- Solutions Manual: Managerial economics by Thomas 12e
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Managerial Economics
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Solutions Manual for th’e textbook 1
Ch. 1:
MANAGERS, PROFITS, AN’D MARKETS
Ess Concepts:
1. Managerial economics applies microeconomic theory—th’e study o/f th’e behavior o/f
individual economic agents—t_o business problems in order t_o teach business decision
makers how t_o use economic analysis t_o make decisions that will achieve th’e firm’s goal—
maximization o/f profit.
2. Economic theory helps managers understand real-world business problems by using
simplifying assumptions t_o abstract away fro’m irrelevant ideas an’d information an’d turn
complexity into relative simplicity.
3. Microeconomics is th’e study an’d analysis o/f th’e behavior o/f individual segments o/f th’e
economy: individual consumers, workers an’d owners o/f resources, individual firms,
industries, an’d markets for goods an’d services. Using marginal analysis, microeconomics
provides th’e foundation for understanding th’e everyday business decisions managers
routinely make in running a business. Such decisions are frequently referred t_o as business
practices or tactics.
4. Industrial organization is a specialized branch o/f microeconomics that focuses on th’e
behavior an’d structure o/f firms an’d industries. Industrial organization supplies th’e
foundation for understanding strategic decisions through th’e application o/f game theory.
5. Strategic decisions differ fro’m routine business practices or tactics because, in contrast t_o
routine business practices, strategic decisions seek t_o shape or alter th’e conditions under
which a firm competes wit’h its rivals in ways that will increase an’d/or protect th’e firm’s
long-run profit. While routine business practices are necessary for keeping organizations
moving toward their goal o/f profit-maximization, strategic decisions are generally optional
actions managers can take as circumstances permit.
6. Industrial organization identifies seven economic forces that promote long-run profitability:
few close substitutes, strong entry barriers, weak rivalry within markets, low market power
o/f input suppliers, low market power o/f consumers, abundant complementary products,
an’d limited harmful government intervention.
7. Th’e economic cost o/f using resources t_o produce a good or service is th’e opportunity cost
t_o th’e owners o/f th’e firm using those resources. Th’e opportunity cost o/f using any kind
o/f resource is wha’t th’e owners o/f th’e firm must give up t_o use th’e resource.
8. Total economic cost is th’e sum o/f th’e opportunity costs o/f market-supplied resources plus
th’e opportunity costs o/f owner-supplied resources. Th’e opportunity costs o/f using
market-supplied resources are th’e out-o/f-pocket monetary payments made t_o th’e owners
o/f resources, which are called explicit costs. Th’e opportunity cost o/f using an owner-
supplied resource is th’e best return th’e owners o/f th’e firm could have received had they
,Solutions Manual for th’e textbook 2
taken their own resource t_o market instead o/f using it themselves. Such nonmonetary
opportunity costs are called implicit costs.
9. Businesses may incur numerous kinds o/f implicit costs, but th’e three most important types
o/f implicit costs are (1) th’e opportunity cost o/f cash provided by owners, known as equity
capital, (2) th’e opportunity cost o/f using land or capital owned by th’e firm, an’d (3) th’e
opportunity cost o/f th’e owner’s time spent managing th’e firm or working for th’e firm in
some other capacity.
10. Economic profit is th’e difference between total revenue an’d total economic cost:
Economic profit = Total revenue – Total economic cost
= Total revenue – Explicit costs – Implicit costs
Economic profit belongs t_o th’e owners an’d will increase th’e wealth o/f th’e owners. When
revenues fall short o/f total economic cost, economic profit is negative, an’d th’e loss must be
paid for out o/f th’e wealth o/f th’e owners.
11. When accountants calculate business profitability for financial reports, they follow a set o/f
rules known as “generally accepted accounting principles” or GAAP. These rules, which are
constructed by th’e Securities an’d Exchange Commission (SEC) an’d th’e Financial
Accounting Standards Board (FASB) do not allow accountants t_o deduct most types o/f
implicit costs for th’e purposes o/f calculating taxable accounting profit. Thus, accounting
profit differs fro’m economic profit because accounting profit does not subtract fro’m total
revenue th’e implicit costs o/f using resources.
Accounting profit = Total revenue – Explicit costs
12. Since th’e owners o/f firms must cover th’e costs o/f all resources used by th’e firm,
maximizing economic profit, rather than accounting profit, is th’e objective o/f th’e firm’s
owners.
13. Th’e value o/f a firm is th’e price for which it can be sold, an’d that price is equal t_o th’e
present value o/f th’e expected future profit o/f th’e firm.
14. Th’e risk associated wit’h not knowing future profits o/f a firm is accounted for by adding a
risk premium t_o th’e discount rate used for calculating th’e present value o/f th’e firm’s
future profits. Th’e larger (smaller) th’e risk associated wit’h future profits, th’e higher
(lower) th’e risk premium used t_o compute th’e value o/f th’e firm, an’d th’e lower (higher)
th’e value o/f th’e firm will be.
15. If cost an’d revenue conditions in any period are independent o/f decisions made in other
time periods, a manager will maximize th’e value o/f a firm by making decisions that
maximize profit in every single time period.
16. Taking a course in managerial economics can help you avoid making a number o/f common
mistakes in business decision making: never increase output simply t_o reduce average costs,
generally avoid th’e pursuit o/f market share because doing so usually lowers profit, focus on
maximizing total profit rather than profit margin, understand that maximizing total revenue
does not maximize profit, an’d avoid th’e use o/f cost-plus pricing methods when setting
prices.
