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Managerial Economics: Theory, Applications, And Cases, 8th Edition Solution Manual

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    Managerial Economics EIGHTH EDITION W. Bruce Allen • Neil A. Doherty • Keith Weigelt • Edwin Mansfield Jean Cupidon TEXAS TECH UNIVERSITY ’S MANUAL

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    v PART 1: THE NEED FOR A GUIDE Chapter 1 | Introduction 1 PART 2: THE NATURE OF MARKETS Chapter 2 | Demand Theory 13 Chapter 3 | Consumer Behavior and Rational Choice 31 Chapter 4 | Estimating Demand Functions 51 PART 3: PRODUCTION AND COST Chapter 5 | Production Theory 70 Chapter 6 | The Analysis of Costs 86 PART 4: MARKET STRUCTURE AND SIMPLE PRICING STRATEGIES Chapter 7 | Perfect Competition 103 Chapter 8 | Monopoly and Monopolistic Competition 115 PART 5: SOPHISTICATED MARKET PRICING Chapter 9 | Managerial Use of Price Discrimination 133 Chapter 10 | Bundling and Intrafi rm Pricing 153 CONTENTS

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    PART 6: THE STRATEGIC WORLD OF MANAGERS Chapter 11 | Oligopoly 169 Chapter 12 | Game Theory 188 Chapter 13 | Auctions 206 PART 7: RISK, UNCERTAINTY, AND INCENTIVES Chapter 14 | Risk Analysis 220 Chapter 15 | Principal– Agent Issues and Managerial Compensation 239 Chapter 16 | Adverse Selection 258 PART 8: GOVERNMENT ACTIONS AND MANAGERIAL BEHAVIOR Chapter 17 | Government and Business 271 Chapter 18 | Optimization Techniques 293 vi | Contents

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    1 Lecture Notes 1. Introduction • Objectives ÿ To provide a guide to making good managerial decisions ÿ To use formal models to analyze the effects of managerial decisions on measures of a firm’s success • Managerial Economics versus Microeconomics 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 functional areas of business together in a single analytical frame- work. ÿ Managerial economics exhibits economies of scope by integrating material from other disciplines and thereby reinforcing and enhancing understanding of those subjects. 2. The Theory of the Firm • Managerial Objective ÿ To make choices that will increase the value of the firm ÿ Managers in profit-oriented organizations try to increase the net pres- ent value of expected future cash flows. ÿ The value of the firm is defined as the present value of future profits: Introduction CHAPTER 1

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    2 | Chapter 1 ÿ Present value of expected future profits + + + + + + $ = 1 (1 ) (1 ) 1 2 2 i i i n n    ÿ More compactly, we write: ÿ Present value of expected future profits ∑ = + = (1 ) 1 i t t t n  ÿ Given that profit  total revenue  total cost, then we write: ÿ Present value of expected future profits (1 ) 1 TR TC i t t t t n ∑ = − + = ÿ Notation * p t Profit in time t  Total Revenue in time t  Total Cost in time t * i Interest rate * n Number of time periods * TR t Total Revenue in time t * TC t Total Cost in time t • Managerial Choices ÿ Influence total revenue by managing demand ÿ Influence total cost by managing production ÿ Influence the relevant interest rate by managing finances and risk • Managerial Constraints ÿ Environmental and antitrust laws ÿ Resource scarcity ÿ Legal or contractual limitations STRATEGY SESSION: Bono Sees Red, and Corporate Profits See Black Discussion Questions 1. 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 Profit ÿ Accounting profit * Historical costs, legal compliance, reporting requirements * The accountant is concerned with controlling the firm’s day-to- day operations, detecting fraud and embezzlement, satisfying tax and other laws, and producing records for various interested groups ÿ Economic profit * Market value; opportunity, or implicit cost

