INTERNATIONAL EIGHTH EDITION

DOMINICK SALVATORE Professor of Economics and Business Fordham University, New York

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New York Oxford OXFORD UNIVERSITY PRESS

CONTENTS

Preface xxxi PART ONE

INTRODUCTION

1

CHARTER 1 The Nature and Scope of Managerial Economics 3 1-1 The Scope of Managerial Economics 4 Definition of Managerial Economics 4 Relationship to Economic Theory 6 Relationship to the Decision Sciences 6 Relationship to the Functional Areas of Business Administration Studies 7 1-2 The Basic Process of Decision Making 7 CASE STUDY 1-1 Peter Drucker—The Man Who Invented Management 9 CASE STUDY 1-2 The Management Revolution 10 1-3 The Theory of the Firm 10 Reasons for the Existence of Firms and Their Functions 11 The Objective and Value of the Firm 12 Constraints on the Operation of the Firm 13 Limitation: of the Theory of the Firm 14 1-4 The Nature and Function of Profits 15 Business versus Economic Profit 15 Theories of Profit 16 Function of Profit 17 1-5 Business Ethics 18 CASE STUDY 1-3 The Global Financial Crisis 20 1-6 The International Framework of Managerial Economics 20 CASE STUDY 1-4 The Rise of the Global Corporation 21 1-7 Managerial Economics in a More Risky, Crisis-Prone, and Sluggish Global Economy 22 CASE STUDY 1 5 The Global Business Leader 23 CASE STUDY 1-6 Global Most Admired Companies 24

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1-8 Managerial Economics and the Internet 26 CASE STUDY 1-7 The Most Important Internet Site Addresses for Managerial Economics 27 Summary « Problems Appendix to Chapter 1 The Basics of Demand, Supply, and Equilibrium 30 The Demand Side of the Market 30 The Supply Side of the Market 31 The Equilibrium Price 31 Shift in the Demand Curve and Equilibrium 32 Shift in the Supply Curve and Equilibrium 32 Appendix Problems • Supplementary Readings

CHAPTER 2 Optimization Techniques and New Management Tools 35 2-1 Methodsof Expressing Economic Relationships 37 2-2 Total, Average, and Marginal Relationships 38 Total, Average, and Marginal Cost 38 Geometrie Derivation of the Average- and Marginal-Cost Curves

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2-3 Optimization Analysis 41 Profit Maximization by the Total-Revenue and Total-Cost Approach 41 Optimization by Marginal Analysis 41 CASE STUDY 2-1 Optimal Pollution Control 43 2-4 Constrained Optimization 44 2-5 New Management Tools for Optimization 44 Benchmarking 44 CASE STUDY 2-2 Pursuing Multiple Objectives under Constraints by Global Corporations 45 CASE STUDY 2-3 Benchmarking at Xerox, Ford, and Mobil 46 Total Quality Management 47 CASE STUDY 2-4 Total Quality Management at Johnson & Johnson, Motorola, General Electric, and Ford 48 Reengineering 49 CASE STUDY 2-5 Reengineering at GE 50 The Learning Organization 50 CASE STUDY 2-6 Applying Learning-Organization Principles at Ford and Southwest Airlines 51

CONTENTS

2-6 Other Management Tools for Optimization 52 2-7 New Management Tools and Functional Specialization 54 CASE STUDY 2-7 The American Business Model 55 CASE STUDY 2-8 When Governance Rules Fail, Public Trust Is Eroded 56 BOX 1 Managerial Economics at Work: Management Practices across the World 57 Summary • Problems • Spreadsheet Problems Appendix 1 to Chapter 2 Optimization Using Spreadsheets 60 Appendix Problem Appendix 2 to Chapter 2 Differential Calculus and Optimization Techniques 62 The Derivative and Rules of Differentiation 62 The Concept of the Derivative 62 Rules of Differentiation 63 Optimization with Calculus 67 Determining a Maximum or a Minimum by Calculus 68 Distinguishing between a Maximum and a Minimum: The Second Derivative 68 Multivariate Optimization 70 Partial Derivatives 70 Maximizing a Multivariable Function 71 Constrained Optimization 72 Constrained Optimization by Substitution 72 Constrained Optimization by the Lagrangian Multiplier Method 73 Appendix Problems • Supplementary Readings INTEGRATING CASE STUDY 1 Steve Jobs: A Genius Departs—The Astonishing Career of the World's Most Revered Chief Executive 77 Three-Way Marriage 78 Oh, and One More Thing 79 PARTTWO

