CHAPTER 1

INTRODUCTION

“Why should I study economics? Will it tell me what the stock market will do
tomorrow? Will it tell me where to invest my money or how to get rich?” Unfortunately,
managerial economics by itself is unlikely to provide definitive answers to such
questions. Obtaining the answers would require an accurate crystal ball. Nevertheless,
managerial economics is a valuable tool for analyzing business situations.

Sadly, billions of dollars are lost each year because many existing managers fail to use
basic tools from managerial economics to shape pricing and output decisions, optimize
the production process and input mix, choose product quality, guide horizontal and
vertical merger decisions, or optimally design internal and external incentives. Happily, if
you learn a few basic principles from managerial economics, you will be poised to drive
the inept managers out of their jobs! You will also understand why the latest recession
was great news to some firms and why some software firms spend millions on the
development of applications for smart phones but permit consumers to download them
for free.

Managerial economics is not only valuable to managers; it is also valuable to

managers of not-for-profit organizations. It is useful to the manager of a food bank
who must decide the best means for distributing food to the needy. It is valuable to the
coordinator of a shelter for the homeless whose goal is to help the largest possible
number of homeless, given a very tight budget. In fact, managerial economics provides
useful insights into every facet of the business and non-business world in which we
live—including household decision making.

Why is managerial economics so valuable to such a diverse group of decision makers?

The answer to this question lies in the meaning of the term managerial economics.

THE MANAGER
A manager is a person who directs resources to achieve a stated goal. This
definition includes all individuals who (1) direct the efforts of others, including those who
delegate tasks within an organization; (2) purchase inputs to be used in the production
of goods and services; or (3) are in charge of making other decisions, such as product
price or quality.

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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 behaviour of individuals for the purpose of accomplishing
some task. While much of our discussion 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.

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. 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 so as
to best meet the manager’s goals.

MANAGERIAL ECONOMICS
Managerial economics, therefore, is the study of how to direct scarce resources
in the way that most efficiently achieves a managerial goal. It is a very broad
discipline in that it describes methods useful for directing everything from the resources
of a household to maximize household welfare to the resources of a firm to maximize
profits.

SITUATIONAL PROBLEM
Amcott Loses 3.5 Million pesos; Manager Fired
On Tuesday software giant Amcott posted a year-end operating loss of P3.5 million.
Reportedly, P1.7 million of the loss stemmed from its foreign language division.
With short-term interest rates at 7 percent, Amcott decided to use P20 million of its
retained earnings to purchase three-year rights to Magic word, a software package that
converts generic word processor files saved as French text into English. First-year sales
revenue from the software was P7 million, but thereafter sales were halted pending a
copyright infringement suit filed by Foreign, Inc. Amcott lost the suit and paid damages

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of P1.7 million. Industry insiders say that the copyright violation pertained to “a very
small component of Magic word.”
Ralph, the Amcott manager who was fired over the incident, was quoted as saying, “I’m
a scapegoat for the attorneys [at Amcott] who didn’t do their homework before buying
the rights to Magic word. I projected annual sales of P7 million per year for three years.
My sales forecasts were right on target.” Do you know why Ralph was fired?

Why was Ralph fired from his managerial post at Amcott? As the manager of the foreign
language division, he probably relied on his marketing department for sales forecasts
and on his legal department for advice on contract and copyright law. The information
he obtained about future sales was indeed accurate, but apparently his legal
department did not fully anticipate all the legal ramifications of distributing Magicword.
Sometimes, managers are given misinformation.
The real problem in this case, however, is that Ralph did not properly act on the
information that was given him. Ralph’s plan was to generate P7 million per year in
sales by sinking P20 million into Magicword. Assuming there were no other costs
associated with the project, the projected net present value to Amcott of purchasing
Magicword was

which means that Ralph should have expected Amcott to lose over P1.6 million by
purchasing Magicword.
Ralph was not fired because of the mistakes of his legal department but for his
managerial ineptness. The lawsuit publicized to Amcott’s shareholders, among others,
that Ralph was not properly processing information given to him: He did not recognize
the time value of money.

