Manecon Reviewer

Costs & Extent
Decisions
based on Ch 4, Froeb, et.al., 5th ed. by
Cengage
By: Dr. Shirley Catley-Rinoza

Institute of Accounts, Business, & Finance
Far Eastern University, Manila
Learning Objectives:
Students should be able to :
• Understand the impact of costs to the business
• Comprehend how different costs relate to each other
• Determine the most profitable output in terms of costs and revenue
• Apply cost analysis in managerial decisions
Outline:
• Review on Production Costs
• Marginal Costs
• Marginal Revenue
• Relationships Between Costs
• Extent Decisions
• Marginal Analysis
Costs & Revenue
• Fixed Costs (FC) – costs that remain constant throughout the production period
• Variable Costs (VC) – costs that change with the output level
• Total Cost (TC) – the sum of all fixed costs & variable costs employed
• Average Cost or Average Total Cost (ATC) – cost of producing each unit, obtained by
dividing total cost by total output (Q).
• The total cost increases by an amount equal to the variable cost.
• The average cost will increase or decrease due to the change in variable cost, but it does
not inform about the most profitable output level ; whether to increase or decrease the
output in relation to profit.
• Marginal Cost and Marginal Revenue – provide the information for extent decisions
• Marginal Cost – the additional cost for producing one more unit
• Marginal Revenue – the additional revenue for producing one more unit
Marginal Cost & Marginal Revenue
• Marginal Cost (MC) = Change in Total Cost divided by
change in Total Output
• MC = TC/ Q
• Marginal Revenue (MR) = Change in Total Revenue divided
by change in Total Output (Q)
• MR = TR/ Q
Calculating for the Marginal Cost
Average Calculations on MC
Fixed Variable Total Marginal Average
Labor Quantity Variable MC = TC2-TC1/Q2-Q1
Cost Cost Cost Cost Total Cost
Cost
$240
1 16 (Q1) $160 $80 $5.00 $15.00 $5.00
(TC1)
$320
2 40 (Q2) $160 $160 $3.30 $8.00 $4.00 320-240/40-16 80/24
(TC2) 3.33
3 60 $160 $240 $400 $4.00 $6.60 $4.00 400-320/60-40 80/20 4
4 72 $160 $320 $480 $6.60 $6.60 $4.40 ? ? ?
5 80 $160 $400 $560 $10.00 $7.00 $5.00 ? ? ?
6 84 $160 $480 $640 $20.00 $7.60 $5.70 ? ? ?
TC1 means initial TC, TC2 means final TC; Q1 means initial Q, Q2 means final Q
Observe the trends in : Labor, Quantity, Marginal Cost
Can you supply the missing values in the MC column?
Calculating for the Marginal Revenue
Average Calculations on MR
Variable Total Marginal Average MR = TR2-TR1/Q2-Q1
Labor Quantity Fixed Cost Total Cost Variable
Cost Revenue Cost Total Cost
Cost
1 16 (Q1) $160 $80 $80 (TR1) $240 $5.00 $15.00 $5.00
2 40 (Q2) $160 $160 200 (TR2) $320 $3.30 $8.00 $4.00 200-80/40-16 120/24 5
3 60 $160 $240 300 $400 $4.00 $6.60 $4.00 300-200/60-40 100/20 5
4 72 $160 $320 360 $480 $6.60 $6.60 $4.40 360-300/72-60 60/12 5
5 80 $160 $400 400 $560 $10.00 $7.00 $5.00 ? ? ?
6 84 $160 $480 $640 $640 $20.00 $7.60 $5.70 ? ? ?
TR1 means initial TR, TR2 means final TR

Can you supply the missing values for MR ?
Comparing Marginal Cost and Marginal Revenue
Fixed Variable Total Total Marginal Marginal Average Total Average

Labor Quantity
Cost Cost Revenue Cost Cost Revenue Cost Variable Cost
1 16 (Q1) $160 $80 $80 (TR1) $240 $5.00 $5 $15.00 $5.00
2 40 (Q2) $160 $160 200 (TR2) $320 $3.30 $5 $8.00 $4.00
3 60 $160 $240 300 $400 $4.00 $5 $6.60 $4.00
4 72 $160 $320 360 $480 $6.60 $5 $6.60 $4.40
5 80 $160 $400 400 $560 $10.00 $5 $7.00 $5.00
6 84 $160 $480 $640 $640 $20.00 $5 $7.60 $5.70
The assumption is that Price per unit is $5

Notice that MC decreases to $3.30 at Q equal to 40, but steadily increases after the 40th Q
Notice that MR is constant at $5 because MR = Price
Notice that with increase in output Q after the 40th unit, the additional cost increases with no additional revenue
generated. What can you conclude about this? What will you suggest?
Relationships Among MC, ATC & AVC
Initially, both ATC and AVC are high, but with

Increasing output, are declining because these
costs are spread over larger outputs. Their decline
Is due to the lower MC. Both ATC & AVC start to
rise as MC gets higher than them because of the
diminishing marginal returns; which implies that
the additional units are costlier to produce.
low marginal costs of production first pull down
average costs and then higher marginal costs
pull them up.
average total costs, average variable costs, and marginal
costs are measures to analyze costs on a per-unit (rather
than a total) basis and are reflected in the curves shown
https://courses.lumenlearning.com/wm- 7.2 The Structure of Costs in the Short Run –
microeconomics/chapter/average-costs-and-curves/ Principles of Economics (opentextbc.ca)
7.2 The Structure of Costs in the Short Run – Principles of
Economics (opentextbc.ca)
7.2 The Structure of Costs in the Short Run – Principles of
Economics (opentextbc.ca)
2 categories of decisions:
• All-or-none decisions
• the manager chooses either to do something or not. Some examples are whether or
not to enter a new market, whether or not to adopt a new technology, and whether or
not to eliminate a product line. The rule for making an all-or-none decision is simple--if
the benefit exceeds the cost, do it!
• Extent Decisions
• requires the manager not only to choose whether or not to do something, but also to
decide the extent of that activity. Examples are how many units of product to produce,
what to spend on advertising, and how many employees to hire.
• (https://www.swlearning.com/mba_primer/product/economics/less2/e24.htm)
Extent Decisions
• Decisions involving “how much” and “how many” Questions
• Production decisions at the marginal:
• how many more? How much more? To increase profit
• When confronted with extent choices, the manager can use the principle of maximum net advantage, which
states that, to get the most net gain, you must choose the quantity at which marginal benefit is equal
to marginal cost. For example, if it costs a hotel $25,000 to have 100 guests and $25,020 for 101 guests, the
marginal cost of the one additional guest is $20 ($25,020 - $25,000).
• If the marginal benefit of one additional guest is greater than its additional cost, then it pays to increase the
accommodation beyond 100 guests, but stop accommodating more when its MR=MC
• Sell more if MR > MC; sell less if MR < MC. If MR = MC, you are selling the right amount (maximizing profit!).
• An incentive compensation scheme that increases marginal revenue or reduces marginal cost will increase
effort. Fixed fees have no effects on effort.
(http://www.swlearning.com/mba_primer/product/economics/less2/e24.htm)
Froeb, et.al.Managerial Economics.5th ed. 2018 Cengage Learning
Marginal Analysis
• Memorial Hospital
• the MC of a delivery was $3,000
• The MR was $5,000
• Therefore, MR>MC so the hospital was not delivering enough babies
• Increase the deliveries up to that point when MR=MC
• TV Ad cost to get one more customer :

• MCTV is $50, If the marginal revenue (MR) generated by this customer
is greater than $50, do more advertising.
Marginal Analysis
• Competing Strategies: Telephone ads or TV ads
Estimated MCPH = $100= ($10,000 / 100)
• So, to get one more customer costs $50 for TV and $100 for phone
MCPH > MCTV so shift ad dollars from phone to TV
• Pay to Performance: flat rate or incentive pay?

