Managerial_economics (1).ppt

Session 1
Introduction to Managerial Economics

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Readings
 Robert Pindyck and Daniel Rubinfeld: Microeconomics (Eighth
Edition), Pearson India – Chapter 1
 Hubbard & O’Brian: Microeconomics (First Edition), Pearson
Education India – Chapter 1
 Mansfield, Allen, Doherty and Weigelt: Managerial
Economics: Theory, Applications and Cases (Seventh
Edition), W. W. Norton and Company – Chapter 1
 Png, Ivan: Managerial Economics (Third Edition), Pearson
Asia Publications – Chapter 1
 Thomas and Maurice: Managerial Economics: Concepts and
Applications (Eighth Edition), Tata McGraw-Hill – Chapter 1
 Webster: Managerial Economics: Theory and Practice,
Academic Press – Chapter 1

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After this session, you should be able to:
1) Discuss these three important economic ideas: People are rational.
People respond to incentives. Optimal decisions are made at the
margin.
2) A preliminary overview on the theory of firms.
3) Understand the role of constraints in economic analysis.
4) Distinguish between microeconomics and macroeconomics.
Session Objectives

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Case 1: The Disney Corporation: Expansion
of the Magic Kingdom
 The Walt Disney Company, often simply known as Disney, is
one of the largest media and entertainment conglomerate in
the world, known for its family-friendly products.
 Founded on October 16, 1923, by brothers Walt Disney and
Roy Disney as an animation studio, it has become one of the
biggest Hollywood studios, and owner and licensor of eleven
theme parks and several television networks, including ABC
and ESPN.
 After its founder Walt Disney died in 1966, the company was
adrift for decades. Though the company retained the high
brand recognition, its managers seemed unable to turn this
recognition into increased sales and profits.

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 Given this lack of performance, Walt Disney narrowly survived
takeover attempts by corporate raiders. Its shareholders Sid
Bass and Roy E. Disney brought in Michael Eisner as the new
CEO to turn the company around.
 Eisner and his management team have unlocked the value of
the Disney name and positioned the Magic Kingdom for the
twenty-first century.
 In less than twenty years, Eisner’s team has increased
revenues tenfold to over $23 billion in 1999. Disney now ranks
as one of the 100 biggest global firms and the second largest
global media company (behind Time-Warner).

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In expanding their Magic Kingdom, Eisner’s team has used analyses
that are based on managerial economics !
 Studies indicated that increases in advertising would raise theme park
attendance and raise profits. According they launched a series of
successful advertising campaigns (to be discussed in Sessions under
Managerial Decisions for Firms with Market Power)
 Eisner’s team has also shown its ability to use both simple and
sophisticated pricing techniques to improve firm performance. When
the Disney animated classic film Pinocchio was released on
videocassette, it was initially priced at $79.95 (as were most
videocassettes). At this price only 1,00,000 copies were sold in the
first two months. Eisner’s team decided to drop the price to $29.95,
and promptly sold over 3,00,000 copies (to be discussed in Sessions
under Demand Elasticity and Its Applications)

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 Disney under Eisner’s initiative, has also been a leader in using
sophisticated pricing strategies such as bundling. They have bundled
together a Disney cruise with a stay at their Disneyland theme park in
Florida, a McDonald kid’s meal and several other such packaging. They
also practice price discrimination. Consumers who buy a Disney
videocassette will find coupons for merchandise at Disney retail stores
(to be discussed in Session under Pricing Techniques)
 The firm’s board of directors agreed to pay Eisner a salary of
$750,000, plus a $750,000 bonus for signing on, plus an annual bonus
equal to 2 percent of the dollar amount by which the firm’s net income
exceeded a 9 percent return on shareholders equity. In addition, he
received options on 2 million shares of Disney stock, which meant that
he could purchase them from the firm at any time during the five-year
life of the contract for only $14 per share (to be discussed in Session
under Managing Incentives: Principal – Agent Problems and Moral
Hazard )

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Case 2: Corporate Decision Making: The
Toyota Prius
 In 1997, Toyota Motor Corporation introduced the Prius in
Japan, and started selling it worldwide in 2001. The Prius, the
first hybrid car to be sold in the United States, can run off both
a gasoline engine and a battery, and the momentum of the car
charges the battery.
 Hybrid cars are more energy efficient than cars with just a
gasoline engine; the Prius, for example, can get 45 to 55 miles
per gallon. The Prius was a big success, and within a few years
other manufacturers began introducing hybrid versions of some
of their cars.
 The design and efficient production of the Prius involved not
only some impressive engineering, but a lot of economics as
well.

