Main Managerial Economics

Managerial Economics

,
Year: 2016
Edition: 14th Revised edition
Publisher: Cengage Learning EMEA
Language: english
Pages: 832 / 833
ISBN 10: 1473709261
ISBN 13: 9781473709263
File: PDF, 35.81 MB
Download (pdf, 35.81 MB)
Preview

You may be interested in

 
 
You can write a book review and share your experiences. Other readers will always be interested in your opinion of the books you've read. Whether you've loved the book or not, if you give your honest and detailed thoughts then people will find new books that are right for them.
1

Mall management

Year: 2012
Language: english
File: PDF, 72.81 MB
1

Managerial

Economics

Mark Hirschey
University of Kansas

Eric Bentzen
Copenhagen Business School

*

CENGAGE
Learning'

Australia • Brazil • Mexico • Singapore • United Kingdom • United States

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and'or eChapteifs).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

•

CENGAGE
Learning'
Managerial Economics, 14th Edition
Mark Hirschey and Eric Bentzen
Publisher: Annabel Ainscow
Development Editor: Hannah Close
Marketing Manager: Vicky Fielding
Content Project Manager: Phillipa
Davidson-Blake
Manufacturing Buyer: Elaine Bevan
Typesetter: MPS Limited
Cover photo: Rawpixel/Shutterstock Inc

© 2016, Cengage Learning EMEA
WCN: 02-300
ALL RIGHTS RESERVED. No part of this work covered by the copyright
herein may be reproduced or distributed in any form or by any means,
except as permitted by U.S. copyright law, without the prior written
permission of the copyright owner.
While the publisher has taken all reasonable care in the preparation of
this book, the publisher makes no representation, express or implied,
with regard to the accuracy of the information contained in this book
and cannot accept any legal responsibility or liability for any errors or
omissions from the book or the consequences thereof. Products and
services that are referred to in this book may be either trademarks
and/or registered trademarks of their respective owners. The publishers
and author/s make no claim to these trademarks. The publisher does
not endorse, and accepts no responsibility or liability for, incorrect or
defamatory content contained in hyperlinked material. All the URLs
in this book are correct at the time of going to press; however the
Publisher accepts no responsibility for the content and continued
availability of third party websites.

For product information and technology assistance,
contact emea.info@cengage.com
For permission to use material from this text or product,
and for permission queries,
email emea.permissions@cengage.com

British Library Cataloguing-ir-Publication Data
A catalogue record for this book is available from the British Library.
ISBN 13: 978-1-4737-0926-3
Cengage Learning EMEA
Cheriton House, North Way, Andover, Hampshire. SPiosBE,
United Kingdom

Cengage Learning products are represented in Canada by
Nelson Education Ltd.
For your lifelong learning solutions, visit www.cengage.co.uk
Purchase your next print book, e-book or e-chapter at
www.cengagebrain.com
Cengage Learning products are represented in Canada by
Nelson Education, Ltd.

Printed in China by RR Donnelly
Print Number: 01
Print Year: 2016
Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and'or eChapteifs).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

"
Dedication

For Christine - I still do.
(Mark Hirschey)
To Birgitte
(Eric Bentzen)

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapteifs). j
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

About the Author

Eric Bentzen, (Copenhagen Business School), is Associate Professor at Copenhagen
Business School, where he teaches undergraduate and graduate courses in managerial
economics and financial econometrics. He is a member of several professional organizations.
He has published in Applied Financial Economics, European Journal of Finance, Management
Decision, Financial Markets and Portfolio Management, and other leading academic journals.
The late Mark Hirschey, Ph.D. (University of Wisconsin-Madison), was the Anderson W.
Chandler Professor of Business at the University of Kansas, where he was teaching
undergraduate and graduate courses in managerial economics and finance. Professor
Hirschey was president of the Association of Financial Economists and a member of several
professional organizations. He has published articles in the American Economic Review, Review
of Economics and Statistics, journal of Business, Journal of Business and Economic Statistics, Journal
of Finance, Journal of Financial Economics, Journal of Industrial Economics, and other leading
academic journals. He was editor of Advances in Financial Economics, and past editor of
Managerial and Decision Economics. Professor Hirschey was also author of Fundamentals of
Managerial Economics and Investments: Analysis & Behavior.

iv
Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
rial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

Brief Contents

Preface

xvi

Part i: Overview of Managerial Economics
1. Nature and Scope of Managerial Economics
2. Economic Optimization 23
3. Demand and Supply 77

3

Part 2: Demand Analysis and Estimation

109

4. Demand Analysis 111
5. Demand Estimation 159
6. Forecasting 195
Part 3: Production and Competitive Markets
7. Production Analysis and Compensation Policy
8. Cost Analysis and Estimation 281
9. Linear Programming 321

239

10. Competitive Markets 369
11. Performance and Strategy in Competitive Markets
Part 4: Imperfect Competition
12. Monopoly and Monopsony

237

403

445

447

13. Monopolistic Competition and Oligopoly 489
14. Game Theory and Competitive Strategy 537
15. Pricing Practices 573
Part 5: Long-Term Investment Decisions

617

16. Risk Analysis 619
17. Capital Budgeting 659
18. Organization Structure and Corporate Governance

701

19. Government in the Market Economy

735

Appendix A: Compounding and the Time Value of Money
Appendix B: Interest Factor Tables
Appendix C: Statistical Tables

791

799

Selected Figures for End of Chapter Problems
Index

775

805

811

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapteifs).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

Contents

1

H

Part i: Overview of Managerial Economics
Chapter i: Nature and Scope of Managerial
Economics

3

How is Managerial Economics Useful?

3

Evaluating Choice Alternatives, 3
Best Decision, 5

8

Making the
5

Theory of the Firm

6

Expected Value Maximization 6 • Constraints
and the Theory of the Firm 7 • Limitations of the
Theory of the Firm, 8
Managerial Application 1.2 The World is
Turning to Capitalism and Democracy

9

Profit Measurement

9
9

Variability

23

Economic Optimization Process

23

Optimal Decisions, 23
of the Firm, 24

9

Maximizing the Value
25

Demand and Total Revenue, 25 • Marginal
Revenue, 28 * Revenue Maximization Example, 29
Managerial Application 2.1 Ethical Aspects
of Corporate Governance

25

Managerial Application 2.2 Do Firms
Really Optimize?

30

Cost Relations

30

Total Cost, 30 • Marginal and Average Cost, 32
9
Average Cost Minimization Example, 33
Profit Relations

Why do Profits Vary Among Firms?
Disequilibrium Profit Theories, 12
• Compensatory Profit Theories, 12
of Profits in the Economy, 13

Chapter 2: Economic Optimization

Revenue Relations

Managerial Application 1.1 Business Ethics

Business Versus Economic Profit 9
of Business Profits, 10

i

12
9

Role

Total and Marginal Profit, 34
Example, 35

34
9

Profit Maximization

Incremental Concept in Economic Analysis

Managerial Application 1.3 Google on Social
Responsibility

13

Role of Business in Society

14

Why Firms Exist, 14 * Social Responsibility of
Business, 15

37

Marginal
Versus Incremental Concept,
0
/ 37
• Incremental Profits, 38 • Incremental Concept
Example, 39
Managerial Application 2.3 Behavioral
Economics

38

Summary

41

Managerial Application 1.4 The IKEA way

16

Questions

42

Structure of this Text

16

Self-Test Problems and Solutions

42

Problems

47
52

Objectives, 16 * Development of Topics, 16
Summary

18

Questions

19

Case Study: Spreadsheet Analysis of the
EOQ at the Neighborhood Pharmacy, Inc.

Case Study: Is Coca-Cola the 'Perfect' Business?

19

Selected References

53

Selected References

22

Appendix 2A: Math Analysis for Managers

54

Properties of Real Numbers

54

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
rial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

vii

Contents

Transitive Property, 54 * Commutative Properties,
54 • Associative Properties, 55 • Distributive
Properties, 55 • Inverse Properties, 55 • Exponents
and Radicals, 55
Equations

Determinants of Demand, 79 • Industry Demand Versus
Firm Demand, 80
Demand Curve
56

Equivalent Operations, 56 • Linear Equations, 57
• Quadratic Equations, 57 • Multiplicative
Equations, 57 • Exponential Functions, 57
• Logarithmic Functions, 58
59

Rules for Differentiating a Function

61

Partial Derivative Concept, 67
Multivariate Functions, 68

Market Supply Function

Supply Curve

85

87

Supply Curve Determination, 87 • Relation
Between Supply Curve and Supply Function, 89
67

Maximizing

Constrained Optimization

How Output Prices Affect Supply, 84 • Other
Factors that Influence Supply, 85

Determinants of Supply, 85 • Industry Supply
Versus Firm Supply, 87

Constants, 61 • Powers, 62 • Sums and
Differences, 62 • Products, 63 • Quotients, 64
• Logarithmic Functions, 64 9 Function of a
Function (Chain Rule), 65

e

Demand Curve Determination, 81 • Relation
Between the Demand Curve and Demand
Function, 82
Basis for Supply

Concept of a Marginal

Appendix 2B: Multivariate Optimization and
the Lagrangian Technique

81

69

Role of Constraints, 70 • Lagrangian Multipliers, 71

Market Equilibrium

91

Surplus and Shortage, 91 • Comparative Statics:
Changing Demand, 93 • Comparative Statics:
Changing Supply, 95 • Comparative Statics:
Changing Demand and Supply, 96
Summary

97

Questions

97

Self-Test Problems and Solutions

98

Problem

75

Chapter 3: Demand and Supply

77

Basis for Demand

77

Problems

101

Case Study: Spreadsheet Analysis of Demand
and Supply for Sunbest Orange Juice

105

Selected Reference

107

Direct Demand, 77 • Derived Demand, 78
Managerial Application 3.1: How the Internet
Affects Demand and Supply

79

Market Demand Function

79

Part 2: Demand Analysis and Estimation
Chapter 4: Demand Analysis

111

Utility Theory

111

Basic Assumptions, 111 • Utility Functions, 112
• Marginal Utility, 113 • Law of Diminishing
Marginal Utility, 114
Managerial Application 4.1: Odd-Number
Pricing Riddle

116

Indifference Curves

116

118

128

Optimal Consumption

128

Marginal Utility and Consumer Choice, 128
• Marginal Rate of Substitution, 129 • Utility
Maximization, 131
132

