I

lHf lHEORY OF TilF fill!!'

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CHAPTER 1

LEAfINING OBJECTIVES

The Heory 01 the Firm

What Is Profit?
ReilS01l51~r

the Existence

01 Prolit

Manageria! Interes!s ilnd the

Principal-Agent Problem

Demand and Supply:

A First Look

The Demand Side 01 a Ma rket

The Supply Side of a Market

INTRODUCTION

behavior.
ceo
lrimanagenal economics, the focus is on
prescribes behavior, whereas the micro world describes the environlilent
focus on managerial behavior provides powerful tools and frameworks (0
managers to better decisions. These tools allow managers to beller
the consequences of alternative courses of action.
Managerial economics plays .two important roles in preparing students for
manageriallilc. Concepts we will discuss ill subsequellt chapters are found in
other functional business courses like accounting, finance, strategy, onpl';llinn<
and marketing. Olir guide is what thc great strategist Sun Tzu called the
it is characterized by what are known as economies of scope. Thai is, (he
better you understand the concepts we discuss, the easier will be your understand
of them when they arise in other busincss classes. And because ITI"n;wl'ri"1
economics recognizes the complexity oLtne managerial
most .integrative of the funliional business classes.
integrative mind-set that is essential for good management, and it also gets them
to think past the snort-term mentality and consider the long-term consequences.

Equilibrium Price

Actual Price

THE THEORY OF THE FIRM

What II the Demand

Curve Shifts?

What IIlhe Supply Curve Shifts?

The main task of managers is to make good decisions. For beller or worse, manag
ers face a complex world, and they need a guide to help them choose well. This is
that guide. Those who gain its understanding will increase the value of their deci
sions at personal and organizational levels.
This guide provides knowledge in the following sense. The ancient Chinese
discllss knowledge as a temporal flow. Knowledge is not storage of memorized
facts but an ability to Ullderstand the actions of others. With this knowledge, you
better anticipate their behavior. Our guide will help you navigate through the
world of behavior.
We construct our guide within the framework of managerial economics.
JVJallagerial economics uses formal models to analyze managerial actions and their
effect on firm performance. We use these models to shed light on business con
cepts such as cost, demand, profit, competition, pricing, compensation, market
entry strategy, and auction strategy. All these concepts are under the control of
managers, and they determine firm performance.
Contrary to the beliefs of many, managerial economics differs signifirantly
from microeconomics: The focus of analysis is different. At best the focus in
microeconomics is at the firm level; many times the analvsis is at the market level.

Managers work within a Jarger organization and ultimately detCIJ1line its

mance. To understand the behavioral world of managers, we must account for the
behavior of firms. Of course firms really don't behave on their own; you
think of them as m,lrionetles with managers controlling the strings. Some man
agement teams are good at pulling these strings, while others can't seem to get
it right. But although management styles differ greatly in tbe millions of firms
rn~n:HJ(l-n Overacross the
III
believe will increase the value of their
organization. So in our theory of the firm, the goals of managers focus on increas
ing this value. We understand there are many ways to create value in an
tion; for example, to a microcredit organization willI a double bottom line, value
from its lending practices might consist of a profit measure and the gains to a local
commullity's economy. But our models must account for behavior across a great
number of firms, so we take the view that managers in profit-oriented
tions try to increase the net present value of expected hllure cash flows. We can
this managerial effort in the follnwinu
PrpA~ent value of
.
expected future proMs

Present value of

expected future profits

'ITl

7T2

- - + ---"- +
1 +i
(1 i

'l~_

(1

+ 1)"

/21

(1

(1.1)

'I

CIIAPTEI1 L INTRODUCTION

WHAT IS PROFIT?

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defined here as
these diverse groups make decisions to affect
'the present va]l1e-o[expccted future
Although managersw3nt to increase their firm's value, they do not have total
control over the level of value. If m3nageriallife were that simple, you would not
have to go to school to Jearn business techniques. 'I\<11at complicates managerial life
are the operating constraints managers face. One constraint is that most resomce,
are scarce. Within the tinn, managerial decision mal<ing often involves allocating
scarce inputs to support the production, distribution, and sales of Roods and ser
vices that are sold llt a price that exceeds their costs.
OtheT constraints, that limit managerial aclions are legal or contractual:For
managers may he bound to pay wages exceeding a certain level because
minimulll wage laws stipulate thai they must do so. Also, they must pay taxes in
, accord with federal, state, and local laws. Further, managers must comply "lith
contracts with customers and suppliers-or t<lke the legal consequences. A wide
from environmental laws to antitrust laws to tax laws)
variety of laws
limit what managers can do, and contracts and other legal agreements further
constrain their actions.

