Managerial Economics and Business Strategy

SIXTH EDITION Managerial Economics and Business Strategy Michael R. Baye Bert Elwert Professor of Business Economics and Public Policy Kelley School of Business Indiana University Boston Burr Ridge, IL Dubuque, IA New York San Francisco St. Louis Bangkok Bogota Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto

CONTENTS CHAPTER ONE The Fundamentals of Managerial Economics 1 Headline: Amcott Loses $3.5 Million; Manager Fired 1 Introduction 2 The Manager 3 Economics 3 Managerial Economics Defined 3 The Economics of Effective Management 4 Identify Goals and Constraints 4 Recognize the Nature and Importance of Profits 5 Economic versus Accounting Profits 5 The Role of Profits 6 The Five Forces Framework and Industry Profitability 8 Understand Incentives 11 Understand Markets 12 Consumer-Producer Rivalry 13 Consumer-Consumer Rivalry 13 Producer-Producer Rivalry 13 Government and the Market 13 Recognize the Time Value of Money 14 Present Value Analysis 14 Present Value of Indefinitely Lived Assets 16 Use Marginal Analysis 19 Discrete Decisions 20 Continuous Decisions 22 Incremental Decisions 24 Learning Managerial Economics 25 Answering the Headline 26 Key Terms and Concepts 26 Conceptual and Computational Questions 27 Problems and Applications 28 Case-Based Exercises 32 Selected Readings 33 Appendix: The Calculus of Maximizing Net Benefits 33 Inside Business 1-1: The Goals of Firms in Our Global Economy 7 Inside Business 1-2: Profits and the Evolution of the Computer Industry 11 Inside Business 1-3: Joining the Jet Set 19 xviii

Contents xix CHAPTER TWO Market Forces: Demand and Supply 35 Headline: Samsung and Hynix Semiconductor to Cut Chip Production 35 Introduction 36 Demand 36 Demand Shifters 38 Income 39 Prices of Related Goods 40 Advertising and Consumer Tastes 40 Population 41 Consumer Expectations 41 Other Factors 42 The Demand Function 42 Consumer Surplus 44 Supply 46 Supply Shifters 47 Input Prices 47 Technology or Government Regulations 47 Number of Firms 48 Substitutes in Production 48 Taxes 48 Producer Expectations 49 The Supply Function 50 Producer Surplus 51 Market Equilibrium 52 Price Restrictions and Market Equilibrium 54 Price Ceilings 55 Price Floors 59 Comparative Statics 60 Changes in Demand 60 Changes in Supply 62 Simultaneous Shifts in Supply and Demand 63 Answering the Headline 65 Summary 65 Key Terms and Concepts 66 Conceptual and Computational Questions 67 Problems and Applications 68 Case-Based Exercises 72 Selected Readings 72 Inside Business 2-1: Asahi Breweries Ltd. and the Asian Recession 39 Inside Business 2-2: NAFTA and the Supply Curve 47 Inside Business 2-3: Price Ceilings and Price Floors around the Globe 58 Inside Business 2 4: Globalization and the Supply of Soft Drinks 62

XX Contents CHAPTER THREE Quantitative Demand Analysis 73 Headline: Winners of Wireless Auction to Pay $7 Billion 73 Introduction 74 The Elasticity Concept 74 Own Price Elasticity of Demand 75 Elasticity and Total Revenue 76 Factors Affecting the Own Price Elasticity 80 Available Substitutes 81 Time 82 Expenditure Share 82 Marginal Revenue and the Own Price Elasticity of Demand 83 Cross-Price Elasticity 85 Income Elasticity 88 Other Elasticities 90 Obtaining Elasticities from Demand Functions 90 Elasticities for Linear Demand Functions 91 Elasticities for Nonlinear Demand Functions 92 Regression Analysis 95 Evaluating the Statistical Significance of Estimated Coefficients 98 Confidence Intervals 99 The ^-Statistic 99 Evaluating the Overall Fit of the Regression Line 100 Thetf-Square 100 The F-Statistic 102 Nonlinear and Multiple Regressions 102 Nonlinear Regressions 102 Multiple Regression 104 A Caveat 107 Answering the Headline 107 Summary 109 Key Terms and Concepts 109 Conceptual and Computational Questions 110 Problems and Applications 111 Case-Based Exercises 116 Selected Readings 116 Inside Business 3-1: Calculating and Using the Arc Elasticity: An Application to the Housing Market 80 Inside Business 3-2: Inelastic Demand for Prescription Drugs 84 Inside Business 3-3: Using Cross-Price Elasticities to Improve New Car Sales in the Wake of Increasing Gasoline Prices 87 Inside Business 3-4: Shopping Online in Europe: Elasticities of Demand for Personal Digital Assistants Based on Nonlinear Regression Techniques 103