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    Introduction | 3 * The economist is concerned with decision making, rational choice among strategies * A more useful measure for managerial decision making 4. Reasons for the Existence of Profit • Profit ÿ Measures the quality of managers’ decision-making skills ÿ Encourages good management decisions by linkage with incentives • Sources of Profit: Three profit-generating areas ÿ Innovation: Producing products that are better than existing products in terms of functionality, technology, and style ÿ Risk taking: Future outcomes and their likelihoods are unknown, as are the reactions of rivals. ÿ Market power: Managers also earn profit by exploiting market ineffi- ciencies. Common tactics include * building barriers to entry * employing sophisticated pricing strategies * diversification efforts * making good strategic production decisions 5. Managerial Interests and the Principal–Agent Problem • Principal–Agent Problem ÿ 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 maximize the value of the firm. * The agents are the managers. They want more compensation and less accountability. Because the firm’s owners find it difficult to adequately distinguish between actions that maximize profits and those that do not, managers have incentives to enrich themselves. * The divergence in goals is the principal–agent problem. * To deal with this problem, owners (the principals) often use contracts to converge their preferences and those of their agents. * Moral hazard exists when a person behaves differently when he or she is not subject to the risks associated with his or her behavior. * Managers who do not maximize the value of the firm may do so because they do not suffer as a result of their behavior.

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    4 | Chapter 1 ÿ Solutions * Devise methods that lead to convergence of the interests of the firm’s own ers and its managers. * Examples: Stock option plans or bonuses linked to profits 6. Demand and Supply: A First Look • Market ÿ A group of firms and individuals that interact with each other to buy or sell a product ÿ Part of an economy’s infrastructure ÿ A social institution that exists to facilitate economic exchange ÿ Relies on binding, enforceable contracts STRATEGY SESSION: Baseball Discovers the Law of Supply and Demand Discussion Questions 1. Do you see a relationship between variable pricing of baseball game tick- ets and odds-making on horse races? 2. How do you think real-time variable pricing would influence the practice of ticket scalping? 7. The Demand Side of a Market • Demand Curve ÿ It shows managers how many units they sell at a given price, holding other 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 fiat • Total Revenue Function ÿ A firm’s total revenue ( TR ) for a given time period is equal to the price charged ( P ) times the quantity sold ( Q ) during that time period. ÿ TR  P  Q ÿ The demand function reflects the effect of changes in P on quantity demanded ( Q ) per time period and, hence, the effect of changes in P on TR .

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    Introduction | 5 8. 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 sell- ers 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 technological progress cause supply curves to shift to the right. 9. Equilibrium Price • Disequilibrium ÿ Price is too high. * Excess supply or surplus * Causes price to fall ÿ Price is too low. * Excess demand or shortage * Causes price to rise • Equilibrium Price ÿ A situation in which quantity demanded is equal to quantity supplied ÿ Price is sustainable. ÿ The market is in balance because everyone who wants to purchase the good can, and every seller who wants to sell the good can. 10. Actual Price • The price that is of interest to the manager • Invisible hand: When no governmental agency is needed to induce pro- ducers to drop or increase their prices • If the actual price is above the equilibrium price, there will be a surplus that will put downward pressure on the actual price. • If the actual price is below the equilibrium price, there will be a shortage that will put upward pressure on the actual price. • If the actual price is equal to the equilibrium price, then there will be nei- ther 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 changes in the environment. • Increase in Demand ÿ Represented by a rightward or upward shift in the demand curve

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    6 | Chapter 1 ÿ Result of a change that makes buyers willing to purchase a larger quantity of a good at the current price and/or to pay a higher price for the current quantity ÿ Will create a shortage and cause the equilibrium price to increase • Decrease in Demand ÿ Represented by a leftward or downward shift in the demand curve ÿ Result of a change that makes buyers purchase a smaller quantity of a good at the current price and/or continue to buy the current quantity only if the price is reduced ÿ Will create a surplus and cause the equilibrium price to decrease 12. What If the Supply Curve Shifts? • Increase in Supply ÿ May be caused by technological advances ÿ Represented by a rightward or downward shift in the supply curve ÿ Result of a change that makes sellers willing to offer a larger quantity of a good at the current price and/or to offer the current quantity at a lower price ÿ Will create a surplus and cause the equilibrium price to decrease • Decrease in Supply ÿ Represented by a leftward or upward shift in the supply curve ÿ Result of a change that makes sellers willing to offer a smaller quan- tity of a good at the current price and/or to offer the current quantity at a higher price ÿ Will create a shortage and cause the equilibrium price to increase STRATEGY SESSION: Life During a Market Movement Discussion Questions 1. Several factors are mentioned as contributing to disequilibrium in global food markets. Among them are emotions (panic), government restric- tions on trade, the Malthusian specter of population growth outpacing food production, slowing productivity growth in the agricultural sector, rising incomes, and the production of ethanol. Which of these are supply factors and which are demand factors? How does each influence market price? 2. The market price for crude oil fluctuated widely during 2008. What sup- ply and demand factors contributed to these fluctuations? Is the petroleum market subject to any of the same factors cited as influencing agricultural markets?

