Managerial economics 3rd a problem solving approach froeb mccann

This is an electronic version of the print textbook Due to electronic rights restrictions, some third party content may be suppressed Editorial review has deemed that any suppressed content does not materially affect the overall learning experience The publisher reserves the right to remove content from this title at any time if subsequent rights restrictions require it For valuable information on pricing, previous editions, changes to current editions, and alternate formats, please visit www.cengage.com/highered to search by ISBN#, author, title, or keyword for materials in your areas of interest Copyright 201 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s) Editorial review has deemed that any suppressed content does not materially affect the overall learning experience Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it A PROBLEM SOLVING APPROACH THIRD EDITION ? Luke M Froeb Vanderbilt University Brian T McCann Vanderbilt University Mikhael Shor University of Connecticut Michael R Ward University of Texas, Arlington Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States Copyright 201 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s) Editorial review has deemed that any suppressed content does not materially affect the overall learning experience Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it Managerial Economics: A Problem Solving Approach, Third Edition Luke M Froeb, Brian T McCann, Mikhael Shor, Michael R Ward Senior Vice President, LRS/Acquisitions & Solutions Planning: Jack W Calhoun © 2014, 2010, 2008 South-Western, Cengage Learning ALL RIGHTS RESERVED No part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or mechanical, including photocopying, recording, taping, Web distribution, information storage and retrieval systems, or in any other manner—except as may be permitted by the license terms herein Editorial Director, Business & Economics: Erin Joyner Editor-in-Chief: Joe Sabatino Executive Acquisition Editor: Mike Worls For product information and technology assistance, contact us at Cengage Learning Customer & Sales Support, 1-800-354-9706 For permission to use material from this text or product, submit all requests online at www.cengage.com/permissions Developmental Editor: Daniel Noguera Further permissions questions can be emailed to permissionrequest@cengage.com Editorial Assistant: Elizabeth Beiting-Lipps Brand Manager: Robin LeFevre Market Development Manager: John Carey Library of Congress Control Number: 2013930455 Art and Cover Direction, Production Management, and Composition: Integra Software Services Pvt Ltd ISBN-13: 978-1-133-95148-3 Media Editor: Anita Verma Rights Acquisition Director: Audrey Pettengill Rights Acquisition Specialist, Text and Image: John Hill ISBN-10: 1-133-95148-1 South-Western Cengage Learning 5191 Natorp Boulevard Mason, OH 45040 USA Manufacturing Planner: Kevin Kluck Cover Image: ©shutterstock.com/isoga Cengage Learning products are represented in Canada by Nelson Education, Ltd For your course and learning solutions, visit www.cengage.com Purchase any of our products at your local college store or at our preferred online store www.cengagebrain.com Printed in the United States of America 18 17 16 15 14 13 Copyright 201 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s) Editorial review has deemed that any suppressed content does not materially affect the overall learning experience Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it For our families: Lisa, Jake, Halley, Chris, Leslie, Jacob, Eliana, Cindy, Alex, and Chris Copyright 201 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s) Editorial review has deemed that any suppressed content does not materially affect the overall learning experience Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it Copyright 201 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s) Editorial review has deemed that any suppressed content does not materially affect the overall learning experience Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it BRIEF CONTENTS Preface: Teaching Students to Solve Problems SECTION I Problem Solving and Decision Making xiii 1 Introduction: What This Book Is About The One Lesson of Business 11 Benefits, Costs, and Decisions 21 Extent (How Much) Decisions 33 Investment Decisions: Look Ahead and Reason Back SECTION II Pricing, Costs, and Profits Simple Pricing 45 57 59 Economies of Scale and Scope 73 Understanding Markets and Industry Changes 85 Relationships Between Industries: The Forces Moving Us Toward 103 Long-Run Equilibrium 10 Strategy: The Quest to Keep Profit from Eroding 11 Foreign Exchange, Trade, and Bubbles SECTION III Pricing for Greater Profit 113 125 137 12 More Realistic and Complex Pricing 139 13 Direct Price Discrimination 149 14 Indirect Price Discrimination 157 SECTION IV Strategic Decision Making 15 Strategic Games 16 Bargaining SECTION V Uncertainty 167 169 187 197 17 Making Decisions with Uncertainty 18 Auctions 199 213 19 The Problem of Adverse Selection 20 The Problem of Moral Hazard SECTION VI Organizational Design 223 233 243 21 Getting Employees to Work in the Firm’s Best Interests 22 Getting Divisions to Work in the Firm’s Best Interests 23 Managing Vertical Relationships 245 