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THE ECONOMICS OF MANAGERIAL DECISIONS

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THE ECONOMICS OF MANAGERIAL DECISIONS

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THE ECONOMICS OF MANAGERIAL DECISIONS

ROGER D. BLAIR University of Florida

MARK RUSH University of Florida

New York, NY

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Ayan
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For Chau, our kids and our grandkids Roger D. Blair

For Sue’s memory and our kids Mark B. Rush

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Roger D. Blair is the Walter J. Matherly Professor and chair of economics at the University of Florida. He has been a visiting professor at the University of Hawaii and the University of California–Berkeley as well as Visiting Scholar in Residence, Center for the Study of American Business, Washington University. Professor Blair’s research centers on antitrust economics and policy. He has published 10 books and 200 journal articles. He has also served as an antitrust consultant to numerous corpo- rations, including Intel, Anheuser-Busch, TracFone, Blue Cross–Blue Shield, Waste Management, Astellas Pharma, and many others.

Mark Rush is a professor of economics at the University of Florida. Prior to teach- ing at Florida, he was an assistant professor of economics at the University of Pittsburgh. He has spent eight months at the Kansas City Federal Reserve Bank as a Visiting Scholar. Professor Rush has taught MBA classes for many years and has won teaching awards for his classes. He has published in numerous professional journals, including the Journal of Political Economy; the Journal of Monetary Economics; the Journal of Money, Credit, and Banking; the Journal of International Money and Finance; and the Journal of Labor Economics.

ABOUT THE AUTHORS

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PART 1 ECONOMIC FOUNDATIONS

1 Managerial Economics and Decision Making 1 2 Demand and Supply 33 3 Measuring and Using Demand 86

PART 2 MARKET STRUCTURE AND MANAGERIAL DECISIONS

4 Production and Costs 138 5 Perfect Competition 186 6 Monopoly and Monopolistic Competition 227 7 Cartels and Oligopoly 274 8 Game Theory and Oligopoly 318 9 A Manager’s Guide to Antitrust Policy 371

PART 3 MANAGERIAL DECISIONS

10 Advanced Pricing Decisions 414 11 Decisions About Vertical Integration

and Distribution 465

12 Decisions About Production, Products, and Location 499

13 Marketing Decisions: Advertising and Promotion 541 14 Business Decisions Under Uncertainty 587 15 Managerial Decisions About Information 635 16 Using Present Value to Make Multiperiod

Managerial Decisions 677

Content on the Web:

Appendix: The Business Plan Chapter: Franchising Decisions

BRIEF CONTENTS

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viii

CONTENTS

1 Managerial Economics and Decision Making 1 Managers at Sears Holdings Use Opportunity Cost to Make Tough Decisions 1

Introduction 1

1.1 Managerial Economics and Your Career 2

1.2 Firms and Their Organizational Structure 3 Definition of a Firm 3 The Legal Organization of Firms 3

1.3 Profit, Accounting Cost, and Opportunity Cost 6 Goal: Profit Maximization 6 Total Revenue 7 Accounting Cost and Opportunity Cost 8

DECISION SNAPSHOT Sunk Costs in the Stock Market 11

DECISION SNAPSHOT Opportunity Cost at Singing the Blues Blueberry Farm 13

Comparing Accounting Cost and Opportunity Cost 15 Using Opportunity Cost to Make Decisions 17

SOLVED PROBLEM Resting Energy’s Opportunity Cost 17

1.4 Marginal Analysis 18 The Marginal Analysis Rule 18 Using Marginal Analysis 19

SOLVED PROBLEM How to Respond Profitably to Changes in Marginal Cost 20

Revisiting How Managers at Sears Holdings Used Opportunity Cost to Make Tough Decisions 21

Summary: The Bottom Line 22

Key Terms and Concepts 23

Questions and Problems 23

MyLab Economics Auto-Graded Excel Projects 25

APPENDIX The Calculus of Marginal Analysis 28 A. Review of Mathematical Results 28 B. Marginal Benefit and Marginal Cost 29 C. Maximizing Total Surplus 29 D. Maximizing Total Surplus: Example 30

