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BUS505textbook.pdf
MICHAEL R. BAYEMICHAEL R. BAYE7e
MANAGERIAL ECONOMICS AND BUSINESS STRATEGY
MICHAEL R. BAYE
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ISBN 978-0-07-337596-0 MHID 0-07-337596-9
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PROVEN. TRUSTED. Managerial Economics and Business Strategy is the best-selling managerial economics textbook on the market today. Michael Baye provides students with tools like intermediate microeconomics, game theory, and industrial organization that are crucial to making sound managerial decisions. The Seventh Edition discusses the latest issues and research shaping managerial economics today.
KEY FEATURES OF THIS NEW EDITION INCLUDE:
UPDATED HEADLINES: Updated and current Headlines begin each chapter with a real-world economic problem. These problems are essentially hand-picked “mini-cases” designed to motivate students to better understand the chapter material.
NEW AND UPDATED INSIDE BUSINESS APPLICATIONS: New Inside Business boxes illustrate real-world applications of theory developed in the chapter; these examples are drawn from both current economic literature and the popular press.
TIME WARNER CASE STUDY: A Case Study in business strategy — Challenges at Time Warner — follows Chapter 14. The case engages students by applying core elements from managerial economics to a rich business environment.
For more information and resources, please visit the text’s Online Learning Center: www.mhhe.com/baye7e
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Managerial Economics and Business Strategy
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Nash Equilibrium • Predatory Pricing • Mergers & Acquisitions •
Demand Elasticity • Vertical Foreclosure • Penetration Pricing •
Marginal Cost • Bottlenecks • First-Mover Advantage • Signaling •
Learning Curve • Marginal Revenue • Repeated Games • Microsoft •
Screening • Network Effects • Antitrust • Cost Complementarities •
Two-Part Pricing • Limit Pricing • Tariffs • Bargaining • Cournot
Oligopoly • American Airlines • Raising Rivals’ Costs • Moral Hazard •
eBay • Price Discrimination • Adverse Selection • Economies of Scope
• Auctions • Bundling • Block Pricing • Stackelberg Oligopoly •
Advertising • Perfect Equilibrium • Coordination • General Motors •
Quotas • Extensive Form Games • Economies of Scale • Netscape •
Hold-up Problem • Patents • Bertrand Oligopoly • Commitment •
Economies of Scale • Tariffs • Antitrust • Transfer Pricing • Collusion
• Piece Rates • Profit-Sharing • Sunk Costs • Takeovers • Trigger
Strategies • Low-Price Guarantees • Sony • Time Warner • Five
Forces Framework • AOL • Globalization • Best-Response Function •
Cannibalization • Product Differentiation • Value of Information
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SEVENTH EDITION
Managerial Economics and Business Strategy
Michael R. Baye Bert Elwert Professor of Business Economics & Public Policy Kelley School of Business Indiana University
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MANAGERIAL ECONOMICS AND BUSINESS STRATEGY
Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2010, 2008, 2006, 2003, 2000, 1997, 1994 by The McGraw-Hill Companies, Inc. All rights reserved. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.
Some ancillaries, including electronic and print components, may not be available to customers outside the United States.
This book is printed on acid-free paper.
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ISBN 978-0-07-337596-0 MHID 0-07-337596-9
Vice president and editor-in-chief: Brent Gordon Publisher: Douglas Reiner Director of development: Ann Torbert Development editor: Anne E. Hilbert Vice president and director of marketing: Robin J. Zwettler Associate marketing manager: Dean Karampelas Vice president of editing, design and production: Sesha Bolisetty Senior project manager: Bruce Gin Senior production supervisor: Debra R. Sylvester Designer: Matt Diamond Senior media project manager: Greg Bates Cover design: Matt Diamond Interior design: Matt Diamond Typeface: 10/12 Times Roman Compositor: Laserwords Private Limited Printer: R. R. Donnelley
Library of Congress Cataloging-in-Publication Data
Baye, Michael R., 1958- Managerial economics and business strategy / Michael R. Baye. — 7th ed.
p. cm. Includes index. ISBN-13: 978-0-07-337596-0 (alk.paper) ISBN-10: 0-07-337596-9 (alk. paper) 1. Managerial economics. 2. Strategic planning. I. Title.
HD30.22.B38 2010 338.5024'658—dc22
2009017267
www.mhhe.com
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The McGraw-Hill Series Economics ESSENTIALS OF ECONOMICS Brue, McConnell, and Flynn Essentials of Economics Second Edition
Mandel Economics: The Basics First Edition
Schiller Essentials of Economics Seventh Edition
PRINCIPLES OF ECONOMICS Colander Economics, Microeconomics, and Macroeconomics Eighth Edition
Frank and Bernanke Principles of Economics, Principles of Microeconomics, Principles of Macroeconomics Fourth Edition
Frank and Bernanke Brief Editions: Principles of Economics, Principles of Microeconomics, Principles of Macroeconomics First Edition
McConnell, Brue, and Flynn Economics, Microeconomics, and Macroeconomics Eighteenth Edition
McConnell, Brue, and Flynn Brief Editions: Microeconomics and Macroeconomics First Edition
Miller Principles of Microeconomics First Edition
Samuelson and Nordhaus Economics, Microeconomics, and Macroeconomics Nineteenth Edition
Schiller The Economy Today, The Micro Economy Today, and The Macro Economy Today Twelfth Edition
Slavin Economics, Microeconomics, and Macroeconomics Ninth Edition
ECONOMICS OF SOCIAL ISSUES Guell Issues in Economics Today Fifth Edition
Sharp, Register, and Grimes Economics of Social Issues Nineteenth Edition
ECONOMETRICS Gujarati and Porter Basic Econometrics Fifth Edition
Gujarati and Porter Essentials of Econometrics Fourth Edition
MANAGERIAL ECONOMICS Baye Managerial Economics and Business Strategy Seventh Edition
Brickley, Smith, and Zimmerman Managerial Economics and Organizational Architecture Fifth Edition
Thomas and Maurice Managerial Economics Tenth Edition
INTERMEDIATE ECONOMICS Bernheim and Whinston Microeconomics First Edition
Dornbusch, Fischer, and Startz Macroeconomics Tenth Edition
Frank Microeconomics and Behavior Eighth Edition
ADVANCED ECONOMICS Romer Advanced Macroeconomics Third Edition
MONEY AND BANKING Cecchetti Money, Banking, and Financial Markets Second Edition
URBAN ECONOMICS O’Sullivan Urban Economics Seventh Edition
LABOR ECONOMICS Borjas Labor Economics Fifth Edition
McConnell, Brue, and Macpherson Contemporary Labor Economics Ninth Edition
PUBLIC FINANCE Rosen and Gayer Public Finance Ninth Edition
Seidman Public Finance First Edition
ENVIRONMENTAL ECONOMICS Field and Field Environmental Economics: An Introduction Fifth Edition
INTERNATIONAL ECONOMICS Appleyard, Field, and Cobb International Economics Seventh Edition
King and King International Economics, Globalization, and Policy: A Reader Fifth Edition
Pugel International Economics Fourteenth Edition
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ABOUT THE AUTHOR
Michael Baye is the Bert Elwert Professor of Business Economics & Public Policy at Indiana University’s Kelley School of Business. He received his B.S. in economics from Texas A&M University in 1980 and earned a Ph.D. in economics from Purdue University in 1983. Prior to joining Indiana University, he taught graduate and under- graduate courses at The Pennsylvania State University, Texas A&M University, and the University of Kentucky. Professor Baye served as the Director of the Bureau of Economics at the Federal Trade Commission from July 2007–December 2008.
Professor Baye has won numerous awards for his outstanding teaching and research and regularly teaches courses in managerial economics and industrial organization at the undergraduate, M.B.A., and Ph.D. levels. Professor Baye has made a variety of contributions to the fields of game theory and industrial organi- zation. His research on mergers, auctions, and contests has been published in such journals as the American Economic Review, the Review of Economic Studies, and the Economic Journal. Professor Baye’s research on pricing strategies in online and other environments where consumers search for price information has been pub- lished in economics journals (such as the American Economic Review, Economet- rica, and the Journal of Political Economy), featured in the popular press (including The Wall Street Journal, Forbes, and The New York Times), and pub- lished in leading marketing journals. His research has been supported by the National Science Foundation, the Fulbright Commission, and other organizations.
Professor Baye has held visiting appointments at Cambridge, Oxford, Erasmus University, Tilburg University, and the New Economic School in Moscow, Russia. He has served on numerous editorial boards in economics as well as marketing, including Economic Theory and the Journal of Public Policy & Marketing. When he is not teaching or engaged in research, Michael enjoys activities ranging from camping to shopping for electronic gadgets.
To Natalie and Mitchell—Thanks for teaching me about the buyer side of the college market.
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PREFACE TO THE SEVENTH EDITION
Thanks to feedback from users around the world, Managerial Economics and Busi- ness Strategy remains the top selling managerial text in the market. I am grateful to all of you for allowing me to provide this updated and improved product. Before highlighting some of the new features of the seventh edition, I would like to stress that the fundamental goal of the book—providing students with the tools from intermediate microeconomics, game theory, and industrial organization that they need to make sound managerial decisions—has not changed.
This book begins by teaching managers the practical utility of basic economic tools such as present value analysis, supply and demand, regression, indifference curves, isoquants, production, costs, and the basic models of perfect competition, monopoly, and monopolistic competition. Adopters and reviewers also praise the book for its real-world examples and because it includes modern topics not con- tained in any other single managerial economics textbook: oligopoly, penetration pricing, multistage and repeated games, foreclosure, contracting, vertical and hori- zontal integration, networks, bargaining, predatory pricing, principal–agent prob- lems, raising rivals’ costs, adverse selection, auctions, screening and signaling, search, limit pricing, and a host of other pricing strategies for firms enjoying mar- ket power. This balanced coverage of traditional and modern microeconomic tools makes it appropriate for a wide variety of managerial economics classrooms. An increasing number of business schools are adopting this book to replace (or use alongside) managerial strategy texts laden with anecdotes but lacking the micro- economic tools needed to identify and implement the business strategies that are optimal in a given situation.