Elasticity Concept, 132 • Point Elasticity, 132
• Arc Elasticity, 133
Price Elasticity of Demand

Characteristics of Budget Constraints, 118 • Effects
of Changing Income and Changing Prices, 121
• Income and Substitution Effects, 122
Individual Demand

Managerial Application 4.2: Relationship
Marketing

Demand Sensitivity Analysis: Elasticity

Basic Characteristics, 116 • Perfect Substitutes
and Perfect Complements, 118
Budget Constraints

Price-Consumption Curve, 122 • IncomeConsumption Curve, 125 • Engle Curves, 125

133

Price Elasticity Formula, 133 • Price Elasticity
and Total Revenue, 135
122

Price Elasticity And Marginal Revenue

137

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapteifs).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

Contents

Elasticity Varies Along a Linear Demand Curve, 137
• Price Elasticity and Price Changes, 138

Standard Error of the Estimate, 175 • Goodness
of Fit, 176 * F Statistic, 178
Judging Variable Significance

Managerial Application 4.3: Haggling
in the Car Business

141

Price Elasticity and Optimal Pricing Policy

141

Optimal Price Formula, 141 • Optimal Pricing
Policy Example, 142
Cross-Price Elasticity of Demand

143

Cross-Price Elasticity Formula, 143 • Substitutes
and Complements, 144
Income Elasticity of Demand

144

• Income Elasticity Formula, 144 • Normal Versus
Inferior Goods, 145
Managerial Application 4.4: What's in a Name?

146

Summary

146

Questions

147

Self-Test Problems and Solutions

148

Problems

153

Case Study: Optimal Level of Advertising

156

Selected References

157

Chapter 5: Demand Estimation

159

Interview and Experimental Methods

159

Two-Tail t Tests, 179 • One-Tail t Tests, 181
Summary

182

Questions

183

Self-Test Problems and Solutions

183

Problems

188

Case Study: Demand Estimation for
Mrs Smyth's Pies

192

Selected Reference

194

Chapter 6: Forecasting

195

Forecasting Applications

195

Macroeconomic Applications, 195 " Microeconomic
Applications, 196 • Forecast Techniques, 196
Managerial Application 6.1: Economic
Forecasting: The Art and the Science

197

Qualitative Analysis

198

Expert Opinion, 198 • Survey Techniques, 198
Trend Analysis and Projection

Consumer Interviews, 159 • Market
Experiments, 160
Simple Demand Curve Estimation

160

• Simple Linear Demand Curves, 160
• Using Simple Linear Demand Curves, 162
161

Simple Market Demand Curve Estimation

163

Graphing the Market Demand Curve, 163
• Evaluating Market Demand, 164
166

Changing Nature of Demand Relations, 166
• Interplay of Demand and Supply, 166 • Shifts
in Demand and Supply, 167 • Simultaneous
Relations, 169
Regression Analysis

199

Trends in Economic Data, 199 • Linear Trend
Analysis, 199 • Growth Trend Analysis, 202
• Linear and Growth Trend Comparison, 204
Managerial Application 6.2: Prediction Markets

204

Business Cycle

205

What is the Business Cycle?, 205 • Economic
Indicators, 207 • Economic Recessions, 208
• Sources of Forecast Information, 210

Managerial Application 5.1: Sampling
Technology for TV Advertising

Identification Problem

179

Managerial Application 6.3: The Stock Market
and the Business Cycle

211

Exponential Smoothing

212

Exponential Smoothing Concept, 212
• One-Parameter (Simple) Exponential
Smoothing, 212 • Two-Parameter (Holt)
Exponential Smoothing, 213 " Three-Parameter
(Winters) Exponential Smoothing, 214 • Practical
Use of Exponential Smoothing, 214
Econometric Forecasting

169

What is a Statistical Relation?, 169 • Specifying the
Regression Model, 172 * Least Squares Method, 173

215

Advantages of Econometric Methods. 215
1
Single-Equation Models, 217 • Multiple-Equation
Systems, 218

Managerial Application 5.2: Market Experiments
on the Web

170

Managerial Application 6.4: How Good is Your
Forecasting Ability?

216

Measures of Regression Model Significance

175

Judging Forecast Reliability

220

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
rial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

Contents

Tests of Predictive Capability, 220 * Correlation
Analysis, 220 • Sample Mean Forecast Error
Analysis, 220
Choosing the Best Forecast Technique

221

Data Requirements, 227 • Time Horizon
Considerations, 221 • Role of Judgment, 223
Summary

Questions

224

Self-Test Problems and Solutions

225

Case Study: Forecasting Global Performance
for a Mickey Mouse Organization

233

Selected Reference

236

223

Part 3: Production and Competitive Markets
Chapter 7: Production Analysis
and Compensation Policy

239

Production Functions

239

Productivity Measurement

Properties of Production Functions, 239 • Returns to
Scale and Returns to a Factor, 240
Total, Marginal, and Average Product

240

• Total Product, 241 * Marginal and Average
Product, 242
Law of Diminishing Returns to a Factor

245

Illustration of Diminishing Returns to a Factor, 247

262

Economic Productivity, 263 • Productivity and
Investment in Computer Technology (ICT), 264
Managerial Application 7.4: Labor productivity
growth in selected countries 2009-2012.

263

Summary

265

Questions

266

Self-Test Problems and Solutions

266

Problems

269

Managerial Application 7.1: Efficiency Wages

246

Case Study: Worker Productivity Among
Giant US Corporations

274

Input Combination Choice

248

Selected References

276

Appendix 7A: A Constrained Optimization
Approach to Developing the Optimal Input
Combination Relationships

277

Constrained Production Maximization

277

Constrained Cost Minimization

279

Problem

280

Chapter 8: Cost Analysis and Estimation

281

Economic and Accounting Costs

281

Production Isoquants, 248 • Input Factor
Substitution, 248 • Marginal Rate of Technical
Substitution, 251 • Rational Limits of Input
Substitution, 251
Marginal Revenue Product and Optimal
Employment

252

Marginal Revenue Product, 252 • Optimal
Level of a Single Input, 253 • Illustration of
Optimal Employment, 254
Managerial Application 7.2: National minimum
wages in the EU

253

Optimal Combination of Multiple Inputs

255

Budget Lines, 255 • Expansion Path, 257
• Illustration of Optimal Input Proportions, 258

283

Incremental Versus Sunk Cost, 283 How is
the Operating Period Defined?, 284
259

Optimal Levels of Multiple Inputs

259

Managerial Application 8.1: GE's '20-70-10' Plan

284

Short-Run Cost Curves

285

Short-Run Cost Categories, 285 • Short-Run
Cost Relations, 286

Optimal Employment and Profit Maximization, 259
• Illustration of Optimal Levels of Multiple
Inputs, 260

• Output Elasticity and Returns to
Scale, 260 12 Returns to Scale Estimation, 261

Role of Time in Cost Analysis
6

Managerial Application 7.3: The Future of
Manufacturing in Europe 2015-2020

Returns to Scale

Historical Versus Current Costs, 281
• Opportunity Costs, 282

260

Managerial Application 8.2: GAAP and IRES

288

Long-Run Cost Curves

288

Long-Run Total Costs, 288" Economies of Scale, 290
• Cost Elasticities and Economies of Scale, 290
• Long-Run Average Costs, 291

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapteifs).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

X

Contents

Managerial Application 8.3: Cost Stickiness

293

Minimum Efficient Scale

293

Competitive Implications of Minimum Efficient
Scale, 293 • Transportation Costs and MES, 293
Firm Size and Plant Size

Graphic Specification and Solution
295

Multiplant Economies and Diseconomies of
Scale, 295 * Economics of Multiplant
Operation: an Example, 296 • Plant Size and
Flexibility, 298
Learning Curves

300

332

Analytic Expression, 332 • Graphing the
Feasible Space, 332 • Graphing the Objective
Function, 334 • Graphic Solution, 335
Algebraic Specification and Solution

Learning Curve Concept, 300 s Learning Curve
Example, 302 • Strategic Implications of the
Learning Curve Concept, 303

336

Algebraic Specification, 336 • Algebraic
Solution, 338
Managerial Application 9.3: LP on the PC!

341

Dual in Linear Programming

342

Duality Concept, 342 • Shadow Prices, 342

Managerial Application 8.4: Bigger isn't
Always Better

301

Economies of Scope

304

Economies of Scope Concept, 304 ® Exploiting
Scope Economies, 305
Cost-Volume-Profit Analysis

Objective Function Specification, 330 • Constraint
Equation Specification, 331 • Non-negativity
Requirement, 331

Dual Specification
Dual Objective Function, 343 • Dual
Constraints, 343 9 Dual Slack Variables, 344
Solving the Dual Problem

305

• Cost-Volume-Profit Charts, 305 • Degree
of Operating Leverage, 307
Summary

309

Questions

310

Self-Test Problems and Solutions

311

Problems

313

Case Study: Estimating Hospitalization Costs
for Regional Hospitals

317

Selected References

320

Chapter 9: Linear Programming

321

Basic Assumptions

321

Inequality Constraints, 327 • Linearity
Assumption, 322

343

345

Dual Solution, 345 • Using the Dual Solution
to Solve the Primal, 346
Summary

348

Questions

349

Self-Test Problems and Solutions

349

Problems

357

Case Study: A LP Pension Funding Model

362

Appendix 9A: Rules for Forming the Dual Linear
Programming Problem

365

Primal Problem

365

Dual Problem

366

Selected References

367

Chapter 10: Competitive Markets

369

Competitive Environment

369

Managerial Application 9.1: Karmarkar's LP
Breakthrough

322

What is Market Structure?, 369 • Vital Role
of Potential Entrants, 370

Production Planning for a Single Product

323

Factors that Shape the Competitive Environment

370

Product Differentiation, 370 • Production
Methods, 372 • Entry and Exit Conditions, 372

Production Processes, 323 • Production
Isoquants, 324 • Least-Cost Input Combinations, 326
• Optimal Input Combinations with Limited
Resources, 327
Managerial Application 9.2: LP: More than a
Visual Approach

330

Production Planning for Multiple Products

330

Managerial Application 10.1: Benefits From
Free Trade

371

Competitive Market Characteristics

373

Basic Features, 373 • Examples of Competitive
Markets, 373 • Profit Maximization Imperative, 375
• Role of Marginal Analysis, 375

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pail. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
orial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

Contents

Managerial Application 10.2: Seasonality
on Stock Markets?

