Baye, m r (2010) managerial economics and business strategy (7th ed) mcgraw hill irwin

The opening Headline and Inside Business applications have been updated, and the chapter includes two new end-of-chapter problems.. CONTENTS CHAPTER ONE The Fundamentals of Managerial Ec

KEY FEATURES OF THIS NEW EDITION INCLUDE:

UPDATED HEADLINES: Updated and current Headlines begin each

chapter with a real-world economic problem These problems are essentially hand-picked “mini-cases” designed to motivate students to better understand the chapter material

NEW AND UPDATED INSIDE BUSINESS APPLICATIONS: New Inside Business boxes illustrate real-world applications of theory developed in the

chapter; these examples are drawn from both current economic literature and the popular press

TIME WARNER CASE STUDY: A Case Study in business strategy —

Challenges at Time Warner — follows Chapter 14 The case engages

students by applying core elements from managerial economics to a rich business environment

For more information and resources, please visit the text’s Online

Learning Center: www.mhhe.com/baye7e

Managerial Economics and

Business Strategy

Nash Equilibrium • Predatory Pricing • Mergers & Acquisitions •

MANAGERIAL ECONOMICS AND BUSINESS STRATEGY

Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the

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1 Managerial economics 2 Strategic planning I Title.

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ABOUT THE AUTHOR

Michael Baye is the Bert Elwert Professor of Business Economics & Public Policy atIndiana University’s Kelley School of Business He received his B.S in economicsfrom Texas A&M University in 1980 and earned a Ph.D in economics from PurdueUniversity in 1983 Prior to joining Indiana University, he taught graduate and under-graduate courses at The Pennsylvania State University, Texas A&M University, andthe University of Kentucky Professor Baye served as the Director of the Bureau ofEconomics at the Federal Trade Commission from July 2007–December 2008

Professor Baye has won numerous awards for his outstanding teaching andresearch and regularly teaches courses in managerial economics and industrialorganization at the undergraduate, M.B.A., and Ph.D levels Professor Baye hasmade a variety of contributions to the fields of game theory and industrial organi-zation His research on mergers, auctions, and contests has been published in such

journals as the American Economic Review, the Review of Economic Studies, and the Economic Journal Professor Baye’s research on pricing strategies in online and

other environments where consumers search for price information has been

pub-lished in economics journals (such as the American Economic Review, rica, and the Journal of Political Economy), featured in the popular press (including The Wall Street Journal, Forbes, and The New York Times), and pub-

Economet-lished in leading marketing journals His research has been supported by theNational Science Foundation, the Fulbright Commission, and other organizations

Professor Baye has held visiting appointments at Cambridge, Oxford, ErasmusUniversity, Tilburg University, and the New Economic School in Moscow, Russia

He has served on numerous editorial boards in economics as well as marketing,

including Economic Theory and the Journal of Public Policy & Marketing When

he is not teaching or engaged in research, Michael enjoys activities ranging fromcamping to shopping for electronic gadgets

To Natalie and Mitchell—Thanks for teaching me about the buyer side of the college market.

PREFACE TO THE SEVENTH EDITION

Thanks to feedback from users around the world, Managerial Economics and ness Strategy remains the top selling managerial text in the market I am grateful to

Busi-all of you for Busi-allowing me to provide this updated and improved product Beforehighlighting some of the new features of the seventh edition, I would like to stressthat the fundamental goal of the book—providing students with the tools fromintermediate microeconomics, game theory, and industrial organization that theyneed to make sound managerial decisions—has not changed

This book begins by teaching managers the practical utility of basic economictools such as present value analysis, supply and demand, regression, indifferencecurves, isoquants, production, costs, and the basic models of perfect competition,monopoly, and monopolistic competition Adopters and reviewers also praise thebook for its real-world examples and because it includes modern topics not con-tained in any other single managerial economics textbook: oligopoly, penetrationpricing, multistage and repeated games, foreclosure, contracting, vertical and hori-zontal integration, networks, bargaining, predatory pricing, principal–agent prob-lems, raising rivals’ costs, adverse selection, auctions, screening and signaling,search, limit pricing, and a host of other pricing strategies for firms enjoying mar-ket power This balanced coverage of traditional and modern microeconomic toolsmakes it appropriate for a wide variety of managerial economics classrooms Anincreasing number of business schools are adopting this book to replace (or usealongside) managerial strategy texts laden with anecdotes but lacking the micro-economic tools needed to identify and implement the business strategies that areoptimal in a given situation

This seventh edition of Managerial Economics and Business Strategy has been

thoroughly updated but retains all of the content that made previous editions cessful The basic structure of the textbook is unchanged

suc-KEY PEDAGOGICAL FEATURES

The seventh edition retains all of the class-tested features of previous editionsthat enhance students’ learning experiences and make it easy to teach from thisbook

Headlines

As in previous editions, each chapter begins with a Headline that is based on a

real-world economic problem—a problem that students should be able to address after

completing the chapter These Headlines are essentially hand-picked “mini-cases” designed to motivate students to learn the material in the chapter Each Headline is

answered at the end of the relevant chapter—when the student is better prepared todeal with the complications of real-world problems Reviewers as well as users of

previous editions praise the Headlines not only because they motivate students to

learn the material in the chapter, but also because the answers at the end of eachchapter help students learn how to use economics to make business decisions

Learning Objectives

Each chapter includes learning objectives designed to enhance the learning ence

experi-Demonstration Problems

The best way to learn economics is to practice solving economic problems So, in

addition to the Headlines, each chapter contains many Demonstration Problems

sprinkled throughout the text, along with detailed answers This provides studentswith a mechanism to verify that they have mastered the material and reduces thecost to students and instructors of having to meet during office hours to discussanswers to problems

Inside Business Applications

Each chapter contains boxed material (called Inside Business applications) to

illus-trate how theories explained in the text relate to a host of different business tions As in previous editions, I have tried to strike a balance between applicationsdrawn from the current economic literature and the popular press

situa-Calculus and Noncalculus Alternatives

Users can easily include or exclude calculus-based material without losing content

or continuity That’s because the basic principles and formulae needed to solve a

particular class of economic problems (e.g., MR  MC) are first stated without

appealing to the notation of calculus Immediately following each stated principle

or formula is a clearly marked Calculus Alternative Each of these calculus

alterna-tives states the preceding principle or formula in calculus notation, and explains therelation between the calculus and noncalculus formula More detailed calculus der-

ivations are relegated to Appendices Thus, the book is designed for use by

instruc-tors who want to integrate calculus into managerial economics and by those who donot require students to use calculus

Key Terms and Marginal Definitions

Each chapter ends with a list of key terms and concepts These provide an easyway for instructors to glean material covered in each chapter and for students tocheck their mastery of terminology In addition, marginal definitions are providedthroughout the text

End-of-Chapter Problems

Three types of problems are offered Highly structured but nonetheless challenging

Conceptual and Computational Questions stress fundamentals These are followed

by Problems and Applications, which are far less structured and, like real-world

deci-sion environments, may contain more information than is actually needed to solve theproblem Many of these applied problems are based on actual business events

