If the inverse demand function for toasters is

Entreeefnuer

Believe it or not, there really were court cases and patent applications for a penut butter and jelly sandwich.
Do you think Smuckers should be given the patent for its crustless peanut butter and jelly sandwich? Use materials in the chapter (Chapter 12) to explain and justify your thinking.
The court eventually ruled against Smuckers, and Smuckers didn’t get its patent. Why do you think the court ruled as it did? Use materials in the chapter (Chapter 12) to explain and justify your thinking.

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MyLabTM Economics is an online homework, tutorial, and assessment program constructed to work with this text to engage students and improve results. It was designed to help students develop and assess the skills and applicable knowl- edge that they will need to succeed in their courses and their future careers.

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For additional details visit: www.pearson.com/mylab/economics

See what more than 55,000 students had to say about MyLab Economics:

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Symbols Used in This Book

∆ [capital delta] = a change in the following variable— for example, the change in p between Periods 1 and 2 is ∆p = p2 - p1, where pi is the price in Period i)

e [epsilon] = the price elasticity of demand

π [pi] = profit = revenue - total cost = R - C θ = proportion or probability or share

Abbreviations, Variables, and Function Names

AFC = average fixed cost = fixed cost divided by output = F>q

AVC = average variable cost = variable cost divided by output = VC>q

AC = average cost = total cost divided by output = C>q

APi = average product of input i—for example, APL is the average product of labor

C = total cost = variable cost + fixed cost = VC + F CS = consumer surplus

D = market demand curve

DWL = deadweight loss

F = fixed cost

i = interest rate

I = indifference curve

K = capital

L = labor

LR = long run

m = constant marginal cost

MC = marginal cost

MPi = marginal (physical) product of input i—for example, MPL is the marginal product of labor

MR = marginal revenue

MRS = marginal rate of substitution

MRTS = marginal rate of technical substitution

n = number of items such as firms in an industry

p = price

PS = producer surplus

Q = market (or monopoly) output

q = firm output

R = revenue = pq

r = price of capital services

s = per@unit subsidy

S = market supply curve

SR = short run

t = specific or unit tax

T = tax revenue (tQ)

TS = total surplus

U = utility

VC = variable cost

w = wage

Y = income or budget

CVR_PERL3786_03_SE_FEP.indd 4 19/12/2018 16:21

Managerial Economics and Strategy

THIRD EDITION

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Managerial Economics and Strategy

THIRD EDITION

Jeffrey M. Perloff University of California, Berkeley

James A. Brander Sauder School of Business, University of British Columbia

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FOR JACKIE, LISA, BARBARA, AND CATHY

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v

Brief Contents Preface xiii

Chapter 1 Introduction 1 Chapter 2 Supply and Demand 9 Chapter 3 Empirical Methods for Demand Analysis 44 Chapter 4 Consumer Choice 87 Chapter 5 Production 124 Chapter 6 Costs 153 Chapter 7 Firm Organization and Market Structure 191 Chapter 8 Competitive Firms and Markets 225 Chapter 9 Monopoly 266 Chapter 10 Pricing with Market Power 307 Chapter 11 Oligopoly and Monopolistic Competition 350 Chapter 12 Game Theory and Business Strategy 385 Chapter 13 Strategies Over Time 424 Chapter 14 Decision Making Under Uncertainty 462 Chapter 15 Asymmetric Information 500 Chapter 16 Government and Business 536 Chapter 17 Global Business 579 Answers to Selected Questions E-1

Definitions E-14

References E-19

Sources for Managerial Problems, Mini-Cases, and Managerial Implications E-27

Index E-38

Credits E-74

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vi

Preface xiii

Chapter 1 Introduction 1

1.1 Managerial Decision Making 1 Profit 2 Trade-Offs 2 Other Decision Makers 2 Strategy 3

1.2 Economic Models 3 MINI-CASE Using an Income Threshold

Model in China 4 Simplifying Assumptions 4 Testing Theories 5 Positive and Normative Statements 6 New Theories 7

1.3 Using Economic Skills in Your Career 7 Summary 8

Chapter 2 Supply and Demand 9 MANAGERIAL PROBLEM Carbon Taxes 9

2.1 Demand 10 The Demand Curve 11 The Demand Function 14 USING CALCULUS Deriving the Slope

of a Demand Curve 16 Summing Demand Curves 16 MINI-CASE Summing Corn Demand Curves 16

2.2 Supply 17 The Supply Curve 18 The Supply Function 19 Summing Supply Curves 20

2.3 Market Equilibrium 20 Using a Graph to Determine the Equilibrium 20 Using Math to Determine the Equilibrium 20 Forces That Drive the Market to Equilibrium 22 MINI-CASE Speed of Adjustment

to New Information 23 2.4 Shocks to the Equilibrium 23

Effects of a Shift in the Demand Curve 23 Q&A 2.1 24 Effects of a Shift in the Supply Curve 25 MINI-CASE The Opioid Epidemic

Reduces Labor Market Participation 26 Q&A 2.2 26 MANAGERIAL IMPLICATION Taking

Advantage of Future Shocks 27

2.5 Effects of Government Interventions 27 Policies That Shift Curves 27 MINI-CASE Occupational Licensing 28 Price Controls 28 MINI-CASE Venezuelan Price Ceilings

and Shortages 30 Sales Taxes 33 Q&A 2.3 35 MANAGERIAL IMPLICATION Cost Pass-Through 36

2.6 When to Use the Supply-and- Demand Model 36 MANAGERIAL SOLUTION Carbon Taxes 37 Summary 39 ■  Questions 39

Chapter 3 Empirical Methods for Demand Analysis 44

MANAGERIAL PROBLEM Estimating the Effect of an iTunes Price Change 44

3.1 Elasticity 45 The Price Elasticity of Demand 45 MANAGERIAL IMPLICATION Changing

Prices to Calculate an Arc Elasticity 47 Q&A 3.1 47 MINI-CASE Demand Elasticities for

Google Play and Apple Apps 49 USING CALCULUS The Point Elasticity of Demand 49 Elasticity Along the Demand Curve 49 Q&A 3.2 51 Other Types of Demand Elasticities 53 MINI-CASE Anti-Smoking Policies May

Reduce Drunk Driving 53 Demand Elasticities over Time 54 Other Elasticities 54 Estimating Demand Elasticities 54

3.2 Regression Analysis 55 A Demand Function Example 55 MINI-CASE The Portland Fish Exchange 57 Multivariate Regression 62 Q&A 3.3 62 Goodness of Fit and the R2 Statistic 63 MANAGERIAL IMPLICATION Focus Groups 64

