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For students in the one-semester MBA Managerial Economics course. This book is also suitable for all readers interested in the field of managerial economics. ¿ Economics for Managers presents the fundamental ideas of microeconomics and macroeconomics and integrates them from a managerial decision-making perspective in a framework that can be used in a single-semester course. ¿ To be competitive in today’s business environment, managers must understand how economic forces affect their business and the factors that must be considered when making business decisions.¿ This is the only book that provides business students and MBAs with a thorough and applied understanding of both micro- and macroeconomic concepts in a way non-economics majors can understand. ¿ The third edition retains all the same core concepts and straightforward material on micro- and macroeconomics while incorporating new case material and real-world examples that relate to today’s managerial student. It may takes up to 1-5 minutes before you received it. Please note: you need to verify every book you want to send to your Kindle. Check your mailbox for the verification email from Amazon Kindle. You can write a book review and share your experiences. Other readers will always be interested in your opinion of the books you've read. Whether you've loved the book or not, if you give your honest and detailed thoughts then people will find new books that are right for them. Economics for Managers For these Global Editions, the editorial team at Pearson has collaborated with educators across the world to address a wide range of subjects and requirements, equipping students with the best possible learning tools. This Global Edition preserves the cutting-edge approach and pedagogy of the original, but also features alterations, customization and adaptation from the North American version. Global edition Global edition Global edition Third edition Farnham Economics for Managers Third edition This is a special edition of an established title widely used by colleges and universities throughout the world. Pearson published this exclusive edition for the benefit of students outside the United States and Canada. If you purchased this book within the United States or Canada you should be aware that it has been imported without the approval of the Publisher or Author. Farnham Pearson Global Edition FARNHAM_1292060093_1 07/08/14 pm Third Edition Economics for Managers Global Edition Paul G. Farnham Georgia State University Boston Columbus Indianapolis New York San Francisco Upper Saddle River Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montréal ­ Toronto Delhi Mexico City São Paulo Sydney Hong Kong Seoul ­ Singapore Taipei Tokyo A01_FARN0095_03_GE_FM. INDD 1 21/08/14 PM Editor in Chief: Donna Battista AVP/Executive Editor: David Alexander Head of Learning Asset Acquisition, Global Editions: Laura Dent Senior Editorial Project Manager: Lindsey Sloan Director of Marketing: Maggie Moylan Executive Marketing Manager: Lori Deshazo Senior Marketing Assistant: Kimberly Lovato Managing Editor: Jeffrey Holcomb Assistant Acquisitions Editor, Global Editions: Debapriya Mukherjee Senior Project Editor, Global Editions: Vaijyanti Art Director: Jayne Conte Cover Designer: Lumina Datamatics Ltd. Screen shots and icons reprinted with permission from the Microsoft Corporation. Cover Art: ©Zoran Orcik/123rf Media Director: Lisa Rinaldi Media Production Manager, Global ­ Editions: M Vikram Kumar Production Manager: Megha; n De Maio Senior Manufacturing Production Controller, Global Editions: Trudy Kimber Full-Service Project Management: Integra Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbook appear on the appropriate page within text. This book is not sponsored or endorsed by or affiliated with the Microsoft Corporation. Microsoft® and Windows® are registered trademarks of the Microsoft Corporation in the U. Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies throughout the world Visit us on the World Wide Web at: Pearson Education Limited 2014 The rights of Paul G. Farnham to be identified as the author of this work have been asserted by him in accordance with the Copyright, Designs and Patents Act 1988. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publisher or a license permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6–10 Kirby Street, London EC1N 8TS. Authorized adaptation from the United States edition, entitled Economics for Managers, 3rd edition, ISBN 978-0-132-077370-6, by Paul G. All trademarks used herein are the property of their respective owners. The use of any trademark in this text does not vest in the author or publisher any trademark ownership rights in such trademarks, nor does the use of such trademarks imply any affiliation with or endorsement of this book by such owners. British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library 10 9 8 7 6 5 4 3 2 1 15 14 13 12 11 ISBN 10: 1-292-06009-3 ISBN 13: 978-1-292-06009-5 Typeset in ITC Century Std by Integra Printed by Courier Kendallville in the United States of America A01_FARN0095_03_GE_FM. INDD 2 21/08/14 PM Dedication To my friend and colleague, Dr. INDD 4 21/08/14 PM Brief Contents Part 1 Microeconomic Analysis 32 1 2 3 4 5 6 7 8 9 10 Part 2 Managers and Economics 32 Demand, Supply, and Equilibrium Prices 46 Demand Elasticities 76 Techniques for Understanding Consumer Demand and Behavior 116 Production and Cost Analysis in the Short Run 144 Production and Cost Analysis in the Long Run 172 Market Structure: Perfect Competition 200 Market Structure: Monopoly and Monopolistic Competition 226 Market Structure: Oligopoly 260 Pricing Strategies for the Firm 288 Macroeconomic Analysis 320 11 12 13 14 15 Measuring Macroeconomic Activity 320 Spending by Individuals, Firms, and Governments on Real Goods and Services The Role of Money in the Macro Economy 390 The Aggregate Model of the Macro Economy 416 International and Balance of Payments Issues in the Macro Economy 446 350 Part 3 Integration of the Frameworks 482 16 Combining Micro and Macro Analysis for Managerial Decision Making 482 Solutions to Even-Numbered Problems 501 Glossary 521 Index 535 A01_FARN0095_03_GE_FM. INDD 6 21/08/14 PM Contents Preface 17 About the Author Part 1 Chapter 1 29 Microeconomic Analysis 32 Managers and Economics 32 Case for Analysis: Micro- and Macroeconomic Influences on the Global Automobile Industry 33 Two Perspectives: Microeconomics and Macroeconomics 35 Microeconomic Influences on Managers 36 Markets 36 Managerial Rule of Thumb: Microeconomic Influences on Managers 39 Macroeconomic Influences on Managers 39 Factors Affecting Macro Spending Behavior 41 Managerial Rule of Thumb: Macroeconomic Influences on Managers 43 End of Chapter Resources Summary 43 • Key Terms 44 • Exercises 44 • Application Questions Chapter 2 Demand, Supply, and Equilibrium Prices 44 46 Case for Analysis: Demand and Supply in the Copper Industry 47 Demand 48 Nonprice Factors Influencing Demand 49 Demand Function 53 Demand Curves 54 Change in Quantity Demanded and Change in Demand 55 Individual Versus Market Demand Curves 56 Linear Demand Functions and Curves 56 Mathematical Example of a Demand Function 57 Managerial Rule of Thumb: Demand Considerations 58 Supply 58 Nonprice Factors Influencing Supply 58 Supply Function 60 Supply Curves 61 Change in Quantity Supplied and Change in Supply 61 Mathematical Example of a Supply Function 62 Summary of Demand and Supply Factors 63 Managerial Rule of Thumb: Supply Considerations 64 A01_FARN0095_03_GE_FM. Jon Mansfield, who ­continues to excel at teaching economics for managers. INDD 7 21/08/14 PM 8 Contents Demand, Supply, and Equilibrium 64 Definition of Equilibrium Price and Equilibrium Quantity Lower-Than-Equilibrium Prices 64 Higher-Than-Equilibrium Prices 66 Mathematical Example of Equilibrium 67 Changes in Equilibrium Prices and Quantities 67 Mathematical Example of an Equilibrium Change 70 End of Chapter Resources Summary 72 • Key Terms Chapter 3 A01_FARN0095_03_GE_FM. INDD 8 • Application Questions 74 Case for Analysis: Demand Elasticity and Procter & Gamble’s Pricing Strategies Demand Elasticity 78 Price Elasticity of Demand 79 The Influence of Price Elasticity on Managerial Decision Making 80 Price Elasticity Values 81 Elasticity and Total Revenue 81 Managerial Rule of Thumb: Estimating Price Elasticity 83 Determinants of Price Elasticity of Demand 83 Number of Substitute Goods 84 Percent of Consumer’s Income Spent on the Product 84 Time Period 85 Numerical Example of Elasticity, Prices, and Revenues 85 Calculating Price Elasticities 85 Numerical Example 87 The Demand Function 87 Other Functions Related to Demand 87 Calculation of Arc and Point Price Elasticities 88 Price Elasticity Versus Slope of the Demand Curve 89 Demand Elasticity, Marginal Revenue, and Total Revenue 90 Vertical and Horizontal Demand Curves 92 Vertical Demand Curves 92 Horizontal Demand Curves 93 Income and Cross-Price Elasticities of Demand 94 Income Elasticity of Demand 94 Managerial Rule of Thumb: Calculating Income Elasticity 95 Cross-Price Elasticity of Demand 95 Elasticity Estimates: Economics Literature 97 Elasticity and Chicken and Agricultural/Food Products 98 Elasticity and Beer 99 Water Demand 100 Elasticity and the Tobacco Industry 100 Elasticity and Health Care 101 Tuition Elasticity in Higher Education 101 Managerial Rule of Thumb: Price Elasticity Decision Making 102 Elasticity Issues: Marketing Literature 102 Marketing Study I: Tellis (1988) 103 Marketing Study II: Sethuraman and Tellis (1991) 104 Marketing Study III: Hoch et al. (1995) 105 Marketing Study Update 105 77 Demand Elasticities 72 • Exercises 72 64 76 21/08/14 PM Contents 9 Managerial Rule of Thumb: Elasticities in Marketing and Decision Making 106 End of Chapter Resources Summary 106 • Appendix 3A Economic Model of Consumer Choice 107 • Key Terms 113 • Exercises 113 • Application Questions 114 Chapter 4 Techniques for Understanding Consumer Demand and Behavior 116 Case for Analysis: The Use of New Technology to Understand and Impact Consumer Behavior 117 Understanding Consumer Demand and Behavior: Marketing Approaches 118 Expert Opinion 118 Consumer Surveys 119 Test Marketing and Price Experiments 120 Analysis of Census and Other Historical Data 121 Unconventional Methods 121 Evaluating the Methods 122 Managerial Rule of Thumb: Marketing Methods for Analyzing Consumer Behavior 123 Consumer Demand and Behavior: Economic Approaches 123 Relationship Between One Dependent and One Independent Variable: Simple Regression Analysis 124 Relationship Between One Dependent and Multiple Independent Variables: Multiple Regression Analysis 129 Other Functional Forms 131 Demand Estimation Issues 132 Managerial Rule of Thumb: Using Multiple Regression Analysis 133 Case Study of Statistical Estimation of Automobile Demand 133 Managerial Rule of Thumb: Using Empirical Consumer Demand Studies 137 Relationships Between Consumer Market Data and Econometric Demand Studies 137 Case Study I: Carnation Coffee-mate 137 Case Study II: Carnation Evaporated Milk 138 Case Study III: The Demand for Cheese in the United States 139 Managerial Rule of Thumb: Using Consumer Market Data 141 End of Chapter Resources Summary 141 • Key Terms 141 • Application Questions 143 Chapter 5 A01_FARN0095_03_GE_FM. INDD 9 • Exercises 142 Production and Cost Analysis in the Short Run 144 Case for Analysis: Production and Cost Analysis in the Fast-Food Industry 145 Defining the Production Function 146 The Production Function 146 Fixed Inputs Versus Variable Inputs 146 Short-Run Versus Long-Run Production Functions 147 Managerial Rule of Thumb: Short-Run Production and Long-Run Planning 147 Productivity and the Fast-Food Industry 147 Model of a Short-Run Production Function 148 Total Product 148 Average Product and Marginal Product 148 Relationships Among Total, Average, and Marginal Product 149 Economic Explanation of the Short-Run Production Function 151 21/08/14 PM 10 Contents Real-World Firm and Industry Productivity Issues 152 Other Examples of Diminishing Returns 152 Productivity and the Agriculture Industry 153 Productivity and the Automobile Industry 154 Productivity Changes Across Industries 155 Model of Short-Run Cost Functions 156 Measuring Opportunity Cost: Explicit Versus Implicit Costs 156 Accounting Profit Measures Versus Economic Profit Measures 157 Managerial Rule of Thumb: The Importance of Opportunity Costs 158 Definition of Short-Run Cost Functions 159 Fixed Costs Versus Variable Costs 159 Relationships Among Total, Average, and Marginal Costs 160 Relationship Between Short-Run Production and Cost 162 Other Short-Run Production and Cost Functions 163 Managerial Rule of Thumb: Understanding Your Costs 164 Empirical Evidence on the Shapes of Short-Run Cost Functions 164 Econometric Estimation of Cost Functions 164 Survey Results on Cost Functions 165 Constant Versus Rising Marginal Cost Curves 166 Implications for Managers 167 End of Chapter Resources Summary 168 • Key Terms 168 • Exercises 169 • Application Questions 170 Chapter 6 Production and Cost Analysis in the Long Run 172 Case for Analysis: The i Phone in China 173 Model of a Long-Run Production Function 174 Input Substitution 174 Model of a Long-Run Cost Function 182 Derivation of the Long-Run Average Cost Curve 182 Economies and Diseconomies of Scale 183 Factors Creating Economies and Diseconomies of Scale 184 Other Factors Influencing the Long-Run Average Cost Curve 185 The Minimum Efficient Scale of Operation 186 Long-Run Average Cost and Managerial Decision Making 189 End of Chapter Resources Summary 189 • Appendix 6A Isoquant Analysis 190 • Key Terms 197 • Exercises 197 • Application Questions 198 Chapter 7 Market Structure: Perfect Competition 200 Case for Analysis: Competition and Cooperative Behavior in the Potato Industry 201 The Model of Perfect Competition 202 Characteristics of the Model of Perfect Competition 202 Model of the Industry or Market and the Firm 203 The Short Run in Perfect Competition 209 Long-Run Adjustment in Perfect Competition: Entry and Exit 209 Adjustment in the Potato Industry 210 Long-Run Adjustment in Perfect Competition: The Optimal Scale of Production 211 A01_FARN0095_03_GE_FM. INDD 10 21/08/14 PM Contents 11 Managerial Rule of Thumb: Competition Means Little Control Over Price Other Illustrations of Competitive Markets 212 Competition and the Agricultural Industry 213 Competition and the Broiler Chicken Industry 214 Competition and the Red-Meat Industry 215 Competition and the Milk Industry 217 Competition and the Trucking Industry 218 Managerial Rule of Thumb: Adopting Strategies to Gain Market Power in Competitive Industries 219 212 End of Chapter Resources Summary 220 • Appendix 7A Industry Supply 220 • Key Terms 222 • Exercises 222 • Application Questions 223 Chapter 8 Market Structure: Monopoly and Monopolistic Competition 226 Case for Analysis: Changing Market Power for Eastman Kodak Co. 227 Firms with Market Power 228 The Monopoly Model 228 Comparing Monopoly and Perfect Competition 230 Sources of Market Power: Barriers to Entry 231 Managerial Rule of Thumb: Using Lock-In as a Competitive Strategy 241 Changes in Market Power 241 Measures of Market Power 243 Antitrust Issues 246 Managerial Rule of Thumb: Understanding Antitrust Laws 251 Monopolistic Competition 251 Characteristics of Monopolistic Competition 252 Short-Run and Long-Run Models of Monopolistic Competition 252 Examples of Monopolistically Competitive Behavior 253 Managerial Rule of Thumb: Maintaining Market Power in Monopolistic Competition 256 End of Chapter Resources Summary 256 • Key Terms 256 • Exercises 257 • Application Questions 257 Chapter 9 Market Structure: Oligopoly 260 Case for Analysis: Oligopoly Behavior in the Airline Industry Case Studies of Oligopoly Behavior 262 The Airline Industry 262 The Soft Drink Industry 264 The Doughnut Industry 265 The Parcel and Express Delivery Industry 266 Oligopoly Models 267 Noncooperative Oligopoly Models 268 The Kinked Demand Curve Model 268 Game Theory Models 269 Strategic Entry Deterrence 272 Predatory Pricing 273 A01_FARN0095_03_GE_FM. INDD 11 261 21/08/14 PM 12 Contents Cooperative Oligopoly Models Cartels 275 Tacit Collusion 281 275 Managerial Rule of Thumb: Coordinated Actions 283 End of Chapter Resources Summary 283 • Key Terms 283 • Exercises 283 • Application Questions 285 Chapter 10 Pricing Strategies for the Firm 288 Case for Analysis: Airline Pricing Strategies: Will They Start Charging for the Use of the Lavatories? 289 The Role of Markup Pricing 290 Marginal Revenue and the Price Elasticity of Demand 291 The Profit-Maximizing Rule 292 Profit Maximization and Markup Pricing 292 Business Pricing Strategies and Profit Maximization 294 Markup Pricing Examples 295 Managerial Rule of Thumb: Markup Pricing 296 Price Discrimination 297 Definition of Price Discrimination 297 Theoretical Models of Price Discrimination 298 Price Discrimination and Managerial Decision Making 305 Marketing and Price Discrimination 312 Macroeconomics and Pricing Policies 313 End of Chapter Resources Summary 315 • Key Terms 315 • Exercises 316 • Application Questions 317 Part 2 Chapter 11 Macroeconomic Analysis 320 Measuring Macroeconomic Activity 320 Case for Analysis: Measuring Changes in Macroeconomic Activity: Implications for Managers 321 Measuring Gross Domestic Product (GDP) 322 The Circular Flow in a Mixed, Open Economy 322 Managerial Rule of Thumb: Spending Patterns 324 National Income Accounting Systems 324 Characteristics of GDP 325 Real Versus Nominal GDP 326 Alternative Measures of GDP 329 Other Important Macroeconomic Variables 337 Price Level Measures 337 Measures of Employment and Unemployment 341 Managerial Rule of Thumb: Price Level and Unemployment 343 Major Macroeconomic Policy Issues 343 What Factors Influence the Spending Behavior of the Different Sectors of the Economy? 344 How Do Behavior Changes in These Sectors Influence the Level of Output and Income in the Economy? 344 Can Policy Makers Maintain Stable Prices, Full Employment, and Adequate Economic Growth over Time? INDD 12 21/08/14 PM Contents 13 How Do Fiscal, Monetary, and Balance of Payments Policies Influence the Economy? 346 What Impact Do These Macro Changes Have on Different Firms and Industries? 346 Managerial Rule of Thumb: Competitive Strategies and the Macro Environment 346 End of Chapter Resources Summary 347 • Key Terms 347 • Exercises 348 • Application Questions 349 Chapter 12 Spending by Individuals, Firms, and Governments on Real Goods and Services 350 Case for Analysis: Mixed Signals on the U. Economy in Summer 2012 Framework for Macroeconomic Analysis 352 Focus on the Short Run 352 Analysis in Real Versus Nominal Terms 353 Treatment of the Foreign Sector 353 Outline for Macroeconomic Analysis 353 The Components of Aggregate Expenditure 354 Personal Consumption Expenditure 354 Gross Private Domestic Investment Expenditure 362 Government Expenditure 371 Net Export Expenditure 372 Aggregate Expenditure and Equilibrium Income and Output Aggregate Expenditure 375 Equilibrium Level of Income and Output 377 Effect of the Interest Rate on Aggregate Expenditures 382 351 375 End of Chapter Resources Summary 383 • Appendix 12A Numerical Example of Equilibrium and the Multiplier 383 • Appendix 12B Algebraic Derivation of the Aggregate Expenditure Function 385 • Key Terms 388 • Exercises 388 • Application Questions 389 Chapter 13 The Role of Money in the Macro Economy 390 Case for Analysis: The Chairman’s Quandary 391 Money and the U. Financial System 392 Definition of Money 392 Measures of the Money Supply 392 Depository Institutions and the Fractional Reserve Banking System 393 The Central Bank (Federal Reserve) 396 Tools of Monetary Policy 398 Managerial Rule of Thumb: Federal Reserve Policy 407 Equilibrium in the Money Market 407 The Supply of Money 407 The Demand for Money 409 Equilibrium in the Money Market 411 Change in the Supply of Money 411 Change in the Demand for Money 412 Overall Money Market Changes 413 End of Chapter Resources Summary 413 • Appendix 13A Monetary Tools and the Market for Bank Reserves 413 • Key Terms 414 • Exercises 415 • Application Questions 415 A01_FARN0095_03_GE_FM. Economy, 2007–20–2012 468 Effects of the Euro in the Macroeconomic Environment 470 Euro Macro Environment Effects on Managerial Decisions 473 Southeast Asia: An Attempt to Maintain Fixed Exchange Rates 474 Macro and Managerial Impact of the Chinese Yuan Since 2003 476 Policy Effectiveness with Different Exchange Rate Regimes 478 End of Chapter Resources Summary 479 • Appendix 15A Specific and General Equations for the Balance of Payments 479 • Key Terms 480 • Exercises 480 • Application Questions 481 A01_FARN0095_03_GE_FM. INDD 13 21/08/14 PM 14 Contents Chapter 14 The Aggregate Model of the Macro Economy 416 Case for Analysis: What Role for Inflation? INDD 14 21/08/14 PM Contents 15 Part 3 Integration of the Frameworks 482 Chapter 16 Combining Micro and Macro Analysis for Managerial Decision Making Case for Analysis: Strong Headwinds for Mc Donald’s 482 483 Microeconomic and Macroeconomic Influences on Mc Donald’s and the Fast-Food Industry 484 Shifting Product Demand 484 Oligopolistic Behavior 485 Strategies to Offset Shifting Demand 487 Cost-Cutting Strategies 488 Innovations for Different Tastes 488 Drawing on Previous Experience 489 2012 and Beyond: A Focus on China and Other Emerging Markets 490 Economic and Political Issues 492 Responses of Other Fast-Food Competitors 494 Calorie Counts on Menus 495 Macroeconomic Influences on the Fast-Food Industry in 20 497 End of Chapter Resources Summary: Macro and Micro Influences on the Fast-Food Industry 497 • Appendix 16A Statistical Estimation of Demand Curves 498 • Exercises 500 • Application Questions 500 Solutions to Even-Numbered Problems 501 Glossary 521 Index 535 A01_FARN0095_03_GE_FM. INDD 16 21/08/14 PM Preface The third edition of Economics for Managers builds on the strengths of the first two editions, while updating the case studies and examples, the data, and the references supporting the discussion. 