• A consulting firm COO received a flat salary of $75,000
• After learning about the benefits of incentive pay
in class, the CEO changed COO compensation to
$50K + (1/3)* (Profits-$150K)
• Profits increased 74% to $1.2 M
• Compensation increased $75Kg$177K
Supplemental lessons on Costs
• Watch this videoclips for the basic calculations on costs -
https://courses.lumenlearning.com/wm-
microeconomics/chapter/average-costs-and-curves/
• Watch this videoclip for the explanation on the relationship between
average total cost and marginal cost -
• https://www.youtube.com/watch?v=C3m9FC3T3vw
References:
• https://courses.lumenlearning.com/wm-
microeconomics/chapter/average-costs-and-curves/
• https://opentextbc.ca/principlesofeconomics/chapter/7-2-the-
structure-of-costs-in-the-short-run/
• https://www.swlearning.com/mba_primer/product/economics/less2/
e24.htm
• Froeb, et.al.Managerial Economics. 5th ed. 2018 Cengage Learning
Benefits, Costs, &
Decisions
based on Ch. 3 by
Froeb, et. al.,
Cengage Learning
Outline:
Types of Costs in Accounting
• Fixed costs are predetermined expenses that remain the same throughout a
specific period. These overhead costs do not vary with output or how the
business is performing. To determine your fixed costs, consider the expenses
you would incur if you temporarily closed your business. You would still continue
to pay for rent, insurance and other overhead expenses.
• Variable costs, however, change over a specified period and are associated
directly to the business activity. These are based on the business performance
and the volume of services the business generates.
• Source: freshbooks.com
Types of Costs in Accounting
• Rent • Direct labor

• Commissions
• Telephone and internet costs
• Taxes
• Insurance
• Operational expenses
• Employee Salaries • Commission on sales, credit card
• Loan Payments fees, wages of part-time staff, etc.
Costs Amount in Pesos
Fixed Costs (FC)
. rent 20,000.00
manager’s salary 40,000.00
depreciation charge 2,000.00
communication (pre-paid internet) 3,000.00
Total Fixed Costs (TFC) 65,000.00
Average Fixed Cost (AFC = TFC/Q) 65.00
Variable Costs (VC)
wages 73,000.00
raw material cost 100,000.00
electricity 5,000.00
water 1,000.00
advertising & promotion 2,000.00
Total Variable Cost (TVC) 180,000.00
Average Variable Cost (AVC = TVC/Q) 180.00
Volume Produced (Q) 1,000 pcs.
Cost Formula & Computation
Sunk costs
Sunk costs
Hidden Costs
• Hidden costs are unforeseen expenses added on to purchases.(pfcu.com)
• all costs associated with either production or maintenance. When associated

with maintenance, hidden costs represent the loss associated with unplanned
downtime.
https://ceopedia.org/index.php/Hidden_cost)
Explicit Costs & Implicit Costs
• An implicit cost is a cost that exists without the exchange of

cash and is not recorded for accounting purposes.
• Implicit costs represent the loss of income but do not
represent a loss of profit.
• These costs are in contrast to explicit costs, which represent
money exchanged or the use of tangible resources by a
company.
• Examples of implicit costs include a small business owner
who may forgo a salary in the early stages of operations to
increase revenue.
• an implicit cost comes from the use of an asset, rather
than renting or buying it.
Accounting Costs
Economic costs
• Economic costs represent any “what-if” scenarios for your
business.
• Economic cost is calculated by taking your accounting cost,
which has already been calculated, and also subtracting any
implicit costs.
Accounting costs vs. Economic costs
Accounting Profit vs. Economic Profit
• Accounting profit is the net income for a company, which is revenue minus expenses.
• Economic profit is similar to accounting profit, but it includes opportunity costs.
• Accounting profit includes explicit costs, such as raw materials and wages.
• Economic profit includes explicit and implicit costs, which are implied or imputed costs.
• Economic profit consists of revenue minus implicit (opportunity) and explicit (monetary)
costs; accounting profit consists of revenue minus explicit costs. (Lumen learning.com)
Accounting Profit & Economic Profit
If Jane should put up her own firm:
Total revenue (projected) $150,000
Gross profit $150,000
Total expenses $ 55,000
Net profit $ 95,000
Jane’s Benefits in her current employment

$95,000 salary and medical benefits worth $5,000 when she leaves
When calculating economic cost, this $100,000 loss is subtracted
from Jane’s current net profit of $95,000, leaving her with a projected
$5,000 loss should she go ahead with her plans.
Sunk Cost Fallacy
Business Case: on Sunk Cost
Hidden Cost Fallacy
Business Case: Should you fire an
employee?
Economic Value Added (EVA)
• Economic value added (EVA) is a measure of a company's financial performance based on the
residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for
taxes on a cash basis. EVA can also be referred to as economic profit, as it attempts to capture the
true economic profit of a company. This measure was devised by management consulting
firm Stern Value Management, originally incorporated as Stern Stewart & Co.
• EVA is the incremental difference in the rate of return (RoR) over a company's cost of capital.
Essentially, it is used to measure the value a company generates from funds invested in it. If a
company's EVA is negative, it means the company is not generating value from the funds invested
into the business. Conversely, a positive EVA shows a company is producing value from the funds
invested in it.
Source: Investopedia.com
Calculating for EVA
• EVA = NOPAT - (Invested Capital * WACC)
• Where:
• NOPAT = Net operating profit after taxes
• Invested capital = Debt + capital leases + shareholders' equity
• WACC = Weighted average cost of capital
Use of EVA
EVA & Hidden Cost
Principles on Cost Decisions
Source: Froeb, et.al.,. Managerial Economics. 5th ed. Cengage Learning.

Psychological Biases
Psychological biases
References:
https://www.freshbooks.com/hub/accounting/fixed-cost-vs-variable-cost?fb_dnt=1
https://www.investopedia.com/terms/s/sunkcost.asp
https://ceopedia.org/index.php/Hidden_cost
https://www.investopedia.com/terms/e/explicitcost.asp
https://www.investopedia.com/terms/i/implicitcost.asp
https://www.fool.com/the-blueprint/accounting-cost/
https://www.investopedia.com/ask/answers/033015/what-difference-between-economic-profit-and-accounting-profit.asp
https://www.investopedia.com/terms/e/eva.asp
https://courses.lumenlearning.com/boundless-economics/chapter/economic-profit/
https://www.indeed.com/career-advice/career-development/sunk-cost-definition-and-examples
CHAPTER
1 Introduction:
What This Book is About
©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on
a password-protected website for classroom use. ©Kamira/Shutterstock Images
Problem: Over-bidding OVI gas tract
● A young geologist was preparing a bid

recommendation for an oil tract in the Gulf of
Mexico.
● The geologist knew the productivity of nearby
tracts also owned by the company.
● Knowing this, he recommended a bid of $5 million.
● Senior management bid $20 million – far over the
next highest bid of $750,000.
● What, if anything, is wrong?
Discuss: the nature of bidding : why bidding is to be held, how do you bid? Which
©2018 Cengage bid is selected?
Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 2
Problem solving
● The goal of this text is to provide tools to help

identify and solve problems like this.
● Two distinct steps:
1) Figure out what’s wrong
• i.e., why overbidding occurred
2) Figure out how to fix it
What is the consequence of overbidding to the firm?
©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
Model of Behavior
● Both steps require a model of behavior

• Why are people making mistakes?
• What can we do to make them change?
● Economists use the rational-actor paradigm to model
behavior.
● The rational actor paradigm states:
• People act rationally, optimally, self-interestedly
• Meaning, they respond to incentives – to change
behavior you must change incentives.
Ex. What is the effect of efficiency wages? (wages above the

minimum)
©2018 Cengage Learning. will
All Rights Reserved. May itcopied,
not be really lead
scanned, to inefficiency?
or duplicated, whole or in part, exceptShould that
for use as permitted be distributed
in a license all? with a certain product or service or
Answer to Overbidding Problem
● Answer the three questions:

1) Senior management made the bad decision to overbid.
2) They had enough information to make the right
decision.
3) They didn’t have the incentive to do so.
● A bonus system created incentives to over-bid.
• Senior managers were rewarded for acquiring reserves
regardless of their profitability
• They had the young geologist “do what he could” to
increase the size of estimated reserves.
• Bonuses also created an incentive to manipulate the
reserve estimate. Why do you think did this happen?
Solution to Overbidding Problem
Now that we know what is wrong, how do we fix it?

