Managerial Economics and Business Strategy !

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ANSWER:
To find the profit-maximizing advertising-to-sales ratio, we simply plug EQ,P = !10 and EQ,A = 0.2
into the formula for the optimal advertising-to-sales ratio:
EQ,A
A = _____ 0.2 = 0.02
__ = ___
R !EQ,P 10
Thus, Corpus Industries’ optimal advertising-to-sales ratio is 2 percent—to maximize profits, the
firm should spend 2 percent of its revenues on advertising.

ANSWERING THE headLINE

As noted earlier in this chapter, the fast-food restaurant business has many features of
monopolistic competition. Indeed, the owner of a typical McDonald’s franchise competes
not only against Burger King and Wendy’s but against a host of other establishments. While
each of these restaurants offers quick meals at reasonable prices, the products offered are
clearly differentiated. Product differentiation gives these businesses some market power.
The McCafé program discussed in the opening headline was designed to further differ-
entiate McDonald’s from the competition. In so doing, McDonald’s hoped to increase its own
demand by attracting customers away from traditional coffee shops and other fast-food
restaurants. In fact, this is exactly what happened, as McDonald’s saw a large increase in its
coffee sales over a short period of time. While a monopolistically competitive business like
McDonald’s might benefit in the short run by introducing new products more quickly than its
rivals, in the long run its competitors will attempt to mimic the strategies that are profitable. For
example, Starbucks subsequently acquired the La Boulange bakery brand, allowing it to offer
more food options along with its coffee—an apparent response to McDonald’s invading its
turf. This type of entry by rival firms would likely reduce the demand for meals (and coffee) at
McDonald’s and ultimately result in long-run economic profits of zero. It is worth noting that a
similar chain of events occurred way back in 1978 when McDonald’s successfully launched its
Egg McMuffin. Other fast-food restaurants eventually responded by launching their own break-
fast items, which ultimately reduced McDonald’s share of the breakfast market and its economic
profits. For these reasons, it is unlikely for strategies such as McDonald’s McCafé program or
Starbucks’ increased food offerings to have a sustainable impact on their bottom lines.

SUMMARY
In this chapter, we examined managerial decisions in three a very large number of firms that produce perfect substi-
market environments: perfect competition, monopoly, and tutes, a manager in this market has no control over price.
monopolistic competition. Each of these market structures A manager in a monopoly, in contrast, needs to recognize
provides a manager with a different set of variables that the relation between price and quantity. By setting a quan-
can influence the firm’s profits. A manager may need to tity at which marginal cost equals marginal revenue, the
pay particularly close attention to different decision pa- manager of a monopoly will maximize profits. This is also
rameters because different market structures allow control true for the manager of a firm in a monopolistically com-
of only certain variables. Managers who recognize which petitive market, who also must evaluate the firm’s product
variables are relevant for a particular industry will make periodically to ensure that it is differentiated from other
more profits for their firms. products in the market. In many instances, the manager of
Managers in perfectly competitive markets should a monopolistically competitive firm will find it advanta-
concentrate on producing the proper quantity and keeping geous to slightly change the product from time to time to
costs low. Because perfectly competitive markets contain enhance product differentiation.
 KEY TERMS AND CONCEPTS
brand equity firm demand curve monopolistic competition
brand myopic free entry monopoly
comparative advertising free exit multiplant monopoly
cost complementarities green marketing niche marketing
deadweight loss of monopoly inverse demand function patents
diseconomies of scale linear inverse demand function perfectly competitive market
economies of scale marginal revenue product differentiation
economies of scope

CONCEPTUAL AND COMPUTATIONAL QUESTIONS

®
1. The following graph summarizes the demand and costs for a firm that operates in a
perfectly competitive market. (LO1, LO6)

$48
46
44
42 MC
40
38
ATC
36
34
32
30
28 D f = MR
26
24 AVC
22
20
18
16
14
12 AFC
10
8
6
4
2
0 Quantity
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6 6.5 7 7.5 8 8.5 9 9.5 10

a. What level of output should this firm produce in the short run?
b. What price should this firm charge in the short run?
c. What is the firm’s total cost at this level of output?
d. What is the firm’s total variable cost at this level of output?
e. What is the firm’s fixed cost at this level of output?
f. What is the firm’s profit if it produces this level of output?
g. What is the firm’s profit if it shuts down?
h. In the long run, should this firm continue to operate or shut down?
2. A firm sells its product in a perfectly competitive market where other firms charge a"price
of $110 per unit. The firm estimates its total costs as C(Q) = 70 + 14Q + 2Q2. (LO3)
a. How much output should the firm produce in the short run?
b. What price should the firm charge in the short run?
c. What are the firm’s short-run profits?
d. What adjustments should be anticipated in the long run?
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3. The following graph summarizes the demand and costs for a firm that operates in a mo-
nopolistically competitive market. (LO1, LO3, LO5)

$220 MC
210
200
190
180
170
160
150
140
130 ATC
120
110
100
90
80
70
60
50
40
30
20
10 MR D
0 Quantity
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

a. What is the firm’s optimal output?

b. What is the firm’s optimal price?
c. What are the firm’s maximum profits?
d. What adjustments should the manager be anticipating?

