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This page is intentionally left blank MANAGERIAL ECONOMICS S E V E N T H E D I T I O N To Our Families W. F. S S. G. M MANAGERIAL ECONOMICS S E V E N T H E D I T I O N W i l l i a m F. S a m u e l s o n Boston University Stephen G. Marks Boston University JOHN WILEY & SONS, INC. VICE PRESIDENT & EXECUTIVE PUBLISHER SENIOR CONTENT EDITOR ASSISTANT EDITOR EDITORIAL ASSISTANT PRODUCT DESIGNER PRODUCTION MANAGER PRODUCTION EDITOR ASSOCIATE DIRECTOR OF MARKETING SENIOR MARKETING MANAGER MARKETING ASSISTANT CREATIVE DIRECTOR SENIOR DESIGNER PRODUCTION MANAGEMENT SERVICES SENIOR ILLUSTRATION EDITOR PHOTO EDITOR COVER PHOTO George Hoffman Jennifer Manias Emily McGee Erica Horowitz Greg Chaput Dorothy Sinclair Erin Bascom Amy Scholz Jesse Cruz Courtney Luzzi Harry Nolan James O’Shea Furino Production Anna Melhorn Sheena Goldstein Henry Georgi/Getty Images, Inc. This book was set in New Baskerville by MPS Limited, and printed and bound by RRD Jefferson City. 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Upon completion of the review period, please return the evaluation copy to Wiley. Return instructions and a free of charge return shipping label are available at www.wiley.com/go/returnlabel. If you have chosen to adopt this textbook for use in your course, please accept this book as your complimentary desk copy. Outside of the United States, please contact your local representative. Library of congress cataloging in Publication Data: Samuelson, William. Managerial economics/William F. Samuelson, Stephen G. Marks. –7th ed. p. cm. ISBN 978-1-118-04158-1(hardback) 1. Managerial economics. 2. Decision making. I. Marks, Stephen G. (Stephen Gary) II. Title. HD30.22.S26 2012 338.5024'658—dc23 2011029116 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1 P R E FA C E The last 25 years have witnessed an unprecedented increase in competition in both national and world markets. In this competitive environment, managers must make increasingly complex business decisions that will determine whether the firm will prosper or even survive. Today, economic analysis is more important than ever as a tool for decision making. OBJECTIVES OF THIS BOOK The aims of this textbook are to illustrate the central decision problems managers face and to provide the economic analysis they need to guide these decisions. It was written with the conviction that an effective managerial economics textbook must go beyond the “nuts and bolts” of economic analysis; it should also show how practicing managers use these economic methods. Our experience teaching managerial economics to undergraduates, M.B.A.s, and executives alike shows that a focus on applications is essential. KEY FEATURES Managerial Decision Making The main feature that distinguishes Managerial Economics, Seventh Edition, is its consistent emphasis on managerial decision making. In a quest to explain economics per se, many current texts defer analysis of basic managerial decisions such as optimal output and pricing policies until later chapters—as special applications or as relevant only to particular market structures. In contrast, decision making is woven throughout every chapter in this book. Each chapter begins with a description of a real managerial problem that challenges students to ponder possible choices and is concluded by revisiting and analyzing the decision in light of the concepts introduced in the chapter. Without exception, the principles of managerial economics are introduced and analyzed by extended decision-making examples. Some of these examples include pricing airline seats (Chapter 3), producing auto parts (Chapter 5), competing as a commercial day-care provider (Chapter 11), choosing between risky research and development projects (Chapter 12), and negotiating to sell a warehouse (Chapter 15). In addition to reviewing important concepts, the summary at the end of each chapter lists essential decision-making principles. The analysis of optimal decisions is presented early in the book. Chapter 2 introduces and analyzes the basic profit-maximization problem of the firm. vi Preface Chapter 3 begins with a traditional treatment of demand and goes on to apply demand analysis to the firm’s optimal pricing problem. Chapters 5 and 6 take a closer look at production and cost as guides to making optimal managerial decisions. The emphasis on decision making continues throughout the remainder of the book because, in our view, this is the best way to teach managerial economics. The decision-making approach also provides a direct answer to students’ perennial question: How and why is this concept useful? A list of real-world applications used throughout the text appears on the inside of the front cover. New Topics At one time, managerial economics books most closely resembled intermediate microeconomics texts with topics reworked here and there. Due to the advance of modern management techniques, the days when this was sufficient are long past. This text goes far beyond current alternatives by integrating the most important of these advances with the principal topic areas of managerial economics. Perhaps the most significant advance is the use of game theory to illuminate the firm’s strategic choices. Game-theoretic principles are essential to understanding strategic behavior. An entire chapter (Chapter 10) is devoted to this topic. Other chapters apply the game-theoretic approach to settings of oligopoly (Chapter 9), asymmetric information and organization design (Chapter 14), negotiation (Chapter 15), and competitive bidding (Chapter 16). A second innovation of the text is its treatment of decision making under uncertainty. Managerial success—whether measured by a particular firm’s profitability or by the international competitiveness of our nation’s businesses as a whole—depends on making decisions that involve risk and uncertainty. Managers must strive to envision the future outcomes of today’s decisions, measure and weigh competing risks, and determine which risks are acceptable. Other managerial economics textbooks typically devote a single, short chapter to decision making under uncertainty after devoting a dozen chapters to portraying demand and cost curves as if they were certain. Decision making under uncertainty is a prominent part of Managerial Economics, Seventh Edition. Chapter 12 shows how decision trees can be used to structure decisions in high-risk environments. Chapter 13 examines the value of acquiring