MANAGERIAL ECONOMICS. Economic Tools for Today's Decision Makers. Paul G. Keat. Philip K.Y. Young SIXTH EDITION

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1 SIXTH EDITION MANAGERIAL ECONOMICS Economic Tools for Today's Decision Makers Paul G. Keat Thunderbird School of Global Management Philip K.Y. Young Nth Degree Systems, Inc. and Duke Corporate Education Pearson Education International

2 Preface xix About the Authors xxiii CHAPTER 1 Introduction 1 Introduction: Economics and Managerial Decision Making 2 The Economics of a Business 5 A Brief Review of Important Economic Terms and Concepts 8 The Case of Global Foods, Inc.: Situations and Solutions 14 Summary of the Situations and Solutions 16 Global Application: Reinventing the Corporation Through Strategy and Ownership 19 Summary 21 Important Concepts 22 Questions 22 CHAPTER 2 The Firm and Its Goals 24 Introduction 25 The Firm 25 Coase and the Internet 28 The Economic Goal of the Firm and Optimal Decision Making 29 Goals Other Than Profit 30 Economic Goals 30 Economic Objectives 31 Noneconomic Objectives 32 Once Again Do Companies Maximize Profits? 32 Profit Maximization, Restated 35 Maximizing the Wealth of Stockholders 36 Market Value Added and Economic Value Added 38 Economic Profits 39 Global Application 40 Summary 42 Important Concepts 42 Questions 43 CHAPTER 3 Supply and Demand 45 Introduction 46 Market Demand 46 Market Supply 50 Market Equilibrium 52 Comparative Statics Analysis 53 Short-Run Market Changes: The "Rationing Function" of Price 53 Long-Run Market Analysis: The "Guiding" or "Allocating Function " of Price 56 Using Supply and Demand in Forecasting 60 IX

3 Supply, Demand, and Price: The Managerial Challenge 61 Case 3.1 Coffee: "Buy Low and Sell High" 62 Case 3.2 Air Travel: "Buy High and Sell Low" 63 Global Application: The Market for Cobalt 64 The Current Market Situation 64 A Brief History of the Market for Cobalt 65 Implications for Managers 65 Summary 68 Important Concepts 68 Questions 69 Problems 70 Appendix 3A The Mathematics of Supply and Demand 74 CHAPTER 4 Demand Elasticity 77 The Economic Concept of Elasticity 78 The Price Elasticity of Demand 78 Measurement of Price Elasticity 79 The Determinants of Elasticity 84 The Effect of Elasticity on Price and Quantity 85 The Elasticity of Derived Demand 86 Elasticity in the Short Run and in the Long Run 87 Demand Elasticity and Revenue 89 The Mathematics of Elasticity 92 Empirical Elasticities 93 The Cross-Elasticity of Demand 94 Empirical Elasticities 96 Income Elasticity 96 Other Elasticity Measures 99 Elasticity of Supply 100 Global Application: Price Elasticities in Asia 100 Summary 103 Important Concepts 103 Questions 104 Problems 105 Appendix 4A Applications of Supply and Demand 109 CHAPTER 5 Demand Estimation and Forecasting 124 Demand Estimation 126 Introduction 126 Key Chapter Objectives 126 The Critical Importance of Good Data 126 Regression Analysis: A Management Briefing 127 Specifying the Regression Equation and Obtaining the Data 127 Estimating and Interpreting the Regression Coefficients 130 Statistical Evaluation of the Regression Results 132 Review of Key Steps for Analyzing Regression Results 133 Implications of the Regression Analysis for Management Decisions 135 Problems in the Use of Regression Analysis 135 The Identification Problem 135 Multicollinearity 137 Autocorrelation 137

4 XI Examples of Regression Analysis in Economic Research 139 Brief Summary of Recent Examples of Economic Studies Using Regression Analysis 139 Global Application: Food in Spain, Cigarettes in Taiwan 140 Forecasting 141 Introduction 141 Subjects of Forecasts 142 Demand Estimating and Demand Forecasting 142 Prerequisites of a Good Forecast 143 Forecasting Techniques 143 Expert Opinion 144 Opinion Polls and Market Research 145 Surveys of Spending Plans 145 Economic Indicators 146 Projections 148 Econometric Models 162 Global Application: Forecasting Exchange Rates 166 Summary 169 Important Concepts 170 Questions 171 Problems 172 Appendix 5A The Demand for White Zinfandel in Los Angeles 178 CHAPTER 6 The Theory and Estimation of Production 186 The Production Function 187 A Short-Run Analysis of Total, Average, and Marginal Product 189 The Law of Diminishing Returns 191 The Three Stages of Production in the Short Run 194 Derived Demand and the Optimal Level of Variable Input Usage 196, TheCaseof Multiple Inputs (Abridged Version) 197 The Long-Run Production Function 199 The Estimation of Production Functions 202 The Various Forms of a Production Function 202 The Cobb-Douglas Production Function 204 Statistical Estimation of Production Functions 206 Aggregate Production Functions 209 The Importance of Production Functions in Managerial Decision Making 210 Careful Planning Can Help a Firm to Use Its Resources in a Rational Manner 211 Going "Beyond the Curves": Current Production Issues and Challenges for Today's Managers 212 Call Centers: Applying the Production Function to a Service 214 International Application: Is China Running Out of Workers? 216 Summary 217 Important Concepts 218 Questions 219 Problems 220 Appendix 6A Productivity in Services 226 Appendix 6B The Multiple-Input Case 237 Appendix 6C Expressing the Production Function with the Use of Calculus 248