3.3 Properties and Statistical Significance of Estimated Coefficients 64 Repeated Samples 64 Desirable Properties for Estimated Coefficients 65 A Focus Group Example 65 Confidence Intervals 67 Hypothesis Testing and Statistical Significance 67

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3.4 Regression Specification 68 Selecting Explanatory Variables 69 MINI-CASE Determinants of CEO Compensation 69 Q&A 3.4 71 Functional Form 72 MANAGERIAL IMPLICATION Experiments 74

3.5 Forecasting 75 Extrapolation 75 Theory-Based Econometric Forecasting 78 MANAGERIAL SOLUTION Estimating

the Effect of an iTunes Price Change 79 Summary 81 ■  Questions 82

Appendix 3A The Identification Problem 85

Chapter 4 Consumer Choice 87 MANAGERIAL PROBLEM Paying Employees

to Relocate 87 4.1 Consumer Preferences 88

Properties of Consumer Preferences 89 MINI-CASE You Can’t Have Too Much Money 90 Preference Maps 90

4.2 Utility 97 Utility Functions 97 Ordinal and Cardinal Utility 98 Marginal Utility 98 USING CALCULUS Marginal Utility 99 Marginal Rates of Substitution 100

4.3 The Budget Constraint 100 Slope of the Budget Line 102 USING CALCULUS The Marginal Rate

of Transformation 102 Effects of a Change in Price on

the Opportunity Set 102 Effects of a Change in Income on

the Opportunity Set 103 Q&A 4.1 104 MINI-CASE Rationing 104 Q&A 4.2 105

4.4 Constrained Consumer Choice 105 The Consumer’s Optimal Bundle 105 Q&A 4.3 107 MINI-CASE Why Americans Buy More

E-Books Than Do Germans 108 Q&A 4.4 109 Promotions 109 MANAGERIAL IMPLICATION Designing

Promotions 111 4.5 Deriving Demand Curves 111 4.6 Behavioral Economics 113

Tests of Transitivity 114 Endowment Effects 114 MINI-CASE How You Ask the

Question Matters 115 Salience 115 MANAGERIAL IMPLICATION Simplifying

Consumer Choices 116

MANAGERIAL SOLUTION Paying Employees to Relocate 117

Summary 118 ■  Questions 119 Appendix 4A The Marginal Rate of Substitution 122 Appendix 4B The Consumer Optimum 123

Chapter 5 Production 124 MANAGERIAL PROBLEM Labor Productivity

During Recessions 124 5.1 Production Functions 125 5.2 Short-Run Production 126

The Total Product Function 127 The Marginal Product of Labor 128 USING CALCULUS Calculating the Marginal

Product of Labor 128 Q&A 5.1 129 The Average Product of Labor 129 Graphing the Product Curves 129 The Law of Diminishing Marginal Returns 132 MINI-CASE Malthus and the Green Revolution 133

5.3 Long-Run Production 134 Isoquants 134 MINI-CASE Self-Driving Trucks 137 Substituting Inputs 138 Q&A 5.2 139 USING CALCULUS Cobb-Douglas

Marginal Products 141 5.4 Returns to Scale 141

Constant, Increasing, and Decreasing Returns to Scale 141

Q&A 5.3 143 MINI-CASE Returns to Scale for Crocs 143 Varying Returns to Scale 144 MANAGERIAL IMPLICATION Small Is

Beautiful 145 5.5 Innovation 146

Process Innovation 146 MINI-CASE Robots and the Food You Eat 147 Organizational Innovation 147 MINI-CASE A Good Boss Raises Productivity 148 MANAGERIAL IMPLICATION Technical

Progress and Competitive Advantage 148 MANAGERIAL SOLUTION Labor

Productivity During Recessions 148 Summary 149 ■  Questions 149

Chapter 6 Costs 153 MANAGERIAL PROBLEM Technology

Choice at Home Versus Abroad 153 6.1 The Nature of Costs 154

Opportunity Costs 154 MINI-CASE The Opportunity Cost of an MBA 155 Q&A 6.1 156 Costs of Durable Inputs 156

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Sunk Costs 157 MANAGERIAL IMPLICATION Ignoring Sunk Costs 158

6.2 Short-Run Costs 158 MINI-CASE Costs of Building a Guitar 158 Common Measures of Cost 159 USING CALCULUS Calculating Marginal Cost 161 Cost Curves 161 Q&A 6.2 163 Production Functions and the Shapes

of Cost Curves 164 Short-Run Cost Summary 167

6.3 Long-Run Costs 168 MINI-CASE Short Run Versus Long Run

in the Sharing Economy 168 Input Choice 169 MANAGERIAL IMPLICATION Cost Minimization

by Trial and Error 174 MINI-CASE The Internet and Outsourcing 175 Q&A 6.3 176 The Shapes of Long-Run Cost Curves 176 MINI-CASE Economies of Scale at Google 178 Q&A 6.4 179

6.4 The Learning Curve 179 MINI-CASE Solar Power Learning Curves 180

6.5 The Costs of Producing Multiple Goods 181 MINI-CASE Medical Economies of Scope 182 MANAGERIAL SOLUTION Technology

Choice at Home Versus Abroad 182 Summary 184 ■  Questions 184

Appendix 6A Calculating Cost Curves 189 Appendix 6B Long-Run Cost Minimization 190

Chapter 7 Firm Organization and Market Structure 191

MANAGERIAL PROBLEM Amazon’s Delivery Services 191

7.1 Ownership and Governance of Firms 192 Private, Public, and Nonprofit Firms 192 MINI-CASE Chinese State-Owned Enterprises 193 Ownership of For-Profit Firms 194 Firm Governance 196

7.2 Profit Maximization 196 Profit 196 Two Steps to Maximizing Profit 197 USING CALCULUS Maximizing Profit 199 Q&A 7.1 200 MANAGERIAL IMPLICATION Marginal

Decision Making 200 Social Responsibility 202 MINI-CASE Trends in Social Responsibility 203 Forcing Firms to Maximize Profit:

The Survivor Principle and Competition for Corporate Control 204

7.3 Profits Over Time 206 Interest Rates 206

Investing and Profit Maximizing Over Time 208 Q&A 7.2 208 MANAGERIAL IMPLICATION Stock Prices

Versus Profit 209 7.4 The Make or Buy Decision 210

Stages of Production 210 Vertical Integration 210 Profitability and the Supply Chain Decision 213 MINI-CASE Netflix 214 MINI-CASE The Gig Economy 215 Market Size and the Life Cycle of a Firm 216

