Managerial Economics

Now in its fourth edition, Ivan Png’s Managerial Economics has been extensively revised
with

• a completely new introductory chapter emphasizing decision-making and behavioral

biases,
• intensive application to current issues including the subprime financial crisis and global
competition, as well as
• streamlined presentation focusing on the economics that managers need to know.

As always, the text presents the key concepts of microeconomics intuitively, without
requiring any sophisticated mathematics. Throughout, it emphasizes actual management
applications, and links to other functions including marketing and finance.
The new fourth edition has been fully updated, including fresh up-to-date discussion ques-
tions from all over the world, and is enhanced with detailed instructor supplements. It is an
ideal text for any course focusing on the practical application of microeconomic principles
to management.
Truly useful economics for managers.
Ivan Png is the Lim Kim San Professor in the School of Business and Professor of
Economics and Information Systems at the National University of Singapore. Previously,
Dr Png was a faculty member at the Anderson School, University of California, Los Ange-
les (1985–96) and the Hong Kong University of Science and Technology (1993–96). His
book, Managerial Economics, has been published in multiple editions and adapted into
Chinese (traditional and simplified characters) and Korean. He received the NUS-UCLA
Executive MBA Teaching Excellence Award in 2008 and 2011. Dr Png is an independent
director of Healthway Medical Corporation Ltd. He was a nominated MP (10th Parlia-
ment of Singapore), 2005–06, a member of the Trustworthy Computing Academic Advisory
Board, Microsoft Corporation, 2006–10, and an independent director of Hyflux Water Trust
Management Pte Ltd., 2007–11.
Managerial Economics
Fourth edition

Ivan Png
This edition published 2012
by Routledge
2 Park Square, Milton Park, Abingdon, Oxon, OX14 4RN
Simultaneously published in the USA and Canada
by Routledge
711 Third Avenue, New York, NY 10017
Routledge is an imprint of the Taylor & Francis Group, an informa business

c 2012 Ivan Png
The right of Ivan Png to be identified as the author of this work has
been asserted by him in accordance with the Copyright,
Designs and Patents Act 1988.
All rights reserved. No part of this book may be reprinted or reproduced or
utilised in any form or by any electronic, mechanical, or other means, now
known or hereafter invented, including photocopying and recording, or in
any information storage or retrieval system, without permission in writing
from the publishers.
Trademark notice: Product or corporate names may be trademarks or
registered trademarks, and are used only for identification and explanation
without intent to infringe.
British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library
Library of Congress Cataloging-in-Publication Data
Png, Ivan, 1957-
Managerial economics/Ivan Png. – 4th ed.
p. cm.
1. Managerial economics. I. Title.
HD30.22.P62 2012
338.5024’658–dc23 2011049066
ISBN: 978-0-415-80948-1 (hbk)
ISBN: 978-0-415-80949-8 (pbk)
ISBN: 978-0-203-11609-8 (ebk)
Typeset in Times New Roman
by Sunrise Setting Ltd, Torquay, UK
For my parents and three Cs – CW, CY, CH
Contents

List of figures ix
List of tables xii
About the author xiv
Acknowledgments xv
Preface xvi

Part I

1 Introduction to managerial economics 1

2 Demand 17

3 Elasticity 36

4 Supply 54

5 Market equilibrium 81

6 Economic efficiency 101

Part II

7 Costs 119

8 Monopoly 144

9 Pricing 168

10 Strategic thinking 190

11 Oligopoly 218
viii Contents
Part III

12 Externalities 242

13 Asymmetric information 265

14 Incentives and organization 288

15 Regulation 311

Answers to selected progress check and review questions 331

Notes 355
Index 358
Figures

1.1 Value added 3

1.2 Economic profit 4
2.1 Individual demand curve 19
2.2 Individual demand curve with lower income 21
2.3 Individual demand curve with more expensive complement 24
2.4 Individual buyer surplus 27
2.5 Package deal 28
2.6 Demand curve for mobile telephone service 29
2.7 Market demand curve 35
3.1 Calculating own-price elasticity 38
3.2 Short- and long-run demand for a non-durable item 48
4.1 Short-run total cost 58
4.2 Short-run marginal, average variable, and average costs 60
4.3 Short-run profit 62
4.4 Short-run production rate 63
4.5 Lower input price 66
4.6 Long-run production rate 68
4.7 Individual seller surplus 71
4.8 Price elasticity of supply 73
4.9 Market supply 80
5.1 Market equilibrium 85
5.2 Supply shift 87
5.3 Price elasticities of demand and supply 88
5.4 Demand shift 91
5.5 Short-run market equilibrium 93
5.6 Long-run market equilibrium 93
5.7 Demand increase: short and long run 95
5.8 Demand reduction: short and long run 95
6.1 Air travel market 105
6.2 Pricing and freight cost 109
6.3 Wholesale price cut vis-à-vis coupons 112
6.4 Air travel tax 113
7.1 Costs in a single period of production 120
7.2 Transfer price 124
x Figures
7.3 Economies of scale 131
7.4 New tanker prices: January 2006 133
7.5 Experience curve 137
8.1 Monopoly production scale 151
8.2 Demand increase 153
8.3 Reduction in marginal cost 154
8.4 Market structure 160
8.5 Monopsony purchasing 162
9.1 Uniform pricing 170
9.2 Complete price discrimination 173
9.3 Direct segment discrimination 177
10.1 Scheduling the evening news: extensive form 199
10.2 Scheduling the evening news: uncertain consequences 201
10.3 Narrow-body jets: new entry 202
10.4 Lithographer’s incentive 203
10.5 Leveraged buyout 204
10.6 Bank deposit – without deposit insurance 207
10.7 Bank deposit – with deposit insurance 207
10.8 Strike 208
10.9 Poison pill 209
10.10 Solving Nash equilibrium in randomized strategies 216
11.1 Monopoly 220
11.2 Price competition with differentiated products: residual demand 222
11.3 Price competition with differentiated products: best response functions 223
11.4 Strategic move 226
11.5 Limit pricing 226
11.6 Capacity competition: residual demand 228
11.7 Capacity competition: best response functions 228
11.8 Capacity leadership 231
12.1 Positive externality 245
12.2 Negative externality 247
12.3 Rivalness 256
12.4 Economically efficient provision of public good 257
13.1 Market with symmetric information 269
13.2 Market with adverse selection 270
13.3 Market failure 272
14.1 Economically efficient effort 290
14.2 Performance pay 294
14.3 Performance quota 295
14.4 Vertical integration 305
15.1 Price regulation 314
15.2 Moral hazard in medical services 319
15.3 Economic efficiency in emissions 323
15.4 User fee 323
15.5 Accidents 325
16.7D 338
16.7F 339
16.8D 340
 Figures xi
16.10E 344
16.11B 346
16.11D 346
16.12A 348
16.13B 350
16.14A 351
16.14C 351
16.15A 353
Tables

