Scope of Managerial Economics

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Q1.
 
Yes. Firms represent a combination of people, physical assets, and information (financial, technical, marketing, and so on). People directly involved include stockholders, managers, workers, suppliers, and customers. Businesses use scarce resources that would otherwise be available for other purposes, pay income and other taxes, provide employment opportunities, and are responsible for much of the material well-being of our society. Thus, all of society is indirectly involved in the firm’s operation. Firms exist because they are useful in the process of allocating resources --producing and distributing goods and services. As such, they are basically economic entities

Q2.

A. The most direct effect of a requirement to install new pollution control equipment would be an increase in the operating cost component of the valuation model. Secondary effects might be expected in the discount rate due to an increase in regulatory risk, and in the revenue function if consumers react positively to the installation of the pollution control equipment in production facilities.

B. All three major components of the valuation model--the revenue function, cost function, and the discount rate--are likely to be affected by an increase in advertising. Revenues and cost will both increase as output is expanded. The discount rate may be affected if the firm's profit outlook changes significantly because of increased demand (growth) or if borrowing is necessary to fund a rapid expansion of plant and equipment to meet increased demand.

C. The primary effect of newer and more efficient production equipment is a reduction in the total cost component of the valuation model. Secondary effects on firm revenues could also be important if lower costs make price reductions possible and result in an increase in the quantity demanded of the firm's products. Likewise, the capitalization rate or discount factor can be affected by the firm’s changing prospects.

D. The time pattern of revenues is affected by such a pricing decision to raise prices in the near term. This will alter production relationships and investment plans, and affect the valuation model through the cost component and capitalization factor.

E. A general lowering of interest rates leads to a reduction in the cost of capital or discount rate in the valuation model.

F. Higher rates of inflation, leading to an increase in the discount rate, cause the present value of a constant income stream to decline. Unless the firm is able to increase product prices in order to maintain profit margins, the value of the firm falls as inflation and the discount rate increases. Of course, the economic effects of inflation on the economic value of the firm are complex, involving both asset and liability valuations, so determining the overall effect of inflation on the economic value of individual firms is a difficult task

Q3.

The economic profit concept provides the most appropriate basis for evaluating the operations of a business since it allows for a risk-adjusted normal rate of return on all capital devoted to the enterprise. Even when business profits are substantial, economic profits can sometimes be negative given the effects of risk, inflation, and other factors. Substantial business profits are no guarantee to the growth, or even maintenance, of capital investment. In actual practice, investors adjust reported accounting data to account for additional factors that must be considered

Q4.

A. Interesting perspective on the characteristics of wonderful businesses has been given by legendary Wall Street investors T. Rowe Price and Warren E. Buffett. The late T. Rowe Price was founder of Baltimore-based T. Rowe Price and Associates, Inc., one of the largest no-load mutual fund organizations in the United States, and the father of the “growth stock" theory of investing. According to Price, attractive growth stocks have low labor costs, superior...
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