Introduction To Economic Decision Making, Lecture Notes - Managerial Economics, Study notes for Managerial Economics. University of Michigan (MI)

Managerial Economics

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ECN 469: Managerial Economics Professor Mark J. Perry
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Opening quote, see page 1.
Decision making is at the heart of most important business and govt. problems.
High-tech company: Undertake a promising but expensive R & D program?
Petrochemical Manufacturer: Cut price in response to increased competition?
Telecommunication Co: What bid to make for govt. contract?
Food company: Introduce a new food product after mixed test-marketing?
Fed Govt.: Stricter rollover standards for SUVs?
City Govt.: Allocate funds to construct harbor tunnel for increased traffic flow?
Fed Govt.: Increase funding for cancer research?
Important question: What is the alternative?”
All decisions are economic decisions involving what comparison?
Managerial Economics (ME) is the analysis of major management decisions using the tools and
concepts of economics: supply and demand and cost, resource allocation, efficiency, cost-benefit,
trade-offs, competition, strategic behavior, industry organization, market structure, etc. Managerial
Economics (ME) is the study of the economic framework and the economic tools used to make
management decisions, in both the private and public sector. For example, think of the thousands of
decisions that get made every month at GM, Genesee County, Hurley Hospital, UM-F, YWCA, etc.
ME provides a formal, systematic decision-making framework that facilitates and enhances sound
decision making within organizations.
ME focuses on the prescriptive approach to managerial decision, meaning a very applied approach
(instead of theoretical) to analyzing practical decisions actually faced by businesses and governments.
Most of the analytical methods covered in ME were developed in response to important, actual real-
world, recurring managerial decisions, such as optimal pricing (e.g., pricing in the airline industry
taking into account consumer demand, profit maximization, elasticity, rivals’ reactions), forecasting
(GM forecasting demand to determine optimal production, pricing, advertising, etc.), capital budgeting
(PV comparison of current costs versus expected future benefits), cost-benefit analysis of regulation or
legislation, etc. ME applies the principles of economics to help us understand how decisions are made
in the public and private sectors.
1. Multinational Production and Pricing. Consider U.S. automaker like GM with production
facilities in 50 countries and sales in almost 200 countries! To maximize profits, what decisions does
ECN 469: Managerial Economics Professor Mark J. Perry
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GM have to make in regard to pricing and production? See example in book, two markets for sales and
production of vehicles for an automaker (p. 3).
2. Forecasting. In the 1980s, Disney decided to enter the European market by investing billions of
dollars to build a new theme park somewhere in Europe, including 5000 hotel rooms, office space,
homes, golf course, etc. Decisions included where to locate in Europe, what attractions to offer, how to
modify Disney for the European market, how to finance the investment, etc. A major part of the initial
decision-making involved forecasting variables such as:
After opening in 1992, the project had many problems including: lower than expected attendance,
higher than expected costs, cultural issues such as alcohol and beards, etc. The original forecasts
turned out to be overly optimistic. Euro Disney illustrates the important role of forecasting in
managerial decisions.
3. R & D decisions. Pharmaceutical companies continually face very important R&D decisions; they
are putting up millions of dollars in research in most cases at least a decade before any revenue is
generated. Average time for FDA approval? There is extreme uncertainty about the outcome of
research, the cost of the research and the potential market value of a new product, so they are faced
with decision-making under uncertainty. In the case in the book, a drug company is faced with two
alternative research approaches to developing a drug to dissolve blood clots, which would potentially
generate huge profits. The case illustrates a common management issue: an investment with large
fixed costs (FC) but small variable costs (VC) versus an investment with small FC but large VC. High
tech approach (High FC, low VC) vs. Low tech approach (Low FC, High VC).
4. Credit Risk. Credit cards are very profitable, sometimes 3X more profitable than ordinary lending
(12-18% for credit cards vs. 4-8% for mortgages and car loans), but credit cards are more risky. Why?
Credit scores and credit-analysis software can be used to supplement human decision-making, and
measure credit risk, and predict what?
