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Managerial Economics: Comprehensive Learning Assessment

Learning Objectives Each chapter includes learning objectives designed to enhance the learning experience. End- of-chapter problems are denoted with the learning objective(s) to which they relate.

Demonstration Problems The best way to learn economics is to practice solving economic problems. So, in addition to the Headlines, each chapter contains many Demonstration Problems sprinkled throughout the text, along with detailed answers. This provides students with a mechanism to verify that they have mastered the material, and reduces the cost to students and instructors of having to meet during office hours to discuss answers to problems. Some of the more challenging demonstration problems have an accompanying video tutorial that walks through the solution step-by-step. These videos are available via Connect and at www.mhhe.com/baye9e.

Inside Business Applications Most chapters contain boxed material (called Inside Business applications) to illustrate how theories explained in the text relate to a host of different business situations. As in previous editions, we have tried to strike a balance between applications drawn from the current eco- nomic literature and the popular press.

Calculus and Non-Calculus Alternatives Users can easily include or exclude calculus-based material without losing content or con- tinuity. That’s because the basic principles and formulae needed to solve a particular class of economic problems (e.g., MR = MC) are first stated without appealing to the notation of calculus. Immediately following each stated principle or formula is a clearly marked Calculus Alternative. Each of these calculus alternatives states the preceding principle or formula in calculus notation, and explains the relation between the calculus-based and non- calculus- based formula. More detailed calculus derivations are relegated to chapter Appendices. Thus, the book is designed for use by instructors who want to integrate calculus into managerial economics and by those who do not require students to use calculus.

Variety of End-of-Chapter Problems Three types of problems are offered. Highly structured but nonetheless challenging Conceptual and Computational Questions stress fundamentals. These are followed by Problems and

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Preface ix

Applications, which are far less structured and, like real-world decision environments, may contain more information than is actually needed to solve the problem. Many of these applied problems are based on actual business events.

Additionally, the Time Warner Cable case that follows Chapter 14 includes 13 problems called Memos that have a “real-world feel” and complement the text. All of these case-based problems may be assigned on a chapter-by-chapter basis as specific skills are introduced, or as part of a capstone experience.

Detailed answers to all problems can be found among the instructor resource material available via Connect.

Case Study A case study in business strategy—Time Warner Cable—follows Chapter 14 and was pre- pared especially for this text. It can be used either as a capstone case for the course or to supplement individual chapters. The case allows students to apply core elements from man- agerial economics to a remarkably rich business environment. Instructors can use the case as the basis for an “open-ended” discussion of business strategy, or they can assign specific “memos” (contained at the end of the case) that require students to apply specific tools from managerial economics to the case. Teaching notes, as well as solutions to all of the memos, are provided among the instructor resource material available via Connect.

Flexibility Instructors of managerial economics have genuinely heterogeneous textbook needs. Reviewers and users continue to praise the book for its flexibility, and they assure us that sections or even entire chapters can be excluded without losing continuity. For instance, an instructor wishing to stress microeconomic fundamentals might choose to cover Chapters 2, 3, 4, 5, 8, 9, 10, 11, and 12. An instructor teaching a more applied course that stresses business strategy might choose to cover Chapters 1, 2, 3, 5, 6, 7, 8, 10, 11, and 13. Each may choose to include additional chapters (for example, Chapter 14 or the Time Warner Cable case) as time permits. More generally, instructors can easily omit topics such as present value analysis, regression, indifference curves, isoquants, or reaction functions without losing continuity.

CHANGES IN THE NINTH EDITION

We have made every effort to update and improve Managerial Economics and Business Strategy while assuring a smooth transition to the ninth edition. Following is a summary of the pedagogical improvements, enhanced supplements, and content changes that make the ninth edition an even more powerful tool for teaching and learning managerial economics and business strategy.

∙ A brand new Case Study—Time Warner Cable—which introduces a whole new set of managerial challenges beyond those posed in our previous case, Challenges at Time Warner.

∙ New and updated end-of-chapter problems. ∙ Learning objective labels for each end-of-chapter problem, to help foster targeted

learning. ∙ New and updated Headlines. ∙ New and updated Inside Business applications.

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x Preface

Chapter-by-Chapter Changes ∙ Chapter 1 contains new and updated examples, several updated end-of-chapter prob-

lems, and a new end-of-chapter problem that carefully distinguishes total benefits and total costs from marginal benefits and marginal costs in an applied setting.

∙ Chapter 2 contains updated demonstration problems and an expanded discussion of price floors in the text and demonstration problems.

∙ Chapter 3 contains a new Headline and an updated table with accompanying discus- sion. It also has several updated end-of-chapter problems.

∙ Chapter 4 contains an updated Headline and updated Inside Business applications. It also has several updated end-of-chapter problems.

∙ Chapter 5 contains an updated Inside Business application with details about the Affordable Care Act. It also includes a formal definition of the law of diminishing marginal returns and has several updated end-of-chapter problems.

∙ Chapter 6 offers a new Inside Business on the duration of franchise contracts, updated examples, and several updated end-of-chapter problems.

∙ Chapter 7 contains a new Headline, updated examples and industry data, as well as several updated end-of-chapter problems.

∙ Chapter 8 contains an updated Inside Business concerning automobile competition in China, updated examples, and several updated end-of-chapter problems.

∙ Chapter 9 contains an updated end-of-chapter problem, as well as a new end-of- chapter problem looking at contestability within airline markets.

∙ Chapter 10 contains a new Inside Business application examining airline competition, as well as improved Demonstration Problem exposition. It also has several updated end-of-chapter problems.

∙ Chapter 11 contains a new Inside Business application discussing the use of fuel points by major U.S. grocery chains. It also has several updated end-of-chapter problems.

∙ Chapter 12 includes a new discussion of online reviews as a means of attracting risk- averse customers. It also includes a new Inside Business application, as well as several updated end-of-chapter problems.

∙ Chapter 13 contains a new Inside Business on limit pricing and the “Southwest Effect.” It also has two updated end-of-chapter problems.

∙ Chapter 14 contains a new Inside Business application discussing the Small Business Act for Europe as a key distinction in competition policy between Europe and the United States. In addition, it has two updated end-of-chapter problems, including one discussing the Trans-Pacific Partnership (TPP).

ORGANIZED LEARNING IN THE NINTH EDITION

Chapter Learning Objectives Students and instructors can be confident that the organization of each chapter reflects com- mon themes outlined by four to seven learning objectives listed on the first page of each chapter. These objectives, along with AACSB and Bloom’s taxonomy learning categories, are connected to all end-of-chapter material and test bank questions to offer a comprehensive and thorough teaching and learning experience.

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Preface xi

Assurance of Learning Ready Many educational institutions today are focused on the notion of assurance of learning, an important element of some accreditation standards. Managerial Economics and Business Strategy is designed specifically to support your assurance of learning initiatives with a sim- ple, yet powerful solution.

Instructors can use Connect to easily query for learning outcomes/objectives that directly relate to the learning objectives of the course. You can then use the reporting features of Connect to aggregate student results in similar fashion, making the collection and presenta- tion of assurance of learning data simple and easy.

AACSB Statement McGraw-Hill Global Education is a proud corporate member of AACSB International. Understanding the importance and value of AACSB accreditation, Managerial Economics and Business Strategy, 9/e, has sought to recognize the curricula guidelines detailed in the AACSB standards for business accreditation by connecting questions in the test bank and end-of-chapter material to the general knowledge and skill guidelines found in the AACSB standards.