4. You are the manager of a monopoly, and your analysts have estimated your demand
and costs functions as P = 300 ! 3Q and C(Q) = 1,500 + 2Q2, respectively.
(LO3, LO4)
a. What price–quantity combination maximizes your firm’s profits?
b. Calculate the maximum profits.
c. Is demand elastic, inelastic, or unit elastic at the profit-maximizing price–quantity
combination?
d. What price–quantity combination maximizes revenue?
e. Calculate the maximum revenues.
f. Is demand elastic, inelastic, or unit elastic at the revenue-maximizing price–quantity
combination?
5. You are the manager of a firm that produces a product according to the cost func-
tion"C(qi) = 160 + 58qi ! 6qi2 + qi3. Determine the short-run supply function if:
(LO1, LO7)
a. You operate a perfectly competitive business.
b. You operate a monopoly.
c. You operate a monopolistically competitive business.

6. The accompanying diagram shows the demand, marginal revenue, and marginal cost of
a monopolist. (LO1, LO3, LO5)
a. Determine the profit-maximizing output and price.
b. What price and output would prevail if this firm’s product were sold by price-taking
firms in a perfectly competitive market?
c. Calculate the deadweight loss of this monopoly.
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 $120 MC
110
100
90
80
70
60
50
40
30
20
10 MR D
0 Quantity
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

7. You are the manager of a monopolistically competitive firm, and your demand and cost
functions are estimated as Q = 36 ! 4P and C(Q) = 4 + 4Q + Q2. (LO1, LO3, LO5)
a. Find the inverse demand function for your firm’s product.
Excel b. Determine the profit-maximizing price and level of production.
Exercises c. Calculate your firm’s maximum profits.
d. What long-run adjustments should you expect? Explain.
8. The elasticity of demand for a firm’s product is –4 and its advertising elasticity of
demand is 0.32. (LO8)
a. Determine the firm’s optimal advertising-to-sales ratio.
b. If the firm’s revenues are $30,000, what is its profit-maximizing level of advertising?
9. A monopolist’s inverse demand function is estimated as"P = 150 ! 3Q. The company pro-
duces output at two facilities; the marginal cost of producing at facility 1 is MC1(Q1) = 6Q1,
and the marginal cost of producing at facility 2 is MC2(Q2) = 2Q2. (LO1, LO8)
a. Provide the equation for the monopolist’s marginal revenue function. (Hint: Recall
that Q1 + Q2 = Q.)
b. Determine the profit-maximizing level of output for each facility.
c. Determine the profit-maximizing price.
10. The manager of a local monopoly estimates that the elasticity of demand for its product
is constant and equal to –4. The firm’s marginal cost is constant at $25 per unit.
(LO1, LO3, LO4)
a. Express the firm’s marginal revenue as a function of its price.
b. Determine the profit-maximizing price.