417 The Model of Aggregate Demand and Supply 418 The Aggregate Demand Curve 418 Fiscal and Monetary Policy Implementation 422 The Aggregate Supply Curve 427 Using the Aggregate Model to Explain Changes in the Economy from 2007 to 2008 and from 2011 to 2012 434 Impact of Macro Changes on Managerial Decisions 438 Measuring Changes in Aggregate Demand and Supply 440 Managerial Rule of Thumb: Judging Trends in Economic Indicators 442 End of Chapter Resources Summary 442 • Appendix 14A Specific and General Equations for the Aggregate Macro Model 442 • Key Terms 444 • Exercises 444 • Application Questions 445 Chapter 15 International and Balance of Payments Issues in the Macro Economy 446 Case for Analysis: Uncertainty in the World Economy in 2012 447 Exchange Rates 448 Managerial Rule of Thumb: Currency Exchange Rates 451 Equilibrium in the Open Economy 452 U. International Transactions in 2011 (Balance of Payments) 453 The Current Account 453 The Financial Account 454 Revenue or T-Account 455 Deriving the Foreign Exchange Market 457 The Demand for and Supply of Dollars in the Foreign Exchange Market 457 Equilibrium in the Foreign Exchange Market 459 Managerial Rule of Thumb: The Foreign Exchange Market 460 Exchange Rate Systems 460 Flexible Exchange Rate System 462 Fixed Exchange Rate System 463 The Effect on the Money Supply 465 Sterilization 465 Policy Examples of International Economic Issues 466 The U. Economics for Managers, Third Edition, does not attempt to cover all the topics in traditional principles of economics texts or in intermediate microeconomic and macroeconomic theory texts. As in the previous editions, the goal of this text is to present the fundamental ideas of microeconomics and macroeconomics and then integrate them from a managerial decision-making perspective into a framework that can be used in a singlesemester course for Master of Business Administration (MBA), Executive MBA (EMBA), and other business students. This edition has been completely revised to update the industry cases and examples in the microeconomics section and the data and analysis in the macroeconomics section. • Twelve of the sixteen chapters have entirely new cases, while the cases in the remaining four chapters have been updated extensively. Economy in Summer 2012; The Chairman’s Quandary; and Strong Headwinds for Mc Donald’s. • New cases include: Micro- and Macroeconomic Influences on the Global Automobile Industry; Demand Elasticity and Procter & Gamble’s Pricing Strategies; The i Phone in China; Changing Market Power for Eastman Kodak Co.; Airline Pricing Strategies: Will They Start Charging for the Use of the Lavatories? • Linkage to the marketing literature, particularly in Chapter 4, Techniques for ­Understanding Consumer Demand and Behavior, and in Chapter 10, Pricing Strategies for the Firm, has been increased. • The macroeconomics section of the text has been completely rewritten, given the changes in the macroeconomy since 2008, when the second edition was drafted. • The macroeconomic data in the tables have been updated to 2011, and the data in the figures show trends from 2000 to first quarter 2012. • The macroeconomics discussion, which makes extensive use of Federal Reserve Monetary Policy Reports to Congress and reports and analyses by the Congressional Budget Office, includes recent policy issues such as the impact of the American Recovery and Reinvestment Act of 2009, the fiscal cliff debates in 2012, and the Federal Reserve’s use of nontraditional policy tools to stimulate the economy. • An extensive discussion of the situation in the European Union from 2010 to 2012, which includes the banking, sovereign debt, and growth crises and the impact of these events on managerial decision making, is presented. INDD 17 21/08/14 PM 18 Preface Motivation for the Text Most micro/managerial economics and intermediate macroeconomics texts are written for economics students who will spend an entire semester using each text. The level of detail and style of writing in these texts are not appropriate for business students or for the time frame of a single-semester course. However, business students need more than a principles of economics treatment of these topics because they have often been exposed to that level of material already. The third edition of Economics for Managers will continue to present economic theory that goes beyond principles of economics, but the text is not as detailed or theoretical as a standard intermediate economics text given the coverage of both micro- and macroeconomics and the additional applications and examples included in this text. The compactness of the text and the style of writing are more appropriate for MBA students than what is typically found in large, comprehensive principles texts. As in the previous editions, each chapter of Economics for Managers, Third Edition, begins with a “Case for Analysis” section, which examines events drawn from the current news media that illustrate the issues in the chapter. Thus, students begin the study of each chapter with a concrete, real-world example that highlights relevant economic concepts, which are then explained with the appropriate economic theory. Numerous real-world examples are used to illustrate the theoretical discussion. This approach appeals to MBA students who typically want to know the relevance and applicability of basic economic concepts and how these concepts can be used to analyze and explain events in the business environment. Intended Audience This text is designed to teach economics for business decision making to students in MBA and EMBA programs. It includes fundamental microeconomic and macroeconomic topics that can be covered in a single quarter or semester or that can be combined with other readers and case studies for an academic year course. The book is purposely titled Economics for Managers and not Managerial ­Economics to emphasize that this is not another applied microeconomics text with heavy emphasis on linear programming, multiple regression analysis, and other quantitative tools. This text is written for business students, most of whom will not take another course in economics, but who will work in firms and industries that are influenced by the economic forces discussed in the text. A course using this text would ideally require principles of microeconomics and macroeconomics as prerequisites. However, the text is structured so that it can be used without these prerequisites. Coverage of the material in this text in one semester does require a substantial degree of motivation and maturity on the part of the students. However, the style of writing and coverage of topics in Economics for Managers will facilitate this process and are intended to generate student interest in these issues that lasts well beyond the end of the course. Economics for Managers can be used with other industry case study books, such as The Structure of American Industry by James Brock. These books present extensive discussions of industry details from an economic perspective. Although they focus primarily on microeconomic and managerial topics, these texts can be used with Economics for Managers to integrate influences from the larger macroeconomic environment with the microeconomic analysis of different firms and industries. INDD 18 21/08/14 PM Preface 19 Organization of the Text The text is divided into three parts. Part 1, Microeconomic Analysis, focuses on how individual consumers and businesses interact with each other in a market economy. Part 2, Macroeconomic Analysis, looks at the aggregate behavior of different sectors of the economy to determine how changes in behavior in each of these sectors influence the overall level of economic activity. And finally, Part 3, Integration of the Frameworks, draws linkages between Parts 1 and 2. Although many of the micro- and macroeconomic topics are treated similarly in other textbooks, this text emphasizes the connections between the frameworks, particularly in the first and last chapters. Changes in macroeconomic variables, such as interest rates, exchange rates, and the overall level of income, usually affect a firm through microeconomic variables such as consumer income, the price of the inputs of production, and the sales revenue the firm receives. Managers must be able to analyze factors relating to both market competition and changes in the overall economic environment so they can develop the best competitive strategies for their firms. To cover all this material in one text, much of the detail and some topics found in other micro and macro texts have been omitted, most of which are not directly relevant for MBA students. There is no calculus in this text, only basic algebra and graphs. Algebraic examples are kept to a minimum and used only after the basic concepts are presented intuitively with examples. Statistical and econometric techniques are covered, particularly for demand estimation, at a very basic level, while references are provided to the standard sources on these topics. The text places greater emphasis than other texts on how managers use nonstatistical and marketing strategies to make decisions about the demand for their products, and it draws linkages between the statistical and nonstatistical approaches. Economics for Managers, Third Edition, includes little formal analysis of input or resource markets, either from the viewpoint of standard marginal ­productivity ­theory or from the literature on the economics of organization, ownership and control, and human resource management. The latter are interesting topics that are covered in other texts with a focus quite different from this one. The macroeconomics portion of this text omits many of the details of alternative macro theories discussed elsewhere. Students are given the basic tools that will help them understand macroeconomics as presented in business sources, such as the Wall Street Journal, that emphasize how the national government and the Federal Reserve manage the economy to promote full employment, a stable price level, and ­economic growth. Chapter-by-Chapter Breakdown: What’s New in This Edition? Part 1: Microeconomic Analysis The third edition of Economics for Managers includes new and updated cases from 2010 to 2012 that introduce each chapter. In some chapters, the cases are on the same topic as in previous editions (e.g., the copper industry in Chapter 2) to facilitate the transition for current users of the text. Chapter 1 introduces an entirely new case on the global automobile industry, which includes a discussion of the microeconomic factors influencing competition among the major players in the industry, and the impact of macroeconomic A01_FARN0095_03_GE_FM. INDD 19 21/08/14 PM 20 Preface changes on the entire industry. The chapter focuses on the competition between Japanese and ­American auto makers, how the American industry has been making a comeback in recent years, and how that change intensified competition among the ­American producers. I also discuss the impact of the 2011 earthquake and ­tsunami on the J­ apanese auto industry and the effect of the 2010 recall and quality issues on ­Toyota. Automobile production and demand changes in China are major issues in this ­chapter. Moreover, the role of China regarding both individual firms’ strategies and in the larger macroeconomic environment will be a significant factor throughout this text. Another theme introduced in this chapter is the impact of the global financial crisis and recession on managerial strategies. The ongoing economic crisis in Europe, which I discuss throughout the text, created major challenges for all players in the global automobile industry. General Motors and Chrysler received a bailout from the U. I also discuss the role of currency exchange rates, particularly the impact of the strong yen on the Japanese auto industry. As in previous editions, this chapter presents the frameworks for the microeconomic and macroeconomic analyses used throughout the text. I introduce the role of relative prices and discuss the different models of market competition. Federal Reserve policy since 2008 of targeting historically low interest rates and fiscal policy issues such as the American Recovery and Reinvestment Act of 2009. I also present the circular flow macroeconomic model that focuses on consumption (C), investment (I), and government spending (G), and spending on exports (X) and imports (M). These microeconomic and macroeconomic issues will be discussed again in the context of the fast-food industry in Chapter 16. The use of two well-known industries to frame both the microeconomic and macroeconomic discussion is a unique feature of Economics for Managers, Third Edition. Chapter 2 updates the case on the copper industry that introduces the concepts of demand and supply and shows the extreme volatility of prices in a competitive industry. The current discussion highlights the issues of the global demand for copper, the particular influence of China, and the problem of copper thefts due to its high price. I have retained much of the discussion of the copper industry from previous editions to illustrate the impact of these changes over time. Even though this chapter focuses on the microeconomic concepts of demand and supply, the copper industry has been given the name “Dr. Copper,” because strong demand and high prices can indicate the overall health of the economy. New examples of the non-price factors influencing demand include (1) the impact on the Zippo Manufacturing Co. of changing attitudes on cigarette smoking; (2) the Chinese demand for pecans; (3) the effect of the Japanese earthquake on the demand for luxury goods in that country; (4) the increased marketing of beer and other products to the Hispanic community; (5) the return of the practice of layaway in department stores; and (6) the effect of substitutes on Nestle bottled water. New examples of the non-price factors influencing supply include (1) the effect of new technology on pecan growers; (2) the impact of high pecan prices as inputs for bakers; (3) the impact of high oil prices on the supply of natural gas; and (4) the effect of Chinese demand on the number of lumber producers. The extensive numerical example on the copper industry that is used throughout Chapter 2 has been updated to reflect recent events in the copper industry. Chapter 3 begins with a new case on the relationship between Procter & Gamble’s pricing strategy and the price elasticity of demand. I have updated information on price elasticity for airline prices, gasoline, and illegal substances such as cocaine and heroin. The discussion of income elasticity now includes the demand for wines, while the cross-elasticity discussion includes the relationship between airline and automobile travel, which influenced the regulation of child airline safety seats, and A01_FARN0095_03_GE_FM. INDD 20 21/08/14 PM Preface 21 consumer demand for wireline and wireless phones. I have updated Table 3.7 with recent estimates of demand elasticity for food, water, and higher education. I have also increased the discussion of the relationship between the economic and marketing approaches to consumer demand, and I have updated an earlier marketing demand elasticity study included in previous editions. Chapter 4 presents a new case on how firms use cable television and Visa/Master Card information to better understand and impact consumer behavior. Although successful from the firm’s viewpoint, these strategies have raised concerns over the invasion of consumer privacy. In the discussion of marketing techniques to estimate consumer demand, I have drawn extensively on two major marketing references: Vithala R. Rao, Handbook of Pricing Research in Marketing, 2009, and Thomas T. Nagle et al., The Strategy and Tactics of Pricing, 5th ed., 2011. I have also updated the econometric references on estimating consumer demand, and I added a new case, “Case Study III: The Demand for Cheese in the United States.” I retained the case study of automobile demand and the illustrations of the use of consumer market data in econometric demand studies from the previous editions. In Chapter 5, I updated the opening case, “Production and Cost Analysis in the Fast-Food Industry,” by adding a discussion of fast-food delivery in various parts of the world. New productivity examples in the chapter include (1) the use of additional workers versus robots by Amazon and Crate & Barrel; (2) eliminating diminishing returns in hospital emergency rooms; (3) a discussion of Toyota’s quality problems; and (4) an updated discussion of overall industry productivity increases. Chapter 6 begins with a new case, “The i Phone in China,” that focuses on the long-run decisions of Apple Inc. to produce i Phones in China and the controversy that ­followed over working conditions in those Chinese factories. I also discuss the location and production decisions of smaller manufacturers such as Standard Motor Products of North Carolina. New examples of long-run production and cost decisions include (1) the use of robots in mining operations and hospitals; (2) crowdsourcing or farming out production tasks to the general public; (3) law firms’ increased use of software for the discovery process; (4) the trade-off between airline use of smaller jets to cut costs and increased time for refueling; and (5) the decreased use of bags in grocery stores. I also describe the limits of lean production that arose during the Japanese earthquake and tsunami, and I update the discussion of the use of nurseto-patient ratios to regulate hospital staffing decisions. Chapter 7 begins with an update of the case of the potato industry from the previous editions of the book. Earlier editions focused on how potato farmers attempted to move away from the competitive market, where they had very little control over price. They formed farmers’ cooperatives to help control production and keep prices high. These moves recently faced consumer challenges as price-fixing arrangements. I discuss other recent influences on the potato industry, including obesity concerns resulting from potato consumption and a move to eliminate white potatoes from federally subsidized school breakfasts and lunches. I also update the analysis of competitive strategies in the broiler chicken, red meat, milk, and trucking industries. The red meat industry discussion includes both the issues of “pink slime” and the National Cattlemen’s Beef Association’s MBA or Master of Beef Advocacy, a training program to promote and defend red meat. The theme in all of these cases is how firms deal with the volatility of the competitive market. Chapter 8 begins with a new case, “Changing Market Power for Eastman Kodak Co.,” which illustrates how the changing markets for cameras and film eroded the market power of this well-known company. In the section on the sources of market power, I have updated the discussion of mergers in the banking, beer, and airlines industries and examined mergers among pharmacy-benefit managers and law firms. New licensing examples include the case of interior decorators and the controversy over who can perform teeth whitening. I have updated the patent discussion with the case of Pfizer’s blockbuster drug Lipitor and the patent infringement A01_FARN0095_03_GE_FM. INDD 21 21/08/14 PM 22 Preface case between Apple Inc. The changing market power section now includes a discussion of how bricks-and-mortar retailers are fighting showrooming and the consumer use of phone apps to compare prices and then purchase online. I have updated the antitrust section with a discussion of the August 2010 revisions in the antitrust guidelines and the use of the Herfindahl-Hirschman Index (HHI). Although the Microsoft antitrust case was an important illustrative example in the two previous editions of the text, it has become dated. I replaced this case with a discussion of the failed merger of AT&T and T-Mobile in 2011. This case clearly illustrates for students the controversies over the existence and use of market power. This discussion is extended in the monopolistic competition section with an update on the cases of independent drugstores and booksellers. The opening case in Chapter 9 builds on the previous case of interdependent airline pricing behavior by adding current examples of oligopolistic strategies. I have also updated the examples of oligopolistic behavior between Coke and Pepsi; in the doughnut industry; and among DHL, Federal Express, and UPS. I added a discussion of the predatory pricing case of Spirit Airlines versus Northwest Airlines, included new references on cartel behavior, and updated the discussion of OPEC and the diamond cartel. Chapter 10 begins with the case, “Airline Pricing Strategies: Will They Start Charging for the Use of the Lavatories? ” This case illustrates revenue or yield management strategies where the airlines have unbundled their services and are charging separately for different services based on demand elasticity and consumer willingness to pay. I have extended this discussion throughout the chapter and have drawn extensively on articles in the Journal of Revenue and Pricing Management, a source that would be very useful for MBA students. As in Chapter 4, I have included more linkages with the marketing literature by including examples and citations from Vithala R. Rao, Handbook of Pricing Research in Marketing, and Thomas T. Nagle et al., The Strategy and Tactics of Pricing, 5th ed. I updated the discussion of major league baseball ticket pricing and peak load pricing with smart electric meters, and I added an example of revenue management by the Atlanta Symphony Orchestra. At the end of the chapter, I added material to the discussion of the macro impacts on pricing in 2011–2012. Part 2: Macroeconomic Analysis Part 2, Macroeconomic Analysis, continues with the framework in the second edition. After introducing the macroeconomic variables in Chapter 11, the text discusses real spending by individuals, firms, and governments (C I G X − M) in Chapter 12. This material draws on the analyses students see daily in the Wall Street Journal and other business publications. A discussion of money, money markets, and Federal Reserve policy is presented in Chapter 13. These elements are combined using the aggregate demand–aggregate supply (AD–AS) model in Chapter 14. Monetary and fiscal policy implementation issues are also presented in this chapter. Chapter 15 continues to focus on exchange rate and balance of payments issues and presents an updated discussion of controversies over the role of the euro and the Chinese yuan. However, as in the previous ­editions, and unlike the presentation in other texts, Economics for Managers, Third Edition, has an extensive discussion in both Chapters 14 and 15 of the impact of macro policy changes on the competitive strategies of both domestic and international firms. Given that the third edition was revised in 2012, I rewrote most of the macro discussion to reflect the substantial economic and policy changes during that period. The text continues to describe the impacts of policy changes in these areas on the U. This is a unique feature of this textbook, which makes it most appropriate for MBA students who will probably never make macroeconomic policy, but who will work in firms and industries influenced by these policy changes. INDD 22 21/08/14 PM Preface 23 The macro section of the second edition of Economics for Managers was revised just as the U. I updated the references for the national income and product accounts and for the underground economy (Chapter 11). I used 2011 data for all the tables, while the fi ­ gures show trends from 2000 to the first quarter of 2012. I updated the discussion of each component of GDP with recent data and events (Chapter 12), and I made extensive use of Federal Reserve Monetary Policy Reports to Congress and the reports and analyses by the Congressional Budget Office. All of the cases reflect the uncertainty about the U. and global economies in 2011–2012 and the slow recovery from the recession of 2007–2009. In the case in Chapter 13, “The Chairman’s Quandary,” I discuss the dilemma facing Federal Reserve officials in summer 2012 as they made decisions on future monetary policy. This discussion includes issues related to the continuation of historically low targeted interest rates, Operation Twist, future bond buying, and the use of public statements to achieve monetary policy goals. I also refer students to Federal Reserve Chairman Ben Bernanke’s 2012 College Lecture Series, The Federal Reserve and the ­Financial Crisis. In Chapter 14, I discuss recent fiscal policy issues, including the American R ­ ecovery and Reinvestment Act of 2009, the fiscal cliff debate in 2012, the impacts of fi ­ scal multipliers and how they are estimated, the role of automatic stabilizers, and the interactions between fiscal and monetary policies. On the supply side, I updated the discussion of productivity growth and the natural rate of unemployment. auto bailout in 2008–2009, and I discussed the impact of the uncertain economic recovery on managerial decisions in 2011–2012. I kept the section on the use of the aggregate macro model to explain changes in the economy from 2007 to 2008, but I added a similar discussion for the period 2011–2012. Chapter 15, which is built around the opening case, “Uncertainty in the World Economy in 2012,” focuses on the U. economy and international issues from 2010 to 2012. The chapter includes an analysis of the weakness in the Chinese economy, the worsening situation in Europe, and capital flows among industrialized and emerging economies. I have updated all tables and figures, included balance of payments data for 2011, and I updated the discussion and references on balance of p ­ ayment issues and the role of fixed versus flexible exchange rates. I include a discussion and extensive references on the euro zone situation that involves the banking crisis, the sovereign debt crisis, the growth crisis, and the issue of the sustainability of the euro, and I show the impact of the euro crisis on managerial decision making. I also updated the discussion of the Southeast Asia crisis from the second edition, and I have included recent policy issues related to the Chinese yuan. Part 3: Integration of the Frameworks As noted earlier in this section, in Part 3 we return to the issues first discussed in Chapter 1, the relationship between microeconomic and macroeconomic influences on managerial decision making. Chapter 16 presents the case, “Strong ­Headwinds for Mc Donald’s,” which examines the effects of changes in the microeconomic and macroeconomic environment on Mc Donald’s competitive strategies. I discuss current challenges facing the company and how these challenges