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    Introduction | 7 Chapter 1: Problem Solutions 1. A book is to be written by Britney Spears. Batman Books agrees to pay Britney $6 million for the rights to this not-yet-written memoir. According to one leading publisher, Batman Books could earn a profit of roughly $1.2 million if it sold 625,000 copies in hardcover. On the other hand, if it sold 375,000 copies, managers would lose about $1.3 million. Publishing execu- tives stated that it was hard to sell more than 500,000 copies of a nonfiction hardcover book, and very exceptional to sell 1 million copies. Were Batman managers taking a substantial risk in publishing this book? Solution: There was a substantial risk of loss. On the other hand, there was substantial opportunity for gain. Risk is often unavoidable. The appropriate balance between risk and return is what should determine managers’ decisions. Suc- cessful decisions in circumstances of risk are a source of profit. 2. Some say that any self-respecting top manager joining a company does so with a front-end signing bonus. In many cases this bonus is in the seven fig- ures. At the same time the entering manager may be given a bonus guaran- tee. No matter what happens to firm profit, he or she gets at least a percentage of 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 in a single industry has a poorly diversified human capital portfolio. Such an executive also often has a significant, undiversified financial investment in the form of stock options and pension plans that are used in partial substi- tution for current salary to align the long-term wealth of the executive with that of the shareholders. As an executive climbs the corporate ladder, the value of his or her human capital becomes more closely tied to the fortunes of the firm and industry. This lack of diversification requires a compensating risk premium. A large signing bonus may allow a risk-averse executive to make an investment, which increases the value of the firm but which the executive would otherwise avoid because of concern for his or her own personal wealth; thus the bonus may reduce the principal–agent conflict. Of course the bene- fits of reduced risk to the executive come at the potential cost of indifference to the wealth of the shareholders. Although a large signing bonus may help solve the incentive alignment problem, compensation that is too great and too insensitive to the fortunes of the shareholders makes the principal–agent problem worse.

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    8 | Chapter 1 3. If the interest rate is 10%, what is the present value of the Monroe Corpora- tion’s profit in the next 10 years? Number of Years in the Future Profit (millions of dollars) 1 8 2 10 3 12 4 14 5 15 6 16 7 17 8 15 9 13 10 10 Solution: Use formula (1.1) for t  1, 2, . . . , 10 to obtain the following table: Number of Years in the Future Profit (millions of dollars) (1  i )  t Present Value (millions of dollars) 1 8 0.90909 7.27272 2 10 0.82645 8.26450 3 12 0.75131 9.01572 4 14 0.68301 9.56214 5 15 0.62092 9.31380 6 16 0.56447 9.03152 7 17 0.51316 8.72372 8 15 0.46651 6.99765 9 13 0.42410 5.51330 10 10 0.38554 3.85540 Total 77.55047 The answer is $77.55047 million. 4. Managers at Du Pont de Nemours and Company expect a profit of $2.9 bil- lion in 2012. Does this mean that Du Pont’s expected economic profit will equal $2.9 billion? Why or why not? Solution: Economic profits differ from accounting profits because of differences in the way depreciation is measured, differences in the way revenues and costs are recognized in terms of timing, and the inclusion of the opportu- nity cost of owner-supplied inputs in the calculation of economic profits.

