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Managerial Economics

Which value is typically larger, accounting profits or economic profits? When are accounting profits equal to economic profits?
Please refer to the Cadbury income statement in Table 3.1. Suppose the depreciation and amortization expenses are based on the prices for buildings and other facilities purchased several years ago, and the annualized opportunity cost for these capital assets is approximately 80% higher in the current market. What is the firm's economic profit?
The authors explain in Chapter 2 that subsidies are the opposite of taxes. Recently, the Trump administration announced that US soybean farmers will receive subsidies to offset the tariffs imposed by China on soybeans imported from the US. Prior to the imposition of tariffs by the US and China, soybeans were selling for about $11 per bushel in the US. The 25% tariff imposed on US soybean imports to China reduced US soybean prices by about 12.5% (because tariffs or taxes are shared by buyers and sellers and only part of the US soybean crop is exported to China). To offset this impact, the US federal government will pay US soybean farmers $1.65 per bushel on one-half of their 2018 production. Does this subsidy completely offset the tariff impact for US soybean farmers?

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Australia • Brazil • Mexico • Singapore • United Kingdom • United States

fifth edition

Managerial economics

A PRoBLem soLVinG APPRoAch

luke M. Froeb Vanderbilt University

Mikhael Shor University of Connecticut

Brian T. McCann Vanderbilt University

Michael r. Ward University of Texas, Arlington

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Managerial Economics, Fifth Edition Luke M. Froeb, Brian T. McCann, Mikhael Shor, Michael R. Ward

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In loving memory of Lisa, and for our families: Donna, David, Jake, Halley, Scott, Chris, Leslie, Jacob, Eliana, Cindy, Alex, and Chris

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v

Preface: Teaching Students to Solve Problems xiii

SECTION I Problem Solving and Decision Making 1 1 Introduction: What This Book Is About 3 2 The One Lesson of Business 15 3 Benefits, Costs, and Decisions 25 4 Extent (How Much) Decisions 37 5 Investment Decisions: Look Ahead and Reason Back 49

SECTION II Pricing, Costs, and Profits 65 6 Simple Pricing 67 7 Economies of Scale and Scope 83 8 Understanding Markets and Industry Changes 95 9 Market Structure and Long-Run Equilibrium 113 10 Strategy: The Quest to Keep Profit from Eroding 125 11 Foreign Exchange, Trade, and Bubbles 137

SECTION III Pricing for Greater Profit 151 12 More Realistic and Complex Pricing 153 13 Direct Price Discrimination 163 14 Indirect Price Discrimination 171

SECTION IV Strategic Decision Making 183 15 Strategic Games 185 16 Bargaining 205

SECTION V Uncertainty 215 17 Making Decisions with Uncertainty 217 18 Auctions 233 19 The Problem of Adverse Selection 243 20 The Problem of Moral Hazard 255

BrieF COnTenTS

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vi BRIEF CONTENTS

SECTION VI Organizational Design 267 21 Getting Employees to Work in the Firm’s Best Interests 269 22 Getting Divisions to Work in the Firm’s Best Interests 283 23 Managing Vertical Relationships 295

SECTION VII Wrapping Up 307 24 Test Yourself 309

Epilogue: Can Those Who Teach, Do? 315

Glossary 317

Index 325

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vii

Preface: Teaching Students to Solve Problems xiii

SECTION I Problem Solving and Decision Making 1

CHAPTER 1 INTRODUCTION: WHAT THIS BOOk IS ABOUT 3 1.1 Using Economics to Solve Problems 3 1.2 Problem-Solving Principles 4 1.3 Test Yourself 6 1.4 Ethics and Economics 7 1.5 Economics in Job Interviews 9 Summary & Homework Problems 11 End Notes 13

CHAPTER 2 THE ONE LESSON Of BUSINESS 15 2.1 Capitalism and Wealth 16 2.2 Does the Government Create Wealth? 17 2.3 How Economics Is Useful to Business 18 2.4 Wealth Creation in Organizations 21 Summary & Homework Problems 21 End Notes 23

