Manecon 1
Manecon 1
Manecon 1
The Manager
A manager is a person who directs resources to achieve a company’s goal (maximize profit and
maximize the value of the firm).This includes all individuals who (1) direct the efforts of others,
including those who delegate tasks within an organization such as a firm, a family, or a club; (2)
purchase inputs to be used in the production of goods and services such as the output of a firm,
food for the needy, or shelter for the homeless; or (3) are in charge of making other decisions,
such as product price or quality.
A manager generally has responsibility for his or her own actions as well as for the actions of
individuals, machines, and other inputs under the manager’s control. This control may involve
responsibilities for the resources of a multinational corporation or for those of a single
household. In each instance, however, a manager must direct resources and the behavior of
individuals for the purpose of accomplishing some task. While much of this book assumes the
manager’s, task is to maximize the profits of the firm that employs the manager, the underlying
principles are valid for virtually any decision process.
A manager is not a person who does a million things at once while employees take a back seat. It is vital
for managers to delegate responsibilities to employees and assist them if they need help.
As a manager you have to put on many hats and be flexible. Imagine you are blindfolded and walking
through a forest. Could you imagine how many times you would hit a tree or trip because you have no
direction? It is your job to help employees navigate. If they trip, it is the manager's job to help them
stand up and motivate them to achieve their goals. A manager who watches his or her employee trip
and fails without helping them is not the kind of manager you want to be. Employees will feed off their
manager's energy, and that positive energy will help create a successful work environment.
Economics
Economics is the science of making decisions in the presence of scarce resources. Resources are
simply anything used to produce a good or service or, more generally, to achieve a goal. It is
concerned with accurate appraisal of facts and events about our material life.Decisions are important
because scarcity implies that by making one choice, you give up another. A computer firm that
spends more resources on advertising has fewer resources to invest in research and
development. A food bank that spends more on soup has less to spend on fruit. Economic
decisions thus involve the allocation of scarce resources, and a manager’s task is to allocate
resources to best meet the manager’s goals.
One of the best ways to comprehend the pervasive nature of scarcity is to imagine that a genie
has appeared and offered to grant you three wishes. If resources were not scarce, you would
tell the genie you have absolutely nothing to wish for; you already have everything you want.
Surely, as you begin this course, you recognize that time is one of the scarcest resources of all.
Your primary decision problem is to allocate a scarce resource—time—to achieve a goal—such
as mastering the subject matter or earning an Ain the course.
To understand the nature of decisions that confront managers of firms, imagine that you are the
manager of a Fortune 500 company that makes computers. You must make a host of decisions
to succeed as a manager: Should you purchase components such as disk drives and chips from
other manufacturers or produce them within your own firm? Should you specialize in making
one type of computer or produce several different types? How many computers should you
produce, and at what price should you sell them? How many employees should you hire, and
how should you compensate them? How can you ensure that employees work hard and produce
quality products? How will the actions of rival computer firms affect your decisions?
The key to making sound decisions is to know what information is needed to make an informed
decision and then to collect and process the data.
LARGE COMPANY
If your goal is to maximize your grade in this course rather than maximize your overall grade
point average, your study habits will differ accordingly. Similarly, if the goal of a food bank is to
distribute food to needy people in rural areas, its decisions and optimal distribution network will
differ from those it would use to distribute food to needy innercity residents. Notice that in both
instances, the decision maker faces constraints that affect the ability to achieve a goal. The 24-
hour day affects your ability to earn an Ain this course; a budget affects the ability of the food
bank to distribute food to the needy.
Unfortunately, constraints make it difficult for managers to achieve goals such as maximizing
profits or increasing market share. These constraints include:
1. the available technology
2. the prices of inputs used in production
The opportunity cost of using a resource includes both the explicit (or accounting) cost of the
resource and the implicit cost of giving up the best alternative use of the resource. The
opportunity cost of producing a good or service generally is higher than accounting costs
because it includes both the peso value of costs (explicit, or accounting, costs) and any implicit
costs.