DEMANP ANALYSIS

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CHAPTER 3 Demand Theory 83 3-1 The Demand for a Commodity 85 An IndividuaPs Demand for a Commodity 85 From Individual to Market Demand 88

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CONTENTS CASE STUDY 3-1 The Demand for Big Macs 90 The Demand Faced by a Firm 91 3-2 Price Elasticity of Demand 93 Point Price Elasticity of Demand 94 Are Price Elasticity of Demand 96 Price Elasticity, Total Revenue, and Marginal Revenue 97 Factors Affecting the Price Elasticity of Demand 101 3-3 Income Elasticity of Demand 101 CASE STUDY 3-2 Price Elasticities of Demand in the Real World 102 CASE STUDY 3-3 Income Elasticities of Demand in the Real World 104 3-4 Cross-Price Elasticity of Demand 105 3-5 Using Elasticities in Managerial Decision Making 107 CASE STUDY 3-4 Cross-Price Elasticities of Demand in the Real World 108 CASE STUDY 3-5 Substitution between Domestic and Foreign Goods 109 BOX 2 Managerial Economics at Work: Decision Time at the Aromatic Coffee Company 110 3-6 International ConvergenceofTastes III CASE STUDY 3-6 Gillette Introduces Space-Technology Global Razors 112 CASE STUDY 3-7 Ford's World Car(s) 113 3-7 Electronic Commerce 114 CASE STUDY 3-8 E-Commerce at Amazon.com 116 CASE STUDY 3-9 Amazon Puts an End to eBay Star Performance 118 Summary • Problems • Spreadsheet Problems Appendix to Chapter 3 Behind the Market Demand Curve— The Theory of Consumer Choice 122 The Consumer's Tastest Indifference Curves 123 The Consumer's Constraints: The Budget Line 124 The Consumer's Equilibrium 124 Derivation of the Consumer's Demand Curve 125 Income and Substitution Effects of a Price Change 125 The Theory of Consumer Choice Mathematically 127 Appendix Problems • Supplementary Readings

CONTENTS

CHAPTER 4 Demand Estimation 129 4-1 The Identification Problem 131 4-2 Marketing Research Approaches to Demand Estimation 133 Consumer Surveys and Observational Research 133 CASE STUDY 4-1 Micromarketing: Marketers Zero in on Their Customers 134 Consumer Clinics 135 Market Experiments 136 CASE STUDY 4-2 Estimation of the Demand for Oranges by Market Experiment 137 Virtual Shopping and Virtual Management 137 CASE STUDY 4-3 Reaching Consumers in the Vanishing Mass Market 139 4-3 Introduction to Regression Analysis 140 4-4 Simple Regression Analysis 143 The Ordinary Least-Squares Method 143 Tests of Significance of Parameter Estimates 145 Other Aspects of Significance Tests and Confidence Intervals 147 Test of Goodness of Fit and Correlation 148 4-5 Multiple Regression Analysis 152 The Multiple Regression Model 152 The Coefficient of Determination and Adjusted R2 154 Analysis of Variance 155 Point and Interval Estimates 156 4-6 Problems in Regression Analysis 157 Multicollinearity 157 Heteroscedasticity 157 Autocorrelation 159 4-7 Demand Estimation by Regression Analysis 160 Model Specificiation 160 Collecting Data on the Variables 161 Specifying the Form of the Demand Equation 161 Testing the Econometric Results 163 4-8 Estimating the Demand for U.S. Imports and Exports 163 CASE STUDY 4-4 Estimation of the Demand for Air Travel over the North Atlantic 164 CASE STUDY 4-5 Price and Income Elasticities of Imports and Exports in the Real World 165 BOX 3 Managerial Economics at Work: BlackBerry Crumbles 166

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Summary • Problems Appendix to Chapter 4 Regression Analysis with Excel 172 Simple Regression 172 Multiple Regression Analysis 174 Appendix Problems • Supplementary Readings