CHAPTER 3 BENEfITS, COSTS, AND DECISIONS 25 3.1 Background: Variable, Fixed, and Total Costs 26 3.2 Background: Accounting versus Economic Profit 27 3.3 Costs Are What You Give Up 29 3.4 Sunk-Cost Fallacy 30 3.5 Hidden-Cost Fallacy 32 3.6 A Final Warning 32 Summary & Homework Problems 33 End Notes 36

CHAPTER 4 ExTENT (HOW MUCH) DECISIONS 37 4.1 Fixed Costs Are Irrelevant to an Extent Decision 38 4.2 Marginal Analysis 39 4.3 Deciding between Two Alternatives 40

COnTenTS

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CONTENTSviii

4.4 Incentive Pay 43 4.5 Tie Pay to Performance Measures That Reflect Effort 44 4.6 Is Incentive Pay Unfair? 45 Summary & Homework Problems 46 End Notes 48

CHAPTER 5 INVESTMENT DECISIONS: LOOk AHEAD AND REASON BACk 49 5.1 Compounding and Discounting 49 5.2 How to Determine Whether Investments Are Profitable 51 5.3 Break-Even Analysis 53 5.4 Choosing the Right Manufacturing Technology 55 5.5 Shut-Down Decisions and Break-Even Prices 56 5.6 Sunk Costs and Post-Investment Hold-Up 57 Summary & Homework Problems 60 End Notes 62

SECTION II Pricing, Costs, and Profits 65

CHAPTER 6 SIMPLE PRICING 67 6.1 Background: Consumer Values and Demand Curves 68 6.2 Marginal Analysis of Pricing 70 6.3 Price Elasticity and Marginal Revenue 72 6.4 What Makes Demand More Elastic? 75 6.5 Forecasting Demand Using Elasticity 76 6.6 Stay-Even Analysis, Pricing, and Elasticity 77 6.7 Cost-Based Pricing 78 Summary & Homework Problems 78 End Notes 81

CHAPTER 7 ECONOMIES Of SCALE AND SCOPE 83 7.1 Increasing Marginal Cost 84 7.2 Economies of Scale 86 7.3 Learning Curves 87 7.4 Economies of Scope 89 7.5 Diseconomies of Scope 90 Summary & Homework Problems 91 End Notes 94

CHAPTER 8 UNDERSTANDING MARkETS AND INDUSTRy CHANGES 95 8.1 Which Industry or Market? 95 8.2 Shifts in Demand 96 8.3 Shifts in Supply 98 8.4 Market Equilibrium 99 8.5 Predicting Industry Changes Using Supply and Demand 100 8.6 Explaining Industry Changes Using Supply and Demand 103 8.7 Prices Convey Valuable Information 104 8.8 Market Making 106

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CONTENTS ix

Summary & Homework Problems 108 End Notes 111

CHAPTER 9 MARkET STRUCTURE AND LONG-RUN EqUILIBRIUM 113 9.1 Competitive Industries 114 9.2 The Indifference Principle 116 9.3 Monopoly 120 Summary & Homework Problems 121 End Notes 123

CHAPTER 10 STRATEGy: THE qUEST TO kEEP PROfIT fROM ERODING 125 10.1 A Simple View of Strategy 126 10.2 Sources of Economic Profit 128 10.3 The Three Basic Strategies 132 Summary & Homework Problems 134 End Notes 136

CHAPTER 11 fOREIGN ExCHANGE, TRADE, AND BUBBLES 137 11.1 The Market for Foreign Exchange 138 11.2 The Effects of a Currency Devaluation 140 11.3 Bubbles 142 11.4 How Can We Recognize Bubbles? 144 11.5 Purchasing Power Parity 146 Summary & Homework Problems 147 End Notes 149

SECTION III Pricing for Greater Profit 151

CHAPTER 12 MORE REALISTIC AND COMPLEx PRICING 153 12.1 Pricing Commonly Owned Products 154 12.2 Revenue or Yield Management 155 12.3 Advertising and Promotional Pricing 157 12.4 Psychological Pricing 158 Summary & Homework Problems 160 End Notes 162