'~

t
.,
;

i
~I.,

where 1T, is the expected profit in year t, i is the interest rate, and t goes from 1
(next year) to '1 (the last year in the planning horizon). Because profit equals total
revenue (TR) minllS lotal cost (TC), this c!luation can also be expressed as
n

2:

Present value 01 expected future profits

,

(1.2)
1

ij

~;1
~

,!
~
5
:~

;1
where TRI is the firm's total revenue ill year I, and Tel is its total cost jn year t.
shows why managers influence firm performance. Manage
determine both the revenues and costs for an organization.
Consider, fur example, the Toyota Motor Company. Its marketing managers and
sales representatives work hard to increase its total revenues, while its production
managers and manufacturing engineers strive to reduce its total costs. At the same
time, its financial managers playa major role in obtaining capital and hence influ
ence equation
its research and development personnel invent new
and processes to increase total revenues and reduce total costs. Managers of all

:!

WHAT IS PROFIT?
As we have seen, firm value is
a function of
Unlike the accounting
world, in the managerial
we measore profit after taking
and labor provided by the owners. For example, suppose
a manager qUIts 11er pos11101l at a large firm to create a smail start-up business.
She receives no salary even though she puts in long hours trying to establish her
business. If she worked 1hesc hours for her previous firm, she would have earned
$65,000. And if she had invested the capit3J she used to begin her business in
some altermtive investlllclit, she (ould h3ve earned $24,000. Let's say in 2008 her
start-up firm earned an accounting profit of $100,000. Her firm's profit in the
managerial economics world is $100,000 $65,000 $24,000 '-" $ J1,000 rather
than the $100,000 shown in accounting statements.
The differences between the profit COllCcpts used by the accountant and the
economist reflect the difference in their focus. The accountant is concerned with
the firm's day-today operations, detecting fraud or embezzlement,
and other laws, and producing records for varions interested groups.
The economist is concerned with decision making and rational choice among
most financial statements of firms conform to the accoun
tant's and not the managerial economist's concept of profil, the latter is more
decisions. (And this, of course, is recognized by sophisti
For cxanlllle, suppose the woman we just discussed is trving to
decide whether 10 conlinue
her business. If she is interested in making
as much money as possible, she should calculate her firm's
based on our

Profit Whell economlsls speaL

profil. Ihey meim profit over 0;"
~bove whatlhe owI1!'r's lobor
capllal employed in Ihe businr
(Ould earn elsewhere.

CHAPHR llNiROIJUCflON

1
. 'l

DEMAND AND SUPPLY A FIRS1 LOOI,

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economist model. If the firm's ecollomic profit is greater than zero, she should
continue iooperate tIle firm; otherwise she sllOuld close it down and pursue her
other

REASONS FOR THE EXISTENCE OF PROFIT

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t1

A firm's economic
isgenerated by the actions ofmanagers. Prolit is one
indicator of their dCC1SJOn-makmg SKills,
fertile' profit-generating areas used
b), maJlagers are innovation, risk, and market power. As we write this
in line for the chance to buy the iPhone, a new cellular
And airlines are committing biUions ofdollars to reserve theopportu
the 787 Drcamliner from Boeing. In both these markets, products
exist; but consumers appare'ntly are more interested in new product~. Both
the iPhone and the 787 are considered produCt innovations. They push the fron
lier relative to existing products in terms of functionality, technology,
we write today, these managerial efforts both generate high profit-reportedly up
to 40 percent. Puture value will depend on how each managerial team executes its
market strategy.
A hallmark of managerial decision making is the need to mal<e risky choices.
Por managers this risk takes many forms. They are asked to make decisions whose
future outcomes are unknown (How successful will this product be in the mar
ket?) when they don't know the reactions of rivals (If I raise my price, wiD my
rivals raise theirs?) and when they do not know the likelihood of a future event
likely is it that a democrat will be elected our next president?). Profit is the.
reward to those who bear risk well.
As we will see later, managers also earn profit by exploiting market inefficien
cies, Good managers understand how to create inefficiencies to give their firm a
sustainable comlJctitive advantalIe. Common tactics in this area include building
3
market entry barriers, Soplllsllcaleu
diversification efforts. and
,
1
output decisions. Such tactics, if done well, can generate a long stream
for
a firm.