CHAPTER 5 Demand Forecasting 177 5-1 Qualitative Forecasts 179 Survey Techniques 179 Opinion Polls 180 Soliciting a Foreign Perspective 181 CASE STUDY 5-1 Forecasting the Number of McDonald's Restaurants Worldwide 181 5-2 Time-Series Analysis 182 Reasons for Fluctuations in Time-Series Data 183 Trend Projection 184 Seasonal Variations 187 CASE STUDY 5 2 Forecasting New-Housing Starts with Time-Series Analysis 189 5-3 Smoothing Techniques 190 Moving Averages 190 Exponential Smoothing 192 CASE STUDY 5-3 Forecasting Lumber Sales with Smoothing Techniques 194 5-4 Barometric Methods 195 CASE STUDY 5-4 Forecasting the Level of Economic Activity with Composite and Diffusion Indexes 199 CASE STUDY 5-5 The Index of Leading Indicators Goes Global 199 5-5 Econometric Models 200 Single-Equation Models 200 CASE STUDY 5-6 Forecasting the Demand for Air Travel over the North Atlantic 201 Multiple-Equation Models 202 CASE STUDY 5-7 Economic Forecasts with Large Econometric Models 204

CONTENTS

BOX 4 Managerial Economics at Work: Risks in Demand Forecasting 205 5-6 Input-Output Forecasting 206 Summary • Problems Appendix to Chapter 5 Forecasting Fluctuations in Time-Series Analysis Using Excel 211 Forecasting New-Housing Starts with Regression Analysis 211 Adjusting the Trend Forecasts of New-Housing Starts for Seasonal Variations by the Ratio-to-Trend Method 213 Adjusting the Trend Forecasts of New-Housing Starts for Seasonal Variations by Using Seasonal Dummies 215 Appendix Problems • Supplementary Readings INTEGRATING CASE STUDY 2 Ford's Bet: It's a Small World After All 219 Ford in the U.S. Automobile Industry 219 Staking Ford's Future 220 Epilogue 220 INTEGRATING CASE STUDY 3 Estimating and Forecasting the U.S. Demand for Electricity 222 PARTTHREE

PRODUCTION AND COST ANALYSIS

225

CHAPTER 6 Production Theory and Estimation

227

6-1 The Organization of Production and the Production Function 229 The Organization of Production 229 The Production Function 230 6-2 The Production Function with One Variable Input 233 Total, Average, and Marginal Product 233 The Law of Diminishing Returns and Stages of Production 235 6-3 Optimal Use of the Variable Input 237 6-4 The Production Function with Two Variable Inputs 239 Production Isoquants 239 Economic Region of Production 241 Marginal Rate of Technical Substitution 242 Perfect Substitutes and Complementary Inputs 243

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6-5 Optimal Combination of Inputs 245 Isocost Lines 245 Optimal Input Combination for Minimizing Costs or Maximizing Output 246 Profit Maximization 248 Effect of Change in Input Prices 249 CASE STUDY 6-1 Substitutability between Gasoline Consumption and Driving Time 250 6-6 Returns to Scale 251 CASE STUDY 6-2 General Motors Decides Smaller Is Better 253 6-7 Empirical Production Functions 254 CASE STUDY 6-3 Output Elasticities in U.S. Manufacturing Industries 255 6-8 The Innovation Process 256 Meaning and Importance of Innovations 256 CASE STUDY 6-4 How Do Firms Get New Technology? 258 How Innovative Is Your Company's Culture? 258 The Open Innovation Model 259 CASE STUDY 6-5 Open Innovations at Procter & Gamble 260 The Next Step in Open Innovation 261 6-9 Innovation and Global Competitiveness 262 Innovations and the International Competitiveness of U.S. Firms 262 BOX 5 Managerial Economics at Work: How Xerox Lost and Regained International Competitiveness and Became a Leader in Information Technology 263 The New Computer-Aided Production Revolution, 3-D Printing, and the International Competitiveness of U.S. Firms 264 CASE STUDY 6-6 The Euro and the International Competitiveness of European Firms 265 Summary • Problems « Spreadheet Problems Appendix to Chapter 6 Production Analysis with Calculus 270 Constrained Output Maximization 270 Constrained Cost Minimization 271 Profit Maximization 272 Appendix Problems » Supplementary Readings