were met in the past. I then broaden the discussion to include Mc Donald’s major rivals in the fast-food industry, Burger King, Subway, Wendy’s, and Starbucks, and I discuss the opportunities and challenges facing all of these companies as they enter emerging markets. I have added a discussion of how these companies are facing public health ­concerns over obesity, and I present a detailed discussion of the impact of regulations requiring calorie counts on menus. I have also kept a statistical study A01_FARN0095_03_GE_FM. INDD 23 21/08/14 PM 24 Preface of ­fast-food industry demand that was included in previous e­ ditions of the text. I discuss macroeconomic influences on the fast-food industry with details from the International Monetary Fund Global Economic Report in October 2012. The text ends by emphasizing its major theme: Changes in the macro environment affect individual firms and industries through the microeconomic factors of demand, production, cost, and profitability. Firms can either try to adapt to these changes or undertake policies to try to modify the environment itself. This theme is particularly important in this third edition of Economics for Managers, given the impact of the slow recovery from the 2007–2009 recession on the overall economy and on the strategies of different firms operating in this environment. Unique Features of the Text Chapter Opening Cases for Analysis Each chapter begins with a “Case for Analysis” section, which examines a case drawn from the current news media that illustrates the issues in the chapter. Thus, students begin the study of each chapter with a concrete, real-world example that highlights relevant economic issues, which are then explained with the appropriate economic theory. For example, Chapter 2 begins with a case on the copper industry that illustrates forces on both the demand and supply sides of the ­market that influence the price of copper and have caused that price to change over time. This example leads directly to a discussion of demand and supply functions and curves, the concept of equilibrium price and quantity, and changes in those equilibria. Within this discussion, I include numerous real-world examples to illustrate demand and supply shifters. The chapter concludes by reviewing how formal demand and s­ upply analysis relates to the introductory case. Students thus go from concrete examples to the relevant economic theory and then back to realworld examples. Interdisciplinary Focus Economics for Managers, Third Edition, continues to have an interdisciplinary focus. For example, Chapter 3 presents demand price elasticity estimates drawn from both the economics and marketing literature. Empirical marketing and economic approaches to understanding consumer demand are both discussed in Chapter 4. The production and cost analysis in Chapters 5 and 6 relates to topics covered in management courses, while the pricing discussion in Chapter 10 draws extensively on the marketing literature. Thus, the third edition of Economics for Managers is uniquely positioned to serve the needs of instructors who are trying to integrate both micro- and macroeconomic topics and who want to relate this material to other parts of the business curriculum. Focus on Global Issues Global and international examples are included in both the microeconomic and macroeconomic sections of the text. For example, Chapter 2 discusses how demand from China, an earthquake in Chile, and the financial crisis in Europe affected the copper industry. I revisit these international issues again in Chapters 15 and 16. Analyses of the impact of changing consumer demand, new production technologies, and rising input costs on both U. and international firms are included in many of the microeconomic chapters. Chapters 14 and 15 include discussions of the effects of U. and international macroeconomic policy changes on firms located around the world. INDD 24 21/08/14 PM Preface 25 As noted previously, Economics for Managers, Third Edition, takes the unique approach in Chapters 1 and 16 to discuss the impact of both microeconomic and macroeconomic factors on firms’ competitive strategies in international markets. The analysis of the global automobile industry in Chapter 1 and the fast-food industry in Chapter 16 helps students see how economic and political issues around the world impact managerial decision making. This integration of micro and macro tools in the global setting has been a key feature of all editions of Economics for Managers. Managerial Decision-Making Perspective Economics for Managers is developed from a firm and industry decision-making perspective. Thus, the demand and elasticity chapters focus on the implications of elasticity for pricing policies, not on abstract models of consumer behavior. To illustrate the basic models of production and cost, the text presents examples of cost-cutting and productivity-improving strategies that firms actually use. It discusses the concept of input substitution intuitively with examples, but places the formal isoquant model in an appendix to Chapter 6. The text then compares and contrasts the various models of market behavior, incorporating discussions and examples of the measurement and use of market power, most of which are drawn from the current news media and the industrial organization literature. Throughout the chapters you will find “Managerial Rule of Thumb” features, which are shortcuts for using specific concepts and brief descriptions of important issues for managers. For example, Chapter 3 contains several quick approaches for determining price and income elasticities of demand. Chapter 4 includes some key points for managers to consider when using different approaches to understanding consumer behavior. Although Economics for Managers, Third Edition, covers the models that include this policy-making perspective, the text also illustrates how the actions of these policy makers influence the decisions managers make in various firms and industries. Macroeconomics presents a particular challenge for managers because the subject matter is traditionally presented from the viewpoint of the decision makers, either the Federal Reserve or the U. This emphasis is important because most students taking an MBA economics course will never work or make policy decisions for the Federal Reserve or the U. government, but they are or will be employed by firms that are affected by these decisions and policies. End-of-Chapter Exercises As you will see, some of the end-of-chapter exercises are straightforward calculation problems that ask students to compute demand-supply equilibria, price elasticities, and profit-maximizing levels of output, for example. However, many exercises are broader analyses of cases and examples drawn from the news media. These exercises have a managerial perspective similar to the examples in the text. The goal is to make students realize that managerial decisions usually involve far more analysis than the calculation of a specific number or an “optimal” mathematical result. One of the exercises at the end of each chapter is related to the “Case for Analysis” discussed at the beginning of that chapter. Instructor Resource Center Economics for Managers is connected to the Instructor Resource Center available at Instructors can access a variety of print, digital, and presentation resources available with this text in downloadable A01_FARN0095_03_GE_FM. Registration is simple and gives you immediate access to new titles and new e­ ditions. As a registered faculty member, you can download resource files and receive immediate access and instructions for installing course management content on your campus server. If you ever need assistance, our dedicated technical support team is ready to help with the media supplements that accompany this text. Visit for answers to frequently asked questions and toll-free user support phone numbers. The following supplements are available to adopting instructors: • Instructor’s Manual • Test Item File also available in Test Gen software for both Windows and Mac ­computers • Power Point Presentations containing all figures and tables from the text Acknowledgments As with any major project, I owe a debt of gratitude to the many individuals who assisted with this book. I first want to thank my friend and colleague, Jon Mansfield, who worked with me in developing materials for the book. Jon and I have discussed the integration of microeconomics and macroeconomics for business students for many years as we both experimented with new ideas for teaching a combined course. We even team-taught one section of the course for EMBA students so that we could directly learn from each other. Jon is a great teacher, and his assistance in developing this approach has been invaluable. I next want to thank the generations of students I have taught, not only in the MBA and EMBA programs, but also in the Master of Public Administration, Master of Health Administration, and Master of Public Health programs at Georgia State. They made it quite clear that students in professional master’s degree programs are different from those in academic degree programs. Although these students are willing to learn theory, they have insisted, sometimes quite forcefully, that the theory must always be applicable to real-world managerial situations. I also want to thank my colleagues Professors Harvey Brightman and Yezdi Bhada, now retired from Georgia State’s Robinson College of Business, for their teaching seminars and for backing the approach I have taken in this book. I always knew that business and other professional students learned differently from economics students. Harvey and Yezdi provided the justification for these observations. I want to acknowledge the following graduate research assistants supported by the Department of Economics, Georgia State University, for their contributions to various editions of the text: Mercy Mvundura, Djesika Amendah, William Holmes, and Sarah Beth Link. They provided substantial assistance in finding the sources used in the text and in developing tables and figures for the book. in economics from the University of California, Berkeley. The Prentice Hall staff has, of course, been of immense help in developing the third edition of the text. For over 30 years, he specialized in teaching economics to students in professional master’s degree programs including the Master of Business Administration and Executive MBA, Master of Public Administration, Master of Health ­Administration, and Master of Public Health. INDD 30 21/08/14 PM Economics for Managers A01_FARN0095_03_GE_FM. I would especially like to thank David Alexander, Executive Editor, Pearson Economics, for his support and Lindsey Sloan, Senior Editorial Project Manager, Economics, Pearson Higher Education, who has been available to answer all my questions at every step of the project. in economics from Union College, Schenectady, New York, and his M. He has received both teaching awards and outstanding student evaluations at Georgia State. Farnham’s research focused first on issues related to the economics of state and local governments and then on public health economic evaluation issues where he has published articles in a variety of journals. INDD 31 21/08/14 PM Part 1 Microeconomic Analysis 1 Managers and Economics W hy should managers study economics? I would also like to thank Fran Russello, Pearson Production Manager, and Anand Natarajan, Project Manager at Integra Software Services, for their assistance in producing the text. INDD 26 21/08/14 PM Preface 27 I would like to thank all those who assisted with supporting materials. Finally, I want to thank my wife, Lynn, and daughters, Ali and Jen, for bearing with me during the writing of all editions of this text. Farnham Pearson would like to thank and acknowledge the following people for their work on the Global Edition. Farnham is Associate Professor Emeritus of Economics at Georgia State University. He co-authored three editions of Cases in Public Policy Analysis (1989, 2000, and 2011), contributed to both editions of Prevention ­Effectiveness: A Guide to Decision Analysis and Economic Evaluation (1996, 2003), and wrote a chapter for the Handbook of Economic Evaluation of HIV Prevention Programs (1998). Many of you are probably asking yourself this question as you open this text. Professor Leonie Stone of SUNY Geneseo contributed to the end-of-chapter questions in the micro section of the text. Sparks, The Citadel; Kasaundra Tomlin, Oakland University; Doina Vlad, Seton Hill University; John E. For her contribution: CHAN Ka Yu Yuka, The Open University of Hong Kong. He is currently a Senior Service Fellow in the Division of HIV/AIDS Prevention at the Centers for Disease Control and Prevention in Atlanta. Students in Master of Business Administration (MBA) and Executive MBA programs usually have some knowledge of the topics that will be covered in their accounting, marketing, finance, and management courses. I also want to acknowledge the assistance of all the reviewers of the various drafts of the text. And for their reviews: Erkan Ilgün, International Burch University; Rajkishan Nair, IILM Graduate School of Management; Ozlem Olgu Akdeniz, College of Administrative Sciences and Economics. You may have already used many of those skills on the job or have decided that you want to concentrate in one of those areas in your program of study. Although you may have taken one or two introductory economics courses at some point in the past, most of you are not going to become economists. These include: Gerald Bialka, University of North Florida; John Boschen, College of William and Mary; Vera Brusentsev, University of Delaware; Chun Lee, Loyola Marymount University; Mikhail Melnik, Niagara University; Franklin E. From these economics classes, you probably have vague memories of different graphs, algebraic equations, and terms such as elasticity of demand and marginal propensity to consume. However, you may have never really understood how economics is relevant to managerial decision making. As you’ll learn in this chapter, managers need to understand the insights of both microeconomics, which focuses on the behavior of ­individual consumers, firms, and industries, and macroeconomics, which analyzes issues in the overall economic environment. Although these subjects are typically taught separately, this text presents the ideas from both approaches and then integrates them from a managerial decision-making perspective. As in all chapters in this text, we begin our analysis with a case study. INDD 32 11/08/14 PM Case for Analysis Micro- and Macroeconomic Influences on the Global Automobile Industry In September 2012, U. automobile sales increased to 1.19 million cars and light trucks per month, a 12.8 percent increase from a year earlier. The case in this chapter, which focuses on the global automobile industry, provides an overview of the issues we’ll discuss throughout this text. This increase represented an annualized rate of 14.94 million vehicles, the highest sales rate since March 2008 before the recession began in the United States. In particular, the case illustrates how the automobile industry is influenced by both the microeconomic issues related to production, cost, and consumer demand and the larger macroeconomic issues including the uncertainty in global economic activity, particularly in Europe, and the value of various countries’ currencies relative to the U. Much of the increase was driven by passenger car sales at Toyota Motor Corp., Honda Motor Co., and Chrysler Group LLC. There was a significant increase in sales for Toyota and Honda from the previous year, as both companies were recovering from the earthquake that hit Japan in March 2011.1 Analysts noted similar increases in August 2012 that were attributed to pent-up consumer demand for replacing aging vehicles and the lowinterest financing and other incentives Japanese auto makers offered to regain market share lost in 2011 due to the lack of availability of their cars.2 Automobile production in the United States had expanded in 2012, given favorable foreign exchange rates and a plentiful supply of affordable labor. all increased their production capacity in the United States with the goal of shipping automobiles to Europe, Korea, the Middle East, and other countries. The strong value of the yen, and conversely the weak U. dollar, gave Japanese producers the incentive to produce cars in the United States for export around the world. automobile industry revived, the competition between Ford and GM again became more intense. This investment by foreign automobile producers helped the U. economy that was still struggling to recover from the recession of 2007–2009. market in 2009, 50.2 percent in 2010, and 50.8 percent in 2011. In 2008, Ford supported the government bailout for GM and Chrysler because Ford was worried that a collapse of these companies would also impact the auto parts industry. Automobile industry employment in the United States was estimated to increase from 566,400 in 2010 to 756,800 in 2015. auto producers, who had once essentially lost the competition to their Japanese rivals in the 1980s and 1990s and who went through government-backed (GM and Chrysler) or private (Ford) restructurings during the U. recession, ­regained profitability and invested in the engineering and redesign of their cars. economy recovered, Americans also began purchasing more trucks and sport-utility vehicles (SUVs), which helped to restore profits and market share for the Detroit auto makers. This segment of the market had been hit particularly hard during the U. As the domestic auto industry recovered, Ford, which had often focused just on Toyota as its key competitor, began developing strategies to counter GM. White, Jeff Bennett, and Lauren Weber, “Car Makers’ U-Turn Steers Job Gains,” Wall Street Journal (Online), January 23, 2012; Neal Boudette, “New U. Car Plants Signal Renewal for Manufacturing,” Wall Street Journal (Online), January 26, 2012. Although these estimates were well below the 1.1 million automobile workers employed in 1999, they indicated that the economic recovery was moving forward. Car Sales Surge,” Wall Street Journal (Online), September 4, 2012. Several Fords were designed with a voiceoperated Sync entertainment system, and the Chevrolet Cruze that was launched in 2010 came with 10 air bags compared with 6 for the Toyota Corolla. Ford realized that customers who had long been loyal to Asian brands were again looking at U. cars, given the generally perceived quality increases in the U. 4 Mike Ramsey and Sharon Terlep, “Americans Embrace SUVs Again,” Wall Street Journal (Online), December 2, 2011; Jeff Bennett and Neal E. General Motors Co., which had once encouraged auto parts 1 Jeff Bennett, “Corporate News: Passenger Cars Lift U. Sales— Big Gains for Toyota, Honda, Chrysler: Pickup Weakness Weighs on GM, Ford,” Wall Street Journal (Online), October 3, 2012. suppliers to relocate in low-wage countries, now encouraged them to locate near U. Boudette, “Revitalized Detroit Makes Bold Bets on New Models,” Wall Street Journal (Online), January 9, 2012. 5 Sharon Terlep and Mike Ramsey, “Ford and GM Renew a Bitter Rivalry,” Wall Street Journal (Online), November 23, 2011. INDD 33 11/08/14 PM 34 Part 1 Microeconomic Analysis Japanese auto makers in 20 faced managerial decisions that were influenced both by the nature of the competition from their rivals and by macroeconomic conditions, most importantly the value of the exchange rate between the yen and the U. dollar.6 Production by both Toyota and Honda was hit by the earthquake and tsunami in Japan in March 2011 and by subsequent flooding in Thailand that disrupted the supply of electronics and other auto parts made there. Toyota sales were also influenced by the recall and quality issues in 2010 related to the gas pedal and floor mat design. Honda’s redesigned 2012 Civic was criticized for its technology and lessthan-luxurious interior. The car was dropped from Consumer Reports’ recommended list in August 2011. The strong yen, which made exports from Japan less price competitive, also gave the Japanese producers the incentive to produce their cars in the United States. Honda officials acknowledged that they had underestimated the competition from U. Honda, which had produced 1.29 million vehicles in North America in 2010, planned to open a new plant in Mexico and expand production in all seven of its existing assembly plants to 2 million cars and trucks per year. Production abroad was a particular issue for Toyota, which made half of its automobiles in Japan, compared to Honda and Nissan, which produced about one-third of their output in Japan. The president of Toyota, Akio Toyoda, grandson of the company founder, had made a public commitment to build at least 3 ­million cars in Japan annually, half of which would be for export. Some company officials argued for streamlining production in Japan by decreasing production without raising costs, essentially redefining the economies of scale in the company’s production process. These officials believed the ­company could meet domestic goals with high-precision production, cost-­cutting, and collaboration on new technology with parts suppliers. Auto producers also focused on China during this period, although there was concern about the slowing Chinese economy.7 Auto sales in China increased only 2.5 percent in 2011 compared with increases of 46 percent in 2009 and 32 percent 6 The following discussion is based on Jeff Bennett and Neal E. Boudette, “Revitalized Detroit Makes Bold Bets on New Models”; Mike Ramsey and Yoshio Takahashi, “Car Wreck: Honda and Toyota,” Wall Street Journal (Online), November 1, 2011; Chester Dawson, “For Toyota, Patriotism and Profits May Not Mix,” Wall Street Journal (Online), November 29, 2011; Mike Ramsey and Neal E. Boudette, “Honda Revs Up Outside Japan,” Wall Street Journal (Online), December 21, 2011; and Yoshio Takahashi and Chester Dawson, “Japan Auto Makers on a Roll,” Wall Street Journal (Online), April 22, 2012. However, the size of the Chinese economy continued to be the major incentive for expansion in that country. 7 This discussion is based on Andrew Galbraith, “Car Makers Still Look to China,” Wall Street Journal (Online), April 19, 2012; Sharon Terlep and Mike Ramsey, “Ford Bets Billion on Made in China,” Wall Street Journal (Online), April 20, 2012; Chester Dawson and Sharon Terlep, “China Ramps Up Auto Exports,” Wall Street Journal (Online), April 24, 2012; and Sharon Terlep, “Balancing the Give and Take in GM’s Chinese Partnership,” Wall Street Journal (Online), August 19, 2012. In April 2012, Ford announced that it would build its fifth factory in eastern China as part of its plan to double its production capacity and sales outlets in the country by 2015. This production increase would make the company capable of producing 1.2 million passenger cars in China, approximately half of the number of cars it built in North America in 2011. Ford lagged behind other major auto producers in entering the world’s largest car market. Ford’s strategy was to build cars from platforms developed elsewhere to minimize costs. However, these platforms might not provide enough space in the back seats to appeal to affluent Chinese, who often employed drivers. General Motors developed a partnership with Chinese SAIC Motor Corp. to become the dominant foreign competitor in China. This partnership resulted in production changes such as designing Cadillacs with softer corners, dashboards with more gadgets, and increasing the comfort of the rear seats to appeal to Chinese consumers. In 2012, the Chinese automobile industry began increasing exports, although these were not thought to be a threat in developed markets in the United States and Europe, given perceived quality issues including lack of air-conditioning and power windows. The challenge for GM was that SAIC could also use GM’s expertise and technology to make itself a major competitor with the U. However, Chinese producers were making inroads into emerging markets in Africa, Asia, and Latin America. The other major influence on the global auto industry in 20 was the recession and economic crisis in Europe.8 In October 2012, Ford announced a plan to cut its operating losses in Europe by closing three auto-assembly and parts factories in the region, reduce its workforce by 13 percent, and decrease automobile production by 18 percent. Ford predicted a loss of S.5 billion in Europe in 2012 and a similar loss in 2013. The cost-cutting in Europe was combined with the introduction of several new commercial vans and SUVs and the introduction of the Mustang sports car for the first time. All European auto makers faced decreased car sales and chronic overcapacity at this time. Daimler AG, maker of Mercedes Benz automobiles, announced that it would not achieve its profit targets, while PSA Peugeot Citroen SA announced a government bailout of its financing arm and a cost-sharing pact with General Motors. There had been a smaller decrease in auto-producing capacity in Europe since the 2008 financial crisis compared with that during the restructuring of the U. auto industry that was influenced by the federal government bailout. 