N 1901, which company famously became the world's first billion-dollar corporation?

Managerial Economics

Theory and Practice

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Managerial Economics

Theory and Practice

Thomas J. Webster Lubin School of Business

Pace University New York, NY

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To my sons, Adam Thomas and Andrew Nicholas

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Contents

1 Introduction

What is Economics 1 Opportunity Cost 3 Macroeconomics Versus Microeconomics 3 What is Managerial Economics 4 Theories and Models 5 Descriptive Versus Prescriptive Managerial Economics 8 Quantitive Methods 8 Three Basic Economic Questions 9 Characteristics of Pure Capitalism 11 The Role of Government in Market Economies 13 The Role of Profit 16 Theory of the Firm 18 How Realistic is the Assumption of Profit Maximization? 21 Owner-Manager/Principle-Agent Problem 23 Manager-Worker/Principle-Agent Problem 25 Constraints on the Operations of the Firm 27 Accounting Profit Versus Economic Profit 27 Normal Profit 30 Variations in Profits Across Industries and Firms 31 Chapter Review 33 Key Terms and Concepts 35 Chapter Questions 37

vii

Chapter Exercises 39 Selected Readings 41

2 Introduction to Mathematical Economics

Functional Relationships and Economic Models 44 Methods of Expressing Economic and Business Relationships 45 The Slope of a Linear Function 47 An Application of Linear Functions to Economics 48 Inverse Functions 50 Rules of Exponents 52 Graphs of Nonlinear Functions of One Independent Variable 53 Sum of a Geometric Progression 56 Sum of an Infinite Geometric Progression 58 Economic Optimization 60 Derivative of a Function 62 Rules of Differentiation 63 Implicit Differentiation 71 Total, Average, and Marginal Relationships 72 Profit Maximization: The First-order Condition 76 Profit Maximization: The Second-order Condition 78 Partial Derivatives and Multivariate Optimization: The First-order

Condition 81 Partial Derivatives and Multivariate Optimization: The Second-order

Condition 82 Constrained Optimization 84 Solution Methods to Constrained Optimization Problems 85 Integration 88 Chapter Review 92 Chapter Questions 94 Chapter Exercises 94 Selected Readings 97

3 The Essentials of Demand and Supply

The Law of Demand 100 The Market Demand Curve 102

viii Contents

Other Determinants of Market Demand 106 The Market Demand Equation 110 Market Demand Versus Firm Demand 112 The Law of Supply 113 Determinants of Market Supply 114 The Market Mechanism: The Interaction of Demand and Supply 118 Changes in Supply and Demand: The Analysis of Price

Determination 123 The Rationing Function of Prices 129 Price Ceilings 130 Price Floors 134 The Allocating Function of Prices 136 Chapter Review 137 Key Terms and Concepts 138 Chapter Questions 140 Chapter Exercises 142 Selected Readings 144 Appendix 3A 145

4 Additional Topics in Demand Theory

Price Elasticity of Demand 149 Price Elasticity of Demand: The Midpoint Formula 152 Price Elasticity of Demand: Weakness of the Midpoint Formula 155 Refinement of the Price Elasticity of Demand Formula: Point-price

Elasticity of Demand 157 Relationship Between Arc-price and Point-price Elasticities

of Demand 160 Price Elasticity of Demand: Some Definitions 160 Point-price Elasticity Versus Arc-price Elasticity 162 Individual and Market Price Elasticities of Demand 164 Determinants of the Price Elasticity of Demand 165 Price Elasticity of Demand, Total Revenue, and Marginal

Revenue 168 Formal Relationship Between the Price Elasticity of Demand and

Total Revenue 174 Using Elasticities in Managerial Decision Making 181 Chapter Review 186 Key Terms and Concepts 188 Chapter Questions 190

Contents ix

Chapter Exercises 191 Selected Readings 194

5 Production

The Role of the Firm 195 The Production Function 197 Short-run Production Function 201 Key Relationships: Total, Average, and Marginal Products 202 The Law of Diminishing Marginal Product 205 The Output Elasticity of a Variable Input 207 Relationships Among the Product Functions 208 The Three Stages of Production 211 Isoquants 212 Long-run Production Function 218 Estimating Production Functions 222 Chapter Review 225 Key Terms and Concepts 226 Chapter Questions 229 Chapter Exercises 231 Selected Readings 232

