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Nature and Scope
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■D
of ManagerialEconomics
Warren E. Buffett, celebratedchairmanof Omaha, Nebraska-basedBerkshireHathaway,Inc., started

an investmentpartnershipwith $100 in 1956 and went on to accumulatea personal net worth in
excess of $50 billion.
Buffett is famous for his razor-sharp focus on the competitiveadvantagesof Berkshire'swide

assortmentof operatingcompanies,includingBenjaminMoore (paints), Borsheim's(jewelry),Clayton
Homes, Dairy Queen, Fruit of the Loom, GEICO (insurance),General Re Corporation (reinsurance),
MidAmericanEnergy, the NebraskaFurnitureMart, See's Candies and Shaw's Industries(carpet and
floor coverings). Berkshiresubsidiariescommonlyearn more than 30 per cent per year on invested
capital, comparedwith the 10 per cent to 12 per cent rate of return earned by other well-managed
companies.Additional contributorsto Berkshire'soutstandingperformanceare substantialcommon
stock holdings in American Express,Coca-Cola,Procter & Gambleand Wells Fargo among others. As
both a skilled manager and an insightful investor,Buffett likes wonderfulbusinesseswith high rates
of return on investment,lofty profit marginsand consistentearningsgrowth.Complicatedbusinesses
that face fierce competitionand requirelargecapitalinvestmentare shunned.1
Buffett'ssuccess is powerfultestimonyto the practical usefulnessof managerialeconomics.

Managerialeconomicsanswersfundamentalquestions.When is the market for a productso attractive
that entry or expansion becomes appealing?When is exit preferable to continued operation?Why
do someprofessionspay well, while others offer only meagerpay? Successfulmanagers make good
decisions,and one of their most useful toolsis the methodologyof managerialeconomics.
HOW IS MANAGERIALECONOMICSUSEFUL?
Economictheory and methodologylay down rules for improvingbusiness and public

policydecisions.
EvaluatingChoiceAlternatives
Managerial Managerialeconomicshelpsmanagersrecognizehow economicforces affect organizations

Economics and describesthe economic consequencesof managerialbehavior. It also links economic
Applieseconomic
toolsand techniques concepts,data and quantitativemethods to develop vital tools for managerialdecision-
to businessand making.This processis illustratedin Figure1.1.
administrativedecision-
making.
1 InformationaboutWarrenBuffett'sinvestmentphilosophyand BerkshireHathaway,Inc., can be found
on the Internet,http://www.berkshirehathaway.com
3
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4 Part 1:OverviewofManagerialEconomics
Figure 1.1 ManagerialEconomicsis a Toolfor ImprovingManagementDecision-Making
Managerialeconomicsuses economicconceptsandquantitativemethodsto solve managerialproblems.
ManagementDecision Problems
Product selection,outputand pricing
Internetstrategy
Organizationdesign
Product developmentand promotion
strategy
Workerhiring and training
Investmentand financing
EconomicConcepts QuantitativeMethods
Marginalanalysis Numericalanalysis
Theory of consumerdemand Statisticalestimation
Theory of the firm Forecastingprocedures
Industrialorganizationand firm Game-theoryconcepts
behavior Optimizationtechniques
Public choicetheory Informationsystems
ManagerialEconomics
Use of economicconceptsand
quantitativemethodsto solve
managementdecision problems
Optimal solutionsto management

decision problems
Managerialeconomics identifies ways to achievegoals efficiently. For example,

suppose a small businessseeks rapid growth to reach a size that permits efficient use
of national media advertising,managerialeconomicscan be used to identify pricing
and productionstrategiesto help meet this short-run objectivequickly and effectively.
Similarly, managerialeconomicsprovidesproductionand marketingrules that permit
the company to maximizenet profits once it has achieved growth or market share
objectives.
Managerialeconomicshas applicationsin both profit and not-for-profitsectors. For
example,an administrator of a nonprofit hospitalstrives to providethe best medical care
possible given limited medicalstaff, equipment,and related resources.Using the tools
and concepts of managerialeconomics,the administratorcan determinethe optimal
allocation of these limited resources.In short, managerial economicshelps managers
arrive at a set of operatingrules that aid in the efficient use of scarce human and capital
Copyright2016CengageLearning.All RightsReserved.May not be copied,scanned,or duplicated,in wholeor in pait. Due to electronicrights,some thirdpartycontent maybe suppressedfromtheeBook and/oreChaptei
Editorialreviewhasdeemedthatanysuppressedcontentdoesnot materiallyaffecttheoveralllearningexperienceCengageLearningreservestherightto removeadditionalcontentat anylimeifsubsequentrightsrestrictionsre
Chapter1: Natureand Scopeof ManagerialEconomics 5
resources.By followingthese rules, businesses,nonprofit organizationsand government

agenciesareable to meet objectivesefficiently.
Makingthe Best Decision
To establish appropriatedecision rules, managersmust understandthe economic

environmentin which they operate.For example,a groceryretailer may offer consumers
a highly price-sensitiveproduct, such as milk, at an extremelylow markup over
cost - say, 1 per cent to 2 per cent - while offeringless price-sensitiveproducts, such
as nonprescriptiondrugs, at markupsof as high as 40 per cent over cost. Managerial
economicsdescribesthe logic of this pricing practice with respect to the goal of profit
maximization.Similarly, managerialeconomicsrevealsthat auto import quotas reduce
the availabilityof substitutesfor domesticallyproduced cars, raise auto prices, and
create the possibilityof monopolyprofits for domesticmanufacturers.It does not explain
whetherimposing quotas is good public policy; that is a decision involvingbroader
politicalconsiderations.Managerialeconomicsonly describesthe predictableeconomic
consequencesof suchactions.
Managerialeconomicsoffers a comprehensiveapplicationof economictheory and
methodologyto managementdecision-making.It is as relevant to the management
of governmentagencies, cooperatives,schools, hospitals,museums,and similar not-
for-profit institutionsas it is to the managementof profit-orientedbusinesses.Although
this text focusesprimarilyon businessapplications,it also includes examples and
problemsfromthe governmentand nonprofit sectorsto illustratethe broad relevanceof
managerialeconomics.
ManagerialApplication1.1
BusinessEthics
In FinancialTimes, you cansometimesfind evidenceof • Acceptresponsibilityforyourmistakes,andfix them.Be

unscrupulousbusinessbehavior.However,unethicalconduct quick toshare creditfor success.
is inconsistentwith value maximizationand contraryto • Leave somethingon the table.Profit with yourcustomer,
the enlightenedself-interestof managementand other not offyour customer.
employees,if honestydidn't pervadecorporations,theability • Stickby yourprinciples.Principlesare not for sale at any
to conductbusinesswouldcollapse.Eventually,the truth price.
alwayscomesout,and whenit does the unscrupulouslose
Does the'highroad' lead tocorporatesuccess?Considerthe
out. For betteror worse,we areknown by the standardswe
experienceof A.P.Moller/Maersk- a Scandinaviancompany.
adopt.Tobecomesuccessfulin business,everyonemust
At A.P. Moller/Maersktheirfounder usedthe phrase:'noloss
adopta set of principles.Ethical rulesto keep in mind when
shouldhitus,which by duediligencecouldbe averted'.
conductingbusinessinclude:
• Aboveall else,keep yourword.Say whatyou mean,and See: http://www.maer5k.com
mean what you say.
• Do the right thing.A handshakewith an honorable
personis worth morethan a ton of legal documentsfrom
a corruptindividual.
Copyright2016CengageLearning.All RightsReserved.May not be copied,scanned,or duplicated,in wholeorin part. Due to electronicrights,some thirdpartycontentmay be suppressedfrom theeBookand/oreChapter
EditorialreviewhasdeemedthatanysuppressedcontentdoesnotmateriallyaffecttheoveralllearningexperienceCengageLearningreservestherightto removeadditionalcontentat anytimeifsubsequentrightsrestrictionsre
THEORYOF THE FIRM
Firms areuseful for producinganddistributinggoods and services.
ExpectedValue Maximization
At its simplestlevel, a business enterpriserepresentsa series of contractualrelationships

