Fundamentals of Managerial Economics PDF

bay23224_ch01_001-036.qxd 12/28/12 7:53 AM Page 1 Rev.Confirming Pages CHAPTER ONE The Fundamentals of Managerial Economics...

bay23224_ch01_001-036.qxd 12/28/12 7:53 AM Page 1 Rev.Confirming Pages CHAPTER ONE The Fundamentals of Managerial Economics Learning Objectives HEADLINE After completing this chapter, you will be able to: Amcott Loses $3.5 Million; LO1 Summarize how goals, constraints, incen- Manager Fired tives, and market rivalry affect economic decisions. On Tuesday software giant Amcott posted a year-end operating loss of $3.5 million. Reportedly, $1.7 million LO2 Distinguish economic versus accounting of the loss stemmed from its foreign language profits and costs. division. LO3 Explain the role of profits in a market With short-term interest rates at 7 percent, economy. Amcott decided to use $20 million of its retained LO4 Apply the five forces framework to analyze earnings to purchase three-year rights to Magicword, the sustainability of an industry’s profits. a software package that converts generic word proces- sor files saved as French text into English. First-year LO5 Apply present value analysis to make sales revenue from the software was $7 million, but decisions and value assets. thereafter sales were halted pending a copyright LO6 Apply marginal analysis to determine infringement suit filed by Foreign, Inc. Amcott lost the optimal level of a managerial control the suit and paid damages of $1.7 million. Industry variable. insiders say that the copyright violation pertained to LO7 Identify and apply six principles of effec- “a very small component of Magicword.” tive managerial decision making. Ralph, the Amcott manager who was fired over the incident, was quoted as saying, “I’m a scapegoat for the attorneys [at Amcott] who didn’t do their home- work before buying the rights to Magicword. I pro- jected annual sales of $7 million per year for three years. My sales forecasts were right on target.” Do you know why Ralph was fired?1 1 Each chapter concludes with an answer to the question posed in that chapter's opening headline. After you read each chapter, you should attempt to solve the opening headline on your own and then compare your solution to that presented at the end of the chapter. 1 bay23224_ch01_001-036.qxd 12/28/12 7:53 AM Page 2 Rev.Confirming Pages 2 Managerial Economics and Business Strategy INTRODUCTION Many students taking managerial economics ask, “Why should I study economics? Will it tell me what the stock market will do tomorrow? Will it tell me where to invest my money or how to get rich?” Unfortunately, managerial economics by itself is unlikely to provide definitive answers to such questions. Obtaining the answers would require an accurate crystal ball. Nevertheless, managerial econom- ics is a valuable tool for analyzing business situations such as the ones raised in the headlines that open each chapter of this book. In fact, if you surf the Internet, browse a business publication such as BusinessWeek or The Wall Street Journal, or read a trade publication like Restaurant News or Supermarket Business News, you will find a host of stories that involve managerial economics. A recent search generated the following headlines: “The Dodge Dart marks Chrysler’s renaissance” “ConocoPhillips completes spinoff of refining business” “Charles Schwab cuts some of its ETF fees. Will rivals match? “Apple accused of price-fixing” “Competition heats up for Northwest wine shipping” “U.S. Government steps up challenges to hospital mergers” “Brands rethink social media strategy” “Google buys QuickOffice” Sadly, billions of dollars are lost each year because many existing managers fail to use basic tools from managerial economics to shape pricing and output deci- sions, optimize the production process and input mix, choose product quality, guide horizontal and vertical merger decisions, or optimally design internal and external incentives. Happily, if you learn a few basic principles from managerial economics, you will be poised to drive the inept managers out of their jobs! You will also understand why the latest recession was great news to some firms and why some software firms spend millions on the development of applications for smart phones but permit consumers to download them for free. Managerial economics is not only valuable to managers of Fortune 500 companies; it is also valuable to managers of not-for-profit organizations. It is useful to the manager of a food bank who must decide the best means for distrib- uting food to the needy. It is valuable to the coordinator of a shelter for the home- less whose goal is to help the largest possible number of homeless, given a very tight budget. In fact, managerial economics provides useful insights into every facet of the business and nonbusiness world in which we live—including house- hold decision making. Why is managerial economics so valuable to such a diverse group of decision makers? The answer to this question lies in the meaning of the term managerial economics. bay23224_ch01_001-036.qxd 12/28/12 7:53 AM Page 3 Rev.Confirming Pages Chapter 1: The Fundamentals of Managerial Economics 3 The Manager manager A manager is a person who directs resources to achieve a stated goal. This definition A person who includes all individuals who (1) direct the efforts of others, including those who del- directs resources egate tasks within an organization such as a firm, a family, or a club; (2) purchase to achieve a stated goal. inputs to be used in the production of goods and services such as the output of a firm, food for the needy, or shelter for the homeless; or (3) are in charge of making other decisions, such as product price or quality. A manager generally has responsibility for his or her own actions as well as for the actions of individuals, machines, and other inputs under the manager’s control. This control may involve responsibilities for the resources of a multinational cor- poration or for those of a single household. In each instance, however, a manager must direct resources and the behavior of individuals for the purpose of accom- plishing some task. While much of this book assumes the manager’s task is to max- imize the profits of the firm that employs the