2.1 Individual demand 18

2.2 Individual demand with lower income 21
2.3 Market demand 34
4.1 Short-run weekly expenses 56
4.2 Analysis of short-run costs 57
4.3 Short-run profit 61
4.4 Long-run weekly expenses 67
4.5 Analysis of long-run costs 68
4.6 Long-run profit 69
4.7 Barrick Gold 77
6.1 Sinopec Exploration and Production segment 108
7.1 Conventional income statement ($ million) 121
7.2 Income statement showing alternatives ($ million) 121
7.3 Income statement showing opportunity cost ($ million) 122
7.4 Conventional income statement ($ million) 126
7.5 Income statement showing alternatives ($ million) 126
7.6 Income statement omitting sunk costs ($ million) 127
7.7 Daily expenses for newspaper production 129
7.8 Analysis of fixed and variable costs 130
7.9 Expenses for two products 134
7.10 Chrysler LLC liquidation ($ million) 141
8.1 Monopoly revenue, cost, and profit 149
8.2 Increase in fixed cost 154
8.3 Advertising–sales ratios, 2010 157
8.4 R&D–sales ratios, 2010 159
8.5 Microsoft sales and R&D, 2003–05 ($ million) 166
9.1 Indirect segment discrimination in air services 181
9.2 Pricing policies: profitability and information 184
9.3 DEWA: electricity rates 187
10.1 Gasoline stations: price war 192
10.2 Battle of the Bismarck Sea 194
10.3 Narrow-body jets: new entry 195
10.4 Gasoline stations: price war (modified) 196
10.5 Scheduling evening news 198
 Tables xiii
11.1 Memory industry: share of production 219
12.1 Customer traffic and profit 244
12.2 Customer traffic and externality 246
13.1 Southwest Airlines 284
15.1 Competition laws 317
16.7A 337
16.7C 338
16.7D 338
About the author

Ivan Png is the Lim Kim San Professor in the NUS Business School, and Professor of Eco-
nomics and Information Systems at the National University of Singapore. He was a Visiting
Professor at the Tuck School of Business, Dartmouth College (2011–12).
Previously, he was a faculty member at the Anderson School, University of California, Los
Angeles (1985–96) and the Hong Kong University of Science and Technology (1993–96).
Dr Png attended the Anglo-Chinese School, Singapore, and graduated with first class hon-
ors in economics from the University of Cambridge (1978) and a PhD from the Stanford
Graduate School of Business (1985).
His research has been published in leading management and economics journals including
Management Science, American Economic Review, and Journal of Political Economy. He
received the NUS-UCLA Executive MBA Teaching Excellence Award in 2008 and again in
2011.
Dr Png was a nominated MP in the 10th Parliament of Singapore (2005–06), member of
the Trustworthy Computing Academic Advisory Board, Microsoft Corporation (2006–10),
and an independent director of Hyflux Water Trust Management Pte Ltd. (2007–11) and
Healthway Medical Corporation (2008–11).
Dr Png speaks English and Chinese (Mandarin). He is married to Ms Joy Cheng. They
have two sons, Max and Lucas.
Acknowledgments

In preparing the fourth edition, I thank Sanjeev Mohta, Paul Murschetz, Le Xu, Stephen
Ching, Chong Lee Kee, Manning Zhang, Lim Wan Ying, Linxi Chang, Emily Jothidas,
Lynda Lo, and Joy Cheng, as well as the anonymous reviewers. I also acknowledge Dale
Lehman for our collaboration on the third edition. Finally, I thank generations of students at
NUS, HKUST, and UCLA for their enthusiastic support and encouragement.
Preface

Managerial economics is the science of directing scarce resources in the management of

a business or other organization. This book presents tools and concepts from managerial
economics that practicing managers can and do use. It

• emphasizes simple, practical ideas,

• focuses on application to business decision-making,
• integrates global business issues and practice,
• provides conceptual rigor without mathematical complexity.

This book is aimed at business students as well as practitioners. Accordingly, it is delib-

erately written in a simple and accessible style. It presents a minimum of technical jargon,
complicated figures, and highbrow mathematics. It starts with the very basics and does not
presume any prior knowledge of economics. While the mathematics is minimal, the eco-
nomics is rigorous. The application of economic concepts to business practice will challenge
even readers with some background in economics.
Managerial economics is unique in integrating the various functions of management. In
addition to presenting the essentials of managerial economics, this book includes many
links to other management functions. Some examples are accounting (transfer pricing),
finance (opportunity cost of capital and takeover strategies), human resource management
(incentives and organization), and marketing (advertising and pricing).
In addition to the managerial focus, two features are worth emphasizing. First, the same
principles of managerial economics apply globally. Reflecting this unity, the book includes
examples and cases from throughout the world. Second, the book uses examples from both
consumer and industrial markets. The reasons are simple: a customer is as likely to be another
business as a human being, and likewise for suppliers.
For most readers, this may be their only formal book on economics. Accordingly, the
book eschews sophisticated theories and models, such as indifference curves and produc-
tion functions, which are more useful in advanced economics courses. Further, the book
recognizes that many topics traditionally covered by managerial economics textbooks are
now the domain of other basic management courses. Accordingly, the book omits linear
programming and capital budgeting.
Regarding language, this book refers to businesses rather than firms. Realistically, many
firms are involved in a wide range of businesses. In economics, the usual unit of analysis
is a business, industry, or market rather than a firm. Also, the book refers to buyers and
sellers rather than consumers and firms, since in most real markets, demand and supply do
 Preface xvii
not neatly divide among households and businesses. To cite just two examples, in the mar-
ket for telecommunications, the demand side consists of businesses and households, while
in the market for human resources, the supply side comprises households and businesses.
Outsourcing has reinforced this diversity of suppliers.
Managerial economics is a practical science. Just as no one learns swimming or tennis
simply by watching a professional, so no one can learn managerial economics merely by
reading this book. Every chapter of this book includes progress checks, and review and
discussion questions. The progress checks and review questions are to help the reader check
and reinforce the chapter material.
Readers must practice their new-found skills on these checks and questions. The discus-
sion questions are intended to challenge, provoke, and stretch. They will be useful for class
and group discussions.

Key features
• Simple, practical ideas for business decision-making
• Integrates managerial economics into finance, accounting, human resources, and other
management functions
• Mini-cases and examples from around the world
• Every chapter begins with a real mini-case
• Every chapter is reinforced with progress checks, review questions, and discussion
questions
• Easy to read with minimal technical jargon, figures, and mathematics
• Complete instructor’s supplements – transparency masters, answers to discussion ques-
tions, casebank, and testbank.