6 Cost

The Relationship Between Production and Cost 235 Short-run Cost 236 Key Relationships: Average Total Cost, Average Fixed Cost, Average

Variable Cost, and Marginal Cost 238 The Functional Form of the Total Cost Function 241 Mathematical Relationship Between ATC and MC 243 Learning Curve Effect 247 Long-run Cost 250 Economies of Scale 251 Reasons for Economies and Diseconomies of Scale 255 Multiproduct Cost Functions 256 Chapter Review 259

x Contents

Key Terms and Concepts 260 Chapter Questions 262 Chapter Exercises 263 Selected Readings 264

7 Profit and Revenue Maximization

Profit Maximization 266 Optimal Input Combination 266 Unconstrained Optimization: The Profit Function 279 Constrained Optimization: The Profit Function 295 Total Revenue Maximization 299 Chapter Review 302 Key Terms and Concepts 303 Chapter Questions 305 Chapter Exercises 305 Selected Readings 309 Appendix 7A 309

8 Market Structure: Perfect Competition

and Monopoly

Characteristics of Market Structure 313 Perfect Competition 316 The Equilibrium Price 317 Monopoly 331 Monopoly and the Price Elasticity of Demand 337 Evaluating Perfect Competition and Monopoly 340 Welfare Effects of Monopoly 342 Natural Monopoly 348 Collusion 350 Chapter Review 350 Key Terms and Concepts 351 Chapter Questions 353 Chapter Exercises 355

Contents xi

Selected Readings 358 Appendix 8A 358

9 Market Structure: Monopolistic Competition

Characteristics of Monopolistic Competition 362 Short-run Monopolistically Competitive Equilibrium 363 Long-run Monopolistically Competitive Equilibrium 364 Advertising in Monopolistically Competitive Industries 371 Evaluating Monopolistic Competition 372 Chapter Review 373 Key Terms and Concepts 375 Chapter Questions 375 Chapter Exercises 376 Selected Readings 377

10 Market Structure: Duopoly and Oligopoly

Characteristics of Duopoly and Oligopoly 380 Measuring Industrial Concentration 382 Models of Duopoly and Oligopoly 385 Game Theory 404 Chapter Review 410 Key Terms and Concepts 411 Chapter Questions 413 Chapter Exercises 414 Selected Readings 417

11 Pricing Practices

Price Discrimination 419 Nonmarginal Pricing 443 Multiproduct Pricing 449

xii Contents

Peak-load Pricing 460 Transfer Pricing 462 Other Pricing Practices 470 Chapter Review 474 Key Terms and Concepts 476 Chapter Questions 479 Chapter Exercises 480 Selected Readings 482

12 Capital Budgeting

Categories of Capital Budgeting Projects 486 Time Value of Money 488 Cash Flows 488 Methods for Evaluating Capital Investment Projects 506 Capital Rationing 537 The Cost of Capital 538 Chapter Review 541 Key Terms and Concepts 542 Chapter Questions 544 Chapter Exercises 546 Selected Readings 549

13 Introduction to Game Theory

Games and Strategic Behavior 552 Noncooperative, Simultaneous-move, One-shot Games 554 Cooperative, Simultaneous-move, Infinitely Repeated Games 568 Cooperative, Simultaneous-move, Finitely Repeated Games 580 Focal-point Equilibrium 586 Multistage Games 589 Bargaining 601 Chapter Review 608 Key Terms and Concepts 610 Chapter Questions 612 Chapter Exercises 613 Selected Readings 619

Contents xiii

xiv Contents

14 Risk and Uncertainty

Risk and Uncertainty 622 Measuring Risk: Mean and Variance 623 Consumer Behavior and Risk Aversion 627 Firm Behavior and Risk Aversion 632 Game Theory and Uncertainty 648 Game Trees 651 Decision Making Under Uncertainty with Complete Ignorance 656 Market Uncertainty and Insurance 664 Chapter Review 677 Key Terms and Concepts 679 Chapter Questions 681 Chapter Exercises 682 Selected Readings 685

15 Market Failure and Government

Intervention

Market Power 688 Landmark U.S. Antitrust Legislation 690 Merger Regulation 695 Price Regulation 695 Externalities 701 Public Goods 715 Chapter Review 722 Key Terms and Concepts 723 Chapter Questions 724 Chapter Exercises 726 Selected Readings 727

Index 729

1

Introduction

1

WHAT IS ECONOMICS?