manager, the underlying principles are valid for virtually any decision process. Economics The primary focus of this book is on the second word in managerial economics. economics Economics is the science of making decisions in the presence of scarce resources. The science of Resources are simply anything used to produce a good or service or, more gener- making decisions ally, to achieve a goal. Decisions are important because scarcity implies that by in the presence of scarce resources. making one choice, you give up another. A computer firm that spends more resources on advertising has fewer resources to invest in research and development. A food bank that spends more on soup has less to spend on fruit. Economic deci- sions thus involve the allocation of scarce resources, and a manager’s task is to allo- cate resources so as to best meet the manager’s goals. One of the best ways to comprehend the pervasive nature of scarcity is to imag- ine that a genie has appeared and offered to grant you three wishes. If resources were not scarce, you would tell the genie you have absolutely nothing to wish for; you already have everything you want. Surely, as you begin this course, you recog- nize that time is one of the scarcest resources of all. Your primary decision problem is to allocate a scarce resource—time—to achieve a goal—such as mastering the subject matter or earning an A in the course. Managerial Economics Defined managerial Managerial economics, therefore, is the study of how to direct scarce resources in economics the way that most efficiently achieves a managerial goal. It is a very broad disci- The study of how pline in that it describes methods useful for directing everything from the to direct scarce resources in the resources of a household to maximize household welfare to the resources of a firm way that most to maximize profits. efficiently achieves To understand the nature of decisions that confront managers of firms, imagine a managerial goal. that you are the manager of a Fortune 500 company that makes computers. You must make a host of decisions to succeed as a manager: Should you purchase com- bay23224_ch01_001-036.qxd 12/28/12 7:53 AM Page 4 Rev.Confirming Pages 4 Managerial Economics and Business Strategy ponents such as disk drives and chips from other manufacturers or produce them within your own firm? Should you specialize in making one type of computer or produce several different types? How many computers should you produce, and at what price should you sell them? How many employees should you hire, and how should you compensate them? How can you ensure that employees work hard and produce quality products? How will the actions of rival computer firms affect your decisions? The key to making sound decisions is to know what information is needed to make an informed decision and then to collect and process the data. If you work for a large firm, your legal department can provide data about the legal ramifica- tions of alternative decisions; your accounting department can provide tax advice and basic cost data; your marketing department can provide you with data on the characteristics of the market for your product; and your firm’s financial analysts can provide summary data for alternative methods of obtaining financial capital. Ultimately, however, the manager must integrate all of this information, process it, and arrive at a decision. The remainder of this book will show you how to perform this important managerial function by using six principles that comprise effective management. THE ECONOMICS OF EFFECTIVE MANAGEMENT The nature of sound managerial decisions varies depending on the underlying goals of the manager. Since this course is designed primarily for managers of firms, this book focuses on managerial decisions as they relate to maximizing profits or, more generally, the value of the firm. Before embarking on this special use of managerial economics, we provide an overview of the basic principles that comprise effective management. In particular, an effective manager must (1) identify goals and con- straints; (2) recognize the nature and importance of profits; (3) understand incen- tives; (4) understand markets; (5) recognize the time value of money; and (6) use marginal analysis. Identify Goals and Constraints The first step in making sound decisions is to have well-defined goals because achieving different goals entails making different decisions. If your goal is to max- imize your grade in this course rather than maximize your overall grade point aver- age, your study habits will differ accordingly. Similarly, if the goal of a food bank is to distribute food to needy people in rural areas, its decisions and optimal distri- bution network will differ from those it would use to distribute food to needy inner- city residents. Notice that in both instances, the decision maker faces constraints that affect the ability to achieve a goal. The 24-hour day affects your ability to earn an A in this course; a budget affects the ability of the food bank to distribute food to the needy. Constraints are an artifact of scarcity. bay23224_ch01_001-036.qxd 12/28/12 7:53 AM Page 5 Rev.Confirming Pages Chapter 1: The Fundamentals of Managerial Economics 5 Different units within a firm may be given different goals; those in a firm’s marketing department might be instructed to use their resources to maximize sales or market share, while those in the firm’s financial group might focus on earnings growth or risk-reduction strategies. Later in this book we will see how the firm’s overall goal—maximizing profits—can be achieved by giving each unit within the firm an incentive to achieve potentially different goals. Unfortunately, constraints make it difficult for managers to achieve goals such as maximizing profits or increasing market share. These constraints include such things as the available technology and the prices of inputs used in production. The goal of maximizing profits requires the manager to decide the optimal price to charge for a product, how much to produce, which technology to use, how much of each input to use, how to react to decisions made by competitors, and so on. This book provides tools for answering these types of questions. Recognize the Nature