CONTENTS

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CHAPTER 7 Cost Theory and Estimation 274 7-1 The Nature ofCosts 276 7-2 Short-Run Cost Functions 277 Short-Run Total and Per-Unit Cost Functions 277 Short-Run Total and Per-Unit Cost Curves 278 7-3 Long-Run Cost Curves 281 Long-Run Total Cost Curves 281 Long-Run Average and Marginal Cost Curves 283 CASE STUDY 7-1 The Long-Run Average Cost Curve in Electricity Generation 285 7-4 Plant Size and Economies of Scale 286 CASE STUDY 7-2 The Shape of the Long-Run Average Cost Curves in Various Industries 288 7-5 Leaming Curves 289 CASE STUDY 7-3 To Reduce Costs, Firms Often Look Far Afieid 291 7-6 Minimizing Costs Internationally—The New Economies of Scale 292 International Trade in Inputs 292 The New International Economies of Scale 293 Immigration of Skilied Labor 294 7-7 LogisticsorSupply-Chain Management 295 CASE STUDY 7-4 Logistics at National Semiconductors, Saturn, and Compaq 296 7-8 Cost-Volume-Profit Analysis and Operating Leverage 297 Cost-Volume-Profit Analysis 297 Operating Leverage 299 CASE STUDY 7-5 Breakeven Analysis for Lockheed's Tri-Star and Europe's Airbus Industrie 301 7-9 Empirical Estimation of Cost Functions 302 Data and Measurement Problems in Estimating Short-Run Cost Functions 302 The Functional Form of Short-Run Cost Functions 304 CASE STUDY 7-6 Estimates of Short-Run and Long-Run Cost Functions 305 Estimating Long-Run Cost Functions with Cross-Sectional Regression Analysis 306 Estimating Long-Run Cost Functions with Engineering and Survival Techniques 308 Summary • Problems • Spreadsheet Problems

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CONTENTS

Appendix to Chapter 7 Cost Analysis with Calculus 313 Appendix Problems • Supplementary Readings INTEGRATING CASE STUDY 4 Production and Cost Functions in the Petroleum Industry 317 INTEGRATING CASE STUDY 5 The Third Industrial Revolution 320 Toward a Third Dimension 320 The Shock of the New 321 INTEGRATING CASE STUDY 6 Toyota: The Machine That Ran Too Hot 322 PART FOUR

MARKET STRUCTURE AND PRICING PRACTICES

325

CHAPTER 8 Market Structure: Perfect Competition, Monopoly, and Monopolistic Competition 327 8-1 Market Structure and Degreeof Competition 328 8-2 Perfect Competition 329 Meaning and Importance of Perfect Competition 330 Price Determination under Perfect Competition 330 CASE STUDY 8-1 Competition in the New York Stock Market 331 Short-Run Analysis of a Perfectly Competitive Firm 333 Short-Run Supply Curve of the Competitive Firm and Market 336 Long-Run Analysis of a Perfectly Competitive Firm 336 CASE STUDY 8-2 Long-Run Adjustment in the U.S. Cotton Textile Industry 338 8-3 Competition in the Global Economy 339 Domestic Demand and Supply, Imports, and Prices 339 The Dollar Exchange Rate and the International Competitiveness of U.S. Firms 340 CASE STUDY 8-3 The Exchange Rate of the U.S. Dollar and the Profitability of U.S. Firms 342 8-4 Monopoly 343 Sources of Monopoly 343 CASE STUDY 8-4 Barriers to Entry and Monopoly by Alcoa 344 Short-Run Price and Output Determination under Monopoly 345 Long-Run Price and Output Determination under Monopoly 347 Comparison of Monopoly and Perfect Competition 348 BOX 6 Managerial Economics at Work: De Beers Abandons Its Diamond Monopoly 350

CONTENTS

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8-5 MortopolisticCompetition 352 Meaning and Importance of Monopolistic Competition 352 CASE STUDY8-5 The Monopolistically Competitive Restaurant Market 353 Short-Run Price and Output Determination under Monopolistic Competition 353 Long-Run Price and Output Determination under Monopolistic Competition 354 Product Variation and Selling Expenses under Monopolistic Competition 356 CASE STUDY 8-6 Advertisers Are Taking on Competitors by Name... and Being Sued 356 Summary • Problems • Spreadsheet Problems Appendix to Chapter 8 Profit Maximization with Calculus 362 Appendix Problems • Supplementär/ Readings