7.5 Market Structure 217 The Four Main Market Structures 217 Comparison of Market Structures 219 Disruptive Innovations and the Evolution

of Market Structure 220 Road Map to the Rest of the Book 220 MANAGERIAL SOLUTION Amazon’s

Delivery Services 221 Summary 221 ■  Questions 222

Chapter 8 Competitive Firms and Markets 225

MANAGERIAL PROBLEM The Rising Cost of Keeping On Truckin’ 225

8.1 Perfect Competition 226 Characteristics of a Perfectly

Competitive Market 226 Deviations from Perfect Competition 228

8.2 Competition in the Short Run 228 How Much to Produce 229 Q&A 8.1 231 USING CALCULUS Profit Maximization

with a Specific Tax 232 Whether to Produce 233 MINI-CASE Fracking and Shutdowns 235 Q&A 8.2 236 MANAGERIAL IMPLICATION Sunk Costs

and the Shutdown Decision 237 The Short-Run Firm Supply Curve 237 The Short-Run Market Supply Curve 238 Short-Run Competitive Equilibrium 240

8.3 Competition in the Long Run 241 Long-Run Competitive Profit

Maximization 241 The Long-Run Firm Supply Curve 242 MINI-CASE The Size of Ethanol

Processing Plants 242 The Long-Run Market Supply Curve 242 MINI-CASE Industries with High Entry and

Exit Rates 243 MINI-CASE An Upward-Sloping Long-Run

Supply Curve for Cotton 246 Long-Run Competitive Equilibrium 246 Q&A 8.3 247 Zero Long-Run Profit with Free Entry 247

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8.4 Competition Maximizes Economic Well-Being 247 Consumer Surplus 248 MANAGERIAL IMPLICATION Willingness to

Pay on eBay 250 MINI-CASE Digital Surplus 251 Producer Surplus 252 Q&A 8.4 254 Q&A 8.5 254 Competition Maximizes Total Surplus 255 MINI-CASE The Deadweight Loss of

Holiday Gifts 257 Effects of Government Intervention 258 Q&A 8.6 258 MANAGERIAL SOLUTION The Rising Cost

of Keeping On Truckin’ 260 Summary 261 ■  Questions 262

Chapter 9 Monopoly 266 MANAGERIAL PROBLEM Brand-Name

and Generic Drugs 266 9.1 Monopoly Profit Maximization 268

Marginal Revenue 268 USING CALCULUS Deriving a Monopoly’s

Marginal Revenue Function 271 Q&A 9.1 271 Choosing Price or Quantity 273 Two Steps to Maximizing Profit 274 USING CALCULUS Solving for the

Profit-Maximizing Output 275 MINI-CASE Apple’s iPad 276 Q&A 9.2 276 Effects of a Shift of the Demand Curve 277 Q&A 9.3 279 MINI-CASE Taylor Swift Concert Pricing 280 Q&A 9.4 280

9.2 Market Power 281 Market Power and the Shape of the

Demand Curve 281 MANAGERIAL IMPLICATION Checking

Whether the Firm Is Maximizing Profit 282 The Lerner Index 283 Q&A 9.5 283 Sources of Market Power 284

9.3 Market Failure Due to Monopoly Pricing 284 Q&A 9.6 286

9.4 Causes of Monopoly 287 Cost-Based Monopoly 288 Q&A 9.7 289 Government Creation of Monopoly 289 MINI-CASE The Canadian Medical

Marijuana Market 290 MINI-CASE Botox 291

9.5 Advertising 293 Deciding Whether to Advertise 293 How Much to Advertise 295

USING CALCULUS Optimal Advertising 295 Q&A 9.8 296 MINI-CASE Super Bowl Commercials 296

9.6 Internet Monopolies: Network Effects and Scale Economies 297 Network Externalities 297 MANAGERIAL IMPLICATION

Introductory Prices 298 Behavioral Network Externalities 298 Two-Sided Markets 299 Natural Monopoly on the Internet 299 MINI-CASE Critical Mass and eBay 300 Disruptive Technologies 300 MANAGERIAL SOLUTION Brand-Name

and Generic Drugs 301 Summary 302 ■  Questions 302

Chapter 10 Pricing with Market Power 307 MANAGERIAL PROBLEM Sale Prices 307

10.1 Conditions for Price Discrimination 309 Why Price Discrimination Pays 309 MINI-CASE Disneyland Pricing 311 Which Firms Can Price Discriminate 311 MANAGERIAL IMPLICATION Preventing Resale 312 MINI-CASE Preventing Resale of Designer Bags 312 Not All Price Differences Are Price

Discrimination 313 Types of Price Discrimination 313

10.2 Perfect Price Discrimination 313 How a Firm Perfectly Price Discriminates 314 Perfect Price Discrimination Is

Efficient but Harms Some Consumers 315 MINI-CASE Botox Revisited 317 Q&A 10.1 318 Individual Price Discrimination 318 MINI-CASE Google Uses Bidding for

Ads to Price Discriminate 319 10.3 Group Price Discrimination 320

Group Price Discrimination with Two Groups 320

USING CALCULUS Maximizing Profit for a Group Discriminating Monopoly 321

MINI-CASE Age Discrimination 323 Q&A 10.2 323 Identifying Groups 325 MANAGERIAL IMPLICATION Discounts 325 Effects of Group Price Discrimination

on Total Surplus 326 10.4 Nonlinear Price Discrimination 327 10.5 Two-Part Pricing 329

Two-Part Pricing with Identical Consumers 330 Two-Part Pricing with Differing

Consumers 331 MINI-CASE Available for a Song 333

10.6 Bundling 334 Pure Bundling 334

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Mixed Bundling 336 Q&A 10.3 337 Requirement Tie-In Sales 338 MANAGERIAL IMPLICATION Ties That Bind 339

10.7 Peak-Load Pricing 339 MINI-CASE Downhill Pricing 340 Peak-Load Pricing with a Capacity Constraint 340 Dynamic Pricing 341 Q&A 10.4 342 MANAGERIAL SOLUTION Sale Prices 343 Summary 344 ■  Questions 345

Chapter 11 Oligopoly and Monopolistic Competition 350

MANAGERIAL PROBLEM Gaining an Edge from Government Aircraft Subsidies 350

11.1 Cartels 352 Why Cartels Succeed or Fail 352 MINI-CASE Employer “No-Poaching” Cartels 354 Maintaining Cartels 355 MINI-CASE Cheating on the Maple

Syrup Cartel 356 11.2 Cournot Oligopoly 357

Airlines 359 USING CALCULUS Deriving the Cournot

Equilibrium 362 The Number of Firms 363 MINI-CASE Mobile Phone Number

Portability 364 Nonidentical Firms 365 Q&A 11.1 366 Q&A 11.2 368 Mergers 369 MINI-CASE Airline Mergers 370