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    Introduction | 9 Du Pont’s economic profits might well be negative if accounting profits do not exceed the risk-adjusted rate of return multiplied by the firm’s equity value. 5. William Howe must decide whether to start a business renting beach umbrel- las at an ocean resort during June, July, and August of next summer. He believes he can rent each umbrella to vacationers at $5 a day, and he intends to lease 50 umbrellas for the three-month period for $3,000. To operate this business, he does not have to hire anyone (but himself), and he has no expenses other than the leasing costs and a fee of $3,000 per month to rent the business location. Howe is a college student, and if he did not operate this business, he could earn $4,000 for the three-month period doing con- struction work. a. If there are 80 days during the summer when beach umbrellas are demanded 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)  $20,000 TC  (3 months)  ($3,000 per month rent)  ($3,000 umbrella lease)  $12,000 Accounting Profit  TR  TC  $8,000 b. Economic Profit  Accounting Profit  Opportunity Cost Economic Profit  $8,000  $4,000  $4,000 6. 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, and profit were estimated as follows, depending on whether the average ticket price was $75 or $65: Average Price of $75 Average Price of $65 Gross revenues $765,000 $680,000 Operating costs 600,000 600,000 Profi t 165,000 80,000 a. With a cast of 71 people, a 30-piece orchestra, and more than 500 cos- tumes, Gypsy cost more than $10 million to stage. This investment was in addition to the operating costs (such as salaries and theater rent). How many weeks would it take before the investors got their money back, according to these estimates, if the average price was $65? If it was $75?

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    10 | Chapter 1 b. George Wachtel, director of research for the League of American The- aters and Producers, has said that about one in three shows opening on Broadway in recent years has at least broken even. Were the investors in Gypsy taking a substantial risk? c. According to one Broadway producer, “Broadway isn’t where you make the money any more. It’s where you establish the project so you can make the money. When you mount a show now, you really have to think about where it’s going to play later.” If so, should the profit figures here be interpreted 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 would pay 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 the investment. This does not provide for any return on investment, however. b. The investors in Gypsy were indeed taking a substantial risk. If only one in three shows breaks even, two out of three make losses. c. The profit figures should be interpreted with caution because they do not take into account the likelihood of profits when, and if, the show goes on the road. d. Yes. 7. If the demand curve for wheat in the United States is P  12.4  Q D where P is the farm price of wheat (in dollars per bushel) and Q D is the quantity of wheat demanded (in billions of bushels), and the supply curve for wheat in the United States is P   2.6  2 Q S where Q S is the quantity of wheat supplied (in billions of bushels), what is the equilibrium price of wheat? What is the equilibrium quantity of wheat sold? Must the actual price equal the equilibrium price? Why or why not? Solution: Setting demand equal to supply in equilibrium, that is, Q D  Q S  Q E , yields 12.4  Q D   2.6  2 Q S Q E  15/3  5 P E  12.4  5   2.6  (2)(5)  $7.40

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    Introduction | 11 The actual price need not be equal to equilibrium price, although it will generally tend to move toward it because of the equilibrating effects of shortage and surplus. Factors that might prevent the actual price from equaling the equilibrium price include the cost and availability of infor- mation, transportation costs, and lack of opportunities for price-equalizing arbitrage. 8. The lumber industry was hit hard by the downturn in housing starts in 2010 and 2011. Prices plunged from $290 per thousand board feet to less than $200 per thousand board feet. Many observers believed this price decrease was caused by the slowing of new home construction because of the glut of unsold homes on the market. Was this price decrease caused by a shift in the supply or demand curve? Solution: Because the demand for lumber is derived in large part from the demand for new housing construction, a decline in construction would be likely to cause the demand for lumber to fall, leading to lower lumber prices since the demand curve shifts to the left. Supply would not be affected by changes in housing construction. 9. From November 2010 to March 2011 the price of gold increased from $1,200 per ounce to over $1,800 per ounce. Newspaper articles during this period said there was little increased demand from the jewelry industry but signifi- cantly more demand from investors who were purchasing gold because of the falling dollar. a. Was this price increase due to a shift in the demand curve for gold, a shift in the supply curve for gold, or both? b. Did this price increase affect the supply curve for gold jewelry? If so, how? Solution: a. A change in the value of the dollar causes the dollar price of globally traded commodities to change. If the value of the dollar falls, the dollar price of commodities will rise. In this case, a decline in the value of the dollar can be expected to cause the market for gold (with price measured in dollars) to experience an increase in demand and a decrease in supply and thus an increase in price. There may also have been an additional increase in demand due to expectations by investors that the dollar price of gold will continue to rise. Finally, there may have been a further supply decrease if producers, speculating that prices would rise further, withheld gold from the market.

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    12 | Chapter 1 b. Gold is an input to the production of jewelry. An increase in the price of gold would therefore be expected to reduce the supply of jewelry, result- ing in higher jewelry prices.

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