Chapter 1
NATURE AND SCOPE OF MANAGERIAL ECONOMICS
QUESTIONS & ANSWERS
Q1.1 Is it appropriate to view firms primarily as economic entities?
Q1.1 ANSWER
Yes. Firms represent a combination of people, physical assets, and information
(financial, technical, marketing, and so on). People directly involved include
stockholders, managers, workers, suppliers, and customers. Businesses use scarce
resources that would otherwise be available for other purposes, pay income and other
taxes, provide employment opportunities, and are responsible for much of the material
well-being of our society. Thus, all of society is indirectly involved in the firm's
operation. Firms exist because they are useful in the process of allocating resources --
producing and distributing goods and services. As such, they are basically economic
entities.
Q1.2 Explain how the valuation model given in Equation 1.2 could be used to describe the
integrated nature of managerial decision making across the functional areas of business.
Q1.2 ANSWER
As seen in the text, Equation 1.2 can be written:
, n
-
Value = TR t TC t
t
t=1 (1 + i )
where TR is total revenue, TC is total cost, i is an appropriate (risk-adjusted) interest rate, and t
indicates the relevant time period. Thus, the value of the firm is the discounted present value of the
stream of expected future profits.
Each of the functional areas of business plays an important role in managerial
decision making since each area provides vital input into the value maximization
process. The marketing department of a firm has a major responsibility for sales, the
production department a major responsibility for costs, and the finance department
has a major responsibility for acquiring the capital necessary to support the firm's
investment activities. There are many important overlaps among these functional
areas--the marketing department, for example, can help reduce the costs associated
with a given level of output by affecting the size and timing of customer orders. The
production department can stimulate sales by improving quality and making new
products available to sales personnel. Other departments within the firm--for example,
accounting, personnel, transportation, and engineering--provide information or
services vital to both continued sales growth and cost control. These activities all affect
the risks of the firm and thereby the discount rate used to determine present values.
Thus, various decisions in different departments of the firm can be appraised in terms
of their effects on the value of the firm as expressed in Equation 1.2. Therefore, the
value maximization model is useful in describing the integrated nature of managerial
decision making across the functional areas of business.
Q1.3 Describe the effects of each of the following managerial decisions or economic influences
on the value of the firm:
A. The firm is required to install new equipment to reduce air pollution.
B. Through heavy expenditures on advertising, the firm's marketing department
increases sales substantially.
C. The production department purchases new equipment that lowers manufacturing
costs.
D. The firm raises prices. Quantity demanded in the short run is unaffected, but in the
longer run, unit sales are expected to decline.
, E. The Federal Reserve System takes actions that lower interest rates dramatically.
F. An expected increase in inflation causes generally higher interest rates, and, hence,
the discount rate increases.
Q1.3 ANSWER
A. The most direct effect of a requirement to install new pollution control
equipment would be an increase in the operating cost component of the
valuation model. Secondary effects might be expected in the discount rate due
to an increase in regulatory risk, and in the revenue function if consumers react
positively to the installation of the pollution control equipment in production
facilities.
B. All three major components of the valuation model--the revenue function, cost
function, and the discount rate--are likely to be affected by an increase in
advertising. Revenues and cost will both increase as output is expanded. The
discount rate may be affected if the firm's profit outlook changes significantly
because of increased demand (growth) or if borrowing is necessary to fund a
rapid expansion of plant and equipment to meet increased demand.
C. The primary effect of newer and more efficient production equipment is a
reduction in the total cost component of the valuation model. Secondary effects
on firm revenues could also be important if lower costs make price reductions
possible and result in an increase in the quantity demanded of the firm's
products. Likewise, the capitalization rate or discount factor can be affected by
the firm's changing prospects.
D. The time pattern of revenues is affected by such a pricing decision to raise prices
in the near term. This will alter production relationships and investment plans,
and affect the valuation model through the cost component and capitalization
factor.
, E. A general lowering of interest rates leads to a reduction in the cost of capital or
discount rate in the valuation model.
F. Higher rates of inflation, leading to an increase in the discount rate, cause the
present value of a constant income stream to decline. Unless the firm is able to
increase product prices in order to maintain profit margins, the value of the firm
falls as inflation and the discount rate increases. Of course, the economic effects
of inflation on the economic value of the firm are complex, involving both asset
and liability valuations, so determining the overall effect of inflation on the
economic value of individual firms is a difficult task.
Q1.4 In the wake of corporate scandals at Enron, Tyco, and WorldCom, some argue that
managers of large, publicly owned firms sometimes make decisions to maximize their
own welfare as opposed to that of stockholders. Does such behavior create problems in
using value maximization as a basis for examining managerial decision making?
Q1.4 ANSWER
Yes, like virtually all theory, the value maximization model involves some
simplification and abstraction from reality. The important question is whether or not
the model is realistic enough to provide useful insight into the managerial decision
making process. While managers undoubtedly do take their own welfare into account
when making decisions, evidence strongly indicates that market pressures provide a
strong incentive for managers to act in accord with the dictates of economic efficiency.
Furthermore, managers who pursue policies detrimental to stockholder interests run
the risk of being replaced following stockholder "revolts" or unfriendly takeovers.
Q1.5 How is the popular notion of business profit different from the economic profit concept
described in the chapter? What role does the idea of normal profits play in this
difference?