Contents CHAPTER FOUR The Theory of Individual Behavior 1 1 7 Headline: Packaging Firm Uses Overtime Pay to Overcome Labor Shortage 117 Introduction 118 Consumer Behavior 118 Constraints 123 The Budget Constraint 123 Changes in Income 126 Changes in Prices 126 Consumer Equilibrium 128 Comparative Statics 129 Price Changes and Consumer Behavior 129 Income Changes and Consumer Behavior 132 Substitution and Income Effects 133 Applications of Indifference Curve Analysis 135 Choices by Consumers 135 Buy One, Get One Free 135 Cash Gifts, In-Kind Gifts, and Gift Certificates 137 Choices by Workers and Managers 140 A Simplified Model of Income-Leisure Choice 140 The Decisions of Managers 142 The Relationship between Indifference Curve Analysis and Demand Curves 143 Individual Demand 143 Market Demand 145 Answering the Headline 145 Summary 147 Key Terms and Concepts 147 Conceptual and Computational Questions 148 Problems and Applications 150 Case-Based Exercises 153 Selected Readings 153 Appendix: A Calculus Approach to Individual Behavior 154 Inside Business 4-1: Indifference Curves and Risk Preferences 122 Inside Business 4-2: Price Changes and Inventory Management for Multiproduct Firms 130 Inside Business 4-3: Income Effects and the Business Cycle 135 Inside Business 4-4: The "Deadweight Loss" of In-Kind Gifts 140 CHAPTER FIVE The Production Process and Costs 156 Headline: GM and UAW Butt Heads over Jobs 156 Introduction 157 -

xxii Contents The Production Function 157 Short-Run versus Long-Run Decisions 157 Measures of Productivity 159 Total Product 159 Average Product 159 Marginal Product 159 The Role of the Manager in the Production Process 161 Produce on the Production Function 161 Use the Right Level of Inputs 162 Algebraic Forms of Production Functions 165 Algebraic Measures of Productivity 166 Isoquants 168 Isocosts 171 Cost Minimization 173 Optimal Input Substitution 175 The Cost Function 177 Short-Run Costs 178 Average and Marginal Costs 180 Relations among Costs 182 Fixed and Sunk Costs 183 Algebraic Forms of Cost Functions 184 Long-Run Costs 185 Economies of Scale 187 A Reminder: Economic Costs versus Accounting Costs 187 Multiple-Output Cost Functions 188 Economies of Scope 188 Cost Complementarity 189 Answering the Headline 191 Summary 191 Key Terms and Concepts 192 Conceptual and Computational Questions 192 Problems and Applications 194 Case-Based Exercises 199 Selected Readings 199 Appendix: The Calculus of Production and Costs 200 Inside Business 5-1: Where Does Technology Come From? 164 Inside Business 5-2: Ford's $1 Billion Write-Off 170 Inside Business 5-3: Fringe Benefits and Input Substitution 178 Inside Business 5-4: International Companies Exploit Economies of Scale 188 CHAPTER SIX The Organization of the Firm 203 Headline: Korean Firm Invests 30 Trillion Won to Vertically Integrate 203 Introduction 204

; Contents xxiii Methods of Procuring Inputs 205 Purchase the Inputs Using Spot Exchange 205 Acquire Inputs under a Contract 206 Produce the Inputs Internally 206 Transaction Costs 207 Types of Specialized Investments 208 Site Specificity 208 Physical-Asset Specificity 208 Dedicated Assets 208 Human Capital 209 Implications of Specialized Investments 209 Costly Bargaining 209 Underinvestment 209 Opportunism and the "Hold-Up Problem" 210 Optimal Input Procurement 211 Spot Exchange 211 Contracts 213 Vertical Integration 216 The Economic Trade-Off 216 Managerial Compensation and the Principal-Agent Problem 219 Forces That Discipline Managers 222 Incentive Contracts 222 External Incentives 223 Reputation 223 Takeovers 223 The Manager-Worker Principal-Agent Problem 224 Solutions to the Manager-Worker Principal-Agent Problem 224 Profit Sharing 224 Revenue Sharing 224 Piece Rates 225 Time Clocks and Spot Checks 226 Answering the Headline 227 Summary 227 Key Terms and Concepts 228 Conceptual and Computational Questions 228 Problems and Applications 229 Case-Based Exercises 231 Selected Readings 232 Appendix : An Indifference Curve Approach to Managerial Incentives 232 Inside Business 6-1: The Cost of Using an Inefficient Method of Procuring Inputs 211 Inside Business 6-2: Factors Affecting the Length of Coal and Natural-Gas Contracts 218 Inside Business 6-3: The Evolution of Input Decisions in the Automobile Industry 220 Inside Business 6-4: Paying for Performance 226

