Baye, m r (2010) managerial economics and business strategy (7th ed) mcgraw hill irwin

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


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Managerial Economics and
Business Strategy

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Equilibrium • Predatory

Demand
Marginal

Elasticity • Vertical

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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


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SEVENTH EDITION

Managerial Economics and
Business Strategy

Michael R. Baye

Bert Elwert Professor of Business Economics & Public Policy
Kelley School of Business
Indiana University

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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


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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


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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.
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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
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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 ϭ 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.


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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


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versions of key tables in the text to enable students to see how key economic
concepts—like marginal cost and profit maximization—can be implemented on standard spreadsheets, and spreadsheet macros that students can use to find the optimum
price and quantity under a variety of market settings, including monopoly, Cournot oligopoly, and Stackelberg oligopoly. Plus, the Web site includes 10 additional full-length
cases (in pdf format) that are described below.
CourseSmart is a new way for faculty to find and review eTextbooks. It’s also a great
option for students who are interested in accessing their course materials digitally.
CourseSmart offers thousands of the most commonly adopted textbooks across hundreds of courses from a wide variety of higher education publishers. It is the only place
for faculty to review and compare the full text of a textbook online. At CourseSmart,
students can save up to 50% off the cost of a print book, reduce their impact on the
environment, and gain access to powerful Web tools for learning including full text
search, notes and highlighting, and email tools for sharing notes between classmates.
Your eBook also includes tech support in case you ever need help.
Finding your eBook is easy. Visit www.CourseSmart.com and search by title,
author, or ISBN.

SUPPLEMENTS
I am pleased to report that the seventh edition of Managerial Economics and Business Strategy truly offers adopters the most comprehensive and easily accessible
supplements in the market. Below I discuss popular features of some of the supplements that have been greatly expanded for this edition.

Cases
In addition to the Time Warner case, the Web site contains nearly a dozen fulllength cases that I prepared along with Patrick Scholten to accompany Managerial
Economics and Business Strategy. These cases complement the textbook by showing how real-world businesses use tools like demand elasticities, markup pricing,
third-degree price discrimination, bundling, Herfindahl indices, game theory, and
predatory pricing to enhance profits or shape business strategies. The cases are
based on actual decisions by companies that include Microsoft, Heinz, Visa, Staples, American Airlines, Sprint, and Kodak. Instructors who adopt the seventh edition obtain the cases on the Web site.

The Web site for the seventh edition contains expanded teaching notes and
solutions for all of the cases—including the Time Warner case.

PowerPoint Slides
The Web site also contains thoroughly updated and fully editable PowerPoint presentations with animated figures and graphs to make teaching and learning a snap. For
instance, a simple mouse click reveals the firm’s demand curve. Another click reveals
the associated marginal revenue curve. Another click shows the firm’s marginal cost. A
few more clicks, and students see how to determine the profit-maximizing output,
price, and maximum profits. Animated graphs and tables are also provided for all other


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relevant concepts (like Cournot and Stackelberg equilibrium, normal form and extensive form games, and the like).

Instructor’s Manual/Test Bank
A thoroughly updated instructor’s manual and test bank, prepared by Michael R.
Baye and Patrick Scholten, provides a summary of each chapter, a teaching outline

for each chapter, complete answers to all end-of-chapter problems, updated and
class-tested problems (including over 1,000 multiple-choice questions and over 250
problems with detailed solutions). The seventh edition Web site contains teaching
notes for the Time Warner case and solutions to the 14 accompanying Memos, as
well as expanded and improved teaching notes for the additional cases.

EZ Test Version of the Test Bank
The password-protected Web site contains test bank files in both EZ Test software as
well as in Microsoft Word format. EZ Test can reproduce high-quality graphs from
the test bank and allows instructors to generate multiple tests with versions that are
“scrambled” to be distinctive. The software is easy to use and allows optimum customization of tests.

