# Foundations of Business Analysis and Strategy

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1 k 11 i- f l I_J I I } I II j "J 1r%\ "J T. "u ' Foundations of Business Analysis and Strategy TENTH EDITION (hristopher R. Thomas University of South Florida Exide Professor of Sustainable Enterprise S. Charles Maurice Texas A&M University Late Professor Emeritus McGraw-Hill Irwin

2 CONTENTS PART I SOME PRELIMINARIES 1 CHAPTER 1 Managers, Profits, and Markets The Economic Way of Thinking about Business Practices and Strategy 3 Economic Theory Simplifies Complexity 3 The Roles of Microeconomics and Industrial Organization Measuring and Maximizing Economic Profit 8 Economic Cost of Using Resources 8 Economic Profit versus Accounting Profit 12 Maximizing the Value of the Firm 15 The Equivalence of Value Maximization and Profit Maximization 16 Some Common Mistakes Managers Make Separation of Ownership and Control 20 The Principal-Agent Problem - 21 Corporate Control Mechanisms Market Structure and Managerial Decision Making 25 What Is a Market? 26 Different Market Structures 26 Globalization of Markets Summary 30 Technical Problems 30 Applied Problems 31 Mathematical Appendix: Review of Present Value Calculations 33 Mathematical Exercises 35 CHAPTER 2 Demand, Supply, and Market Equilibrium Demand 37 The General Demand Function: Q d =f(p,m,p R,?r,P e,n) 37 Direct Demand Functions: Q d = f(p) 42 Inverse Demand Functions: P = f(qj) 44 Movements along Demand 45 Shifts in Demand Supply 49 The General Supply Function: Q s =f(p,p,,p r,t,p e,f) 50 Direct Supply Functions: Q s = f(p) 53 Inverse Supply Functions: P = /(Q s ) 54 Shifts in Supply Market Equilibrium Measuring the Value of Market Exchange 60 Consumer Surplus 61 Producer Surplus 63 Social Surplus Changes in Market Equilibrium 65 Changes in Demand (Supply Constant) 65 Changes in Supply (Demand Constant) 66 Simultaneous Shifts in Both Demand and Supply 67 Predicting the Direction of Change in Airfares: A Qualitative Analysis 70 Advertising and the Price of Potatoes: A Quantitative Analysis Ceiling and Floor Prices Summary 76 Technical Problems 78 Applied Problems 83 CHAPTER 3 Marginal Analysis for Optimal Decisions Concepts and Terminology Unconstrained Maximization 89 The Optimal Level of Activity (A*) 89 Marginal Benefit and Marginal Cost 93 Finding Optimal Activity Levels with Marginal Analysis 95 Maximization with Discrete Choice Variables 97 Sunk Costs, Fixed Costs, and Average Costs Are Irrelevant Constrained Optimization 101 Marginal Benefit per Dollar Spent on an Activity 101 Constrained Maximization 102 Optimal Advertising Expenditures: An Example of Constrained Maximization 104 Constrained Minimization 105