Contents CHAPTER SEVEN The Nature of Industry 235 Headline: Microsoft Puts Halt to Intuit Merger 235 Introduction 236 Market Structure 236 Firm Size 236 Industry Concentration 237 Measures of Industry Concentration 238 The Concentration of U.S. Industry 239 Limitations of Concentration Measures 241 Technology 243 Demand and Market Conditions 243 Potential for Entry 245 Conduct 246 Pricing Behavior 247 Integration and Merger Activity 248 Vertical Integration 249 Horizontal Integration 249 Conglomerate Mergers 251 Research and Development 251 Advertising 252 Performance 252 Profits 252 Social Welfare 252 The Structure-Conduct-Performance Paradigm 253 The Causal View 254 The Feedback Critique 254 Relation to the Five-Forces Framework 254 Overview of the Remainder of the Book 255 Perfect Competition 255 Monopoly 256 Monopolistic Competition 256 Oligopoly 256 Answering the Headline 258 Summary 258 Key Terms and Concepts 259 Conceptual and Computational Questions 259 Problems and Applications 260 Case-Based Exercises 263 Selected Readings 263 Inside Business 7-1: The North American Industry Classification System (NAICS) 242 Inside Business 7-2: The Elasticity of Demand at the Firm and Market Levels 246 Inside Business 7-3: The Language of Corporate Takeovers 250 Inside Business 1-^: The Evolution of Market Structure in the Computer Industry 257

Contents XXV CHAPTER EIGHT Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets 265 Headline: McDonald's Adds New Tastes and Products to Menu Boards 265 Introduction 266 Perfect Competition 266 Demand at the Market and Firm Levels 267 Short-Run Output Decisions 268 Maximizing Profits 268 Minimizing Losses 272 The Short-Run Firm and Industry Supply Curves 275 Long-Run Decisions 276 Monopoly 278 Monoply Power 279 Sources of Monopoly Power 280 Economies of Scale 280 Economies of Scope 281 Cost Complementarity 282 Patents and Other Legal Barriers 282 Maximizing Profits 283 Marginal Revenue 283 The Output Decision 287 The Absence of a Supply Curve 290 Multiplant Decisions 290 Implications of Entry Barriers 292 Monopolistic Competition 294 Conditions for Monopolistic Competition 294 Profit Maximization 295 Long-Run Equilibrium 297 Implications of Product Differentiation 300 Optimal Advertising Decisions 301 Answering the Headline 303 Summary 303 Key Terms and Concepts 304 Conceptual and Computational Questions 304 Problems and Applications 307 Case-Based Exercises 311 Selected Readings 311 Appendix: The Calculus of Profit Maximization 312 Appendix: The Algebra of Perfectly Competitive Supply Functions 313 Inside Business 8-1: Peugeot-Citroen of France: A Price-Taker in China's Auto Market 272 Inside Business 8-2: Patent, Trademark, and Copyright Protection 284 Inside Business 8-3: Product Differentiation, Cannibalization, and Colgate's Smile 297

xxvi Contents CHAPTER NINE Basic Oligopoly Models 315 Headline: Crude Oil Prices Fall, but Consumers in Some Areas See No Relief at the Pump 315 Introduction 316 Conditions for Oligopoly 316 The Role of Beliefs and Strategic Interaction 316 Profit Maximization in Four Oligopoly Settings 318 Sweezy Oligopoly 318 Cournot Oligopoly 320 Reaction Functions and Equilibrium 320 Isoprofit Curves 325 Changes in Marginal Costs 328 Collusion 330 Stackelberg Oligopoly 332 Bertrand Oligopoly 336 Comparing Oligopoly Models 338 Cournot 338 Stackelberg 339 Bertrand 339 Collusion 339 Contestable Markets 341 Answering the Headline 342 Summary 343 Key Terms and Concepts 344 Conceptual and Computational Questions 344 Problems and Applications 346 Case-Based Exercises 349 Selected Readings 350 Appendix: Differentiated-Product Bertrand Oligopoly 350 Inside Business 9-1: Commitment in Stackelberg Oligopoly 334 Inside Business 9-2: Price Competition and the Number of Sellers: Evidence from Online and Laboratory Markets 337 Inside Business 9-3: Using a Spreadsheet to Calculate Cournot, Stackelberg, and Collusive Outcomes 340 CHAPTER TEN Game Theory: Inside Oligopoly 352 Headline: Airline Seeks Government Regulation of Carry-On Baggage 352 Introduction 353 Overview of Games and Strategic Thinking 353 Simultaneous-Move, One-Shot Games 354 Theory 354 Applications of One-Shot Games 357

