Michael R. Baye,

Session 1

The Fundamentals of

Managerial Economics

Economic Mysteries

• Why is airline food so bad?

• Why have paper towels

replaced hot-air hand

dryers in public restrooms?

More Economic Mysteries

• Why do prices of some goods, like

apples, go down during months of

heaviest consumption, while others

like beachfront cottages, go up?

• Why do National Football League

games cost so much more than major

league baseball games?

Even More Economic

Mysteries

• Why is gravel made by hand in

Nepal, but by machine in the U.S.?

• Why do color photographs cost less

than black and white photographs?

• Why do manual transmissions have

five forward speeds and automatics

have only four?

Economics Reasoning Quiz

(Worksheet 1)

The best things in life are free.

(True or False)

The largest cost of going to

college is tuition, room and

board.

(True or False)

The purpose of economic activity is to

improve the well-being of some people at

the expense of others.

(True or False)

Anything worth doing is worth doing well.

(True or False)

Life is priceless.

(True or False)

Economics Reasoning Quiz

Guide to Economics Reasoning

Worksheet 2

PEOPLE ECONOMIZE. People

choose the alternative which seems

best to them because it involves the

least cost and the greatest benefit.

ALL CHOICES INVOLVE COST.

Cost is the second best choice given

up when people make their best

choice.

Guide to Economics Reasoning

PEOPLE RESPOND TO

INCENTIVES. Incentives are

actions or rewards that

encourage people to act. When

incentives change, people’s

behavior changes in predictable

ways.

Guide to Economics Reasoning

ECONOMIC SYSTEMS

INFLUENCE INDIVIDUAL

CHOICES AND INCENTIVES.

How people cooperate is governed

by written and unwritten rules. As

rules change, incentives change and

behavior changes.

Guide to Economics Reasoning

VOLUNTARY TRADE CREATES

WEALTH. People can produce

more in less time by concentrating

on what they do best. The surplus

goods or services they produce can

be traded to obtain other valuable

goods or services.

Guide to Economics Reasoning

THE CONSEQUENCES OF

CHOICES LIE IN THE FUTURE. The important costs and benefits in

economic decision making are those

which will appear in the future.

Economics stresses making decisions

about the future because it is only the

future that we can influence. We cannot

influence things that have happened in

the past.

Cost-Benefit Approach to

Decision Making

• C(X) = Cost of doing

activity X

• B(X) = Benefit of doing

activity X

• If B(X) > C(X) then do X

Pitfalls to good decision making

• Ignoring opportunity costs in

making decisions.

Opportunity costs should be included.

• Including sunk costs in making

decisions.

Sunk costs should NOT be included.

Should I go skiing today?

• B(X) = $50 to you.

• C(X) = $30 for lift ticket

& equipment.

• Do you go skiing?

Should graduate student sell a

car to his father-in-law?

• $10,000 Chevrolet

• Does not have to pay the normal 50%

tariff.

• Car sells for $15,000 in home country.

• Estimates he can sell it for $14,000.

• Father-in-law wants to pay $10,000.

• What is the graduate student’s

opportunity cost if he sells it to his father-

in-law?

What is the opportunity cost of

going to college?

Why does it make more sense

to attend college at age 20 than

at age 50?

Is it fair to charge interest

when lending a friend some

money?

Why do banks pay interest in

the first place?

Sunk Costs

• Sometimes an expenditure seems

like a relevant cost when in

reality it is not.

• Sunk costs are beyond recovery

at the moment a decision is

made.

Should I drive to Boston or

take the bus?

• 250 mile trip

• Bus fare is $100

• Costs of typical 10,000 mile driving year for your car are: Insurance $1000

Interest $2000

Fuel, oil $2000

• Total = $5000

• Cost per mile is 5000/10,000 = 50 cents?

Pizza Experiment

• All you can eat lunch for $3.

• One-half of the tables are given a $3

refund.

• They other half gets no refund.

• What differences do you predict in

the amounts eaten by these two

groups?

Tickets To A Concert

• Jim wins a ticket from a radio

station.

• Mike paid $18 for a ticket.

• On the evening of the concert there

is a tremendous thunderstorm.

• If they have the same tastes, should

there be a difference in their

behavior as to whether or not to

attend the concert?

Should you keep your business

open for one additional hour?

–Scenario: You are managing a fast

food hamburger restaurant.

–You currently close at 10 pm every

night, but are considering

extending your hours to 11 pm on

weekends.

–What are the relevant

considerations?

Your monthly rent?

Other sunk costs?

The hourly wages you pay your

employees?

Other variable costs associated

with the extra hour?

Your weekly revenues?

Your likely revenues for the extra

hour?

