1. Introduction to Firm_Dr. Nishant Sapra.pptx

Theory of Firm and Introduction to Managerial Economics

1. Managerial Economics Section 3E/H Instructor: Dr. Nishant Sapra

2. Your Expectations Before Classes Begin

3. Dr. Nishant Sapra FPM: Management Development Institute (MDI) Gurgaon. Qualified JRF M.Com : DoC , Delhi School of Economics, Delhi University. B.Com (Hons.): Zakir Husain Delhi College, Delhi University. 3

4. Teaching and Industry Experience 4 Teaching Experience Cluster Innovation Centre, DU. [Contractual, 2020] Maharaj Agrasen College, NCWEB, DU [Contractual, 2020-2021] Galgotias University, Greater Noida, UP. [Regular, 2017-18] Designed B. Com (Hons.) International Accounting and Finance in association with ACCA, UK. Courses Taught Financial Reporting and Analysis Cost Accounting Audit and Assurance Income Tax Laws Business and Corporate Law Industry Experience Royal Auto Parts (Sole Proprietor) Bulletstore.in (Online Store for Royal Enfield Spares)

5. Evaluation 5 S. no. Evaluation Component Weightage (%) 1 In-class activities (quizzes, assignments, etc.) 10% 2 Take-home Assignments (max 2) 20% 3 Class Tests (max 5) 40% 4 End Term Exam 30%

6. Class Rules: Coming Soon 6

7. Course-Contents 7

8. Role as a Manager 8

9. Flow Of Presentation 9

10. Some Basic Decisions !! What will be the demand? How can this demand be fulfilled? What will be the optimum level of output? How to respond to new competitors in the market? Increase operational efficiency including concepts like service time? How do government regulations affect our business? How can we mitigate risks associated with economic fluctuations? 10

11. Economics Economics as Mother discipline or Inspiration for following Disciplines: Finance Managerial Economics Human Resource Management Marketing Econometrics 11

12. What Economics is All About Scarcity : the limited nature of society’s resources Economics : the study of how society manages its scarce resources, e.g. how people decide what to buy, how much to work, how much to save, and how much to spend how firms decide how much to produce, and how many workers to hire how society decides how to divide its resources between national defense, consumer goods, protecting the environment, and other needs 12

13. Basic Questions of Economics What to produce? How to produce? For whom to produce? 13

14. Managerial Economics Managerial economics lies at the intersection of microeconomics and business management, focusing on applying economic principles to decision-making within organizations 14

15. Managerial Economics 15 Managerial economics is a branch of economics that applies microeconomic analysis to decision methods of businesses or other management units. Managerial economics is the study of allocation of resources available to a business firm or an organization. This is fundamentally concerned with the art of economizing, i.e., making rational choices to yield maximum return out of minimum resources and efforts, by making the best selection among alternative courses of action.

16. Process of Decision Making 16

17. Why Decision Making is important???

18. Cases: Food for Thought Product 18 Industry

19. Sudden Surge? Boon or Bane 19

20. Impact of Government Regulations 20

21. Automobile Industry: Case for Regulatory Challenges Scrappage Policy: 15-year cap on vehicle life. Introducing the Bharat standard emissions norms Calling in Electric vehicles Entire ecosystem for supporting EV Mandate for Flex-Fuel Engines Incentives for Local Manufacturing Phasing Out of Diesel Vehicles

22. We look for the answers to these set of questions: What kinds of questions does economics address? Principles of how people make decisions? Principles of how people interact? 22

23. The principles of How People Make Decisions? 23

24. PRINCIPLE 1: People Face Tradeoffs All decisions involve tradeoffs. Going to a party the night before your midterm leaves less time for studying. Having more money to buy stuff requires working longer hours, which leaves less time for leisure. Protecting the environment requires resources that could otherwise be used to produce consumer goods. 24

25. PRINCIPLE 1: People Face Tradeoffs Society faces an important tradeoff: Efficiency vs. Equality Efficiency : when society gets the most from its scarce resources Equality : when prosperity is distributed uniformly among society’s members Tradeoffs : To achieve greater equality, could redistribute income from wealthy to poor. But this reduces incentive to work and produce, shrinks the size of the economic “pie.” 25

