Chapter 1 Vocab

Question 1

Managerial Economics is…

Answer 1

…the application of microeconomics to decision problems faced in the private and public sectors.

Question 2

Managerial economics assists managers in…

Answer 2

…efficiently allocating scarce resources, planning organizational strategy, and executing effective tactics.

Question 3

Name the 4 managerial decision making seeks to do the following:

Answer 3

1 - Identify the alternatives
2 - Select the choice that accomplishes the objectives in the most efficient manner
3 - Taking into account the constraints
4 - The likely actions and reactions of rival decision makers

Question 4

What 2 things that decision makers MUST do:

Answer 4

1 - Establish the objectives
2 - Identify the problem

Question 5

Managers create organization structure and culture based on…

Answer 5

…the organization’s mission.

Question 6

Senior management especially is responsible for…

Answer 6

…establishing a vision of new business directions and setting stretch goals to get there.

Question 7

Managers coordinate the integration of… (3)

Answer 7

…marketing, operations, and finance functions.

Question 8

True or False: Teamwork skills and the ability to motivate teams is widely acknowledged as the single most critical trait of effective managers.

Answer 8

TRUE

Question 9

What is the Moral Hazard problem in team-making?

Answer 9

How does a manager attain the commitment from a team to put forth 110% effort when doing less would not impose as much personal sacrifice, and when individual shirking on one’s effort may not be transparently obvious.

Question 10

If penalties and sanctions are few and far between, only a sense of ___ ___ induces full-effort teamwork rather than the ___ ___ associated with free riding.

Answer 10

moral duty; reduced effort

Question 11

How can moral hazards in teams be avoided?

Answer 11

What is needed is a manager or supervisor who imposes sanctions for the shirking behavior of teammates that decide to free ride.

Question 12

Managers in a capitalist economy are motivated to monitor teamwork ultimately because…

Answer 12

…of their overarching goal to maximize returns to the owners of the business - that is, economic profits.

Question 13

Economic Profit

Answer 13

The difference between total sales revenue (price times units sold) and total economic cost

Question 14

The economic cost of any activity may be thought of as…

Answer 14

…the highest valued alternative opportunity that is forgone.

Question 15

To attract labor, capital, intellectual property, land, and materiel, the firm must offer to pay a price that is…

Answer 15

…sufficient to convince the owners of these resources to forego other alternative activities and commit their resources to this use.

Question 16

Economic costs should always be thought of as opportunity costs, which are…

Answer 16

…the costs of attracting a resource such as investment capital from its next best alternative use.

Question 17

True or False: In a free enterprise system, economic profits do not play an important role in guiding the decisions made by the thousands of competing independent resource owners.

Answer 17

False - economic profits DO play an important role in decision making

Question 18

True or False: The existence of profits determines the type and quantity of goods and services that are produced and sold.

Answer 18

True

Question 19

What is the Risk-Bearing Theory of Profit?

Answer 19

Economic profits arise in part to compensate the owners of the firm for the risk they assume when making their investments.

A firm’s shareholders are not entitled to a fixed rate of return on their investment –> they are claimants to the firm’s residual cash flows after all other contractual payments have been made.

They need to be compensated for the risk in the form of a higher rate of return.

Question 20

What is the Temporary Disequilibrium Theory of Profit?

Answer 20

Although there exists a long-run equilibrium normal rate of profit (adjusted for risk) that all firms should tend to earn, at any point in time, firms may find themselves earning a rate of return above or below this long-run normal return level.

This can occur because of temporary dislocations (shocks) in various sectors of the economy.

Question 21

What is the Monopoly Theory of Profit?

Answer 21

In some industries, one firm is effectively able to dominate the market and persistently earn above-normal rates of return.

Question 22

What 4 factors make a monopoly able to dominate the market?

Answer 22

This ability to dominate the market may arise from:

• Economies of scale
• Control of essential natural resources
• Control of critical patents
• Governmental restrictions that prohibit competition

Question 23

What is the Innovation Theory of Profit?

Answer 23

This suggests that above-normal profits are the reward for successful innovations

Question 24

The US patent system is designed to ensure that…

Answer 24

… above-normal return opportunities furnish strong incentives for continued innovation.

Question 25

What is the Managerial Efficiency Theory of Profit?

Answer 25

Above-normal profits can arise because of the exceptional managerial skills of well-managed firms.

