $826 $7,916 0.04 $317

High (P = 0.4) $12,500 $10,325 $11,961 0.12 $1,435
−
$2,000
Medium (P =
0.3)
$4,000 $3,636 Medium (P =
0.4)
$5,000 $4,130 $5,766 0.12 $692
Low (P = 0.2) $1,000 $826 $2,462 0.06 $148
High (P = 0.4) $12,500 $10,325 $7,416 0.20 $1,483
Low (P = 0.5) −$1,000 −$909 Medium (P =
0.4)
$5,000 $4,130 $1,221 0.20 $244
Low (P = 0.2) $1,000 $826 −$2,083 0.10 −$208
ENPV = $6,402
You can see that the table looks something like a tree
lying on its side—the trunk of the tree in year 0 (column
1)
splits into three branches in year 1 and each of these
branches splits into three more branches in year 2
(column 5),
making nine possible outcomes at the end of year 2
(column 8). These terminal branches each have a joint

probability of occurring, equal to the joint probability of
demand being high, medium, or low in the first year in
combina�on with being either high, medium, or low in
the second year.6
ns/sec1.4#Ch1footNote6) Weigh�ng the NPV (in column 10,
which is the sum
of columns 1, 4, and 7) by the joint probabili�es gives
us the ENPV for each terminal branch, and summing these
ver�cally in column 10 gives us the ENPV of the
entrepreneur's project.7
ns/sec1.4#Ch1footNote7) Because the ENPV is posi�ve and
of significant
magnitude, we conclude that the young entrepreneur should
certainly invest in this project, unless he could u�lize
his �me and money in an even more lucra�ve project
(i.e., one with a higher ENPV).
We should make it perfectly clear that the expected value
analysis presumes that the individual makes many similar
decisions, such that over all these decisions the total
outcome would approximate the sum of the expected
values
for all the decisions. So, for a construc�on manager who
con�nually tenders quotes for building new buildings, she
can win some and lose some and expect to be be�er off
at the end of the year by using the expected value
approach. But for a one-shot deal, such as the T-shirt
project, the actual outcome might be as high as $17,415
or as
low as −$2,083 in NPV terms, and there are no other

similar ventures the entrepreneur could use to "average
out"
the profit outcomes. But, if this entrepreneur did con�nue
to undertake similar projects he would, in effect, be
conduc�ng many trials of this gamble and should expect
to earn the sum of the ENPV of those many projects.
The
ENPV analysis we have conducted here essen�ally
assumes the decision maker is risk neutral with respect to
any one project, which may not be true, of
1.4#Ch1footNote6
1.4#Ch1footNote7
9/12/2019 Print
course. In Chapter 2, we will consider different a�tudes
to risk and risk-adjusted decision making, and you will be
equipped to advise the entrepreneur
whether or not he should undertake this project.
5. Note that because we are talking about economic profits,
these costs in each period must be economic costs (i.e., both
explicit and implicit costs) rather than simply the actual
(explicit) costs. [return

6. The joint probabili�es in column 9 are found by mul�plying
the probability in column 2 by the probability in column 5. The
joint probability of an event is the probability of two events
occurring together, and is found by mul�plying the probability
of one event by the probability of the second event. For
example, the probability of demand being high in the first year
(0.2, or 20%) is mul�plied by probability of demand also being
high in the second year (0.4, or 40%) to find the joint
probability of demand being high in both years to be 0.2 x 0.4 =
0.08. [return
7. The ENPV is effec�vely a weighted average of the NPVs,
where the weights a�ached to each branch of the decision tree
is the joint probability of being on that branch. [return
1.4#return5
1.4#return6
1.4#return6
9/12/2019 Print
Summary
In this chapter we have introduced and considered the

nature of, and the fundamental building blocks of,
managerial economics. Managerial economics is
based on microeconomics, the study of individual economic
en��es, such as consumers and business firms. The
economic way of thinking is to consider
changes at the margin and to incorporate monetary trade-
offs for nonmonetary costs and benefits. The study of
economics makes liberal use of models, or
simplified depic�on of reality, to explain, predict, and
teach people about complex systems. We have argued that
managerial economics should be
integrated into the accoun�ng, financial, human resource,
marke�ng, and strategic decisions that managers make,
since in all cases managers are trying to
increase the profitability of the firm, or are considering
monetary trade-offs to achieve the nonmonetary objec�ves
of the firm (when pursuing the triple
bo�om line outcome of a suitable balance between
economic, social, and environmental net benefits).
We noted that economic actors each pursue their objec�ve
func�on and must make alloca�on decisions because of
rela�ve scarcity. Consumers have limited
means (income and/or assets to sell) but have effec�vely
unlimited appe�tes for u�lity. Firms have limited funds
to allocate amongst different resource
combina�ons but must choose the combina�on that
maximizes their profits. If firms observe the triple bo�om
line objec�ve func�on, they will seek a
balance between profits and benefits to society and to the
natural environment. The extent of this balance, which
typically involves a trade-off between
profit and the other nonmonetary benefits, will be driven
by shareholders who push the firms to pay more (or less)
a�en�on to the social and
environmental outcomes. Other organiza�ons, such as