Calculus Questions and Problems 31

PART 1 ECONOMIC FOUNDATIONS

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Contents ix

2 Demand and Supply 33 Managers at Red Lobster Cope with Early Mortality Syndrome 33

Introduction 33 2.1 Demand 34

Law of Demand 34 Demand Curve 35 Factors That Change Demand 37

DECISION SNAPSHOT Demand for the Cadillac Escalade 41

Changes in Demand: Demand Function 41

SOLVED PROBLEM Demand for Lobster Dinners 43

2.2 Supply 44 Law of Supply 44 Supply Curve 44 Factors That Change Supply 46 Changes in Supply: Supply Function 49

SOLVED PROBLEM The Supply of Gasoline-Powered Cars and the Price of Hybrid Cars 50

2.3 Market Equilibrium 51 Equilibrium Price and Equilibrium Quantity 51 Demand and Supply Functions: Equilibrium 53

SOLVED PROBLEM Equilibrium Price and Quantity of Plush Toys 54

2.4 Competition and Society 54 Total Surplus 54 Consumer Surplus 58 Producer Surplus 59

SOLVED PROBLEM Total Surplus, Consumer Surplus, and Producer Surplus in the Webcam Market 60

2.5 Changes in Market Equilibrium 61 Use of the Demand and Supply Model When One Curve Shifts: Demand 61 Use of the Demand and Supply Model When One Curve Shifts: Supply 63 Use of the Demand and Supply Model When Both Curves Shift 64 Demand and Supply Functions: Changes in Market Equilibrium 68

SOLVED PROBLEM Demand and Supply for Tablets Both Change 70

2.6 Price Controls 70 Price Ceiling 70 Price Floor 72

SOLVED PROBLEM The Effectiveness of a Minimum Wage 74

2.7 Using the Demand and Supply Model 75 Predicting Your Costs 75 Predicting Your Price 76

Revisiting How Managers at Red Lobster Coped with Early Mortality Syndrome 78

Summary: The Bottom Line 78

Key Terms and Concepts 79

Questions and Problems 80

MyLab Economics Auto-Graded Excel Projects 83

MANAGERIAL APPLICATION

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x Contents

3 Measuring and Using Demand 86 Managers at the Gates Foundation Decide to Subsidize Antimalarial Drugs 86

Introduction 87

3.1 Regression: Estimating Demand 87 The Basics of Regression Analysis 88 Regression Analysis 89 Regression Results: Estimated Coefficients and Estimated Demand Curve 92

SOLVED PROBLEM Regression Analysis at Your Steak Chain 94

3.2 Interpreting the Results of Regression Analysis 94 Estimated Coefficients 94 Fit of the Regression 99

SOLVED PROBLEM Confidence Intervals and Predictions for the Demand for Doors 100

3.3 Limitations of Regression Analysis 101 Specification of the Regression Equation 101 Functional Form of the Regression Equation 102

SOLVED PROBLEM Which Regression to Use? 104

3.4 Elasticity 105 The Price Elasticity of Demand 105

DECISION SNAPSHOT Advertising and the Price Elasticity of Demand 117

Income Elasticity and Cross-Price Elasticity of Demand 117

SOLVED PROBLEM The Price Elasticity of Demand for a Touch-Screen Smartphone 119

3.5 Regression Analysis and Elasticity 120 Using Regression Analysis 120 Using the Price Elasticity of Demand 122 Using the Income Elasticity of Demand Through the Business Cycle 122

Revisiting How Managers at the Gates Foundation Decided to Subsidize Antimalarial Drugs 123

Summary: The Bottom Line 123

Key Terms and Concepts 124

Questions and Problems 124

MyLab Economics Auto-Graded Excel Projects 128

CASE STUDY Decision Making Using Regression 130

APPENDIX The Calculus of Elasticity 133 A. Price Elasticity of Demand for a Linear and a Log-Linear Demand Function 133 B. Total Revenue Test 134 C. Income Elasticity of Demand and Cross-Price Elasticity of Demand 135

