Chapter 1:
MANAGERS, PROFITS, AND MARKETS
Essential Concepts
1. 1Managerial economics applies microeconomic theory—the study of the
behavior of individual economic agents—to business problems in order to teach
business decision makers how to use economic analysis to make decisions that
will achieve the firm’s goal—maximization of profit.
2. 1Economic theory helps managers understand real-world business problems by
using simplifying assumptions to abstract away from irrelevant ideas and
information and turn complexity into relative simplicity.
3. Microeconomics is the study and analysis of the behavior of individual segments
of the economy: individual consumers, workers and owners of resources,
individual firms, industries, and markets for goods and services. Using marginal
analysis, microeconomics provides the foundation for understanding the
everyday business decisions managers routinely make in running a business.
Such decisions are frequently referred to as business practices or tactics.
4. Industrial organization is a specialized branch of microeconomics that focuses
on the behavior and structure of firms and industries. Industrial organization
supplies the foundation for understanding strategic decisions through the
application of game theory.
5. Strategic decisions differ from routine business practices or tactics because, in
contrast to routine business practices, strategic decisions seek to shape or alter
the conditions under which a firm competes with its rivals in ways that will
increase and/or protect the firm’s long-run profit. While routine business
practices are necessary for keeping organizations moving toward their goal of
profit-maximization, strategic decisions are generally optional actions managers
can take as circumstances permit.
6. Industrial organization identifies seven economic forces that promote long-run
profitability: few close substitutes, strong entry barriers, weak rivalry within
markets, low market power of input suppliers, low market power of consumers,
abundant complementary products, and limited harmful government
intervention.
,7. The economic cost of using resources to produce a good or service is the
opportunity cost to the owners of the firm using those resources. The
opportunity cost of using any kind of resource is what the owners of the firm
must give up to use the resource.
8. 1Total economic cost is the sum of the opportunity costs of market-supplied
resources plus the opportunity costs of owner-supplied resources. The
opportunity costs of using market-supplied resources are the out-of-pocket
monetary payments made to the owners of resources, which are called explicit
costs. The opportunity cost of using an owner-supplied resource is the best
return the owners of the firm could have received had they taken their own
resource to market instead of using it themselves. Such nonmonetary
opportunity costs are called implicit costs.
9. Businesses may incur numerous kinds of implicit costs, but the three most
important types of implicit costs are (1) the opportunity cost of cash provided
by owners, known as equity capital, (2) the opportunity cost of using land or
capital owned by the firm, and (3) the opportunity cost of the owner’s time
spent managing the firm or working for the firm in some other capacity.
10. Economic profit is the difference between total revenue and total economic cost:
Economic profit = Total revenue – Total economic cost
= Total revenue – Explicit costs – Implicit costs
Economic profit belongs to the owners and will increase the wealth of the
owners. When revenues fall short of total economic cost, economic profit is
negative, and the loss must be paid for out of the wealth of the owners.
11. When accountants calculate business profitability for financial reports, they
follow a set of rules known as “generally accepted accounting principles” or
GAAP. These rules, which are constructed by the Securities and Exchange
Commission (SEC) and the Financial Accounting Standards Board (FASB) do not
allow accountants to deduct most types of implicit costs for the purposes of
calculating taxable accounting profit. Thus, accounting profit differs from
economic profit because accounting profit does not subtract from total revenue
the implicit costs of using resources.
Accounting profit = Total revenue – Explicit costs
12. Since the owners of firms must cover the costs of all resources used by the firm,
maximizing economic profit, rather than accounting profit, is the objective of the
firm’s owners.
13. 1The value of a firm is the price for which it can be sold, and that price is equal
to the present value of the expected future profit of the firm.
,14. 1The risk associated with not knowing future profits of a firm is accounted for
by adding a risk premium to the discount rate used for calculating the present
value of the firm’s future profits. The larger (smaller) the risk associated with
future profits, the higher (lower) the risk premium used to compute the value of
the firm, and the lower (higher) the value of the firm will be.
15. 1If cost and revenue conditions in any period are independent of decisions made
in other time periods, a manager will maximize the value of a firm by making
decisions that maximize profit in every single time period.
16. Taking a course in managerial economics can help you avoid making a number
of common mistakes in business decision making: never increase output simply
to reduce average costs, generally avoid the pursuit of market share because
doing so usually lowers profit, focus on maximizing total profit rather than
profit margin, understand that maximizing total revenue does not maximize
profit, and avoid the use of cost-plus pricing methods when setting prices.
17. The decision to hire professional managers to run a business separates business
ownership and management and creates a principal-agent relationship in which
a firm’s owner (the principal) contracts with a CEO or executive management
team (the agent) to perform tasks designed to further the objectives or goals of
the owner. Contracts between owners and managers cannot be designed and
executed perfectly because it is nearly impossible for owners to foresee all of the
many ways that managers could behave opportunistically to benefit themselves
at the expense of the owners.
18. A principal-agent problem arises when owners cannot be certain that managers
are making decisions to further the owner’s objective, which is to maximize the
value of the firm. A principal–agent problem requires the presence of two
conditions: (1) the manager’s objectives must be different from those of the
owner, and (2) the owner must find it impossible or simply too costly to monitor
and verify that the management is indeed advancing the owner’s objective by
making decisions that will maximize the firm’s value.
