Managerial Economics - Key Concepts and Basic Terms | Robert Reed | Skillshare

Managerial Economics - Key Concepts and Basic Terms

Robert Reed

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5 Lessons (22m)
    • 1. Final Intro to First Lessons

      0:40
    • 2. Intro to managerial

      7:50
    • 3. Time value of money

      7:48
    • 4. Project profitability index

      2:14
    • 5. Value of Perpetuity

      3:43

About This Class

Welcome!

Managerial Economics is a field of Economics that business owners use to make effective decisions. I have broken this course into several sections. In this first section of the course, we will learn the basic terms and key concepts that managers use to  make effective decisions. 

Topics Covered

  • The Concept of Managerial Economics
  • Accounting Profit vs Economic Profit
  • Profit Incentives in the Free Market
  • Time Value of Money
  • Project Profitability Index
  • Value of a Perpetual Cash Flow

This is the shortest course in the series about Managerial Economics, but it is important to understand the basics before you progress to the more advanced topics in the series. 

About the Instructor

Robert Reed is a current Masters of Business Administration candidate and veteran with four years of service in the 82nd Airborne Division of the United States Army. He holds a B.A. in Economics and has served as a student tutor for three years.

Transcripts

1. Final Intro to First Lessons: well, welcome to the course in managerial economics in these first few lessons were going to be laying a solid foundation for the rest of the course. We'll talk about some basic terms and managerial economics. What is the manager and what do they do? What is economics and why? It's the concept of scarcity so important we'll talk about the time value of money. If I can make an investment now that pays off in the future. Should I do it? Is this investment worth it? Now? This is going to be the very basics of the course. It's going to allow us to have a solid foundation for the rest of the coursework. I hope that you find these videos useful and let's start learning. 2. Intro to managerial: Hello. Welcome to managerial economics. I'm very excited to teach this course because managerial economics is all about business, how businesses make decisions. Now, in this first lecture, we're going to be just laying the foundation, kind of building the basic understanding that we need to go forward with the class and understand how businesses make decisions. With that. Let's start right with the word manager and the word economics. A manager is someone who directs. Resource is to achieve a goal. For example, if I'm the owner of a store, ah, higher certain employees. I have certain employees working the grocery section. Certain employees work at the cashiers I'm using. Different resource is to achieve a goal. And it's the same thing. If I was to work at a manufacturing plant and suppose that I have to buy certain amounts of different raw materials, I have to buy steel. I have to buy. Would I have to buy all these different things? I have to buy machines, and my job as a manager is to use all of these different resource is to achieve some goal. Now there's many different levels of managers, obviously the CEO of a corporation is a manager, but also someone who on Lee has a few employees, is also a manager. And again, managers are found in all types of jobs. Just because you don't work in an office doesn't mean that you're not a manager. You could be working in a very heavy manual field, but you're still a manager if you're using these resource is and directing them so that you can achieve a goal. Now economics is making decisions when faced with scarcity. And what does that mean? Scarcity essentially means that there's not enough of everything, right. Let's say that I am a local government official and we take in so much money in taxes. Now the amount of money that I have is fixed, and let's say that I can either provide a new school for the people or I can provide a new hospital. I can't have both of these. I simply don't have the money. So the question becomes which one of these is best going to serve the local people and the way that we make that decision is based on economics, which is making decisions when we can't have both choices. Now, managerial economics is simply putting both of these terms together. It's using scarce resource is, but we're trying to achieve the goals of an organization now. Typically, this will be a business, and the goal of a business is to maximize their profit for the shareholders. Now, when we talk about profit, there's really two different types. The first of these is probably what you're more familiar with accounting profit, and this is simply the total revenue minus the dollar cost of production. So if I am a if I own a hot dog stand and I sell ah, $100 worth of hot dogs that day. But I had to spend $30 to buy the hot dogs to use the grill to cook the hot dogs. My profit is $70 because yes, I'm made $100 but it cost me $30 to make that money. Now economists look at this a little bit differently. Yes, they take account of total revenue. The $100. Yes, they account for the $30 that we had to spend to produce our product, but they also look at the implicit cost. For example, if I wasn't selling hot dogs, could I be a professional basketball player. Could I be a teacher? What is my best alternative to selling hot dogs? So hopefully this gives an example. In this example, we have Rob's Diner and let's suppose that on a given time period this could be in an hour , in a day, whatever. I made $100. I sold $100 worth of food. Now it costs me $30 to produce that food. Perhaps I had to spend $10 to hire a cook. I had to spend $10 for the food and $10 for electricity. Now an accountant would look at this and say You made $100. You spent $30. You made a profit of $70 but on Economist looks at this and says you made $100. You spent $30. But you also turned down an opportunity to be a attendant at the movie theater. You turned down an attendant to be a software developer for $20. So, yes, you actually spent $30. But because you were working at the diner, you also gave up the opportunity to earn $20 at this other job. So you're riel. Economic profit is $50 now. One more thing when we're just talking about the basics of managerial economics is that we expect there to be free competition. In other words, we cannot be forced toe work. We cannot be forced toe open a certain type of business, and the importance of that is that we can't necessarily control our employees all the time . For example, Adam Smith