The nature of markets

CHAPTER 1
THE NATURE OF MARKETS

THE NATURE OF MARKETS
1. The Theory of the Firm
2. What is Profit?
3. Managerial Interest and the
Principal – Agent Problem
4. Demand and Supply
5. Equilibrium Price

The Story of Bottled Water

www.storyofstuff.org/movies-all/story-of-bottled-water/

Managerial economics
• use formal models to analyze managerial
actions and their effect onfirm performance
• to shed light on business concepts such as cost,
demand, profit, competition, pricing, compensation,
market, entry strategy, and auction strategy
• All these concepts are under the control of the
managers, and they determine firm performance

The focus is on managerial behavior
• whereas the micro world describes the
environment
• This helps students learn theintegrative mind-set

that is essential for good management
• It also gets them to think past the short-term

consequences
• To increase the value of their decisions at personal
and organizational levels

The goals of managers focus on increasing
the value of their organization
• Our models must account for behavior across a
great number of firms

• in profit-oriented organizations managerstry to
increase the net present value of expected future
cash flows

Managerial decisions clearly determine both the
revenues and costs for an organization
• Because profit equals total revenue (TR) minutes total
cost (TC), this equation can also be expressed as

where is the firm´s total revenue in year t, and
its total cost in year t

is

• Constraint: most resources are scarce.Other constraints
that limit managerial actions are legal or contractual

Two Videos
A. How To Calculate Net Present Value
B. FIN3403 Time Value of Money

3. What is Profit?
• We measure profit after taking account of the
capital and labor provide by the owners
Profit: When economists speak of profit,
they mean profit over and above what the owner´s labor
and capital employed in thebusiness could earn elsewhere

• Differences between the profit concepts:
difference in their focus
– The accountant: Controlling the firm´s day-to-day
operations
– The economist: Decisions making and rational choice
among strategies

What is Profit?
• If she is interested in making as much money as
possible, she should calculate her firm´s profit
based on our economist model

• Ifthe firm´s economic profit is greater than zero,
she should continue to operate the firm;
otherwise she should close it down and pursue
her other opportunities

Profit is one indicator of the managers
decision-making skills
• Three fertile profit-generating areas used by
managers are innovation, risk, and market power
• Examples: iPhone from Apple + the 787 Dreamliner
from Boeing
•Future value will depend on how each managerial
team executes its market strategy

Profit is the reward to those who bear risk well
• Future outcomes unknown:
How successful will this product be in the market?
• Actions of rivals unknown:
If I raise my price, will my rivals raise theirs?
• Likelihood of a future event unknown:
How likely is it that a democrat will be elected our nextpresident?

• Managers also earn profit by exploiting market inefficiencies

Exercise
• Economic Profit vs Accounting Profit

Managers are agents who work for the firm´s
owners, who are the shareholders or principals
The principal-agent problem
when mangers pursue their own objectives,
even though this decreases the profit of the owners

• The principal-agent problem centers on whethermanagers
may pursue their own objectives at a cost to the owners
• Because the firm´s owners find it difficult to distinguish

between benefits that bolster profit and those that do not,
managers have incentives to enrich themselves

The managerial world revolves
around markets
• The managers must understand basic market
principles in order to anticipate behavior people in
markets
•...