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Toyota Prius
 First, Toyota had to think carefully about how the public would react
to the design and performance of this new product. How strong would
demand be initially, and how fast would it grow? How would demand
depend on the prices that Toyota charges? Understanding consumer
preferences and trade-offs and predicting demand and its
responsiveness to price are essential to Toyota and every other
automobile manufacturer (to be discussed in Sessions under
Consumer Behaviour and Rational Choice and Demand Elasticity and
Its Applications)
 Secondly, Toyota had to be concerned with the cost of manufacturing
these cars – whether produced in Japan or, starting in 2010, in the
United States. How high would production costs be? How would the
cost of each car depend on the total number of cars produced each
year? How would the cost of labour and the prices of steel and other
raw materials affect costs? How much and how fast would per unit
costs decline as mangers and workers gained experience with the
production process? And to maximize profit, how many of these cars
should Toyota plan to produce each year? (to be discussed in Sessions
under Production Theory and Cost Analysis)

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Toyota Prius
 Finally, Toyota also had to design a pricing strategy and consider how
competitors would react to it. Although the Prius was the first hybrid
car, Toyota knew that it would compete with other small fuel-efficient
cars, and that soon other manufacturers would introduce their own
hybrid cars. Should Toyota charge a relatively low price for a basic
stripped-down version of the Prius and high prices for individual
options like leather seats? Or would it be more profitable to make
these options “standard” items and charge a higher price for the whole
package? Whatever pricing strategy Toyota chose, how were
competitors likely to react? Would Ford or Nissan try to undercut by
lowering the prices of its small cars, or rush to bring out their own
hybrid cars at lower prices? Might Toyota be able to deter Ford and
Nissan from lowering prices by threatening to respond with its own
price cuts? (to be discussed in Sessions under Strategic Thinking in
Oligopoly Markets)

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What is Managerial Economics?
 Managerial economics is the application of economic theory to
management decision making. It is the science of directing
scarce resources to manage effectively.
 Wants, desires: unlimited
 Resources: scarce
 Economic choice
 Economics: How people use scarce resources to satisfy
unlimited wants
Whenever resources are scarce, a manager can make more
effective decisions – make the best of scarce resources – by
applying the discipline of managerial economics.

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How People Make Decisions – Principle 1
Decision-making is at the heart of Managerial
Economics
 Every decision involves tradeoffs (Principle #1)
 “Guns and Butter” – The more we spend on national defense
(guns) to protect our borders, the less we can spend on consumer
goods (butter) to raise our standard of living at home.
 Having more money to buy a flat in Delhi requires working longer
hours, which leaves less time for leisure.
 Laws that require firms to reduce pollution raise the cost of
producing goods and services.

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Society faces an important trade-off: efficiency vs. equity
• Efficiency: getting the most out of its scarce resources
• Equity: distributing the benefits of those resource fairly
among society’s members.
 Tradeoff: To increase equity, can redistribute income from
the well-off to the poor. But this reduces the incentive to
work and produce and shrinks the size of the economic
“pie”.

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 The Cost of Something is What You Give up to Get
Something (Principle #2)
 Making decisions requires comparing the costs and benefits
of alternative choices.
 Example: The decision to join the MBA Programme
 Benefits: intellectual enrichment and better job opportunities
 Costs: money spend on the course, including tuition, books, library
and computer facilities.