says it is not from the benevolence of the butcher, the baker or the brewer that we expect our dinner, but from regard to their own interest. In other words, someone for the most part doesn't open a business simply to serve other people. We open businesses, we goto work. We have jobs because we're expecting a benefit, right? We're expecting a paycheck, a salary which brings to the forefront the importance of incentives. Now an incentive is something that convinces you to do something. Let's suppose that I am the owner of a car dealership and I want to sell as many cars as possible. Now, if I hire an employee and I tell him I'm going to pay him $10 an hour, perhaps he sells a lot of cars. Perhaps he doesn't because the thing is, he knows he's going to get paid the same amount $10 per hour. So if he sells a lot of cars, if he researches the course so he has all this information, he's still only going to make $10 an hour, so I can't force him toe work harder. But what I can do is provide an incentive that encourages him toe work harder. So what I can do is give him a commission based payment. I can say for every core you sell, I'm going to let you keep 1% of the purchase price. So if he sells $1000 car, he gets to keep $10. Or if he sells a $10,000 car, he gets to keep Ah, $100 and this works for both of us because it encourages him toe work harder. But it also helps me because I'm selling more cars now. In summary, we've just laid the groundwork and the foundation for managerial economics we've discussed a manager is someone who directs resource is to achieve a goal. We've discussed how economics is making decisions when we can't have both of the things that we want. We talked about how accounting profit is different from economic profit, and then we've talked about how managers can use incentives to help achieve the goals they want. I hope this first video has been useful, and I will see you next time. 3. Time value of money: Hello. Welcome back to the course on managerial economics today. We're talking about a concept known as the time value of money. And essentially, this concept says that a dollar today is better than a dollar tomorrow. And let's think about this conceptually, before we get into the mathematics, let's say that you have a dollar in your pocket right now. You can go to a snack machine and get some potato chips. You can go to a vending machine and get some coke. You can use that dollar and you have exactly $1. Now let's say that you don't have a dollar, but your friend owes you a dollar, and you know that he's going to give you that dollar tomorrow. It's still going to be the same numeric value, $1 but it's less useful to you because you don't have control over that dollar in the present, you can't buy your potato chips. You can't get something to drink. So essentially the value of this dollar in the present is more than a value in the future, and the present value is something that we're asking. How many dollars are we going to need in the future to make up for a dollar today, and the longer we have to wait for our friend to pay us back, the more money we're going to want. If he just asked to borrow a dollar for, you know, a few hours and then we don't really need that much, maybe a dollar in 10 cents. You know it's fine. But if we wait five years to get this money back, we're going to want Mawr compensation to make up for the fact that we've been waiting five years to get our potato chips right. So the longer we wait, the more money we need to make up for that lost purchasing power in the present. Now, mathematically, this is shown as present value PV is equal to future value, divided by one plus the interest rate raised to the number of periods. Now there's a few things that I want to clarify. The interest rate is always given as a percent like 5% 10% 3%. But in this mathematic equation, one plus the interest rate were always going to express the interest rate as a decimal, so 5% becomes 50.5 and number of months or days or years. We can adapt this formula for anything. We can use it in terms of years or months. As long has, that corresponds to the period over which the interest rate is being paid. So if our interest rate is 5% per month and the number of months we're waiting is five than the end in, this equation would be five. So I know it's kind of hard to think about without an example. So let's jump into an example. In this example. We have the formula, and we know that the present value of $10 in one year at a 7% interest rates. So what we're wanting to know is if we're getting $10 in the future, how much is that? $10 a year from now worth today. And what we do is we say present value is equal to the future value, which is $10 divided by one plus the interest rate so 1.7 to the power of one, which gives us $9.35. Let's think about this Maurin a business perspective, and let's say that we are a ah wealthy individual and we make loans to businesses. We make loans, toe entrepreneurs and someone comes to us and they say I need $50 I can. If you give me a $45 today in one year from now, I will give you $50. So what we're wanting to do is say, Is this a good investment? If we give this man $45 today, he's going to give us $50 in one year from now. And let's say that we know the interest rate is currently 5%. So the present value is equal to the future value in this chase. $50 divided by one plus the interest rate to the power of one. So once we do art calculations, we see that this is a present value of $47.62. So the present value of that $50 is $47.62 and we're only having to pay $45 to get that amount. Now let's look at some more advanced topics in present value, and let's say again that I own a gas station or a restaurant and a salesman comes to me and he says, For $300 I will give you this Coke machine. And let's suppose that we know that this Coke machine will generate $110 of sales in year one 100 and $25 of sales in year two and $110 in year three. Now we also know that this machine is going to be completely broke after three years, and we know the interest rate is 8%. So what we want to do is in this example, we have three separate years, and in each year we're going to be making a certain amount of money. So what we want to do is we want to add the total present value off all of these future values to determine if this is a good investment. And again we use the same formula. But notice how it changes in the first example. Year one is just what we've been doing. $110 divided by one plus the interest rate to the power of one now noticed that for year two the future values $125. The interest rate is still 5%. But this time