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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
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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
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3
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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
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47
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55
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63
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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
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129
132
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134
134
137
138
139
141
141
141
143
143
145
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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
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185
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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
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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
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247
247
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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
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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
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280
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283
283
285
285
286
286
287
288
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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
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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
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372
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374
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380
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381
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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
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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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