Additionally, the Time Warner case that follows Chapter 14 includes 14 lems called Memos that have a “real-world feel” and complement the text All ofthese case-based problems may be assigned on a chapter-by-chapter basis as spe-cific skills are introduced, or as part of a capstone experience Solutions to all of thememos are contained online at www.mhhe.com/baye7e

prob-Answers to selected end-of-chapter Conceptual and Computational Questions

are presented at the end of the book; detailed answers to all problems—including

Problems and Applications and the Time Warner case Memos, are available to

instructors on the password-protected Web site

Case Study

A case study in business strategy—Challenges at Time Warner—follows Chapter

14 and was prepared by Kyle Anderson, Michael Baye, and Dong Chen especiallyfor this text It can be used either as a capstone case for the course or to supplementindividual chapters The case allows students to apply core elements from manage-rial economics to a remarkably rich business environment Instructors can use thecase as the basis for an “open-ended” discussion of business strategy, or they canassign specific “memos” (contained at the end of the case) that require students toapply specific tools from managerial economics to the case Teaching notes, as well

as solutions to all of the memos, are provided on the Web site

1, 2, 3, 5, 6, 7, 8, 10, 11, and 13 Each may choose to include additional chapters (forexample, Chapter 14 or the Time Warner case) as time permits More generally,instructors can easily omit topics such as present value analysis, regression, indif-ference curves, isoquants, or reaction functions without losing continuity

Online Resources at www.mhhe.com/baye7e

A large assortment of student supplements for Managerial Economics and Business Strategy are available online at www.mhhe.com/baye7e This includes data for the Time Warner case Memos, data needed for various end-of-chapter problems, spreadsheet

versions of key tables in the text to enable students to see how key economic concepts—like marginal cost and profit maximization—can be implemented on stan-dard spreadsheets, and spreadsheet macros that students can use to find the optimumprice and quantity under a variety of market settings, including monopoly, Cournot oli-gopoly, and Stackelberg oligopoly Plus, the Web site includes 10 additional full-lengthcases (in pdf format) that are described below.

CourseSmart is a new way for faculty to find and review eTextbooks It’s also a greatoption for students who are interested in accessing their course materials digitally

CourseSmart offers thousands of the most commonly adopted textbooks across dreds of courses from a wide variety of higher education publishers It is the only placefor faculty to review and compare the full text of a textbook online At CourseSmart,students can save up to 50% off the cost of a print book, reduce their impact on theenvironment, and gain access to powerful Web tools for learning including full textsearch, notes and highlighting, and email tools for sharing notes between classmates

hun-Your eBook also includes tech support in case you ever need help

Finding your eBook is easy Visit www.CourseSmart.com and search by title,author, or ISBN

In addition to the Time Warner case, the Web site contains nearly a dozen

full-length cases that I prepared along with Patrick Scholten to accompany Managerial Economics and Business Strategy These cases complement the textbook by show-

ing how real-world businesses use tools like demand elasticities, markup pricing,third-degree price discrimination, bundling, Herfindahl indices, game theory, andpredatory pricing to enhance profits or shape business strategies The cases arebased on actual decisions by companies that include Microsoft, Heinz, Visa, Sta-ples, American Airlines, Sprint, and Kodak Instructors who adopt the seventh edi-tion obtain the cases on the Web site

The Web site for the seventh edition contains expanded teaching notes andsolutions for all of the cases—including the Time Warner case

PowerPoint Slides

The Web site also contains thoroughly updated and fully editable PowerPoint tations with animated figures and graphs to make teaching and learning a snap Forinstance, a simple mouse click reveals the firm’s demand curve Another click revealsthe associated marginal revenue curve Another click shows the firm’s marginal cost Afew more clicks, and students see how to determine the profit-maximizing output,price, and maximum profits Animated graphs and tables are also provided for all other

presen-relevant concepts (like Cournot and Stackelberg equilibrium, normal form and sive form games, and the like).

exten-Instructor’s Manual/Test Bank

A thoroughly updated instructor’s manual and test bank, prepared by Michael R.Baye and Patrick Scholten, provides a summary of each chapter, a teaching outlinefor each chapter, complete answers to all end-of-chapter problems, updated andclass-tested problems (including over 1,000 multiple-choice questions and over 250problems with detailed solutions) The seventh edition Web site contains teaching

notes for the Time Warner case and solutions to the 14 accompanying Memos, as well as expanded and improved teaching notes for the additional cases.

EZ Test Version of the Test Bank

The password-protected Web site contains test bank files in both EZ Test software aswell as in Microsoft Word format EZ Test can reproduce high-quality graphs fromthe test bank and allows instructors to generate multiple tests with versions that are

“scrambled” to be distinctive The software is easy to use and allows optimum tomization of tests

cus-Digital Image Library

The Digital Image Library contains all the figures in the textbook in electronic mat This gives instructors the flexibility to integrate figures from the textbook into PowerPoint presentations or to directly print the figures on overhead transparencies

for-Study Guide

In addition to the numerous problems and answers contained in the textbook, anupdated study guide prepared by yours truly is available to enhance student per-formance at minimal cost to students and professors

Student Web Site

Please visit the enhanced Web site for Managerial Economics and Business Strategy

at www.mhhe.com/baye7e This site provides a host of information for students and

instructors, including online quizzes, PowerPoint presentations, Inside Business applications from previous editions of the text, sample problems from the Study Guide, and other material designed to help students and instructors more effectively use both the textbook and Study Guide.

Instructor Web Site

Electronic versions of all instructor supplements (including the full-length casescomplete with teaching notes, PowerPoint presentations, Digital Image Library, theelectronic test bank, detailed solutions to every end-of-chapter problem and TimeWarner case, chapter outlines, chapter summaries, and more) may be convenientlyaccessed on the password-protected Instructor's Web site This makes it easy forinstructors to use the many supplements designed to make teaching managerialeconomics from the seventh edition easy and fun

CHANGES IN THE SEVENTH EDITION

I have made every effort to update and improve Managerial Economics and ness Strategy while assuring a smooth transition to the seventh edition Below is a

Busi-summary of the pedagogical improvements, enhanced supplements, and contentchanges that make the seventh edition an even more powerful tool for teaching andlearning managerial economics and business strategy

• All of the class-tested problems from the previous edition, plus over 25 newend-of-chapter problems Where appropriate, problems from the previousedition have been updated to reflect the current economic climate

• Updated Test Bank available on the Instructor’s Web site in two formats:

Computerized (EZ Test) and in Microsoft Word format

• Updated Headlines.

• New and updated Inside Business applications.

• The financial crisis is reshaping the global economic and regulatory

landscape, and it is likely to take years for its ultimate effects on the economy

to be fully recognized In preparing this edition, I have revised the book toensure that the economic examples presented are timeless and will not growinto “historical examples” as a result of bankruptcies, new legislation, orchanges in the country’s taste for regulation As in previous editions, thisedition continues to equip students with the economic tools required to managebusinesses and, more generally, to evaluate current events The virtues ofmarkets, as well as potential market failures, are presented without editorialcomment on my part Adopters of this book have praised this approach, as itprovides a positive foundation that permits individual instructors to rigorouslydiscuss current events—including the plethora of political proposals andopinions regarding the financial crisis that emerge each and every day

• Updated Instructor’s Web site that offers full teaching notes and solutions to

Memos for the Time Warner case—plus a host of additional supplements.