Digital Image Library
The Digital Image Library contains all the figures in the textbook in electronic format. This gives instructors the flexibility to integrate figures from the textbook into
PowerPoint presentations or to directly print the figures on overhead transparencies.

Study Guide
In addition to the numerous problems and answers contained in the textbook, an
updated study guide prepared by yours truly is available to enhance student performance at minimal cost to students and professors.

Student Web Site
Please visit the enhanced Web site for Managerial Economics and Business Strategy
at www.mhhe.com/baye7e. This site provides a host of information for students and
instructors, including online quizzes, PowerPoint presentations, Inside Business
applications from previous editions of the text, sample problems from the Study
Guide, and other material designed to help students and instructors more effectively
use both the textbook and Study Guide.

Instructor Web Site
Electronic versions of all instructor supplements (including the full-length cases

complete with teaching notes, PowerPoint presentations, Digital Image Library, the
electronic test bank, detailed solutions to every end-of-chapter problem and Time
Warner case, chapter outlines, chapter summaries, and more) may be conveniently
accessed on the password-protected Instructor's Web site. This makes it easy for
instructors to use the many supplements designed to make teaching managerial
economics from the seventh edition easy and fun.


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CHANGES IN THE SEVENTH EDITION
I have made every effort to update and improve Managerial Economics and Business Strategy while assuring a smooth transition to the seventh edition. Below is a
summary of the pedagogical improvements, enhanced supplements, and content
changes that make the seventh edition an even more powerful tool for teaching and
learning managerial economics and business strategy.
• All of the class-tested problems from the previous edition, plus over 25 new
end-of-chapter problems. Where appropriate, problems from the previous
edition have been updated to reflect the current economic climate.

• Updated Test Bank available on the Instructor’s Web site in two formats:
Computerized (EZ Test) and in Microsoft Word format.
• Updated Headlines.
• New and updated Inside Business applications.
• The financial crisis is reshaping the global economic and regulatory
landscape, and it is likely to take years for its ultimate effects on the economy
to be fully recognized. In preparing this edition, I have revised the book to
ensure that the economic examples presented are timeless and will not grow
into “historical examples” as a result of bankruptcies, new legislation, or
changes in the country’s taste for regulation. As in previous editions, this
edition continues to equip students with the economic tools required to manage
businesses and, more generally, to evaluate current events. The virtues of
markets, as well as potential market failures, are presented without editorial
comment on my part. Adopters of this book have praised this approach, as it
provides a positive foundation that permits individual instructors to rigorously
discuss current events—including the plethora of political proposals and
opinions regarding the financial crisis that emerge each and every day.
• Updated Instructor’s Web site that offers full teaching notes and solutions to
Memos for the Time Warner case—plus a host of additional supplements.
These include over 10 additional full-length cases complete with expanded
teaching notes and links to chapter content, complete solutions to all end-ofchapter problems, an updated and expanded electronic test bank, animated
PowerPoint presentations, chapter summaries, chapter outlines, the Digital
Image Library, and more.
• Chapters 1–4 have been revised to include more timely Headlines, updated
Inside Business applications, and additional in-text examples. Each chapter
also contains new end-of-chapter problems, as well as updated versions of
the class-tested problems you enjoyed in the previous edition.
• Chapter 5 opens with a new Headline and contains updated examples
throughout. It also offers a new Inside Business application that shows how
to estimate cost functions using regression techniques, as well as updated and

new end-of-chapter problems.
• Chapter 6 offers updated examples and Inside Business applications. The
chapter also includes two new end-of-chapter problems.