Calculus Questions and Problems 136

MANAGERIAL APPLICATION

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Contents xi

4 Production and Costs 138 Pizza Hut Managers Learn That Size Matters 138

Introduction 138 4.1 Production 139

Production Function 139 Short-Run Production Function 141 Long-Run Production Function 145

SOLVED PROBLEM Marginal Product of Labor at a Bicycle Courier Service 147

4.2 Cost Minimization 147 Cost-Minimization Rule 148 Generalizing the Cost-Minimization Rule 149

SOLVED PROBLEM Cost Minimization at a Construction Firm 150

4.3 Short-Run Cost 150 Fixed Cost, Variable Cost, and Total Cost 151 Average Fixed Cost, Average Variable Cost, and Average Total Cost 152 Marginal Cost 153

DECISION SNAPSHOT Input Price Changes and Changes in the Marginal Cost of an Eiffel Tower Tour 154

Competitive Return 156 Shifts in Cost Curves 157

DECISION SNAPSHOT Changes in Input Prices and Cost Changes at Shagang Group 159

SOLVED PROBLEM Calculating Different Costs at a Caribbean Restaurant 161

4.4 Long-Run Cost 162 Long-Run Average Cost 162 Economies of Scale, Constant Returns to Scale, and Diseconomies of Scale 166

SOLVED PROBLEM Long-Run Average Cost 169

4.5 Using Production and Cost Theory 170 Effects of a Change in the Price of an Input 170 Economies and Diseconomies of Scale 171

Revisiting How Pizza Hut Managers Learned That Size Matters 173

Summary: The Bottom Line 174

Key Terms and Concepts 174

Questions and Problems 175

MyLab Economics Auto-Graded Excel Projects 178

APPENDIX The Calculus of Cost 179 A. Marginal Product 179 B. Cost Minimization 180 C. Marginal Cost and the Marginal/Average Relationship 183

Calculus Questions and Problems 184

MANAGERIAL APPLICATION

PART 2 MARKET STRUCTURE AND MANAGERIAL DECISIONS

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xii Contents

5 Perfect Competition 186 Burger King Managers Decide to Let Chickens Have It Their Way 186

Introduction 186

5.1 Characteristics of Competitive Markets 187 Defining Characteristics of Perfect Competition 188 Perfectly Competitive Markets 189

SOLVED PROBLEM The Markets for Fencing and Cell Phones 190

5.2 Short-Run Profit Maximization in Competitive Markets 191 Marginal Analysis 191 Using Marginal Analysis to Maximize Profit 194

DECISION SNAPSHOT Marginal Analysis at the American Cancer Society 196

Changes in Costs 196 Amount of Profit 197 Shutting Down 201

DECISION SNAPSHOT Lundberg Family Farms Responds to a Fall in the Price of Rice 203

The Firm’s Short-Run Supply Curve 204

DECISION SNAPSHOT A Particleboard Firm Responds to a Fall in the Price of an Input 205

The Short-Run Market Supply Curve 206

SOLVED PROBLEM Amount of Profit and Shutting Down at a Plywood Producer 207

5.3 Long-Run Profit Maximization in Competitive Markets 208 Long-Run Effects of an Increase in Market Demand 208 Change in Technology 212

SOLVED PROBLEM The Long Run at a Plywood Producer 214

5.4 Perfect Competition 215 Applying Marginal Analysis 215 Optimal Long-Run Adjustments 215

Revisiting How Burger King Managers Decided to Let Chickens Have It Their Way 217

Summary: The Bottom Line 218

Key Terms and Concepts 218

Questions and Problems 219

MyLab Economics Auto-Graded Excel Projects 222

APPENDIX The Calculus of Profit Maximization for Perfectly Competitive Firms 224 A. Marginal Revenue 224 B. Maximizing Profit 224 C. Maximizing Profit: Example 224

