Introduction, Basic Principles and Methodology The central themes of Managerial Economics: • Identify problems and opportunities • Analyzing alternatives from which choices can be made • Making choices that are best from the standpoint of the firm or organization
Not true that all managers must be managerial economists • But managers who understand the economic dimensions of business problems and apply economic analysis to specific problems often choose more wisely than those who do not.
Some Economic Principles of Managers 1. Role of manager is to make decisions. Firms come in all sizes but no firm has unlimited resources so managers must decide how resources are employed
Decisions are always among alternatives. • Decision alternatives always have costs and benefits Opportunity cost = next best alternative foregone. Marginal or incremental approach 4. Anticipated objective of management is to increase the firm’s value
Maximize shareholder’s wealth • Negative impact = principal-agent problem • Firm’s value is measured by its expected profits Time value of money, discount rates 6. The firm must minimize cost for each level of production
The firm’s growth depends on rational investment decisions Capital budgeting decisions 8. Successful firms deal rationally and ethically with laws and regulations
Macroeconomics & Microeconomics • Economists generally divide their discipline into two main branches: • Macroeconomics is the study of the aggregate economy. • National Income Analysis (GDP) • Unemployment • Inflation • Fiscal and Monetary policy • Trade and Financial relationships among nations
Microeconomics is the study of individual consumers and producers in specific markets. • Supply and demand • Pricing of output • Production processes • Cost structure • Distribution of income and output Microeconomics is the basis of managerial economics
Methodology, data and application Methodology- is a branch of philosophy that deals with how knowledge is obtained. How can you know that you are managing efficiently and effectively? You need some theory to do some analysis. Without theory, there can be no good analysis
Microeconomics (probably more than other disciplines) provides the methodology for managerial economics Managerial Economics is about both methodology and data You need data to plug into some model to do some analysis. This gives you the information to manage Managerial Economics lends empirical content to the study of effective management
Review of Economic Terms • Resources are factors of production or inputs. • Examples: • Land • Labor • Capital • Entrepreneurship
Managerial Economics • The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.
Managerial economics is the use of economic analysis to make business decisions involving the best use (allocation) of an organization’s scarce resources.
Relationship to other business disciplines • Marketing: Demand, Price Elasticity • Finance: Capital Budgeting, Break-Even Analysis, Opportunity Cost, Economic Value Added • Management Science: Linear Programming, Regression Analysis, Forecasting • Strategy: Types of Competition, Structure-Conduct-Performance Analysis • Managerial Accounting: Relevant Cost, Break-Even Analysis, Incremental Cost Analysis, Opportunity Cost
Questions that managers must answer: • What are the economic conditions in a particular market? • Market Structure? • Supply and Demand Conditions? • Technology? • Government Regulations? • International Dimensions? • Future Conditions? • Macroeconomic Factors?
Questions that managers must answer: • Should our firm be in this business? • If so, what price and output levels achieve our goals?
Questions that managers must answer: • How can we maintain a competitive advantage over our competitors? • Cost-leader? • Product Differentiation? • Market Niche? • Outsourcing, alliances, mergers, • acquisitions? • International Dimensions?
Questions that managers must answer: • What are the risks involved? • Risk is the chance or possibility that actual future outcomes will differ from those expected today.
Types of risk • Changes in demand and supply conditions • Technological changes and the effect of competition • Changes in interest rates and inflation rates • Exchange rates for companies engaged in international trade • Political risk for companies with foreign operations
Because of scarcity, an allocation decision must be made. The allocation decision is comprised of three separate choices: • What and how many goods and services should be produced? • How should these goods and services be produced? • For whom should these goods and services be produced?
Economic Decisions for the Firm • What: The product decision – begin or stop providing goods and/or services. • How: The hiring, staffing, procurement, and capital budgeting decisions. • For whom: The market segmentation decision – targeting the customers most likely to purchase.
Three processes to answer what, how, and for whom • Market Process: use of supply, demand, and material incentives • Command Process: use of government or central authority, usually indirect • Traditional Process: use of customs and traditions
Profits are a signal to resource holders where resources are most valued by society • So what factors impact sustainability of industry profitability? • Porter’s 5-forces framework discusses 5 categories of forces that impacts profitability
Entry • Power of input sellers • Power of buyers • Industry rivalry • Substitutes and Complements
Entry: Heightens competition Reduces margin of existing firms Ability to sustain profits depends on the barriers to entry: cost, regulations, networking, etc. Profits are higher where entry is low
Power of input suppliers: Do input suppliers have power to negotiate favorable input prices? Less power if • inputs are standardized, • not highly concentrated • alternative inputs available Profits are high when suppliers power is low
Power of buyers: High buyer power if • buyers can negotiate favorable terms for the good/service • Buyer concentration is high • Cost of switching to other products is low • perfect information leading to less costly buyer search
Industry rivalry: Rivalry tends to be less intense • in concentrated industries • high product differentiation • high consumer switching cost Profits are low where industry rivalry is intense
Substitutes and complements: Profitability is eroded when there are close substitutes Government policies (restrictions e.g. import restriction on drugs from Canada to US) can affect the availability of substitutes.
Entry • Entry Costs • Speed of Adjustment • Sunk Costs • Economies of Scale • Network Effects • Reputation • Switching Costs • Government Restraints Sustainable Industry Profits • Power of • Input Suppliers • Supplier Concentration • Price/Productivity of Alternative Inputs • Relationship-Specific Investments • Supplier Switching Costs • Government Restraints • Power of • Buyers • Buyer Concentration • Price/Value of Substitute Products or Services • Relationship-Specific Investments • Customer Switching Costs • Government Restraints Industry Rivalry Substitutes & Complements • Concentration • Price, Quantity, Quality, or Service Competition • Degree of Differentiation • Price/Value of Surrogate Products or Services • Price/Value of Complementary Products or Services • Network Effects • Government Restraints • Switching Costs • Timing of Decisions • Information • Government Restraints The Five Forces Framework
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.