This seventh edition of Managerial Economics and Business Strategy has been thoroughly updated but retains all of the content that made previous editions suc- cessful. The basic structure of the textbook is unchanged.
KEY PEDAGOGICAL FEATURES
The seventh edition retains all of the class-tested features of previous editions that enhance students’ learning experiences and make it easy to teach from this book.
Headlines
As in previous editions, each chapter begins with a Headline that is based on a real- world economic problem—a problem that students should be able to address after completing the chapter. These Headlines are essentially hand-picked “mini-cases” designed to motivate students to learn the material in the chapter. Each Headline is
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answered at the end of the relevant chapter—when the student is better prepared to deal with the complications of real-world problems. Reviewers as well as users of previous editions praise the Headlines not only because they motivate students to learn the material in the chapter, but also because the answers at the end of each chapter help students learn how to use economics to make business decisions.
Learning Objectives
Each chapter includes learning objectives designed to enhance the learning experi- ence.
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.
Inside Business Applications
Each chapter contains boxed material (called Inside Business applications) to illus- trate how theories explained in the text relate to a host of different business situa- tions. As in previous editions, I have tried to strike a balance between applications drawn from the current economic literature and the popular press.
Calculus and Noncalculus Alternatives
Users can easily include or exclude calculus-based material without losing content or continuity. 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 alterna- tives states the preceding principle or formula in calculus notation, and explains the relation between the calculus and noncalculus formula. More detailed calculus der- ivations are relegated to Appendices. Thus, the book is designed for use by instruc- tors who want to integrate calculus into managerial economics and by those who do not require students to use calculus.
Key Terms and Marginal Definitions
Each chapter ends with a list of key terms and concepts. These provide an easy way for instructors to glean material covered in each chapter and for students to check their mastery of terminology. In addition, marginal definitions are provided throughout the text.
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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 Applications, which are far less structured and, like real-world deci- sion 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 case that follows Chapter 14 includes 14 prob- lems 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 spe- cific skills are introduced, or as part of a capstone experience. Solutions to all of the memos are contained online at www.mhhe.com/baye7e.
Answers to selected end-of-chapter Conceptual and Computational Questions are presented at the end of the book; detailed answers to all problems—including Problems and Applications and the Time Warner case Memos, are available to instructors on the password-protected Web site.
Case Study
A case study in business strategy—Challenges at Time Warner—follows Chapter 14 and was prepared by Kyle Anderson, Michael Baye, and Dong Chen 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 manage- rial 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 on the Web site.
Flexibility
Instructors of managerial economics have genuinely heterogeneous textbook needs. Reviewers and users continue to praise the book for its flexibility, and 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 case) as time permits. More generally, instructors can easily omit topics such as present value analysis, regression, indif- ference curves, isoquants, or reaction functions without losing continuity.
Online Resources at www.mhhe.com/baye7e
A large assortment of student supplements for Managerial Economics and Business Strategy are available online at www.mhhe.com/baye7e. This includes data for the Time Warner case Memos, data needed for various end-of-chapter problems, spreadsheet
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versions of key tables in the text to enable students to see how key economic concepts—like marginal cost and profit maximization—can be implemented on stan- dard spreadsheets, and spreadsheet macros that students can use to find the optimum price and quantity under a variety of market settings, including monopoly, Cournot oli- gopoly, and Stackelberg oligopoly. Plus, the Web site includes 10 additional full-length cases (in pdf format) that are described below.
CourseSmart is a new way for faculty to find and review eTextbooks. It’s also a great option for students who are interested in accessing their course materials digitally. CourseSmart offers thousands of the most commonly adopted textbooks across hun- dreds of courses from a wide variety of higher education publishers. It is the only place for faculty to review and compare the full text of a textbook online. At CourseSmart, students can save up to 50% off the cost of a print book, reduce their impact on the environment, and gain access to powerful Web tools for learning including full text search, notes and highlighting, and email tools for sharing notes between classmates. Your eBook also includes tech support in case you ever need help.
Finding your eBook is easy. Visit www.CourseSmart.com and search by title, author, or ISBN.
SUPPLEMENTS
I am pleased to report that the seventh edition of Managerial Economics and Busi- ness Strategy truly offers adopters the most comprehensive and easily accessible supplements in the market. Below I discuss popular features of some of the supple- ments that have been greatly expanded for this edition.
Cases
In addition to the Time Warner case, the Web site contains nearly a dozen full- length cases that I prepared along with Patrick Scholten to accompany Managerial Economics and Business Strategy. These cases complement the textbook by show- ing how real-world businesses use tools like demand elasticities, markup pricing, third-degree price discrimination, bundling, Herfindahl indices, game theory, and predatory pricing to enhance profits or shape business strategies. The cases are based on actual decisions by companies that include Microsoft, Heinz, Visa, Sta- ples, American Airlines, Sprint, and Kodak. Instructors who adopt the seventh edi- tion obtain the cases on the Web site.
The Web site for the seventh edition contains expanded teaching notes and solutions for all of the cases—including the Time Warner case.
PowerPoint Slides
The Web site also contains thoroughly updated and fully editable PowerPoint presen- tations with animated figures and graphs to 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
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relevant concepts (like Cournot and Stackelberg equilibrium, normal form and exten- sive form games, and the like).
Instructor’s Manual/Test Bank
A thoroughly updated instructor’s manual and test bank, prepared by Michael R. Baye and Patrick Scholten, provides a summary of each chapter, a teaching outline for each chapter, complete answers to all end-of-chapter problems, updated and class-tested problems (including over 1,000 multiple-choice questions and over 250 problems with detailed solutions). The seventh edition Web site contains teaching notes for the Time Warner case and solutions to the 14 accompanying Memos, as well as expanded and improved teaching notes for the additional cases.
EZ Test Version of the Test Bank
The password-protected Web site contains test bank files in both EZ Test software as well as in Microsoft Word format. EZ Test can reproduce high-quality graphs from the test bank and allows instructors to generate multiple tests with versions that are “scrambled” to be distinctive. The software is easy to use and allows optimum cus- tomization of tests.
Digital Image Library
The Digital Image Library contains all the figures in the textbook in electronic for- mat. This gives instructors the flexibility to integrate figures from the textbook into PowerPoint presentations or to directly print the figures on overhead transparencies.
Study Guide
In addition to the numerous problems and answers contained in the textbook, an updated study guide prepared by yours truly is available to enhance student per- formance at minimal cost to students and professors.
Student Web Site
Please visit the enhanced Web site for Managerial Economics and Business Strategy at www.mhhe.com/baye7e. This site provides a host of information for students and instructors, including online quizzes, PowerPoint presentations, Inside Business applications from previous editions of the text, sample problems from the Study Guide, and other material designed to help students and instructors more effectively use both the textbook and Study Guide.
Instructor Web Site
Electronic versions of all instructor supplements (including the full-length cases complete with teaching notes, PowerPoint presentations, Digital Image Library, the electronic test bank, detailed solutions to every end-of-chapter problem and Time Warner case, chapter outlines, chapter summaries, and more) may be conveniently accessed on the password-protected Instructor's Web site. This makes it easy for instructors to use the many supplements designed to make teaching managerial economics from the seventh edition easy and fun.
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CHANGES IN THE SEVENTH EDITION
I have made every effort to update and improve Managerial Economics and Busi- ness Strategy while assuring a smooth transition to the seventh edition. Below is a summary of the pedagogical improvements, enhanced supplements, and content changes that make the seventh edition an even more powerful tool for teaching and learning managerial economics and business strategy.
• All of the class-tested problems from the previous edition, plus over 25 new end-of-chapter problems. Where appropriate, problems from the previous edition have been updated to reflect the current economic climate.
• Updated Test Bank available on the Instructor’s Web site in two formats: Computerized (EZ Test) and in Microsoft Word format.
• Updated Headlines. • New and updated Inside Business applications. • The financial crisis is reshaping the global economic and regulatory
landscape, and it is likely to take years for its ultimate effects on the economy to be fully recognized. In preparing this edition, I have revised the book to ensure that the economic examples presented are timeless and will not grow into “historical examples” as a result of bankruptcies, new legislation, or changes in the country’s taste for regulation. As in previous editions, this edition continues to equip students with the economic tools required to manage businesses and, more generally, to evaluate current events. The virtues of markets, as well as potential market failures, are presented without editorial comment on my part. Adopters of this book have praised this approach, as it provides a positive foundation that permits individual instructors to rigorously discuss current events—including the plethora of political proposals and opinions regarding the financial crisis that emerge each and every day.
• Updated Instructor’s Web site that offers full teaching notes and solutions to Memos for the Time Warner case—plus a host of additional supplements. These include over 10 additional full-length cases complete with expanded teaching notes and links to chapter content, complete solutions to all end-of- chapter problems, an updated and expanded electronic test bank, animated PowerPoint presentations, chapter summaries, chapter outlines, the Digital Image Library, and more.
• Chapters 1–4 have been revised to include more timely Headlines, updated Inside Business applications, and additional in-text examples. Each chapter also contains new end-of-chapter problems, as well as updated versions of the class-tested problems you enjoyed in the previous edition.
• Chapter 5 opens with a new Headline and contains updated examples throughout. It also offers a new Inside Business application that shows how to estimate cost functions using regression techniques, as well as updated and new end-of-chapter problems.