Implicit costs are very hard to measure and therefore managers often overlook them. Effective
managers, however, continually seek out data from other sources to identify and quantify
implicit costs. Managers of large firms can use sources within the company, including the firm’s
finance, marketing, and/or legal departments, to obtain data about the implicit costs of
decisions. In other instances, managers must collect data on their own.
Suppose you own a building in New York that you use to run a small pizzeria. Food supplies are
your only accounting costs. At the end of the year, your accountant informs you that these
costs were $20,000 and that your revenues were $100,000. Thus, your accounting profits are
$80,000. However, these accounting profits overstate your economic profits, because the costs
include only accounting costs. First, the costs do not include the time you spent running the
business. Had you not run the business, you could have worked for someone else, and this fact
reflects an economic cost not accounted for in accounting profits. To be concrete, suppose you
could have worked for someone else for $30,000. Your opportunity cost of time would have
been $30,000 for the year. Thus, $30,000 of your accounting profits are not profits at all but one
of the implicit costs of running the pizzeria. Second, accounting costs do not account for the fact
that, had you not run the pizzeria, you could have rented the building to someone else. If the
rental value of the building is $100,000 per year, you gave up this amount to run your own
business. Thus, the costs of running the pizzeria include not only the costs of supplies ($20,000)
but the $30,000 you could have earned in some other business and the $100,000 you could have
earned in renting the building to someone else. The economic cost of running the pizzeria is
$150,000—the amount you gave up to run your business. Considering the revenue of $100,000,
you actually lost $50,000 by running the pizzeria; your economic profits were $50,000.
Adam Smith’s classic line from The Wealth of Nations: “It is not out of the benevolence of the
butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their
own interest.”
Smith is saying that by pursuing its self-interest—the goal of maximizing profits—a firm
ultimately meets the needs of society. If you cannot make a living as a rock singer, it is probably
because society does not appreciate your singing; society would more highly value your talents
in some other employment. If you break five dishes each time you clean up after dinner, your
talents are perhaps better suited for filing paperwork or mowing the lawn. Similarly, the profits
of businesses signal where society’s scarce resources are best allocated.
When firms in each industry earn economic profits, the opportunity cost to resource holders
outside the industry increases. Owners of other resources soon recognize that, by continuing to
operate their existing businesses, they are giving up profits. This induces new firms to enter the
markets in which economic profits are available. As more firms enter the industry, the market
price falls, and economic profits decline. Thus, profits signal the owners of resources where the
resources are most highly valued by society. By moving scarce resources toward the production
of goods most valued by society, the total welfare of society is improved. As Adam Smith first
noted, this phenomenon is due not to benevolence on the part of the firms ‘managers but to
the self-interested goal of maximizing the firms ‘profits.
Factors that impact industry profitability. “Five Forces” Framework pioneered by Michael Porter
Five categories or “forces” that impact the sustainability of industry profits also known as
Porter’s f Forces
(1) entry,
(2) power of input suppliers,
(3) power of buyers,
(4) industry rivalry, and
(5) substitutes and complements
Entry
Entry heightens competition and reduces the margins of existing firms in a wide variety of
industry settings. For this reason, the ability of existing firms to sustain profits depends on how
barriers to entry affect the ease with which other firms can enter the industry. Entry can come
from a number of directions, including the formation of new companies
Barriers to Entry
• Entry costs – the higher the capital needed to enter the industry, the more difficult for the
new entrant to enter the industry
• Sunk costs - cost that is forever lost after it has been paid; irrelevant in decision making; ex.
Advance rental payment that can’t be withdraw or utilized, cost in processing business permit
or government documents when the business will not continue; the higher the sunk cost, the
more difficult to enter the industry.
• Network effects - In many industries (including airlines, electric power, and Internet auction
markets), phenomena known as network effects give incumbents first-mover advantages that
are difficult for potential entrants to overcome.
A network consists of links that connect different points (called nodes) in geographic or
economic space.
The simplest type of network is a one-way network in which services flow in only one direction.
