MANAGERIAL ECONOMICS WILEY A JOHN WILEY & SONS, INC., PUBLICATION. A Mathematical Approach

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1 MANAGERIAL ECONOMICS A Mathematical Approach M. J. ALHABEEB L. JOE MOFFITT Isenberg School of Management University of Massachusetts Amherst, MA, USA WILEY A JOHN WILEY & SONS, INC., PUBLICATION

2 PREFACE xix UNIT I METHODOLOGICAL PRELIMINARIES 1 Qualitative Fundamentals Economic Theory and Managerial Economics Some Methodological Fallacies Paradigms, Models, and the Scientific Method The Descriptive and Prescriptive Treatments The Profit Function: Accounting versus Economics Entrepreneurship, Management, and Leadership 9 Summary 11 Key Terms 12 Exercises 12 2 Quantitative Fundamentals Introduction Functions Exponents Logarithms and the Number e Differential Calculus Multivariate and Equality Constrained Optimization Inequality Constrained Optimization: Linear Programming Selected Statistical Concepts Maximum Likelihood Estimation Ordinary and Nonlinear Least Squares Estimation 37

3 Summary 38 Key Terms 40 List of Formulas 40 Exercises 42 UNIT II DECISIONS AT THE CONSUMER LEVEL 3 Theory of Consumer Choice Consumer Preferences Indifference Curve Marginal Rate of Substitution (MRS) Nontypical Indifference Curves 3.2 Consumer's Affordability Budget Line Slope of the Budget Line Shift, Swing, and Kink of the Budget Line The Shift The Swing The Kink Three-Dimensional Budget 3.3 The Optimal Choice Interior and Corner Solutions Utility and Its Measurability Utility Maximization 3.4 Effects on the Optimal Choice Change in Income Normal and Inferior Commodities Income-Consumption Curve Engel Curve: Nominal and Real Engel Curve and Income-Consumption Curve for Homothetic and Quasi-Linear Preferences Income Elasticity of Demand Change in Prices Giffen and Non-Giffen Commodities Price-Consumption Curve Price Change and the Demand Curve Price Elasticity of Demand Substitutes and Complements Cross-Price Elasticity of Demand 3.5 Income and Substitution Effects 3.6 Slutsky Equation Summary Key Terms List of Formulas Exercises

4 xi 4 Consumer Demand: Theoretical Analysis Demand and Supply: Functions and Laws Deriving a Demand Function from Utility Maximization Homogeneity and the Numeraire Inverse Demand Function Demand and Supply: Table and Curves Market Equilibrium From Individual to Market Demand Demand and Network Externalities The Case of the Bandwagon Effect The Case of the Snob Effect Deriving a Market Demand Function under Externalities Changes in Q D and Q s versus Changes in D and S Changes in Equilibrium The Case of Thanksgiving Turkey The Case of Sales and Excise Taxes Market Disequilibrium The Case of a Price Ceiling The Case of a Price Floor Marshallian versus Hicksian Demand Curves Shephard Lemma and the Expenditure Function Deriving the Hicksian (Compensated) Demand Curve Revealed Preferences Interdependent Demand 152 Summary 155 Key Terms 157 List of Formulas 157 Exercises Consumer Demand: Empirical Estimation Simple Market Experimentation Linearity of the Demand Function: From Visual to Regression Reliability of the Estimation Quality of Fitting Fitting by Computerized Regression Demand Estimation by the Multiple Regression Method Results and Interpretation Goodness of Fit The Overall Explanatory Power of the Model Major Problems to Check On 183 Multicollinearity 183 Autocorrelation 184 Heteroscedasticity Nonregression Approaches to Estimation Market Experimentation 186

5 xii CONTENTS Observational Studies Micromarketing and Virtual Shopping Advanced Demand Estimation: The Pad Model Model Specification 188 Desired Demand 188 Adjustment Equation 188 Estimating Equation Graph of the Linear PAD Model 189 Summary 196 Key Terms 196 List of Formulas 196 Exercises Consumer Demand: Economic Forecasting Forecasting Models Quantitative Models Qualitative Models Time Series Analysis Secular Trends Seasonal Variations Cyclical Fluctuations Random Changes From Symbolic to Numeric Fitting Adjusting for Seasonality The Simple Average of Errors Method The Actual-to-Forecast (A/F) Ratio Method The Dummy Variables Method Smoothed Forecasts Simple Moving Average Method 214 The RMSE Check The Weighted Moving Average Exponential Smoothing 219 Mean Absolute Deviation (MAD) Barometric Forecasting Econometric Models Single-Equation Model Multiple-Equation Model Input-Output Matrix Judgmental Models Opinions and Polls Surveys and Market Research Forecasting Accuracy and Reliability 234 Summary 235 Key Terms 236 List of Formulas 236 Exercises 238