I
,I

MANAGERIAL INTERESTS AND THE

PRINCIPAL-AGENT PROBLEM
managerial economists generally assume that managers want to maxi
mize profit (and hence firm value, as defined in equation (1.1)), they recognize
additional goals that managers may strive to achieve. Some of these goals may
enhance the firm's long-term value, like building market share or establishing a
bra nd name. Other managerial goals may have less to do with firm value and more
to do with increasing managerial compensation,

As we will see, our model recognizes that preferences of firm owners and
managers'sometimes diverge, Alld when managers make choices between maxia firm's value and increasing the payoffs to a single manager or man
agement team, some choose the selfish path. This too is a trait of managerial
behavior. The tendency to focus on self-interest is growingin importance because
the separation between the ownership and management of firms is
[0 increaSe on a
Tbe owners of i he
of the firm's operations. As we will see, even ,3
firm's board of directors has limited information relative to the management
team. Management is generally given a great deal of freedom as long as it seems
to be performing adequately, Consequently, firm behavior may be driven by the
interests of the nonowner management group. At the least, this behavior results
in higher pay and more perquisites for managers; at worst, it creates an Enron
spectacle.
Managerial economists call this the principal-agent problem. Managers are
agents who work for the firm's owners, who are the shareholders or
principal-agent problem centers on whether managers may pursue their own
objectives at a cost to the owners. Consider the thoughts ofJoseph Wagner, aman
ager of a local pharmaceutical firm. "Let me see. The cost of the
staff, company paid travel, and so on) I receive are borne entirely by the
owners." We ask students in our class, "If we send you to Atlantic City with our
money, would your behavior change?" Because the firm's owners find it difficult
to distinguish between benefits that bolster profit and those that do not, managers
have incentives to enrich UJcmselves.
To deal with this problem, owners often use contracts to converge their
preferences and those of their agents. For example, owners may give managers a
financial stake in future firm success. Many corporations use stock
whereby managers can purchase shares of common stock at less
These plans give managers an incentive to increase firm profit and comply with
owners' interest. There is some evidence these plans do change behavior. Accord
ing to one study, if managers own between 5 and 20 percent of a firm, the firm
is likely to perform better (that is, cam more profit) than if they own less than 5
percent. In some firms managers are forced to purchase stock, and boards of direc
tors are compensated in stock. This and other moral hazard issues are discussed
extensively in Chapter 14,

DEMAND AND SUPPLY: A FIRST LOOK

1 10 understand behavior in any

its institutions, The

whether in Tokyo, New York,
principles in order to ,ntic;,

we must have a working knowledge of

world revolves around markets. Any manager,
or Toronto, must understand basic market
behavior. A si~nificant Dortion of tlus book is

The principal-a9~nt probten'

When managers pursue thei;
own objectives. even though ['
rlecreJses the prolil 01 tHe uv'

HIE DEMAND SIDE OF A MAHI{Ff

CHAPTER liNmODUC110N

50urce: "All Games Are Not Created.

.
aj:J!e Pricing: PhiladelphIa Inquirer. April 2, 2003,

devoted to helping you underst~nd the behavior of people in markets. We first give
an overview of markets and then examine both tIle demand and supply sides of
markets in greater detail.

Market A group 01 finns and

individuals thai interacl wilh e<leh
01 her 10 buy o[5ell a good.

One issue faced by managers long ago involved the facilitation of economic
exchange. Whereas two individuals can negotiate face-Io-face, coordination COSls
mount quickly as more people join the deal. So managers had to devise a plan to
reduce coordination costs and encourage more trade. They chose to create a social
institution called a market.
A market exists when there is economic exchange; that is, multiple parties

enter binding contracts. lbday countless markets exist in the world. The business
world operates within these markets, and we need to examine (and understand)
the number ~nd diversity of markets in the
world, they all follow general principles. II is these principles we now fOCllS on
because understanding them is essential to understanding market behavior. We
examine the behavior of individuals who enter contracts and on the aggregate
effect that they create.