● Let someone else decide? NO
● Change information flow? NO
● Change incentives? YES
• Change performance evaluation metric
• Ex: Increased profitability as measurement of success instead of
increased acquired reserves
• Reward scheme
• Ex: Make bonuses tied to profitability, not acquired reserves
NAR Problem
● In 2006, a TV reporter was sent into a National

Auto Repair (NAR) shop with a perfectly good
car
● The reporter came out with a new muffler and
transmission – and a bill for over $8,000
● The news story badly hurt NAR’s profits
● How do you solve this problem?
● Good reputation vs. profitability?
Problem-Solving Algorithm
1) Who is making the bad decision?

• The mechanic recommended unnecessary repairs.
2) Does the decision maker have enough information to
make a good decision?
• Yes, in fact, the mechanic is the only one with enough
information to know whether repairs are necessary.
Problem-Solving Algorithm
3) Does the decision maker have the incentive to

make a good decision?
• No, the mechanic is evaluated based on the amount
of repair work he does, and receives bonuses or
commissions tied to the amount of repair work.
• Why is this wrong?
NAR Solution
● There was an incentive issue

● NAR tried two solutions
1) reorganized into two division – led to colluding
2) adopted flat pay – led to less incentive to work hard
● Suggested resolution: add an additional performance
evaluation metric to original commission scheme
• Ex: Sporadically send in “secret shoppers” like the
news reporter
● This shows the trade-offs you face when creating
solutions
● Do you have other suggestions?
Ethics and Economics
● The rational-actor paradigm can make students

uncomfortable
• It seems to disregard personal ethics to guide behavior.
• Consequentialists?
● You have to understand why unethical behavior

occurs to fix it though
• Be able to anticipate opportunistic behavior to know
how to avoid it
Value System
● Debates about ethics and economics really are

about different value systems
● Deontologists: actions are good or ethical if they
conform to a set of principles (ex: The Golden
Rule)
● Consequentialists: actions are judged based on
whether they lead to a good consequence
● Economics is more consequentialist
• Uses analysis to understand the consequences of
different solutions
SUMMARY OF MAIN POINTS
● Problem solving requires two steps:

1) figure out what’s causing the problem
2) figure out how to fix it
● For both steps, predict how people behave
● rational-actor paradigm: assumes that people act
rationally, optimally, and self-interestedly.
● Simply put, people respond to incentives.
● Good incentives come from rewarding good
performance.
• Ex: commission on sales
● A well-designed organization aligns employee
incentives with organizational goals.
● Specifically, employees have enough information to
make good decisions, and the incentive to do so.
● Three questions to find the source of the problem:
1) Who is making the bad decision?
2) Does the decision maker have enough information
to make a good decision?
3) Does the decision maker have the incentive to make
a good decision?
● Answers to these questions will suggest solutions:
1) Letting someone with better information or
incentives make the decision
2) Giving the decision maker more information
3) Changing the decision maker’s incentives.
CHAPTER
2 The One Lesson
of Business
Kidney Transplants
● Two prominent hospitals recently refused patients for

kidney transplants because the organs were from
“directed donations.”
• The kidneys were meant for specific people
● Demand for organs is high – far exceeding supply –
and many never receive them.
● Despite high demand and low supply, buying and
selling organs is illegal.
● Why?
Apartments
Suppose you want to move from Detroit to Nashville
● First, you would try a two-way trade Detroit Nashville
● Failing that, you’d try a three-way Detroit Nashville

connection with another city Los Angeles
● Need to find correct trades with

correct timing = difficult!
● Like with kidney transplants, compatibility problems

lead to inefficiency
Capitalism 101
To identify money-making opportunities,

you must first understand how wealth is created
(and sometimes destroyed).
● Key note: Wealth is created when assets are moved
from lower to higher-valued uses
● Definition: Value = willingness to pay
Desire + Income = You want something + you can pay for it
● Key note: Voluntary transactions, between individuals

or firms, create wealth.
• Meaning, people create wealth by pursuing self-interest.
Housing Example
A house is for sale:

● The buyer values the house at $130,000
• This is the buyer’s top dollar – willingness to pay
● The seller values the house at $120,000
• This is the seller’s bottom line – won’t accept less
The buyer and seller must agree to a price that “splits”
surplus between buyer and seller. Here, $128,000.
Surplus
The buyer and seller both benefit from this transaction:

● Buyer surplus = buyer’s value minus the price
$130,000 - $128,000 = $2,000 buyer surplus
● Seller surplus = the price minus the seller’s value

$128,000 - $120,000 = $8,000 seller surplus
● Total surplus = buyer + seller surplus = difference in

values
$2,000 + $8,000 = $10,000 → $130,000 - $120,000 = $10,000
$10,000 are the gains from trade
Wealth-Creating Transactions
● Which assets do these transactions move to higher-

valued uses?
• Factory Owners • Corporate Raiders
• Real Estate Agents • Insurance Salesman
• Investment Bankers
● Discussion: How does eBay create wealth?
● Discussion: Which individual has created the most
wealth during your lifetime?
● Discussion: How do you create wealth?
Do Mergers Create Wealth?
● Do mergers follow the wealth-creating engine of

capitalism? Do they move assets to a higher-valued use?
• Our largest and most valuable assets are corporations.
● Ex: Dell-Alienware merger:
• In 2006, Dell purchased Alienware, a manufacturer of
high-end gaming computers.
• Dell left design, marketing, sales and support in
Alienware’s hands.
• Dell took over manufacturing though, using its expertise
to build Alienware’s computers at a much lower cost.
Do Mergers Create Wealth?
● However, many mergers and acquisitions do not

create value
• If they do, value creation is rarely so clear
● To create value, the assets of the acquired firm

must be more valuable to the buyer than to the
seller
Does Government Create Wealth?
● Discussion: What’s the government’s role is wealth creation?