11.3 Bertrand Oligopoly 370 Identical Products 370 Differentiated Products 372 MANAGERIAL IMPLICATION Differentiating

a Product Through Marketing 373 MINI-CASE Rising Market Power 374

11.4 Monopolistic Competition 374 MANAGERIAL IMPLICATION Managing in

the Monopolistically Competitive Food Truck Market 375

Equilibrium 376 Q&A 11.3 377 Profitable Monopolistically

Competitive Firms 377 MINI-CASE Subsidizing the Entry Cost

of Dentists 378 MANAGERIAL SOLUTION Gaining an Edge

from Government Aircraft Subsidies 378 Summary 380 ■  Questions 380

Appendix 11A Nash-Bertrand Equilibrium 384

Chapter 12 Game Theory and Business Strategy 385

MANAGERIAL PROBLEM Dying to Work 385 12.1 Oligopoly Games 388

Dominant Strategies 388 Best Responses 390 Failure to Maximize Joint Profits 392 MINI-CASE Strategic Advertising 394 Q&A 12.1 395 Pricing Games in Two-Sided Markets 396

12.2 Types of Nash Equilibria 397 Multiple Equilibria 397 MINI-CASE Cheap Talk in eBay’s Best

Offer Market 399 MINI-CASE Timing Radio Ads 400 Mixed-Strategy Equilibria 400 MINI-CASE Competing E-Book Formats 404 Q&A 12.2 404

12.3 Information and Rationality 405 Incomplete Information 406 MANAGERIAL IMPLICATION Solving

Coordination Problems 407 Rationality 407 MANAGERIAL IMPLICATION Using Game

Theory to Make Business Decisions 408 12.4 Bargaining 409

Bargaining Games 409 The Nash Bargaining Solution 409 Q&A 12.3 411 USING CALCULUS Maximizing the

Nash Product 411 MINI-CASE Nash Bargaining over Coffee 412 Inefficiency in Bargaining 412

12.5 Auctions 413 Elements of Auctions 413 Bidding Strategies in Private-Value Auctions 414 MINI-CASE Experienced Bidders 415 The Winner’s Curse 416 MANAGERIAL IMPLICATION Auction Design 417 MANAGERIAL SOLUTION Dying to Work 417 Summary 418 ■  Questions 419

Chapter 13 Strategies Over Time 424 MANAGERIAL PROBLEM Intel and AMD’s

Advertising Strategies 424 13.1 Repeated Games 426

Strategies and Actions in Dynamic Games 426 Cooperation in a Repeated

Prisoners’ Dilemma Game 426 MINI-CASE Tit-for-Tat Strategies in

Trench Warfare 429 Implicit Versus Explicit Collusion 430 MINI-CASE Signaling Drug Price Increases 430 Finitely Repeated Games 430

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13.2 Sequential Games 431 Stackelberg Oligopoly 432 Q&A 13.1 435 Credible Threats 436 Q&A 13.2 436

13.3 Deterring Entry 437 Exclusion Contracts 438 MINI-CASE Pay-for-Delay Agreements 439 Limit Pricing 440 MINI-CASE Pfizer Uses Limit Pricing

to Slow Entry 440 Q&A 13.3 441 Entry Deterrence in a Repeated Game 442

13.4 Cost and Innovation Strategies 443 Investing to Lower Marginal Cost 443 Learning by Doing 445 Raising Rivals’ Costs 445 Q&A 13.4 445 MINI-CASE Auto Union Negotiations 446

13.5 Disadvantages of Moving First 447 The Holdup Problem 447 MINI-CASE Venezuelan Nationalization 448 MANAGERIAL IMPLICATION Avoiding

Holdups 449 Too-Early Product Innovation 450 MINI-CASE Advantages and

Disadvantages of Moving First 450 13.6 Behavioral Game Theory 451

Ultimatum Games 451 MINI-CASE GM’s Ultimatum 451 Levels of Reasoning 453 MANAGERIAL IMPLICATION Taking

Advantage of Limited Strategic Thinking 454 MANAGERIAL SOLUTION Intel and AMD’s

Advertising Strategies 454 Summary 455 ■  Questions 456

Appendix 13A A Mathematical Approach to Stackelberg Oligopoly 461

Chapter 14 Decision Making Under Uncertainty 462

MANAGERIAL PROBLEM BP’s Risk and Limited Liability 462

14.1 Assessing Risk 464 Probability 464 MINI-CASE Risk of a Cyberattack 465 Expected Value 466 Q&A 14.1 467 Variance and Standard Deviation 467 MANAGERIAL IMPLICATION Summarizing Risk 469

14.2 Attitudes Toward Risk 469 Expected Utility 469 Risk Aversion 470 Q&A 14.2 472

USING CALCULUS Diminishing Marginal Utility of Wealth 472

MINI-CASE Stocks’ Risk Premium 473 Risk Neutrality 473 Risk Preference 474 MINI-CASE Gambling 474 Risk Attitudes of Managers 476 Q&A 14.3 476

14.3 Reducing Risk 477 Obtaining Information 478 MINI-CASE Bond Ratings 478 Diversification 479 MANAGERIAL IMPLICATION Diversify Your

Savings 481 Insurance 482 Q&A 14.4 483 MINI-CASE Flooded by Insurance Claims 484

14.4 Investing Under Uncertainty 485 Risk-Neutral Investing 485 Risk-Averse Investing 486 Q&A 14.5 487 Oligopolistic R&D Investments Under

Uncertainty 487 14.5 Behavioral Economics and Uncertainty 488

Biased Assessment of Probabilities 488 MINI-CASE Biased Estimates 489 Violations of Expected Utility Theory 490 Prospect Theory 491 MANAGERIAL IMPLICATION Loss Aversion

Contracts 493 MANAGERIAL SOLUTION BP’s Risk and

Limited Liability 493 Summary 494 ■  Questions 495

Chapter 15 Asymmetric Information 500 MANAGERIAL PROBLEM Clawing Back

Bonuses 500 15.1 Adverse Selection 502

Adverse Selection in Insurance Markets 502 Products of Unknown Quality 503 Q&A 15.1 505 Q&A 15.2 506 MINI-CASE Reducing Consumers’ Information 506

15.2 Reducing Adverse Selection 507 Restricting Opportunistic Behavior 507 Equalizing Information 508 MANAGERIAL IMPLICATION Using Brand

Names and Warranties as Signals 509 MINI-CASE Discounts for Data 510 MINI-CASE Adverse Selection and