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But Think!
 The sacrifice you make by forgoing opportunities
for jobs after completion of your graduate studies.
The opportunity cost of an item is what you give up
to get that item.
It is the relevant cost for decision-making

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 Usually, in choosing an alternative A, a number of alternatives
will be forgone, say, B, C, D etc. It is the next best alternative
that should be considered in calculating the opportunity cost of
A.
 Suppose you spend an extra hour watching TV. You should
have studied either Physics or Mathematics or Botany during
that one hour. By studying an extra hour, you have got 5 more
marks in Physics, 6 more marks in Mathematics and 3 more
marks in Botany. The opportunity cost of watching TV for one
hour is therefore the 6 marks you lost by not studying
Mathematics during that time, since that is the best you could
have done otherwise

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 Suppose you are deciding whether to go to a one-day cricket
match between India and Australia.
 Benefit: The rupee value of the psychic satisfaction from going
to the game is, say, Rs. 1000.
 Costs:
• Explicit costs include: Rs. 300 (price of a ticket)
Rs. 100 (cost of transportation)
Rs 50 (cost of a coke and vada pao)
• Implicit costs include: Rs.100 (if you had not gone to the game, you
could have made this money in the share market)
Rs. 40 (you are shy, reclusive and normally
dislike crowds)
 The total cost = Explicit + Implicit costs = Rs. 590. This is
exceeded by the benefits and hence the decision should go to
the match

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 Some costs should not be included in the opportunity cost but
often are. People should include sunk costs in their calculations
of their opportunity cost, even though they should not do so.
 A sunk cost is one that cannot be recovered, for example, the
cost of repairing your car which broke down a day before the
match.
 In practice, you might think that having incurred the
expenditure, you are under an obligation to go to the match.
This cost is however irrecoverable and should not enter into the
decision to attend the match since ‘one should not cry over
spilt milk’.
 In other words, the cost of resources forgone here (the cost of
repairing the car) is independent of the decision made (to
attend the match or not) and should not be included in the cost
of taking the decision.

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Example :
You need Rs.1,00,000 to start your business. The interest rate
is 5%.
Case 1: borrow Rs.1,00,000
explicit cost = Rs.5000 interest on loan
Case 2: use Rs.40,000 of your savings, borrow the other
Rs.60,000
 explicit cost = Rs.3000 (5%) interest on the loan
 implicit cost = Rs.2000 (5%) foregone interest you could have
earned on your Rs.40,000
In both cases, total (exp + imp) costs are Rs.5000.

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 This example shows that an important implicit cost is the cost
of capital, the foregone returns you could have earned had you
used your savings to buy bonds or other assets instead of
investing them in your business.
 Accounting profit
= total revenue minus total explicit costs
Accountants keep track of how much money flows into and out of
the firm, so they ignore implicit costs.
 Economic profit
= total revenue minus total costs (including explicit and implicit
costs)
Economists study the pricing and production decisions of firm,
which are affected by implicit as well as explicit costs
 Accounting profit ignores implicit costs, so it’s higher than
economic profit.

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 Rational People Think at the Margin (Principle #3)
Rational: The standard assumption in managerial
economics is that people make decisions rationally.
 Rationality means that, when presented with various
alternatives, individuals choose the alternative that gives them
the greatest difference between value and cost. This means
that their behaviour will follow some predictable patterns based
on what they judge to be in their best interest.
 For instance, if Microsoft charges a price of $239 for a copy of
Windows, economists assume that the managers at Microsoft
have estimated that a price of $ 239 will yield Microsoft the
most profit. The managers may be wrong; perhaps a price of
$265 would be more profitable, but economists assume that
the managers at Microsoft have acted rationally on the basis of
information available to them in choosing the price.

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Many decisions are not “all or nothing”, but involve marginal
changes – small incremental adjustments to a plan of action
 When examination is near your decision is not between not studying at all
or studying 24 hours a day, but whether to spend an extra hour reviewing
your notes instead of watching TV.
Evaluating the costs and benefits of marginal changes is an
important part of decision-making
 Your decision whether to join the MBA course is arrived at by
comparing the extra fees you pay and the extra time you forgo
to the extra income you could earn by an additional degree
 The firm decides whether to increase output, comparing the
cost of the additional labour and materials to the extra
revenue

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Quick Thinking!
 Suppose that flying a 200-seat Indian plane from Bhubaneswar to
Delhi costs the airline Rs.1o,00,000 which means that the average
cost of each seat is Rs.5ooo. Suppose further that the plane is an
hour from departure and a passenger is willing to pay Rs.2500 for a
seat. Should the airline sell it to him?

