Solution Manual Managerial Economics 7th Edition Allen
Solution Manual Managerial Economics 7th Edition Allen
Managerial Economics
SEVENTH EDITION
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INSTRUCTOR’S MANUAL
Managerial Economics
SEVENTH EDITION
Robert Brooker
GANNON UNIVERSITY
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[Copyright TK]
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Contents
Chapter 1 Introduction 1
Chapter 2 Demand Theory 12
Chapter 3 Consumer Behavior and Rational Choice 28
Chapter 4 Production Theory 45
Chapter 5 The Analysis of Costs 59
Chapter 6 Perfect Competition 73
Chapter 7 Monopoly and Monopolistic Competition 83
Chapter 8 Managerial Use of Price Discrimination 99
Chapter 9 Bundling and Intrafirm Pricing 117
Chapter 10 Oligopoly 132
Chapter 11 Game Theory 148
Chapter 12 Auctions 163
Chapter 13 Risk Analysis 173
Chapter 14 Principal–Agent Issues and Managerial Compensation 189
Chapter 15 Adverse Selection 204
Chapter 16 Government and Business 214
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CHAPTER 1 Introduction
Lecture Notes
1. Introduction
• Objectives
ÿ Provide a guide to making good managerial decisions.
ÿ Use formal models to analyze the effects of managerial decisions on
measures of a firm’s success.
• Managerial Economics
ÿ Differs from microeconomics in that the former focuses on descrip-
tion and prediction while managerial economics is prescriptive
ÿ Is an integrative course that brings the various functional areas of
business together in a single analytical framework
ÿ Exhibits economies of scope by integrating material from other disci-
plines and thereby reinforcing and enhancing understanding of those
subjects
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2 | Chapter 1
ÿ Notation
pt Profit in time t total revenue in time t total cost in time t
i Interest rate
n Number of time periods
TRt Total revenue in time t
TCt Total cost in time t
• Managerial Choices
ÿ Influence total revenue by managing demand
ÿ Influence total cost by managing production
ÿ Influence the relevant interest rate by managing finances and risk
• Managerial Constraints
ÿ Available technologies
ÿ Resource scarcity
ÿ Legal or contractual limitations
STRATEGY SESSION:
Bono Sees Red and Corporate Participants See Black
Discussion Questions
1. 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 Profit
ÿ Accounting profit
* Historical costs
* Legal compliance
* Reporting requirements
ÿ Economic profit
* Market value
* Opportunity, or implicit cost
* More useful measure for managerial decision making
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Introduction | 3
ÿ Risk taking: Knowing that future outcomes and their likelihoods are
unknown, as are the reactions of rivals.
ÿ Exploiting market inefficiencies: Building barriers to entry, employ-
ing sophisticated pricing strategies, diversifying, and making good
strategic production decisions
STRATEGY SESSION:
Baseball Discovers the Law of Supply and Demand
Discussion Questions
1. Do you see a relationship between variable pricing of baseball game tick-
ets and odds making on horse races?
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4 | Chapter 1
2. How do you think real-time variable pricing would influence the practice
of ticket scalping?
STRATEGY SESSION:
Demand and Supply—How High Oil Prices Coax
High-Cost Suppliers into the Market
Discussion Questions
1. During 2008, the price of a barrel of crude oil rose to above $130. In the
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last quarter of 2008, financial crisis lead to a global economic slowdown.
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Introduction | 5
The price of oil promptly dropped by half. Were these price fluctuations
the result of changes in supply or demand?
2. Given the volatility of crude oil prices, do you think that private investors
will be likely to develop projects to extract oil from oil shale? How do you
think investment in alternative technologies like solar, geothermal, wind,
and biomass are likely to respond to oil price volatility?
3. Government can encourage the development of alternative sources of
energy such as extraction of oil from oil shale by offering incentives such as
tax credits or subsidies or by direct investment. Should it? What are the
pros and cons of government intervention in the development of energy
technologies?
9. Equilibrium Price
• Disequilibrium Price
ÿ Price is too high.
* Excess supply
* Surplus
* Causes price to fall
ÿ Price is too low.
* Excess demand
* Shortage
* Causes price to rise
• Equilibrium Price
ÿ Quantity demanded is equal to quantity supplied.
ÿ Price is stable.