257 269 v Copyright 201 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s) Editorial review has deemed that any suppressed content does not materially affect the overall learning experience Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it vi BRIEF CONTENTS SECTION VII Wrapping Up 279 24 You Be the Consultant 281 Epilogue: Can Those Who Teach, Do? Glossary 291 Index 295 289 Copyright 201 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s) Editorial review has deemed that any suppressed content does not materially affect the overall learning experience Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it CONTENTS Preface: Teaching Students to Solve Problems xiii SECTION I Problem Solving and Decision Making CHAPTER INTRODUCTION: WHAT THIS BOOK IS ABOUT Using Economics to Solve Problems Problem Solving Principles Test Yourself Ethics and Economics Economics in Job Interviews Summary & Homework Problems 10 End Notes 10 CHAPTER THE ONE LESSON OF BUSINESS 11 Capitalism and Wealth 12 Does the Government Create Wealth? 13 Why Economics is Useful to Business 14 Wealth Creation in Organizations 16 Summary & Homework Problems 17 End Notes 19 CHAPTER BENEFITS, COSTS, AND DECISIONS 21 Background: Variable, Fixed, and Total Costs 22 Background: Accounting Versus Economic Profit 23 Costs are What You Give Up 25 Sunk-Cost Fallacy 26 Hidden-Cost Fallacy 28 A Final Warning 28 Summary & Homework Problems 29 End Notes 31 CHAPTER EXTENT (HOW MUCH) DECISIONS 33 Background: Average and Marginal Costs 34 Marginal Analysis 35 Incentive Pay 37 Tie Pay to Performance Measures that Reflect Effort Is Incentive Pay Unfair? 39 38 vii Copyright 201 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s) Editorial review has deemed that any suppressed content does not materially affect the overall learning experience Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it viii CONTENTS Summary & Homework Problems End Notes 42 40 CHAPTER INVESTMENT DECISIONS: LOOK AHEAD AND REASON BACK Compounding and Discounting 45 How to Determine Whether Investments are Profitable 46 Breakeven Analysis 47 Choosing the Right Manufacturing Technology 48 Shutdown Decisions and Breakeven Prices 49 Sunk Costs and Post-Investment Hold-Up 50 Anticipate Hold-Up 51 Summary & Homework Problems 52 End Notes 55 SECTION II Pricing, Costs, and Profits CHAPTER SIMPLE PRICING 59 Background: Consumer Values and Demand Curves Marginal Analysis of Pricing 62 Price Elasticity and Marginal Revenue 64 What Makes Demand More Elastic? 66 Forecasting Demand Using Elasticity 67 Stay-Even Analysis, Pricing, and Elasticity 68 Cost-Based Pricing 69 Summary & Homework Problems 69 End Notes 72 45 57 60 73 CHAPTER ECONOMIES OF SCALE AND SCOPE Increasing Marginal Cost 74 Economies of Scale 75 Learning Curves 76 Economies of Scope 78 Diseconomies of Scope 79 Summary & Homework Problems 80 End Notes 82 CHAPTER UNDERSTANDING MARKETS AND INDUSTRY CHANGES Which Industry or Market? 85 Shifts in Demand 86 Shifts in Supply 88 Market Equilibrium 89 Predicting Industry Changes Using Supply and Demand 90 Explaining Industry Changes Using Supply and Demand 92 Prices Convey Valuable Information 95 Market Making 96 85 Copyright 201 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s) Editorial review has deemed that any suppressed content does not materially affect the overall learning experience Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it GLOSSARY A Accounting costs costs that appear on the financial statements of a company Accounting profit profits as shown on a company’s financial statements Accounting profit does not necessarily correspond to real or economic profit Adverse selection refers to the fact that “bad types” are likely to be selected in transactions where one party is better informed than the other Examples include higher-risk individuals being more likely to purchase insurance, more lowquality cars (lemons) being offered for sale, or lazy workers being more likely to accept job offers Adverse selection is a pre-contractual problem that arises from hidden information about risks, quality, or character Agency costs costs associated with moral hazard and adverse selection problems Agent a person who acts on behalf of another individual (a principal) Principal– agent problems are created by the incentive conflict between principals and agents Aggregate demand curve describes the buying behavior of a group of consumers We add up all the individual demand curves to get an aggregate demand curve (the relationship between the price and the number of purchases made by a group of consumers) Arbitrage a means to defeat a price discrimination scheme; it occurs when low-value individuals are able to resell their lower-priced goods to the highervalue group Average cost the total cost of production divided by the number of units produced Avoidable costs costs that you get back if you shut down operations B Breakeven price the price that you must charge to at least break even (make zero profit) It is equal to average avoidable cost per unit Breakeven quantity the amount you need to sell to at least break even (make zero profit) The formula (assuming that you can sell all you want at price and with constant marginal cost) is Q = F/(P – MC), where F is fixed costs, P is price, and MC is marginal