These include over 10 additional full-length cases complete with expandedteaching notes and links to chapter content, complete solutions to all end-of-chapter problems, an updated and expanded electronic test bank, animatedPowerPoint presentations, chapter summaries, chapter outlines, the DigitalImage Library, and more

• Chapters 1–4 have been revised to include more timely Headlines, updated

Inside Business applications, and additional in-text examples Each chapter

also contains new end-of-chapter problems, as well as updated versions ofthe class-tested problems you enjoyed in the previous edition

• Chapter 5 opens with a new Headline and contains updated examples

throughout It also offers a new Inside Business application that shows how

to estimate cost functions using regression techniques, as well as updated andnew end-of-chapter problems

• Chapter 6 offers updated examples and Inside Business applications The

chapter also includes two new end-of-chapter problems

• Chapter 7 contains thoroughly updated examples and industry data, along with

a new Inside Business application that describes the 2007 North American

Industry Classification System (NAICS) Additionally, the in-text discussion

of horizontal mergers has been revised to reflect current practices at theFederal Trade Commission and Antitrust Division of the U.S Department ofJustice The chapter also includes two new end-of-chapter problems

• Chapter 8 offers a new opening Headline, updated Inside Business

applications and in-text examples, and new content on the pitfalls of brand myopia Several new end-of-chapter problems are provided, along with

updated versions of the problems contained in the previous edition

• Chapter 9 provides improved exposition of a variety of oligopoly models.

The opening Headline and Inside Business applications have been updated,

and the chapter includes two new end-of-chapter problems

• Chapter 10 opens with a new Headline and includes two new end-of-chapter

problems

• Chapter 11 now offers some caveats to managers who use markup formulas

to price their products or services, and includes an improved exposition ofprice discrimination Examples have been updated throughout, and two newend-of-chapter problems are provided

• Chapters 12–14 include updated Headlines, updated Inside Business

applications, and new end-of-chapter problems Chapters 13 and 14 now offersuccinct coverage of antitrust issues that can constrain the scope of businessstrategies, such as pricing and mergers

Fatma Abdel-Raouf, Goldey-Beacom CollegeBurton Abrams, University of DelawareRashid Al-Hmoud, Texas Tech UniversityAnthony Paul Andrews, Governors State UniversitySisay Asefa, Western Michigan University

Simon Avenell, Murdoch UniversityJoseph P Bailey, University of MarylandDean Baim, Pepperdine University

Sheryl Ball, Virginia Polytechnic UniversityKlaus Becker, Texas Tech UniversityRichard Beil, Auburn UniversityBarbara C Belivieu, University of ConnecticutDan Black, University of Chicago

Louis Cain, Northwestern UniversityLeo Chan, University of KansasRobert L Chapman, Florida Metropolitan UniversityBasanta Chaudhuri, Rutgers University-New BrunswickKwang Soo Cheong, Johns Hopkins University

Christopher B Colburn, Old Dominion UniversityMichael Conlin, Syracuse University

Keith Crocker, Penn State UniversityIan Cromb, University of Western OntarioDean Croushore, Federal Reserve

Wilffrid W Csaplar Jr., Bethany CollegeShah Dabirian, California State University, Long BeachGeorge Darko, Tusculum College

Tina Das, Elon UniversityRon Deiter, Iowa State UniversityCasey Dirienzo, Appalachian State UniversityEric Drabkin, Hawaii Pacific UniversityMartine Duchatelet, Barry UniversityKeven C Duncan, University of Southern ColoradoYvonne Durham, Western Washington UniversityIbrahim Elsaify, Goldey-Beacom College

Mark J Eschenfelder, Robert Morris UniversityDavid Ely, San Diego State University

David Figlio, University of FloridaRay Fisman, Graduate School of Business, Columbia UniversitySilke Forbes, University of California—San Diego

David Gerard, Carnegie Mellon UniversitySharon Gifford, Rutgers UniversityLynn G Gillette, Northeast Missouri State UniversityOtis Gilley, Louisiana Tech University

Roy Gobin, Loyola UniversityStephan Gohmann, University of LouisvilleSteven Gold, Rochester Institute of TechnologyThomas A Gresik, Mendoza College of Business (University of Notre Dame)Andrea Mays Griffith, California State University

Madhurima Gupta, University of Notre DameCarl Gwin, Pepperdine University

Gail Heyne Hafer, Lindenwood CollegeKaren Hallows, George Mason UniversityWilliam Hamlen Jr., SUNY BuffaloShawkat Hammoudeh, Drexel UniversityMehdi Harian, Bloomsburg UniversityNile W Hatch, Marriott School (Brigham Young University)Clifford Hawley, West Virginia University

Ove Hedegaard, Copenhagen Business SchoolSteven Hinson, Webster University

Hart Hodges, Western Washington UniversityJack Hou, California State University—Long BeachLowel R Jacobsen, William Jewell College

Thomas D Jeitschko, Texas A&M UniversityJaswant R Jindia, Southern UniversityPaul Kattuman, Judge Business School (Cambridge University)Brian Kench, University of Tampa

Peter Klein, University of Georgia, University of Missouri-ColumbiaAudrey D Kline, University of Louisville

W J Lane, University of New OrleansDaniel Lee, Shippensburg UniversityDick Leiter, American Public UniversityCanlin Li, University of California-RiversideVahe Lskavyan, Ohio University-AthensHeather Luea, Newman UniversityThomas Lyon, University of MichiganRichard Marcus, University of Wisconsin—MilwaukeeVincent Marra, University of Delaware

Wade Martin, California State University, Long BeachCatherine Matraves, Michigan State University-East LansingJohn Maxwell, Indiana University

David May, Oklahoma City UniversityAlan McInnes, California State University, FullertonChristopher McIntosh, University of Minnesota Duluth Edward Millner, Virginia Commonwealth UniversityJohn Moran, Syracuse University

John Morgan, Haas Business School (University of California—Berkeley)Ram Mudambi, Temple University

Francis Mummery, California State University-FullertonInder Nijhawan, Fayetteville State University

Albert A Okunade, University of MemphisDarrell Parker, Georgia Southern UniversityStephen Pollard, California State University, Los Angeles

Dwight A Porter, College of St ThomasStanko Racic, University of PittsburghEric Rasmusen, Indiana UniversityMatthew Roelofs, Western Washington UniversityChristian Roessler, National University of SingaporeBansi Sawhney, University of Baltimore

Craig Schulman, University of ArkansasKaren Schultes, University of Michigan—DearbornPeter M Schwartz, University of North CarolinaEdward Shinnick, University College IrelandDean Showalter, Southwest Texas State UniversityChandra Shrestha, Virginia Commonwealth UniversityKaren Smith, Columbia Southern University

John Stapleford, Eastern UniversityMark Stegeman, Virginia Polytechnic University

Ed Steinberg, New York UniversityBarbara M Suleski, Cardinal Stritch CollegeCaroline Swartz, University of North Carolina CharlotteBill Taylor, New Mexico Highlands University

Roger Tutterow, Kennesaw State CollegeNora Underwood, University of Central FloridaLskavyan Vahe, Ohio University

Lawrence White, Stern School of Business (New York University)Leonard White, University of Arkansas

Keith Willett, Oklahoma State University-StillwaterMike Williams, Bethune Cookman College

Richard Winkelman, Arizona State UniversityEduardo Zambrano, University of Notre DameRick Zuber, University of North Carolina, Charlotte