5 Xll Contents CHAPTER 7 The Theory and Estimation of Cost 252 The Importance of Cost in Managerial Decisions 253 The Definition and Use of Cost in Economic Analysis 255 Historical versus Replacement Cost 255 Opportunity Cost versus Out-of-Pocket Cost 255 Sunk versus Incremental Cost 256 The Relationship between Production and Cost 257 The Short-Run Cost Function 259 Increasing Cost Efficiency in the Short Run 262 Alternative Specifications of the Total Cost Function 262 The Long-Run Cost Function 264 The Relationship between Long-Run Production and Long-Run Cost 264 Economies of Scale 266 The Long-Run Average Cost Curve as the Envelope of Short-Run Average Cost 269 Using Long-Run Average Cost as a Decision-Making Tool: The Importance of Coordinating Production Plans with Market Forecasts 271 The Learning Curve 273 Economies of Scope 276 Economies of Scale: The Short Run versus the Long Run 277 Supply Chain Management 277 Examples of Ways Companies Have Cut Costs to Remain Competitive 280 Cautionary Note to Managers about the Use of Cost-Cutting as a Strategy 285 Global Application: Toll Manufacturing of Chemicals in China 286 Summary 289 Important Concepts 289 Questions 290 Problems 292 Appendix 7A A Mathematical Restatement of the Short-Run Cost Function 297 Appendix 7B The Estimation of Cost 298 CHAPTER 8 Pricing and Output Decisions: Perfect Competition and Monopoly 309 Introduction 310 Competition and Market Types in Economic Analysis 312 The Meaning of Competition 312 Examples of Market Types 313 Market Types and Competition in Theory and Reality 314 Pricing and Output Decisions in Perfect Competition 315 The Basic Business Decision 315 Key Assumptions of the Perfectly Competitive Market 315 The Total Revenue-Total Cost Approach to Selecting the Optimal Output Level 319 The Marginal Revenue-Marginal Cost Approach to Finding the Optimal Output Level 320 Economic Profit, Normal Profit, Loss, and Shutdown 323 The Competitive Market in the Long Run 326 Pricing and Output Decisions in Monopoly Markets 328

6 Xlll The Implications of Perfect Competition and Monopoly for Managerial Decision Making 331 Global Application: The Brutal Economics of the Market for Bluefin Tuna 333 Summary 337 Important Concepts 337 Questions 338 Problems 339 Appendix 8A The Use of Calculus in Pricing and Output Decisions 342 Appendix 8B Break-Even Analysis (Volume-Cost-Profit) 344 CHAPTER 9 Pricing and Output Decisions: Monopolistic Competition and Oligopoly 358 Introduction 359 Monopolistic Competition 360 i Oligopoly 362 Market Concentration 362 Pricing in an Oligopolistic Market: Rivalry and Mutual Interdependence 364 Competing in Imperfectly Competitive Markets 367 Nonprice Competition 367 Economic Optimization and Nonprice Competition 370 The Reality of Monopolistic Competition and Oligopoly: "Imperfect" Competition 371 Strategy: The Fundamental Challenge for Firms in Imperfect Competition 372 Industrial Organization 373 Strategy and the Ideas of Michael Porter 3 75 Concluding Remarks on the Linkages between Managerial Economics j and Strategy 377 Global Application: The World's Market for Beer 377 Summary 379 Important Concepts 379 Questions 380 Problems 381 CHAPTER 10 Special Pricing Practices 384 Introduction 385 Cartel Arrangements 385 Cases of Price Fixing by Cartels 387 Price Leadership 389 Barometric Price Leadership 390 Dominant Price Leadership 390 Revenue Maximization 392 Price Discrimination 393 Third-Degree Discrimination 395 Examples of Price Discrimination 398 Some Recent Examples of Price Discrimination Practices 399 Pricing in the Hotel Industry: Example of Price Discrimination 401 Tying Arrangements: A Possible Extension of Price Discrimination 402 Social Welfare Implications of Price Discrimination 404