19. When the goals of owners are different from the goals of managers, economists
say that owner and manager goals are not aligned or that managers and owners
possess conflicting objectives. A manager, like any self-interested person, will
search for opportunities to make decisions for the business that promote the
best interests of the manager, and some of these decisions will harm the owners
of the firm. These conflicting managerial actions might include taking excessive
perks or following unprofitable pursuits the managers finds personally
satisfying such as increasing the size of the firm or its market share.
20. When the objectives of owners and managers are not aligned, it makes sense for
the owners to include legal stipulations in the manager’s contract forcing
managers to make decisions that are strictly designed to generate the greatest
possible profit and value for the firm. Monitoring managers can be largely
, impossible when managers are able to take hidden actions that cannot be
observed by owners. Hidden actions are possible when there is asymmetric
information between owners and managers. Asymmetric information means
that managers possess more or better information than owners possess about
profit opportunities available to the firm and the nature of the decisions
required to maximize the firm’s profit.
21. When managers behave opportunistically by exploiting information
asymmetries to take hidden actions harming owners but benefiting managers in
some way then a principle-agent problem called moral hazard is created. Moral
hazard is both a problem of nonaligned objectives and a problem of harmful
hidden actions. If either one of these two aspects is missing then there is no
moral hazard problem.
22. 1In order to address principal-agent problems caused by nonalignment of
owner and management goals, owners can employ a variety of corporate control
mechanisms:
(1) Require managers to hold enough of the firm’s equity stock to make
managers care intensely about maximize the value of the firm,
(2) Increase the number of outsiders serving on the company’s board of
directors, and
(3) Finance corporate investments with debt instead of equity.
Beyond these three internal measures, there is an important external force or
event – a corporate takeover-- that can also motivate managers to make
decisions that maximize the value of a firm.
23. 1A price-taking firm cannot set the price of the product it sells because price is
determined strictly by the market forces of demand and supply.
24. 1A price-setting firm sets the price of its product because it possesses some
degree of market power, which is the ability to raise price without losing all
sales.
25. 1A market is any arrangement that enables buyers and sellers to exchange
goods and services, usually for money payments. Markets exist to reduce
transaction costs, the costs of making a transaction.
26. 1Market structure is a set of characteristics that determines the economic
environment in which a firm operates:
(1) the number and size of firms operating in the market,
(2) the degree of product differentiation, and
(3) the likelihood of new firms’ entering.
MANAGERS, PROFITS, AND MARKETS
Essential Concepts
1. 1Managerial economics applies microeconomic theory—the study of the
behavior of individual economic agents—to business problems in order to teach
business decision makers how to use economic analysis to make decisions that
will achieve the firm’s goal—maximization of profit.
2. 1Economic theory helps managers understand real-world business problems by
using simplifying assumptions to abstract away from irrelevant ideas and
information and turn complexity into relative simplicity.
3. Microeconomics is the study and analysis of the behavior of individual segments
of the economy: individual consumers, workers and owners of resources,
individual firms, industries, and markets for goods and services. Using marginal
analysis, microeconomics provides the foundation for understanding the
everyday business decisions managers routinely make in running a business.
Such decisions are frequently referred to as business practices or tactics.
4. Industrial organization is a specialized branch of microeconomics that focuses
on the behavior and structure of firms and industries. Industrial organization
supplies the foundation for understanding strategic decisions through the
application of game theory.
5. Strategic decisions differ from routine business practices or tactics because, in
contrast to routine business practices, strategic decisions seek to shape or alter
the conditions under which a firm competes with its rivals in ways that will
increase and/or protect the firm’s long-run profit. While routine business
practices are necessary for keeping organizations moving toward their goal of
profit-maximization, strategic decisions are generally optional actions managers
can take as circumstances permit.
6. Industrial organization identifies seven economic forces that promote long-run
profitability: few close substitutes, strong entry barriers, weak rivalry within
markets, low market power of input suppliers, low market power of consumers,
abundant complementary products, and limited harmful government
intervention.
,7. The economic cost of using resources to produce a good or service is the
opportunity cost to the owners of the firm using those resources. The
opportunity cost of using any kind of resource is what the owners of the firm
must give up to use the resource.
8. 1Total economic cost is the sum of the opportunity costs of market-supplied
resources plus the opportunity costs of owner-supplied resources. The
opportunity costs of using market-supplied resources are the out-of-pocket
monetary payments made to the owners of resources, which are called explicit
costs. The opportunity cost of using an owner-supplied resource is the best
return the owners of the firm could have received had they taken their own
resource to market instead of using it themselves. Such nonmonetary
opportunity costs are called implicit costs.
9. Businesses may incur numerous kinds of implicit costs, but the three most
important types of implicit costs are (1) the opportunity cost of cash provided
by owners, known as equity capital, (2) the opportunity cost of using land or
capital owned by the firm, and (3) the opportunity cost of the owner’s time
spent managing the firm or working for the firm in some other capacity.