that specifythe rightsand responsibilities
of variousparties (seeFigure1.2). People directly
involved includecustomers,stockholders,management,employees,and suppliers.Society
is also involved becausebusinessesuse scarce resources,pay taxes, provide employment
opportunities,and produce much of society's materialand servicesoutput. The model
Theoryof the of business is called the theoryof the firm. In its simplestversion, the firm is thought to
Firm have profit maximizationas its primary goal. The firm's owner-manageris assumed to be
Basic modelof
business. working to maximizethe firm's short-runprofits. Today, the emphasison profits has been
broadenedto encompassuncertaintyand the time value of money. In this more complete
Expected Value model, the primarygoalof the firm is long-termexpectedvaluemaximization.
Maximization The value of the firm is the present value of the firm's expectedfuture net cash
Optimizationof
profits in lightof flows. If cash flows are equated to profits for simplicity,the value of the firm today, or
uncertaintyand its presentvalue, is the value of expected profits, discountedback to the present at an
the time valueof appropriateinterest rate.2
money.
This modelcan be expressedas follows
Valueof the Firm
Presentvalue of
the firm's expected Value of the Firm =Present Value of ExpectedFuture Profits
future net cash
flows. - ^ + _£2, . . . + 1.-!
(1+ 01 (l + o2 d + O"
Present Value
Worth in current TT,
dollars. =1
1 =1 d + O'
Here, tt], 772, ..., tt,, represent expected profits in each year, t, and i is the appropriate
interest, or discount, rate. The final form for Equation (1.1) is simply a shorthand
expressionin whichsigma (S) stands for 'sumup'or 'add together'.Theterm
( =1
means, 'Add togetheras t goes from 1 to n the valuesof the term on the right'. For Equation
(1.1), the process is as follows: Let t — I and find the value of the term rq/O + 01, the
present value of year 1 profit; then let t-2 and calculate772/(1 + 02 , the presentvalue of
year 2 profit; continueuntil t = n, the last year included in the analysis; then add up these
present-valueequivalentsof yearlyprofits to find the currentorpresentvalue of the firm.
Because profits (77) are equal to total revenues(TR) minus total costs (TC), Equation
(1.1) can be rewrittenas
, V TR, — TCf
Value = Z* —7^—rrr1 1.2
f=i (1+/)'
2 Discountingis required becauseprofits obtainedin the futureare less valuablethanprofits earned

presently.Oneeurotoday isworth morethan€1 tobe receiveda year fromnow because€1 todaycan
be investedand, withinterest,grow to a larger amountbythe end of theyear. One euroinvestedat
10 percent interestwouldgrowto €1.10 in1 year. Thus, €1 is defined as the presentvalueof €1.10 due in
1 yearwhenthe appropriateinterestrateis 10 per cent.
Copyright2016CengageLearning.All RightsReserved.May not be copied,scanned,or duplicated,in wholeor in pait. Due to electronicrights,some thirdpartycontentmay be suppressedfromtheeBook and'oreChaptei
Chapter1: Natureand Scopeof ManagerialEconomics
Figure1.2 The Corporationis a Legal Device
The firm can be viewedas a seriesof contractualrelationshipsthatconnectsuppliers,investors,

workersand managementin a jointeffort to servecustomers.
Society
Suppliers Investors
Firm
Management Employees
\
Customers
This expanded equationcan be used to examinehow the expectedvalue maximization

modelrelates to a firm's various functionaldepartments.The marketingdepartmentoften
has primary responsibilityfor promotionand sales (TR); the productiondepartmenthas
primaryresponsibilityfor developmentcosts(TC); and the finance departmenthas primary
responsibilityfor acquiringcapitaland, hence,for the discountfactor (/) in the denominator.
Importantoverlapsexist amongthese functionalareas. The marketingdepartmentcan help
reduce costs for a given level of output by influencingcustomerorder size and timing.
The productiondepartmentcan stimulatesales by improvingquality. Other departments,
for example,accounting,human resources,transportation,and engineering,provide
informationand services vital to sales growth and cost control. The determinationof TR
and TC is a difficult and complextask. All managerialdecisionsshould be analyzed in
termsof their effectson value,as expressedin Equations(1.1) and (1.2).
Constraintsand the Theory of the Firm
Organizationsfrequentlyface limitedavailabilityof essential inputs,such as skilled labor,

raw materials,energy, specializedmachineryand warehousespace. Managersoften
face limitationson the amount of investment fundsavailable for a particularproject or
activity.Decisionscan also be constrainedby contractualrequirements.For example,labor
contracts limit flexibilityin workerschedulingandjob assignments.Contractssometimes
require that a minimumlevel of output be producedto meet deliveryrequirements.In
most instances,output must also meet quality requirements.Some common examples
of output quality constraints are nutritionalrequirementsfor feed mixtures,audience

exposurerequirementsfor marketing promotions,reliabilityrequirementsfor electronic
products,and customerservicerequirementsfor minimumsatisfactionlevels.
Legal restrictions,which affect both productionand marketingactivities, can also
play an importantrole inmanagerialdecisions.Laws that define minimumwages,health
and safetystandards,pollutionemissionstandards,fuel efficiency requirements,and fair
pricing andmarketingpracticesall limitmanagerialflexibility.
The role that constraintsplay in managerialdecisionsmakes the topicof constrained
optimizationa basicelementof managerialeconomics.Later chaptersconsiderimportant
economic implicationsof self-imposedand socialconstraints. Thisanalysis is important
because value maximizationand allocativeefficiency in society depend on the efficient
use ofscarceeconomicresources.
Limitationsof the Theoryof the Firm
Optimize In practice, do managerstry to optimize(seek the best result) or merely satisfice

Seekthe best (seek satisfactoryrather than optimal results)? Do managers seek the sharpestneedle
solution.
in a haystack (optimize),or do they stop after finding one sharp enough for sewing
Satisfice (satisfice)? How can one tell whether companysupportof the UnitedWay, for example,
Seek satisfactory
leads to long-run valuemaximization?Aregeneroussalariesand stockoptionsnecessary
ratherthan optimal
results. to attract and retain managerswho can keep the firm ahead of the competition?When
a risky ventureis turned down, is this inefficient risk avoidance?Or does it reflect an
appropriatedecisionfrom the standpointof valuemaximization?
It is impossibleto give definitive answersto questionslike these, and this dilemma
has led to the developmentof alternativetheories of firm behavior.Some of the more
prominentalternativesare modelsin which size or growth maximizationis the assumed
primaryobjectiveof management,modelsthat argue that managersare most concerned
with their own personalutility or welfaremaximization,and models that treat the firm as
a collectionof individualswithwidely divergentgoalsratherthanas a single,identifiable
unit. These alternativetheories, or models, of managerialbehavior have added to our
understandingof the firm. Still, none can supplantthe basic value maximizationconcept
as a foundationfor analyzingmanagerialdecisions. Examiningwhy provides additional
insight into the value of studyingmanagerialeconomics.
Researchshows that vigorouscompetitiontypicallyforcesmanagers to seek value
maximizationin their operating decisions.Competitionin the capital markets forces
managersto seek value maximizationin their financing decisionsas well. Stockholders
are, of course, interested in value maximizationbecauseit affects their rates of return
on commonstock investments.Managers who pursue their own interestsinstead of
stockholders'interestsrun the risk of losing theirjob. Unfriendlytakeoversare especially
hostile to inefficient managementthat is replaced.Moreover,recentstudiesshow a strong
correlationbetweenfirm profits and managerialcompensation.Managementhas strong
economicincentivesto pursuevaluemaximizationthroughtheirdecisions.
It is sometimesoverlooked that managersmust consider all relevant costs and
benefits beforethey can make reasoneddecisions.It is unwise to seekthe best technical
solution to a problem if the costs of finding such a solutiongreatly exceed resulting
benefits. As a result, whatoften appearsto be satisficing on the part of managementcan
be interpretedas value-maximizingbehavioronce the costs of informationgatheringand
analysis are considered.Similarly,short-rungrowth maximizationstrategiesare often
consistentwith long-runvalue maximizationwhen the production,distributionand
promotionaladvantagesof largefirm size are better understood.
Finally, the value maximizationmodel also offers insight into a firm's voluntary
'socially responsible' behavior.The criticismthat the traditionaltheory of the firm
emphasizesprofits and value maximizationwhile ignoring the issue of social
responsibilityis importantand will be discussed later in the chapter. For now, it will
proveuseful to examinethe conceptof profits,whichis centralto the theoryof the firm.
PROFITMEASUREMENT
Free enterprisedependsupon profits and the profit motive. Both play a role in the
efficient allocationof economicresourcesworldwide.
BusinessVersus EconomicProfit
Profit is usuallydefined as the residualof sales revenueminus the explicitcosts of doing

