MANAGERIAL ECONOMICS THEORY, APPLICATIONS, AND CASES EIGHTH EDITION W.Bruce Allen The Wharton School University of Pennsylvania Neil A. Doherty The Wharton School University of Pennsylvania Keith Weigelt The Wharton School University of Pennsylvania Edwin Mansfield late of University of Pennsylvania W. W. NORTON & COMPANY NEW YORK LONDON
PREFACE xix PART 1: THE NEED FOR A GUIDE CHAPTER 1 INTRODUCTION 2 3 The Theory of the Firm 5 What is Profit? 6 Reasons for the Existence of Profit 6 Managerial Interests and the Principal-Agent Problem 7 Demand and Supply: A First Look 11 The Demand Side of a Market 13 The Supply Side of a Market 1 4 Equilibrium Price 15 Actual Price 17 What If the Demand Curve Shifts? 18 What If the Supply Curve Shifts? 20 Summary 21 Problems 24 Excel Exercise: Demand, Supply, and Market Equilibrium PART 2: THE NATURE OF MARKETS 27 CHAPTER 2 DEMAND THEORY 28 29 The Market Demand Curve 33 Industry and Firm Demand Functions 36 The Own-Price Elasticity of Demand 39 Point and Arc Elasticities 40 Using the Demand Function to Calculate the Price Elasticity of Demand 4 1 The Effect of Price Elasticity on the Firm's Revenue 43 Funding Public Transit 44 Determinants of the Own-Price Elasticity of Demand 45 The Strategic Use of the Price Elasticity of Demand
48 Total Revenue, Marginal Revenue, and Price Elasticity 53 The Income Elasticity of Demand 55 Cross-Price Elasticities of Demand 57 The Advertising Elasticity of Demand 59 The Constant-Elasticity and Unitary Elastic Demand Function 60 Summary 61 Problems CHAPTER 3 CONSUMER BEHAVIOR AND RATIONAL CHOICE 66 Indifference Curves 68 The Marginal Rate of Substitution 69 The Concept of Utility 70 The Budget Line 73 The Equilibrium Market Bundle 76 Maximizing Utility: A Closer Look 76 Corner Solutions 79 How Managers Can Strategically Influence Consumer Choices 84 Deriving the Individual Demand Curve 88 Deriving the Market Demand Curve 90 Consumer Surplus 92 Summary 93 Problems 65 CHAPTER 4 ESTIMATING DEMAND FUNCTIONS 97 97 The Identification Problem 100 Consumer Interviews 101 Market Experiments 101 Regression Analysis 103 Simple Regression Model 105 Sample Regression Line 106 Method of Least Squares 10 9 Coefficient of Determination 109 Multiple Regression 113 Software Packages and Computer Printouts 114 Interpreting the Output of Statistical Software 118 Multicollinearity 119 Serial Correlation 120 Further Analysis of the Residuals
123 Summary 125 Problems 131 Appendix: The Coefficient of Determination and the Concept of Explained Variation PART 3: PRODUCTION AND COST 135 CHAPTER 5 PRODUCTION THEORY 136 137 The Production Function with One Variable Input 143 The Law of Diminishing Marginal Returns 143 The Production Function with Two Variable Inputs 146 Isoquants 149 The Marginal Rate of Technical Substitution 152 The Optimal Combination of Inputs 156 Corner Solutions 156 Returns to Scale 160 The Output Elasticity 161 Estimations of Production Functions 165 Summary 165 Problems 168 Appendix: Lagrangian Multipliers and Optimal Input Combinations CHAPTER 6 THE ANALYSIS OF COSTS 172 173 Opportunity Costs 174 Short-Run Cost Functions 177 Average and Marginal Costs 184 Long-Run Cost Functions 189 Managerial Use of Scale Economies 191 Managerial Use of Scope Economies 194 Transactions Costs Can Take Many Forms 198 Network Economies 201 Managerial Use of Break-Even Analysis 203 Profit Contribution Analysis 204 Summary 205 Problems 209 Excel Exercise: Production and Cost 211 Appendix A: Break-Even Analysis and Operating Leverage 214 Appendix B: Measurement of Short-Run Cost Functions: The Choice of a Mathematical Form
