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After reading the section titled “Dominant Microprocessor Company Intel Adapts to Next Trend” (Chapter 11 pg. 384-385) and the article titled “2018-2019 Intel Corporate Responsibility Report: Creating Value through Transparency,” complete a list of reasons how a single firm like Intel comes to dominate some markets.

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MANAGERIAL ECONOMICS

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MANAGERIAL ECONOMICS APPLICATIONS, STRATEGY, and TACTICS

13e

JAMES R. McGUIGAN JRM Investments

R. CHARLES MOYER University of Louisville

FREDERICK H. deB. HARRIS School of Business Wake Forest University

Australia • Brazil • Mexico • Singapore • United Kingdom • United States

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Managerial Economics: Applications, Strategy, and Tactics, 13th Edition James R. McGuigan, R. Charles Moyer, and Frederick H. deB. Harris

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To my family J.R.M.

To Sally, Laura, and Craig R.C.M.

To my family and Ken Elzinga F.H.B.H.

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Brief Table of Contents

Preface xix About the Authors xxiii

PART I

INTRODUCTION 1 1 Introduction and Goals of the Firm 2 2 Fundamental Economic Concepts 28

PART II

DEMAND AND FORECASTING 63 3 Demand Analysis 64 4 Estimating Demand 99

4A Problems in Applying the Linear Regression Model 127

5 Business and Economic Forecasting 139 6 Managing in the Global Economy 176

6A Foreign Exchange Risk Management 230

PART III

PRODUCTION AND COST 233 7 Production Economics 234

7A Production Economics of Renewable and Exhaustible Natural Resources, Advanced Material 270

8 Cost Analysis 280 9 Applications of Cost Theory 305

PART IV

PRICING AND OUTPUT DECISIONS: STRATEGY AND TACTICS 331

10 Prices, Output, and Strategy: Pure and Monopolistic Competition 332

11 Price and Output Determination: Monopoly and Dominant Firms 382

12 Price and Output Determination: Oligopoly 409

13 Best-Practice Tactics: Game Theory 444 13A Entry Deterrence and Accommodation

Games 489 14 Pricing Techniques and Analysis 500

14A The Practice of Revenue Management 535

PART V

ORGANIZATIONAL ARCHITECTURE AND REGULATION 547

15 Contracting, Governance, and Organizational Form 548

15A Auction Design and Information Economics 583

16 Government Regulation 611 17 Long-Term Investment Analysis 648

APPENDICES A The Time Value of Money A-1 B Differential Calculus Techniques

in Management B-1 C Tables C-1 D Check Answers to Selected

End-of-Chapter Exercises D-1 Glossary G-1 Index I-1 Notes

WEB APPENDICES A Consumer Choice Using Indifference

Curve Analysis B International Parity Conditions C Linear-Programming Applications D Capacity Planning and Pricing against a

Low-Cost Competitor: A Case Study of Piedmont Airlines and People Express

E Pricing of Joint Products and Transfer Pricing F Decisions under Risk and Uncertainty G Maximization of Production Output Subject

to a Cost Constraint, Advanced Material H Long-Run Costs with a Cobb-Douglas

Production Function, Advanced Material

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Contents

Preface xix About the Authors xxiii

PART I

INTRODUCTION 1

1 Introduction and Goals of the Firm 2 Chapter Preview 2

Managerial Challenge: How to Achieve Sustainability: Southern Company Electric Power Generation 2

What Is Managerial Economics? 4 The Decision-Making Model 5

The Responsibilities of Management 5

What Went Right/What Went Wrong: Saturn Corporation 6 Moral Hazard in Teams 6

The Role of Profits 8 Risk-Bearing Theory of Profit 8 Temporary Disequilibrium Theory of Profit 9 Monopoly Theory of Profit 9 Innovation Theory of Profit 9 Managerial Efficiency Theory of Profit 9

Objective of the Firm 9 The Shareholder Wealth-Maximization

Model of the Firm 10 Separation of Ownership and Control:

The Principal-Agent Problem 11 Divergent Objectives and Agency Conflict 11 Agency Problem 13

Implications of Shareholder Wealth Maximization 15

What Went Right/What Went Wrong: Eli Lilly Depressed by Loss of Prozac Patent 15 Caveats to Maximizing Shareholder Value 17 Residual Claimants 19 Goals in the Public Sector and Not-for-Profit

