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

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ManagerialEconomicsEIGHTH EDITIONW. Bruce Allen • Neil A. Doherty •Keith Weigelt • Edwin MansfieldJean CupidonTEXAS TECH UNIVERSITY’S MANUAL

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vPART 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 Discrimination133Chapter 10 | Bundling and Intrafi rm Pricing153CONTENTS

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1Lecture Notes1.Introduction•ObjectivesÿTo provide a guide to making good managerial decisionsÿTo use formal models to analyze the effects of managerial decisionson measures of a firm’s success•Managerial Economics versus MicroeconomicsÿManagerial economics differs from microeconomics in that microeco-nomics focuses on description and prediction while managerial eco-nomics is prescriptive.ÿManagerial economics prescribes behavior, whereas microeconomicsdescribes the environment.ÿManagerial economics is an integrative course that brings the variousfunctional areas of business together in a single analytical frame-work.ÿManagerial 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 ObjectiveÿTo make choices that will increase the value of the firmÿManagers in profit-oriented organizations try to increase the net pres-ent value of expected future cash flows.ÿThe value of the firm is defined as the present value of future profits:IntroductionCHAPTER 1

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2|Chapter 1ÿPresent value ofexpected future profits++++++$= 1(1)(1)122iiinnÿMore compactly, we write:ÿPresent value ofexpected future profits∑=+=(1)1itttnÿGiven that profittotal revenuetotal cost, then we write:ÿPresent value ofexpected future profits(1)1TRTCittttn∑=−+=ÿNotation*ptProfit in timetTotal Revenue in timetTotal Cost intimet*iInterest rate*nNumber of time periods*TRtTotal Revenue in timet*TCtTotal Cost in timet•Managerial ChoicesÿInfluence total revenue by managing demandÿInfluence total cost by managing productionÿInfluence the relevant interest rate by managing finances and risk•Managerial ConstraintsÿEnvironmental and antitrust lawsÿResource scarcityÿLegal or contractual limitationsSTRATEGY 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 ProfitÿAccounting 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 taxand other laws, and producing records for various interestedgroupsÿEconomic profit*Market value; opportunity, or implicit cost

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Introduction|3*The economist is concerned with decision making, rational choiceamong strategies*A more useful measure for managerial decision making4.Reasons for the Existence of Profit•ProfitÿMeasures the quality of managers’ decision-making skillsÿEncourages good management decisions by linkage with incentives•Sources of Profit: Three profit-generating areasÿInnovation: Producing products that are better than existing productsin terms of functionality, technology, and styleÿRisk taking: Future outcomes and their likelihoods are unknown, asare the reactions of rivals.ÿMarket 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 decisions5.Managerial Interests and the Principal–Agent Problem•Principal–Agent ProblemÿThe interests of a firm’s owners and those of its managers may differ,unless the manager is the owner.ÿSeparation 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.*Todealwiththisproblem,owners(theprincipals)oftenuse contracts to converge their preferences and those of theiragents.*Moral hazardexists 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 behavior.

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4|Chapter 1ÿSolutions*Devise methods that lead to convergence of the interests of thefirm’s own ers and its managers.*Examples:Stock option plans or bonuses linked to profits6.Demand and Supply: A First Look•MarketÿA group of firms and individuals that interact with each other to buy orsell a productÿPart of an economy’s infrastructureÿA social institution that exists to facilitate economic exchangeÿRelies 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 tick-ets 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 CurveÿIt shows managers how many units they sell at a given price, holdingother possible influences constant.ÿIt is negatively sloped.ÿIt pertains to a particular period of time.Other influences on demand decisions include*consumer income*prices of substitutes and complements*advertising expenditures*product quality*government fiat•Total Revenue FunctionÿA 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.ÿTRPQÿThe demand function reflects the effect of changes inPon quantitydemanded (Q) per time period and, hence, the effect of changes inPonTR.

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Introduction|58.The Supply Side of a Market•Supply side is represented by a market supply curve.ÿThe market supply curve shows how many units of a commodity sell-ers will offer at any price.ÿIt is positively sloped.ÿIt pertains to a particular period of time.ÿDecreases in the cost of inputs (labor, capital, land) or technologicalprogress cause supply curves to shift to the right.9.Equilibrium Price•DisequilibriumÿPrice is too high.*Excess supply or surplus*Causes price to fallÿPrice is too low.*Excess demand or shortage*Causes price to rise•Equilibrium PriceÿA situation in which quantity demanded is equal to quantity suppliedÿPrice is sustainable.ÿThe 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 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 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 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 changesin the environment.•Increase in DemandÿRepresented by a rightward or upward shift in the demand curve

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6|Chapter 1ÿResult 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 quantityÿWill create a shortage and cause the equilibrium price to increase•Decrease in DemandÿRepresented by a leftward or downward shift in the demand curveÿResult 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 reducedÿWill create a surplus and cause the equilibrium price to decrease12. What If the Supply Curve Shifts?•Increase in SupplyÿMay be caused by technological advancesÿRepresented by a rightward or downward shift in the supply curveÿResult 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 priceÿWill create a surplus and cause the equilibrium price to decrease•Decrease in SupplyÿRepresented by a leftward or upward shift in the supply curveÿResult 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 ata higher priceÿWill 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 restric-tions 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 sup-ply and demand factors contributed to these fluctuations? Is the petroleummarket subject to any of the same factors cited as influencing agriculturalmarkets?