THE DEMAND SIDE OF A MARKET

Every market consists of demanders and suppliers. A manager needs to know how
customers value a product or service, and must be abJe to estimate the
quantity of goods demanded at various prices. One
mize firm value. The ability to focus on profit requires a
especially the behavior of revenue as price
to the number of units sold (Q) multiplied by the
(TR"" PX Q).
The association of price and quantity demanded often depends on manyvari
abJes, some controlled by the manager and some not. Possible influences include
income and tastes, prices of substitutes and complementary
dollars, product quality (as well as the quality of substitutes and collJplements
and govern men
called a firm's demand function (holding other pOSSIble influences
A demand curve shows managers how many Ilnits they will sell at a
Consider Figure 1.1, which shows the demand curve for copper inlhe world
9

Demand function (Juantily

demanded relative to Wice. hOi
ing other possible influences
c(}n~,tanL

lHE SUPPLY SIDE Of' A MARKET

CHAt'i tcH I: IN I H()llUCTION

FIGURE 1.1

The Market Demand Curve for Copper, World Market

The nwliPI demand curve for copper showslhe amounl 01 copper that
like 10 purchase 31 various

bUyl'fS

would.

Price
ldolia~s

per pound)

of oil

3.2D

and the costs of extracting were

3.10

exnecreaL Whals dillerent now?

oil crises 10 197Z~ 1973 and in 1980

for long ThiS tatest price in.crease
I~-"-

3.00

--

Demand

14.3

10.<

MilhOflS of metric 10flS per yeur

we can again expect to

are demanded

.abaadoned oil shale activities in the West.

shows that about 16.2 million metric tons of copper

if the price is $3.10 per pound; about 14.3 million metric

Ca'utiillls u.s. Boom 111 0,1 Shale, The New York

21, 2006, www.nyl;mes.com!200b/121211

tons are demanded if the price is $3.00 per pound. An important [cason why cop
per has experienced recent growth lJl
demanded is its increasing use in
like China and India.
to a
of the demand curve can depend on the
curve for copper slopes downward to the right. In mathcmaticalterms, we say it
has a negative slope; that is, the quantity of copper demanded increases as the
falls. This is true of demand curves for most commodities: They almost
downward to the right. This makes sense; we would expect increases
to result in a smaller quantity demanded.
lly demand curve is based on the assumption that other influences like tastes
and incomes are held constant. Changes in any of these factors are likely to shift
the position of a commodity's demand curve, So if consumers' tastes shift toward
10

goods that use considerable copper or if consumers' incomes increase (and they
thus buy more goods using copper), the demand curve for copper will shift to
the right. In otherwords, holding the price of copper constant, more copper is
demanded at any price. We will discuss this more fully in Chapter 2.

THE SUPPLY SIDE OF A MARKET

The supply side of a market is represented by a market supply curve that shows
how many units of a commodity sellers will offer at any price. Figure J.2 shows
the SUDDlv curve for copper in the world market in 2008. According to the

CHAPTE~

1: INWOOUCllON

EQUILIBRIUM PRICE

EQUIUBRIlH1

FIGURE 1.1

The Market Supply Curv~ for'Copper, World Market

The markel supply curve lor copper shows the amounl 01 (opper that sellers would
olfer at various prices
Price

ldolla!S

SUPPlY

p81 jlQ'Jnd)

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3.20

P!ZiCi~

Economists represent markel, as the interaction of dClhand alJd supply curves. To

illustrate, conSider the world copper market shown in
1.1 We construct the
by overlaying the dcmilnd curve
J.J with the
1.2). Now we can determine market behavior at variolls
of copper is
pel
metric tons of copper are
million metric tons
there.is a mismatch between the
1.3, there is excess supply of 3.1 million metric
tons. Some prodllCcrs will not be able to sell all their inventories at
Jllay be tempted to cut their prices to reduce these inventories. Hence a market
price of $3.20 per pound creates 811 unbalance in the market---there is too much
Because of this excess supply, producers will drop theil' prices, so $3.20 is
not a sustainable market price.

;1

Ii

F!GURE1.3

Equilibrium Price of Copper, World Market

~~

Million" of melric Ions per year

~

The eqUilibrium price is $3. ill per pound, since qUJlllily demanded equals tile quan
tity supplied al this price.