• Chapter 6 offers updated examples and Inside Business applications. The chapter also includes two new end-of-chapter problems.
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• Chapter 7 contains thoroughly updated examples and industry data, along with a new Inside Business application that describes the 2007 North American Industry Classification System (NAICS). Additionally, the in-text discussion of horizontal mergers has been revised to reflect current practices at the Federal Trade Commission and Antitrust Division of the U.S. Department of Justice. The chapter also includes two new end-of-chapter problems.
• Chapter 8 offers a new opening Headline, updated Inside Business applications and in-text examples, and new content on the pitfalls of brand myopia. Several new end-of-chapter problems are provided, along with updated versions of the problems contained in the previous edition.
• Chapter 9 provides improved exposition of a variety of oligopoly models. The opening Headline and Inside Business applications have been updated, and the chapter includes two new end-of-chapter problems.
• Chapter 10 opens with a new Headline and includes two new end-of-chapter problems.
• Chapter 11 now offers some caveats to managers who use markup formulas to price their products or services, and includes an improved exposition of price discrimination. Examples have been updated throughout, and two new end-of-chapter problems are provided.
• Chapters 12–14 include updated Headlines, updated Inside Business applications, and new end-of-chapter problems. Chapters 13 and 14 now offer succinct coverage of antitrust issues that can constrain the scope of business strategies, such as pricing and mergers.
ACKNOWLEDGMENTS
I thank the many users of Managerial Economics and Business Strategy who pro- vided 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 my book in their own classrooms, col- leagues who unselfishly gave up their own time to provide me with comments and suggestions, and reviewers who provided detailed suggestions to improve this and previous editions of the book. I especially thank the following professors for enlightening me on the market’s diverse needs and for providing suggestions and constructive criticisms to improve this book:
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 Dean Baim, Pepperdine University
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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 Leo Chan, University of Kansas Robert L. Chapman, Florida Metropolitan University Basanta Chaudhuri, Rutgers University-New Brunswick Kwang Soo Cheong, Johns Hopkins University Christopher B. Colburn, Old Dominion University Michael Conlin, Syracuse 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 George Darko, Tusculum College Tina Das, Elon University Ron Deiter, Iowa State 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 Ibrahim Elsaify, Goldey-Beacom College Mark J. Eschenfelder, Robert Morris University David Ely, San Diego State University 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 Thomas A. Gresik, Mendoza College of Business (University of Notre Dame) Andrea Mays Griffith, California State University Madhurima Gupta, University of Notre Dame Carl Gwin, Pepperdine University
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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) Clifford Hawley, West Virginia University Ove Hedegaard, Copenhagen Business School Steven Hinson, Webster University Hart Hodges, Western Washington University Jack Hou, California State University—Long Beach Lowel R. Jacobsen, William Jewell College Thomas D. Jeitschko, Texas A&M University Jaswant R. Jindia, Southern University Paul Kattuman, Judge Business School (Cambridge University) Brian Kench, University of Tampa Peter Klein, University of Georgia, University of Missouri-Columbia Audrey D. Kline, University of Louisville W. J. Lane, University of New Orleans Daniel Lee, Shippensburg University Dick Leiter, American Public University Canlin Li, University of California-Riverside Vahe Lskavyan, Ohio University-Athens Heather Luea, Newman University Thomas Lyon, University of Michigan Richard Marcus, University of Wisconsin—Milwaukee Vincent Marra, University of Delaware Wade Martin, California State University, Long Beach Catherine Matraves, Michigan State University-East Lansing John Maxwell, Indiana University David May, Oklahoma City University Alan McInnes, California State University, Fullerton Christopher McIntosh, University of Minnesota Duluth Edward Millner, Virginia Commonwealth University John Moran, Syracuse University John Morgan, Haas Business School (University of California—Berkeley) Ram Mudambi, Temple University Francis Mummery, California State University-Fullerton Inder Nijhawan, Fayetteville State University Albert A. Okunade, University of Memphis Darrell Parker, Georgia Southern University Stephen Pollard, California State University, Los Angeles
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Dwight A. Porter, College of St. Thomas Stanko Racic, University of Pittsburgh Eric Rasmusen, Indiana University Matthew Roelofs, Western Washington University Christian Roessler, National University of Singapore Bansi Sawhney, University of Baltimore Craig Schulman, University of Arkansas Karen Schultes, University of Michigan—Dearborn Peter M. Schwartz, University of North Carolina Edward Shinnick, University College Ireland Dean Showalter, Southwest Texas State University Chandra Shrestha, Virginia Commonwealth University Karen Smith, Columbia Southern University John Stapleford, Eastern University Mark Stegeman, Virginia Polytechnic University Ed Steinberg, New York University Barbara M. Suleski, Cardinal Stritch College Caroline Swartz, University of North Carolina Charlotte Bill Taylor, New Mexico Highlands University Roger Tutterow, Kennesaw State College Nora Underwood, University of Central Florida Lskavyan Vahe, Ohio University Lawrence White, Stern School of Business (New York University) Leonard White, University of Arkansas Keith Willett, Oklahoma State 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
I thank Anne Hilbert, Douglas Reiner, and Bruce Gin at McGraw-Hill for all they have done to make this project a success, and Alexander V. Borisov and Lan Zhang for assisting me during various stages of the revision. I once again am indebted to Patrick Scholten for his efforts to improve this book and its supplements. Also, my thanks to Philip Powell and Patrick Scholten for their review. Finally, I thank my family— M’Lissa, Natalie, and Mitchell—for their continued love and support.
As always, I welcome your comments and suggestions for the next edition. Visit my Web site, http://www.nash-equilibrium.com/, or write to me directly at [email protected].
Michael R. Baye Bloomington, Indiana
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BRIEF TABLE OF CONTENTS
Chapter 1. The Fundamentals of Managerial Economics 1
Chapter 2. Market Forces: Demand and Supply 35
Chapter 3. Quantitative Demand Analysis 73
Chapter 4. The Theory of Individual Behavior 117
Chapter 5. The Production Process and Costs 155
Chapter 6. The Organization of the Firm 202
Chapter 7. The Nature of Industry 235
Chapter 8. Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets 264
Chapter 9. Basic Oligopoly Models 313
Chapter 10. Game Theory: Inside Oligopoly 350
Chapter 11. Pricing Strategies for Firms with Market Power 395
Chapter 12. The Economics of Information 433
Chapter 13. Advanced Topics in Business Strategy 473
Chapter 14. A Manager’s Guide to Government in the Marketplace 507
Case Study. Challenges at Time Warner 546
Appendix A Answers to Selected End-of-Chapter Problems 582
Appendix B Additional Readings and References 585
Name Index 603
General Index 609
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CONTENTS
CHAPTER ONE The Fundamentals of Managerial Economics 1
Headline: Amcott Loses $3.5 Million; Manager Fired 1 Introduction 2
The Manager 3 Economics 3 Managerial Economics Defined 3
The Economics of Effective Management 4 Identify Goals and Constraints 4 Recognize the Nature and Importance of Profits 5
Economic versus Accounting Profits 5 The Role of Profits 6 The Five Forces Framework and Industry Profitability 8
Understand Incentives 11 Understand Markets 12
Consumer–Producer Rivalry 13 Consumer–Consumer Rivalry 13 Producer–Producer Rivalry 13 Government and the Market 13
Recognize the Time Value of Money 14 Present Value Analysis 14 Present Value of Indefinitely Lived Assets 16
Use Marginal Analysis 19 Discrete Decisions 20 Continuous Decisions 22 Incremental Decisions 24
Learning Managerial Economics 25 Answering the Headline 26 Key Terms and Concepts 26 Conceptual and Computational Questions 27 Problems and Applications 28 Case-Based Exercises 32 Selected Readings 33 Appendix: The Calculus of Maximizing Net Benefits 33 Inside Business 1–1: The Goals of Firms in Our Global Economy 7 Inside Business 1–2: Profits and the Evolution of the Computer Industry 11 Inside Business 1–3: Joining the Jet Set 19
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CHAPTER TWO Market Forces: Demand and Supply 35
Headline: Samsung and Hynix Semiconductor to Cut Chip Production 35 Introduction 36 Demand 36
Demand Shifters 38 Income 39 Prices of Related Goods 40 Advertising and Consumer Tastes 40 Population 41 Consumer Expectations 41 Other Factors 42
The Demand Function 42 Consumer Surplus 44
Supply 46 Supply Shifters 46
Input Prices 47 Technology or Government Regulations 47 Number of Firms 47 Substitutes in Production 47 Taxes 48 Producer Expectations 49
The Supply Function 49 Producer Surplus 51
Market Equilibrium 52 Price Restrictions and Market Equilibrium 54
Price Ceilings 54 Price Floors 58