ÿ The market is in balance because everyone who wants to purchase the
good can, and every seller who wants to sell the good can.
• Actual Price
ÿ Invisible hand is the situation when no governmental agency is needed
to induce producers to drop or increase their prices.
ÿ If the actual price is above the equilibrium price, there will be a sur-
plus that will put downward pressure on the actual price.
ÿ If the actual price is below the equilibrium price, there will be a short-
age that will put downward pressure on the actual price.
ÿ If the actual price is equal to the equilibrium price, there will be nei-
ther a shortage nor a surplus and price will be stable.
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6 | Chapter 1
STRATEGY SESSION:
Life During a Market Movement
Discussion Questions
1. Several factors are mentioned as contributing to disequilibrium in global
food markets. Among them are emotions (panic), government restrictions
on trade, the Malthusian specter of population growth outpacing food pro-
duction, slowing productivity growth in the agricultural sector, rising
incomes, and the production of ethanol. Which of these are supply factors,
and which are demand factors? How does each influence market price?
2. The market price for crude oil fluctuated widely during 2008. What sup-
ply and demand factors contributed to these fluctuations? Is the petroleum
market subject to any of the same factors cited as influencing agricultural
markets?
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Introduction | 7
Solution:
There was a substantial risk of loss. On the other hand, there was substantial
opportunity for gain. Risk is unavoidable. The appropriate balance between
risk and return is what should determine managers’ decisions. Successful
decisions in circumstances of risk are a source of profit.
2. Some say that any self-respecting top manager joining a company does so
with 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 percentage
of 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 in a sin-
gle industry has a poorly diversified human capital portfolio. Such an execu-
tive also often has a significant, undiversified financial investment in the
form of stock options and pension plans that are used in partial substitution
for current salary to align the long-term wealth of the executive with that of
the shareholders. As an executive climbs the corporate ladder, the value
of his or her human capital becomes more closely tied to the fortunes of the
firm and industry. This lack of diversification requires a compensating risk
premium. A large signing bonus may allow a risk-averse executive to make
an investment that increases the value of the firm but that the executive
would otherwise avoid because of concern for his or her own personal wealth;
thus the bonus may reduce the principal–agent conflict. Of course, the ben-
efits of reduced risk to the executive come at the potential cost of indifference
to the wealth of the shareholders. Although a large signing bonus may help
solve the incentive alignment problem, compensation that is too great and too
insensitive to the fortunes of the shareholders makes the principal–agent prob-
lem worse.
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8 | Chapter 1
3. If the interest rate is 10 percent, what is the present value of the Monroe
Corporation’s profit in the next 10 years?
Number of Years Profit
in the Future (millions of dollars)
1 8
2 10
3 12
4 14
5 15
6 16
7 17
8 15
9 13
10 10
Solution:
Number of Years Profit Present Value
in the Future (millions of dollars) (1 i)t (millions of dollars)
1 8 0.90909 7.27272
2 10 0.82645 8.26450
3 12 0.75131 9.01572
4 14 0.68301 9.56214
5 15 0.62092 9.31380
6 16 0.56447 9.03152
7 17 0.51316 8.72372
8 15 0.46651 6.99765
9 13 0.42410 5.51330
10 10 0.38554 3.85540
Total 77.55047
The answer is $77.55047 million.
Solution:
Economic profits differ from accounting profits because of differences in
the way depreciation is measured, differences in the way revenues and costs
are recognized in terms of timing, and the inclusion of the opportunity cost
of owner-supplied inputs in the calculation of economic profits. Du Pont’s
-1— economic profits might well be negative if accounting profits do not exceed
0— the risk-adjusted rate of return multiplied by the firm’s equity value.
