Session 1

The Fundamentals of
Managerial Economics

Michael R. Baye,
 Economic Mysteries

• Why is airline food so bad?

• Why have paper towels
replaced hot-air hand
dryers in public restrooms?
 More Economic Mysteries

• Why do prices of some goods, like

apples, go down during months of
heaviest consumption, while others
like beachfront cottages, go up?
• Why do National Football League
games cost so much more than major
league baseball games?
 Even More Economic
Mysteries
• Why is gravel made by hand in
Nepal, but by machine in the U.S.?
• Why do color photographs cost less
than black and white photographs?
• Why do manual transmissions have
five forward speeds and automatics
have only four?
 Economics Reasoning Quiz
(Worksheet 1)
The best things in life are free.
 (True or False)
The largest cost of going to
college is tuition, room and
board.
 (True or False)
Economics Reasoning Quiz
 The purpose of economic activity is to
improve the well-being of some people at
the expense of others.
 (True or False)
 Anything worth doing is worth doing well.
 (True or False)
 Life is priceless.
 (True or False)
 Guide to Economics Reasoning
Worksheet 2
PEOPLE ECONOMIZE. People
choose the alternative which seems
best to them because it involves the
least cost and the greatest benefit.
 ALL CHOICES INVOLVE COST.
Cost is the second best choice given
up when people make their best
choice.
Guide to Economics Reasoning

PEOPLE RESPOND TO
INCENTIVES. Incentives are
actions or rewards that
encourage people to act. When
incentives change, people’s
behavior changes in predictable
ways.
Guide to Economics Reasoning
ECONOMIC SYSTEMS
INFLUENCE INDIVIDUAL
CHOICES AND INCENTIVES.
How people cooperate is governed
by written and unwritten rules. As
rules change, incentives change and
behavior changes.
 Guide to Economics Reasoning
VOLUNTARY TRADE CREATES
WEALTH. People can produce
more in less time by concentrating
on what they do best. The surplus
goods or services they produce can
be traded to obtain other valuable
goods or services.
 Guide to Economics Reasoning
THE CONSEQUENCES OF
CHOICES LIE IN THE FUTURE.
The important costs and benefits in
economic decision making are those
which will appear in the future.
Economics stresses making decisions
about the future because it is only the
future that we can influence. We cannot
influence things that have happened in
the past.
 Cost-Benefit Approach to
Decision Making

• C(X) = Cost of doing

activity X
• B(X) = Benefit of doing
activity X
• If B(X) > C(X) then do X
Pitfalls to good decision making
• Ignoring opportunity costs in
making decisions.

Opportunity costs should be included.
• Including sunk costs in making
decisions.

Sunk costs should NOT be included.
 Should I go skiing today?

• B(X) = $50 to you.

• C(X) = $30 for lift ticket
& equipment.
• Do you go skiing?
Should graduate student sell a
car to his father-in-law?
• $10,000 Chevrolet
• Does not have to pay the normal 50%
tariff.
• Car sells for $15,000 in home country.
• Estimates he can sell it for $14,000.
• Father-in-law wants to pay $10,000.
• What is the graduate student’s
opportunity cost if he sells it to his father-
in-law?
What is the opportunity cost of
going to college?
 Why does it make more sense
to attend college at age 20 than
at age 50?
Is it fair to charge interest
when lending a friend some
money?
Why do banks pay interest in
the first place?
 Sunk Costs

• Sometimes an expenditure seems

like a relevant cost when in
reality it is not.
• Sunk costs are beyond recovery
at the moment a decision is
made.
 Should I drive to Boston or
take the bus?
• 250 mile trip
• Bus fare is $100
• Costs of typical 10,000 mile driving
year for your car are:

