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7e MANAGERIAL ECONOMICS BUSINESS STR ATEGY PROVEN. TRUSTED. AND Managerial Economics and Business Strategy is the best-selling managerial economics textbook on the market today. Michael Baye provides students with tools like intermediate microeconomics, game theory, and industrial organization that are crucial to making sound managerial decisions. The Seventh Edition discusses the latest issues and research shaping managerial economics today. KEY FEATURES OF THIS NEW EDITION INCLUDE: UPDATED HEADLINES: Updated and current Headlines begin each chapter with a real-world economic problem. These problems are essentially hand-picked “mini-cases” designed to motivate students to better understand the chapter material. MD DALIM #1042728 8/14/09 CYAN MAG YELO BLK NEW AND UPDATED INSIDE BUSINESS APPLICATIONS: New Inside Business boxes illustrate real-world applications of theory developed in the chapter; these examples are drawn from both current economic literature and the popular press. TIME WARNER CASE STUDY: A Case Study in business strategy — Challenges at Time Warner — follows Chapter 14. The case engages students by applying core elements from managerial economics to a rich business environment. 7e MICHAEL R. BAYE MICHAEL R. BAYE MANAGERIAL ECONOMICS AND BUSINESS STR ATEGY BAYE For more information and resources, please visit the text’s Online Learning Center: www.mhhe.com/baye7e ISBN 978-0-07-337596-0 MHID 0-07-337596-9 90000 9 780073 375960 www.mhhe.com MICHAEL R. BAYE bay75969_fm_i-xxxii.qxd 8/20/09 14:58 Page i Managerial Economics and Business Strategy Confirming Pages bay75969_fm_i-xxxii.qxd Nash 8/20/09 14:58 Page ii Equilibrium • Predatory Demand Marginal Elasticity • Vertical Confirming Pages Pricing • Mergers & Acquisitions • Foreclosure • Penetration Cost • Bottlenecks • First-Mover Pricing • Advantage • Signaling • Learning Curve • Marginal Revenue • Repeated Games • Microsoft • Screening • Network Two-Part Effects • Antitrust • Cost Pricing • Limit Complementarities • Pricing • Tariffs • Bargaining • Cournot Oligopoly • American Airlines • Raising Rivals’ Costs • Moral Hazard • eBay • Price Discrimination • Adverse Selection • Economies of Scope • Auctions • Bundling • Block Advertising • Perfect Pricing • Stackelberg Equilibrium • Coordination • General Oligopoly • Motors • Quotas • Extensive Form Games • Economies of Scale • Netscape • Hold-up Problem • Patents • Bertrand Oligopoly • Commitment • Economies of Scale • Tariffs • Antitrust • Transfer Pricing • Collusion • Piece Rates • Profit-Sharing • Sunk Costs • Takeovers • Trigger Strategies • Low-Price Guarantees • Sony • Time Warner • Five Forces Framework • AOL • Globalization • Best-Response Function • Cannibalization • Product Differentiation • Value of Information bay75969_fm_i-xxxii.qxd 8/20/09 14:58 Page iii SEVENTH EDITION Managerial Economics and Business Strategy Michael R. Baye Bert Elwert Professor of Business Economics & Public Policy Kelley School of Business Indiana University Confirming Pages bay75969_fm_i-xxxii.qxd 8/20/09 14:58 Page iv Confirming Pages MANAGERIAL ECONOMICS AND BUSINESS STRATEGY Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2010, 2008, 2006, 2003, 2000, 1997, 1994 by The McGraw-Hill Companies, Inc. All rights reserved. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside the United States. This book is printed on acid-free paper. 1 2 3 4 5 6 7 8 9 0 DOC/DOC 0 9 ISBN 978-0-07-337596-0 MHID 0-07-337596-9 Vice president and editor-in-chief: Brent Gordon Publisher: Douglas Reiner Director of development: Ann Torbert Development editor: Anne E. Hilbert Vice president and director of marketing: Robin J. Zwettler Associate marketing manager: Dean Karampelas Vice president of editing, design and production: Sesha Bolisetty Senior project manager: Bruce Gin Senior production supervisor: Debra R. Sylvester Designer: Matt Diamond Senior media project manager: Greg Bates Cover design: Matt Diamond Interior design: Matt Diamond Typeface: 10/12 Times Roman Compositor: Laserwords Private Limited Printer: R. R. Donnelley Library of Congress Cataloging-in-Publication Data Baye, Michael R., 1958Managerial economics and business strategy / Michael R. Baye. — 7th ed. p. cm. Includes index. ISBN-13: 978-0-07-337596-0 (alk.paper) ISBN-10: 0-07-337596-9 (alk. paper) 1. Managerial economics. 