PROBLEMS AND APPLICATIONS

®
11. The CEO of a major automaker overheard one of its division managers make the follow-
ing statement regarding the firm’s production plans: “In order to maximize profits, it is es-
sential that we operate at the minimum point of our average total cost curve.” If"you were
the CEO of the automaker, would you praise or chastise the manager? Explain. (LO3)
12. You are the manager of a small U.S. firm that sells nails in a competitive U.S. market (the
nails you sell are a standardized commodity; stores view your nails as identical to those
available from hundreds of other firms). You are concerned about two events you recently
learned about through trade publications: (a) the overall market supply of nails will decrease
by 2 percent, due to exit by foreign competitors, and (b) due to a growing U.S. economy, the
overall market demand for nails will increase by 2 percent. Based on this information, should
you plan to increase or decrease your production of nails? Explain. (LO1, LO7)
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13. When the first Pizza Hut opened its doors back in 1958, it offered consumers one style
of pizza: its Original Thin Crust Pizza. Since its modest beginnings, Pizza Hut has es-
tablished itself as the leader of the $25 billion pizza industry. Today, Pizza Hut offers
six styles of pizza, including Pan Pizza, Stuffed Crust Pizza, and its Hand-Tossed Style.
Explain why Pizza Hut has expanded its offerings of pizza over the past six decades,
and discuss the long-run profitability of such a strategy. (LO1, LO2, LO5)
14. You are the manager of a small pharmaceutical company that received a patent on a new
drug three years ago. Despite strong sales ($150 million last year) and a low marginal
cost of producing the product ($0.50 per pill), your company has yet to show a profit
from selling the drug. This is, in part, due to the fact that the company spent $1.7 billion
developing the drug and obtaining FDA approval. An economist has estimated that, at
the current price of $1.50 per pill, the own price elasticity of demand for the drug is –2.
Based on this information, what can you do to boost profits? Explain. (LO1, LO3, LO4)
15. The second-largest public utility in the nation is the sole provider of electricity in
32"counties of southern Florida. To meet the monthly demand for electricity in these
counties, which is represented by the estimated inverse demand function P = 1,200 ! 4Q,
the utility company has set up two electric generating facilities: Q1 kilowatts are pro-
duced at facility 1 and Q2 kilowatts are produced at facility 2 (so Q = Q1 + Q2). The
costs of producing electricity at each facility are estimated as C1(Q1) = 8,000 + 6Q12
and C2(Q2) = 6,000 + 3Q22, respectively. Determine the profit-maximizing amounts of
electricity to produce at the two facilities, the optimal price, and the utility company’s
profits. (LO1, LO8)
16. You are the manager of College Computers, a manufacturer of customized computers
that meet the specifications required by the local university. More than 90 percent of
your clientele consists of college students. College Computers is not the only firm that
builds computers to meet this university’s specifications; indeed, it competes with
many manufacturers online and through traditional retail outlets. To attract its large
student clientele, College Computers runs a weekly ad in the student paper advertising
its “free service after the sale” policy in an attempt to differentiate itself from the com-
petition. The weekly demand for computers produced by College Computers is given
by Q = 800 ! 2P, and its weekly cost of producing computers is C(Q) = 1,200 + 2Q2.
If other firms in the industry sell PCs at $300, what price and quantity of computers
should you produce to maximize your firm’s profits? What long-run adjustments
should you anticipate? Explain. (LO1, LO2, LO3, LO5)
17. You are the general manager of a firm that manufactures personal computers. Due to
a"soft economy, demand for PCs has dropped 50 percent from the previous year. The
sales manager of your company has identified only one potential client, who has re-
ceived several quotes for 10,000 new PCs. According to the sales manager, the client is
willing to pay $800 each for 10,000 new PCs. Your production line is currently idle, so
you can easily produce the 10,000 units. The accounting department has provided you
with the following information about the unit (or average) cost of producing three
potential quantities of PCs:"

!",""" PCs !#,""" PCs $",""" PCs

Materials (PC components) $ !"" $!"" $!""
Depreciation #"" $$% &%"
Labor &%" &%" &%"
Total unit cost $&,"%" $'(% $'""

Based on this information, should you accept the offer to produce 10,000 PCs at $800
each? Explain. (LO6)
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 18. You are a manager at Spacely Sprockets—a small firm that manufactures Type A and
Type B bolts. The accounting and marketing departments have provided you with the
following information about the per-unit costs and demand for Type A bolts:

Marketing Data for

Accounting Data for Type A Bolts Type A Bolts
Item Unit Cost Quantity Price
Materials and labor $$.(% " $&"
Overhead ) %."" & '
$ *
Total cost per unit $(.(% # (
+ !
% %