chari�es and not-for-profit organiza�ons, typically seek to
maximize the social and/or environmental
benefits while earning enough revenue to avoid a deficit.
Economic costs are defined to include both explicit and
implicit costs, both of which should be valued at their
opportunity costs. These o�en differ from
accoun�ng costs, which typically neglect the implicit costs
in order to adhere to the "generally accepted accoun�ng
principles" required by the Securi�es
and Exchange Commission (in the United States, or
equivalent body in other na�ons). It follows that the
economic profits of firms may differ from the
accoun�ng profits, since costs may be measured
differently.
Understanding the market mechanism is fundamental to an
understanding of managerial economics. While different
market forms will be discussed in
Chapters 7 and 8, we introduced the no�on of
compe��ve markets, like the stock exchange, where the
forces of demand and supply combine to determine
the equilibrium market price, where buyers and sellers
have to be price takers. In other market forms, with fewer
sellers and/or differen�ated products,
sellers can be price makers. The price chosen in these
markets is important because the price charged for goods
and services (the explicit cost) should be
equal to its opportunity cost, since this underlies the
calcula�on of economic profit.
Next we defined certainty, risk, and uncertainty. Business
managers typically must make their decisions in a context
of risk and uncertainty. Risk can be
narrowly defined as the situa�on where alterna�ve
outcomes are known, with known probabili�es, whereas in

uncertainty, all outcomes may not be
foreseen and probabili�es cannot be reliably es�mated.
We commonly treat risk and uncertainty as a composite
concept, o�en simply referring to it as
"risk." Informa�on search cost can be incurred to obtain
more informa�on, which will usually allow more reliable
es�mates of the outcome magnitudes and
of the probabili�es.
When there is more than one possible outcome to a
decision, we need to calculate the expected value (EV) of
the decision, which is the value of the
outcome mul�plied by the probability of its occurring.
Where the financial outcomes of a decision are spread
over more than one year, we need to calculate
the present value (PV) of the decision, which is the sum
of the products of the cash flows in any year mul�plied
by the appropriate discount factor. The
appropriate discount factor is the opportunity cost of the
funds involved, at equal risk. When there are both
mul�ple possible outcomes and these occur
over mul�ple years we need to calculate the expected net
present value (ENPV) of the decision. We calculate the
ENPV by first summing the present values
of the net cash flows for each terminal branch on the
decision tree, then mul�plying this by the joint
probability of its occurring, and finally summing these
ENPVs of the terminal branches to find the overall ENPV
of the decision. The ENPV approach will be appropriate
for most real-world business decision
problems because revenues and costs are received to be
incurred into the future, and the values of these cash
flows are not known with certainty.
Ques�ons for Review and Discussion

Click on each ques�on to reveal the answer.
1. Why do some business firms pursue a triple bo�om line
outcome while others focus only on profit maximiza�on?
ns/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12
.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo
Firms pursue triple-bo�om line (TBL) outcomes to the
extent that their managers and shareholders want them to.
If the human and ins�tu�onal
owners of shares in the firm do not pressure the managers
to seek beneficial social and environmental outcomes, or if
the managers are not mo�vated
independently to do so, TBL outcomes are less likely to
happen.
2. In what ways can customers influence a firm to pay more
a�en�on to the preserva�on of the natural environment?
Customers can communicate directly to firms that they
prefer to purchase from firms that pursue TBL outcomes;
withdraw their purchasing from firms
that do not achieve sa�sfactory TBL outcomes; seek to
publicize using TV, print, and social media that par�cular
firms are, or are not, pursuing TBL
outcomes; sell any shares they hold in firms that do not
pursue TBL outcomes.
3. What do we mean when we say that consumer needs and
wants are unlimited? Do we mean they are greedy and would not
give part of their income to
chari�es?

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We mean that rela�ve to the limited (finite) wealth of
individuals, wants and needs are unlimited (infinite).
However, note that the individual consumer
might want to donate money to a charity or an
environmental cause (gaining psychic u�lity from that).
So, while consumers are hedonis�c (u�lity
seeking), they are not necessarily opposed to helping
others or the natural environment.
4. Why are the explicit costs of an item that you could purchase
usually equal to the opportunity cost of that item? Can you
envision a situa�on where the
explicit cost of an owned resource would be less than its
opportunity cost?