It is important to note that the statements contained in Managerial Economics and Business Strategy, 9/e, are provided only as a guide for the users of this text. The AACSB leaves content coverage and assessment within the purview of individual schools, the mission of the school, and the faculty. While Managerial Economics and Business Strategy, 9/e, and the teaching package make no claim of any specific AACSB qualification or evaluation, we have labeled questions according to the general knowledge and skill areas.

ACKNOWLEDGMENTS

We thank the many users of Managerial Economics and Business Strategy who provided both direct and indirect feedback that has helped improve your book. This includes thousands of students at Indiana University’s Kelley School of Business and instructors worldwide who have used this book in their own classrooms, colleagues who unselfishly gave up their own time to provide comments and suggestions, and reviewers who provided detailed suggestions to improve this and previous editions of the book. We especially thank the following profes- sors, past and present, for enlightening us on the market’s diverse needs and for providing suggestions and constructive criticisms to improve this book.

Contributing reviewers for this edition:

Narine Badasyan, Murray State University Cristanna Cook, Husson University Robert Daffenbach, University of

Oklahoma

Jeffrey Edwards, North Carolina A&T University

Silke Forbes, Case Western Reserve University

Martin Heintzelman, Clarkson University Craig Hovey, Brenau University, Gainesville

Anand Jha, Texas A&M International University

Harlan Platt, Northeastern University Stefan Ruediger, Arizona State University Charles Sebuhara, Virginia Technical

University

Thomas White, Fontbonne University Keith Willett, Oklahoma State University,

Stillwater

Laura Youderian, Xavier University

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xii Preface

Contributing reviewers for previous editions:

Fatma Abdel-Raouf, Goldey-Beacom College

Burton Abrams, University of Delaware Rashid Al-Hmoud, Texas Tech University Anthony Paul Andrews, Governors State

University

Sisay Asefa, Western Michigan University Simon Avenell, Murdoch University Joseph P. Bailey, University of Maryland Dale G. Bails Christian Brothers University Dean Baim, Pepperdine University Sheryl Ball, Virginia Polytechnic University Klaus Becker, Texas Tech University Richard Beil, Auburn University Barbara C. Belivieu, University of

Connecticut

Dan Black, University of Chicago Louis Cain, Northwestern University Kerem Cakirer, Indiana University Leo Chan, University of Kansas Robert L. Chapman, Florida Metropolitan

University

Joni Charles, Texas State University—San Marcos

Basanta Chaudhuri, Rutgers University— New Brunswick

Shuo Chen, State University of New York at Geneseo

Xiujian Chen, State University of New York—Binghamton University

Kwang Soo Cheong, Johns Hopkins University

Christopher B. Colburn, Old Dominion University

Daniel Patrick Condon, Dominican University

Michael Conlin, Syracuse University Cristanna Cook, Husson University Keith Crocker, Penn State University Ian Cromb, University of Western Ontario Dean Croushore, Federal Reserve

Wilffrid W. Csaplar Jr., Bethany College Shah Dabirian, California State University,

Long Beach

Joseph DaBoll-Lavioe, Nazareth College of Rochester

George Darko, Tusculum College Tina Das, Elon University Ron Deiter, Iowa State University Jonathan C. Deming, Seattle Pacific

University

Casey Dirienzo, Appalachian State University

Eric Drabkin, Hawaii Pacific University Martine Duchatelet, Barry University Keven C. Duncan, University of Southern

Colorado

Yvonne Durham, Western Washington University

Eugene F. Elander, Brenau University Ibrahim Elsaify, Goldey-Beacom College David Ely, San Diego State University Mark J. Eschenfelder, Robert Morris

University

Li Feng, Texas State University–San Marcos David Figlio, University of Florida Ray Fisman, Graduate School of Business,

Columbia University

Silke Forbes, University of California—San Diego

David Gerard, Carnegie Mellon University Sharon Gifford, Rutgers University Lynn G. Gillette, Northeast Missouri State

University

Otis Gilley, Louisiana Tech University Roy Gobin, Loyola University Stephan Gohmann, University of Louisville Steven Gold, Rochester Institute of

Technology

Julie Hupton Gonzalez, University of California—Santa Cruz

Thomas A. Gresik, Mendoza College of Business (University of Notre Dame)

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Preface xiii

Andrea Mays Griffith, California State University

Madhurima Gupta, University of Notre Dame

Carl Gwin, Pepperdine University Gail Heyne Hafer, Lindenwood College Karen Hallows, George Mason University William Hamlen Jr., SUNY Buffalo Shawkat Hammoudeh, Drexel University Mehdi Harian, Bloomsburg University Nile W. Hatch, Marriott School (Brigham

Young University)

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School

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University

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Long Beach

Lowel R. Jacobsen, William Jewell College

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Jaswant R. Jindia, Southern University Russell Kashian, University of

Wisconsin—Whitewater

Paul Kattuman, Judge Business School (Cambridge University)

Brian Kench, University of Tampa Kimberley L. Kinsley, University of Mary

Washington

Peter Klein, University of Georgia, University of Missouri—Columbia

Audrey D. Kline, University of Louisville Robert A. Krell, George Mason

University

Paul R. Kutasovic, New York Institute of Technology

W. J. Lane, University of New Orleans Daniel Lee, Shippensburg University

Dick Leiter, American Public University Canlin Li, University of

California—Riverside

Chung-Ping Loh, University of North Florida

Vahe Lskavyan, Ohio University—Athens Heather Luea, Newman University Nancy L. Lumpkin, Georgetown

College

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Wisconsin—Milwaukee

Vincent Marra, University of Delaware Wade Martin, California State University,

Long Beach

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John Maxwell, Indiana University David May, Oklahoma City University Alan McInnes, California State University,

Fullerton

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John Moran, Syracuse University Shahriar Mostashari, Campbell University John Morgan, Haas Business School

(University of California—Berkeley)

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University—Fullerton

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Los Angeles

Dwight A. Porter, College of St. Thomas Stanko Racic, University of Pittsburgh

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xiv Preface

Eric Rasmusen, Indiana University Matthew Roelofs, Western Washington

University

Christian Roessler, National University of Singapore

Bansi Sawhney, University of Baltimore George L. Schatz, Maine Maritime

Academy

Craig Schulman, University of Arkansas Karen Schultes, University of

Michigan—Dearborn

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Richard Alan Seals Jr., Oklahoma City University

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College

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Florida

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(New York University)

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University—Stillwater

Mike Williams, Bethune Cookman College Richard Winkelman, Arizona State

University

Eduardo Zambrano, University of Notre Dame Rick Zuber, University of North Carolina,

Charlotte

We thank Katie Hoenicke, Christina Kouvelis, James Heine, and Doug Ruby at McGraw- Hill for all they have done to make this project a success. We also thank Mitchell Baye, Patrick Scholten, Eric Schmidbauer, Susan Kayser, Kyle Anderson, and Vikram Ahuja for sugges- tions and assistance during various stages of the revision, and Ellie Mafi-Kreft, Haizhen Lin, and Steven Kreft, who graciously agreed to class test the Connect features in their classrooms. Finally, we thank our families for their continued love and support.