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• Chapter 7 contains thoroughly updated examples and industry data, along with

•

•

•
•

•

a new Inside Business application that describes the 2007 North American
Industry Classification System (NAICS). Additionally, the in-text discussion
of horizontal mergers has been revised to reflect current practices at the
Federal Trade Commission and Antitrust Division of the U.S. Department of
Justice. The chapter also includes two new end-of-chapter problems.
Chapter 8 offers a new opening Headline, updated Inside Business
applications and in-text examples, and new content on the pitfalls of brand
myopia. Several new end-of-chapter problems are provided, along with
updated versions of the problems contained in the previous edition.
Chapter 9 provides improved exposition of a variety of oligopoly models.
The opening Headline and Inside Business applications have been updated,
and the chapter includes two new end-of-chapter problems.
Chapter 10 opens with a new Headline and includes two new end-of-chapter
problems.
Chapter 11 now offers some caveats to managers who use markup formulas
to price their products or services, and includes an improved exposition of
price discrimination. Examples have been updated throughout, and two new
end-of-chapter problems are provided.
Chapters 12–14 include updated Headlines, updated Inside Business
applications, and new end-of-chapter problems. Chapters 13 and 14 now offer
succinct coverage of antitrust issues that can constrain the scope of business
strategies, such as pricing and mergers.

ACKNOWLEDGMENTS
I thank the many users of Managerial Economics and Business Strategy who provided both direct and indirect feedback that has helped improve your book. This
includes thousands of students at Indiana University’s Kelley School of Business
and instructors worldwide who have used my book in their own classrooms, colleagues who unselfishly gave up their own time to provide me with comments and
suggestions, and reviewers who provided detailed suggestions to improve this and
previous editions of the book. I especially thank the following professors for
enlightening me on the market’s diverse needs and for providing suggestions and

constructive criticisms to improve this book:
Fatma Abdel-Raouf, Goldey-Beacom College
Burton Abrams, University of Delaware
Rashid Al-Hmoud, Texas Tech University
Anthony Paul Andrews, Governors State University
Sisay Asefa, Western Michigan University
Simon Avenell, Murdoch University
Joseph P. Bailey, University of Maryland
Dean Baim, Pepperdine University


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Sheryl Ball, Virginia Polytechnic University
Klaus Becker, Texas Tech University
Richard Beil, Auburn University
Barbara C. Belivieu, University of Connecticut
Dan Black, University of Chicago

Louis Cain, Northwestern University
Leo Chan, University of Kansas
Robert L. Chapman, Florida Metropolitan University
Basanta Chaudhuri, Rutgers University-New Brunswick
Kwang Soo Cheong, Johns Hopkins University
Christopher B. Colburn, Old Dominion University
Michael Conlin, Syracuse University
Keith Crocker, Penn State University
Ian Cromb, University of Western Ontario
Dean Croushore, Federal Reserve
Wilffrid W. Csaplar Jr., Bethany College
Shah Dabirian, California State University, Long Beach
George Darko, Tusculum College
Tina Das, Elon University
Ron Deiter, Iowa State University
Casey Dirienzo, Appalachian State University
Eric Drabkin, Hawaii Pacific University
Martine Duchatelet, Barry University
Keven C. Duncan, University of Southern Colorado
Yvonne Durham, Western Washington University
Ibrahim Elsaify, Goldey-Beacom College
Mark J. Eschenfelder, Robert Morris University
David Ely, San Diego State University
David Figlio, University of Florida
Ray Fisman, Graduate School of Business, Columbia University
Silke Forbes, University of California—San Diego
David Gerard, Carnegie Mellon University
Sharon Gifford, Rutgers University
Lynn G. Gillette, Northeast Missouri State University
Otis Gilley, Louisiana Tech University

Roy Gobin, Loyola University
Stephan Gohmann, University of Louisville
Steven Gold, Rochester Institute of Technology
Thomas A. Gresik, Mendoza College of Business (University of Notre Dame)
Andrea Mays Griffith, California State University
Madhurima Gupta, University of Notre Dame
Carl Gwin, Pepperdine University