Comparative Statics 60 Changes in Demand 60 Changes in Supply 61 Simultaneous Shifts in Supply and Demand 63
Answering the Headline 65 Summary 65 Key Terms and Concepts 66 Conceptual and Computational Questions 66 Problems and Applications 68 Case-Based Exercises 72 Selected Readings 72 Inside Business 2–1: Asahi Breweries Ltd. and the Asian Recession 39 Inside Business 2–2: The Trade Act of 2002, NAFTA, and the Supply Curve 47 Inside Business 2–3: Price Ceilings and Price Floors around the Globe 58 Inside Business 2–4: Globalization and the Supply of Soft Drinks 62 Inside Business 2–5: Using a Spreadsheet to Calculate Equilibrium in the Supply and Demand Model 63
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CHAPTER THREE Quantitative Demand Analysis 73
Headline: Winners of Wireless Auction to Pay $7 Billion 73 Introduction 74 The Elasticity Concept 74 Own Price Elasticity of Demand 75
Elasticity and Total Revenue 76 Factors Affecting the Own Price Elasticity 79
Available Substitutes 80 Time 82 Expenditure Share 82
Marginal Revenue and the Own Price Elasticity of Demand 83 Cross-Price Elasticity 85 Income Elasticity 88 Other Elasticities 90 Obtaining Elasticities from Demand Functions 90
Elasticities for Linear Demand Functions 91 Elasticities for Nonlinear Demand Functions 92
Regression Analysis 95 Evaluating the Statistical Significance of Estimated Coefficients 98
Confidence Intervals 99 The t-Statistic 99
Evaluating the Overall Fit of the Regression Line 100 The R-Square 100 The F-Statistic 102
Nonlinear and Multiple Regressions 102 Nonlinear Regressions 102 Multiple Regression 104
A Caveat 107 Answering the Headline 107 Summary 109 Key Terms and Concepts 109 Conceptual and Computational Questions 110 Problems and Applications 112 Case-Based Exercises 116 Selected Readings 116 Inside Business 3–1: Calculating and Using the Arc Elasticity: An Application to the Housing Market 80 Inside Business 3–2: Inelastic Demand for Prescription Drugs 84 Inside Business 3–3: Using Cross-Price Elasticities to Improve New Car Sales in the Wake of Increasing Gasoline Prices 87 Inside Business 3–4: Shopping Online in Europe: Elasticities of Demand for Personal Digital Assistants Based on Nonlinear Regression Techniques 103
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CHAPTER FOUR The Theory of Individual Behavior 117
Headline: Packaging Firm Uses Overtime Pay to Overcome Labor Shortage 117 Introduction 118 Consumer Behavior 118 Constraints 122
The Budget Constraint 123 Changes in Income 125 Changes in Prices 126
Consumer Equilibrium 128 Comparative Statics 129
Price Changes and Consumer Behavior 129 Income Changes and Consumer Behavior 131 Substitution and Income Effects 133
Applications of Indifference Curve Analysis 135 Choices by Consumers 135
Buy One, Get One Free 135 Cash Gifts, In-Kind Gifts, and Gift Certificates 136
Choices by Workers and Managers 139 A Simplified Model of Income–Leisure Choice 140 The Decisions of Managers 141
The Relationship between Indifference Curve Analysis and Demand Curves 143 Individual Demand 143 Market Demand 144
Answering the Headline 145 Summary 146 Key Terms and Concepts 147 Conceptual and Computational Questions 147 Problems and Applications 149 Case-Based Exercises 152 Selected Readings 152 Appendix: A Calculus Approach to Individual Behavior 153 Inside Business 4–1: Indifference Curves and Risk Preferences 122 Inside Business 4–2: Price Changes and Inventory Management for Multiproduct Firms 130 Inside Business 4–3: Income Effects and the Business Cycle 134 Inside Business 4–4: The “Deadweight Loss” of In-Kind Gifts 139
CHAPTER FIVE The Production Process and Costs 155
Headline: Boeing Loses the Battle but Wins the War 155 Introduction 156
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The Production Function 156 Short-Run versus Long-Run Decisions 156 Measures of Productivity 158
Total Product 158 Average Product 158 Marginal Product 158
The Role of the Manager in the Production Process 160 Produce on the Production Function 160 Use the Right Level of Inputs 161
Algebraic Forms of Production Functions 164 Algebraic Measures of Productivity 165 Isoquants 167 Isocosts 170 Cost Minimization 171 Optimal Input Substitution 173
The Cost Function 175 Short-Run Costs 176 Average and Marginal Costs 178 Relations among Costs 180 Fixed and Sunk Costs 181 Algebraic Forms of Cost Functions 182 Long-Run Costs 183 Economies of Scale 185 A Reminder: Economic Costs versus Accounting Costs 186
Multiple-Output Cost Functions 187 Economies of Scope 187 Cost Complementarity 187
Answering the Headline 190 Summary 190 Key Terms and Concepts 191 Conceptual and Computational Questions 191 Problems and Applications 194 Case-Based Exercises 198 Selected Readings 198 Appendix: The Calculus of Production and Costs 199 Inside Business 5–1: Where Does Technology Come From? 163 Inside Business 5–2: Fringe Benefits and Input Substitution 176 Inside Business 5–3: Estimating Production Functions, Cost Functions, and Returns to Scale 184 Inside Business 5–4: International Companies Exploit Economies of Scale 186
CHAPTER SIX The Organization of the Firm 202
Headline: Korean Firm Invests 30 Trillion Won to Vertically Integrate 202 Introduction 203
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Methods of Procuring Inputs 204 Purchase the Inputs Using Spot Exchange 204 Acquire Inputs under a Contract 205 Produce the Inputs Internally 205
Transaction Costs 206 Types of Specialized Investments 207
Site Specificity 207 Physical-Asset Specificity 207 Dedicated Assets 207 Human Capital 208
Implications of Specialized Investments 208 Costly Bargaining 208 Underinvestment 208 Opportunism and the “Hold-Up Problem” 209
Optimal Input Procurement 210 Spot Exchange 210 Contracts 212 Vertical Integration 215 The Economic Trade-Off 216
Managerial Compensation and the Principal–Agent Problem 219 Forces That Discipline Managers 221
Incentive Contracts 221 External Incentives 222
Reputation 222 Takeovers 222
The Manager–Worker Principal–Agent Problem 223 Solutions to the Manager–Worker Principal–Agent Problem 223
Profit Sharing 223 Revenue Sharing 223 Piece Rates 224 Time Clocks and Spot Checks 224
Answering the Headline 226 Summary 226 Key Terms and Concepts 226 Conceptual and Computational Questions 227 Problems and Applications 228 Case-Based Exercises 231 Selected Readings 231 Appendix : An Indifference Curve Approach to Managerial Incentives 231 Inside Business 6–1: The Cost of Using an Inefficient Method of Procuring Inputs 210 Inside Business 6–2: Factors Affecting the Length of Coal and Natural-Gas Contracts 214 Inside Business 6–3: The Evolution of Input Decisions in the Automobile Industry 217 Inside Business 6–4: Paying for Performance 225
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CHAPTER SEVEN The Nature of Industry 235
Headline: Microsoft Puts Halt to Intuit Merger 235 Introduction 236 Market Structure 236
Firm Size 236 Industry Concentration 237
Measures of Industry Concentration 238 The Concentration of U.S. Industry 239 Limitations of Concentration Measures 241
Technology 243 Demand and Market Conditions 243 Potential for Entry 245
Conduct 246 Pricing Behavior 247 Integration and Merger Activity 248
Vertical Integration 249 Horizontal Integration 249 Conglomerate Mergers 250
Research and Development 250 Advertising 251
Performance 251 Profits 251 Social Welfare 251
The Structure–Conduct–Performance Paradigm 253 The Causal View 253 The Feedback Critique 253 Relation to the Five-Forces Framework 254
Overview of the Remainder of the Book 254 Perfect Competition 255 Monopoly 255 Monopolistic Competition 255 Oligopoly 255
Answering the Headline 257 Summary 257 Key Terms and Concepts 258 Conceptual and Computational Questions 258 Problems and Applications 260 Case-Based Exercises 263 Selected Readings 263 Inside Business 7–1: The 2007 North American Industry Classification System (NAICS) 242 Inside Business 7–2: The Elasticity of Demand at the Firm and Market Levels 246 Inside Business 7–3: The Evolution of Market Structure in the Computer Industry 256
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CHAPTER EIGHT Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets 264
Headline: McDonald’s New Buzz: Specialty Coffee 264 Introduction 265 Perfect Competition 265
Demand at the Market and Firm Levels 266 Short-Run Output Decisions 267
Maximizing Profits 267 Minimizing Losses 271 The Short-Run Firm and Industry Supply Curves 274
Long-Run Decisions 275 Monopoly 277
Monopoly Power 278 Sources of Monopoly Power 279
Economies of Scale 279 Economies of Scope 280 Cost Complementarity 281 Patents and Other Legal Barriers 281
Maximizing Profits 282 Marginal Revenue 282 The Output Decision 286 The Absence of a Supply Curve 289 Multiplant Decisions 289
Implications of Entry Barriers 291 Monopolistic Competition 293
Conditions for Monopolistic Competition 293 Profit Maximization 294 Long-Run Equilibrium 296 Implications of Product Differentiation 299
Optimal Advertising Decisions 300 Answering the Headline 302 Summary 302 Key Terms and Concepts 303 Conceptual and Computational Questions 303 Problems and Applications 306 Case-Based Exercises 310 Selected Readings 310 Appendix: The Calculus of Profit Maximization 311 Appendix: The Algebra of Perfectly Competitive Supply Functions 312 Inside Business 8–1: Peugeot-Citroën of France: A Price-Taker in China’s Auto Market 273 Inside Business 8–2: Patent, Trademark, and Copyright Protection 283 Inside Business 8–3: Product Differentiation, Cannibalization, and Colgate’s Smile 296
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CHAPTER NINE Basic Oligopoly Models 313
