Since the inception of business practices and public companies as a whole, the mindset has always been for businesses to maximize profit and ensure their fat cats and general shareholders

MICHAEL R. BAYEMICHAEL R. BAYE7e

MANAGERIAL ECONOMICS AND BUSINESS STRATEGY

MICHAEL R. BAYE

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PROVEN. TRUSTED. Managerial Economics and Business Strategy is the best-selling managerial economics textbook on the market today. Michael Baye provides students with tools like intermediate microeconomics, game theory, and industrial organization that are crucial to making sound managerial decisions. The Seventh Edition discusses the latest issues and research shaping managerial economics today.

KEY FEATURES OF THIS NEW EDITION INCLUDE:

UPDATED HEADLINES: Updated and current Headlines begin each chapter with a real-world economic problem. These problems are essentially hand-picked “mini-cases” designed to motivate students to better understand the chapter material.

NEW AND UPDATED INSIDE BUSINESS APPLICATIONS: New Inside Business boxes illustrate real-world applications of theory developed in the chapter; these examples are drawn from both current economic literature and the popular press.

TIME WARNER CASE STUDY: A Case Study in business strategy — Challenges at Time Warner — follows Chapter 14. The case engages students by applying core elements from managerial economics to a rich business environment.

For more information and resources, please visit the text’s Online Learning Center: www.mhhe.com/baye7e

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Managerial Economics and Business Strategy

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Nash Equilibrium • Predatory Pricing • Mergers & Acquisitions •

Demand Elasticity • Vertical Foreclosure • Penetration Pricing •

Marginal Cost • Bottlenecks • First-Mover Advantage • Signaling •

Learning Curve • Marginal Revenue • Repeated Games • Microsoft •

Screening • Network Effects • Antitrust • Cost Complementarities •

Two-Part Pricing • Limit Pricing • Tariffs • Bargaining • Cournot

Oligopoly • American Airlines • Raising Rivals’ Costs • Moral Hazard •

eBay • Price Discrimination • Adverse Selection • Economies of Scope

• Auctions • Bundling • Block Pricing • Stackelberg Oligopoly •

Advertising • Perfect Equilibrium • Coordination • General Motors •

Quotas • Extensive Form Games • Economies of Scale • Netscape •

Hold-up Problem • Patents • Bertrand Oligopoly • Commitment •

Economies of Scale • Tariffs • Antitrust • Transfer Pricing • Collusion

• Piece Rates • Profit-Sharing • Sunk Costs • Takeovers • Trigger

Strategies • Low-Price Guarantees • Sony • Time Warner • Five

Forces Framework • AOL • Globalization • Best-Response Function •

Cannibalization • Product Differentiation • Value of Information

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SEVENTH EDITION

Managerial Economics and Business Strategy

Michael R. Baye Bert Elwert Professor of Business Economics & Public Policy Kelley School of Business Indiana University

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MANAGERIAL ECONOMICS AND BUSINESS STRATEGY

Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2010, 2008, 2006, 2003, 2000, 1997, 1994 by The McGraw-Hill Companies, Inc. All rights reserved. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

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ISBN 978-0-07-337596-0 MHID 0-07-337596-9

Vice president and editor-in-chief: Brent Gordon Publisher: Douglas Reiner Director of development: Ann Torbert Development editor: Anne E. Hilbert Vice president and director of marketing: Robin J. Zwettler Associate marketing manager: Dean Karampelas Vice president of editing, design and production: Sesha Bolisetty Senior project manager: Bruce Gin Senior production supervisor: Debra R. Sylvester Designer: Matt Diamond Senior media project manager: Greg Bates Cover design: Matt Diamond Interior design: Matt Diamond Typeface: 10/12 Times Roman Compositor: Laserwords Private Limited Printer: R. R. Donnelley

Library of Congress Cataloging-in-Publication Data

Baye, Michael R., 1958- Managerial economics and business strategy / Michael R. Baye. — 7th ed.

p. cm. Includes index. ISBN-13: 978-0-07-337596-0 (alk.paper) ISBN-10: 0-07-337596-9 (alk. paper) 1. Managerial economics. 2. Strategic planning. I. Title.

