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INSTRUCTOR’S MANUALManagerial EconomicsEIGHTH al-Economics-8th-edition-by-W-Bruce-Allen


INSTRUCTOR’S MANUALManagerialEconomicsEIGHTH EDITIONW. Bruce Allen Neil A. Doherty Keith Weigelt Edwin MansfieldJean CupidonTEXAS TECH UNIVERSITYBW W NORTON & COMPANY NEW YORK l-Economics-8th-edition-by-W-Bruce-Allen

W. W. Norton & Company has been independent since its founding in 1923, when William WarderNorton and Mary D. Herter Norton first published lectures delivered at the People’s Institute, theadult education division of New York City’s Cooper Union. The fi rm soon expanded its programbeyond the Institute, publishing books by celebrated academics from America and abroad. Bymidcentury, the two major pillars of Norton’s publishing program—trade books and college texts—were firmly established. In the 1950s, the Norton family transferred control of the company to itsemployees, and today—with a staff of four hundred and a comparable number of trade, college, andprofessional titles published each year—W. W. Norton & Company stands as the largest and oldestpublishing house owned wholly by its employees.Copyright 2013 by W. W. Norton & Company, Inc.All rights reserved.Printed in the United States of America.Associate media editor: Nicole SawaProduction manager: Ben ReynoldsComposition by Westchester Publishing Ser vicesManufacturing by Sterling PierceISBN 978- 0-393-92049-9W. W. Norton & Company, Inc.500 Fifth Avenue, New York, N.Y. 10110- 0017wwnorton.comW. W. Norton & Company Ltd.Castle House, 75/76 Wells Street, London W1T 3QT1 2 3 4 5 6 7 8 9 nomics-8th-edition-by-W-Bruce-Allen

CONTENTSPART 1: THE NEED FOR A GUIDEChapter 1 Introduction1PART 2: THE NATURE OF MARKETSChapter 2 Demand Theory13Chapter 3 Consumer Behavior and Rational Choice31Chapter 4 Estimating Demand Functions51PART 3: PRODUCTION AND COSTChapter 5 Production Theory70Chapter 6 The Analysis of Costs86PART 4: MARKET STRUCTURE ANDSIMPLE PRICING STRATEGIESChapter 7 Perfect Competition103Chapter 8 Monopoly and Monopolistic Competition115PART 5: SOPHISTICATED MARKET PRICINGChapter 9 Managerial Use of Price DiscriminationChapter 10 Bundling and Intrafirm al-Economics-8th-edition-by-W-Bruce-Allen133153v

vi ContentsPART 6: THE STRATEGIC WORLD OF MANAGERSChapter 11 Oligopoly169Chapter 12 Game Theory188Chapter 13 Auctions206PART 7: RISK, UNCERTAINTY, AND INCENTIVESChapter 14 Risk Analysis220Chapter 15 Principal–Agent Issues and Managerial Compensation 239Chapter 16 Adverse Selection258PART 8: GOVERNMENT ACTIONS ANDMANAGERIAL BEHAVIORChapter 17 Government and Business271Chapter 18 Optimization nagerial-Economics-8th-edition-by-W-Bruce-Allen

CHAPTER 1IntroductionLecture Notes1. Introduction Objectivesÿ To provide a guide to making good managerial decisionsÿ To use formal models to analyze the effects of managerial decisionson measures of a firm’s successManagerial Economics versus Microeconomicsÿ Managerial economics differs from microeconomics in that microeconomics focuses on description and prediction while managerial economics is prescriptive.ÿ Managerial economics prescribes behavior, whereas microeconomicsdescribes the environment.ÿ Managerial economics is an integrative course that brings the variousfunctional areas of business together in a single analytical framework.ÿ Managerial economics exhibits economies of scope by integratingmaterial from other disciplines and thereby reinforcing and enhancingunderstanding of those subjects.2. The Theory of the Firm Managerial Objectiveÿ To make choices that will increase the value of the firmÿ Managers in profit-oriented organizations try to increase the net present value of expected future cash flows.ÿ The value of the firm is defined as the present value of future ial-Economics-8th-edition-by-W-Bruce-Allen1