Calculus Questions and Problems 226

MANAGERIAL APPLICATION

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6 Monopoly and Monopolistic Competition 227 Premature Rejoicing by the Managers at KV Pharmaceutical 227

Introduction 228

6.1 A Monopoly Market 228 Defining Characteristics of a Monopoly Market 228 Demand and Marginal Revenue for a Monopoly 229

DECISION SNAPSHOT Is Delta Airlines a Monopoly? 229

SOLVED PROBLEM The Relationship Among the Price Elasticity of Demand, Marginal Revenue, and Price 233

6.2 Monopoly Profit Maximization 234 Profit Maximization for a Monopoly 234

DECISION SNAPSHOT Profit-Maximizing Range of Prices for Tires 237

Comparing Perfect Competition and Monopoly 239 Barriers to Entry 241

SOLVED PROBLEM Merck’s Profit-Maximizing Price, Quantity, and Economic Profit 247

6.3 Dominant Firm 247 Dominant Firm’s Profit Maximization 248

DECISION SNAPSHOT How a Technology Firm Responds to Changes in the Competitive Fringe 251

SOLVED PROBLEM The Demand for Shoes at a Dominant Firm 252

6.4 Monopolistic Competition 252 Defining Characteristics of Monopolistic Competition 253 Short-Run Profit Maximization for a Monopolistically Competitive Firm 253 Long-Run Equilibrium for a Monopolistically Competitive Firm 255

SOLVED PROBLEM J-Phone’s Camera Phone 256

6.5 The Monopoly, Dominant Firm, and Monopolistic Competition Models 257 Using the Models in Managerial Decision Making 257 Applying the Monopolistic Competition Model 259

Revisiting Premature Rejoicing by the Managers at KV Pharmaceutical 261

Summary: The Bottom Line 261

Key Terms and Concepts 262

Questions and Problems 262

MyLab Economics Auto-Graded Excel Projects 268

APPENDIX The Calculus of Profit Maximization for Firms with Market Power 269 A. Marginal Revenue Curve 269 B. Elasticity, Price, and Marginal Revenue 269 C. Maximizing Profit 270 D. Maximizing Profit: Example 271

Calculus Questions and Problems 272

MANAGERIAL APPLICATION

Contents xiii

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xiv Contents

7 Cartels and Oligopoly 274 Managers at Major Publishers Read the e-Writing on the e-Wall 274

Introduction 274

7.1 Cartels 275 Cartel Profit Maximization 276 Instability of a Cartel 277

SOLVED PROBLEM Potential Profit from a Cellular Telephone Cartel 280

7.2 Tacit Collusion 280 Price Visibility 281

DECISION SNAPSHOT A Contract in the Market for Propane 282

Preannouncements 283 Precommitments 283 Price Leadership 284

SOLVED PROBLEM Price Leadership in the Market for Insulin 284

7.3 Four Types of Oligopolies 285 Cournot Oligopoly 285

DECISION SNAPSHOT South Africa’s Impala Platinum as a Cournot Oligopolist 293

Chamberlin Oligopoly 294 Stackelberg Oligopoly 296 Bertrand Oligopoly 297 Comparing Oligopoly Models 298

SOLVED PROBLEM Coca-Cola Reacts to PepsiCo 299

7.4 Cartels and Oligopoly 300 Using Cartel Theory and Tacit Collusion for Managerial Decision Making 301 Using Types of Oligopolies for Managerial Decision Making 301

Revisiting How Managers at Major Publishers Read the e-Writing on the e-Wall 302

Summary: The Bottom Line 303

Key Terms and Concepts 303

Questions and Problems 304

MyLab Economics Auto-Graded Excel Projects 307

APPENDIX The Calculus of Oligopoly 309 A. Cournot Oligopoly 309 B. Stackelberg Oligopoly 315

Calculus Questions and Problems 316

MANAGERIAL APPLICATION

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8 Game Theory and Oligopoly 318 Managers at Pfizer Welcome a Competitor in the Market for Lipitor 318