Role for Government
374

Marginal Cost and Firm Supply

379

Short-Run Firm Supply Curve, 379 • Long-Run
Firm Supply Curve, 381
Managerial Application 10.3: Dot.com

382

Competitive Market Supply Curve

382

Market Supply with a Fixed Number of
Competitors, 382 • Market Supply with Entry
and Exit, 384
Competitive Market Equilibrium

410

How Government Influences Competitive
Markets, 410 • Broad Social Considerations, 411
Managerial Application 11.2: Corn Growers
Discover Oil!

411

Subsidy and Tax Policy

411

Anti-Subsidy Rules, 412 • Deadweight Loss
from Taxes, 412
Tax Incidence and Burden

385

Balance of Supply and Demand, 386 • Normal
Profit Equilibrium, 387
Managerial Application 10.4: The Enron
Debacle

388

Summary

388

Questions

389

Self-Test Problems and Solutions

390

Problems

395

Case Study: Profitability Effects of Firm
Size for DJIA Companies

399

Selected References

401

414

Role of Elasticity, 414 • Tax Cost-Sharing
Example, 415
Managerial Application 11.3: Measuring
Economic Profits

418

Price Controls

418

Price Floors, 418 * Price Ceilings, 420
Business Profit Rates

422

Return on Stockholders' Equity, 422 • Typical
Profit Rates, 423
Market Structure and Profit Rates

425

Profit Rates in Competitive Markets, 425
• Mean Reversion in Profit Rates, 426
Competitive Market Strategy

426

Short-Run Firm Performance, 427

Chapter n: Performance and Strategy
in Competitive Markets

403

Long-Run Firm Performance

428

Competitive Market Efficiency

403

Summary

428

Questions

430

Self-Test Problems and Solutions

431

Problems

437

Case Study: The Most Profitable S&P 500
Companies

441

Selected References

444

Why is it Called Perfect Competition?, 403
• Deadweight Loss Problem, 404 • Deadweight
Loss Illustration, 406
Managerial Application 11.1: The Wal-Mart
Phenomenon

407

Market Failure

408

Structural Problems, 408 * Incentive Problems, 409

Part 4: Imperfect Competition

445

Chapter 12: Monopoly and Monopsony

447

Monopoly Market Characteristics

447

Price-Output Decisions, 449 • Role of Marginal
Analysis, 451
Social Costs of Monopoly

Basic Features, 447 • Examples of Monopoly, 448

453

Monopoly Underproduction, 453 • Deadweight Loss
from Monopoly, 453

Managerial Application 12.1: The EU
Commission fines parking heaters producer
€68 million in cartel settlement

449

Profit Maximization Under Monopoly

449

Social Benefits of Monopoly

457

Economies of Scale, 457 • Invention and Innovation, 457

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

xii

Contents

Monopoly Regulation

458

Dilemma of Natural Monopoly, 458 • Utility Price
and Profit Regulation, 460 • Utility Price and Profit
Regulation Example, 462 • Problems with Utility Price
and Profit Regulation, 464
459

Monopsony

464

468

Antitrust Policy

468

Overview of Antitrust Law, 468

507

Bertrand Oligopoly: Identical Products, 507
• Bertrand Oligopoly: Differentiated Products,
508 • Sweezy Oligopoly, 511 • Oligopoly Model
Comparison, 512

469

Market Structure Measurement

513

Economic Census, 513 • NAICS System, 514
Census Measures of Market Concentration

Questions

473

Self-Test Problems and Solutions

473

Problems

480

Case Study: Effect of R&D on Tobin's q

484

Selected References

487

489
489

Monopolistic Competition, 489 • Oligopoly, 490
• Dynamic Nature of Competition, 491
491

Monopolistic Competition Characteristics, 491
• Monopolistic Competition Price-Output
Decisions, 493

516

Concentration Ratios, 516 * HerfindahlHirschmann Index, 518 • Limitations of
Census Information, 518
Managerial Application 13.4: Horizontal
Merger Guidelines

519

Summary

522

Questions

524

Self-Test Problems and Solutions

524

Problems

528

Case Study: Market Structure Analysis
at Columbia Drugstores, Inc.

533

Selected References

535

Chapter 14: Game Theory and Competitive
Strategy

537

Game Theory Basics

537

Types of Games, 537 • Role of Interdependence,
538 • Strategic Considerations, 539
492

Managerial Application 13.2: Intel: Running
Fast to Stay in Place

495

Monopolistic Competition Process

495

Short-Run Monopoly Equilibrium, 495
• Long-Run High-Price/Low-Output
Equilibrium, 496 • Long-Run Low-Price/
High-Output Equilibrium, 498

501

513

472

Managerial Application 13.1: Dell's Price
War with Dell

Oligopoly Output-Setting Models

469

Summary

Monopolistic Competition

500

Managerial Application 13.3: Contestable
Airline Passenger Service Markets

Market Niches, 469 • Information Barriers to
Competitive Strategy, 470

Contrast Between Monopolistic Competition
and Oligopoly

Cartels and Collusion

Oligopoly Price-Setting Models

Managerial Application 12.3: is this why
they Call it 'Hardball'?

Chapter 13: Monopolistic Competition
and Oligopoly

Oligopoly Market Characteristics, 499
• Examples of Oligopoly, 499

Cournot Oligopoly, 501 • Stackelberg
Oligopoly, 504

Buyer Power, 464 • Bilateral Monopoly
Illustration, 465

Competitive Strategy in Monopoly Markets

498

Overt and Covert Agreements, 500
Enforcement Problems, 501

Managerial Application 12.2: Is Ticketmaster
a Monopoly?

Managerial Application 12.4: Price Fixing
by the Insurance Cartel

Oligopoly

Managerial Application 14.1: Asymmetric
Information

539

Prisoner's Dilemma

540

Classic Riddle, 540 • Business Application,
541 • Broad Implications, 542
Nash Equilibrium
Nash Equilibrium Concept, 543
Bargaining, 544

543
e

Nash

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
rial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

Contents

Infinitely Repeated Games

545

Role of Reputation, 545 • Product Quality
Games, 546
547

Finitely Repeated Games

547

Uncertain Final Period, 547 • End-of-Came
Problem, 548
549

First-Mover Advantages, 549 9 Auction Types, 549
• Public Policy Applications, 550
551

Competitive Strategy

551

Competitive Advantage, 551
is a Disadvantage, 553

581

Two-Part Pricing

586

One-Price Policy and Consumer Surplus, 586
• Capturing Consumer Surplus with Two-Part
Pricing, 588 • Consumer Surplus and Bundle
Pricing, 588

553

Limit Pricing, 553 9 Network Externalities, 555
• Market Penetration Pricing, 555
556

Nonprice Competition

556

Advantages of Nonprice Competition, 556
• Optimal Level of Advertising, 557
• Optimal Advertising Example, 559

591

joint Products in Variable Proportions, 591
• Joint Products in Fixed Proportions, 591
Joint Product Pricing Example

Managerial Application 14.4: Network
Switching Costs

589

Demand Interrelations, 589 • Production
Interrelations, 590
Joint Products

When Large Size

Pricing Strategies

Managerial Application 15.2: Do Colleges
Price Discriminate?

Multiple-Product Pricing

Managerial Application 14.3: Wrigley's Success
Formula

9

580

Price-Output Determination Case I, 581
• One-Price Alternative, 583 9 Price-Output
Determination Case II, 585

Managerial Application 14.2: The Market
for Lemons

Game Theory and Auction Strategy

Price Discrimination Example

593

joint Products without Excess By-Product, 593
• Joint Production with Excess By-Product
(Dumping), 596
Managerial Application 15.3: lOc for a Gallon
of Gas in Dayton, Ohio

594

Managerial Application 15.4: Why Some
Price Wars Never End

598

Summary

561

Summary

598

Questions

562

Questions and Answers

599

Self-Test Problems and Solutions

562

Self-Test Problems and Solutions

600

Problems

565

Problems

602

Case Study: Time Warner, Inc., is Playing
Games with Stockholders

570

Case Study: Pricing Practices in the Denver,
Colorado, Newspaper Market

606

Selected References

572

Selected References

608

Chapter 15: Pricing Practices

573

Appendix 15A: Transfer Pricing

609

Pricing Rules-of-Thumb

573

Transfer Pricing Problem

609

Competitive Markets, 573 • Imperfectly
Competitive Markets, 574
Managerial Application 15.1: Mark-Up Pricing
Technology

575

Mark-Up Pricing and Profit Maximization

575

9

Optimal Mark-Up on Cost, 575 Optimal
Mark-Up on Price, 576 9 Why Do Optimal
Mark-Ups Vary?, 577
Price Discrimination
Profit-Making Criteria, 578 • Degrees of Price
Discrimination, 579

578

Divisional Relationships, 609 • Products without
External Markets, 610 • Products with Competitive
External Markets, 610 • Products with Imperfectly
Competitive External Markets, 611
Global Transfer Pricing Example

611

Profit Maximization for an Integrated Firm, 611
• Transfer Pricing with No External Market. 612
• Competitive External Market with Excess Internal
Demand, 613 9 Competitive External Market with
Excess Internal Supply, 614
Problem

615

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

XIV

Contents

Part 5: Long-Term Investment Decisions
Chapter 16: Risk Analysis

619

Concepts of Risk and Uncertainty

619

Economic Risk and Uncertainty, 619 * General
Risk Categories, 620 • Special Risks of Global
Operations, 621
Probability Concepts

621

Managerial Application 17.1: Market-Based
Capital Budgeting

662

Cash Flow Estimation Example

662

Project Description, 662 • Cash Flow
Estimation and Analysis, 663

• Probability Distribution, 622 • Expected
Value, 623 • Absolute Risk Measurement, 625
• Relative Risk Measurement, 627 • Other Risk
Measures, 627

Capital Budgeting Decision Rules

Managerial Application 16.1: Behavioral Finance

622

Standard Normal Concept

628

Normal Distribution, 628 • Standardized
Variables, 629 • Use of the Standard Normal
Concept: an Example, 629

665

Net Present-Value Analysis, 665 • Profitability
Index or Benefit/Cost Ratio Analysis, 668
Internal Rate of Return Analysis, 668
• Payback Period Analysis, 669
Project Selection

670

Decision Rule Conflict Problem, 670

Managerial Application 16.2: Why are
Lotteries Popular?