Question 26

True or False: No single theory of profit can explain the observed profit rates in each industry, nor are these theories necessarily mutually exclusive.

Answer 26

True.

Question 27

List 5 variables that affect profit performance:

Answer 27

- Differential risk - Innovation - Managerial skills - The existence of monopoly power - Chance occurrences

Question 28

How is shareholder wealth measured?

Answer 28

Shareholder wealth is measured by the market value of a firm's common stock, which is equal to the present value of all expected future cash flows to equity owners discounted at the shareholders' required rate of return, plus a value for the firm's embedded real options.

Question 29

What does real option value represent?

Answer 29

The cost savings of revenue expansions that arise from preserving flexibility in the business plans the managers adopt.

Question 30

How are the owners and managers referred to, respectively?

Answer 30

Owners = The principals Managers = The agents

Question 31

True or False: Because the manager-agents usually have much more to lose than the owner-principals, the agents often seek maximum levels of profit and shareholder wealth while pursuing their own self-interests.

Answer 31

False: agents have much LESS to lose than owner-principals, and so therefore will seek acceptable levels of profit and shareholder wealth, rather than maximum levels.

Question 32

What is the Agency Conflict, or the Principal-Agent Problem?

Answer 32

Manager-agents are not as incentivized to perform at a maximum capacity as Principal-agents are.

Question 33

True or False: Pursuing their own self-interests can also lead managers to focus on their own long-term job security. In some instances, this can motivate them to limit the amount of risk taken by the firm because an unfavorable outcome resulting from the risk could lead to their dismissal.

Answer 33

True.

Question 34

What do the principal-agent problems arise from?

Answer 34

The inherent unobservability of managerial effort combined with the presence of random disturbances in team production.

Question 35

The creative ingenuity in anticipating and then proactively solving problems before they arise is inherently unobservable.

Answer 35

This is what senior managers are hired to do.

Question 36

True or False: It can be difficult for owners to know when to reward managers for upturns and when to blame them for poor performance.

Answer 36

True, because while owners know creative ingenuity when they see it, they often don't recognize when it is missing because a manager's creative ingenuity is often inseparable from good and bad luck.

Question 37

Separation of ownership (shareholders) and control (management) in large corporations permits managers to pursue goals...

Answer 37

...that are not always in the long-term interests of shareholders.

Question 38

How do performance-based bonuses work?

Answer 38

They assure that a larger proportion of the manager's pay occurs in the form of these bonuses, thus keeps the managers focused on the company's interests rather than their own.

Question 39

List three methods of implementing performance-based bonuses:

Answer 39

1 - Tying executive bonuses to the performance of comparably situated competitor companies 2 - By raising the performance hurdles that trigger executive bonuses 3 - By eliminating severance packages that provide windfalls for executives whose poor performance leads to a takeover or their own dismissal

Question 40

In an attempt to mitigate agency problems, firms incur several agency costs, which include the following: (list 4)

Answer 40

1 - Grants of stocks options or restricted stock from Treasury stock so executive compensation aligns the incentives for management with shareholder interests 2 - Internal audits and accounting oversight boards to monitor management's actions 3 - Bonding expenditures and fraud liability insurance to protect the shareholders from managerial dishonesty 4 - complex internal approval processes to limit discretion, but which prevent timely responses to business opportunities

Question 41

Short-term cash flow reflects only a small fraction of the firm's share price...

Answer 41

The first 5 years of expected dividend payouts explain only 18% and the first 10 years only 35% of the share prices of US stocks

Question 42

True or False: The goal of the shareholder wealth maximization requires a long-term focus

Answer 42

True

Question 43

Value-maximizing managers MUST anticipate ______ and make contingency plans

Answer 43

change

Question 44

Shareholder wealth maximization also reflects dynamic changes in the information available to the public about a company's...

Answer 44

...expected future cash flows and foreseeable risks.

Question 45

Stock price reflect not only ___ but also ____

Answer 45

the firm's preexisting net present value investments; the firm's strategic investment opportunities a management team develops

Question 46

What are "embedded real options"?

Answer 46

Strategic investment opportunities Additional sources of equity value

Question 47

In general, a company can create flexibility in their capital budgeting by -

Answer 47

1 - facilitating follow-on projects through growth options 2 - exiting early without penalty through abandonment options 3 - staging investment over a learning period until better information is available through deferral options