CHAPTER 13 DIRECT PRICE DISCRIMINATION 163 13.1 Why (Price) Discriminate? 164 13.2 Direct Price Discrimination 166 13.3 Robinson-Patman Act 167 13.4 Implementing Price Discrimination 168 13.5 Only Schmucks Pay Retail 169 Summary & Homework Problems 169 End Notes 170

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CONTENTSx

CHAPTER 14 INDIRECT PRICE DISCRIMINATION 171 14.1 Indirect Price Discrimination 172 14.2 Volume Discounts as Discrimination 176 14.3 Bundling Different Goods Together 177 Summary & Homework Problems 178 End Notes 181

SECTION IV Strategic Decision Making 183

CHAPTER 15 STRATEGIC GAMES 185 15.1 Sequential-Move Games 186 15.2 Simultaneous-Move Games 188 15.3 Prisoners’ Dilemma 190 15.4 Other Games 195 Summary & Homework Problems 199 End Notes 202

CHAPTER 16 BARGAINING 205 16.1 Strategic View of Bargaining 206 16.2 Nonstrategic View of Bargaining 208 16.3 Conclusion 210 Summary & Homework Problems 211 End Note 214

SECTION V Uncertainty 215

CHAPTER 17 MAkING DECISIONS WITH UNCERTAINTy 217 17.1 Random Variables and Probability 218 17.2 Uncertainty in Pricing 222 17.3 Data-Driven Decision Making 223 17.4 Minimizing Expected Error Costs 226 17.5 Risk versus Uncertainty 227 Summary & Homework Problems 228 End Notes 231

CHAPTER 18 AUCTIONS 233 18.1 Oral Auctions 234 18.2 Second-Price Auctions 235 18.3 First-Price Auctions 236 18.4 Bid Rigging 236 18.5 Common-Value Auctions 238 Summary & Homework Problems 240 End Notes 242

CHAPTER 19 THE PROBLEM Of ADVERSE SELECTION 243 19.1 Insurance and Risk 243 19.2 Anticipating Adverse Selection 244

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CONTENTS xi

19.3 Screening 246 19.4 Signaling 249 19.5 Adverse Selection and Internet Sales 250 Summary & Homework Problems 251 End Notes 253

CHAPTER 20 THE PRoblEm of moRAl HAzARd 255 20.1 Introduction 255 20.2 Insurance 256 20.3 Moral Hazard versus Adverse Selection 257 20.4 Shirking 258 20.5 Moral Hazard in Lending 260 20.6 Moral Hazard and the 2008 Financial Crisis 261 Summary & Homework Problems 262 End Notes 265

SECTIoN VI organizational design 267

CHAPTER 21 GETTING EmPloyEES To WoRk IN THE fIRm’S bEST INTERESTS 269 21.1 Principal–Agent Relationships 270 21.2 Controlling Incentive Conflict 271 21.3 Marketing versus Sales 273 21.4 Franchising 274 21.5 A Framework for Diagnosing and Solving Problems 275 Summary & Homework Problems 278 End Notes 281

CHAPTER 22 GETTING dIVISIoNS To WoRk IN THE fIRm’S bEST INTERESTS 283 22.1 Incentive Conflict between Divisions 283 22.2 Transfer Pricing 285 22.3 Organizational Alternatives 287 22.4 Budget Games: Paying People to Lie 289 Summary & Homework Problems 291 End Notes 294

CHAPTER 23 mANAGING VERTICAl RElATIoNSHIPS 295 23.1 How Vertical Relationships Increase Profit 296 23.2 Double Marginalization 297 23.3 Incentive Conflicts between Retailers and Manufacturers 297 23.4 Price Discrimination 299 23.5 Antitrust Risks 300 23.6 Do Buy a Customer or Supplier Simply Because It Is Profitable 301 Summary & Homework Problems 302 End Notes 304