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 CHAPTER 2
MANAGERIAL ECONOMICS AS A TOOL FOR DECISION MAKING

MANAGERIAL ECONOMICS AS A TOOL FOR DECISION MAKING

The Economics of Effective Management
The nature of sound managerial decisions varies depending on the underlying goals of
the manager. Since this presentation is designed primarily for managers of firms, it
focuses on managerial decisions as they relate to maximizing profits or, more generally,
the value of the firm. Before embarking on this special use of managerial economics, we
provide an overview of the basic principles that comprise effective management. In
particular, an effective manager must (1) identify goals and constraints; (2) recognize
the nature and importance of profits; (3) understand incentives; (4) understand markets;
(5) recognize the time value of money; and (6) use marginal analysis.

Identify Goals and Constraints

The first step in making sound decisions is to have well-defined goals because
achieving different goals entails making different decisions. 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. Notice that in this instance, the decision maker faces
constraints that affect the ability to achieve a goal.
Unfortunately, constraints make it difficult for managers to achieve goals such as
maximizing profits or increasing market share. Constraints are an artefact of scarcity.
These constraints include such things as the available technology and the prices of
inputs used in production. The goal of maximizing profits requires the manager to
decide the optimal price to charge for a product, how much to produce, which
technology to use, how much of each input to use, how to react to decisions made by
competitors, and so on.

Recognize the Nature and Importance of Profits

The overall goal of most firms is to maximize profits or the firm’s value. Before we
provide these details, let us examine the nature and importance of profits in a free-
market economy.

Economic versus Accounting Profits

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When most people hear the word profit, they think of accounting profits. Accounting
profit is the total amount of money taken in from sales (total revenue, or price times
quantity sold) minus the cost of producing goods or services. Accounting profits are
what show up on the firm’s income statement and are typically reported to the manager
by the firm’s accounting department.
A more general way to define profits is in terms of what economists refer to as
economic profits. Economic profits are the difference between the total revenue and the
total opportunity cost of producing the firm’s goods or services. 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 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. For example, what does it cost you to read a book? The price you paid the
bookseller for that book is an explicit (or accounting) cost, while the implicit cost is the
value of what you are giving up by reading the book. You could be studying some other
subject or watching TV, and each of these alternatives has some value to you. The
“best” of these alternatives is your implicit cost of reading this book; you are giving up
this alternative to read the book. Similarly, the opportunity cost of going to school is
much higher than the cost of tuition and books; it also includes the amount of money
you would earn had you decided to work rather than go to school.
In the business world, the opportunity cost of opening a restaurant is the best alternative
use of the resources used to establish the restaurant—say, opening a hairstyling salon.
Again, these resources include not only the explicit financial resources needed to open
the business but any implicit costs as well. Suppose you own a building in Quezon City
that you use to run a small laundry shop. At the end of the year, your accountant
informs you that actual costs were P 50,000.00 and that your revenues were P
150,000.00. Thus, your accounting profits are P 100,000.00.
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 P 60,000.00. Your
opportunity cost of time would have been P 60,000.00 for the year. Thus, P 60,000.00
of your accounting profits are not profits at all but one of the implicit costs of running the
laundry shop.

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Second, accounting costs do not account for the fact that, had you not run the laundry
shop, you could have rented the building to someone else. If the rental value of the
building is P 120,000.00 per year, you gave up this amount to run your own business.
Thus, the costs of running the laundry shop include not only the actual costs (P
20,000.00) but the P 60,000.00 you could have earned in some other business and the
P 120,000.00 you could have earned in renting the building to someone else. The
economic cost of running the laundry shop is P 230,000.00—the amount you gave up
running your business. Considering the revenue of P 150,000.00, you actually lost P
80,000.00 by running the laundry shop; your economic profits were – P 80,000.00.