Economics is the study of how individuals and societies make choices subject to constraints. The need to make choices arises from scarcity. From the perspective of society as a whole, scarcity refers to the limitations placed on the production of goods and services because factors of production are finite. From the perspective of the individual, scarcity refers to the limita- tions on the consumption of goods and services because of limited of personal income and wealth.

Definition: Economics is the study of how individuals and societies choose to utilize scarce resources to satisfy virtually unlimited wants.

Definition: Scarcity describes the condition in which the availability of resources is insufficient to satisfy the wants and needs of individuals and society.

The concepts of scarcity and choice are central to the discipline of economics. Because of scarcity, whenever the decision is made to follow one course of action, a simultaneous decision is made to forgo some other course of action. Thus, any action requires a sacrifice. There is another common admonition that also underscores the all pervasive concept of scarcity: if an offer seems too good to be true, then it probably is.

Individuals and societies cannot have everything that is desired be- cause most goods and services must be produced with scarce productive resources. Because productive resources are scarce, the amounts of goods and services produced from these ingredients must also be finite in supply. The concept of scarcity is summarized in the economic admonition that

there is no “free lunch.” Goods, services, and productive resources that are scarce have a positive price. Positive prices reflect the competitive interplay between the supply of and demand for scarce resources and commodities. A commodity with a positive price is referred to as an economic good. Commodities that have a zero price because they are relatively unlimited in supply are called free goods.1

What are these scarce productive resources? Productive resources, some- times called factors of production or productive inputs, are classified into one of four broad categories: land, labor, capital, and entrepreneurial ability. Land generally refers to all natural resources. Included in this category are wildlife, minerals, timber, water, air, oil and gas deposits, arable land, and mountain scenery.

Labor refers to the physical and intellectual abilities of people to produce goods and services. Of course, not all workers are the same; that is, labor is not homogeneous. Different individuals have different physical and intellectual attributes. These differences may be inherent, or they may be acquired through education and training. Although the Declaration of Independence proclaims that everyone has certain unalienable rights, in an economic sense all people are not created equal. Thus some people will become fashion models, professional athletes, or college professors; others will work as clergymen, cooks, police officers, bus drivers, and so forth. Dif- ferences in human talents and abilities in large measure explain why some individuals’ labor services are richly rewarded in the market and others, despite their noble calling, such as many public school teachers, are less well compensated.

Capital refers to manufactured commodities that are used to produce goods and services for final consumption. Machinery, office buildings, equip- ment, warehouse space, tools, roads, bridges, research and development, fac- tories, and so forth are all a part of a nation’s capital stock. Economic capital is different from financial capital, which refers to such things as stocks, bonds, certificates of deposits, savings accounts, and cash. It should be noted, however, that financial capital is typically used to finance a firm’s acquisition of economic capital. Thus, there is an obvious linkage between an investor’s return on economic capital and the financial asset used to underwrite it.

In market economies, almost all income generated from productive activity is returned to the owners of factors of production. In politically and economically free societies, the owners of the factors of production are collectively referred to as the household sector. Businesses or firms, on the

2 Introduction

1 Is air a free good? Many students would assert that it is, but what is the price of a clean environment? Inhabitants of most advanced industrialized societies have decided that a cleaner environment is a socially desirable objective. Environmental regulations to control the disposal of industrial waste and higher taxes to finance publicly mandated environmental pro- tection programs, which are passed along to the consumer in the form of higher product prices, make it clear that clean air and clean water are not free.

other hand, are fundamentally activities, and as such have no independent source of income.That activity is to transform inputs into outputs. Even firm owners are members of the household sector. Financial capital is the vehicle by which business acquire economic capital from the household sector. Businesses accomplish this by issuing equity shares and bonds and by bor- rowing from financial intermediaries, such as commercial banks, savings banks, and insurance companies.

Entrepreneurial ability refers to the ability to recognize profitable opportunities, and the willingness and ability to assume the risk associated with marshaling and organizing land, labor, and capital to produce the goods and services that are most in demand by consumers. People who exhibit this ability are called entrepreneurs.