2 Chapter 1 n 2ÿ Present value of 1 expected future profits 1 i (1 i ) 2(1 i ) nÿ More compactly, we write:n tÿ Present value of expected future profits t 1 (1 i)t ÿ Given that profit total revenue total cost, then we write:nTRt TCtÿ Present value of expected future profits t 1 (1 i)tÿ NotationProfit in time t Total Revenue in time t Total Cost in* pttime tInterest rate* inNumber of time periods*TRTotal Revenue in time t*tTCTotal Cost in time t*tManagerial Choicesÿ Influence total revenue by managing demandÿ Influence total cost by managing productionÿ Influence the relevant interest rate by managing finances and riskManagerial Constraintsÿ Environmental and antitrust lawsÿ Resource scarcityÿ Legal or contractual limitations STRATEGY SESSION:Bono Sees Red, and Corporate Profits See BlackDiscussion Questions1. How can a firm assess the benefits and costs of cause marketing?2. What other examples of cause marketing can you identify?3. What Is Profit? Two Measures of Profitÿ Accounting profit* Historical costs, legal compliance, reporting requirements* The accountant is concerned with controlling the firm’s day-today operations, detecting fraud and embezzlement, satisfying taxand other laws, and producing records for various interestedgroupsÿ Economic profit* Market value; opportunity, or implicit Economics-8th-edition-by-W-Bruce-Allen

Introduction 3**The economist is concerned with decision making, rational choiceamong strategiesA more useful measure for managerial decision making4. Reasons for the Existence of Profit Profitÿ Measures the quality of managers’ decision-making skillsÿ Encourages good management decisions by linkage with incentivesSources of Profit: Three profit-generating areasÿ Innovation: Producing products that are better than existing productsin terms of functionality, technology, and styleÿ Risk taking: Future outcomes and their likelihoods are unknown, asare the reactions of rivals.ÿ Market power: Managers also earn profit by exploiting market inefficiencies. Common tactics include* building barriers to entry* employing sophisticated pricing strategies* diversification efforts* making good strategic production decisions5. Managerial Interests and the Principal–Agent Problem Principal–Agent Problemÿ The interests of a firm’s owners and those of its managers may differ,unless the manager is the owner.ÿ Separation of ownership and control* The principals are the owners. They want managers to maximizethe value of the firm.* The agents are the managers. They want more compensation andless accountability. Because the firm’s owners find it difficult toadequately distinguish between actions that maximize profitsand those that do not, managers have incentives to enrichthemselves.* The divergence in goals is the principal–agent problem.* To deal with this problem, owners (the principals) oftenuse contracts to converge their preferences and those of theiragents.* Moral hazard exists when a person behaves differently when heor she is not subject to the risks associated with his or herbehavior.* Managers who do not maximize the value of the firm may do sobecause they do not suffer as a result of their rial-Economics-8th-edition-by-W-Bruce-Allen

4 Chapter 1ÿ Solutions* Devise methods that lead to convergence of the interests of thefirm’s owners and its managers.* Examples: Stock option plans or bonuses linked to profits6. Demand and Supply: A First Look Marketÿ A group of firms and individuals that interact with each other to buy orsell a productÿ Part of an economy’s infrastructureÿ A social institution that exists to facilitate economic exchangeÿ Relies on binding, enforceable contractsSTRATEGY SESSION:Baseball Discovers the Law of Supply and DemandDiscussion Questions1. Do you see a relationship between variable pricing of baseball game tickets and odds-making on horse races?2. How do you think real-time variable pricing would influence the practiceof ticket scalping?7. The Demand Side of a Market Demand Curveÿ It shows managers how many units they sell at a given price, holdingother possible influences constant.ÿ It is negatively sloped.ÿ It pertains to a par ticular period of time.Other influences on demand decisions include* consumer income* prices of substitutes and complements* advertising expenditures* product quality* government fiatTotal Revenue Functionÿ A firm’s total revenue (TR) for a given time period is equal to the pricecharged (P) times the quantity sold (Q) during that time period.ÿ TR P Qÿ The demand function reflects the effect of changes in P on quantitydemanded (Q) per time period and, hence, the effect of changes in Pon conomics-8th-edition-by-W-Bruce-Allen

