01 - Fundamentals Flashcards
Economics
The study of how people use their scarce resources to try to satisfy their unlimited wants.
Manager
A person who directs resources to achieve goals.
Managerial Economics
The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal. The goal is primarily maximizing profits.
Resources
Anything used to produce a good or service or achieve a goal.
Natural Resources Labor Capital Human Social Cultural Management - entrepreneurial ability
Capital
Things used to produce other things. Equipment Human Capital Social Capital Cultural Capital
Scarcity
You can’t always get all you want for free.
When trying to achieve goals, we will face time and resource constraints.
You can’t choose something without giving up something else.
Drives the economics of conservation.
Constraints
The artifacts of scarcity.
Theory
Used to make sense of complex reality.
Like a map - simplified to point of optimal effectiveness.
Nominal Price
Price denominated in money.
Real Price
The nominal price adjusted for the changing value of money.
Real Wage calc.
Base yr Wage =
(Today$ / CPI) x Base yr $
Base yr 1993 = $100 CPI = $263 $10 today in 1993? (10/263)100 = $3.80 So $3.80 in 1993 same as $10 today.
Self Interest
People are interested in filling THEIR goals. NOT that they are selfish.
Explicit Costs
Same as Accounting Costs. Direct outlays of the firm.
Implicit Costs
The cost of giving up the next best or most lucrative use of the resource.
Time is the best example.
Accounting Cost
Explicit cost of a resource. The direct outlays of a firm.
Opportunity Cost
Same as economic costs which include implicit and explicit costs.
Economic Costs
Accounting (explicit) costs + implicit costs.
Economic costs are opportunity costs and include both implicit and explicit costs.
Economic Profit
The difference between total revenue and total economic cost.
Also the difference between total revenue and total opportunity cost.
Economic cost is same as opportunity cost which include explicit + implicit costs
Effective Manager - Goals
Have well defined and effective goals. Inappropriate goals reduce ability to meet customer needs and make a profit.
Effective Manager - Profits
Understand that profits are a signal to where resources are most valued by society.
Effective Manager - Incentives
Understand what what incentives people are facing and how they will respond to those incentives.
Remember that not all people will respond the same way to single incentive.
Effective Manager - Markets
Understand how markets affect the amount of competition between consumers and producers.
Effective Manager - Present Value
Understand present value analysis and the timing of decisions.
Sunk Costs
Costs already incurred that cannot be recovered.
Not relevant to current decisions.
Calculated as original cost minus what can be recovered.
Effective Manager - Activity
Increase or decrease an activity to the point where the marginal value equals the marginal cost.
Five Forces
Developed by Michael Porter
Forces that impact level growth and sustainability of profits.
Entry Substitutes and Compliments Power of Buyers Power of Sellers Rivalry
Five Forces Objectives
- Reduce competition from direct and indirect competitors.
- Dominate over suppliers and buyers.
- Reduce threat of new competitors.
- Innovate through evolutionary improvements.
Incrementally improve existing products to maintain hold on existing customers and attract new customers through critical mass. Work toward a monopolistic state.
Five Forces 1
Entry
Resource costs Speed of adjustment Sunk costs Network effects - cell coverage Reputation Switching costs Govt. constraints
Five Forces 2
Substitutes and Complements
Value of similar substitutes choices
Value of complementary choices
Network effects
Govt. constraints
Five Forces 3
Power of Buyers
Buyer concentration Value of substitute choices Relationship specific investments Customer switching costs Govt. constraints
Five Forces 4
Power of Input Suppliers
Supplier concentration Productivity of input choices Relationship specific investments Supplier switching costs Govt. constraints
Five Forces - 5
Industry Rivalry
Concentration of firms Value of service offered by competitor Degree of differentiation Switching cost Timing of decisions Information access Govt. constraints
Consumer-Consumer Rivalry
Consumer-Producer Rivalry
Producer-Producer Rivalry
Competitive Impact on Industry
Rivalry increases competition which leads to superior performance.
Short run
Firms suppress rivals = profits up, comp dn
Long run
Competitors move in = comp up, profits dn
For reasons above, monopolies weaken industry but advantages are usually short lived.
Principals of Incentives
- Incite action or greater effort
- Determine how resources are used and how hard people work
- Should increase profits
- Unintended outcomes arise when customers intemperate offer as negative signal
- Distinguish between how business is and how you wish it were - goal setting
- Start by assuming everyone is greedy
- Design so if employees are working in their best interest, they are also working in firm’s best interest.
Disruptive Innovation Objectives
Disruptive Innovation by Clayton Christensen is a new application of Joseph Schumpeter’s Creative Destruction.
- Begin with novel solution to former need.
- Introduce in new lower-end market to achieve rapid growth under the radar of established large firms.
- Dominate firms focus on high-end and overlook threat.
- Disruptive solution usually has lower performance but accepted as good enough at far lower price. Disrupter attracts all as new standard.
Present value of a single future value. PV
The amount that would need to be invested today at the prevailing interest rate to generate the given future value.
Present value reflects the difference between the future value and the opportunity cost of waiting.
The higher the interest rate (i) the greater the opportunity cost of waiting.