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 People Respond to Incentives (Principle #4)
 incentive: something that induces a person to act, i.e., the
prospect of a reward or punishment
 Because rational people make decisions by weighing costs and
benefits, their decisions may change in response to incentives.
 When the price of a good rises, consumers will buy less of it
because its cost has risen.
 When the price of the same good rises, producers will allocate more
resources to the production of the good because the benefit from
producing the good has risen.

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 According to an article in the Wall Street Journal, the FBI couldn’t
understand why banks were not taking steps to improve security in
the face of an increase in robberies.
 FBI officials suggest that banks place uniformed, armed guards
outside their doors and install bullet-resistant plastic, known as
‘bandit barrier’, in front of teller windows.
 FBI officials were surprised that few banks took their advice. But the
article also reported that installing bullet-resistant plastic costs
$10,000 to $20,000 and a well-trained security guard receives
$50,000 per year in salary and benefits. The average loss in a bank
robbery is only about $1,200.
 The economic incentive to bank is clear: It is less costly to put up
with bank robberies than to take additional security measures. That
banks respond as they do to the threat of robberies may be surprising
to the FBI – but not the economists.

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The Theory of Firm
 Managerial economics is based on the “model of
the firm.”
 The model of the firm is based on the assumption
that firms, or managers of firms, are “optimizers.”
What is it that managers optimize—i.e., what is
the nature of the managerial “objective function”?

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The Theory of Firm
 In its most stripped-down version, the theory of firm assumes
that the firm tries to maximize its profits. The firm’s owner-
manager is assumed to be working to maximize the firm’s
short-run profits.
 But this version is too naïve to be useful in many
circumstances, particularly where a problem facing the firm
has important dynamic elements and where risk is involved.
 A richer version of the theory assumes that the firm tries to
maximize its wealth or value.
 A firm’s value will be defined as the present value of its
expected future cash flows. For the moment, we can regard a
firm’s cash flow as being same as its profit.

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The Theory of Firm
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Thus, expressed as an equation, the value of the firm (V)
= Present value of expected future profits

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The Theory of Firm
 A careful inspection of the equation suggests how a firm’s
managers and workers can influence its value.
 Consider, for example, the Tata Motor Company. Its marketing
managers and sales representatives work hard to increase its
total revenues, while its production managers and
manufacturing engineers strive to reduce its total costs.
 At the same time, its financial managers play a major role in
obtaining capital, and hence influence the equation.
 Finally, its research and development personnel invent new
products and processes that both increase the firm’s total
revenues and reduce its total costs.
 All these diverse groups affect Tata Motor’s value, defined here
as the present value of its expected profits.

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The Role of Constraints
 Managerial economists generally assume that managers want to
maximize firm value. However, this does not mean that managers
have complete control over firm value and can set it at any level
they choose. On the contrary, managers must cope with the fact
that there are many constraints on what they can achieve in this
regard.
 Types of constraints:
a) The amount of certain types of inputs may be limited. In the
relevant period of time, managers may be unable to obtain more
than a particular amount of specialized equipment, skilled labour,
essential materials, or other inputs. Particularly, if the period of
time is relatively short, these input constraints may be quite severe.
For example, because it takes many months to expand the capacity
of a steel plant, many short-run problems facing a steel firm must
be solved on the basis of the recognition that plant capacity is
essentially fixed. However, in dealing with longer-run problems, the
firm has more flexibility and can alter (within limits) its capacity.

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The Role of Constraints
Types of constraints:
b) Another important type of constraint that limits managerial
actions is legal or contractual in nature. For example, a firm
may be bound to pay wages exceeding a certain level
because minimum wage laws stipulate that it must do so.
Also, it must pay taxes in accord with central, state and local
laws. Further, it must act in accord with its contracts with
customers and suppliers – take the legal consequences. A
wide variety of laws (ranging from environmental laws to
antitrust laws to tax laws) limit what managers can do, and
the contracts and other legal agreements made by them
further constrain their actions.

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Microeconomics and Macroeconomics
 Microeconomics focuses on the individual parts of
the economy.
 It is the study of how households and businesses make
choices, how they interact in markets, and how the
government attempts to influence their choices
 Macroeconomics looks at the economy as a whole.
 It is the study of economy-wide phenomena, including
inflation, unemployment, and economic growth

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