ACCOUNTING PROFIT
The total amount of money taken in from sales (total revenue) minus the cost of
producing goods and services.
Accounting Profit = Sales – Cost of Producing Goods and Services

ECONOMIC PROFIT
The difference between the total revenue (sales) and the total opportunity cost of
producing the firm's goods or services.
Economic Profit = Total Revenue – Total Opportunity Cost of Producing Goods and
Services

OPPORTUNITY COST
The opportunity cost of using a resource includes both explicit (or accounting cost) and
implicit cost of giving up the best alternative use of the resource.
Implicit costs are very hard to measure and therefore managers often overlook them.
Opportunity Cost = Total Revenue – Economic Profit

EXPLICIT COST VS. IMPLICIT COST

Example, an employee could take a vacation and travel.
The explicit costs would include travel expenses, the cost of a hotel room, and costs
related to entertainment.
The implicit costs relate to the tradeoff, namely the wages that the employee could have
earned if the vacation was not taken.

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THE ROLE OF PROFITS
A common misconception is that the firm’s goal of maximizing profits is necessarily bad
for society. Individuals who want to maximize profits often are considered self-
interested, a quality that many people view as undesirable. However, consider
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.”

Principle: Profits Are a Signal

Profits signal to resource holders where resources are most highly valued by society.

FIG. 1–1. THE FIVE FORCES FRAMEWORK AND INDUSTRY PROFITABILITY

A key theme of this textbook is that many interrelated forces and decisions
influence the level, growth, and sustainability of profits. If you or other managers in
the industry are clever enough to identify strategies that yield a windfall to shareholders

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this quarter, there is no guarantee that these profits will be sustained in the long run.
You must recognize that profits are a signal—if your business earns superior profits,
existing and potential competitors will do their best to get a piece of the action.

Figure 1–1 illustrates the “five forces” framework pioneered by Michael Porter.
This framework organizes many complex managerial economics issues into five
categories or “forces” that impact the sustainability of industry profits: (1) entry, (2)
power of input suppliers, (3) power of buyers, (4) industry rivalry, and (5) substitutes and
complements. The discussion below explains how these forces influence industry
profitability and highlights the connections among these forces and material covered in
the remaining chapters of the subject.

Entry
As we will see in next chapters, 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.
As shown in Figure 1–1, a number of economic factors affect the ability of entrants to
erode existing industry profits. In subsequent chapters, you will learn why entrants are
less likely to capture market share quickly enough to justify the costs of entry in
environments where there are sizeable sunk costs, significant economies of scale, or
significant network effects, or where existing firms have invested in strong reputations
for providing value to a sizeable base of loyal consumers or to aggressively fight
entrants. In addition, you will gain a better appreciation for the role that governments
play in shaping entry through patents and licenses, trade policies, and environmental
legislation. We will also identify a variety of strategies to raise the costs to consumers of
“switching” to would-be entrants, thereby lowering the threat that entrants will erode
your profits.

Power of Input Suppliers

Industry profits tend to be lower when suppliers have the power to negotiate favourable
terms for their inputs. Supplier power tends to be low when inputs are relatively
standardized and relationship-specific investments are minimal, input markets are not
highly concentrated, or alternative inputs are available with similar marginal
productivities per peso spent. In many countries, the government constrains the prices
of inputs through price ceilings and other controls, which limits to some extent the ability
of suppliers to expropriate profits from firms in the industry.

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Power of Buyers
Similar to the case of suppliers, industry profits tend to be lower when customers or
buyers have the power to negotiate favourable terms for the products or services
produced in the industry. In most consumer markets, buyers are fragmented and thus
buyer concentration is low. Buyer concentration and hence customer power tend to be
higher in industries that serve relatively few “high-volume” customers. Buyer power
tends to be lower in industries where the cost to customers of switching to other
products is high—as is often the case when there are relationship-specific investments
and hold-up problems, imperfect information that leads to costly consumer search, or
few close substitutes for the product. Government regulations, such as price floors or
price ceilings, can also impact the ability of buyers to obtain more favourable terms.

