In this chapter we have introduced the subject of managerial economics and proceeded to build a framework for business decision making. Managerial economics was defined as the application of economic principles and methodologies to the decisionmaking process within the firm or organization. It is a normative discipline, seeking to provide rules that allow the firm to best pursue its objective function. The use of models in managerial economics was examined, and we noted that the purpose of models may be either pedagogical, explanatory, or predictive. In this course we will
l2 See S. A. Ross, “The Economic Theory of Agency: The Principal’s Problem,” American Economic Review, 58 (May 1973), pp. 134-39; M. Harris and A. Raviv, “Some Results on Incentive Contracts with Applications to Education and Employment, Health Insurance, and Law Enforcement,” American Economic Review, 68 (March 1978), pp. 20-30; and S. Shavell, “Risk Sharing and Incentives in the Principal and Agent Relationship,” Bell Journal of Economics, 10 (Spring 1979), pp. 55-73.
use symbolic models, including verbal, graphic, and some simple mathematical expressions.
Present-value analysis and expected-value analysis were introduced and examined in detail. The former involves the discounting of future cash flows so that they may be properly compared with present cash flows for decision-making purposes. The appropriate rate of discount is the opportunity interest rate, defined as the best rate of
return available elsewhere at similar risk.
Expected-value analysis allows the summary of a probability distribution of outcomes in a single number, which may then be compared with the expected values of other decision alternatives. The expected value of a decision is the weighted mean of the possible outcomes, where the weight for each outcome is the prior probability of its occurring. Expected present-value analysis requires discounting the expected value of future profits back to present-value terms before aggregation to find the expected present value of each decision alternative.
If the firm’s planning period is sufficiently short that its time horizon falls within the present period, the firm should maximize its profits within the present period (if it has full information) or maximize the expected value of its profits (if it operates under uncertainty). If the firm’s planning period is longer, so that its time horizon falls in a future period, the firm should maximize the present value of its profit stream (under certainty) or the expected present value of its profit stream (under uncertainty).
1-1. Distinguish between certainty, and risk and uncertainty.
1-2. Under what circumstances is it appropriate that a model be based on assumptions that are extremely simplistic? Could it, nevertheless, be a good model? Could a model be based on false assumptions and yet serve a purpose? Discuss.
1-3. What advantages are there in the graphical or algebraic representation of a model, as compared with a verbal representation of the same phenomena?
1-4. What is the firm’s time horizon? What kinds of considerations determine the firm’s time horizon?
1-5. What determines the opportunity discount rate to be used when evaluating the present value of a multiperiod profit stream?
1-6. Which discounting formula should be used to most accurately calculate the present value of a stream of revenues received each week throughout the year? If, instead, you used daily discount factors, would this cause an overestimate or an underestimate of the true present value? Would the difference be important?
1-7. What is a decision problem? Is it necessarily a situation in which there is a crisis or in which remedial action is necessary? What has the firm’s objective function to do with the existence (or nonexistence) of a decision problem?
1-8. Explain the notion of uncertainty in terms of the probability distribution of outcomes associated with each decision alternative.
1-9. Summarize the modifications necessary to the firm’s objective function as the firm’s time horizon shifts from the present to a future period and as we relax the assumption of full information.
1-10. Briefly outline the “principal-agent” problem and what it might mean for the achievement of the firm’s objectives.