CHAPTER 9 Oligopoly and Firm Architecture 366 9-1 Oligopoly and Market Concentration 367 Oligopoly: Meaning and Sources 367 CASE STUDY 9-1 Brands: Thriveor Die 369 Concentration Ratios, the Herfindahl Index, and Contestable Markets 370 CASE STUDY 9-2 Industrial Concentration in the United States 371 9-2 Oligopoly Models 372 The Cournot Model 372 The Kinked Demand Curve Model 374 Carte! Arrangements 376 CASE STUDY 9-3 The Organization of Petroleum Exporting Countries (OPEC) Cartel 377 Price Leadership 378 9-3 Profitability and Efficiency Implications of Oligopoly 380 Porter's Strategie Framework 380 Efficiency Implications of Oligopoly 381 CASE STUDY 9-4 Firm Size and Profitability 382 CASE STUDY 9-5 Measuring the Pure Efficiency of Operating Units 383 9-4 The Sales Maximization Model 384

9-5 The March of Global Ollgopolists 385 CASE STUDY 9-6 The Globalizationofthe Automobile Industry 387 CASE STUDY 9-7 Aising Competition in Global Banking 388 CASE STUDY 9-8 The Globalization of the Pharmaceutical Industry 390 BOX 7 Managerial Economics at Work: Multinational Corporations Follow Better Management Practices Than National Corporations 391 9-6 The Architecture of the Ideal Firm and the Creative Company 392 The Architecture of the Ideal Firm 392 The Evolution of the Creative Company 394 CASE STUDY 9-9 Firm Architecture and Organizational Competitiveness of High-Performance Organizations 395 CASE STUDY 9-10 The Most Innovative Companies in the World 396 9-7 The Virtual Corporation and Relationship Enterprises 397 The Virtual Corporation 397 Relationship Enterprises 398 CASE STUDY 9-11 Relationship Enterprises in Aerospace, Airlines, Telecommunications, and Automobiles 399 Summary • Problems • Spreadsheet Problems Appendix to Chapter 9 Oligopoly Theory Mathematically 403 The Cournot Model 403 The Kinked Demand Curve Model 406 The Centralized Cartel Model 407 The Market-Sharing Cartel 408 The Sales Maximization Model 409 Appendix Problems • Supplementary Readings

CHAPTER 10 Game Theory and Strategie Behavior 413 10-1 Strategie Behavior and GameTheory 414 CASE STUDY 10-1 Military Strategy and Strategie Business Decisions 415 10-2 Dominant Strategy and Nash Equilibrium 416 Dominant Strategy 416 Nash Equilibrium 417 CASE STUDY 10-2 Dell Computers and Nash Equilibrium 419 10-3 The Prisoners' Dilemma 420

CONTENTS

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10-4 Price and Nonprice Competition, Cartel Cheating, and Prisoners' Dilemma 421 Price Competition and the Prisoners' Dilemma 421 Nonprice Competition, Cartel Cheating, and the Prisoners' Dilemma 422 10-5 Repeated Games and Tit-for-Tat Strategy 422 10-6 Strategie Moves 423 Threat, Commitments, and Credibility 423 Entry Deterrence 424 CASE STUDY 10-3 Wal-Mart's Preemptive Expansion Marketing Strategy 425 10-7 Strategie Behavior and International Competitiveness 426 BOX 8 Managerial Economics at Work: Companies' Strategie Mistakes and Faiiures 428 10-8 Sequential Games and Decision Trees 429 CASE STUDY 10-4 Airbus's Decision to Build the A380 and Boeing': Sonic Cruiser Response and the 747-8 431 Summary • Problems • Spreadsheet Problems • Supplementary Readings

CHARTER 11 Prlcing Practices 437 11-1 Pricing of Multiple Products 438 Pricing of Products with Interrelated Demands 439 Plant Capacity Utilization and Optimal Product Pricing 440 Optimal Pricing of Joint Products Produced in Fixed Proportions 442 Optimal Pricing and Output of Joint Products Produced in Variable Proportions 443 CASE STUDY 11-1 Optimal Pricing and Output by Gillette 445 11-2 Price Discrimination 446 Meaning of and Conditions for Price Discrimination 446 First- and Second-Degree Price Discrimination 448 Third-Degree Price Discrimination Graphically 449 CASE STUDY 11-2 Price Discrimination by Con Edison 451 Third-Degree Price Discrimination Algebraically 452 11-3 International Price Discrimination and Dumping 454 11-4 Transfer Pricing 455 Meaning and Nature of Transfer Pricing 455 Transfer Pricing with No External Market for the Intermediate Product 456