Headline: Crude Oil Prices Fall, but Consumers in Some Areas See No Relief at the Pump 313 Introduction 314 Conditions for Oligopoly 314 The Role of Beliefs and Strategic Interaction 314 Profit Maximization in Four Oligopoly Settings 316
Sweezy Oligopoly 316 Cournot Oligopoly 318
Reaction Functions and Equilibrium 318 Isoprofit Curves 324 Changes in Marginal Costs 326 Collusion 328
Stackelberg Oligopoly 330 Bertrand Oligopoly 334
Comparing Oligopoly Models 336 Cournot 336 Stackelberg 337 Bertrand 337 Collusion 337
Contestable Markets 339 Answering the Headline 340 Summary 341 Key Terms and Concepts 342 Conceptual and Computational Questions 342 Problems and Applications 344 Case-Based Exercises 347 Selected Readings 348 Appendix: Differentiated-Product Bertrand Oligopoly 348 Inside Business 9–1: Commitment in Stackelberg Oligopoly 332 Inside Business 9–2: Price Competition and the Number of Sellers: Evidence from Online and Laboratory Markets 335 Inside Business 9–3: Using a Spreadsheet to Calculate Cournot, Stackelberg, and Collusive Outcomes 338
CHAPTER TEN Game Theory: Inside Oligopoly 350
Headline: USAirways Brings Back Complementary Drinks 350 Introduction 351 Overview of Games and Strategic Thinking 351 Simultaneous-Move, One-Shot Games 352
Theory 352 Applications of One-Shot Games 355
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Pricing Decisions 355 Advertising and Quality Decisions 358 Coordination Decisions 359 Monitoring Employees 360 Nash Bargaining 361
Infinitely Repeated Games 363 Theory 363
Review of Present Value 363 Supporting Collusion with Trigger Strategies 364
Factors Affecting Collusion in Pricing Games 367 Number of Firms 367 Firm Size 367 History of the Market 368 Punishment Mechanisms 369
An Application of Infinitely Repeated Games to Product Quality 369 Finitely Repeated Games 370
Games with an Uncertain Final Period 370 Repeated Games with a Known Final Period: The End-of-Period Problem 373 Applications of the End-of-Period Problem 375
Resignations and Quits 375 The “Snake-Oil” Salesman 375
Multistage Games 376 Theory 376 Applications of Multistage Games 379
The Entry Game 379 Innovation 380 Sequential Bargaining 381
Answering the Headline 384 Summary 385 Key Terms and Concepts 385 Conceptual and Computational Questions 386 Problems and Applications 389 Case-Based Exercises 394 Selected Readings 394 Inside Business 10–1: Hollywood’s (not so) Beautiful Mind: Nash or “Opie” Equilibrium? 356 Inside Business 10–2: Trigger Strategies in the Waste Industry 368 Inside Business 10–3: Entry Strategies in International Markets: Sprinkler or Waterfall? 380
CHAPTER ELEVEN Pricing Strategies for Firms with Market Power 395
Headline: Mickey Mouse Lets You Ride “for Free” at Disney World 395 Introduction 396
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Basic Pricing Strategies 396 Review of the Basic Rule of Profit Maximization 396 A Simple Pricing Rule for Monopoly and Monopolistic Competition 397 A Simple Pricing Rule for Cournot Oligopoly 400
Strategies That Yield Even Greater Profits 402 Extracting Surplus from Consumers 402
Price Discrimination 402 Two-Part Pricing 408 Block Pricing 410 Commodity Bundling 412
Pricing Strategies for Special Cost and Demand Structures 415 Peak-Load Pricing 415 Cross-Subsidies 416 Transfer Pricing 417
Pricing Strategies in Markets with Intense Price Competition 419 Price Matching 420 Inducing Brand Loyalty 421 Randomized Pricing 422
Answering the Headline 423 Summary 424 Key Terms and Concepts 425 Conceptual and Computational Questions 425 Problems and Applications 428 Case-Based Exercises 431 Selected Readings 431 Inside Business 11–1: Pricing Markups as Rules of Thumb 398 Inside Business 11–2: Bundling and “Price Frames” in Online Markets 414 Inside Business 11–3: The Prevalence of Price-Matching Policies and Other Low- Price Guarantees 421 Inside Business 11–4: Randomized Pricing in the Airline Industry 423
CHAPTER TWELVE The Economics of Information 433
Headline: Firm Chickens Out in the FCC Spectrum Auction 433 Introduction 434 The Mean and the Variance 434 Uncertainty and Consumer Behavior 437
Risk Aversion 437 Managerial Decisions with Risk-Averse Consumers 437
Consumer Search 439 Uncertainty and the Firm 442
Risk Aversion 442 Producer Search 446 Profit Maximization 446
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Uncertainty and the Market 448 Asymmetric Information 448
Adverse Selection 449 Moral Hazard 450
Signaling and Screening 452 Auctions 454
Types of Auctions 455 English Auction 455 First-Price, Sealed-Bid Auction 455 Second-Price, Sealed-Bid Auction 456 Dutch Auction 456
Information Structures 457 Independent Private Values 457 Correlated Value Estimates 458
Optimal Bidding Strategies for Risk-Neutral Bidders 458 Strategies for Independent Private Values Auctions 459 Strategies for Correlated Values Auctions 461
Expected Revenues in Alternative Types of Auctions 463 Answering the Headline 465 Summary 465 Key Terms and Concepts 466 Conceptual and Computational Questions 466 Problems and Applications 469 Case-Based Exercises 472 Selected Readings 472 Inside Business 12–1: Risk Aversion and the Value of Selling the Firm: The St. Petersburg Paradox 438 Inside Business 12–2: The Value of Information in Online Markets 443 Inside Business 12–3: Second-Price Auctions on eBay 456 Inside Business 12–4: Auctions with Risk-Averse Bidders 464
CHAPTER THIRTEEN Advanced Topics in Business Strategy 473
Headline: Barkley and Sharpe to Announce Plans at Trade Show 473 Introduction 474 Limit Pricing to Prevent Entry 475
Theoretical Basis for Limit Pricing 475 Limit Pricing May Fail to Deter Entry 477 Linking the Preentry Price to Postentry Profits 478
Commitment Mechanisms 478 Learning Curve Effects 479 Incomplete Information 480 Reputation Effects 480
Dynamic Considerations 481
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Predatory Pricing to Lessen Competition 483 Raising Rivals’ Costs to Lessen Competition 486
Strategies Involving Marginal Cost 486 Strategies Involving Fixed Costs 487 Strategies for Vertically Integrated Firms 488
Vertical Foreclosure 489 The Price–Cost Squeeze 489
Price Discrimination as a Strategic Tool 489 Changing the Timing of Decisions or the Order of Moves 490
First-Mover Advantages 490 Second-Mover Advantages 493
Penetration Pricing to Overcome Network Effects 493 What Is a Network? 494 Network Externalities 495 First-Mover Advantages Due to Consumer Lock-In 496 Using Penetration Pricing to “Change the Game” 498
Answering the Headline 499 Summary 500 Key Terms and Concepts 500 Conceptual and Computational Questions 500 Problems and Applications 503 Case-Based Exercises 506 Selected Readings 506 Inside Business 13–1: Business Strategy at Microsoft 476 Inside Business 13–2: U.S. Steel Opts against Limit Pricing 482 Inside Business 13–3: First to Market, First to Succeed? Or First to Fail? 492 Inside Business 13–4: Network Externalities and Penetration Pricing by Yahoo! Auctions 497
CHAPTER FOURTEEN A Manager’s Guide to Government in the Marketplace 507
Headline: FTC Conditionally Approves $10.3 Billion Merger 507 Introduction 508 Market Failure 508
Market Power 508 Antitrust Policy 509 Price Regulation 513
Externalities 518 The Clean Air Act 519
Public Goods 522 Incomplete Information 526
Rules against Insider Trading 527 Certification 527 Truth in Lending 528
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Truth in Advertising 529 Enforcing Contracts 529
Rent Seeking 531 Government Policy and International Markets 532
Quotas 532 Tariffs 534
Lump-Sum Tariffs 535 Excise Tariffs 535
Answering the Headline 536 Summary 537 Key Terms and Concepts 537 Conceptual and Computational Questions 538 Problems and Applications 541 Case-Based Exercises 544 Selected Readings 544 Inside Business 14–1: European Commission Asks Airlines to Explain Price Discrimination Practices 512 Inside Business 14–2: Electricity Deregulation 517 Inside Business 14–3: Canada’s Competition Bureau 530
CASE STUDY Challenges at Time Warner 546
Author’s Note about the Case 545 Headline 546 Background 547 Overview of the Industry and Time Warner’s Operations 548 America Online 548
Market Conditions 549 AOL Operations 550 AOL Europe 551
Filmed Entertainment 551 Motion Picture Production and Distribution 552
The Film Industry 552 Competition 554
Television Programming 555 Home Video Distribution 555
Publishing 555 Magazine Publishing 556 Magazines Online 557 Book Publishing 557
Programming Networks 558 Cable Systems 559
Analog and Digital Cable TV 559 High-Speed Internet Service 560
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Telephone Service 560 Competition 561
Direct Broadcast Satellite Operators 561 Overbuilders 561
Bundling 562 Regulatory Considerations 563 Technological Considerations 563
High-Definition Television (HDTV) 563 Digital Video Recorders (DVRs) 564
Challenges 565 Case-Based Exercises 565 Memos 565 Selected Readings and References 574 Appendix: Exhibits 576
Appendix A Answers to Selected End-of-Chapter Problems 582
Appendix B Additional Readings and References 585
Name Index 603
General Index 609
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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 mil- lion of the loss stemmed from its foreign language division.
With short-term interest rates at 7 percent, 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 home- work before buying the rights to Magicword. I pro- jected 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
C H
A P TE
R O
N E
HEADLINE
The Fundamentals of Managerial Economics
1
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.
Learning Objectives After completing this chapter, you will be able to:
LO1 Summarize how goals, constraints, incen- tives, and market rivalry affect economic 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 effec- tive managerial decision making.