Organization
This book is organized into three parts. Following the Introduction, Part I presents the
framework of perfectly competitive markets. Chapters 2–6 are the basic starting point of
managerial economics. These are presented at a very gradual pace, accessible to readers
with no prior background in economics.
The book gathers pace in Parts II and III. These are relatively self-contained, so the reader
may skip Part II and go directly to Part III. Part II broadens the perspective to situations
of market power, while Part III focuses on the issues of management in imperfect markets.
Chapter 15 on regulation is the only chapter in Part III that depends on understanding Part II.
A complete course in managerial economics would cover the entire book. For shorter
courses, there are three alternatives. One is a course focusing on the managerial economics
of strategy, which would comprise Chapters 1–11. Another alternative focuses on the man-
agerial economics of organization and would comprise Chapters 1–7 and 12–14. The third
alternative focuses on modern managerial economics – strategy and organization – and
would comprise Chapters 1–4 and 7–14.

Website
Online support for this book can be found at http://www.mecon.nus.edu.sg. The site contains
additional cases and applications, as well as updates and corrections to the book. The site also
contains a link to resources for instructors, including transparencies, answers to discussion
questions, a testbank, and a casebank.
1 Introduction to managerial
economics

Learning objectives

• Appreciate the objective of managerial economics.

• Understand value added and economic profit.
• Apply total benefit and total cost to decide participation.
• Apply marginal benefit and marginal cost to decide extent.
• Appreciate the effect of bounded rationality on decision-making.
• Apply net present value to evaluate benefits and costs that flow over time.
• Understand the vertical and horizontal boundaries of an organization.
• Distinguish competitive markets, market power, and imperfect markets.
• Understand the implications of falling barriers to trade and costs of communication.

What is managerial economics?

Airbus and Boeing comprise a duopoly in the manufacture of large commercial jet aircraft
(with 150 or more seats).1 Boeing’s most successful and profitable plane is the Boeing 737,
a twin-engine, single-aisle, medium-range jet. First flown in 1967, the Boeing 737 has been
developed into nine models. As of December 2010, Boeing had delivered 6,687 units of the
737, with a further 2,186 on order. The Boeing 737 competes with Airbus’s A320 family,
comprising five models – the A318, A319, A320, A321, and ACJ business jet. According to
Boeing forecasts, airlines would buy 23,370 new single-aisle planes in the next 20 years.
However, at the Paris Air Show in June 2011, Jim Albaugh, CEO of Boeing Commercial
Airplanes, conceded: “The days of the duopoly with Airbus are over.” Manufacturers, from
China, Canada, Russia, and Brazil, have developed, launched, or are poised to launch new
aircraft to compete with Boeing’s 737 and Airbus’s A320 family.
In 2006, the predecessor to the Commercial Aircraft Corporation of China launched the
C919, a 150-seat single-aisle plane. The C919 is scheduled to fly in 2014 and begin com-
mercial deliveries in 2016. In November 2010, COMAC announced 100 orders, mainly from
three Chinese carriers – Air China, China Southern Airlines, and China Eastern Airlines.
Another entrant to the market for 150-seat single-aisle jets is the Canadian manufacturer,
Bombardier. Bombardier had long manufactured regional jets, which are smaller short-range
planes with up to 100 seats. It aspired to expand into larger aircraft, but only began develop-
ment in 2008, upon securing an order from Deutsche Lufthansa. The new CSeries, a family of
100- to 149-seat aircraft, is scheduled to enter service in 2013. The CSeries will reduce fuel
 2 Introduction
consumption by 20% through use of advanced materials and a more fuel-efficient engine,
the PW1000G from Pratt & Whitney.
Two other entrants are Irkut of Russia and Embraer of Brazil. Primarily a manufacturer
of military aircraft, Irkut is seeking to diversify into commercial jets. It launched the MC-21
in 2007, and secured orders from Russian airlines. The MC-21 is scheduled to enter service
around 2016.
Embraer, like Bombardier, is an established manufacturer of regional jets. However, as
of June 2011, it had not secured any orders and had deferred a decision on whether to com-
mence development. CEO Frederico Curado remarked: “Going up against Boeing and Airbus
in head-to-head competition is really tough, not only because of their size, but because of
their existing product line and industrial capacity. . . They can have a very quick response
and literally flood the market.” Moreover, Tom Enders, CEO of Airbus, cautioned that there
might not be sufficient room for six manufacturers.
In December 2010, Airbus announced that it would develop a new version of the A320 –
the A320neo (“new engine option”). The A320neo would be powered by either CFM
International’s LEAP-X engine or the engine in Bombardier’s CSeries, Pratt & Whitney’s
PW1000G. In March 2011, Airbus announced that it would raise production of the A320
family from 34 to 36 units per month.
Boeing’s Jim Albaugh acknowledged that the CSeries 300 appeared to target customers
of the Boeing 737. He insisted that Boeing would respond: “I look at the 737 business that
we have and it is one of the cornerstones of Boeing Commercial and it is a marketplace
we are going to defend.” Just before the Paris Air Show, Boeing announced an increase in
production of the Boeing 737 from 31.5 units to 42 units per month.
Why did Bombardier wait until securing orders from Lufthansa before launching the
CSeries? Why does Bombardier emphasize the fuel efficiency of its CSeries? Who among
the new entrants that have commenced development – Bombardier, COMAC, and Irkut – has
the best chance of succeeding in competition with Boeing and Airbus? Should Embraer stay
out of the market?
What about Boeing? How should it respond to the new entry? Should it launch a new
product or, like Airbus, modify its existing plane? Did it make sense to expand production
of the 737? Why did Airbus respond to the entry of Bombardier and COMAC with a new
version of the A320 rather than a totally new plane?
All of these are questions of managerial economics. Managerial
Managerial economics is the science of cost-effective management of scarce
economics: The science resources. Wherever resources are scarce, managers can make more
of cost-effective cost-effective decisions by applying the discipline of managerial
management of scarce
economics. The decisions may regard customers, suppliers, com-
resources.
petitors, or the internal workings of the organization. Whether the
organization is a profit-oriented business, non-profit organization, or household, managers
must make the best use of scarce resources.
Boeing has limited financial, human, and physical resources. Boeing managers seek to
maximize the financial return from these limited resources. The same is true of Airbus. While
Boeing is a publicly traded company with diversified shareholders, Airbus is controlled by
French, German, and Spanish corporate shareholders. Despite the differences in organiza-
tion, the principles of managerial economics apply to both Airbus and Boeing. Each must
compete effectively against each other and against Bombardier, COMAC, and Irkut, each
must allocate resources to research and development (R&D), each must manage demand
and costs, and each must set prices.
 Introduction 3
Managerial economics consists of three branches: competitive markets, market power, and
imperfect markets. Accordingly, this book is organized into three parts, with one part on each
branch. Before introducing the three branches of managerial economics, let us first develop
some background.

