Solution Manual for Managerial Economics, 8th Edition

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1-1CHAPTER ONEINTRODUCTION TO ECONOMICDECISION MAKINGOBJECTIVES1.To introduce Managerial Economicsandprovide concrete examples ofmanagerial decisions2.To provide a framework for analyzing decisions (Six Steps to DecisionMaking)4.Tocompare decisions of the private firm (where maximum profit is theobjective) to public sector decisions (where maximum societal netbenefit is the objective).(Private and Public Decisions)5.To introduce the student to the book and its organization.(Things toCome)TEACHING SUGGESTIONSI.Introduction and MotivationThechapterbeginsbystressingconcreteapplicationsofmanagerialeconomics (the eight examples) rather than speaking generally about topicsand methods.Our practice in class is tolead a brief discussion of some ofthetextexamples(thethreewelikebest)augmentedwithadditionalrepresentative examples from the current business press.A.Additional questions on text examples:1.Multinational Production and Pricing(RevisitedinChapter 3 andinProblem S2(global production of microchips)of Chapter6). Whymight the company want to charge different prices homeandabroad?

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1-2(What if the company had to charge the same price because of anti-dumping restrictions?) Why might it want to shipoutputoverseas?2.Market Entry(RevisitedinChapter 10). In a market that can supportonly one store, is there an advantage to being the first in?Are therestrategic advantages to commitment?(Here you might tell the story ofthe game of chicken. Any advantage if one driver pulls off the steeringwheel and throws it out the window?)How might an office supplystore commit? What if both commit? (Both throw their steering wheelsout the window?)3.Building a NewBridge.(RevisitedinChapter 11). Building a bridge isusually a public responsibility (paid for out of public funds raised viataxes). Why is this the case? How might a public planner determine theneed for a new bridge? How should tolls (if any) be set?4.A Regulatory Problem(Revisited inChapter 11). Does regulation puttoo great a cost burden on business?How should the benefits ofenvironmental regulation be weighed against the costs?5.BP and the Risks of Oil Exploration(RevisitedinChapter12.)Howcan BP identify and quantify crucial riskfactors?What measures (andat what cost) can it take to reduce or manage key risks?6.AnR&DDecision(RevisitedinChapter12).MightthepharmaceuticalcompanybewisetopursuebothR&Dmethodssimultaneously?7.Wooing David Letterman(RevisitedinChapter 15).What bargainingstrategy should Letterman adopt to get the best deal? How can a value-maximizing deal be achieved?

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1-3B.Additional Vignettes. A good way to spice up the discussion is to(1) preview decision examples from later chapters or (2) take examplesfrom chapters that are not assigned. Here are some suggestions.• Airline price discrimination (Chapter Three)•Introducing New Coke (Chapter Four)• Euro Disney (Chapter Four)• The OPEC Cartel (Chapter Eight)• Battle for Air Passengers (Chapter Ten)• Regulating AZT (ChapterEleven)• An Oil Wildcatter (ChapterTwelve)• Predicting Credit Risks (Chapter Thirteen)• Constructing an Optimal Portfolio (ChapterSixteen)I. Teaching the “Nuts and Bolts”A. Issues deserving extra emphasis1.The meaning of economic tradeoffs:• benefits versus costs.• short-term profit versus long-term profit.• risk versus return.• tradeoffs among multiple objectives (For example in autoregulation: safety vs. emission reduction vs. fuel economy2.The virtues of simple models (predictive models, the model of thefirm)3.Coming to grips withuncertainty