In market economies, the value of land, labor, and capital is directly determined through the interaction of supply and demand. This is not the case for entrepreneurial ability. The return to the entrepreneur is called profit. Profit is defined as the difference between total revenue earned from the production and sale of a good or service and the total cost associated with producing that good or service. Although profit is indirectly deter- mined by the interplay of supply and demand, it is convenient to view the return to the entrepreneur as a residual.

OPPORTUNITY COST

The concepts of scarcity and choice are central to the discipline of eco- nomics. These concepts are used to explain the behavior of both producers and consumers. It is important to understand, however, that in the face of scarcity whenever the decision is made to follow one course of action, a simultaneous decision is made to forgo some other course of action. When a high school graduate decides to attend college or university, a simul- taneous decision is made to forgo entering the work force and earning an income. Scarcity necessitates trade-offs. That which is forgone whenever a choice is made is referred to by economists as opportunity cost. That which is sacrificed when a choice is made is the next best alternative. It is the path that we would have taken had our actual choice not been open to us.

Definition: Opportunity cost is the highest valued alternative forgone whenever a choice is made.

MACROECONOMICS VERSUS MICROECONOMICS

Scarcity, and the manner in which individuals and society make choices, are fundamental to the study of economics. To examine these important

Macroeconomics versus Microeconomics 3

issues, the field of economics is divided into two broad subfields: macro- economics and microeconomics.

As the name implies, macroeconomics looks at the big picture. Macro- economics is the study of entire economies and economic systems and specifically considers such broad economic aggregates as gross domestic product, economic growth, national income, employment, unemployment, inflation, and international trade. In general, the topics covered in macro- economics are concerned with the economic environment within which firm managers operate. For the most part, macroeconomics focuses on the vari- ables over which the managerial decision maker has little or no control but may be of considerable importance in the making of economic decisions at the micro level of the individual, firm, or industry.

Definition: Macroeconomics is the study of aggregate economic behav- ior. Macroeconomists are concerned with such issues as national income, employment, inflation, national output, economic growth, interest rates, and international trade.

By contrast, microeconomics is the study of the behavior and interaction of individual economic agents. These economic agents represent individual firms, consumers, and governments. Microeconomics deals with such topics as profit maximization, utility maximization, revenue or sales maximization, production efficiency, market structure, capital budgeting, environmental protection, and governmental regulation.

Definition: Microeconomics is the study of individual economic behav- ior. Microeconomists are concerned with output and input markets, product pricing, input utilization, production costs, market structure, capital bud- geting, profit maximization, production technology, and so on.

WHAT IS MANAGERIAL ECONOMICS?

Managerial economics is the application of economic theory and quantitative methods (mathematics and statistics) to the managerial decision-making process. Simply stated, managerial economics is applied microeconomics with special emphasis on those topics of greatest interest and importance to managers. The role of managerial economics in the decision-making process is illustrated in Figure 1.1.

Definition: Managerial economics is the synthesis of microeconomic theory and quantitative methods to find optimal solutions to managerial decision-making problems.

To illustrate the scope of managerial economics, consider the case the owner of a company that produces a product. The manner in which the firm owner goes about his or her business will depend on the company’s orga- nizational objectives. Is the firm owner a profit maximizer, or is manage-

4 Introduction

ment more concerned something else, such as maximizing the company’s market share? What specific conditions must be satisfied to optimally achieve these objectives? Economic theory attempts to identify the conditions that need to be satisfied to achieve optimal solutions to these and other management decision problems.

As we will see, if the company’s organizational objective is profit maxi- mization then, according to economic theory, the firm should continue to produce widgets up to the point at which the additional cost of producing an additional widget (marginal cost) is just equal to the additional revenue earned from its sale (marginal revenue). To apply the “marginal cost equals marginal revenue” rule, however, the firm’s management must first be able to estimate the empirical relationships of total cost of widget production and total revenues from widget sales. In other words, the firm’s operations must be quantified so that the optimization principles of economic theory may be applied.

