Managerial Economics

M. J. ALHABEEB, PhD, is Professor of Economics and Finance in the Department of Resource Economics at the University of Massachusetts, Amherst. Dr. Alhabeeb has been teaching finance and economics for over thirty years and is a recipient of the Academy of Educational Leadership’s Outstanding Teaching Award for Innovative and Creative Teaching.L. JOE MOFFITT, PhD, is Professor in the Department of Resource Economics at the University of Massachusetts, Amherst. The author of over fifty journal articles, Dr. Moffitt received his PhD.

• PREFACE xixUNIT I METHODOLOGICAL PRELIMINARIES1 Qualitative Fundamentals 31.1 Economic Theory and Managerial Economics 31.2 Some Methodological Fallacies 51.3 Paradigms, Models, and the Scientific Method 61.4 The Descriptive and Prescriptive Treatments 81.5 The Profit Function: Accounting versus Economics 81.6 Entrepreneurship, Management, and Leadership 9Summary 11Key Terms 12Exercises 122 Quantitative Fundamentals 132.1 Introduction 132.2 Functions 142.3 Exponents 162.4 Logarithms and the Number e 182.5 Differential Calculus 192.6 Multivariate and Equality Constrained Optimization 222.7 Inequality Constrained Optimization: Linear Programming 302.8 Selected Statistical Concepts 302.9 Maximum Likelihood Estimation 362.10 Ordinary and Nonlinear Least Squares Estimation 37Summary 38Key Terms 40List of Formulas 40Exercises 42UNIT II DECISIONS AT THE CONSUMER LEVEL3 Theory of Consumer Choice 473.1 Consumer Preferences 473.1.1 Indifference Curve 503.1.2 Marginal Rate of Substitution (MRS) 523.1.3 Nontypical Indifference Curves 553.2 Consumer’s Affordability 583.2.1 Budget Line 583.2.2 Slope of the Budget Line 603.2.3 Shift, Swing, and Kink of the Budget Line 60The Shift 60The Swing 63The Kink 643.2.4 Three-Dimensional Budget 663.3 The Optimal Choice 683.3.1 Interior and Corner Solutions 693.3.2 Utility and Its Measurability 713.3.3 Utility Maximization 763.4 Effects on the Optimal Choice 813.4.1 Change in Income 81Normal and Inferior Commodities 82Income–Consumption Curve 83Engel Curve: Nominal and Real 83Engel Curve and Income–Consumption Curve for Homothetic and Quasi-Linear Preferences 85Income Elasticity of Demand 863.4.2 Change in Prices 88Giffen and Non-Giffen Commodities 90Price–Consumption Curve 90Price Change and the Demand Curve 91Price Elasticity of Demand 91Substitutes and Complements 93Cross-Price Elasticity of Demand 943.5 Income and Substitution Effects 953.6 Slutsky Equation 96Summary 98Key Terms 99List of Formulas 99Exercises 1014 Consumer Demand: Theoretical Analysis 1034.1 Demand and Supply: Functions and Laws 1034.2 Deriving a Demand Function from Utility Maximization 1054.3 Homogeneity and the Numeraire 1094.4 Inverse Demand Function 1114.5 Demand and Supply: Table and Curves 1114.6 Market Equilibrium 1144.7 From Individual to Market Demand 1204.8 Demand and Network Externalities 1224.8.1 The Case of the Bandwagon Effect 1224.8.2 The Case of the Snob Effect 1244.9 Deriving a Market Demand Function under Externalities 1264.10 Changes in QD and QS versus Changes in D and S 1294.11 Changes in Equilibrium 1314.11.1 The Case of Thanksgiving Turkey 1324.11.2 The Case of Sales and Excise Taxes 1344.12 Market Disequilibrium 1384.12.1 The Case of a Price Ceiling 1394.12.2 The Case of a Price Floor 1424.13 Marshallian versus Hicksian Demand Curves 1444.13.1 Shephard Lemma and the Expenditure Function 1454.14 Deriving the Hicksian (Compensated) Demand Curve 1474.15 Revealed Preferences 1494.16 Interdependent Demand 152Summary 155Key Terms 157List of Formulas 157Exercises 1575 Consumer Demand: Empirical Estimation 1605.1 Simple Market Experimentation 1605.2 Linearity of the Demand Function: From Visual to Regression 1635.3 Reliability of the Estimation 1685.4 Quality of Fitting 1705.5 Fitting by Computerized Regression 1725.6 Demand Estimation by the Multiple Regression Method 1745.6.1 Results and Interpretation 1795.6.2 Goodness of Fit 1815.6.3 The Overall Explanatory Power of the Model 1825.6.4 Major Problems to Check On 183Multicollinearity 