and Importance of Profits The overall goal of most firms is to maximize profits or the firm’s value, and the remainder of this book will detail strategies managers can use to achieve this goal. Before we provide these details, let us examine the nature and importance of prof- its in a free-market economy. Economic versus Accounting Profits When most people hear the word profit, they think of accounting profits. Accounting profit is the total amount of money taken in from sales (total revenue, or price times quantity sold) minus the dollar cost of producing goods or services. Accounting profits are what show up on the firm’s income statement and are typically reported to the manager by the firm’s accounting department. A more general way to define profits is in terms of what economists refer to as economic profits economic profits. Economic profits are the difference between the total revenue and The difference the total opportunity cost of producing the firm’s goods or services. The opportunity between total cost of using a resource includes both the explicit (or accounting) cost of the resource revenue and total opportunity cost. and the implicit cost of giving up the best alternative use of the resource. The oppor- tunity cost of producing a good or service generally is higher than accounting costs opportunity cost The explicit cost because it includes both the dollar value of costs (explicit, or accounting, costs) and of a resource plus any implicit costs. the implicit cost of Implicit costs are very hard to measure and therefore managers often overlook giving up its best them. Effective managers, however, continually seek out data from other sources alternative use. to identify and quantify implicit costs. Managers of large firms can use sources within the company, including the firm’s finance, marketing, and/or legal depart- ments, to obtain data about the implicit costs of decisions. In other instances man- agers must collect data on their own. For example, what does it cost you to read this book? The price you paid the bookseller for this book is an explicit (or accounting) cost, while the implicit cost is the value of what you are giving up by reading the book. You could be studying some other subject or watching TV, and each of these alternatives has some value to you. The “best” of these alternatives is bay23224_ch01_001-036.qxd 12/28/12 7:53 AM Page 6 Rev.Confirming Pages 6 Managerial Economics and Business Strategy your implicit cost of reading this book; you are giving up this alternative to read the book. Similarly, the opportunity cost of going to school is much higher than the cost of tuition and books; it also includes the amount of money you would earn had you decided to work rather than go to school. In the business world, the opportunity cost of opening a restaurant is the best alternative use of the resources used to establish the restaurant—say, opening a hairstyling salon. Again, these resources include not only the explicit financial resources needed to open the business but any implicit costs as well. Suppose you own a building in New York that you use to run a small pizzeria. Food supplies are your only accounting costs. At the end of the year, your accountant informs you that these costs were $20,000 and that your revenues were $100,000. Thus, your accounting profits are $80,000. However, these accounting profits overstate your economic profits, because the costs include only accounting costs. First, the costs do not include the time you spent running the business. Had you not run the business, you could have worked for someone else, and this fact reflects an economic cost not accounted for in accounting profits. To be concrete, suppose you could have worked for someone else for $30,000. Your opportunity cost of time would have been $30,000 for the year. Thus, $30,000 of your accounting profits are not profits at all but one of the implicit costs of running the pizzeria. Second, accounting costs do not account for the fact that, had you not run the pizzeria, you could have rented the building to someone else. If the rental value of the building is $100,000 per year, you gave up this amount to run your own busi- ness. Thus, the costs of running the pizzeria include not only the costs of supplies ($20,000) but the $30,000 you could have earned in some other business and the $100,000 you could have earned in renting the building to someone else. The eco- nomic cost of running the pizzeria is $150,000—the amount you gave up to run your business. Considering the revenue of $100,000, you actually lost $50,000 by running the pizzeria; your economic profits were $50,000. Throughout this book, when we speak of costs, we mean economic costs. Eco- nomic costs are opportunity costs and include not only the explicit (accounting) costs but also the implicit costs of the resources used in production. The Role of Profits A common misconception is that the firm’s goal of maximizing profits is necessar- ily bad for society. Individuals who want to maximize profits often are considered self-interested, a quality that many people view as undesirable. However, consider Adam Smith’s classic line from The Wealth of Nations: “It is not out of the benevo- lence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.”2 2 Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, 1776. bay23224_ch01_001-036.qxd 12/28/12 7:53 AM Page 7 Rev.Confirming Pages Chapter 1: The Fundamentals of Managerial Economics 7 INSIDE BUSINESS 1–1 The Goals of Firms in Our Global Economy Recent trends in globalization have forced businesses through business conduct that balances the pursuit of around the world to more keenly focus on profitability. earnings with socially responsible behavior.” This trend is also present in Japan, where historical Ultimately, the goal of any continuing company links between banks and businesses have traditionally must be to maximize the value of the firm. This goal is blurred the goals of firms. For example, the Japanese often achieved by trying to hit intermediate targets, such business engineering firm, Mitsui & Co. Ltd., laun- as minimizing costs or increasing market share. If you— ched “Challenge 21,” a plan directed at helping the as a manager—do not maximize your firm’s