THEORIES AND MODELS

The world is a very complicated place. In attempting to understand how markets operate, for example, the economist makes a number of simplify- ing assumptions.Without these assumptions, the ability to make predictions about cause-and-effect relationships becomes unmanageable. The “law” of demand asserts that the price of a good or service and its quantity demanded are inversely related, ceteris paribus. This theory asserts that, other factors remaining unchanged (i.e., ceteris paribus), individuals will tend to purchase increasing amounts of a good or service as prices fall and decreasing amounts as the prices rise. Of course, other things do not remain unchanged. Along with changes in the price of the good or service, dispos- able income, the prices of related commodities, tastes, and so on, may also change. It is difficult, if not impossible, to generalize consumer behavior when multiple demand determinants are simultaneously changing.

Theories and Models 5

Management decision problems

Economic theory

Quantitative methods

Managerial economics

Optimal solutions to specific organizational objectives

FIGURE 1.1 The role of managerial economics in the decision-making process.

Definition: Ceteris paribus is an assertion in economic theory that in the analysis of the relationship between two variables, all other variables are assumed to remain unchanged.

It is good to remember that economics is a social, not a physical, science. Economists cannot conduct controlled, laboratory experiments, which makes economic theorizing all the more difficult. It also makes economists vulnerable to ridicule. One economic quip, for example, asserts that if all the economists in the world were laid end to end, they would never reach a conclusion. This is, of course, an unfair criticism. In business, the objective is to reduce uncertainty.The study of economics is an attempt to bring order out of seeming chaos. Are economists sometimes wrong? Certainly. But the alternative for managers would be to make decisions in the dark.

What then are theories? Theories are abstractions that attempt to strip away unnecessary detail to expose only the essential elements of observ- able behavior. Theories are often expressed in the form of models. A model is the formal expression of a theory. In economics, models may take the form of diagrams, graphs, or mathematical statements that summarize the relationship between and among two or more variables. More often than not, there will be more than one theory to explain any given economic phenomenon. When this is the case, which theory should we use?

“GOOD” THEORIES VERSUS “BAD” THEORIES

The ultimate test of a theory is its ability to make predictions. In general, “good” theories predict with greater accuracy than “bad” theories. If one theory is known to predict a particular phenomenon with 95% accuracy, and another theory of the same phenomena is known to predict with 96% accuracy, the former theory is replaced by the latter theory. It is in the nature of scientific progress that “good” theories replace “bad” theories. Of course, “good” and “bad” are relative concepts. If one theory predicts an event with greater accuracy, then it will replace alternative theories, no matter how well those theories may have predicted the same event in the past.

Another important observation in the process of theorizing is that all other factors being equal, simpler models, or theories, tend to predict better than more complicated ones. This principle of parsimony is referred to as Ockham’s razor, which was named after the fourteenth-century English philosopher William of Ockham.

Definition: Ockham’s razor is the principle that, other things being equal, the simplest explanation tends to be the correct explanation.

The category of “bad” theories includes two common errors in econom- ics. The most common error, perhaps, relates to statements or theories regarding cause and effect. It is tempting in economics to look at two sequential events and conclude that the first event caused the second event.

6 Introduction

Clearly, this is not always the case, some financial news reports not with standing. For example, a report that the Dow Jones Industrial Average fell 200 points might be attributed to news of increased tensions in the Middle East. Empirical research has demonstrated, however, while specific events may indirectly affect individual stock prices, daily fluctuations in stock market averages tend, on average, to be random. This common error is called the fallacy of post hoc, ergo propter hoc (literally, “after this, there- fore because of this”).

Related to the pitfall of post hoc, ergo propter hoc is the confusion that often arises between correlation and causation. Case and Fair (1999) offer the following illustration. Large cities have many automobiles and also have high crime rates. Thus, there is a high correlation between automobile own- ership and crime. But, does this mean that automobiles cause crime? Obvi- ously not, although many other factors that are highly correlated with a high concentration of automobiles (e.g., population density, poverty, drug abuse) may provide a better explanation of the incidence of crime. Certainly, the presence of automobiles is not one of these factors.

The second common error in economic theorizing is the fallacy of com- position. The fallacy of composition is the belief that what is true for a part is necessarily true for the whole. An example of this may be found in the paradox of thrift. The paradox of thrift asserts that while an increase in saving by an individual may be virtuous (“a penny saved is a penny earned”), if all individuals in an economy increase their saving, the result may be no change, or even a decline, in aggregate saving. The reason is that an increase in aggregate saving means a decrease in aggregate spending, resulting in lower national output and income. Since saving depends upon income, increased savings may be less advantageous under certain circum- stances for the economy as a whole. At a more fundamental level, while it may be rational for an individual to run for the exit when he is the only person in a burning theater, for all individuals in a crowded burning theater to decide to run for the exit would not be.