• Enforcing property rights and contracts legal tools that
facilitate wealth creating transactions
• Ensures that buyers and sellers keep gains from trade
● Discussion: Why are some countries so poor?
• No property rights
• No rule of law
● Discussion: Much of the justification for government
intervention comes from the assertion that markets have
failed. One money manager scoffed at this idea. “The markets
are working fine, but they’re giving people answers that they
don’t like, so people cry market failure.”
Property rights
● Property rights are commonly identified as a right to own or

possess something, such as land or an automobile, and to be
able to dispose of it as one chooses. However, this is only one
aspect of property rights that focuses on the exclusive right to
ownership.
● The main legal property rights are the right of possession, the
right of control, the right of exclusion, the right to derive
income, and the right of disposition. There are exceptions to
these rights, and property owners have obligations as well as
rights.Set 10, 2020
● Source: Google.com
The One Lesson of Economics
● Definition: An economy is efficient if all assets are employed in

their highest-valued assets.
• This is an unattainable, but useful benchmark
● The One Lesson of Economics: The art of economics consists in

looking not merely at the immediate but at the longer effects of any
act or policy; it consists in tracing the consequences of that policy
not merely for one group but for all groups.
● Must look at the intended and unintended effects of policies to
understand their efficiency
● The economist’s solution to inefficient outcomes is to argue for a
change in public policy.
● Business person’s solution is to try to make money on the
inefficiency
The One Lesson of Business
● Definition: Inefficiency implies the existence of

unconsummated, wealth-creating transactions
● The One Lesson of Business: The art of business
consists of identifying assets in lower valued uses
and devising ways to profitably moving them to
higher valued uses.
● In other words, make money by identifying
unconsummated wealth-creating transactions and
devise ways to profitably consummate them.
Destroying Wealth
Anything that stops assets from moving to higher

valued uses is destroying wealth.
• Taxes Destroy Wealth:
• By deterring wealth-creating transactions – when the tax is
larger than the surplus for a transaction.
• Subsidies Destroy Wealth:
• Example: flood insurance encourages people to build in areas
that they otherwise wouldn’t
• Price Controls Destroy Wealth:
• Example: rent control (price ceiling) in New York City
deters transactions between owners and renters
● Which assets end up in lower-valued uses?

Profiting from Inefficiency
● Taxes create a profit opportunity

• Discussion: 1983 Sweden tax
● Subsidies create opportunity

• Discussion: health insurance
● Price-controls create opportunity

• Discussion: Regulation Q. & euro dollars
• Discussion: What about ethics?
Wealth Creation in Organizations
● Companies = a collection of transactions

● They buy raw materials (capital, labor, etc.) and create
and sell higher-valued goods and services
● Can equate market-level problems (taxes, subsidies
and price controls) with organization-level goal
alignment problems
• Ex: The overbidding from the oil company = “subsidy”
paid to management for acquiring oil reserves
● Allows us to use the same analysis
● Voluntary transactions create wealth by moving assets from
lower- to higher-valued uses.
● Anything that impedes the movement of assets to higher-
valued uses, like taxes, subsidies, or price controls, destroys
wealth.
● Economic analysis is useful to business for identifying assets
in lower-valued uses.
● The art of business consists of identifying assets in low-
valued uses and devising ways to profitably move them to
higher-valued ones.
● A company can be thought of as a series of transactions.
A well-designed organization rewards employees who
identify and consummate profitable transactions or who stop
Managerial
Economics &
Decision Making
IABF-FEU
February 01, 2022
At the end of the presentation, students should be able to:
• Understand the nature and scope of Managerial Economics;
• Appreciate how the course is significant to decision making in
business;
• Analyze the process of decision making employed in business
problems;
• Choose and apply a decision making process in a given managerial
problem
Outline:
• Scope of Managerial Economics
• Problem Solving & Decision Making
• Steps in Decision Making
• Sample Problems from the e-book (Ch 1, 2, 3, 4)
Nature &
Scope
The
economic
manager
The
economic
manager
Scope
Economics &
decision
making
Other
disciplines in
managerial
economics
Scientific
approach in
building and
testing
economic
models
Steps in
decision
making
Finding the source of the problem of
implementation
" . . . we use the tools of economics to address the problem of
implementation. If people act rationally, optimally, and self-
interestedly, then mistakes have only one of two causes: either people
lack the information necessary to make good decisions or they lack the
incentive to do so. This immediately suggests a problem-solving
algorithm; ask:
1. Who is making the bad decision?
2. Do they have enough information to make a good decision?
3. Do they have the incentive to do so?
Solution to the problem:
1. Let someone else make the decision, someone with better
information or incentives
2. Give more information to the current decision maker
3. Change the current decision maker’s incentives
The book (Froeb, et.al.) begins by showing students how to use this
algorithm, and subsequent chapters illustrate its use in a variety of
contexts, for example, extent decisions, investments, pricing,
bargaining, principal–agent relationships, and uncertain environments.
References:
• https://theinvestorsbook.com/managerial-economics.html
• Dr. Itty Benjamin, retrieved from https://slideplayer.com/slide/4036429/

• Managerial Economics Quick Guide Retrieved from:
https://www.tutorialspoint.com/managerial_economics/managerial_economics_quick_guide.htm
• https://slideplayer.com/slide/4036429/
• Froeb, Luke, Brian McCann, Michael Ward, and Mikhael Shor. Managerial Economics, A Problem-Solving
Approach. 5th ed. Cengage Learning. 2018.
Class Tasks:
• Prepare for Quiz 1 – Feb. 07, 2022 on Canvas Course MGT1115
• covers Lessons 1 & 2
1. A Review of Microeconomic Concepts
2. Managerial Economics & Decision Making
• Watch the videoclip : Property Rights 1: Private v. Collective | Marginal Revolution University
(mru.org)
• Assignment – Read Chapters 1 & 2, pp. 20-40 of e-book FMWS for discussion on
Feb 5-12
• Read Chapters 3 & 4, pp. 45-66 for Feb. 15-26
• Be ready to participate in class discussions
CHAPTER
6 Simple Pricing
● Aggregate demand or market demand is the total number of
units that will be purchased by a group of consumers at a
given price.
● Pricing is an extent decision. Reduce price (increase quantity)
if MR > MC. Increase price (reduce quantity) if MR < MC.
The optimal price is where MR = MC.
● Price elasticity of demand: e = (% change in quantity
demanded) ÷ (% change in price)
• Estimated price elasticity is used to estimate demand from a
price and quantity change.
[(Q1 - Q2)/(Q1 + Q2)] ÷ [(P1 - P2)/(P1 + P2)]
• If |e| > 1, demand is elastic; if |e| < 1, demand is inelastic.
• continued
● %ΔRevenue ≈ %ΔPrice + %ΔQuantity

• Elastic Demand (|e| > 1): Quantity changes more than price.
• Inelastic Demand (|e| < 1): Quantity changes less than price.
● MR > MC implies that (P - MC)/P > 1/|e|; in words, if the
actual margin is bigger than the desired margin, reduce
price
• Equivalently, sell more
● Four factors make demand more elastic:
1) Products with close substitutes (or distant complements) have
more elastic demand.
2) Demand for brands is more elastic than industry demand.
3) In the long run, demand becomes more elastic.
4) As price increases, demand becomes more elastic.
• continued
● Income elasticity, cross-price elasticity, and

advertising elasticity are measures of how changes
in these other factors affect demand.
● It is possible to use elasticity to forecast changes in
demand:
• %ΔQuantity ≈ (factor elasticity)*(%ΔFactor).
● Stay-even analysis can be used to determine the
volume required to offset a change in costs or prices,
which is how businesses often implement marginal
analysis.
Hot Wheels
● Mattel introduced Hot Wheels in 1968

● They kept price below $1.00 for 40 years, even as
production costs rose
● Finally tested a price increase, experienced profit
increase of 20%
• Why? Profit=(P-C)xQ
• Businesses tend to focus on C and Q, neglect P
● In many instances, companies can make money by
simply raising price
Simple Pricing
In this chapter, we consider “simple pricing”:

● A single firm selling a single product at a single price
● Most firms sell: in competition with rivals; multiple
products, and at different prices, so this is rare
● Important to understand simple pricing first though
● Simple pricing has become part of business
vernacular
• When your boss says that “demand is elastic,” she often
means that price is too high.
Background: Consumer Surplus and Demand Curves
● First Law of Demand - consumers demand more