Value added and economic profit

For the most part, this book takes the viewpoint of a profit-oriented business, while also
considering the management of non-profit organizations and households. The primary goal
of a profit-oriented business is to maximize profit. Indeed, the aim of competitive strategy is
to deliver sustained profit above the competitive level.
Accordingly, an essential concept for managerial decision-making is economic profit. Eco-
nomic profit is related to but not the same as the accounting measure of profit. Here, we
explain the concept of economic profit and then its relation to accounting profit.

Value added
To appreciate the concept of economic profit, we use the basic equation of managerial
economics:

Value added = Buyer benefit − Seller cost

= Buyer surplus + Seller economic profit (1.1)

This equation states that value added is the difference between

buyer benefit and seller cost. It is only to the extent that businesses Value added: Buyer
deliver benefit to buyers that exceeds the cost of production that benefit less seller cost.
they create value. Equation (1.1) is basic to all organizations – Comprises buyer surplus
and seller economic
whether profit-oriented, non-profits, or households. To create value,
profit.
they must deliver benefit that exceeds cost. Anyone who delivers
benefit which is less than the cost of production is destroying value.
Referring to Figure 1.1, value added is shared by buyer and seller. The buyer gets some
part of the value added in buyer surplus, which is the difference between the buyer’s benefit
and their expenditure. The seller gets the other part of the value added in economic profit,

Buyer
surplus
Value added
Seller
Buyer benefit economic
profit
Buyer’s expenditure =
Seller Seller’s revenue
cost

Figure 1.1 Value added.

Note: Value added = Buyer benefit − Seller cost = Buyer surplus + Seller economic profit.
Source: adapted from Luke M. Froeb and Brian T. McCann, Managerial Economics: A Problem-Solving
Approach, Mason, OH: South-Western, 2010, p. 127.
 4 Introduction
which is the difference between the revenue that the seller receives (equal to the buyer’s
expenditure) and the cost of production.
The larger is the value added, the larger is the amount to be shared by buyer and seller.
For profit-oriented businesses, that means the potential for economic profit is greater!

Progress check 1A. Explain the relation among the following: buyer benefit, seller cost, value
added, buyer surplus, and economic profit.

Economic and accounting profit

Practically, the most readily available information on profit is the accounting measure.
Hence, it helps to calculate economic profit from accounting profit. We do so by making
adjustments so that the measure is more relevant to managerial decision-making.
Specifically, economic profit differs from accounting profit by excluding opportunity cost
and including sunk cost:

Economic profit = Accounting profit − Opportunity cost + Sunk cost (1.2)

Figure 1.2 illustrates the relation between economic profit and accounting profit.
Here, to relate economic to accounting profit, we briefly intro-
Economic profit: duce opportunity cost and sunk cost, while leaving the details to
Accounting profit less Chapter 7. Consider the following example.
opportunity cost plus Luna Biotech has accumulated cash of $10 million. It commenced
sunk cost.
a $10 million R&D project to develop a new drug to treat a rare
disease. The new drug is expected to generate a profit contribution
of $20 million. (Profit contribution is revenues less the cost of producing and selling the
product, not including R&D expenditures.) So far, Luna Biotech has already spent $6 million
on R&D.
Meanwhile, a scientist has already developed a drug to treat the same disease. The scientist
has offered to sell her invention to Luna Biotech for $2 million. The scientist’s drug would
be just as good and also yield profit contribution of $20 million.
Luna has only $4 million cash on hand and cannot borrow, so it must choose between
continuing R&D on its own drug and buying the scientist’s invention. How should Luna
decide?

Economic
profit Sunk cost

Accounting
profit

Opportunity
cost

Figure 1.2 Economic profit.

Note: Economic profit = Accounting profit − Opportunity cost + Sunk cost.
 Introduction 5
If Luna continues with its own R&D, its accounting profit would be $(20 − 10) million =
$10 million. If Luna cancels its own R&D and buys the scientist’s invention, its accounting
profit would be $(20 − 6 − 2) million = $12 million. So, Luna would earn more by canceling
its own R&D and buying the scientist’s invention.
Let us study this decision in another way, using the concept of economic profit. If Luna
continues with its own R&D, it will forgo the opportunity to earn $(20 − 2) million =
$18 million by buying the scientist’s invention. So, Luna would incur an opportunity cost
of $18 million. Further, at the present time, Luna’s expenditure of $6 million on R&D has
already been incurred and cannot be reversed. The $6 million is a sunk cost.
Hence, using equation (1.2) above, the economic profit of continuing its own R&D is
$(10 − 18 + 6) million = −$2 million. Continuing its own R&D leads to an economic loss.
Using the concept of economic profit, the manager can clearly see that continuing Luna’s
own R&D is the worse choice.
The concept of economic profit takes out opportunity cost because this is a cost of con-
tinuing the status quo. By continuing the status quo, the manager is forgoing the profit
contribution from the alternative course of action. To make correct business decisions,
managers must take account of opportunity costs.
The concept of economic profit adds back sunk cost because the accounting measure
of profit takes out sunk cost. However, the sunk cost is irrelevant to the current decision
because it has already been incurred and cannot be reversed. Hence, to make correct business
decisions, managers must ignore any sunk cost.

Progress check 1B. Suppose that the scientist demands $4 million for her invention. What would
be Luna’s economic profit from continuing R&D?

Decision-making
The two fundamental decisions in business can be stated simply as participation (“which”)
and extent (“how much”). Which market to enter? How much to produce? Which products
to sell? What price to set? Which R&D path to follow? How much to spend on R&D? Which
job to take? How many hours to work?
Here, we present fundamental techniques to decide on participation and extent. Then we
discuss psychological limitations in individual decision-making. These are relevant as all
organizations – whether businesses, non-profits, or households – are managed by individual
human beings.

Which and how much?