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CONTENTSxii

SECTION VII Wrapping Up 307

CHAPTER 24 TEST yOURSELf 309 24.1 Should You Keep Frequent Flyer Points for Yourself? 309 24.2 Should You Lay Off Employees in Need? 310 24.3 Manufacturer Hiring 310 24.4 American Airlines 311 24.5 Law Firm Pricing 311 24.6 Should You Give Rejected Food to Hungry Servers? 312 24.7 Managing Interest-Rate Risk at Banks 313 24.8 What You Should Have Learned 313

Epilogue: Can Those Who Teach, Do? 315

Glossary 317

Index 325

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xiii

teaching students to solve Problems1 by Luke Froeb

When I started teaching MBA students, I taught economics as I had learned it, using models and public policy applications. My students complained so much that the dean took me out to the proverbial woodshed and gave me an ultimatum, “improve customer satisfaction or else.” With the help of some disgruntled students who later became teaching assistants, I was able to turn the course around.

The problem I faced can be easily described using the language of eco- nomics: the supply of business education (professors are trained to provide abstract theory) is not closely matched to demand (students want practical knowledge). This mismatch is found throughout academia, but it is perhaps most acute in a business school. Business students expect a return on a fairly sizable investment and want to learn material with immediate and obvious value.

One implication of the mismatch is that teaching economics in the usual way—with models and public policy applications—is not likely to satisfy stu- dent demand. In this book, we use what we call a “problem-solving pedagogy” to teach microeconomic principles to business students. We begin each chapter with a business problem, like the fixed-cost fallacy, and then give students just enough analytic structure to understand the cause of the problem and how to fix it.

Teaching students to solve real business problems, rather than learn models, satisfies student demand in an obvious way. Our approach also allows stu- dents to absorb the lessons of economics without as much of the analytical “overhead” as a model-based pedagogy. This is an advantage, especially in a terminal or stand-alone course, like those typically taught in a business school. To see this, ask yourself which of the following ideas is more likely to stay with a student after the class is over: the fixed-cost fallacy or that the partial derivative of profit with respect to price is independent of fixed costs.

eleMenTS OF a PrOBleM-SOlving PedagOgy Our problem-solving pedagogy has three elements.

PreFaCe

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xiv PREFaCE

1. Begin with a Business Problem Beginning with a real-world business problem puts the particular ahead of the abstract and motivates the material in a straightforward way. We use narrow, focused problems whose solutions require students to use the analytical tools of interest.

2. Teach Students to view inefficiency as an Opportunity The second element of our pedagogy turns the traditional focus of benefit– cost analysis on its head. Instead of teaching students to spot and eliminate inefficiency, for example, by changing public policy, we teach them to view each underemployed asset as a money-making opportunity.

3. Use economics to implement Solutions After you find an underemployed asset, moving it to a higher-valued use is often hard to do, particularly when the inefficiency occurs within an organi- zation. The third element of our pedagogy addresses the problem of incentive alignment: how to design organizations where employees have enough infor- mation to make profitable decisions and the incentive to do so.

Again, we use the tools of economics to address the problem of implemen- tation. If people act rationally, optimally, and self-interestedly, then mistakes have only one of two causes: either people lack the information necessary to make good decisions or they lack the incentive to do so. This immediately sug- gests a problem-solving algorithm; ask:

1. Who is making the bad decision? 2. Do they have enough information to make a good decision? 3. Do they have the incentive to do so?

Answers to these three questions will point to the source of the problem and suggest one of three potential solutions:

1. Let someone else make the decision, someone with better information or incentives

2. Give more information to the current decision maker 3. Change the current decision maker’s incentives

The book begins by showing students how to use this algorithm, and subsequent chapters illustrate its use in a variety of contexts, for example, extent decisions, investments, pricing, bargaining, principal–agent relationships, and uncertain environments.

USing The BOOk The book is designed to be read cover-to-cover as it is short, concise, and accessible to anyone who can read and think clearly. The pedagogy is built around business problems, so the book is most effective for those with some work experience. Its relatively short length makes it reasonably easy to cus- tomize with ancillary material.