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Gail Heyne Hafer, Lindenwood College
Karen Hallows, George Mason University
William Hamlen Jr., SUNY Buffalo
Shawkat Hammoudeh, Drexel University
Mehdi Harian, Bloomsburg University
Nile W. Hatch, Marriott School (Brigham Young University)
Clifford Hawley, West Virginia University

Ove Hedegaard, Copenhagen Business School
Steven Hinson, Webster University
Hart Hodges, Western Washington University
Jack Hou, California State University—Long Beach
Lowel R. Jacobsen, William Jewell College
Thomas D. Jeitschko, Texas A&M University
Jaswant R. Jindia, Southern University
Paul Kattuman, Judge Business School (Cambridge University)
Brian Kench, University of Tampa
Peter Klein, University of Georgia, University of Missouri-Columbia
Audrey D. Kline, University of Louisville
W. J. Lane, University of New Orleans
Daniel Lee, Shippensburg University
Dick Leiter, American Public University
Canlin Li, University of California-Riverside
Vahe Lskavyan, Ohio University-Athens
Heather Luea, Newman University
Thomas Lyon, University of Michigan
Richard Marcus, University of Wisconsin—Milwaukee
Vincent Marra, University of Delaware
Wade Martin, California State University, Long Beach
Catherine Matraves, Michigan State University-East Lansing
John Maxwell, Indiana University
David May, Oklahoma City University
Alan McInnes, California State University, Fullerton
Christopher McIntosh, University of Minnesota Duluth
Edward Millner, Virginia Commonwealth University
John Moran, Syracuse University
John Morgan, Haas Business School (University of California—Berkeley)
Ram Mudambi, Temple University

Francis Mummery, California State University-Fullerton
Inder Nijhawan, Fayetteville State University
Albert A. Okunade, University of Memphis
Darrell Parker, Georgia Southern University
Stephen Pollard, California State University, Los Angeles


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Preface

Dwight A. Porter, College of St. Thomas
Stanko Racic, University of Pittsburgh
Eric Rasmusen, Indiana University
Matthew Roelofs, Western Washington University
Christian Roessler, National University of Singapore
Bansi Sawhney, University of Baltimore
Craig Schulman, University of Arkansas
Karen Schultes, University of Michigan—Dearborn
Peter M. Schwartz, University of North Carolina

Edward Shinnick, University College Ireland
Dean Showalter, Southwest Texas State University
Chandra Shrestha, Virginia Commonwealth University
Karen Smith, Columbia Southern University
John Stapleford, Eastern University
Mark Stegeman, Virginia Polytechnic University
Ed Steinberg, New York University
Barbara M. Suleski, Cardinal Stritch College
Caroline Swartz, University of North Carolina Charlotte
Bill Taylor, New Mexico Highlands University
Roger Tutterow, Kennesaw State College
Nora Underwood, University of Central Florida
Lskavyan Vahe, Ohio University
Lawrence White, Stern School of Business (New York University)
Leonard White, University of Arkansas
Keith Willett, Oklahoma State University-Stillwater
Mike Williams, Bethune Cookman College
Richard Winkelman, Arizona State University
Eduardo Zambrano, University of Notre Dame
Rick Zuber, University of North Carolina, Charlotte
I thank Anne Hilbert, Douglas Reiner, and Bruce Gin at McGraw-Hill for all they
have done to make this project a success, and Alexander V. Borisov and Lan Zhang for
assisting me during various stages of the revision. I once again am indebted to Patrick
Scholten for his efforts to improve this book and its supplements. Also, my thanks to
Philip Powell and Patrick Scholten for their review. Finally, I thank my family—
M’Lissa, Natalie, and Mitchell—for their continued love and support.
As always, I welcome your comments and suggestions for the next edition.
Visit my Web site, or write to me directly at

Michael R. Baye

Bloomington, Indiana


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BRIEF TABLE OF CONTENTS
Chapter 1.

The Fundamentals of Managerial Economics 1

Chapter 2.

Market Forces: Demand and Supply 35

Chapter 3.