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Introduction | 9
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. He
believes he can rent each umbrella to vacationers at $5 a day, and he intends to
lease 50 umbrellas for the three-month period for $3,000. To operate this busi-
ness, he does not have to hire anyone (but himself), and he has no expenses
other than the leasing costs and a fee of $3,000 per month to rent the business
location. Howe is a college student, and if he did not operate this business, he
could earn $4,000 for the three-month period doing construction work.
a. If there are 80 days during the summer when beach umbrellas are
demanded, 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) $20,000
TC (3 months) ($3,000 per month rent) ($3,000 umbrella lease)
$12,000
Accounting Profit TR TC $8,000
b. Economic profit accounting profit opportunity cost
Economic profit $8,000 $4,000 $4,000
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10 | Chapter 1
the money. When you mount a show now, you really have to think about
where it’s going to play later.” If so, should the profit figures here be inter-
preted with caution?
d. If the investors in this revival of Gypsy make 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 would pay
off the $10 million investment in 10,000/165 60.6 or 61 weeks. If the
price is $65, it would take 10,000/80 125 weeks to pay off the invest-
ment. This does not provide for any return on investment, however.
b. The investors in Gypsy were indeed taking a substantial risk. If only one
in three shows breaks even, two out of three make losses.
c. The profit figures should be interpreted with caution because they do not
take into account the likelihood of profits when, and if, the show goes on
the road.
d. Yes.
Solution:
Setting demand equal to supply yields
12.4 4Q 2.6 2Q
Q 15/6 2.5
P 12.4 (4)(2.5) 2.6 (2)(2.5) $2.40
The actual price need not be equal to equilibrium price, although it will gen-
erally tend to move toward it because of the equilibrating effects of shortage
and surplus. Factors that might prevent the actual price from equaling the equi-
librium price include the cost and availability of information, transportation
costs, and a lack of opportunities for price equalizing arbitrage.
-1— 8. The lumber industry was hit hard by the subprime mortgage turmoil in
0— 2008. Prices plunged from $290 per thousand board feet to less than $200
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Introduction | 11
per thousand board feet. Many observers believed this price decrease was
caused by the slowing of new home construction because of the glut of
unsold homes on the market. Was this price decrease caused by a shift in the
supply or demand curve?
Solution:
Because the demand for lumber is derived in large part from the demand for
new housing construction, a decline in construction would be likely to cause
the demand for lumber to fall, leading to lower lumber prices. Supply would
not be affected by changes in housing construction.
9. From November 2007 to March 2008, the price of gold increased from $865
per pound to over $1,000 per pound. Newspaper articles during this period
said there was little increased demand from the jewelry industry but signifi-
cantly more demand from investors who were purchasing gold because of
the falling dollar.
a. Was this price increase due to a shift in the demand curve for gold, a shift
in 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 globally
traded commodities to change. If the value of the dollar falls, the dollar
price of commodities will rise. In this case, a decline in the value of the
dollar can be expected to cause the market for gold (with price measured
in dollars) to experience an increase in demand and a decrease in supply,
and thus an increase in price. There may also have been an additional
increase in demand due to expectations by investors that the dollar price
of gold would continue to rise. Finally, there may have been a further
supply decrease if producers, speculating that prices would rise further,
withheld gold from the market.
b. Gold is an input to the production of jewelry. An increase in the price of
gold would therefore be expected to reduce the supply of jewelry, result-
ing in higher jewelry prices.
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CHAPTER 2 Demand Theory
Lecture Notes
1. Introduction
• Objectives
ÿ Explain the importance of market demand in the determination of
profit.
ÿ Understand the many factors that influence demand.
* Elasticity: Measures the percentage change in one factor given a
small (marginal) percentage change in another factor.
* Demand elasticity: Measures the percentage change in quantity
demanded given a small (marginal) percentage change in another
factor that is related to demand.
ÿ Explain the role of managers in controlling and predicting market
demand.
* Managers can influence demand by controlling, among other things,
price, advertising, product quality, and distribution strategies.
* Managers cannot control, but need to understand, elements of the
competitive environment that influence demand, including the avail-
ability of substitute goods, their pricing, and the advertising strate-
gies employed by their sellers.
* Managers cannot control, but need to understand how the macro-
economic environment influences demand, including interest rates,
taxes, and both local and global levels of economic activity.
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Demand Theory | 13
STRATEGY SESSION:
The Customer Is Always Right—Wrong!
Discussion Questions
1. Like retail technology stores, clothing stores have their angels and devils.
How do you think the devils prey on clothing stores, and how could their
behavior be discouraged? How do you think angels could be encouraged
to shop at a par ticular clothing store?
Answer: Devils buy clothes, wear them, and then return them for a refund.
Stores can refuse to provide refunds on returns and, instead, provide a credit
for future purchases or only allow exchanges. Angels buy lots of clothes on
impulse. Stores could offer quantity discounts or a “shoppers club” with
special notification of sales.