Remanufactured Goods 511 15.3 Moral Hazard 512

Moral Hazard in Insurance Markets 512 Moral Hazard in Principal-Agent

Relationships 513

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MINI-CASE Honest Cabbies? 513 The Owner-Manager Relationship 514 MINI-CASE Company Jets 514 Q&A 15.3 518

15.4 Using Contracts to Reduce Moral Hazard 519 Fixed-Fee Contracts 519 Contingent Contracts 520 Q&A 15.4 521 MINI-CASE Sing for Your Supper 523 Q&A 15.5 524

15.5 Using Monitoring to Reduce Moral Hazard 525 Hostages 526 MINI-CASE Capping Oil and Gas Bankruptcies 527 MANAGERIAL IMPLICATION Efficiency Wages 527 After-the-Fact Monitoring 528 MANAGERIAL SOLUTION Clawing Back Bonuses 528 Summary 529 ■  Questions 530

Chapter 16 Government and Business 536 MANAGERIAL PROBLEM Licensing Inventions 536

16.1 Market Failure and Government Policy 537 The Pareto Principle 537 Cost-Benefit Analysis 538

16.2 Regulation of Imperfectly Competitive Markets 539 Regulating to Correct a Market Failure 539 Q&A 16.1 541 MINI-CASE Natural Gas Regulation 543 Regulatory Capture 544 Applying the Cost-Benefit Principle

to Regulation 544 16.3 Antitrust Law and Competition Policy 545

Mergers 547 MINI-CASE Are Monopoly Mergers Harmful? 548 Q&A 16.2 548 Predatory Actions 549 Vertical Relationships 550 MINI-CASE Piping Up About Exclusive Dealing 551

16.4 Externalities 552 MANAGERIAL IMPLICATION Disney

Internalizes an Externality 552 The Inefficiency of Competition with

Externalities 553 Reducing Externalities 555 MINI-CASE Pulp and Paper Mill Pollution

and Regulation 557 Q&A 16.3 558 MINI-CASE Why Tax Drivers 559 The Coase Theorem 560 MANAGERIAL IMPLICATION Buying a Town 562

16.5 Open-Access, Club, and Public Goods 562 Open-Access Common Property 563 MINI-CASE Spam 564 Club Goods 565 MINI-CASE Piracy 565 Public Goods 565

16.6 Intellectual Property 568 Patents 568 Q&A 16.4 569 MANAGERIAL IMPLICATION Trade Secrets 570 Copyright Protection 571 MANAGERIAL SOLUTION Licensing Inventions 571 Summary 573 ■  Questions 574

Chapter 17 Global Business 579 MANAGERIAL PROBLEM Responding to

Exchange Rates 579 17.1 Reasons for International Trade 581

Comparative Advantage 581 Q&A 17.1 583 MANAGERIAL IMPLICATION Brian May’s

Comparative Advantage 584 Increasing Returns to Scale 584 MINI-CASE Barbie Doll Varieties 585

17.2 Exchange Rates 586 Determining the Exchange Rate 586 Exchange Rates and the Pattern of Trade 587 MANAGERIAL IMPLICATION Limiting

Arbitrage and Gray Markets 587 Managing Exchange Rate Risk 588

17.3 International Trade Policies 589 Quotas and Tariffs in Competitive Markets 589 MINI-CASE Russian Food Ban 591 Q&A 17.2 594 Rent Seeking 595 Noncompetitive Reasons for Trade Policy 596 MINI-CASE Protection of U.S. Steel,

Aluminum, and Washing Machines 598 Trade Liberalization and the World

Trading System 599 Trade Liberalization Problems 600

17.4 Multinational Enterprises 601 Becoming a Multinational 601 MINI-CASE What’s an American Car? 602 International Transfer Pricing 602 Q&A 17.3 604 MINI-CASE Profit Repatriation 606

17.5 Outsourcing 606 MANAGERIAL SOLUTION Responding

to Exchange Rates 608 Summary 609 ■  Questions 610

Answers to Selected Questions E-1

Definitions E-14

References E-19

Sources for Managerial Problems, Mini-Cases, and Managerial Implications E-27

Index E-38

Credits E-74

Contents

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Preface

What’s New in the Third Edition We have substantially revised the third edition based in large part on the very help- ful suggestions of instructors and students who used the second edition. We have updated and revised every chapter. Key revisions include:

 ● Spreadsheet-based Q&A Exercises are a new feature in Chapters 3, 6–10, and 12–16. This major innovation helps students learn how to address real-world busi- ness problems using spreadsheets, which is an increasingly important skill in today's business world.

 ● Chapters 1, 5, 6, 7, 9, and 14 have a new theme on disruptive innovations: innova- tions, such as online retailing, 3D printing, and social media, that dramatically change consumer options or the way an industry is structured, possibly creating new industries and destroying old ones.

 ● A new feature is the 21 Common Confusions, which explain why a widely held belief is incorrect.

 ● Over three-quarters of the Mini-Cases (brief applications of the theory) are new (22) or revised (48).

 ● Of the 655 end-of-chapter questions, 150 are new or revised.  ● Nearly a quarter of the Managerial Implications (brief discussions of how to

use economic theory to improve managerial decisions) are new or substantially revised.

 ● This edition is even more user-friendly. It drops some of the more technical mate- rial from Chapters 2, 4, 6, 7, 8, and 11, and adds more emphasis on current mana- gerial issues in both the main text and the features.

 ● Because instructors and students enjoyed the cartoons in the second edition, this edition has 45% more cartoons. In addition to providing entertainment, these cartoons convey important economic points in a memorable way.

The Managerial Economics Program This book differs from other managerial economics books in three main ways:

1. Modern Theories. We place greater emphasis than other texts on modern theories that are increasingly useful to managers. These include: • Modern contract theory to show students how to write contracts to avoid or

minimize problems • Behavioral economics to explain why people deviate from rational behavior

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• Game theory to help students think about business strategies and choose strate- gies that maximize profits

• Analysis of real-world pricing tools. 2. Real-world Examples. We make more extensive use of real-world business exam-

ples to illustrate how to use economic theory in making business decisions. To illustrate important economic concepts, we use calculations, graphs, and spread- sheets based on actual markets and real data.

3. Problem-based Learning. We employ a problem-based learning approach to dem- onstrate how to apply economic theory to specific business decisions. In each chapter, we solve problems using a step-by-step approach to model good problem- solving techniques, and each end of chapter section includes an extensive set of questions.