As always, we welcome your comments and suggestions for the next edition. Please feel free to write to us directly at mbaye@indiana.edu or jeffprin@indiana.edu.

Michael R. Baye Jeffrey T. Prince

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Preface xv

SUPPLEMENTS

We know the content and reliability of new editions and book supplements are of utmost impor- tance to users of our book. Because of this, and unlike most other managerial economics books, we personally are involved in crafting and accuracy checking virtually every content update and supplement for our book. Below we discuss popular features of some of the supplements that have been greatly expanded for this edition. The following ancillaries are available for quick download and convenient access via the instructor resource material available through Connect.

Cases In addition to the Time Warner Cable case, nearly a dozen full-length cases were updated and prepared to accompany Managerial Economics and Business Strategy. These cases comple- ment the textbook by showing how real-world businesses use tools like demand elasticities, markup pricing, third-degree price discrimination, bundling, Herfindahl indices, game the- ory, and predatory pricing to enhance profits or shape business strategies. The cases are based on actual decisions by companies that include Microsoft, Heinz, Visa, Staples, American Airlines, and Nasdaq. Expanded teaching notes and solutions for all of the cases—including the Time Warner Cable case—are also provided.

PowerPoint Slides Thoroughly updated and fully editable PowerPoint presentations with animated figures and graphs, make teaching and learning a snap. For instance, a simple mouse click reveals the firm’s demand curve. Another click reveals the associated marginal revenue curve. Another click shows the firm’s marginal cost. A few more clicks, and students see how to determine the profit-maximizing output, price, and maximum profits. Animated graphs and tables are also provided for all other relevant concepts (like Cournot and Stackelberg equilibrium, nor- mal form and extensive form games, and the like).

Solutions Manual We have prepared a solutions manual that provides detailed answers to all end-of-chapter problems, all of which have been class-tested for accuracy.

Test Bank An updated test bank, offers well over 1,000 multiple-choice questions categorized by learning objectives, AACSB learning categories, Bloom’s taxonomy objectives, and level of difficulty.

Computerized Test Bank TestGen is a complete, state-of-the-art test generator and editing application software that allows instructors to quickly and easily select test items from McGraw Hill’s test bank content. The instructors can then organize, edit and customize questions and answers to rapidly generate tests for paper or online administration. Questions can include stylized text, symbols, graphics, and equations that are inserted directly into questions using built-in mathematical templates. TestGen’s random generator provides the option to display different text or calculated number values each time questions are used. With both quick-and-simple test creation and flexible and robust editing tools, TestGen is a complete test generator system for today’s educators.

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Required=Results

McGraw-Hill Connect® Learn Without Limits Connect is a teaching and learning platform that is proven to deliver better results for students and instructors.

Connect empowers students by continually adapting to deliver precisely what they need, when they need it, and how they need it, so your class time is more engaging and effective.

Mobile

Connect Insight® Connect Insight is Connect’s new one-of-a-kind visual analytics dashboard—now available for both instructors and students—that provides at-a-glance information regarding student performance, which is immediately actionable. By presenting assignment, assessment, and topical performance results together with a time metric that is easily visible for aggregate or individual results, Connect Insight gives the user the ability to take a just-in-time approach to teaching and learning, which was never before available. Connect Insight presents data that empowers students and helps instructors improve class performance in a way that is efficient and effective.

73% of instructors who use Connect require it; instructor satisfaction increases by 28%

when Connect is required.

Students can view their results for any

Connect course.

Analytics

Connect’s new, intuitive mobile interface gives students and instructors flexible and convenient, anytime–anywhere access to all components of the Connect platform.

Using Connect improves retention rates by 19.8%, passing rates by 12.7%, and exam scores by 9.1%.

©Getty Images/iStockphoto

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SmartBook® Proven to help students improve grades and study more efficiently, SmartBook contains the same content within the print book, but actively tailors that content to the needs of the individual. SmartBook’s adaptive technology provides precise, personalized instruction on what the student should do next, guiding the student to master and remember key concepts, targeting gaps in knowledge and offering customized feedback, and driving the student toward comprehension and retention of the subject matter. Available on tablets, SmartBook puts learning at the student’s fingertips—anywhere, anytime.

Adaptive

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Education products more intelligent, reliable, and precise.

THE ADAPTIVE READING EXPERIENCE DESIGNED TO TRANSFORM THE WAY STUDENTS READ

More students earn A’s and B’s when they use McGraw-Hill Education Adaptive products.

www.mheducation.com

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xviii

Brief Contents

1 The Fundamentals of Managerial Economics 1

2 Market Forces: Demand and Supply 30

3 Quantitative Demand Analysis 64

4 The Theory of Individual Behavior 101

5 The Production Process and Costs 135

6 The Organization of the Firm 175

7 The Nature of Industry 203

8 Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets 229

9 Basic Oligopoly Models 270

10 Game Theory: Inside Oligopoly 302

11 Pricing Strategies for Firms with Market Power 340

12 The Economics of Information 372

13 Advanced Topics in Business Strategy 406

14 A Manager’s Guide to Government in the Marketplace 435

Case Study Time Warner Cable 468

Glossary 497

Appendix Additional Readings and References 505

Name Index 525

General Index 534

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xix

CHAPTER 1

The Fundamentals of Managerial Economics 1

HEADLINE: Amcott Loses $3.5 Million; Manager Fired 1

INTRODUCTION 2 The Manager 2 Economics 3 Managerial Economics Defined 3

THE ECONOMICS OF EFFECTIVE MANAGEMENT 4 Identify Goals and Constraints 4 Recognize the Nature and Importance of Profits 4

Economic versus Accounting Profits 4 The Role of Profits 5 The Five Forces Framework and Industry Profitability 7

Understand Incentives 10 Understand Markets 11

Consumer–Producer Rivalry 11 Consumer–Consumer Rivalry 11 Producer–Producer Rivalry 11 Government and the Market 12

Recognize the Time Value of Money 12 Present Value Analysis 12 Present Value of Indefinitely Lived Assets 14

Use Marginal Analysis 16 Discrete Decisions 17 Continuous Decisions 19 Incremental Decisions 20

LEARNING MANAGERIAL ECONOMICS 21

ANSWERING THE HEADLINE 22

KEY TERMS AND CONCEPTS 23 / CONCEPTUAL AND COMPUTATIONAL QUESTIONS 23 / PROBLEMS AND APPLICATIONS 25 / SELECTED READINGS 28 / APPENDIX: THE CALCULUS OF MAXIMIZING NET BENEFITS 29

INSIDE BUSINESS 1–1: The Goals of Firms in Our Global Economy 6

INSIDE BUSINESS 1–2: Profits and the Evolution of the Computer Industry 9

INSIDE BUSINESS 1–3: Joining the Jet Set 16

CHAPTER 2

Market Forces: Demand and Supply 30

HEADLINE: Samsung and Hynix Semiconductor to Cut Chip Production 30

INTRODUCTION 31

DEMAND 31 Demand Shifters 33

Income 33 Prices of Related Goods 34 Advertising and Consumer Tastes 35 Population 35 Consumer Expectations 36 Other Factors 36

The Demand Function 36 Consumer Surplus 38

SUPPLY 39 Supply Shifters 40

Input Prices 40 Technology or Government Regulations 40 Number of Firms 40 Substitutes in Production 41 Taxes 41 Producer Expectations 42

