Nature and Scope of Managerial Economics (Chapter 1 Hirschey )

1. Nature and Scope of Managerial Economics (Chapter 1 Hirschey) INTRODUCTION

2. Nature and Scope of Managerial Economics • Definition of Managerial Economics • Application of economic tools and techniques to business and administrative decision-making; another term for the title of this course, namely economic analysis for agribusiness and management. • Helps decision-makers recognize how economic forces affect organizations and describes the economic consequences of managerial behavior. How? By linking economic concepts and quantitative methods to develop tools for managerial decision-making. • Simply put, managerial economics uses economic concepts and quantitative methods to solve managerial problems. • We place emphasis on the practical application of economic analysis to managerial decision problems; the primary virtue of managerial economics lies in its usefulness.

3. Economic Concepts • Economic concepts: • influence which products to produce, which costs to consider, and the prices to charge; • necessitates the collection, organization, and analysis of information. • Emphasis is placed on microeconomic topics, although macroeconomic relations have implications for managerial decision-making as well.

4. Economic decision-making requires the following: • Optimization techniques (calculus-based and linear programming) • Statistical relations • Demand analysis and estimation (through regression) • Forces of demand and supply • Forecasting of firm activities (sales, production, demand, prices) • Risk analysis

5. Firms • Firms are useful for producing and distributing goods and services • Motivation for firms: • profit maximization or expected value maximization; free enterprise depends upon profits and the profit motive • Expected value of maximization: • optimization of profits in light of uncertainty and time value of money.

6. Value of the firm + …

7. Example: Value of the firm • Suppose that Chevron Corporation makes projections of profits (expected profits) over the next five years: • 2011 = $18,690 million • 2012= $15,560 million • 2013= $14,935 million • 2014= $20,125 million • 2015= $24,585 million

8. Example, cont. • Let the discount rate be equal to three percent. Calculate the value of Chevron Corporation today. • Value of the firm ( in millions) = • Value of the firm discounted back to the present = $_____________ million 85,653

9. Expected value maximization • Expected value maximization relates to the various functional departments of the firm; also illustrates the value of forecasting • TR: marketing department, primary responsibility for promotion and sales • TC: production department, primary responsibility for costs • i: finance department, primary responsibility for the acquisition of capital and hence the discount factor i.

10. Total Revenue and Total Costs • The determination of TR and TC is a non-trivial and often complex task. • Suppose that a firm produces only one product. • TRt = PtQt-1 requires the notion of a demand function • TCt = fixed costst + variable costst • Variable costs are a function of Q TCt = f(Qt) • Even more complex situation if a firm produces more than one product.

11. Firm faces constraints • Skilled labor • Raw materials • Energy • Specialized machinery • Warehouse space • Amount of investment funds available for a particular project or activity • Legal /contractual restrictions • Consequently, optimization techniques with constraints are important in decision-making • Linear programming • Calculus-based optimization

12. Profit measurement • Business Profit: • = TR – TC • the residual of sales revenue minus the explicit costs of doing business. • Economic Profit: • = business profit minus the implicit costs of capital and any other owner-provided inputs • reflects the opportunity cost for the effort of the owner-entrepreneur.

13. Profit measurement • Opportunity Costs: • Owner-provided inputs are a notable part of business profits, especially among small businesses. • Profit Margin: • = business profit (net income)/sales, • Expressed as a percent

14. Example: Profit Margin • In 2007, the sales revenue of the American Express Company was $27,136 million. The Business profit or net income for this firm was $3,729 million. What was the profit margin for the American Express Company? Profit Margin = b

15. Equity • Return on Equity(ROE) • business profit (net income)/equity • Expressed as a percent • Equity • total assets – total liabilities = net worth=equity

16. Example: ROE • In 2007, the net income for Microsoft Corporation was $11,909 million. The equity (or net worth) of this firm was $36,708 million. What is the ROE for Microsoft Corporation? ROE =