THEORIES VERSUS LAWS

It is important to distinguish between theories and laws. The distinction relates to the ability to make predictions. Laws are statements of fact about the real world.They are statements of relationships that are, as far as is com- monly known, invariant with respect to specified underlying assumptions or preconditions. As such, laws predict with absolute certainty. “The sun rises in the east” is an example of a law. A law in economics is the law of diminishing marginal returns. This law asserts that for an efficient produc- tion process, as increasing amounts of a variable input are combined with one or more fixed inputs, at some point the additions to total output will get progressively smaller.

Theories and Models 7

By contrast, a theory is an attempt to explain or predict the behavior of objects or events in the real world. Unlike laws, theories cannot predict events with complete accuracy. There are very few laws in economics, although some economic theories are inappropriately referred to as “laws.” This is because economics deals with people, whose behavior is not absolutely predictable.

DESCRIPTIVE VERSUS PRESCRIPTIVE MANAGERIAL ECONOMICS

Managerial economics has both descriptive and prescriptive elements. Managerial economics is descriptive in that it attempts to interpret observed phenomena and to formulate theories about possible cause-and- effect relationships. Managerial economics is prescriptive in that it attempts to predict the outcomes of specific management decisions. Thus, the princi- ples developed in a course in managerial economics may be used to prescribe the most efficient way to achieve an organization’s objectives, such as profit maximization, sales (revenue) maximization, and maximizing market share.

Managerial economics can be utilized by goal-oriented managers in two ways. First, given the existing economic environment, the principles of managerial economics may provide a framework for evaluating whether managers are efficiently allocating resources (land, labor, and capital) to produce the firm’s output at least cost. If not, the principles of economics may be used as a guide for reallocating the firm’s operating budget away from, say, marketing and toward retail sales to achieve the organization’s objectives.

Second, the principles of managerial economics can help managers respond to various economic signals. For example, given an increase in the price of output or the development of a new lower cost production tech- nology, the appropriate response generally would be for a firm to increase output.

QUANTITATIVE METHODS

Quantitative methods refer to the tools and techniques of analysis, including optimization analysis, statistical methods, game theory, and capital budgeting. Managerial economics makes special use of mathematical economics and econometrics to derive optimal solutions to managerial decision-making problems. Managerial economics attempts to bring eco- nomic theory into the real world. Consider, for example, the formal (math- ematical) demand model represented by Equation (1.1).

8 Introduction

(1.1)

Equation (1.1) says that the quantity demand of a good or service com- modity QD is functionally related to its selling price P, per-capita income I, the price of a competitor’s product Ps, and advertising expenditures A.2 By collecting data on Q, P, I, and Ps it should be possible to quantify this rela- tionship. If we assume that this relationship is linear, Equation (1.1) may be specified as

(1.2)

It is possible to estimate the parameters of Equation (1.2) by using the methodology of regression analysis discussed in Green (1997), Gujarati (1995), and Ramanathan (1998). The resulting estimated demand equation, as well as other estimated relationships, may then be used by management to find optimal solutions to managerial decision-making problems. Such decision-making problems may entail optimal product pricing or optimal advertising expenditures to achieve such organizational objectives as revenue maximization or profit maximization.

THREE BASIC ECONOMIC QUESTIONS

Economic theory is concerned with how society answers the basic eco- nomic questions of what goods and services should be produced, and in what amounts, how these goods and services should be produced (i.e., the choice of the appropriate production technology), and for whom these goods and services should be produced.

WHAT GOODS AND SERVICES SHOULD BE PRODUCED?

In market economies, what goods and services are produced by society is a matter determined not by the producer, but rather by the consumer. Profit-maximizing firms produce only the goods and services that their cus- tomers demand. Firms that produce commodities that are not in demand by consumers—manual typewriters to day, for example—will flounder or go out of business entirely. Consumers express their preferences through their purchases of goods and services in the market. The authority of con- sumers to determine what goods and services are produced is often referred to as consumer sovereignty. Woe to the arrogant manager who forgets this fundamental economic fact of life.