Finance 30210: Managerial Economics

Finance 30210: Managerial Economics Introduction

“Economics deals with the allocation of scarce resources to satisfy unlimited wants”

“You can’t always get what you want…” - Mick Jagger We have limited incomes to spend on a wide variety of goods and services (both now and in the future) We have a finite number of hours in the day to work, relax, go to school, etc Firms have finite capacity and limited financial resources, to produce goods and services The economy as a whole has a finite number of resources trying to satisfy a population with unlimited wants! We need to make choices!!

What’s the difference between Macroeconomics and Microeconomics? Nothing!!! Both are interested in allocations of resources…. Micro Macro • We allocate our time towards a variety of different activities • We allocate consumption/investment goods across a range of uses • We allocate our time towards either leisure or labor • We allocate our available resources towards either consumption ,investment, or government Macro allocations determine the size of the pie Micro allocations determine who gets what slice

Macro Example: The US Economy Consumption GDP Business Investment Government 1950 1960 1970 1980 1990 2000 2010 • Consumption (62%) • Investment (12%) • Government(24%) • Net Exports (2%) • Consumption (69%) • Investment (17%) • Government(18%) • Net Exports (-4%)

Micro Example: Uses of corn 1950 1960 1970 1980 1990 2000 2010 • Fed to livestock (60%) • Exported (22%) • High Fructose corn syrup (6%) • Ethanol Production (6%) • Food and Industrial Products (6%) • Fed to livestock (75%) • Exported (13%) • Food and Industrial Products (12%)

How do we rank various allocations? Efficiency vs. Equity An allocation of resources provides a “fair” distribution of welfare An allocation of resources that maximize total welfare

Suppose that Exxon acquires drilling rights within a remote area where there will be negligible environmental damage in the traditional sense VS. The Sierra club files a lawsuit to block the drilling (Their personal serenity has been threatened by the knowledge that the oil is being removed from it’s natural habitat) If you are the judge, who should prevail?

If you are interested in efficiency you are trying to allocate resources to their highest value VS. • If Exxon Wins: • Exxon stockholders gain • Workers gain from added jobs • Motorists see falling gasoline prices • If Exxon Wins: • Sierra club members lay awake at night screaming $5M $10M A ruling against Exxon in this example would be inefficient – a missed opportunity to make everyone better off.

Introducing homo economicus….also known as “Economic Man” Economic man is a RATIONAL being

The Fundamental Rule of Economics: Individuals are rational beings and therefore respond to incentives – i.e. they respond to opportunities with Economic Profit Economic Profit = Benefit – Opportunity Cost Opportunity cost = Direct (Money) Costs + Implicit Costs In other words, think about opportunity cost as the value of ALL the resources that are being used

Example: What would be the opportunity cost of attending Notre Dame as an undergraduate? Do students have an incentive to go to Notre Dame? So if you wanted a 10% return on your college education, you would need to earn $22,000 a year more per year after college $55,260 x 4 = $221,040 Is this right?

Example: What is IBM’s opportunity cost? Is IBM earning economic profit? Current Stock Price: $166 Shares Outstanding: 1,287M $166 * 1,287M = $213.6B Is 5% a reasonable rate of return? $213.6B * .05 = $213.6B = $10.7B * In Millions Economic Profit = $14.8B - $10.7B = $4.1B

What does this mean from a business perspective? That is, why should we care? Efficiency vs. Equity An allocation of resources that maximum total welfare An allocation of resources provides a “fair” distribution of welfare If we have an efficient outcome, there are no opportunities to create wealth. With inefficient outcomes, there are wealth creating opportunities. An inefficiency offers an opportunity to create wealth by moving resources to higher value uses! This is done through voluntarytransactions.