2. Strategic planning. I. Title. HD30.22.B38 2010 338.5024'658—dc22 2009017267 www.mhhe.com bay75969_fm_i-xxxii.qxd 8/20/09 14:58 Page v Confirming Pages The McGraw-Hill Series Economics ESSENTIALS OF ECONOMICS Brue, McConnell, and Flynn Essentials of Economics Second Edition Mandel Economics: The Basics First Edition Schiller Essentials of Economics Seventh Edition PRINCIPLES OF ECONOMICS Colander Economics, Microeconomics, and Macroeconomics Eighth Edition Frank and Bernanke Principles of Economics, Principles of Microeconomics, Principles of Macroeconomics Fourth Edition Frank and Bernanke Brief Editions: Principles of Economics, Principles of Microeconomics, Principles of Macroeconomics First Edition McConnell, Brue, and Flynn Economics, Microeconomics, and Macroeconomics Eighteenth Edition McConnell, Brue, and Flynn Brief Editions: Microeconomics and Macroeconomics First Edition Miller Principles of Microeconomics First Edition Samuelson and Nordhaus Economics, Microeconomics, and Macroeconomics Nineteenth Edition Schiller The Economy Today, The Micro Economy Today, and The Macro Economy Today Twelfth Edition Slavin Economics, Microeconomics, and Macroeconomics Ninth Edition ECONOMICS OF SOCIAL ISSUES Guell Issues in Economics Today Fifth Edition Sharp, Register, and Grimes Economics of Social Issues Nineteenth Edition ECONOMETRICS Gujarati and Porter Basic Econometrics Fifth Edition Gujarati and Porter Essentials of Econometrics Fourth Edition MANAGERIAL ECONOMICS Baye Managerial Economics and Business Strategy Seventh Edition Brickley, Smith, and Zimmerman Managerial Economics and Organizational Architecture Fifth Edition Thomas and Maurice Managerial Economics Tenth Edition MONEY AND BANKING Cecchetti Money, Banking, and Financial Markets Second Edition URBAN ECONOMICS O’Sullivan Urban Economics Seventh Edition LABOR ECONOMICS Borjas Labor Economics Fifth Edition McConnell, Brue, and Macpherson Contemporary Labor Economics Ninth Edition PUBLIC FINANCE Rosen and Gayer Public Finance Ninth Edition Seidman Public Finance First Edition ENVIRONMENTAL ECONOMICS Field and Field Environmental Economics: An Introduction Fifth Edition INTERMEDIATE ECONOMICS Bernheim and Whinston Microeconomics First Edition Dornbusch, Fischer, and Startz Macroeconomics Tenth Edition Frank Microeconomics and Behavior Eighth Edition ADVANCED ECONOMICS Romer Advanced Macroeconomics Third Edition INTERNATIONAL ECONOMICS Appleyard, Field, and Cobb International Economics Seventh Edition King and King International Economics, Globalization, and Policy: A Reader Fifth Edition Pugel International Economics Fourteenth Edition bay75969_fm_i-xxxii.qxd 8/20/09 14:58 Page vi Confirming Pages To Natalie and Mitchell—Thanks for teaching me about the buyer side of the college market. ABOUT THE AUTHOR Michael Baye is the Bert Elwert Professor of Business Economics & Public Policy at Indiana University’s Kelley School of Business. He received his B.S. in economics from Texas A&M University in 1980 and earned a Ph.D. in economics from Purdue University in 1983. Prior to joining Indiana University, he taught graduate and undergraduate courses at The Pennsylvania State University, Texas A&M University, and the University of Kentucky. Professor Baye served as the Director of the Bureau of Economics at the Federal Trade Commission from July 2007–December 2008. Professor Baye has won numerous awards for his outstanding teaching and research and regularly teaches courses in managerial economics and industrial organization at the undergraduate, M.B.A., and Ph.D. levels. Professor Baye has made a variety of contributions to the fields of game theory and industrial organization. His research on mergers, auctions, and contests has been published in such journals as the American Economic Review, the Review of Economic Studies, and the Economic Journal. Professor Baye’s research on pricing strategies in online and other environments where consumers search for price information has been published in economics journals (such as the American Economic Review, Econometrica, and the Journal of Political Economy), featured in the popular press (including The Wall Street Journal, Forbes, and The New York Times), and published in leading marketing journals. His