we're raising the 1.5 to the power of to and then in your three, we raise 1.5 to the power of three. Because each year that we get further away from the present. We need more money to compensate us for this longer time period. Which is why we see that the present value of $110.1 year from now is $104. But the present value of $110.3 years from now is only $95 because we're having toe wait longer to get that money. So once we do all of our calculations, we find the present value off all of this machine all three years is $313.56 and we only have to spend $300 to buy this machine. In summary, we have talked about present value, and the mathematics can be complicated sometimes and honestly. There's a lot of online calculators that will calculate present value for you. So what I want you to specifically think about is not so much the math and the numbers themselves. But I want us to think about the concepts right and conceptual e. It makes sense that a dollar today is more valuable than to us than a dollar a year from now. So what present value does is it tries to account for how much something in the future is worth to us today. And it's very important for making decisions because it allows us to compare spending money in the present with receiving some kind of return on that investment in the future. I hope the video has been useful and I will see you in the next lesson. 4. Project profitability index: Hello. Welcome back to the course in managerial economics. In today's lesson, we're going to be looking at the Project Profitability Index, and essentially, what this does is we know that when we're considering a project, if the NPV of future earnings is greater than the initial investment, we know that this is going to be a profitable investment. But we don't know which investment is going to be mawr profitable. So what we can do is compare different investments using this formula. And this is a very simple formula that simply says, Let's take all the future Tash flow earnings, discount them to the present value and then divide them by the initial investment. In other words, how much initial investment are we having to spend to get a certain present value? So let's do an example, because I think that makes it a little bit more clear. Let's suppose that we have investment Alfa for $1000. The present value of future cash flows will be $2000 the project profitability in next is there for $2000 divided by $1000 for a index of two. Now, Project Bravo is $500 invested, and the present value of future Tash flows is $2000. So first off, these investments are both profitable. In both cases were getting more money than we're investing, and they both have the exact same present value of those future cash flows. But the Project Profitability index of investment Bravo is greater than that of investment Alfa. So what this really does is it allows us to not just say, is a project profitable yes or no, but it allows us to compare different projects and evaluate them accordingly. So we see that investment Bravo, in the end, is the better investment. In summary, this goes back to maximizing the return on our investments. We don't want to simply have a investment that is profitable. We want to use our money where it's going to give us the best return. I hope you found the video useful, and I will see you in the next lesson. 5. Value of Perpetuity: welcome back to the course in managerial economics. In today's lesson, we're talking about the value of perpetuity or, in other words, infinite tash flow. Now I know you think that this may sound like a get rich quick scheme or something like that. But infinite cash flow is actually a useful concept that's describing investments or decisions that we make that return a certain amount of money into an indefinite time period . So in the British Empire hundreds of years ago, they issued what were known as console bonds, and people would buy these bonds, and the bonds would never pay back the principal. They would only pay back a certain amount of interest, and these bonds were traded for hundreds and hundreds of years. It's somewhat similar to an annuity. If you think of that concept, or if we're looking at it from a business perspective, we can think of it as some kind of investment that is supposed to pay dividends into an indefinite time period. So not a soda machine. We're not talking about something here that we can buy and use for two or three years. Similarly, we're not talking about something that needs constant repairs. What we're talking about is something that you purchase once, and then it keeps paying a dividend into and beyond the foreseeable future. So let's suppose that we cut a trail through the mountain, and once we cut this trail, it stays there. The mountain doesn't grow back, and every year we can charge $150 worth of tolls. Or there's other things you can think of, perhaps some employee training program. And once you train this employee, he or she can perform this task indefinitely into the future. So now that we understand a little bit more about how that works, let's look at the actual formula. The formula for the present value is the dividend or the fixed payment divided by the interest rate. So going back to the clearing the Mountain Trail example. Let's suppose that it costs us $100 to clear a trail through the mountain, and every year I can charge $5 worth of tolls. The interest rate is 3% so the present value is equal to $5 divided by 50.3 Remember, we expressed the interest rate as a decimal. Which brings us to a present value about 100 and $66.67. So what this tells us is that it is a good decision to create this mountain trail because we will get Maurin present value than we're spending in present value. Now this is the question. If we get a certain amount of money $5 into infinity, why is present value not infinite? We get $5.5 dollars, $5. So $5 added. An infinite number of times should be an infinite amount of money, right? Well, technically, this is true. However, this does not account of the time value of money. Remember that $5 today is much, much more valuable than $5 a year from now, or $5 a decade, especially once we start stretching out into periods of 100 years from now. The real value of that $5.100 years from now is almost insignificant, so the further we go away from the present, even though we're technically getting $5 the present value of that $5 is almost minuscule. So what this formula does is it takes this value and converts it into riel present value to enable accurate calculations and business decision making. I hope you found the video useful and I will see you in the next lesson.