I thank Anne Hilbert, Douglas Reiner, and Bruce Gin at McGraw-Hill for all theyhave done to make this project a success, and Alexander V Borisov and Lan Zhang forassisting me during various stages of the revision I once again am indebted to PatrickScholten for his efforts to improve this book and its supplements Also, my thanks toPhilip Powell and Patrick Scholten for their review Finally, I thank my family—

M’Lissa, Natalie, and Mitchell—for their continued love and support

As always, I welcome your comments and suggestions for the next edition

Visit my Web site, http://www.nash-equilibrium.com/, or write to me directly atmbaye@indiana.edu

Michael R Baye Bloomington, Indiana

BRIEF TABLE OF CONTENTS

Chapter 1. The Fundamentals of Managerial Economics 1

Chapter 2. Market Forces: Demand and Supply 35

Chapter 3. Quantitative Demand Analysis 73

Chapter 4. The Theory of Individual Behavior 117

Chapter 5. The Production Process and Costs 155

Chapter 6. The Organization of the Firm 202

Chapter 7. The Nature of Industry 235

Chapter 8. Managing in Competitive, Monopolistic, and

Monopolistically Competitive Markets 264

Chapter 9. Basic Oligopoly Models 313

Chapter 10. Game Theory: Inside Oligopoly 350

Chapter 11. Pricing Strategies for Firms with Market Power 395

Chapter 12. The Economics of Information 433

Chapter 13. Advanced Topics in Business Strategy 473

Chapter 14. A Manager’s Guide to Government in the

Marketplace 507

Case Study. Challenges at Time Warner 546Appendix A Answers to Selected End-of-Chapter Problems 582Appendix B Additional Readings and References 585

Name Index 603General Index 609

CONTENTS

CHAPTER ONE

The Fundamentals of Managerial Economics 1

Headline: Amcott Loses $3.5 Million; Manager Fired 1Introduction 2

The Manager 3Economics 3Managerial Economics Defined 3The Economics of Effective Management 4Identify Goals and Constraints 4

Recognize the Nature and Importance of Profits 5Economic versus Accounting Profits 5

The Role of Profits 6The Five Forces Framework and Industry Profitability 8Understand Incentives 11

Understand Markets 12Consumer–Producer Rivalry 13Consumer–Consumer Rivalry 13Producer–Producer Rivalry 13Government and the Market 13Recognize the Time Value of Money 14Present Value Analysis 14

Present Value of Indefinitely Lived Assets 16Use Marginal Analysis 19

Discrete Decisions 20Continuous Decisions 22Incremental Decisions 24Learning Managerial Economics 25Answering the Headline 26

Key Terms and Concepts 26Conceptual and Computational Questions 27Problems and Applications 28

Case-Based Exercises 32Selected Readings 33Appendix: The Calculus of Maximizing Net Benefits 33Inside Business 1–1: The Goals of Firms in Our Global Economy 7Inside Business 1–2: Profits and the Evolution of the Computer Industry 11Inside Business 1–3: Joining the Jet Set 19

CHAPTER TWO

Market Forces: Demand and Supply 35

Headline: Samsung and Hynix Semiconductor to Cut Chip Production 35Introduction 36

Demand 36Demand Shifters 38Income 39Prices of Related Goods 40Advertising and Consumer Tastes 40Population 41

Consumer Expectations 41Other Factors 42

The Demand Function 42Consumer Surplus 44Supply 46

Supply Shifters 46Input Prices 47Technology or Government Regulations 47Number of Firms 47

Substitutes in Production 47Taxes 48

Producer Expectations 49The Supply Function 49Producer Surplus 51Market Equilibrium 52Price Restrictions and Market Equilibrium 54Price Ceilings 54

Price Floors 58Comparative Statics 60Changes in Demand 60Changes in Supply 61Simultaneous Shifts in Supply and Demand 63Answering the Headline 65

Summary 65Key Terms and Concepts 66Conceptual and Computational Questions 66Problems and Applications 68

Case-Based Exercises 72Selected Readings 72Inside Business 2–1: Asahi Breweries Ltd and the Asian Recession 39Inside Business 2–2: The Trade Act of 2002, NAFTA, and the Supply Curve 47Inside Business 2–3: Price Ceilings and Price Floors around the Globe 58Inside Business 2–4: Globalization and the Supply of Soft Drinks 62Inside Business 2–5: Using a Spreadsheet to Calculate Equilibrium in the Supply andDemand Model 63

CHAPTER THREE

Quantitative Demand Analysis 73

Headline: Winners of Wireless Auction to Pay $7 Billion 73Introduction 74

The Elasticity Concept 74Own Price Elasticity of Demand 75Elasticity and Total Revenue 76Factors Affecting the Own Price Elasticity 79Available Substitutes 80

Time 82Expenditure Share 82Marginal Revenue and the Own Price Elasticity of Demand 83Cross-Price Elasticity 85

Income Elasticity 88Other Elasticities 90Obtaining Elasticities from Demand Functions 90Elasticities for Linear Demand Functions 91Elasticities for Nonlinear Demand Functions 92Regression Analysis 95

Evaluating the Statistical Significance of Estimated Coefficients 98Confidence Intervals 99

The t-Statistic 99Evaluating the Overall Fit of the Regression Line 100

The R-Square 100

The F-Statistic 102Nonlinear and Multiple Regressions 102Nonlinear Regressions 102

Multiple Regression 104

A Caveat 107Answering the Headline 107Summary 109

Key Terms and Concepts 109Conceptual and Computational Questions 110Problems and Applications 112

Case-Based Exercises 116Selected Readings 116Inside Business 3–1: Calculating and Using the Arc Elasticity: An Application to theHousing Market 80

Inside Business 3–2: Inelastic Demand for Prescription Drugs 84Inside Business 3–3: Using Cross-Price Elasticities to Improve New Car Sales in theWake of Increasing Gasoline Prices 87

Inside Business 3–4: Shopping Online in Europe: Elasticities of Demand for PersonalDigital Assistants Based on Nonlinear Regression Techniques 103

CHAPTER FOUR

The Theory of Individual Behavior 117

Headline: Packaging Firm Uses Overtime Pay to Overcome Labor Shortage 117Introduction 118

Consumer Behavior 118Constraints 122

The Budget Constraint 123Changes in Income 125Changes in Prices 126Consumer Equilibrium 128Comparative Statics 129Price Changes and Consumer Behavior 129Income Changes and Consumer Behavior 131Substitution and Income Effects 133

Applications of Indifference Curve Analysis 135Choices by Consumers 135

Buy One, Get One Free 135Cash Gifts, In-Kind Gifts, and Gift Certificates 136Choices by Workers and Managers 139

A Simplified Model of Income–Leisure Choice 140The Decisions of Managers 141

The Relationship between Indifference Curve Analysis and Demand Curves 143Individual Demand 143

Market Demand 144Answering the Headline 145Summary 146

Key Terms and Concepts 147Conceptual and Computational Questions 147Problems and Applications 149

Case-Based Exercises 152Selected Readings 152Appendix: A Calculus Approach to Individual Behavior 153Inside Business 4–1: Indifference Curves and Risk Preferences 122Inside Business 4–2: Price Changes and Inventory Management for MultiproductFirms 130

Inside Business 4–3: Income Effects and the Business Cycle 134Inside Business 4–4: The “Deadweight Loss” of In-Kind Gifts 139