The decisions on participation (which) and extent (how much) resolve into analyzing the total
and marginal benefits and costs. Let us use the following example to introduce the concepts
of total and marginal, and then relate them to the decisions of which and how much.
Nancy must decide how to invest $10,000. Her bank pays 2% interest on savings accounts
of any amount. The bank also offers a fund in units of $10,000 with an interest rate of 3%.
If Nancy were to deposit the money in a savings account, her interest income would be
2% × $10,000 = $200. If Nancy were to deposit the money in the fund, her interest income
would be 3% × $10,000 = $300. So, to maximize her interest income, Nancy should invest
in the fund.
 6 Introduction
In deciding which investment to make, Nancy should choose
Average value: The
according to the total interest income. She should invest in the
total value of the
variable divided by the savings account.
total quantity of the Closely related to the total is the concept of average. Generally,
measure. the average value of a variable with respect to some measure is
the total value of the variable divided by the total quantity of the
measure. Nancy could also choose the investment according to the average interest income.
Her average interest income would be 2% from the savings account and 3% from the fund.
Now, suppose that Nancy’s uncle gives her $1,000. How should she invest the gift? For
incremental decisions such as how to invest the additional $1,000, or generally, how much to
invest, the decision-maker should consider the marginal benefits and costs.
The marginal value of a variable with respect to some measure
Marginal value: The is the change in the variable associated with a unit increase in the
change in the variable measure. If Nancy were to deposit the gift in the savings account, her
associated with a unit interest income would be 2% × $1,000 = $20. Hence, her marginal
increase in a measure.
interest income from a deposit of $1,000 in the savings account
would be $20.
Nancy cannot deposit the gift in the fund because the fund is sold in units of $10,000.
So, the marginal interest income from a deposit of $1,000 in the money market fund is zero.
Thus, to maximize her interest income, Nancy should deposit the gift in the savings account.
Generally, the marginal value of a variable may be less than, equal to, or greater than the
average value. The relation between the marginal and average values with respect to some
measure depends on whether the average value is decreasing, constant, or increasing with
respect to the measure.

Progress check 1C. What would be Nancy’s marginal interest income from deposits of $1,000,
$2,000, . . ., $9,000, $10,000 in the fund?

Here is another example of using total and marginal benefits and costs to decide on par-
ticipation and extent. Max is working as an associate in a management consulting firm for
after-tax earnings of $30,000 per year. Should he get an MBA, forgoing two years of earnings
and possibly securing a higher-paid job after graduation? After the MBA, having secured a
job, how many hours should he work?
In deciding which career path to follow – whether to continue with his current job or get
an MBA – Max should consider the total earnings (and total costs) of each alternative. To be
precise, since these earnings and costs flow over time, Max should consider the net present
value of the total earnings and total costs of each alternative. (The next section explains
the concept of net present value.) He should choose the alternative that maximizes the net
present value of the total earnings and total costs.
Having secured a job, Max must decide how many hours to work. In deciding how much
to work, Max should consider the marginal earnings and marginal cost of each additional
hour.
He should work up to the point that the marginal earnings per hour equal the marginal cost
per hour. If the marginal earnings exceed the marginal cost, then he should work more. The
additional earnings would exceed the additional cost. By contrast, if the marginal earnings
are less than the marginal cost, then he should work less. The reduction in earnings would
be less than the reduction in cost.
 Introduction 7
Generally,

• in decisions on participation – which market, which product, which job – the manager
should compare the total benefit and total cost.
• in decisions on extent – how much to produce, what price to set, how many hours to
work – the manager should compare the marginal benefit and marginal cost.

Bounded rationality
Managers are human and as such are subject to bounded rationality. Typically, managerial
economics models assume that people make decisions rationally, in the sense that individuals
always choose the alternative that maximizes the difference between benefit and cost.
However, people do not always behave rationally, and indeed, they make systematic errors
in decisions. Human beings behave with bounded rationality (less than full rationality)
because they have limited cognitive abilities and cannot fully exercise self-control.
Individuals tend to adopt simplified rules in making decisions, especially under conditions
of uncertainty. These simplified rules result in systematic biases, including the following:

• Sunk-cost fallacy. The psychologists Hal Arkes and Catherine Blumer gave discounts
at random to consumers who were buying regular price season theater subscriptions.
Consumers who paid the regular price attended more plays than those who received the
unanticipated discounts. But the subscription was a sunk cost. It should have no effect
on the (forward-looking) benefit from attending any particular play. However, the experi-
ment showed that consumers who had incurred a larger sunk cost tended to consume more
(perhaps to rationalize the size of the sunk cost).
• Status quo. The economists Jack Knetsch and Jack Sinden randomly gave students either
$3 cash or a lottery ticket. The students with $3 cash were offered the opportunity to
buy lottery tickets for $3, while those with lottery tickets were offered the opportunity to
sell the tickets for $3 in cash. Systematically, those with cash preferred to keep the cash,
while those with lottery tickets preferred to keep the tickets. However, if the status quo
had no effect, the proportions of students buying/keeping the tickets should be the same.
The experiment illustrated status quo bias – decision-makers tend (perhaps out of sheer
inertia) to prefer the status quo.
• Anchoring. The management scholar Dan Ariely asked students to write the last two dig-
its of their social security numbers, and then bid on wine and chocolate. Students with
higher social security numbers bid 60% to 120% more. Absent any other information, the
students anchored their beliefs of the value of wine and chocolate on their social security
numbers! Retailers exploit anchoring by posting high list prices and offering discounts.
Consumers anchor on the list price and are attracted by the discounts.

Given that individuals are subject to bounded rationality, the role for managerial eco-
nomics is even larger than when individuals are fully rational. The techniques of managerial
economics help to correct systematic biases in individual decision-making as well as show
how to make better overall decisions.

Timing
Managerial economics analysis includes two types of models. Static models describe behav-
ior at a single point of time, or equivalently, disregard differences in the sequence of actions
 8 Introduction
and payments. Examples include the model of competitive markets (Chapters 2–5) and the
analysis of organizational architecture (Chapter 14).
By contrast, dynamic models explicitly focus on the timing and sequence of actions and
payments. Examples include games in extensive form (Chapter 10), one seller’s commitment
to increase production and so persuade competitors to produce less (Chapter 11), and the
effect of critical mass in a market with network effects (Chapter 12).
In dynamic settings, receipts and expenditures often occur at different times. In principle,
one dollar now is different from one dollar in the future. To put the two amounts on the same
basis, the dollar in the future must be discounted to its present value. While a comprehensive
analysis of present value is the subject of financial theory and outside the scope of this book,
a brief introduction here would be helpful.

Discounting
Investments necessarily involve using resources at some times in order to receive benefits at
other times. In order to account correctly for the importance of time for managerial decisions,
it is necessary to discount future values so that they can be compared with the present.
If we put $1 in the bank today and it earns 10% interest, it will
Discounting: A grow to $1.10 next year. Hence, this year’s dollars and next year’s
procedure to transform dollars should be treated as if they are measured in different units
future dollars into an (just as if they were different currencies).
equivalent number of
Specifically, divide next year’s dollars by 1.10 to show that $1
present dollars.
next year is equivalent to $1/1.10 this year, or approximately $0.91.
The reason why $1 next year is only worth 91 cents now, is that the
91 cents, after growing for one year at 10% interest, will become $1 next year. For similar
reasons, $1 two years from now is worth around $0.83 now (since $0.83 now, after growing
at 10% interest for two years, will become $1 in two years’ time).
Present value can be calculated over any period of time – years, months, and even weeks.
Whatever the period, the key is to apply an appropriate discount rate for that period.