business. It is the amountavailable to fund equity capital after payment for all other
BusinessProfit resourcesused by the firm. This definition of profit is accountingprofit, or business
Residualof sales profit.
revenueminusthe
explicitaccounting The economistalso defines profit as the excess of revenuesover costs. However,
costsof doing inputs providedby owners, including entrepreneurialeffort and capital, are resources
business. that must be compensated.The economistincludes a normal rate of return on equity
capital plus an opportunitycost for the effort of the owner-entrepreneur as costs of
doing business,just as the interest paid on debt and the wages are costs in calculating
The World is Turningto Capitalismand Democracy
Capitalismand democracyare mutuallyreinforcing.Some Competitionis a fundamentallyattractivefeatureof

philosophershavegoneso far as tosay thatcapitalismand the capitalisticsystem because it keepscosts and prices
democracyare intertwined.Withoutcapitalism,democracy low. By operatingefficiently,firmsare ableto producethe
may be impossible.Without democracy,capitalismmay fail. maximumquantityand qualityofgoodsand services.
At a minimum,freelycompetitivemarketsgive consumers Mass productionis, by definition,productionfor the
broadchoices,and reinforcethe individualfreedoms masses.Competitionalso limits concentrationofeconomic
protectedin a democraticsociety.In democracy,government and politicalpower.Similarly,the democraticform of
does notgrant individualfreedom.Instead,the political governmentis inconsistentwithconsolidatedeconomic
powerof governmentemanatesfrom the people.Similarly, influenceand decision-making.
theflow of economicresourcesoriginateswith the individual Totalitarianformsof governmentare in retreat.China
customerin a capitalisticsystem.It is notcentrallydirected has experiencedviolentupheavalas thecountryembarks
by government. on much-neededeconomicand politicalreforms.In the
Capitalismis sociallydesirablebecauseof its decentralized formerSovietUnion,Eastern Europe,India and Latin America,
and customer-orientednature.Themenuof productsto be years of economicfailureforced governmentsto dismantle
produced is derivedfrom marketpriceandoutputsignals entrenchedbureaucracyand installeconomicincentives.
originatingin competitivemarkets,notfrom the output Rising living standardsand politicalfreedomhave made life
schedulesof a centralized planningagency.Resourcesand in the West the envy ofthe world.Againstthis backdrop,the
productsare alsoallocatedthroughmarketforces.Theyare future is brightfor capitalismanddemocracy!
not earmarkedonthe basis of favoritismor social status.
Throughtheirpurchasedecisions,customersdictatethe See: ThomasB. Edsall'Capitalismvs.Democracy,'The New YorkTimes,
quantityandqualityof productsbroughtto market. January28,2014,http://www.wsj.com
Normal Rateof businessprofit. The risk-adjustednormalrate of returnon capitalis the minimumreturn

Return
necessaryto attract and retain investment.Similarly,the opportunitycost of owner
Averageprofit
necessaryto effort is determinedby the value that could be received in alternativeemployment.In
attractand retain economicterms,profit is businessprofit minus the implicit(noncash)costs ofcapital and
investment. other owner-providedinputs used by the firm. This profit conceptis called economic
EconomicProfit profit.
Businessprofit The conceptsof businessprofit and economicprofit can be used to explain the role
minusthe implicit
costsof capitaland of profits in a free-enterpriseeconomy.A normal rate of return is necessaryto induce
any other owner- individualsto invest funds rather than spend them for currentconsumption.Normal
providedinputs. profit is simplya cost for capital;it is no differentfrom the cost of otherresources,suchas
labor, materials,and energy.A similarpriceexists for the entrepreneurialeffortof a firm's
owner-managerand for other resourcesthat ownersbring to the firm. Opportunitycosts
for owner-providedinputsare often a big part of businessprofits, especiallyamongsmall
businesses.
Variabilityof BusinessProfits
In practice,reported profits fluctuate widely. Table 1.1 shows business profits for
a sampleof 30 well-knownindustrialgiants: companiesthat comprise the Dow
Jones Industrial Average.Business profit is often measured in dollar terms or as a
Profit Margin percentageof sales revenue, called profit margin, as in Table 1.1. The economist's
Accountingnet concept of a normal rate of profit is typically assessed in terms of the realized
incomedivided by
sales. rate of return on stockholders'equity (ROE). Return on stockholders'equity is
defined as accountingnet income dividedby the book value of the firm. As seen in
Return on
Stockholders' Table 1.1, the average ROE for industrialgiants found in the Dow Jones Industrial
Equity Average falls in a broad range around 15 per cent to 25 per cent per year. Although
Accountingnet an average annual ROE of roughly 20 per cent can be regarded as a typicalor
incomedivided by
normal rate of returnin the USA and Canada,this standardis routinelyexceededby
thebook valueof
total assets minus companiessuch as BoeingCompany,which has consistentlyearneda ROE in excess
total liabilities. of 35 per cent per year.
Some of the variation in ROE depicted in Table 1.1 represents the influence of
differential risk premiums.In the pharmaceuticalsindustry,for example, hoped-for
discoveriesof effectivetherapies for importantdiseases are often a long shot at best.
Thus, profit ratesreportedby Merck, Pfizer,and otherleadingpharmaceuticalcompanies
overstatethe relativeprofitabilityof the drug industry;it could be cut by one-halfwith
proper risk adjustment.Similarly,reported profit rates can overstate differencesin
economic profits if accountingerror or bias causes investmentswith long-term benefits
to be omitted from the balancesheet. For example, current accountingpractice often
fails to consideradvertisingor research and developmentexpendituresas intangible
investmentswithlong-termbenefits. Becauseadvertisingand researchand development
expendituresare immediatelyexpensed rather than capitalized and written off over
their useful lives, intangibleassets can be grosslyunderstatedfor certain companies.The
balance sheet of Coca-Cola does not reflect the hundreds of millionsof dollars spent to
establishand maintainthe brand-namerecognitionof Coca-Cola,just as Pfizer's balance
sheet fails to reflect research dollarsspent to develop importantproduct names like
cholesterol-lowering Lipitor (the world'sbest-sellingdrug), Inspra(for the treatmentof
congestiveheart failure) and Viagra (for the treatmentof male impotence).As a result,
businessprofit rates for both Coca-Cola and Pfizer overstate each company'strue
economicperformance.
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11
WHY DO PROFITSVARYAMONG FIRMS?
Many firms earn significanteconomicprofitsor experiencemeaningfullosses.
DisequilibriumProfit Theories
FrictionalProfit One explanationof economic profits or losses is frictional profit theory. It states that
Theory marketsare sometimesin disequilibriumbecauseof unanticipatedchangesin demandor
Abnormalprofits
observedfollowing cost conditions.Unanticipatedshocks producepositive or negativeeconomicprofits for
unanticipated some firms.
changes indemand For example,automatedteller machines(ATMs) make it possible for customersof
or cost conditions.
financial institutionsto easily obtain cash, enter deposits,and make loan payments.
ThoughATMs render obsolete manyof the functions thatused to be carried out at branch
offices, they foster ongoing consolidationin the industry.Similarly, new user-friendly
software increasesdemand for high-poweredpersonalcomputers(PCs) and boosts returns
for efficient PC manufacturersand softwarevendors.A rise in the use of plasticsand
aluminumin automobilesdrivesdownthe profits of steel manufacturers.Overtime,barring
impassable barriersto entry and exit, resourcesflow into or out of financial institutions,
computermanufacturers,and steel manufacturers,thus driving rates of return back to
normal levels.Duringinterim periods,profits might be above or below normal becauseof
frictionalfactorsthat preventinstantaneousadjustmentto new marketconditions.
MonopolyProfit A furtherexplanationof above-normalprofits is the monopolyprofit theory, an
Theory extension of frictionalprofit theory. Some firms earn above-normalprofits becausethey
Above-normal
profits causedby are shelteredfrom competitionby high barriers to entry. Economiesof scale, high capital
barriersto entrythat requirements,patentsor importprotectionenablesome firms tobuild monopolypositions
limitcompetition. that allow above-normalprofits for extendedperiods. Monopolyprofits can also arise
because of luck (being in the right industryat the right time) or from anticompetitive
behavior. Unlike other potentialsources of above-normalprofits, monopolyprofits are
often seenas unwarrantedand subject to heavytaxesor otherwiseregulated.
CompensatoryProfit Theories
Innovation Profit Innovationprofit theory describesabove-normalprofits that arise followingsuccessful