Residential water service is a commonly used example of a one-way network: Water typically
flows one-way from the local water company to homes. Not surprisingly, one-way networks can
lead to first-mover advantages because of economies of scale or scope. Since a network
provider (the local water company) often enjoys economies of scale in creating a network to
deliver service to its customers, new entrants typically find it difficult to build a network that
supplants the network services of a well-established incumbent. The distinguishing feature of a
one-way network is that its value to each user does not directly depend on how many other
people use the new network.
In a two-way network, the value to each user depends directly on how many other people use
the network. This may permit an existing two-way network provider to enjoy significant first-
mover advantages even in the absence of any significant economies of scale.
A Star Network
Substantial network effects can create an effective barrier to entry and therefore degree of
monopoly power.
• Switching costs - are the costs that a consumer incurs as a result of changing brands,
suppliers, or products. Although most prevalent switching costs are monetary in nature, there
are also psychological, effort-based, and time-based switching costs. For example, many cellular
phone carriers charge very high cancellation fees for canceling contracts in hopes that the costs
involved with switching to another carrier will be high enough to prevent their customers from
doing so. High switching cost means difficulty to enter the industry.
• Speed of adjustment - adjustment speed the rate at which MARKETS adjust to changing
economic circumstances. Adjustment speeds will tend to vary between different types of
market. For example, in the case of the FOREIGN EXCHANGE MARKET, the exchange rate of a
currency will tend to adjust rapidly to EXCESS SUPPLY or EXCESS DEMAND for it. Another
Example, the market for consumer goods (vegetables, fruits) tend to adjust rapidly to the
changes in supply and demand of the products. The more rapid the adjustment speed in a given
market the easier for the business to enter the market.
• Economies of scale – Economies of scale are cost advantages that large firms obtain due to
their size. They occur because the cost per unit of output decreases with increasing scale, as
fixed costs are spread over more units of output.
• Reputation – if the existing business in the industry has good and stable reputation, it would
be difficult for the new business to enter the market.
• Government restraints – Industries heavily regulated by the government are usually the most
difficult to penetrate; examples include commercial airlines, defense contractors, and cable
companies. The government creates formidable barriers to entry for varying reasons. In the
case of commercial airlines, not only are regulations stout, but the government limits new
entrants to limit air traffic and simplifying monitoring.
Power of Buyers
This force analyzes to what extent the customers can put the company under pressure,
which also affects the customer’s sensitivity to price changes.
The customers have a lot of power when they are few and when the customers have
many alternatives to buy from. Moreover, it should be easy for them to switch from one
company to another.
Buying power is low however when customers purchase products in small amounts, act
independently and when the seller’s product is very different from any of its
competitors. Companies can take measures to reduce buyer power by for example
implementing loyalty programs or by differentiating their products and services.
Industry Rivalry
The intensity of rivalry among competitors in an industry refers to the extent to which
firms within an industry put pressure on one another and limit each other’s profit
potential.
If rivalry is fierce, then competitors are trying to steal profit and market share from one
another. As a result, this reduces profit potential for all firms within the industry.
According to Porter’s 5 forces framework, the intensity of rivalry among firms is one of
the main forces that shape the competitive structure of an industry.
When rivalry is high, competitors are likely to actively engage in advertising and price
wars, which can hurt a business’s bottom line.
In addition, rivalry will be more intense when barriers to exit are high, forcing
companies to remain in the industry even though profit margins are declining.
3. Understand Incentives
In our discussion of the role of profits, we emphasized that profits signal the holders of
resources when to enter and exit industries. In effect, changes in profits provide an
incentive to resource holders to alter their use of resources.
Within a firm, incentives affect how resources are used and how hard workers work.
To succeed as a manager, you must have a clear grasp of the role of incentives within an
organization such as a firm and how to construct incentives to induce maximal effort
from those you manage.
4. Understand Markets
In studying microeconomics in general, and managerial economics, it is important to
bear in mind that there are two sides to every transaction in a market: 1. For every
buyer of a good there is a corresponding seller. 2. The outcome of the market process,
depends on the relative power of buyers and sellers in the marketplace.