Enterprises 19 Not-for-Profit Objectives 20 The Efficiency Objective in Not-for-Profit

Organizations 20

Summary 21 Exercises 22 Case Exercise: Designing a Managerial

Incentives Contract 23 Case Exercise: Shareholder Value of Renewable

Energy from Wind Power at Hydro Co.: Is RE < C? 24

2 Fundamental Economic Concepts 28 Chapter Preview 28

Managerial Challenge: Why Charge $25 per Bag on Airline Flights? 28

Demand and Supply: A Review 29 The Diamond-Water Paradox and the

Marginal Revolution 31 Marginal Utility and Incremental Cost

Simultaneously Determine Equilibrium Market Price 32

Individual and Market Demand Curves 33 The Demand Function 34 Import-Export Traded Goods 36 Individual and Market Supply Curves 37 Equilibrium Market Price of Gasoline 38

Marginal Analysis 43 Total, Marginal, and Average Relationships 44

The Net Present Value Concept 48 Determining the Net Present Value of an

Investment 48 Sources of Positive Net Present Value Projects 50 Risk and the NPV Rule 51

Meaning and Measurement of Risk 52 Probability Distributions 52 Expected Values 53 Standard Deviation: An Absolute Measure

of Risk 54 Normal Probability Distribution 54 Coefficient of Variation: A Relative Measure

of Risk 56

What Went Right/What Went Wrong: Long-Term Capital Management (LTCM) 56

Risk and Required Return 57 Summary 59 Exercises 59 Case Exercise: Revenue Management at

American Airlines 61

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PART II

DEMAND AND FORECASTING 63

3 Demand Analysis 64 Chapter Preview 64

Managerial Challenge: Health Care Reform and Cigarette Taxes 64

Demand Relationships 66 The Demand Schedule Defined 66 Constrained Utility Maximization and

Consumer Behavior 67

What Went Right/What Went Wrong: Chevy Volt 71

The Price Elasticity of Demand 72 Price Elasticity Defined 73 Interpreting the Price Elasticity: The Relationship

between the Price Elasticity and Sales Revenue 76 The Importance of Elasticity-Revenue

Relationships 82 Factors Affecting the Price Elasticity of Demand 84

International Perspectives: Free Trade and the Price Elasticity of Demand: Nestlé Yogurt 86

The Income Elasticity of Demand 87 Income Elasticity Defined 87

Cross Elasticity of Demand 90 Cross Price Elasticity Defined 90 Interpreting the Cross Price Elasticity 90 Antitrust and Cross Price Elasticities 90 An Empirical Illustration of Price, Income,

and Cross Elasticities 92 The Combined Effect of Demand Elasticities 92

Summary 93 Exercises 94 Case Exercise: Polo Golf Shirt Pricing 97

4 Estimating Demand 99 Chapter Preview 99

Managerial Challenge: Demand for Whitman’s Chocolate Samplers 99

Statistical Estimation of the Demand Function 100 Specification of the Model 101

A Simple Linear Regression Model 103 Assumptions Underlying the Simple Linear

Regression Model 104 Estimating the Population Regression

Coefficients 105 Using the Regression Equation to Make

Predictions 108 Inferences about the Population Regression

Coefficients 110 Correlation Coefficient 113

The Analysis of Variance 114 Multiple Linear Regression Model 116

Use of Computer Programs 116 Estimating the Population Regression

Coefficients 116 Using the Regression Model to Make Forecasts 116 Inferences about the Population Regression

Coefficients 117 The Analysis of Variance 119 Summary 120 Exercises 120 Case Exercise: Soft Drink Demand Estimation 124

4A Problems in Applying the Linear Regression Model 127 Introduction 127

Autocorrelation 127 Heteroscedasticity 129 Specification and Measurement Errors 130 Multicollinearity 131 Simultaneous Equation Relationships and

the Identification Problem 131 Nonlinear Regression Models 134

Semilogarithmic Transformation 134 Double-Log Transformation 134 Reciprocal Transformation 135 Polynomial Transformation 135 Summary 136 Exercises 136