cost Bundling the practice of offering multiple goods for sale as one combined product Buyer surplus the difference between the buyer’s value (what he is willing to pay) and the price (what he has to pay) C Common-value auction in a commonvalue auction, the value is the same for each bidder, but no one knows what it is Each bidder has only an estimate of the unknown value, and the value is the same for everyone In common-value auctions, bidders have to bid below their values in order to avoid the winner’s curse Compensating wage differentials in equilibrium, differences in wages that reflect differences in the inherent attractiveness of various professions or jobs Competitive industry competitive industries are characterized by three factors: (1) firms produce a product or service with very close substitutes so they have very elastic demand, (2) firms have many rivals and no cost advantage over those rivals, and (3) the industry has no barriers to entry or exit Complement a good whose demand increases when the price of another good decreases Examples include a parking lot and shopping mall or a hamburger and a hamburger bun Constant returns to scale when average costs are constant with respect to output level Consumer surplus see Buyer surplus Contribution margin the amount that one unit contributes to profit It is defined as Price–Marginal Cost Controllable factor something that affects demand that a company can change Examples include price, advertising, warranties, and product quality Cost center a division whose parent company rewards it for reducing the cost of producing a specified output Cross-price elasticity of demand the cross-price elasticity of demand for Good A with respect to the price of 291 Copyright 201 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s) Editorial review has deemed that any suppressed content does not materially affect the overall learning experience Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it 292 GLOSSARY Good B measures the percentage change in demand of Good A caused by a percentage change in the price of Good B Decreasing returns to scale see Diseconomies of scale Fixed cost costs that not vary with output Fixed-cost fallacy consideration of costs that not vary with the consequences of your decision (also known as the sunk-cost fallacy) Demand curves describe buyer behavior and tell you how much consumers will buy at a given price Functionally organized firm a firm in which various divisions perform separate tasks, such as production and sales D Direct price discrimination scheme a price discrimination scheme in which we can identify members of the lowvalue group, charge them a lower price, and prevent them from reselling their lower-priced goods to the higher-value group Diseconomies of scale diseconomies of scale exist when average costs rise with output Diseconomies of scope diseconomies of scope exist when the cost of producing two products jointly is more than the cost of producing those two products separately E Economic profit a measure of profit that includes recognition of implicit costs (like the cost of equity capital) Economic profit measures the true profitability of decisions Economies of scale economies of scale exist when average costs fall as output increases Economies of scope economies of scope exist when the cost of producing two products jointly is less than the cost of producing those two products separately Efficient an economy is efficient if all assets are employed in their highestvalued uses Elastic a demand curve on which percentage quantity changes more than percentage price is said to be elastic, or sensitive to price If |e| > 1, demand is elastic, where e is the price elasticity of demand English auction see Oral auction Exclusion the practice of blocking competitors from participating in a market Extent decision a decision regarding how much or how many of a product to produce F First Law of Demand consumers demand (purchase) more as price falls (i.e., demand curves slope downward), assuming other factors are held constant H Hidden-cost fallacy occurs when you ignore relevant costs, those costs that vary with the consequences of your decision I Implicit costs additional costs that not appear on the financial statements of a company These costs include items like the opportunity cost of capital Incentive conflict the fact that principals and agents often have different goals Income elasticity of demand income elasticity of demand measures the percentage change in demand arising from a percentage change in income Increasing returns to scale see Economies of scale Indifference principle if an asset is mobile, then in long-run equilibrium, the asset will be indifferent about where it is used; that is, it will make the same profit no matter where it goes Indirect price discrimination scheme a price discrimination scheme in which a seller cannot directly identify low- and high-value consumers or cannot prevent arbitrage between two groups The seller can still practice indirect price discrimination by designing products or services that appeal to groups with different price elasticities of demand Inelastic a demand curve on which percentage change in quantity is smaller than percentage change in price is said to be inelastic, or insensitive to price If |e|