HD30.22.B38 2010 338.5024'658—dc22

2009017267

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The McGraw-Hill Series Economics ESSENTIALS OF ECONOMICS

Brue, McConnell, and Flynn Essentials of Economics Second Edition

Mandel Economics: The Basics First Edition

Schiller Essentials of Economics Seventh Edition

PRINCIPLES OF ECONOMICS

Colander Economics, Microeconomics, and Macroeconomics Eighth Edition

Frank and Bernanke Principles of Economics, Principles of Microeconomics, Principles of Macroeconomics Fourth Edition

Frank and Bernanke Brief Editions: Principles of Economics, Principles of Microeconomics, Principles of Macroeconomics First Edition

McConnell, Brue, and Flynn Economics, Microeconomics, and Macroeconomics Eighteenth Edition

McConnell, Brue, and Flynn Brief Editions: Microeconomics and Macroeconomics First Edition

Miller Principles of Microeconomics First Edition

Samuelson and Nordhaus Economics, Microeconomics, and Macroeconomics Nineteenth Edition

Schiller The Economy Today, The Micro Economy Today, and The Macro Economy Today Twelfth Edition

Slavin Economics, Microeconomics, and Macroeconomics Ninth Edition

ECONOMICS OF SOCIAL ISSUES

Guell Issues in Economics Today Fifth Edition

Sharp, Register, and Grimes Economics of Social Issues Nineteenth Edition

ECONOMETRICS

Gujarati and Porter Basic Econometrics Fifth Edition

Gujarati and Porter Essentials of Econometrics Fourth Edition

MANAGERIAL ECONOMICS

Baye Managerial Economics and Business Strategy Seventh Edition

Brickley, Smith, and Zimmerman Managerial Economics and Organizational Architecture Fifth Edition

Thomas and Maurice Managerial Economics Tenth Edition

INTERMEDIATE ECONOMICS

Bernheim and Whinston Microeconomics First Edition

Dornbusch, Fischer, and Startz Macroeconomics Tenth Edition

Frank Microeconomics and Behavior Eighth Edition

ADVANCED ECONOMICS

Romer Advanced Macroeconomics Third Edition

MONEY AND BANKING

Cecchetti Money, Banking, and Financial Markets Second Edition

URBAN ECONOMICS

O’Sullivan Urban Economics Seventh Edition

LABOR ECONOMICS

Borjas Labor Economics Fifth Edition

McConnell, Brue, and Macpherson Contemporary Labor Economics Ninth Edition

PUBLIC FINANCE

Rosen and Gayer Public Finance Ninth Edition

Seidman Public Finance First Edition

ENVIRONMENTAL ECONOMICS

Field and Field Environmental Economics: An Introduction Fifth Edition

INTERNATIONAL ECONOMICS

Appleyard, Field, and Cobb International Economics Seventh Edition

King and King International Economics, Globalization, and Policy: A Reader Fifth Edition

Pugel International Economics Fourteenth Edition

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ABOUT THE AUTHOR

Michael Baye is the Bert Elwert Professor of Business Economics & Public Policy at Indiana University’s Kelley School of Business. He received his B.S. in economics from Texas A&M University in 1980 and earned a Ph.D. in economics from Purdue University in 1983. Prior to joining Indiana University, he taught graduate and under- graduate courses at The Pennsylvania State University, Texas A&M University, and the University of Kentucky. Professor Baye served as the Director of the Bureau of Economics at the Federal Trade Commission from July 2007–December 2008.

Professor Baye has won numerous awards for his outstanding teaching and research and regularly teaches courses in managerial economics and industrial organization at the undergraduate, M.B.A., and Ph.D. levels. Professor Baye has made a variety of contributions to the fields of game theory and industrial organi- zation. His research on mergers, auctions, and contests has been published in such journals as the American Economic Review, the Review of Economic Studies, and the Economic Journal. Professor Baye’s research on pricing strategies in online and other environments where consumers search for price information has been pub- lished in economics journals (such as the American Economic Review, Economet- rica, and the Journal of Political Economy), featured in the popular press (including The Wall Street Journal, Forbes, and The New York Times), and pub- lished in leading marketing journals. His research has been supported by the National Science Foundation, the Fulbright Commission, and other organizations.

Professor Baye has held visiting appointments at Cambridge, Oxford, Erasmus University, Tilburg University, and the New Economic School in Moscow, Russia. He has served on numerous editorial boards in economics as well as marketing, including Economic Theory and the Journal of Public Policy & Marketing. When he is not teaching or engaged in research, Michael enjoys activities ranging from camping to shopping for electronic gadgets.

To Natalie and Mitchell—Thanks for teaching me about the buyer side of the college market.

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PREFACE TO THE SEVENTH EDITION

Thanks to feedback from users around the world, Managerial Economics and Busi- ness Strategy remains the top selling managerial text in the market. I am grateful to all of you for allowing me to provide this updated and improved product. Before highlighting some of the new features of the seventh edition, I would like to stress that the fundamental goal of the book—providing students with the tools from intermediate microeconomics, game theory, and industrial organization that they need to make sound managerial decisions—has not changed.