PART 4: MARKET STRUCTURE AND SIMPLE PRICING STRATEGIES 223 CHAPTER 7 PERFECT COMPETITION 224 225 Market Structure 227 Market Price in Perfect Competition 229 Shifts in Supply and Demand Curves 229 The Output Decision of a Perfectly Competitive Firm 234 Setting the Marginal Cost Equal to the Price 240 Another Way of Viewing the Price Equals Marginal Cost Profit-Maximizing Rule 242 Producer Surplus in the Short Run 245 Long-Run Equilibrium of the Firm 247 The Long-Run Adjustment Process: A Constant-Cost Industry 249 The Long-Run Adjustment Process: An Increasing-Cost Industry 251 How a Perfectly Competitive Economy Allocates Resources 252 Summary 252 Problems 254 Excel Exercise: Perfect Competition CHAPTER 8 MONOPOLY AND MONOPOLISTIC COMPETITION 257 259 Pricing and Output Decisions in Monopoly 267 Cost-Pius Pricing 269 Cost-Pius Pricing at Therma-Stent 269 Cost-Pius Pricing at Internet Companies and Government-Regulated Industries 271 Can Cost-Plus Pricing Maximize Profit? 273 The Multiple-Product Firm: Demand Interrelationships 274 Pricing of Joint Products: Fixed Proportions 277 Output of Joint Products: Variable Proportions 281 Monopsony 282 Monopolistic Competition 285 Advertising Expenditures: A Simple Rule 287 Using Graphs to Help Determine Advertising Expenditure 288 Advertising, Price Elasticity, and Brand Equity: Evidence on Managerial Behavior 289 Summary 290 Problems 294 Excel Exercise: Simple Monopoly 298 Appendix: Allocation of Output among Plants
PART 5: SOPHISTICATED MARKET PRICING 303 CHAPTER 9 MANAGERIAL USE OF PRICE DISCRIMINATION 304 305 Motivation for Price Discrimination 306 Price Discrimination 318 Using Coupons and Rebates for Price Discrimination 319 Peak Load Pricing 324 Two-Part Tariffs 339 Summary 340 Problems 344 Excel Exercise: Perfect Price Discrimination 346 Excel Exercise: Third-Degree Price Discrimination 3 51 Appendix: Two-Part Tariff with Intersecting Demands CHAPTER 10 BUNDLING AND INTRAFIRM PRICING 357 358 The Mechanics of Bundling 377 When to Unbundle 381 Bundling as a Preemptive Entry Strategy 386 Tying at IBM, Xerox, and Microsoft 388 Transfer Pricing 392 Transfer Pricing: A Perfectly Competitive Market for the Upstream Product 395 The Global Use of Transfer Pricing 398 Summary 399 Problems 403 Excel Exercise: Transfer Pricing PART 6: THE STRATEGIC WORLD OF MANAGERS 409 CHAPTER 11 OLIGOPOLY 410 411 Cooperative Behavior 413 The Breakdown of Collusive Agreements 414 Price Leadership 417 Possible Behavior in Markets with Few Rivals 435 Duopolists and Price Competition with Differentiated Products 439 The Sticky Pricing of Managers 440 Summary 441 Problems 447 Excel Exercise: Dominant Firm Price Leader
449 Excel Exercise: Cournot 457 Excel Exercise: Stackelberg CHAPTER 12 460 461 463 467 467 468 472 479 483 485 487 489 493 494 495 498 CHAPTER 13 502 504 505 507 510 515 518 519 520 522 523 524 526 GAME THEORY 460 Making Strategy and Game Theory Strategy Basics Visual Representation Solution Concepts Equilibria Dominant Strategies The Nash Equilibrium Strategic Foresight: The Use of Backward Induction Repeated Games Incomplete Information Games Reputation Building Coordination Games Strictly Competitive Games Summary Problems Excel Exercise: Game Theory AUCTIONS 501 A Short History of Auctions Types of Auction Mechanisms Auction Mechanism and Revenue Generation Bidding Strategies Strategies for Sellers Value of Information Risk Aversion Number of Bidders Winner's Curse Concerns in Auction Design Summary Problems Excel Exercise: Auctions PART 7: RISK, UNCERTAINTY, AND INCENTIVES 531 CHAPTER 14 RISK ANALYSIS 532 533 Risk and Probability 536 Probability Distributions and Expected Values