value over company emerge as Japan’s leading business engi- time, you will be in danger of either going out of busi- neering group. According to a spokesperson for the ness, being taken over by other owners (as in a leveraged company, “[This plan permits us to] create new value buyout), or having stockholders elect to replace you and and maximize profitability by taking steps such as other managers. renewing our management framework and prioritizing Source: “Mitsui & Co., Ltd. UK Regulatory the allocation of our resources into strategic areas. We Announcement: Final Results,” Business Wire, are committed to maximizing shareholder value May 13, 2004. Smith is saying that by pursuing its self-interest—the goal of maximizing profits—a firm ultimately meets the needs of society. If you cannot make a living as a rock singer, it is probably because society does not appreciate your singing; society would more highly value your talents in some other employment. If you break five dishes each time you clean up after dinner, your talents are perhaps better suited for filing paperwork or mowing the lawn. Similarly, the profits of businesses signal where society’s scarce resources are best allocated. When firms in a given industry earn economic profits, the opportunity cost to resource holders outside the industry increases. Owners of other resources soon recognize that, by continuing to operate their existing businesses, they are giving up profits. This induces new firms to enter the markets in which economic profits are available. As more firms enter the industry, the market price falls, and economic profits decline. Thus, profits signal the owners of resources where the resources are most highly valued by society. By moving scarce resources toward the production of goods most valued by society, the total welfare of society is improved. As Adam Smith first noted, this phenomenon is due not to benevolence on the part of the firms’ managers but to the self-interested goal of maximizing the firms’ profits. Principle Profits Are a Signal Profits signal to resource holders where resources are most highly valued by society. bay23224_ch01_001-036.qxd 12/28/12 7:53 AM Page 11 Rev.Confirming Pages Chapter 1: The Fundamentals of Managerial Economics 11 INSIDE BUSINESS 1–2 Profits and the Evolution of the Computer Industry When profits in a given industry are higher than in other the early 1980s—sold its PC business to China-based industries, new firms will attempt to enter that industry. Lenovo. Compaq—an early leader in the market for When losses are recorded, some firms will likely leave PCs—has since been acquired by Hewlett-Packard. the industry. This sort of “evolution” has changed the A handful of small PC makers have enjoyed some global landscape of personal computer markets. success competing against the remaining traditional At the start of the PC era, personal computer mak- players, which include Dell and Hewlett-Packard. ers enjoyed positive economic profits. These higher By the late 2000s, Dell's strategy switched from sell- profits led to new entry and heightened competition. ing computers directly to consumers to entering into Over the past two decades, entry has led to declines in relationships with retailers such as BestBuy and Sta- PC prices and industry profitability despite significant ples. While only time will tell how these strategies increases in the speed and storage capacities of PCs. will impact the long-run viability of traditional play- Less efficient firms have been forced to exit the market. ers, competitive pressures continue to push PC prices In the early 2000s, IBM—the company that and industry profits downward. launched the PC era when it introduced the IBM PC in framework is not a substitute for understanding the economic principles that under- lie sound business decisions. Understand Incentives In our discussion of the role of profits, we emphasized that profits signal the hold- ers of resources when to enter and exit particular industries. In effect, changes in profits provide an incentive to resource holders to alter their use of resources. Within a firm, incentives affect how resources are used and how hard workers work. To succeed as a manager, you must have a clear grasp of the role of incen- tives within an organization such as a firm and how to construct incentives to induce maximal effort from those you manage. Chapter 6 is devoted to this special aspect of managerial decision making, but it is useful here to provide a synopsis of how to construct proper incentives. The first step in constructing incentives within a firm is to distinguish between the world, or the business place, as it is and the way you wish it were. Many pro- fessionals and owners of small establishments have difficulties because they do not fully comprehend the importance of the role incentives play in guiding the deci- sions of others. A friend of ours—Mr. O—opened a restaurant and hired a manager to run the business so he could spend time doing the things he enjoys. Recently, we asked him how his business was doing, and he reported that he had been losing money ever since the restaurant opened. When asked whether he thought the manager was doing a good job, he said, “For the $75,000 salary I pay the manager each year, the manager should be doing a good job.” bay23224_ch01_001-036.qxd 12/28/12 7:53 AM Page 12 Rev.Confirming Pages 12 Managerial Economics and Business Strategy Mr. O believes the manager “should be doing a good job.” This is the way he wishes the world was. But individuals often are motivated by self-interest. This is not to say that people never act out of kindness or charity, but rather that human nature is such that people naturally tend to look after their own self-interest. Had Mr. O taken a managerial economics course, he would know how to provide the manager with an incentive to do what is in Mr. O’s best interest. The key is to design a mechanism such that if the manager does what is in his own interest, he will indirectly do what is best for Mr. O. Since Mr. O is not physically present at the restaurant to watch over the man- ager, he has no way of knowing what the manager is up to. Indeed, his unwilling- ness to spend time at the restaurant is what induced him to