Chapter 1 Managers Profits Markets 2016 by Mc
Chapter 1 Managers, Profits, & Markets © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -1
Learning Objectives v Understand why managerial economics relies on microeconomics and industrial organization to analyze business practices and design business strategies. v Explain the difference between economic and accounting profit and relate economic profit to the value of the firm. v Describe how separation of ownership and management can lead to a principal-agent problem when goals of owners and managers are not aligned and monitoring managers is costly or impossible for owners. v Explain the difference between price-taking and price-setting firms and discuss the characteristics of the four market structures. v Discuss the primary opportunities and threats presented by the globalization of markets in business. © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -2
Managerial Economics & Theory v Managerial economics applies microeconomic theory to business problems ~ How to use economic analysis to make decisions to achieve firm’s goal of profit maximization v Economic theory helps managers understand real-world business problems ~ Uses simplifying assumptions to turn complexity into relative simplicity © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -3
Microeconomics v Microeconomics ~ Study of behavior of individual consumers, business firms, and markets v Business practices or tactics ~ Routine business decisions managers must make to earn the greatest profit under prevailing market conditions ~ Using marginal analysis, microeconomics provides the foundation for understanding everyday business decisions © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -4
Microeconomics v Industrial organization ~ Specialized branch of microeconomics focusing on behavior and structure of firms and industries ~ Provides foundation for understanding strategic decisions through application of game theory © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -5
Strategic Decisions v Business actions taken to alter market conditions and behavior of rivals ~ Increase/protect strategic firm’s profit v While common business practices are necessary for the goal of profitmaximization, strategic decisions are generally optimal actions managers can take as circumstances permit © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -6
Economic Forces that Promote Long-Run Profitability (Figure 1. 1) © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -7
Economic Cost of Resources v Opportunity cost is: ~ What firm owners must give up to use resources to produce goods and services v Market-supplied resources ~ Owned by others and hired, rented, or leased v Owner-supplied resources ~ Owned and used by the firm © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -8
Total Economic Cost v Total Economic Cost ~ Sum of opportunity costs of both marketsupplied resources and owner-supplied resources v Explicit Costs ~ Monetary opportunity costs of using marketsupplied resources v Implicit Costs ~ Nonmonetary opportunity costs of using owner -supplied resources © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -9
Types of Implicit Costs v Opportunity cost of cash provided by owners ~ Equity capital (money provided to businesses by the owners) v Opportunity cost of using land or capital owned by the firm v Opportunity cost of owner’s time spent managing or working for the firm © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -10
Economic Cost of Using Resources (Figure 1. 2) + = © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -11
Economic Profit vs. Accounting Profit Economic profit = Total revenue – Total economic cost = Total revenue – Explicit costs – Implicit costs Accounting profit = Total revenue – Explicit costs v Accounting profit does not subtract implicit costs from total revenue v Firm owners must cover all costs of all resources used by the firm ~ Objective is to maximize profit © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -12
Maximizing the Value of a Firm v Value of a firm ~ Price for which it can be sold ~ Equal to the present value of expected future profits v Risk premium ~ An increase in the discount rate to compensate investors for uncertainty about future profits ~ The larger the risk, the higher the risk premium, and the lower the firm’s value © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -13
Maximizing the Value of a Firm v Maximize firm’s value by maximizing profit in each time period ~ Cost & revenue conditions must be independent across time periods v Value of a firm = © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -14
Some Common Mistakes Managers Make v Never increase output simply to reduce average costs v Pursuit of market share usually reduces profit v Focusing on profit margin won’t maximize total profit v Maximizing total revenue reduces profit v Cost-plus pricing formulas don’t produce profit-maximizing prices © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -15
Principal-Agent Relationship v Relationship formed when a business owner (the principal) enters an agreement with an executive manager (the agent) whose job is to formulate and implement tactical and strategic business decisions that will further the objectives of the business owner (the principal). © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -16
Separation of Ownership & Control v Principal-agent problem ~ A manager takes an action or makes a decision that advances the interests of the manager but reduces the value of the firm. v Complete contract ~ An employment contract that protects owners from every possible deviation by managers from value-maximizing decisions. © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -17
Separation of Ownership & Control v Hidden actions ~ Actions or decisions taken by managers that cannot be observed by owners for any feasible amount of monitoring effort. v Moral Hazard ~ A situation in which managers take hidden actions that harm the owners of the firm but further the interests of the managers. © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -18
Corporate Control Mechanisms v Internal control mechanisms ~ Require managers to hold stipulated amount of firm’s equity ~ Increase percentage of outsiders serving on board of directors ~ Finance corporate investments with debt instead of equity v External mechanism ~ Corporate takeovers © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -19
Price-Takers vs. Price-Setters v Price-taking firm ~ Cannot set price of its product ~ Price is determined strictly by market forces of demand & supply v Price-setting firm ~ Can set price of its product ~ Has a degree of market power, which is the ability to raise price without losing all sales © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -20
What is a Market? v A market is any arrangement through which buyers & sellers exchange anything of value v Markets reduce transaction costs ~ Costs of making a transaction happen, other than the price of the good or service itself © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -21
Market Structures v Market characteristics that determine the economic environment in which a firm operates ~ Number and size of firms in market ~ Degree of product differentiation among competing firms ~ Likelihood of new firms entering market when incumbent firms are earning economic profits © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -22
Perfect Competition v Large number of relatively small firms v Undifferentiated product v Price takers with no market power v No barriers to entry ~ Any economic profit earned will vanish as new firms enter © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -23
Monopoly v Single firm v Produces product with no close substitutes v Protected by a barrier to entry ~ Allows the monopolist to raise its price without concern that economic profits will attract new firms © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -24
Monopolistic Competition v Large number of relatively small firms v Differentiated products ~ Gives the monopolistic competitor some degree of market power v Price setters v No barriers to entry ~ Ensures any economic profits will be bid away by new entrants © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -25
Oligopoly v Few firms produce all or most of market output v Profits are interdependent ~ Actions by any one firm will affect sales and profits of the other firms © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -26
Globalization of Markets v Economic integration of markets located in nations around the world ~ Provides opportunity to sell more goods & services to foreign buyers ~ Presents threat of increased competition from foreign producers © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -27
Summary v Managerial economics applies concepts/theories from microeconomics and industrial organization ~ Marginal analysis provides the foundation for everyday business practices or tactics v Opportunity cost of using any resource is what the firm owners must give up to use the resource ~ Unlike economic profit, accounting profit does not subtract implicit (opportunity) costs from total revenue v With the separation of ownership and management, a principalagent problem can arise because owners cannot be certain that managers are making decisions to maximize the value of the firm v For price-taking firms, price is determined solely by market forces of supply and demand, while price-setters have some degree of market power to set price © 2016 by Mc. Graw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 -28
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