information about relevant risks, including optimal search strategies. Subsequent chapters apply the techniques of decision making under uncertainty to topics that are on the cutting edge of managerial economics: organization design, negotiation, and competitive bidding. A third innovation is the expanded coverage of international topics and applications. In place of a stand-alone chapter on global economic issues, we have chosen to integrate international applications throughout the text. For instance, early applications in Chapters 2 and 3 include responding to Preface exchange-rate changes and multinational pricing. Comparative advantage, tariffs and quotas, and the risks of doing international business are additional applications taken up in later chapters. In all, 15 of the 17 chapters contain international applications. In short, our aim is to leave the student with a first-hand appreciation of business decisions within the global economic environment. A fourth innovation is the addition of end-of-chapter spreadsheet problems. In the last 25 years, spreadsheets have become the manager’s single most important quantitative tool. It is our view that spreadsheets provide a natural means of modeling managerial decisions. In their own way, they are as valuable as the traditional modeling approaches using equations and graphs. (This admission comes from a long ago college math major who first saw spreadsheets as nothing more than “trivial” arithmetic and a far cry from “true” programming.) Optimization is one hallmark of quantitative decision making, and with the advent of optimizer tools, managers can use spreadsheets to model problems and to find and explore profit-maximizing solutions. A second hallmark is equilibrium analysis. Again, spreadsheet tools allow immediate solutions of what otherwise would be daunting sets of simultaneous equations. Spreadsheets offer a powerful way of portraying economic decisions and finding optimal solutions without a large investment in calculus methods. We have worked hard to provide a rich array of spreadsheet problems in 15 of the 16 principal chapters. Some of these applications include optimal production and pricing, cost analysis with fixed and variable inputs, competitive market equilibrium in the short and long runs, monopoly practices, Nash equilibrium behavior, identifying superior mutual fund performance, and the welfare effects of externalities. In each case, students are asked to build and analyze a simple spreadsheet based on an example provided for them. In addition, a special appendix in Chapter 2 provides a self-contained summary of spreadsheet optimization. In short, using spreadsheets provides new insights into managerial economics and teaches career-long modeling skills. Organization, Coverage, and Level This textbook can be used by a wide range of students, from undergraduate business majors in second-level courses to M.B.A. students and Executive Program participants. The presentation of all topics is self-contained. Although most students will have taken an economics principles course in their recent, or not so recent, past, no prior economic tools are presumed. The presentations begin simply and are progressively applied to more and more challenging applications. Each chapter contains a range of problems designed to test students’ basic understanding. A number of problems explore advanced applications and are indicated by an asterisk. Answers to all odd-numbered problems are given on our book’s web site at www.wiley.com/college/samuelson. vii viii Preface Suggested references at the end of each chapter direct students to extensions and advanced applications of the core topics presented in the chapter. Although this text has many unique features, its organization and coverage are reasonably standard. All of the topics that usually find a home in managerial economics are covered and are in the usual sequence. As noted earlier, the analytics of profit maximization and optimal pricing are presented up front in Chapter 2 and the second part of Chapter 3. If the instructor wishes, he or she can defer these optimization topics until after the chapters on demand and cost. In addition, the book is organized so that specific chapters can be omitted without loss of continuity. In the first section of the book, Chapters 4 and 5 fit into this category. In the second section of the book, Chapters 7, 8, and 9 are core chapters that can stand alone or be followed by any combination of the remaining chapters. The book concludes with applications chapters, including chapters on decision making under uncertainty, asymmetric information, negotiation, and linear programming that are suitable for many broad-based managerial economics courses. Analyzing managerial decisions requires a modest amount of quantitative proficiency. In our view, understanding the logic of profit-maximizing behavior is more important than mathematical sophistication; therefore, Managerial Economics, Seventh Edition, uses only the most basic techniques of differential calculus. These concepts are explained and summarized in the appendix to Chapter 2. Numerical examples and applications abound throughout all of the chapters. In our view, the best way for students to master the material is to learn by example. Four to six “Check Stations”—mini-problems that force students to test themselves on their quantitative understanding—appear throughout each chapter. In short, the text takes a quantitative approach to managerial decision making without drowning students in mathematics. THE SEVENTH EDITION While continuing to emphasize managerial decision making, the Seventh Edition of Managerial Economics contains several changes. First, we have extensively revised and updated the many applications in the text. Analyzing the economics of Groupon; optimally pricing a best-seller, both the hardback edition and the e-book version; using regression analysis to estimate box-office revenues for film releases; judging the government’s antitrust case against Microsoft; or weighing the challenges of corporate governance in the aftermath of the financial crisis—these are all important and timely economic applications. Second, we have highlighted and expanded an applications feature called Business Behavior. The rapidly growing area of behavioral economics asks: How does actual decision-making behavior and practice compare with the prescriptions of economics and decision analysis? In many cases, the answer is that