Net present value

Evaluating flows of revenues and costs over time requires repeated
Net present value: The application of the principle of discounting. Every dollar amount
sum of discounted values should be discounted according to how far in the future it occurs to
of inflows and outflows evaluate its present value. The net present value (NPV) is the sum
over time.
of the discounted values of inflows and outflows over time. Intu-
itively, the NPV represents the current valuation of various flows of
dollars over time.
Consider, for instance, Max’s decision whether to get an MBA. Suppose that he is limiting
his planning to the next five years and that his discount rate is 8% per year. Assuming no
increase in earnings, the NPV of continuing in the current job is

$30,000 $30,000 $30,000 $30,000

$30,000 + + + + = $129,364.
1.08 1.082 1.083 1.084

Suppose that the tuition and other costs of the MBA are $50,000 for each of two years,
and that Max expects after-tax earnings of $95,000 after graduation. Then the NPV
 Introduction 9
of getting an MBA is

$50,000 $95,000 $95,000 $95,000

−$50,000 − + + + = $130,393.
1.08 1.082 1.083 1.084
So, Max would get a higher NPV from the MBA.
Using NPV, a manager can evaluate a series of inflows and outflows that occur at different
times from the vantage point of the present. If the NPV is positive, then the inflows exceed
the outflows after accounting for the timing of the inflows and outflows. Conversely, if the
NPV is negative, then the outflows exceed the inflows. In Max’s case, the NPV of the MBA
exceeds the NPV of continuing in the current job, so he should get the MBA.
The key to calculating the NPV is the discount rate. When borrowing money to purchase
a car, the discount rate should be the interest rate on the loan. When using money from your
bank account to invest in real estate, the discount rate should be the bank’s interest rate (since
you forgo the opportunity to earn the interest).

Progress check 1D. If Max’s discount rate is 10%, should he get the MBA?

Organization
Throughout this book, we will take the viewpoint of an organization, which may be a busi-
ness, non-profit, or household. Managers of all such organizations face the same issue of
how to effectively manage scarce resources. Since our analysis focuses on the organization,
we first must identify its boundaries. We briefly discuss this issue here, while leaving the
detailed analysis to Chapters 7 and 14.

Organizational boundaries
The activities of an organization are subject to vertical and hor-
izontal boundaries. The vertical boundaries of an organization Vertical boundaries:
Delineate activities
delineate activities closer to or further from the end user. By con-
closer to or further from
trast, the horizontal boundaries of an organization are defined by the end user.
the organization’s scale and scope of operations. Scale refers to the
rate of production or delivery of a good or service, while scope
Horizontal boundaries:
refers to the range of different items produced or delivered.
Defined by the scale and
In the aircraft manufacturing industry, the vertical chain of pro- scope of the
duction runs from aluminum and other materials, to wings, tails, organization’s
landing gear, engines, and other parts, and, finally, to assembly of operations.
the aircraft. The end users of jet aircraft are passengers and shippers
of freight.
Consider two aircraft manufacturers. Suppose that one produces wings and landing gear,
while the other does not. With regard to vertical boundaries, the aircraft manufacturer that
produces wings and landing gear is more vertically integrated than the aircraft manufacturer
that does not produce wings and landing gear.
With regard to horizontal boundaries, an aircraft manufacturer that produces planes at the
rate of 40 units per month is producing on a larger scale than one producing at the rate of
30 units per month. An aircraft manufacturer that produces both commercial and military
aircraft is producing with a larger scope than one that specializes in commercial aircraft.
 10 Introduction
In the cable TV industry, the vertical chain runs from content including movies, sports,
and financial information to programming and, finally, to distribution. The end users include
households and commercial customers like hotels and bars.
With regard to vertical boundaries, a cable TV provider that produces movies is more
vertically integrated than a cable TV provider that buys movies from others. With regard to
horizontal boundaries, a cable TV provider that also provides broadband service is operating
with a larger scope than one that specializes in just cable TV.

Progress check 1E. Explain the difference between the vertical and horizontal boundaries of an
organization.

Comcast-NBC Universal
In January 2011, the cable TV provider Comcast merged with NBC Universal, a broadcast TV
network and movie producer. By merging with NBC Universal, Comcast extended its vertical
boundaries into movie production and its horizontal boundaries into broadcast television.
Until the merger, NBC Universal was owned by the conglomerate General Electric. By divest-
ing NBC Universal, General Electric was shrinking its horizontal boundaries. The chairman and
CEO of General Electric, Jeff Immelt, expressed confidence that NBCU would be in “good
hands” with Comcast.
Source: CNN, “U.S. approves Comcast-NBC merger,” January 18, 2011.

Markets
One concept of managerial economics – the market – is so funda-
Market: Buyers and mental that it appears in the names of each branch of the discipline.
sellers who A market consists of buyers and sellers who communicate with one
communicate with one another for voluntary exchange. In this sense, a market is not limited
another for voluntary
to any physical structure or particular location. The market extends
exchange.
as far as there are buyers or sellers who can communicate and trade
at relatively low cost.
Consider, for instance, the market for cotton. This extends beyond the Intercontinental
Exchange in New York to growers in the Carolinas and textile manufacturers in East Asia.
If the price on the Intercontinental Exchange increases, then that price increase will affect
Carolina growers and Asian textile manufacturers. Likewise, if the demand for cotton in Asia
increases, this will be reflected in the price on the Exchange.
In markets for consumer products, the buyers are households and sellers are busi-
nesses. In markets for industrial products, both buyers and sellers are businesses. Finally,
in markets for human resources, buyers are businesses and sellers are households.
By contrast with a market, an industry consists of businesses
Industry: Businesses engaged in the production or delivery of the same or similar items.
engaged in production For instance, the clothing industry consists of all clothing manufac-
or delivery of the same turers, and the textile industry consists of all textile manufacturers.
or similar items.
Members of an industry can be buyers in one market and sellers in
another. The clothing industry is a buyer in the textile market and a
seller in the clothing market.
 Introduction 11
Competitive markets
The global cotton market includes many competing producers and buyers. How should a
producer respond to an increase in the price of water, a drop in the price of cotton, or a
change in labor laws? How will these changes affect buyers?
The basic starting point of managerial economics is the model of competitive markets.
This applies to markets with many buyers and many sellers. The market for cotton is an
example of a competitive market. In a competitive market, buyers provide the demand
and sellers provide the supply. Accordingly, the model is also called the demand–supply
model.
The model describes the systematic effect of changes in prices and other economic vari-
ables on buyers and sellers. Further, the model describes the interaction of these changes.
In the cotton example, the model can describe how the cotton producer should adjust prices
when the price of water increases, the price of cotton drops, and labor laws change. These
changes affect all cotton producers. The model also describes the interaction among the
adjustments of the various cotton producers and how these affect buyers.
Part I of this book presents the model of competitive markets. It begins with the demand
side, considering how buyers respond to changes in prices and income (Chapter 2). Next, we
develop a set of quantitative methods that support precise estimates of changes in economic
behavior (Chapter 3). Then we look at the supply side of the market, considering how sellers
respond to changes in the prices of products and inputs (Chapter 4). We bring demand and
supply together and analyze their interaction in Chapter 5, then show that the outcome of
market competition is efficient (Chapter 6).