Industry Rivalry
The sustainability of industry profits also depends on the nature and intensity of rivalry
among firms competing in the industry. Rivalry tends to be less intense (and hence the
likelihood of sustaining profits is higher) in concentrated industries—that is, those with
relatively few firms.
The level of product differentiation and the nature of the game being played— whether
firms’ strategies involve prices, quantities, capacity, or quality/service attributes, for
example—also impact profitability. In later chapters you will learn why rivalry tends to be
more intense in industry settings where there is little product differentiation and firms
compete in price and where consumer switching costs are low. You will also learn how
imperfect information and the timing of decisions affect rivalry among firms.

Substitutes and Complements

The level and sustainability of industry profits also depend on the price and value of
interrelated products and services. Porter’s original five forces framework emphasized
that the presence of close substitutes erodes industry profitability. In the next topics we
will learn how to quantify the degree to which surrogate products are close substitutes
by using elasticity analysis and models of consumer behaviour. We will also see that
government policies can directly impact the availability of substitutes and thus industry
profits. More recent work by economists and business strategists emphasizes that
complementarities also affect industry profitability.
It is also important to stress that the five forces framework is primarily a tool for helping
managers see the “big picture”; it is a schematic you can use to organize various
industry conditions that affect industry profitability and assess the efficacy of alternative
business strategies. However, it would be a mistake to view it as a comprehensive list of

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all factors that affect industry profitability. The five forces framework is not a substitute
for understanding the economic principles that underlie sound business decisions.

ECONOMIC INCENTIVES
In our discussion of the role of profits, we emphasized that profits signal the holders of
resources when to enter and exit particular 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.
Fortunately, most business owners understand the problem just described. The owners
of large corporations are shareholders, and most never set foot on company ground.
How do they provide incentives for chief executive officers (CEOs) to be effective
managers? Very simply, they provide them with “incentive plans” in the form of
bonuses. These bonuses are in direct proportion to the firm’s profitability. If the firm
does well, the CEO receives a large bonus. If the firm does poorly, the CEO receives no
bonus and risks being fired by the stockholders. These types of incentives are also
present at lower levels within firms. Some individuals earn commissions based on the
revenue they generate for the firm’s owner. If they put forth little effort, they receive little
pay; if they put forth much effort and hence generate many sales, they receive a
generous commission.
The thrust of managerial economics is to provide you with a broad array of skills that
enable you to make sound economic decisions and to structure appropriate incentives
within your organization. We will begin under the assumption that everyone with whom
you come into contact is greedy, that is, interested only in his or her own self-interest. In
such a case, understanding incentives is a must. Of course, this is a worst-case
scenario; more likely, some of your business contacts will not be so selfishly inclined. If
you are so lucky, your job will be all the easier.

MARKET
In studying microeconomics in general and managerial economics in particular, it is
important to bear in mind that there are two sides to every transaction in a
market: For every buyer of a good there is a corresponding seller. The final outcome of
the market process, then, 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:
consumer–producer rivalry, consumer–consumer rivalry, and producer–producer rivalry.
Each form of rivalry serves as a disciplining device to guide the market process, and

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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. In a very loose sense, consumers attempt to “rip off”
producers, and producers attempt to “rip off” consumers. Of course, there are limits to
the ability of these parties to achieve their goals. 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). An illustrative example of this type of rivalry is the common haggling over
price between a potential car buyer and salesperson.

Consumer–Consumer Rivalry
A second source of rivalry that guides the market process occurs among consumers.
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.

Producer–Producer Rivalry
A third source of rivalry in the marketplace is producer–producer rivalry. Unlike the other
forms of rivalry, this disciplining device 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, when two gas stations located across the street from one another compete on
price, they are engaged in producer–producer rivalry.

GOVERNMENT AND THE MARKET

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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.

THE TIME VALUE OF MONEY AND MARGINAL ANALYSIS

Time Value of Money
The timing of many decisions involves a gap between the time when the costs of a
project are borne and the time when the benefits of the project are received. In these
instances it is important to recognize that $1 today is worth more than $1 received in the
future. The reason is simple: The opportunity cost of receiving the $1 in the future is the
forgone interest that could be earned were $1 received today. This opportunity cost
reflects the time value of money. To properly account for the timing of receipts and
expenditures, the manager must understand present value analysis.