10. Economic profit is the difference between total revenue and total economic cost:
Economic profit = Total revenue – Total economic cost
= Total revenue – Explicit costs – Implicit costs
Economic profit belongs to the owners and will increase the wealth of the
owners. When revenues fall short of total economic cost, economic profit is
negative, and the loss must be paid for out of the wealth of the owners.
11. When accountants calculate business profitability for financial reports, they
follow a set of rules known as “generally accepted accounting principles” or
GAAP. These rules, which are constructed by the Securities and Exchange
Commission (SEC) and the Financial Accounting Standards Board (FASB) do not
allow accountants to deduct most types of implicit costs for the purposes of
calculating taxable accounting profit. Thus, accounting profit differs from
economic profit because accounting profit does not subtract from total revenue
the implicit costs of using resources.
Accounting profit = Total revenue – Explicit costs
12. Since the owners of firms must cover the costs of all resources used by the firm,
maximizing economic profit, rather than accounting profit, is the objective of the
firm’s owners.
13. 1The value of a firm is the price for which it can be sold, and that price is equal
to the present value of the expected future profit of the firm.
,14. 1The risk associated with not knowing future profits of a firm is accounted for
by adding a risk premium to the discount rate used for calculating the present
value of the firm’s future profits. The larger (smaller) the risk associated with
future profits, the higher (lower) the risk premium used to compute the value of
the firm, and the lower (higher) the value of the firm will be.
15. 1If cost and revenue conditions in any period are independent of decisions made
in other time periods, a manager will maximize the value of a firm by making
decisions that maximize profit in every single time period.
16. Taking a course in managerial economics can help you avoid making a number
of common mistakes in business decision making: never increase output simply
to reduce average costs, generally avoid the pursuit of market share because
doing so usually lowers profit, focus on maximizing total profit rather than
profit margin, understand that maximizing total revenue does not maximize
profit, and avoid the use of cost-plus pricing methods when setting prices.
17. The decision to hire professional managers to run a business separates business
ownership and management and creates a principal-agent relationship in which
a firm’s owner (the principal) contracts with a CEO or executive management
team (the agent) to perform tasks designed to further the objectives or goals of
the owner. Contracts between owners and managers cannot be designed and
executed perfectly because it is nearly impossible for owners to foresee all of the
many ways that managers could behave opportunistically to benefit themselves
at the expense of the owners.
18. A principal-agent problem arises when owners cannot be certain that managers
are making decisions to further the owner’s objective, which is to maximize the
value of the firm. A principal–agent problem requires the presence of two
conditions: (1) the manager’s objectives must be different from those of the
owner, and (2) the owner must find it impossible or simply too costly to monitor
and verify that the management is indeed advancing the owner’s objective by
making decisions that will maximize the firm’s value.
19. When the goals of owners are different from the goals of managers, economists
say that owner and manager goals are not aligned or that managers and owners
possess conflicting objectives. A manager, like any self-interested person, will
search for opportunities to make decisions for the business that promote the
best interests of the manager, and some of these decisions will harm the owners
of the firm. These conflicting managerial actions might include taking excessive
perks or following unprofitable pursuits the managers finds personally
satisfying such as increasing the size of the firm or its market share.
20. When the objectives of owners and managers are not aligned, it makes sense for
the owners to include legal stipulations in the manager’s contract forcing
managers to make decisions that are strictly designed to generate the greatest
possible profit and value for the firm. Monitoring managers can be largely
, impossible when managers are able to take hidden actions that cannot be
observed by owners. Hidden actions are possible when there is asymmetric
information between owners and managers. Asymmetric information means
that managers possess more or better information than owners possess about
profit opportunities available to the firm and the nature of the decisions
required to maximize the firm’s profit.
21. When managers behave opportunistically by exploiting information
asymmetries to take hidden actions harming owners but benefiting managers in
some way then a principle-agent problem called moral hazard is created. Moral
hazard is both a problem of nonaligned objectives and a problem of harmful
hidden actions. If either one of these two aspects is missing then there is no
moral hazard problem.
22. 1In order to address principal-agent problems caused by nonalignment of
owner and management goals, owners can employ a variety of corporate control
mechanisms:
(1) Require managers to hold enough of the firm’s equity stock to make
managers care intensely about maximize the value of the firm,
(2) Increase the number of outsiders serving on the company’s board of
directors, and
(3) Finance corporate investments with debt instead of equity.
Beyond these three internal measures, there is an important external force or
event – a corporate takeover-- that can also motivate managers to make
decisions that maximize the value of a firm.
23. 1A price-taking firm cannot set the price of the product it sells because price is
determined strictly by the market forces of demand and supply.
24. 1A price-setting firm sets the price of its product because it possesses some
degree of market power, which is the ability to raise price without losing all
sales.
25. 1A market is any arrangement that enables buyers and sellers to exchange
goods and services, usually for money payments. Markets exist to reduce
transaction costs, the costs of making a transaction.
26. 1Market structure is a set of characteristics that determines the economic
environment in which a firm operates:
(1) the number and size of firms operating in the market,
(2) the degree of product differentiation, and
(3) the likelihood of new firms’ entering.