2. Some electronics stores refuse to allow customers to return or exchange
products, instead requiring them to deal directly with the manufacturer.
What are the pros and cons of this approach with regard to the stores’
objective of encouraging angels and discouraging devils?
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14 | Chapter 2
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Demand Theory | 15
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16 | Chapter 2
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Demand Theory | 17
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18 | Chapter 2
PROBLEM SOLVED:
Price Elasticity of Demand: Philip Morris
Discussion Questions
1. The decline in total revenue from cigarette sales in 1993 is attributed to
Philip Morris’s cut in the price of cigarettes. Are there other factors that
might have contributed to this decline in revenue?
Answer: The price elasticity of demand assumes that “all other things”
are held constant. Changes in taxes, consumer income, or attitudes toward
tobacco during this period might have reduced demand, while the price
cut increased quantity demanded. If this were the case, then the true price
elasticity would likely be closer to 1.
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Demand Theory | 19
STRATEGY SESSION:
Elasticity in Use
Discussion Questions
1. Suppose that a manufacturer sells a product through an upscale boutique
and, with a different brand name, through a discount retailer. The elastic-
ity of demand at the boutique is 1.2 and at the discount retailer is 2.6.
If the optimal price at the boutique is $85, what price (PD) should be
charged at the discount retailer?
Answer: 85(1 1/1.2) PD (1 1/2.6), so PD $23.02.
2. A consulting firm charges $250 per hour to Fortune 500 companies. The
estimated elasticity of demand for consulting services is 3.1. The firm is
planning to spin off a subsidiary firm that will work with smaller busi-
nesses. The estimated elasticity of demand for these firms is 7.3. What
price per hour (PS), to the nearest dollar, should be charged by the
subsidiary?
Answer: 250(1 1/3.1) PS (1 1/7.3), so PS $200.
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20 | Chapter 2
STRATEGY SESSION:
Verizon and the Elasticity of Demand
Discussion Questions
1. What assumption was Verizon making about the elasticity of demand for
Internet services?
Answer: That it was inelastic
2. What assumption was Verizon making about its marginal revenue from
Internet services?
Answer: That it was negative
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Demand Theory | 21
PROBLEM SOLVED:
Income Elasticity of Demand
Discussion Questions
1. Suppose that a market demand function is defined as Q 20,000 8P
0.1I, where P 2,000 and I 20,000. What is the income elasticity of
demand?
Answer: Q 6,000, so hI 0.1(20000/6000) 1
3
2. If the income elasticity of demand for a product is unitary, then a 1 per-
cent change in income will change demand in the same direction by 1
percent. If price remains constant, then spending on the product will
change by 1 percent, and consequently, spending on the product will be
the same percentage of income after the income change as it was before.
If the income elasticity of demand is greater than 1, then spending will
increase as a percentage of income as income increases. If it is less than 1,
spending will decrease as a percentage of income as income increases.
How do you think the percentage of income spent on jewelry, food, cloth-
ing, housing, and automobiles responds to a 1 percent increase in income?
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22 | Chapter 2
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Demand Theory | 23
a. To sell 20 engines per month, what price would Dolan have to charge?
b. If managers set a price of $500, how many engines will Dolan sell per
month?
c. What is the price elasticity of demand if price equals $500?
d. At what price, if any, will the demand for Dolan’s engines be of unitary
elasticity?
Solution:
a. For Q 20, P 2,000 50(20) $1,000
b. For P 500, Q 40 500/50 30
c. h (Q/P)(P/Q) (1/50)(500/30) 1⁄3
d. For P $1,000, h (Q/P)(P/Q) (1/50)(1,000/20) 1
2. The Johnson Robot Company’s marketing managers estimate that the demand
curve for the company’s robots in 2008 is
P 3,000 40Q
where P is the price of a robot and Q is the number sold per month.
a. Derive the marginal revenue curve for the firm.
b. At what prices is the demand for the firm’s product price elastic?
c. If the firm wants to maximize its dollar sales volume, what price should
it charge?