Insurance $1000

Interest $2000

Fuel, oil $2000
• Total = $5000
• Cost per mile is 5000/10,000 = 50
cents?
 Pizza Experiment
• All you can eat lunch for $3.
• One-half of the tables are given a $3
refund.
• They other half gets no refund.
• What differences do you predict in
the amounts eaten by these two
groups?
 Tickets To A Concert
• Jim wins a ticket from a radio
station.
• Mike paid $18 for a ticket.
• On the evening of the concert there
is a tremendous thunderstorm.
• If they have the same tastes, should
there be a difference in their
behavior as to whether or not to
attend the concert?
Should you keep your business
open for one additional hour?
– Scenario: You are managing a fast
food hamburger restaurant.
– You currently close at 10 pm every
night, but are considering
extending your hours to 11 pm on
weekends.
– What are the relevant
considerations?
Your monthly rent?
Other sunk costs?
The hourly wages you pay your
employees?
Other variable costs associated
with the extra hour?
Your weekly revenues?
Your likely revenues for the extra
hour?
 The Invisible Hand
• Decentralized
• Freedom
• Self-interest
• Motivated by incentives
 Overview of Managerial
Economics
The Economics of Effective
Management
– Identify Goals and Constraints
– Recognize the Role of Profits
– Understand Incentives
– Understand Markets
– Recognize the Time Value of Money
– Use Marginal Analysis
Managerial Economics
 Manager
– A person who directs resources to achieve a
stated goal.
 Economics
– The science of making decisions in the
presence of scare resources.
 Managerial Economics
– The study of how to direct scarce resources
in the way that most efficiently achieves a
managerial goal.
 Economic vs. Accounting Profits
 Accounting Profits
– Total revenue (sales) minus dollar cost
of producing goods or services
– Reported on the firm’s income
statement
 Economic Profits
– Total revenue minus total opportunity
cost
 Opportunity Cost
 Accounting Costs
– The explicit costs of the resources needed to
produce produce goods or services
– Reported on the firm’s income statement
 Opportunity Cost
– The cost of the explicit and implicit resources
that are foregone when a decision is made
 Economic Profits
– Total revenue minus total opportunity cost
 Market Interactions
 Consumer-Producer Rivalry
– Consumers attempt to locate low prices, while
producers attempt to charge high prices
 Consumer-Consumer Rivalry
– Scarcity of goods reduces the negotiating
power of consumers as they compete for the
right to those goods
 Producer-Producer Rivalry
– Scarcity of consumers causes producers to
compete with one another for the right to
service customers
 The Role of Government
– Disciplines the market process
 The Time Value of Money
 Present value (PV) of an amount (FV) to be
received at the end of “n” periods when
the per-period interest rate is “i”:

FV
PV 
1  i  n

Examples?
 Present Value of a Series

 Present value of a stream of future

amounts (FVt) received at the end of
each period for “n” periods:
FV1 FV2 FVn
PV  1  2  . . .
1  i  1  i  1  i  n
 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

FV1 FV2 FVn

N PV  C 0  1  2  . . .
1  i  1  i  1  i  n

NPV < 0: Reject

NPV > 0: Accept
 Firm Valuation
 The value of a firm equals the present
value of all its future profits
– PV = t / (1 + i)t
 If profits grow at a constant rate, g < i,
then:
– PV = i) / ( i - g), current profit level.
 Maximizing Short-Term Profits
– 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.
Marginal (Incremental) Analysis
 Control Variables
– Output
– Price
– Product Quality
– Advertising
– R&D
 Basic Managerial Question: How
much of the control variable should
be used to maximize net benefits?
 Net Benefits

 Net Benefits = Total Benefits -

Total Costs
 Profits = Revenue - Costs
 Marginal Benefit (MB)

 Change in total benefits arising

from a change in the control
variable, Q:
MB = B / Q
 Slope (calculus derivative) of the
total benefit curve
 Marginal Cost (MC)

 Change in total costs arising

from a change in the control
variable, Q:
MC = C / Q
 Slope (calculus derivative) of the
total cost curve
 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
 Marginal Analysis
 The marginal cost of any good or
activity is its opportunity cost
 The opportunity cost is the next best
alternative given up when a decision
is made?
 What is your opportunity cost for
being here today?
 Is it the same for everyone in this
room?
 The Geometry of Optimization
Costs
Benefits & Costs
Benefits
Slope =MB

B
C Slope = MC

Q* Q
 Cancer Screening Program
(Worksheet)
Population Total Annual Total Lives
Screened Cost Saved
60-70 yr. olds $ 80,000 35
50-70 yr. olds $160,000 65
40-70 yr. olds $240,000 85
30-70 yr. olds $320,000 95
20-70 yr. olds $400,000 100
 Mobile Cardiac
Arrest Units
Number of Total Annual Total Lives
Units Cost Saved
1 $ 80,000 100
2 $160,000 150
3 $240,000 175
4 $320,000 190
5 $400,000 200
 Summary
 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)
Relevant Articles & Worksheets

 Worksheets, pp. 1-5, 1-6, and 1-8.

 “Eager to Boost Traffic, More Internet
Firms Give Away Services,”, pp. 1-9
& 1-10.
 “Beyond the Information
Revolution”, pp. 1-11 to 1-18f
 Problem Set #1, worksheets pages 1-
19 and 1-20