8 This discussion is based on Sharon Terlep and Sam Schechner, “GM, Peugeot Take Aim at Europe Woes,” Wall Street Journal (Online), July 12, 2012; Mike Ramsey, David Pearson, and Matthew Curtin, “Daimler Warns as Europe Car Makers Cut Back,” Wall Street Journal (Online), October 24, 2012; and Marietta Cauchi and Mike Ramsey, “Ford to Shut 3 Europe Plants,” Wall Street Journal (Online), October 25, 2012. 11/08/14 PM chapter 1 Managers and Economics 35 Two Perspectives: Microeconomics and Macroeconomics As noted above, microeconomics is the branch of economics that analyzes the ­decisions that individual consumers and producers make as they operate in a market economy. When microeconomics is applied to business decision making, it is called managerial economics. The key element in any market system is pricing, because this type of system is based on the buying and selling of goods and services. As we’ll discuss later in the chapter, prices—the amounts of money that are charged for different goods and services in a market economy—act as signals that influence the behavior of both consumers and producers of these goods and services. Managers must understand how prices are determined—for both the ­outputs, or products sold by a firm, and the inputs, or resources (such as land, labor, capital, raw materials, and entrepreneurship) that the firm must purchase in order to produce its output. Output prices influence the revenue a firm derives from the sale of its products, while input prices influence a firm’s costs of production. As you’ll learn throughout this text, many managerial actions and decisions are based on expected responses to changes in these prices and on the ability of a manager to influence these prices. Managerial decisions are also influenced by events that occur in the larger economic environment in which businesses operate. Changes in the overall level of economic activity, interest rates, unemployment rates, and exchange rates both at home and abroad create new opportunities and challenges for a firm’s competitive strategy. This is the subject matter of macroeconomics, which we’ll cover in the second half of this text. Managers need to be familiar with the underlying macroeconomic models that economic forecasters use to predict changes in the macroeconomy and with how different firms and industries respond to these changes. Most of these changes affect individual firms via the pricing mechanism, so there is a strong connection between microeconomic and macroeconomic analysis.9 In essence, macroeconomic analysis can be thought of as viewing the economy from an airplane 30,000 feet in the air, whereas with microeconomics the observer is on the ground walking among the firms and consumers. While on the ground, an observer can see the interaction between individual firms and consumers and the competitive strategies that various firms develop. At 30,000 feet, however, an observer doesn’t see the same level of detail. In macroeconomics, we analyze the behavior of individuals aggregated into different sectors in the economy to determine the impact of changes in this behavior on the overall level of economic activity. In turn, this overall level of activity combines with changes in various macro variables, such as interest rates and exchange rates, to affect the competitive strategies of individual firms and industries, the subject matter of microeconomics. Let’s now look at these microeconomic influences on managers in more detail. Microeconomics The branch of economics that ­analyzes the decisions that ­individual consumers, firms, and ­industries make as they produce, buy, and sell goods and services. Managerial economics Microeconomics applied to ­business decision making. Prices The amounts of money that are charged for goods and services in a market economy. Prices act as ­signals that influence the behavior of both consumers and producers of these goods and services. Outputs The final goods and services ­produced and sold by firms in a market economy. Inputs The factors of production, such as land, labor, capital, raw materials, and entrepreneurship, that are used to produce the outputs, or final goods and services, that are bought and sold in a market economy. Macroeconomics The branch of economics that focuses on the overall level of ­economic activity, changes in the price level, and the amount of ­unemployment by analyzing group or aggregate behavior in different sectors of the economy. 9 Note that the terms micro and macro are used differently in various business disciplines. For example, in Marketing Management, The Millennium Edition (Prentice Hall, 2000), Philip Kotler describes the “macro environment” as dealing with all forces external to the firm. His examples include both (1) the gradual opening of new markets in many countries and the growth in global brands of various products (microeconomic factors for the economist) and (2) the debt problems of many countries and the fragility of the international financial system (macroeconomic problems from the economic perspective). In each business discipline, you need to learn how these terms and concepts are defined. INDD 35 11/08/14 PM 36 Part 1 Microeconomic Analysis Microeconomic Influences on Managers Relative prices The price of one good in relation to the price of another, similar good, which is the way prices are defined in microeconomics. The discussion of the global automobile industry in the opening case illustrates several microeconomic factors influencing managerial decisions. In 2012, Japanese auto makers used low-interest financing and other incentives to regain market share lost in previous years. auto makers reengineered and redesigned their production processes to add features with greater customer appeal. Toyota had to recover from the impact of its recall and negative quality issues in 2010, while Honda stumbled on the redesign of its 2012 Civic by not incorporating features offered by its competitors. They also responded to the increased demand for trucks and SUVs, a market segment that had been negatively impacted by the recession. Ford and GM began reengaging in their traditional market rivalry. All producers who planned to sell in China, the world’s largest automobile market, had to recognize the difference in tastes and preferences of Chinese consumers, such as the desire for larger back seats. Decisions about demand, supply, production, and market structure are all microeconomic choices that managers must make. Some decisions focus on the factors that affect consumer behavior and the willingness of consumers to buy one firm’s product as opposed to that of a competitor. Thus, managers need to understand the variables influencing consumer demand for their products. Because consumers typically have a choice among competing products, these choices and the demand for each product are influenced by relative prices, the price of one good in relation to that of another, similar good. Relative prices are the focus of microeconomic analysis. The Japanese auto makers’ use of low-interest financing and other pricing incentives noted above is an example of a strategy based on influencing relative prices. All auto makers discussed in the case had to respond to changing consumer demand over time and to variations in consumer tastes and preferences that influenced demand in different countries. Production technology and the prices paid for the resources used in production influence a company’s final costs of production. The relative prices of these resources or factors of production will influence the choices that managers make among different production methods. Whether a production process uses large amounts of plant and equipment relative to the amount of workers and whether a business operates out of a small office or a giant factory are microeconomic production and cost decisions managers must make. used production platforms developed elsewhere to minimize its production costs as it entered the Chinese market. However, this cost-minimizing strategy was not appropriate for producing cars with larger back seats that appealed to affluent Chinese customers. General Motors also had to redesign its Cadillac to meet Chinese demand. Markets Markets The institutions and mechanisms used for the buying and selling of goods and services. The four major types of markets in microeconomic analysis are perfect c­ ompetition, monopolistic competition, ­oligopoly, and monopoly. All of the auto makers in the opening case made strategic decisions in light of their knowledge of the market environment or structure. INDD 36 Perfect competition Monopolistic competition Oligopoly Monopoly 11/08/14 PM chapter 1 Managers and Economics 37 Large Number of Firms Perfect Competition Single Firm Monopolistic Competition Oligopoly Monopoly Figure 1.1 Market Structure These market structures can be located along a continuum, as shown in Figure 1.1. Markets, the institutions and mechanisms used for the buying and selling of goods and services, vary in structure from those with hundreds or thousands of buyers and sellers to those with very few participants. At the left end of the continuum, there are a large number of firms in the market, whereas at the right end of the continuum there is only one firm. These different types of markets influence the strategic decisions that managers make because markets affect both the ability of a given firm to influence the price of its product and the amount of independent control the firm has over its actions. (We’ll discuss other characteristics that distinguish the markets later in the chapter.) The two market structures at the ends of the continuum, perfect competition and monopoly, are essentially hypothetical models. There are four major types of markets in microeconomic analysis: 1. No real-world firms meet all the assumptions of perfect competition, and few could be classified as monopolies. However, these models serve as benchmarks for analysis. All real-world firms contain combinations of the characteristics of these two models. Managers need to know where their firm lies along this continuum because market structure will influence the strategic variables that a firm can use to face its competition. The major characteristics that distinguish these market structures are 1. The number of firms competing with one another that influences the firm’s control over its price 2. Whether the products sold in the markets are differentiated or undifferentiated 3. A large number of firms in the market An undifferentiated product Ease of entry into the market Complete information available to all market participants In perfect competition, we distinguish between the behavior of an individual firm and the outcomes for the entire market or industry, which represents all firms producing the product. Whether entry into and exit from the market by other firms is easy or difficult 4. Economists make the assumption that there are so many firms in a perfectly competitive industry that no single firm has any influence on the price of the product. The amount of information available to market participants The Perfect Competition Model The model of perfect competition, which is on the left end of the continuum in Figure 1.1, is a market structure characterized by 1. For example, in many agricultural industries, whether an individual farmer produces more or less product in a given season has no influence on the price of these products. The individual farmer’s output is small relative to the entire market, so the market price is determined by the actions of all farmers supplying the product and all consumers who purchase the goods. Because individual producers can sell any amount of output they bring to market at that price, we characterize the perfectly competitive firm as a price-taker. This firm does not have to lower its price to sell more output. In fact, it cannot influence the price of its product. However, if the price for the entire amount of output in the market increases, consumers will buy less, and if the market price of the product decreases, they will buy more. In the model of perfect competition, economists also assume that all firms in an industry produce the same homogeneous product, so there is no product differentiation. For example, within a given grade of an agricultural product, potatoes or peaches are undifferentiated. This market characteristic means that consumers do not care about the identity of the specific supplier of the product they purchase. They may not even know who supplies the product, and that knowledge would be irrelevant to their purchase decision, which will be based largely on the price of the product. INDD 37 Perfect competition A market structure c­ haracterized by a large number of firms in an ­industry, an undifferentiated ­product, ease of entry into the market, and complete information available to participants. Price-taker A characteristic of a perfectly competitive firm in which the firm cannot influence the price of its product, but can sell any amount of its output at the price established by the market. 11/08/14 PM 38 Part 1 Microeconomic Analysis Profit The difference between the total revenue that a firm receives for ­selling its product and the total cost of producing that product. Market power The ability of a firm to influence the prices of its products and develop other competitive strategies that enable it to earn large profits over longer periods of time. Imperfect competition Market structures of ­monopolistic competition, oligopoly, and ­monopoly, in which firms have some degree of market power. Monopoly A market structure characterized by a single firm producing a product with no close substitutes. Barriers to entry Structural, legal, or regulatory ­characteristics of a firm and its market that keep other firms from easily producing the same or similar products at the same cost. Monopolistic competition A market structure characterized by a large number of small firms that have some market power as a result of producing differentiated products. Oligopoly A market structure characterized by competition among a small number of large firms that have market power, but that must take their rivals’ actions into account when developing their own competitive strategies. INDD 38 The third assumption of the perfectly competitive model is that entry into the industry by other firms is costless. This means that if a perfectly competitive firm is making a profit (earning revenues in excess of its costs), other firms will also enter the industry in an attempt to earn profits. However, these actions will compete away excess profits for all firms in a perfectly competitive industry. The final assumption of the perfectly competitive model is that complete information is available to all market participants. This means that all participants know which firms are earning the greatest profits and how they are doing so. Thus, other firms can easily emulate the strategies and techniques of the profitable firms, which will result in greater competition and further pressure on any excess profits. While the details of this process will be described in later chapters, these four assumptions mean that perfectly competitive firms have no market power—the ability to influence their prices and develop other competitive strategies that allow them to earn large profits over longer periods of time. All of the other market structures in Figure 1.1 represent imperfect competition, in which firms have some degree of market power. How much market power these firms have and how they are able to maintain it differ among the market structures. The Monopoly Model At the right end of the market structure continuum in Figure 1.1 is the monopoly model, in which a single firm produces a product for which there are no close substitutes. Thus, as we move rightward along the continuum, the number of firms producing the product keeps decreasing until we reach the monopoly model of one firm. A monopoly firm typically produces a product that has characteristics and qualities different from the products of its competitors. This product differentiation often means that consumers are willing to pay more for this product because similar products are not considered to be close substitutes. In the monopoly model, there are also barriers to entry, which are structural, legal, or regulatory characteristics of the market that keep other firms from easily producing the same or similar products at the same cost and that give a firm market power. However, while market power allows a firm to influence the prices of its products and develop competitive strategies that enable it to earn larger profits, a firm with market power cannot sell any amount of output at a given market price, as in perfect competition. If a monopoly firm raises its price, it will sell less output, whereas if it lowers its price, it will sell more output. The Monopolistic Competition and Oligopoly Models The intermediate models of monopolistic competition and oligopoly in Figure 1.1 better characterize the behavior of real-world firms and industries because they represent a blend of competitive and monopolistic behavior. In monopolistic ­competition, firms produce differentiated products, so they have some degree of market power. However, because these firms are closer to the left end of the continuum in Figure 1.1, there are many firms competing with one another. Each firm has only limited ability to earn above-average profits before they are competed away over time. In oligopoly markets, a small number of large firms dominate the market, even if other producers are present. Mutual interdependence is the key characteristic of this market structure because firms need to take the actions of their rivals into a­ ccount when developing their own competitive strategies. Oligopoly firms typically have market power, but how they use that power may be limited by the ­actions and reactions of their competitors. The opening case of this chapter did not explicitly discuss the market structure of the major auto producers. automobile sales were at an annualized rate of 14.94 million vehicles in 2012. The Goal of Profit Maximization In all of the market models we have just presented, we assume that the goal of firms is profit maximization, or earning the largest amount of profit possible. However, because all of these firms are large multinational companies that sell globally, they obviously have substantial market power 11/08/14 PM chapter 1 Managers and Economics 39 and are located far from the model of perfect competition on the continuum in Figure 1.1. Large national or multinational companies typically find themselves operating in multiple markets, making the analysis of market structure more complicated as the market environment may differ substantially among these markets. Because profit, as defined above, represents the difference between the revenues a firm receives for selling its output and its costs of production, firms may develop strategies to either increase revenues or reduce costs in an effort to increase profits. If firms in one sector of the economy earn above-average profits, other firms will ­attempt to produce the same or similar products to increase their profitability. Each of these markets has its own characteristics in terms of the number and size of the competitors and product characteristics. Thus, resources will flow from areas of low to high profitability. As we will see, however, the increased competition that results from this process will eventually lead to lower prices and revenues, thus eliminating most or all of these excess profits. Profitability is the standard by which firms are judged in a market economy. Profitability affects stock prices and investor decisions. If firms are unprofitable, they will go out of business, be taken over by other more profitable companies, or have their management replaced. Subsequently, we model a firm’s profit-­maximization decision largely in terms of static, single-period models where information on consumer behavior, revenues, and costs is known with certainty. Real-world managers must deal with uncertainty in all of these areas, which may lead to less-than-optimal decisions, and managers must be concerned with maximizing the firm’s value over time. The models we present illustrate the basic forces influencing managerial decisions and the key role of profits as a motivating incentive. Profit maximization The assumed goal of firms, which is to develop strategies to earn the largest amount of profit possible. This can be accomplished by focusing on revenues, costs, or both. Managerial Rule of Thumb Microeconomic Influences on Managers To develop a competitive advantage and increase their firm’s profitability, managers need to understand: How consumer behavior affects their revenues How production technology and input prices affect their costs How the market and regulatory environment in which managers operate influences their ability to set prices and to respond to the strategies of their competitors ■ Macroeconomic Influences on Managers The discussion of the impact of the global recession, the continued problems in Europe’s financial recovery, and the role of currency exchange rates in the case that opened this chapter can be placed within the circular flow model of M01_FARN0095_03_GE_C01. INDD 39 Circular flow model The macroeconomic model that portrays the level of economic activity as a flow of expenditures from consumers to firms, or ­producers, as consumers purchase goods and services produced by these firms. This flow then returns to consumers as income received from the production process. 