CHAPTER FIVE

The Production Process and Costs 155

Headline: Boeing Loses the Battle but Wins the War 155Introduction 156

The Production Function 156Short-Run versus Long-Run Decisions 156Measures of Productivity 158

Total Product 158Average Product 158Marginal Product 158The Role of the Manager in the Production Process 160Produce on the Production Function 160

Use the Right Level of Inputs 161Algebraic Forms of Production Functions 164Algebraic Measures of Productivity 165Isoquants 167

Isocosts 170Cost Minimization 171Optimal Input Substitution 173The Cost Function 175

Short-Run Costs 176Average and Marginal Costs 178Relations among Costs 180Fixed and Sunk Costs 181Algebraic Forms of Cost Functions 182Long-Run Costs 183

Economies of Scale 185

A Reminder: Economic Costs versus Accounting Costs 186Multiple-Output Cost Functions 187

Economies of Scope 187Cost Complementarity 187Answering the Headline 190Summary 190

Key Terms and Concepts 191Conceptual and Computational Questions 191Problems and Applications 194

Case-Based Exercises 198Selected Readings 198Appendix: The Calculus of Production and Costs 199Inside Business 5–1: Where Does Technology Come From? 163Inside Business 5–2: Fringe Benefits and Input Substitution 176Inside Business 5–3: Estimating Production Functions, Cost Functions, and Returns

to Scale 184Inside Business 5–4: International Companies Exploit Economies of Scale 186

CHAPTER SIX

The Organization of the Firm 202

Headline: Korean Firm Invests 30 Trillion Won to Vertically Integrate 202Introduction 203

Methods of Procuring Inputs 204Purchase the Inputs Using Spot Exchange 204Acquire Inputs under a Contract 205

Produce the Inputs Internally 205Transaction Costs 206

Types of Specialized Investments 207Site Specificity 207

Physical-Asset Specificity 207Dedicated Assets 207

Human Capital 208Implications of Specialized Investments 208Costly Bargaining 208

Underinvestment 208Opportunism and the “Hold-Up Problem” 209Optimal Input Procurement 210

Spot Exchange 210Contracts 212Vertical Integration 215The Economic Trade-Off 216Managerial Compensation and the Principal–Agent Problem 219Forces That Discipline Managers 221

Incentive Contracts 221External Incentives 222Reputation 222Takeovers 222The Manager–Worker Principal–Agent Problem 223Solutions to the Manager–Worker Principal–Agent Problem 223Profit Sharing 223

Revenue Sharing 223Piece Rates 224Time Clocks and Spot Checks 224Answering the Headline 226

Summary 226Key Terms and Concepts 226Conceptual and Computational Questions 227Problems and Applications 228

Case-Based Exercises 231Selected Readings 231Appendix : An Indifference Curve Approach to Managerial Incentives 231Inside Business 6–1: The Cost of Using an Inefficient Method of

Procuring Inputs 210Inside Business 6–2: Factors Affecting the Length of Coal and Natural-Gas Contracts 214

Inside Business 6–3: The Evolution of Input Decisions in the Automobile Industry 217

Inside Business 6–4: Paying for Performance 225

CHAPTER SEVEN

The Nature of Industry 235

Headline: Microsoft Puts Halt to Intuit Merger 235Introduction 236

Market Structure 236Firm Size 236Industry Concentration 237Measures of Industry Concentration 238The Concentration of U.S Industry 239Limitations of Concentration Measures 241Technology 243

Demand and Market Conditions 243Potential for Entry 245

Conduct 246Pricing Behavior 247Integration and Merger Activity 248Vertical Integration 249

Horizontal Integration 249Conglomerate Mergers 250Research and Development 250Advertising 251

Performance 251Profits 251Social Welfare 251The Structure–Conduct–Performance Paradigm 253The Causal View 253

The Feedback Critique 253Relation to the Five-Forces Framework 254Overview of the Remainder of the Book 254Perfect Competition 255

Monopoly 255Monopolistic Competition 255Oligopoly 255

Answering the Headline 257Summary 257

Key Terms and Concepts 258Conceptual and Computational Questions 258Problems and Applications 260

Case-Based Exercises 263Selected Readings 263Inside Business 7–1: The 2007 North American Industry Classification System(NAICS) 242

Inside Business 7–2: The Elasticity of Demand at the Firm and Market Levels 246Inside Business 7–3: The Evolution of Market Structure in the Computer Industry 256

CHAPTER EIGHT

Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets 264

Headline: McDonald’s New Buzz: Specialty Coffee 264Introduction 265

Perfect Competition 265Demand at the Market and Firm Levels 266Short-Run Output Decisions 267

Maximizing Profits 267Minimizing Losses 271The Short-Run Firm and Industry Supply Curves 274Long-Run Decisions 275

Monopoly 277Monopoly Power 278Sources of Monopoly Power 279Economies of Scale 279Economies of Scope 280Cost Complementarity 281Patents and Other Legal Barriers 281Maximizing Profits 282

Marginal Revenue 282The Output Decision 286The Absence of a Supply Curve 289Multiplant Decisions 289

Implications of Entry Barriers 291Monopolistic Competition 293Conditions for Monopolistic Competition 293Profit Maximization 294

Long-Run Equilibrium 296Implications of Product Differentiation 299Optimal Advertising Decisions 300

Answering the Headline 302Summary 302

Key Terms and Concepts 303Conceptual and Computational Questions 303Problems and Applications 306

Case-Based Exercises 310Selected Readings 310Appendix: The Calculus of Profit Maximization 311Appendix: The Algebra of Perfectly Competitive Supply Functions 312Inside Business 8–1: Peugeot-Citroën of France: A Price-Taker in China’s AutoMarket 273

Inside Business 8–2: Patent, Trademark, and Copyright Protection 283Inside Business 8–3: Product Differentiation, Cannibalization, and Colgate’s Smile 296

CHAPTER NINE

Basic Oligopoly Models 313

Headline: Crude Oil Prices Fall, but Consumers in Some Areas See

No Relief at the Pump 313Introduction 314

Conditions for Oligopoly 314The Role of Beliefs and Strategic Interaction 314Profit Maximization in Four Oligopoly Settings 316Sweezy Oligopoly 316

Cournot Oligopoly 318Reaction Functions and Equilibrium 318Isoprofit Curves 324

Changes in Marginal Costs 326Collusion 328

Stackelberg Oligopoly 330Bertrand Oligopoly 334Comparing Oligopoly Models 336Cournot 336

Stackelberg 337Bertrand 337Collusion 337Contestable Markets 339Answering the Headline 340Summary 341

Key Terms and Concepts 342Conceptual and Computational Questions 342Problems and Applications 344

Case-Based Exercises 347Selected Readings 348Appendix: Differentiated-Product Bertrand Oligopoly 348Inside Business 9–1: Commitment in Stackelberg Oligopoly 332Inside Business 9–2: Price Competition and the Number of Sellers: Evidence fromOnline and Laboratory Markets 335

Inside Business 9–3: Using a Spreadsheet to Calculate Cournot, Stackelberg, andCollusive Outcomes 338

CHAPTER TEN

Game Theory: Inside Oligopoly 350

Headline: USAirways Brings Back Complementary Drinks 350Introduction 351

Overview of Games and Strategic Thinking 351Simultaneous-Move, One-Shot Games 352Theory 352