Introduction 58. The Supply Side of a Market Supply side is represented by a market supply curve.ÿ The market supply curve shows how many units of a commodity sellers will offer at any price.ÿ It is positively sloped.ÿ It pertains to a par ticular period of time.ÿ Decreases in the cost of inputs (labor, capital, land) or technologicalprogress cause supply curves to shift to the right.9. Equilibrium Price Disequilibriumÿ Price is too high.* Excess supply or surplus* Causes price to fallÿ Price is too low.* Excess demand or shortage* Causes price to riseEquilibrium Priceÿ A situation in which quantity demanded is equal to quantity suppliedÿ Price is sustainable.ÿ The market is in balance because everyone who wants to purchase thegood can, and every seller who wants to sell the good can.10. Actual Price The price that is of interest to the managerInvisible hand: When no governmental agency is needed to induce producers to drop or increase their pricesIf the actual price is above the equilibrium price, there will be a surplusthat will put downward pressure on the actual price.If the actual price is below the equilibrium price, there will be a shortagethat will put upward pressure on the actual price.If the actual price is equal to the equilibrium price, then there will be neither a shortage nor a surplus and the market is said to be in equilibrium.11. What If the Demand Curve Shifts? Demand and supply curves are not static. They shift in reaction to changesin the environment.Increase in Demandÿ Represented by a rightward or upward shift in the demand -Economics-8th-edition-by-W-Bruce-Allen

6 Chapter 1 ÿ Result of a change that makes buyers willing to purchase a largerquantity of a good at the current price and/or to pay a higher price forthe current quantityÿ Will create a shortage and cause the equilibrium price to increaseDecrease in Demandÿ Represented by a leftward or downward shift in the demand curveÿ Result of a change that makes buyers purchase a smaller quantity of agood at the current price and/or continue to buy the current quantityonly if the price is reducedÿ Will create a surplus and cause the equilibrium price to decrease12. What If the Supply Curve Shifts? Increase in Supplyÿ May be caused by technological advancesÿ Represented by a rightward or downward shift in the supply curveÿ Result of a change that makes sellers willing to offer a larger quantityof a good at the current price and/or to offer the current quantity at alower priceÿ Will create a surplus and cause the equilibrium price to decreaseDecrease in Supplyÿ Represented by a leftward or upward shift in the supply curveÿ Result of a change that makes sellers willing to offer a smaller quantity of a good at the current price and/or to offer the current quantity ata higher priceÿ Will create a shortage and cause the equilibrium price to increaseSTRATEGY SESSION:Life During a Market MovementDiscussion Questions1. Several factors are mentioned as contributing to disequilibrium in globalfood markets. Among them are emotions (panic), government restrictions on trade, the Malthusian specter of population growth outpacingfood production, slowing productivity growth in the agricultural sector,rising incomes, and the production of ethanol. Which of these are supplyfactors and which are demand factors? How does each influence marketprice?2. The market price for crude oil fluctuated widely during 2008. What supply and demand factors contributed to these fluctuations? Is the petroleummarket subject to any of the same factors cited as influencing llen

Introduction 7Chapter 1: Problem Solutions1. A book is to be written by Britney Spears. Batman Books agrees to payBritney 6 million for the rights to this not-yet-written memoir. Accordingto one leading publisher, Batman Books could earn a profit of roughly 1.2million if it sold 625,000 copies in hardcover. On the other hand, if it sold375,000 copies, managers would lose about 1.3 million. Publishing executives stated that it was hard to sell more than 500,000 copies of a nonfictionhardcover book, and very exceptional to sell 1 million copies. Were Batmanmanagers taking a substantial risk in publishing this book?Solution:There was a substantial risk of loss. On the other hand, there was substantialopportunity for gain. Risk is often unavoidable. The appropriate balancebetween risk and return is what should determine managers’ decisions. Successful decisions in circumstances of risk are a source of profit.2. Some say that any self-respecting top manager joining a company does sowith a front-end signing bonus. In many cases this bonus is in the seven figures. At the same time the entering manager may be given a bonus guarantee. No matter what happens to firm profit, he or she gets at least a percentageof that bonus. Do long-term bonus guarantees help to solve the principal–agent problem, or do they exacerbate it? Why?Solution:An executive who spends a lifetime working for a single company or ina single industry has a poorly diversified human capital portfolio. Such anexecutive also often has a significant, undiversified financial investmentin the form of stock options and pension plans that are used in partial substitution for current salary to align the long-term wealth of the executive withthat of the shareholders. As an executive climbs the corporate ladder, thevalue of his or her human capital becomes more closely tied to the fortunes ofthe firm and industry. This lack of diversification requires a compensating riskpremium. A large signing bonus may allow a risk-averse executive to makean investment, which increases the value of the firm but which the executivewould otherwise avoid because of concern for his or her own personal wealth;thus the bonus may reduce the principal–agent conflict. Of course the benefits of reduced risk to the executive come at the potential cost of indifferenceto the wealth of the shareholders. Although a large signing bonus may helpsolve the incentive alignment problem, compensation that is too great andtoo insensitive to the fortunes of the shareholders makes the principal–agentproblem l-Economics-8th-edition-by-W-Bruce-Allen

