Lecture 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:
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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