Introduction To Economic Decision Making, Lecture Notes - Managerial Economics, Study notes for Managerial Economics. University of Michigan (MI)
myboy12 October 2011

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

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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.

ECN 469: Managerial Economics Professor Mark J. Perry

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Sequential decision making and contingent plans: Most managerial decisions are NOT single, one

time decisions (Yes or No) at one point in time, but involve many continuous, sequential decisions

from alternatives, over time and contingent upon what happens at different stages of the process.

Example: Euro Disney involved sequential decisions requiring many adjustments.

4. Predict the consequences of alternatives, often using an economic, deterministic or

probabilistic model. In chapters 3-7, we study economic models of demand and cost that can be used

to make decisions about price and output to maximize profits. For example, if a firm cuts prices by

10%, we can predict the effect on demand and sales revenue if we know the firm's demand curve and

elasticity. Using an economic model of competitive behavior among oligopolists, we can predict how

Borders and Barnes & Noble will respond to each other's competitive strategies.

Other models to predict consequences might be based on engineering (constructing a new airport or

converting to coal), statistical (test marketing a product like eye surgery), legal (lawsuit example) or

scientific relationships (R&D example). We distinguish between: deterministic (certain outcomes) and

probabilistic models (uncertain outcomes), most typical.

Example: Predicting future demographic trends might be deterministic, e.g. based on the current

population, we can predict with a fairly high level of certainty: a) the number of high school graduates

in 2010 or b) the number of people eligible for Social Security in 2017. Predicting future demand for

enrollment at UM-F in 2010 or the future demand for retirement homes in Florida in 2010 is much less

certain, and involves probabilities of different outcomes.

5. Make a Choice, Select the Optimal Alternative. Most of the ME course involves steps 4 and 5,

with the assumption that objectives and outcomes are directly measurable and quantifiable (profit

max.). Once we know the demand for a firm's product and its cost schedule, it is fairly straightforward

to calculate the quantity of output that will maximize the firm's profit.

6. Perform sensitivity analysis. How sensitive is the optimal decision to changes in the variables and

underlying assumptions of the model - sensitivity analysis addresses that question by answering

“what-if” questions. What if sales are X% lower (higher) than expected? What if costs reductions are

X% higher (lower) than expected? What if Rival X responds by cutting its price by X%, etc. To which

of the key variables is the optimal outcome most sensitive?

Sensitivity analysis is easily performed with ________________????


ME is based on the “theory of the firm,” which assumes that management's primary goal is to

maximize the value of the firm (or maximize shareholder wealth), where a firm's value = PV of

expected future profits (see footnote 4 on page 15) and Profit = ______________. Managerial

decisions should be based on the goal of value maximization. However, value maximization may NOT

always take place, because of reasons such as:

ECN 469: Managerial Economics Professor Mark J. Perry

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1. The incentives of managers may not always be perfectly aligned with the goal of shareholders,

and because the managers control the firm (separation of ownership and control), they may not always

engage in value maximization. How might a manager's incentives deviate from shareholders’ goal of

maximizing their wealth?




2. Managers may lack the necessary information, or fail to get the information, necessary for

value maximization.

3. Managers may formulate but fail to implement optimal decisions.

Another Issue: There may be a difference of opinion about the optimal level of a firm's risk between

shareholders and managers. Under what conditions might the managers take on too much risk, or too

little risk from the shareholder's perspective?

Managers take on too little risk:

Managers take on too much risk:


Issue: Maximizing Sales or Market Share is not equal to Maximizing Profits. As we will see in CH 2,

Sales Max. usually occurs at level output greater than Profit Maximization. Managers may be more

interested in maximizing sales than profits. Why? What can be done to avoid this?


Firms, in the self-interested pursuit of profits for shareholders, generally promote the general interest

and welfare of society (invisible hand theory). How?

What are possible examples of profit-maximizing firms failing to promote the public interest?

ECN 469: Managerial Economics Professor Mark J. Perry

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Issue: Do firms have a “social responsibility” that goes beyond profit maximization? If so, what other

stakeholders should be considered? Controversial issue. Milton Friedman handout.

Although possibly controversial, the economic model of maximization of profit / value / shareholder

wealth is our underlying assumption for ME.

See page 20, Figure 1.2 for a diagram of future chapters and areas of study.

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