These innovative hallmarks are woven throughout the text. To improve student results, we recommend pairing the text content with MyLab

Economics, which is the teaching and learning platform that empowers instructors to reach every student. By combining trusted author content with digital tools and a flexible platform, MyLab personalizes the learning experience and will help students learn and retain key course concepts while developing skills that future employers are seeking in their candidates. MyLab Economics allows professors increased flex- ibility in designing and teaching their courses. Learn more at www.pearson.com/ mylab/economics.

Solving Teaching and Learning Challenges As teachers, we understand the challenges of managerial economics courses. Our experience teaching managerial economics at the Wharton School (University of Pennsylvania) and the Sauder School of Business (University of British Columbia) as well as teaching a wide variety of students at the Massachusetts Institute of Technol- ogy; Queen’s University; and the University of California, Berkeley, has convinced us that students do best with an emphasis on problem solving and real-world issues and examples from actual markets. In the features of the book and MyLab Economics, we show how to apply economic theory to managerial decisions using actual busi- ness examples and real data.

We demonstrate that economics is practical and useful to managers by examining real markets and actual business decisions. Successful managers make extensive use of economic tools to reduce the cost of production, to choose pricing structures or output levels to maximize profit, and to make many other managerial decisions. We highlight applications of these tools in the Managerial Problems, Mini-Cases, Managerial Implications, and Q&As throughout the book, and the videos in MyLab Economics.

Managerial Problems After the introductory chapter, each chapter starts with a Managerial Problem that motivates the chapter by posing a real-world managerial question. At the end of each chapter, we answer this question in the Managerial Solution using the economic

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principles discussed in that chapter. Thus, each Managerial Problem–Managerial Solution pair combines the essence of a Mini-Case and a Q&A.

Mini-Cases The Mini-Cases apply economic theory to interesting and important managerial prob- lems. For example, Mini-Cases demonstrate how price increases on iTunes affect music downloads using actual data, how to estimate Crocs’ production function for shoes using real-world data, why top-end designers limit the number of designer bags customers can buy, the effect of cyberattacks, how Pfizer used limit pricing to slow the entry of rivals, why advertisers pay so much for Super Bowl commercials, and how managers of auto manufacturing firms organize production and trade to avoid taxes and tariffs.

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Managerial Implications The Managerial Implications feature provides bottom-line statements of economic principles that managers can use to make key managerial decisions. For example, we describe how managers can assess whether they are maximizing profit. We also show how they can structure discounts to maximize profits, promote customer loy- alty, design auctions, prevent gray markets, and use important insights from game theory to make good managerial decisions.

Q&As and End-of-Chapter Questions The largest challenge facing students is learning how to apply economics concepts to solve problems. To help them learn this crucial skill, we provide three to five Q&As (Questions & Answers) in each chapter after the introductory chapter. Each Q&A poses a qualitative or quantitative problem and then uses a step-by-step approach to solve the problem. The Q&As focus on important managerial issues such as how a cost-minimizing firm should adjust to changing factor prices, how a manager prices bundles of goods to maximize profits, how to determine Intel’s and AMD’s profit- maximizing quantities and prices using their estimated demand curves and marginal costs, and how to allocate production across plants internationally.

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At the end of the book, we provide solutions to selected end-of-chapter questions. In addition, detailed answers to all the end-of-chapter questions are provided in MyLab Economics so that students can confirm their understanding without having to contact a professor and also be better prepared for exams.

MyLab Economics Videos Today's students learn best when they analyze and discuss topics in the text outside of class. To further students’ understanding of what they are reading and discussing in the classroom, we provide a set of videos in MyLab Economics. In these videos, Tony Lima presents key figures, tables, Excel applications and concepts in step-by- step animations with audio explanations that discuss the economics behind each step. For example, some of these show students how to use Excel to run regressions, analyze different pricing strategies, cover applications of game theory, address risk and diversification, and choose contracts that reduce moral hazard in principal-agent relationships.

Using Calculus Sections and Calculus Exercises Some students learn economics best using verbal or graphical explanations. How- ever, others find mathematical explanations clearer. Consequently, some managerial economics courses use calculus while others do not. Both types of course can use this book effectively due to the optional Using Calculus sections in the text. Non-calculus courses can omit these short sections with no loss of continuity. For courses that require calculus, Using Calculus sections reinforce the graphical, verbal, and algebraic treatment of major topics.

In contrast, many other books relegate calculus to appendices, mix calculus in with other material where it cannot easily be skipped, or avoid calculus entirely. Our approach has proven effective in courses that use no calculus and have very limited mathematical prerequisites, and in courses with significant calculus content. End- of-chapter questions that require calculus are clearly indicated.

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Developing Career Skills You may be asking yourself, why study economics if I want to manage a business or work as a consultant, as a financial analyst, as an investment banker, in human resources, or in marketing? The reason is that employers know that you need eco- nomic skills to perform well. To get a great job upon graduation and have a success- ful career, you need a range of economic skills and need to know how to apply these skills to solve traditional and new managerial challenges.

How to Use Economic Reasoning on the Job This book starts by illustrating how to use economic reasoning to analyze and solve a variety of problems. It trains you to use logical analysis based on empirical evidence. You will learn how to apply a variety of techniques that firms value such as how to work with spreadsheets to solve decision problems, conduct regression analyses and interpret the results, use game trees to map strategic decisions, and analyze the effects of pricing decisions.

The book shows you how to approach problems that you are likely to encoun- ter on the job. These applications include using basic economic tools to predict the effects of input price changes or government actions on a market. But they also include using modern economic theories to address new managerial challenges such as

 ● developing strategies to compete in oligopolistic markets,  ● structuring stock options to motivate executives,  ● using online platforms (two-sided markets) that bring buyers and sellers together,

such as eBay,  ● responding to cyberattacks and to potentially disruptive innovations such as 3D

printing.

Spreadsheet Exercises In contrast to other managerial economics textbooks, a major feature of this book helps you develop a facility in using spreadsheets and shows how to use them to solve real-world managerial problems.

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Managers increasingly rely on spreadsheets. Spreadsheets make it easier than ever to apply economic principles to managerial decisions. Earlier editions of this book included spreadsheet-based end-of-chapter questions. In this edition, we've added 11 spreadsheet Q&As, which train you by taking you step-by-step through spread- sheets to solve a managerial problem. These Q&As show how to use spreadsheets to calculate elasticities, determine the effect of price changes on revenue and profit, calculate present values, assess the benefits of dynamic pricing, simplify decision- making under uncertainty, and analyze other important questions.