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2 Managerial Economics and Business Strategy
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 definitive answers to such questions. Obtaining the answers would require an accurate crystal ball. Nevertheless, managerial econom- ics 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 BusinessWeek or The Wall Street Journal, or read a trade publication like Restaurant News or Supermarket Business, you will find a host of stories that involve manage- rial economics. A recent search generated the following headlines:
“Nintendo Wii Continues to Dominate Xbox 360, PS3 in Sales” “Comcast denies predatory pricing allegations” “FTC Seeks to Block Whole Foods’Acquisition of Wild Oats” “Boeing Cuts 4,500 Commercial Jobs as Economy Weakens” “Instant Messenger War: How Yahoo!, Microsoft and AOL Kill Google Talk” “LG, Sharp, and Chunghwa Nailed for LCD Price-Fixing” “DeBeers’ Multifaceted Strategy Shift” “Verizon Wireless Completes $28.1 Billion Alltel Buy” “The Recession: Great News?” “Free Software on the Internet”
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 deci- sions, 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 managers 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 software development but permit consumers to download it for free.
Managerial economics is not only valuable to managers of Fortune 500 com- panies; 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 household deci- sion making.
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The Fundamentals of Managerial Economics 3
manager A person who directs resources to achieve a stated goal.
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 del- egate 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.
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 cor- poration 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 accom- plishing some task. While much of this book assumes the manager’s task is to max- imize the profits of the firm that employs the manager, the underlying 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 gener- ally, to achieve a goal. Decisions are important because scarcity implies that by making one choice, you give up another. A computer 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 deci- sions thus involve the allocation of scarce resources, and a manager’s task is to allo- cate resources so as to best meet the manager’s goals.
One of the best ways to comprehend the pervasive nature of scarcity is to imag- ine 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 recog- nize 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 disci- pline in that it describes methods useful for directing everything from the resources of a household to maximize household welfare to the resources of a firm to maximize profits.
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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4 Managerial Economics and Business Strategy
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 compen- sate them? How can you ensure that employees work hard and produce quality prod- ucts? 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 department can provide you with data on the characteris- tics 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, process 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.
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 manager must (1) identify goals and con- straints; (2) recognize the nature and importance of profits; (3) understand incen- tives; (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 different goals entails making different decisions. If your goal is to max- imize your grade in this course rather than maximize your overall grade point aver- age, 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 distri- bution 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.
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The Fundamentals of Managerial Economics 5
economic profits The difference between total revenue and total opportunity cost.
opportunity cost The cost of the explicit and implicit resources that are forgone when a decision is made.
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 different goals.
Unfortunately, constraints make it difficult for managers to achieve goals such as maximizing 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 decisions 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 remainder 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 prof- its in a free-market economy.
Economic versus Accounting Profits When most people hear the word profit, they think of accounting profits. Accounting profit is 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 accounting department.
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 opportunity 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 oppor- tunity cost of producing a good or service 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, including the firm’s finance, marketing, and/or legal depart- ments, to obtain data about the implicit costs of decisions. In other instances man- agers must collect data on their own. For example, what does it cost you to read this book? The price you paid the bookstore 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
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6 Managerial Economics and Business Strategy
your implicit cost of reading this book; you are giving up this alternative to read the book. Similarly, the opportunity 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 hairstyling 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 busi- ness. 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 eco- nomic 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.
Throughout this book, when we speak of costs, we mean economic costs. Eco- nomic 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 necessar- ily bad for society. Individuals who want to maximize profits often are considered self-interested, a quality that many people view as undesirable. However, consider Adam Smith’s classic line from The Wealth of Nations: “It is not out of the benevo- lence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.”2
2Adam Smith, An Inquiry into the Causes of the Wealth of Nations, ed. Edwin Cannan (Chicago: University of Chicago Press, 1976).
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INSIDE BUSINESS 1–1
The Goals of Firms in Our Global Economy
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 business engineering firm, Mitsui & Co. Ltd., recently launched “Challenge 21,” a plan directed at helping the company emerge as Japan’s leading business engi- neering 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
through business conduct that balances the pursuit of earnings with socially responsible behavior.”
Ultimately, the goal of any continuing company must be to maximize the value of the firm. This goal is often achieved by trying to hit intermediate targets, such as minimizing costs or increasing market share. If you— as a manager—do not maximize your firm’s value over time, you will be in danger of either going out of busi- ness, being taken over by other owners (as in a leveraged buyout), or having stockholders elect to replace you and other managers.
Source: “Mitsui & Co., Ltd. UK Regulatory Announcement: Final Results,” Business Wire, May 13, 2004.
The Fundamentals of Managerial Economics 7
Smith is saying that by pursuing its self-interest—the goal of maximizing profits—a firm ultimately meets the needs of society. If you cannot make a living as a rock singer, it is probably because society does not appreciate your singing; society would more highly value your talents in some other employment. If you break five dishes each time you clean up after dinner, your talents are perhaps better suited for balancing the checkbook or mowing the lawn. Similarly, the profits of businesses signal where society’s scarce resources are best allocated. When firms in a given industry earn economic profits, the opportunity cost to resource holders outside the industry increases. Owners of other resources soon recognize that, by continuing to operate their existing businesses, they are giving up profits. This induces new firms to enter the markets in which economic profits are available. As more firms enter the industry, the market price falls, and eco- nomic profits decline.
Thus, profits signal the owners of resources where the resources are most highly valued by society. By moving scarce resources toward the production of goods most valued by society, the total welfare of society is improved. As Adam Smith first noted, this phenomenon is due not to benevolence on the part of the firms’ managers but to the self-interested goal of maximizing the firms’ profits.
Principle Profits Are a Signal Profits signal to resource holders where resources are most highly valued by society.
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FIGURE 1–1 The Five Forces Framework
Sustainable Industry Profits
• Entry costs • Sunk costs • Network effects • Switching costs • Speed of adjustment • Economies of scale • Reputation • Government restraints
Entry
• Supplier concentration • Price/productivity of alternative inputs • Relationship-specific investments • Supplier switching costs • Government restraints
Power of Input Suppliers
• Buyer concentration • Price/value of substitute products or services • Relationship-specific investments • Customer switching costs • Government restraints
Power of Buyers
• Concentration • Switching costs • Price, quantity, quality, or • Timing of decisions service competition • Information • Degree of differentiation • Government restraints
Industry Rivalry • Price/value of surrogate • Network effects products or services • Government restraints • Price/value of complementary products or services
Substitutes and Complements
8 Managerial Economics and Business Strategy
3Michael Porter, Competitive Strategy (New York: Free Press, 1980).
The Five Forces Framework and Industry Profitability A key theme of this textbook is that many interrelated forces and decisions influ- ence the level, growth, and sustainability of profits. If you or other managers in the industry are clever enough to identify strategies that yield a windfall to sharehold- ers this quarter, there is no guarantee that these profits will be sustained in the long run. You must recognize that profits are a signal—if your business earns superior profits, existing and potential competitors will do their best to get a piece of the action. In the remaining chapters we will examine a variety of business strategies designed to enhance your prospects of earning and sustaining profits. Before we do so, however, it is constructive to provide a conceptual framework for thinking about some of the factors that impact industry profitability.
Figure 1–1 illustrates the “five forces” framework pioneered by Michael Porter.3
This framework organizes many complex managerial economics issues into five categories or “forces” that impact the sustainability of industry profits: (1) entry, (2) power of input suppliers, (3) power of buyers, (4) industry rivalry, and (5) substi- tutes and complements. The discussion below explains how these forces influence industry profitability and highlights the connections among these forces and mate- rial covered in the remaining chapters of the text.
Entry. As we will see in Chapters 2, 7, and 8, entry heightens competition and reduces the margins of existing firms in a wide variety of industry settings. For this reason, the ability of existing firms to sustain profits depends on how barriers to
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The Fundamentals of Managerial Economics 9
entry affect the ease with which other firms can enter the industry. Entry can come from a number of directions, including the formation of new companies (Wendy’s entered the fast-food industry in the 1970s after its founder, Dave Thomas, left KFC); globalization strategies by foreign companies (Toyota sold vehicles in Japan since the 1930s but waited until the middle of the last century to enter the U.S. auto- mobile market); and the introduction of new product lines by existing firms (the cel- lular phone industry’s recent entry into the market for personal digital assistants).
As shown in Figure 1–1, a number of economic factors affect the ability of entrants to erode existing industry profits. In subsequent chapters, you will learn why entrants are less likely to capture market share quickly enough to justify the costs of entry in environments where there are sizeable sunk costs (Chapters 5, 9), significant economies of scale (Chapters 5, 8), or significant network effects (Chapter 13), or where existing firms have invested in strong reputations for providing value to a size- able base of loyal consumers (Chapter 11) or to aggressively fight entrants (Chapters 10, and 13). In addition, you will gain a better appreciation for the role that govern- ments play in shaping entry through patents and licenses (Chapter 8), trade policies (Chapters 5 and 14), and environmental legislation (Chapter 14). We will also iden- tify a variety of strategies to raise the costs to consumers of “switching” to would-be entrants, thereby lowering the threat that entrants erode your profits.
Power of Input Suppliers. Industry profits tend to be lower when suppliers have the power to negotiate favorable terms for their inputs. Supplier power tends to be low when inputs are relatively standardized and relationship-specific investments are minimal (Chapter 6), input markets are not highly concentrated (Chapter 7), or alternative inputs are available with similar marginal productivities per dollar spent (Chapter 5). In many countries, the government constrains the prices of inputs through price ceilings and other controls (Chapters 2 and 14), which limits to some extent the ability of suppliers to expropriate profits from firms in the industry.
Power of Buyers. Similar to the case of suppliers, industry profits tend to be lower when customers or buyers have the power to negotiate favorable terms for the products or services produced in the industry. In most consumer markets, buy- ers are fragmented and thus buyer concentration is low. Buyer concentration and hence customer power tend to be higher in industries that serve relatively few “high-volume” customers. Buyer power tends to be lower in industries where the cost to customers of switching to other products is high—as is often the case when there are relationship-specific investments and hold-up problems (Chapter 6), imperfect information that leads to costly consumer search (Chapter 12), or few close substitutes for the product (Chapters 2, 3, 4, and 11). Government regulations, such as price floors or price ceilings (Chapters 2 and 14), can also impact the abil- ity of buyers to obtain more favorable terms.