630

Utility Theory and Risk Analysis

630

Possible Risk Attitudes, 631 • Relation
Between Money and its Utility, 631
Adjusting the Valuation Model for Risk

Sequence of Project Valuation, 660 • Cash
Flow Estimation, 661 • Incremental Cash
Flow Evaluation, 661

Managerial Application 17.2: Is the Sun
Setting on Japan's Vaunted MOF?
Reasons for Decision Rule Conflict, 672
• Ranking Reversal Problem, 672 • Making
the Correct Investment Decision, 675
Cost of Capital

632

Basic Valuation Model, 632 • Certainty
Equivalent Adjustments, 633 • Certainty
Equivalent Adjustment Example, 635
• Risk-Adjusted Discount Rates, 636,
• Risk-Adjusted Discount Rate Example, 637

671

675

Component Cost of Debt Financing, 675
• Component Cost of Equity Financing, 676
• Weighted-Average Cost of Capital, 679
Managerial Application 17.3: Federal Government
Support for R&D
676

Managerial Application 16.3: Stock Option
Backdating Scandal

633

Decision Trees and Computer Simulation

638

Managerial Application 17.4; Capital Allocation
at Berkshire Hathaway, Inc.

681

Optimal Capital Budget

681

Investment Opportunity Schedule, 681
• Marginal Cost of Capital, 683 • Postaudit, 683

Decision Trees, 638 • Computer Simulation, 639
• Computer Simulation Example, 640
Managerial Application 16.4: Internet Fraud

642

Summary

643

Questions

644

Self-Test Problems and Solutions

645

Problems

649

Summary

684

Questions

684

Self-Test Problems and Solutions

685

Problems

689

Case Study: Sophisticated NPV Analysis at
Level 3 Communications, Inc.

694

Selected References

698

Case Study: Stock-Price Beta Estimation
for Google, Inc.

653

Selected References

657

Chapter 18: Organization Structure and
Corporate Governance

701

Chapter 17: Capital Budgeting

659

Organization Structure

701

Capital Budgeting Process

659

What is Capital Budgeting?, 659 • Project
Classification Types, 660
Steps in Capital Budgeting

What is Organization Structure?, 701 • Optimal
Design is Dynamic, 702
Transaction Cost Theory of the Firm

660

703

Nature of Firms, 703 • Coase Theorem' 704

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
orial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

Contents

The Firm's Agency Problem

704

Sources of Conflict within Firms, 704 • Risk
Management Problems, 705 • Investment Horizon
Problems, 707 • Information Asymmetry
Problems, 707
Managerial Application 18.1: Organization
Design at GE

705

Organization Design

708

710

712

713

Corporate Governance Inside the Firm, 714
Managerial Application 18.3: Sarbanes-Oxley
Ownership Structure as a Corporate
Governance Mechanism

715
715

Dimensions of Ownership Structure, 715
• Is Ownership Structure Endogenous?, 719
Managerial Application 18.4: Institutional
Investors are Corporate Activists

720

Agreements and Alliances Among Firms

720

Franchising, 720 • Strategic Alliances, 721
Legal and Ethical Environment

Optimal Allocation of Social Resources

744

Pareto Improvement, 744 • Marginal Social
Costs and Benefits, 744
746

Benefit-Cost Criteria

748

Social Net Present-Value, 748 • Benefit-Cost
Ratio, 750 9 Social Internal Rate of Return, 751
• Limitations of Benefit-Cost Analysis, 752
Additional Methods of Improving Public
Management

Role Played by Boards of Directors, 712
Managerial Application 18.2: Company
Information on the Internet

743

Benefit-Cost Concepts, 746 • Social Rate
of Discount, 747

Assigning Decision Rights, 710 ' Decision
Process, 711
Corporate Governance

Managerial Application 19.2: Political
Corruption

Benefit-Cost Methodology

Resolving Unproductive Conflict within
Firms, 708 • Centralization Versus
Decentralization, 709
Decision Management and Control

Rivalry and Exclusion, 740 • Free Riders and
Hidden Preferences, 741

722

Sarbanes-Oxley Act, 722 • Business Ethics, 723

752

Cost-Effectiveness Analysis, 752 • Privatization, 753
Managerial Application 19.3: Free Trade Helps
Everyone

753

Regulatory Reform in the New Millennium

755

Promoting Competition in Electric Power
Generation, 755 • Fostering Competition in
Telecommunications, 755 w Reforming
Environmental Regulation, 756 9 Improving
Regulation of Health and Safety, 756
Managerial Application 19.4: Price Controls
for Pharmaceutical Drugs

757

Health Care Reform

757

Managed Competition, 757 • Outlook for
Health Care Reform, 759

Summary

723

Questions

725

Summary

760

Self-Test Problems and Solutions

726

Questions

761

Problems

728

Self-Test Problems and Solutions

762

Case Study: Do Boards of Directors Make
Good Corporate Watchdogs?

Problems

767

731

Selected References

734

Case Study: Oh, Lord, Won't You Buy
Me a Mercedes-Benz (Factory)?

772

Selected References

774

Appendix A: Compounding and the
Time Value of Money

775

Appendix B; Interest Factor Tables

791

Appendix C: Statistical Tables

799

Selected Check Figures for End-of-Chapter
Problems

805

Index

811

Chapter 19: Government in the Market
Economy

735

Externalities

735

Negative Externalities, 735 • Positive
Externalities, 736
Managerial Application 19.1: 'Tobacco'Ethics

738

Solving Externalities

738

Government Solutions, 738 • Market
Solutions, 739
Public Goods

740

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

Preface

Economic concepts show how to apply common sense to understand business and solve
managerial problems. Economic intuition is really useful. It helps managers decide on which
products to produce, costs to consider, and prices to charge. It also helps them decide on the
best hiring policy and the most effective style of organization. Students and future managers
need to learn these things. The topics covered in managerial economics are powerful tools
that can be used to make them more effective and their careers more satisfying. By studying
managerial economics, those seeking to further their business careers learn how to more
effectively collect, organize and analyze information.
A key feature of this book is its depiction of the firm as a cohesive organization. Effective
management involves an integration of the accounting, finance, marketing, personnel, and
production functions. This integrative approach demonstrates that important managerial
decisions are interdisciplinary in the truest sense of the word.
Although both microeconomic and macroeconomic relations have implications for
managerial decision making, this book concentrates on microeconomic topics. Following
development of the economic model of the firm, the vital role of profits is examined. Because
economic decision making often requires an elementary understanding of optimization
techniques and statistical relations, those basic concepts are described early in the text.
Because demand for a firm's products plays a crucial role in determining its profitability and
ongoing success, demand analysis and estimation is an essential area of study. An important
part of this study is an investigation of the basic forces of demand and supply. This naturally
leads to discussion of economic forecasting and methods for assessing forecast reliability.
Production theory and cost analysis are then explored as means for understanding the
economics of resource allocation and employment.
Once the internal workings of a successful firm are understood, attention can turn
toward consideration of the firm's external economic environment. Market structure analysis
provides the foundation for studying the external economic environment and for defining
an effective competitive strategy. The role of government in the market economy, including
the constraints it imposes on business, requires a careful examination of regulation and
antitrust law. Risk analysis and capital budgeting are also shown as methods for introducing
marginal analysis into the long-range strategic planning and control process. Finally, given
government's increasing role in managing demand and supply for basic services, such as
education and health care, the use of economic principles to understand and improve public
management is also considered.
Managerial Economics, 14th Edition, takes a practical problem-solving approach. The focus
is on the economics—not the mathematics—of the managerial decision process. Quantitative
tools are sometimes employed, but the emphasis is on economic intuition.

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
rial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

Preface

xvii

THIS i/|TH EDITION
Students and instructors will find that Managerial Economics, 14th Edition provides an efficient
calculus-based introduction and guide to the optimization process. Chapter 2, Economic
Optimization, illustrates how the concept of a derivative can be used as a practical tool to
understand and apply marginal analysis. Multivariate Optimization and the Lagrangian Technique,
Appendix 2B, examines the optimization process for equations with three or more variables.
Such techniques are especially helpful when managers face constrained optimization problems,
or decision situations with limited alternatives. Throughout the text, a wide variety of problems
describing real-world decisions can be solved using such techniques.
Managerial Economics, 14th Edition provides an intuitive guide to marginal analysis and basic
economic relations. Although differential calculus is an obviously helpful tool for understanding
the process of economic optimization, it is important that students not let mathematical
manipulation get in the way of their basic grasp of economic concepts. The concept of a
marginal can also be described graphically in an intuitive noncalculus-based approach. Once
students learn to grasp the importance of marginal revenue and marginal cost concepts, the
process of economic optimization becomes intuitively obvious. Although those using a noncalculus based approach can safely skip parts of Chapter 2 and Appendix 2B, all other material
is fully and completely assessable. With practice using a wide variety of problems and examples
throughout the text, all students are able to gain a simple, practical understanding of how
economics can be used to understand and improve managerial decisions.

Learning Aids
•

•

•

•

•

Each chapter incorporates a wide variety of simple numerical examples and detailed
practical illustrations of chapter concepts. These features portray the valuable use and
real-world implications of covered material.
Each chapter includes short Managerial Applications boxes to show current examples of
how the concepts introduced in managerial economics apply to real-world situations.
New Managerial Applications based on articles from the Internet or Barron's, Business
Week, Forbes, Fortune, and The Wall Street Journal are provided. This feature stimulates
student interest and offers a popular basis for classroom discussion.
The book incorporates several new regression-based illustrations of chapter concepts
using actual company data, or hypothetical data adapted from real-world situations. Like
all aspects of the text, this material is self-contained and intuitive.
Effective managers must be sensitive to the special challenges posed by an increasingly
global marketplace. To increase student awareness of such issues, a number of examples.
Managerial Applications, and case studies that relate to global business topics are featured.
Each chapter is accompanied by a case study that provides in-depth treatment of chapter
concepts. To meet the needs of all instructors and their students, these case studies are
written to allow, but do not require, a computer-based approach. These case studies
are fully self-contained and especially helpful to instructors who wish to more fully

•

incorporate the use of basic spreadsheet and statistical software in their courses.
New end-of-chapter questions and problems are provided, after having been subject
to necessary revision and class testing. Questions are designed to give students the
opportunity to grasp basic concepts on an intuitive level and express their understanding
in a nonquantitative fashion. Problems cover a wide variety of decision situations and
illustrate the role of economic analysis from within a simple numerical framework.