,1

R-ice

(dollars

SUjJfJly

per pound)

about \6.2 million metric tons of copper are supplied if the price of copper isl
17.4 million tons ifthc price is $3.20 per pound. and about},'
14.9 million tons if the price is $3.00 per p o u n d . j
.
.\
Note that the supply curve for copper slopes upward to the nght. In math- ]
other words, the quantity of copper
increasrs as the price rises. This seems plausible: Higher prices provide an 1
to produce more copper to sell. Any supply curve is based on 'f
the assumption
technology is held constant. If lower-cost produc-l
tion tecnnOlogy
That is, technological change often causes
The supply curve for a product is affected by the cost of production inputs
and land). When costs of inputs decrease, managers realize lower
costs and are willing to supply a given amount at a lower price. So
decreases in the cost of inputs cause supply curves to shift to the right.
costs increase, managers are willing to supply a given amount only at a higher
(because their costs arc higher). Hence the supply curve shifts to the left.

3.00

Demand

12

Ivlillions 01 metric Ions per year

13

PRICE

The market is
good can, and every seller
In Figure 1.3,
Where some oee a
raise prices
never seem to be
when prices faUI. economJsls see Ihe power of the
marl<et at work. The person in the street feels that
a pipeline shutdown or a refinery lire allects tomar
row's supply; but to day's gas was produced with pre-.
event oil, so why should lUl'l
go ur today as a
resull of such events?
It's explained bya concept called storage arbi
trage. Suppose you owned an acre of corn.
corn prices today are $3 per bushel
Ihat (om will sell for $3.50 per bushel tomor
row. You wouldn't sell your corn at $3 today
defer your harvest by a day and sell il tomorrow
las
to go up
your fellow corn farmers also decide to wait until
tomorrow. Thus corn becomes scarce tod3v and
price increases. To what
would induce the corn growers to sell today rother
than wait until tomorroW

pur(ha~,e the go
and evelY seller who wan"

won'!!;!O

lite good can.

ACTUAL PRICE

rest of the wurld rise and in the United States <lre leg
islatively held low, where will the Canadians and Mexi
cans sell their oil? They like us, but not thai much l

Katrina and Rila concluded Ihat such dpadweiahl

loss costs would be $1.9 billion.

the demand curve indicates that 17.9 mil

demanded, while the supply curve indicates that 14.9 million
So a market price of $3.00 also creates an unbalance in
supply to satisfy demand. In fact, at this price
consumers want to purchase an additional 3million metric tons, but they can find
no suppliers. \A/hen suppliers realize there is a shortage of copper they will increase
their prices. Hellce $3.00 is not a sustainable market price.
So what is a sustainable market Driee? ADrice is sustainable when
1';

Equilibrium When the m;"

in balance bH3use evelY

Of course price managers are interested in the actual price-the price that really
the eqtlilibriulll price. In general economists assume the actual
approXlmates the equilibrium price, which seems reasonable enough because the
basic forces at work tend 10 push the actual price toward the
Therefore, if conditions .remain fairl), stable for a time, the actual price should
move toward the
To see this, consider the global market for copper, as
l.3.
What if the actual price of copper is $3.20 per
level will cause downward pressure on the
responding to this pressure, falls to $3.15 per
demanded with the quantit), supplied at $3.15 per
downward
demanded.
quanti ty demanded with
at this price, we
find there is still downward pressure on

to move toward the equilibrium

ment can vary. Sometimes it takes a long time for the
equilibrium price, and sometimes it
This price adjustment process is what Adam Smith called the market's
agency is needed to ind lice producers to drop or
increase their
act more or less in unison and cause the market
to change.

WHAT IF THE DEMAND CURVE SHIFTS?

like Figure 1.3 is essentially a
of the
situation during aparticular time. The results in
ular period because demand and
shift in reaction
to
price of a
when its demand curve
need to
and forecast changes in

tnvisibte hand When no gov

ernmental agency is needec,
10 induce producers 10 drop
ir:crease Ihelr prices.

WHAT IF HIt: SUPPLY CURV~ SHIHS?