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CONTENTS Transfer Pricing with a Perfectly Competitive Market for the Intermediate Product 457 Transfer Pricing with an Imperfectly Competitive Market for the Intermediate Product 459 CASE STUDY 11-3 Transfer Pricing by Multinational Operating in Emerging Markets 461 CASE STUDY 11-4 Transfer Pricing in Advanced Countries 462 11-5 Pricing in Practice 462 Cost-Plus Pricing 463 Evaluation of Cost-Plus Pricing 463 Incremental Analysis in Pricing 465 CASE STUDY 11-5 Incremental Pricing at Continental Airlines 466 Peak-Load Pricing, TVo-Part Tariff, Tying, and Bundling 467 Other Pricing Practices 468 CASE STUDY 11-6 Bundling in the Leasing of Movies 469 CASE STUDY 11-7 No-Haggling Value Pricing in Car Buying 471 CASE STUDY 11-8 Name Your Price at Priceline 471 Summary • Problems • Spreadsheet Problems Appendix to Chapter 11 Third-Degree Price Discrimination with Calculus 476 Appendix Problems • Supplementary Readings INTEGRATING CASE STUDY 7 eBay and Competition on the Internet 481 No Safe Hävens 481 Customers Behind the Wheel 482 INTEGRATING CASE STUDY 8 Has Apple Peaked and Are Its Best Days Behind It? 483 INTEGRATING CASE STUDY 9 Pricing on the Internet 485

PART F1VE

REGULATION, RtSK ANALYSIS, AND CAPITAL BUDGETING CHAPTER 12 Regulation and Antitrust: The Role of Government in the Economy 489 12-1 Government Regulation to Support Business and to Protect Consumers,Workers, and the Environment 491 Government Regulations That Restrict Competition 491 Government Regulations to Protect Consumers, Workers, and the Environment 492 CASE STUDY121 Regulation Greatly Reduced Air Pollution 494

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CONTENTS

12-2 Externalities and Regulation 495 The Meaning and Importance of Externalities 495 Policies to Deal with Externalities 497 12-3 Public Utility Regulation 499 Public Utilities as Natural Monopolies 499 CASE STUDY 12-2 The Market for Dumping Rights 500 Difficulties in Public Utility Regulation 502 12-4 Antitrust: Government Regulation of Market Structure and Conduct 503 Sherman Act (1890) 504 Clayton Act (1914) 504 Federal Trade Commission Act (1914) 505 Robinson-Patman Act (1936) 505 Wheeler-Lea Act (1938) 505 Celler-Kefauver Antimerger Act (1950) 505 12-5 Enforcement of Antitrust Laws and the Deregulation Movement 505 Enforcement of Antitrust Laws: Some General Observation 506 Enforcement of Antitrust Laws: Structure 506 CASE STUDY 12-3 The IBM and AT&T Cases 507 CASE STUDY 12-4 Antitrust and the New Merger Boom 509 Enforcement of Antitrust Laws: Conduct 510 CASE STUDY 12-5 The Microsoft Antitrust Case 511 The Deregulation Movement 512 CASE STUDY 12-6 Deregulation of the Airline Industry: An Assessment 514 12-6 Regulation of International Competition 515 CASE STUDY 12-7 Voluntary Export Restraints on Japanese Automobiles to the United States 517 12-7 The Effect of Taxation on Business Decisions 517 BOX 9 Managerial Economics at Work: Corporate Tax Rates around the World and Multinational' Behavior 518 Summary • Problems • Spreadsheet Problems • Supplementary Readings

CHARTER 13 Risk Analysis 525 13-1 Risk and Uncertainty in Managerial Decision Making 527 CASE STUDY 13-1 The Risk Faced by Coca-Cola in Changing Its Secret Formula 528