The extent of e-commerce markets

A bricks-and-mortar bookstore serves a geographical area defined by a reasonable traveling
time. By contrast, an Internet bookstore serves a much larger market – defined by the reach of
telecommunications and the cost of shipping.
In June 2011, the market value of Internet bookstore Amazon.com was 78 times greater than
that of America’s leading bricks-and-mortar bookstore, Barnes and Noble. The vast disparity
reflected the stock market’s assessment of the difference in the long-term profitability of the two
companies.
An e-commerce business can serve a much larger geographical market than a traditional
bricks-and-mortar retailer. Further, the e-commerce business can more readily expand into other
product lines. Finally, by avoiding the costs of inventory and store rental, the e-commerce
business may achieve lower costs.

Market power
In a competitive market, an individual manager may have little freedom of action. Key vari-
ables such as prices, scale of operations, and input mix are determined by market forces. The
role of a manager is simply to follow the market and survive. Not all markets, however, have
so many buyers and sellers to be competitive.
Market power is the ability of a buyer or seller to influence mar-
ket conditions. A seller with market power will have relatively more Market power: The
freedom to choose suppliers, set prices, and use advertising to influ- ability of a buyer or
ence demand. A buyer with market power will be able to influence seller to influence
market conditions.
the supply of products that it purchases.
 12 Introduction
A business with market power must determine its horizontal boundaries. These depend
on how its costs vary with the scale and scope of operations. Accordingly, businesses with
market power – whether buyers or sellers – need to understand and manage their costs.
In addition to managing costs, sellers with market power need to manage their demand.
Three key tools in managing demand are price, advertising, and policy toward competitors.
What price maximizes profit? A lower price boosts sales, while a higher price brings in
higher margins. A similar issue arises in determining advertising expenditure. What is the
best way to compete with other businesses?
Part II of this book addresses all of these issues. We begin by analyzing costs (Chapter 7),
then consider management in the extreme case of market power, where there is only one
seller or only one buyer (Chapter 8). Next, we discuss pricing policy (Chapter 9), and strate-
gic thinking in general (Chapter 10) and in the context of competition among several sellers
or buyers in particular (Chapter 11).

Imperfect markets
Businesses with market power have relatively more freedom of
Imperfect market: One action than those in competitive markets. Managers will also have
party directly conveys a relatively more freedom of action in markets that are subject to
benefit or cost to others, imperfections. A market may be imperfect in two ways: when one
or one party has better
party directly conveys a benefit or cost to others, or where one party
information than others.
has better information than others. The challenge for managers oper-
ating in imperfect markets is to resolve the imperfection and so
enable the cost-effective provision of their products.
Consider the market for residential mortgages. Applicants for mortgages have better
knowledge of their ability and willingness to repay than potential lenders. In this case, the
market is imperfect owing to differences in information. The challenge for lenders is how to
resolve the informational differences so that they can provide loans in a cost-effective way.
Managers of businesses in imperfect markets need to think strategically. For instance,
a residential mortgage lender may require all loan applicants to pay for a credit evalu-
ation, with the lender refunding the cost if the credit evaluation is favorable. The lender
might reason that bad borrowers would not be willing to pay for a credit evaluation because
they would fail the check. Good borrowers, however, would pay for the evaluation because
they would get their money back from the lender. Hence, the credit evaluation requirement
will screen out the bad borrowers. This is an example of strategic thinking in an imperfect
market.
Differences in information and conflicts of interest can cause a market to be imperfect.
The same imperfection can arise within an organization, where some members have better
information than others and interests diverge. Accordingly, another issue is how to structure
incentives and organization.
Part III of this book addresses all of these issues. We begin by considering the sources of
market imperfections – where one party directly conveys a benefit or cost to others (Chap-
ter 12) and where one party has better information than others (Chapter 13). Then we study
the appropriate structure of incentives and organization (Chapter 14). Finally, we discuss
how government regulation can resolve market imperfections (Chapter 15).

Progress check 1F. Distinguish the three branches of managerial economics.

 Introduction 13
Globalization
A market extends as far as there are buyers or sellers who can communicate and trade at
relatively low cost. Owing to the relatively high costs of communication and trade, some
markets are local. Examples include grocery retailing, housing, and live entertainment. The
price in one local market will be independent of prices in other local markets. For instance,
an increase in the price of apartments in New York City does not affect the housing market
in Houston.
By contrast, some markets are global because the costs of communication and trade are
relatively low. Examples include commodities, financial services, and shipping. In the case
of an item with a global market, the price in one place will move together with the prices
elsewhere. When the price of gold increases in London, the price will also rise in Tokyo.
Whether a market is local or global, the same managerial economics principles apply.
For instance, when the price of fresh vegetables in Britain increases, consumers will switch
to frozen vegetables. The same will be true in Japan, the United States, and elsewhere. An
airline with market power in Germany will use that power to raise prices above the compet-
itive level, and a mortgage lender in Australia will act strategically to resolve differences in
information relative to borrowers. The same will be true all over the world.

Communications costs and trade barriers

With developments in technology and deregulation, costs of international transport and com-
munication have systematically fallen. The Internet operates over national and international
telecommunications links. The explosive growth of the Internet is due in large part to cheap
telecommunications.
Further, bilateral and multilateral agreements between governments have reduced barriers
to trade. The World Trade Organization actively promotes the lowering of tariffs and other
barriers to trade.
These trends have caused many markets to become relatively more integrated across geo-
graphical boundaries. For instance, Canadian insurers sell life insurance and mutual funds
in Asia, Israeli growers ship fresh flowers by air to Europe, and Internet telephony services
offer cheap international telephone calls throughout the world.
With the trend toward greater integration, managers must pay increasing attention to
markets in other places. Some markets may be similar, while others are different. In all
cases, managers must not allow their planning to be limited by traditional geographical
boundaries.