(purchase more) as price falls, assuming other factors are
held constant.
● Consumers make consumption decisions using marginal
analysis, consume more if marginal value > price
● But, the marginal value of consuming each subsequent
unit diminishes the more you consume.
● Consumer surplus = value to consumer - price paid
● Definition: Demand curves are functions that relate the
price of a product to the quantity demanded by consumers
Consumer Surplus and Demand Curves Example
Pizza consumer
● Values first slice at $5, next at $4 . . . fifth at $1
Pizza Demand Schedule
● Note that if pizza slice price is $3, consumer will

purchase 3 slices
Pizza Example (cont.)
● For the first slice, the total and marginal value are the
same at $5
● For the second, the marginal value is $4, while the
total value is $9 = $5 + $4
Pizza Value Table
Background: Aggregate Demand
● Aggregate Demand: the buying behavior of a group of

consumers; a total of all the individual demand curves.
● To construct demand, sort by value.
Pizza Consumer Surplus
Aggregate Demand (cont.)
● Demand curves describe buyer behavior and tell you how

much they will buy at a given price.
● If something other than price causes an increase in demand, we

say that “demand shifts” to the right or “demand increases” such
that consumers purchase more at the same prices
Pricing Trade-Off
● Pricing is an extent decision

● Profit= Revenue - Cost
● Demand curves turn pricing decisions into quantity
decisions:
• “what price should I charge?” is equivalent to “how much
should I sell?”
● Fundamental tradeoff:
• Lower priceg sell more, but earn less on each unit sold
• Higher priceg sell less, but earn more on each unit sold
● Tradeoff created by downward sloping demand
Marginal analysis of pricing
● Marginal analysis finds the profit increasing

solution to the pricing tradeoff.
• It tells you which direction to go (to raise or lower
price), but not how far to go.
● Definition: marginal revenue (MR) is change in
total revenue from selling another unit.
● If MR>0, then total revenue will increase if you sell
one more.
● If MR>MC, then total profit will increase if you sell
one more.
● Proposition: Profit is maximized when MR = MC
Example: Find the Optimal Price
● Once you reach the 4th unit, total profit decreases by

%0.50 because the MR from the 4th unit is only $1,
which is less than $1.50 MC
● Therefore, the profit maximizing quantity is 3 and
we see that the price is $5.00 for 3 units to be sold
Optimal Price
How Do We Estimate MR?
● Price elasticity allows us to calculate MR.

● Definition: price elasticity of demand (e)
(%change in quantity demanded)
(%change in price)
• If |e| is less than one, demand is said to be inelastic.
• If |e| is greater than one, demand is said to be elastic.
Mistake in 3rd Edition
● The Correct Answer

• Elastic Demand implies |e|>1
• Inelastic Demand implies |e|<1
● The following figures are mis-labled (The inequality
in parentheses should be reversed)
Elastic Demand [|e| < 1]
Inelastic Demand [|e| > 1]
Price Elasticity Example
● Mayor Marion Barry increased taxes on gasoline

sales in DC by 6%.
● Before the tax, gas station predicted that the increase
in a sales tax would reduce quantity demanded by
40%.
● The gas station owners were indirectly arguing that
gasoline revenue, and the taxes collected out of
revenues, would decline because gasoline sales in
DC has a very elastic demand.
Estimating elasticities
● Definition: Arc (price) elasticity=

[(q1-q2)/(q1+q2)]
[(p1-p2)/(p1+p2)]
• Discussion: Compute elasticity, when price changes
from $10 to $8, and quantity changes from 1 to 2?
● Example: On a promotion week for Vlasic, the price
of Vlasic pickles drops by 25% and quantity
increases by 300%.
• Is the price elasticity of demand -12?
• HINT: could something other than price be changing?
Intuition: MR and Price Elasticity
● Revenue and price elasticity are related by the

following approximation.
% Rev ≈ % P + % Q
● Elasticity tells you the size of |% P| relative to |% Q|

● If demand is elastic
• If Pthen Rev • If Pthen Rev
● If demand is inelastic
• If Pthen Rev • If Pthen Rev
Formula: Elasticity and MR
● Proposition: MR = P(1-1/|e|)
• If |e|>1, MR>0.
• If |e|<1, MR<0.
● Discussion: If demand for Nike sneakers is inelastic,
should Nike raise or lower price?
● Discussion: If demand for Nike sneakers is elastic,
should Nike raise or lower price?
Elasticity and Pricing
● MR>MC is equivalent to
• P(1-1/|e|)>MC
• P>MC/(1-1/|e|)
• (P-MC)/P>1/|e|
● MR > MC means that (P-MC)/P > 1/|e|

● The left side of the expression is the current margin = (P-MC)/P
● The right side is the desired margin, or the inverse elasticity = 1/|e|
● If the current margin is greater than the desired margin, reduce the
price because MR>MC and vice versa.
● Intuition: the more elastic demand becomes (1/|e| becomes smaller),
the less you can raise price over MC because you lose too many
customers
What Makes Demand More Elastic?
5 factors that affect demand elasticity and optimal

pricing:
1) Products with close substitutes have elastic demand.
2) Demand for an individual brand is more elastic than
industry aggregate demand.
3) Products with many complements have less elastic
demand.
4) In the long run, demand curves become more elastic.
5) As price increases, demand becomes more elastic.
Factor 1
1. Products with close substitutes have elastic

demand.
● Consumers respond to a price increase by switching
to their next-best alternative.
● If their next-best alternative is a very close substitute,
then it doesn’t take much change in price for them to
switch.
● When Mayor Barry raised the price of gasoline, DC
commuters began buying gasoline in nearby Virginia
and Maryland.
Factor 2
2. Demand for an individual brand is more elastic

than industry aggregate demand.
● Rough rule of thumb: brand price elasticity is
approximately equal to industry price elasticity divided
by brand share
● Example:
• elasticity of demand for all running shoes = -0.4
• Market share of Nike running shoes is 20%
• Price elasticity of demand for Nike running shoes is -0.4/.20 = -2
• Using our optimal pricing formula, this would give Nike a desired
margin of 50%
Factor 3
3. Products with many complements have less

elastic demand.
● Products that are consumed as a larger bundle of
complementary goods have less elastic demand.
● Example: iPhones have less elastic demand because
of the number of apps run on them
• If the price of an iPhone increases, you are less likely
to substitute to another product due to the
complementary apps
Factor 4
4. In the long run, demand curves become

more elastic.
● This can also be explain by the speed at which price
information is spread; or the ability of consumers to
find more substitutes in the long run.
● Example: ATM fees
• At a selected number of ATMs, a bank raised user fees from
$1.50 to $2.00.
• When informed of the fee increase, users typically
completed the current transaction but avoided the higher-
priced ATMs in the future.
Factor 5
5. As price increases, demand becomes

more elastic.
● Example: high-fructose corn syrup (HFCS)
• Primary use is a caloric sweetener in soft drinks
• Sugar is the perfect substitute for HCFS
• Import quotas and sugar price supports have raised the
US domestic price of sugar about twice that of HFCS.
• Bottlers have shifted to HFCS.
• Bottlers have no close substitute for low-priced HFCS,
although as the price of HFCS approaches that of sugar,
demand for HFCS becomes very elastic.
Other Elasticities
● Definition: income elasticity measures the change in

demand arising from a change in income
(%change in quantity demanded) (%change in income)
• Inferior goods (negative): as income increases, demand declines
• normal goods (positive): as income increases, demand increases
● Definition: cross-price elasticity of good one with

respect to the price of good two
(%change in quantity of good one) (%change in price of good two)
• Substitute (positive): as the price of a substitute increases,
demand increases
• Complement (negative): as the price of a complement increase,
demand decreases
Stay-Even Analysis
● Stay-even analysis tells you how many sales you need

when changing price to maintain the same profit level
• How to implement marginal analysis of pricing using
stay-even quantity:
%ΔQ = (%ΔP)
(%ΔP + margin)
● Margin=40%, %ΔP=5%, then %ΔQ = 11.1%