CHAPfcR 1. INfROOlJC1IQ1,

When the markel moves, planets can lremble

early'spring 2008 shifting demand and supply curves
VJere impacting every country. The global rood

December 2007. The

'13 percent between
$3.46

01 corn increased by

Rising food
General toDd price indeX, 2005, 2006, 2007
Food commodilv
Rising t
Rising
prices
prices

2007 and April 2008 [from

bushel to- $6 a bushel]. Wheat increased by

123 perCEnt in this same period [lrorT)

a hushell In China, the price of pork increased by 63

.350

200

2007

percent

mere inconvenience of
the United Stales is one or life or
deatb to lh.ose whQ .live on the fringes. lor ,th.e 300
who live in poverty, food accounts for
of household oxpenses,
Look al whal caused Ihis commotion The figure
food prices prior to mid-20GB.
see the acceleration 01
groups. I his is a shift in the
The

shilt in the demand curve for

lood was attributed to several lactors. One theory
was
the mathernntical doomsday machine of
Malthus was finally reaching iruition
worldpopulation continues to' expand While
cult,Jral acreage continues 10 shrink. Many govern
ments in
countries have focused ellorts
on economic development and not agriculture A
UN report .shows the annual
In agricultural
slowed to 1 percent by 2002, A giowing
middle class in ldrge developing coulltries like
and India consumes more food. As people increase
their income, they
eal more !ood In China
meat has doubled as
income has II1creased Finally, the increased use 01
corn, !or the
of ethanol
products out of the food market.
more. individuals are leaving rural areas Ifarmsl

shift of a demand curve, consider the

scale (copper

2007

300

250

150r,..,."",,--~

2007

in developing countries and moving to urban areas,

These trends are apt to move the supply curve to the
left and the demand curve to the right and

Sources. 'Countries Rush to Reslrict Trade in !.lasie Foods:

Financial TImes, Aprit 2, 2008, pi; -Food Prices Give Asian

Nations a Wake-Up Call: Financial Times, APli13, 2008, p, 4.

WHAT If' THE SUPPLY CURVE SHIFTS?

What happens to

of I-'igure 1.4, managers

that such a rightward shift of the demand curve would cause
of copper from Pto P).ln fact the global
pound. By 2008 this price had increased to $3.1 O.
In mid- 2008, we see a leftward shift in the demand curve for co[mcr as shown

2006 was roughly

in the left panel of Figure l/L Because of slow economic

States and other countries, there was less demand for copper, This meant that the
demand curve for copper shifted left, so there was less quantity demanded at any
price, Figure lA shows a decrease in price from Pta PI
16

Jail
?ODS

. curve intersects the demand

to P4 (where the new supply curve intersects the demand

On the other hand, suppose there is a

increase in the wage rates
of copper workers. This increase will cause the suppJy curve to shift to the left, as
shown in the left panel of Figure 15, This shift will cause the equilibrium price to

SUMMARY

CHAPTER lIN1RODUCTION

increase from P(where the

supply curve intersects the demand
P, (where the new supply curve intersects lhe demand curve).

FIGURE 1.4

Effects of Leftward and Rightward Shifts of the Demand Curve

on the Equilibrium Price of Copper
A leftward shilt of the demand curve results in a decrease ill Ihe equillhrium
a rrghtward shift results in an increase in the

Price
(dollars

per

Price
(dollars
per

pound)

5UI-.1MARY
1. The main task of managers is to make decisions. 'vile offer a gllide for tbat
managerial world; it is based on the behavioral economics of the mallagerial model.
In contrast to m;~mprrm()mir~ which i~ br!JPlv-clp~rrintivp

pound)

P?

P,

Supply

to

0,

()

Millions oj metric tons per yoar

()

Q,

Millions 01 metric tor IS per year

FIGURE 1.5

Effects of Leftward and Rightward Shifts of the

the EQuilibrium Price of

Curve on

of the firm.
The theory
by most managerial economists is that the owners want to
maximize its value, defined as the present value of its expected future net cash
flows (which for now are equated with
subject to constraints because the firm has limited inputs, particularly in the very
short run, illld mllst comply with a variety of laws and contracts.
3. Managerial economists defulc profit somewhat differently from the way
accountants do. When economists speak of profit, they mean profit over and above
what the owners' labor and capital employed in the business could earn elsewhere.
To a considerable extent, the differences between the concepts of profit used by the
accountant and the economist reflect the difference in their functions.
4. Three important reasons for the existence of profit are innovation, risk,
free
too
;mnrrrt.nt incentives for innovation and risk
are

a
Price
Idollars I Demand
p r

pound)
P3

Demand

SUPP'I

arises if man
agers pursue thm own interests, even
of the owncrs. To address this problem, owners often
managers a financial stake in the
future success of a firm.
6. Every market has a demand side and a supply side. The market demand
curve shows the amoullt or a product buyers will purchase at various prices. The
market supply curve shows the amount of a product producers are willing to sell
at various prices. The equilibrium price is the price where the quantity demanded
equals the quantity supplied. This price is also called the
7. Both demand curves and supply curves can shift over time. This results in
shifts in the demand curve (and leftward
Leftward shifts in the demand
curve (and

CIL~PTER

wwnorton. (Om/stlJdY~P2C(->

I INTRODUCTION

PR08lH1:,

PROBLEMS

"~t{

a.