7 XIV Contents Nonmarginal Pricing 404 Cost-Pius Pricing 405 Incremental Pricing and Costing Analysis 408 Multiproduct Pricing 408 Products Complementary in Demand 409 Products Substitutable in Demand 410 Joint Products with Fixed Proportions 411 Joint Products in Variable Proportions 412 Transfer Pricing 413 No External Markets 414 External Markets 415 Other Pricing Practices 416 Global Application: The Decline of European Cartels 416 The European Carton-Board Cartel 416 The European Vitamin Cartel 417 The European Copper Pipe Cartel 417 Other Price-Fixing Cases in Europe 417 Price Discrimination by Airlines 418 Summary 419 Important Concepts 420 Questions 420 Problems 421 CHAPTER 11 Game Theory and Asymmetric Information 425 Introduction 426 Game Theory 426 A Selected Sample of Games of Particular Relevance in Economics 427 Prisoners'Dilemma 427 Beach Kiosk Game 430 Repeated Games 431 Sequential Games and First Mover Advantage 431 Game Theory and Auctions 433 Strategy and Game Theory 435 Commitment 436 Incentives 438 A General Framework 439 Asymmetric Information 440 Markets with Asymmetric Information 440 Example: Adverse Selection The Market for Lemons 441 Example: Moral Hazard Insurance 442 Market Responses to Asymmetric Information 442 Reputation 443 Example: Reputation in ebay Auctions 443 Standardization 443 Market Signaling 444 Example: Education as a Signal in Labor Markets 444 Example: Guarantees and Warranties 445 A Final Example: Two Banking Systems as Responses to Information Asymmetries 445

8 XV Summary 448 Important Concepts 448 Questions 449 Problem 449 CHAPTER 12 Capital Budgeting and Risk 450 Introduction 451 The Capital Budgeting Decision 452 Types of Capital Budgeting Decisions 452 Time Value of Money 453 Methods of Capital Project Evaluation 453 Net Present Value 453 Internal Rate of Return 455 The Profitability Index 456 NPV versus IRR 456 Capital Budgeting in Practice 459 Cash Flows 459 Types of Cash Floius 460 Cost of Capital 461 Debt 462 Equity 462 The Weighted Cost of Capital 464 The Capital Budgeting Model 464 Capital Rationing 466 Risk versus Uncertainty 466 Sources of Business Risk 467 The Measures of Risk 467 Expected Value 468 i The Standard Deviation 469 Discrete versus Continuous Distributions and the Normal Curve 470 The Coefficient of Variation 471 Capital Budgeting under Conditions of Risk 472 Two Other Methods for Incorporating Risk 473 The Risk-Adjusted Discount Rate 4 73 Certainty Equivalents 474 Present Value Break-Even Analysis 475 Sensitivity and Scenario Analysis 475 Simulation 476 Decision Trees 477 Real Options in Capital Budgeting 479 Real Options in Practice 480 An Abandonment Option 480 Global Application: Political Risk 482 Political Risk 482 A Political Risk Index 483 Containing International Risk 483 Capital Budgeting in Practice 483 Summary 486 Important Concepts 487

9 XVI Contents Questions 488 Problems 489 Appendix 12A The Value of a Corporation 495 CHAPTER 13 The Multinational Corporation and Globalization 497 Introduction 498 Globalization 499 Is Globalization Good or Bad? 500 Proglobalization Arguments 500 Antiglobalization Arguments 501 Globalization and the Future 502 Risks Faced by a Multinational Corporation 504 Exchange Rates 505 Exchange Rate Hedging 506 Offsetting Transactions 506 The Forward Market 506 The Futures Market 506 Currency Options 506 Currency Swaps 507 Foreign Direct Investment 507 Multinational Capital Budgeting 508 Intercompany Fund Flows 508 Inflation Rates 508 Exchange Rates 508 Tax Differences 509 Differences in Cash F lows 509 Cost of Capital 509 The Final Project Valuation 509 The Repositioning of Funds 510 Multinational Transfer Pricing 510 Multinational Transfer Pricing Example 511 Transfer Pricing in Practice 512 Global Application: "From Here to the Moon in Six Months" 514 Summary 517 Important Concepts 518 Questions 518 Problems 519 CHAPTER 14 Government and Industry: Challenges and Opportunities for Today's Manager 520 Introduction 521 The Rationale for Government Involvement in a Market Economy 521 Providing a Legal Framework for Competition: The Antitrust Laws 522 Dealing with Market Externalities: Another Key Function of Government in the Market Economy 525 Stabilization of the Aggregate Economy: Monetary and Fiscal Policy 527 Monetary Policy 527 Fiscal Policy 528 Lags 529

10 XVU Doing Business with the U.S. Government 529 The Government Market 530 The Government and the Market Economy 532 Government Deregulation, Mergers, and Acquisitions 534 Why Firms Merge 535 Global Application: The Failed Attempt to Merge by General Electric and Honeywell 539 Summary 540 Important Concepts 541 Questions 541 CHAPTER 15 Managerial Economics in Action: The Case of the Refreshment Beverage Industry 542 Introduction 543 Economic Overview of the Industry 544 Industry Trends 544 Analysis of the Refreshment Beverage Industry 552 Carbonated Soft Drinks (CFDs) 552 Bottled Water 553 Manufacturing and Distribution 555 Competition 556 Consumer Demand 557 Summary 562 Questions for Further Study 562 Appendix 15A Interview with Key Beverage Industry Executives 564 Appendix A Statistical and Financial Tables 571 Index 586 The following appendices will be found online, Review of Mathematical Concepts Used urmanagerial Economics Linear Programming Calculations for Time Value of Money Solutions to Odd-Numbered Problems Demand for White Zinfandel in Los Angeles: Additional Data and Analysis