The Invisible Hand

• Decentralized

• Freedom

• Self-interest

• Motivated by incentives

Overview of Managerial

Economics

The Economics of Effective Management

– Identify Goals and Constraints

–Recognize the Role of Profits

–Understand Incentives

–Understand Markets

–Recognize the Time Value of Money

–Use Marginal Analysis

Managerial Economics

Manager

– A person who directs resources to achieve a stated goal.

Economics

– The science of making decisions in the presence of scare resources.

Managerial Economics

– The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.

Economic vs. Accounting Profits

Accounting Profits

– Total revenue (sales) minus dollar cost

of producing goods or services

– Reported on the firm’s income

statement

Economic Profits

– Total revenue minus total opportunity

cost

Opportunity Cost

Accounting Costs

– The explicit costs of the resources needed to

produce produce goods or services

– Reported on the firm’s income statement

Opportunity Cost

– The cost of the explicit and implicit resources

that are foregone when a decision is made

Economic Profits

– Total revenue minus total opportunity cost

Market Interactions Consumer-Producer Rivalry

– Consumers attempt to locate low prices, while producers attempt to charge high prices

Consumer-Consumer Rivalry– Scarcity of goods reduces the negotiating

power of consumers as they compete for the right to those goods

Producer-Producer Rivalry– Scarcity of consumers causes producers to

compete with one another for the right to service customers

The Role of Government– Disciplines the market process

The Time Value of Money

Present value (PV) of an amount (FV) to be

received at the end of “n” periods when

the per-period interest rate is “i”:

PV

FV

in

1Examples?

Present Value of a Series

Present value of a stream of future

amounts (FVt) received at the end of

each period for “n” periods:

PV

FV

i

FV

i

FV

i

n

n

1

1

2

21 1 1

...

Net Present Value

Suppose a manager can purchase a stream

of future receipts (FVt ) by spending “C0”

dollars today. The NPV of such a decision is

NPV C

FV

i

FV

i

FV

i

n

n

0

1

1

2

21 1 1

...

NPV < 0: Reject

NPV > 0: Accept

Firm Valuation

The value of a firm equals the present value of all its future profits– PV = S pt / (1 + i)t

If profits grow at a constant rate, g < i,

then:– PV = po 1i) / ( i - g), po current profit level.

Maximizing Short-Term Profits– If the growth rate in profits < interest rate and

both remain constant, maximizing the present value of all future profits is the same as maximizing current profits.

Control Variables

– Output

– Price

– Product Quality

– Advertising

– R&D

Basic Managerial Question: How much of the control variable should be used to maximize net benefits?

Marginal (Incremental) Analysis

Net Benefits

Net Benefits = Total Benefits -

Total Costs

Profits = Revenue - Costs

Marginal Benefit (MB)

Change in total benefits arising

from a change in the control

variable, Q:

MB = DB / DQ

Slope (calculus derivative) of the

total benefit curve

Marginal Cost (MC)

Change in total costs arising

from a change in the control

variable, Q:

MC = DC / DQ

Slope (calculus derivative) of the

total cost curve

Marginal Principle

To maximize net benefits, the managerial control variable should be increased up to the point where MB = MC

MB > MC means the last unit of the control variable increased benefits more than it increased costs

MB < MC means the last unit of the control variable increased costs more than it increased benefits

Marginal Analysis

The marginal cost of any good or

activity is its opportunity cost

The opportunity cost is the next best

alternative given up when a decision

is made?

What is your opportunity cost for

being here today?

Is it the same for everyone in this

room?

The Geometry of Optimization

Q

Benefits & Costs

Benefits

Costs

Q*

B

CSlope = MC

Slope =MB

Cancer Screening Program

(Worksheet)

Population

Screened

Total Annual

Cost

Total Lives

Saved

60-70 yr. olds $ 80,000 35

50-70 yr. olds $160,000 65

40-70 yr. olds $240,000 85

30-70 yr. olds $320,000 95

20-70 yr. olds $400,000 100

Mobile Cardiac

Arrest Units

Number of

Units

Total Annual

Cost

Total Lives

Saved

1 $ 80,000 100

2 $160,000 150

3 $240,000 175

4 $320,000 190

5 $400,000 200

Summary

Make sure you include all costs and benefits when making decisions (opportunity cost)

When decisions span time, make sure you are comparing apples to apples (PV analysis)

Optimal economic decisions are made at the margin (marginal analysis)

Relevant Articles & Worksheets

Worksheets, pp. 1-5, 1-6, and 1-8.

“Eager to Boost Traffic, More Internet Firms Give Away Services,”, pp. 1-9 & 1-10.

“Beyond the Information Revolution”, pp. 1-11 to 1-18f

Problem Set #1, worksheets pages 1-19 and 1-20