● In other words, a 5% price increase would be
profitable if quantity went down by less than 11.1%.
● Use elasticity estimates or marketing surveys to
determine whether quantity would go down by 11.1%.
Cost-Based Pricing
● Our expression for optimal pricing, MR=MC or (P-

MC)/P= 1/|e|, takes into account the firm’s cost
structure and its consumer demand
● Often, the consumer side is ignored in pricing
decisions, leading to cost-based pricing. Why?
● Often, firms do not have the demand picture
● They need to invest in a market research division to
take profitability seriously
Extra: Quick and Dirty estimators
● Linear Demand Curve Formula:

e= p / (pmax-p)
● Discussion: How high would the price of the brand
have to go before you would switch to another
brand of running shoes?
● Discussion: How high would the price of all running
shoes have to go before you should switch to a
different type of shoe?
Extra: Market Share Formula
● Proposition: The individual brand demand elasticity

is approximately equal to the industry elasticity
divided by the brand share.
• Discussion: Suppose that the elasticity of demand for
running shoes is –0.4 and the market share of a
Saucony brand running shoe is 20%. What is the price
elasticity of demand for Saucony running shoes?
● Proposition: Demand for aggregate categories is
less-elastic than demand for the individual brands in
aggregate.
Title?
● In 1994, the peso devalued by 40% in Mexico

• Interest rates and unemployment shot up
• Overall economy slowed dramatically and consumer income fell
● Concurrently, demand for Sara Lee hot dogs declined
• This surprised managers because they thought demand would
hold steady, or even increase, since hot dogs were more of a
consumer staple than a luxury item.
• Surveys revealed the decline was mostly confined to premium
hot dogs
• And, consumers were using creative substitutes
• Lower priced brands did take off but were priced too low.
● Failure to understand demand and to price accordingly was
costly.
CHAPTER 5 Investment
Decisions:
Look Ahead and Reason
Back
● Investments imply willingness to trade dollars in the present for dollars in the
future. Wealth-creating transactions occur when individuals with low discount
rates (rate at which they value future vs. current dollars) lend to those with high
discount rates.
● Companies, like individuals, have different discount rates, determined by their
cost of capital. They invest only in projects that earn a return higher than the cost
of capital.
● The NPV rule states that if the present value of the net cash flow of a project is
larger than zero, the project earns economic profit (i.e., the investment earns more
than the cost of capital).
● Although NPV is the correct way to analyze investments, not all companies use it.
Instead, they use break-even analysis because it is easier and more intuitive.
● Break-even quantity is equal to fixed cost divided by the contribution margin. If
you expect to sell more than the break-even quantity, then your investment is
profitable.
• continued
● Avoidable costs can be recovered by shutting down. If the

benefits of shutting down (you recover your avoidable costs)
are larger than the costs (you forgo revenue), then shut down.
The break-even price is average avoidable cost.
● If you incur sunk costs, you are vulnerable to post-investment
hold-up. Anticipate hold-up and choose contracts or
organizational forms that minimize the costs of hold-up.
● Once relationship-specific investments are made, parties are
locked into a trading relationship with each other, and can be
held up by their trading partners. Anticipate hold-up and
choose organizational or contractual forms to give each party
both the incentive to make relationship-specific investments
and to trade after these investments are made.
Title?
● In summer 2007, Bert Matthews was contemplating purchasing a 48-unit

apartment building.
• The building was 95% occupied and generated $550,000 in annual profit.
• Investors expected a 15% return on their capital
• The bank offered to loan Mr. Matthews 80% of the purchase price at a rate
of 5.5%
● Mr. Matthews computed the cost of capital as a weighted average
of equity and debt.
.2*(15%) + .8*(5.5%) = 7.4%
• Mr. Matthews could pay no more than $550,000/7.4% = $7.4 million and still
break even.
● Mr. Matthews decided not to buy the building. A good decision – one year
later, the cost of capital was 10.125% and Mr. Matthews could offer only
$5.4 million for the building.
● This story illustrates both the effect of the bursting credit bubble on real
estate valuations and, more importantly, the relevant costs and benefits of
investment decisions.
Background: Investment Profitability
● All investments represent a trade-off between

possible future gain and current sacrifice.
● Willingness to invest in projects with a low rate of
return, indicates a willingness to trade current dollars
for future dollars at a relatively low rate.
• This is also known as having a low discount rate (r).
• Individuals with low discount rates would willingly
lend to those with higher discount rates.
• Discounting helps you figure out if future gains are
larger than current sacrifice.
Compounding
● To understand discounting, let’s first look at

compounding:
(future value, k periods in the future) = (present value) x (1 + r) K
● Example: If you invest $1 (present value) today at a

10% (r), then you would expect to have $1.10 in one
year.
• In two years, $1 becomes $1.21 = $1.10 x (1+.1)
● A good compounding rule of thumb:
“Rule of 72”: If you invest at a rate of return r,
divide 72 by r to get the number of years it takes to
double your money
Discounting
● Discounting (the inverse of compounding):

Present value = (future value, k periods in the future)
(1 + r)k
● Example: At a 10% r, $1 is worth:
• Next year: ($1)/1.1 = $0.91
• Two years: ($0.91)/1.1 =$0.83
● Discussion: If my discount rate is 10%, would I lend
to or borrow from someone with a discount rate of
15%?
• What does this say about behavior?
Example: Nashville Pension Obligations
● The city of Nashville uses discounting to decide how

much to save for future pension obligations.
● For a pension that pays out $100,000 in 20 years,
with a discount rate of 8.25% Nashville must save:
• $100,000/(1.0825)20 =$20,485
• If the city invests the $20,485 and earns 8.25%, then the
savings will compound in 20 years – unrealistic!
• Somewhat of high savings rate that may not be returned;
however, a high savings rate means less current spending,
which is politically popular
• A more realistic (but less popular) discount rate would be
6.5%, which would lead to saving $28,380 now.
Determining the Profitability of Investments
● Remember the simple rule: discount the future benefits of

an investment, and compare them to the current cost.
● Companies use discount rates, which are determined by
cost of capital.
• A company’s cost of capital is a blend of debt and equity, its
“weighted average cost of capital” or WACC
● Time is a critical element in investment decisions
• Cash flows to be received in the future need to be
discounted to present value using the cost of capital
● The NPV Rule: if the present value of the net cash flows
is larger than zero, then the project earns more than the
cost of capital.
The NPV Rule In Action
● Consider two projects that each require an initial

investment of $100
• Project 1 returns $115 at the end of the first year
• Project 2 returns $60 at the end of the first, and $60 at the
end of the second
• The company’s cost of capital is 14%
• Project 1 earns more than the cost of capital. Project 2 does not.
NPV and Economic Profit
● Projects with a positive NPV create economic profit.