Applications of One-Shot Games 355

Pricing Decisions 355Advertising and Quality Decisions 358Coordination Decisions 359

Monitoring Employees 360Nash Bargaining 361Infinitely Repeated Games 363Theory 363

Review of Present Value 363Supporting Collusion with Trigger Strategies 364Factors Affecting Collusion in Pricing Games 367Number of Firms 367

Firm Size 367History of the Market 368Punishment Mechanisms 369

An Application of Infinitely Repeated Games to Product Quality 369Finitely Repeated Games 370

Games with an Uncertain Final Period 370Repeated Games with a Known Final Period: The End-of-Period Problem 373Applications of the End-of-Period Problem 375

Resignations and Quits 375The “Snake-Oil” Salesman 375Multistage Games 376

Theory 376Applications of Multistage Games 379The Entry Game 379

Innovation 380Sequential Bargaining 381Answering the Headline 384Summary 385

Key Terms and Concepts 385Conceptual and Computational Questions 386Problems and Applications 389

Case-Based Exercises 394Selected Readings 394Inside Business 10–1: Hollywood’s (not so) Beautiful Mind: Nash or “Opie”

Equilibrium? 356Inside Business 10–2: Trigger Strategies in the Waste Industry 368Inside Business 10–3: Entry Strategies in International Markets: Sprinkler orWaterfall? 380

CHAPTER ELEVEN

Pricing Strategies for Firms with Market Power 395

Headline: Mickey Mouse Lets You Ride “for Free” at Disney World 395Introduction 396

Basic Pricing Strategies 396Review of the Basic Rule of Profit Maximization 396

A Simple Pricing Rule for Monopoly and Monopolistic Competition 397

A Simple Pricing Rule for Cournot Oligopoly 400Strategies That Yield Even Greater Profits 402Extracting Surplus from Consumers 402Price Discrimination 402

Two-Part Pricing 408Block Pricing 410Commodity Bundling 412Pricing Strategies for Special Cost and Demand Structures 415Peak-Load Pricing 415

Cross-Subsidies 416Transfer Pricing 417Pricing Strategies in Markets with Intense Price Competition 419Price Matching 420

Inducing Brand Loyalty 421Randomized Pricing 422Answering the Headline 423Summary 424

Key Terms and Concepts 425Conceptual and Computational Questions 425Problems and Applications 428

Case-Based Exercises 431Selected Readings 431Inside Business 11–1: Pricing Markups as Rules of Thumb 398Inside Business 11–2: Bundling and “Price Frames” in Online Markets 414Inside Business 11–3: The Prevalence of Price-Matching Policies and Other Low-Price Guarantees 421

Inside Business 11–4: Randomized Pricing in the Airline Industry 423

CHAPTER TWELVE

The Economics of Information 433

Headline: Firm Chickens Out in the FCC Spectrum Auction 433Introduction 434

The Mean and the Variance 434Uncertainty and Consumer Behavior 437Risk Aversion 437

Managerial Decisions with Risk-Averse Consumers 437Consumer Search 439

Uncertainty and the Firm 442Risk Aversion 442

Producer Search 446Profit Maximization 446

Uncertainty and the Market 448Asymmetric Information 448Adverse Selection 449Moral Hazard 450Signaling and Screening 452Auctions 454

Types of Auctions 455English Auction 455First-Price, Sealed-Bid Auction 455Second-Price, Sealed-Bid Auction 456Dutch Auction 456

Information Structures 457Independent Private Values 457Correlated Value Estimates 458Optimal Bidding Strategies for Risk-Neutral Bidders 458Strategies for Independent Private Values Auctions 459Strategies for Correlated Values Auctions 461

Expected Revenues in Alternative Types of Auctions 463Answering the Headline 465

Summary 465Key Terms and Concepts 466Conceptual and Computational Questions 466Problems and Applications 469

Case-Based Exercises 472Selected Readings 472Inside Business 12–1: Risk Aversion and the Value of Selling the Firm: The St

Petersburg Paradox 438Inside Business 12–2: The Value of Information in Online Markets 443Inside Business 12–3: Second-Price Auctions on eBay 456

Inside Business 12–4: Auctions with Risk-Averse Bidders 464

CHAPTER THIRTEEN

Advanced Topics in Business Strategy 473

Headline: Barkley and Sharpe to Announce Plans at Trade Show 473Introduction 474

Limit Pricing to Prevent Entry 475Theoretical Basis for Limit Pricing 475Limit Pricing May Fail to Deter Entry 477Linking the Preentry Price to Postentry Profits 478Commitment Mechanisms 478

Learning Curve Effects 479Incomplete Information 480Reputation Effects 480Dynamic Considerations 481

Predatory Pricing to Lessen Competition 483Raising Rivals’ Costs to Lessen Competition 486Strategies Involving Marginal Cost 486Strategies Involving Fixed Costs 487Strategies for Vertically Integrated Firms 488Vertical Foreclosure 489

The Price–Cost Squeeze 489Price Discrimination as a Strategic Tool 489Changing the Timing of Decisions or the Order of Moves 490First-Mover Advantages 490

Second-Mover Advantages 493Penetration Pricing to Overcome Network Effects 493What Is a Network? 494

Network Externalities 495First-Mover Advantages Due to Consumer Lock-In 496Using Penetration Pricing to “Change the Game” 498Answering the Headline 499

Summary 500Key Terms and Concepts 500Conceptual and Computational Questions 500Problems and Applications 503

Case-Based Exercises 506Selected Readings 506Inside Business 13–1: Business Strategy at Microsoft 476Inside Business 13–2: U.S Steel Opts against Limit Pricing 482Inside Business 13–3: First to Market, First to Succeed? Or First to Fail? 492Inside Business 13–4: Network Externalities and Penetration Pricing by Yahoo!

Auctions 497

CHAPTER FOURTEEN

A Manager’s Guide to Government in the Marketplace 507

Headline: FTC Conditionally Approves $10.3 Billion Merger 507Introduction 508

Market Failure 508Market Power 508Antitrust Policy 509Price Regulation 513Externalities 518The Clean Air Act 519Public Goods 522Incomplete Information 526Rules against Insider Trading 527Certification 527

Truth in Lending 528

Truth in Advertising 529Enforcing Contracts 529Rent Seeking 531

Government Policy and International Markets 532Quotas 532

Tariffs 534Lump-Sum Tariffs 535Excise Tariffs 535Answering the Headline 536Summary 537

Key Terms and Concepts 537Conceptual and Computational Questions 538Problems and Applications 541

Case-Based Exercises 544Selected Readings 544Inside Business 14–1: European Commission Asks Airlines to Explain PriceDiscrimination Practices 512

Inside Business 14–2: Electricity Deregulation 517Inside Business 14–3: Canada’s Competition Bureau 530

CASE STUDY

Challenges at Time Warner 546

Author’s Note about the Case 545Headline 546

Background 547Overview of the Industry and Time Warner’s Operations 548America Online 548

Market Conditions 549AOL Operations 550AOL Europe 551Filmed Entertainment 551Motion Picture Production and Distribution 552The Film Industry 552

Competition 554Television Programming 555Home Video Distribution 555Publishing 555

Magazine Publishing 556Magazines Online 557Book Publishing 557Programming Networks 558Cable Systems 559

Analog and Digital Cable TV 559High-Speed Internet Service 560

Telephone Service 560Competition 561Direct Broadcast Satellite Operators 561Overbuilders 561