research has been supported by the National Science Foundation, the Fulbright Commission, and other organizations. Professor Baye has held visiting appointments at Cambridge, Oxford, Erasmus University, Tilburg University, and the New Economic School in Moscow, Russia. He has served on numerous editorial boards in economics as well as marketing, including Economic Theory and the Journal of Public Policy & Marketing. When he is not teaching or engaged in research, Michael enjoys activities ranging from camping to shopping for electronic gadgets. vi bay75969_fm_i-xxxii.qxd 8/20/09 14:58 Page vii Confirming Pages PREFACE TO THE SEVENTH EDITION Thanks to feedback from users around the world, Managerial Economics and Business Strategy remains the top selling managerial text in the market. I am grateful to all of you for allowing me to provide this updated and improved product. Before highlighting some of the new features of the seventh edition, I would like to stress that the fundamental goal of the book—providing students with the tools from intermediate microeconomics, game theory, and industrial organization that they need to make sound managerial decisions—has not changed. This book begins by teaching managers the practical utility of basic economic tools such as present value analysis, supply and demand, regression, indifference curves, isoquants, production, costs, and the basic models of perfect competition, monopoly, and monopolistic competition. Adopters and reviewers also praise the book for its real-world examples and because it includes modern topics not contained in any other single managerial economics textbook: oligopoly, penetration pricing, multistage and repeated games, foreclosure, contracting, vertical and horizontal integration, networks, bargaining, predatory pricing, principal–agent problems, raising rivals’ costs, adverse selection, auctions, screening and signaling, search, limit pricing, and a host of other pricing strategies for firms enjoying market power. This balanced coverage of traditional and modern microeconomic tools makes it appropriate for a wide variety of managerial economics classrooms. An increasing number of business schools are adopting this book to replace (or use alongside) managerial strategy texts laden with anecdotes but lacking the microeconomic tools needed to identify and implement the business strategies that are optimal in a given situation. This seventh edition of Managerial Economics and Business Strategy has been thoroughly updated but retains all of the content that made previous editions successful. The basic structure of the textbook is unchanged. KEY PEDAGOGICAL FEATURES The seventh edition retains all of the class-tested features of previous editions that enhance students’ learning experiences and make it easy to teach from this book. Headlines As in previous editions, each chapter begins with a Headline that is based on a realworld economic problem—a problem that students should be able to address after completing the chapter. These Headlines are essentially hand-picked “mini-cases” designed to motivate students to learn the material in the chapter. Each Headline is vii bay75969_fm_i-xxxii.qxd viii 8/20/09 14:58 Page viii Confirming Pages Preface answered at the end of the relevant chapter—when the student is better prepared to deal with the complications of real-world problems. Reviewers as well as users of previous editions praise the Headlines not only because they motivate students to learn the material in the chapter, but also because the answers at the end of each chapter help students learn how to use economics to make business decisions. Learning Objectives Each chapter includes learning objectives designed to enhance the learning experience. Demonstration Problems The best way to learn economics is to practice solving economic problems. So, in addition to the Headlines, each chapter contains many Demonstration Problems sprinkled throughout the text, along with detailed answers. This provides students with a mechanism to verify that they have mastered the material and reduces the cost to students and instructors of having to meet during office hours to discuss answers to problems. Inside Business Applications Each chapter contains boxed material (called Inside Business applications) to illustrate how