5 Business and Economic Forecasting 139 Chapter Preview 139

Managerial Challenge: Excess Fiber Optic Capacity at Global Crossing Inc. 139

The Significance of Forecasting 141 Selecting a Forecasting Technique 141

Hierarchy of Forecasts 141 Criteria Used to Select a Forecasting

Technique 142 Evaluating the Accuracy of Forecasting Models 142

What Went Right/What Went Wrong: Crocs Shoes 142

Alternative Forecasting Techniques 143 Deterministic Trend Analysis 143

Components of a Time Series 143 Some Elementary Time-Series Models 144 Secular Trends 145 Seasonal Variations 148

Smoothing Techniques 150 Moving Averages 151 First-Order Exponential Smoothing 153

Barometric Techniques 156 Leading, Lagging, and Coincident Indicators 156

Survey and Opinion-Polling Techniques 157 Forecasting Macroeconomic Activity 158

x Contents

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Sales Forecasting 159 Econometric Models 159

Advantages of Econometric Forecasting Techniques 159

Single-Equation Models 159 Multi-Equation Models 161 Consensus Forecasts: Livingston and

Blue Chip Forecaster Surveys 162 Stochastic Time-Series Analysis 163 Forecasting with Input-Output Tables 166

International Perspectives: Long-Term Sales Forecasting by General Motors in Overseas Markets 166 Summary 167 Exercises 167 Case Exercise: Cruise Ship Arrivals in Alaska 171 Case Exercise: Lumber Price Forecast 172 Case Exercise: Forecasting in the Global

Financial Crisis 173

6 Managing in the Global Economy 176 Chapter Preview 176

Managerial Challenge: Financial Crisis Slows U.S. Household Consumption and Crushes Business Investment: Can Exports to China Provide a Recovery? 176

Introduction 179

What Went Right/What Went Wrong: Export Market Pricing at Toyota 180

Import-Export Sales and Exchange Rates 180 Foreign Exchange Risk 180

International Perspectives: Collapse of Export and Domestic Sales at Cummins Engine 182

Outsourcing 184 China Trade Blossoms 186

China Today 188 The Market for U.S. Dollars as Foreign

Exchange 190 Import-Export Flows and Transaction

Demand for a Currency 190 The Equilibrium Price of the U.S. Dollar 192 Speculative Demand, Government Transfers,

and Coordinated Intervention 192 Short-Term Exchange Rate Fluctuations 193

Determinants of Long-Run Trends in Exchange Rates 193 The Role of Real Growth Rates 194 The Role of Real Interest Rates 196 The Role of Expected Inflation 197

Purchasing Power Parity 198 PPP Offers a Better Yardstick of

Comparative Size of Business Activity 199

What Went Right/What Went Wrong: Big Box U.S. Retailers in China 200 Relative Purchasing Power Parity 201 Qualifications of PPP 202 The Appropriate Use of PPP: An Overview 202

What Went Right/What Went Wrong: GM, Toyota, and the Celica GT-S Coupe 203 Trade-Weighted Exchange Rate Index 204

International Trade: A Managerial Perspective 207 Shares of World Trade and Regional Trading

Blocs 207 Comparative Advantage and Free Trade 210 Import Controls and Protective Tariffs 212 The Case for Strategic Trade Policy 214 Increasing Returns 216 Network Externalities 216

Free Trade Areas: The European Union and NAFTA 217 Optimal Currency Areas 218 Intraregional Trade 219 Mobility of Labor 219 Correlated Macroeconomic Shocks 219

Largest U.S. Trading Partners: The Role of NAFTA 220 A Comparison of the EU and NAFTA 222 Gray Markets, Knockoffs, and Parallel

Importing 223

What Went Right/What Went Wrong: Ford Motor Co. and Exide Batteries: Are Country Managers Here to Stay? 224

Perspectives on the U.S. Trade Deficit 225 Summary 227 Exercises 228 Case Exercise: Predicting the Long-Term

Trends in Value of the U.S. Dollar and the Euro 229

Case Exercise: Elaborate the Debate on NAFTA 229

6A Foreign Exchange Risk Management 230

International Perspectives: Toyota and Honda Buy U.S. Assembly Capacity 231

PART III

PRODUCTION AND COST 233

7 Production Economics 234 Chapter Preview 234

Managerial Challenge: Green Power Initiatives Examined: What Went Wrong in California’s Deregulation of Electricity? 234

Contents xi

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The Production Function 236 Fixed and Variable Inputs 237