11/08/14 PM 40 Part 1 Microeconomic Analysis Figure 1.2 GDP and the Circular Flow C = consumption spending I = investment spending G = government spending X = export spending M = import spending Y = household income S = household saving TP = personal taxes TB = business taxes Foreign Sector X M Domestic Markets for Currently Produced Goods and Services C Revenue I G Household Sector TP S Government Sector Borrowing Borrowing TB Firm Sector Borrowing Financial Markets Y Income: Wages, Rent, Interest, Profit Absolute price level A measure of the overall level of prices in the economy. Personal consumption­ ­expenditures (C) The total amount of spending by households on durable goods, nondurable goods, and services in a given period of time. Gross private domestic ­investment spending (I) The total amount of spending on nonresidential structures, ­equipment, software, residential structures, and business inventories in a given period of time. INDD 40 Expenses Resource Markets macroeconomics, shown in Figure 1.2. This model portrays the level of economic activity in a country as a flow of expenditures from the household sector to business firms as consumers purchase goods and services currently produced by these firms and sold in the country’s output markets. This flow then returns to consumers as ­income received for supplying firms with the inputs or factors of production, ­including land, labor, capital, raw materials, and entrepreneurship, which are bought and sold in the resource markets. These payments, which include wages, rents, interest, and profits, become consumer income, which is again used to purchase goods and services—hence, the name circular flow. Figure 1.2 also shows spending by firms, by governments, and by the foreign sector of the economy. Corresponding to these total levels of expenditures and income are the amounts of output produced and resources employed. The levels of expenditures, income, output, and employment in relation to the total capacity of the economy to produce goods and services will determine whether resources are fully employed in the economy or whether there is unemployed labor and excess plant capacity. This relationship will also determine whether and how much the absolute price level in the economy is increasing. The absolute price level is a measure of the overall price level in the economy as compared with the microeconomic concept of relative prices, which refers to the price of one particular good compared to that of another, as we discussed earlier. Economists use the circular flow model in Figure 1.2 to define and analyze the spending behavior of different sectors of the economy, including Personal consumption expenditures (C) by all households on durable goods, nondurable goods, and services Gross private domestic investment spending (I) by households and firms on nonresidential structures, equipment, software, residential structures, and inventories 11/08/14 PM chapter 1 Managers and Economics 41 Federal, state, and local government consumption expenditures and gross investment (G) Net export spending (F) or total export spending (X) minus total import spending (M) Consumption spending (C) is largely determined by consumer income (Y), but it is also influenced by other factors such as consumer confidence, as noted below. Much business investment spending (I) is derived from borrowing in the financial markets and is, therefore, affected by prevailing interest rates. The availability of funds for borrowing is influenced by the amount of income that consumers save (S) or do not spend on goods and services.10 Some consumer income (Y) is also used to pay personal taxes (TP) to the government sector to finance the purchase of its goods and services. The government also imposes taxes on business (TB). If government spending (G) exceeds the total amount of taxes collected (T = TP TB), the resulting deficit must be financed by borrowing in the financial markets. For students in the one-semester MBA Managerial Economics course. This book is also suitable for all readers interested in the field of managerial economics. ¿ Economics for Managers presents the fundamental ideas of microeconomics and macroeconomics and integrates them from a managerial decision-making perspective in a framework that can be used in a single-semester course. ¿ To be competitive in today’s business environment, managers must understand how economic forces affect their business and the factors that must be considered when making business decisions.¿ This is the only book that provides business students and MBAs with a thorough and applied understanding of both micro- and macroeconomic concepts in a way non-economics majors can understand. ¿ The third edition retains all the same core concepts and straightforward material on micro- and macroeconomics while incorporating new case material and real-world examples that relate to today’s managerial student. It may takes up to 1-5 minutes before you received it. 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INDD 2 21/08/14 PM Dedication To my friend and colleague, Dr. INDD 4 21/08/14 PM Brief Contents Part 1 Microeconomic Analysis 32 1 2 3 4 5 6 7 8 9 10 Part 2 Managers and Economics 32 Demand, Supply, and Equilibrium Prices 46 Demand Elasticities 76 Techniques for Understanding Consumer Demand and Behavior 116 Production and Cost Analysis in the Short Run 144 Production and Cost Analysis in the Long Run 172 Market Structure: Perfect Competition 200 Market Structure: Monopoly and Monopolistic Competition 226 Market Structure: Oligopoly 260 Pricing Strategies for the Firm 288 Macroeconomic Analysis 320 11 12 13 14 15 Measuring Macroeconomic Activity 320 Spending by Individuals, Firms, and Governments on Real Goods and Services The Role of Money in the Macro Economy 390 The Aggregate Model of the Macro Economy 416 International and Balance of Payments Issues in the Macro Economy 446 350 Part 3 Integration of the Frameworks 482 16 Combining Micro and Macro Analysis for Managerial Decision Making 482 Solutions to Even-Numbered Problems 501 Glossary 521 Index 535 A01_FARN0095_03_GE_FM. INDD 6 21/08/14 PM Contents Preface 17 About the Author Part 1 Chapter 1 29 Microeconomic Analysis 32 Managers and Economics 32 Case for Analysis: Micro- and Macroeconomic Influences on the Global Automobile Industry 33 Two Perspectives: Microeconomics and Macroeconomics 35 Microeconomic Influences on Managers 36 Markets 36 Managerial Rule of Thumb: Microeconomic Influences on Managers 39 Macroeconomic Influences on Managers 39 Factors Affecting Macro Spending Behavior 41 Managerial Rule of Thumb: Macroeconomic Influences on Managers 43 End of Chapter Resources Summary 43 • Key Terms 44 • Exercises 44 • Application Questions Chapter 2 Demand, Supply, and Equilibrium Prices 44 46 Case for Analysis: Demand and Supply in the Copper Industry 47 Demand 48 Nonprice Factors Influencing Demand 49 Demand Function 53 Demand Curves 54 Change in Quantity Demanded and Change in Demand 55 Individual Versus Market Demand Curves 56 Linear Demand Functions and Curves 56 Mathematical Example of a Demand Function 57 Managerial Rule of Thumb: Demand Considerations 58 Supply 58 Nonprice Factors Influencing Supply 58 Supply Function 60 Supply Curves 61 Change in Quantity Supplied and Change in Supply 61 Mathematical Example of a Supply Function 62 Summary of Demand and Supply Factors 63 Managerial Rule of Thumb: Supply Considerations 64 A01_FARN0095_03_GE_FM. Jon Mansfield, who ­continues to excel at teaching economics for managers. INDD 7 21/08/14 PM 8 Contents Demand, Supply, and Equilibrium 64 Definition of Equilibrium Price and Equilibrium Quantity Lower-Than-Equilibrium Prices 64 Higher-Than-Equilibrium Prices 66 Mathematical Example of Equilibrium 67 Changes in Equilibrium Prices and Quantities 67 Mathematical Example of an Equilibrium Change 70 End of Chapter Resources Summary 72 • Key Terms Chapter 3 A01_FARN0095_03_GE_FM. INDD 8 • Application Questions 74 Case for Analysis: Demand Elasticity and Procter & Gamble’s Pricing Strategies Demand Elasticity 78 Price Elasticity of Demand 79 The Influence of Price Elasticity on Managerial Decision Making 80 Price Elasticity Values 81 Elasticity and Total Revenue 81 Managerial Rule of Thumb: Estimating Price Elasticity 83 Determinants of Price Elasticity of Demand 83 Number of Substitute Goods 84 Percent of Consumer’s Income Spent on the Product 84 Time Period 85 Numerical Example of Elasticity, Prices, and Revenues 85 Calculating Price Elasticities 85 Numerical Example 87 The Demand Function 87 Other Functions Related to Demand 87 Calculation of Arc and Point Price Elasticities 88 Price Elasticity Versus Slope of the Demand Curve 89 Demand Elasticity, Marginal Revenue, and Total Revenue 90 Vertical and Horizontal Demand Curves 92 Vertical Demand Curves 92 Horizontal Demand Curves 93 Income and Cross-Price Elasticities of Demand 94 Income Elasticity of Demand 94 Managerial Rule of Thumb: Calculating Income Elasticity 95 Cross-Price Elasticity of Demand 95 Elasticity Estimates: Economics Literature 97 Elasticity and Chicken and Agricultural/Food Products 98 Elasticity and Beer 99 Water Demand 100 Elasticity and the Tobacco Industry 100 Elasticity and Health Care 101 Tuition Elasticity in Higher Education 101 Managerial Rule of Thumb: Price Elasticity Decision Making 102 Elasticity Issues: Marketing Literature 102 Marketing Study I: Tellis (1988) 103 Marketing Study II: Sethuraman and Tellis (1991) 104 Marketing Study III: Hoch et al. (1995) 105 Marketing Study Update 105 77 Demand Elasticities 72 • Exercises 72 64 76 21/08/14 PM Contents 9 Managerial Rule of Thumb: Elasticities in Marketing and Decision Making 106 End of Chapter Resources Summary 106 • Appendix 3A Economic Model of Consumer Choice 107 • Key Terms 113 • Exercises 113 • Application Questions 114 Chapter 4 Techniques for Understanding Consumer Demand and Behavior 116 Case for Analysis: The Use of New Technology to Understand and Impact Consumer Behavior 117 Understanding Consumer Demand and Behavior: Marketing Approaches 118 Expert Opinion 118 Consumer Surveys 119 Test Marketing and Price Experiments 120 Analysis of Census and Other Historical Data 121 Unconventional Methods 121 Evaluating the Methods 122 Managerial Rule of Thumb: Marketing Methods for Analyzing Consumer Behavior 123 Consumer Demand and Behavior: Economic Approaches 123 Relationship Between One Dependent and One Independent Variable: Simple Regression Analysis 124 Relationship Between One Dependent and Multiple Independent Variables: Multiple Regression Analysis 129 Other Functional Forms 131 Demand Estimation Issues 132 Managerial Rule of Thumb: Using Multiple Regression Analysis 133 Case Study of Statistical Estimation of Automobile Demand 133 Managerial Rule of Thumb: Using Empirical Consumer Demand Studies 137 Relationships Between Consumer Market Data and Econometric Demand Studies 137 Case Study I: Carnation Coffee-mate 137 Case Study II: Carnation Evaporated Milk 138 Case Study III: The Demand for Cheese in the United States 139 Managerial Rule of Thumb: Using Consumer Market Data 141 End of Chapter Resources Summary 141 • Key Terms 141 • Application Questions 143 Chapter 5 A01_FARN0095_03_GE_FM. INDD 9 • Exercises 142 Production and Cost Analysis in the Short Run 144 Case for Analysis: Production and Cost Analysis in the Fast-Food Industry 145 Defining the Production Function 146 The Production Function 146 Fixed Inputs Versus Variable Inputs 146 Short-Run Versus Long-Run Production Functions 147 Managerial Rule of Thumb: Short-Run Production and Long-Run Planning 147 Productivity and the Fast-Food Industry 147 Model of a Short-Run Production Function 148 Total Product 148 Average Product and Marginal Product 148 Relationships Among Total, Average, and Marginal Product 149 Economic Explanation of the Short-Run Production Function 151 21/08/14 PM 10 Contents Real-World Firm and Industry Productivity Issues 152 Other Examples of Diminishing Returns 152 Productivity and the Agriculture Industry 153 Productivity and the Automobile Industry 154 Productivity Changes Across Industries 155 Model of Short-Run Cost Functions 156 Measuring Opportunity Cost: Explicit Versus Implicit Costs 156 Accounting Profit Measures Versus Economic Profit Measures 157 Managerial Rule of Thumb: The Importance of Opportunity Costs 158 Definition of Short-Run Cost Functions 159 Fixed Costs Versus Variable Costs 159 Relationships Among Total, Average, and Marginal Costs 160 Relationship Between Short-Run Production and Cost 162 Other Short-Run Production and Cost Functions 163 Managerial Rule of Thumb: Understanding Your Costs 164 Empirical Evidence on the Shapes of Short-Run Cost Functions 164 Econometric Estimation of Cost Functions 164 Survey Results on Cost Functions 165 Constant Versus Rising Marginal Cost Curves 166 Implications for Managers 167 End of Chapter Resources Summary 168 • Key Terms 168 • Exercises 169 • Application Questions 170 Chapter 6 Production and Cost Analysis in the Long Run 172 Case for Analysis: The i Phone in China 173 Model of a Long-Run Production Function 174 Input Substitution 174 Model of a Long-Run Cost Function 182 Derivation of the Long-Run Average Cost Curve 182 Economies and Diseconomies of Scale 183 Factors Creating Economies and Diseconomies of Scale 184 Other Factors Influencing the Long-Run Average Cost Curve 185 The Minimum Efficient Scale of Operation 186 Long-Run Average Cost and Managerial Decision Making 189 End of Chapter Resources Summary 189 • Appendix 6A Isoquant Analysis 190 • Key Terms 197 • Exercises 197 • Application Questions 198 Chapter 7 Market Structure: Perfect Competition 200 Case for Analysis: Competition and Cooperative Behavior in the Potato Industry 201 The Model of Perfect Competition 202 Characteristics of the Model of Perfect Competition 202 Model of the Industry or Market and the Firm 203 The Short Run in Perfect Competition 209 Long-Run Adjustment in Perfect Competition: Entry and Exit 209 Adjustment in the Potato Industry 210 Long-Run Adjustment in Perfect Competition: The Optimal Scale of Production 211 A01_FARN0095_03_GE_FM. INDD 10 21/08/14 PM Contents 11 Managerial Rule of Thumb: Competition Means Little Control Over Price Other Illustrations of Competitive Markets 212 Competition and the Agricultural Industry 213 Competition and the Broiler Chicken Industry 214 Competition and the Red-Meat Industry 215 Competition and the Milk Industry 217 Competition and the Trucking Industry 218 Managerial Rule of Thumb: Adopting Strategies to Gain Market Power in Competitive Industries 219 212 End of Chapter Resources Summary 220 • Appendix 7A Industry Supply 220 • Key Terms 222 • Exercises 222 • Application Questions 223 Chapter 8 Market Structure: Monopoly and Monopolistic Competition 226 Case for Analysis: Changing Market Power for Eastman Kodak Co. 227 Firms with Market Power 228 The Monopoly Model 228 Comparing Monopoly and Perfect Competition 230 Sources of Market Power: Barriers to Entry 231 Managerial Rule of Thumb: Using Lock-In as a Competitive Strategy 241 Changes in Market Power 241 Measures of Market Power 243 Antitrust Issues 246 Managerial Rule of Thumb: Understanding Antitrust Laws 251 Monopolistic Competition 251 Characteristics of Monopolistic Competition 252 Short-Run and Long-Run Models of Monopolistic Competition 252 Examples of Monopolistically Competitive Behavior 253 Managerial Rule of Thumb: Maintaining Market Power in Monopolistic Competition 256 End of Chapter Resources Summary 256 • Key Terms 256 • Exercises 257 • Application Questions 257 Chapter 9 Market Structure: Oligopoly 260 Case for Analysis: Oligopoly Behavior in the Airline Industry Case Studies of Oligopoly Behavior 262 The Airline Industry 262 The Soft Drink Industry 264 The Doughnut Industry 265 The Parcel and Express Delivery Industry 266 Oligopoly Models 267 Noncooperative Oligopoly Models 268 The Kinked Demand Curve Model 268 Game Theory Models 269 Strategic Entry Deterrence 272 Predatory Pricing 273 A01_FARN0095_03_GE_FM. INDD 11 261 21/08/14 PM 12 Contents Cooperative Oligopoly Models Cartels 275 Tacit Collusion 281 275 Managerial Rule of Thumb: Coordinated Actions 283 End of Chapter Resources Summary 283 • Key Terms 283 • Exercises 283 • Application Questions 285 Chapter 10 Pricing Strategies for the Firm 288 Case for Analysis: Airline Pricing Strategies: Will They Start Charging for the Use of the Lavatories? 289 The Role of Markup Pricing 290 Marginal Revenue and the Price Elasticity of Demand 291 The Profit-Maximizing Rule 292 Profit Maximization and Markup Pricing 292 Business Pricing Strategies and Profit Maximization 294 Markup Pricing Examples 295 Managerial Rule of Thumb: Markup Pricing 296 Price Discrimination 297 Definition of Price Discrimination 297 Theoretical Models of Price Discrimination 298 Price Discrimination and Managerial Decision Making 305 Marketing and Price Discrimination 312 Macroeconomics and Pricing Policies 313 End of Chapter Resources Summary 315 • Key Terms 315 • Exercises 316 • Application Questions 317 Part 2 Chapter 11 Macroeconomic Analysis 320 Measuring Macroeconomic Activity 320 Case for Analysis: Measuring Changes in Macroeconomic Activity: Implications for Managers 321 Measuring Gross Domestic Product (GDP) 322 The Circular Flow in a Mixed, Open Economy 322 Managerial Rule of Thumb: Spending Patterns 324 National Income Accounting Systems 324 Characteristics of GDP 325 Real Versus Nominal GDP 326 Alternative Measures of GDP 329 Other Important Macroeconomic Variables 337 Price Level Measures 337 Measures of Employment and Unemployment 341 Managerial Rule of Thumb: Price Level and Unemployment 343 Major Macroeconomic Policy Issues 343 What Factors Influence the Spending Behavior of the Different Sectors of the Economy? 344 How Do Behavior Changes in These Sectors Influence the Level of Output and Income in the Economy? 344 Can Policy Makers Maintain Stable Prices, Full Employment, and Adequate Economic Growth over Time? INDD 12 21/08/14 PM Contents 13 How Do Fiscal, Monetary, and Balance of Payments Policies Influence the Economy? 346 What Impact Do These Macro Changes Have on Different Firms and Industries? 346 Managerial Rule of Thumb: Competitive Strategies and the Macro Environment 346 End of Chapter Resources Summary 347 • Key Terms 347 • Exercises 348 • Application Questions 349 Chapter 12 Spending by Individuals, Firms, and Governments on Real Goods and Services 350 Case for Analysis: Mixed Signals on the U. Economy in Summer 2012 Framework for Macroeconomic Analysis 352 Focus on the Short Run 352 Analysis in Real Versus Nominal Terms 353 Treatment of the Foreign Sector 353 Outline for Macroeconomic Analysis 353 The Components of Aggregate Expenditure 354 Personal Consumption Expenditure 354 Gross Private Domestic Investment Expenditure 362 Government Expenditure 371 Net Export Expenditure 372 Aggregate Expenditure and Equilibrium Income and Output Aggregate Expenditure 375 Equilibrium Level of Income and Output 377 Effect of the Interest Rate on Aggregate Expenditures 382 351 375 End of Chapter Resources Summary 383 • Appendix 12A Numerical Example of Equilibrium and the Multiplier 383 • Appendix 12B Algebraic Derivation of the Aggregate Expenditure Function 385 • Key Terms 388 • Exercises 388 • Application Questions 389 Chapter 13 The Role of Money in the Macro Economy 390 Case for Analysis: The Chairman’s Quandary 391 Money and the U. Financial System 392 Definition of Money 392 Measures of the Money Supply 392 Depository Institutions and the Fractional Reserve Banking System 393 The Central Bank (Federal Reserve) 396 Tools of Monetary Policy 398 Managerial Rule of Thumb: Federal Reserve Policy 407 Equilibrium in the Money Market 407 The Supply of Money 407 The Demand for Money 409 Equilibrium in the Money Market 411 Change in the Supply of Money 411 Change in the Demand for Money 412 Overall Money Market Changes 413 End of Chapter Resources Summary 413 • Appendix 13A Monetary Tools and the Market for Bank Reserves 413 • Key Terms 414 • Exercises 415 • Application Questions 415 A01_FARN0095_03_GE_FM. Economy, 2007–20–2012 468 Effects of the Euro in the Macroeconomic Environment 470 Euro Macro Environment Effects on Managerial Decisions 473 Southeast Asia: An Attempt to Maintain Fixed Exchange Rates 474 Macro and Managerial Impact of the Chinese Yuan Since 2003 476 Policy Effectiveness with Different Exchange Rate Regimes 478 End of Chapter Resources Summary 479 • Appendix 15A Specific and General Equations for the Balance of Payments 479 • Key Terms 480 • Exercises 480 • Application Questions 481 A01_FARN0095_03_GE_FM. INDD 13 21/08/14 PM 14 Contents Chapter 14 The Aggregate Model of the Macro Economy 416 Case for Analysis: What Role for Inflation? INDD 14 21/08/14 PM Contents 15 Part 3 Integration of the Frameworks 482 Chapter 16 Combining Micro and Macro Analysis for Managerial Decision Making Case for Analysis: Strong Headwinds for Mc Donald’s 482 483 Microeconomic and Macroeconomic Influences on Mc Donald’s and the Fast-Food Industry 484 Shifting Product Demand 484 Oligopolistic Behavior 485 Strategies to Offset Shifting Demand 487 Cost-Cutting Strategies 488 Innovations for Different Tastes 488 Drawing on Previous Experience 489 2012 and Beyond: A Focus on China and Other Emerging Markets 490 Economic and Political Issues 492 Responses of Other Fast-Food Competitors 494 Calorie Counts on Menus 495 Macroeconomic Influences on the Fast-Food Industry in 20 497 End of Chapter Resources Summary: Macro and Micro Influences on the Fast-Food Industry 497 • Appendix 16A Statistical Estimation of Demand Curves 498 • Exercises 500 • Application Questions 500 Solutions to Even-Numbered Problems 501 Glossary 521 Index 535 A01_FARN0095_03_GE_FM. INDD 16 21/08/14 PM Preface The third edition of Economics for Managers builds on the strengths of the first two editions, while updating the case studies and examples, the data, and the references supporting the discussion. 417 The Model of Aggregate Demand and Supply 418 The Aggregate Demand Curve 418 Fiscal and Monetary Policy Implementation 422 The Aggregate Supply Curve 427 Using the Aggregate Model to Explain Changes in the Economy from 2007 to 2008 and from 2011 to 2012 434 Impact of Macro Changes on Managerial Decisions 438 Measuring Changes in Aggregate Demand and Supply 440 Managerial Rule of Thumb: Judging Trends in Economic Indicators 442 End of Chapter Resources Summary 442 • Appendix 14A Specific and General Equations for the Aggregate Macro Model 442 • Key Terms 444 • Exercises 444 • Application Questions 445 Chapter 15 International and Balance of Payments Issues in the Macro Economy 446 Case for Analysis: Uncertainty in the World Economy in 2012 447 Exchange Rates 448 Managerial Rule of Thumb: Currency Exchange Rates 451 Equilibrium in the Open Economy 452 U. International Transactions in 2011 (Balance of Payments) 453 The Current Account 453 The Financial Account 454 Revenue or T-Account 455 Deriving the Foreign Exchange Market 457 The Demand for and Supply of Dollars in the Foreign Exchange Market 457 Equilibrium in the Foreign Exchange Market 459 Managerial Rule of Thumb: The Foreign Exchange Market 460 Exchange Rate Systems 460 Flexible Exchange Rate System 462 Fixed Exchange Rate System 463 The Effect on the Money Supply 465 Sterilization 465 Policy Examples of International Economic Issues 466 The U. Economics for Managers, Third Edition, does not attempt to cover all the topics in traditional principles of economics texts or in intermediate microeconomic and macroeconomic theory texts. As in the previous editions, the goal of this text is to present the fundamental ideas of microeconomics and macroeconomics and then integrate them from a managerial decision-making perspective into a framework that can be used in a singlesemester course for Master of Business Administration (MBA), Executive MBA (EMBA), and other business students. This edition has been completely revised to update the industry cases and examples in the microeconomics section and the data and analysis in the macroeconomics section. • Twelve of the sixteen chapters have entirely new cases, while the cases in the remaining four chapters have been updated extensively. Economy in Summer 2012; The Chairman’s Quandary; and Strong Headwinds for Mc Donald’s. • New cases include: Micro- and Macroeconomic Influences on the Global Automobile Industry; Demand Elasticity and Procter & Gamble’s Pricing Strategies; The i Phone in China; Changing Market Power for Eastman Kodak Co.; Airline Pricing Strategies: Will They Start Charging for the Use of the Lavatories? • Linkage to the marketing literature, particularly in Chapter 4, Techniques for ­Understanding Consumer Demand and Behavior, and in Chapter 10, Pricing Strategies for the Firm, has been increased. • The macroeconomics section of the text has been completely rewritten, given the changes in the macroeconomy since 2008, when the second edition was drafted. • The macroeconomic data in the tables have been updated to 2011, and the data in the figures show trends from 2000 to first quarter 2012. • The macroeconomics discussion, which makes extensive use of Federal Reserve Monetary Policy Reports to Congress and reports and analyses by the Congressional Budget Office, includes recent policy issues such as the impact of the American Recovery and Reinvestment Act of 2009, the fiscal cliff debates in 2012, and the Federal Reserve’s use of nontraditional policy tools to stimulate the economy. • An extensive discussion of the situation in the European Union from 2010 to 2012, which includes the banking, sovereign debt, and growth crises and the impact of these events on managerial decision making, is presented. INDD 17 21/08/14 PM 18 Preface Motivation for the Text Most micro/managerial economics and intermediate macroeconomics texts are written for economics students who will spend an entire semester using each text. The level of detail and style of writing in these texts are not appropriate for business students or for the time frame of a single-semester course. However, business students need more than a principles of economics treatment of these topics because they have often been exposed to that level of material already. The third edition of Economics for Managers will continue to present economic theory that goes beyond principles of economics, but the