L-1 Introduction.pdf

Managerial Economics – An Introduction Introduction Human Nature and Reality People have unlimited wants. People have limited resources to acquire the things they want. As a result, they must make choices (trade-offs). Choices involve pursuing some things while forgoing others...

Managerial Economics – An Introduction Introduction Human Nature and Reality People have unlimited wants. People have limited resources to acquire the things they want. As a result, they must make choices (trade-offs). Choices involve pursuing some things while forgoing others (Opportunity cost). The choices we make depend on the incentives we face. An incentive is a reward that encourages an action or a penalty that discourages an action. Incentives have two pieces: Measure performance Reward good performance Introduction Economics Defined Economics is the study of how individuals and societies choose to use the scarce resources that nature and previous generations have provided. Alternately, “Economics deals with the allocation of scarce resources to satisfy unlimited wants”. The keywords in the above definition is choose and scarce. Economics is a behavioural, or social, science. In large measure it is the study of how people make choices. The choices that people make, when added up, translate into societal choices. Because economics studies the actions of individuals, it is a social science. Economics is therefore similar to other social science disciplines, such as psychology, political science, and sociology. As a social science, economics considers human behavior - particularly decision-making behavior - in every context, not just in the context of business. Scarcity: The situation in which unlimited wants exceed the limited resources available to fulfil those wants. Introduction Need to understand individual motives to determine what choices they will make The rational-actor paradigm assumes that people act rationally, optimally, and self-interestedly. To change behavior, you have to change incentives. Can include possibility that someone might care about someone else’s well-being (e.g. children’s welfare, charity) Same motivation even if acting as consumer, firm, or employee Microeconomics and Macroeconomics Microeconomics The branch of economics that examines the functioning of the economy at the level of individual consumers, workers, firms, goods, and markets. looks at the individual unit - the household, the firm, the industry. It sees and examines the “trees.” Macroeconomics The branch of economics that examines the economic behavior of aggregates - income, employment, output, and so on - on a national scale. looks at the whole, the aggregate. It sees and analyzes the “forest.”  The Scope of Economics Examples of Microeconomic and Macroeconomic Concerns DIVISION OF ECONOMICS PRODUCTION PRICES INCOME EMPLOYMENT Microeconomics Production/output in individual Price of individual Distribution of Employment by individual industries and businesses goods and services income and wealth businesses and industries Price of medical care Jobs in the steel How much steel Price of gasoline Wages in the auto industry How much office space Food prices industry Number of employees in a How many cars Apartment rents Minimum wage firm Executive salaries Number of accountants Poverty Macroeconomics National production/output Aggregate price level National income Employment and unemployment in the economy Consumer prices Total industrial output Producer prices Total wages and Total number of jobs Gross domestic product Rate of inflation salaries Unemployment rate Growth of output Total corporate profits Managerial Economics Managerial economics applies microeconomic theory to business problems How to use economic analysis to make decisions to achieve firm’s primary goal of maximizing the value of the firm/ profit maximization, and do so most efficiently Mathematical Economics Expresses and analyzes economic models using the tools of mathematics. Econometrics Employs statistical methods to estimate and test economic models using empirical data. Economics and Managerial Decision Making 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? Should our firm be in this business? If so, what price and output levels achieve our goals? Economics and Managerial Decision Making 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? Economics and Managerial Decision Making 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 Economic Systems Institutions, including laws and customs, define a society’s procedures for allocating resources Centrally planned/Communist economy Economic decisions are highly centralized The state owns and controls the means of production and distribution Market/Capitalist economy Means of production are owned and controlled by and for the benefit of private individuals Resources are allocated by voluntary trading among businesses and consumers No economy is completely centralized or decentralized; all economies are a combination of both. Examine statistics on the size of government for a rough measure of centralization The Method of Economics All Else Equal: Ceteris Paribus ceteris paribus, or all else equal: A device used to analyze the relationship between two variables while the values of other variables are held unchanged. Using the device of ceteris paribus is one part of the process of abstraction - so that changes due to the factor being studied may be examined independently of those other factors. In formulating economic theory, the concept helps us simplify reality to focus on the relationships that interest us. Expressing Models in Words, Graphs, and Equations The most common method of expressing the quantitative relationship between two variables is graphing that relationship on a two-dimensional plane. Factors of Production Goods and services are produced by using productive resources that economists call factors of production. Factors of production are grouped into four categories: Land - The “gifts of nature” that we use to produce goods and services Labor - The work time and work effort that people devote to producing goods and services. The quality of labor depends on human capital, which is the knowledge and skill that people obtain from education, on-the-job training, and work experience. Capital - The tools, instruments, machines, buildings, and other constructions that businesses use to produce goods and services. Entrepreneurship - The human resource that organizes land, labor, and capital  Production Possibility Frontier (PPF) If a country produces only computers and TVs, million Computers using all their resources: it can produce 10 million computers and 5 10 A million TVs, or it can produce 6 million computers and 12 million TVs. 6 B 5 12 million Televisions 14  Production Possibility Frontier (PPF) PPF is a line that shows combinations million Computers of goods a country can make using all of its productive resources. 10 A It shows tradeoffs a country has to face. By moving from one point to another 6 B on PPF, a country has to give up production of one good for another. 5 12 million Televisions 15 Production Possibility Frontier (PPF) Inside PPF million Computers = Not using all resources = Can produce more of both D Outside PPF = Production is not possible C million Televisions 16  Production Possibility Frontier (PPF) Increase in wealth results from increase in Computers production. Specialization = developing high skills by concentrating on only one task. High skills = more and better production. New PPF after innovation Innovation = Finding new improved ways for production. = Increase in production possibility shifts PPF outwards. Old PPF Televisions 17 What is a Market? Market A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade, to determine the price of a product or set of products. Market Characteristics Markets include buyers and sellers May be governed by explicit rules (e.g., BSE; NYSE) or by custom (e.g., open bazaar) Often, but not always, sellers are companies and buyers are individuals Trade in modern markets is usually governed by price, the rate at which someone can swap money for a good or service (Price of factors of production?) Markets can function only if a system of transferable property rights is established and enforced Markets reduce transaction costs i.e. costs of making a transaction other than the price of the good or service  Class Exercise Goal Alignment at a Small Manufacturing Concern The owners of a small manufacturing concern have hired a manager to run the company with the expectation that he will buy the company after five years. Compensation of the new vice president is a flat salary plus 75% of first $150,000 of profit, and then 10% of profit over $150,000. Purchase price for the company is set as 4½ times earnings (profit), computed as average annual profitability over the next five years. Does this contract align the incentives of the new vice president with the goals of the owners? Class Exercise Goal Alignment at a Small Manufacturing Concern Q: The owners of a small manufacturing concern have hired a manager to run the company with the expectation that he will buy the company after five years. Compensation of the new vice president is a flat salary plus 75% of first $150,000 of profit, and then 10% of profit over $150,000. Purchase price for the company is set as 4½ times earnings (profit), computed as average annual profitability over the next five years. Does this contract align the incentives of the new vice president with the goals of the owners? No. Both the purchase price and the profit sharing create perverse incentives. The VP keeps $0.75 of each dollar earned up to $150,000, but only $0.10 of each dollar earned after $150K. Since earning more requires more effort (increasing marginal effort), the manager has little incentive to earn more than $150,000. And every dollar the VP earns raises the price that he will eventually pay for the company by $4.50, effectively penalizing him for increasing company profitability.