This book begins by teaching managers the practical utility of basic economic tools such as present value analysis, supply and demand, regression, indifference curves, isoquants, production, costs, and the basic models of perfect competition, monopoly, and monopolistic competition. Adopters and reviewers also praise the book for its real-world examples and because it includes modern topics not con- tained in any other single managerial economics textbook: oligopoly, penetration pricing, multistage and repeated games, foreclosure, contracting, vertical and hori- zontal integration, networks, bargaining, predatory pricing, principal–agent prob- lems, raising rivals’ costs, adverse selection, auctions, screening and signaling, search, limit pricing, and a host of other pricing strategies for firms enjoying mar- ket power. This balanced coverage of traditional and modern microeconomic tools makes it appropriate for a wide variety of managerial economics classrooms. An increasing number of business schools are adopting this book to replace (or use alongside) managerial strategy texts laden with anecdotes but lacking the micro- economic tools needed to identify and implement the business strategies that are optimal in a given situation.

This seventh edition of Managerial Economics and Business Strategy has been thoroughly updated but retains all of the content that made previous editions suc- cessful. The basic structure of the textbook is unchanged.

KEY PEDAGOGICAL FEATURES

The seventh edition retains all of the class-tested features of previous editions that enhance students’ learning experiences and make it easy to teach from this book.

Headlines

As in previous editions, each chapter begins with a Headline that is based on a real- world economic problem—a problem that students should be able to address after completing the chapter. These Headlines are essentially hand-picked “mini-cases” designed to motivate students to learn the material in the chapter. Each Headline is

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answered at the end of the relevant chapter—when the student is better prepared to deal with the complications of real-world problems. Reviewers as well as users of previous editions praise the Headlines not only because they motivate students to learn the material in the chapter, but also because the answers at the end of each chapter help students learn how to use economics to make business decisions.

Learning Objectives

Each chapter includes learning objectives designed to enhance the learning experi- ence.

Demonstration Problems

The best way to learn economics is to practice solving economic problems. So, in addition to the Headlines, each chapter contains many Demonstration Problems sprinkled throughout the text, along with detailed answers. This provides students with a mechanism to verify that they have mastered the material and reduces the cost to students and instructors of having to meet during office hours to discuss answers to problems.

Inside Business Applications

Each chapter contains boxed material (called Inside Business applications) to illus- trate how theories explained in the text relate to a host of different business situa- tions. As in previous editions, I have tried to strike a balance between applications drawn from the current economic literature and the popular press.

Calculus and Noncalculus Alternatives

Users can easily include or exclude calculus-based material without losing content or continuity. That’s because the basic principles and formulae needed to solve a particular class of economic problems (e.g., MR � MC) are first stated without appealing to the notation of calculus. Immediately following each stated principle or formula is a clearly marked Calculus Alternative. Each of these calculus alterna- tives states the preceding principle or formula in calculus notation, and explains the relation between the calculus and noncalculus formula. More detailed calculus der- ivations are relegated to Appendices. Thus, the book is designed for use by instruc- tors who want to integrate calculus into managerial economics and by those who do not require students to use calculus.

Key Terms and Marginal Definitions

Each chapter ends with a list of key terms and concepts. These provide an easy way for instructors to glean material covered in each chapter and for students to check their mastery of terminology. In addition, marginal definitions are provided throughout the text.

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End-of-Chapter Problems

Three types of problems are offered. Highly structured but nonetheless challenging Conceptual and Computational Questions stress fundamentals. These are followed by Problems and Applications, which are far less structured and, like real-world deci- sion environments, may contain more information than is actually needed to solve the problem. Many of these applied problems are based on actual business events.

Additionally, the Time Warner case that follows Chapter 14 includes 14 prob- lems called Memos that have a “real-world feel” and complement the text. All of these case-based problems may be assigned on a chapter-by-chapter basis as spe- cific skills are introduced, or as part of a capstone experience. Solutions to all of the memos are contained online at www.mhhe.com/baye7e.

Answers to selected end-of-chapter Conceptual and Computational Questions are presented at the end of the book; detailed answers to all problems—including Problems and Applications and the Time Warner case Memos, are available to instructors on the password-protected Web site.

Case Study

A case study in business strategy—Challenges at Time Warner—follows Chapter 14 and was prepared by Kyle Anderson, Michael Baye, and Dong Chen especially for this text. It can be used either as a capstone case for the course or to supplement individual chapters. The case allows students to apply core elements from manage- rial economics to a remarkably rich business environment. Instructors can use the case as the basis for an “open-ended” discussion of business strategy, or they can assign specific “memos” (contained at the end of the case) that require students to apply specific tools from managerial economics to the case. Teaching notes, as well as solutions to all of the memos, are provided on the Web site.

