Managerial Economics &

Business Strategy
Chapter 1
The Fundamentals of Managerial
Economics

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
I. Introduction Overview

II. The Economics of Effective

Management Identify Goals and Constraints
Q

Q Recognize the Role of Profits

Q Understand Incentives

Q Five Forces Model

Q Understand Markets

Q Recognize the Time Value of Money

Q Use Marginal Analysis

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006

Managerial Economics
• Manager
Q A person who directs resources to achieve a stated goal.
• Economics
Q The science of making decisions in the presence of
scare resources.
• Managerial Economics
Q The study of how to direct scarce resources in the way
that most efficiently achieves a managerial goal.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006

Economic vs. Accounting

Profits
• Accounting Profits
Q Total revenue (sales) minus dollar cost of producing
goods or services.
Q Reported on the firm’s income statement.

• Economic Profits
Q Total revenue minus total opportunity cost.Michael R.

Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006

Opportunity Cost
• Accounting Costs
Q The explicit costs of the resources needed to produce
produce goods or services.
 Q Reported on the firm’s income statement.
• Opportunity Cost
Q The cost of the explicit and implicit resources that are
foregone when a decision is made.
• Economic Profits
Q Total revenue minus total opportunity cost.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006

The Five Forces Framework

Power of ∙Speed of Adjustment ∙Sunk Entry ∙Reputation Power of
∙Entry Costs Costs ∙Network Effects ∙Switching Costs
∙Economies of Scale ∙Government Restraints
Input Suppliers Industry Rivalry Substitutes & Complements
∙Supplier Concentration ∙Concentration
∙Price/Productivity of ∙Price, Quantity, Quality, or Service
Alternative Inputs Competition
Sustainable Industry Profits ∙Degree of Differentiation
∙Relationship-Specific
Investments Buyers ∙Switching Costs
∙Supplier Switching Costs ∙Buyer Concentration ∙Timing of Decisions ∙Information
∙Government Restraints ∙Price/Value of Substitute ∙Government Restraints
Products or Services ∙Price/Value of Surrogate Products ∙Network
∙Relationship-Specific Effects or Services ∙Government ∙Price/Value
Investments of Complementary Restraints Products or
∙Customer Switching Costs Services
∙Government Restraints

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006

Market Interactions
• Consumer-Producer Rivalry
Q Consumers attempt to locate low prices, while producers
attempt to charge high prices.
• Consumer-Consumer Rivalry
Q Scarcity of goods reduces the negotiating power of
 consumers as they compete for the right to those goods. •
Producer-Producer Rivalry
Q Scarcity of consumers causes producers to compete with
one another for the right to service customers.
• The Role of Government
Q Disciplines the market process.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006

The Time Value of Money

• Present value (PV) of a lump-sum amount
(FV) to be received at the end of “n” periods
when the per-period interest rate is “i”:
FV (1+ i)n
• Examples: PV =

Q Lotto winner choosing between a single lump-sum payout of $104

million or $198 million over 25 years.
Q Determining damages in a patent infringement case. Michael R.

Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006

Present Value of a Series

• Present value of a stream of future amounts
(FVt) received at the end of each period for
“n” periods:

PV = FV1 (1+ i)1 + FV2 (1+ i)2

+...+ FVn (1+ i)n

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006

Net Present Value

• Suppose a manager can purchase a stream of
future receipts (FVt) by spending “C0” dollars
today. The NPV of such a decision is

NPV = (1+ i)1 + FV2 +...+ (1+ i)n − C0

FV1 (1+ i) 2
FVn
 Decision Rule:
If NPV < 0: Reject project
NPV > 0: Accept project

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006

Manajer dari Automated Products menimbang pembelian sebuah

mesin baru seharga $300.000 dan memiliki masa manfaat lima
tahun. Mesin ini akan menghasilkan (akhir tahun) pengurangan
biaya Automated Products $50.000 pada tahun 1, $60.000 pada
tahun 2, $75.000 pada tahun 3, dan $90.000 pada tahun 4 dan 5.
Berapakah nilai sekarang bersih dari penghematan biaya mesin
jika suku bunga 8%? Haruskah manajer membeli mesin tersebut?
Jawab:
���� =50.000
60.000
(1+0,8)+
2
(1+0,8) +75.000
 3
(1+0,8) +90.000
4
(1+0,8) +90.000
5
(1+0,8)

= $284.679
Sehingga NPV = PV - ��0 = $284.679 - $300.000 = -$15.321
Karena nilai sekarang dari mesin negative, manajer seharusnya tidak
membeli mesin. Dengan kata lain, manajer dapat menghasilkan
lebih banyak dengan menginvestasikan $300.000 pada bunga 8%
dibandingkan menghabiskan uang untuk teknologi yang menghemat
biaya
Present Value of a Perpetuity
• An asset that perpetually generates a stream of cash flows
(CF) at the end of each period is called a perpetuity. • The
present value (PV) of a perpetuity of cash flows paying the
 same amount at the end of each period is

CF CF CF
PVPerpetuity (1 + i) 23
+ ...
=++ (1 + i) (1 + i) CF
= i

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006

Firm Valuation
• The value of a firm equals the present value of current and
future profits.
Q PV = Σ πt / (1 + i)t
• If profits grow at a constant rate (g < i) and current period
profits are πο:
 1+i before current profits have been paid out as
PV = π
dividends;
Firm 0
i−g

PV Ex−Dividend
Firm immediately after current dividends.
1+g0 profits are paid out as
=π i−g

• If the growth rate in profits < interest rate and both remain
constant, maximizing the present value of all future
profits is the same as maximizing current profits.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006

Marginal (Incremental)
Analysis
• Control Variables
 Q Output
Q Price

Q Product Quality

Q Advertising

Q R&D

• Basic Managerial Question: How much of

the control variable should be used to
maximize net benefits?
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006

Net Benefits
• Net Benefits = Total Benefits - Total
Costs • Profits = Revenue - Costs
 Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006

Marginal Benefit (MB)

• Change in total benefits arising from a change
in the control variable, Q:

MB =ΔB
ΔQ
• Slope (calculus derivative) of the total benefit
curve.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Marginal Cost (MC)
• Change in total costs arising from a change in
the control variable, Q:

MC =ΔC
ΔQ
• Slope (calculus derivative) of the total cost
curve

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Marginal Principle
• To maximize net benefits, the managerial
control variable should be increased up to
the point where MB = MC.
• MB > MC means the last unit of the control
variable increased benefits more than it
increased costs.
• MB < MC means the last unit of the control
variable increased costs more than it
increased benefits.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 The Geometry of Optimization
Total
Benefits
& Total
C
Costs
osts
Ben
efits
Slope
=MB

B
Slope
C
= MC
Q* Q
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006

Conclusion
• Make sure you include all costs and benefits
when making decisions (opportunity cost). •
When decisions span time, make sure you are
comparing apples to apples (PV analysis).
• Optimal economic decisions are made at the
margin (marginal analysis).

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006