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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 execu-tives 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. 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 sowith 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 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 substi-tution 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 bene-fits 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 worse.

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8|Chapter 13.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 Yearsin the FutureProfit(millions of dollars)182103124145156167178159131010Solution:Use formula (1.1) fort1, 2, . . . , 10 to obtain the following table:Number of Yearsin the FutureProfit(millions of dollars)(1i)tPresent Value(millions of dollars)180.909097.272722100.826458.264503120.751319.015724140.683019.562145150.620929.313806160.564479.031527170.513168.723728150.466516.997659130.424105.5133010100.385543.85540Total77.55047The 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 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 opportu-nity cost of owner-supplied inputs in the calculation of economic profits.

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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 umbrel-las 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 con-struction 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 ProfitTRTC$8,000b. Economic ProfitAccounting ProfitOpportunity CostEconomic Profit$8,000$4,000$4,0006.On March 3, 2008, a revival ofGypsy,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:Average Priceof $75Average Priceof $65Gross revenues$765,000$680,000Operating costs600,000600,000Profi t165,00080,000a. With a cast of 71 people, a 30-piece orchestra, and more than 500 cos-tumes,Gypsycost 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 $75?

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10|Chapter 1b. George Wachtel, director of research for the League of American The-aters and Producers, has said that about one in three shows opening onBroadway in recent years has at least broken even. Were the investors inGypsytaking 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 ofGypsymake 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 10,000/16560.6 or 61 weeks.If the price is $65, it would take 10,000/80125 weeks to pay off theinvestment. This does not provide for any return on investment,however.b. The investors inGypsywere indeed taking a substantial risk. If only onein three shows breaks even, two out of three make losses.c. The profit figures should be interpreted with caution because they do nottake into account the likelihood of profits when, and if, the show goes onthe road.d. Yes.7.If the demand curve for wheat in the United States isP12.4QDwherePis the farm price of wheat (in dollars per bushel) andQDis thequantity of wheat demanded (in billions of bushels), and the supply curvefor wheat in the United States isP2.62QSwhereQSis the quantity of wheat supplied (in billions of bushels), whatis the equilibrium price of wheat? What is the equilibrium quantity ofwheat sold? Must the actual price equal the equilibrium price? Why orwhy not?Solution:Setting demand equal to supply in equilibrium, that is, QDQSQE, yields12.4QD2.62QSQE15/35PE12.452.6(2)(5)$7.40

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Introduction|11The actual price need not be equal to equilibrium price, although it willgenerally tend to move toward it because of the equilibrating effects ofshortage and surplus. Factors that might prevent the actual price fromequaling the equilibrium price include the cost and availability of infor-mation, transportation costs, and lack of opportunities for price-equalizingarbitrage.8.The lumber industry was hit hard by the downturn in housing starts in 2010and 2011. Prices plunged from $290 per thousand board feet to less than$200 per thousand board feet. Many observers believed this price decreasewas caused by the slowing of new home construction because of the glut ofunsold homes on the market. Was this price decrease caused by a shift in thesupply or demand curve?Solution:Because the demand for lumber is derived in large part from the demand fornew housing construction, a decline in construction would be likely to causethe demand for lumber to fall, leading to lower lumber prices since the demandcurve shifts to the left. Supply would not be affected by changes in housingconstruction.9.From November 2010 to March 2011 the price of gold increased from $1,200per ounce to over $1,800 per ounce. Newspaper articles during this periodsaid there was little increased demand from the jewelry industry but signifi-cantly more demand from investors who were purchasing gold because ofthe falling dollar.a. Was this price increase due to a shift in the demand curve for gold, a shiftin 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 globallytraded commodities to change. If the value of the dollar falls, the dollarprice of commodities will rise. In this case, a decline in the value of thedollar can be expected to cause the market for gold (with price measuredin dollars) to experience an increase in demand and a decrease in supplyand thus an increase in price. There may also have been an additionalincrease in demand due to expectations by investors that the dollar price ofgold will continue to rise. Finally, there may have been a further supplydecrease if producers, speculating that prices would rise further, withheldgold from the market.

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

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