Quantitative Demand Analysis 73

Chapter 4.

The Theory of Individual Behavior 117

Chapter 5.

The Production Process and Costs 155

Chapter 6.

The Organization of the Firm 202

Chapter 7.

The Nature of Industry 235

Chapter 8.

Managing in Competitive, Monopolistic, and
Monopolistically Competitive Markets 264

Chapter 9.

Basic Oligopoly Models 313

Chapter 10.

Game Theory: Inside Oligopoly 350

Chapter 11.

Pricing Strategies for Firms with Market Power 395

Chapter 12.

The Economics of Information 433

Chapter 13.

Advanced Topics in Business Strategy 473

Chapter 14. A Manager’s Guide to Government in the
Marketplace 507
Case Study.

Challenges at Time Warner 546

Appendix A Answers to Selected End-of-Chapter Problems 582
Appendix B Additional Readings and References 585
Name Index 603
General Index 609

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CONTENTS

CHAPTER ONE

The Fundamentals of Managerial Economics 1
Headline: Amcott Loses $3.5 Million; Manager Fired 1
Introduction 2
The Manager 3
Economics 3
Managerial Economics Defined 3
The Economics of Effective Management 4
Identify Goals and Constraints 4
Recognize the Nature and Importance of Profits 5
Economic versus Accounting Profits 5
The Role of Profits 6
The Five Forces Framework and Industry Profitability 8
Understand Incentives 11
Understand Markets 12
Consumer–Producer Rivalry 13
Consumer–Consumer Rivalry 13
Producer–Producer Rivalry 13
Government and the Market 13
Recognize the Time Value of Money 14
Present Value Analysis 14
Present Value of Indefinitely Lived Assets 16
Use Marginal Analysis 19
Discrete Decisions 20
Continuous Decisions 22
Incremental Decisions 24

Learning Managerial Economics 25
Answering the Headline 26
Key Terms and Concepts 26
Conceptual and Computational Questions 27
Problems and Applications 28
Case-Based Exercises 32
Selected Readings 33
Appendix: The Calculus of Maximizing Net Benefits 33
Inside Business 1–1: The Goals of Firms in Our Global Economy 7
Inside Business 1–2: Profits and the Evolution of the Computer Industry
Inside Business 1–3: Joining the Jet Set 19
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CHAPTER TWO

Market Forces: Demand and Supply 35
Headline: Samsung and Hynix Semiconductor to Cut Chip Production 35
Introduction 36
Demand 36
Demand Shifters 38
Income 39
Prices of Related Goods 40
Advertising and Consumer Tastes 40
Population 41
Consumer Expectations 41
Other Factors 42
The Demand Function 42
Consumer Surplus 44
Supply 46
Supply Shifters 46
Input Prices 47
Technology or Government Regulations 47
Number of Firms 47
Substitutes in Production 47
Taxes 48
Producer Expectations 49
The Supply Function 49
Producer Surplus 51
Market Equilibrium 52
Price Restrictions and Market Equilibrium 54
Price Ceilings 54
Price Floors 58
Comparative Statics 60
Changes in Demand 60

Changes in Supply 61
Simultaneous Shifts in Supply and Demand 63
Answering the Headline 65
Summary 65
Key Terms and Concepts 66
Conceptual and Computational Questions 66
Problems and Applications 68
Case-Based Exercises 72
Selected Readings 72
Inside Business 2–1: Asahi Breweries Ltd. and the Asian Recession 39
Inside Business 2–2: The Trade Act of 2002, NAFTA, and the Supply Curve 47
Inside Business 2–3: Price Ceilings and Price Floors around the Globe 58
Inside Business 2–4: Globalization and the Supply of Soft Drinks 62
Inside Business 2–5: Using a Spreadsheet to Calculate Equilibrium in the Supply and
Demand Model 63


