Lecture 1: Economic Issues in Management

ECON 2106

Managerial Economics
ECON 2106: Managerial Economics Prof. Colin Mang, 2011

Lecture 1: Economic Issues in Management

The Manager
An Effective Manager Must
1. Identify the goals of the organization 2. Understand the constraints facing production (budgetary, legal, environmental, labour related, etc.) 3. Recognize the importance of Profits 4. Understand Incentives 5. Understand Markets 6. Understand the Time Value of Money 7. Be able to use Marginal Analysis
ECON 2106: Managerial Economics Prof. Colin Mang, 2011

Lecture 1: Economic Issues in Management

Economic vs. Accounting Profits

Opportunity Cost
To undertake one activity, you must forego another We can call it an Implicit Cost because we dont actually have to pay for it the way we would an Explicit Cost Effective managers must always consider the implicit costs of a decision, otherwise they may be foregoing a valuable opportunity

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 1: Economic Issues in Management

Economic vs. Accounting Profits

Accounting Profits
Appear on a Firms Balance Sheet Include Only Explicit Costs

Economic Profits
Include both Explicit AND Implicit Costs

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 1: Economic Issues in Management

Economic vs. Accounting Profits

Ex. For an Individual
John must decide whether to invest his $1000 in some stock from AB Corporation (ABC) or in a Federal Bond paying 4% and maturing in 1 year. John opts for the stock, and after a stellar year of sales, ABC stock rises 9%. Calculate Johns Accounting and Economic Profits.
ECON 2106: Managerial Economics Prof. Colin Mang, 2011

Lecture 1: Economic Issues in Management

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 1: Economic Issues in Management

Economic vs. Accounting Profits

Ex. For a Firm
ABC must decide whether to spend $100,000 on a new marketing campaign or on new Research and Development. The Marketing campaign is projected to increase accounting profits by $300,000 while increased R&D would develop a new product bringing in $500,000. In the end, ABC opts for the marketing campaign. Calculate the Accounting and Economic Profits.
ECON 2106: Managerial Economics Prof. Colin Mang, 2011

Lecture 1: Economic Issues in Management

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 1: Economic Issues in Management

Economic Profits
Economic Profits are a way of making comparisons, of evaluating the true benefits of a decision Economic Profits can also be used for comparison across companies

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 1: Economic Issues in Management

Economic Profits
A common use of Economic Profits is in evaluating investor returns

Economic Profit () = Accounting Profit NRR

Normal Rate of Return (NRR)
How much a firm should pay its investors, some benchmark level of profitability (could be the average of all firms in the market) The return will vary across industries depending on the level of risk
ECON 2106: Managerial Economics Prof. Colin Mang, 2011

Lecture 1: Economic Issues in Management

Positive Economic Profits

Any Firm with Economic Profits is MORE PROFITABLE than other firms

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 1: Economic Issues in Management

Negative Economic Profits

These firms may still have Accounting Profits (Revenues exceed Explicit Costs) However, they are underperforming the market Their Accounting Profit (what they actually earn for their shareholders) is less than what they should be earning Their Accounting Profit could be negative as well
ECON 2106: Managerial Economics Prof. Colin Mang, 2011

Lecture 1: Economic Issues in Management

Porters Five Forces Affecting Profitability Entry Power of Input Suppliers Industry Rivalry
ECON 2106: Managerial Economics

Power of Buyers

Substitutes / Complements
From: Michael Porter, Competitive Strategy (1980)

Prof. Colin Mang, 2011

Lecture 1: Economic Issues in Management

Marginal Analysis
When making decisions, Managers will consider the Marginal implications of their actions Marginal Benefit (MB)
Increase in Total Benefits accruing from the decision

Marginal Cost (MC)

Increase in Total Costs accruing from the decision
ECON 2106: Managerial Economics Prof. Colin Mang, 2011

Lecture 1: Economic Issues in Management

Marginal Analysis
Marginal Net Benefit (MNB)

MNB = MB MC
A Manager should ONLY consider courses of action that have a positive MNB
ECON 2106: Managerial Economics Prof. Colin Mang, 2011

Lecture 1: Economic Issues in Management

Marginal Analysis
If for some action the MB > MC, then undertaking more of that action increases profitability The Maximum Net Benefit always occurs when MB = MC ( or MNB = 0 ) Beyond that point, since MB < MC, the costs of further action outweigh the benefits and profitability declines
ECON 2106: Managerial Economics Prof. Colin Mang, 2011

Lecture 1: Economic Issues in Management

Time Value of Money

Canadian Consumer Price Index 1950-2010
1950 = $1 (2005 Basket)

10 9 8 7 Dollars 6 5 4 3 2 1 0

Remember that money in the future is worth less than money today Why? Because inflation erodes the value of cash (remember Macro class)

19 50 19 54 19 58 19 62 19 66 19 70 19 74 19 78 19 82 19 86 19 90 19 94 19 98 20 02 20 06 20 10

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 1: Economic Issues in Management

Time Value of Money

Any time we consider either revenues or expenses that will be accrued some time in the future we must convert or discount their dollar value back into current dollars using the formula:

$X PV = n (1 + i )
ECON 2106: Managerial Economics

where $X is the future amount, n is the numbers of periods into the future we will receive/pay the money, and i is the per period discount/interest rate
Prof. Colin Mang, 2011

Lecture 1: Economic Issues in Management

Uncertainty
In a previous example, the AB Corporation had to choose between a marketing campaign and an R & D project; however, it is unlikely that the benefits to either enterprise would be known with certainty At times throughout the course, we will consider the impact of uncertainty and incomplete information and their impact on the decision making process
ECON 2106: Managerial Economics Prof. Colin Mang, 2011