Theory inventionor modernization.Forexample,innovationprofit theorysuggeststhat Microsoft
Above-normal
profits that follow Corporationhas earned superiorrates of return because it successfullyintroducedand
successfulinvention marketed the graphicaluser interface,a superior image-basedrather than command-
or modernization. based approach to computersoftwareinstructions.Microsofthas continuedto earn
above-normalreturnsas other firms scramble to offer a wide variety of 'user friendly'
software for personaland businessapplications.Only after competitorshave introduced
and successfullysaturated the market for user-friendlysoftwarewill Microsoft profits
be driven downto normallevels. Similarly,Apple Corporationhas earned above-normal
rates of return as an earlyinnovatorwith its iPod line of portable digitalmusicand video
players. With increasedcompetitionfromMicrosoft'sline of Zune devices, amongothers,
it remains to be seen if Apple can maintainits position in the portable digital device
market, or will instead see its marketdominanceand above-normalreturns decline. As
in the case of frictionalor disequilibriumprofits, profits that are due to innovationare
Compensatory susceptibleto the onslaughtofcompetitionfrom newand establishedcompetitors.
Profit Theory In general, compensatoryprofit theory describesabove-normalrates of return that
Above-normal
ralesof returnthat rewardfirms for extraordinarysuccessin meetingcustomerneeds and maintainingefficient
rewardefficiency. operations.If firms that operateat the industry'saveragelevel of efficiency receive normal
ratesof return,it is reasonableto expectfirms operatingat above-averagelevels of efficiency

to earn above-normalrates of return.Inefficientfirms earnbelow-normalrates of return.
Compensatoryprofit theoryalso recognizeseconomicprofit asan importantrewardto the
entrepreneurialfunctionof ownersand managers.Every productstarts as an idea for serving
better some establishedor perceivedneed of existing or potentialcustomers. This need
remainsunmetuntil someonedesigns,plans, and implementsa solution.Theopportunityfor
economicprofitsis an importantmotivationfor suchentrepreneurialactivity.
Role of Profits in the Economy
Each of the precedingtheories describeseconomicprofits obtainedfor differentreasons.

In some cases, several theoriesmay apply An efficient manufacturerlike Boeing may
earnan above-normalrate of return in accordancewith compensatorytheory,but, during
a strike by competitorAirbusemployees,these above-averageprofits may be augmented
by frictional profits. Microsoft's profit position can be partly explainedby all four
theories:The companyhas earned high frictionalprofits while Google, IBM, and Oracle,
amonga host of others, scrambleto offer new computersoftware, games, and services;
Microsofthas earned monopolyprofits because it has some copyrightand patent
protection;it has certainlybenefitted fromsuccessfulinnovation;and it is well managed
and thus has earned compensatory profits.
Economicprofits play an importantrole in any market-basedeconomy.Above-normal
profits serve as a valuable signal that firm or industryoutput should be increased.
Expansionby establishedfirms or entry by new competitorsoccurs quicklyduringhigh-
profit periods. Just as above-normalprofits signal the need for expansionand entry,
below-normalprofits signal the need for contractionand exit. Economic profits are
Googleon Social Responsibility
Form S-1 registrationstatementsare filed withthe Securities usersand advertisersefficiently,helpingboth.AdSensehelps

and ExchangeCommissionby companiesthat wantto sell fund a huge varietyof onlinewebsitesand enablesauthors
sharesto the investingpublic.Usuallywrittenby lawyers whocould not otherwisepublish/In2003,thecompany
and filled withlegalese,GooglecofounderLarry Page createdGoogleGrantstofund programsin whichhundredsof
shatteredWall Streettraditionwhen he usedthe company's nonprofits addressissues,includingthe environment,poverty
S-1 statementto lay outGoogle'sphilosophyon the social and humanrights,receive freeadvertisingto furthertheir
responsibilityof business. mission.In 2004,the companycommittedpartof theproceeds
'Don't be evil,' Pagewrote.'Webelievestronglythat in from its initial publicofferingand 1 per centof ongoingprofits
the long term,we will be betterserved- as shareholdersand to fundthe GoogleFoundation,an organizationintendedto
in all otherways- by a companythat does goodthings for ambitiouslyapply innovationand resourcestowardthe solution
theworld even if weforgo some short-termgains.Thisis an ofworld problems.
importantaspectof ourcultureand is broadlyshared within Googleis committedto optimizefor thelong term,and
the company.' will supporthigh-risk,high-rewardprojectsand manage
'We aspireto makeGooglean institutionthat makesthe them as a portfolio.Thecompanywill be run collaboratively
worlda betterplace.Withour products,Google connectspeople in aneffortto attract creative,committednewemployees.
and informationall around theworldforfree.We are adding It will be interestingto track their progress.
other powerfulservicessuch as Gmailthat providesan efficient
1-gigabyteGmailaccountforfree.By releasingservicesfor free, See:http://www.$ec.gov/Archives/edgar/data/1288776/000119312504073639
we hopeto help bridgethe digital divide.AdWordsconnects /dsl.htm
one of the most importantfactors affecting the allocationof scarce economicresources.

Above-normalprofits also rewardinnovationand efficiency, just as below-normalprofits
penalize stagnationand inefficiency. Profits play a vital role in providing incentivesfor
innovationand productiveefficiency and in allocatingscarceresources.
ROLE OF BUSINESSIN SOCIETY
Businessmakes a big contributionto economic bettermentin the USA and around the
globe.
Why Firms Exist
Firms exist because they are useful. They survive by public consent to serve social
needs. If social welfare could be preciselymeasured,business firms might be expected
to operatein a mannerthat maximizessome index of social well-being.Maximizationof
social welfarerequiresansweringthe followingimportantquestions:What combination
of goods and services (includingnegative by-products,such as pollution)should be
produced?How should goodsand servicesbe provided?How shouldgoods andservices
be distributed?These are the most vital questionsfaced in a free-enterprisesystem,and
they are key socialissues.
Although the process of market-determinedproductionand allocationof goods
and services is highly efficient, problems sometimesarise in an unconstrainedmarket
economy. Society has developedmethods for alleviating these problemsthrough the
politicalsystem.To illustrate,the economicsof producingand distributingelectricpower
are such that only one firm can efficiently serve a given community.Furthermore,there
is no good substitutefor electriclighting.As a result, electriccompaniesare in a position
to exploit consumers;they could chargehigh prices and earn excessiveprofits. To avoid
potentialexploitation,prices chargedby electriccompaniesand otherutilities are held to
levels thoughtto be justsufficient to providea fair rate of returnon investment.In theory,
the regulatoryprocessis simple.In practice,it is costly,and difficult to implement.It can
be arbitraryand a poor,but sometimesnecessary,substitutefor competition.
Problemscan also occur when, because of economiesof scale or other barriers to
entry, a limited numberof firms serve a given market. If firms competefairly with each
other, no difficulty arises. However,if they conspirewith one anotherin setting prices,
they may be able to restrict output, obtain excessiveprofits, and reduce social welfare.
Antitrust laws are designed to prevent such collusion. Like direct regulation,antitrust
laws containarbitraryelementsand are costly to administer,but they too arenecessaryif
socialjusticeis to be served.
The market economysometimesfaces difficulty when firms impose costs on others
by dumping wastes into the air or water. If a factory pollutes the air, causing nearby
residents to suffer lung ailments, a meaningfulcost is imposed on those people and
society in general. Failure to shift these costs back onto the firm and, ultimately,to the
consumersof its products,means that the firm and its customersbenefit unfairlyby not
having to pay the full costs ofproduction.Pollutionand otherexternalitiesmay result in
an inefficient and inequitableallocationof resources. In both governmentand business,
considerableattentionis directed at the problem of internalizingthese costs. Some of
the practicesused to internalizesocial costs include setting health and safety standards
for productsand work conditions,establishingemissionslimits on manufacturing,and
imposingfines or closingfirms that do not meetestablishedstandards.
Copyright2016CengageLearning.All RightsReserved.May not be copied,scanned,or duplicated,in wholeor in pait. Due to electronicrights,some thirdpartycontentmay be suppressedfromtheeBook and/oreChaptei
Social Responsibilityof Business
Whatdoes all this meanwith respectto the social responsibilityof business?Is the value
maximizationtheory of the firm adequatefor examiningissues of social responsibility
and for developingrulesthat reflect the role of businessin society?
As seen in Figure 1.3, firms are primarilyeconomicentities and can be expected
to analyze social responsibilityfrom within the contextof the economicmodel of the
firm. This is an importantconsiderationwhen examininginducementsused to channel
the efforts of business in directions that society desires. Similarconsiderationsshould
also be taken into account before applyingpoliticalpressureor regulationsto constrain
firm operations.For example,from the consumer'sstandpointit is desirableto pay low
rates for gas, electricityand telecom services. If public pressuresdrive rates down too
Figure1.3 ValueMaximizationis a ComplexProcess
Value maximizationis a complexprocess thatinvolvesan ongoingsequenceof successful