183Autocorrelation 184Heteroscedasticity 1855.7 Nonregression Approaches to Estimation 1865.7.1 Market Experimentation 1865.7.2 Observational Studies 1875.7.3 Micromarketing and Virtual Shopping 1875.8 Advanced Demand Estimation: The Pad Model 1885.8.1 Model Specification 188Desired Demand 188Adjustment Equation 188Estimating Equation 1895.8.2 Graph of the Linear PAD Model 189Summary 196Key Terms 196List of Formulas 196Exercises 1986 Consumer Demand: Economic Forecasting 2006.1 Forecasting Models 2016.1.1 Quantitative Models 2016.1.2 Qualitative Models 2026.2 Time Series Analysis 2026.2.1 Secular Trends 2026.2.2 Seasonal Variations 2026.2.3 Cyclical Fluctuations 2036.2.4 Random Changes 2036.3 From Symbolic to Numeric Fitting 2036.4 Adjusting for Seasonality 2076.4.1 The Simple Average of Errors Method 2086.4.2 The Actual-to-Forecast (A/F) Ratio Method 2106.4.3 The Dummy Variables Method 2126.5 Smoothed Forecasts 2146.5.1 Simple Moving Average Method 214The RMSE Check 2176.5.2 The Weighted Moving Average 2186.5.3 Exponential Smoothing 219Mean Absolute Deviation (MAD) 2236.6 Barometric Forecasting 2246.7 Econometric Models 2266.7.1 Single-Equation Model 2276.7.2 Multiple-Equation Model 2296.8 Input–Output Matrix 2316.9 Judgmental Models 2336.9.1 Opinions and Polls 2336.9.2 Surveys and Market Research 2336.10 Forecasting Accuracy and Reliability 234Summary 235Key Terms 236List of Formulas 236Exercises 238UNIT III MANAGERIAL DECISIONS AT THE FIRM LEVEL7 Production Theory 2437.1 Variability of Inputs throughout Time 2437.2 Production Function 2447.3 Graphical Representation of the Production Function 2467.4 Short-Run, One Variable Input Function 2507.5 Dynamic Relations among Production Curves 2527.6 Law of Diminishing Marginal Returns 2607.7 Long-Run, Two Variable Input Function 261Isoquants 2617.8 Marginal Rate of Technical Substitution (MRTS) 2637.9 The Economically Efficient Region of Production 2667.10 Returns to Scale 2677.11 Elasticity of Substitution 2697.11.1 Elasticity of the Cobb–Douglas Production Function 2707.11.2 Elasticity of the Leontief Production Function 2717.11.3 Leontief Technology and Linear Programming 2727.11.4 Elasticity of the Linear Production Function 2737.11.5 Elasticity of the CES Production Function 2747.11.6 Graphical Representation of CES 2757.12 Optimal Employment of an Input 2777.13 Technological Progress, Invention, and Innovation 2787.14 Technological Progress and Production Function 280Summary 282Key Terms 283List of Formulas 283Exercises 2858 Cost Theory 2878.1 Cost Concepts and Categories 2878.2 Short-Run Costs 2898.3 The Optimal Combination of Inputs 2978.3.1 Isocost 2978.4 Minimizing Input Cost and Maximizing Output 2988.5 Long-Run Costs 3018.6 Short-Run and Long-Run Average Costs: Economies of Scale 3038.7 Derivation of the Cost Function 3068.8 Economies of Scope: Basic Concept and Cost Complementarities 3118.9 Economies of Scope: Synergy and Input Indivisibility 3138.10 The Learning Curve 3168.11 Cost–Volume–Profit Analysis and Operating Leverage 3218.11.1 Break-Even Quantity and Break-Even Revenue 322Fixed Cost 323Variable Cost 323Contribution Margin 3248.11.2 Cash Break-Even Technique 3268.11.3 The Break-Even Point and Target Profit 3278.11.4 An Algebraic Approach to the Break-Even Point 3298.11.5 Break-Even Time 3308.11.6 The Dual Break-Even Points 3348.12 Leverage 3378.12.1 Operating Leverage 3388.12.2 Operating Leverage, Fixed Cost, and Business Risk 341Summary 342Key Terms 344List of Formulas 344Exercises 3479 Production and Cost: Estimation and Forecasting 3499.1 Estimation of the Production Function 3509.2 Estimation of the Cost Function 3529.3 Forecasting Output 3559.4 Forecasting Cost 3599.5 Meeting Obligations through Decisions with Probabilistic Results 360Summary 361Key Terms 361List of Formulas 361Exercises 363UNIT IV MANAGERIAL DECISIONS AT THE MARKET LEVEL10 Market Structure and Business Organization 36710.1 Perfect Competition 36810.1.1 Characteristics of Perfect Competition 36810.1.2 Profit Maximization for Competitive Firms 36910.1.3 