The Supply Function 43 Producer Surplus 44

MARKET EQUILIBRIUM 45

PRICE RESTRICTIONS AND MARKET EQUILIBRIUM 47 Price Ceilings 47 Price Floors 51

Contents

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xx Contents

Elasticities for Nonlinear Demand Functions 81

REGRESSION ANALYSIS 84 Evaluating the Statistical Significance of Estimated Coefficients 85

Confidence Intervals 86 The t-Statistic 87

Evaluating the Overall Fit of the Regression Line 88

The R-Square 88 The F-Statistic 89

Regression for Nonlinear Functions and Multiple Regression 89

Regression for Nonlinear Functions 89 Multiple Regression 91

A Caveat 93

ANSWERING THE HEADLINE 94

SUMMARY 94 / KEY TERMS AND CONCEPTS 95 / CONCEPTUAL AND COMPUTATIONAL QUESTIONS 95 / PROBLEMS AND APPLICATIONS 97 / SELECTED READINGS 100

INSIDE BUSINESS 3–1: Calculating and Using the Arc Elasticity: An Application to the Housing Market 70

INSIDE BUSINESS 3–2: Inelastic Demand for Prescription Drugs 74

INSIDE BUSINESS 3–3: Using Cross-Price Elasticities to Improve New Car Sales in the Wake of Increasing Gasoline Prices 77

INSIDE BUSINESS 3–4: Shopping Online in Europe: Elasticities of Demand for Personal Digital Assistants Based on Regression Techniques 93

CHAPTER 4

The Theory of Individual Behavior 101

HEADLINE: Packaging Firm Uses Overtime Pay to Overcome Labor Shortage 101

INTRODUCTION 102

CONSUMER BEHAVIOR 102

CONSTRAINTS 106 The Budget Constraint 106 Changes in Income 108 Changes in Prices 110

COMPARATIVE STATICS 53 Changes in Demand 53 Changes in Supply 54 Simultaneous Shifts in Supply and Demand 55

ANSWERING THE HEADLINE 57

SUMMARY 58 / KEY TERMS AND CONCEPTS 58 / CONCEPTUAL AND COMPUTATIONAL QUESTIONS 58 / PROBLEMS AND APPLICATIONS 60 / SELECTED READINGS 63

INSIDE BUSINESS 2–1: Asahi Breweries Ltd. and the Asian Recession 34

INSIDE BUSINESS 2–2: The Trade Act of 2002, NAFTA, and the Supply Curve 42

INSIDE BUSINESS 2–3: Unpopular Equilibrium Prices 46

INSIDE BUSINESS 2–4: Price Ceilings and Price Floors around the Globe 50

INSIDE BUSINESS 2–5: Globalization and the Supply of Automobiles 54

INSIDE BUSINESS 2–6: Using a Spreadsheet to Calculate Equilibrium in the Supply and Demand Model 55

CHAPTER 3

Quantitative Demand Analysis 64

HEADLINE: Walmart Hoping for Another Big Holiday Showing 64

INTRODUCTION 65

THE ELASTICITY CONCEPT 65

OWN PRICE ELASTICITY OF DEMAND 66 Elasticity and Total Revenue 67 Factors Affecting the Own Price Elasticity 71

Available Substitutes 71 Time 72 Expenditure Share 72

Marginal Revenue and the Own Price Elasticity of Demand 73

CROSS-PRICE ELASTICITY 75

INCOME ELASTICITY 77

OTHER ELASTICITIES 79

OBTAINING ELASTICITIES FROM DEMAND FUNCTIONS 79 Elasticities for Linear Demand Functions 80

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Contents xxi

THE PRODUCTION FUNCTION 136 Short-Run versus Long-Run Decisions 137 Measures of Productivity 138

Total Product 138 Average Product 138 Marginal Product 138

The Role of the Manager in the Production Process 140

Produce on the Production Function 140 Use the Right Level of Inputs 140

Algebraic Forms of Production Functions 143 Algebraic Measures of Productivity 144 Isoquants 146 Isocosts 148 Cost Minimization 149 Optimal Input Substitution 151

THE COST FUNCTION 152 Short-Run Costs 153 Average and Marginal Costs 156 Relations among Costs 158 Fixed and Sunk Costs 159 Algebraic Forms of Cost Functions 160 Long-Run Costs 160 Economies of Scale 161 A Reminder: Economic Costs versus Accounting Costs 162

MULTIPLE-OUTPUT COST FUNCTIONS 163 Economies of Scope 164 Cost Complementarity 164

ANSWERING THE HEADLINE 166

SUMMARY 166 / KEY TERMS AND CONCEPTS 167 / CONCEPTUAL AND COMPUTATIONAL QUESTIONS 167 / PROBLEMS AND APPLICATIONS 169 / SELECTED READINGS 173 / APPENDIX: THE CALCULUS OF PRODUCTION AND COSTS 173

INSIDE BUSINESS 5–1: Where Does Technology Come From? 142

INSIDE BUSINESS 5–2: The Affordable Care Act, Employer Mandate, and Input Substitution 154

INSIDE BUSINESS 5–3: Estimating Production Functions, Cost Functions, and Returns to Scale 162

INSIDE BUSINESS 5–4: International Companies Exploit Economies of Scale 163

CONSUMER EQUILIBRIUM 111

COMPARATIVE STATICS 112 Price Changes and Consumer Behavior 112 Income Changes and Consumer Behavior 114 Substitution and Income Effects 116

APPLICATIONS OF INDIFFERENCE CURVE ANALYSIS 117 Choices by Consumers 117

Buy One, Get One Free 117 Cash Gifts, In-Kind Gifts, and Gift Certificates 118

Choices by Workers and Managers 121 A Simplified Model of Income–Leisure Choice 121 The Decisions of Managers 122

THE RELATIONSHIP BETWEEN INDIFFERENCE CURVE ANALYSIS AND DEMAND CURVES 124 Individual Demand 124 Market Demand 125

ANSWERING THE HEADLINE 126

SUMMARY 127 / KEY TERMS AND CONCEPTS 127 / CONCEPTUAL AND COMPUTATIONAL QUESTIONS 128 / PROBLEMS AND APPLICATIONS 130 / SELECTED READINGS 133 / APPENDIX: A CALCULUS APPROACH TO INDIVIDUAL BEHAVIOR 133

INSIDE BUSINESS 4–1: Indifference Curves and Risk Preferences 105

INSIDE BUSINESS 4–2: The Budget Constraints and Credit Cards 109

INSIDE BUSINESS 4–3: Price Changes and Inventory Management for Multiproduct Firms 113

INSIDE BUSINESS 4–4: Income Effects and the Business Cycle 115

INSIDE BUSINESS 4–5: The “Deadweight Loss” of In-Kind Gifts 122

INSIDE BUSINESS 4–6: Public Health Centers and Output-Oriented Incentives 126

CHAPTER 5

The Production Process and Costs 135

HEADLINE: Boeing Loses the Battle but Wins the War 135

INTRODUCTION 136

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xxii Contents

INSIDE BUSINESS 6–1: The Cost of Using an Inefficient Method of Procuring Inputs 182

INSIDE BUSINESS 6–2: What Determines Contract Length in Franchising? 186

INSIDE BUSINESS 6–3: The Evolution of Input Decisions in the Automobile Industry 187