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CHAPTER THREE

Quantitative Demand Analysis 73
Headline: Winners of Wireless Auction to Pay $7 Billion 73
Introduction 74
The Elasticity Concept 74
Own Price Elasticity of Demand 75
Elasticity and Total Revenue 76
Factors Affecting the Own Price Elasticity 79
Available Substitutes 80
Time 82
Expenditure Share 82
Marginal Revenue and the Own Price Elasticity of Demand 83
Cross-Price Elasticity 85
Income Elasticity 88
Other Elasticities 90
Obtaining Elasticities from Demand Functions 90
Elasticities for Linear Demand Functions 91
Elasticities for Nonlinear Demand Functions 92
Regression Analysis 95
Evaluating the Statistical Significance of Estimated Coefficients 98
Confidence Intervals 99
The t-Statistic 99
Evaluating the Overall Fit of the Regression Line 100
The R-Square 100
The F-Statistic 102
Nonlinear and Multiple Regressions 102
Nonlinear Regressions 102
Multiple Regression 104

A Caveat 107
Answering the Headline 107
Summary 109
Key Terms and Concepts 109
Conceptual and Computational Questions 110
Problems and Applications 112
Case-Based Exercises 116
Selected Readings 116
Inside Business 3–1: Calculating and Using the Arc Elasticity: An Application to the
Housing Market 80
Inside Business 3–2: Inelastic Demand for Prescription Drugs 84
Inside Business 3–3: Using Cross-Price Elasticities to Improve New Car Sales in the
Wake of Increasing Gasoline Prices 87
Inside Business 3–4: Shopping Online in Europe: Elasticities of Demand for Personal
Digital Assistants Based on Nonlinear Regression Techniques 103


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CHAPTER FOUR

The Theory of Individual Behavior 117
Headline: Packaging Firm Uses Overtime Pay to Overcome Labor Shortage 117
Introduction 118
Consumer Behavior 118
Constraints 122
The Budget Constraint 123
Changes in Income 125
Changes in Prices 126
Consumer Equilibrium 128
Comparative Statics 129
Price Changes and Consumer Behavior 129
Income Changes and Consumer Behavior 131
Substitution and Income Effects 133
Applications of Indifference Curve Analysis 135
Choices by Consumers 135
Buy One, Get One Free 135
Cash Gifts, In-Kind Gifts, and Gift Certificates 136
Choices by Workers and Managers 139
A Simplified Model of Income–Leisure Choice 140
The Decisions of Managers 141
The Relationship between Indifference Curve Analysis and Demand Curves 143
Individual Demand 143
Market Demand 144
Answering the Headline 145
Summary 146
Key Terms and Concepts 147
Conceptual and Computational Questions 147
Problems and Applications 149

Case-Based Exercises 152
Selected Readings 152
Appendix: A Calculus Approach to Individual Behavior 153
Inside Business 4–1: Indifference Curves and Risk Preferences 122
Inside Business 4–2: Price Changes and Inventory Management for Multiproduct
Firms 130
Inside Business 4–3: Income Effects and the Business Cycle 134
Inside Business 4–4: The “Deadweight Loss” of In-Kind Gifts 139
CHAPTER FIVE

The Production Process and Costs 155
Headline: Boeing Loses the Battle but Wins the War 155
Introduction 156


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The Production Function 156

Short-Run versus Long-Run Decisions 156
Measures of Productivity 158
Total Product 158
Average Product 158
Marginal Product 158
The Role of the Manager in the Production Process 160
Produce on the Production Function 160
Use the Right Level of Inputs 161
Algebraic Forms of Production Functions 164
Algebraic Measures of Productivity 165
Isoquants 167
Isocosts 170
Cost Minimization 171
Optimal Input Substitution 173
The Cost Function 175
Short-Run Costs 176
Average and Marginal Costs 178
Relations among Costs 180
Fixed and Sunk Costs 181
Algebraic Forms of Cost Functions 182
Long-Run Costs 183
Economies of Scale 185
A Reminder: Economic Costs versus Accounting Costs 186
Multiple-Output Cost Functions 187
Economies of Scope 187
Cost Complementarity 187
Answering the Headline 190
Summary 190
Key Terms and Concepts 191
Conceptual and Computational Questions 191

