Advanced Managerial Economics - PDF Free Download

Advanced Managerial Economics Andy McLennan July 27, 2016

Course outline Topics covered in Gans Core Economics for Managers : 1. Economic decision-making (Chapters 2-4) (July 27, August 4, 11) 2. Negotiations (Chapters 5-7) (August 18, 25, September 1) 3. Pricing strategies (Chapters 8-10) (September 15, 22, October 6) 4. Contracting and incentives (Chapters 11-13) (October 13, 20, 27) Guest lecturers: Claudio Mezzetti, July 27 Shino Takayama, August 25

Course requirements Midterm exam (September 8-25%) Three parts: (1) multiple choice; (2) short answer; (3) problem solving Group project report and slides (October 14, 12:00 noon; via the online submission folder, Blackboard - 30%) Managerial economics analysis of movies (e.g., Blood Diamond, The Godfather, Heat) Report, min 3 - max 5 pages, and slides for 15 minute presentation Final exam (examination period - 45%) Three parts: (1) multiple choice; (2) short answer; (3) problem solving Office hours: 520 Colin Clark Bldg, Friday 14:00-16:00 (or 2:00-4:00pm)

Introduction KEY IDEAS of Managerial Economics: Incentives matter (most of the time) Decision makers are (mostly) rational: stable and well-defined preferences and/or goals Prices provide correct signals of relative scarcities Optimal decisions take into account the environment: customers, suppliers, competitors and complementors Information and beliefs are relevant

Introduction KEY TOOLS of Managerial Economics: Mathematical models of consumer and firm behavior Competition models: perfect competition, oligopolistic competition, monopoly Game theory: strategic interaction among players (consumers, firms, regulators, providers) Models of decision theory under uncertainty or incomplete information

Individual Decision-Making

Fundamentals of decision-making Rational decision-makers: optimizing agents with stable, well-defined preferences and goals Constraints: environment determines what is or isn t feasible (affordability/feasibility) Information: decisions under complete or incomplete information (expected profit) Time: static or dynamic decision Strategic interaction: among different players (other firms, government policies)

Decision tree Tool used to frame the decision process as an optimization problem Nodes for new available information decision node chance node Branches represent available alternatives Final nodes describe payoffs

Example TimeScape Ltd (Gans p. 15) TimeScape Ltd is a company that produces a software used on handheld computers. Catherine (managing director) has to make a decision on whether to invest in the development of a new technology that would allow their software to be used on smart phones. Develop ($200k) C Take the risk? Don t develop time

Example TimeScape Ltd (Gans p. 15) Chance node Success: 50% Develop ($200k) Enter or not? C Failure: 50% Don t develop = h time

Example TimeScape Ltd (Gans p. 15) Chance node Enter Profit hand + mob = h + M - c - 200k C Develop ($200k) Success: 50% Failure: 50% Don t Enter = h - 200k Profit hand + mob = h + m - c - 200k Don t develop = h Don t = h - 200k time

Example TimeScape Ltd (Gans p. 15) M > m Chance node Enter Profit hand + mob = h + M - c - 200k C Develop ($200k) Success: 50% Failure: 50% Don t Enter = h - 200k Profit hand + mob = h + m - c - 200k Don t develop = h Don t = h - 200k time

Solving the tree Solve it by backward induction. Chance node M > c Enter Profit hand + mob = h + M - c - 200k C Develop ($200k) Success: 50% Failure: 50% Don t M < c Enter = h - 200k Profit hand + mob = h + m - c - 200k Don t develop = h Don t = h - 200k time

Solving the tree Chance node Enter Profit hand + mob = h + M - c - 200k C Develop ($200k) Success: 50% Failure: 50% Don t m > c Enter = h - 200k Profit hand + mob = h + m - c - 200k Don t develop = h Don t m < c = h - 200k time

Three relevant cases to consider Expected profit: Develop Do not develop Case 1 0.5(h + M c 200,000) h M > m > c +0.5(h + m c 200,000) Case 2 0.5(h + M c 200,000) h M > c > m +0.5(h 200,000) Case 3 0.5(h 200,000) h c > M > m +0.5(h 200,000)

Three relevant cases to consider Expected profit: Develop Do not develop Case 1 h + 0.5(M + m) c 200,000 h M > m > c Case 2 h + 0.5(M c) 200,000 h M > c > m Case 3 h 200,000 h c > M > m

Cases 1 and 2 are ambiguous Case 1: the best option for Catherine is to develop if h+0.5(m +m) c 200,000 > h 0.5(M +m) c > 200,000 not develop otherwise. Case 2: the best option for Catherine is to develop if h + 0.5(M c) 200,000 > h M c > 400,000 not develop otherwise.

Common pitfalls: sunk cost Definition Sunk cost = expenditure that has been made and cannot be recovered. It should not be taken into account when making decisions!

Sunk costs in the example Suppose that TimeScape had already spent $100,000 on exploration of the mobile software option. Enter Profit hand + mob = h + M - c - 300k Develop Success: 50% Don t = h - 300k C Failure: 50% Enter Profit hand + mob = h + m - c - 300k Don t develop = h - 100k Don t = h - 300k time

Common pitfalls: economic versus accounting profit Definition Accounting profit = revenue - accounting cost Accounting cost = actual expenses + depreciation Definition Economic profit = revenue - economic cost Economic cost = cost to a firm of using economic resources in production, including opportunity cost Economic cost includes the opportunity cost: Definition Opportunity cost = cost associated with opportunities that are foregone when a firm s resources are not put to their best alternative use.

How to calculate economic cost Example (economic versus accounting cost) You run a small consulting firm. A portion of your firm s costs covers the office space it occupies. If you wanted to, you could sublet or rent the office space to another company for $2,500 per month. Three scenarios: 1. Two years ago, you signed a five-year lease ($2,000 per month). 2. Two years ago, you bought the office space and are paying a mortgage ($3,000 per month). 3. Two years ago, you bought your office building for $1,170,000 in cash and expect the building to be useful for 30 years. Accounting cost Economic cost Case 1 $2,000 $2,500 Case 2 $3,000 $2,500 Case 3 $3,250 $2,500

Opportunity costs in a merger Example (Disney s acquisition of ABC) One thing written in the popular press about this acquisition was that it was great. Now ABC can get programming from Disney for free. But that really does not make sense. If Disney did not give that programming to ABC, what would they do with it? They would sell the programming to some other broadcast network. And so if Disney gives a programme to ABC, they forego revenues from some other opportunity. When we think about the cost of running ABC, we have to not just include the cost that we actually see on the balance sheet that ABC pays, we have to take into account the revenues that Disney had to forego by giving programmes to ABC rather than selling them to somebody else.

Concluding remarks Decision trees help with cost-benefit analysis of choices. Identify trade-offs between the alternatives you have available. Clear out noise and irrelevant information.