INSIDE BUSINESS 6–4: Paying for Performance 194

CHAPTER 7

The Nature of Industry 203

HEADLINE: AT&T Puts Halt to T-Mobile Merger 203

INTRODUCTION 204

MARKET STRUCTURE 204 Firm Size 204 Industry Concentration 205

Measures of Industry Concentration 206 The Concentration of U.S. Industry 207 Limitations of Concentration Measures 208

Technology 209 Demand and Market Conditions 210 Potential for Entry 212

CONDUCT 214 Pricing Behavior 214 Integration and Merger Activity 215

Vertical Integration 216 Horizontal Integration 216 Conglomerate Mergers 217

Research and Development 217 Advertising 217

PERFORMANCE 218 Profits 218 Social Welfare 218

THE STRUCTURE–CONDUCT–PERFORMANCE PARADIGM 219 The Causal View 220 The Feedback Critique 220 Relation to the Five Forces Framework 220

OVERVIEW OF THE REMAINDER OF THE BOOK 221 Perfect Competition 221 Monopoly 222 Monopolistic Competition 222 Oligopoly 222

ANSWERING THE HEADLINE 224

CHAPTER 6

The Organization of the Firm 175

HEADLINE: Google Buys Motorola Mobility to Vertically Integrate 175

INTRODUCTION 176

METHODS OF PROCURING INPUTS 177 Purchase the Inputs Using Spot Exchange 177 Acquire Inputs Under a Contract 177 Produce the Inputs Internally 178

TRANSACTION COSTS 179 Types of Specialized Investments 179

Site Specificity 179 Physical-Asset Specificity 180 Dedicated Assets 180 Human Capital 180

Implications of Specialized Investments 180 Costly Bargaining 180 Underinvestment 180 Opportunism and the “Hold-Up Problem” 181

OPTIMAL INPUT PROCUREMENT 182 Spot Exchange 182 Contracts 183 Vertical Integration 186 The Economic Trade-Off 186

MANAGERIAL COMPENSATION AND THE PRINCIPAL–AGENT PROBLEM 189

FORCES THAT DISCIPLINE MANAGERS 191 Incentive Contracts 191 External Incentives 192

Reputation 192 Takeovers 192

THE MANAGER–WORKER PRINCIPAL–AGENT PROBLEM 192 Solutions to the Manager–Worker Principal–Agent Problem 192

Profit Sharing 192 Revenue Sharing 193 Piece Rates 193 Time Clocks and Spot Checks 194

ANSWERING THE HEADLINE 195

SUMMARY 195 / KEY TERMS AND CONCEPTS 196 / CONCEPTUAL AND COMPUTATIONAL QUESTIONS 196 / PROBLEMS AND APPLICATIONS 197 / SELECTED READINGS 200 / APPENDIX: AN INDIFFERENCE CURVE APPROACH TO MANAGERIAL INCENTIVES 200

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OPTIMAL ADVERTISING DECISIONS 260

ANSWERING THE HEADLINE 262

SUMMARY 263 / KEY TERMS AND CONCEPTS 263 / CONCEPTUAL AND COMPUTATIONAL QUESTIONS 263 / PROBLEMS AND APPLICATIONS 265 / SELECTED READINGS 268 / APPENDIX: THE CALCULUS OF PROFIT MAXIMIZATION 269 / APPENDIX: THE ALGEBRA OF PERFECTLY COMPETITIVE SUPPLY FUNCTIONS 269

INSIDE BUSINESS 8–1: Peugeot-Citroën of France: A Price-Taker in China’s Auto Market 235

INSIDE BUSINESS 8–2: Patent, Trademark, and Copyright Protection 246

INSIDE BUSINESS 8–3: Product Differentiation, Cannibalization, and Colgate’s Smile 255

CHAPTER 9

Basic Oligopoly Models 270

HEADLINE: Crude Oil Prices Fall, but Consumers in Some Areas See No Relief at the Pump 270

INTRODUCTION 271

CONDITIONS FOR OLIGOPOLY 271

THE ROLE OF BELIEFS AND STRATEGIC INTERACTION 271

PROFIT MAXIMIZATION IN FOUR OLIGOPOLY SETTINGS 273 Sweezy Oligopoly 273 Cournot Oligopoly 274

Reaction Functions and Equilibrium 275 Isoprofit Curves 279 Changes in Marginal Costs 281 Collusion 283

Stackelberg Oligopoly 284 Bertrand Oligopoly 288

COMPARING OLIGOPOLY MODELS 290 Cournot 290 Stackelberg 291 Bertrand 291 Collusion 291

CONTESTABLE MARKETS 292

ANSWERING THE HEADLINE 293

SUMMARY 295 / KEY TERMS AND CONCEPTS 295 / CONCEPTUAL AND COMPUTATIONAL QUESTIONS 295 / PROBLEMS AND APPLICATIONS 297 / SELECTED

SUMMARY 224 / KEY TERMS AND CONCEPTS 224 / CONCEPTUAL AND COMPUTATIONAL QUESTIONS 225 / PROBLEMS AND APPLICATIONS 226 / SELECTED READINGS 228

INSIDE BUSINESS 7–1: The 2012 North American Industry Classification System (NAICS) 210

INSIDE BUSINESS 7–2: The Elasticity of Demand at the Firm and Market Levels 213

INSIDE BUSINESS 7–3: The Evolution of Market Structure in the Computer Industry 223

CHAPTER 8

Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets 229

HEADLINE: McDonald’s New Buzz: Specialty Coffee 229

INTRODUCTION 230

PERFECT COMPETITION 230 Demand at the Market and Firm Levels 231 Short-Run Output Decisions 232

Maximizing Profits 232 Minimizing Losses 236 The Short-Run Firm and Industry Supply Curves 238

Long-Run Decisions 239

MONOPOLY 241 Monopoly Power 241 Sources of Monopoly Power 242

Economies of Scale 242 Economies of Scope 243 Cost Complementarity 244 Patents and Other Legal Barriers 244

Maximizing Profits 244 Marginal Revenue 245 The Output Decision 248 The Absence of a Supply Curve 251 Multiplant Decisions 251

Implications of Entry Barriers 253

MONOPOLISTIC COMPETITION 255 Conditions for Monopolistic Competition 255 Profit Maximization 256 Long-Run Equilibrium 257 Implications of Product Differentiation 259

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xxiv Contents

MULTISTAGE GAMES 325 Theory 325 Applications of Multistage Games 328

The Entry Game 328 Innovation 329 Sequential Bargaining 330

ANSWERING THE HEADLINE 331

SUMMARY 332 / KEY TERMS AND CONCEPTS 332 / CONCEPTUAL AND COMPUTATIONAL QUESTIONS 333 / PROBLEMS AND APPLICATIONS 335 / SELECTED READINGS 339

INSIDE BUSINESS 10–1: Hollywood’s (not so) Beautiful Mind: Nash or “Opie” Equilibrium? 307

INSIDE BUSINESS 10–2: Cola Wars in India 309

INSIDE BUSINESS 10–3: Trigger Strategies in the Waste Industry 318

INSIDE BUSINESS 10–4: Multimarket Contact and Price Competition 320

INSIDE BUSINESS 10–5: Entry Strategies in International Markets: Sprinkler or Waterfall? 327