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapteifs).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

xviii

Preface

•

Each chapter includes self-test problems with detailed solutions to show students how
economic tools and techniques can be used to solve practical business problems. These
self-test problems are a proven study aid that greatly enhances the learning value of endof-chapter questions and problems.

Ancillary Package
Managerial Economics, 14th Edition, is supported by the most comprehensive ancillary
package available in managerial economics to make teaching and learning the material
both easy and enjoyable.
Instructor's Manual The Instructor's Manual offers learning suggestions, plus detailed
answers and solutions for all chapter questions and problems. Case study data are also
provided to adopters with the Instructor's Manual. The Instructor's Manual files can be found
on the website international.cengage.com.
Test Bank A comprehensive Test Bank is also provided that offers a variety of multiple-choice
questions, one-step, and multistep problems for every chapter. Full solutions are included, of
course. With nearly 1,000 questions and problems, the Test Bank is a valuable tool for exam
preparation. The Test Bank files can be found on the website international.cengage.com.

Acknowledgments
A number of people have aided in the preparation of Managerial Economics. Helpful suggestions
and constructive comments have been received from a great number of instructors and students
who have used previous editions. Numerous reviewers have also provided insights and assistance
in clarifying difficult material. Among those who have been especially helpful in the development
of previous editions are: Barry Keating, University of Notre Dame; Stephen Conroy, University of
San Diego; Xu Wang, Texas A&M University; Michael Brandl, University of Texas—Austin; Neil
Garston, California State University—Los Angeles; Albert Okunade, University of Memphis;
David Carr, University of South Dakota; Steven Rock, Western Illinois University; Mel Borland,
Western Kentucky University; Tom Staley, San Francisco State University.
For the present edition I thank Kjeld Tyllesen and Carsten Scheibye both from
Copenhagen Business School.
I am also indebted to staff at Cengage Learning for making the 14th a reality.
Many thanks to the reviewers of this edition, Gu Guowei of London South Bank
University, UK and Dr Tendeukayi Mugadza of Monash University, South Africa.
Every effort has been made to minimize errors in the book. However, errors do
occasionally slip through despite diligent efforts to provide an error-free package of text
and ancillary materials. Readers are invited to correspond with me directly concerning any
corrections or other suggestions.
It is obvious that economic efficiency is an essential ingredient in the successful
management of both business and public-sector organizations. Like any dynamic area of
study, the field of managerial economics continues to undergo profound change in response
to the challenges imposed by a rapidly evolving environment. It is exciting to participate
in these developments. I sincerely hope that Managerial Economics contributes to a better
understanding of the usefulness of economic theory.
Finally, I would like to thank my wife Birgitte for her patience and understanding.
Eric Bentzen
bentzen@cbs.dk
November 2015

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
rial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

Overview

of Managerial
1

T

Economics

1

Nature and Scope
of Managerial Economics

R

CHAPTER

<
CHAPTER

2

Economic Optimization

CHAPTER

Q.

2

Demand and Supply

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. IXie to electronic rights, some third party content may be suppressed from the eBook and'or eChapteifs).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapteifs).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

Nature and Scope

>
■D

of Managerial Economics

Warren E. Buffett, celebrated chairman of Omaha, Nebraska-based Berkshire Hathaway, Inc., started
an investment partnership with $100 in 1956 and went on to accumulate a personal net worth in
excess of $50 billion.
Buffett is famous for his razor-sharp focus on the competitive advantages of Berkshire's wide
assortment of operating companies, including Benjamin Moore (paints), Borsheim's (jewelry), Clayton
Homes, Dairy Queen, Fruit of the Loom, GEICO (insurance), General Re Corporation (reinsurance),
MidAmerican Energy, the Nebraska Furniture Mart, See's Candies and Shaw's Industries (carpet and
floor coverings). Berkshire subsidiaries commonly earn more than 30 per cent per year on invested
capital, compared with the 10 per cent to 12 per cent rate of return earned by other well-managed
companies. Additional contributors to Berkshire's outstanding performance are substantial common
stock holdings in American Express, Coca-Cola, Procter & Gamble and Wells Fargo among others. As
both a skilled manager and an insightful investor, Buffett likes wonderful businesses with high rates
of return on investment, lofty profit margins and consistent earnings growth. Complicated businesses
that face fierce competition and require large capital investment are shunned.1
Buffett's success is powerful testimony to the practical usefulness of managerial economics.
Managerial economics answers fundamental questions. When is the market for a product so attractive
that entry or expansion becomes appealing? When is exit preferable to continued operation? Why
do some professions pay well, while others offer only meager pay? Successful managers make good
decisions, and one of their most useful tools is the methodology of managerial economics.

HOW IS MANAGERIAL ECONOMICS USEFUL?
Economic theory and methodology lay down rules for improving business and public
policy decisions.

Evaluating Choice Alternatives
Managerial
Economics
Applies economic
tools and techniques
to business and
administrative decisionmaking.

Managerial economics helps managers recognize how economic forces affect organizations
and describes the economic consequences of managerial behavior. It also links economic
concepts, data and quantitative methods to develop vital tools for managerial decisionmaking. This process is illustrated in Figure 1.1.

1

Information about Warren Buffett's investment philosophy and Berkshire Hathaway, Inc., can be found
on the Internet, http://www.berkshirehathaway.com
3

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from theeBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

4

Part 1: Overview of Managerial Economics

Figure 1.1

Managerial Economics is a Tool for Improving Management Decision-Making

Managerial economics uses economic concepts and quantitative methods to solve managerial problems.

Management Decision Problems
Product selection, output and pricing
Internet strategy
Organization design
Product development and promotion
strategy
Worker hiring and training
Investment and financing

Economic Concepts
Marginal analysis
Theory of consumer demand
Theory of the firm
Industrial organization and firm
behavior
Public choice theory

Quantitative Methods
Numerical analysis
Statistical estimation
Forecasting procedures
Game-theory concepts
Optimization techniques
Information systems

Managerial Economics
Use of economic concepts and
quantitative methods to solve
management decision problems
7
Optimal solutions to management
decision problems

Managerial economics identifies ways to achieve goals efficiently. For example,
suppose a small business seeks rapid growth to reach a size that permits efficient use
of national media advertising, managerial economics can be used to identify pricing
and production strategies to help meet this short-run objective quickly and effectively.
Similarly, managerial economics provides production and marketing rules that permit
the company to maximize net profits once it has achieved growth or market share
objectives.
Managerial economics has applications in both profit and not-for-profit sectors. For
example, an administrator of a nonprofit hospital strives to provide the best medical care
possible given limited medical staff, equipment, and related resources. Using the tools
and concepts of managerial economics, the administrator can determine the optimal
allocation of these limited resources. In short, managerial economics helps managers
arrive at a set of operating rules that aid in the efficient use of scarce human and capital

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapteifs).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

Chapter 1: Nature and Scope of Managerial Economics

5

resources. By following these rules, businesses, nonprofit organizations and government
agencies are able to meet objectives efficiently.

Making the Best Decision
To establish appropriate decision rules, managers must understand the economic
environment in which they operate. For example, a grocery retailer may offer consumers
a highly price-sensitive product, such as milk, at an extremely low markup over
cost - say, 1 per cent to 2 per cent - while offering less price-sensitive products, such
as nonprescription drugs, at markups of as high as 40 per cent over cost. Managerial
economics describes the logic of this pricing practice with respect to the goal of profit
maximization. Similarly, managerial economics reveals that auto import quotas reduce
the availability of substitutes for domestically produced cars, raise auto prices, and
create the possibility of monopoly profits for domestic manufacturers. It does not explain
whether imposing quotas is good public policy; that is a decision involving broader
political considerations. Managerial economics only describes the predictable economic
consequences of such actions.
Managerial economics offers a comprehensive application of economic theory and
methodology to management decision-making. It is as relevant to the management
of government agencies, cooperatives, schools, hospitals, museums, and similar notfor-profit institutions as it is to the management of profit-oriented businesses. Although
this text focuses primarily on business applications, it also includes examples and
problems from the government and nonprofit sectors to illustrate the broad relevance of
managerial economics.

Managerial Application 1.1
Business Ethics
In Financial Times, you can sometimes find evidence of
unscrupulous business behavior. However, unethical conduct
is inconsistent with value maximization and contrary to
the enlightened self-interest of management and other
employees, if honesty didn't pervade corporations, the ability
to conduct business would collapse. Eventually, the truth
always comes out, and when it does the unscrupulous lose
out. For better or worse, we are known by the standards we
adopt.To become successful in business, everyone must
adopt a set of principles. Ethical rules to keep in mind when
conducting business include:

•

•

See: http://www.maer5k.com

•

Above all else, keep your word. Say what you mean, and
mean what you say.
Do the right thing. A handshake with an honorable
person is worth more than a ton of legal documents from
a corrupt individual.

•
•

Accept responsibility for your mistakes, and fix them. Be
quick to share credit for success.
Leave something on the table. Profit with your customer,
not off your customer.
Stick by your principles. Principles are not for sale at any
price.

Does the'high road' lead to corporate success? Consider the
experience of A.P.Moller/Maersk - a Scandinavian company.
At A.P. Moller/Maersk their founder used the phrase:'no loss
should hit us, which by due diligence could be averted'.

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from theeBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

6

Part 1: Overview of Managerial Economics

THEORY OF THE FIRM
Firms are useful for producing and distributing goods and services.

Expected Value Maximization
At its simplest level, a business enterprise represents a series of contractual relationships
that specify the rights and responsibilities of various parties (see Figure 1.2). People directly
involved include customers, stockholders, management, employees, and suppliers. Society
is also involved because businesses use scarce resources, pay taxes, provide employment
opportunities, and produce much of society's material and services output. The model
Theory of the
Firm
Basic model of
business.
Expected Value
Maximization
Optimization of
profits in light of
uncertainty and
the time value of
money.

of business is called the theory of the firm. In its simplest version, the firm is thought to
have profit maximization as its primary goal. The firm's owner-manager is assumed to be
working to maximize the firm's short-run profits. Today, the emphasis on profits has been
broadened to encompass uncertainty and the time value of money. In this more complete
model, the primary goal of the firm is long-term expected value maximization.
The value of the firm is the present value of the firm's expected future net cash
flows. If cash flows are equated to profits for simplicity, the value of the firm today, or
its present value, is the value of expected profits, discounted back to the present at an
appropriate interest rate.2
This model can be expressed as follows

Value of the Firm
Present value of
the firm's expected
future net cash
flows.

Value of the Firm = Present Value of Expected Future Profits
-

Present Value
Worth in current
dollars.

^
+ _£2, . . . +
(1+ 01
(l + o2
d + O"

1.-!

TT,
=1
1 = 1 d + O'
Here, tt], 772, ..., tt,, represent expected profits in each year, t, and i is the appropriate
interest, or discount, rate. The final form for Equation (1.1) is simply a shorthand
expression in which sigma (S) stands for 'sum up'or 'add together'. The term

(=1
means, 'Add together as t goes from 1 to n the values of the term on the right'. For Equation
(1.1), the process is as follows: Let t — I and find the value of the term rq/O + 01, the
present value of year 1 profit; then let t-2 and calculate 772/(1 + 02, the present value of
year 2 profit; continue until t = n, the last year included in the analysis; then add up these
present-value equivalents of yearly profits to find the current or present value of the firm.
Because profits (77) are equal to total revenues (TR) minus total costs (TC), Equation
(1.1) can be rewritten as
,
V TR, — TCf
Value = Z* —7^—rrr1
f=i (1+/)'

2

1.2

Discounting is required because profits obtained in the future are less valuable than profits earned
presently. One euro today is worth more than €1 to be received a year from now because €1 today can
be invested and, with interest, grow to a larger amount by the end of the year. One euro invested at
10 per cent interest would grow to €1.10 in 1 year. Thus, €1 is defined as the present value of €1.10 due in
1 year when the appropriate interest rate is 10 per cent.

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and'or eChapteifs).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

Chapter 1: Nature and Scope of Managerial Economics

Figure 1.2

The Corporation is a Legal Device

The firm can be viewed as a series of contractual relationships that connect suppliers, investors,
workers and management in a joint effort to serve customers.

Society

Suppliers

Investors

Firm

Management

Employees
\

Customers

This expanded equation can be used to examine how the expected value maximization
model relates to a firm's various functional departments. The marketing department often
has primary responsibility for promotion and sales (TR); the production department has
primary responsibility for development costs (TC); and the finance department has primary
responsibility for acquiring capital and, hence, for the discount factor (/) in the denominator.
Important overlaps exist among these functional areas. The marketing department can help
reduce costs for a given level of output by influencing customer order size and timing.
The production department can stimulate sales by improving quality. Other departments,
for example, accounting, human resources, transportation, and engineering, provide
information and services vital to sales growth and cost control. The determination of TR
and TC is a difficult and complex task. All managerial decisions should be analyzed in
terms of their effects on value, as expressed in Equations (1.1) and (1.2).

Constraints and the Theory of the Firm
Organizations frequently face limited availability of essential inputs, such as skilled labor,
raw materials, energy, specialized machinery and warehouse space. Managers often
face limitations on the amount of investment funds available for a particular project or
activity. Decisions can also be constrained by contractual requirements. For example, labor
contracts limit flexibility in worker scheduling and job assignments. Contracts sometimes
require that a minimum level of output be produced to meet delivery requirements. In
most instances, output must also meet quality requirements. Some common examples

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and'or eChapteifs).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

8

Part 1: Overview of Managerial Economics

of output quality constraints are nutritional requirements for feed mixtures, audience
exposure requirements for marketing promotions, reliability requirements for electronic
products, and customer service requirements for minimum satisfaction levels.
Legal restrictions, which affect both production and marketing activities, can also
play an important role in managerial decisions. Laws that define minimum wages, health
and safety standards, pollution emission standards, fuel efficiency requirements, and fair
pricing and marketing practices all limit managerial flexibility.
The role that constraints play in managerial decisions makes the topic of constrained
optimization a basic element of managerial economics. Later chapters consider important
economic implications of self-imposed and social constraints. This analysis is important
because value maximization and allocative efficiency in society depend on the efficient
use of scarce economic resources.

Limitations of the Theory of the Firm
Optimize
Seek the best
solution.

In practice, do managers try to optimize (seek the best result) or merely satisfice
(seek satisfactory rather than optimal results)? Do managers seek the sharpest needle
in a haystack (optimize), or do they stop after finding one sharp enough for sewing

Satisfice
Seek satisfactory
rather than optimal
results.

(satisfice)? How can one tell whether company support of the United Way, for example,
leads to long-run value maximization? Are generous salaries and stock options necessary
to attract and retain managers who can keep the firm ahead of the competition? When
a risky venture is turned down, is this inefficient risk avoidance? Or does it reflect an
appropriate decision from the standpoint of value maximization?
It is impossible to give definitive answers to questions like these, and this dilemma
has led to the development of alternative theories of firm behavior. Some of the more
prominent alternatives are models in which size or growth maximization is the assumed
primary objective of management, models that argue that managers are most concerned
with their own personal utility or welfare maximization, and models that treat the firm as
a collection of individuals with widely divergent goals rather than as a single, identifiable
unit. These alternative theories, or models, of managerial behavior have added to our
understanding of the firm. Still, none can supplant the basic value maximization concept
as a foundation for analyzing managerial decisions. Examining why provides additional
insight into the value of studying managerial economics.
Research shows that vigorous competition typically forces managers to seek value
maximization in their operating decisions. Competition in the capital markets forces
managers to seek value maximization in their financing decisions as well. Stockholders
are, of course, interested in value maximization because it affects their rates of return
on common stock investments. Managers who pursue their own interests instead of
stockholders' interests run the risk of losing their job. Unfriendly takeovers are especially
hostile to inefficient management that is replaced. Moreover, recent studies show a strong
correlation between firm profits and managerial compensation. Management has strong
economic incentives to pursue value maximization through their decisions.
It is sometimes overlooked that managers must consider all relevant costs and
benefits before they can make reasoned decisions. It is unwise to seek the best technical
solution to a problem if the costs of finding such a solution greatly exceed resulting
benefits. As a result, what often appears to be satisficing on the part of management can
be interpreted as value-maximizing behavior once the costs of information gathering and
analysis are considered. Similarly, short-run growth maximization strategies are often
consistent with long-run value maximization when the production, distribution and
promotional advantages of large firm size are better understood.

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and'or eChapteifs).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

Chapter 1: Nature and Scope of Managerial Economics

9

Finally, the value maximization model also offers insight into a firm's voluntary
'socially responsible' behavior. The criticism that the traditional theory of the firm
emphasizes profits and value maximization while ignoring the issue of social
responsibility is important and will be discussed later in the chapter. For now, it will
prove useful to examine the concept of profits, which is central to the theory of the firm.

PROFIT MEASUREMENT
Free enterprise depends upon profits and the profit motive. Both play a role in the
efficient allocation of economic resources worldwide.

Business Versus Economic Profit
Profit is usually defined as the residual of sales revenue minus the explicit costs of doing
Business Profit
Residual of sales
revenue minus the
explicit accounting
costs of doing
business.

business. It is the amount available to fund equity capital after payment for all other
resources used by the firm. This definition of profit is accounting profit, or business
profit.
The economist also defines profit as the excess of revenues over costs. However,
inputs provided by owners, including entrepreneurial effort and capital, are resources
that must be compensated. The economist includes a normal rate of return on equity
capital plus an opportunity cost for the effort of the owner-entrepreneur as costs of
doing business, just as the interest paid on debt and the wages are costs in calculating

Managerial Application 1.2
The World is Turning to Capitalism and Democracy
Capitalism and democracy are mutually reinforcing. Some
philosophers have gone so far as to say that capitalism and
democracy are intertwined. Without capitalism, democracy
may be impossible.Without democracy, capitalism may fail.
At a minimum,freely competitive markets give consumers
broad choices, and reinforce the individual freedoms
protected in a democratic society. In democracy, government
does not grant individual freedom. Instead, the political
power of government emanates from the people. Similarly,
the flow of economic resources originates with the individual
customer in a capitalistic system. It is not centrally directed
by government.
Capitalism is socially desirable because of its decentralized
and customer-oriented nature.The menu of products to be
produced is derived from market price and output signals
originating in competitive markets, not from the output
schedules of a centralized planning agency. Resources and
products are also allocated through market forces.They are
not earmarked on the basis of favoritism or social status.
Through their purchase decisions, customers dictate the
quantity and quality of products brought to market.

Competition is a fundamentally attractive feature of
the capitalistic system because it keeps costs and prices
low. By operating efficiently,firms are able to produce the
maximum quantity and quality of goods and services.
Mass production is, by definition, production for the
masses. Competition also limits concentration of economic
and political power. Similarly, the democratic form of
government is inconsistent with consolidated economic
influence and decision-making.
Totalitarian forms of government are in retreat. China
has experienced violent upheaval as the country embarks
on much-needed economic and political reforms. In the
former Soviet Union, Eastern Europe, India and Latin America,
years of economic failure forced governments to dismantle
entrenched bureaucracy and install economic incentives.
Rising living standards and political freedom have made life
in the West the envy of the world. Against this backdrop, the
future is bright for capitalism and democracy!
See: Thomas B. Edsall 'Capitalism vs. Democracy,' The New York Times,
January 28,2014, http://www.wsj.com

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from theeBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

10

Normal Rate of
Return
Average profit
necessary to
attract and retain
investment.
Economic Profit
Business profit
minus the implicit
costs of capital and
any other ownerprovided inputs.

Part 1: Overview of Managerial Economics

business profit. The risk-adjusted normal rate of return on capital is the minimum return
necessary to attract and retain investment. Similarly, the opportunity cost of owner
effort is determined by the value that could be received in alternative employment. In
economic terms, profit is business profit minus the implicit (noncash) costs of capital and
other owner-provided inputs used by the firm. This profit concept is called economic
profit.
The concepts of business profit and economic profit can be used to explain the role
of profits in a free-enterprise economy. A normal rate of return is necessary to induce
individuals to invest funds rather than spend them for current consumption. Normal
profit is simply a cost for capital; it is no different from the cost of other resources, such as
labor, materials, and energy. A similar price exists for the entrepreneurial effort of a firm's
owner-manager and for other resources that owners bring to the firm. Opportunity costs
for owner-provided inputs are often a big part of business profits, especially among small
businesses.

Variability of Business Profits
In practice, reported profits fluctuate widely. Table 1.1 shows business profits for

Profit Margin
Accounting net
income divided by
sales.
Return on
Stockholders'
Equity
Accounting net
income divided by
the book value of
total assets minus
total liabilities.

a sample of 30 well-known industrial giants: companies that comprise the Dow
Jones Industrial Average. Business profit is often measured in dollar terms or as a
percentage of sales revenue, called profit margin, as in Table 1.1. The economist's
concept of a normal rate of profit is typically assessed in terms of the realized
rate of return on stockholders' equity (ROE). Return on stockholders' equity is
defined as accounting net income divided by the book value of the firm. As seen in
Table 1.1, the average ROE for industrial giants found in the Dow Jones Industrial
Average falls in a broad range around 15 per cent to 25 per cent per year. Although
an average annual ROE of roughly 20 per cent can be regarded as a typical or
normal rate of return in the USA and Canada, this standard is routinely exceeded by
companies such as Boeing Company, which has consistently earned a ROE in excess
of 35 per cent per year.
Some of the variation in ROE depicted in Table 1.1 represents the influence of
differential risk premiums. In the pharmaceuticals industry, for example, hoped-for
discoveries of effective therapies for important diseases are often a long shot at best.
Thus, profit rates reported by Merck, Pfizer, and other leading pharmaceutical companies
overstate the relative profitability of the drug industry; it could be cut by one-half with
proper risk adjustment. Similarly, reported profit rates can overstate differences in
economic profits if accounting error or bias causes investments with long-term benefits
to be omitted from the balance sheet. For example, current accounting practice often
fails to consider advertising or research and development expenditures as intangible
investments with long-term benefits. Because advertising and research and development
expenditures are immediately expensed rather than capitalized and written off over
their useful lives, intangible assets can be grossly understated for certain companies. The
balance sheet of Coca-Cola does not reflect the hundreds of millions of dollars spent to
establish and maintain the brand-name recognition of Coca-Cola, just as Pfizer's balance
sheet fails to reflect research dollars spent to develop important product names like
cholesterol-lowering Lipitor (the world's best-selling drug), Inspra (for the treatment of
congestive heart failure) and Viagra (for the treatment of male impotence). As a result,
business profit rates for both Coca-Cola and Pfizer overstate each company's true
economic performance.

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and'or eChapteifs).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

£
2 crw
<u w o
* c *
o ^

to
OX
i<
d-

ON
d!
CO
d-

IN
CO
cd
00

ID
CO
O
co

ID CO IN d- dT—< '—1 d- cd d;
In
In IN co
nH o
td CO td T 1

X td X T-H i—i T-k
o •£ CN CN oo cd X NO
O^ x IN On O ID
£
td r—
^ £?
PS CN CN

p °
11 =
c E

o ON o ON On
CO1 O X IN p
d
ID r—
T-k LD
td T 1 CO r—i

d
kIN
d

d
p
On
Or
kH

kOn
d
to

CO
koo
d

On
p
CO
d
kH

CO
ID
d
co

00
T '
cd
oo

>1
-Oi -d
"d

.SO

ON
In
td
On

IN
CO
ID
ID

ID
CO
IN
ID

o
X
cd
ID

to
LO
ID
CO

ON
P
o
CO

d
IN
oi
CO

IN
T 1
IN
T »

T '
LO
T 1
td

ON
d
o
(N

X
X
IN
td

co
X
T-H
CO

IN
td
o
td

IN
p
NO
td

CO
o
td
td

td
ON
o
d

d
o
csi
CO

ID
In
r-j
T 1

CO
X
d
td

td
On
In
T--

LO CO ID T-H td co
o
p p X CO o T-H kH
ON cd cd o td ID CO
kH
T—T ' X T-H

CO
p
d
IN

ID
IN
On
(d

In
d
cd
td

oc
T 1
cd
td

In
T-H
d
td
T-H

CO
p
cd
CO

kX
ON
td

X o
X X (N In On co On ON td td d co td cd
In T-H In ON p o X r- p X X IN d X o ID
kH IN d- d T-H r-i td ON T-H
td
T-H cd ID NO ID ON NO
T-H id
I—t co
td

kH
td
d
On

o
p
X
d

d
d
IN
td

td
p
kH
CO

d
p
td
d

CO
p
X
oc

o
CO
In
IN

kX
ON
d

X
p
cd
co

CO
X
ltd
(N

O
p
ID
kT 1

O
kID
X

O oc ON kN o td T-H
d
td
X ■ON
k- IN
In
td
T 1 d co

d
E
d
3. to
3
O
U

O
S Dh "6
3
to
3
C
U < u

M
as to

■u

"d to
-

Uh as

3
P3
cx
£
o
U
to
to
2J
CX
X
m
as 3
3 3
O

>>
3
3
CX
£
o
U
to
3
'as
o
as
CO
u
^
B
« CX 3 as re
Z < <
U

as ~

C ns Q, (j
TJ to -d
-= S s
-3
po U rq
U ixi

3 ^
«- I
I u
l-i
O
>
u os
.2 -3
U U

>,
3
re
CX
£
o
U
-o
3
re
CO
si
§
£
z
as
•d
3
O
CX
3
■d
hX
w

as
k.
re
as

43
C -rj T3

-a
as
■o
_3
c

_as

X
IN
o
CO

^ to

1
D
as
.c

!5
■(0
M
•P
o
k.
a.

00
td
od
td

d
CO
td
T—

o as 50
as -a

as
o>
ns
k.
as
<
n

ro
'6
as
*-•
TO
k.
o
a
k.
o
u
o
>.
■M

d"
p
T 1
td

00
•d
ON
id

T— ON ID O ID d* cd o co CO ID td o co
ITi 00 d< In oo td X ID td d- CO o In cd
ON ID ID CO IN o^
cd NO td kX
T-H CO IN ID
co
T—T
T 1 T—' T-H

01 C
On td 00
CO S o o
td X kH
a< C S p
cd d o ud
■r
00 to ON ID
> P
cn £
g kH

i/i
3
"D
C
1/1
as
c
0
—1

ID td o X
00 o d; p
d*
cd r—i
T—T IN
X
O
T—■ T-H td

3
re
>-.
Cu
c
s
S.O
g u
o as
U C
as
as _as
3
to W
"re
SH
as
3
3
i U

=
CX
^
2
u
to
r3
o
re
an
3
re
£
■d
o
U

3
O
■4—*
re
kH
o
Cx
kH
o
u
to
as
■3
^H
x:
as
re
as
3
O

So
o
.£
3

D
as
£
0
1
H ^

to
•d
34 re
re
3 as
2
as o
re
o
re 3
as
■43
re
d to
Xs
H
S-H 3
as
g
3 £
to
OS ■3 £
re
P 0D O
fi
2
re
£
=
So
O
to
3 re
re
EHi°03S3!y>>HC3(«ts»S353k;
"
o
u
"to
u
OS 5^toc5Sk^3l2tCtoa'-3^
^|j
re5>t?Crec3&-rePSSS3^iS!f
3 > c/s
OS re cs
X re 3
3 2"
r2 t- *d f2 r2
2
CO p 0CXCQCQ0-UCXiX<CxUxSUUHC4:O

>.
3
o re
u CX
£
3
o
o
to
3 re
JS
II X o
U
B. ^ 3 V
re
(j
o 3 re
£P
o
o
u CO o U
"a! 3 2 2
3 O

CO
|
d
3

3
•B
re
kH
o
CX
kH
o
u
to
d
03
c
Q

z'
re u
cx
£ ^
o X
u
ro

>,
c
re
3£
o
U

3
O
•a-s
r—"
re
1o
CX
k.
o
u
os
3
kH
asv
34
Z

as
3
T-H
v
Jh
as
N
p
e-

s
3
3
re
U
*
a>
•4-»
g
C-

as
3
HH
t/1H
as
•tH
3
re
Oh
c
3
O
u
cn
1—
_as
"as
>
re
kn
H
as
rt—

33
2
u
X
HH
"re
as
X
"3
3
D

3
C
P
re
kH
c
3h
kH
O
u
CA
as
'ob
_o
"o
3
•6
&
T3
•g
f—I
5
D

u
c
co
C
O<
•-i-j
re
as as
3
—
3 to
£ as
kH
o
£ -k
o CD
u HH
3 kH
re
.§ °

3
C
'h-H
re
k
C
CX
kH
C

U
• •—<
"§

3
O
X
X
II w

E
8
g
E
I
5
Jc!•

o
X
E
or

s-1
CX CX
H
< x < <
< < CQ U

O
u X _
^ > Q CD "^SizggoyilllEoSzb
N
U U Q
UUX2SS,£;^SS2Sz£a:HDP > >

o
X
11

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from theeBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

12

Part 1: Overview of Managerial Economics

WHY DO PROFITS VARY AMONG FIRMS?
Many firms earn significant economic profits or experience meaningful losses.

Disequilibrium Profit Theories
Frictional Profit
Theory
Abnormal profits
observed following
unanticipated
changes in demand
or cost conditions.

