Managerial Economics

Applications, Strategies and Tactics, 14e

James R. McGuigan
R. Charles Moyer
Frederick H. deB. Harris

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 PART I – INTRODUCTION

Chapter 2 –
Fundamental Economic Concepts

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 Chapter 2 – Fundamental Economic Concepts
Overview
• DEMAND AND SUPPLY: A REVIEW
• MARGINAL ANALYSIS
• THE NET PRESENT VALUE CONCEPT
• MEANING AND MEASUREMENT OF RISK
• RISK AND REQUIRED RETURN

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 Figure 2.1 – Demand and Supply Determine
the Equilibrium Market Price

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 Chapter 2 – Fundamental Economic Concepts
Demand and Supply: A Review (1 of 5)
• Demand and supply simultaneously determine equilibrium
market price. (Peq )
• Peq equates the desired rate of purchase with the planned rate
of sale; both represent intentions
• Demand is like potential sales
• Supply is like scenario planning
• Both are rates per unit time period
• Even when cost of production and intrinsic use value are nearly
identical and intrinsic, equilibrium market prices can differ
markedly
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 Chapter 2 – Fundamental Economic Concepts
Demand and Supply: A Review (2 of 5)
• The Diamond-Water Paradox and the Marginal
Revolution
• Marginal use value: the additional value of one more unit
• Marginal utility: the use value obtained from the last unit consumed
• Marginal Utility & Incremental Cost Simultaneously
Determine Equilibrium Market Price
• But variable cost at the margin (marginal cost) determines
the minimum asking price producers are willing to accept for
each additional unit supplied
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 Figure 2.2 – The Diamond-Water Paradox
Resolved

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 Table 2.1 –
Simplified Demand Schedule: Pizza Hut Restaurant

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 Chapter 2 – Fundamental Economic Concepts
Demand and Supply: A Review (3 of 5)
• Individual and Market Demand Curves
• The lower the price, the greater the quantity demanded
• The Demand Function…
• Is the relationship between quantity demanded per unit of time and
all of the determinants of demand

• Substitute goods are alternative products whose demand increases

when the price of the focal product rises
• Complementary goods are those whose demand decreases when the
price of the focal product rises
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 Table 2.2 –
Partial List of Factors Affecting Demand

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 Figure 2.3 – Shifts in Demand

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 Chapter 2 – Fundamental Economic Concepts
Demand and Supply: A Review (4 of 5)
• Import-Export Traded Goods
• U.S. firms prefer to be paid in U.S. dollars tied to the price of the
dollar against other currencies
• Individual and Market Supply Curves
• Supply function: a relationship between quantity supplied and all
the determinants of supply

• Supply curve: a relationship between price and quantity supplied

per unit time, holding other determinants of supply constant
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 Table 2.3 –
Partial List of Factors Affecting Supply

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 Chapter 2 – Fundamental Economic Concepts
Demand and Supply: A Review (5 of 5)
• Equilibrium Market Price of Gasoline
• In April-July 2008, the price of a gallon of gasoline skyrocketed
from $3.00/gallon to $$4.10 (Fig 2.4)
• Customer demand shrank from 16 gallons/week to 11.5 gallons
• Resource scarcity was the likely explanation (Fig. 2.5)
• Americans purchased fuel-efficient hybrids (Fig 2.6)
• Saudi production rose (Fig 2.7)
• The late 2008 crude oil price collapse (Fig 2.8) caused by a
combination of increasingly supply, slowing demand, and
speculative expectation that crude prices would be lower
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 Figure 2.4 – Regular Octane Gas Prices in the
U.S., 2005-2011

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 Figure 2.5 – Supply Disruptions and Developing
Country Demand Cause Crude Oil Price Spikes

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 Figure 2.6 –
Demand for Smartcar-Mini 2008-2010

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 Figure 2.7 –
Saudi Arabia Crude Oil Production

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 Figure 2.8 –
Crude Oil Price, West Texas Intermediate AMEND?