26. PRINCIPLE 2: The Cost of something is what you give up to get it Making decisions requires comparing the costs and benefits of alternative choices. The opportunity cost of any item is whatever must be given up to obtain it. It is the relevant cost for decision making. 26

27. PRINCIPLE 2: The Cost of something is what you give up to get it The opportunity cost of… …going to college for a year is not just the tuition, books, and fees, but also the foregone wages. …seeing a movie is not just the price of the ticket, but the value of the time you spend in the theater. …blabbering at the cost and time of study. 27

28. PRINCIPLE 3: Rational People Think at the Margin Rational people Systematically and purposefully do the best they can to achieve their objectives. Make decisions by evaluating costs and benefits of marginal changes , incremental adjustments to an existing plan. 28

29. PRINCIPLE 3: Rational People Think at the Margin When a student considers whether to go to college for an additional year, he compares the fees & foregone wages to the extra income he could earn with the extra year of education. When a manager considers whether to increase output, s/he compares the cost of the needed labor and materials to the extra revenue. When a student want to score more in the tests, he/she compares leisure activity with the time spent in study. 29

30. PRINCIPLE 4: People Respond to Incentives Incentive : something that induces a person to act, i.e. the prospect of a reward or punishment. Rational people respond to incentives. When gas prices rise, consumers buy more hybrid cars and fewer gas guzzling SUVs. When cigarette taxes increase, teen smoking falls. If you maintain discipline you may get an additional weightage. If you are coming to class on time ( what incentives you have?? ) 30

31. Problem at Hand !! You are selling your 2016 TATA car. You have already spent $1000 on repairs. At the last minute, the transmission dies. You can pay $700 to have it repaired, or sell the car “as is.” In each of the following scenarios, should you have the transmission repaired? Explain. Blue book value (what you could get for the car) is $6500 if transmission works, $5700 if it doesn’t Blue book value is $6000 if transmission works, $5600 if it doesn’t 31

32. Solutions Cost of fixing transmission = $700 A. Blue book value is $6500 if transmission works, $5700 if it doesn’t Benefit of fixing the transmission = $800 ($6500 – 5700). It’s worthwhile to have the transmission fixed. B. Blue book value is $6000 if transmission works, $5600 if it doesn’t Benefit of fixing the transmission is only $400. Paying $700 to fix transmission is not worthwhile. 32

33. Observations The $1000 you previously spent on repairs is irrelevant. What matters is the cost and benefit of the marginal repair (the transmission). The change in incentives from scenario A to scenario B caused your decision to change. 33

34. How people interact? 34

35. PRINCIPLE 5: Trade Can Make Everyone Better Off Rather than being self-sufficient, people can specialize in producing one good or service and exchange it for other goods. Countries also benefit from trade and specialization: Get a better price abroad for goods they produce Buy other goods more cheaply from abroad than could be produced at home 35

36. PRINCIPLE 6: Markets Are Usually A Good Way to Organize Economic Activity Market : a group of buyers and sellers : Exchange (need not be in a single location) “Organize economic activity” means determining what goods to produce how to produce them how much of each to produce who gets them 36

37. PRINCIPLE 6: Markets Are Usually A Good Way to Organize Economic Activity A market economy allocates resources through the decentralized decisions of many households and firms as they interact in markets. Famous insight by Adam Smith in The Wealth of Nations (1776): Each of these households and firms acts as if “led by an invisible hand ” to promote general economic well-being. 37

38. PRINCIPLE 6: Markets Are Usually A Good Way to Organize Economic Activity The invisible hand works through the price system: The interaction of buyers and sellers determines prices. Each price reflects the good’s value to buyers and the cost of producing the good. Prices guide self-interested households and firms to make decisions that, in many cases, maximize society’s economic well-being. 38

39. PRINCIPLE 7: Governments Can Sometimes Improve Market Outcomes Important role for government: enforce property rights / law and order (with police, courts etc.) People are less inclined to work, produce, invest, or purchase if large risk of their property being stolen. 39

40. PRINCIPLE 7: Governments Can Sometimes Improve Market Outcomes Market failure: when the market fails to allocate society’s resources efficiently Causes of market failure: Externalities , when the production or consumption of a good affects bystanders (e.g. pollution) Market power , a single buyer or seller has substantial influence on market price (e.g. monopoly) Public policy may promote efficiency . 40