Present Value Analysis

The present value (PV) of an amount received in the future is the amount that would
have to be invested today at the prevailing interest rate to generate the given future
value.
Formula (Present Value). The present value (PV) of a future value (FV) received n
years in the future is (1–1) where ι is the rate of interest, or the opportunity cost of funds.
𝐹𝑉
𝑃𝑉 =
(1 + 𝜄)𝑛

For example, the present value of P 100.00 in 10 years if the interest rate is at 7 percent
is $50.83, since
100 100
𝑃𝑉 = 10
= 𝑃𝑉 = = 𝑃50.83
(1 + 0.7) 1.9672
This essentially means that if you invested P 50.83 today at a 7 percent interest rate, in
10 years your investment would be worth P 100.00.

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Notice that the interest rate appears in the denominator of the expression in Equation
1–1. This means that the higher the interest rate, the lower the present value of a future
amount, and conversely. The present value of a future payment reflects the difference
between the future value (FV) and the opportunity cost of waiting (OCW): PV= FV-
OCW. Intuitively, the higher the interest rate, the higher the opportunity cost of waiting
to receive a future amount and thus the lower the present value of the future amount.
For example, if the interest rate is zero, the opportunity cost of waiting is zero, and the
present value and the future value coincide. This is consistent with Equation 1–1, since
PV = FV when the interest rate is zero.
The basic idea of the present value of a future amount can be extended to a series of
future payments. For example, if you are promised FV1 one year in the future, FV2 two
years in the future, and so on for n years, the present value of this sum of future
payments is
𝐹𝑉1 𝐹𝑉2 𝐹𝑉3 𝐹𝑉𝑛
𝑃𝑉 = + + … … . +
(1 + 𝜄)1 (1 + 𝜄)2 (1 + 𝜄)3 (1 + 𝜄)𝑛

Formula (Present Value of a Stream). When the interest rate is i, the present value of a
stream of future payments of FV1, FV2, . . . , FVn is

Given the present value of the income stream that arises from a project, one can easily
compute the net present value of the project. The net present value (NPV) of a project is
simply the present value (PV) of the income stream generated by the project minus the
current cost (CO) of the project: NPV = PV – Co. If the net present value of a project is
positive, then the project is profitable because the present value of the earnings from
the project exceeds the current cost of the project. On the other hand, a manager
should reject a project that has a negative net present value, since the cost of such a
project exceeds the present value of the income stream that project generates.

Formula (Net Present Value). Suppose that by sinking C0 dollars into a project today, a
firm will generate income of FV1 one year in the future, FV2 two years in the future, and
so on for n years. If the interest rate is i, the net present value of the project is

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DEMONSTRATION PROBLEM
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?

By spending $300,000 today on a new machine, the firm will reduce costs by $365,000
over five years. However, the present value of the cost savings is only

Consequently, the net present value of the new machine is

Since the net present value of the machine is negative, the manager should not
purchase the machine. In other words, the manager could earn more by investing the
$300,000 at 8 percent than by spending the money on the cost-saving technology.

PRESENT VALUE OF INDEFINITELY LIVED ASSETS

Some decisions generate cash flows that continue indefinitely. For instance, consider
an asset that generates a cash flow of CF0 today, CF1 one year from today, CF2 two
years from today, and so on for an indefinite period of time. If the interest rate is, the
value of the asset is given by the present value of these cash flows:

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While this formula contains terms that continue indefinitely, for certain patterns of future
cash flows one can readily compute the present value of the asset. For instance,
suppose that the current cash flow is zero (CFO = 0) and that all future cash flows are
identical (CF1 = CF2 = . . . ). In this case the asset generates a perpetual stream of
identical cash flows at the end of each period. If each of these future cash flows is CF,
the value of the asset is the present value of the perpetuity:

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 particular, if pi0 is the firm’s current level of
profits, and p1 is next year’s profit, and so on, then the value of the firm is

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.

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Notice that the value of a firm takes into account 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.