text is not as detailed or theoretical as a standard intermediate economics text given the coverage of both micro- and macroeconomics and the additional applications and examples included in this text. The compactness of the text and the style of writing are more appropriate for MBA students than what is typically found in large, comprehensive principles texts. As in the previous editions, each chapter of Economics for Managers, Third Edition, begins with a “Case for Analysis” section, which examines events drawn from the current news media that illustrate the issues in the chapter. Thus, students begin the study of each chapter with a concrete, real-world example that highlights relevant economic concepts, which are then explained with the appropriate economic theory. Numerous real-world examples are used to illustrate the theoretical discussion. This approach appeals to MBA students who typically want to know the relevance and applicability of basic economic concepts and how these concepts can be used to analyze and explain events in the business environment. Intended Audience This text is designed to teach economics for business decision making to students in MBA and EMBA programs. It includes fundamental microeconomic and macroeconomic topics that can be covered in a single quarter or semester or that can be combined with other readers and case studies for an academic year course. The book is purposely titled Economics for Managers and not Managerial ­Economics to emphasize that this is not another applied microeconomics text with heavy emphasis on linear programming, multiple regression analysis, and other quantitative tools. This text is written for business students, most of whom will not take another course in economics, but who will work in firms and industries that are influenced by the economic forces discussed in the text. A course using this text would ideally require principles of microeconomics and macroeconomics as prerequisites. However, the text is structured so that it can be used without these prerequisites. Coverage of the material in this text in one semester does require a substantial degree of motivation and maturity on the part of the students. However, the style of writing and coverage of topics in Economics for Managers will facilitate this process and are intended to generate student interest in these issues that lasts well beyond the end of the course. Economics for Managers can be used with other industry case study books, such as The Structure of American Industry by James Brock. These books present extensive discussions of industry details from an economic perspective. Although they focus primarily on microeconomic and managerial topics, these texts can be used with Economics for Managers to integrate influences from the larger macroeconomic environment with the microeconomic analysis of different firms and industries. INDD 18 21/08/14 PM Preface 19 Organization of the Text The text is divided into three parts. Part 1, Microeconomic Analysis, focuses on how individual consumers and businesses interact with each other in a market economy. Part 2, Macroeconomic Analysis, looks at the aggregate behavior of different sectors of the economy to determine how changes in behavior in each of these sectors influence the overall level of economic activity. And finally, Part 3, Integration of the Frameworks, draws linkages between Parts 1 and 2. Although many of the micro- and macroeconomic topics are treated similarly in other textbooks, this text emphasizes the connections between the frameworks, particularly in the first and last chapters. Changes in macroeconomic variables, such as interest rates, exchange rates, and the overall level of income, usually affect a firm through microeconomic variables such as consumer income, the price of the inputs of production, and the sales revenue the firm receives. Managers must be able to analyze factors relating to both market competition and changes in the overall economic environment so they can develop the best competitive strategies for their firms. To cover all this material in one text, much of the detail and some topics found in other micro and macro texts have been omitted, most of which are not directly relevant for MBA students. There is no calculus in this text, only basic algebra and graphs. Algebraic examples are kept to a minimum and used only after the basic concepts are presented intuitively with examples. Statistical and econometric techniques are covered, particularly for demand estimation, at a very basic level, while references are provided to the standard sources on these topics. The text places greater emphasis than other texts on how managers use nonstatistical and marketing strategies to make decisions about the demand for their products, and it draws linkages between the statistical and nonstatistical approaches. Economics for Managers, Third Edition, includes little formal analysis of input or resource markets, either from the viewpoint of standard marginal ­productivity ­theory or from the literature on the economics of organization, ownership and control, and human resource management. The latter are interesting topics that are covered in other texts with a focus quite different from this one. The macroeconomics portion of this text omits many of the details of alternative macro theories discussed elsewhere. Students are given the basic tools that will help them understand macroeconomics as presented in business sources, such as the Wall Street Journal, that emphasize how the national government and the Federal Reserve manage the economy to promote full employment, a stable price level, and ­economic growth. Chapter-by-Chapter Breakdown: What’s New in This Edition? Part 1: Microeconomic Analysis The third edition of Economics for Managers includes new and updated cases from 2010 to 2012 that introduce each chapter. In some chapters, the cases are on the same topic as in previous editions (e.g., the copper industry in Chapter 2) to facilitate the transition for current users of the text. Chapter 1 introduces an entirely new case on the global automobile industry, which includes a discussion of the microeconomic factors influencing competition among the major players in the industry, and the impact of macroeconomic A01_FARN0095_03_GE_FM. INDD 19 21/08/14 PM 20 Preface changes on the entire industry. The chapter focuses on the competition between Japanese and ­American auto makers, how the American industry has been making a comeback in recent years, and how that change intensified competition among the ­American producers. I also discuss the impact of the 2011 earthquake and ­tsunami on the J­ apanese auto industry and the effect of the 2010 recall and quality issues on ­Toyota. Automobile production and demand changes in China are major issues in this ­chapter. Moreover, the role of China regarding both individual firms’ strategies and in the larger macroeconomic environment will be a significant factor throughout this text. Another theme introduced in this chapter is the impact of the global financial crisis and recession on managerial strategies. The ongoing economic crisis in Europe, which I discuss throughout the text, created major challenges for all players in the global automobile industry. General Motors and Chrysler received a bailout from the U. I also discuss the role of currency exchange rates, particularly the impact of the strong yen on the Japanese auto industry. As in previous editions, this chapter presents the frameworks for the microeconomic and macroeconomic analyses used throughout the text. I introduce the role of relative prices and discuss the different models of market competition. Federal Reserve policy since 2008 of targeting historically low interest rates and fiscal policy issues such as the American Recovery and Reinvestment Act of 2009. I also present the circular flow macroeconomic model that focuses on consumption (C), investment (I), and government spending (G), and spending on exports (X) and imports (M). These microeconomic and macroeconomic issues will be discussed again in the context of the fast-food industry in Chapter 16. The use of two well-known industries to frame both the microeconomic and macroeconomic discussion is a unique feature of Economics for Managers, Third Edition. Chapter 2 updates the case on the copper industry that introduces the concepts of demand and supply and shows the extreme volatility of prices in a competitive industry. The current discussion highlights the issues of the global demand for copper, the particular influence of China, and the problem of copper thefts due to its high price. I have retained much of the discussion of the copper industry from previous editions to illustrate the impact of these changes over time. Even though this chapter focuses on the microeconomic concepts of demand and supply, the copper industry has been given the name “Dr. Copper,” because strong demand and high prices can indicate the overall health of the economy. New examples of the non-price factors influencing demand include (1) the impact on the Zippo Manufacturing Co. of changing attitudes on cigarette smoking; (2) the Chinese demand for pecans; (3) the effect of the Japanese earthquake on the demand for luxury goods in that country; (4) the increased marketing of beer and other products to the Hispanic community; (5) the return of the practice of layaway in department stores; and (6) the effect of substitutes on Nestle bottled water. New examples of the non-price factors influencing supply include (1) the effect of new technology on pecan growers; (2) the impact of high pecan prices as inputs for bakers; (3) the impact of high oil prices on the supply of natural gas; and (4) the effect of Chinese demand on the number of lumber producers. The extensive numerical example on the copper industry that is used throughout Chapter 2 has been updated to reflect recent events in the copper industry. Chapter 3 begins with a new case on the relationship between Procter & Gamble’s pricing strategy and the price elasticity of demand. I have updated information on price elasticity for airline prices, gasoline, and illegal substances such as cocaine and heroin. The discussion of income elasticity now includes the demand for wines, while the cross-elasticity discussion includes the relationship between airline and automobile travel, which influenced the regulation of child airline safety seats, and A01_FARN0095_03_GE_FM. INDD 20 21/08/14 PM Preface 21 consumer demand for wireline and wireless phones. I have updated Table 3.7 with recent estimates of demand elasticity for food, water, and higher education. I have also increased the discussion of the relationship between the economic and marketing approaches to consumer demand, and I have updated an earlier marketing demand elasticity study included in previous editions. Chapter 4 presents a new case on how firms use cable television and Visa/Master Card information to better understand and impact consumer behavior. Although successful from the firm’s viewpoint, these strategies have raised concerns over the invasion of consumer privacy. In the discussion of marketing techniques to estimate consumer demand, I have drawn extensively on two major marketing references: Vithala R. Rao, Handbook of Pricing Research in Marketing, 2009, and Thomas T. Nagle et al., The Strategy and Tactics of Pricing, 5th ed., 2011. I have also updated the econometric references on estimating consumer demand, and I added a new case, “Case Study III: The Demand for Cheese in the United States.” I retained the case study of automobile demand and the illustrations of the use of consumer market data in econometric demand studies from the previous editions. In Chapter 5, I updated the opening case, “Production and Cost Analysis in the Fast-Food Industry,” by adding a discussion of fast-food delivery in various parts of the world. New productivity examples in the chapter include (1) the use of additional workers versus robots by Amazon and Crate & Barrel; (2) eliminating diminishing returns in hospital emergency rooms; (3) a discussion of Toyota’s quality problems; and (4) an updated discussion of overall industry productivity increases. Chapter 6 begins with a new case, “The i Phone in China,” that focuses on the long-run decisions of Apple Inc. to produce i Phones in China and the controversy that ­followed over working conditions in those Chinese factories. I also discuss the location and production decisions of smaller manufacturers such as Standard Motor Products of North Carolina. New examples of long-run production and cost decisions include (1) the use of robots in mining operations and hospitals; (2) crowdsourcing or farming out production tasks to the general public; (3) law firms’ increased use of software for the discovery process; (4) the trade-off between airline use of smaller jets to cut costs and increased time for refueling; and (5) the decreased use of bags in grocery stores. I also describe the limits of lean production that arose during the Japanese earthquake and tsunami, and I update the discussion of the use of nurseto-patient ratios to regulate hospital staffing decisions. Chapter 7 begins with an update of the case of the potato industry from the previous editions of the book. Earlier editions focused on how potato farmers attempted to move away from the competitive market, where they had very little control over price. They formed farmers’ cooperatives to help control production and keep prices high. These moves recently faced consumer challenges as price-fixing arrangements. I discuss other recent influences on the potato industry, including obesity concerns resulting from potato consumption and a move to eliminate white potatoes from federally subsidized school breakfasts and lunches. I also update the analysis of competitive strategies in the broiler chicken, red meat, milk, and trucking industries. The red meat industry discussion includes both the issues of “pink slime” and the National Cattlemen’s Beef Association’s MBA or Master of Beef Advocacy, a training program to promote and defend red meat. The theme in all of these cases is how firms deal with the volatility of the competitive market. Chapter 8 begins with a new case, “Changing Market Power for Eastman Kodak Co.,” which illustrates how the changing markets for cameras and film eroded the market power of this well-known company. In the section on the sources of market power, I have updated the discussion of mergers in the banking, beer, and airlines industries and examined mergers among pharmacy-benefit managers and law firms. New licensing examples include the case of interior decorators and the controversy over who can perform teeth whitening. I have updated the patent discussion with the case of Pfizer’s blockbuster drug Lipitor and the patent infringement A01_FARN0095_03_GE_FM. INDD 21 21/08/14 PM 22 Preface case between Apple Inc. The changing market power section now includes a discussion of how bricks-and-mortar retailers are fighting showrooming and the consumer use of phone apps to compare prices and then purchase online. I have updated the antitrust section with a discussion of the August 2010 revisions in the antitrust guidelines and the use of the Herfindahl-Hirschman Index (HHI). Although the Microsoft antitrust case was an important illustrative example in the two previous editions of the text, it has become dated. I replaced this case with a discussion of the failed merger of AT&T and T-Mobile in 2011. This case clearly illustrates for students the controversies over the existence and use of market power. This discussion is extended in the monopolistic competition section with an update on the cases of independent drugstores and booksellers. The opening case in Chapter 9 builds on the previous case of interdependent airline pricing behavior by adding current examples of oligopolistic strategies. I have also updated the examples of oligopolistic behavior between Coke and Pepsi; in the doughnut industry; and among DHL, Federal Express, and UPS. I added a discussion of the predatory pricing case of Spirit Airlines versus Northwest Airlines, included new references on cartel behavior, and updated the discussion of OPEC and the diamond cartel. Chapter 10 begins with the case, “Airline Pricing Strategies: Will They Start Charging for the Use of the Lavatories? ” This case illustrates revenue or yield management strategies where the airlines have unbundled their services and are charging separately for different services based on demand elasticity and consumer willingness to pay. I have extended this discussion throughout the chapter and have drawn extensively on articles in the Journal of Revenue and Pricing Management, a source that would be very useful for MBA students. As in Chapter 4, I have included more linkages with the marketing literature by including examples and citations from Vithala R. Rao, Handbook of Pricing Research in Marketing, and Thomas T. Nagle et al., The Strategy and Tactics of Pricing, 5th ed. I updated the discussion of major league baseball ticket pricing and peak load pricing with smart electric meters, and I added an example of revenue management by the Atlanta Symphony Orchestra. At the end of the chapter, I added material to the discussion of the macro impacts on pricing in 2011–2012. Part 2: Macroeconomic Analysis Part 2, Macroeconomic Analysis, continues with the framework in the second edition. After introducing the macroeconomic variables in Chapter 11, the text discusses real spending by individuals, firms, and governments (C I G X − M) in Chapter 12. This material draws on the analyses students see daily in the Wall Street Journal and other business publications. A discussion of money, money markets, and Federal Reserve policy is presented in Chapter 13. These elements are combined using the aggregate demand–aggregate supply (AD–AS) model in Chapter 14. Monetary and fiscal policy implementation issues are also presented in this chapter. Chapter 15 continues to focus on exchange rate and balance of payments issues and presents an updated discussion of controversies over the role of the euro and the Chinese yuan. However, as in the previous ­editions, and unlike the presentation in other texts, Economics for Managers, Third Edition, has an extensive discussion in both Chapters 14 and 15 of the impact of macro policy changes on the competitive strategies of both domestic and international firms. Given that the third edition was revised in 2012, I rewrote most of the macro discussion to reflect the substantial economic and policy changes during that period. The text continues to describe the impacts of policy changes in these areas on the U. This is a unique feature of this textbook, which makes it most appropriate for MBA students who will probably never make macroeconomic policy, but who will work in firms and industries influenced by these policy changes. INDD 22 21/08/14 PM Preface 23 The macro section of the second edition of Economics for Managers was revised just as the U. I updated the references for the national income and product accounts and for the underground economy (Chapter 11). I used 2011 data for all the tables, while the fi ­ gures show trends from 2000 to the first quarter of 2012. I updated the discussion of each component of GDP with recent data and events (Chapter 12), and I made extensive use of Federal Reserve Monetary Policy Reports to Congress and the reports and analyses by the Congressional Budget Office. All of the cases reflect the uncertainty about the U. and global economies in 2011–2012 and the slow recovery from the recession of 2007–2009. In the case in Chapter 13, “The Chairman’s Quandary,” I discuss the dilemma facing Federal Reserve officials in summer 2012 as they made decisions on future monetary policy. This discussion includes issues related to the continuation of historically low targeted interest rates, Operation Twist, future bond buying, and the use of public statements to achieve monetary policy goals. I also refer students to Federal Reserve Chairman Ben Bernanke’s 2012 College Lecture Series, The Federal Reserve and the ­Financial Crisis. In Chapter 14, I discuss recent fiscal policy issues, including the American R ­ ecovery and Reinvestment Act of 2009, the fiscal cliff debate in 2012, the impacts of fi ­ scal multipliers and how they are estimated, the role of automatic stabilizers, and the interactions between fiscal and monetary policies. On the supply side, I updated the discussion of productivity growth and the natural rate of unemployment. auto bailout in 2008–2009, and I discussed the impact of the uncertain economic recovery on managerial decisions in 2011–2012. I kept the section on the use of the aggregate macro model to explain changes in the economy from 2007 to 2008, but I added a similar discussion for the period 2011–2012. Chapter 15, which is built around the opening case, “Uncertainty in the World Economy in 2012,” focuses on the U. economy and international issues from 2010 to 2012. The chapter includes an analysis of the weakness in the Chinese economy, the worsening situation in Europe, and capital flows among industrialized and emerging economies. I have updated all tables and figures, included balance of payments data for 2011, and I updated the discussion and references on balance of p ­ ayment issues and the role of fixed versus flexible exchange rates. I include a discussion and extensive references on the euro zone situation that involves the banking crisis, the sovereign debt crisis, the growth crisis, and the issue of the sustainability of the euro, and I show the impact of the euro crisis on managerial decision making. I also updated the discussion of the Southeast Asia crisis from the second edition, and I have included recent policy issues related to the Chinese yuan. Part 3: Integration of the Frameworks As noted earlier in this section, in Part 3 we return to the issues first discussed in Chapter 1, the relationship between microeconomic and macroeconomic influences on managerial decision making. Chapter 16 presents the case, “Strong ­Headwinds for Mc Donald’s,” which examines the effects of changes in the microeconomic and macroeconomic environment on Mc Donald’s competitive strategies. I discuss current challenges facing the company and how these challenges were met in the past. I then broaden the discussion to include Mc Donald’s major rivals in the fast-food industry, Burger King, Subway, Wendy’s, and Starbucks, and I discuss the opportunities and challenges facing all of these companies as they enter emerging markets. I have added a discussion of how these companies are facing public health ­concerns over obesity, and I present a detailed discussion of the impact of regulations requiring calorie counts on menus. I have also kept a statistical study A01_FARN0095_03_GE_FM. INDD 23 21/08/14 PM 24 Preface of ­fast-food industry demand that was included in previous e­ ditions of the text. I discuss macroeconomic influences on the fast-food industry with details from the International Monetary Fund Global Economic Report in October 2012. The text ends by emphasizing its major theme: Changes in the macro environment affect individual firms and industries through the microeconomic factors of demand, production, cost, and profitability. Firms can either try to adapt to these changes or undertake policies to try to modify the environment itself. This theme is particularly important in this third edition of Economics for Managers, given the impact of the slow recovery from the 2007–2009 recession on the overall economy and on the strategies of different firms operating in this environment. Unique Features of the Text Chapter Opening Cases for Analysis Each chapter begins with a “Case for Analysis” section, which examines a case drawn from the current news media that illustrates the issues in the chapter. Thus, students begin the study of each chapter with a concrete, real-world example that highlights relevant economic issues, which are then explained with the appropriate economic theory. For example, Chapter 2 begins with a case on the copper industry that illustrates forces on both the demand and supply sides of the ­market that influence the price of copper and have caused that price to change over time. This example leads directly to a discussion of demand and supply functions and curves, the concept of