Contents xxvii Pricing Decisions 357 Advertising and Quality Decisions 360 Coordination Decisions 361 Monitoring Employees 362 Nash Bargaining 363 Infinitely Repeated Games 365 Theory 365 Review of Present Value 365 Supporting Collusion with Trigger Strategies 366 Factors Affecting Collusion in Pricing Games 369 Number of Firms 369 Firm Size 369 History of the Market 370 Punishment Mechanisms 371 An Application of Infinitely Repeated Games to Product Quality 371 Finitely Repeated Games 372 Games with an Uncertain Final Period 372 Repeated Games with a Known Final Period: The End-of-Period Problem 375 Applications of the End-of-Period Problem 377 Resignations and Quits 377 The "Snake-Oil" Salesman 377 Multistage Games 378 Theory 378 Applications of Multistage Games 381 The Entry Game 381 Innovation 382 Sequential Bargaining 383 Answering the Headline 386 Summary 387 Key Terms and Concepts 387 Conceptual and Computational Questions 388 Problems and Applications 390 Case-Based Exercises 396 Selected Readings 396 Inside Business 10-1: Hollywood's (not so) Beautiful Mind: Nash or "Opie" Equilibrium? 358 Inside Business 10-2: Trigger Strategies in the Waste Industry 370 Inside Business 10-3: Entry Strategies in International Markets: Sprinkler or Waterfall? 382 CHAPTER ELEVEN Pricing Strategies for Firms with Market Power 397 Headline: Mickey Mouse Lets You Ride "for Free" at Disney World 397 Introduction 398 Basic Pricing Strategies 398

xxviii Contents Review of the Basic Rule of Profit Maximization 398 A Simple Pricing Rule for Monopoly and Monopolistic Competition 399 A Simple Pricing Rule for Cournot Oligopoly 402 Strategies That Yield Even Greater Profits 404 Extracting Surplus from Consumers 404 Price Discrimination 404 Two-Part Pricing 410 Block Pricing 412 Commodity Bundling 414 Pricing Strategies for Special Cost and Demand Structures 417 Peak-Load Pricing 417 Cross-Subsidies 419 Transfer Pricing 419 Pricing Strategies in Markets with Intense Price Competition 422 Price Matching 422 Inducing Brand Loyalty 424 Randomized Pricing 424 Answering the Headline 426 Summary 427 Key Terms and Concepts 427 Conceptual and Computational Questions 427 Problems and Applications 430 Case-Based Exercises 433 Selected Readings 433 Inside Business 11-1: Pricing Markups as Rules of Thumb 400 Inside Business 11-2: Bundling and "Price Frames" in Online Markets 416 Inside Business 11-3: The Prevalence of Price-Matching Policies and Other Low- Price Guarantees 423 Inside Business 11-4: Randomized Pricing in the Airline Industry 425 CHAPTER TWELVE The Economics of Information 435 Headline: Firm Chickens Out in the FCC Spectrum Auction 435 Introduction 436 The Mean and the Variance 436 Uncertainty and Consumer Behavior 439 Risk Aversion 439 Managerial Decisions with Risk-Averse Consumers 439 Consumer Search 441 Uncertainty and the Firm 444 Risk Aversion 444 Producer Search 448 Profit Maximization 448 Uncertainty and the Market 450