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1-4B.The six decision stepsmostly speak for themselves. (In our experience,students find them relatively easy to grasp.) The instructor may wish toreemphasizethembydiscussingsomeofthestepsinclass.Alternatively, the six steps can be applied by discussing the decisionvignettes in question 4 at the end of the chapter.In each instance, didthe individual make a faulty decision?If so, in what step(s) did he orshe go wrong? (See answers below).C.Guinea PigQuestions.One way of previewing a number of upcomingtopics in the course is to present a number of short, so-called“guineapig”questions.Studentsmeetthesequestions“cold”withoutanyadvanced background or preparation.The main idea is to challengethem to think about possible solutions.By necessity, they usually relyon their general judgment or intuition rather than on any systematicanalysis.(It's a good idea for the teacher to tell the students that thequestions are in some sense“unfair”; students don't have enoughinformation find the best solution.But neither do managers in real-lifebusiness decisions.)1.Locating a Shopping Mall.(Instructor’s online site, Chapter Two).2.Finding the Best Item(Instructor’s online site, Chapter Thirteen).Suppose that you will be shown three “prizes” in order. Ahead of time,you know absolutely nothing about how valuable the prizes might be.Only after viewing all three can you determine which you like best.You are shown the prizes in order and are allowed to select one.However,thereisno“goingback.”Youmustselectaprizeimmediately after seeing it, and before seeing any subsequent prize.a)Yoursoleobjectiveistoobtainthebestof thethreeprizes.(Second best doesn't count.)A random selection provides a one-third chance of getting the best prize.Find a strategy that providesa strictly greater chance (and compute the actual chance).

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1-5b)What if there are a large number of prizes (say 10, 50, or 100)?Describe in general terms the kind of strategy you might use.3.Let's make a Deal(ChapterThirteen, Problem 6).Consider thefollowing simplified version of the game “Let's Make a Deal.” There isa grand prize behind one of three curtains.The other two curtains areempty.As the contestant, you get to choose a curtain at random.Let'ssay you choose curtain three.Before revealing what's behind thecurtain, the game show host offers to show you what's behind one of theother curtains.Suppose he shows you that curtain two is empty.Infact, healwaysshows you an empty curtain. (You know that's how thegame works, the audience knows it, everybody knows it.)Now youmust decide: do you stick with your original choice, curtain three, orswitch to curtain one?Which action gives you the better chance offinding the grand prize?4.A Competitive Decision.Consider the following game involving twoplayers. The players will alternate choosing the nine integers: 1, 2, 3, 4,5, 6, 7, 8, 9. If the first player picks 4 (let's say), the second player canchoose any one of the remaining digits, and so on. The first player thatobtains three digits that add up to exactly 15 wins.For instance, thefirst player wins with the digits, 2, 3, 6, and 7 since 2 + 6 + 7 = 15. Hewouldnotwin with 6, 7, 8, and 9 since no three of them add up to 15.Ask for two volunteers to play this game (with the rest of the class freeto kibitz).Questions to think about: How would you play?Is it anadvantage to move first?What well-known game does this numbergame resemble?

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1-6D.Discussion of Guinea Pig Questions.Though these questions aredeliberately set in non-business situations, almost all have interestingbusiness counterparts.Question 1 demonstrates marginal analysis.Questions 2 and3involve decisions under uncertainty.Question 4 is acompetitive decision.1.Siting a Shopping Mall.For discussion, seeInstructor’sManual,Chapter Two, also theInstructor’s Online Site, Chapter Two.2.Finding the Best Item.For an arbitrary number of items (not onlythree), this is variously called the“secretary problem” (interviewingand selecting the best secretary), the “hotel problem” (deciding to stopat one of three hotels situated hours apart along a cross-country route),or the “art gallery problem” (in the gallery you are allowed to viewpaintings one at a time and choose only one, without going back). Yourbest strategy is as follows:Observe the first item but bypass it. Then, select the second item only ifit is better than the first. If it isn't, go on to the third item and select it.This plan delivers the best item with probability 1/2, the second-bestitem with probability 1/3, and the worst item with probability 1/6. Hereare the six equally likely orders in which the items might appear:First Item:bestbest2nd best2ndbestworstworstSecond Item:2nd bestworstbestworstbest2nd bestThird Item:worst2nd bestworstbest2nd bestbestThe bold-faced outcomes show the result of using the “wait and see”strategy. As shown, the strategy delivers threebests, two2nd bests, andoneworst.For more on generalizations of this example, see ChapterThirteenof this instructor's manual.