Introduction 318

8.1 Basic Game Theory and Games 319 Elements of a Game 320 A Sample Game 320 Nash Equilibrium 322 A Dilemma 323

DECISION SNAPSHOT An Advertising Game 324

Repeated Games 325

DECISION SNAPSHOT TragoCo and Boca-Cola Play a Repeated Game 327

Dominated Strategies 330

SOLVED PROBLEM Games Between Two Smartphone Producers 332

8.2 Advanced Games 334 Multiple Nash Equilibria 334 Mixed-Strategy Nash Equilibrium 337

SOLVED PROBLEM Custom’s Flower of the Day 343

8.3 Sequential Games 344 An Entry Game 344

DECISION SNAPSHOT Game Tree Between Disney and Warner Brothers 347

Commitment and Credibility 348

SOLVED PROBLEM A Pharmaceutical Company Uses Game Theory to Make an Offer 352

8.4 Game Theory 354 Using Basic Games for Managerial Decision Making 354 Using Advanced Games for Managerial Decision Making 356 Using Sequential Games for Managerial Decision Making 357

SOLVED PROBLEM Is a Threat Credible? 359

Revisiting How Managers at Pfizer Welcomed a Competitor in the Market for Lipitor 360

Summary: The Bottom Line 361

Key Terms and Concepts 362

Questions and Problems 362

MyLab Economics Auto-Graded Excel Projects 368

MANAGERIAL APPLICATION

Contents xv

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xvi Contents

9 A Manager’s Guide to Antitrust Policy 371 The Managers of Sea Star Line Walk the Plank 371

Introduction 372

9.1 Overview of U.S. Antitrust Policy 372 The Monopoly Problem 372 The Sherman Act, 1890 374 The Clayton Act, 1914 374 The Federal Trade Commission Act, 1914 375 Sanctions for Antitrust Violations 375 Recent Antitrust Cases 377

SOLVED PROBLEM A Perfectly Competitive Market Versus a Monopoly Market 378

9.2 The Sherman Act 379 Sherman Act Section 1: Restraint of Trade 379 Sherman Act Section 2: Monopolization and Attempt to Monopolize 383

SOLVED PROBLEM Going, Going, Gone: Price Fixing in the Market for Fine Art 387

9.3 The Clayton Act 388 Clayton Act Section 2: Price Discrimination 388 Clayton Act Section 3: Conditional Sales 388 Clayton Act Section 7: Mergers 391

SOLVED PROBLEM The Business Practices Covered in the Clayton Act 392

9.4 U.S. Merger Policy 392 Economic Effects of Horizontal Mergers 393 Antitrust Merger Policy 394

DECISION SNAPSHOT The XM/Sirius Satellite Radio Merger 396

SOLVED PROBLEM Mergers in the Office-Supply Market 397

9.5 International Competition Laws 398 European Union Laws 398 Chinese Laws 400 Worldwide Competition Laws 401

SOLVED PROBLEM Gazprom Gas Prices Create Indigestion in the European Union 402

9.6 Antitrust Policy 402 Using the Sherman Act and the Clayton Act 402 Using International Competition Laws 403 Antitrust Advice for Managers 403

Revisiting How the Managers of Sea Star Line Walked the Plank 404

Summary: The Bottom Line 405

Key Terms and Concepts 405

Questions and Problems 406

MyLab Economics Auto-Graded Excel Projects 410

CASE STUDY Student Athletes and the NCAA 412

MANAGERIAL APPLICATION

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10 Advanced Pricing Decisions 414 Managers at the Turtle Bay Resort Think Kama’aina Pricing Is Par for the Course 414

Introduction 414

10.1 Price Discrimination 416 First-Degree Price Discrimination 416 Second-Degree Price Discrimination 418 Third-Degree Price Discrimination 419

DECISION SNAPSHOT American Airlines Identifies a Customer Type 425

SOLVED PROBLEM Price Discrimination at Warner Brothers: That’s All, Folks! 426

10.2 Peak-Load Pricing 427 Long-Run Capacity Decision 428 Short-Run Pricing and Quantity Decisions 429

DECISION SNAPSHOT Peak-Load Pricing by the Minneapolis–St. Paul Metropolitan Airport 432