From a business standpoint, an inefficiency offers an opportunity to create wealth by moving resources to higher value uses! This is done through voluntarytransactions. My Value - $80,000 Consumer Surplus = $5,000 Suppose that you own a Porsche that you value at $65,000, but I value at $80,000 The sale of your car creates $15,000 of new wealth. The sale price determines how that wealth is allocated between us Example: Sale Price = $75,000 Producer Surplus = $10,000 Your Value - $65,000

Exxon- $10M Consumer Surplus = $2M Example: Sale Price = $8M Rather than bringing a judge into the Exxon/Sierra Club problem, we could let the free market solve the problem The sale creates $5M of new wealth. The sale price determines how that wealth is allocated Producer Surplus = $3M Sierra Club- $5M

“A subtle but damaging factor in this is the dominance of economists at business schools. Although there is no evidence that economists are less ethical than members of other discipline, approaching the world through the dollar sign does make people more cynical”* AmitaiEtzioni, “When it comes to Ethics, B-Schools Get an F”, Washington Post, August 4, 2002

“In 2006, when Notre Dame played Michigan, the south bend Marriott charged $649 per night - $500 above its usual rate of $149”* Ethicist Joe Holt responds… “It is an act of moral abdication for businesses to pretend that they have no choice but to charge as much as they can based on supply and demand” * Ilan Brat, “Notre Dame Football introduces its Fans to Inflationary Spiral”, Wall Street Journal, September 6, 2006

ALL voluntary transactions create wealth!! Value = $700/Night Consumer Surplus = $50 Consumer Surplus = $550 Price = $650 Either way, $600 of wealth is created! Producer Surplus = $550 Price = $150 Producer Surplus = $50 Cost = $100/Night

Cost = $100/Night Value = $800/Night Value = $1000/Night You have three rooms to rent. How do you set the price to create the most wealth? Value = $200/Night Cost = $100/Night Value = $600/Night Value = $400/Night Cost = $100/Night

CS = $400 Value = $1000/Night At a $600 per night price we create $2100 of wealth PS = $500 Cost = $100/Night CS = $200 Value = $800/Night CS = $600 PS = $1500 PS = $500 Cost = $100/Night Value = $600/Night PS = $500 Cost = $100/Night

CS = $850 Value = $1000/Night At a $150 per night price we could create $2100 of wealth PS = $50 Cost = $100/Night CS = $650 Value = $800/Night CS = $1950 PS = $150 PS = $50 Cost = $100/Night CS = $450 Value = $600/Night PS = $50 Cost = $100/Night

CS = $50 Value = $200/Night At a $150 per night price we could create $900 of wealth PS = $50 Cost = $100/Night CS = $250 Value = $400/Night CS = $750 PS = $150 PS = $50 Cost = $100/Night CS = $450 Value = $600/Night PS = $50 If Marriott charged $150 per night, what should happen? Cost = $100/Night

Charles Darwin vs. Adam Smith: Efficiency and the Competitive Marketplace "Greed captures the essence of the evolutionary spirit." -Gordon Gekko

Markets and prices allow resources to be distributed in a way to take advantage of differences. Consider the following example. Two countries (the US and Mexico) producing two different goods (Agriculture and Manufacturing). Mexico USA The United States has an Absolute advantage in both goods (we require less labor for everything we produce)

Opportunity cost measures all the costs involved with an activity. In this example, the cost of agriculture in the USA is the time spent. We need to value that time. 1 Unit of agricultural goods 10/8 = 5/4 units of agriculture lost 1/8 hour of time spent 10 units of manufacturing per hour USA 1.25 units of manufacturing per unit of agriculture 8 units of agriculture per hour

Now, lets figure out the opportunity cost for Mexico of producing agriculture. 1 Unit of agriculture 4/5 units of manufacturing lost 1/5 hour of time spent 4 units of manufacturing per hour Mexico .80 units of manufacturing per unit of agriculture 5 units of agriculture per hour

In terms of opportunity cost, Mexico has the lower cost of agriculture (in terms of lost manufacturing) . Likewise, US has a lower cost of Manufacturing (in terms of lost agriculture). We would say that Mexico has a comparative advantage in agriculture while the US has a comparative advantage in manufacturing Mexico USA

Suppose that both the US and Mexico had 40 hrs per week available to produce both goods: For every unit of agriculture produced, the US gives up 1.25 units of manufactured products For every unit of agriculture produced, Mexico gives up .80 units of manufactured products 400 Slope = 1.25 Slope = .80 300 160 80 80 320 100 200 If the US devotes 10 hours to agriculture and 30 hours to manufacturing, we could have 80 units of agriculture and 300 units of manufacturing If Mexico devoted half its resources to each sector, it could have 100 units of agriculture and 80 units of manufacturing