CHAPTER 11

Pricing Strategies for Firms with Market Power 340

HEADLINE: Mickey Mouse Lets You Ride “for Free” at Disney World 340

INTRODUCTION 341

BASIC PRICING STRATEGIES 341 Review of the Basic Rule of Profit Maximization 341 A Simple Pricing Rule for Monopoly and Monopolistic Competition 342 A Simple Pricing Rule for Cournot Oligopoly 345

STRATEGIES THAT YIELD EVEN GREATER PROFITS 347 Extracting Surplus from Consumers 347

Price Discrimination 347 Two-Part Pricing 351 Block Pricing 354 Commodity Bundling 356

Pricing Strategies for Special Cost and Demand Structures 358

Peak-Load Pricing 358 Cross-Subsidies 359 Transfer Pricing 360

READINGS 300 / APPENDIX: DIFFERENTIATED- PRODUCT BERTRAND OLIGOPOLY 300

INSIDE BUSINESS 9–1: OPEC Members Can’t Help but Cheat 285

INSIDE BUSINESS 9–2: Commitment in Stackelberg Oligopoly 287

INSIDE BUSINESS 9–3: Price Competition and the Number of Sellers: Evidence from Online and Laboratory Markets 289

INSIDE BUSINESS 9–4: Using a Spreadsheet to Calculate Cournot, Stackelberg, and Collusive Outcomes 292

CHAPTER 10

Game Theory: Inside Oligopoly 302

HEADLINE: Bring Back Complimentary Drinks! 302

INTRODUCTION 303

OVERVIEW OF GAMES AND STRATEGIC THINKING 303

SIMULTANEOUS-MOVE, ONE-SHOT GAMES 304 Theory 304 Applications of One-Shot Games 307

Pricing Decisions 307 Advertising and Quality Decisions 309 Coordination Decisions 310 Monitoring Employees 311 Nash Bargaining 312

INFINITELY REPEATED GAMES 314 Theory 314

Review of Present Value 314 Supporting Collusion with Trigger Strategies 314

Factors Affecting Collusion in Pricing Games 317 Number of Firms 317 Firm Size 317 History of the Market 317 Punishment Mechanisms 318

An Application of Infinitely Repeated Games to Product Quality 319

FINITELY REPEATED GAMES 320 Games with an Uncertain Final Period 320 Repeated Games with a Known Final Period: The End-of-Period Problem 323 Applications of the End-of-Period Problem 324

Resignations and Quits 324 The “Snake-Oil” Salesman 325

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AUCTIONS 390 Types of Auctions 391

English Auction 391 First-Price, Sealed-Bid Auction 391 Second-Price, Sealed-Bid Auction 392 Dutch Auction 392

Information Structures 393 Independent Private Values 393 Correlated Value Estimates 394

Optimal Bidding Strategies for Risk-Neutral Bidders 394

Strategies for Independent Private Values Auctions 394 Strategies for Correlated Values Auctions 396

Expected Revenues in Alternative Types of Auctions 397

ANSWERING THE HEADLINE 399

SUMMARY 400 / KEY TERMS AND CONCEPTS 400 / CONCEPTUAL AND COMPUTATIONAL QUESTIONS 400 / PROBLEMS AND APPLICATIONS 402 / SELECTED READINGS 405

INSIDE BUSINESS 12–1: Risk Aversion and the Value of Selling the Firm: The St. Petersburg Paradox 376

INSIDE BUSINESS 12–2: Obfuscation to Counter Low Internet Search Costs 379

INSIDE BUSINESS 12–3: Groucho Marx the Economist? 386

INSIDE BUSINESS 12–4: Second-Price Auctions on eBay 392

INSIDE BUSINESS 12–5: Auctions with Risk-Averse Bidders 399

CHAPTER 13

Advanced Topics in Business Strategy 406

HEADLINE: Local Restaurateur Faces Looming Challenge from Morton’s 406

INTRODUCTION 407

LIMIT PRICING TO PREVENT ENTRY 408 Theoretical Basis for Limit Pricing 408 Limit Pricing May Fail to Deter Entry 409 Linking the Preentry Price to Postentry Profits 410

Commitment Mechanisms 411 Learning Curve Effects 412 Incomplete Information 412 Reputation Effects 413

Dynamic Considerations 413

Pricing Strategies in Markets with Intense Price Competition 362

Price Matching 362 Inducing Brand Loyalty 364 Randomized Pricing 364

ANSWERING THE HEADLINE 366

SUMMARY 366 / KEY TERMS AND CONCEPTS 367 / CONCEPTUAL AND COMPUTATIONAL QUESTIONS 367 / PROBLEMS AND APPLICATIONS 369 / SELECTED READINGS 371

INSIDE BUSINESS 11–1: Pricing Markups as Rules of Thumb 343

INSIDE BUSINESS 11–2: Is Price Discrimination Bad for Consumers? 352

INSIDE BUSINESS 11–3: Bundling and “Price Frames” in Online Markets 357

INSIDE BUSINESS 11–4: The Prevalence of Price-Matching Policies and Other Low-Price Guarantees 363

INSIDE BUSINESS 11–5: Kroger Combines Pricing Strategies 364

INSIDE BUSINESS 11–6: Randomized Pricing in the Airline Industry 365

CHAPTER 12

The Economics of Information 372

HEADLINE: Firm Chickens Out in the FCC Spectrum Auction 372

INTRODUCTION 373

THE MEAN AND THE VARIANCE 373

UNCERTAINTY AND CONSUMER BEHAVIOR 375 Risk Aversion 375

Managerial Decisions with Risk-Averse Consumers 376

Consumer Search 378

UNCERTAINTY AND THE FIRM 380 Risk Aversion 381 Producer Search 383 Profit Maximization 383

UNCERTAINTY AND THE MARKET 384 Asymmetric Information 384

Adverse Selection 386 Moral Hazard 387

Signaling and Screening 388

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xxvi Contents

Externalities 444 The Clean Air Act 446

Public Goods 448 Incomplete Information 451

Rules against Insider Trading 452 Certification 452 Truth in Lending 453 Truth in Advertising 454 Enforcing Contracts 454

RENT SEEKING 455

GOVERNMENT POLICY AND INTERNATIONAL MARKETS 457 Quotas 457 Tariffs 459

Lump-Sum Tariffs 459 Excise Tariffs 460

ANSWERING THE HEADLINE 461

SUMMARY 461 / KEY TERMS AND CONCEPTS 461 / CONCEPTUAL AND COMPUTATIONAL QUESTIONS 462 / PROBLEMS AND APPLICATIONS 464 / SELECTED READINGS 466

INSIDE BUSINESS 14–1: European Commission Moves to Protect Small Businesses 439

INSIDE BUSINESS 14–2: Electricity Deregulation 443

INSIDE BUSINESS 14–3: Canada’s Competition Bureau 455

CASE STUDY

Time Warner Cable 468

HEADLINE 468

BACKGROUND 469 Time Warner Cable History 469 Cable Television History 469 Broadband Internet 470

BUSINESS AND MARKETS 471 Video Programming 471 Internet Services 473 Telephone 473

COMPETITION 474 Cable Companies 474

Comcast 474 Comcast/Time Warner Cable Proposed Acquisition 475 Charter Communications 475 Other Cable Players 476