5. Market entry, competition, market structure. Giant book retailers Barnes & Noble and Borders
have been engaged in a cutthroat retail battle across the country, like in other industries such as:
Intense competition between dominant firms (superstores) in an industry results in many interesting
issues affecting decisions. If Borders enters a new market, will Barnes & Noble follow? Can an
incumbent erect barriers to entry? How to best compete against your rival, on which dimension to
ECN 469: Managerial Economics Professor Mark J. Perry
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compete, for example:
Intense competition exists in most industries, meaning that decisions involve strategic behavior,
strategic interdependence, e.g. if we lower our prices, will our rivals follow? If we enter a new market,
will our competitors follow? If we increase advertising, will our rivals follow? Point: decisions in
competitive industries involve both: a) internal criteria, and b) expected behavior of competitors, rivals.
6. Legal disputes, lawsuits, liability and uncertainty. The legal dispute between Texaco and
Pennzoil illustrates another example of decision making under uncertainty. Legal outcomes are always
uncertain, so decisions have to be made about: whether to settle or go to trial, whether to appeal if
ruling goes against you, etc.
7. Public sector investment. Should a city build a new expanded airport facility to accommodate
more flights at a cost of $50m-75m for construction, plus additional costs of operation? What are the
benefits, what are the costs, and what are the alternative uses of those resources? Other public sector
projects: building a new bridge (p. 6-7) or a sports stadium.
8. Government regulation. In 1970s electric utilities were required to convert from oil to coal.
Benefits: Reduced dependence on foreign oil.
Costs: Coal generates more pollution than oil, and requires costly equipment to reduce pollution.
Strip mining is required to obtain coal in Western states.
Locating coal-burning plants in remote areas to reduce pollution in populated areas would then disturb
and pollute wilderness areas.
Coal is more costly than oil, raising the cost of electricity to consumers.
Tradeoffs involve productive efficiency vs. pollution (spillover cost, negative externality). Govt. must
balance many issues: environmental, foreign security, cost of energy to consumers, etc. We probably
can't have cheap electricity and clean air at the same time, we have to give up something.
ECN 469: Managerial Economics Professor Mark J. Perry
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ME is a systematic way of thinking, approaching, analyzing managerial decisions.
SIX STEPS TO DECISION MAKING (see Figure 1.1 on page 7):
1. Define the problem. Clearly defining the problem and identifying the “decision context” is the
first step toward analyzing, evaluating and solving the problem.
2. Determine the objective. What exactly is the goal or goals? Evaluating alternatives requires
knowing what the goal(s) is (are). What is objective of most decisions in the private sector?
_______________ .
The objective of public decisions is usually broader and less clear than private decisions, but involves
cost-benefit analysis (maximize net benefits or minimize net costs), e.g. case #8 involving utility
regulation and pollution. However, a public project may be desirable even if it doesn't generate a
profit, e.g. the airport example.
a. Timing. Cost-benefit analysis is important in both private and public decisions, which involves
careful consideration of the timing of costs and benefits. Costs are generally incurred now for expected
benefits in the future, so the timing has to be considered, and future benefits have to be converted
(discounted) to present value (PV) dollars to compare to the costs (which are typically in PV dollars).
In public decisions, decision-making can be distorted by the political process, given the
shortsightedness effect. Public choice economics predicts that the political process favors legislation
that involves immediate and easily identifiable benefits for a concentrated special interest group, at the
expense of future costs that are complex, difficult to identify and dispersed over millions of
consumers/taxpayers, even when the B < C, e.g. trade protection. Why???
b. Risk and Uncertainty. Decision making generally involves comparing two or more risky options,
with uncertainty being a major factor. Following the profit-maximization principle doesn't always
necessarily guide us to the proper decision, because we can't determine with certainty ahead of time
which of two risky options yield the most profit.
3. Explore the alternatives. Ideally, we would like to consider all available options, and choose the
one that best achieves the objectives. However, consideration of all options is not usually
economically feasible, why???
Carmaker example: a) Alternatives are various prices to charge for vehicles in domestic market and
foreign market, and b) domestic production vs. foreign production of its vehicles. In this case, the
alternatives are fairly clear and obvious when determining P1, P2, Q1 and Q2 to maximize profits.
Other cases: Disney must decide whether to build new park, if so which location, what size, what
prices to charge, how to advertise, how to finance, etc.
For Drug Company, alternatives include deciding whether to pursue one R&D strategy or the other, or
both simultaneously or both sequentially or neither.
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