8 Chapter 13. If the interest rate is 10%, what is the present value of the Monroe Corporation’s profit in the next 10 years?Number of Yearsin the FutureProfit(millions of dollars)123456789108101214151617151310Solution:Use formula (1.1) for t 1, 2, . . . , 10 to obtain the following table:Number of Yearsin the FutureProfit(millions of dollars)(1 i) 4Present Value(millions of 031528.723726.997655.513303.8554077.55047The answer is 77.55047 million.4. Managers at Du Pont de Nemours and Company expect a profit of 2.9 billion in 2012. Does this mean that Du Pont’s expected economic profit willequal 2.9 billion? Why or why not?Solution:Economic profits differ from accounting profits because of differences inthe way depreciation is measured, differences in the way revenues andcosts are recognized in terms of timing, and the inclusion of the opportunity cost of owner-supplied inputs in the calculation of economic ial-Economics-8th-edition-by-W-Bruce-Allen

Introduction 9Du Pont’s economic profits might well be negative if accounting profits donot exceed the risk-adjusted rate of return multiplied by the firm’s equityvalue.5. William Howe must decide whether to start a business renting beach umbrellas at an ocean resort during June, July, and August of next summer. Hebelieves he can rent each umbrella to vacationers at 5 a day, and he intendsto lease 50 umbrellas for the three-month period for 3,000. To operate thisbusiness, he does not have to hire anyone (but himself), and he has noexpenses other than the leasing costs and a fee of 3,000 per month to rentthe business location. Howe is a college student, and if he did not operatethis business, he could earn 4,000 for the three-month period doing construction work.a. If there are 80 days during the summer when beach umbrellas aredemanded and Howe rents all 50 of his umbrellas on each of these days,what will be his accounting profit for the summer?b. What will be his economic profit for the summer?Solution:a. TR (80 days) (50 umbrellas) ( 5 per day) 20,000TC (3 months) ( 3,000 per month rent) ( 3,000 umbrella lease) 12,000Accounting Profit TR TC 8,000b. Economic Profit Accounting Profit Opportunity CostEconomic Profit 8,000 4,000 4,0006. On March 3, 2008, a revival of Gypsy, the Stephen Sondheim musical,opened at the St. James Theater in New York. Ticket prices ranged from 117 to 42 per seat. The show’s weekly gross revenues, operating costs, andprofit were estimated as follows, depending on whether the average ticketprice was 75 or 65:Gross revenuesOperating costsProfitAverage Priceof 75Average Priceof 65 765,000600,000165,000 680,000600,00080,000a. With a cast of 71 people, a 30-piece orchestra, and more than 500 costumes, Gypsy cost more than 10 million to stage. This investment wasin addition to the operating costs (such as salaries and theater rent).How many weeks would it take before the investors got their moneyback, according to these estimates, if the average price was 65? If itwas conomics-8th-edition-by-W-Bruce-Allen

10 Chapter 1b. George Wachtel, director of research for the League of American Theaters and Producers, has said that about one in three shows opening onBroadway in recent years has at least broken even. Were the investors inGypsy taking a substantial risk?c. According to one Broadway producer, “Broadway isn’t where you makethe money any more. It’s where you establish the project so you can makethe money. When you mount a show now, you really have to think aboutwhere it’s going to play later.” If so, should the profit figures here beinterpreted with caution?d. If the investors in this revival of Gypsy make a profit, will this profit be,at least in part, a reward for bearing risk?Solution:a. Given a price of 75, the weekly operating profit of 165,000 wouldpay off the 10 million investment in 10,000/165 60.6 or 61 weeks.If the price is 65, it would take 10,000/80 125 weeks to pay off theinvestment. This does not provide for any return on investment,however.b. The investors in Gypsy were indeed taking a substantial risk. If only onein three shows breaks even, two out of three make losses.c. The profit figu

ÿ Managerial economics differs from microeconomics in that microeco-nomics focuses on description and prediction while managerial eco-nomics is prescriptive. ÿ Managerial economics prescribes behavior, whereas microeconomics describes the environment. ÿ Managerial economics is an integrative course that brings the various

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