PREDATORY PRICING TO LESSEN COMPETITION 415

RAISING RIVALS’ COSTS TO LESSEN COMPETITION 417 Strategies Involving Marginal Cost 418 Strategies Involving Fixed Costs 419 Strategies for Vertically Integrated Firms 419

Vertical Foreclosure 420 The Price–Cost Squeeze 420

PRICE DISCRIMINATION AS A STRATEGIC TOOL 420

CHANGING THE TIMING OF DECISIONS OR THE ORDER OF MOVES 421 First-Mover Advantages 421 Second-Mover Advantages 423

PENETRATION PRICING TO OVERCOME NETWORK EFFECTS 424 What Is a Network? 424 Network Externalities 425 First-Mover Advantages Due to Consumer Lock-In 426 Using Penetration Pricing to “Change the Game” 427

ANSWERING THE HEADLINE 429

SUMMARY 429 / KEY TERMS AND CONCEPTS 430 / CONCEPTUAL AND COMPUTATIONAL QUESTIONS 430 / PROBLEMS AND APPLICATIONS 432 / SELECTED READINGS 434

INSIDE BUSINESS 13–1: Business Strategy at Microsoft 410

INSIDE BUSINESS 13–2: Limit Pricing and the “Southwest Effect” 415

INSIDE BUSINESS 13–3: First to Market, First to Succeed? Or First to Fail? 423

INSIDE BUSINESS 13–4: Network Externalities and Penetration Pricing by Yahoo! Auctions 427

CHAPTER 14

A Manager’s Guide to Government in the Marketplace 435

HEADLINE: FTC Conditionally Approves $10.3 Billion Merger 435

INTRODUCTION 436

MARKET FAILURE 436 Market Power 436

Antitrust Policy 437 Price Regulation 440

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REGULATION IN THE CABLE INDUSTRY 483 Carriage of Broadcast Television 484 Cable Pricing Regulation 484 Net Neutrality 484 Connect America Fund 484

CHALLENGES 484

CASE-BASED EXERCISES 485

MEMOS 485

SELECTED READINGS AND REFERENCES 492 / APPENDIX: EXHIBITS 493

Glossary 497

Appendix Additional Readings and References 505

Name Index 525

General Index 534

Satellite 476 AT&T DirecTV 476

Dish Network 477 Telephone Providers 477

Verizon 477 AT&T 477 Other Companies 478

Online Video Distributors 478 Netflix 478 Amazon Prime Video 479 Hulu 479 Google/YouTube 479

SUPPLIERS 480 Cable Networks 480 Broadcast Networks 480 Sports Programming 481 Carriage Disputes 481 Over-the-Top Content 482

MARKET TRENDS AND CONSUMER BEHAVIOR 482 Digital Video Recorders (DVRs) 482 Cutting the Cord 483 Going Mobile 483

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1

headLINE Amcott Loses $3.5 Million; Manager Fired On Tuesday software giant Amcott posted a year-end operating loss of $3.5 million. Reportedly, $1.7 million of the loss stemmed from its foreign language division.

At a time when Amcott was paying First National a hefty 7 percent rate to borrow short-term funds, Amcott decided to use $20 million of its retained earnings to purchase three-year rights to Magicword, a software package that converts generic word proces- sor files saved as French text into English. First-year sales revenue from the software was $7 million, but thereafter sales were halted pending a copyright infringement suit filed by Foreign, Inc. Amcott lost the suit and paid damages of $1.7 million. Industry insiders say that the copyright violation pertained to “a very small component of Magicword.”

Ralph, the Amcott manager who was fired over the incident, was quoted as saying, “I’m a scapegoat for the attorneys [at Amcott] who didn’t do their homework before buy- ing the rights to Magicword. I projected annual sales of $7 million per year for three years. My sales forecasts were right on target.”

Do you know why Ralph was fired?1

The Fundamentals of Managerial Economics

1 LEARNING OBJECTIVES

After completing this chapter, you will be able to:

LO1 Summarize how goals, constraints, incentives, and market rivalry affect eco- nomic decisions.

LO2 Distinguish economic versus accounting profits and costs. LO3 Explain the role of profits in a market economy. LO4 Apply the five forces framework to analyze the sustainability of an industry’s profits. LO5 Apply present value analysis to make decisions and value assets. LO6 Apply marginal analysis to determine the optimal level of a managerial

control variable.

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

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

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INTRODUCTION

Many students taking managerial economics ask, “Why should I study economics? Will it tell me what the stock market will do tomorrow? Will it tell me where to invest my money or how to get rich?” Unfortunately, managerial economics by itself is unlikely to provide defini- tive answers to such questions. Obtaining the answers would require an accurate crystal ball. Nevertheless, managerial economics is a valuable tool for analyzing business situations such as the ones raised in the headlines that open each chapter of this book.

In fact, if you surf the Internet, browse a business publication such as Bloomberg Businessweek or The Wall Street Journal, or read a trade publication like Restaurant News or Supermarket Business News, you will find a host of stories that involve managerial econom- ics. A recent search generated the following headlines:

“From iPhones to Automobiles: Apple Car Reportedly Ready to Hit the Streets in 2019” “Ferrari Spinoff Generates $4 Billion Windfall for Fiat Chrysler” “Target to Match Online Prices with Online Rivals” “U.S. Indicts Three in Auto Parts Price-Fixing Probe” “Competition Heats Up for Northwest Wine Shipping” “U.S. Government Steps Up Challenges to Hospital Mergers” “Brands Rethink Social Media Strategy” “Comcast Calls Off Time Warner Cable Merger”

Sadly, billions of dollars are lost each year because many existing managers fail to use basic tools from managerial economics to shape pricing and output decisions, optimize the production process and input mix, choose product quality, guide horizontal and vertical merger decisions, or optimally design internal and external incentives. Happily, if you learn a few basic principles from managerial economics, you will be poised to drive the inept man- agers out of their jobs! You will also understand why the latest recession was great news to some firms and why some software firms spend millions on the development of applications for smartphones but permit consumers to download them for free.

Managerial economics is not only valuable to managers of Fortune 500 companies; it is also valuable to managers of not-for-profit organizations. It is useful to the manager of a food bank who must decide the best means for distributing food to the needy. It is valuable to the coordinator of a shelter for the homeless whose goal is to help the largest possible number of homeless, given a very tight budget. In fact, managerial economics provides useful insights into every facet of the business and nonbusiness world in which we live—including house- hold decision making.

Why is managerial economics so valuable to such a diverse group of decision makers? The answer to this question lies in the meaning of the term managerial economics.

The Manager A manager is a person who directs resources to achieve a stated goal. This definition includes all individuals who (1) direct the efforts of others, including those who delegate tasks within an organization such as a firm, a family, or a club; (2) purchase inputs to be used in the production of goods and services such as the output of a firm, food for the needy, or shelter for the homeless; or (3) are in charge of making other decisions, such as product price or quality.

manager A person who directs resources to achieve a stated goal.

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A manager generally has responsibility for his or her own actions as well as for the actions of individuals, machines, and other inputs under the manager’s control. This control may involve responsibilities for the resources of a multinational corporation or for those of a single household. In each instance, however, a manager must direct resources and the behavior of individuals for the purpose of accomplishing some task. While much of this book assumes the manager’s task is to maximize the profits of the firm that employs the manager, the underly- ing principles are valid for virtually any decision process.