17. Th’e decision t_o hire professional managers t_o run a business separates business ownership
an’d management an’d creates a principal-agent relationship in which a firm’s owner (th’e
principal) contracts wit’h a CEO or executive management team (th’e agent) t_o perform tasks
,Solutions Manual for th’e textbook 3
designed t_o further th’e objectives or goals o/f th’e owner. Contracts between owners an’d
managers cannot be designed an’d executed perfectly because it is nearly impossible for
owners t_o foresee all o/f th’e many ways that managers could behave opportunistically t_o
benefit themselves at th’e expense o/f th’e owners.
18. A principal-agent problem arises when owners cannot be certain that managers are making
decisions t_o further th’e owner’s objective, which is t_o maximize th’e value o/f th’e firm. A
principal–agent problem requires th’e presence o/f two conditions: (1) th’e manager’s
objectives must be different fro’m those o/f th’e owner, an’d (2) th’e owner must find it
impossible or simply too costly t_o monitor an’d verify that th’e management is indeed
advancing th’e owner’s objective by making decisions that will maximize th’e firm’s value.
19. When th’e goals o/f owners are different fro’m th’e goals o/f managers, economists say that
owner an’d manager goals are not aligned or that managers an’d owners possess conflicting
objectives. A manager, like any self-interested person, will search for opportunities t_o make
decisions for th’e business that promote th’e best interests o/f th’e manager, an’d some o/f
these decisions will harm th’e owners o/f th’e firm. These conflicting managerial actions
might include taking excessive perks or following unprofitable pursuits th’e managers finds
personally satisfying such as increasing th’e size o/f th’e firm or its market share.
20. When th’e objectives o/f owners an’d managers are not aligned, it makes sense for th’e
owners t_o include legal stipulations in th’e manager’s contract forcing managers t_o make
decisions that are strictly designed t_o generate th’e greatest possible profit an’d value for
th’e firm. Monitoring managers can be largely impossible when managers are able t_o take
hidden actions that cannot be observed by owners. Hidden actions are possible when there is
asymmetric information between owners an’d managers. Asymmetric information means
that managers possess more or better information than owners possess about profit
opportunities available t_o th’e firm an’d th’e nature o/f th’e decisions required t_o maximize
th’e firm’s profit.
21. When managers behave opportunistically by exploiting information asymmetries t_o take
hidden actions harming owners but benefiting managers in some way then a principle-agent
problem called moral hazard is created. Moral hazard is both a problem o/f nonaligned
objectives an’d a problem o/f harmful hidden actions. If either one o/f these two aspects is
missing then there is no moral hazard problem.
22. In order t_o address principal-agent problems caused by nonalignment o/f owner an’d
management goals, owners can employ a variety o/f corporate control mechanisms:
1. Require managers t_o hold enough o/f th’e firm’s equity stock t_o make managers care
intensely about maximize th’e value o/f th’e firm,
2. Increase th’e number o/f outsiders serving on th’e company’s board o/f directors, an’d
3. Finance corporate investments wit’h debt instead o/f equity.
Beyond these three internal measures, there is an important external force or event – a
corporate takeover-- that can also motivate managers t_o make decisions that maximize th’e
value o/f a firm.
23. A price-taking firm cannot set th’e price o/f th’e product it sells because price is determined
strictly by th’e market forces o/f demand an’d supply.
24. A price-setting firm sets th’e price o/f its product because it possesses some degree o/f
market power, which is th’e ability t_o raise price without losing all sales.
, Solutions Manual for th’e textbook 4
25. A market is any arrangement that enables buyers an’d sellers t_o exchange goods an’d
services, usually for money payments. Markets exist t_o reduce transaction costs, th’e costs
o/f making a transaction.
26. Market structure is a set o/f characteristics that determines th’e economic environment in
which a firm operates:
1. th’e number an’d size o/f firms operating in th’e market,
2. th’e degree o/f product differentiation, an’d
3. th’e likelihood o/f new firms’ entering.
27. Markets may be structured as one o/f four types:
1. A perfectly competitive market has a large number o/f relatively small firms selling an
undifferentiated product in a market wit’h no barriers t_o entry.
2. A monopoly market is one in which a single firm, protected by a barrier t_o entry,
produces a product that has no close substitutes.
3. In monopolistically competitive markets, a large number o/f relatively small firms
produce differentiated products without any barriers t_o entry.
4. In oligopoly markets, there are only a few firms whose profits are interdependent—
each firm’s decisions about pricing, output, advertising, an’d so forth affects all other
firms’ profits—wit’h varying degrees o/f product differentiation.
28. Globalization o/f markets is th’e economic integration o/f markets located in nations around
th’e world. Globalization provides managers wit’h both an opportunity t_o sell more goods
an’d services t_o foreign buyers as well as th’e threat o/f increased competition fro’m foreign
producers.
Applied Problems
1. T_o say that a decision rule or process does not work in theory is t_o say that th’e answer produced by
th’e rule is not going t_o be th’e “correct” answer. In business decision making, managers get th’e
“correct” answer when their solutions are ones that lead t_o th’e greatest level o/f profit.
For example, it is rather easy t_o calculate th’e profit margin for a good or service an’d t_o make
a pricing decision that will maximize th’e profit margin on th’e good or service. While that may
be a very practical method o/f determining price, pricing t_o maximize profit margin does not in
theory lead t_o th’e price that maximizes th’e profit or value o/f th’e firm –except by accident in
extremely rare circumstances. Th’e same can be said for making decisions that lead t_o th’e
lowest possible unit or average cost o/f production. Unit cost is easy t_o measure, an’d so it is
useful in practice, yet unit cost is not theoretically th’e correct measure o/f cost –i.e., managers
cannot, except by accident, find th’e profit-maximizing price or output level by using average
cost data. You will learn that th’e theoretically correct cost measure is marginal cost for making
profit-maximizing decisions.
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