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1-73.Let's make a Deal. Almost all students (if they have not seen theproblem before) believe that either curtain offers a 50-50 chance ofhaving the prize. This is incorrect. In fact, the chance is one-third thatthe grand prize is behind your chosen curtain and two-thirds thatit’sbehind the other curtain.After all, choosing your original curtain atrandom offers a one-third winning chance. The fact that you are shownan empty curtain doesnotchange this prior probability (although it doeseliminate one curtain from consideration). Since your winning chancesare 1/3 if you “stick”, you should switch and gain a 2/3 winning chance.Many students will still be unconvinced by this argument.Oneresponse is to challenge students (in pairs) to simulate the setup forthemselves. The simulation could mean shuffling 2 black playing cardsand one red card (the prize), and playing 60 times.Always “sticking”with one's original card after a black card has been revealed willproduce only 20 wins on average. A second argument is to imaginethat there are 100 curtains and one prize. After a curtain is chosen (say,curtain 1), the host reveals 98 empty curtains (all but curtain 71). Moststudents will easily see that the odds are 99 to 1 in favor of curtain 71over curtain 1.This classic problemhas been discussed among social scientistssince the mid 1970s andhasevenmade it to the front page ofThe NewYorkTimes:“BehindMontyHall'sDoors:Puzzle,Debate,andAnswer,”NYT,July 21, 1991, p. 1. The discussion and analysis arerecommended.Even in the 21stcentury,the riddle is still going strong.4.A Competitive Decision.This is a tough game because it involvesmentalarithmeticandkeepingtrackofmanypossibilities.The“sneaky” way toplay this game is by using the following magic square:816357492In a magic square, all rows, columns, and diagonals add up to the samenumber (in this case 15).Using the magic square, we see that the

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1-8number game is strategically equivalent to tic tac toe.The ways youcan win in the number game are identical to the ways you can win in tictac toe.There are many ways to play either game optimally--blockyour opponent whenever he has a potential winning move and never lethim set up two ways to win.The result of optimal play is a draw.When students play, the first mover often wins because the secondmover is apt to make the first mistake.A typical play of the gamemight be: 6, 9, 8, 1, 4, 3, 5, the first player wins with 6 + 4 + 5 = 15.You can use this game to make two points:(1) Optimal competitivestrategies (see Chapter Ten) often require looking ahead to anticipatecompetitors' moves and counter moves. (2) Often the best way to solvea new decision problem is to see that it is similar to a problem youalready know how to solve.

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1-9ADDITIONAL MATERIALSI.Recommended ReadingsD.Kahneman,ThinkingFastandSlow,Farrar,Straus,andGirouxPublishing, NewYork, 2011.M. Bazermanand D. Moore,Judgment in ManagerialDecision Making,,7thedition,2008(especially chapters 1, 2and 9).J. E. Russo, M. Hittleman, and P. J. Schoemaker.Winning Decisions.NewYork: Bantam Dell Publishers, 2001.J. E. Russo and P. J. Schoemaker,Decision Traps, Fireside Publishing, NewYork, 1990.G. Belsky and T. Gilovich.Why Smart People Make Big Money Mistakesand How to Correct Them.New York: Simon and Schuster, 2000.N.R.Augustine,Augustine'sLaws,PenguinBooks,1987.(Anicecommentary on thefoibles of managerial decision making)II.Short ReadingsRobert Shiller, “The Rationality Debate, Simmering in Stockholm,The NewYork Times,January 19, 2014, p. BU6.Gardiner Harris and Katie Thomas, “Low-Cost Drugs in Poor Nations Get aLift in Indian Court,”The New York Times, April 2, 2013, p. A1.Carolyn Preston, “Getting Back More than a Warm Feeling,”The New YorkTimes,November 9, 2012, F1.