Economics The primary focus of this book is on the second word in managerial economics. Economics is the science of making decisions in the presence of scarce resources. Resources are simply anything used to produce a good or service or, more generally, to achieve a goal. Decisions are important because scarcity implies that by making one choice, you give up another. A com- puter firm that spends more resources on advertising has fewer resources to invest in research and development. A food bank that spends more on soup has less to spend on fruit. Economic decisions thus involve the allocation of scarce resources, and a manager’s task is to allocate resources so as to best meet the manager’s goals.

One of the best ways to comprehend the pervasive nature of scarcity is to imagine that a genie has appeared and offered to grant you three wishes. If resources were not scarce, you would tell the genie you have absolutely nothing to wish for; you already have everything you want. Surely, as you begin this course, you recognize that time is one of the scarcest resources of all. Your primary decision problem is to allocate a scarce resource—time—to achieve a goal—such as mastering the subject matter or earning an A in the course.

Managerial Economics Defined Managerial economics, therefore, is the study of how to direct scarce resources in the way that most efficiently achieves a managerial goal. It is a very broad discipline in that it describes methods useful for directing everything from the resources of a household to maxi- mize household welfare to the resources of a firm to maximize profits.

To understand the nature of decisions that confront managers of firms, imagine that you are the manager of a Fortune 500 company that makes computers. You must make a host of decisions to succeed as a manager: Should you purchase components such as disk drives and chips from other manufacturers or produce them within your own firm? Should you specialize in making one type of computer or produce several different types? How many computers should you produce, and at what price should you sell them? How many employees should you hire, and how should you compensate them? How can you ensure that employees work hard and produce quality products? How will the actions of rival computer firms affect your decisions?

The key to making sound decisions is to know what information is needed to make an informed decision and then to collect and process the data. If you work for a large firm, your legal department can provide data about the legal ramifications of alternative decisions; your accounting department can provide tax advice and basic cost data; your marketing depart- ment can provide you with data on the characteristics of the market for your product; and your firm’s financial analysts can provide summary data for alternative methods of obtaining financial capital. Ultimately, however, the manager must integrate all of this information, pro- cess it, and arrive at a decision. The remainder of this book will show you how to perform this important managerial function by using six principles that comprise effective management.

economics The science of making decisions in the presence of scarce resources.

managerial economics The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.

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THE ECONOMICS OF EFFECTIVE MANAGEMENT

The nature of sound managerial decisions varies depending on the underlying goals of the manager. Since this course is designed primarily for managers of firms, this book focuses on managerial decisions as they relate to maximizing profits or, more generally, the value of the firm. Before embarking on this special use of managerial economics, we provide an overview of the basic principles that comprise effective management. In particular, an effective man- ager must (1) identify goals and constraints, (2) recognize the nature and importance of prof- its, (3) understand incentives, (4) understand markets, (5) recognize the time value of money, and (6) use marginal analysis.

Identify Goals and Constraints The first step in making sound decisions is to have well-defined goals because achieving dif- ferent goals entails making different decisions. If your goal is to maximize your grade in this course rather than maximize your overall grade point average, your study habits will differ accordingly. Similarly, if the goal of a food bank is to distribute food to needy people in rural areas, its decisions and optimal distribution network will differ from those it would use to distribute food to needy inner-city residents. Notice that, in both instances, the decision maker faces constraints that affect the ability to achieve a goal. The 24-hour day affects your ability to earn an A in this course; a budget affects the ability of the food bank to distribute food to the needy. Constraints are an artifact of scarcity.

Different units within a firm may be given different goals; those in a firm’s marketing department might be instructed to use their resources to maximize sales or market share, while those in the firm’s financial group might focus on earnings growth or risk-reduction strategies. Later in this book we will see how the firm’s overall goal—maximizing profits— can be achieved by giving each unit within the firm an incentive to achieve potentially differ- ent goals.

Unfortunately, constraints make it difficult for managers to achieve goals such as max- imizing profits or increasing market share. These constraints include such things as the available technology and the prices of inputs used in production. The goal of maximizing profits requires the manager to decide the optimal price to charge for a product, how much to produce, which technology to use, how much of each input to use, how to react to deci- sions made by competitors, and so on. This book provides tools for answering these types of questions.

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

Economic versus Accounting Profits When most people hear the word profit, they think of accounting profits. Accounting profits are the total amount of money taken in from sales (total revenue, or price times quantity sold) minus the dollar cost of producing goods or services. Accounting profits are what show up on the firm’s income statement and are typically reported to the manager by the firm’s account- ing department.

accounting profits The total amount of money taken in from sales (total revenue, or price times quantity sold) minus the dollar cost of producing goods or services.

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A more general way to define profits is in terms of what economists refer to as economic profits. Economic profits are the difference between the total revenue and the total opportu- nity cost of producing the firm’s goods or services. The opportunity cost of using a resource includes both the explicit (or accounting) cost of the resource and the implicit cost of giving up the best alternative use of the resource. The opportunity cost of producing a good or ser- vice generally is higher than accounting costs because it includes both the dollar value of costs (explicit, or accounting, costs) and any implicit costs.

Implicit costs are very hard to measure and therefore managers often overlook them. Effective managers, however, continually seek out data from other sources to identify and quantify implicit costs. Managers of large firms can use sources within the company, includ- ing the firm’s finance, marketing, and/or legal departments, to obtain data about the implicit costs of decisions. In other instances managers must collect data on their own. For example, what does it cost you to read this book? The price you paid the bookseller for this book is an explicit (or accounting) cost, while the implicit cost is the value of what you are giving up by reading the book. You could be studying some other subject or watching TV, and each of these alternatives has some value to you. The “best” of these alternatives is your implicit cost of reading this book; you are giving up this alternative to read the book. Similarly, the opportu- nity cost of going to school is much higher than the cost of tuition and books; it also includes the amount of money you would earn had you decided to work rather than go to school.

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

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

Second, accounting costs do not account for the fact that, had you not run the pizzeria, you could have rented the building to someone else. If the rental value of the building is $100,000 per year, you gave up this amount to run your own business. Thus, the costs of running the pizzeria include not only the costs of supplies ($20,000) but the $30,000 you could have earned in some other business and the $100,000 you could have earned in renting the building to someone else. The economic cost of running the pizzeria is $150,000—the amount you gave up to run your business. Considering the revenue of $100,000, you actually lost $50,000 by running the pizzeria; your economic profits were –$50,000.

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

The Role of Profits A common misconception is that the firm’s goal of maximizing profits is necessarily bad for society. Individuals who want to maximize profits often are considered self-interested, a

economic profits The difference between total revenue and total opportunity cost.

opportunity cost The explicit cost of a resource plus the implicit cost of giving up its best alternative use.

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Recent trends in globalization have forced businesses around the world to more keenly focus on profitability. This trend is also present in Japan, where historical links between banks and businesses have traditionally blurred the goals of firms. For example, the Japanese busi- ness engineering firm Mitsui & Co. Ltd. launched “Challenge 21,” a plan directed at helping the company emerge as Japan’s leading business engineering group. According to a spokesperson for the company, “[This plan permits us to] create new value and maximize profitability by taking steps such as renewing our management framework and prioritizing the allocation of our resources into strategic areas. We are committed to maximizing shareholder value