Bundling 562Regulatory Considerations 563Technological Considerations 563High-Definition Television (HDTV) 563Digital Video Recorders (DVRs) 564Challenges 565

Case-Based Exercises 565Memos 565

Selected Readings and References 574Appendix: Exhibits 576

Appendix A Answers to Selected End-of-Chapter Problems 582

Appendix B Additional Readings and References 585

Name Index 603

General Index 609

Amcott Loses $3.5 Million;

Manager Fired

On Tuesday software giant Amcott posted a year-end

operating loss of $3.5 million Reportedly, $1.7

mil-lion of the loss stemmed from its foreign language

division

With short-term interest rates at 7 percent,Amcott decided to use $20 million of its retained

earnings to purchase three-year rights to Magicword,

a software package that converts generic word

proces-sor files saved as French text into English First-year

sales revenue from the software was $7 million, but

thereafter sales were halted pending a copyright

infringement suit filed by Foreign, Inc Amcott lost

the suit and paid damages of $1.7 million Industry

insiders say that the copyright violation pertained to

“a very small component of Magicword.”

Ralph, the Amcott manager who was fired over theincident, was quoted as saying, “I’m a scapegoat for

the attorneys [at Amcott] who didn’t do their

home-work before buying the rights to Magicword I

pro-jected annual sales of $7 million per year for three years My sales forecasts were right on target.”

Do you know why Ralph was fired?1

HEADLINE

The Fundamentals of Managerial Economics

1

1 Each chapter concludes with an answer to the question posed in that chapter's opening headline After you read each chapter, you should attempt to solve the opening headline on your own and then compare your solution to that presented at the end of the chapter.

incen-LO2 Distinguish economic versus accounting profits and costs.

LO3 Explain the role of profits in a market economy.

LO4 Apply the five forces framework to analyze the sustainability of an industry’s profits.

LO5 Apply present value analysis to make decisions and value assets.

LO6 Apply marginal analysis to determine the optimal level of a managerial control variable.

LO7 Identify and apply six principles of tive managerial decision making.

Many students taking managerial economics ask, “Why should I study economics?

Will it tell me what the stock market will do tomorrow? Will it tell me where toinvest my money or how to get rich?” Unfortunately, managerial economics byitself is unlikely to provide definitive answers to such questions Obtaining theanswers would require an accurate crystal ball Nevertheless, managerial econom-ics is a valuable tool for analyzing business situations such as the ones raised in theheadlines that open each chapter of this book

In fact, if you surf the Internet, browse a business publication such as

BusinessWeek or The Wall Street Journal, or read a trade publication like Restaurant News or Supermarket Business, you will find a host of stories that involve manage-

rial economics A recent search generated the following headlines:

“Nintendo Wii Continues to Dominate Xbox 360, PS3 in Sales”

“Comcast denies predatory pricing allegations”

“FTC Seeks to Block Whole Foods’ Acquisition of Wild Oats”

“Boeing Cuts 4,500 Commercial Jobs as Economy Weakens”

“Instant Messenger War: How Yahoo!, Microsoft and AOL Kill Google Talk”

“LG, Sharp, and Chunghwa Nailed for LCD Price-Fixing”

“DeBeers’ Multifaceted Strategy Shift”

“Verizon Wireless Completes $28.1 Billion Alltel Buy”

“The Recession: Great News?”

“Free Software on the Internet”

Sadly, billions of dollars are lost each year because many existing managersfail to use basic tools from managerial economics to shape pricing and output deci-sions, optimize the production process and input mix, choose product quality, guidehorizontal and vertical merger decisions, or optimally design internal and externalincentives Happily, if you learn a few basic principles from managerial economics,you will be poised to drive the inept managers out of their jobs! You will alsounderstand why the latest recession was great news to some firms and why somesoftware firms spend millions on software development but permit consumers todownload it for free

Managerial economics is not only valuable to managers of Fortune 500

com-panies; it is also valuable to managers of not-for-profit organizations It is useful

to the manager of a food bank who must decide the best means for distributingfood to the needy It is valuable to the coordinator of a shelter for the homelesswhose goal is to help the largest possible number of homeless, given a very tightbudget In fact, managerial economics provides useful insights into every facet ofthe business and nonbusiness world in which we live—including household deci-sion making

Why is managerial economics so valuable to such a diverse group of decision

makers? The answer to this question lies in the meaning of the term managerial economics.

The Manager

A manager is a person who directs resources to achieve a stated goal This definition

includes all individuals who (1) direct the efforts of others, including those who egate tasks within an organization such as a firm, a family, or a club; (2) purchaseinputs to be used in the production of goods and services such as the output of a firm,food for the needy, or shelter for the homeless; or (3) are in charge of making otherdecisions, such as product price or quality

del-A manager generally has responsibility for his or her own actions as well as forthe actions of individuals, machines, and other inputs under the manager’s control.This control may involve responsibilities for the resources of a multinational cor-poration or for those of a single household In each instance, however, a managermust direct resources and the behavior of individuals for the purpose of accom-plishing some task While much of this book assumes the manager’s task is to max-imize the profits of the firm that employs the manager, the underlying principles arevalid for virtually any decision process

Economics

The primary focus of this book is on the second word in managerial economics Economics is the science of making decisions in the presence of scarce resources Resources are simply anything used to produce a good or service or, more gener-

ally, to achieve a goal Decisions are important because scarcity implies that bymaking one choice, you give up another A computer firm that spends moreresources on advertising has fewer resources to invest in research and development

A food bank that spends more on soup has less to spend on fruit Economic sions thus involve the allocation of scarce resources, and a manager’s task is to allo-cate resources so as to best meet the manager’s goals

deci-One of the best ways to comprehend the pervasive nature of scarcity is to ine that a genie has appeared and offered to grant you three wishes If resourceswere not scarce, you would tell the genie you have absolutely nothing to wish for;you already have everything you want Surely, as you begin this course, you recog-nize that time is one of the scarcest resources of all Your primary decision problem

imag-is to allocate a scarce resource—time—to achieve a goal—such as mastering thesubject matter or earning an A in the course

Managerial Economics Defined

Managerial economics, therefore, is the study of how to direct scarce resources in

the way that most efficiently achieves a managerial goal It is a very broad pline in that it describes methods useful for directing everything from theresources of a household to maximize household welfare to the resources of a firm

To understand the nature of decisions that confront managers of firms, imagine

that you are the manager of a Fortune 500 company that makes computers You must

make a host of decisions to succeed as a manager: Should you purchase componentssuch as disk drives and chips from other manufacturers or produce them within yourown firm? Should you specialize in making one type of computer or produce severaldifferent types? How many computers should you produce, and at what price shouldyou sell them? How many employees should you hire, and how should you compen-sate them? How can you ensure that employees work hard and produce quality prod-ucts? How will the actions of rival computer firms affect your decisions?