Contents xxix Asymmetrie Information 450 Adverse Selection 451 Moral Hazard 452 Signaling and Screening 454 Auctions 456 Types of Auctions 457 English Auction 457 First-Price, Sealed-Bid Auction 457 Second-Price, Sealed-Bid Auction 458 Dutch Auction 458 Information Structures 459 Independent Private Values 459 Correlated Value Estimates 460 Optimal Bidding Strategies for Risk-Neutral Bidders 460 Strategies for Independent Private Values Auctions 461 Strategies for Correlated Values Auctions 463 Expected Revenues in Alternative Types of Auctions 465 Answering the Headline 467 Summary 467 Key Terms and Concepts 468 Conceptual and Computational Questions 468 Problems and Applications 470 Case-Based Exercises 473 Selected Readings 474 Inside Business 12-1: Risk Aversion and the Value of Selling the Firm: The St. Petersburg Paradox 440 Inside Business 12-2: The Value of Information in Online Markets 445 Inside Business 12-3: Second-Price Auctions on ebay 458 Inside Business 12-4: Auctions with Risk-Averse Bidders 466 CHAPTER THIRTEEN Advanced Topics in Business Strategy 475 Headline: Barkley and Sharpe to Announce Plans at Trade Show 475 Introduction 476 Limit Pricing to Prevent Entry 477 Theoretical Basis for Limit Pricing 477 Limit Pricing May Fail to Deter Entry 479 Linking the Preentry Price to Postentry Profits 480 Commitment Mechanisms 480 Learning Curve Effects 481 Incomplete Information 482 Reputation Effects 482 Dynamic Considerations 483 Predatory Pricing to Lessen Competition 485

XXX Contents Raising Rivals' Costs to Lessen Competition 488 Strategies Involving Marginal Cost 488 Strategies Involving Fixed Costs 489 Strategies for Vertically Integrated Firms 490 Vertical Foreclosure 491 The Price-Cost Squeeze 491 Price Discrimination as a Strategic Tool 491 Changing the Timing of Decisions or the Order of Moves 492 First-Mover Advantages 492 Second-Mover Advantages 495 Penetration Pricing to Overcome Network Effects 495 What Is a Network? 496 Network Externalities 497 First-Mover Advantages Due to Consumer Lock-In 498 Using Penetration Pricing to "Change the Game" 500 Answering the Headline 501 Summary 502 Key Terms and Concepts 502 Conceptual and Computational Questions 502 Problems and Applications 505 Case-Based Exercises 508 Selected Readings 508 Inside Business 13-1: Business Strategy at Microsoft 478 Inside Business 13-2: Dynamic Limit Pricing 484 Inside Business 13-3: First to Market, First to Succeed? Or First to Fail? 494 Inside Business 13 4: Network Externalities and Penetration Pricing by Yahoo! Auctions 499 CHAPTER FOURTEEN A Manager's Guide to Government in the Marketplace 509 Headline: FTC Conditionally Approves $10.3 Billion Merger 509 Introduction 510 Market Failure 510 Market Power 510 Antitrust Policy 511 Price Regulation 515 Externalities 520 The Clean Air Act 521 Public Goods 524 Incomplete Information 528 Rules against Insider Trading 529 Certification 529 Truth in Lending 530 Truth in Advertising 531 Enforcing Contracts 531

Contents xxxi Rent Seeking 533 Government Policy and International Markets 534 Quotas 534 Tariffs 536 Lump-Sum Tariffs 537 Excise Tariffs 537 Answering the Headline 539 Summary 539 Key Terms and Concepts 539 Conceptual and Computational Questions 540 Problems and Applications 543 Case-Based Exercises 546 Selected Readings 546 Inside Business 14-1: European Commission Asks Airlines to Explain Price Discrimination Practices 514 Inside Business 14-2: Electricity Deregulation 519 Inside Business 14-3: Canada's Competition Bureau 532 CASE STUDY Challenges at Time Warner 548 Author's Note about the Case 547 Headline 548 Background 549 Overview of the Industry and Time Warner's Operations 550 America Online 550 Market Conditions 551 AOL Operations 552 AOL Europe 553 Filmed Entertainment 553 Motion Picture Production and Distribution 554 The Film Industry 554 Competition 556 Television Programming 557 Home Video Distribution 557 Publishing 557 Magazine Publishing 558 Magazines Online 559 Book Publishing 559 Programming Networks 560 Cable Systems 561 Analog and Digital Cable TV 561 High-Speed Internet Service 562 Telephone Service 562 Competition 563 Direct Broadcast Satellite Operators 563

XXXII Contents Overbuilders 563 Bundling 564 Regulatory Considerations 565 Technological Considerations 565 High-Definition Television (HDTV) 565 Digital Video Recorders (DVRs) 566 Challenges 567 Case-Based Exercises 567 Memos 567 Selected Readings and References 576 Appendix: Exhibits 578 Appendix A Answers to Selected End-of-Chapter Problems Appendix В Additional Readings and References 587 Name Index 605 General Index 610