Industry Rivalry. The sustainability of industry profits also depends on the nature and intensity of rivalry among firms competing in the industry. Rivalry tends to be less intense (and hence the likelihood of sustaining profits is higher) in concentrated
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10 Managerial Economics and Business Strategy
4See, for example, Barry J. Nalebuff and Adam M. Brandenburger, Co-Opetition (New York: Doubleday, 1996) as well as R. Preston McAfee, Competitive Solutions (Princeton: Princeton University Press, 2002).
industries—that is, those with relatively few firms. In Chapter 7 we will take a closer look at various measures that can be used to gauge industry concentration.
The level of product differentiation and the nature of the game being played— whether firms’ strategies involve prices, quantities, capacity, or quality/service attributes, for example—also impact profitability. In later chapters you will learn why rivalry tends to be more intense in industry settings where there is little prod- uct differentiation and firms compete in price (Chapters 8, 9, 10, and 11) and where consumer switching costs are low (Chapters 11 and 12). You will also learn how imperfect information and the timing of decisions affect rivalry among firms (Chapters 10, 12, and 13).
Substitutes and Complements. The level and sustainability of industry profits also depend on the price and value of interrelated products and services. Porter’s original five forces framework emphasized that the presence of close substitutes erodes industry profitability. In Chapters 2, 3, 4, and 11 you will learn how to quantify the degree to which surrogate products are close substitutes by using elas- ticity analysis and models of consumer behavior. We will also see that government policies (such as restrictions limiting the importation of prescription drugs from Canada into the United States) can directly impact the availability of substitutes and thus industry profits.
More recent work by economists and business strategists emphasizes that com- plementarities also affect industry profitability.4 For example, Microsoft’s prof- itability in the market for operating systems is enhanced by the presence of complementary products ranging from relatively inexpensive computer hardware to a plethora of Windows-compatible application software. In Chapters 3, 5, 10, and 13 you will learn how to quantify these complementarities or “synergies” and identify strategies to create and exploit complementarities and network effects.
In concluding, it is important to recognize that the many forces that impact the level and sustainability of industry profits are interrelated. For instance, the U.S. automobile industry suffered a sharp decline in industry profitability during the 1970s as a result of sharp increases in the price of gasoline (a complement to auto- mobiles). This change in the price of a complementary product enabled Japanese automakers to enter the U.S. market through a differentiation strategy of marketing their fuel-efficient cars, which sold like hotcakes compared to the gas-guzzlers American automakers produced at that time. These events, in turn, have had a pro- found impact on industry rivalry in the automotive industry—not just in the United States, but worldwide.
It is also important to stress that the five forces framework is primarily a tool for helping managers see the “big picture”; it is a schematic you can use to organize various industry conditions that affect industry profitability and assess the efficacy of alternative business strategies. However, it would be a mistake to view it as a comprehensive list of all factors that affect industry profitability. The five forces
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INSIDE BUSINESS 1–2
Profits and the Evolution of the Computer Industry
When profits in a given industry are higher than in other industries, new firms will attempt to enter that industry. When losses are recorded, some firms will likely leave the industry. This sort of “evolution” has changed the global landscape of personal computer markets.
At the start of the PC era, personal computer mak- ers enjoyed positive economic profits. These higher profits led to new entry and heightened competition. Over the past two decades, entry has led to declines in PC prices and industry profitability despite significant increases in the speed and storage capacities of PCs. Less efficient firms have been forced to exit the market.
In the early 2000s, IBM—the company that launched the PC era when it introduced the IBM PC in
the early 1980s—sold its PC business to China-based Lenovo. Compaq—an early leader in the market for PCs—has since been acquired by Hewlett-Packard. A handful of small PC makers have enjoyed some success competing against the remaining traditional players, which include Dell and Hewlett-Packard. By the late 2000s, Dell's strategy switched from sell- ing computers directly to consumers to entering into relationships with retailers such as BestBuy and Sta- ples. While only time will tell how these strategies will impact the long-run viability of traditional play- ers, competitive pressures continue to push PC prices and industry profits downwards.
The Fundamentals of Managerial Economics 11
framework is not a substitute for understanding the economic principles that under- lie sound business decisions.
Understand Incentives
In our discussion of the role of profits, we emphasized that profits signal the hold- ers of resources when to enter and exit particular industries. In effect, changes in profits provide an incentive to resource holders to alter their use of resources. Within a firm, incentives affect how resources are used and how hard workers work. To succeed as a manager, you must have a clear grasp of the role of incen- tives within an organization such as a firm and how to construct incentives to induce maximal effort from those you manage. Chapter 6 is devoted to this special aspect of managerial decision making, but it is useful here to provide a synopsis of how to construct proper incentives.
The first step in constructing incentives within a firm is to distinguish between the world, or the business place, as it is and the way you wish it were. Many pro- fessionals and owners of small establishments have difficulties because they do not fully comprehend the importance of the role incentives play in guiding the deci- sions of others.
A friend of mine—Mr. O—opened a restaurant and hired a manager to run the business so he could spend time doing the things he enjoys. Recently, I asked him how his business was doing, and he reported that he had been losing money ever since the restaurant opened. When asked whether he thought the manager was doing a good job, he said, “For the $75,000 salary I pay the manager each year, the manager should be doing a good job.”
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Mr. O believes the manager “should be doing a good job.” This is the way he wishes the world was. But individuals often are motivated by self-interest. This is not to say that people never act out of kindness or charity, but rather that human nature is such that people naturally tend to look after their own self-interest. Had Mr. O taken a managerial economics course, he would know how to provide the manager with an incentive to do what is in Mr. O’s best interest. The key is to design a mechanism such that if the manager does what is in his own interest, he will indirectly do what is best for Mr. O.
Since Mr. O is not physically present at the restaurant to watch over the man- ager, he has no way of knowing what the manager is up to. Indeed, his unwilling- ness to spend time at the restaurant is what induced him to hire the manager in the first place. What type of incentive has he created by paying the manager $75,000 per year? The manager receives $75,000 per year regardless of whether he puts in 12-hour or 2-hour days. The manager receives no reward for working hard and incurs no penalty if he fails to make sound managerial decisions. The manager receives the same $75,000 regardless of the restaurant’s profitability.
Fortunately, most business owners understand the problem just described. The owners of large corporations are shareholders, and most never set foot on company ground. How do they provide incentives for chief executive officers (CEOs) to be effective managers? Very simply, they provide them with “incentive plans” in the form of bonuses. These bonuses are in direct proportion to the firm’s profitability. If the firm does well, the CEO receives a large bonus. If the firm does poorly, the CEO receives no bonus and risks being fired by the stockholders. These types of incentives are also present at lower levels within firms. Some individuals earn com- missions based on the revenue they generate for the firm’s owner. If they put forth little effort, they receive little pay; if they put forth much effort and hence generate many sales, they receive a generous commission.
The thrust of managerial economics is to provide you with a broad array of skills that enable you to make sound economic decisions and to structure appropri- ate incentives within your organization. We will begin under the assumption that everyone with whom you come into contact is greedy, that is, interested only in his or her own self-interest. In such a case, understanding incentives is a must. Of course, this is a worst-case scenario; more likely, some of your business contacts will not be so selfishly inclined. If you are so lucky, your job will be all the easier.
Understand Markets
In studying microeconomics in general, and managerial economics in particular, it is important to bear in mind that there are two sides to every transaction in a mar- ket: For every buyer of a good there is a corresponding seller. The final outcome of the market process, then, depends on the relative power of buyers and sellers in the marketplace. The power, or bargaining position, of consumers and producers in the market is limited by three sources of rivalry that exist in economic transactions: consumer–producer rivalry, consumer–consumer rivalry, and producer–producer
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The Fundamentals of Managerial Economics 13
rivalry. Each form of rivalry serves as a disciplining device to guide the market process, and each affects different markets to a different extent. Thus, your ability as a manager to meet performance objectives will depend on the extent to which your product is affected by these sources of rivalry.
Consumer–Producer Rivalry Consumer–producer rivalry occurs because of the competing interests of con- sumers and producers. Consumers attempt to negotiate or locate low prices, while producers attempt to negotiate high prices. In a very loose sense, consumers attempt to “rip off” producers, and producers attempt to “rip off” consumers. Of course, there are limits to the ability of these parties to achieve their goals. If a con- sumer offers a price that is too low, the producer will refuse to sell the product to the consumer. Similarly, if the producer asks a price that exceeds the consumer’s valuation of a good, the consumer will refuse to purchase the good. These two forces provide a natural check and balance on the market process even in markets in which the product is offered by a single firm (a monopolist).
Consumer–Consumer Rivalry A second source of rivalry that guides the market process occurs among consumers. Consumer–consumer rivalry reduces the negotiating power of consumers in the marketplace. It arises because of the economic doctrine of scarcity. When limited quantities of goods are available, consumers will compete with one another for the right to purchase the available goods. Consumers who are willing to pay the high- est prices for the scarce goods will outbid other consumers for the right to consume the goods. Once again, this source of rivalry is present even in markets in which a single firm is selling a product. A good example of consumer–consumer rivalry is an auction, a topic we will examine in detail in Chapter 12.
Producer–Producer Rivalry A third source of rivalry in the marketplace is producer–producer rivalry. Unlike the other forms of rivalry, this disciplining device functions only when multiple sellers of a product compete in the marketplace. Given that customers are scarce, producers compete with one another for the right to service the customers available. Those firms that offer the best-quality product at the lowest price earn the right to serve the customers.