Suppose that, rather than producing both goods, the US specialized in Manufacturing and Mexico specialized in Agriculture…we could both be better off! With trade, The US could specialize in manufacturing (produce 400 units) and then trade 100 units of them for 100 units of agriculture With trade, Mexico could specialize in agriculture (produces 200 units) and then trade 100 units of them for 100 units of manufacturing Production point 400 300 160 Consumption point Consumption point 100 200 80 Production point 100 200 80 100 320 Gain = 20 Manufactured Goods Gain = 20 Agricultural Goods

Prices will determine what actually gets produced in each country: Suppose that the wage rate in the US is $10/hr USA $1 unit cost 1 unit = 1/10 hr $1.25 unit cost 1 unit = 1/8 hr Lets look at the profitability of each industry in the US With a wage of $10/hr, the price of agriculture has to be at least $1.25/unit while manufacturing has to be at least $1 to be profitable

Suppose that manufactured goods sell for $4, while agricultural goods sell for $5 Suppose that the wage rate in the US is $10/hr USA $1 unit cost 1 unit = 1/10 hr $1.25 unit cost 1 unit = 1/8 hr • Manufacturing • Agriculture Every hour of labor generates $30 of profit Every hour of labor generates $30 of profit

Let’s look at these prices in relative terms… A unit of manufacturing sells for $4.00 A unit of agriculture sells for $5.00 The relative price of agriculture (in terms of manufacturing) is $5.00 = 1.25 (Units of manufacturing per unit of agriculture) $4.00 When the relative price of agriculture equals 1.25 (the relative cost), both industries are equally profitable!

Suppose that manufactured goods sell for $4.50, while agricultural goods sell for $5 Suppose that the wage rate in the US is $10/hr USA $1 unit cost 1 unit = 1/10 hr $1.25 unit cost 1 unit = 1/8 hr • Manufacturing • Agriculture Every hour of labor generates $35 of profit Every hour of labor generates $30 of profit

Let’s look at these prices in relative terms… A unit of manufacturing sells for $4.50 A unit of agriculture sells for $5.00 The relative price of agriculture (in terms of manufacturing) is $5.00 = 1.11 (Units of manufacturing per unit of agriculture) $4.50 When the relative price of agriculture is less than 1.25 (the relative cost), manufacturing is more profitable!

Suppose that manufactured goods sell for $4.00, while agricultural goods sell for $5.50 Suppose that the wage rate in the US is $10/hr USA $1 unit cost 1 unit = 1/10 hr $1.25 unit cost 1 unit = 1/8 hr • Manufacturing • Agriculture Every hour of labor generates $30 of profit Every hour of labor generates $34 of profit

Let’s look at these prices in relative terms… A unit of manufacturing sells for $4.00 A unit of agriculture sells for $5.50 The relative price of agriculture (in terms of manufacturing) is $5.50 = 1.38 (Units of manufacturing per unit of agriculture) $4.00 When the relative price of agriculture is more than 1.25 agriculture is more profitable!

So relative prices are driving production patterns… Example #2: manufactured goods sell for $4.50, while agricultural goods sell for $5 Relative price of agriculture is less than 1.25 Example #1: manufactured goods sell for $4.50, while agricultural goods sell for $5 Relative price of agriculture is equal to 1.25 400 Example #3: manufactured goods sell for $4.00, while agricultural goods sell for $5.50 Relative price of agriculture is greater than 1.25 320

Note that, keeping relative prices constant, changing absolute prices and wages has no affect on production, but alters the distribution of gains between workers and factory owners. Suppose that manufactured goods sell for $4, while agricultural goods sell for $5, the wage rate is $10/hr • Manufacturing • Agriculture 1 Hour of Labor 1 Hour of Labor $40 of Output $10 of Wages $30 of Profits $40 of Output $10 of Wages $30 of Profits

We get similar results in Mexico Relative price of agriculture is less than .80 Relative price of agriculture is equal to .80 Relative price of agriculture is greater than .80 160 200