Solution:
a. MR TR/Q 3,000 80Q
b. P $1,500
c. P $1,500
Solution:
a. h (Q/P)(P/Q) (3)(10/1,110) 3/111
b. hI (Q/I)(I/Q) (0.1)(6,000/1,110) 60/111
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24 | Chapter 2
Solution:
a. Whether total revenue will go up or down when the product price is low-
ered and more units are sold depends on whether the quantity of units
sold increases by a greater percentage than the price is reduced by. That
is, it depends on whether the demand is elastic or inelastic.
b. Assuming that the marketing manager is correct that the demand elastic-
ity is 0.5, than a price reduction will cause the number of units sold to
increase by a smaller percentage than the price has fallen, and both the
president and executive vice president will have egg on their faces when
total revenues decline after the price is reduced.
Solution:
a. At P 1, MR 3. The price is too low; increasing the price and sell-
ing fewer units would increase revenues.
b. No. While Q/P 1, (Q/P)(P/Q) 1/4 at P 1.
6. On the basis of historical data, Richard Tennant has concluded, “The con-
sumption of cigarettes is . . . [relatively] insensitive to changes in price. . . .
-1— In contrast, the demand for individual brands is highly elastic in its response
0— to price. . . . In 1918, for example, Lucky Strike was sold for a short time at
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Demand Theory | 25
a higher retail price than Camel or Chesterfield and rapidly lost half its
business.”
a. Explain why the demand for a par ticular brand is more elastic than the
demand for all cigarettes. If Lucky Strike raised its price by 1 percent in
1918, was the price elasticity of demand for its product greater than 2?
b. Do you think that the demand curve for cigarettes is the same now as it
was in 1918? If not, describe in detail the factors that have shifted the
demand curve and whether each has shifted it to the left or right.
Solution:
a. As we define a product more narrowly, consumers have better substitutes
(whose prices are held constant) as the price of the good under consider-
ation varies. This makes the demand for a good more elastic the more
narrowly the good is defined. We are not told how much Lucky Strike was
priced above Camel and Chesterfield, but assuming that the margin was less
than 25 percent, we can conclude that the cross-price elasticity was greater
than 2. This isn’t exactly right; we must also assume that Lucky Strike’s
fall in sales resulted from a reduction in the price of Camels and Chester-
fields for the cross-price elasticities as explained to students.
b. Population, per capita income, and subsidized health care have all
increased; this probably caused the demand curve for cigarettes to shift
out, or to the right. Public health education and general education have
increased; this probably shifted the demand curve in, or to the left.
Solution:
a. Cigarette consumption would fall by between 4.5 and 6.0 percent.
b. Assuming that the prices of cigarettes were to remain constant, a 50 per-
cent increase in income would cause sales of cigarettes to increase 25
percent. The weighted average of all income elasticities equals 1, so con-
sumption of noncigarette items would increase by more than 50 percent
and certainly more than the 25 percent performance of cigarettes. I would
not follow the broker’s advice.
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26 | Chapter 2
8. Using the PIMS (Profit Impact of Market Strategies) survey of major U.S.
firms, Michael Hagerty, James Carman, and Gary Russell estimated that, on
average, the advertising elasticity of demand was only about 0.003. Doesn’t
this indicate that firms spend too much on advertising?
Solution:
No. The fact that the elasticity of demand with respect to advertising is rela-
tively small (0.003) does not necessarily mean that an additional dollar
spent on advertising would not be profitable or that the last dollar spent was
not profitable.
Solution:
a. The price elasticity of demand is 3.1.
b. An increase in price will cause revenues to fall because the demand is
elastic.
c. The income elasticity of demand is 2.3.
d. The advertising elasticity of demand is 0.1.
e. If P, I, and A are held constant, per capita consumption is constant. There-
fore, a 10 percent increase in population gives rise to a 10 percent increase
in the quantity demanded.
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Demand Theory | 27
Solution:
a. Sales will increase by 20 units per month.
b. Price must be increased by $6.67 per unit.
c. Two possible interpretations, both lead to more elastic demand. You
could assume that the question is asking if demand is more elastic after
both the income and price have increased. Since Q/P is unchanged
and P/Q has increased, the demand will be more elastic. Alternatively,
you might assume that the question is asking, as we increase the price to
choke off the anticipated increase in the quantity demanded after income
has gone up, does the demand become more or less elastic? This is, of
course, just moving up a linear demand curve, which implies an increas-
ingly elastic demand.
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