equilibrium price and quantity, and changes in those equilibria. Within this discussion, I include numerous real-world examples to illustrate demand and supply shifters. The chapter concludes by reviewing how formal demand and s­ upply analysis relates to the introductory case. Students thus go from concrete examples to the relevant economic theory and then back to realworld examples. Interdisciplinary Focus Economics for Managers, Third Edition, continues to have an interdisciplinary focus. For example, Chapter 3 presents demand price elasticity estimates drawn from both the economics and marketing literature. Empirical marketing and economic approaches to understanding consumer demand are both discussed in Chapter 4. The production and cost analysis in Chapters 5 and 6 relates to topics covered in management courses, while the pricing discussion in Chapter 10 draws extensively on the marketing literature. Thus, the third edition of Economics for Managers is uniquely positioned to serve the needs of instructors who are trying to integrate both micro- and macroeconomic topics and who want to relate this material to other parts of the business curriculum. Focus on Global Issues Global and international examples are included in both the microeconomic and macroeconomic sections of the text. For example, Chapter 2 discusses how demand from China, an earthquake in Chile, and the financial crisis in Europe affected the copper industry. I revisit these international issues again in Chapters 15 and 16. Analyses of the impact of changing consumer demand, new production technologies, and rising input costs on both U. and international firms are included in many of the microeconomic chapters. Chapters 14 and 15 include discussions of the effects of U. and international macroeconomic policy changes on firms located around the world. INDD 24 21/08/14 PM Preface 25 As noted previously, Economics for Managers, Third Edition, takes the unique approach in Chapters 1 and 16 to discuss the impact of both microeconomic and macroeconomic factors on firms’ competitive strategies in international markets. The analysis of the global automobile industry in Chapter 1 and the fast-food industry in Chapter 16 helps students see how economic and political issues around the world impact managerial decision making. This integration of micro and macro tools in the global setting has been a key feature of all editions of Economics for Managers. Managerial Decision-Making Perspective Economics for Managers is developed from a firm and industry decision-making perspective. Thus, the demand and elasticity chapters focus on the implications of elasticity for pricing policies, not on abstract models of consumer behavior. To illustrate the basic models of production and cost, the text presents examples of cost-cutting and productivity-improving strategies that firms actually use. It discusses the concept of input substitution intuitively with examples, but places the formal isoquant model in an appendix to Chapter 6. The text then compares and contrasts the various models of market behavior, incorporating discussions and examples of the measurement and use of market power, most of which are drawn from the current news media and the industrial organization literature. Throughout the chapters you will find “Managerial Rule of Thumb” features, which are shortcuts for using specific concepts and brief descriptions of important issues for managers. For example, Chapter 3 contains several quick approaches for determining price and income elasticities of demand. Chapter 4 includes some key points for managers to consider when using different approaches to understanding consumer behavior. Although Economics for Managers, Third Edition, covers the models that include this policy-making perspective, the text also illustrates how the actions of these policy makers influence the decisions managers make in various firms and industries. Macroeconomics presents a particular challenge for managers because the subject matter is traditionally presented from the viewpoint of the decision makers, either the Federal Reserve or the U. This emphasis is important because most students taking an MBA economics course will never work or make policy decisions for the Federal Reserve or the U. government, but they are or will be employed by firms that are affected by these decisions and policies. End-of-Chapter Exercises As you will see, some of the end-of-chapter exercises are straightforward calculation problems that ask students to compute demand-supply equilibria, price elasticities, and profit-maximizing levels of output, for example. However, many exercises are broader analyses of cases and examples drawn from the news media. These exercises have a managerial perspective similar to the examples in the text. The goal is to make students realize that managerial decisions usually involve far more analysis than the calculation of a specific number or an “optimal” mathematical result. One of the exercises at the end of each chapter is related to the “Case for Analysis” discussed at the beginning of that chapter. Instructor Resource Center Economics for Managers is connected to the Instructor Resource Center available at Instructors can access a variety of print, digital, and presentation resources available with this text in downloadable A01_FARN0095_03_GE_FM. Registration is simple and gives you immediate access to new titles and new e­ ditions. As a registered faculty member, you can download resource files and receive immediate access and instructions for installing course management content on your campus server. If you ever need assistance, our dedicated technical support team is ready to help with the media supplements that accompany this text. Visit for answers to frequently asked questions and toll-free user support phone numbers. The following supplements are available to adopting instructors: • Instructor’s Manual • Test Item File also available in Test Gen software for both Windows and Mac ­computers • Power Point Presentations containing all figures and tables from the text Acknowledgments As with any major project, I owe a debt of gratitude to the many individuals who assisted with this book. I first want to thank my friend and colleague, Jon Mansfield, who worked with me in developing materials for the book. Jon and I have discussed the integration of microeconomics and macroeconomics for business students for many years as we both experimented with new ideas for teaching a combined course. We even team-taught one section of the course for EMBA students so that we could directly learn from each other. Jon is a great teacher, and his assistance in developing this approach has been invaluable. I next want to thank the generations of students I have taught, not only in the MBA and EMBA programs, but also in the Master of Public Administration, Master of Health Administration, and Master of Public Health programs at Georgia State. They made it quite clear that students in professional master’s degree programs are different from those in academic degree programs. Although these students are willing to learn theory, they have insisted, sometimes quite forcefully, that the theory must always be applicable to real-world managerial situations. I also want to thank my colleagues Professors Harvey Brightman and Yezdi Bhada, now retired from Georgia State’s Robinson College of Business, for their teaching seminars and for backing the approach I have taken in this book. I always knew that business and other professional students learned differently from economics students. Harvey and Yezdi provided the justification for these observations. I want to acknowledge the following graduate research assistants supported by the Department of Economics, Georgia State University, for their contributions to various editions of the text: Mercy Mvundura, Djesika Amendah, William Holmes, and Sarah Beth Link. They provided substantial assistance in finding the sources used in the text and in developing tables and figures for the book. in economics from the University of California, Berkeley. The Prentice Hall staff has, of course, been of immense help in developing the third edition of the text. For over 30 years, he specialized in teaching economics to students in professional master’s degree programs including the Master of Business Administration and Executive MBA, Master of Public Administration, Master of Health ­Administration, and Master of Public Health. INDD 30 21/08/14 PM Economics for Managers A01_FARN0095_03_GE_FM. I would especially like to thank David Alexander, Executive Editor, Pearson Economics, for his support and Lindsey Sloan, Senior Editorial Project Manager, Economics, Pearson Higher Education, who has been available to answer all my questions at every step of the project. in economics from Union College, Schenectady, New York, and his M. He has received both teaching awards and outstanding student evaluations at Georgia State. Farnham’s research focused first on issues related to the economics of state and local governments and then on public health economic evaluation issues where he has published articles in a variety of journals. INDD 31 21/08/14 PM Part 1 Microeconomic Analysis 1 Managers and Economics W hy should managers study economics? I would also like to thank Fran Russello, Pearson Production Manager, and Anand Natarajan, Project Manager at Integra Software Services, for their assistance in producing the text. INDD 26 21/08/14 PM Preface 27 I would like to thank all those who assisted with supporting materials. Finally, I want to thank my wife, Lynn, and daughters, Ali and Jen, for bearing with me during the writing of all editions of this text. Farnham Pearson would like to thank and acknowledge the following people for their work on the Global Edition. Farnham is Associate Professor Emeritus of Economics at Georgia State University. He co-authored three editions of Cases in Public Policy Analysis (1989, 2000, and 2011), contributed to both editions of Prevention ­Effectiveness: A Guide to Decision Analysis and Economic Evaluation (1996, 2003), and wrote a chapter for the Handbook of Economic Evaluation of HIV Prevention Programs (1998). Many of you are probably asking yourself this question as you open this text. Professor Leonie Stone of SUNY Geneseo contributed to the end-of-chapter questions in the micro section of the text. Sparks, The Citadel; Kasaundra Tomlin, Oakland University; Doina Vlad, Seton Hill University; John E. For her contribution: CHAN Ka Yu Yuka, The Open University of Hong Kong. He is currently a Senior Service Fellow in the Division of HIV/AIDS Prevention at the Centers for Disease Control and Prevention in Atlanta. Students in Master of Business Administration (MBA) and Executive MBA programs usually have some knowledge of the topics that will be covered in their accounting, marketing, finance, and management courses. I also want to acknowledge the assistance of all the reviewers of the various drafts of the text. And for their reviews: Erkan Ilgün, International Burch University; Rajkishan Nair, IILM Graduate School of Management; Ozlem Olgu Akdeniz, College of Administrative Sciences and Economics. You may have already used many of those skills on the job or have decided that you want to concentrate in one of those areas in your program of study. Although you may have taken one or two introductory economics courses at some point in the past, most of you are not going to become economists. These include: Gerald Bialka, University of North Florida; John Boschen, College of William and Mary; Vera Brusentsev, University of Delaware; Chun Lee, Loyola Marymount University; Mikhail Melnik, Niagara University; Franklin E. From these economics classes, you probably have vague memories of different graphs, algebraic equations, and terms such as elasticity of demand and marginal propensity to consume. However, you may have never really understood how economics is relevant to managerial decision making. As you’ll learn in this chapter, managers need to understand the insights of both microeconomics, which focuses on the behavior of ­individual consumers, firms, and industries, and macroeconomics, which analyzes issues in the overall economic environment. Although these subjects are typically taught separately, this text presents the ideas from both approaches and then integrates them from a managerial decision-making perspective. As in all chapters in this text, we begin our analysis with a case study. INDD 32 11/08/14 PM Case for Analysis Micro- and Macroeconomic Influences on the Global Automobile Industry In September 2012, U. automobile sales increased to 1.19 million cars and light trucks per month, a 12.8 percent increase from a year earlier. The case in this chapter, which focuses on the global automobile industry, provides an overview of the issues we’ll discuss throughout this text. This increase represented an annualized rate of 14.94 million vehicles, the highest sales rate since March 2008 before the recession began in the United States. In particular, the case illustrates how the automobile industry is influenced by both the microeconomic issues related to production, cost, and consumer demand and the larger macroeconomic issues including the uncertainty in global economic activity, particularly in Europe, and the value of various countries’ currencies relative to the U. Much of the increase was driven by passenger car sales at Toyota Motor Corp., Honda Motor Co., and Chrysler Group LLC. There was a significant increase in sales for Toyota and Honda from the previous year, as both companies were recovering from the earthquake that hit Japan in March 2011.1 Analysts noted similar increases in August 2012 that were attributed to pent-up consumer demand for replacing aging vehicles and the lowinterest financing and other incentives Japanese auto makers offered to regain market share lost in 2011 due to the lack of availability of their cars.2 Automobile production in the United States had expanded in 2012, given favorable foreign exchange rates and a plentiful supply of affordable labor. all increased their production capacity in the United States with the goal of shipping automobiles to Europe, Korea, the Middle East, and other countries. The strong value of the yen, and conversely the weak U. dollar, gave Japanese producers the incentive to produce cars in the United States for export around the world. automobile industry revived, the competition between Ford and GM again became more intense. This investment by foreign automobile producers helped the U. economy that was still struggling to recover from the recession of 2007–2009. market in 2009, 50.2 percent in 2010, and 50.8 percent in 2011. In 2008, Ford supported the government bailout for GM and Chrysler because Ford was worried that a collapse of these companies would also impact the auto parts industry. Automobile industry employment in the United States was estimated to increase from 566,400 in 2010 to 756,800 in 2015. auto producers, who had once essentially lost the competition to their Japanese rivals in the 1980s and 1990s and who went through government-backed (GM and Chrysler) or private (Ford) restructurings during the U. recession, ­regained profitability and invested in the engineering and redesign of their cars. economy recovered, Americans also began purchasing more trucks and sport-utility vehicles (SUVs), which helped to restore profits and market share for the Detroit auto makers. This segment of the market had been hit particularly hard during the U. As the domestic auto industry recovered, Ford, which had often focused just on Toyota as its key competitor, began developing strategies to counter GM. White, Jeff Bennett, and Lauren Weber, “Car Makers’ U-Turn Steers Job Gains,” Wall Street Journal (Online), January 23, 2012; Neal Boudette, “New U. Car Plants Signal Renewal for Manufacturing,” Wall Street Journal (Online), January 26, 2012. Although these estimates were well below the 1.1 million automobile workers employed in 1999, they indicated that the economic recovery was moving forward. Car Sales Surge,” Wall Street Journal (Online), September 4, 2012. Several Fords were designed with a voiceoperated Sync entertainment system, and the Chevrolet Cruze that was launched in 2010 came with 10 air bags compared with 6 for the Toyota Corolla. Ford realized that customers who had long been loyal to Asian brands were again looking at U. cars, given the generally perceived quality increases in the U. 4 Mike Ramsey and Sharon Terlep, “Americans Embrace SUVs Again,” Wall Street Journal (Online), December 2, 2011; Jeff Bennett and Neal E. General Motors Co., which had once encouraged auto parts 1 Jeff Bennett, “Corporate News: Passenger Cars Lift U. Sales— Big Gains for Toyota, Honda, Chrysler: Pickup Weakness Weighs on GM, Ford,” Wall Street Journal (Online), October 3, 2012. suppliers to relocate in low-wage countries, now encouraged them to locate near U. Boudette, “Revitalized Detroit Makes Bold Bets on New Models,” Wall Street Journal (Online), January 9, 2012. 5 Sharon Terlep and Mike Ramsey, “Ford and GM Renew a Bitter Rivalry,” Wall Street Journal (Online), November 23, 2011. INDD 33 11/08/14 PM 34 Part 1 Microeconomic Analysis Japanese auto makers in 20 faced managerial decisions that were influenced both by the nature of the competition from their rivals and by macroeconomic conditions, most importantly the value of the exchange rate between the yen and the U. dollar.6 Production by both Toyota and Honda was hit by the earthquake and tsunami in Japan in March 2011 and by subsequent flooding in Thailand that disrupted the supply of electronics and other auto parts made there. Toyota sales were also influenced by the recall and quality issues in 2010 related to the gas pedal and floor mat design. Honda’s redesigned 2012 Civic was criticized for its technology and lessthan-luxurious interior. The car was dropped from Consumer Reports’ recommended list in August 2011. The strong yen, which made exports from Japan less price competitive, also gave the Japanese producers the incentive to produce their cars in the United States. Honda officials acknowledged that they had underestimated the competition from U. Honda, which had produced 1.29 million vehicles in North America in 2010, planned to open a new plant in Mexico and expand production in all seven of its existing assembly plants to 2 million cars and trucks per year. Production abroad was a particular issue for Toyota, which made half of its automobiles in Japan, compared to Honda and Nissan, which produced about one-third of their output in Japan. The president of Toyota, Akio Toyoda, grandson of the company founder, had made a public commitment to build at least 3 ­million cars in Japan annually, half of which would be for export. Some company officials argued for streamlining production in Japan by decreasing production without raising costs, essentially redefining the economies of scale in the company’s production process. These officials believed the ­company could meet domestic goals with high-precision production, cost-­cutting, and collaboration on new technology with parts suppliers. Auto producers also focused on China during this period, although there was concern about the slowing Chinese economy.7 Auto sales in China increased only 2.5 percent in 2011 compared with increases of 46 percent in 2009 and 32 percent 6 The following discussion is based on Jeff Bennett and Neal E. Boudette, “Revitalized Detroit Makes Bold Bets on New Models”; Mike Ramsey and Yoshio Takahashi, “Car Wreck: Honda and Toyota,” Wall Street Journal (Online), November 1, 2011; Chester Dawson, “For Toyota, Patriotism and Profits May Not Mix,” Wall Street Journal (Online), November 29, 2011; Mike Ramsey and Neal E. Boudette, “Honda Revs Up Outside Japan,” Wall Street Journal (Online), December 21, 2011; and Yoshio Takahashi and Chester Dawson, “Japan Auto Makers on a Roll,” Wall Street Journal (Online), April 22, 2012. However, the size of the Chinese economy continued to be the major incentive for expansion in that country. 7 This discussion is based on Andrew Galbraith, “Car Makers Still Look to China,” Wall Street Journal (Online), April 19, 2012; Sharon Terlep and Mike Ramsey, “Ford Bets Billion on Made in China,” Wall Street Journal (Online), April 20, 2012; Chester Dawson and Sharon Terlep, “China Ramps Up Auto Exports,” Wall Street Journal (Online), April 24, 2012; and Sharon Terlep, “Balancing the Give and Take in GM’s Chinese Partnership,” Wall Street Journal (Online), August 19, 2012. In April 2012, Ford announced that it would build its fifth factory in eastern China as part of its plan to double its production capacity and sales outlets in the country by 2015. This production increase would make the company capable of producing 1.2 million passenger cars in China, approximately half of the number of cars it built in North America in 2011. Ford lagged behind other major auto producers in entering the world’s largest car market. Ford’s strategy was to build cars from platforms developed elsewhere to minimize costs. However, these platforms might not provide enough space in the back seats to appeal to affluent Chinese, who often employed drivers. General Motors developed a partnership with Chinese SAIC Motor Corp. to become the dominant foreign competitor in China. This partnership resulted in production changes such as designing Cadillacs with softer corners, dashboards with more gadgets, and increasing the comfort of the rear seats to appeal to Chinese consumers. In 2012, the Chinese automobile industry began increasing exports, although these were not thought to be a threat in developed markets in the United States and Europe, given perceived quality issues including lack of air-conditioning and power windows. The challenge for GM was that SAIC could also use GM’s expertise and technology to make itself a major competitor with the U. However, Chinese producers were making inroads into emerging markets in Africa, Asia, and Latin America. The other major influence on the global auto industry in 20 was the recession and economic crisis in Europe.8 In October 2012, Ford announced a plan to cut its operating losses in Europe by closing three auto-assembly and parts factories in the region, reduce its workforce by 13 percent, and decrease automobile production by 18 percent. Ford predicted a loss of S.5 billion in Europe in 2012 and a similar loss in 2013. The cost-cutting in Europe was combined with the introduction of several new commercial vans and SUVs and the introduction of the Mustang sports car for the first time. All European auto makers faced decreased car sales and chronic overcapacity at this time. Daimler AG, maker of Mercedes Benz automobiles, announced that it would not achieve its profit targets, while PSA Peugeot Citroen SA announced a government bailout of its financing arm and a cost-sharing pact with General Motors. There had been a smaller decrease in auto-producing capacity in Europe since the 2008 financial crisis compared with that during the restructuring of the U. auto industry that was influenced by the federal government bailout. 8 This discussion is based on Sharon Terlep and Sam Schechner, “GM, Peugeot Take Aim at Europe Woes,” Wall Street Journal (Online), July 12, 2012; Mike Ramsey, David Pearson, and Matthew Curtin, “Daimler Warns as Europe Car Makers Cut Back,” Wall Street Journal (Online), October 24, 2012; and Marietta Cauchi and Mike Ramsey, “Ford to Shut 3 Europe Plants,” Wall Street Journal (Online), October 25, 2012. 