3 Contents xv 3.4 Summary 108 Technical Problems 108 Applied Problems 113 Mathematical Appendix: A Brief Presentation of Optimization Theory 116 Mathematical Exercises 118 CHAPTER 4 Basic Estimation Techniques The Simple Linear Regression Model 121 A Hypothetical Regression Model 121 The Random Error Term Fitting a Regression Line Testing for Statistical Significance 127 The Relative Frequency Distribution for b 128 The Concept of a f-ratio 130 Performing a f-test for Statistical Significance 131 Using p-values to Determine Statistical Significance Evaluation of the Regression Equation 134 The Coefficient of Determination (R 2 ) 135 The F-Statistic 136 Controlling Product Quality at SLM: A Regression Example Multiple Regression 140 The Multiple Regression Model Nonlinear Regression Analysis 140 Quadratic Regression Models 141 Log-Linear Regression Models Regression Analysis in Managerial Decision Making Summary 149 Technical Problems 149 Applied Problems 153 / Statistical Appendix: Problems Encountered in Regression Analysis 156 PART II DEMAND ANALYSIS 159 CHAPTER 5 Theory of Consumer Behavior Basic Assumptions of Consumer Theory 161 The Consumer's Optimization Problem 161 Properties of Consumer Preferences 161 The Utility Function Indifference Curves 165 Properties 165 Marginal Rate of Substitution 166 Indifference Maps 168 A Marginal Utility Interpretation of MRS The Consumer's Budget Constraint 171 Budget Lines 171 Shifting the Budget Line Utility Maximization 175 Maximizing Utility Subject to a Limited Money Income 175 Marginal Utility Interpretation of Consumer Optimization 178 Finding the Optimal Bundle of Hot Dogs and Cokes Individual Consumer and Market Demand Curves 182 An Individual Consumer's Demand Curve 183 Market Demand and Marginal Benefit Substitution and Income Effects 186 Substitution Effect 187 Income Effect 188 Why Demand Slopes Downward Summary 192 Technical Problems 193 Applied Problems 200 Mathematical Appendix: A Brief Presentation of Consumer Theory 201 Mathematical Exercises 203 CHAPTER 6 Elasticity and Demand The Price Elasticity of Demand 205 Predicting the Percentage Change in Quantity Demanded 207 Predicting the Percentage Change in Price Price Elasticity and Total Revenue 208 Price Elasticity and Changes in Total Revenue 208 Changing Price at Borderline Music Emporium: A Numerical Example Factors Affecting Price Elasticity of Demand 211 Availability of Substitutes 211 Percentage of Consumer's Budget 212 Time Period of Adjustment Calculating Price Elasticity of Demand 213 Computation of Elasticity over an Interval 214 Computation of Elasticity at a Point 214 Elasticity (Generally) Varies along a Demand Curve Marginal Revenue, Demand, and Price Elasticity 220 Marginal Revenue and Demand 220 Marginal Revenue and Price Elasticity Other Demand Elasticities 225 Income Elasticity (E M ) 226 Cross-Price Elasticity ( XR ) 227

4 xvi Contents 6.7 Summary 230 Technical Problems 232 Applied Problems 238 Mathematical Appendix: Demand Elasticity 239 Mathematical Exercises 241 CHAPTER 7 Demand Estimation and Forecasting Direct Methods of Demand Estimation 245 Consumer Interviews 245 -\ Market Studies and Experiments Specification of the Empirical Demand Function 249 A General Empirical Demand Specification 249 A Linear Empirical Demand Specification 250 A Nonlinear Empirical Demand Specification 251 Choosing a Demand Specification Estimating Demand for a Price-Setting Firm 253 Estimating Demand for a Pizza Firm: An Example Time-Series Forecasts of Sales and Price 259 Linear Trend Forecasting 259 A Sales Forecast for Terminator Pest Control 260 A Price Forecast for Georgia Lumber Products Seasonal (or Cyclical) Variation 262 Correcting for Seasonal Variation by Using Dummy Variables 263 The Dummy-Variable Technique: An Example Some Final Warnings Summary 275 Technical Problems 276 Applied Problems 279 Mathematical Appendix: Empirical Elasticities 281 Data Appendix: Data for Checkers Pizza 282 Online Topic 1: Estimating and Forecasting Demand for Price-Taking Firms PART III PRODUCTION AND COST ANALYSIS 283 CHAPTER 8 Production and Cost in the Short Run Some General Concepts in Production and Cost 285 Production Functions 286 Technical Efficiency and Economic Efficiency 286 Variable and Fixed Inputs in Production 287 Short-Run and Long-Run Production Periods 288 Sunk Costs versus Avoidable Costs 290 Fixed or Variable Proportions Production in the Short Run 292 Total Product 292 Average and Marginal Products 293 Law of Diminishing Marginal Product 296 Changes in Fixed Inputs Short-Run Costs of Production 299 Short-Run Total Costs 300 Average and Marginal Costs 303 General Short-Run Average and Marginal Cost Curves Relations between Short-Run Costs and Production 306 Total Costs and the Short-Run Production Function 307 Average Variable Cost and Average Product 308 Marginal Cost and Marginal Product 309 The Graphical Relation between AVC, SMC, AP, and MP Summary 312 Technical Problems 312 Applied Problems 316 Mathematical Appendix: Short-Run Production and Cost Relations 317 Mathematical Exercises 319 CHAPTER 9 Production and Cost in the Long Run Production Isoquants 321 Characteristics of Isoquants 322 Marginal Rate of Technical Substitution 323 Relation of MRTS to Marginal Products Isocost Curves 325 Characteristics of Isocost Curves 325 Shifts in Isocost Curves Finding the Optimal Combination of Inputs 327 Production of a Given Output at Minimum Cost 328 The Marginal Product Approach to Cost Minimization 329 Production of Maximum Output with a Given Level of Cost Optimization and Cost 333 An Expansion Path" 333 The Expansion Path and the Structure of Cost Long-Run Costs 336 Derivation of Cost Schedules from a Production Function Forces Affecting Long-Run Costs 341 Economies and Diseconomies of Scale 341 Economies of Scope in Multiproduct Firms 346 Purchasing Economies of Scale 351 Learning or Experience Economies 352