Government and the Market When agents on either side of the market find themselves disadvantaged in the mar- ket process, they frequently attempt to induce government to intervene on their behalf. For example, the market for electricity in most towns is characterized by a sole local supplier of electricity, and thus there is no producer–producer rivalry. Consumer groups may initiate action by a public utility commission to limit the power of utilities in setting prices. Similarly, producers may lobby for government
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14 Managerial Economics and Business Strategy
assistance to place them in a better bargaining position relative to consumers and foreign producers. Thus, in modern economies government also plays a role in dis- ciplining the market process. Chapter 14 explores how government affects manage- rial decisions.
Recognize the Time Value of Money
The timing of many decisions involves a gap between the time when the costs of a project are borne and the time when the benefits of the project are received. In these instances it is important to recognize that $1 today is worth more than $1 received in the future. The reason is simple: The opportunity cost of receiving the $1 in the future is the forgone interest that could be earned were $1 received today. This opportunity cost reflects the time value of money. To properly account for the timing of receipts and expenditures, the manager must understand present value analysis.
Present Value Analysis The present value (PV) of an amount received in the future is the amount that would have to be invested today at the prevailing interest rate to generate the given future value. For example, suppose someone offered you $1.10 one year from today. What is the value today (the present value) of $1.10 to be received one year from today? Notice that if you could invest $1.00 today at a guaranteed interest rate of 10 per- cent, one year from now $1.00 would be worth $1.00 � 1.1 � $1.10. In other words, over the course of one year, your $1.00 would earn $.10 in interest. Thus, when the interest rate is 10 percent, the present value of receiving $1.10 one year in the future is $1.00.
A more general formula follows:
Formula (Present Value). The present value (PV ) of a future value (FV ) received n years in the future is
(1–1)
where i is the rate of interest. For example, the present value of $100.00 in 10 years if the interest rate is at 7
percent is $50.83, since
This essentially means that if you invested $50.83 today at a 7 percent interest rate, in 10 years your investment would be worth $100.
Notice that the interest rate appears in the denominator of the expression in Equation 1–1. This means that the higher the interest rate, the lower the present value of a future amount, and conversely. The present value of a future payment reflects the
PV � $100
(1 � .07)10 �
$100
1.9672 � $50.83
PV � FV
(1 � i)n
present value The amount that would have to be invested today at the prevailing interest rate to generate the given future value.
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The Fundamentals of Managerial Economics 15
difference between the future value (FV) and the opportunity cost of waiting (OCW): PV � FV � OCW. Intuitively, the higher the interest rate, the higher the opportunity cost of waiting to receive a future amount and thus the lower the present value of the future amount. For example, if the interest rate is zero, the opportunity cost of waiting is zero, and the present value and the future value coincide. This is consistent with Equation 1–1, since PV � FV when the interest rate is zero.
The basic idea of the present value of a future amount can be extended to a series of future payments. For example, if you are promised FV1 one year in the future, FV2 two years in the future, and so on for n years, the present value of this sum of future payments is
Formula (Present Value of a Stream). When the interest rate is i, the present value of a stream of future payments of FV1, FV2, . . . , FVn is
Given the present value of the income stream that arises from a project, one can easily compute the net present value of the project. The net present value (NPV) of a project is simply the present value (PV ) of the income stream generated by the project minus the current cost (C0) of the project: NPV � PV � C0. If the net pres- ent value of a project is positive, then the project is profitable because the present value of the earnings from the project exceeds the current cost of the project. On the other hand, a manager should reject a project that has a negative net present value, since the cost of such a project exceeds the present value of the income stream that project generates.
Formula (Net Present Value). Suppose that by sinking C0 dollars into a project today, a firm will generate income of FV1 one year in the future, FV2 two years in the future, and so on for n years. If the interest rate is i, the net present value of the project is
Demonstration Problem 1–1
The manager of Automated Products is contemplating the purchase of a new machine that will cost $300,000 and has a useful life of five years. The machine will yield (year-end) cost reductions to Automated Products of $50,000 in year 1, $60,000 in year 2, $75,000 in year 3, and $90,000 in years 4 and 5. What is the present value of the cost savings of the machine if the interest rate is 8 percent? Should the manager purchase the machine?
NPV � FV1
(1 � i)1 �
FV2 (1 � i)2
� FV3
(1 � i)3 � L �
FVn (1 � i)n
� C0
PV � � n
t�1
FVt (1 � i)t
PV � FV1
(1 � i)1 �
FV2 (1 � i)2
� FV3
(1 � i)3 � L �
FVn (1 � i)n
net present value The present value of the income stream generated by a project minus the current cost of the project.
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16 Managerial Economics and Business Strategy
Answer: By spending $300,000 today on a new machine, the firm will reduce costs by $365,000 over five years. However, the present value of the cost savings is only
Consequently, the net present value of the new machine is
Since the net present value of the machine is negative, the manager should not purchase the machine. In other words, the manager could earn more by investing the $300,000 at 8 percent than by spending the money on the cost-saving technology.
Present Value of Indefinitely Lived Assets Some decisions generate cash flows that continue indefinitely. For instance, con- sider an asset that generates a cash flow of CF0 today, CF1 one year from today, CF2 two years from today, and so on for an indefinite period of time. If the interest rate is i, the value of the asset is given by the present value of these cash flows:
While this formula contains terms that continue indefinitely, for certain patterns of future cash flows one can readily compute the present value of the asset. For instance, suppose that the current cash flow is zero (CF0 � 0) and that all future cash flows are identical (CF1 � CF2 � . . . ). In this case the asset generates a per- petual stream of identical cash flows at the end of each period. If each of these future cash flows is CF, the value of the asset is the present value of the perpetuity:
Examples of such an asset include perpetual bonds and preferred stocks. Each of these assets pays the owner a fixed amount at the end of each period, indefinitely. Based on the above formula, the value of a perpetual bond that pays the owner $100 at the end of each year when the interest rate is fixed at 5 percent is given by
Present value analysis is also useful in determining the value of a firm, since the value of a firm is the present value of the stream of profits (cash flows) generated by
PVPerpetual bond � CF
i �
$100
.05 � $2,000
� CF
i
PVPerpetuity � CF
(1 � i) �
CF
(1 � i)2 �
CF
(1 � i)3 � L
PVAsset � CF0 � CF1
(1 � i) �
CF2 (1 � i)2
� CF3
(1 � i)3 � L
NPV � PV � C0 � $284,679 � $300,000 � � $15,321
PV � 50,000
1.08 �
60,000
1.082 �
75,000
1.083 �
90,000
1.084 �
90,000
1.085 � $284,679
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The Fundamentals of Managerial Economics 17
Principle Profit Maximization Maximizing profits means maximizing the value of the firm, which is the present value of current and future profits.
the firm’s physical, human, and intangible assets. In particular, if p0 is the firm’s cur- rent level of profits, then p1 is next year’s profit, and so on. Therefore, the value of the firm is:
In other words, the value of the firm today is the present value of its current and future profits. To the extent that the firm is a “going concern” that lives on forever even after its founder dies, firm ownership represents a claim to assets with an indefinite profit stream.
Notice that the value of a firm takes into account the long-term impact of man- agerial decisions on profits. When economists say that the goal of the firm is to maximize profits, it should be understood to mean that the firm’s goal is to maxi- mize its value, which is the present value of current and future profits.
PVFirm �p0 � p1
(1 � i) �
p2
(1 � i)2 �
p3
(1 � i)3 � L
While it is beyond the scope of this book to present all the tools Wall Street analysts use to estimate the value of firms, it is possible to gain insight into the issues involved by making a few simplifying assumptions. Suppose a firm’s current prof- its are p0, and that these profits have not yet been paid out to stockholders as divi- dends. Imagine that these profits are expected to grow at a constant rate of g percent each year, and that profit growth is less than the interest rate (g � i). In this case, profits one year from today will be (1 + g)p0, profits two years from today will be (1 + g)2p0, and so on. The value of the firm, under these assumptions, is
For a given interest rate and growth rate of the firm, it follows that maximizing the lifetime value of the firm (long-term profits) is equivalent to maximizing the firm’s current (short-term) profits of p0.
You may wonder how this formula changes if current profits have already been paid out as dividends. In this case, the present value of the firm is the present value of future profits (since current profits have already been paid out). The value of the firm immediately after its current profits have been paid out as dividends (called the ex-dividend date) may be obtained by simply subtracting p0 from the above equation:
PVFirm Ex-dividend � PVFirm �p0
�p0¢1 � ii � g≤ PVFirm �p0 �
p0(1 � g)
(1 � i) � p0(1 � g)2
(1 � i)2 � p0(1 � g)3
(1 � i)3 � L
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Confirming Pages
18 Managerial Economics and Business Strategy
This may be simplified to yield the following formula:
Thus, so long as the interest rate and growth rate are constant, the strategy of maxi- mizing current profits also maximizes the value of the firm on the ex-dividend date.
PVFirm Ex-dividend �p0¢1 � gi � g ≤
Demonstration Problem 1–2
Suppose the interest rate is 10 percent and the firm is expected to grow at a rate of 5 percent for the foreseeable future. The firm’s current profits are $100 million.
(a) What is the value of the firm (the present value of its current and future earnings)? (b) What is the value of the firm immediately after it pays a dividend equal to its cur-
rent profits?
Answer: (a) The value of the firm is
(b) The value of the firm on the ex-dividend date is this amount ($2,200 million) less the current profits paid out as dividends ($100 million), or $2,100 million. Alter- natively, this may be calculated as
� ($100)¢ 1 � .05 .1 � .05
≤� ($100)(21) � $2,100 million PVFirmEx-dividend �p0¢1 � gi � g ≤
� $100¢ 1 � .1 .1 � .05
≤� ($100)(22) � $2,200 million
�p0¢1