Present value of a stream of future values. PV
The present value is the sum of each year’s future value estimate. So for each year, divide FV by interest rate estimate to the power of that year.
Net Present Value NPV
Same as Present value of a stream of future values MINUS the current cost of the project.
Important analysis because large future values may mislead mgr. to believe project is worthy. Must not forget to account for economic costs of project execution.
Negative NPV means current funds should be invested elsewhere or costs must be reduced.
Present value of Indefinitely Lived Assets. PVasset
If cash flow CF varies, must add up the present value of CF for each year including the first year.
If CF is consistent and into perpetuity, simply divide the single year CF by the interest rate.
Profit Maximization Principal
Maximizing profits means maximizing value of firm - which is the present value of current and future profits. Similar to PV of indefinitely lived assets.
If annual profit varies, must add up the present value of profit for each year including the first year.
If profit is consistent and into perpetuity, simply divide the single year profit by the interest rate.
Estimating value of firms with constant growth rate.
Adjust each year’s projected annual profit by growth rate before dividing by interest rate estimate.
Long and short formulas-
Subtract any dividends paid from PVfirm for ex-dividend firm value.
Short formula and PVfirm adjustment
Marginal Principle
Marginal Analysis:
One of the most important management tools!
Optimal decisions involve comparing the marginal (incremental) benefits with the marginal costs.
To maximize net benefits, the manager should increase the managerial control variable up to the point where marginal benefits equal marginal costs. This level of the managerial control variable (Q for qty) corresponds to the level at which marginal bet benefits are zero; nothing more can be gained by further changes to that variable.
Do more if MB>MC
Do less if MB
B(Q)
C(Q)
N(Q)
MB(Q)
MC(Q)
MNB(Q)
Q = the variable under the manager's control - the Control Variable B(Q) = total benefit from producing Q units. C(Q) = total costs from producing Q units. N(Q) = total net benefits N(Q) = B(Q) - C(Q)
MB(Q) = change in B(Q) from previous Q MC(Q) = change in C(Q) from previous Q MNB(Q) = change in NB(Q) from previous Q Or MNB(Q) = MB(Q) - MC(Q)
Discrete Decisions
When the Managerial Control Variable is constrained to whole units rather than fractional or continuous values.
Optimal Output Level
Where MB(Q) = MC(Q)
or
MNB(Q) = 0
Marginal Benefit
The additional benefits that arise from use of an additional unit of the managerial control variable.
The marginal benefit is derived from the difference of the benefit at current Q minus benefits from prior level of Q. It is the change in benefits between current and most recent qtys.
When MB(Q) > MC(Q) it makes sense to produce more because more profits can be reaped.
Marginal Cost
The additional costs that arise from use of an additional unit of the managerial control variable.
The marginal cost is derived from the difference of the cost at current Q minus costs from prior level of Q. It is the change in costs between current and most recent qtys.
When MB(Q) < MC(Q) it does NOT make sense to produce more because increasing costs are mitigating profits.
Marginal Net Benefits
The change in net benefits that arise between current and next previous level of Q.
Important:
May also be calculated by
MNB(Q) = MB(Q) - MC(Q)
Maximizing Net Benefits vs Maximizing Total Benefits
Total Benefits B(Q) will always exceed Net Benefits N(Q) because N(Q) takes costs into account.
For an accurate N(Q) value, make sure economic costs ( explicit + implicit) or accounting and opportunity costs are involved in calculation.
Continuous Decisions
Same principles as discrete decisions except managerial control variable can be other than whole units.
The slope (rise/run) of a continuos function (benefit or cost) is the derivative (change in function value / change in control variable).
MB = dB(Q) / dQ MC = dC(Q) / dQ MNB = dN(Q) / dQ
Continuous Variable Analysis
Net benefits are maximized at value Q where difference between B(Q) and C(Q) is the greatest.
The slope of B(Q) = dB(Q) / dQ or MB
The slope of C(Q) = dC(Q) / dQ or MC
The slopes of B(Q) and C(Q) are equal (parallel) when N(Q) is maximized which again means Profits are maximized at MB = MC.
Steps to find maximum level of net $ benefits and Q to achieve so.
Benefit and cost structures will be provided as well as appropriate MB and MC values.
- Identify optimal Q level - set MB = MC and solve for Q.
- Determine maximized net benefit by subtracting cost function from benefit function then solve for $$$ with derived optimal Q level from step 1.
Incremental Decisions
Yes/No decisions
Incremental Revenues are the additional revenues derived from pending decision.
Incremental Costs are the additional costs from same project.
If IR > IC project is a winner.
Don’t add sunk costs to IC but should consider implicit or opportunity costs.
Keys to effective decision making.
- Include all costs and benefits. Do not forget opportunity costs. Don’t be fooled by sunk costs.
- Use appropriate present value analysis when decisions span time.
- Optimal economic decisions are made at the margin using marginal analysis.
Ability to achieve goals is always affected by constraints.
A strong incentive structure:
Aligns worker and employer interests
Offers bonuses based on firm performance
Best implemented locally
Profits improve total welfare by:
Inducing market entry generating competition and choices.
Signaling where scarce resources are most valued.
