Managerial Economics

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KEY CONCEPTS
• managerial economics • theory of the firm • expected value maximization • value of the firm • present value • optimize • satisfice • business profit • normal rate of return • economic profit • profit margin • return on stockholders' equity • frictional profit theory • monopoly profit theory • innovation profit theory • compensatory profit theory

Managers, Profits, and Markets

Chapter 1

How Is Managerial Economics Useful?
• Evaluating Choice Alternatives

• Identify ways to efficiently achieve goals. • Specify pricing and production strategies. • Provide production and marketing rules to help maximize net profits.

• Making the Best Decision

• Managerial economics can be used to efficiently meet management objectives. • Managerial economics can be used to understand logic of company, consumer, and government decisions.

Managerial Economics & Theory
• Managerial economics applies microeconomic theory to business problems • How to use economic analysis to make decisions to achieve firm’s goal of profit maximization

Theory of the Firm
• Expected Value Maximization
• Owner-managers maximize short-run profits. • Primary goal is long-term expected value maximization.

• Constraints and the Theory of the Firm
• Resource constraints. • Social constraints

• Microeconomics
• Study of behavior of individual economic agents

• Limitations of the Theory of the Firm

• Alternative theory adds perspective. • Competition forces efficiency. • Hostile takeovers threaten inefficient managers.

1

Profit Measurement
• Business Versus Economic Profit
§

Economic Cost of Resources
• Opportunity cost of using any resource is:

Business (accounting) profit reflects explicit costs and revenues. Economic profit. – Profit above a risk -adjusted normal return. – Considers cash and noncash items.

• What firm owners must give up to use the resource • Owned by others & hired, rented, or leased • Owned & used by the firm

§

• Market-supplied resources

• Variability of Business Profits
§

• Owner-supplied resources

Business profits vary widely.

Total Economic Cost
• Total Economic Cost
• Sum of opportunity costs of both market-supplied resources & ownersupplied resources • Monetary payments to owners of market-supplied resources • Nonmonetary opportunity costs of using owner-supplied resources

Economic Cost of Using Resources (Figure 1.1)
Explicit Costs
of Market-Supplied Resources The monetary payments to resource owners

+
Implicit Costs
of Owner-Supplied Resources The returns forgone by not taking the owners’ resources to market

• Explicit Costs

• Implicit Costs

=

Total Economic Cost
The total opportunity costs of both kinds of resources

Types of Implicit Costs
• Opportunity cost of cash provided by owners
• Equity capital

Economic Profit versus Accounting Profit
• Economic profit = Total revenue – Total economic cost = Total revenue – Explicit costs – Implicit costs • Accounting profit = Total revenue – Explicit costs

• Opportunity cost of using land or capital owned by the firm • Opportunity cost of owner’s time spent managing or working for the firm

• Accounting profit does not subtract implicit costs from total revenue • Firm owners must cover all costs of all resources used by the firm • Objective is to maximize economic profit

2

Maximizing the Value of a Firm
• Value of a firm
• Price for which it can be sold • Equal to net present value of expected future profit • Accounts for risk of not knowing future profits • The larger the rise, the higher the risk premium, & the lower the firm’s value

Maximizing the Value of a Firm
• Maximize firm’s value by maximizing profit in each time period • Cost & revenue conditions must be independent across time periods

• Risk premium

• Value of a firm =
T π1 π2 πT πt + + ... + =∑ 2 T t (1 + r ) (1 + r ) (1+ r ) t =1 (1 + r )

Separation of Ownership & Control
•...
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