managementdecisions.
Businessand Social Environment
Technology MarketEnvironment Legal Environment

• Productioncapacity • Customerdemand • Tax burden
• Workerknowledge • Level of competition • Regulatorypolicy
• Communications capability • Suppliercapability • Trade policy
• Researchand development
CompetitiveStrategy
• Productchoice
• Pricingstrategy
• Promotionstrategy
1
OrganizationDesign
• Assignmentof decision rights
• Match workerincentiveswith
managerialmotives
• Decisionmanagementand
control
1
Pay for Performance
• Worker payfor performance
• Divisionalpay for performance
• Managementpay for
performance
1
The IKEA way
The SwedishcompanyIKEA,one ofthe world'slargest initiateda purchasingmodel(IWAY)thatcoverssocial,safety

furniturecompanies,has designedeasyto assemble andenvironmentalissues.Thefocuswith IWAY is to make
furniture.Besidesits moderndesign they have developed surethat IKEAsuppliersfollowthe law in each countrywhere
theirown way ofdoingbusiness.Theyhave paidspecial theyare based.
attentionto cost control,consumers'preferences,and layout Have a closer lookat IKEAand discusstheir wayof doing
of store design. In societyIKEA are involvedwithUNICEF sustainablebusiness.
where IKEASocialInitiativecontributed€1 to UNICEF and
Save the Children from eachsoft toy sold duringa set period.
Todaythey have raised morethan €20 million.Also theyhave See: http://www.ikea.com
low, however,utilityprofits could fall below the level necessary to providean adequate
return to investors. In that event, capital would flow out of regulated industries,
innovationwouldcease, andservicewould deteriorate.When suchissuesare considered,
the economicmodel of the firm provides useful insight. This model emphasizesthe
close relationbetween the firm and society, and indicatesthe importanceof business
participationin the developmentand achievementof social objectives.
STRUCTUREOF THIS TEXT
Objectives
This text shouldhelp you accomplishthe followingobjectives:

• Developa clear understandingof the economicmethodin managerialdecision-
making.
• Acquire a frameworkfor understandingthe nature of thefirm as an integratedwhole
as opposedto a looselyconnectedset of functionaldepartments.
• Recognizethe relationbetweenthe firm and societyand the role of businessas a tool
for social betterment.
Throughoutthe text, the emphasisis on the practical applicationof economic analysisto
managerialdecisionproblems.
Developmentof Topics
The value maximizationframeworkis useful for characterizingactual managerial

decisionsand for developingrulesthat can be used to improvethose decisions.The basic
test of the value maximizationmodel, or any model,is its ability to explain real-world
behavior.This text highlights the complementaryrelationbetweentheory and practice.
Theory isused to improvemanagerialdecision-making, and practicalexperienceleads to
the developmentof better theory.
Chapter 2, 'Economic Optimization',begins by examiningthe importantrole that

marginal analysisplays in the optimizationprocess. The balancingof marginalrevenues
and marginalcosts to determinethe profit-maximizingoutputlevel is explored, as are
other fundamentaleconomic relations that help organizationsemployscarce resources
efficiently. All of these economicrelations are consideredbased on the simplifying
assumptionthat cost and revenue relationsare knownwith certainty.Later in the book,
this assumptionis relaxed, and the more realistic circumstanceof decision-making
with uncertaintyis examined.This material shows how optimizationconceptscan be
effectivelyemployed in situationswhen managershave extensiveinformationabout
the chance or probabilityof certainoutcomes,but the end result of managerialdecisions
cannotbe forecastprecisely.
The conceptsof demand and supply are basic to understandingthe effective
use of economic resources.The general overview of 'Demand and Supply' in
Chapter 3 provides a frameworkfor the more detailed inquiry that follows.
Chapter4, 'Demand Analysis',emphasizesthat the successfulmanagementof any
organizationrequires a complete understandingof the demand for its products.
The demand function relates the sales of a product to such importantfactors as
the price of the product itself, prices of other goods, income, advertisingand even
weather.The role of demandelasticities,which measure the strength of relations
expressed in the demand function, is also emphasized.Given the challengesposed
by a rapidly changing global environment,a careful statisticalanalysis of demand
relations is often conductedto provide the informationnecessaryfor effective
decision-making.Tools used by managersin the statistical analysisof demand
relationsare the subject of Chapter 5, 'Demand Estimation'. Issues addressed in
Chapter6, 'Forecasting',providea useful frameworkfor the estimationof demand
and costrelations.
Chapters 7 and 8 examineproductionand cost concepts. The economics of
resourceemploymentin the manufactureand distributionof goods and services
is the focus of this material.These chapterspresent economicanalysis as a context
for understandingthe logic of managerialdecisions and as a means for developing
improvedpractices. Chapter 7, 'ProductionAnalysisand CompensationPolicy',
develops rules for optimal employmentand demonstrateshow labor and other
resourcescan be used in a profit-maximizingmanner. Chapter 8, 'Cost Analysis and
Estimation',focuses on the identificationof cost-outputrelationsso that appropriate
decisionsregardingproduct pricing, plant size and location and so on can be made.
Chapter 9, 'Linear Programming',introducesa tool from the decision sciences
that can be used to solve a variety of optimizationproblems.This technique offers
managers input for short-run operatingdecisions and informationhelpful in the
long-runplanningprocess.
The remainderof the book builds on the foundationprovided in Chapters 1
through9 to examinea variety of topics in the theory and practiceof managerial
economics.Chapter10, 'CompetitiveMarkets', offers perspectiveon the nature
of competitionin vigorouslycompetitivemarkets; Chapter 11, 'Performanceand
Strategyin CompetitiveMarkets', shows how firms succeed in competitivemarkets
by being cheaper, faster, or better than the competition.Chapter 12, 'Monopoly
and Monopsony',illustrateshow productdifferentiation,barriers to entry, and the
availabilityof informationinteractto determinethe vigor of competitionin markets
dominatedby a singleseller (monopoly)or a single buyer(monopsony).Chapter 13,
'MonopolisticCompetition and Oligopoly', considers industries in which
interactionsamong competitorsare normal. In Chapter 14, 'Game Theory and