The Decision to Shut Down 37310.1.4 The Competitive Firm in the Long Run 37710.2 Monopoly 38110.2.1 Monopoly’s Equilibrium in the Short Run 38110.2.2 Monopoly’s Equilibrium in the Long Run 38510.2.3 Monopoly Power and the Lerner Index 38810.3 Monopolistic Competition 38910.3.1 Monopolistic Competition Equilibrium in the Short Run 39010.3.2 Monopolistic Competition Equilibrium in the Long Run 39110.4 Oligopoly 39310.4.1 The Concentration Ratio and the Herfindahl Index 39410.4.2 Models of Oligopoly 395Cournot Model 395Stackelberg Model 399Bertrand Model 403Sweezy Model 407Summary 410Key Terms 411List of Formulas 411Exercises 41211 Pricing Decisions and Practices 41411.1 Basics of Price Setting 41411.2 The Markup Rule 41511.3 Multiproduct Pricing Strategies 41811.4 Joint Products with Independent Demands 41911.4.1 Product Set of Fixed Proportions 41911.4.2 Product Set of Variable Proportions 42111.5 Transfer Pricing 42311.5.1 The Intermediate Product in a Perfectly Competitive Market 42411.5.2 The Intermediate Product in an Imperfectly Competitive Market 42911.6 Pricing Strategies and Practices 43011.7 Price Discrimination 43311.7.1 First-Degree Price Discrimination 43411.7.2 Second-Degree Price Discrimination 43611.7.3 Third-Degree Price Discrimination 437Summary 445Key Terms 446List of Formulas 446Exercises 447UNIT V MANAGERIAL DECISIONS IN THE LONG RUN12 Capital Budgeting and Investment Project Evaluation 45112.1 What is Capital Budgeting? 45112.2 Basic Model of Capital Budgeting 45312.3 Selection Process and Project Evaluation 45412.4 Methods of Evaluation for Proposed Investment Projects 45512.4.1 Net Present Value 45512.4.2 Internal Rate of Return 45912.4.3 NPV versus IRR for Mutually Exclusive Projects 46212.4.4 NPV Profile, Crossover Rate, and the Ranking Reversal 46512.5 Profitability Index and Capital Rationing 46712.6 Payback Method 46912.7 Cost of Capital 47112.7.1 Cost of Debt Capital 47212.7.2 Cost of Equity Capital 473The CAPM Estimation 473The Dividend Valuation Estimation 47412.7.3 The Weighted Marginal Cost of Capital 47612.7.4 Capitalization and Capitalized Cost 47812.7.5 Last Words on the Cost of Capital 481Summary 481Key Terms 483List of Formulas 483Exercises 48513 Risk Analysis and Managerial Decisions under Uncertainty 48713.1 Risk and Uncertainty 48713.2 Sources of Risk 48813.2.1 Economic Sources 48813.2.2 Political Sources 48813.2.3 Social Sources 48913.2.4 International Sources 48913.3 Measurement of Risk 48913.3.1 The Absolute Measure 49013.3.2 The Relative Measure 49513.4 Risk Aversion 49513.5 Risk Attitudes and Utility of Money 49613.6 Expected Utility of Money versus Expected Monetary Return 49813.7 Risk Discount and Certainty Equivalent 50113.8 Risk Impact on the Valuation Model 50313.8.1 Risk Premium Adjustment 50313.8.2 Certainty-Equivalent Adjustment 50613.9 Diversifiable versus Nondiversifiable Risk 50913.10 Portfolio Risk 51013.11 Risk of Two-Asset Portfolio 51813.12 Lending and Borrowing at the Risk-Free Rate of Return 52013.13 Measuring the Systematic Risk by Beta (β) 52213.14 The CAPM Model 52513.15 The Security Market Line (SML) 52613.15.1 SML Shift by Inflation 52713.15.2 SML Swing by Risk Aversion 52813.16 Managerial Decision Tree 53213.17 Mathematical Simulation and Sensitivity Analysis 53313.18 Advanced Choice under Risk, Ambiguity, and Uncertainty 53613.18.1 Stochastic Dominance 536Assumptions 537Expected Utility 537First-Degree Stochastic Dominance 537Interpretation of FSD Conditions 538Second-Degree Stochastic Dominance 538Interpretation of FSD Conditions 538Applications of SSD Conditions 53913.18.2 Choice under Ambiguity 53913.18.3 Choice under Uncertainty 539Summary 541Key Terms 542List of Formulas 543Exercises 54414 Management Consultants and Information 54614.1 Measuring Information and Its Impact on Uncertainty 54614.2 Perfect Management Information 54814.3 Valuing Perfect Management Information 54914.4 Valuing Less-than-Perfect Management Information 549Summary 556Key Terms 557List of Formulas 557Exercises 558APPENDIX 560FURTHER READING 569INDEX 573