When you buy an item, you are effec�vely preven�ng the
seller from selling that item to another customer – thus
the seller should expect to gain from
you a price at least equal to what the seller could gain
by selling it to the next customer. The seller's opportunity
cost of the item is what it is worth in
the next-best alterna�ve usage. The explicit cost of an
owned resource could exceed its opportunity cost if you
paid above market value for it, or if its
market value fell a�er you bought it; or if the item is
temporarily on sale at less than its fair market value in
order for the seller to quickly reduce
excess stock of that item.
5. When will economic profits be less than accoun�ng profits
and why?
Economic profit will be less than accoun�ng profit when
the accoun�ng costs do not reflect one or more implicit
or future economic costs, or where
the accoun�ng revenues do not reflect one or more
implicit or future economic revenues, or some combina�on
thereof. This would occur because
accountants are bound by their "Generally Accepted
Accoun�ng Principles" to include only explicit present
period costs or alloca�ons of prior period
explicit costs (such as deprecia�on allowances).
6. What would be the result, in a price-maker market, if a
decision was made to price an item (its explicit cost) at a level

higher than its opportunity cost?
The seller's opportunity cost is the cost of replacing the
item to be sold, e.g., by making or buying another one.
If the seller can replace the item in
inventory at less than the price it can obtain from a
buyer, the seller would make a pure (economic) profit on
the sale, since economic revenue would
exceed economic costs. The buyer's opportunity cost is the
price at which he or she can buy the same item
elsewhere (inclusive of all search,
transac�on and delivery costs). If the buyer can buy the
same product elsewhere for less, he or she will not buy
from this seller.
7. Dis�nguish among certainty, risk, and uncertainty, and
explain how informa�on search could reduce uncertainty or
even change uncertainty to certainty.
Certainty means the outcome of a decision (or ac�on) is
known in advance (i.e., it can be fearlessly predicted).
Risk means the outcome is not known
in advance but the alterna�ve possible outcomes are
known, and their probabili�es of occurring are known.
Uncertainty means the outcome is not
known in advance and that the alterna�ve outcomes are
not known in advance and the probabili�es of these
outcomes occurring are also not known
in advance (and must be es�mated). Note we generally
lump together "risk and uncertainty" to include any

situa�on in which an ac�on might lead to
one of several possible outcomes.
8. What is the profit-maximizing decision criterion when there
is uncertainty and the costs and revenue outcomes are spread
over several years? Why?
In uncertainty we calculate the expected value (EV) of the
outcome, which is the sum of the products of the
predicted value of each outcome and its
probability of occurring. When costs and revenues occur
over several years, we must discount the future sums back
to present value terms and add the
products of the cash flows (posi�ve or nega�ve) and the
discount factors to find the present value (PV) of those
cash flows. When there is both
uncertainty and future period cash flows, we first find the
PV of the cash flow and then mul�ply that by its
probability to find the expected present
value (EPV) of that cash flow, and summing the nega�ve
EPVs (rela�ng to costs) and the posi�ve EPVs (rela�ng
to revenues) we find the expected net
present value (ENPV) associated with the decision or
ac�on.
9. Using the concept of a decision tree, explain what we mean
by the "path-dependency" of outcomes.
Path-dependency means that achieving an outcome is
dependent upon following a par�cular path to that

outcome. To arrive at a par�cular branch of a
decision tree, one must have travelled along a path
comprising the trunk and lower (earlier) branches of that
decision tree.
10. Why is the joint probability of two uncertain events always
smaller than the individual probabili�es of those events
occurring separately?
The joint probability of two uncertain events must be
smaller than the probabili�es of two separate events. This
is because the probabili�es are
frac�ons of one (or percentages less than 100%) such that
when they are mul�plied together to find the probability
of them occurring jointly, the
arithme�c product must be less than either of the two
separate probabili�es.
Decision Problems
1. A global so� drink company has announced it will establish a
founda�on to provide scholarships to students at a local
university. It proposes two alterna�ve
�melines, due to a current cash-flow problem: Either it will
provide an immediate $10m fund, or it will provide $11.5m over
two years, payable $2.5m
immediately, $4m next year, and $5m in two years. The
university president announces to the faculty that he will accept
the $11.5m alterna�ve. As a
managerial economics student you are concerned that he has not
made the best decision.
a. Assuming the opportunity interest rate is 14%, what is the

present value of the $11.5m alterna�ve?
b. Would your decision change if the opportunity interest rate
was 16% or 12% instead of 14%?
c. Explain to the president, in a memo of 200 words or less,
which alterna�ve should be accepted.
2. The Pulitzer Publishing Company is considering offering a
contract to an author who has wri�en a book on the European
Debt Crisis. This project would
involve reviewing, edi�ng, designing artwork, and layout of the
book at an es�mated cost of $160,000, payable at the end of
year 1 before a single book is

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