Chapter 1: Managers, Profits, and Markets
Chapter 1:
MANAGERS, PROFITS, AND MARKETS
Essential Concepts
1. Managerial economics applies microeconomic theory—the study of the behavior of
2. Economic 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,
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
6. Industrial organization identifies seven economic forces that promote long-run profitability:
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. Total 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–
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
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
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. The 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. The 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
15. If 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,
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
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
Chapter 1: Managers, Profits, and Markets
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
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
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
22. In 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.
23. A 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.
25. A 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. Market structure is a set of characteristics that determines the economic environment in
which a firm operates:
Chapter 1: Managers, Profits, and Markets
27. Markets may be structured as one of four types:
(1) A perfectly competitive market has a large number of relatively small firms selling an
undifferentiated product in a market with no barriers to entry.
profits—with varying degrees of product differentiation.
28. Globalization of markets is the economic integration of markets located in nations around the
world. Globalization provides managers with both an opportunity to sell more goods and
Answers to Applied Problems
1. To say that a decision rule or process does not work in theory is to say that the answer produced by
the rule is not going to be the “correct” answer. In business decision making, managers get the
“correct” answer when their solutions are ones that lead to the greatest level of profit.
For example, it is rather easy to calculate the profit margin for a good or service and to make a
pricing decision that will maximize the profit margin on the good or service. While that may be a
very practical method of determining price, pricing to maximize profit margin does not in theory lead
2. a. Total explicit cost = $793,000 (= 555,000 + 45,000 + 28,000 + 165,000)
Total implicit cost = $190,000 (= 175,000 + 0.15 100,000)
3. The $8,000 of lost income, even though not tax-deductible, is indeed part of the economic cost the
Chapter 1: Managers, Profits, and Markets
4. a. Burton’s explicit cost’s are $18,000 per month. His implicit costs are $20,000 per month ($15,000
+ $5,000).
5. One cost of opening a tennis shop would be the forgone salary of the previous job. Given that
Nadal’s or Venus’ foregone income would be much larger than that of a university coach, their
opportunity cost would be higher.
6. Linking the board of directors’ compensation to return on equity creates an incentive for management
to pursue profit-maximization as a goal, thereby reducing the agency problem between managers and
7. a. Some Marriott franchises are shirking their responsibility to maintain high quality hotels, and this
shirking damages the reputation of all Marriott franchises.
8. Even though the financial arrangement with Delta and United limited the growth in SkyWest’s
economic profits in future years, the agreement decreased the risk associated with SkyWest’s profits.
In the Fortune article, one financial analyst states, “They (SkyWest) shield themselves from the
factors that lead to volatility in earnings—fuel prices, ticket prices, and load factors—and bring
investors the certainty they are looking for.” The lower level of risk reduces the risk-adjusted
discount rate, and, for a given stream of profits, the value of the SkyWest rises.
Answers to Mathematical Exercises
1. a. PV = NCF/(1 + r)t = $1,000/(1.065) = $938.97
2. The present value is calculated as follows:
3. Option A: Ashton pays Demi $1,000,000 each year for 10 years (Ashton wishes to make each
payment at year-end.)
Chapter 1: Managers, Profits, and Markets
Option B: Ashton pays Demi $5,000,000 in cash now.
4. Since the lease payment is a constant amount for each of the 100 years –and 100 years is a long time, we can get
a very good approximation of the present value by using the formula for a perpetual stream of profit payments: