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Demand Estimation: Lecture Video

1. Study Chapters 5 and 6 of the recommended textbook.

2. Based on the materials in chapters 5 and 6, prepare a lecture note video in power point:

A. Include your picture in your video. Video without your picture will not be graded.

B. Your video should be limited to more than 10 minutes

C. Include at least one solved problem in your video. Your solved problem should be one of the problems listed in either chapter 5 or chapter 6. Provide explanations of the problem you solve and discuss how you would apply the concepts in managerial decision-making.

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Managerial Economics and Strategy THE P E ARS O N S ER IES IN EC ON OM IC S Abel/Bernanke/Croushore Macroeconomics* Froyen Macroeconomics Bade/Parkin Foundations of Economics* Fusfeld The Age of the Economist Berck/Helfand The Economics of the Environment Gerber International Economics* Laidler The Demand for Money Leeds/von Allmen The Economics of Sports Leeds/von Allmen/Schiming Economics* Lipsey/Ragan/Storer Economics* Lynn Economic Development: Theory and Practice for a Divided World Miller Economics Today* Understanding Modern Economics Miller/Benjamin The Economics of Macro Issues Miller/Benjamin/North The Economics of Public Issues Mills/Hamilton Urban Economics González-Rivera Forecasting for Economics and Business Bierman/Fernandez Game Theory with Economic Applications Gordon Macroeconomics* Blanchard Macroeconomics* Greene Econometric Analysis Blau/Ferber/Winkler The Economics of Women, Men, and Work Gregory Essentials of Economics Boardman/Greenberg/ Vining/ Weimer Cost-Benefit Analysis Gregory/Stuart Russian and Soviet Economic Performance and Structure Boyer Principles of Transportation Economics Hartwick/Olewiler The Economics of Natural Resource Use Branson Macroeconomic Theory and Policy Heilbroner/Milberg The Making of the Economic Society Brock/Adams The Structure of American Industry Heyne/Boettke/Prychitko The Economic Way of Thinking Bruce Public Finance and the American Economy Carlton/Perloff Modern Industrial Organization Caves/Frankel/Jones World Trade and Payments: An Introduction Cooter/Ulen Law & Economics Downs An Economic Theory of Democracy Folland/Goodman/Stano The Economics of Health and Health Care Fort Sports Economics Nafziger The Economics of Developing Countries O’Sullivan/Sheffrin/Perez Economics: Principles, Applications and Tools* Hubbard/O’Brien/Rafferty Macroeconomics* Chapman Environmental Economics: Theory, Application, and Policy Farnham Economics for Managers Murray Econometrics: A Modern Introduction Holt Markets, Games, and Strategic Behavior Hubbard/O’Brien Economics* Money, Banking, and the Financial System* Case/Fair/Oster Principles of Economics* Ehrenberg/Smith Modern Labor Economics Hoffman/Averett Women and the Economy: Family, Work, and Pay Mishkin The Economics of Money, Banking, and Financial Markets* The Economics of Money, Banking, and Financial Markets, Business School Edition* Macroeconomics: Policy and Practice* Parkin Economics* Hughes/Cain American Economic History Husted/Melvin International Economics Jehle/Reny Advanced Microeconomic Theory Perloff Microeconomics* Microeconomics: Theory and Applications with Calculus* Johnson-Lans A Health Economics Primer Perloff/Brander Managerial Economics and Strategy* Keat/Young/Erfle Managerial Economics Phelps Health Economics Klein Mathematical Methods for Economics Pindyck/Rubinfeld Microeconomics* Krugman/Obstfeld/Melitz International Economics: Theory & Policy* *denotes MyEconLab titles Riddell/Shackelford/Stamos/ Schneider Economics: A Tool for Critically Understanding Society Ritter/Silber/Udell Principles of Money, Banking & Financial Markets* Roberts The Choice: A Fable of Free Trade and Protection Rohlf Introduction to Economic Reasoning Ruffin/Gregory Principles of Economics Sargent Rational Expectations and Inflation Sawyer/Sprinkle International Economics Scherer Industry Structure, Strategy, and Public Policy Schiller The Economics of Poverty and Discrimination Sherman Market Regulation Silberberg Principles of Microeconomics Stock/Watson Introduction to Econometrics Studenmund Using Econometrics: A Practical Guide Tietenberg/Lewis Environmental and Natural Resource Economics Environmental Economics and Policy Todaro/Smith Economic Development Waldman Microeconomics Waldman/Jensen Industrial Organization: Theory and Practice Walters/Walters/Appel/ Callahan/Centanni/Maex/ O’Neill Econversations: Today’s Students Discuss Today’s Issues Weil Economic Growth Williamson Macroeconomics Visit www.myeconlab.com to learn more. Managerial Economics and Strategy Jeffrey M. Perloff University of California, Berkeley James A. Brander Sauder School of Business, University of British Columbia Boston Columbus Indianapolis New York San Francisco Upper Saddle River Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montreal Toronto Delhi Mexico City Sao Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo For Jackie, Lisa, Barbara, and Cathy Editor-in-Chief: Donna Battista Executive Acquisitions Editor: Adrienne D’Ambrosio Editorial Project Manager: Sarah Dumouchelle Editorial Assistant: Elissa Senra-Sargent Executive Marketing Manager: Lori DeShazo Managing Editor: Jeff Holcomb Senior Production Project Manager: Meredith Gertz Senior Procurement Specialist: Carol Melville Art Director: Jonathan Boylan Cover Designer: John Christiana Cover Image: Artisilense/Shutterstock Image Manager: Rachel Youdelman Photo Research: Integra Software Services, Ltd. Associate Project Manager—Text Permissions: Samantha Blair Graham Text Permissions Research: Electronic Publishing Services Director of Media: Susan Schoenberg Content Leads, MyEconLab: Noel Lotz and Courtney Kamauf Executive Media Producer: Melissa Honig Project Management and Text Design: Gillian Hall, The Aardvark Group Composition and Illustrations: Laserwords Maine Copyeditor: Rebecca Greenberg Proofreader: Holly McLean-Aldis Indexer: John Lewis Printer/Binder: RR Donnelley Cover Printer: Lehigh Phoenix Text Font: Palatino Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbook appear on the appropriate page within text or on page E-51. Copyright © 2014 by Pearson Education, Inc. All rights reserved. Manufactured in the United States of America. This publication is protected by Copyright, and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. To obtain permission(s) to use material from this work, please submit a written request to Pearson Education, Inc., Permissions Department, One Lake Street, Upper Saddle River, New Jersey 07458, or you may fax your request to 201-236-3290. Many of the designations by manufacturers and sellers to distinguish their products are claimed as trademarks. Where those designations appear in this book, and the publisher was aware of a trademark claim, the designations have been printed in initial caps or all caps. Library of Congress Cataloging-in-Publication Data Perloff, Jeffrey M. Managerial economics and strategy/Jeffrey Perloff, James Brander. — First edition. pages cm Includes bibliographical references and index. ISBN 978-0-321-56644-7 1. Managerial economics. I. Brander, James A. II. Title. HD30.22.P436 2014 338.5024’658 — dc23 2013022387 10 9 8 7 6 5 4 3 2 1 www.pearsonhighered.com ISBN 10: 0-321-56644-0 ISBN 13: 978-0-321-56644-7 Brief Contents Preface xiii Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapter 14 Chapter 15 Chapter 16 Chapter 17 Introduction 1 Supply and Demand 7 Empirical Methods for Demand Analysis 42 Consumer Choice 85 Production 124 Costs 154 Firm Organization and Market Structure 193 Competitive Firms and Markets 232 Monopoly 273 Pricing with Market Power 311 Oligopoly and Monopolistic Competition 354 Game Theory and Business Strategy 389 Strategies over Time 428 Managerial Decision Making Under Uncertainty 464 Asymmetric Information 500 Government and Business 533 Global Business 573 Answers to Selected Questions E-1 Definitions E-13 References E-18 Sources for Managerial Problems, Mini-Cases, and Managerial Implications E-24 Index E-32 Credits E-51 v Contents Preface Chapter 1 Introduction 1.1 Managerial Decision Making Profit Trade-Offs Other Decision Makers Strategy 1.2 Economic Models MINI-CASE Using an Income Threshold Model in China Simplifying Assumptions Testing Theories Positive and Normative Statements Summary Chapter 2 Supply and Demand MANAGERIAL PROBLEM Carbon Taxes 2.1 Demand The Demand Curve The Demand Function USING CALCULUS Deriving the Slope of a Demand Curve Summing Demand Curves MINI-CASE Aggregating the Demand for Broadband Service 2.2 Supply The Supply Curve The Supply Function Summing Supply Curves 2.3 Market Equilibrium Using a Graph to Determine the Equilibrium Using Algebra to Determine the Equilibrium Forces That Drive the Market to Equilibrium 2.4 Shocks to the Equilibrium Effects of a Shift in the Demand Curve Effects of a Shift in the Supply Curve Q&A 2.1 MANAGERIAL IMPLICATION Taking Advantage of Future Shocks Effects of Shifts in Both Supply and Demand Curves MINI-CASE Genetically Modified Foods Q&A 2.2 vi xiii 1 1 2 2 3 3 3 4 4 5 5 6 7 7 9 10 13 14 14 15 15 16 17 18 18 18 19 20 21 21 21 22 23 24 24 25 2.5 Effects of Government Interventions Policies That Shift Curves MINI-CASE Occupational Licensing Price Controls MINI-CASE Disastrous Price Controls Sales Taxes Q&A 2.3 MANAGERIAL IMPLICATION Cost Pass- 26 26 26 27 29 31 33 Through 34 2.6 When to Use the Supply-and-Demand Model 34 MANAGERIAL SOLUTION Carbon Taxes 36 Summary 37 ■ Questions 38 Chapter 3 Empirical Methods for Demand Analysis 42 MANAGERIAL PROBLEM Estimating the Effect of an iTunes Price Change 3.1 Elasticity The Price Elasticity of Demand MANAGERIAL IMPLICATION Changing Prices to Calculate an Arc Elasticity Q&A 3.1 USING CALCULUS The Point Elasticity of Demand Q&A 3.2 Elasticity Along the Demand Curve Other Demand Elasticities MINI-CASE Substitution May Save Endangered Species Demand Elasticities over Time Other Elasticities Estimating Demand Elasticities MINI-CASE Turning Off the Faucet 3.2 Regression Analysis A Demand Function Example MINI-CASE The Portland Fish Exchange Multivariate Regression Q&A 3.3 Goodness of Fit and the R2 Statistic MANAGERIAL IMPLICATION Focus Groups 3.3 Properties and Statistical Significance of Estimated Coefficients Repeated Samples Desirable Properties for Estimated Coefficients A Focus Group Example Confidence Intervals 42 43 44 45 45 47 47 47 50 51 52 52 52 53 53 54 55 60 61 61 62 63 63 63 64 65 Contents Hypothesis Testing and Statistical Significance 3.4 Regression Specification Selecting Explanatory Variables MINI-CASE Determinants of CEO Compensation Q&A 3.4 Functional Form MANAGERIAL IMPLICATION Experiments 3.5 Forecasting Extrapolation Theory-Based Econometric Forecasting MANAGERIAL SOLUTION Estimating the Effect of an iTunes Price Change Summary 80 ■ Questions 81 Appendix 3 The Excel Regression Tool Chapter 4 Consumer Choice MINI-CASE How You Ask the Question Matters 66 67 67 67 69 71 73 74 74 76 77 84 85 MANAGERIAL PROBLEM Paying Employees to Relocate 4.1 Consumer Preferences Properties of Consumer Preferences MINI-CASE You Can’t Have Too Much Money Preference Maps 4.2 Utility Utility Functions Ordinal and Cardinal Utility Marginal Utility USING CALCULUS Marginal Utility Marginal Rates of Substitution 4.3 The Budget Constraint Slope of the Budget Line USING CALCULUS The Marginal Rate of Transformation Effects of a Change in Price on the Opportunity Set Effects of a Change in Income on the Opportunity Set Q&A 4.1 MINI-CASE Rationing Q&A 4.2 4.4 Constrained Consumer Choice The Consumer’s Optimal Bundle Q&A 4.3 MINI-CASE Why Americans Buy More E-Books Than Do Germans Q&A 4.4 Promotions 85 87 87 88 89 95 95 96 96 97 98 98 100 101 Consumer Choices to Relocate Summary 118 ■ Questions 119 Appendix 4A The Marginal Rate of Substitution Appendix 4B The Consumer Optimum Chapter 5 Production 116 122 122 124 MANAGERIAL PROBLEM Labor Productivity During Recessions 5.1 Production Functions 5.2 Short-Run Production The Total Product Function The Marginal Product of Labor USING CALCULUS Calculating the Marginal Product of Labor Q&A 5.1 The Average Product of Labor Graphing the Product Curves The Law of Diminishing Marginal Returns MINI-CASE Malthus and the Green Revolution 5.3 Long-Run Production Isoquants MINI-CASE A Semiconductor Isoquant Substituting Inputs Q&A 5.2 USING CALCULUS Cobb-Douglas Marginal Products 5.4 Returns to Scale Constant, Increasing, and Decreasing Returns to Scale 102 102 102 102 103 103 105 Manufacturing Varying Returns to Scale 110 110 113 113 113 116 MANAGERIAL SOLUTION Paying Employees Q&A 5.3 MINI-CASE Returns to Scale in U.S. 106 107 108 114 115 MANAGERIAL IMPLICATION Simplifying 101 MANAGERIAL IMPLICATION Designing Promotions 4.5 Deriving Demand Curves 4.6 Behavioral Economics Tests of Transitivity Endowment Effects Salience vii MANAGERIAL IMPLICATION Small Is Beautiful 5.5 Productivity and Technological Change Relative Productivity MINI-CASE U.S. Electric Generation Efficiency Innovation MINI-CASE Tata Nano’s Technical and Organizational Innovations MANAGERIAL SOLUTION Labor Productivity During Recessions Summary 150 ■ Questions 151 Chapter 6 Costs 124 125 127 127 128 128 129 129 129 132 133 134 134 137 138 139 141 141 141 143 143 145 146 146 146 147 147 148 149 154 MANAGERIAL PROBLEM Technology Choice at Home Versus Abroad 154 viii Contents 6.1 The Nature of Costs Opportunity Costs MINI-CASE The Opportunity Cost of an MBA Q&A 6.1 Costs of Durable Inputs Sunk Costs 155 155 156 157 157 158 MANAGERIAL IMPLICATION Ignoring Sunk Costs 6.2 Short-Run Costs Common Measures of Cost USING CALCULUS Calculating Marginal Cost Cost Curves Production Functions and the Shapes of Cost Curves USING CALCULUS Calculating Cost Curves Short-Run Cost Summary 6.3 Long-Run Costs Input Choice MANAGERIAL IMPLICATION Cost Minimization by Trial and Error MINI-CASE The Internet and Outsourcing Q&A 6.2 The Shapes of Long-Run Cost Curves MINI-CASE Economies of Scale in Nuclear Power Plants Q&A 6.3 Long-Run Average Cost as the Envelope of Short-Run Average Cost Curves MINI-CASE Long-Run Cost Curves in Beer Manufacturing and Oil Pipelines 6.4 The Learning Curve MINI-CASE Learning by Drilling 6.5 The Costs of Producing Multiple Goods MINI-CASE Scope MANAGERIAL SOLUTION Technology Choice at Home Versus Abroad Summary 187 ■ Questions 187 Appendix 6 Long-Run Cost Minimization 159 159 159 161 161 163 166 167 168 168 173 174 175 176 178 179 180 181 182 183 184 185 185 192 Chapter 7 Firm Organization and Market Structure 193 MANAGERIAL PROBLEM Clawing Back Bonuses 7.1 Ownership and Governance of Firms Private, Public, and Nonprofit Firms MINI-CASE Chinese State-Owned Enterprises Ownership of For-Profit Firms Firm Governance 7.2 Profit Maximization Profit Two Steps to Maximizing Profit USING CALCULUS Maximizing Profit Q&A 7.1 MANAGERIAL IMPLICATION Marginal Decision Making 193 195 195 197 197 199 199 199 200 201 202 202 Profit over Time 204 MANAGERIAL IMPLICATION Stock Prices Versus Profit 7.3 Owners’ Versus Managers’ Objectives Consistent Objectives Q&A 7.2 Conflicting Objectives Q&A 7.3 MINI-CASE Company Jets Monitoring and Controlling a Manager’s Actions Takeovers and the Market for Corporate Control MINI-CASE The Yahoo! Poison Pill 7.4 The Make or Buy Decision Stages of Production Vertical Integration Profitability and the Supply Chain Decision MINI-CASE Vertical Integration at American Apparel MINI-CASE Aluminum Market Size and the Life Cycle of a Firm 7.5 Market Structure The Four Main Market Structures Comparison of Market Structures Road Map to the Rest of the Book MANAGERIAL SOLUTION Clawing Back Bonuses Summary 226 ■ Questions 227 Appendix 7 Interest Rates, Present Value, and Future Value 204 205 205 207 208 209 210 211 212 214 214 215 215 217 218 219 221 222 222 224 224 225 230 Chapter 8 Competitive Firms and Markets 232 MANAGERIAL PROBLEM The Rising Cost of Keeping On Truckin’ 8.1 Perfect Competition Characteristics of a Perfectly Competitive Market Deviations from Perfect Competition 8.2 Competition in the Short Run How Much to Produce Q&A 8.1 USING CALCULUS Profit Maximization with a Specific Tax Whether to Produce MINI-CASE Oil, Oil Sands, and Oil Shale Shutdowns The Short-Run Firm Supply Curve The Short-Run Market Supply Curve Short-Run Competitive Equilibrium 8.3 Competition in the Long Run Long-Run Competitive Profit Maximization The Long-Run Firm Supply Curve MINI-CASE The Size of Ethanol Processing Plants 232 233 234 235 236 236 239 240 240 242 243 244 246 247 247 248 248 Contents The Long-Run Market Supply Curve MINI-CASE Fast-Food Firms’ Entry in Russia MINI-CASE Upward-Sloping Long-Run Supply Curve for Cotton Long-Run Competitive Equilibrium Zero Long-Run Profit with Free Entry 8.4 Competition Maximizes Economic Well-Being Consumer Surplus MANAGERIAL IMPLICATION Willingness to Pay on eBay Producer Surplus Q&A 8.2 Q&A 8.3 Competition Maximizes Total Surplus MINI-CASE The Deadweight Loss of Christmas Presents Effects of Government Intervention Q&A 8.4 MANAGERIAL SOLUTION The Rising Cost of Keeping On Truckin’ Summary 268 ■ Questions 248 249 251 252 254 254 255 257 258 260 261 262 264 265 266 267 269 Chapter 9 Monopoly 273 MANAGERIAL PROBLEM Brand-Name and Generic Drugs 9.1 Monopoly Profit Maximization Marginal Revenue USING CALCULUS Deriving a Monopoly’s Marginal Revenue Function Q&A 9.1 Choosing Price or Quantity Two Steps to Maximizing Profit USING CALCULUS Solving for the ProfitMaximizing Output Effects of a Shift of the Demand Curve 9.2 Market Power Market Power and the Shape of the Demand Curve MANAGERIAL IMPLICATION Checking Whether the Firm Is Maximizing Profit MINI-CASE Cable Cars and Profit Maximization The Lerner Index MINI-CASE Apple’s iPad Q&A 9.2 Sources of Market Power 9.3 Market Failure Due to Monopoly Pricing Q&A 9.3 9.4 Causes of Monopoly Cost-Based Monopoly Q&A 9.4 Government Creation of Monopoly MINI-CASE Botox 273 275 275 278 279 280 281 283 283 285 285 286 286 287 288 289 289 9.5 Advertising Deciding Whether to Advertise How Much to Advertise USING CALCULUS Optimal Advertising Q&A 9.5 MINI-CASE Super Bowl Commercials 9.6 Networks, Dynamics, and Behavioral Economics Network Externalities Network Externalities and Behavioral Economics Network Externalities as an Explanation for Monopolies MINI-CASE Critical Mass and eBay MANAGERIAL IMPLICATION Introductory Prices MANAGERIAL SOLUTION Brand-Name and Generic Drugs Summary 307 ■ Questions 307 Chapter 10 Pricing with Market Power MANAGERIAL PROBLEM Sale Prices 10.1 Conditions for Price Discrimination Why Price Discrimination Pays MINI-CASE Disneyland Pricing Which Firms Can Price Discriminate MANAGERIAL IMPLICATION Preventing Resale MINI-CASE Preventing Resale of Designer Bags Not All Price Differences Are Price Discrimination Types of Price Discrimination 10.2 Perfect Price Discrimination How a Firm Perfectly Price Discriminates Perfect Price Discrimination Is Efficient but Harms Some Consumers MINI-CASE Botox Revisited Q&A 10.1 Individual Price Discrimination MINI-CASE Dynamic Pricing at Amazon 10.3 Group Price Discrimination Group Price Discrimination with Two Groups USING CALCULUS Maximizing Profit for a Group Discriminating Monopoly MINI-CASE Reselling Textbooks Q&A 10.2 Identifying Groups MANAGERIAL IMPLICATION Discounts 290 292 293 294 295 296 297 Effects of Group Price Discrimination on Total Surplus 10.4 Nonlinear Price Discrimination 10.5 Two-Part Pricing Two-Part Pricing with Identical Consumers Two-Part Pricing with Differing Consumers MINI-CASE Available for a Song ix 298 299 299 300 301 301 302 302 303 304 304 305 305 311 311 313 313 315 315 316 317 317 318 318 318 319 321 322 323 324 324 325 326 328 328 330 331 332 333 335 335 337 338 x Contents 10.6 Bundling Pure Bundling Mixed Bundling Q&A 10.3 Requirement Tie-In Sales MANAGERIAL IMPLICATION Ties That Bind 10.7 Peak-Load Pricing MINI-CASE Downhill Pricing MANAGERIAL SOLUTION Sale Prices Summary 348 ■ Questions 349 339 340 341 343 344 344 344 346 347 354 MANAGERIAL PROBLEM Gaining an Edge from Government Aircraft Subsidies 11.1 Cartels Why Cartels Succeed or Fail MINI-CASE A Catwalk Cartel Maintaining Cartels 11.2 Cournot Oligopoly Airlines USING CALCULUS Deriving a Cournot Firm’s Marginal Revenue The Number of Firms MINI-CASE Air Ticket Prices and Rivalry Nonidentical Firms Q&A 11.1 Q&A 11.2 MANAGERIAL IMPLICATION Differentiating a Product Through Marketing Mergers MINI-CASE Acquiring Versus Merging 11.3 Bertrand Oligopoly Identical Products Differentiated Products 11.4 Monopolistic Competition MANAGERIAL IMPLICATION Managing in the Monopolistically Competitive Food Truck Market Equilibrium Q&A 11.3 Profitable Monopolistically Competitive Firms MINI-CASE Zoning Laws as a Barrier to Entry by Hotel Chains MANAGERIAL SOLUTION Gaining an Edge from Government Aircraft Subsidies Summary 383 ■ Questions 383 Appendix 11A Cournot Oligopoly with Many Firms Appendix 11B Nash-Bertrand Equilibrium 354 356 356 358 359 360 361 365 366 366 368 369 371 372 372 374 374 375 376 378 378 379 380 380 381 381 386 387 MANAGERIAL PROBLEM Dying to Work 12.3 Information and Rationality Incomplete Information MANAGERIAL IMPLICATION Solving Coordination Problems Rationality MANAGERIAL IMPLICATION Using Game Theory to Make Business Decisions 12.4 Bargaining Bargaining Games The Nash Bargaining Solution Q&A 12.3 USING CALCULUS Maximizing the Nash Product MINI-CASE Nash Bargaining over Coffee Inefficiency in Bargaining 12.5 Auctions Elements of Auctions Bidding Strategies in Private-Value Auctions MINI-CASE Experienced Bidders MINI-CASE Google Advertising The Winner’s Curse MANAGERIAL IMPLICATION Auction Design MANAGERIAL SOLUTION Dying to Work Summary 421 ■ Questions 422 Appendix 12 Determining a Mixed Strategy Chapter 13 Strategies over Time 389 389 392 393 394 396 398 399 400 401 403 403 406 407 408 408 409 410 411 411 412 412 413 414 414 414 415 415 416 417 418 419 420 420 427 428 MANAGERIAL PROBLEM Intel and AMD’s Advertising Strategies 13.1 Repeated Games Strategies and Actions in Dynamic Games Cooperation in a Repeated Prisoner’s Dilemma Game MINI-CASE Tit-for-Tat Strategies in Trench Warfare Implicit Versus Explicit Collusion Finitely Repeated Games 13.2 Sequential Games Stackelberg Oligopoly Credible Threats Q&A 13.1 Chapter 12 Game Theory and Business Strategy Q&A 12.1 12.2 Types of Nash Equilibria Multiple Equilibria MINI-CASE Timing Radio Ads Mixed-Strategy Equilibria MINI-CASE Competing E-Book Formats Q&A 12.2 Chapter 11 Oligopoly and Monopolistic Competition 12.1 Oligopoly Games Dominant Strategies Best Responses Failure to Maximize Joint Profits MINI-CASE Strategic Advertising 13.3 Deterring Entry Exclusion Contracts MINI-CASE Pay-for-Delay Agreements 428 430 430 431 433 434 434 435 436 439 440 441 441 442 Contents Limit Pricing MINI-CASE Pfizer Uses Limit Pricing to Slow Entry Q&A 13.2 Entry Deterrence in a Repeated Game 13.4 Cost Strategies Investing to Lower Marginal Cost Learning by Doing Raising Rivals’ Costs Q&A 13.3 MINI-CASE Auto Union Negotiations 13.5 Disadvantages of Moving First The Holdup Problem MINI-CASE Venezuelan Nationalization MANAGERIAL IMPLICATION Avoiding Holdups Moving Too Quickly MINI-CASE Advantages and Disadvantages of Moving First 13.6 Behavioral Game Theory Ultimatum Games MINI-CASE GM’s Ultimatum Levels of Reasoning MANAGERIAL IMPLICATION Taking Advantage of Limited Strategic Thinking MANAGERIAL SOLUTION Intel and AMD’s Advertising Strategies Summary 458 ■ Questions 459 Appendix 13 A Mathematical Approach to Stackelberg Oligopoly 443 444 444 445 446 446 448 448 448 449 450 450 451 452 453 453 454 454 454 456 457 457 463 Chapter 14 Managerial Decision Making Under Uncertainty 464 MANAGERIAL PROBLEM Risk and Limited Liability 14.1 Assessing Risk Probability Expected Value Q&A 14.1 Variance and Standard Deviation MANAGERIAL IMPLICATION Summarizing Risk 14.2 Attitudes Toward Risk Expected Utility Risk Aversion Q&A 14.2 USING CALCULUS Diminishing Marginal Utility of Wealth MINI-CASE Stocks’ Risk Premium Risk Neutrality Risk Preference MINI-CASE Gambling Risk Attitudes of Managers 14.3 Reducing Risk Obtaining Information MINI-CASE Bond Ratings Diversification 464 466 466 467 469 469 470 471 471 472 474 474 475 475 476 476 478 478 479 479 480 xi MANAGERIAL IMPLICATION Diversifying Retirement Funds Insurance Q&A 14.3 MINI-CASE Limited Insurance for Natural Disasters 14.4 Investing Under Uncertainty Risk-Neutral Investing Risk-Averse Investing Q&A 14.4 14.5 Behavioral Economics and Uncertainty Biased Assessment of Probabilities MINI-CASE Biased Estimates Violations of Expected Utility Theory Prospect Theory MANAGERIAL SOLUTION Risk and Limited Liability Summary 495 ■ Questions 496 Chapter 15 Asymmetric Information 482 483 484 485 487 487 488 488 489 489 490 491 492 494 500 MANAGERIAL PROBLEM Limiting Managerial Incentives 15.1 Adverse Selection Adverse Selection in Insurance Markets Products of Unknown Quality Q&A 15.1 Q&A 15.2 MINI-CASE Reducing Consumers’ Information 15.2 Reducing Adverse Selection Restricting Opportunistic Behavior Equalizing Information MANAGERIAL IMPLICATION Using Brand Names and Warranties as Signals MINI-CASE Changing a Firm’s Name MINI-CASE Adverse Selection on eBay Motors 15.3 Moral Hazard Moral Hazard in Insurance Markets Moral Hazard in Principal-Agent Relationships MINI-CASE Selfless or Selfish Doctors? Q&A 15.3 15.4 Using Contracts to Reduce Moral Hazard Fixed-Fee Contracts Contingent Contracts MINI-CASE Contracts and Productivity in Agriculture Q&A 15.4 15.5 Using Monitoring to Reduce Moral Hazard Hostages MANAGERIAL IMPLICATION Efficiency Wages After-the-Fact Monitoring MINI-CASE Abusing Leased Cars MANAGERIAL SOLUTION Limiting Managerial Incentives Summary 528 ■ Questions 529 500 502 502 503 505 506 506 507 507 508 510 510 512 512 513 513 517 517 518 518 519 522 522 524 524 526 526 526 527 xii Contents Chapter 16 Government and Business 533 MANAGERIAL PROBLEM Licensing Inventions 16.1 Market Failure and Government Policy The Pareto Principle Cost-Benefit Analysis 16.2 Regulation of Imperfectly Competitive Markets Regulating to Correct a Market Failure Q&A 16.1 MINI-CASE Natural Gas Regulation Regulatory Capture Applying the Cost-Benefit Principle to Regulation 16.3 Antitrust Law and Competition Policy Mergers MINI-CASE Hospital Mergers: Market Power Versus Efficiency Predatory Actions Vertical Relationships MINI-CASE An Exclusive Contract for a Key Ingredient 16.4 Externalities MINI-CASE Negative Externalities from Spam The Inefficiency of Competition with Externalities Reducing Externalities MINI-CASE Pulp and Paper Mill Pollution and Regulation Q&A 16.2 MINI-CASE Why Tax Drivers The Coase Theorem MANAGERIAL IMPLICATION Buying a Town 16.5 Open-Access, Club, and Public Goods Open-Access Common Property MINI-CASE For Whom the Bridge Tolls Club Goods MINI-CASE Piracy Public Goods 16.6 Intellectual Property Patents Q&A 16.3 MANAGERIAL IMPLICATION Trade Secrets Copyright Protection MANAGERIAL PROBLEM Responding to Exchange Rates 17.1 Reasons for International Trade Comparative Advantage 536 537 539 540 542 Comparative Advantage Increasing Returns to Scale MINI-CASE Barbie Doll Varieties 17.2 Exchange Rates Determining the Exchange Rate Exchange Rates and the Pattern of Trade MANAGERIAL IMPLICATION Limiting Arbitrage and Gray Markets Managing Exchange Rate Risk 17.3 International Trade Policies Quotas and Tariffs in Competitive Markets 542 543 545 546 546 546 548 548 549 549 552 553 554 555 556 557 557 558 559 560 560 560 563 563 564 565 566 566 ■ Questions 569 573 533 534 535 536 MANAGERIAL SOLUTION Licensing Inventions Summary 568 Chapter 17 Global Business Q&A 17.1 MANAGERIAL IMPLICATION Paul Allen’s Q&A 17.2 MINI-CASE Managerial Responses to the Chicken Tax Trade War Rent Seeking Noncompetitive Reasons for Trade Policy MINI-CASE Dumping and Countervailing Duties for Solar Panels Trade Liberalization and the World Trading System Trade Liberalization Problems 17.4 Multinational Enterprises Becoming a Multinational MINI-CASE What’s an American Car? International Transfer Pricing Q&A 17.3 MINI-CASE Profit Repatriation 17.5 Outsourcing 573 575 575 577 578 578 579 580 580 581 582 582 583 583 588 589 589 590 592 593 594 595 596 596 597 598 600 601 MANAGERIAL SOLUTION Responding to Exchange Rates Summary 604 ■ Questions 603 605 Answers to Selected Questions Definitions References Sources for Managerial Problems, Mini-Cases, and Managerial Implications Index Credits E–1 E–13 E–18 E–24 E–32 E–51 Preface Successful managers make extensive use of economic tools when making important decisions. They use these tools to produce at minimum cost, to choose an output level to maximize profit, and for many other managerial decisions including: ◗ Whether to offer buy-one-get-one-free deals ◗ How much to advertise ◗ Whether to sell various goods as a bundle ◗ What strategies to use to compete with rival firms ◗ How to design compensation contracts to provide appropriate incentives for employees ◗ How to structure an international supply chain to take advantage of cross-country differences in production costs We illustrate how to apply economic theory using actual business examples and real data. Our experience teaching managerial economics at the Wharton School (University of Pennsylvania) and the Sauder School of Business (University of British Columbia) as well as teaching a wide variety of students at the Massachusetts Institute of Technology; Queen’s University; and the University of California, Berkeley, has convinced us that students prefer our emphasis on real-world issues and examples from actual markets. Main Innovations This book differs from other managerial economics texts in three main ways. ◗ It places greater emphasis than other texts on modern theories that are increasingly useful to managers in areas such as industrial organization, transaction cost theory, game theory, contract theory, and behavioral economics. ◗ It makes more extensive use of real-world business examples to illustrate how to use economic theory in making business decisions. ◗ It employs a problem-based approach to demonstrate how to apply economic theory to specific business decisions. Modern Theories for Business Decisions This book has all the standard economic theory, of course. However, what sets it apart is its emphasis on modern theories that are particularly useful for managers. Industrial Organization. How do managers differentiate their products to increase their profits? When do mergers pay off? When should a firm take (legal) xiii xiv Preface actions to prevent entry of rivals? What effects do government price regulations have on firms’ behavior? These and many other questions are addressed by industrial organization theories. Transaction Cost Theory. Why do some firms produce inputs while others buy them from a market? Why are some firms vertically integrated whiles others are not? We use transaction cost theory to address questions such as these, particularly in Chapter 7. Game Theory. Should the manager of a radio station schedule commercial breaks at the same time as rival firms? What strategy should a manager use when bidding in an auction for raw materials? The major issue facing many managers is deciding what strategies to use in competing with rivals. This book goes well beyond other managerial economics texts by making significant use of game theory in Chapters 12–14 to examine such topics as oligopoly quantity and price setting, entry and exit decisions, entry deterrence, and strategic trade policy. Game theory provides a way of thinking about strategies and it provides methods to choose strategies that maximize profits. Unlike most microeconomic and managerial economics books, our applications of game theory are devoted almost exclusively to actual business problems. Contract Theory. What kind of a contract should a manager offer a worker to induce the employee to work hard? How do managers avoid moral hazard problems so they aren’t taken advantage of by people who have superior information? We use modern contract theory to show how to write contracts to avoid or minimize such problems. Behavioral Economics. Should a manager allow workers to opt in or opt out of a retirement system? How can the manager of a motion picture firm take advantage of movie reviews? We address questions such as these using behavioral economics— one of the hottest new areas of economic theory—which uses psychological research and theory to explain why people deviate from rational behavior. These theories are particularly relevant for managers, but sadly they have been largely ignored by most economists until recently. Real-World Business Examples We demonstrate that economics is practical and useful to managers by examining real markets and actual business decisions. We do so in two ways. In our presentation of the basic theory, we use real-world data and examples. Second, we examine many real-world problems in our various application features. To illustrate important economic concepts, we use graphs and calculations based on actual markets and real data. Students learn the basic model of supply and demand using estimated supply and demand curves for avocados, and they practice estimating demand curves using real data such as from the Portland Fish Exchange. They study how imported oil limits pricing by U.S. oil producers using real estimated supply and demand curves, derive cost curves from Japanese beer manufacturers using actual estimated production functions, and analyze oligopoly strategies using estimated demand curves and cost and profit data from the real-world rivalries between United Airlines and American Airlines and between Coke and Pepsi. Preface xv Problem-Based Learning Managers have to solve business problems daily. We use a problem-solving approach to demonstrate how economic theory can help mangers make good decisions. In each chapter, we solve problems using a step-by-step approach to model good problem-solving techniques. At the end of the chapter, we have an extensive set of questions. Some of these require the student to solve problems similar to the solved problems in the chapter, while others ask the student to use the tools of the chapter to answer questions about applications within the chapter or new real-world problems. We also provide exercises asking students to use spreadsheets to apply the theory they have learned to real-world problems. Features This book has more features dedicated to showing students how to apply theory to real-world problems than do rival texts. Managerial Implications. Managerial Implications sections contain simple bottom-line statements of economic principles that managers can use to make key managerial decisions. For example, we describe how managers can assess whether they are maximizing profit by using data to estimate demand elasticities. We also show how they can structure discounts to maximize profits, promote customer loyalty, design auctions, prevent gray markets, and use important insights from game theory to improve managerial decisions. Mini-Cases. Over a hundred Mini-Cases apply economic theory to interesting and important managerial problems. For example, Mini-Cases demonstrate how price increases on iTunes affect music downloads (using actual data), how to estimate Blackberry’s production function using real-world data, why some top-end designers limit the number of designer bags customers can buy, how “poison pills” at Yahoo! affected shareholders, how Pfizer used limit pricing to slow entry of rivals, why advertisers pay so much for Superbowl commercials, and how managers of auto manufacturing firms react to tariffs and other regulations. Q&As. After the introductory chapter, each chapter provides three to five Q&As (Questions & Answers). Each Q&A poses a qualitative or quantitative problem and then uses a step-by-step approach to solve the problem. Most of the 55 Q&As focus on important managerial issues such as how a cost-minimizing firm would adjust to changing factor prices, how a manager prices bundles of goods to maximize profits, how to determine Intel’s and AMD’s profit-maximizing quantities and prices using their estimated demand curves and marginal costs, and how to allocate production across plants internationally. Managerial Problems and Managerial Solutions. After the introductory chapter, each chapter starts with a Managerial Problem that motivates the chapter by posing real-world managerial questions that can be answered using the economic principles and methods developed in the chapter. At the end of each chapter, we answer these questions in the Managerial Solution. Thus, each pair of these features combines the essence of a Mini-Case and a Q&A. xvi Preface End-of-Chapter Questions. Starting with Chapter 2, each chapter ends with an extensive set of questions, many of which are based on real-world problems. Each Q&A has at least one associated end-of-chapter question that references the Q&A and allows the student to answer a similar problem, and many of the questions are related to Mini-Cases that appear in the book. The answers to selected end-of-chapter problems appear at the end of the book, and all of the end-of-chapter questions are available in MyEconLab for self-assessment, homework, or testing. Spreadsheet Exercises. In addition to the verbal, graphical, and mathematical exercises, each chapter has two end-of-chapter spreadsheet exercises. These exercises demonstrate how managers can use a spreadsheet to apply the economic methods described in the chapter. They address important managerial issues such a choosing the profit-maximizing level of advertising or designing compensation contracts to effectively motivate employees. Students can complete the spreadsheet exercises in MyEconLab, which includes additional spreadsheet exercises. Using Calculus. Calculus presentations of the theory appear at the appropriate points in the text in a Using Calculus feature. In contrast, most other books relegate calculus to appendices, mix calculus in with other material where it cannot easily be skipped, or avoid calculus entirely. We have a few appendices, but most of our calculus material is in Using Calculus sections, which are clearly identified and structured as discrete treatments. Therefore this book may be conveniently used both by courses that use calculus and those that do not. Some end-of-chapter questions are designed to use calculus and are clearly indicated. Alternative Organizations Because instructors differ in the order in which they cover material and in the range of topics covered, this text has been designed for maximum flexibility. The most common approach to teaching managerial economics is to follow the sequence of the chapters in the order presented. However, many variations are possible. For example, some instructors choose to address empirical methods (Chapter 3) first. Some instructors skip consumer theory (Chapter 4), which they can safely do without causing problems in later chapters. Chapter 7, Firm Organization and Market Structure, provides an overview of the key issues that are discussed in later chapters, such as types of firms, profit maximization and its alternatives, conflicts between managers and owners (and other “agency” issues), and the structure of markets. We think that presenting this material early in the course is ideal, but all of this material except for the section on profit maximization can be covered later. Because our treatment of game theory is divided into two chapters (Chapters 12 and 13), instructors can conveniently choose how much game theory to present. Later chapters that reference game theory do so in such a way that the game theoretical material can be easily skipped. Although Chapter 11 on oligopoly and monopolistic competition precedes the game theory chapters, a course could cover the game theory chapters first (with only minor explanations by the instructor). And a common variant is to present Chapter 14 on uncertainty earlier in the course. The last chapter, Global Business (17), should be very valuable for instructors who take an international perspective. To promote this viewpoint, every chapter contains examples of dealing with firms based in a variety of countries in addition to the United States. Preface xvii MyEconLab MyEconLab’s powerful assessment and tutorial system works hand-in-hand with this book. Features for Students MyEconLab puts students in control of their learning through a collection of testing, practice, and study tools. Students can study on their own, or they can complete assignments created by their instructor. In MyEconLab’s structured environment, students practice what they learn, test their understanding, and pursue a personalized study plan generated from their performance on sample tests and quizzes. In Homework or Study Plan mode, students have access to a wealth of tutorial features, including the following: ◗ Instant feedback on exercises taken directly from the text helps students understand and apply the concepts. ◗ Links to the eText version of this textbook allow the student to quickly revisit a concept or an explanation. ◗ Enhanced Pearson eText, available within the online course materials and offline via an iPad/Android app, allows instructors and students to highlight, bookmark, and take notes. ◗ Learning aids help students analyze a problem in small steps, much the same way an instructor would do during office hours. ◗ Temporary Access for students who are awaiting financial aid provides a 14-day grace period of temporary access. Experiments in MyEconLab Experiments are a fun and engaging way to promote active learning and mastery of important economic concepts. Pearson’s Experiment program is flexible and easy for instructors and students to use. ◗ Single-player experiments allow students to play against virtual players from anywhere at any time they have an Internet connection. ◗ Multiplayer experiments allow instructors to assign and manage a real-time experiment with their classes. ◗ Pre- and post-questions for each experiment are available for assignment in MyEconLab. For a complete list of available experiments, visit www.myeconlab.com. Features for Instructors MyEconLab includes comprehensive homework, quiz, text, and tutorial options, where instructors can manage all assessment needs in one program. ◗ All of the end-of-chapter questions are available for assignment and auto-grading. ◗ Test Item File questions are available for assignment or testing. ◗ The Custom Exercise Builder allows instructors the flexibility of creating their own problems for assignments. xviii Preface ◗ The powerful Gradebook records each student’s performance and time spent on the tests, study plan, and homework and can generate reports by student or by chapter. ◗ Advanced Communication Tools enable students and instructors to communicate through email, discussion board, chat, and ClassLive. ◗ Customization options provide new and enhanced ways to share documents, add content, and rename menu items. ◗ A prebuilt course option provides a turn-key method for instructors to create a MyEconLab course that includes assignments by chapter. Supplements A full range of supplementary materials to support teaching and learning accompanies this book. ◗ The Online Instructor’s Manual by Souren Soumbatiants of Franklin University has many useful and creative teaching ideas. It also offers additional discussion questions, and provides solutions for all the end-of-chapter questions in the text. ◗ The Online Test Bank by Todd Fitch of the University of California, Berkeley, features problems of varying levels of complexity, suitable for homework assignments and exams. Many of these multiple-choice questions draw on current events. ◗ The Computerized Test Bank reproduces the Test Bank material in the TestGen software, which is available for Windows and Macintosh. With TestGen, instructors can easily edit existing questions, add questions, generate tests, and print the tests in a variety of formats. ◗ The Online PowerPoint Presentation by Nelson Altamirano of National University contains text figures and tables, as well as lecture notes. These slides allow instructors to walk through examples from the text during in-class presentations. These teaching resources are available online for download at the Instructor Resource Center, www.pearsonhighered.com/perloff, and on the catalog page for Managerial Economics and Strategy. Acknowledgments Our greatest debt is to our very patient students at MIT; the University of British Columbia; the University of California, Berkeley; and the University of Pennsylvania for tolerantly dealing with our various approaches to teaching them economics. We appreciate their many helpful (and usually polite) suggestions. We also owe a great debt to our editors, Adrienne D’Ambrosio and Jane Tufts. Adrienne D’Ambrosio, Executive Acquisitions Editor, was involved in every stage in designing the book, writing the book, testing it, and developing supplemental materials. Jane Tufts, our developmental editor, reviewed each chapter of this book for content, pedagogy, and presentation. By showing us how to present the material as clearly and thoroughly as possible, she greatly strengthened this text. Preface xix Our other major debt is to Satyajit Ghosh, University of Scranton, for doing most of the work on the spreadsheet exercises in the chapters and in MyEconLab. We benefitted greatly from his creative ideas about using spreadsheets to teach managerial economics. We thank our teaching colleagues who provided many helpful comments and from whom we have shamelessly borrowed ideas. We particularly thank Tom Davidoff, Stephen Meyer, Nate Schiff, Ratna Shrestha, Mariano Tappata, and James Vercammen for using early versions of the textbook and for making a wide range of helpful contributions. We are also grateful to our colleagues Jen Baggs, Dennis Carlton, Jean-Etienne de Bettignes, Keith Head, Larry Karp, John Ries, Tom Ross, Leo Simon, Chloe Tergiman, and Ralph Winter for many helpful comments. We thank Evan Flater, Kai Rong Gan, Guojun He, Joyce Lam, WeiYi Shen, and Louisa Yeung for their valuable work as research assistants on the book. We are very grateful to the many reviewers who spent untold hours reading and commenting on our original proposal and several versions of each chapter. Many of the best ideas in this book are due to them. We’d especially like to thank Kristen Collett-Schmitt, Matthew Roelofs, and Adam Slawski for carefully reviewing the accuracy of the entire manuscript multiple times and for providing very helpful comments. We thank all the following reviewers, all of whom provided valuable comments at various stages: Laurel Adams, Northern Illinois University Jack Hou, California State University, Long Beach James C. W. Ahiakpor, California State University, East Bay Timothy James, Arizona State University Nelson Altamirano, National University Peter Daniel Jubinski, St. Joseph’s University Ariel Belasen, Southern Illinois University, Edwardsville Chulho Jung, Ohio University Bruce C. Brown, California State Polytechnic University, Pomona Barry Keating, University of Notre Dame Donald Bumpass, Sam Houston State University Dale Lehman, Alaska Pacific University Tom K. Lee, California State University, Northridge James H. Cardon, Brigham Young University Vincent J. Marra Jr., University of Delaware Jihui Chen, Illinois State University Sheila J. Moore, California Lutheran University Ron Cheung, Oberlin College Thomas Patrick, The College of New Jersey Abdur Chowdhury, Marquette University Anita Alves Pena, Colorado State University George Clarke, Texas A&M International University Troy Quast, Sam Houston State University Kristen Collett-Schmitt, University of Notre Dame Barry Ritchey, Anderson University Douglas Davis, Virginia Commonwealth University Matthew R. Roelofs, Western Washington University Christopher S. Decker, University of Nebraska, Omaha Amit Sen, Xavier University Craig A. Depken, II, University of North Carolina, Charlotte Stephanie Shayne, Husson University Jed DeVaro, California State University, East Bay Adam Slawski, Pennsylvania State University David Ely, San Diego State University Caroline Swartz, University of North Carolina, Charlotte Asim Erdilek, Case Western Reserve University Scott Templeton, Clemson University Satyajit Ghosh, University of Scranton Keith Willett, Oklahoma State University Rajeev Goel, Illinois State University Douglas Wills, University of Washington, Tacoma Abbas P. Grammy, California State University, Bakersfield Mark L. Wilson, Troy University Clifford Hawley, West Virginia University David Wong, California State University, Fullerton Matthew John Higgins, Georgia Institute of Technology xx Preface It was a pleasure to work with the excellent staff at Pearson, who were incredibly helpful in producing this book. Meredith Gertz did a wonderful job of supervising the production process, assembling the extended publishing team, and managing the design of the handsome interior. Gillian Hall and the rest of the team at The Aardvark Group Publishing Services, including our copyeditor, Rebecca Greenberg, have our sincere gratitude for designing the book and keeping the project on track and on schedule. Ted Smykal did a wonderful job drawing most of the cartoons. Sarah Dumouchelle helped edit, arranged for the supplements, and was helpful in many other ways. We also want to acknowledge, with appreciation, the efforts of Melissa Honig, Courtney Kamauf, and Noel Lotz in developing MyEconLab, the online assessment and tutorial system for the book. Finally, we thank our wives, Jackie Persons and Barbara Spencer, for their great patience and support during the nearly endless writing process. We apologize for misusing their names—and those of our other relatives and friends—in the book! J. M. P. J. A. B. Introduction 1 An Economist’s Theory of Reincarnation: If you’re good, you come back on a higher level. Cats come back as dogs, dogs come back as horses, and people—if they’ve been very good like George Washington—come back as money. I f all the food, clothing, entertainment, and other goods and services we wanted were freely available, no one would study economics, and we would not need managers. However, most of the good things in life are scarce. We cannot have everything we want. Consumers cannot consume everything but must make choices about what to purchase. Similarly, managers of firms cannot produce everything and must make careful choices about what to produce, how much to produce, and how to produce it. Studying such choices is the main subject matter of economics. Economics is the study of decision making in the presence of scarcity.1 Managerial economics is the application of economic analysis to managerial decision making. Managerial economics concentrates on how managers make economic decisions by allocating the scarce resources at their disposal. To make good decisions, a manager must understand the behavior of other decision makers, such as consumers, workers, other managers, and governments. In this book, we examine decision making by such participants in the economy, and we show how managers can use this understanding to be successful. Ma in Topics In this chapter, we examine two main topics: 1.1 1. Managerial Decision Making: Economic analysis helps managers develop strategies to achieve a firm’s objective—such as maximizing profit—in the presence of scarcity. 2. Economic Models: Managers use models based on economic theories to help make predictions about consumer and firm behavior, and as an aid to managerial decision making. Managerial Decision Making A firm’s managers allocate the limited resources available to them to achieve the firm’s objectives. The objectives vary for different managers within a firm. A production manager’s objective is normally to achieve a production target at the lowest possible cost. A marketing manager must allocate an advertising budget to promote the product most effectively. Human resource managers design compensation systems 1Many dictionaries define economics as the study of the production, distribution, and consumption of goods and services. However, professional economists think of economics as applying more broadly, including any decisions made subject to scarcity. 1 2 CHAPTER 1 Introduction to encourage employees to work hard. The firm’s top manager must coordinate and direct all these activities. Each of these tasks is constrained by resource scarcity. At any moment in time, a production manager has to use the existing factory and a marketing manager has a limited marketing budget. Such resource limitations can change over time but managers always face constraints. Profit Most private sector firms want to maximize profit, which is the difference between revenue and cost. The job of the senior manager in a firm, usually called the chief executive officer (CEO), is to focus on the bottom line: maximizing profit. The CEO orders the production manager to minimize the cost of producing the particular good or service, asks the market research manager to determine how many units can be sold at any given price, and so forth. Minimizing cost helps the firm to maximize profit, but the CEO must also decide how much output to produce and what price to charge. It is the job of the CEO (and other senior executives) to ensure that all managerial functions are coordinated so that the firm makes as much profit as possible. It would be a major coordination failure if the marketing department set up a system of pricing and advertising based on selling 8,000 units a year, while the production department managed to produce only 2,000 units. The CEO is also often concerned with how a firm is positioned in a market relative to its rivals. Senior executives at Coca-Cola and Pepsi spend a lot of time worrying about each other’s actions. Managers in such situations have a natural tendency to view business rivalries like sporting events, with a winner and a loser. However, it is critical to the success of any firm that the CEO focus on maximizing the firm’s profit rather than beating a rival. Trade-Offs People and firms face trade-offs because they can’t have everything. Managers must focus on the trade-offs that directly or indirectly affect profits. Evaluating tradeoffs often involves marginal reasoning: considering the effect of a small change. Key trade-offs include: ◗ How to produce: To produce a given level of output, a firm must use more of one input if it uses less of another input. Car manufacturers choose between metal and plastic for many parts, which affects the car’s weight, cost, and safety. ◗ What prices to charge: Some firms, such as farms, have little or no control over the prices at which their goods are sold and must sell at the price determined in the market. However, many other firms set their prices. When a manager of such a firm sets the price of a product, the manager must consider whether raising the price by a dollar increases the profit margin on each unit sold by enough to offset the loss from selling fewer units. Consumers, given their limited budgets, buy fewer units of a product when its price rises. Thus, ultimately, the manager’s pricing decision is constrained by the scarcity under which consumers make decisions. 1.2 Economic Models 3 Other Decision Makers It is important for managers of a firm to understand how decisions made by consumers, workers, managers of other firms, and governments constrain their firm. Consumers purchase products subject to their limited budgets. Workers decide on which jobs to take and how much to work given their scarce time and limits on their abilities. Rivals may introduce new, superior products or cut the prices of existing products. Governments around the world may tax, subsidize, or regulate products. Thus, managers must understand how others make decisions. Most economic analysis is based on the assumption that decision makers are maximizers: they do the best they can with their limited resources. However, economists also consider some contexts in which economic decision makers do not successfully maximize for a variety of psychological reasons—a topic referred to as behavioral economics. Interactions between economic decision makers take place primarily in markets. A market is an exchange mechanism that allows buyers to trade with sellers. A market may be a town square where people go to trade food and clothing, or it may be an international telecommunications network over which people buy and sell financial securities. When we talk about a single market, we refer to trade in a single good or group of goods that are closely related, such as soft drinks, movies, novels, or automobiles. The primary participants in a market are firms that supply the product and consumers who buy it, but government policies such as taxes also play an important role in the operation of markets. Strategy When interacting with a small number of rival firms, a manager uses a strategy—a battle plan that specifies the actions or moves that the manager will make to maximize the firm’s profit. A CEO’s strategy might involve choosing the level of output, the price, or advertising now and possibly in the future. In setting its production levels and price, Pepsi’s managers must consider what choices Coca-Cola’s managers will make. One tool that is helpful in understanding and developing such strategies is game theory, which we use in several chapters. 1.2 Economic Models Economists use economic models to explain how managers and other decision makers make decisions and to explain the resulting market outcomes. A model is a description of the relationship between two or more variables. Models are used in many fields. For example, astronomers use models to describe and predict the movement of comets and meteors, medical researchers use models to describe and predict the effect of medications on diseases, and meteorologists use models to predict weather. Business economists construct models dealing with economic variables and use such models to describe and predict how a change in one variable will affect another. Such models are useful to managers in predicting the effects of their decisions and in understanding the decisions of others. Models allow managers to consider hypothetical situations—to use a what-if analysis—such as “What would happen if we raised our prices by 10%?” or “Would profit rise if we phased out one of our product lines?” Models help managers predict answers to what-if questions and to use those answers to make good decisions. CHAPTER 1 4 Mini-Case Using an Income Threshold Model in China Introduction According to an income threshold model, no one who has an income level below a particular threshold buys a particular consumer durable, such as a refrigerator or car. The theory also holds that almost everyone whose income is above that threshold buys the product. If this theory is correct, we predict that, as most people's incomes rise above the threshold in emergent economies, consumer durable purchases will increase from near zero to large numbers virtually overnight. This prediction is consistent with evidence from Malaysia, where the income threshold for buying a car is about $4,000. In China, incomes have risen rapidly and now exceed the threshold levels for many types of durable goods. As a result, many experts correctly predicted that the greatest consumer durable goods sales boom in history would take place there. Anticipating this boom, many companies have greatly increased their investments in durable goods manufacturing plants in China. Annual foreign direct investments have gone from $916 million a year in 1983 to $116 billion in 2011. In expectation of this growth potential, even traditional political opponents of the People's Republic—Taiwan, South Korea, and Russia—are investing in China. One of the most desirable durable goods is a car. Li Rifu, a 46-year-old Chinese farmer and watch repairman, thought that buying a car would improve the odds that his 22- and 24-year-old sons would find girlfriends, marry, and produce grandchildren. Soon after Mr. Li purchased his Geely King Kong for the equivalent of $9,000, both sons met girlfriends, and his older son got married. Four-fifths of all new cars sold in China are bought by first-time customers. An influx of first-time buyers was responsible for China's ninefold increase in car sales from 2000 to 2009. By 2010, China became the second largest producer of automobiles in the world, trailing only Germany. In addition, foreign automobile companies built Chinese plants. For example, Ford invested $600 million in its Chongqing factory in 2012.2 Simplifying Assumptions Everything should be made as simple as possible, but not simpler. —Albert Einstein A model is a simplification of reality. The objective in building a model is to include the essential issues, while leaving aside the many complications that might distract us or disguise those essential elements. For example, the income threshold model focuses on only the relationship between income and purchases of durable goods. Prices, multiple car purchases by a single consumer, and other factors that might affect durable goods purchases are left out of the model. Despite these simplifications, the model—if correct—gives managers a good general idea of how the automobile market is likely to evolve in countries such as China. We have described the income threshold model in words, but we could have presented it using graphs or mathematics. Representing economic models using mathematical formulas in spreadsheets has become very important in managerial decision making. Regardless of how the model is described, an economic model is a simplification of reality that contains only its most important features. Without simplifications, it is difficult to make predictions because the real world is too complex to analyze fully. 2The sources for Mini-Cases are available at the back of the book. 1.2 Economic Models 5 Economists make many assumptions to simplify their models. When using the income threshold model to explain car purchasing behavior in China, we assume that factors other than income, such as the color of cars, do not have an important effect on the decision to buy cars. Therefore, we ignore the color of cars that are sold in China in describing the relationship between income and the number of cars consumers want. If this assumption is correct, by ignoring color, we make our analysis of the auto market simpler without losing important details. If we’re wrong and these ignored issues are important, our predictions may be inaccurate. Part of the skill in using economic models lies in selecting a model that is appropriate for the task at hand. Testing Theories Blore’s Razor: When given a choice between two theories, take the one that is funnier. Economic theory refers to the development and use of a model to test hypotheses, which are proposed explanations for some phenomenon. A useful theory or hypothesis is one that leads to clear, testable predictions. A theory that says “If the price of a product rises, the quantity demanded of that product falls” provides a clear prediction. A theory that says “Human behavior depends on tastes, and tastes change randomly at random intervals” is not very useful because it does not lead to testable predictions and provides little explanation of the choices people make. Economists test theories by checking whether the theory’s predictions are correct. If a prediction does not come true, they might reject the theory—or at least reduce their confidence in the theory. Economists use a model until it is refuted by evidence or until a better model is developed for a particular use. A good model makes sharp, clear predictions that are consistent with reality. Some very simple models make sharp or precise predictions that are incorrect. Some more realistic and therefore more complex models make ambiguous predictions, allowing for any possible outcome, so they are untestable. Neither incorrect models nor untestable models are helpful. The skill in model building lies in developing a model that is simple enough to make clear predictions but is realistic enough to be accurate. Any model is only an approximation of reality. A good model is one that is a close enough approximation to be useful. Although economists agree on the methods they use to develop and apply testable models, they often disagree on the specific content of those models. One model might present a logically consistent argument that prices will go up next quarter. Another, using a different but equally logical theory, may contend that prices will fall next quarter. If the economists are reasonable, they will agree that pure logic alone cannot resolve their dispute. Indeed, they will agree that they’ll have to use empirical evidence—facts about the real world—to find out which prediction is correct. One goal of this book is to teach managers how to think like economists so that they can build, apply, and test economic models to deal with important managerial problems. Positive and Normative Statements Economic analysis sometimes leads to predictions that seem undesirable or cynical. For instance, an economist doing market research for a producer of soft drinks might predict that “if we double the amount of sugar in this soft drink we will significantly increase sales to children.” An economist making such a statement is not seeking to undermine the health of children by inducing them to consume excessive amounts of sugar. The economist is only making a scientific prediction about the relationship between cause and effect: more sugar in soft drinks is appealing to children. 6 CHAPTER 1 Introduction Such a scientific prediction is known as a positive statement: a testable hypothesis about matters of fact such as cause-and-effect relationships. Positive does not mean that we are certain about the truth of our statement; it indicates only that we can test the truth of the statement. An economist may test the hypothesis that the quantity of soft drinks demanded decreases as the price increases. Some may conclude from that study that “The government should tax soft drinks so that people will not consume so much sugar.” Such a statement is a value judgment. It may be based on the view that people should be protected from their own unwise choices, so the government should intervene. This judgment is not a scientific prediction. It is a normative statement: a belief about whether something is good or bad. A normative statement cannot be tested because a value judgment cannot be refuted by evidence. A normative statement concerns what somebody believes should happen; a positive statement concerns what is or what will happen. Normative statements are sometimes called prescriptive statements because they prescribe a course of action, while positive statements are sometimes called descriptive statements because they describe reality. Although a normative conclusion can be drawn without first conducting a positive analysis, a policy debate will be better informed if a positive analysis is conducted first.3 Good economists and managers emphasize positive analysis. This emphasis has implications for what we study and even for our use of language. For example, many economists stress that they study people’s wants rather than their needs. Although people need certain minimum levels of food, shelter, and clothing to survive, most people in developed economies have enough money to buy goods well in excess of the minimum levels necessary to maintain life. Consequently, in wealthy countries, calling something a “need” is often a value judgment. You almost certainly have been told by some elder that “you need a college education.” That person was probably making a value judgment—“you should go to college”—rather than a scientific prediction that you will suffer terrible economic deprivation if you do not go to college. We can’t test such value judgments, but we can test a (positive) hypothesis such as “Graduating from college or university increases lifetime income.” S U MMARY 1. Managerial Decision Making. Economic analy- 2. Economic Models. Managers use models based sis helps managers develop strategies to pursue their objectives effectively in the presence of scarcity. Various managers within a firm face different objectives and different constraints, but the overriding objective in most private-sector firms is to maximize profits. Making decisions subject to constraints implies making trade-offs. To make good managerial decisions, managers must understand how consumers, workers, other managers, and governments will act. Economic theories normally (but not always) assume that all decision makers attempt to maximize their well-being given the constraints they face. on economic theories to help make predictions and decisions, which they use to run their firms. A good model is simple to use and makes clear, testable predictions that are supported by evidence. Economists use models to construct positive hypotheses such as causal statements linking changes in one variable, such as income, to its effects, such as purchases of automobiles. These positive propositions can be tested. In contrast, normative statements, which are value judgments, cannot be tested. 3Some argue that, as (social) scientists, we economists should present only positive analyses. Others argue that we shouldn't give up our right to make value judgments just like the next person (who happens to be biased, prejudiced, and pigheaded, unlike us). Supply and Demand 2 Talk is cheap because supply exceeds demand. M a nagerial P roblem Carbon Taxes Burning fossil fuels such as gasoline, coal, and heating oil releases gases containing carbon into the atmosphere.1 These “greenhouse” gases are widely believed to contribute to global warming. To reduce this problem and raise tax revenues, many environmentalists and political leaders have proposed levying a carbon tax on the carbon content in fossil fuels.2 When governments impose carbon taxes on gasoline, managers of firms that sell gasoline need to think about how much of the tax they have to absorb and how much they can pass through to firms and consumers who buy gasoline. Similarly, managers of firms that purchase gasoline must consider how any pass-through charges will affect their costs of shipping, air travel, heating, and production. This pass-through analysis is critical in making short-run managerial decisions concerning how much to produce, whether to operate or shut down, and how to set prices and make long-run decisions such as whether to undertake capital investments. The first broad-based carbon taxes on fuels containing carbon (such as gasoline) were implemented in Finland and Sweden at the beginning of the 1990s. Various other European countries soon followed suit. However, strong opposition to carbon taxes has limited adoption in the United States and Canada. The first North American carbon tax was not introduced until 2006 in Boulder, Colorado, where it was applied to only electricity generation. In 2007 and 2008, the Canadian provinces of Quebec and British Columbia became the first provinces or states in North America to impose a broad-based carbon tax. Australia adopted a carbon tax in 2012. During the 2012–2013 U.S. federal government budget negotiations, several Congressional leaders called for carbon taxes to help balance the budget. Such carbon taxes harm some industries and help others. The tax hurts owners and managers of gasoline retailing firms, who need to consider whether they can stay in business in the face of a significant carbon tax. Shippers and 1Each chapter from Chapter 2 on begins with a Managerial Problem that contains a specific question, which is answered at the end of the chapter using the theories presented in the chapter. Sources for the Managerial Problems, Mini-Cases, and Managerial Implications appear at the back of the book. 2Their political opponents object, claiming that fears about global warming are exaggerated and warning of large price increases from such taxes. 7 8 CHAPTER 2 Supply and Demand manufacturers that use substantial amounts of fuel in production, as well as other firms, would also see their costs of operating rise. Although a carbon tax harms some firms and industries, it creates opportunities for others. For example, wind power, which is an alternative to fossil fuels in generating electricity, would become much more attractive. Anticipating greater opportunities in this market in the future, Google invested nearly $1 billion in wind and other renewable energy as of 2012. In 2013, Warren Buffett acquired two utility-scale solar plants in Southern California for between $2 and $2.5 billion. DONG Energy A/S and Iberdrola (IBE) SA’s Scottish Power unit announced that they would invest £1.6 billion ($2.6 billion) to build a large wind farm off northwest England by 2014. Motor vehicle sector managers would need to consider whether to change their product mix in response to a carbon tax, perhaps focusing more on fuel-efficient vehicles. Even without a carbon tax, recent increases in gasoline prices have induced consumers to switch from sport utility vehicles (SUVs) to smaller cars. A carbon tax would favor fuel-efficient vehicles even more. At the end of this chapter, we will return to this topic and answer a question of critical importance to managers in the motor vehicle industry and in other industries affected by gasoline prices: What will be the effect of imposing a carbon tax on the price of gasoline? T o analyze the price and other effects of carbon taxes, managers use an economic tool called the supply-and-demand model. Managers who are able to anticipate and act on the implications of the supply-and-demand model by responding quickly to changes in economic conditions, such as tax changes, make more profitable decisions. The supply-and-demand model provides a good description of many markets and applies particularly well to markets in which there are many buyers and many sellers, as in most agricultural markets, much of the construction industry, many retail markets (such as gasoline retailing), and several other major sectors of the economy. In markets where this model is applicable, it allows us to make clear, testable predictions about the effects of new taxes or other shocks on prices and other market outcomes. M ain Topics In this chapter, we examine six main topics 1. Demand: The quantity of a good or service that consumers demand depends on price and other factors such as consumer incomes and the prices of related goods. 2. Supply: The quantity of a good or service that firms supply depends on price and other factors such as the cost of inputs and the level of technological sophistication used in production. 3. Market Equilibrium: The interaction between consumers’ demand and producers’ supply determines the market price and quantity of a good or service that is bought and sold. 4. Shocks to the Equilibrium: Changes in a factor that affect demand (such as consumer income) or supply (such as the price of inputs) alter the market price and quantity sold of a good or service. 5. Effects of Government Interventions: Government policy may also affect the equilibrium by shifting the demand curve or the supply curve, restricting price or quantity, or using taxes to create a gap between the price consumers pay and the price firms receive. 6. When to Use the Supply-and-Demand Model: The supply-and-demand model applies very well to highly competitive markets, which are typically markets with many buyers and sellers. 2.1 Demand 2.1 9 Demand Consumers decide whether to buy a particular good or service and, if so, how much to buy based on its price and on other factors, including their incomes, the prices of other goods, their tastes, and the information they have about the product. Government regulations and other policies also affect buying decisions. Before concentrating on the role of price in determining quantity demanded, let’s look briefly at some other factors. Income plays a major role in determining what and how much to purchase. People who suddenly inherit great wealth might be more likely to purchase expensive Rolex watches or other luxury items and would probably be less likely to buy inexpensive Timex watches and various items targeted toward lower-income consumers. More broadly, when a consumer’s income rises, that consumer will often buy more of many goods. The price of a related good might also affect consumers’ buying decisions. Related goods can be either substitutes or complements. A substitute good is a good that might be used or consumed instead of the good in question. Before deciding to go to a movie, a consumer might consider the prices of potential substitutes such as streaming a movie purchased online or going to a sporting event or a concert. Streaming movies, sporting events, and concerts compete with movie theaters for the consumer’s entertainment dollar. If sporting events are too expensive, many consumers might choose to see movies instead. Different brands of essentially the same good are often very close substitutes. Before buying a pair of Levi’s jeans, a customer might check the prices of other brands and substitute one of those brands for Levi’s if its price is sufficiently attractive. A complement is a good that is used with the good under consideration. Digital audio players such as the iPod application (app) for the iPhone and online audio recordings are complements because consumers obtain recordings online and then download them to audio players to listen to them. A decline in the price of digital audio players would affect the demand for online music. As consumers respond to the decline in the price of audio players by purchasing more such devices, they would also be more inclined to purchase and download online music. Thus, sellers of online music would experience an increase in demand for their product arising from the price decline of a complementary good (audio players). Consumers’ tastes are important in determining their demand for a good or service. Consumers do not purchase foods they dislike or clothes they view as unfashionable or uncomfortable. The importance of fashion illustrates how changing tastes affect consumer demand. Clothing items that have gone out of fashion can often be found languishing in discount sections of clothing stores even though they might have been readily purchased at high prices a couple of years (or even a few weeks) earlier when they were in fashion. Firms devote significant resources to trying to change consumer tastes through advertising. Similarly, information about the effects of a good has an impact on consumer decisions. In recent years, as positive health outcomes have been linked to various food items, demand for these healthy foods (such as soy products and high-fiber breads) has typically risen when the information became well known. Government rules and regulations affect demand. If a city government bans the use of skateboards on its streets, demand for skateboards in that city falls. Governments might also restrict sales to particular groups of consumers. For example, many political jurisdictions do not allow children to buy tobacco products, which reduces the quantity of cigarettes consumed. 10 CHAPTER 2 Supply and Demand Other factors might also affect the demand for specific goods. For example, consumers are more likely to use Facebook if most of their friends use Facebook. This network effect arises from the benefits of being part of a network and from the potential costs of being outside the network. Although many factors influence demand, economists focus most on how a good’s own price affects the quantity demanded. The relationship between price and quantity demanded plays a critical role in determining the market price and quantity in supply-and-demand analysis. To determine how a change in price affects the quantity demanded, economists ask what happens to quantity when price changes and other factors affecting demand such as income and tastes are held constant. The Demand Curve The amount of a good that consumers are willing to buy at a given price, holding constant the other factors that influence purchases, is the quantity demanded. The quantity demanded of a good or service can exceed the quantity actually sold. For example, as a promotion, a local store might sell DVDs for $2 each today only. At that low price, you might want to buy 25 DVDs, but the store might run out of stock before you can select the DVDs you want. Or the store might limit each consumer to a maximum of, for example, 10 DVDs. The quantity you demand is 25; it is the amount you want, even though the amount you actually buy might be only 10. Using a diagram, we can show the relationship between price and the quantity demanded. A demand curve shows the quantity demanded at each possible price, holding constant the other factors that influence purchases. Figure 2.1 shows the estimated monthly demand curve, D1, for avocados in the United States.3 Although this demand curve is a straight line, demand curves may also be smooth curves or wavy lines. By convention, the vertical axis of the graph measures the price, p, per unit of the good. Here the price of avocados is measured in dollars per pound (abbreviated “lb”). The horizontal axis measures the quantity, Q, of the good, which is usually expressed in some physical measure per time period. Here, the quantity of avocados is measured in millions of pounds (lbs) per month. The demand curve hits the vertical axis at $4, indicating that no quantity is demanded when the price is $4 per lb or higher. The demand curve hits the horizontal quantity axis at 160 million lbs, the quantity of avocados that consumers would want if the price were zero. To find out what quantity is demanded at a price between zero and $4, we pick that price—say, $2—on the vertical axis, draw a horizontal line across until we hit the demand curve, and then draw a vertical line down to the horizontal quantity axis. As the figure shows, the quantity demanded at a price of $2 per lb is 80 million lbs per month. One of the most important things to know about the graph of a demand curve is what is not shown. All relevant economic variables that are not explicitly 3To obtain our estimated supply and demand curves, we used estimates from Carman (2007), which we updated with more recent (2012) data from the California Avocado Commission and supplemented with information from other sources. The numbers have been rounded so that the figures use whole numbers. 2.1 Demand 11 The estimated demand curve, D1, for avocados shows the relationship between the quantity demanded per month and the price per lb. The downward slope of this demand curve shows that, holding other factors that influence demand constant, consumers demand fewer avocados when the price is high and more when the price is low. That is, a change in price causes a movement along the demand curve. p, $ per lb F IG U RE 2. 1 A Demand Curve 4.00 3.00 2.00 1.50 Avocado demand curve, D1 0 40 80 100 160 Q, Million lbs of avocados per month shown on the demand curve graph—income, prices of other goods (such as other fruits or vegetables), tastes, information, and so on—are held constant. Thus, the demand curve shows how quantity varies with price but not how quantity varies with income, the price of substitute goods, tastes, information, or other variables. Effects of a Price Change on the Quantity Demanded. One of the most important results in economics is the Law of Demand: consumers demand more of a good if its price is lower, holding constant income, the prices of other goods, tastes, and other factors that influence the amount they want to consume. According to the Law of Demand, demand curves slope downward, as in Figure 2.1. A downward-sloping demand curve illustrates that consumers demand a larger quantity of this good when its price is lowered and a smaller quantity when its price is raised. What happens to the quantity of avocados demanded if the price of avocados drops and all other variables remain constant? If the price of avocados falls from $2.00 per lb to $1.50 per lb in Figure 2.1, the quantity consumers want to buy increases from 80 million lbs to 100 million lbs.4 Similarly, if the price increases from $2 to $3, the quantity consumers demand decreases from 80 to 40. These changes in the quantity demanded in response to changes in price are movements along the demand curve. Thus, the demand curve is a concise summary of the answer to the question “What happens to the quantity demanded as the price changes, when all other factors are held constant?” Although we generally expect demand curves to slope down as does the one for avocados, a vertical or horizontal demand curve is possible. We can think of horizontal and vertical demand curves as being extreme cases of downward-sloping demand. The Law of Demand rules out demand curves that have an upward slope. The Law of Demand is an empirical claim—a claim about what actually happens. It is not a claim about general theoretical principles. It is theoretically possible that 4From now on, we will not state the relevant physical and time period measures unless they are particularly relevant. We refer to quantity rather than specific units per time period such as “million lbs per month” and price rather than “dollars per lb.” Thus, we say that the price is $2 (with the “per lb” understood) and the quantity as 80 (with the “millions of lbs per month” understood). 12 CHAPTER 2 Supply and Demand a demand curve could slope upward. However, the available empirical evidence strongly supports the Law of Demand. Effects of Other Factors on Demand. A demand curve shows the effects of price changes when all other factors that affect demand are held constant. But we are often interested in how other factors affect demand. For example, we might be interested in the effect of changes in income on the amount demanded. How would we illustrate the effect of income changes on demand? One approach is to draw the demand curve in a three-dimensional diagram with the price of avocados on one axis, income on a second axis, and the quantity of avocados on the third axis. But just thinking about drawing such a diagram is hard enough, and actually drawing it without sophisticated graphing software is impossible for many of us. Economists use a simpler approach to show the effect of factors other than a good’s own price on demand. A change in any relevant factor other than the price of the good causes a shift of the demand curve rather than a movement along the demand curve. These shifts can be readily illustrated in suitable diagrams. The price of substitute goods affects the quantity of avocados demanded. Many consumers view tomatoes as a substitute for avocados. If the price of tomatoes rises, consumers are more inclined to use more avocados instead, and the demand for avocados rises. The original, estimated avocado demand curve in Figure 2.1 is based on an average price of tomatoes of $0.80 per lb. Figure 2.2 shows how the avocado demand curve shifts outward or to the right from the original demand curve D1 to a new demand curve D2 if the price of tomatoes increases by 55¢ to $1.35 per lb. On the new demand curve, D2, more avocados are demanded at any given price than on D1 because tomatoes, a substitute good, have become more expensive. At a price of $2 per lb, the quantity of avocados demanded goes from 80 million lbs on D 1, before the increase in the price of tomatoes, to 91 million lbs on D2, after the increase. Similarly, consumers tend to buy more avocados as their incomes rise. Thus, if income rises, the demand curve for avocados shifts to the right, indicating that consumers demand more avocados at any given price. The demand curve for avocados shifts to the right from D1 to D2 as the price of tomatoes, a substitute, increases by 55¢ per lb. As a result of the increase in the price of tomatoes, more avocados are demanded at any given price. p, $ per lb F IG U RE 2. 2 A Shift of the Demand Curve D1, tomatoes 80¢ per lb D 2, tomatoes $1.35 per lb Effect of a 55¢ increase in the price of tomatoes 2.00 0 80 91 Q, Million lbs of avocados per month 2.1 Demand 13 In addition, changes in other factors that affect demand, such as information, can shift a demand curve. Reinstein and Snyder (2005) found that movie reviews affect the demand for some types of movies. Holding price constant, they determined that if a film received two-thumbs-up reviews on the then extremely popular Siskel and Ebert movie-review television program the opening weekend demand curve shifted to the right by 25% for a drama, but the demand curve did not significantly shift for an action film or a comedy. To properly analyze the effects of a change in some variable on the quantity demanded, we must distinguish between a movement along a demand curve and a shift of a demand curve. A change in the good’s own price causes a movement along a demand curve. A change in any other relevant factor besides the good’s own price causes a shift of the demand curve. The Demand Function The demand curve shows the relationship between the quantity demanded and a good’s own price, holding other relevant factors constant at some particular levels. We illustrate the effect of a change in one of these other relevant factors by shifting the demand curve. We can represent the same information—information about how price, income, and other variables affect quantity demanded—using a mathematical relationship called the demand function. The demand function shows the effect of all the relevant factors on the quantity demanded. If the factors that affect the amount of avocados demanded include the price of avocados, the price of tomatoes, and income, the demand function, D, can be written as Q = D(p, pt, Y) (2.1) where Q is the quantity of avocados demanded, p is the price of avocados, pt is the price of tomatoes, and Y is the income of consumers. This expression says that the quantity of avocados demanded varies with the price of avocados, the price of tomatoes (which is a substitute product), and the income of consumers. We ignore other factors that are not explicitly listed in the demand function because we assume that they are irrelevant (such as the price of laptop computers) or are held constant (such as the prices of other related goods, tastes, and information). Equation 2.1 is a general functional form—it does not specify a particular form for the relationship between quantity, Q, and the explanatory variables, p, pt, and Y. The estimated demand function that corresponds to the demand curve D1 in Figures 2.1 and 2.2 has a specific (linear) form. If we measure quantity in millions of lbs per month, avocado and tomato prices in dollars per lb, and average monthly income in dollars, the demand function is Q = 104 - 40p + 20pt + 0.01Y. (2.2) When we draw the demand curve D1 in Figures 2.1 and 2.2, we hold pt and Y at specific values. The price per lb for tomatoes is $0.80, and average income is $4,000 per month. If we substitute these values for pt and Y in Equation 2.2, we can rewrite the quantity demanded as a function of only the price of avocados: Q = 104 - 40p + 20pt + 0.01Y = 104 - 40p + (20 * 0.80) + (0.01 * 4,000) = 160 - 40p. (2.3) 14 CHAPTER 2 Supply and Demand The demand function in Equation 2.3 corresponds to the straight-line demand curve D1 in Figure 2.1 with particular fixed values for the price of tomatoes and for income. The constant term, 160, in Equation 2.3 is the quantity demanded (in millions of lbs per month) if the price is zero. Setting the price equal to zero in Equation 2.3, we find that the quantity demanded is Q = 160 - (40 * 0) = 160. Figure 2.1 shows that Q = 160 where D1 hits the quantity axis—where price is zero. Equation 2.3 also shows us how quantity demanded varies with a change in price: a movement along the demand curve. If the price falls from p1 to p2, the change in price, Δp, equals p2 - p1. (The Δ symbol, the Greek letter delta, means “change in” the variable following the delta, so Δp means “change in price.”) If the price of avocados falls from p1 = $2 to p2 = $1.50, then Δp = $1.50 - $2 = -$0.50. Quantity demanded changes from Q1 = 80 at a price of $2 to Q2 = 100 at a price of $1.50, so ΔQ = Q2 - Q1 = 100 - 80 = 20 million lbs per month. More generally, the quantity demanded at p1 is Q1 = D(p1), and the quantity demanded at p2 is Q2 = D(p2). The change in the quantity demanded, ΔQ = Q2 - Q1, in response to the price change (using Equation 2.3) is ΔQ = = = = = Q2 - Q1 D(p2 ) - D(p1 ) (160 - 40p2) - (160 - 40p1) -40(p2 - p1) -40Δp. Thus, the change in the quantity demanded, ΔQ, is -40 times the change in the price, Δp. For example, if Δp = -$0.50, then ΔQ = -40Δp = -40( -0.50) = 20 million lbs. The change in quantity demanded is positive when the price falls, as in this example. This effect is consistent with the Law of Demand. We can see that a 50¢ decrease in price causes a 20 million lb per month increase in quantity demanded. Similarly, raising the price would cause the quantity demanded to fall. Using Calculus Deriving the Slope of a Demand Curve We can determine how the quantity changes as the price increases using calculus. Given the demand function for avocados is Q = 160 - 40p, the derivative of the demand function with respect to price is dQ/dp = -40. Therefore, the slope of the demand curve in Figure 2.1, dp/dQ, is also negative, which is consistent with the Law of Demand. Summing Demand Curves The overall demand for avocados is composed of the demand of many individual consumers. If we know the demand curve for each of two consumers, how do we determine the total demand curve for the two consumers combined? The total quantity demanded at a given price is the sum of the quantity each consumer demands at that price. We can use individual demand curves to determine the total demand of several consumers. Suppose that the demand curve for Consumer 1 is Q1 = D1(p) and the demand curve for Consumer 2 is Q2 = D2(p). 2.2 Supply 15 At price p, Consumer 1 demands Q1 units, Consumer 2 demands Q2 units, and the total quantity demanded by both consumers is the sum of these two quantities: Q = Q1 + Q2 = D1(p) + D2(p). We can generalize this approach to look at the total demand for three, four, or more consumers, or we can apply it to groups of consumers rather than just to individuals. It makes sense to add the quantities demanded only when all consumers face the same price. Adding the quantity Consumer 1 demands at one price to the quantity Consumer 2 demands at another price would not be meaningful for this purpose—the result would not show us a point on the combined demand curve. We illustrate how to combine individual demand curves to get a total demand curve graphically using estimated demand curves of broadband (high-speed) Internet service (Duffy-Deno, 2003). The figure shows the demand curve for small firms (1–19 employees), the demand curve for larger firms, and the total demand curve for all firms, which is the horizontal sum of the other two demand curves. At the current average rate of 40¢ per kilobyte per second (Kbps), the quantity demanded by small firms is Qs = 10 (in millions of Kbps) and the quantity demanded by larger firms is Ql = 11.5. Thus, the total quantity demanded at that price is Q = Qs + Ql = 10 + 11.5 = 21.5. Mini-Case Price, ¢ per Kbps Aggregating the Demand for Broadband Service Small firms’ demand Large firms’ demand 40¢ Qs = 10 Ql = 11.5 Total demand Q = 21.5 Q, Broadband access capacity in millions of Kbps 2.2 Supply Knowing how much consumers want is not enough by itself to tell us what price and quantity will be observed in a market. To determine the market price and quantity, we also need to know how much firms want to supply at any given price. Firms determine how much of a good to supply on the basis of the price of that good and on other factors, including the costs of producing the good. Usually, we expect firms to supply more at a higher price. Before concentrating on the role of price in determining supply, we describe the role of some other factors. Costs of production (how much the firm pays for factors of production such as labor, fuel, and machinery) affect how much of a product firms want to sell. As a firm’s cost falls, it is usually willing to supply more, holding price and other factors constant. Conversely, a cost increase will often reduce a firm’s willingness to produce. If the firm’s cost exceeds what it can earn from selling the good, the firm will 16 CHAPTER 2 Supply and Demand produce nothing. Thus, factors that affect costs also affect supply. If a technological advance allows a firm to produce its good at lower cost, the firm supplies more of that good at any given price, holding other factors constant. Government rules and regulations can also affect supply directly without working through costs. For example, in some parts of the world, retailers may not sell most goods and services on particular days of religious significance. Supply on those days is constrained by government policy to be zero. The Supply Curve The quantity supplied is the amount of a good that firms want to sell at a given price, holding constant other factors that influence firms’ supply decisions, such as costs and government actions. We can show the relationship between price and the quantity supplied graphically. A supply curve shows the quantity supplied at each possible price, holding constant the other factors that influence firms’ supply decisions. Figure 2.3 shows the estimated supply curve, S1, for avocados. As with the demand curve, the price on the vertical axis is measured in dollars per physical unit (dollars per lb), and the quantity on the horizontal axis is measured in physical units per time period (millions of lbs per month). Because we hold fixed other variables that may affect supply, the supply curve concisely answers the question “What happens to the quantity supplied as the price changes, holding all other relevant factors constant?” Effects of Price on Supply. We illustrate how price affects the quantity supplied using the supply curve for avocados in Figure 2.3. The supply curve is upward sloping. As the price increases, firms supply more. If the price is $2 per lb, the quantity supplied by the market is 80 million lbs per month. If the price rises to $3, the quantity supplied rises to 95 million lbs. An increase in the price of avocados causes a movement along the supply c...
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Explanation & Answer

Attached.

MANAGERIAL ECONOMICS AND
STRATEGY
PRODUCTION AND COSTS

PRODUCTION



a)
b)
c)

Production is a fundamental economic function that entails
the conversion of inputs through various production processes
to produce the output that consumers want.
Production Functions
Production functions focus on the ways that firms, with the
help of technology, convert inputs into outputs that may be
consumed by consumers.
The key input categories include:
Capital (K) – land, buildings and equipment
Labor (L) – skilled and unskilled employees
Materials (M) – raw materials and natural resources
necessary for production activities
In practice, the production function, q, summarizes the ways
and combinations in which inputs are converted into outputs
with the help of technology. In this case, an organization that
utilizes capital and labor only has its production as follows;
q = f(L,K), with q being the output units, L being the labor
units and K being the capital units.

PRODUCTION





In this case, the production function, q, indicates the
maximum output amount that labor and capital units can
produce.
Short-Run Production
Short-Run production occurs in a period when at least one
fixed input is available in a production process where labor
and capital are the only available inputs, and provided that
capital is the fixed input, then the labor input is taken as the
variable input. As such, increasing the labor units is the only
way of increasing output. The Short-Run production function
is given as follows;
q=f(L,K)̅ ,
with q being the output, L the labor amount and K̅ being the
fixed amount of capital in an organization.
Total Product Function
The Total Product Function shows the association between
labor, output and total product and is defined by the equation,

q=f(L,K).

PRODUCTION


Marginal Product of Labor
The Marginal Product of Labor describes the change
in the total output that occurs as a result of adding an
extra labor unit while capital inputs remain constant.
The Marginal Product of Labor is denoted as follows;

MPL =



Where
is the change in output and is the
increase in labor units
Solved Q & A 5.1
For a linear production function q = f(L, K) = 2L + K
and a multiplicative production function q = LK, what
are the short-run production functions given that...


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