6 xiii UNIT III MANAGERIAL DECISIONS AT THE FIRM LEVEL 7 Production Theory Variability of Inputs throughout Time Production Function Graphical Representation of the Production Function Short-Run, One Variable Input Function Dynamic Relations among Production Curves Law of Diminishing Marginal Returns Long-Run, Two Variable Input Function 261 Isoquants Marginal Rate of Technical Substitution (MRTS) The Economically Efficient Region of Production Returns to Scale Elasticity of Substitution Elasticity of the Cobb-Douglas Production Function Elasticity of the Leontief Production Function Leontief Technology and Linear Programming Elasticity of the Linear Production Function Elasticity of the CES Production Function Graphical Representation of CES Optimal Employment of an Input Technological Progress, Invention, and Innovation Technological Progress and Production Function 280 Summary 282 Key Terms 283 List of Formulas 283 Exercises Cost Theory Cost Concepts and Categories Short-Run Costs The Optimal Combination of Inputs Isocost Minimizing Input Cost and Maximizing Output Long-Run Costs Short-Run and Long-Run Average Costs: Economies of Scale Derivation of the Cost Function Economies of Scope: Basic Concept and Cost Complementarities Economies of Scope: Synergy and Input Indivisibility The Learning Curve Cost-Volume-Profit Analysis and Operating Leverage Break-Even Quantity and Break-Even Revenue 322 Fixed Cost 323 Variable Cost 323 Contribution Margin 324

7 xiv CONTENTS Cash Break-Even Technique The Break-Even Point and Target Profit An Algebraic Approach to the Break-Even Point Break-Even Time The Dual Break-Even Points 8.12 Leverage Operating Leverage Operating Leverage, Fixed Cost, and Business Risk Summary Key Terms List of Formulas Exercises Production and Cost: Estimation and Forecasting 9.1 Estimation of the Production Function 9.2 Estimation of the Cost Function 9.3 Forecasting Output 9.4 Forecasting Cost 9.5 Meeting Obligations through Decisions with Probabilistic Results Summary Key Terms List of Formulas Exercises UNIT IV MANAGERIAL DECISIONS AT THE MARKET LEVEL 10 Market Structure and Business Organization Perfect Competition Characteristics of Perfect Competition Profit Maximization for Competitive Firms The Decision to Shut Down The Competitive Firm in the Long Run Monopoly Monopoly's Equilibrium in the Short Run Monopoly's Equilibrium in the Long Run Monopoly Power and the Lerner Index Monopolistic Competition Monopolistic Competition Equilibrium in the Short Run Monopolistic Competition Equilibrium in the Long Run Oligopoly The Concentration Ratio and the Herfindahl Index Models of Oligopoly 395 Cournot Model 395 Stackelberg Model 399 Bertrand Model 403 Sweezy Model 407

8 XV Summary 410 Key Terms 411 List of Formulas 411 Exercises Pricing Decisions and Practices Basics of Price Setting The Markup Rule Multiproduct Pricing Strategies Joint Products with Independent Demands Product Set of Fixed Proportions Product Set of Variable Proportions Transfer Pricing The Intermediate Product in a Perfectly Competitive Market The Intermediate Product in an Imperfectly Competitive Market Pricing Strategies and Practices Price Discrimination First-Degree Price Discrimination 434 W.I.2 Second-Degree Price Discrimination Third-Degree Price Discrimination 437 Summary 445 Key Terms 446 List of Formulas 446 Exercises 447 UNIT V MANAGERIAL DECISIONS IN THE LONG RUN 12 Capital Budgeting and Investment Project Evaluation What is Capital Budgeting? Basic Model of Capital Budgeting Selection Process and Project Evaluation Methods of Evaluation for Proposed Investment Projects Net Present Value Internal Rate of Return NPV versus IRR for Mutually Exclusive Projects NPV Profile, Crossover Rate, and the Ranking Reversal Profitability Index and Capital Rationing Payback Method Cost of Capital Cost of Debt Capital Cost of Equity Capital 473 The CAPM Estimation 473 The Dividend Valuation Estimation The Weighted Marginal Cost of Capital Capitalization and Capitalized Cost Last Words on the Cost of Capital 481

9 xvi CONTENTS Summary 481 Key Terms 483 List of Formulas 483 Exercises Risk Analysis and Managerial Decisions under Uncertainty Risk and Uncertainty Sources of Risk Economic Sources Political Sources Social Sources International Sources Measurement of Risk The Absolute Measure The Relative Measure Risk Aversion Risk Attitudes and Utility of Money Expected Utility of Money versus Expected Monetary Return Risk Discount and Certainty Equivalent Risk Impact on the Valuation Model Risk Premium Adjustment Certainty-Equivalent Adjustment Diversifiable versus Nondiversifiable Risk Portfolio Risk Risk of Two-Asset Portfolio Lending and Borrowing at the Risk-Free Rate of Return Measuring the Systematic Risk by Beta (P) The CAPM Model The Security Market Line (SML) SML Shift by Inflation SML Swing by Risk Aversion Managerial Decision Tree Mathematical Simulation and Sensitivity Analysis Advanced Choice under Risk, Ambiguity, and Uncertainty Stochastic Dominance. 536 Assumptions 537 Expected Utility 537 First-Degree Stochastic Dominance 537 Interpretation of FSD Conditions 538 Second-Degree Stochastic Dominance 538 Interpretation of FSD Conditions 538 Applications of SSD Conditions Choice under Ambiguity Choice under Uncertainty 539 Summary 541 Key Terms 542

10 xvii List of Formulas 543 Exercises Management Consultants and Information Measuring Information and Its Impact on Uncertainty Perfect Management Information Valuing Perfect Management Information Valuing Less-than-Perfect Management Information 549 Summary 556 Key Terms 557 List of Formulas 557 Exercises 558 APPENDIX 560 FURTHER READING 569 INDEX 573

Contents in Brief. Preface

Contents in Brief. Preface Contents in Brief Preface Page v PART 1 INTRODUCTION 1 Chapter 1 Nature and Scope of Managerial Economics and Finance 3 Chapter 2 Equations, Graphs and Optimisation Techniques 21 Chapter 3 Demand, Supply