11/08/14 PM chapter 1 Managers and Economics 35 Two Perspectives: Microeconomics and Macroeconomics As noted above, microeconomics is the branch of economics that analyzes the ­decisions that individual consumers and producers make as they operate in a market economy. When microeconomics is applied to business decision making, it is called managerial economics. The key element in any market system is pricing, because this type of system is based on the buying and selling of goods and services. As we’ll discuss later in the chapter, prices—the amounts of money that are charged for different goods and services in a market economy—act as signals that influence the behavior of both consumers and producers of these goods and services. Managers must understand how prices are determined—for both the ­outputs, or products sold by a firm, and the inputs, or resources (such as land, labor, capital, raw materials, and entrepreneurship) that the firm must purchase in order to produce its output. Output prices influence the revenue a firm derives from the sale of its products, while input prices influence a firm’s costs of production. As you’ll learn throughout this text, many managerial actions and decisions are based on expected responses to changes in these prices and on the ability of a manager to influence these prices. Managerial decisions are also influenced by events that occur in the larger economic environment in which businesses operate. Changes in the overall level of economic activity, interest rates, unemployment rates, and exchange rates both at home and abroad create new opportunities and challenges for a firm’s competitive strategy. This is the subject matter of macroeconomics, which we’ll cover in the second half of this text. Managers need to be familiar with the underlying macroeconomic models that economic forecasters use to predict changes in the macroeconomy and with how different firms and industries respond to these changes. Most of these changes affect individual firms via the pricing mechanism, so there is a strong connection between microeconomic and macroeconomic analysis.9 In essence, macroeconomic analysis can be thought of as viewing the economy from an airplane 30,000 feet in the air, whereas with microeconomics the observer is on the ground walking among the firms and consumers. While on the ground, an observer can see the interaction between individual firms and consumers and the competitive strategies that various firms develop. At 30,000 feet, however, an observer doesn’t see the same level of detail. In macroeconomics, we analyze the behavior of individuals aggregated into different sectors in the economy to determine the impact of changes in this behavior on the overall level of economic activity. In turn, this overall level of activity combines with changes in various macro variables, such as interest rates and exchange rates, to affect the competitive strategies of individual firms and industries, the subject matter of microeconomics. Let’s now look at these microeconomic influences on managers in more detail. Microeconomics The branch of economics that ­analyzes the decisions that ­individual consumers, firms, and ­industries make as they produce, buy, and sell goods and services. Managerial economics Microeconomics applied to ­business decision making. Prices The amounts of money that are charged for goods and services in a market economy. Prices act as ­signals that influence the behavior of both consumers and producers of these goods and services. Outputs The final goods and services ­produced and sold by firms in a market economy. Inputs The factors of production, such as land, labor, capital, raw materials, and entrepreneurship, that are used to produce the outputs, or final goods and services, that are bought and sold in a market economy. Macroeconomics The branch of economics that focuses on the overall level of ­economic activity, changes in the price level, and the amount of ­unemployment by analyzing group or aggregate behavior in different sectors of the economy. 9 Note that the terms micro and macro are used differently in various business disciplines. For example, in Marketing Management, The Millennium Edition (Prentice Hall, 2000), Philip Kotler describes the “macro environment” as dealing with all forces external to the firm. His examples include both (1) the gradual opening of new markets in many countries and the growth in global brands of various products (microeconomic factors for the economist) and (2) the debt problems of many countries and the fragility of the international financial system (macroeconomic problems from the economic perspective). In each business discipline, you need to learn how these terms and concepts are defined. INDD 35 11/08/14 PM 36 Part 1 Microeconomic Analysis Microeconomic Influences on Managers Relative prices The price of one good in relation to the price of another, similar good, which is the way prices are defined in microeconomics. The discussion of the global automobile industry in the opening case illustrates several microeconomic factors influencing managerial decisions. In 2012, Japanese auto makers used low-interest financing and other incentives to regain market share lost in previous years. auto makers reengineered and redesigned their production processes to add features with greater customer appeal. Toyota had to recover from the impact of its recall and negative quality issues in 2010, while Honda stumbled on the redesign of its 2012 Civic by not incorporating features offered by its competitors. They also responded to the increased demand for trucks and SUVs, a market segment that had been negatively impacted by the recession. Ford and GM began reengaging in their traditional market rivalry. All producers who planned to sell in China, the world’s largest automobile market, had to recognize the difference in tastes and preferences of Chinese consumers, such as the desire for larger back seats. Decisions about demand, supply, production, and market structure are all microeconomic choices that managers must make. Some decisions focus on the factors that affect consumer behavior and the willingness of consumers to buy one firm’s product as opposed to that of a competitor. Thus, managers need to understand the variables influencing consumer demand for their products. Because consumers typically have a choice among competing products, these choices and the demand for each product are influenced by relative prices, the price of one good in relation to that of another, similar good. Relative prices are the focus of microeconomic analysis. The Japanese auto makers’ use of low-interest financing and other pricing incentives noted above is an example of a strategy based on influencing relative prices. All auto makers discussed in the case had to respond to changing consumer demand over time and to variations in consumer tastes and preferences that influenced demand in different countries. Production technology and the prices paid for the resources used in production influence a company’s final costs of production. The relative prices of these resources or factors of production will influence the choices that managers make among different production methods. Whether a production process uses large amounts of plant and equipment relative to the amount of workers and whether a business operates out of a small office or a giant factory are microeconomic production and cost decisions managers must make. used production platforms developed elsewhere to minimize its production costs as it entered the Chinese market. However, this cost-minimizing strategy was not appropriate for producing cars with larger back seats that appealed to affluent Chinese customers. General Motors also had to redesign its Cadillac to meet Chinese demand. Markets Markets The institutions and mechanisms used for the buying and selling of goods and services. The four major types of markets in microeconomic analysis are perfect c­ ompetition, monopolistic competition, ­oligopoly, and monopoly. All of the auto makers in the opening case made strategic decisions in light of their knowledge of the market environment or structure. INDD 36 Perfect competition Monopolistic competition Oligopoly Monopoly 11/08/14 PM chapter 1 Managers and Economics 37 Large Number of Firms Perfect Competition Single Firm Monopolistic Competition Oligopoly Monopoly Figure 1.1 Market Structure These market structures can be located along a continuum, as shown in Figure 1.1. Markets, the institutions and mechanisms used for the buying and selling of goods and services, vary in structure from those with hundreds or thousands of buyers and sellers to those with very few participants. At the left end of the continuum, there are a large number of firms in the market, whereas at the right end of the continuum there is only one firm. These different types of markets influence the strategic decisions that managers make because markets affect both the ability of a given firm to influence the price of its product and the amount of independent control the firm has over its actions. (We’ll discuss other characteristics that distinguish the markets later in the chapter.) The two market structures at the ends of the continuum, perfect competition and monopoly, are essentially hypothetical models. There are four major types of markets in microeconomic analysis: 1. No real-world firms meet all the assumptions of perfect competition, and few could be classified as monopolies. However, these models serve as benchmarks for analysis. All real-world firms contain combinations of the characteristics of these two models. Managers need to know where their firm lies along this continuum because market structure will influence the strategic variables that a firm can use to face its competition. The major characteristics that distinguish these market structures are 1. The number of firms competing with one another that influences the firm’s control over its price 2. Whether the products sold in the markets are differentiated or undifferentiated 3. A large number of firms in the market An undifferentiated product Ease of entry into the market Complete information available to all market participants In perfect competition, we distinguish between the behavior of an individual firm and the outcomes for the entire market or industry, which represents all firms producing the product. Whether entry into and exit from the market by other firms is easy or difficult 4. Economists make the assumption that there are so many firms in a perfectly competitive industry that no single firm has any influence on the price of the product. The amount of information available to market participants The Perfect Competition Model The model of perfect competition, which is on the left end of the continuum in Figure 1.1, is a market structure characterized by 1. For example, in many agricultural industries, whether an individual farmer produces more or less product in a given season has no influence on the price of these products. The individual farmer’s output is small relative to the entire market, so the market price is determined by the actions of all farmers supplying the product and all consumers who purchase the goods. Because individual producers can sell any amount of output they bring to market at that price, we characterize the perfectly competitive firm as a price-taker. This firm does not have to lower its price to sell more output. In fact, it cannot influence the price of its product. However, if the price for the entire amount of output in the market increases, consumers will buy less, and if the market price of the product decreases, they will buy more. In the model of perfect competition, economists also assume that all firms in an industry produce the same homogeneous product, so there is no product differentiation. For example, within a given grade of an agricultural product, potatoes or peaches are undifferentiated. This market characteristic means that consumers do not care about the identity of the specific supplier of the product they purchase. They may not even know who supplies the product, and that knowledge would be irrelevant to their purchase decision, which will be based largely on the price of the product. INDD 37 Perfect competition A market structure c­ haracterized by a large number of firms in an ­industry, an undifferentiated ­product, ease of entry into the market, and complete information available to participants. Price-taker A characteristic of a perfectly competitive firm in which the firm cannot influence the price of its product, but can sell any amount of its output at the price established by the market. 11/08/14 PM 38 Part 1 Microeconomic Analysis Profit The difference between the total revenue that a firm receives for ­selling its product and the total cost of producing that product. Market power The ability of a firm to influence the prices of its products and develop other competitive strategies that enable it to earn large profits over longer periods of time. Imperfect competition Market structures of ­monopolistic competition, oligopoly, and ­monopoly, in which firms have some degree of market power. Monopoly A market structure characterized by a single firm producing a product with no close substitutes. Barriers to entry Structural, legal, or regulatory ­characteristics of a firm and its market that keep other firms from easily producing the same or similar products at the same cost. Monopolistic competition A market structure characterized by a large number of small firms that have some market power as a result of producing differentiated products. Oligopoly A market structure characterized by competition among a small number of large firms that have market power, but that must take their rivals’ actions into account when developing their own competitive strategies. INDD 38 The third assumption of the perfectly competitive model is that entry into the industry by other firms is costless. This means that if a perfectly competitive firm is making a profit (earning revenues in excess of its costs), other firms will also enter the industry in an attempt to earn profits. However, these actions will compete away excess profits for all firms in a perfectly competitive industry. The final assumption of the perfectly competitive model is that complete information is available to all market participants. This means that all participants know which firms are earning the greatest profits and how they are doing so. Thus, other firms can easily emulate the strategies and techniques of the profitable firms, which will result in greater competition and further pressure on any excess profits. While the details of this process will be described in later chapters, these four assumptions mean that perfectly competitive firms have no market power—the ability to influence their prices and develop other competitive strategies that allow them to earn large profits over longer periods of time. All of the other market structures in Figure 1.1 represent imperfect competition, in which firms have some degree of market power. How much market power these firms have and how they are able to maintain it differ among the market structures. The Monopoly Model At the right end of the market structure continuum in Figure 1.1 is the monopoly model, in which a single firm produces a product for which there are no close substitutes. Thus, as we move rightward along the continuum, the number of firms producing the product keeps decreasing until we reach the monopoly model of one firm. A monopoly firm typically produces a product that has characteristics and qualities different from the products of its competitors. This product differentiation often means that consumers are willing to pay more for this product because similar products are not considered to be close substitutes. In the monopoly model, there are also barriers to entry, which are structural, legal, or regulatory characteristics of the market that keep other firms from easily producing the same or similar products at the same cost and that give a firm market power. However, while market power allows a firm to influence the prices of its products and develop competitive strategies that enable it to earn larger profits, a firm with market power cannot sell any amount of output at a given market price, as in perfect competition. If a monopoly firm raises its price, it will sell less output, whereas if it lowers its price, it will sell more output. The Monopolistic Competition and Oligopoly Models The intermediate models of monopolistic competition and oligopoly in Figure 1.1 better characterize the behavior of real-world firms and industries because they represent a blend of competitive and monopolistic behavior. In monopolistic ­competition, firms produce differentiated products, so they have some degree of market power. However, because these firms are closer to the left end of the continuum in Figure 1.1, there are many firms competing with one another. Each firm has only limited ability to earn above-average profits before they are competed away over time. In oligopoly markets, a small number of large firms dominate the market, even if other producers are present. Mutual interdependence is the key characteristic of this market structure because firms need to take the actions of their rivals into a­ ccount when developing their own competitive strategies. Oligopoly firms typically have market power, but how they use that power may be limited by the ­actions and reactions of their competitors. The opening case of this chapter did not explicitly discuss the market structure of the major auto producers. automobile sales were at an annualized rate of 14.94 million vehicles in 2012. The Goal of Profit Maximization In all of the market models we have just presented, we assume that the goal of firms is profit maximization, or earning the largest amount of profit possible. However, because all of these firms are large multinational companies that sell globally, they obviously have substantial market power 11/08/14 PM chapter 1 Managers and Economics 39 and are located far from the model of perfect competition on the continuum in Figure 1.1. Large national or multinational companies typically find themselves operating in multiple markets, making the analysis of market structure more complicated as the market environment may differ substantially among these markets. Because profit, as defined above, represents the difference between the revenues a firm receives for selling its output and its costs of production, firms may develop strategies to either increase revenues or reduce costs in an effort to increase profits. If firms in one sector of the economy earn above-average profits, other firms will ­attempt to produce the same or similar products to increase their profitability. Each of these markets has its own characteristics in terms of the number and size of the competitors and product characteristics. Thus, resources will flow from areas of low to high profitability. As we will see, however, the increased competition that results from this process will eventually lead to lower prices and revenues, thus eliminating most or all of these excess profits. Profitability is the standard by which firms are judged in a market economy. Profitability affects stock prices and investor decisions. If firms are unprofitable, they will go out of business, be taken over by other more profitable companies, or have their management replaced. Subsequently, we model a firm’s profit-­maximization decision largely in terms of static, single-period models where information on consumer behavior, revenues, and costs is known with certainty. Real-world managers must deal with uncertainty in all of these areas, which may lead to less-than-optimal decisions, and managers must be concerned with maximizing the firm’s value over time. The models we present illustrate the basic forces influencing managerial decisions and the key role of profits as a motivating incentive. Profit maximization The assumed goal of firms, which is to develop strategies to earn the largest amount of profit possible. This can be accomplished by focusing on revenues, costs, or both. Managerial Rule of Thumb Microeconomic Influences on Managers To develop a competitive advantage and increase their firm’s profitability, managers need to understand: How consumer behavior affects their revenues How production technology and input prices affect their costs How the market and regulatory environment in which managers operate influences their ability to set prices and to respond to the strategies of their competitors ■ Macroeconomic Influences on Managers The discussion of the impact of the global recession, the continued problems in Europe’s financial recovery, and the role of currency exchange rates in the case that opened this chapter can be placed within the circular flow model of M01_FARN0095_03_GE_C01. INDD 39 Circular flow model The macroeconomic model that portrays the level of economic activity as a flow of expenditures from consumers to firms, or ­producers, as consumers purchase goods and services produced by these firms. This flow then returns to consumers as income received from the production process. 11/08/14 PM 40 Part 1 Microeconomic Analysis Figure 1.2 GDP and the Circular Flow C = consumption spending I = investment spending G = government spending X = export spending M = import spending Y = household income S = household saving TP = personal taxes TB = business taxes Foreign Sector X M Domestic Markets for Currently Produced Goods and Services C Revenue I G Household Sector TP S Government Sector Borrowing Borrowing TB Firm Sector Borrowing Financial Markets Y Income: Wages, Rent, Interest, Profit Absolute price level A measure of the overall level of prices in the economy. Personal consumption­ ­expenditures (C) The total amount of spending by households on durable goods, nondurable goods, and services in a given period of time. Gross private domestic ­investment spending (I) The total amount of spending on nonresidential structures, ­equipment, software, residential structures, and business inventories in a given period of time. INDD 40 Expenses Resource Markets macroeconomics, shown in Figure 1.2. This model portrays the level of economic activity in a country as a flow of expenditures from the household sector to business firms as consumers purchase goods and services currently produced by these firms and sold in the country’s output markets. This flow then returns to consumers as ­income received for supplying firms with the inputs or factors of production, ­including land, labor, capital, raw materials, and entrepreneurship, which are bought and sold in the resource markets. These payments, which include wages, rents, interest, and profits, become consumer income, which is again used to purchase goods and services—hence, the name circular flow. Figure 1.2 also shows spending by firms, by governments, and by the foreign sector of the economy. Corresponding to these total levels of expenditures and income are the amounts of output produced and resources employed. The levels of expenditures, income, output, and employment in relation to the total capacity of the economy to produce goods and services will determine whether resources are fully employed in the economy or whether there is unemployed labor and excess plant capacity. This relationship will also determine whether and how much the absolute price level in the economy is increasing. The absolute price level is a measure of the overall price level in the economy as compared with the microeconomic concept of relative prices, which refers to the price of one particular good compared to that of another, as we discussed earlier. Economists use the circular flow model in Figure 1.2 to define and analyze the spending behavior of different sectors of the economy, including Personal consumption expenditures (C) by all households on durable goods, nondurable goods, and services Gross private domestic investment spending (I) by households and firms on nonresidential structures, equipment, software, residential structures, and inventories 11/08/14 PM chapter 1 Managers and Economics 41 Federal, state, and local government consumption expenditures and gross investment (G) Net export spending (F) or total export spending (X) minus total import spending (M) Consumption spending (C) is largely determined by consumer income (Y), but it is also influenced by other factors such as consumer confidence, as noted below. Much business investment spending (I) is derived from borrowing in the financial markets and is, therefore, affected by prevailing interest rates. The availability of funds for borrowing is influenced by the amount of income that consumers save (S) or do not spend on goods and services.10 Some consumer income (Y) is also used to pay personal taxes (TP) to the government sector to finance the purchase of its goods and services. The government also imposes taxes on business (TB). If government spending (G) exceeds the total amount of taxes collected (T = TP TB), the resulting deficit must be financed by borrowing in the financial markets.

date: 25-Aug-2021 22:01next


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