hire the manager in the first place. What type of incentive has he created by paying the manager $75,000 per year? The manager receives $75,000 per year regardless of whether he puts in 12-hour or 2-hour days. The manager receives no reward for working hard and incurs no penalty if he fails to make sound managerial decisions. The manager receives the same $75,000 regardless of the restaurant’s profitability. Fortunately, most business owners understand the problem just described. The owners of large corporations are shareholders, and most never set foot on company ground. How do they provide incentives for chief executive officers (CEOs) to be effective managers? Very simply, they provide them with “incentive plans” in the form of bonuses. These bonuses are in direct proportion to the firm’s profitability. If the firm does well, the CEO receives a large bonus. If the firm does poorly, the CEO receives no bonus and risks being fired by the stockholders. These types of incentives are also present at lower levels within firms. Some individuals earn com- missions based on the revenue they generate for the firm’s owner. If they put forth little effort, they receive little pay; if they put forth much effort and hence generate many sales, they receive a generous commission. The thrust of managerial economics is to provide you with a broad array of skills that enable you to make sound economic decisions and to structure appropri- ate incentives within your organization. We will begin under the assumption that everyone with whom you come into contact is greedy, that is, interested only in his or her own self-interest. In such a case, understanding incentives is a must. Of course, this is a worst-case scenario; more likely, some of your business contacts will not be so selfishly inclined. If you are so lucky, your job will be all the easier. Understand Markets In studying microeconomics in general, and managerial economics in particular, it is important to bear in mind that there are two sides to every transaction in a mar- ket: For every buyer of a good there is a corresponding seller. The final outcome of the market process, then, depends on the relative power of buyers and sellers in the marketplace. The power, or bargaining position, of consumers and producers in the market is limited by three sources of rivalry that exist in economic transactions: consumer–producer rivalry, consumer–consumer rivalry, and producer–producer rivalry. Each form of rivalry serves as a disciplining device to guide the market bay23224_ch01_001-036.qxd 12/28/12 7:53 AM Page 13 Rev.Confirming Pages Chapter 1: The Fundamentals of Managerial Economics 13 process, and each affects different markets to a different extent. Thus, your ability as a manager to meet performance objectives will depend on the extent to which your product is affected by these sources of rivalry. Consumer–Producer Rivalry Consumer–producer rivalry occurs because of the competing interests of consumers and producers. Consumers attempt to negotiate or locate low prices, while producers attempt to negotiate high prices. In a very loose sense, consumers attempt to “rip off” producers, and producers attempt to “rip off” consumers. Of course, there are limits to the ability of these parties to achieve their goals. If a consumer offers a price that is too low, the producer will refuse to sell the product to the consumer. Similarly, if the producer asks a price that exceeds the consumer’s valuation of a good, the con- sumer will refuse to purchase the good. These two forces provide a natural check and balance on the market process even in markets in which the product is offered by a single firm (a monopolist). An illustrative example of this type of rivalry is the common haggling over price between a potential car buyer and salesperson. Consumer–Consumer Rivalry A second source of rivalry that guides the market process occurs among consumers. Consumer–consumer rivalry reduces the negotiating power of consumers in the marketplace. It arises because of the economic doctrine of scarcity. When limited quantities of goods are available, consumers will compete with one another for the right to purchase the available goods. Consumers who are willing to pay the high- est prices for the scarce goods will outbid other consumers for the right to consume the goods. Once again, this source of rivalry is present even in markets in which a single firm is selling a product. A good example of consumer–consumer rivalry is an auction, a topic we will examine in detail in Chapter 12. Producer–Producer Rivalry A third source of rivalry in the marketplace is producer–producer rivalry. Unlike the other forms of rivalry, this disciplining device functions only when multiple sellers of a product compete in the marketplace. Given that customers are scarce, producers compete with one another for the right to service the customers available. Those firms that offer the best-quality product at the lowest price earn the right to serve the customers. For example, when two gas stations located across the street from one another compete on price, they are engaged in producer–producer rivalry. Government and the Market When agents on either side of the market find themselves disadvantaged in the market process, they frequently attempt to induce government to intervene on their behalf. For example, the market for electricity in most towns is characterized by a sole local supplier of electricity, and thus there is no producer–producer rivalry. Consumer groups may initiate action by a public utility commission to limit the power of utilities in setting prices. Similarly, producers may lobby for government bay23224_ch01_001-036.qxd 12/28/12 7:53 AM Page 14 Rev.Confirming Pages 14 Managerial Economics and Business Strategy assistance to place them in a better bargaining position relative to consumers and foreign producers. Thus, in modern economies government also plays a role in disciplining the market process. Chapter 14 explores how government affects managerial decisions. Recognize the Time Value of Money The timing of many decisions involves a gap between the time when the costs of a project are borne and the time when the benefits of the project are received. In these instances it