Outsourcing
One implication of greater international integration is outsourcing
Outsourcing: The
to other countries. Outsourcing is the purchase of services or sup-
purchase of services or
plies from external sources. The external sources could be within supplies from external
the same country or foreign. sources.
Owing to dramatic reductions in international communications
costs and trade barriers, international outsourcing has grown rapidly. US financial ser-
vices businesses outsource customer service to contractors in the Philippines and India, and
European manufacturers outsource production to contractors in eastern Europe. We discuss
outsourcing in detail in Chapter 14 on incentives and organizations.
14 Introduction

New business organization: peer-to-peer

Some of the fastest-growing businesses challenge conventional thinking about business orga-
nization. Janus Friis and Niklas Zennstrom applied peer-to-peer technology to develop Skype,
software for voice calls over the Internet. They remarked: “The telephony market is character-
ized both by what we think is rip-off pricing and a reliance on heavily centralized infrastructure.
We just couldn’t resist the opportunity to help shake this up a bit.”
Unlike conventional businesses, Skype is located nowhere and everywhere. It operates from
the computers of over 120 million worldwide users and through the Internet. As for organization,
its vertical chain is short, while its horizontal boundaries are large in terms of scale but, with
just one product, narrow in terms of scope. In May 2011, software publisher Microsoft acquired
Skype for $8.5 billion.
Source: CNET, “Kazaa founders tout PTP VoIP,” October 19, 2004.

Key takeaways
• Managerial economics is the science of cost-effective management of scarce resources.
• Value added is the difference between buyer benefit and seller cost, and comprises buyer
surplus and seller economic profit.
• Economic profit is accounting profit less opportunity cost plus sunk cost.
• In decisions on participation, compare the total benefit and total cost.
• In decisions on extent, compare the marginal benefit and marginal cost.
• In decision-making, take care to avoid systematic biases including the sunk-cost fallacy,
status quo bias, and anchoring.
• When evaluating benefits and costs that flow over time, use net present value with the
appropriate discount rate.
• The vertical boundaries of an organization delineate activities closer to or further from
the end user.
• The horizontal boundaries of an organization are defined by the scale and scope of
operations.
• Businesses with market power must manage their costs, pricing, advertising, and relations
with competitors.
• Businesses in imperfect markets should act strategically to resolve the imperfection.
• Falling trade barriers and communication costs result in global markets being more
integrated.

Review questions
1 Consider a charity that gives free mosquito nets to poor people. Since the charity receives
no revenue while mosquito nets are costly, does the free distribution mean that the charity
is destroying value?
2 How does economic profit differ from accounting profit?
3 Give an example in which the marginal exceeds the average value.
4 Give an example in which the marginal is less than the average value.
5 Why do individuals act with bounded rationality?
6 Explain why an employer expecting $1 million of future pension costs need not provide
$1 million today in order to meet the pension fund’s future obligations.
 Introduction 15
7 Referring to the net present value example in the section above on timing, under what
circumstances, if any, could the NPV be positive?
8 Describe the vertical boundaries of your local cable television provider. In what ways
could the vertical boundaries be expanded or reduced?
9 Describe the horizontal boundaries of your university. In what ways could the horizontal
boundaries be expanded or reduced?
10 Explain the difference between: (a) the market for electricity; and (b) the electricity
industry.
11 True or false?
(a) In every market, all buyers are consumers.
(b) In every market, all sellers are businesses.
12 What is another name for the model of competitive markets?
13 What distinguishes a manufacturer with market power from one without market power?
14 Should managers operating in an imperfect market: (a) set high prices to make up for the
imperfection, or (b) act strategically to resolve the imperfection?
15 Explain the consequences of the falling costs of international communication and trade.

Discussion questions
1 Luna Biotech has accumulated cash of $10 million. It commenced a $10 million R&D
project to develop a new drug to treat a rare disease. The new drug is expected to generate
a profit contribution of $20 million. So far, Luna Biotech has already spent $6 million
on R&D. Meanwhile, a scientist has already developed a drug to treat the same disease.
The scientist has offered to sell her invention to Luna Biotech for $2 million. Her drug
would be just as effective and also yield profit contribution of $20 million. Luna has only
$4 million cash on hand and cannot borrow, so it must choose between continuing its own
R&D or buying the scientist’s invention.
(a) What is the maximum that Luna should pay to the scientist for her invention?
(b) Suppose that the scientist demands $3 million for her invention. (i) What is Luna’s
accounting profit from continuing with R&D? (ii) What is Luna’s economic profit from
continuing with R&D? (iii) Should Luna continue its own R&D or buy the scientist’s
invention?
(c) How would your answer in (a) change if Luna had not yet spent anything on its own
R&D project?
2 Alan and Hilda are clerks at a department store. The store pays each clerk $10 per hour for
a basic eight-hour day, $15 per hour for overtime of up to four hours, and $20 for overtime
exceeding four hours a day.
(a) Alan works 10 hours a day. What are his: (i) marginal pay; and (ii) average pay?
(b) Hilda works 14 hours a day. What are her: (i) marginal pay; and (ii) average pay?
(c) Under what pay structure would the marginal pay be less than the average pay?
3 Ford offers a three-year or 36,0000-mile warranty on the Explorer car. Consumers must
pay for extended warranties beyond the manufacturer’s warranty period. The Auto Club
offers an extended warranty for a Ford Explorer in Hanover, New Hampshire, at a price of
$1,259. This would cover years 4 and 5, after the expiry of the manufacturer’s warranty.
16 Introduction
(a) Explain the role of discounting in your decision whether or not to purchase the
extended warranty.
(b) Suppose that the expected cost of repair is $800 in each of years 4 and 5. If your
discount rate is 6% per year, should you purchase the extended warranty?
(c) Would your decision be different if your discount rate were 1% per year?
4 In each of the following instances, discuss whether horizontal or vertical boundaries have
been changed, and whether they were extended or shrunk.
(a) The Canadian manufacturer of regional jets, Bombardier, launched the CSeries,
a family of 100- to 149-seat, long-range jets.
(b) The software publisher Microsoft acquired Skype, a provider of Internet telephony
services.
(c) The conglomerate General Electric divested its subsidiary, NBC Universal, which
merged with cable TV provider, Comcast.
5 Referring to the definition of a market, answer the following questions:
(a) Opponents of the Iraqi government periodically sabotage the pipelines through which
Iraq exports oil to the rest of the world. Is Iraq part of the world market for oil?
(b) Prisoners cannot freely work outside jail. How would changes in prisoners’ wages
affect the national labor market?
(c) The Australian national electricity transmission grid links eastern states including New
South Wales, South Australia, and Victoria, but not Western Australia. How would
price changes in Western Australia affect the other states?

You are the consultant!

In your organization or personal experience, identify and explain any decisions that have been
systematically biased by: (a) sunk-cost fallacy, (b) status quo bias, or (c) anchoring. Explain how
the organization or you could have achieved a better outcome by controlling the bias.