The key to making sound decisions is to know what information is needed tomake an informed decision and then to collect and process the data If you work for

a large firm, your legal department can provide data about the legal ramifications ofalternative decisions; your accounting department can provide tax advice and basiccost data; your marketing department can provide you with data on the characteris-tics of the market for your product; and your firm’s financial analysts can providesummary data for alternative methods of obtaining financial capital Ultimately,however, the manager must integrate all of this information, process it, and arrive at

a decision The remainder of this book will show you how to perform this importantmanagerial function by using six principles that comprise effective management

THE ECONOMICS OF EFFECTIVE MANAGEMENT

The nature of sound managerial decisions varies depending on the underlying goals

of the manager Since this course is designed primarily for managers of firms, thisbook focuses on managerial decisions as they relate to maximizing profits or, moregenerally, the value of the firm Before embarking on this special use of managerialeconomics, we provide an overview of the basic principles that comprise effectivemanagement In particular, an effective manager must (1) identify goals and con-straints; (2) recognize the nature and importance of profits; (3) understand incen-tives; (4) understand markets; (5) recognize the time value of money; and (6) usemarginal analysis

Identify Goals and Constraints

The first step in making sound decisions is to have well-defined goals because

achieving different goals entails making different decisions If your goal is to imize your grade in this course rather than maximize your overall grade point aver-age, your study habits will differ accordingly Similarly, if the goal of a food bank

max-is to dmax-istribute food to needy people in rural areas, its decmax-isions and optimal dmax-istri-bution network will differ from those it would use to distribute food to needy inner-

distri-city residents Notice that in both instances, the decision maker faces constraints

that affect the ability to achieve a goal The 24-hour day affects your ability to earn

an A in this course; a budget affects the ability of the food bank to distribute food tothe needy Constraints are an artifact of scarcity

Unfortunately, constraints make it difficult for managers to achieve goals such

as maximizing profits or increasing market share These constraints include suchthings as the available technology and the prices of inputs used in production Thegoal of maximizing profits requires the manager to decide the optimal price tocharge for a product, how much to produce, which technology to use, how much ofeach input to use, how to react to decisions made by competitors, and so on Thisbook provides tools for answering these types of questions

Recognize the Nature and Importance of Profits

The overall goal of most firms is to maximize profits or the firm’s value, and theremainder of this book will detail strategies managers can use to achieve this goal.Before we provide these details, let us examine the nature and importance of prof-its in a free-market economy

Economic versus Accounting Profits

When most people hear the word profit, they think of accounting profits Accounting profit is the total amount of money taken in from sales (total revenue, or price times

quantity sold) minus the dollar cost of producing goods or services Accountingprofits are what show up on the firm’s income statement and are typically reported tothe manager by the firm’s accounting department

A more general way to define profits is in terms of what economists refer to as

economic profits Economic profits are the difference between the total revenue and the total opportunity cost of producing the firm’s goods or services The opportunity cost of using a resource includes both the explicit (or accounting) cost of the resource and the implicit cost of giving up the best alternative use of the resource The oppor-

tunity cost of producing a good or service generally is higher than accounting costsbecause it includes both the dollar value of costs (explicit, or accounting, costs) andany implicit costs

Implicit costs are very hard to measure and therefore managers often overlookthem Effective managers, however, continually seek out data from other sources

to identify and quantify implicit costs Managers of large firms can use sourceswithin the company, including the firm’s finance, marketing, and/or legal depart-ments, to obtain data about the implicit costs of decisions In other instances man-agers must collect data on their own For example, what does it cost you to readthis book? The price you paid the bookstore for this book is an explicit (oraccounting) cost, while the implicit cost is the value of what you are giving up byreading the book You could be studying some other subject or watching TV, andeach of these alternatives has some value to you The “best” of these alternatives is

your implicit cost of reading this book; you are giving up this alternative to readthe book Similarly, the opportunity cost of going to school is much higher thanthe cost of tuition and books; it also includes the amount of money you would earnhad you decided to work rather than go to school.

In the business world, the opportunity cost of opening a restaurant is the bestalternative use of the resources used to establish the restaurant—say, opening ahairstyling salon Again, these resources include not only the explicit financialresources needed to open the business but any implicit costs as well Suppose youown a building in New York that you use to run a small pizzeria Food supplies areyour only accounting costs At the end of the year, your accountant informs youthat these costs were $20,000 and that your revenues were $100,000 Thus, youraccounting profits are $80,000

However, these accounting profits overstate your economic profits, because thecosts include only accounting costs First, the costs do not include the time youspent running the business Had you not run the business, you could have workedfor someone else, and this fact reflects an economic cost not accounted for inaccounting profits To be concrete, suppose you could have worked for someoneelse for $30,000 Your opportunity cost of time would have been $30,000 for theyear Thus, $30,000 of your accounting profits are not profits at all but one of theimplicit costs of running the pizzeria

Second, accounting costs do not account for the fact that, had you not run thepizzeria, you could have rented the building to someone else If the rental value ofthe building is $100,000 per year, you gave up this amount to run your own busi-ness Thus, the costs of running the pizzeria include not only the costs of supplies

($20,000) but the $30,000 you could have earned in some other business and the

$100,000 you could have earned in renting the building to someone else The nomic cost of running the pizzeria is $150,000—the amount you gave up to runyour business Considering the revenue of $100,000, you actually lost $50,000 byrunning the pizzeria

eco-Throughout this book, when we speak of costs, we mean economic costs nomic costs are opportunity costs and include not only the explicit (accounting)costs but also the implicit costs of the resources used in production

Eco-The Role of Profits

A common misconception is that the firm’s goal of maximizing profits is ily bad for society Individuals who want to maximize profits often are consideredself-interested, a quality that many people view as undesirable However, consider

necessar-Adam Smith’s classic line from The Wealth of Nations: “It is not out of the

benevo-lence of the butcher, the brewer, or the baker, that we expect our dinner, but fromtheir regard to their own interest.”2

2Adam Smith, An Inquiry into the Causes of the Wealth of Nations, ed Edwin Cannan (Chicago:

University of Chicago Press, 1976).

INSIDE BUSINESS 1–1

The Goals of Firms in Our Global Economy

Recent trends in globalization have forced businesses

around the world to more keenly focus on profitability

This trend is also present in Japan, where historical

links between banks and businesses have traditionally

blurred the goals of firms For example, the Japanese

business engineering firm, Mitsui & Co Ltd., recently

launched “Challenge 21,” a plan directed at helping

the company emerge as Japan’s leading business

engi-neering group According to a spokesperson for the

company, “[This plan permits us to] create new value

and maximize profitability by taking steps such as

renewing our management framework and prioritizing

the allocation of our resources into strategic areas We

are committed to maximizing shareholder value

through business conduct that balances the pursuit ofearnings with socially responsible behavior.”

Ultimately, the goal of any continuing companymust be to maximize the value of the firm This goal isoften achieved by trying to hit intermediate targets, such

as minimizing costs or increasing market share If you—

as a manager—do not maximize your firm’s value overtime, you will be in danger of either going out of busi-ness, being taken over by other owners (as in a leveragedbuyout), or having stockholders elect to replace you andother managers

Source: “Mitsui & Co., Ltd UK Regulatory

Announcement: Final Results,” Business Wire,

up profits This induces new firms to enter the markets in which economic profitsare available As more firms enter the industry, the market price falls, and eco-nomic profits decline

Thus, profits signal the owners of resources where the resources are mosthighly valued by society By moving scarce resources toward the production ofgoods most valued by society, the total welfare of society is improved As AdamSmith first noted, this phenomenon is due not to benevolence on the part of thefirms’ managers but to the self-interested goal of maximizing the firms’ profits

Profits signal to resource holders where resources are most highly valued by society