is important to recognize that $1 today is worth more than $1 received in the future. The reason is simple: The opportunity cost of receiving the $1 in the future is the forgone interest that could be earned were $1 received today. This opportunity cost reflects the time value of money. To properly account for the timing of receipts and expenditures, the manager must understand present value analysis. Present Value Analysis present value The present value (PV) of an amount received in the future is the amount that would The amount that have to be invested today at the prevailing interest rate to generate the given future would have to be value. For example, suppose someone offered you $1.10 one year from today. What invested today at the prevailing is the value today (the present value) of $1.10 to be received one year from today? interest rate to Notice that if you could invest $1.00 today at a guaranteed interest rate of 10 per- generate the given cent, one year from now $1.00 would be worth $1.00  1.1  $1.10. In other future value. words, over the course of one year, your $1.00 would earn $.10 in interest. Thus, when the interest rate is 10 percent, the present value of receiving $1.10 one year in the future is $1.00. A more general formula follows: Formula (Present Value). The present value (PV ) of a future value (FV ) received n years in the future is FV PV  (1–1) (1  i)n where i is the rate of interest, or the opportunity cost of funds. For example, the present value of $100.00 in 10 years if the interest rate is at 7 percent is $50.83, since $100 $100 PV    $50.83 (1 .07)10 1.9672 This essentially means that if you invested $50.83 today at a 7 percent interest rate, in 10 years your investment would be worth $100. Notice that the interest rate appears in the denominator of the expression in Equation 1–1. This means that the higher the interest rate, the lower the present value of a future amount, and conversely. The present value of a future payment reflects the bay23224_ch01_001-036.qxd 12/28/12 7:53 AM Page 15 Rev.Confirming Pages Chapter 1: The Fundamentals of Managerial Economics 15 difference between the future value (FV) and the opportunity cost of waiting (OCW): PV  FV  OCW. Intuitively, the higher the interest rate, the higher the opportunity cost of waiting to receive a future amount and thus the lower the present value of the future amount. For example, if the interest rate is zero, the opportunity cost of waiting is zero, and the present value and the future value coincide. This is consistent with Equation 1–1, since PV  FV when the interest rate is zero. The basic idea of the present value of a future amount can be extended to a series of future payments. For example, if you are promised FV1 one year in the future, FV2 two years in the future, and so on for n years, the present value of this sum of future payments is FV1 FV2 FV3 FVn PV    ...  (1  i) 1 (1  i) 2 (1  i) 3 (1  i)n Formula (Present Value of a Stream). When the interest rate is i, the present value of a stream of future payments of FV1, FV2,... , FVn is n FVt PV   t1(1  i) t Given the present value of the income stream that arises from a project, one can net present value easily compute the net present value of the project. The net present value (NPV) of The present value a project is simply the present value (PV ) of the income stream generated by the of the income project minus the current cost (C0) of the project: NPV  PV  C0. If the net pres- stream generated by a project minus ent value of a project is positive, then the project is profitable because the present the current cost of value of the earnings from the project exceeds the current cost of the project. On the the project. other hand, a manager should reject a project that has a negative net present value, since the cost of such a project exceeds the present value of the income stream that project generates. Formula (Net Present Value). Suppose that by sinking C0 dollars into a project today, a firm will generate income of FV1 one year in the future, FV2 two years in the future, and so on for n years. If the interest rate is i, the net present value of the project is FV1 FV2 FV3 FVn NPV    ...   C0 (1  i)1 (1  i)2 (1  i)3 (1  i)n Demonstration Problem 1–1 The manager of Automated Products is contemplating the purchase of a new machine that will cost $300,000 and has a useful life of five years. The machine will yield (year-end) cost reductions to Automated Products of $50,000 in year 1, $60,000 in year 2, $75,000 in year 3, and $90,000 in years 4 and 5. What is the present value of the cost savings of the machine if the interest rate is 8 percent? Should the manager purchase the machine? bay23224_ch01_001-036.qxd 12/28/12 7:53 AM Page 16 Rev.Confirming Pages 16 Managerial Economics and Business Strategy Answer: By spending $300,000 today on a new machine, the firm will reduce costs by $365,000 over five years. However, the present value of the cost savings is only 50,000 60,000 75,000 90,000 90,000 PV       $284,679 1.08 1.082 1.083 1.084 1.085 Consequently, the net present value of the new machine is NPV  PV  C0  $284,679  $300,000   $15,321 Since the net present value of the machine is negative, the manager should not purchase the machine. In other words, the manager could earn more by investing the $300,000 at 8 percent than by spending the money on the cost-saving technology. Present Value of Indefinitely Lived Assets Some decisions generate cash flows that continue indefinitely. For instance, con- sider an asset that generates a cash flow of CF0 today, CF1 one year from today, CF2 two years from today, and so on for an indefinite period of time. If the interest rate is i, the value of the asset is given by the present value of these cash flows: CF1 CF2 CF3 PVAsset  CF0    L (1  i) (1  i) 2 (1  i)3 While this formula contains terms that continue indefinitely, for certain patterns of future cash flows one can readily compute the present value of the asset. For instance, suppose that the current cash flow is zero (CF0  0) and that all future cash flows are identical (CF1  CF2 ... ). In this case the asset generates a per- petual stream of identical cash flows at the end of each period. If each of these future cash flows is CF, the value