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1-10G. Mankiw, “A Course Load in the Game of Life,”The New York Times,September 5, 2010, p. BU5.“Let’s Hear those Ideas,” The Economist, August 14, 2010, pp. 55-57.(This article discusses “social entrepreneurs.”)R.Frank,“FlawinFreeMarkets:Humans,”TheNewYorkTimes,September13, 2009, p.BU4.D. Brooks, “The Behavioral Revolution,”The New York Times, October 28,2008, p. A23.R. Trudel and J. Cotte, “Does being Ethical Pay?”The Wall Street Journal,May 12, 2008, p.R1.D. A. Garvin and M. A. Roberto, “What You Don’t Know about MakingDecisions,”Harvard Business Review, September 2001, pp. 108-116.III.CasesFighting Aids and Pricing Drugs(9-502-061), Harvard Business School,2002.Decision Making at the Top(9-398-061), Harvard Business School, 1997.Canonical Decision Problems(9-396-308), Harvard Business School, 1997.Teaching Note (5-396-313)

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1-11IV.Quips and QuotesGeneral maxims about decision making:There are three valid answers to making adecision: yes, no, or no decisionright now. Only 20% of the answers should be an immediate yes or no.Find two good reasons to do something.(You can always find one goodreason.)When making a decision of minor importance, I have always found itadvantageous to consider all the pros and cons.In vital matters, however,such as the choice of a mate or a profession, the decisions should come fromthe unconscious, from somewhere within ourselves. (Sigmund Freud)Never, never use intuition (General Omar Bradley)When asked what he'd done during the terror of the French revolution, AbbeSieyes replied, “I survived.” (An example of satisficing?)If you don't know where you're going, chances are you won't get there.We never make the same mistake twice. All our blunders are different.I'd like to rush for 1500 or 2000 yards, whichever comes first.(FormerWashington Redskin running back George Rodgers)In a choice between two evils, I make it my general rule to choose the one Ihaven't triedyet. (Mae West).If the only tool you have is a hammer, you tend to see every problem as anail.The real objective of a committee is not to reach a decision but to avoid it.

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1-12It is better to know nothing than to know what ain't so.A decision is always a choice among alternative perceived images of thefuture. (Kenneth E. Boulding)Economic activity is rational activity . . . it consists firstly in valuation ofends, and then in the valuation of the means leading to these ends.(Ludwig von Mises)Here is a slightly exaggerated example from an Ann Landers column:Dear Ann, Our marriage was once so beautiful but things have changed.My spouse treats me like a slave, never shows any affection, comes homedrunk every night, slaps me around, and may be having an affair with mybest friend. I alternate between loneliness and fear. I have gained weightand am severely depressed.My life is a living hell and I pray to getthrough the next day. Ann, what should I do?(Ann Landers responded with a question.Are you better off with him orwithouthim?Thatis,whataretheoutcomesassociatedwitheachalternative? Additional query: are these the only alternatives?)

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1-13Answers to Back-of-the-Chapter Problems1.Managerialeconomicsistheanalysisofimportantmanagementdecisions using the tools of economics. Most business decisions aremotivated by the goal of maximizing the firm’s profit. The tools ofmanagerial economics provide a guide to profit-maximizing decisions.2.i)Multinational Production and Pricing.The global automobilecompany needs information on demand (how many vehicles can be soldin each market at different prices) and production costs.ii)Market Entry.The office storesnotonly need information on localmarketdemand,theyalsoneedinformationontheabilityandwillingness of the other company to compete.This means gatheringinformation on the rival's cost structure, sources of supply, access tocapital, etc.iii)Building a New Bridge.The authority should estimate usage ofthebridgeoveritsusefullife,thelikelycostofbuildingandmaintaining the bridge, and other important side-effects, pro and con--including positive effects on business activity and the impacts on airpollution and traffic congestion.iv)A Regulatory Problem.Before deciding whether to promote theoil-to-coal conversion, government regulators need information on howmuch oil would be saved (and the dollar value of savings) and the costof the chain of side-effects--not only the direct cost of electricityprovision but also pollution costs and environmental damage.v)Oil Exploration.Some of the information BP needs–such ascurrent oil prices, rig worker wages, and other operatingcosts–isreadilyavailable.Otherinformation—suchasdatagleanedfromgeological surveys, seismic tests, safety audits; wear and tear on