Q1.5 ANSWER
NATURE AND SCOPE OF MANAGERIAL ECONOMICS
QUESTIONS & ANSWERS
Q1.1 Is it appropriate to view firms primarily as economic entities?
Q1.1 ANSWER
Yes. Firms represent a combination of people, physical assets, and information
(financial, technical, marketing, and so on). People directly involved include
stockholders, managers, workers, suppliers, and customers. Businesses use scarce
resources that would otherwise be available for other purposes, pay income and other
taxes, provide employment opportunities, and are responsible for much of the material
well-being of our society. Thus, all of society is indirectly involved in the firm's
operation. Firms exist because they are useful in the process of allocating resources --
producing and distributing goods and services. As such, they are basically economic
entities.
Q1.2 Explain how the valuation model given in Equation 1.2 could be used to describe the
integrated nature of managerial decision making across the functional areas of business.
Q1.2 ANSWER
As seen in the text, Equation 1.2 can be written:
, n
-
Value = TR t TC t
t
t=1 (1 + i )
where TR is total revenue, TC is total cost, i is an appropriate (risk-adjusted) interest rate, and t
indicates the relevant time period. Thus, the value of the firm is the discounted present value of the
stream of expected future profits.
Each of the functional areas of business plays an important role in managerial
decision making since each area provides vital input into the value maximization
process. The marketing department of a firm has a major responsibility for sales, the
production department a major responsibility for costs, and the finance department
has a major responsibility for acquiring the capital necessary to support the firm's
investment activities. There are many important overlaps among these functional
areas--the marketing department, for example, can help reduce the costs associated
with a given level of output by affecting the size and timing of customer orders. The
production department can stimulate sales by improving quality and making new
products available to sales personnel. Other departments within the firm--for example,
accounting, personnel, transportation, and engineering--provide information or
services vital to both continued sales growth and cost control. These activities all affect
the risks of the firm and thereby the discount rate used to determine present values.
Thus, various decisions in different departments of the firm can be appraised in terms
of their effects on the value of the firm as expressed in Equation 1.2. Therefore, the
value maximization model is useful in describing the integrated nature of managerial
decision making across the functional areas of business.
Q1.3 Describe the effects of each of the following managerial decisions or economic influences
on the value of the firm:
A. The firm is required to install new equipment to reduce air pollution.
B. Through heavy expenditures on advertising, the firm's marketing department
increases sales substantially.
C. The production department purchases new equipment that lowers manufacturing
costs.
D. The firm raises prices. Quantity demanded in the short run is unaffected, but in the
longer run, unit sales are expected to decline.
, E. The Federal Reserve System takes actions that lower interest rates dramatically.
F. An expected increase in inflation causes generally higher interest rates, and, hence,
the discount rate increases.
Q1.3 ANSWER
A. The most direct effect of a requirement to install new pollution control
equipment would be an increase in the operating cost component of the
valuation model. Secondary effects might be expected in the discount rate due
to an increase in regulatory risk, and in the revenue function if consumers react
positively to the installation of the pollution control equipment in production
facilities.
B. All three major components of the valuation model--the revenue function, cost
function, and the discount rate--are likely to be affected by an increase in
advertising. Revenues and cost will both increase as output is expanded. The
discount rate may be affected if the firm's profit outlook changes significantly
because of increased demand (growth) or if borrowing is necessary to fund a
rapid expansion of plant and equipment to meet increased demand.
C. The primary effect of newer and more efficient production equipment is a
reduction in the total cost component of the valuation model. Secondary effects
on firm revenues could also be important if lower costs make price reductions
possible and result in an increase in the quantity demanded of the firm's
products. Likewise, the capitalization rate or discount factor can be affected by
the firm's changing prospects.
D. The time pattern of revenues is affected by such a pricing decision to raise prices
in the near term. This will alter production relationships and investment plans,
and affect the valuation model through the cost component and capitalization
factor.
, E. A general lowering of interest rates leads to a reduction in the cost of capital or
discount rate in the valuation model.
F. Higher rates of inflation, leading to an increase in the discount rate, cause the
present value of a constant income stream to decline. Unless the firm is able to
increase product prices in order to maintain profit margins, the value of the firm
falls as inflation and the discount rate increases. Of course, the economic effects
of inflation on the economic value of the firm are complex, involving both asset
and liability valuations, so determining the overall effect of inflation on the
economic value of individual firms is a difficult task.
Q1.4 In the wake of corporate scandals at Enron, Tyco, and WorldCom, some argue that
managers of large, publicly owned firms sometimes make decisions to maximize their
own welfare as opposed to that of stockholders. Does such behavior create problems in
using value maximization as a basis for examining managerial decision making?
Q1.4 ANSWER
Yes, like virtually all theory, the value maximization model involves some
simplification and abstraction from reality. The important question is whether or not
the model is realistic enough to provide useful insight into the managerial decision
making process. While managers undoubtedly do take their own welfare into account
when making decisions, evidence strongly indicates that market pressures provide a
strong incentive for managers to act in accord with the dictates of economic efficiency.
Furthermore, managers who pursue policies detrimental to stockholder interests run
the risk of being replaced following stockholder "revolts" or unfriendly takeovers.
Q1.5 How is the popular notion of business profit different from the economic profit concept
described in the chapter? What role does the idea of normal profits play in this
difference?
Q1.5 ANSWER