B;1tl11<111 Books agrres to pay

$6 million for the rights to this

it sold 625,000
lt~$~ i11(l11\.igefs would Jose
executives stated lhat
it was
than 500,000 copies of a nonllction hardcover book,
,md very exceptJoll<l to sell I million
Were Batman managers taking a

r<;:'

i,

book?
2. Some say Ihat anv .Ielf-respecting top manager joining a company does so with
banns. In many cases this bonos is in the seven figures.
At the s,lme time the entering manager may be given 3 bonus goarantee. No
matter what happens to firm profit, be or she gets at least a.perccntage of
lhat boilllS, Do long-term bonus gl1,lranlees help to solve the
or do they exacerbate it? \%y)
3. If the interest rate is ]0 percent, what is the present value 01 the Monroe Cor
in the next 10
Num ber of Years in the Future

Profit [Millions at Dollars)

10

12
J I,

15
16
17
15

10

4,

10

at DuPont de

in 2008

expect a profit of$2,9 billion

economic profit will equal

$2.9

5, William Howe mosl decide whether to start

umbrellas
at an ocean resort
JOlle, July, and August of next summer. He believes
he can rent each umbrella to vacationers at $5 a day, and he intends to lease 50
umbrellas for the three-month period for $3,000. To operate this busilless, he
does not have to hire anyone (but himself), and he has no expenses other than
the leasing costs and a fee of $3,000 per month to rent the business location,
Howe is a college student, and if he did not operate this business, he could
earn $4,000 for the three-lllonth period doing construction work.
20

Jl there ,iJe 80 days during the summer when beach umbrellas arc
demauded and HO'.-I'nents aliSO of his umbrellas Oll each of these
wh,rt will be his accounting profit for the summer?
b, What will be his economic profit for the summer?

'0. On

anile St. J"mcs Theater ill New York.

per seal. The show's weekly gross revenues,
.estimated as follows, depending on whether

from $117 to $42

were

or $65:

Average Price
of $75

Average Price
01$65

Gross revenues

$765,000

costs

600,000
i 65.000

$6BO,000
600,000
80.000

Profit

a, With a cast of 71 people, a

orchestra, and more than 500 cos
tnmes,
more tllan.$IO million to stnge, This investment was in
addition to the operatillg costs (such as salaries and theater rent), How
many weeks would it take before the investors got their mane), back,
these estimates) if the average
b. George Wachtel, director of
for the
of American

Theaters and Producers, has said that about one in three shows

in recent years has at least broken even. Were the investors

a substantial risk?
c. According to one Broadway prod Llcer, "Broadway
make
the money any more. It's where you establish the
so you call make
the money. \%en YOlllllount ,1 show now, YOll
have to think about
to play later:' If so, should the
figures here be
caution?
d, If the investors in this revival of
make a
will this profit bc. at
least in part, a reward for bearing risk?
7. If the demand curve for wheat in the United States is
P

12.4

where P is the farm price of wheat (in dollars per

tit)'of wheat demanded (in billions of bushels), and
in the United Stales is
P

-2.6 +

the quan
curve for wheat

~HAPTEfll.

INTRODUCTION

where Os is the quantity of wh,'at

price of wheat? 'vI/hat is the
the eqUtlibriu
8. The lumber industry was hit hard by the ;,ubprimc mortgage turmoil in
Pricrs pillngeo from $290 per thousand board feet to less than $200 per
sand board feet. Many observers believed this
of new hOlllC construction because of the
the market. Was this
decrease caused by a shift in
curve 1
9.

more demand from investors who were

dollar.
a. Was this price increase clue to a shift ill the demand curve for gold; a shift
in the supply curve for gold, or both?
b. Did this price increase affect the supply curve for gold jewelry? If so,
how?

7?