This leaves us with three possibilities… 400 #1: The relative price of agriculture is below .80 – both countries specialize in manufacturing (no trade) Slope = 1.25 #2: The relative price of agriculture is between .80 and 1.25 – US produces manufactured goods, Mexico produces agriculture countries specialize in manufacturing (trade) 320 #3: The relative price of agriculture is above 1.25 – both countries specialize in agriculture (no trade) 160 Slope = .80 200

Suppose that the relative price of agriculture is 1 Price of manufacturing equals $8 Price of agriculture equals $8 Wages equal $10/hr With trade, The US specializes in manufacturing (produces 400 units) and then trades 100 units of them for 100 units of agriculture With trade, Mexico specializes in agriculture (produces 200 units) and then sells 100 units of them for 100 units of manufacturing Production point 400 300 160 Consumption point Consumption point 100 200 80 Production point 100 200 80 100 320 Gain = 20 Manufactured Goods Gain = 20 Agricultural Goods

Suppose that the relative price of agriculture is 1 Price of manufacturing equals $8 Price of agriculture equals $8 Wages equal $10/hr 400 400 300 300 200 80 100 320 80 320 • Manufacturing (40 hours): • Output: $3200 • Wages Paid: $400 • Profits: $2800 • Agriculture (0 Hours): • Output: $0 • Wages Paid: $0 • Profits: $0 • Manufacturing (30 hours): • Output: $2400 • Wages Paid: $300 • Profits: $2100 • Agriculture (10 Hours): • Output: $640 • Wages Paid: $100 • Profits: $540 Net gain is $160 in extra profits (i.e. 20 agricultural goods)

Suppose the agreed upon relative price of agriculture is .80 Price of manufacturing equals $10 Price of agriculture equals $8 Wages equal $10/hr With trade, Mexico specializes in agriculture (produces 200 units) and then sells 125 units of them for 100 units of manufacturing With trade, The US specializes in manufacturing (produces 400 units) and then sells 100 units of them for 125 units of agriculture Production point 400 300 Consumption point 160 200 100 80 125 320 75 200 Gain = 0 Gain = 45 Agricultural Goods

Suppose the agreed upon price of agriculture is .80 (each agricultural item is traded for .80 manufactured items Price of manufacturing equals $10 Price of agriculture equals $8 Wages equal $10/hr 400 400 300 300 200 80 125 320 80 320 • Manufacturing (40 hours): • Output: $4000 • Wages Paid: $400 • Profits: $3600 • Agriculture (0 Hours): • Output: $0 • Wages Paid: $0 • Profits: $0 • Manufacturing (30 hours): • Output: $3000 • Wages Paid: $300 • Profits: $2700 • Agriculture (10 Hours): • Output: $640 • Wages Paid: $100 • Profits: $540 Net gain is $360 in extra profits (i.e. 45 agricultural goods)

Suppose the agreed upon relative price of agriculture is 1.25 Price of manufacturing equals $10 Price of agriculture equals $12.50 Wages equal $10/hr With trade, Mexico specializes in agriculture (produces 200 units) and then sells 100 units of them for 125 units of manufacturing With trade, The US specializes in manufacturing (produces 400 units) and then sells 125 units of them for 100 units of agriculture Production point 400 275 Consumption point 160 200 125 80 100 320 100 200 Gain = 0 Gain = 45 Manufactured Goods

Suppose the agreed upon price of agriculture is 1.25 Price of manufacturing equals $10 Price of agriculture equals $12.50 Wages equal $10/hr 400 400 300 300 200 80 320 80 320 • Manufacturing (40 hours): • Output: $4000 • Wages Paid: $400 • Profits: $3600 • Agriculture (0 Hours): • Output: $0 • Wages Paid: $0 • Profits: $0 • Manufacturing (30 hours): • Output: $3000 • Wages Paid: $300 • Profits: $2700 • Agriculture (10 Hours): • Output: $1000 • Wages Paid: $100 • Profits: $900 Net gain is $0 in extra profits

We can actually sketch out the world supply curve for agriculture… For prices above 1.25, both countries specialize in agriculture 1.25 For prices between .80 and 1.25, both countries are completely specialized (US in manufacturing, Mexico in Agriculture) .80 200 520 For prices below .80, neither country produces agriculture

Finance 30210: Managerial Economics