41. PRINCIPLE 7: Governments Can Sometimes Improve Market Outcomes Government may alter market outcome to “ promote equity” If the market’s distribution of economic well-being is not desirable, tax or welfare policies can change how the economic “pie” is divided. 41

42. SUMMARY The principles of how people make decisions are: People face tradeoffs. The cost of any action is measured in terms of foregone opportunities. Rational people make decisions by comparing marginal costs and marginal benefits. People respond to incentives. 42

43. SUMMARY The principles of interactions among people are: Trade can be mutually beneficial. Markets are usually a good way of coordinating trade. Government can potentially improve market outcomes if there is a market failure or if the market outcome is inequitable. 43

44. Introduction to the Theory of the Firm Definition : Firm is defined as a collection of resources that is transformed into products demanded by consumers. The Theory of the Firm explains how firms make decisions regarding production, costs, and pricing to maximize profits. Objective : Firms aim to maximize profits by choosing the optimal combination of inputs (labor, capital) and output levels. Key Questions: How does a firm determine the optimal level of production? What factors influence the firm's cost structure? How do firms decide on pricing strategies? 44

45. Cost Structures and Production Decisions Short-Run vs. Long-Run : Short-Run : At least one input is fixed (e.g., capital); firms adjust variable inputs (e.g., labor) to change output. Long-Run : All inputs are variable; firms can change scale of production. Cost Curves : Total Cost (TC) : Sum of fixed and variable costs. Average Cost (AC) : Cost per unit of output; important for pricing decisions. Marginal Cost (MC) : Cost of producing one additional unit; crucial for determining profit-maximizing output. Profit Maximization : Occurs where Marginal Cost (MC) = Marginal Revenue (MR) . 45

46. How do Costs Behave? 46

47. Market Structures and Firm Behavior Perfect Competition : (Example: Agricultural products) Many firms, homogeneous products, no pricing power. Firms are price takers; produce where P = MC . Monopoly : (Example: Railway/ Electricity Distribution) Single firm, significant pricing power, high barriers to entry. Firm sets price above MC, produces where MR = MC . Oligopoly : (Example: Telecom, Automobile etc.) Few firms, interdependent pricing, potential for collusion. Strategic behavior; firms consider rivals' actions in pricing and output decisions. Monopolistic Competition : (Ex :Retail clothing and food outlets) Many firms, differentiated products, some pricing power. Firms aim to differentiate products and maximize profits through product variation and branding. 47

48. What is Profit Maximization? Definition: The objective of increasing a company's earnings to the highest possible level within a specific period, focusing on maximizing the difference between total revenues and total costs. Profits are typically measured using accounting metrics such as: Net Profit: Total revenues minus total expenses. Gross Profit: Revenue minus the cost of goods sold (COGS). EBIT (Earnings Before Interest and Taxes): A measure of profitability that excludes interest and tax expenses. 48

49. What is Wealth Maximization? Definition: The process of increasing the overall value of shareholders' investment in a company over the long term, focusing on maximizing the company's market value and ensuring sustainable growth. Market Value Orientation: Focuses on increasing the company's market value, often reflected in stock prices and dividends. Takes into account the company's risk profile and future earning potential. How is it measured? Market Capitalization Share Price Appreciation Economic Value Added (Net profit after deducting the cost of capital) 49

50. Profit Vs Wealth Maximization 50 Aspect Profit Maximization Wealth Maximization Objective Increase short-term profits Increase long-term shareholder wealth Time Horizon Short-term focus Long-term focus Measurement Accounting profits, EBIT Market value, stock price, dividends Decision Basis Immediate financial gains Sustainable growth and risk-adjusted returns Risk Consideration Often ignores risk Actively considers risk

51. Principle Agent Problem or Agency Problem Definition: The Principal-Agent problem arises when one party (the principal) delegates work to another party (the agent) who performs that work. It’s a common issue in scenarios where there's a separation between ownership and control, such as in corporations. Key Concepts: Principal: The entity or person who hires the agent (e.g., shareholders, employers). Agent: The individual or entity who performs tasks on behalf of the principal (e.g., managers, employees). Information Asymmetry: The agent often has more information about the actions they take than the principal, leading to a potential conflict of interest. 51