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1-14drillingcomponents; short-term and long-term weather conditions; theoutlook concerning the global demand for oil–is probabilistic innature.vi)An R&D Decision.The pharmaceutical company should quiz itsscientists on the chances of success (and the timetable for completion)for each R&D approach.The company's marketing department wouldsupply estimates of possible revenues from the drug; its productiondepartment would estimate possible costs.vii)David Letterman.Dave must carefully assess what he wantsfrom a new contract (in particular how much he values the earlier timeslot). As the negotiations unfold, Dave will glean valuable informationas to the current competing offers of CBS and NBC. Of course, Davemust also try to assess how far the two networks might be willing to goin sweetening their offers.3.The six steps might lead the soft-drink firm to consider the followingquestions. Step 1: What is the context? Is this the firm’s first such softdrink? Will it be first to the marketplace, or is it imitating a competitor?Step 2: What is the profit potential for such a drink? Would the drinkachieve other objectives? Is the fruit drink complementary to the firm’sother products? Would it enhance the firm’s image? Step 3: Which ofsix versions of the drink should the firm introduce? When (now or later)and where (regionally, nationally, or internationally) should it introducethe drink? What is an appropriate advertising and promotion policy?Step 4: What are the firm’s profit forecasts for the drink in its first,second, and third years? What are the chances that the drink will be afailure after 15 months? Should the firm test market the drink beforelaunching it? Step 5: Based on the answers to the questions in Steps 1through 4, what is the firm’s most profitable course of action? Step 6:In light of expected (or unexpected) developments in the first year ofthe launch, how should the firm modify its course of action?

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1-154. Decision vignettesa.A couple who buy the first house they view have probably sampled toofew houses. Housing markets are notoriously imperfect.Houses comeinvariousshapes,sizes,conditions,neighborhoods,andprices.Personal preferences for houses also vary enormously.The couple islikely to get a "better" house for themselves if they view a dozen, twodozen, or more houses over the course of time before buying their"most-preferred" house from the lot. Circumstances justifying the first-house purchase include: (1) the house is so good that viewing others is awaste of time, (2) the house is so good and the commitment must bemade now or another buyer will claim the house, (3) the couple mustbuy now (a job transfer has brought them to the area and schools opentomorrow), (4) they already have full information about the types ofother houses available (the wife's best friend is a real estate agent).b. The company seems to be launching the product to avoid "wasting" the$6 million already spent in development.This "sunk" cost is irrelevantand should be ignored. What does matter for the reinvestment decisionare the future revenues and costs of continuing.(Reinvest if the netpresent value of future profits is positive.)Some "close-to-home"examples of the sunk cost fallacy: i) A fellow pays $250 for a year-longtennis membership but develops severe tennis elbow after two months.He continues to play in great pain in order to get his money's worth. ii)Ms. K has a subscription to a series of six plays for $150. She braves asnow storm so as not to waste the $25 cost.On reflection, she admitsthat she wouldn't have gone had she been given the ticket for free.c.It's in the individual motorist's best interest to drive on.(Stopping isrisky and inconvenient).But it's in the collective interest of all thedelayed motorists to have someone stop and move the mattress.Here'san example of the potential conflict between private and public interests(between private profit and social welfare).In such circumstances,there is a potential role for government intervention.

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