The power, or bargaining position, of consumers and producers in the market is limited
by three sources of rivalry that exist in economic transactions: 1. consumer–producer
rivalry, 2. consumer–consumer rivalry, and 3. producer–producer rivalry.
Each form of rivalry serves as a disciplining device to guide the market process, and each
affects different markets to a different extent. Thus, your ability as a manager to meet
performance objectives will depend on the extent to which your product is affected by
these sources of rivalry.
Consumer–Producer Rivalry
Consumer–producer rivalry occurs because of the competing interests of consumers
and producers. Consumers attempt to negotiate or locate low prices, while producers
attempt to negotiate high prices. If a consumer offers a price that is too low, the
producer will refuse to sell the product to the consumer. Similarly, if the producer asks a
price that exceeds the consumer’s valuation of a good, the consumer will refuse to
purchase the good. These two forces provide a natural check and balance on the market
process even in markets in which the product is offered by a single firm (a monopolist).
Consumer–consumer rivalry
Consumer–consumer rivalry reduces the negotiating power of consumers in the
marketplace. It arises because of the economic doctrine of scarcity. When limited
quantities of goods are available, consumers will compete with one another for the right
to purchase the available goods. Consumers who are willing to pay the highest prices for
the scarce goods will outbid other consumers for the right to consume the goods. Once
again, this source of rivalry is present even in markets in which a single firm is selling a
product. A good example of consumer–consumer rivalry is an auction.
Producer–Producer Rivalry
Producer–producer rivalry is a disciplining device that functions only when multiple
sellers of a product compete in the marketplace. Given that customers are scarce,
producers compete with one another for the right to service the customers available.
Those firms that offer the best-quality product at the lowest price earn the right to
serve the customers. For example, McDonalds and Jollibee located across the street,
they are engaged in producer–producer rivalry.
Government and the Market
When agents on either side of the market find themselves disadvantaged in the market
process, they frequently attempt to induce government to intervene on their behalf. For
example, the market for electricity in most towns is characterized by a sole local
supplier of electricity, and thus there is no producer–producer rivalry. Consumer groups
may initiate action by a public utility commission to limit the power of utilities in setting
prices. Similarly, producers may lobby for government assistance to place them in a
better bargaining position relative to consumers and foreign producers. Thus, in modern
economies government also plays a role in disciplining the market process.
$1.10. In other words, over the course of one year, your $1.00 would earn $.10 in
interest. Thus, when the interest rate is 10 percent, the present value of receiving $1.10
one year in the future is $1.00.
or
Demonstration Problem 1–1
The manager of Automated Products is contemplating the purchase of a new machine
that will cost $300,000 and has a useful life of five years. The machine will yield (year-
end) cost reductions to Automated Products of $50,000 in year 1, $60,000 in year 2,
$75,000 in year 3, and $90,000 in years 4 and 5. What is the present value of the cost
savings of the machine if the interest rate is 8 percent? Should the manager purchase
the machine?
Present Value of Indefinitely Lived Assets (Perpetuity or infinite amount of time)
Some decisions generate cash flows that continue indefinitely. In finance, perpetuity is a
constant stream of identical cash flows with no end. The present value of a security with
perpetual cash flows can be determined as:
Examples of such an asset include perpetual bonds and preferred stocks. Each of these
assets pays the owner a fixed amount at the end of each period, indefinitely. Based on
the above formula, the value of a perpetual bond that pays the owner $100 at the end
of each year when the interest rate is fixed at 5 percent is given by
Present value analysis is also useful in determining the value of a firm, since the value of
a firm is the present value of the stream of profits (cash flows) generated by the firm’s
physical, human, and intangible assets.
In other words, the value of the firm today is the present value of its current and future
profits. To the extent that the firm is a “going concern” that lives on even after its
founder dies, firm ownership represents a claim to assets with an indefinite profit
stream.
The value of a firm considers the long-term impact of managerial decisions on profits.
When economists say that the goal of the firm is to maximize profits, it should be
understood to mean that the firm’s goal is to maximize its value, which is the present
value of current and future profits