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In addition to these Q&As, each chapter except the first has three end-of-chapter spreadsheet exercises addressing topics such as choosing the profit-maximizing level of advertising and designing compensation contracts to motivate employees. All spreadsheet exercises are available in MyLab Economics as static exercises, and select exercises (marked with an in the text) are available in an auto-graded for- mat. Using proven, field-tested technology, auto-graded Excel Projects let profes- sors seamlessly integrate Microsoft® Excel® content into the course without having to manually grade spreadsheets. Students can practice important skills in Excel, helping you master key concepts and gain proficiency with the program. Simply download a spreadsheet, work live on a problem in Excel, and then upload that file back to MyLab Economics. Within minutes, you will receive a report that provides personalized, detailed feedback and, if necessary, pinpoints where you went astray in the problem. This feedback helps nurture your understanding of the key topics in the course while building confidence in your Excel skills, preparing you for success in class and in your career.

Table of Contents Overview Because instructors differ in the order in which they cover material and in the range of topics they choose to teach, this text allows for flexibility. The most common approach to teaching managerial economics is to follow the sequence of the chapters in order. However, many variations are possible. For example, some instructors choose to address empirical methods (Chapter 3) first.

Instructors may skip consumer theory (Chapter 4) without causing problems in later chapters. Or, they may cover consumer theory after the chapters on production and cost (Chapters 5 and 6).

Chapter 7, “Firm Organization and Market Structure,” provides an overview of the key issues that are discussed in later chapters, such as types of firms, profit

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maximization and its alternatives, and the structure of markets. We think that pre- senting this material early in the course is ideal, but an instructor can cover all of this material except for the section on profit maximization later.

An instructor may teach pricing with market power (Chapter 10) at any point after discussing monopoly (Chapter 9). Because game theory is introduced in two chap- ters (Chapters 12 and 13), instructors can conveniently choose how much game theory to present. Although Chapter 11 on oligopoly and monopolistic competition precedes the game theory chapters, a course could cover the game theory chapters first.

A common variant is to present Chapter 14 on uncertainty earlier in the course. A course could present asymmetric information (Chapter 15) at any point after the uncertainty chapter. Thus, a course could cover both the uncertainty and informa- tion chapters early.

Chapter 16 on government and business discusses market failures, government regulation, externalities, public goods, and intellectual property. A course could cover this material earlier. For example, the regulation and intellectual property material could follow monopoly. The externality and public good treatment could be presented at any point after Chapter 8 on competitive firms and markets.

The final chapter, Global Business (Chapter 17), is valuable in a course that stresses international issues. An instructor could cover this chapter at any point after the competition and monopoly chapters.

Instructor Teaching Resources This book has a full range of supplementary materials that support teaching and learning. This program comes with the following teaching resources:

Supplements available to instructors at www.pearsonhighered.com Features of the Supplement

Instructor’s Manual Authored by Matt Roelofs of Western Washington University

• Chapter Outlines include key terminology, teaching notes, and lecture suggestions.

• Teaching Tips and Additional Discussion Questions provide tips for alter- native ways to cover the material and brief reminders on additional help to provide students.

• Solutions are provided for all problems in the book.

Test Bank Authored by Todd Fitch of the University of California, Berkeley

• Multiple-choice problems of varying levels of complexity, suitable for homework assignments and exams

• Many of these draw on current news and events

Computerized TestGen TestGen allows instructors to: • Customize, save, and generate classroom tests • Edit, add, or delete questions from the Test Item Files • Analyze test results • Organize a database of tests and student results.

PowerPoints Authored by Nelson Altamirano of National University

• Slides include all the graphs, tables, and equations in the textbook, as well as lecture notes.

• PowerPoints meet accessibility standards for students with disabilities. Features include, but not limited to: • Keyboard and Screen Reader access • Alternative text for images • High color contrast between background and foreground colors

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xxii Preface

Acknowledgments Our greatest debt is to our very patient students at MIT; the University of British Columbia; the University of California, Berkeley; and the University of Pennsylvania for tolerantly dealing with our various approaches to teaching them economics. We appreciate their many helpful (and usually polite) suggestions.

We also owe a great debt to our editors for the first edition, Adrienne D’Ambrosio and Jane Tufts. Adrienne D’Ambrosio, Editorial Director, was involved in every stage in designing the book, writing the book, testing it, and developing supplemental materials. Jane Tufts, our developmental editor, reviewed each chapter of this book for content, pedagogy, and presentation. By showing us how to present the material as clearly and thoroughly as possible, she greatly strengthened this text. For the sec- ond edition, we thank Christina Masturzo for guiding us as our Portfolio Manager on the print and digital resources.

We are also grateful to Satyajit Ghosh, University of Scranton, for doing most of the work on the end-of-chapter spreadsheet exercises in the first two editions and in MyLab Economics. We benefitted greatly from his creative ideas about using spreadsheets to teach managerial economics. Our other major debt is to Tony Lima for his outstanding work creating MyLab Economics videos and for valuable com- ments on the text.

We thank our teaching colleagues who provided many helpful comments and from whom we have shamelessly borrowed ideas. We particularly thank Tom Davidoff, Isaac Holloway, Stephen Meyer, Nate Schiff, Ratna Shrestha, Mariano Tappata, James Vercammen, and Lanny Zrill for using earlier versions of the textbook and for mak- ing a wide range of helpful contributions. We are also grateful to our colleagues Jen Baggs, Michael Brar, Dennis Carlton, Jean-Etienne de Bettignies, Keith Head, Larry Karp, John Ries, Juliana Rogo, Tom Ross, Leo Simon, Scott Templeton, Chloe Tergiman, and Ralph Winter for many helpful comments. We thank Sophie Endl, Evan Flater, Kai Rong Gan, Albina Gibadullina, Guojun He, Joyce Lam, WeiYi Shen, Yihang Xu, Louisa Yeung, and Maddison Zapach for their valuable work as research assistants on the book.

We are very grateful to the many reviewers who spent untold hours reading and commenting on our original proposal and several versions of each chapter. Many of the best ideas in this book are due to them.

We’d especially like to thank Matthew Roelofs for carefully reviewing the accu- racy of the entire manuscript for the first two editions and for many contributions to the end-of-chapter questions in this edition, along with other helpful comments. We also thank Gordon Lenjosek for checking the accuracy of this edition and sug- gesting useful changes.