One explanation of economic profits or losses is frictional profit theory. It states that
markets are sometimes in disequilibrium because of unanticipated changes in demand or
cost conditions. Unanticipated shocks produce positive or negative economic profits for
some firms.
For example, automated teller machines (ATMs) make it possible for customers of
financial institutions to easily obtain cash, enter deposits, and make loan payments.
Though ATMs render obsolete many of the functions that used to be carried out at branch
offices, they foster ongoing consolidation in the industry. Similarly, new user-friendly
software increases demand for high-powered personal computers (PCs) and boosts returns
for efficient PC manufacturers and software vendors. A rise in the use of plastics and
aluminum in automobiles drives down the profits of steel manufacturers. Over time, barring

Monopoly Profit
Theory
Above-normal
profits caused by
barriers to entry that
limit competition.

impassable barriers to entry and exit, resources flow into or out of financial institutions,
computer manufacturers, and steel manufacturers, thus driving rates of return back to
normal levels. During interim periods, profits might be above or below normal because of
frictional factors that prevent instantaneous adjustment to new market conditions.
A further explanation of above-normal profits is the monopoly profit theory, an
extension of frictional profit theory. Some firms earn above-normal profits because they
are sheltered from competition by high barriers to entry. Economies of scale, high capital
requirements, patents or import protection enable some firms to build monopoly positions
that allow above-normal profits for extended periods. Monopoly profits can also arise
because of luck (being in the right industry at the right time) or from anticompetitive
behavior. Unlike other potential sources of above-normal profits, monopoly profits are
often seen as unwarranted and subject to heavy taxes or otherwise regulated.

Compensatory Profit Theories
Innovation Profit
Theory
Above-normal
profits that follow
successful invention
or modernization.

Innovation profit theory describes above-normal profits that arise following successful
invention or modernization. For example, innovation profit theory suggests that Microsoft
Corporation has earned superior rates of return because it successfully introduced and
marketed the graphical user interface, a superior image-based rather than commandbased approach to computer software instructions. Microsoft has continued to earn
above-normal returns as other firms scramble to offer a wide variety of 'user friendly'
software for personal and business applications. Only after competitors have introduced
and successfully saturated the market for user-friendly software will Microsoft profits
be driven down to normal levels. Similarly, Apple Corporation has earned above-normal
rates of return as an early innovator with its iPod line of portable digital music and video
players. With increased competition from Microsoft's line of Zune devices, among others,
it remains to be seen if Apple can maintain its position in the portable digital device

Compensatory
Profit Theory
Above-normal
rales of return that
reward efficiency.

market, or will instead see its market dominance and above-normal returns decline. As
in the case of frictional or disequilibrium profits, profits that are due to innovation are
susceptible to the onslaught of competition from new and established competitors.
In general, compensatory profit theory describes above-normal rates of return that
reward firms for extraordinary success in meeting customer needs and maintaining efficient
operations. If firms that operate at the industry's average level of efficiency receive normal

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and'or eChapteifs).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

Chapter 1: Nature and Scope of Managerial Economics

13

rates of return, it is reasonable to expect firms operating at above-average levels of efficiency
to earn above-normal rates of return. Inefficient firms earn below-normal rates of return.
Compensatory profit theory also recognizes economic profit as an important reward to the
entrepreneurial function of owners and managers. Every product starts as an idea for serving
better some established or perceived need of existing or potential customers. This need
remains unmet until someone designs, plans, and implements a solution. The opportunity for
economic profits is an important motivation for such entrepreneurial activity.

Role of Profits in the Economy
Each of the preceding theories describes economic profits obtained for different reasons.
In some cases, several theories may apply An efficient manufacturer like Boeing may
earn an above-normal rate of return in accordance with compensatory theory, but, during
a strike by competitor Airbus employees, these above-average profits may be augmented
by frictional profits. Microsoft's profit position can be partly explained by all four
theories: The company has earned high frictional profits while Google, IBM, and Oracle,
among a host of others, scramble to offer new computer software, games, and services;
Microsoft has earned monopoly profits because it has some copyright and patent
protection; it has certainly benefitted from successful innovation; and it is well managed
and thus has earned compensatory profits.
Economic profits play an important role in any market-based economy. Above-normal
profits serve as a valuable signal that firm or industry output should be increased.
Expansion by established firms or entry by new competitors occurs quickly during highprofit periods. Just as above-normal profits signal the need for expansion and entry,
below-normal profits signal the need for contraction and exit. Economic profits are

Managerial Application 1.3
Google on Social Responsibility
Form S-1 registration statements are filed with the Securities
and Exchange Commission by companies that want to sell
shares to the investing public. Usually written by lawyers
and filled with legalese, Google cofounder Larry Page
shattered Wall Street tradition when he used the company's
S-1 statement to lay out Google's philosophy on the social
responsibility of business.
'Don't be evil,' Page wrote.'We believe strongly that in
the long term, we will be better served - as shareholders and
in all other ways - by a company that does good things for
the world even if we forgo some short-term gains.This is an
important aspect of our culture and is broadly shared within
the company.'
'We aspire to make Google an institution that makes the
world a better place. With our products,Google connects people
and information all around the world for free. We are adding
other powerful services such as Gmail that provides an efficient
1-gigabyte Gmail account for free. By releasing services for free,
we hope to help bridge the digital divide. AdWords connects

users and advertisers efficiently, helping both. AdSense helps
fund a huge variety of online websites and enables authors
who could not otherwise publish/In 2003,the company
created Google Grants to fund programs in which hundreds of
nonprofits address issues, including the environment, poverty
and human rights, receive free advertising to further their
mission. In 2004, the company committed part of the proceeds
from its initial public offering and 1 per cent of ongoing profits
to fund the Google Foundation, an organization intended to
ambitiously apply innovation and resources toward the solution
of world problems.
Google is committed to optimize for the long term, and
will support high-risk, high-reward projects and manage
them as a portfolio.The company will be run collaboratively
in an effort to attract creative, committed new employees.
It will be interesting to track their progress.
See: http://www.$ec.gov/Archives/edgar/data/1288776/000119312504073639
/dsl.htm

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from theeBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

14

Part 1: Overview of Managerial Economics

one of the most important factors affecting the allocation of scarce economic resources.
Above-normal profits also reward innovation and efficiency, just as below-normal profits
penalize stagnation and inefficiency. Profits play a vital role in providing incentives for
innovation and productive efficiency and in allocating scarce resources.

ROLE OF BUSINESS IN SOCIETY
Business makes a big contribution to economic betterment in the USA and around the
globe.

Why Firms Exist
Firms exist because they are useful. They survive by public consent to serve social
needs. If social welfare could be precisely measured, business firms might be expected
to operate in a manner that maximizes some index of social well-being. Maximization of
social welfare requires answering the following important questions: What combination
of goods and services (including negative by-products, such as pollution) should be
produced? How should goods and services be provided? How should goods and services
be distributed? These are the most vital questions faced in a free-enterprise system, and
they are key social issues.
Although the process of market-determined production and allocation of goods
and services is highly efficient, problems sometimes arise in an unconstrained market
economy. Society has developed methods for alleviating these problems through the
political system. To illustrate, the economics of producing and distributing electric power
are such that only one firm can efficiently serve a given community. Furthermore, there
is no good substitute for electric lighting. As a result, electric companies are in a position
to exploit consumers; they could charge high prices and earn excessive profits. To avoid
potential exploitation, prices charged by electric companies and other utilities are held to
levels thought to be just sufficient to provide a fair rate of return on investment. In theory,
the regulatory process is simple. In practice, it is costly, and difficult to implement. It can
be arbitrary and a poor, but sometimes necessary, substitute for competition.
Problems can also occur when, because of economies of scale or other barriers to
entry, a limited number of firms serve a given market. If firms compete fairly with each
other, no difficulty arises. However, if they conspire with one another in setting prices,
they may be able to restrict output, obtain excessive profits, and reduce social welfare.
Antitrust laws are designed to prevent such collusion. Like direct regulation, antitrust
laws contain arbitrary elements and are costly to administer, but they too are necessary if
social justice is to be served.
The market economy sometimes faces difficulty when firms impose costs on others
by dumping wastes into the air or water. If a factory pollutes the air, causing nearby
residents to suffer lung ailments, a meaningful cost is imposed on those people and
society in general. Failure to shift these costs back onto the firm and, ultimately, to the
consumers of its products, means that the firm and its customers benefit unfairly by not
having to pay the full costs of production. Pollution and other externalities may result in
an inefficient and inequitable allocation of resources. In both government and business,
considerable attention is directed at the problem of internalizing these costs. Some of
the practices used to internalize social costs include setting health and safety standards
for products and work conditions, establishing emissions limits on manufacturing, and
imposing fines or closing firms that do not meet established standards.

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapteifs).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

Chapter 1: Nature and Scope of Managerial Economics

15

Social Responsibility of Business
What does all this mean with respect to the social responsibility of business? Is the value
maximization theory of the firm adequate for examining issues of social responsibility
and for developing rules that reflect the role of business in society?
As seen in Figure 1.3, firms are primarily economic entities and can be expected
to analyze social responsibility from within the context of the economic model of the
firm. This is an important consideration when examining inducements used to channel
the efforts of business in directions that society desires. Similar considerations should
also be taken into account before applying political pressure or regulations to constrain
firm operations. For example, from the consumer's standpoint it is desirable to pay low
rates for gas, electricity and telecom services. If public pressures drive rates down too

Figure 1.3

Value Maximization is a Complex Process

Value maximization is a complex process that involves an ongoing sequence of successful
management decisions.

Business and Social Environment

•
•
•
•

Technology
Production capacity
Worker knowledge
Communications capability
Research and development

Market Environment
• Customer demand
• Level of competition
• Supplier capability

Legal Environment
• Tax burden
• Regulatory policy
• Trade policy

Competitive Strategy
• Product choice
• Pricing strategy
• Promotion strategy

1
Organization Design
• Assignment of decision rights
• Match worker incentives with
managerial motives
• Decision management and
control
1
Pay for Performance
• Worker pay for performance
• Divisional pay for performance
• Management pay for
performance

1

Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in pait. Due to electronic rights, some third party content may be suppressed from the eBook and'or eChapteifs).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any lime if subsequent rights restrictions require it.

16

Part 1: Overview of Managerial Economics

The IKEA way
The Swedish company IKEA, one of the world's largest
furniture companies, has designed easy to assemble
furniture. Besides its modern design they have developed
their own way of doing business.They have paid special
attention to cost control, consumers' preferences, and layout
of store design. In society IKEA are involved with UNICEF
where IKEA Social Initiative contributed €1 to UNICEF and
Save the Children from each soft toy sold during a set period.
Today they have raised more than €20 million. Also they have

initiated a purchasing model (IWAY) that covers social, safety
and environmental issues.The focus with IWAY is to make
sure that IKEA suppliers follow the law in each country where
they are based.
Have a closer look at IKEA and discuss their way of doing
sustainable business.

Se