Flexibility

Instructors of managerial economics have genuinely heterogeneous textbook needs. Reviewers and users continue to praise the book for its flexibility, and assure us that sections or even entire chapters can be excluded without losing continuity. For instance, an instructor wishing to stress microeconomic fundamentals might choose to cover Chapters 2, 3, 4, 5, 8, 9, 10, 11, and 12. An instructor teaching a more applied course that stresses business strategy might choose to cover Chapters 1, 2, 3, 5, 6, 7, 8, 10, 11, and 13. Each may choose to include additional chapters (for example, Chapter 14 or the Time Warner case) as time permits. More generally, instructors can easily omit topics such as present value analysis, regression, indif- ference curves, isoquants, or reaction functions without losing continuity.

Online Resources at www.mhhe.com/baye7e

A large assortment of student supplements for Managerial Economics and Business Strategy are available online at www.mhhe.com/baye7e. This includes data for the Time Warner case Memos, data needed for various end-of-chapter problems, spreadsheet

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versions of key tables in the text to enable students to see how key economic concepts—like marginal cost and profit maximization—can be implemented on stan- dard spreadsheets, and spreadsheet macros that students can use to find the optimum price and quantity under a variety of market settings, including monopoly, Cournot oli- gopoly, and Stackelberg oligopoly. Plus, the Web site includes 10 additional full-length cases (in pdf format) that are described below.

CourseSmart is a new way for faculty to find and review eTextbooks. It’s also a great option for students who are interested in accessing their course materials digitally. CourseSmart offers thousands of the most commonly adopted textbooks across hun- dreds of courses from a wide variety of higher education publishers. It is the only place for faculty to review and compare the full text of a textbook online. At CourseSmart, students can save up to 50% off the cost of a print book, reduce their impact on the environment, and gain access to powerful Web tools for learning including full text search, notes and highlighting, and email tools for sharing notes between classmates. Your eBook also includes tech support in case you ever need help.

Finding your eBook is easy. Visit www.CourseSmart.com and search by title, author, or ISBN.

SUPPLEMENTS

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

Cases

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

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

PowerPoint Slides

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

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relevant concepts (like Cournot and Stackelberg equilibrium, normal form and exten- sive form games, and the like).

Instructor’s Manual/Test Bank

A thoroughly updated instructor’s manual and test bank, prepared by Michael R. Baye and Patrick Scholten, provides a summary of each chapter, a teaching outline for each chapter, complete answers to all end-of-chapter problems, updated and class-tested problems (including over 1,000 multiple-choice questions and over 250 problems with detailed solutions). The seventh edition Web site contains teaching notes for the Time Warner case and solutions to the 14 accompanying Memos, as well as expanded and improved teaching notes for the additional cases.

EZ Test Version of the Test Bank

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

Digital Image Library

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

Study Guide

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

Student Web Site

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

Instructor Web Site

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

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CHANGES IN THE SEVENTH EDITION

I have made every effort to update and improve Managerial Economics and Busi- ness Strategy while assuring a smooth transition to the seventh edition. Below is a summary of the pedagogical improvements, enhanced supplements, and content changes that make the seventh edition an even more powerful tool for teaching and learning managerial economics and business strategy.

• All of the class-tested problems from the previous edition, plus over 25 new end-of-chapter problems. Where appropriate, problems from the previous edition have been updated to reflect the current economic climate.

• Updated Test Bank available on the Instructor’s Web site in two formats: Computerized (EZ Test) and in Microsoft Word format.

• Updated Headlines. • New and updated Inside Business applications. • The financial crisis is reshaping the global economic and regulatory

landscape, and it is likely to take years for its ultimate effects on the economy to be fully recognized. In preparing this edition, I have revised the book to ensure that the economic examples presented are timeless and will not grow into “historical examples” as a result of bankruptcies, new legislation, or changes in the country’s taste for regulation. As in previous editions, this edition continues to equip students with the economic tools required to manage businesses and, more generally, to evaluate current events. The virtues of markets, as well as potential market failures, are presented without editorial comment on my part. Adopters of this book have praised this approach, as it provides a positive foundation that permits individual instructors to rigorously discuss current events—including the plethora of political proposals and opinions regarding the financial crisis that emerge each and every day.

• Updated Instructor’s Web site that offers full teaching notes and solutions to Memos for the Time Warner case—plus a host of additional supplements. These include over 10 additional full-length cases complete with expanded teaching notes and links to chapter content, complete solutions to all end-of- chapter problems, an updated and expanded electronic test bank, animated PowerPoint presentations, chapter summarie

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