Production Functions with One Variable Input 239 Marginal and Average Product Functions 239 The Law of Diminishing Marginal

Returns 240

What Went Right/What Went Wrong: Factory Bottlenecks at a Boeing Assembly Plant 241 Increasing Returns with Network Effects 241 Producing Information Services under

Increasing Returns 243 The Relationship between Total, Marginal,

and Average Product 244 Determining the Optimal Use of the

Variable Input 246 Marginal Revenue Product 247 Marginal Factor Cost 247 Optimal Input Level 247

Production with Multiple Variable Inputs 248 Production (Output Constant) Isoquants 248 The Marginal Rate of Technical

Substitution 250 Determining the Optimal Combination of

Inputs 252 Isocost Lines 253 Minimizing Cost Subject to an Output

Constraint 254 A Fixed Proportions Optimal Production

Process 255 Production Processes and Process Rays 256

Measuring the Efficiency of a Production Process 257

Returns to Scale 258 Measuring Returns to Scale 259 Increasing and Decreasing Returns to Scale 260 The Cobb-Douglas Production Function 260 Empirical Studies of the Cobb-Douglas

Production Function in Manufacturing 261 A Cross-Sectional Analysis of U.S.

Manufacturing Industries 261 Summary 264 Exercises 265 Case Exercise: The Production Function

for Wilson Company 268

7A Production Economics of Renewable and Exhaustible Natural Resources, Advanced Material 270 Renewable Resources 270 Exhaustible Natural Resources 274

Exercises 279

8 Cost Analysis 280 Chapter Preview 280

Managerial Challenge: Can a Leaner General Motors Compete Effectively? 280

The Meaning and Measurement of Cost 281 Accounting versus Economic Costs 281 Three Contrasts between Accounting

and Economic Costs 282 Short-Run Cost and Product Functions 286

Average and Marginal Cost Functions 286 Long-Run Cost Functions 291

Optimal Capacity Utilization: Three Concepts 291

Economies and Diseconomies of Scale 292 The Percentage of Learning 293 Diseconomies of Scale 296 The Overall Effects of Scale Economies and

Diseconomies 296

International Perspectives: How Japanese Companies Deal with the Problems of Size 297 Summary 299 Exercises 300 Case Exercise: Cost Analysis of Patio Furniture 302 Case Exercise: Profit Margins on the

Amazon Kindle 304

9 Applications of Cost Theory 305 Chapter Preview 305

Managerial Challenge: How Exactly Have Computerization and Information Technology Lowered Costs at Chevron, Timken, and Merck? 305

Estimating Cost Functions 306 Issues in Cost Definition and Measurement 307 Controlling for Other Variables 307 The Form of the Empirical Cost-Output

Relationship 308

What Went Right/What Went Wrong: Boeing: The Rising Marginal Cost of Wide-Bodies 309 Statistical Estimation of Short-Run Cost

Functions 310 Statistical Estimation of Long-Run Cost

Functions 311 Determining the Optimal Scale of an Operation 311 Economies of Scale versus Economies of Scope 314 Engineering Cost Techniques 314 The Survivor Technique 316 A Cautionary Tale 317

Break-Even Analysis 317 Graphical Method 318

xii Contents

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Algebraic Method 318 Some Limitations of Break-Even Analysis 321 Doing a Break-Even versus a Contribution

Analysis 321 A Limitation of Contribution Analysis 323 Operating Leverage 323 Inherent Business Risk 325 Summary 325 Exercises 326 Case Exercise: Cost Functions 327 Case Exercise: Charter Airline Operating

Decisions 328

PART IV

PRICING AND OUTPUT DECISIONS: STRATEGY AND TACTICS 331

1 0 Prices, Output, and Strategy: Pure and Monopolistic Competition 332 Chapter Preview 332

Managerial Challenge: Resurrecting Apple in the Tablet World 332

Introduction 333 Competitive Strategy 334

What Went Right/What Went Wrong: Xerox 335 Generic Types of Strategies 336 Product Differentiation Strategy 336 Cost-Based Strategy 336 Information Technology Strategy 337 The Relevant Market Concept 339

Porter’s Five Forces Strategic Framework 339 The Threat of Substitutes 340 The Threat of Entry 341 The Power of Buyers and Suppliers 344 The Intensity of Rivalrous Tactics 345 The Myth of Market Share 349