● Only positive NPV projects earn a return higher than
the company’s cost of capital.
● Projects with negative NPV may create accounting
profits, but not economic profit.
● In making investment decisions, choose only projects
with a positive NPV.
Another Method: Break-Even Quantities
● The break-even quantity is the amount you need to

sell to just cover your costs
• At this sales level, profit is zero.
● The break-even quantity is:
Q=FC/(P-MC)
FC: fixed costs P: price MC:marginal cost
• (P-MC) is the “contribution margin” – what’s left

after marginal cost to “contribute” to covering fixed
costs
Break-Even Example: Nissan Truck
● Nissan’s popular truck model, the Titan, had only two years
remaining on its production cycle. Redesigning the “Titan” would
cost $400M.
• Cost of capital was 12%, implying annual fixed cost of $48M
• Contribution margin on each truck is $1,500
• Break-even quantity is 32,000 trucks
• The decision to redesign or not came down to a break-even analysis
● Nissan had a 3% share of the market, implying only 12,000 Titan
sales per year – not enough to break even.
● Instead they decided to license the Dodge Ram Truck, which
would reduce the fixed cost of redesign, and a lower break-even
point.
● After the Government took over Chrysler, Nissan reconsidered.
Deciding Between Two Technologies
● In 1983, John Deere was in the midst of building a

Henry-Ford-style production line factory for large 4WD
tractors
• Unexpectedly, wheat prices fell dramatically reducing
demand for large tractors
● Deere decided to abandon the new factory and instead
purchased Versatile, a company that assembled tractors
in a garage using off-the-shelf components
● Deere chose one manufacturing technology over another
• A discrete investment decision – the factory had big FC and
small MC, Versatile had small FC but bigger MC
John Deere: Right Decision?
● Was purchasing Versatile the right choice?

● It depends… on how much John Deere expected to sell.
• Suppose the capital-intensive technology would
involve $100 FC and $10 MC
• Suppose Versatile’s technology had $50 FC and $20 MC
• To determine break-even quantity (point of indifference),
solve for the quantity that equates the costs: $150 for 5
units
• If you expect to sell less than 5 units, choose the
low-MC technology
• If you expect to sell more than 5 units, choose the
low-FC technology
John Deere Lesson
● John Deere made the right decision by acquiring

Versatile; however, the Antitrust Division of he U.S.
Department of Justice challenged the acquisition as
anticompetitive.
● John Deere and Versatile were only two of 4 firms
selling 4WD tractors in North America.
Break-Even Advice
● Remember this advice: Do not invoke break-even

analysis to justify higher prices or greater output.
● Managers sometimes believe they must raise prices
to cover fixed costs or they must sell as much as
possible to make average costs lower
● These are extent decisions though!
• They require marginal analysis, not break-even
The Decision to Shut-Down
● Shut-down decisions are made using break-even

prices rather than quantities.
• The break-even price is the average avoidable cost
per unit
• Profit = (Rev-Cost)= (P-AC)(Q)
● If you shut down, you lose your revenue, but you get
back your avoidable cost.
• If average avoidable cost is less than price, shut down.
● Determining avoidable costs can be difficult.
• To identify avoidable costs firms use Cost Taxonomy
Cost Taxonomy
● Example: FC=$100, MC=$5, and you produce 100 units/year

● How low of a price before you shut down? IT DEPENDS
● It depends on which costs are avoidable
• Long-run: fixed costs become avoidable so they are included
in the shutdown price
• Short run: they are unavoidable and should not be included
in the shutdown price Costs
Avoidable Unavoidable
Costs or “Sunk” Costs
Fixed Costs Variable Costs

(avoidable in long run) (avoidable in short run)
Sunk Costs and Post-Investment Hold Up
● Always remember the business maxim “look ahead

and reason back.” This can help you avoid potential
hold up.
● Before making a sunk cost investment, ask what you
will do if you are held up.
● What would you do to address hold up?
Sunk Costs and Post-Investment Hold Up Example
● National Geographic can reduce shipping costs by

printing with regional printers.
• To print a high quality magazine, the printer must buy a
$12 million printing press.
• Each magazine has a MC of $1 and the printer would print
12 million copies over two years.
• The break-even cost/average cost is $7 = ($12M / 2M
copies) + $1/copy
• BUT once the press is purchased, the cost is sunk and the
break-even price changes.
• Because of this the magazine can hold up the printer by
renegotiating the terms of the deal – because the price of
the press is unavoidable, and sunk, the break-even price
falls to $1, the marginal cost.
Vertical Integration
● One possible solution to post-investment hold-up is

vertical integration.
● Example: Bauxite mine and alumina refinery
• Refineries are tailored to specific qualities of ore
• The transaction options are:
• Spot-market transactions
• Long-term contracts
• Vertical integration
– Vertical integration refers to the common ownership of two firms in
separate stages of the vertical supply chain that connects raw
materials to finished goods
• Discussion: How is vertical integration a solution to hold up?
● Contractual view of marriage
• Long-term contracts induce higher levels of relationship-
specific investment
Investment Decisions
Investment Decisions
based on Ch. 5, Froeb, 5th ed. by Cengage
based on Ch. 5, Froeb, 5th ed. by Cengage Learning
Learning

Institute of Accounts, Business,
& Finance
Far Eastern University, Manila
https://www.thebalance.com/investing-terms-you-should-know-356338
• Students should be able to:
• Calculate using compounding formula
• Calculate using discounting formula
• Understand NPV calculation
• Understand how to apply break-even analysis
• Evaluate the worthiness of an investment
• Choose an investment analysis method, given a set of data
Outline:
• Investment, definition & importance
• Break-even Analysis (BEA) vs. Net Present Value
• Compounding
• Discounting
• Net Present Value (NPV)
• NPV & Economic Profit
• Rules in Investment
• Applications in Business
Investment
• An investment is an asset or item acquired with the goal of generating income or appreciation.
Appreciation refers to an increase in the value of an asset over time. When an individual
purchases a good as an investment, the intent is not to consume the good but rather to use it in
the future to create wealth.
• involves putting capital to use today in order to increase its value over time.
• An investment can refer to any medium or mechanism used for generating future income,
including bonds, stocks, real estate property, or a business, among other examples.
(https://www.investopedia.com/terms/i/investment.asp)
• All investments represent a trade-off between possible future gain and current sacrifice. (Froeb,
et.al.)
• Investing is the act of buying financial assets with the potential to increase in value, such as
stocks, bonds, or shares in Exchange Traded Funds (ETF) or mutual funds. Investments are not
guaranteed to hold or increase their value over time.
• https://www.becu.org/articles/how-investing-works
Break-Even Analysis
• Break-even quantity is equal to fixed cost divided by the
contribution margin. If you expect to sell more than the
break-even quantity, then your investment is profitable.
• BEQ = Total Fixed Costs/contribution margin
• For more information, visit:
• https://www.youtube.com/watch?v=5XOVUPGPcbg
• Contribution margin = price – per unit variable cost