theories explained in the text relate to a host of different business situations. As in previous editions, I have tried to strike a balance between applications drawn from the current economic literature and the popular press. Calculus and Noncalculus Alternatives Users can easily include or exclude calculus-based material without losing content or continuity. That’s because the basic principles and formulae needed to solve a particular class of economic problems (e.g., MR  MC) are first stated without appealing to the notation of calculus. Immediately following each stated principle or formula is a clearly marked Calculus Alternative. Each of these calculus alternatives states the preceding principle or formula in calculus notation, and explains the relation between the calculus and noncalculus formula. More detailed calculus derivations are relegated to Appendices. Thus, the book is designed for use by instructors who want to integrate calculus into managerial economics and by those who do not require students to use calculus. Key Terms and Marginal Definitions Each chapter ends with a list of key terms and concepts. These provide an easy way for instructors to glean material covered in each chapter and for students to check their mastery of terminology. In addition, marginal definitions are provided throughout the text. bay75969_fm_i-xxxii.qxd 8/20/09 14:58 Page ix Confirming Pages ix Preface End-of-Chapter Problems Three types of problems are offered. Highly structured but nonetheless challenging Conceptual and Computational Questions stress fundamentals. These are followed by Problems and Applications, which are far less structured and, like real-world decision environments, may contain more information than is actually needed to solve the problem. Many of these applied problems are based on actual business events. Additionally, the Time Warner case that follows Chapter 14 includes 14 problems called Memos that have a “real-world feel” and complement the text. All of these case-based problems may be assigned on a chapter-by-chapter basis as specific skills are introduced, or as part of a capstone experience. Solutions to all of the memos are contained online at www.mhhe.com/baye7e. Answers to selected end-of-chapter Conceptual and Computational Questions are presented at the end of the book; detailed answers to all problems—including Problems and Applications and the Time Warner case Memos, are available to instructors on the password-protected Web site. Case Study A case study in business strategy—Challenges at Time Warner—follows Chapter 14 and was prepared by Kyle Anderson, Michael Baye, and Dong Chen especially for this text. It can be used either as a capstone case for the course or to supplement individual chapters. The case allows students to apply core elements from managerial economics to a remarkably rich business environment. Instructors can use the case as the basis for an “open-ended” discussion of business strategy, or they can assign specific “memos” (contained at the end of the case) that require students to apply specific tools from managerial economics to the case. Teaching notes, as well as solutions to all of the memos, are provided on the Web site. Flexibility Instructors of managerial economics have genuinely heterogeneous textbook needs. Reviewers and users continue to praise the book for its flexibility, and assure us that sections or even entire chapters can be excluded without losing continuity. For instance, an instructor wishing to stress microeconomic fundamentals might choose to cover Chapters 2, 3, 4, 5, 8, 9, 10, 11, and 12. An instructor teaching a more applied course that stresses business strategy might choose to cover Chapters 1, 2, 3, 5, 6, 7, 8, 10, 11, and 13. Each may choose to include additional chapters (for example, Chapter 14 or the Time Warner case) as time permits. More generally, instructors can easily omit topics such as present value analysis, regression, indifference curves, isoquants, or reaction functions without losing continuity. Online Resources at www.mhhe.com/baye7e A large assortment of student supplements for Managerial Economics and Business Strategy are available online at www.mhhe.com/baye7e. This includes data for the Time Warner case Memos, data needed for various end-of-chapter problems, spreadsheet