CompetitiveStrategy',competitionamong the few is describedwith an eye towards
understandingand improvingbusinessstrategy. Chapter 15, 'Pricing Practices',
shows how the forces of supply and demand interact in settings where market
power is prevalent. Importantly,this chapter analyzespricing practicescommonly
observed in business and shows how they reflect the predictionsof economic
theory.
Chapter 16, 'Risk Analysis', illustrateshow the predictionsof economic theorycan
be applied in the real-worldsetting of uncertainty;and Chapter 17, 'CapitalBudgeting',
examines key elements of an effective long-termplanningframework.Chapter 18,
'OrganizationStructureand CorporateGovernance',offers insightconcerningthe value-
maximizingdesign of the firm and documentsthe importanceof businessethics.Finally,
Chapter 19, 'Governmentin the Market Economy',studies the role of governmentand
how the tools and techniques of managerialeconomics can be used to analyze and
improve publicsectordecisions.
SUMMARY
Managerialeconomicsfocuses on the applicationof • Economicprofit is businessprofit minusthe

economictheory and methodologyto the solution of implicitcostsof equityand otherowner-provided
practicalbusinessproblems. inputsused by the firm.
• Managerialeconomicsapplieseconomictheory • Profit margin,or net incomedividedby sales,and
andmethodsto businessandadministrative the returnon stockholders'equity,or accounting
decision-making. net incomedividedby the book valueof total assets
• The basic modelof the businessenterpriseis called minustotal liabilities,are practicalindicatorsof
the theoryof the firm. firm performance.
• The primarygoal is seenas long-termexpected • Frictionalprofit theory describesabnormalprofits
valuemaximization. observedfollowingunanticipatedchangesin
productdemandor cost conditions.
• The value of the firm is the presentvalueof the
firm's expectedfuturenet cash flows, where • Monopolyprofit theoryassertsthat above-normal
presentvalueis the valueof expectedcash flows profits are sometimescausedby barriersto entry
discountedback to the present atan appropriate that limit competition.
interestrate. • Innovationprofit theorydescribesabove-normal
• Valid questionsare sometimesraised about profits that arise as a result of successfulinvention
whethermanagersreallyoptimize (seekthe best or modernization.
solution)or merelysatisfice (seek satisfactory • Compensatoryprofit theoryholdsthatabove-
ratherthan optimalresults).Most often,especially normalrates of returncan sometimesbe seen as a
wheninformationcosts are considered,managers rewardto firms that are extraordinarilysuccessful
canbe seen as optimizing. in meetingcustomerneeds, maintainingefficient
• Businessprofit, or accountingprofit, is the residual operations,and so forth.
ofsales revenueminus the explicitaccountingcosts The use of economic methodologyto analyze and
ofdoing business. improve the managerial decision-makingprocess
• Businessprofit often incorporatesa normalrate of combinesthe study of theoryand practice.The primary
returnon capital, or the minimumreturnnecessary virtue of managerialeconomicslies in its usefulness.
to attract and retain investmentfor a particularuse. It works!
Copyright2016CengageLearning.All RightsReserved.May not be copied,scanned,or duplicated,in wholeor in pait. Due to electronicrights,some thirdpartycontentmay be suppressedfromtheeBook and/oreChapter
rialreviewhasdeemedthatanysuppressedcontentdoesnot materiallyaffecttheoveralllearningexperienceCengageLearningreservestherightto removeadditionalcontentat anylimeifsubsequentrightsrestrictionsre
QUESTIONS
Q1.1 Is it appropriateto view firms primarilyas to maximizetheir own welfare as opposed to that of
economicentities? stockholders.Does such behaviorcreate problemsin
Q1.2 Explain how the valuationmodel given in using value maximizationas a basis for examining
Equation (1.2) couldbe used to describethe integrated managerialdecision-making?
nature of managerialdecision-makingacross the Q1.5 How is the popularnotion of business profit
functionalareasof business. differentfrom the economic profit concept?What role
Q1.3 Describe the effects of each of the following does the idea of normalprofits play in this difference?
managerialdecisionsor economic influenceson the Q1.6 Which concept- the businessprofit conceptor the
valueof the firm: economicprofit concept- providesthe moreappropriate
A. The firm is requiredto install new equipment to basis for evaluatingbusinessoperations?Why?
reduceair pollution. Q1.7 Some arguethat prescriptiondrug manufacturers,
B. Through heavy expenditureson advertising, like Pfizer, gouge consumerswith high prices and
the firm's marketingdepartment increases sales make excessiveprofits. Others contend that high
substantially. profits are necessary to give leading pharmaceutical
C. The production departmentpurchases new companiesthe incentiveto conductrisky research and
equipmentthat lowersmanufacturingcosts. development.What factors should be consideredin
D. The firm raises prices. Quantity demandedin the examiningthe adequacyof profits for a firm or industry?
short run is unaffected,but in the longer run, unit Q1.8 Why is the conceptof enlightenedself-interest
salesare expectedto decline. importantin economics?
E. TheFederal ReserveSystemtakes actionsthatlower Q1.9 'In the long run, a profit-maximizingfirm
interestratesdramatically. would never knowinglymarket unsafe products.
F. An expectedincreasein inflation causes generally However,in the shortrun, unsafe productscan do a lot
higher interest rates, and, hence,the discountrate of damage.'Discussthis statement.
increases. Q1.10 Is it reasonableto expect firms to take actions
Q1.4 In the wake of corporatescandalsat Enron, that are in the public interest but are detrimentalto
Tyco, and WorldCom,some argue that managersof stockholders?Is regulation alwaysnecessary and
large, publiclyowned firms sometimesmakedecisions appropriateto inducefirms to act in the publicinterest?
CASE Study Is Coca-Colathe 'Perfect'Business?3
What does a perfect business look like? For and old alike. It would be cold ratherthan hot
Warren Buffett and his partnerCharlie Munger, so as to provide relief from climatic effects. It
vice chairmanof BerkshireHathaway,Inc., it mustbe orderedby name- a trademarkedname.
looks a lot like Coca-Cola.To see why, imagine Nobodygets rich selling easy-to-imitategeneric
going back in time to 1885, to Atlanta, Georgia, products.It mustgeneratea lot of repeatbusiness
and tryingto inventfrom scratch a nonalcoholic throughwhat psychologistscall conditioned
beveragethat would make you, yourfamily, and reflexes. To get the desired positiveconditioned
all of your friendsrich. reflex, you will want to make it sweet, rather
Your beverage would be nonalcoholicto than bitter, with no after-taste.Withoutany after-
ensure widespreadappeal among both young taste, consumerswill be able to drink as much
3 SeeCharlesT. Munger,'How DoYou Get WorldlyWisdom?'OutstandingInvestorDigest,December29,

1997,24-31.
continued
of your productas they like. By adding sugar to can also better safeguardits 'secret ingredients'.
make your beverage sweet, it gains food value This also avoidsthe problemof having to investa
in addition to a positive stimulant.To get extra- substantialamount in bottlingplants, machinery,
powerful combinatorialeffects, you may want deliverytrucks and so on. This minimizescapital
to add caffeine as an additional stimulant.Both requirements and boosts the rate of return
sugar and caffeine work; by combining them, on investedcapital. Moreover,if you correctly
you get more than a doubleeffect, you get what price the key syrup ingredient,you can ensure
Munger calls a 'lollapalooza'effect. Additional that the enormousprofits generatedby carefully
combinatorialeffects could be realized if you developed lollapaloozaeffects accrue to your
design the product to appear exotic. Coffee is company, and not to the bottlers.Of course, you
another popular product, so making your wantto offer independentbottlersthe potentialfor
beveragedark in colorseems like a safe bet. By highly satisfactoryprofits in order to providethe
addingcarbonation,a little fizz can be addedto necessaryincentivefor themto push yourproduct.
yourbeverage'sappearanceand its appeal. You not only want to 'leave somethingon the
To keep the lollapaloozaeffects coming, you table' for the bottlersin terms of the bottlers'profit
will want to advertise. If people associate your potential,but theyin turn mustalso be encouraged
beverage with happy times, they will tend to to 'leave somethingon the table' for restaurant
reach for it wheneverthey are happy, or want and other customers.This means that you must
to be happy. (Isn't that always, as in 'Always demand that bottlersdelivera consistentlyhigh-
Coca-Cola'?)Make it available at sporting qualityproduct at carefullyspecified pricesif they
events, concerts,the beach and at theme parks - are to maintaintheir valuablefranchiseto sell your
wherever and whenever people have fun. beveragein the local area.
Enclose your productin bright, upbeat colors If you had indeed gone back to 1885, to
that customers tend to associatewith festive Atlanta, Georgia, and followed all of these
occasions(anothercombinatorialeffect). Red and suggestions,you would havecreated what you
white packagingwould be a good choice. Also and I know as The Coca-ColaCompany.To be
make sure that customersassociateyourbeverage sure, therewould have been surprisesalong the
with festive occasions.Well-timed advertising way. Take widespreadrefrigeration,for example.
and price promotionscan help in this regard - Early on, Coca-Cola managementsaw the
annualprice promotionstied to the Fourth of July fountain business as the primary driver in cold
holiday,for example,wouldbe a good idea. carbonatedbeveragesales. They did not foretell
To ensureenormousprofits, profit marginsand that widespread refrigerationwould make
the rate of return on investedcapitalmustboth be grocery store sales and in-home consumption
high. To ensure a high rate of return on sales, the popular. Still, much of Coca-Cola'ssuccess has
price charged must be substantiallyabove unit been achieved because its managementhad,
costs. Becauseconsumerstend to be least price and still has, a good grasp of both the economics
sensitivefor moderatelypriced items, you would and the psychologyof the beveragebusiness.
like to havea modest 'pricepoint', say roughly€1 By gettinginto rapidly growingforeignmarkets
to €2 per serving.This is a big problemfor most with a winningformula, they hope to create
beveragesbecausewater is a key ingredient,and local brand-namerecognition,scale economies
water is very expensiveto ship long distances. in distribution,and achieve other 'first mover'
To get around this cost-of-deliverydifficulty, you advantageslike the ones they have nurtured in
will not want to sell the beverageitself, but a key the USAfor more than 100 years.
ingredient,like syrup, to local bottlers. By selling As shown in Figure 1.4, in a world where
syrup to independentbottlers, your company the typical companyearns 10 per cent rates
orialreviewhasdeemedthatanysuppressedcontentdoesnot materiallyaffecttheoveralllearningexperienceCengageLearningreservestherightto removeadditionalcontentat anylimeifsubsequentrightsrestrictionsre
continued
Figure 1.4 Coca-Colais a WonderfulBusiness
HECENT RtlATPIt i Oft :iv: VALUE

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25.E% ZtP: 2S7\ 35. % 32C%
3A5.C 7SZ.0 773.3 332.C &«■> v-Z'. £52
£029 9 m:
339.2 Depreeistcn {Jmill} C'.VJ
LToulimereaico.tragv tOx; F 4-290 ^33.C 2K-SC' S6S9.3 3979 C 11033 4793.3 j3J4C- £ &53 i>39.a 6735 Net ProfitiSmilTi 3
733% ofCEp*fi 31.5% 2?.f.% r-c;% 271% 29.6% 2? C% ?! '% 23.5% 22.4% 22 IncomeFa*Rate 2&55S
PensionAsseis-U.CSS:t.»4 b/l Oblig.33.05 btl 21.9% 156% '63% 79% 22.7% 21.C% 22,5% 23.1% - i -., Met ProfitKargin dVC'M
PldSlockNone C'4 1'3 mz -46T0 .27-11 jl2tC '
■ ) 513.3 1146.0 4 4 3 0443.: MISS Working Cap l.>11]
3 99;.C K4C 635.5 I213.C 2701 3 2617.1 11570 ":4.3 1314.3 'MC Long-TcmiOebifJinill! y
fy-f) 8(33.0 351SC ESlo.: 11 SEE HECO '*333 llrr; tEt^ in);: '?0-f !:i.y «fewuiw»* 23775
CommonSlock ?.M5CO;,OCOsl>S 512% 291% j-.ss SI4% Ml • ., 266% 26 2% 2S5S. 23.3% 33.7% 235*. 28.3% Return on TotalCap! MM MM
555% A2C% 54 OS 304% r,: 341-1, •1' 3'5% 31.3% 326% -V.S', MM MM Return on Shf,Equity MMMM
MARKETCAP:5133billion (LargeCap| 37.5% 24.4% 17 4% 2-3% 1334 17.5% *60 r ■02V 15.4% 15.7% IM MM "f RetaineCtoCcniEo ICH
CURRENTPOSITION TOOi. V2M7 3-:% 4J% iyS 45% 45% 46% 436 52% 5f% MM-, Ail Oiedeto Met Plot
IJHLL) • "MOM 4811.0
Cssll AsSdS
=ecer,'abls3 4767,0
228'.u izH/.C ntib.u BUSINESS:
bevaraga :
err
TEe Cccs-Cob Ccmparr/ ie Ihe 'VM'tlr lagsel EmnmsfiM.MCEi iea 3bYeov.'iedeolidnrk bails,.Ai-.srsng
parry It ds-rburea najor bards ICoce-Cola. fler eeFar^s.11% ol wwnuBS.Hss a;proeiTatey71060sntlo.-ses;
nvenlory
OlIW (AvgCsl) 1424.0 ic-i;
1776,0 1623 C MO"2120 00 Cose. Myrr.M, Barfs .M.' f\B3, Farta, F'sscn Dossm. Ev-sn Bcrtshro .Yitln.n.y ysns8.6Vbf gcc, (3437Piqxyl,CluilTor
CurrentAssols 10253.0 5441..: 12095.0 DkVxrse Poaoraas, Mnuio .'.fsMo ma ulletii orrcustiIrMtWrs aidCl-ul Emtuirt CHfcer e Nc.illti»sot iranpoiakO:Oou-
amun rue .,;ri) asnsssounWoNnflh AraedcaaicotrrsdIre ware-A.Mrey!:On;CkoCcIs Pl«a.Alaaa,Creavia30313 Tel-
AKlsPuyublu
Oeb: 4493,0 55 7133 I MM0 71% cf net salesanl 74% ol oseraiing profils h 2L06 C:ca-3ola qpitne,404^75-2121.Insfrel. :;ca-xt' o:ri
OtEcrDae 4546.0
797,0 IM-ii-i
m:?-M M'154
CurrentLisb. 08360 Iinhb.il Coca-Cola's resultsarc still sparkling. plant modifications and expansions, and
ANNUALRATES Peal Past ist'd Ol-'OS It reported a thivd-quam-rshare-netgain by boosting capacity with acquisitions.
IMr'' above the previous Also, product line extensionshave iMNtn a
cllb5T.e;a!ill lOYre SYll 10'10-12 apprnxiinfttely year's liillv. Inierciatioiial pcrforinuuce fia-us. Notable new offerings include
Sales
"CashFlow 4 0%
77,5% 3,134-.
61 7 5% )C.C-.t 1135%
35% was a bright spot, with sales growing al- CaribouCoffee,tor sale in thet'.S., and an
Earnings
Orviderds 10.0% S.O-.i
4.5% 3i :4 most 20--; From last year. The bottom line enhanced water from Onhani, Although
aoukVaiuo 125% 1?C,% aanIstongoing
i benefited fi-om a liiwer tax rale and these growth initiatives are drivingex-
shnrc-ropurchascplan, both of penses higher in the short term, such
Cal- QUARTERLYSALES Istpill I FuB
endar MarPecJun30rSepPecDecPer Year which will likelybolsterfull-yearearnings. measuresshould result in both top- and
2004 Mra o£6S 36=2 S2S? 21362 from its K<) Elnwevcr, has not Itet-n immune hottoin-lineadvances over fhe long term-
share of problems. Excep- Margins are also facing some strain as
2005 Era 6313 6(357 MM 23104 tionally cool and damp weather in the commoditycosts continue to climb but, so
2006 E226 6475 6454 5332 24C86 l.I.K. and Kurope its cold offer- far. management has been effective at.
2007 MX' •733 •'660 8444 27970 ings during the hampered summer. Also, warm mininiiziiigthe impact on earnings. One
2008 6MD 6255 8955 7475 30375 weather hurt the company's Georgia Cof way this has been achievedIs via price in-
Cal- itarPerEARIIW3SFERSHARE* FuB
endar Jun.PorSep.PerDcc.Pcr Year fee. India,
a caffeine drink availablein Bahrain, creases. Another has been by simulta-
and ,Iapan. In addition, like its enin- neously increasingpersonnel in its lower-
2004 46 .64 .5(3 46 ? CO pelilor, I'epsiCn.. KO is struggling to ensi I'lnitipinesplant, hul tentativelyclos-
2005 47 .67 .57 46 217 revitalize its bubbly offerings as con ingoneof its more costlyIrish plants.
2006 42 .74 ,62 52 23? snmorsopt for healthierchoices.
2007 56 ES .71 .56 2.58 The beverage giunt eonfinues to post This stock is set to outperform the
2008 .62 .95 .75 B.63 295 solid results because of its global broader marketover thenext six to 12
Cal- QUARTERLYOViDcllDSPAID ■ FuB reach and expandingbrand portfolio. lO'V sinceThe inontlis. issue hu,- advanced about
our last report, and manage-
endar ManSI 306-30 Sep.M Dec.31 Year It is ftliaisingon brandpromotion in China ment's continued focuson iiicrsl.iveHCiqui-
2003 .72 22 .44
2004 ?i 26 •W I 00 for Beijing.
the upemning Huimner Olyrnpiea in sitinns mid inmivntiveproduct expansions
In India and Russia, the company- o ugurs well lor future earnings for this
2M5 .?? 28 ■En I 12 is concentrating on improvingresults of beveragegiant.
2005 .31 31 .6' 124 both sparkling and still beverages via AVro Mn/uiraj Nuixmber2. 2007
2007 JM—
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slis.ht'ujt.Mi Nv«itorairgsicpcrl ttiusaly ni.-ilunklivlcoMllly[Ci,.Jdcul Apil1,,jly I rates'tol-oiol.ilv,and wpwisce fF|,0% SlocksPrkoSUbilily iro
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o* r -uy»ignxvxa Mini ik:ko- iiarincxaia, p nvy«»:rcii:o-eremm nvyinrn-yura\;in;in, pvk-if sikKasxinisolstays :r:ry.x'
Reproducedwiththe permissionof Value LinePublishing,Inc.
Copyright2016CengageLearning.All RightsReserved.May not be copied,scanned,or duplicated,in wholeorin part. Due to electronicrights,some thirdpartycontentmay be suppressedfrom theeBookand'oreChapter
continued
of return on investedcapital, Coca-Colaearns A. One of the most importantskills to learn

three and four times as much. Typicalprofit in managerial economicsis the ability to
rates, let alone operatinglosses, are unheard identifya goodbusiness.Discussat least four
of at Coca-Cola.It enjoys large and growing characteristicsof a goodbusiness.
profits, and requires practically no tangible B. Identifyand talk aboutat least fourcompanies
capital investment.Almost its entire value that you regard as having the characteristics
is derived from brand equity derived from listed here.
generationsof advertising and carefully C. Supposeyou boughtcommonstock in each
nurtured positive lollapaloozaeffects. On of the four companiesidentified here. Three
an overall basis, it is easy to see why Buffett years from now, how wouldyou know if your
and Munger regard Coca-Colaas a 'perfect' analysis was correct? What would convince
business. you thatyour analysiswas wrong?
SELECTEDREFERENCES
Coase, R. 'The Natureof theFirm.'Economica,1937, 386-405. Milgrom, P. & J. Roberts. Economics, Organizations,and
Cyert, R.M. & J.G. Marsh. A BehavioralTheory of the Firm. Management.PrenticeHall, 1992.
Prentice-Hall,1963. Mueller, D. C. Profits in the Long Run, CambridgeUniversity
Foss, N.J. The Theory ofthe Firm:Critical Perspectiveson Business Press, Cambridge.1986.
and Management.Routledge,2000.
Jensen, M.C. & W.H. Meckling. 'Managerialbehavior,
agency costs and ownershipstructure.'Journal of Financial
Economics,1976,305-360.
rialreviewhasdeemedthatanysuppressedcontentdoesnot materiallyaffecttheoveralllearningexperienceCengageLearningreservestherightto removeadditionalcontentat anylimeifsubsequentrightsrestrictionsre

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Nature and Scope

Warren E. Buffett, celebratedchairmanof Omaha, Nebraska-basedBerkshireHathaway,Inc., started

Buffett is famous for his razor-sharp focus on the competitiveadvantagesof Berkshire'swide

Buffett'ssuccess is powerfultestimonyto the practical usefulnessof managerialeconomics.

Economictheory and methodologylay down rules for improvingbusiness and public

Managerial Managerialeconomicshelpsmanagersrecognizehow economicforces affect organizations

Figure 1.1 ManagerialEconomicsis a Toolfor ImprovingManagementDecision-Making

Managerialeconomicsuses economicconceptsandquantitativemethodsto solve managerialproblems.

Optimal solutionsto management

Managerialeconomics identiﬁes ways to achievegoals eﬃciently. For example,

resources.By followingthese rules, businesses,nonproﬁt organizationsand government

Makingthe Best Decision

To establish appropriatedecision rules, managersmust understandthe economic

In FinancialTimes, you cansometimesﬁnd evidenceof • Acceptresponsibilityforyourmistakes,andﬁx them.Be

THEORYOF THE FIRM

Firms areuseful for producinganddistributinggoods and services.

At its simplestlevel, a business enterpriserepresentsa series of contractualrelationships

2 Discountingis required becauseproﬁts obtainedin the futureare less valuablethanproﬁts earned

Figure1.2 The Corporationis a Legal Device

The ﬁrm can be viewedas a seriesof contractualrelationshipsthatconnectsuppliers,investors,

This expanded equationcan be used to examinehow the expectedvalue maximization

Constraintsand the Theory of the Firm

Organizationsfrequentlyface limitedavailabilityof essential inputs,such as skilled labor,

of output quality constraints are nutritionalrequirementsfor feed mixtures,audience

Limitationsof the Theoryof the Firm

Optimize In practice, do managerstry to optimize(seek the best result) or merely satisﬁce

Proﬁt is usuallydeﬁned as the residualof sales revenueminus the explicitcosts of doing

The World is Turningto Capitalismand Democracy

Capitalismand democracyare mutuallyreinforcing.Some Competitionis a fundamentallyattractivefeatureof

Normal Rateof businessproﬁt. The risk-adjustednormalrate of returnon capitalis the minimumreturn

X td X T-H i—i T-k o ON o ON On d" 00 X co IN IN CO td d ID CO td LO CO ID T-H td co o

WHY DO PROFITSVARYAMONG FIRMS?

Many firms earn significanteconomicprofitsor experiencemeaningfullosses.

Innovation Profit Innovationprofit theory describesabove-normalprofits that arise followingsuccessful

ratesof return,it is reasonableto expectﬁrms operatingat above-averagelevels of eﬃciency

Role of Proﬁts in the Economy

Each of the precedingtheories describeseconomicproﬁts obtainedfor differentreasons.

Googleon Social Responsibility

Form S-1 registrationstatementsare ﬁled withthe Securities usersand advertiserseﬃciently,helpingboth.AdSensehelps

one of the most importantfactors affecting the allocationof scarce economicresources.

ROLE OF BUSINESSIN SOCIETY

Why Firms Exist

Social Responsibilityof Business

Figure1.3 ValueMaximizationis a ComplexProcess

Value maximizationis a complexprocess thatinvolvesan ongoingsequenceof successful

Businessand Social Environment

Technology MarketEnvironment Legal Environment

The IKEA way

The SwedishcompanyIKEA,one ofthe world'slargest initiateda purchasingmodel(IWAY)thatcoverssocial,safety

STRUCTUREOF THIS TEXT

This text shouldhelp you accomplishthe followingobjectives:

The value maximizationframeworkis useful for characterizingactual managerial

Chapter 2, 'Economic Optimization',begins by examiningthe importantrole that

interactionsamong competitorsare normal. In Chapter 14, 'Game Theory and

Managerialeconomicsfocuses on the applicationof • Economicproﬁt is businessproﬁt minusthe

CASE Study Is Coca-Colathe 'Perfect'Business?3

3 SeeCharlesT. Munger,'How DoYou Get WorldlyWisdom?'OutstandingInvestorDigest,December29,

Figure 1.4 Coca-Colais a WonderfulBusiness

HECENT RtlATPIt i Oft :iv: VALUE

of return on investedcapital, Coca-Colaearns A. One of the most importantskills to learn

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