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CONTENTS 13-2 Measuring Risk with Probability Distribution; 528 Probability Distribution: 529 An Absolute Measure of Risk: The Standard Deviation 531 Measuring Probabilities with the Normal Distribution 533 A Relative Measure of Risk: The Coefficient of Variation 534 CASE STUDY 13-2 RiskMetrics: A Method of Measuring Value at Risk 535 13-3 Utility Theory and Risk Aversion 536 CASE STUDY 13-3 The Purchase of Insurance and Gambling by the Same Individual—A Seeming Contradiction 539 13-4 Adjusting the Valuation Model for Risk 540 Risk-Adjusted Discount Rates 541 Certainty-Equivalent Approach 543 CASE STUDY 13-4 Adjusting the Valuation Model for Risk in the Real World 545 13-5 OtherTechniques for Incorporating Risk into Decision Making 546 Decision Trees 546 Simulation 548 13-6 Decision Making under Uncertainty 549 The Maximin Criterion 549 The Minimax Regret Criterion 550 Other Methods of Dealing with Uncertainty 551 CASE STUDY 13-5 Spreading Risks in the Choice of a Portfolio 552 13-7 Foreign-Exchange Risks and Hedging 553 CASE STUDY 13-6 Information, Risk, and the Collapse of Long-Term Capital Management 555 13-8 Information and Risk 556 Asymmetrie Information and the Market for Lemons 556 The Insurance Market and Adverse Selection 557 The Problem of Moral Hazard 557 The Principal-Agent Problem 558 CASE STUDY 13-7 Do Golden Parachutes Reward Failure? 559 Auctions 560 CASE STUDY 13-8 Auctioning of the Airwaves 561 Summary • Problems • Spreadsheet Problems • Supplementary Readings

CONTENTS CHARTER 14 Long-Run Investment Decisions: Capital Budgeting 570 14-1 Capital Budgeting: An Overview 571 Meaning and Importance of Capital Budgeting 571 Overview of the Capital Budgeting Process 573 CASE STUDY 14-1 Cost-Benefit Analysis and the SST 575 14-2 The Capital Budgeting Process 575 Projecting Cash Flows 575 CASE STUDY 14-2 The Eurotunnel: Another Bad French-British Investment? 576 Net Present Value (NPV) 578 Internal Rate of Return (IRR) 579 Comparison of NPV and IRR 579 CASE STUDY 14-3 Pennzoil's $3 Billion Capital Budgeting Challenge 580 CASE STUDY 14-4 Capital Budgeting for Investments in Human Capital 581 BOX 10 Managerial Economics at Work: Is a College Education Still Worth It? 582 14-3 Capital Rationing and the Profitability Index 583 14-4 The Cost of Capital 585 The Cost of Debt 585 The Cost of Equity Capital: The Risk-Free Rate Plus Premium 585 The Cost of Equity Capital: The Dividend Valuation Model 586 The Cost of Equity Capital: The Capital Asset Pricing Model (CAPM) 587 The Weighted Cost of Capital 589 14-5 Reviewing Investment Projects After Implementation 589 CASE STUDY 14-5 The Choice between Equity and Debt 590 14-6 The Cost of Capital and International Competitiveness 591 Summary • Problems • Spreadsheet Problems • Supplementary Readings INTEGRATING CASE STUDY 10 How Silicon Valley Conquered the Carriers 597 INTEGRATING CASE STUDY 11 Technology Giants at War 599 The Iron Phone 599 Search Engines and Siege Engines 599 Content-Maesters 600 Stark Realities 601

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APPENDIXES

603 APPENDIX A A-1 A-2 A-3 A-4 A-5 A-6 A-7

COMPOUNDING, DISCOUNTING, AND PRESENT VALUE 605 Future Value and Compounding 605 Presen! Value and Discounting 607 Future Value of an Annuity 607 Present Value of an Annuity 608 Compounding and Discounting Periods 608 Determining the Internst Rate 609 Perpetuities 609

APPENDIX B INTEREST FACTOR TABLES 611 TABLE B-1 Compound Value of $1 612 TABLE B-2 Present Value of $1 613 TABLE B-3 Future Value of an Annuity of $1 for n Periods 614 TABLE B-4 Present Value of an Annuity of $1 for n Periods 615 APPENDIX C STATISTICAL TABLES 616 TABLE C-l Areas under the Standard Normal Distribution 617 TABLE C-2 Areas in the Tails of the t Distribution 618 TABLE C-3 F Distribution for 5 Percent and 1 Percent Significance 619 TABLE C-4 Durbin-Watson Statistic for 5 Percent and 1 Percent Significance Points of dL and du 621 APPENDIX D ANSWERS TO SELECTED (ASTERISKED) PROBLEMS 623 Glossary 653 Index 667