5 Contents xvii 9.7 Relations between Short-Run and Long-Run Costs 355 Long-Run Average Cost as the Planning Horizon 356 Restructuring Short-Run Costs Summary 360 Technical Problems 361 Applied Problems 365 Mathematical Appendix: Production and Cost Relations with Two Variable Inputs 367 Mathematical Exercises 370 CHAPTER 10 Production and Cost Estimation Specification of the Short-Run Production Function Estimation of a Short-Run Production Function Short-Run Cost Estimation: Some Problems with Measuring Cost 378 Correcting Data for the Effects of Inflation 378 Problems Measuring Economic Cost Estimation of a Short-Run Cost Function 380 Estimation of Typical Short-Run Costs 380 Estimation of Short-Run Costs at Rockford Enterprises: An Example Summary 386 Technical Problems 386 Applied Problems 388 Mathematical Appendix: Empirical Production and Cost Relations 389 Mathematical Exercises Online Topic 2: Linear Programming PART IV PROFIT MAXIMIZATION IN VARIOUS MARKET STRUCTURES 397 CHAPTER 11 Managerial Decisions in Competitive Markets Characteristics of Perfect Competition Demand Facing a Price-Taking Firm Profit Maximization in the Short Run 403 The Output Decision: Earning Positive Economic Profit 404 The Output Decision: Operating at a Loss or Shutting Down 409 The Irrelevance of Sunk Costs, Fixed Costs, and Average Costs 413 Short-Run Supply for the Firm and Industry 415 Producer Surplus and Profit in Short-Run Competitive Equilibrium Profit Maximization in the Long Run 418 Profit-Maximizing Equilibrium for the Firm in the Long Run 418 Long-Run Competitive Equilibrium for the Industry 419 Long-Run Supply for a Perfectly Competitive Industry 421 Economic Rent and Producer Surplus in Long-Run Equilibrium Profit-Maximizing Input Usage 429 Marginal Revenue Product and the Hiring Decision 429 Average Revenue Product and the Shutdown Decision Implementing the Profit-Maximizing Output Decision 433 General Rules for Implementation 433 Profit Maximization at Beau Apparel: An Illustration Summary 441 Technical Problems 441 Applied Problems 447 Mathematical Appendix: Profit Maximization for Price-Taking Firms 450 CHAPTER 12 Managerial Decisions for Firms with Market Power Measurement of Market Power 455 Market Definition 456 Elasticity of Demand 456 The Lerner Index 457 Cross-Price Elasticity of Demand Barriers to Entry 458 Economies of Scale 459 Barriers Created by Government 459 Essential Input Barriers 462 Brand Loyalties 463 Consumer Lock-In 463 Network Externalities (or Network Effects) 464 Sunk Costs as a General Barrier to Entry Profit Maximization under Monopoly: Output and Pricing Decisions 467 Demand and Marginal Revenue for a Monopolist 468 Maximizing Profit at Southwest Leather Designs: An Example 469 Short-Run Equilibrium: Profit Maximization or Loss Minimization 471 Long-Run Equilibrium 474