52. Some Examples of Agency Problem Example 1. Executive Compensation: Scenario: CEOs and top executives (agents) are tasked with maximizing shareholder value (principal). Problem: Executives might prioritize short-term gains or personal bonuses (e.g., stock options) over long-term company health, potentially engaging in risky projects or manipulative accounting practices. Real-World Example: The 2008 financial crisis, where some executives pursued high-risk strategies to maximize bonuses, leading to catastrophic outcomes for shareholders and the economy. 52

53. Some Examples of Agency Problem Example 2. R&D Investment Decisions: Scenario: Managers (agents) are responsible for making investment decisions in Research and Development (R&D) to foster innovation. Problem: Managers might underinvest in R&D if they perceive that the benefits will not materialize within their tenure, thus focusing on projects with short-term returns instead. Real-World Example: Companies in the tech industry sometimes face underinvestment in disruptive technologies because managers focus on products with immediate revenue potential rather than long-term innovation. 53

54. Some Examples of Agency Problem Example 3. Mergers and Acquisitions: Scenario: Executives (agents) pursue mergers or acquisitions to grow the company, supposedly to benefit shareholders (principals). Problem: Executives may pursue deals that enhance their personal prestige or increase the size of the company they control, even if such deals do not add shareholder value. Real-World Example: Time Warner merged with AOL in a deal valued at $165 billion, with the promise of creating a dominant media and internet company. This was the worst mergers in history. 54

55. Some Examples of Agency Problem ICICI Bank and Chanda Kochhar (2018) Example 3. Unfair Advantage to Friends & Relatives: Scenario: Chanda Kochhar, the former CEO of ICICI Bank, was one of the highest-paid executives in the Indian banking sector. Problem: Allegations emerged that Kochhar had favored certain borrowers in exchange for personal gains, including loans to companies with which her family had business interests. The scandal raised concerns about conflicts of interest and governance issues. Outcome: Kochhar was forced to step down, and ICICI Bank’s reputation and stock price suffered as a result of the controversy. The case highlighted issues of executive misconduct and the risks of aligning executive compensation with unchecked decision-making power. 55

56. ICICI Bank and Videocon Case: Agency Problem 56 Chanda kochhar , Former CEO of ICICI Bank Business Standard: https://www.youtube.com/watch?v=wAPXzsTztQ8 Crux Video: https://www.youtube.com/watch?v=TE2LuiRlcuM

57. Solutions to the Principal-Agent Problem 57

58. What is Market Value Added (MVA)? Definition: Market Value Added (MVA) is a financial metric that measures the difference between the current market value of a company and the total capital contributed by investors (both equity and debt holders). It reflects the wealth created for shareholders and debt holders by the company over time. MVA= Market Value of the Company − Total Capital Invested Where, Market Value of Company=Market Value of Equity + Market Value of Debt Total Capital Invested=Book Value of Equity + Book Value of Debt 58

59. What is Economic Value Added (EVA)? Definition: Economic Value Added (EVA) is a financial performance metric that measures the value a company generates from its invested capital after accounting for the cost of that capital. EVA is a measure of a company’s ability to generate returns in excess of its cost of capital, effectively indicating whether the company is creating or destroying shareholder value. EVA=NOPAT − (Capital Invested × Cost of Capital) Where, NOPAT = Net operating Income After Tax 59

60. Market Value Added vs Economic Value Added 60 Aspect Market Value Added (MVA) Economic Value Added (EVA) Definition Measures total value created over time Measures value created in a specific period Focus Long-term wealth creation Operational efficiency and profitability Time Frame Cumulative (long-term) Period-specific (short-term) Measurement Basis Market-based (market value vs. invested capital) Accounting-based (NOPAT vs. cost of capital) Purpose Assess overall company success Evaluate management performance Calculation Complexity Simpler, uses market values More complex, involves detailed financial data Dependence on Market Influenced by market conditions Focused on internal operations Usage Strategic overview Decision-making and performance incentives

61. Covered so far !! Basics of Decision Making Definition of Managerial Economics Challenges in Decision Making Cases for brainstorming: Parle G and Automobile Industry 7 Principles: How people interact and take decisions? (Car Repair example) Theory of Firm Cost & Production Decisions Market Structures and Firm Behaviour Profit Vs Wealth Maximization Principal-Agent Problem (Examples, Scenarios including ICICI Scam as case) Market Value Added Vs Economic Value Added 61

62. Thank You for Your Time 62