A Continuum of Market Structures 349 Pure Competition 350 Monopoly 351 Monopolistic Competition 352 Oligopoly 352

Price-Output Determination under Pure Competition 353 Short Run 353 Profit Maximization under Pure Competition

(Short Run): Adobe Corporation 356 Long Run 357

Price-Output Determination under Monopolistic Competition 360

What Went Right/What Went Wrong: The Dynamics of Competition at Amazon.com 361 Short Run 361 Long Run 361

Selling and Promotional Expenses 363 Determining the Optimal Level of Selling

and Promotional Outlays 364 Optimal Advertising Intensity 365 The Net Value of Advertising 366

Competitive Markets under Asymmetric Information 367 Incomplete versus Asymmetric Information 367 Search Goods versus Experience Goods 368 Adverse Selection and the Notorious Firm 368 Insuring and Lending under Asymmetric

Information: Another Lemons Market 370 Solutions to the Adverse Selection Problem 371

Mutual Reliance: Hostage Mechanisms Support Asymmetric Information Exchange 371

Brand-Name Reputations as Hostages 372 Price Premiums with Non-Redeployable Assets 374 Summary 376 Exercises 377 Case Exercise: Netflix and Redbox Compete

for Movie Rentals 379 Case Exercise: Saving Sony Music 380

1 1 Price and Output Determination: Monopoly and Dominant Firms 382 Chapter Preview 382

Managerial Challenge: Dominant Microprocessor Company Intel Adapts to Next Trend 382

Monopoly Defined 383 Sources of Market Power for a Monopolist 383

Increasing Returns from Network Effects 384

What Went Right/What Went Wrong: Pilot Error at Palm 387

Price and Output Determination for a Monopolist 388 Spreadsheet Approach: Profit versus Revenue

Maximization for Polo Golf Shirts 388 Graphical Approach 389 Algebraic Approach 390 The Importance of the Price Elasticity of

Demand 391 The Optimal Markup, Contribution Margin,

and Contribution Margin Percentage 393 Gross Profit Margins 395 Components of the Margin 395 Monopolists and Capacity Investments 396

Contents xiii

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Limit Pricing 397 Using Limit Pricing to Hamper the Sales

of Generic Drugs 398 Regulated Monopolies 399

Electric Power Companies 400

What Went Right/What Went Wrong: The Public Service Company of New Mexico 400 Natural Gas Companies 401

The Economic Rationale for Regulation 401 Natural Monopoly Argument 401 Summary 403 Exercises 403 Case Exercise: Differential Pricing of

Pharmaceuticals: The HIV/AIDS Crisis 407

1 2 Price and Output Determination: Oligopoly 409 Chapter Preview 409

Managerial Challenge: Google’s Android and Apple’s iPhone Displace Nokia in Smart phones? 409

Oligopolistic Market Structures 411 Oligopoly in the United States: Relative

Market Shares 411 Interdependencies in Oligopolistic Industries 416

The Cournot Model 416 Cartels and Other Forms of Collusion 418

Factors Affecting the Likelihood of Successful Collusion 420

Cartel Profit Maximization and the Allocation of Restricted Output 421

International Perspectives: The OPEC Cartel 423 Cartel Analysis: Algebraic Approach 428

Price Leadership 430 Barometric Price Leadership 430 Dominant Firm Price Leadership 431

The Kinked Demand Curve Model 434 Avoiding Price Wars 435

What Went Right/What Went Wrong: Good-Better-Best Product Strategy at Marriott Corporation and Kodak 438 Summary 440 Exercises 441 Case Exercise: Web-Based Satellite Phones

Displace Motorola’s Mobile Phone 443

1 3 Best-Practice Tactics: Game Theory 444 Chapter Preview 444

Managerial Challenge: Large-Scale Entry Deterrence of Low-Cost Discounters: Southwest Airline/AirTran 444

Oligopolistic Rivalry and Game Theory 446

What Went Right/What Went Wrong: Nintendo’s Wii U 446 A Conceptual Framework for Game Theory

Analysis 447 Components of a Game 448 Cooperative and Noncooperative Games 450 Other Types of Games 450

Analyzing Simultaneous Games 451 The Prisoner’s Dilemma 451 Dominant Strategy and Nash Equilibrium

Strategy Defined 453 The Escape from Prisoner’s Dilemma 456

Multip