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 Chapter 2 – Fundamental Economic Concepts
Marginal Analysis (1 of 2)
• Marginal analysis: a basis for making various
economic decisions that analyzes the additional
(marginal) benefits derived from a particular
decision and compares them with the additional
(marginal) costs incurred
• The familiar profit maximization rule is to set output
at the point where marginal cost equals marginal
revenue
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 Chapter 2 – Fundamental Economic Concepts
Marginal Analysis (2 of 2)
• Total, Marginal, and Average Relationships
• Revenue, cost, profit and other economic relationships
can be presented using tabular (Table 2.4), graphic (Fig
2.9), and algebraic frameworks
• Examining the total profit function, we see that profit is
maximized at the output level of Q = 9 units
• The firm would expand production as long as the net
marginal return is positive

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 Table 2.4 –
Total, Marginal, & Average Profit Relationships

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 Figure 2.9 –
Total, Average, and Marginal Profit Functions

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 Chapter 2 – Fundamental Economic Concepts
The Net Present Value Concept (1 of 3)
• Determining the Net Present Value of an Investment
• The present value (Pvo) of an amount received 1 year in
the future (FV1) is equal to that amount times the
discount factor:
• The NPV of an investment is equal to:

• Present value is the value today of a future amount of money or a

series of future payments evaluated at the appropriate discount rate

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 Chapter 2 – Fundamental Economic Concepts
The Net Present Value Concept (2 of 3)
• Sources of Positive Net Present Value Projects
• 1. Buyer preferences for established brand names
• 2. Ownership or control of favored distribution systems
• 3. Patent control of superior product designs, etc.
• 4. Exclusive ownership of superior natural resource deposits
• 5. Inability of new firms to acquire necessary factors of
production
• 6. Superior access to financial resources at lower costs
• 7. Economies of large-scale production and distribution
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 Table 2.5 – Lifetime Cost Savings of
Compact Fluorescent Light (CFL) Bulbs

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 Chapter 2 – Fundamental Economic Concepts
The Net Present Value Concept (3 of 3)
• Risk and the NPV Rule
• To compensate for a perceived risk of an investment, you may
require a higher percent rate of return
• A primary problem facing managers is the difficulty of evaluating
the risk associated with investments and then translating that risk
into a discount rate that reflects an adequate level of risk
compensation

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 Chapter 2 – Fundamental Economic Concepts
Meaning and Measurement of Risk (1 of 5)
• Risk: a decision-making situation in which there is
variability in the possible outcomes, and the
probabilities of these outcomes can be specified by
the decision-maker
• Probability: the percentage chance that a particular
outcome will occur

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 Chapter 2 – Fundamental Economic Concepts
Meaning and Measurement of Risk (2 of 5)
• Probability Distributions
• An objective determination is based on past outcomes
of similar events
• A subjective determination is an opinion made by an
individual
• The decision maker can develop a probability
distribution for possible outcomes (Table 2.6)

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 Table 2.6 – Probability Distributions of the Annual Net
Cash Flows (NCF) From Two Investments

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 Chapter 2 – Fundamental Economic Concepts
Meaning and Measurement of Risk (3 of 5)
• Expected Values
• Expected value: the weighted average of the possible
outcomes where the weights are the probabilities of the
respective outcomes:
• Standard Deviation: An Absolute Measure of Risk
• Normal Probability Distribution
• Coefficient of Variation: A Relative Measure of Risk
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 Table 2.7 – Possible Outcomes from Investing
in American Airlines Bonds

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 Table 2.8 – Computation of the Expected
Returns from Two Investments

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 Chapter 2 – Fundamental Economic Concepts
Meaning and Measurement of Risk (4 of 5)
• Standard Deviation: An Absolute Measure of Risk
• Standard deviation: a statistical measure of the
dispersion or variability of possible outcomes

• Normal Probability Distribution

• Assuming a normal probability distribution greatly
simplifies the analysis of many possible outcomes
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 Table 2.9 – Computation of the Standard
Deviations for Two Investments

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 Figure 2.10 – A Sample Illustration of Areas under the
Normal Probability Distribution Curve

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 Chapter 2 – Fundamental Economic Concepts
Meaning and Measurement of Risk (5 of 5)
• Coefficient of Variation: A Relative Measure of Risk
• Coefficient of variation: The ration of the standard
deviation to the expected value. A relative measure of
risk
• Provides a better measure of risk when the alternatives
are of differing size

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 What Went Right? ● What Went Wrong?
Long Term Capital Management (LTCM)
• LTCM was a “hedge fund” run by some top-notch finance
experts (1993-1998)
• LTCM looked for small pricing deviations between interest
rates and derivatives, such as bond futures
• They earned 45% returns, but that may be due to high risks in
their type of arbitrage activity
• The Russian default in 1998 changed the risk level of
government debt, and TLCM lost $2 billion

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 Chapter 2 – Fundamental Economic Concepts
Risk and Required Return (1 of 1)
• The relationship between risk and required return
on an investment can be defined as:

• The risk-free rate of return refers to the return available on an

investment with no risk of default
• The risk premium may arise for many reasons, including default,
seniority, liquidity, maturity, or volatility, among others

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