6 xviii Contents 12.4 Profit-Maximizing Input Usage Monopolistic Competition 481 Short-Run Equilibrium 482 Long-Run Equilibrium Implementing the Profit-Maximizing Output and Pricing Decision 485 General Rules for Implementation 487 Maximizing Profit at Aztec Electronics: An Example Multiplant Firms 493 Multiplant Production at Mercantile Enterprises Summary 498 Technical Problems 499 Applied Problems 505 Mathematical Appendix: Profit Maximization for a Monopoly 508 CHAPTER 13 Strategic Decision Making in Oligopoly Markets Decision Making When Rivals Make Simultaneous Decisions 513 The Prisoners' Dilemma 516 Decisions with One Dominant Strategy 518 Successive Elimination of Dominated Strategies 520 Nash Equilibrium: Making Mutually Best Decisions 522 Super Bowl Advertising: An Example of Nash Equilibrium 524 Best-Response Curves and Continuous Decision Choices Strategy When Rivals Make Sequential Decisions 533 Making Sequential Decisions 533 First-Mover and Second-Mover Advantages 536 Strategic Moves: Commitments, Threats, and Promises Cooperation in Repeated Strategic Decisions 541 One-Time Prisoners' Dilemma Decisions 541 Punishment for Cheating in Repeated Decisions 543 Deciding to Cooperate 544 Trigger Strategies for Punishing Cheating 546 Pricing Practices That Facilitate Cooperation 547 Explicit Price-Fixing Agreements and Cartels 550 Tacit Collusion Strategic Entry Deterrence 555 Limit Pricing 555 Capacity Expansion as a Barrier to Entry Summary 561 Technical Problems 562 Applied Problems 566 Mathematical Appendix: Derivation of Best- Response Curves for Continuous Simultaneous Decisions 570 Mathematical Exercises 573 PARTV ADVANCED TOPICS IN MANAGERIAL ECONOMICS 575 CHAPTER 14 Advanced Pricing Techniques Price Discrimination: Capturing Consumer Surplus 577 The Trouble with Uniform Pricing 577 Types of Price Discrimination 579 Conditions for Profitable Price Discrimination First-Degree (or Perfect) Price Discrimination Second-Degree Price Discrimination Methods 583 Two-Part Pricing 585 Declining Block Pricing Third-Degree Price Discrimination 595 Allocation of Sales in Two Markets to Maximize Revenue 595 Profit Maximization with Third-Degree Price Discrimination Pricing Practices for Multiproduct Firms 603 Pricing Multiple Products Related in Consumption 604 Bundling Multiple Products Cost-Pius Pricing 610 Practical and Conceptual Shortcomings Summary 615 Technical Problems 615 Applied Problems 618 Mathematical Appendix: Two-Part Pricing with Two Identical Groups of Buyers 622 Online Topic 3: Pricing Multiple Products Related in Production CHAPTER 15 Decisions Under Risk and Uncertainty Distinctions between Risk and Uncertainty Measuring Risk with Probability Distributions 626 Probability Distributions 626 Expected Value of a Probability Distribution 627 Dispersion of a Probability Distribution Decisions under Risk 631 Maximization of Expected Value 631 Mean-Variance Analysis 633 Coefficient of Variation Analysis 634 Which Rule Is Best? Expected Utility: A Theory of Decision Making under Risk 636 A Manager's Utility Function for Profit 637 Deriving a Utility Function for Profit 639 Maximization of Expected Utility 641

7 Contents xix 15.5 Decisions under Uncertainty 644 The Maximax Criterion 644 The Maximin Criterion 646 The Minimax Regret Criterion 646 The Equal Probability Criterion Summary 647 Technical Problems 648 Applied Problems 651 Mathematical Appendix: Decisions under Risk 652 CHAPTER 16 Government Regulation of Business Market Competition and Social Economic Efficiency 654 Efficiency Conditions for Society 655 Social Economic Efficiency under Perfect Competition Market Failure and the Case for Government Intervention Market Power and Public Policy 661 Market Power and Allocative Inefficiency 661 Market Power and Deadweight Loss 662 Promoting Competition through Antitrust Policy 663 Natural Monoploy and Market Failure 665 Regulating Price under Natural Monoploy The Problem of Negative Externality 670 Pollution: Market Failure and Regulation Nonexcludability 680 Common Property Resources 680 Public Goods Information and Market Failure 684 Imperfect Information about Prices 684 Imperfect Information about Product Quality 685 Information as a Public Good Summary 688 Technical Problems 689 Applied Problems 695 Online Topic 4: The Investment Decision APPENDIX: STATISTICAL TABLES 697 ANSWERS TO TECHNICAL PROBLEMS 701 INDEX 734