537 Comparisons of Expected Profit 538 Road Map to Decision 540 The Expected Value of Perfect Information 542 Measuring Attitudes toward Risk: The Utility Approach 548 Attitudes toward Risk: Three Types 551 The Standard Deviation and Coefficient of Variation: Measures of Risk 553 Adjusting the Valuation Model for Risk 554 Certainty Equivalence and the Market for Insurance 557 Summary 558 Problems 562 Excel Exercise: Expected Utility CHAPTER 15 PRINCIPAL-AGENT ISSUES AND MANAGERIAL COMPENSATION 567 567 Principal-Agent Issues 569 The Diverging Paths of Owners and Managers 570 The Principal-Agent Situation 572 The Effect of Risk, Information, and Compensation on Principal-Agent Issues 581 Resolving the Incentive Conflict When Output Is Risky and Effort Is Not Observable 589 Some Refinements to Managerial Compensation 594 Principal-Agent Issues in Other Contexts 607 Product Liability and the Safety of Consumer Goods 612 Summary 613 Problems 616 Excel Exercise: Moral Hazard CHAPTER 16 ADVERSE SELECTION 619 620 The Market for "Lemons" 622 Adverse Selection in Automobile Insurance 627 The Market for Annuities 634 Resolving Adverse Selection through Self-Selection 639 Using Education as a Signal: Adverse Selection in the Job Market 640 Using Warranties as Signals: Adverse Selection in the Product Market 648 Summary 648 Problems 650 Excel Exercise: Adverse Selection
PART 8: GOVERNMENT ACTIONS AND MANAGERIAL BEHAVIOR 655 CHAPTER 17 GOVERNMENT AND BUSINESS 656 658 Competition versus Monopoly 660 Regulation of Monopoly 664 The One Star Gas Company: A Pseudo-Case Study 666 Effects of Regulation on Efficiency 667 The Concentration of Economic Power 674 The Sherman Act 676 The Clayton Act, the Robinson-Patman Act, and the Federal Trade Commission Act 677 Interpretation of the Antitrust Laws 680 The Patent System 682 Trade and Trade Policy 698 Government Price Ceilings and Price Floors 702 The Welfare Impacts of Taxes 703 Regulation of Environmental Pollution 714 Public Goods 720 Summary 721 Problems 725 Excel Exercise: Externalities CHAPTER 18 OPTIMIZATION TECHNIQUES 728 728 Functional Relationships 729 Marginal Analysis 731 Relationships among Total, Marginal, and Average Values 734 The Concept of a Derivative 738 How to Find a Derivative 744 Using Derivatives to Solve Maximization and Minimization Problems 748 Marginal Cost Equals Marginal Revenue and the Calculus of Optimization 750 Partial Differentiation and the Maximization of Multivariable Functions 752 Constrained Optimization 754 Lagrangian Multipliers 756 Comparing Incremental Costs with Incremental Revenues 758 Summary 758 Problems
APPENDIX A TECHNOLOGICAL CHANGE AND INDUSTRIAL INNOVATION 763 763 Technological Change 765 Labor Productivity 766 Total Factor Productivity 767 Using Total Factor Productivity to Track Factory Performance 769 Research and Development: A Learning Process 770 Parallel Development Efforts 771 What Makes for Success? 772 Project Selection 774 Innovation 774 Time-Cost Trade-Offs 777 The Learning Curve 777 Applications of the Learning Curve 779 Henry Ford's Model T and Douglas Aircraft's DC-9 780 Diffusion Models 782 Forecasting the Rate of Diffusion of Numerically Controlled Machine Tools 785 Summary 786 Problems APPENDIX B BUSINESS AND ECONOMIC FORECASTING 791 792 Survey Techniques 793 Taking Apart a Time Series 795 How to Estimate a Linear Trend 797 How to Estimate a Nonlinear Trend 798 Seasonal Variation 799 Calculation of Seasonal Variation 802 Cyclical Variation 804 Elementary Forecasting Techniques 806 How Leading Indicators are Used 807 How Econometric Models are Used 809 The Purvere Corporation: A Numerical Example 810 "Study Your Residuals" 812 Summary 813 Problems 817 Appendix: Exponential Smoothing and Forecasting
APPENDIX C DISCOUNTING AND PRESENT VALUES 821 823 Present Value of a Series of Payments 824 The Use of Periods Other Than a Year 826 Determining the Internal Rate of Return APPENDIX D PROBLEMS 829 ANSWERS TO SELECT END-OF-CHAPTER APPENDIX E TABLES 861 INDEX 877