of the asset is the present value of the perpetuity: CF CF CF PVPerpetuity    L (1  i) (1  i) 2 (1  i)3 CF  i Examples of such an asset include perpetual bonds and preferred stocks. Each of these assets pays the owner a fixed amount at the end of each period, indefinitely. Based on the above formula, the value of a perpetual bond that pays the owner $100 at the end of each year when the interest rate is fixed at 5 percent is given by CF $100 PVPerpetual bond    $2,000 i.05 Present value analysis is also useful in determining the value of a firm, since the value of a firm is the present value of the stream of profits (cash flows) generated by the firm’s physical, human, and intangible assets. In particular, if p0 is the firm’s bay23224_ch01_001-036.qxd 12/28/12 7:53 AM Page 17 Rev.Confirming Pages Chapter 1: The Fundamentals of Managerial Economics 17 current level of profits, and p1 is next year’s profit, and so on, then the value of the firm is p1 p2 p3 PVFirm  p0    L (1  i) (1  i) 2 (1  i)3 In other words, the value of the firm today is the present value of its current and future profits. To the extent that the firm is a “going concern” that lives on even after its founder dies, firm ownership represents a claim to assets with an indefinite profit stream. Notice that the value of a firm takes into account the long-term impact of man- agerial decisions on profits. When economists say that the goal of the firm is to maximize profits, it should be understood to mean that the firm’s goal is to maxi- mize its value, which is the present value of current and future profits. Principle Profit Maximization Maximizing profits means maximizing the value of the firm, which is the present value of current and future profits. While it is beyond the scope of this book to present all the tools Wall Street analysts use to estimate the value of firms, it is possible to gain insight into the issues involved by making a few simplifying assumptions. Suppose a firm’s current prof- its are p0, and that these profits have not yet been paid out to stockholders as divi- dends. Imagine that these profits are expected to grow at a constant rate of g percent each year, and that profit growth is less than the interest rate (g  i). In this case, profits one year from today will be (1  g)p0, profits two years from today will be (1  g)2p0, and so on. The value of the firm, under these assumptions, is p0(1  g) p0(1  g)2 p0(1  g)3 PVFirm  p0    L (1  i) (1  i)2 (1  i)3 1i  p0 ¢ ≤ ig For a given interest rate and growth rate of the firm, it follows that maximizing the lifetime value of the firm (long-term profits) is equivalent to maximizing the firm’s current (short-term) profits of p0. You may wonder how this formula changes if current profits have already been paid out as dividends. In this case, the present value of the firm is the present value of future profits (since current profits have already been paid out). The value of the firm immediately after its current profits have been paid out as dividends (called the ex-dividend date) may be obtained by simply subtracting p0 from the above equation: Ex-dividend  PV PV Firm Firm  p0 bay23224_ch01_001-036.qxd 12/28/12 7:53 AM Page 18 Rev.Confirming Pages 18 Managerial Economics and Business Strategy This may be simplified to yield the following formula: Ex-dividend  p ¢ 1g PV Firm 0 ≤ ig Thus, so long as the interest rate and growth rate are constant, the strategy of maxi- mizing current profits also maximizes the value of the firm on the ex-dividend date. Principle Maximizing Short-Term Profits May Maximize Long-Term Profits If the growth rate in profits is less than the interest rate and both are constant, maximizing current (short-term) profits is the same as maximizing long-term profits. Demonstration Problem 1–2 Suppose the interest rate is 10 percent and the firm is expected to grow at a rate of 5 percent for the foreseeable future. The firm’s current profits are $100 million. (a) What is the value of the firm (the present value of its current and future earnings)? (b) What is the value of the firm immediately after it pays a dividend equal to its cur- rent profits? Answer: (a) The value of the firm is p0(1  g) p0(1  g)2 p0(1  g)3 PVFirm  p0    L (1  i) (1  i)2 (1  i)3 1i  p0 ¢ ≤ ig 1 .1  $100¢ ≤  ($100)(22)  $2,200 million.1 .05 (b) The value of the firm on the ex-dividend date is this amount ($2,200 million) less the current profits paid out as dividends ($100 million), or $2,100 million. Alter- natively, this may be calculated as Ex-dividend  p ¢ 1g PV Firm 0 ≤ ig 1 .05  ($100) ¢ ≤  ($100)(21)  $2,100 million.1 .05 bay23224_ch01_001-036.qxd 12/28/12 7:53 AM Page 19 Rev.Confirming Pages Chapter 1: The Fundamentals of Managerial Economics 19 INSIDE BUSINESS 1–3 Joining the Jet Set Recently, US Airways offered a standard one-year money is paid today. If you pay every three months, you membership into its US Airways Club for $450. Alter- pay $120 today, $120 in three months, $120 in six natively, one could purchase a three-month member- months, and $120 in nine months. Given an interest rate ship for $120. Many managers and executives join air of 8 percent per year, which translates into a quarterly clubs because they offer a quiet place to work or relax rate of 2 percent, the present value of payments is while on the road; thus, productivity is enhanced. Let’s assume you wish to join the club for one $120 $120 $120 PV  $120   2  year. Should you pay the up-front $450 fee for a 1.02 (1.02) (1.02)3 one-year membership or buy four three-month mem- berships at $120 each, for total payments of $480? or For simplicity, let’s suppose the airline will not PV  120  117.65  115.34  113.08 change the three-month fee of $120 over the next  $466.07 year. On the surface it appears that you save $30 by Thus, in present value terms, you save $16.07 if paying for a one-year membership in advance. But you pay for an annual membership in advance. If you this approach ignores the time value of money. Is pay- wish to join for one year and expect three-month fees ing for a full year in advance profitable when you take to either remain constant or rise over the next year, it the time value of money into account? is better to pay in advance. Given the current interest The present