The authors use the text in full-time MBA programs, executive MBA programs (weekends), healthcare management executive programs (one night

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xvPREFaCE

a week), and nondegree executive education. However, some of our biggest customers use the book in online business classes at both the graduate and undergraduate levels.

In the degree programs, we supplement the material in the book with online interactive programs like Cengage’s MindTap. Complete Blackboard courses, including syllabi, quizzes, homework, slides, videos to complement each chapter, and links to supplementary material, can be downloaded from the Cengage website. Our ManagerialEcon.com blog is a good source of new business applications for each of the chapters.

In this fifth edition, we have updated and improved the presentation and ped- agogy of the book. The biggest substantive change is to Chapter 17, where we present the decomposition of an observed difference between two groups into a treatment effect + selection bias. Michael Ward has been using this in his classes at University of Texas at Arlington, and rewrote the chapter to include it. We are also beginning work to add interactive “activities” to the electronic text in MindTap, Cengage’s new learning platform. These activities help comprehension, especially for weaker students. In addition, we continue to rewrite and update the supple- mentary material: videos, worked video problems, and the test bank. In addition to the other updates throughout the text, Chapter 24 has two new sections.

We wish to acknowledge numerous classes of MBA, executive MBA, non- degree executive education, and healthcare management students, without whom none of this would have been possible—or necessary. Many of our for- mer students will recognize stories from their companies in the book. Most of the stories in the book are from students and are for teaching purposes only.

Thanks to everyone who contributed, knowingly or not, to the book. Professor Froeb owes intellectual debts to former colleagues at the U.S. Department of Justice (among them, Cindy Alexander, Tim Brennan, Ken Heyer, Kevin James, Bruce Kobayahsi, and Greg Werden); to former colleagues at the Federal Trade Commission (among them, James Cooper, Pauline Ippolito, Tim Muris, Dan O’Brien, Maureen Ohlhausen, Paul Pautler, Mike Vita, and Steven Tenn); to colleagues at Vanderbilt (among them, Germain Boer, Jim Bradford, Bill Christie, Mark Cohen, Myeong Chang, Craig Lewis, Rick Oliver, David Parsley, David Rados, Steven Tschantz, David Scheffman, and Bart Victor); and to numerous friends and colleagues who offered suggestions, problems, and anecdotes for the book (among them, Lily Alberts, Olafur Arnarson, Raj Asirvatham, Bert Bailey, Justin Bailey, Pat Bajari, Molly Bash, Sarah Berhalter, Roger Brinner, the Honorable Jim Cooper, Matthew Dixon Cowles, Abie Del Favero, Kelsey Duggan, Vince Durnan, Marjorie Eastman, Tony Farwell, Keri Floyd, Josh Gapp, Brock Hardisty, Trent Holbrook, Jeff and Jenny Hubbard, Brad Jenkins, Dan Kessler, Bev Landstreet [B5], Bert Mathews, Christine Milner, Jim Overdahl, Craig Perry, Rich Peoples, Annaji Pervajie, Jason Rawlins, Mike Saint, David Shayne, Jon Shayne, Bill Shughart, Doug Tice, Whitney Tilson, and Susan Woodward). We owe intellectual and pedagogical debts to Armen Alchian and William Allen3; Henry Hazlitt4; Shlomo Maital5; John MacMillan6; Steven Landsburg7; Ivan Png8; Victor Tabbush9; Michael Jensen and William Meckling10; and James Brickley, Clifford Smith, and Jerold Zimmerman.11 Special thanks to everyone who guided us through the publishing process, including Molly Umbarger, Christopher Rader, and Jason Fremder.

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xvi

end nOTeS

PREFaCE

1. Much of the material is taken from Luke M. Froeb and James C. Ward, “Teaching Managerial Economics with Problems Instead of Models,” in The International Handbook on Teaching and Learning Economics, eds. Gail Hoyt and KimMarie McGoldrick (Northampton, MA: Edward Elgar Publishing, 2012).