Problems and Applications 194
Case-Based Exercises 198
Selected Readings 198
Appendix: The Calculus of Production and Costs 199
Inside Business 5–1: Where Does Technology Come From? 163
Inside Business 5–2: Fringe Benefits and Input Substitution 176
Inside Business 5–3: Estimating Production Functions, Cost Functions, and Returns
to Scale 184
Inside Business 5–4: International Companies Exploit Economies of Scale 186
CHAPTER SIX

The Organization of the Firm 202
Headline: Korean Firm Invests 30 Trillion Won to Vertically Integrate 202
Introduction 203


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Methods of Procuring Inputs 204
Purchase the Inputs Using Spot Exchange 204
Acquire Inputs under a Contract 205
Produce the Inputs Internally 205
Transaction Costs 206
Types of Specialized Investments 207
Site Specificity 207
Physical-Asset Specificity 207
Dedicated Assets 207
Human Capital 208
Implications of Specialized Investments 208
Costly Bargaining 208
Underinvestment 208
Opportunism and the “Hold-Up Problem” 209
Optimal Input Procurement 210
Spot Exchange 210
Contracts 212
Vertical Integration 215
The Economic Trade-Off 216
Managerial Compensation and the Principal–Agent Problem 219
Forces That Discipline Managers 221
Incentive Contracts 221
External Incentives 222
Reputation 222
Takeovers 222
The Manager–Worker Principal–Agent Problem 223
Solutions to the Manager–Worker Principal–Agent Problem 223
Profit Sharing 223
Revenue Sharing 223
Piece Rates 224

Time Clocks and Spot Checks 224
Answering the Headline 226
Summary 226
Key Terms and Concepts 226
Conceptual and Computational Questions 227
Problems and Applications 228
Case-Based Exercises 231
Selected Readings 231
Appendix : An Indifference Curve Approach to Managerial Incentives 231
Inside Business 6–1: The Cost of Using an Inefficient Method of
Procuring Inputs 210
Inside Business 6–2: Factors Affecting the Length of Coal and Natural-Gas
Contracts 214
Inside Business 6–3: The Evolution of Input Decisions in the Automobile
Industry 217
Inside Business 6–4: Paying for Performance 225


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CHAPTER SEVEN

The Nature of Industry 235
Headline: Microsoft Puts Halt to Intuit Merger 235
Introduction 236
Market Structure 236
Firm Size 236
Industry Concentration 237
Measures of Industry Concentration 238
The Concentration of U.S. Industry 239
Limitations of Concentration Measures 241
Technology 243
Demand and Market Conditions 243
Potential for Entry 245
Conduct 246
Pricing Behavior 247
Integration and Merger Activity 248
Vertical Integration 249
Horizontal Integration 249
Conglomerate Mergers 250
Research and Development 250
Advertising 251
Performance 251
Profits 251
Social Welfare 251
The Structure–Conduct–Performance Paradigm 253
The Causal View 253
The Feedback Critique 253

Relation to the Five-Forces Framework 254
Overview of the Remainder of the Book 254
Perfect Competition 255
Monopoly 255
Monopolistic Competition 255
Oligopoly 255
Answering the Headline 257
Summary 257
Key Terms and Concepts 258
Conceptual and Computational Questions 258
Problems and Applications 260
Case-Based Exercises 263
Selected Readings 263
Inside Business 7–1: The 2007 North American Industry Classification System
(NAICS) 242
Inside Business 7–2: The Elasticity of Demand at the Firm and Market Levels 246
Inside Business 7–3: The Evolution of Market Structure in the Computer Industry 256