value of the cost of membership if you rate, the airline is offering a good deal, but the present pay for one year in advance is $450, since all of that value of the savings is $16.07, not $30. While the notion of the present value of a firm is very general, the simplified formula presented above is based on the assumption that the growth rate of the firm’s profits is constant. In reality, however, the investment and marketing strate- gies of the firm will affect its growth rate. Moreover, the strategies used by com- petitors generally will affect the growth rate of the firm. In such instances, there is no substitute for using the general present value formula and understanding the concepts developed in later chapters in this book. Use Marginal Analysis Marginal analysis is one of the most important managerial tools—a tool we will use repeatedly throughout this text in alternative contexts. Simply put, marginal analysis states that optimal managerial decisions involve comparing the marginal (or incre- mental) benefits of a decision with the marginal (or incremental) costs. For example, the optimal amount of studying for this course is determined by comparing (1) the improvement in your grade that will result from an additional hour of studying and (2) the additional costs of studying an additional hour. So long as the benefits of studying an additional hour exceed the costs of studying an additional hour, it is profitable to continue to study. However, once an additional hour of studying adds more to costs than it does to benefits, you should stop studying. bay23224_ch01_001-036.qxd 12/28/12 7:53 AM Page 25 Rev.Confirming Pages Chapter 1: The Fundamentals of Managerial Economics 25 TABLE 1–2 Incremental Costs and Revenues of the New Drilling Project Current After New Incremental Situation Drilling Project Revenues and Costs Total revenue $1,740,400 $1,923,600 $183,200 Variable cost Drill augers 750,000 840,000 90,000 Temporary workers 500,000 575,000 75,000 Total variable cost 1,250,000 1,415,000 165,000 Direct fixed costs Depreciation—equipment 120,000 120,000 Total direct fixed cost 120,000 120,000 0 Indirect fixed costs Supervisors’ salaries 240,000 240,000 Office supplies 30,000 30,000 Total indirect fixed cost 270,000 270,000 0 Profit $ 100,400 $ 118,600 $18,200 (MB < MC). In this case, the manager should give a “thumbs down” to the second unit, since it adds more to costs than benefits. LEARNING MANAGERIAL ECONOMICS Before we continue our analysis of managerial economics, it is useful to provide some hints about how to study economics. Becoming proficient in economics is like learning to play music or ride a bicycle: The best way to learn economics is to practice, practice, and practice some more. Practicing managerial economics means practicing making decisions, and the best way to do this is to work and rework the problems presented in the text and at the end of each chapter. Before you can be effective at practicing, however, you must understand the language of economics. The terminology in economics has two purposes. First, the definitions and for- mulas economists use are needed for precision. Economics deals with very com- plex issues, and much confusion can be avoided by using the language economists have designed to break down complex issues into manageable components. Sec- ond, precise terminology helps practitioners of economics communicate more effi- ciently. It would be difficult to communicate if, like Dr. Seuss, each of us made words mean whatever we wanted them to mean. However, the terminology is not an end in itself but simply a tool that makes it easier to communicate and analyze different economic situations. Understanding the definitions used in economics is like knowing the difference between a whole note and a quarter note in music. Without such an understanding, it would be very difficult for anyone other than an extremely gifted musician to learn to play an instrument or to communicate to another musician how to play a new song. Given an understanding of the language of music, anyone who is willing to take the time to practice can make beautiful music. The same is true of economics: bay23224_ch01_001-036.qxd 12/28/12 7:53 AM Page 26 Rev.Confirming Pages 26 Managerial Economics and Business Strategy Anyone who is willing to learn the language of economics and take the time to prac- tice making decisions can learn to be an effective manager. ANSWERING THE HEADLINE Why was Ralph fired from his managerial post at Amcott? As the manager of the foreign language division, he probably relied on his marketing department for sales forecasts and on his legal department for advice on contract and copyright law. The information he obtained about future sales was indeed accurate, but apparently his legal department did not fully anticipate all the legal ramifications of distributing Magicword. Sometimes, managers are given misinformation. The real problem in this case, however, is that Ralph did not properly act on the information that was given him. Ralph’s plan was to generate $7 million per year in sales by sinking $20 million into Magicword. Assuming there were no other costs associated with the project, the projected net present value to Amcott of purchasing Magicword was $7,000,000 $7,000,000 $7,000,000 NPV     $20,000,000 (1 .07)1 (1 .07)2 (1 .07)3   $1,629,788 which means that Ralph should have expected Amcott to lose over $1.6 million by purchasing Magicword. Ralph was not fired because of the mistakes of his legal department but for his managerial ineptness. The lawsuit publicized to Amcott’s shareholders, among oth- ers, that Ralph was not properly processing information given to him: He did not recognize the time value of money. KEY TERMS AND CONCEPTS accounting cost manager accounting profits managerial economics constraints marginal analysis consumer–consumer rivalry marginal benefit consumer–producer rivalry marginal cost economic profits marginal net benefit economics net present value (NPV) ex-dividend date opportunity cost explicit cost perpetuity five forces framework present value (PV) future value (FV) producer–producer rivalry goals profit implicit cost resources incentives time value of money incremental cost value of a firm incremental revenue