2. Armen Alchian and William Allen, Exchange and Production, 3rd ed. (Belmont, CA: Wadsworth, 1983).

3. Henry Hazlitt, Economics in One Lesson (New York: Crown, 1979).

4. Shlomo Maital, Executive Economics: Ten Essential Tools for Managers (New York: Free Press, 1994).

5. John McMillan, Games, Strategies, and Managers (Oxford: Oxford University Press, 1992).

6. Steven Landsburg, The Armchair Economist: Economics and Everyday Life (New York: Free Press, 1993).

7. Ivan Png, Managerial Economics (Maiden, MA: Blackwell, 1998).

8. http://www.mbaprimer.com 9. Michael Jensen and William Meckling,

A Theory of the Firm: Governance, Residual Claims and Organizational Forms (Cambridge, MA: Harvard University Press, 2000).

10. James Brickley, Clifford Smith, and Jerold Zimmerman, Managerial Economics and Organizational Architecture (Chicago: Irwin, 1997).

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1

1 Introduction: What This Book Is About

2 The One Lesson of Business

3 Benefits, Costs, and Decisions

4 Extent (How Much) Decisions

5 Investment Decisions: Look Ahead and Reason Back

Problem Solving and Decision Making

1Section

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3

1

In 1992, a junior geologist was preparing a bid recommendation for an oil tract in the Gulf of Mexico. She suspected that the tract contained a large accumulation of oil because her company, Oil Ventures International (OVI), had an adjacent tract with several productive wells. Since no competitors had neighboring tracts, none of them suspected a large accumulation of oil. Be- cause of this, she thought that the tract could be won relatively cheaply and recommended a bid of $5 million. Surprisingly, OVI’s senior management ig- nored the recommendation and submitted a bid of $21 million. OVI won the tract over the next-highest bid of $750,000.

If the board of directors asked you to review the bidding procedures at OVI, how would you proceed? Where would you begin your investigation? What questions would you ask?

You’d find it difficult to gather information from those closest to the bid- ding. Senior management would be suspicious and uncooperative because no one likes to be singled out for bidding $20 million more than was necessary. Likewise, our junior geologist would be reluctant to criticize her superiors. You might be able to rely on your experience—provided that you had run into a similar problem. But without experience, or when facing novel problems, you would have to rely on your analytic ability.

This book is designed to show you how to complete an assignment like this.

1.1 Using Economics to Solve Problems Solving a problem like OVI’s requires two steps: first, figure out what’s caus- ing the problem; and second, how to fix it. In this case, you would want to know whether the $21 million bid was too high at the time it was made, not just in retrospect. If the bid was too aggressive, then you’d have to figure out why the senior managers overbid and how to make sure they don’t do it again.

Introduction: What This Book Is About

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SECTION I • Problem Solving and Decision Making 4

Both steps require that you predict how people behave in different cir- cumstances, and this is where the economic content of the book comes in. The one thing that unites economists is their use of the rational-actor paradigm. Simply put, it says that people act rationally, optimally, and self-interestedly. The paradigm not only helps you figure out why people behave the way they do but also suggests ways to get them to change. To change behavior, you have to change self-interest, and you do that by changing incentives.

Incentives are created by rewarding good performance with, for exam- ple, a commission on sales or a bonus based on profitability. The performance evaluation metric (revenue, cost, profit, or return on investment, ROI) is sepa- rate from the reward structure (commission, bonus, raise, or promotion), but they work together to create an incentive to behave a certain way.

To illustrate, let’s go back to OVI’s story and try to find the source of the problem. After her company won the auction, our geologist increased the company’s oil reserves by the amount of oil estimated to be in the tract. But when the company drilled a well, it was essentially “dry,” so the acquisition did little to increase the size of the company’s oil reserves. Using the informa- tion from the newly drilled well, our geologist updated the reservoir map and reduced the estimated reserves to where they was before OVI won the tract.