PRINCIPLE: PROFIT MAXIMIZATION

Maximizing profits means maximizing the value of the firm, which is the present
value of current and future profits.
While it is beyond the scope of this book to present all the tools Wall Street analysts use
to estimate the value of firms, it is possible to gain insight into the issues involved by
making a few simplifying assumptions. Suppose a firm’s current profits are, and that
these profits have not yet been paid out to stockholders as dividends. Imagine that
these profits are expected to grow at a constant rate of g percent each year, and that
profit growth is less than the interest rate (g < ). In this case, profits one year from today
will be (1 + g) 0, profits two years from today will be (1 + g)2 0, and so on. The value of
the firm, under these assumptions, is

For a given interest rate and growth rate of the firm, it follows that maximizing the
lifetime value of the firm (long-term profits) is equivalent to maximizing the firm’s current
(short-term) profits of 0.
You may wonder how this formula changes if current profits have already been paid out
as dividends. In this case, the present value of the firm is the present value of future
profits (since current profits have already been paid out). The value of the firm
immediately after its current profits have been paid out as dividends (called the ex-
dividend date) may be obtained by simply subtracting p0 from the above equation:

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This may be simplified to yield the following formula:

Thus, so long as the interest rate and growth rate are constant, the strategy of
maximizing current profits also maximizes the value of the firm on the ex-dividend date.

PRINCIPLE MAXIMIZING: SHORT-TERM PROFITS MAY MAXIMIZE LONG-TERM

PROFITS
If the growth rate in profits is less than the interest rate and both are constant,
maximizing current (short-term) profits is the same as maximizing long-term profits.

DEMONSTRATION PROBLEM
Suppose the interest rate is 10 percent and the firm is expected to grow at a rate of 5
percent for the foreseeable future. The firm’s current profits are P100 million.
(a) What is the value of the firm (the present value of its current and future earnings)?
(b) What is the value of the firm immediately after it pays a dividend equal to its current
profits?

a. The value of the firm is

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b. The value of the firm on the ex-dividend date is this amount ($2,200 million) less the
current profits paid out as dividends ($100 million), or $2,100 million. Alternatively, this
may be calculated as

MARGINAL ANALYSIS
Marginal analysis is one of the most important managerial tools—a tool we will use
repeatedly throughout this subject in alternative contexts. Simply put, marginal analysis
studying an additional hour. So long as the benefits of studying an additional hour
exceed the costs of studying an additional hour, it is profitable to continue to study.
However, once an additional hour of studying adds more to costs than it does to
benefits, you should stop studying.
More generally, let B(Q) denote the total benefits derived from Q units of some variable
that is within the manager’s control. This is a very general idea: B(Q) may be the
revenue a firm generates from producing Q units of output; it may be the benefits
associated with distributing Q units of food to the needy; or, in the context of our
previous example, it may represent the benefits derived by studying Q hours for an
exam. Let C(Q) represent the total costs of the corresponding level of Q. Depending on
the nature of the decision problem, C(Q) may be the total cost to a firm of producing Q
units of output, the total cost to a food bank of providing Q units of food to the needy, or
the total cost to you of studying Q hours for an exam.

DISCRETE DECISIONS
We first consider the situation where the managerial control variable is discrete. In this
instance, the manager faces a situation like that summarized in columns 1 through 3 in
Table 1–1. Notice that the manager cannot use fractional units of Q; only integer values
are possible. This reflects the discrete nature of the problem. In the context of a
production decision, Q may be the number of gallons of soft drink produced. The
manager must decide how many gallons of soft drink to produce (0, 1, 2, and so on), but
cannot choose to produce fractional units (for example, one pint). Column 2 of Table 1–

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1 provides hypothetical data for total benefits; column 3 gives hypothetical data for total
costs.
Suppose the objective of the manager is to maximize the net benefits
N(Q)=B(Q)-C(Q)
which represent the premium of total benefits over total costs of using Q units of the
managerial control variable, Q. The net benefits—N(Q)—for our hypothetical

TBL 1–1. DETERMINING THE OPTIMAL LEVEL OF A CONTROL VARIABLE: THE

DISCRETE CASE

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