SOLVED PROBLEM Peak-Load Pricing 433

10.3 Nonlinear Pricing 434 Two-Part Pricing 434 All-or-Nothing Offers 440

DECISION SNAPSHOT Nonlinear Pricing at the 55 Bar 443

Commodity Bundling 443

SOLVED PROBLEM Movie Magic 446

10.4 Using Advanced Pricing Decisions 447 Managerial Use of Price Discrimination 447 Managerial Use of Peak-Load Pricing 448 Managerial Use of Nonlinear Pricing 449

Revisiting How the Managers at Turtle Bay Resort Came to Think Kama’aina Pricing Is Par for the Course 450

Summary: The Bottom Line 451

Key Terms and Concepts 451

Questions and Problems 451

MyLab Economics Auto-Graded Excel Projects 456

APPENDIX The Calculus of Advanced Pricing Decisions 458 A. Third-Degree Price Discrimination 458 B. Two-Part Pricing 459

Calculus Questions and Problems 463

MANAGERIAL APPLICATION

PART 3 MANAGERIAL DECISIONS

Contents xvii

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xviii Contents

12 Decisions About Production, Products, and Location 499 Managers at Freeport-McMoRan Dig Deep to Make a Decision 499

Introduction 500

12.1 Joint Production 500 Fixed Proportions 501 Variable Proportions 502

SOLVED PROBLEM A Refinery Responds to an Increase in the Profit from Gasoline 506

11 Decisions About Vertical Integration and Distribution 465 Why Would Walgreens Boots Alliance Purchase Wholesaler AmerisourceBergen? 465

Introduction 465

11.1 The Basics of Vertical Integration 467 Markets Versus Vertical Integration 467 Types of Vertical Integration 468 Transfer Prices and Taxes 469

SOLVED PROBLEM Vertical Integration 470

11.2 The Economics of Vertical Integration 471 Synergies 471 Costs of Using a Market: Transaction Costs, the Holdup Problem, and Technological Interdependencies 471

DECISION SNAPSHOT PepsiCo Reduces Transaction Costs 473

Costs of Using Vertical Integration 476

DECISION SNAPSHOT Pilgrim’s Pride and the Limits of Vertical Integration 477

SOLVED PROBLEM IBM Avoids a Holdup Problem 478

11.3 Vertical Integration and Market Structure 478 Vertical Integration with Competitive Distributors 479 Vertical Integration with a Monopoly Distributor 483

SOLVED PROBLEM Price and Quantity with Competitive Distributors and a Monopoly Distributor 488

11.4 Vertical Integration and Distribution 489 Using the Economics of Vertical Integration for Managerial Decision Making 489 Using Vertical Integration and Market Structure for Managerial Decision Making Within a Firm 490

Revisiting Why Walgreens Boots Alliance Would Purchase Wholesaler AmerisourceBergen 490

Summary: The Bottom Line 491

Key Terms and Concepts 492

Questions and Problems 492

MyLab Economics Auto-Graded Excel Projects 496

MANAGERIAL APPLICATION

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13 Marketing Decisions: Advertising and Promotion 541 Heads Up for Advertising Decisions at Riddell 541

Introduction 541

13.1 Profit-Maximizing Advertising by a Firm 542 Advertising and Profit Maximization 543 Choosing Advertising Media 547

Contents xix

12.2 The Multi-Plant Firm 506 Marginal Cost for a Multi-Plant Firm 507 Profit Maximization for a Multi-Plant Firm 508

SOLVED PROBLEM Can Producing Too Many Cookies Hurt Your Firm’s Profit? 510

12.3 Location Decisions 511 Changes in Costs from Adding Plants 511 The Effect of Transportation Costs on Location Decisions 513

DECISION SNAPSHOT Quaker Oats’ Location Decision 514

DECISION SNAPSHOT Walgreens and CVS Compete for Your Drug Prescription 515