• Ex. TFC = Php 20,000 contri. M = Php 20.00 BEQ?
Break-even Analysis
• In summer 2007, Bert Matthews was contemplating purchasing a 48-unit apartment building.
• The building was 95% occupied and generated $550,000 in annual profit. Investors expected a
15% return on their capital. The bank offered to loan Mr. Matthews 80% of the purchase price at
a rate of 5.5% . Mr. Matthews computed the cost of capital as a weighted average
of equity and debt.
equity (rate of return) + loan (interest rate) = cost of capital
.2*(15%) + .8*(5.5%) = 7.4%
• Profit/cost of capital : $ 550,000/.074 = $7.4 million
• Mr. Matthews could pay no more than $550,000/7.4% = $7.4 million and still break even.
• Mr. Matthews decided not to buy the building. A good decision – one year later, the cost of
capital was 10.125% and Mr. Matthews could offer only $5.4 million for the building.
• $550,000/10.125% = $550,000/.10125 = 5,432,098.76 rounded off to $5.4 million
Compounding
• Compounding is the ability of an asset to generate earnings, which are then
reinvested or remain invested with the goal of generating their own earnings. In
other words, compounding refers to generating earnings from previous earnings.
• Formula: (same as time value of money)
(future value, k periods in the future) = (present value) x (1 + r)K
• Given: present value, interest rate (r) , number of years (k)
• Calculate for the future value
• Example: If you invest $1 (present value) today at a 10% (r), then you would expect to have
$1.10 in one year. : = $1 (1.1) = $1.10
– At same rate, In two years, $1 becomes : $1 x (1 + .10) 2 = ?
– In three years: ?
• What is the future value of Php10,000 after 5 years at 5% p.a. compounded?
• = 10,000 x (1+ .05)5
• Php12,762.8
Rule of 72
• A good compounding rule of thumb:
“Rule of 72”: If you invest at a rate of return r, divide 72 by r to get the number
of years it takes to double your money (Froeb, 5th ed.)
• The Rule of 72 is a simplified formula that calculates how long it'll take for an
investment to double in value, based on its rate of return.
• The Rule of 72 applies to compounded interest rates and is reasonably accurate
for interest rates that fall in the range of 6% and 10%.
• The Formula for the Rule of 72
• Years to double = 72/interest rate
• Interest rate is the rate of return on an investment
• For more info, pls. visit the link:
• https://www.bankrate.com/investing/what-is-the-rule-of-72/
Discounting
• Discounting is the process of determining the present value of a payment or a
stream of payments that is to be received in the future. Given the time value of
money, a dollar is worth more today than it would be worth tomorrow.
Discounting is the primary factor used in pricing a stream of tomorrow's cash
flows.
• From a business perspective, an asset has no value unless it can produce cash
flows in the future. Stocks pay dividends. Bonds pay interest, and projects
provide investors with incremental future cash flows. The value of those future
cash flows in today's terms is calculated by applying a discount factor to future
cash flows.
• A higher discount indicates a greater level of risk associated with an investment
and its future cash flows.
• Discounting helps you figure out if future gains are larger than current sacrifice.
Discounting
• the discounted, or present value, is the value of the bond today. The future value is the value of
the bond at some time in the future. The difference in value between the future and the present is
created by discounting the future back to the present using a discount factor, which is a function
of time and interest rates.
• a bond can have a par value of $1,000 and be priced at a 20% discount, which is $800. In other
words, the investor can purchase the bond today for a discount and receive the full face value of
the bond at maturity. The difference is the investor's return.
• Present value = $1,000/(1+ r)k = $1,000/(1+ 0.2) = $833 It’s like you’re buying an instrument now for $833,
keep it for k years, and redeem it at face value ($1000
upon maturity)
• What will be the selling price of a bond at face value Php20,000 today with 5 years maturity at
10% discount? Other relevant examples: insurance policy, educational plans
• Present value = Php20,000/(1+ 0.10) 5
• = Php12,422.36
Discounting
• Discounting (the inverse of compounding):
Present value = (future value, k periods in the future)
(1 + r)k
Given: future value, periods in the future or years (k), discount rate (r)
Calculate for the present value
• Example: At a 10% r, $1 is worth:

– Next year: ($1)/1.1 = $0.91
– Two years: ($0.91)/1.1 =$0.83
– $1/(1+r)k = $1/(1+r)k = $1/(1.1)2 = $1/1.21 = $0.83
– Three years: ?
Practice set
Present value Future value 1+r No. of years

10,000 1 + .10 3
10,000 1 + .11 3
10,000 1 + .12 3
10,000 1 + .13 4
10,000 1 + .13 5
Instruction:
After calculating for the present values, be able to answer the question below:
What can you conclude?
Net Present Value
Same as:
NPV = Sum of Inflows in present value – Sum of Outflows in present value
Choosing Between 2 Projects based on
NPVs
NPV = SUM OF INFLOWS – OUTFLOW

Project 1:
NPV = $100.88 – 100
= $0.88
Project 2:
NPV = ($52.63 + $46.17) - $100
= $98.8 - $100
= -$1.2
NPV & Economic Profit
• Projects with a positive NPV create economic profit.
• Only positive NPV projects earn a return higher than the
company’s cost of capital.
• Projects with negative NPV may create accounting profits,
but not economic profit.
• In making investment decisions, choose only projects with a
positive NPV.
Application: Break-even Analysis
• Nissan’s popular truck model, the Titan, had only two years remaining on its production cycle.
Redesigning the “Titan” would cost $400M.
– Cost of capital was 12%, implying annual fixed cost of $48M
– Contribution margin on each truck is $1,500
– Break-even quantity is 32,000 trucks
– TR = price x quantity TC = Total Cost = Fixed Costs + Variable Costs
– TR = $1,500 x 32,000 units = $48 M TC = $400M x 12% = $48 M
– The decision to redesign or not came down to a break-even analysis
• Nissan had a 3% share of the market, implying only 12,000 Titan sales per year – not enough to
break even.
• Instead, they decided to license the Dodge Ram Truck, which would reduce the fixed cost of
redesign, and a lower break-even point.
Advice on Break-even Analysis
• Remember this advice: Do not invoke break-even analysis
to justify higher prices or greater output.
• Managers sometimes believe they must raise prices to cover
fixed costs or they must sell as much as possible to make
average costs lower
• These are extent decisions though!
– They require marginal analysis, not break-even
References:
• https://www.investopedia.com/terms/n/npv.asp
• https://www.becu.org/articles/how-investing-works
• https://www.investopedia.com/terms/i/investment.asp
• https://www.investopedia.com/terms/d/discounting.asp
• Managerial Economics. Froeb, et.al. 5th ed. Cengage
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Costs & Extent

By: Dr. Shirley Catley-Rinoza

1 16 (Q1) $160 $80 $80 (TR1) $240 $5.00 $15.00 $5.00

TR1 means initial TR, TR2 means final TR

Fixed Variable Total Total Marginal Marginal Average Total Average

The assumption is that Price per unit is $5

Initially, both ATC and AVC are high, but with

• TV Ad cost to get one more customer :

• Pay to Performance: flat rate or incentive pay?

• Rent • Direct labor

• all costs associated with either production or maintenance. When associated

• An implicit cost is a cost that exists without the exchange of

Net profit $ 95,000

Jane’s Benefits in her current employment

Source: Froeb, et.al.,. Managerial Economics. 5th ed. Cengage Learning.

● A young geologist was preparing a bid

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● Answer the three questions:

Now that we know what is wrong, how do we fix it?

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1) Who is making the bad decision?

3) Does the decision maker have the incentive to

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● Need to find correct trades with

● Like with kidney transplants, compatibility problems

To identify money-making opportunities,

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The buyer and seller both benefit from this transaction:

● Seller surplus = the price minus the seller’s value

● Total surplus = buyer + seller surplus = difference in

● Which assets do these transactions move to higher-

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● However, many mergers and acquisitions do not

● To create value, the assets of the acquired firm

● Discussion: What’s the government’s role is wealth creation?

● Property rights are commonly identified as a right to own or

● Definition: An economy is efficient if all assets are employed in

● The One Lesson of Economics: The art of economics consists in

● Definition: Inefficiency implies the existence of

Anything that stops assets from moving to higher

● Which assets end up in lower-valued uses?

● Taxes create a profit opportunity

● Subsidies create opportunity

● Price-controls create opportunity

● Companies = a collection of transactions

• Dr. Itty Benjamin, retrieved from https://slideplayer.com/slide/4036429/