We also thank the following reviewers and others, who provided valuable com- ments at various stages:

Laurel Adams, Northern Illinois University

James C. W. Ahiakpor, California State University, East Bay

Nelson Altamirano, National University

Ariel Belasen, Southern Illinois University, Edwardsville

Bruce C. Brown, California State Polytechnic University, Pomona

Donald Bumpass, Sam Houston State University

James H. Cardon, Brigham Young University

Jihui Chen, Illinois State University

Ron Cheung, Oberlin College

Abdur Chowdhury, Marquette University

George Clarke, Texas A&M International University

Kristen Collett-Schmitt, Notre Dame University

Douglas Davis, Virginia Commonwealth University

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xxiiiPreface

Christopher S. Decker, University of Nebraska, Omaha

Craig A. Depken, II, University of North Carolina, Charlotte

Jed DeVaro, California State University, East Bay

Casey DiRienzo, Elon University

David Ely, San Diego State University

Asim Erdilek, Case Western Reserve University

John Fizel, Penn State University

Satyajit Ghosh, University of Scranton

Rajeev Goel, Illinois State University

Abbas P. Grammy, California State University, Bakersfield

Clifford Hawley, West Virginia University

Cary Heath, University of Louisiana

Matthew John Higgins, Georgia Institute of Technology

Jack Hou, California State University, Long Beach

Andrew Hussey, University of Memphis

Timothy James, Arizona State University

Charles Johnston, Baker College

Michael Jones, University of Cincinnati

Peter Daniel Jubinski, St. Joseph’s University

Chulho Jung, Ohio University

David E. Kalist, Shippensburg University

Barry Keating, University of Notre Dame

Daniel Lee, Shippensburg University

Tom K. Lee, California State University, Northridge

Dale Lehman, Alaska Pacific University

Tony Lima, California State University, East Bay

Albert Loh, University of North Florida

Vincent J. Marra Jr., University of Delaware

Scott McGann,. San Diego State University

Sheila J. Moore, California Lutheran University

Thomas Patrick, The College of New Jersey

Anita Alves Pena, Colorado State University

Troy Quast, Sam Houston State University

Jack Reardon,. Hamline University

Barry Ritchey, Anderson University

Matthew Roelofs, Western Washington University

Charles Sebuharara, Binghampton University

Amit Sen, Xavier University

Stephanie Shayne, Husson University

Maura Shelton, University of Washington

Nancy Sowers, Berea College

Caroline Swartz, University of North Carolina, Charlotte

Scott Templeton, Clemson University

Xiahua (Ken) Wei, University of Washington

Keith Willett, Oklahoma State University

Douglas Wills, University of Washington, Tacoma

Mark L. Wilson, Troy University

David Wong, California State University, Fullerton

It was a pleasure to work with the highly skilled people at Pearson and Pearson CSC, who were incredibly helpful in producing this book. Carolyn Philips, Kathy Smith, and Nicole Suddeth did a wonderful job of supervising the production process, assembling the extended publishing team, and managing the schedule. We also want to acknowl- edge, with appreciation, the efforts of Melissa Honig, Courtney Kamauf, and Noel Lotz, in developing the MyLab Economics online assessment and tutorial system for the book.

Finally, we thank our wives, Jackie Persons and Barbara Spencer, for their great patience and support during the nearly endless writing process. We apologize for misusing their names—and those of our other relatives and friends—in the book!

J. M. P. J. A. B.

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1

If all the food, clothing, entertainment, and other goods and services we wanted were freely available, no one would study economics, and we would not need managers. However, most of the good things in life are scarce. We cannot have everything we want. Consumers cannot consume everything but must make choices about what to purchase. Similarly, managers of firms cannot produce everything and must make careful choices about what to produce, how much to produce, and how to produce it. Studying such choices is the main subject matter of economics. Eco- nomics is the study of decision making in the presence of scarcity.1

Managerial economics is the application of economic analysis to managerial deci- sion making. It focuses on how managers make economic decisions by allocating the scarce resources at their disposal. To make good decisions, a manager must under- stand the behavior of other decision makers, such as consumers, workers, other managers, and governments. In this book, we examine decision making by such participants in the economy, and we show how managers can use this understand- ing to be successful.

1Many dictionaries define economics as the study of the production, distribution, and consump- tion of goods and services. However, professional economists think of economics as applying more broadly, including any decisions made subject to scarcity.

1Introduction An Economist’s Theory of Reincarnation: If you’re good, you come back on a higher level. Cats come back as dogs, dogs come back as horses, and people— if they’ve been very good like George Washington—come back as money.

Learning Objectives

1. Describe the major business decisions managers face.

2. Explain how economic models are useful in managerial decision making.

3. Illustrate how a knowledge of economics can help your career.

1.1 Managerial Decision Making A firm’s managers allocate the limited resources available to them to achieve the firm’s objectives. The objectives vary for different managers within a firm but each managerial task is constrained by resource scarcity. At any moment in time, a pro- duction manager has to use the existing factory and a marketing manager has a limited marketing budget. Such resource limitations can change over time, but man- agers always face constraints.

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2 CHAPTER 1 Introduction

Profit The main objective of most private-sector firms is to maximize profit, which is the difference between revenue and cost. Senior managers of a firm might have other concerns as well, including social responsibility and personal career objectives. How- ever, the primary responsibility of senior managers to the owners of the firm is to focus on the bottom line: maximizing profit.

Managers have a variety of roles in the profit maximization process. The produc- tion manager seeks to minimize the cost of producing a particular good or service. The market research manager determines how many units of any particular product can be sold at a given price, which helps to determine how much output to produce and what price to charge. The research and development (R&D) manager supervises the development of new products that will be attractive to consumers. The most senior manager, usually called the chief executive officer (CEO), coordinates the firm’s managerial functions and sets its overall strategy.

Trade-Offs People and firms face trade-offs because they can’t have everything. Managers must focus on the trade-offs that directly or indirectly affect profits. Evaluating trade- offs often involves marginal reasoning: considering the effect of a small change. Key trade-offs include:

●● How to produce: To produce a given level of output, a firm trades off inputs, deciding whether to use more of one and less of another. Car manufacturers choose between metal and plastic for many parts, which affects the car’s weight, cost, and safety.

●● What prices to charge: Some firms, such as farms, have little or no control over the prices at which their goods are sold and must sell at the price determined in the market. However, many other firms set their prices. When a manager of such a firm sets the price of a product, the manager must consider whether raising the price by a dollar increases the profit margin on each unit sold by enough to offset the loss from selling fewer units. Consumers, given their limited budgets, buy fewer units of a product when its price rises. Thus, ultimately, the man- ager’s pricing decision is constrained by the scarcity under which consumers make decisions.

●● Whether to innovate: One of the major trade-offs facing managers is whether to maximize profit in the short run or in the long run. For example, a forward- looking firm may invest substantially in innovation—designing new products and better production methods—which lowers profit in the short run, but may raise profit in the long run.

Other Decision Makers It is important for managers of a firm to understand how the decisions made by consumers, workers, managers of other firms, and governments constrain their