Materials and labor are obtained in a competitive market on an as-needed basis, and
the reported costs per unit for materials and labor are constant over the relevant range
of output. The reported unit overhead costs reflect the $10 spent last month on ma-
chines, divided by the projected output of 2 units that was planned when the machines
were purchased. In addition to the above information, you know that the firm’s assem-
bly line can produce no more than five bolts. Since the firm also makes Type B bolts,
this means that each Type A bolt produced reduces the number of Type B bolts that
can be produced by one unit; the total number of Types A and B bolts produced can-
not exceed 5 units. A"call to a reputable source has revealed that unit costs for produc-
ing Type B bolts are identical to those for producing Type A bolts and that Type B
bolts can be sold at a constant price of $4.75 per unit. Determine your relevant
marginal cost of producing Type A bolts and your profit-maximizing production
of"Type A bolts. (LO3)
19. In a statement to P&G shareholders, the CEO of Gillette (which is owned by P&G)
indicated, “Despite several new product launches, Gillette’s advertising-to-sales de-
clined dramatically . . . to 7.5 percent last year. Gillette’s advertising spending, in fact,
is"one of the lowest in our peer group of consumer product companies.” If the elasticity
of demand for Gillette’s consumer products is similar to that of other firms in its peer
group (which averages –4), what is Gillette’s advertising elasticity? Is Gillette’s
demand more or less responsive to advertising than other firms in its peer group?
Explain. (LO8)
20. Recently, the spot market price of U.S. hot rolled steel plummeted to $400 per ton. Just
one year ago, this same ton of steel cost $700. According to Metals Monitor, the drop
in"price was due to falling oil prices, along with a rise in cheap imports and excess
capacity. These dramatic market changes have greatly impacted the supply of raw steel.
Suppose that last year the supply for raw steel was QSraw = 600 + 4P, but this year it has
shifted to QSraw = 4,200 + 4P. Assuming the market for raw steel is competitive and that
the current worldwide demand for steel is Qdraw = 9,000 – 8P, compute the equilibrium
price and quantity for the steel market one year ago, and the equilibrium price–quantity
combination for the current steel market. Suppose the cost function of a representative
steel producer is C(Q) = 1,200 + 15Q2. Compare the change in the quantity of raw steel
exchanged at the market level with the change in raw steel produced by a representative
firm. How do you explain this difference? (LO1, LO3, LO7)
21. The French government announced plans to convert state-owned power firms EDF and
GDF into separate limited companies that operate in geographically distinct markets.
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 BBC News reported that France’s CFT union responded by organizing a mass strike,
which triggered power outages in some Paris suburbs. Union workers are concerned that
privatizing power utilities would lead to large-scale job losses and power outages similar
to those experienced in parts of the eastern coast of the United States and parts of Italy
in 2003. Suppose that prior to privatization, the price per kilowatt-hour of electricity
was €0.13 and that the inverse demand for electricity in each of these two regions of
France is estimated as P = 1.35 ! 0.002Q!(in euros). Furthermore, to supply electricity
to its particular region of France, it costs each firm C(Q) = 120 + 0.13Q (in euros).
Once privatized, each firm will have incentive to maximize profits. Determine the
number of kilowatt-hours of electricity each firm will produce and supply to the market
and the per-kilowatt-hour price. Compute the price elasticity of demand at the profit-
maximizing price–quantity combination. Explain why the price elasticity makes sense
at"the profit-maximizing price–quantity combination. Compare the price–quantity com-
bination before and after privatization. How much more profit will each firm earn as a
result of privatization? (LO2, LO3)
22. The owner of an Italian restaurant has just been notified by her landlord that the
monthly lease on the building in which the restaurant operates will increase by
20"percent at the beginning of the year. Her current prices are competitive with
nearby restaurants of similar quality. However, she is now considering raising her
prices by 20 percent to offset the increase in her monthly rent. Would you recom-
mend that she raise prices? Explain. (LO3)
23. Last month you assumed the position of manager for a large car dealership. The distin-
guishing feature of this dealership is its “no hassle” pricing strategy; prices (usually well
below the sticker price) are posted on the windows, and your sales staff has a reputation
for not negotiating with customers. Last year, your company spent $2 million on adver-
tisements to inform customers about its “no hassle” policy and had overall sales revenue
of $40 million. A recent study from an agency on Madison Avenue indicates that, for
each 3 percent increase in TV advertising expenditures, a car dealer can expect to sell
12 percent more cars—but that it would take a 4 percent decrease in price to generate
the same 12 percent increase in units sold. Assuming the information from Madison
Avenue is correct, should you increase or decrease your firm’s level of advertising?
Explain. (LO1, LO2, LO8)
24. As a manager in a monopolistically competitive industry, you are trying to determine
the optimal price for your product. You’ve asked the analysts in your firm to determine
as closely as possible the inverse demand curve for your product and your cost function.
They’ve reported back to you the following two tables:

Price regressed on Quantity:

Coefficients Standard Error t-Stat P-value Lower %#% Upper %#%

Intercept #"".$*( &.""% $'*.!% (."%E-$&! $'*.#"" #"$.$(#
Quantity –+."+* "."!$ –!%.!( +.('E-&&% –+.&(" –#.'$!

Costs regressed on Quantity:

Coefficients Standard Error t-Stat P-value Lower %#% Upper %#%

Intercept *.$+' &."%$ (.*+% !.%*E-&# !.&($ &".#$!
Quantity #."($ "."!+ +(.!%& &.((E-'+ $.'++ #.&''

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 Using this information, determine:
a. The estimated inverse demand curve and cost function for your product, and com-
ment on whether these are precisely estimated.
b. The profit maximizing quantity and price for your product.
c. The maximum profits you can attain.
®

25. As a newly hired manager at your firm, you decide to start your tenure by assessing the
sensibility of your current advertising expenditure. To do this, you ask your analytics
team to collect useful data on the quantity of your product sold, the price, and advertis-
Excel ing (in thousands) across a range of markets where your product is sold. The data they
Exercises collected are in Q08-25.xls.
a. Using these data, determine the advertising elasticity of demand and the own-price
elasticity of demand. (Hint: Recall what a log-log regression provides in terms of
estimates).
b. What is the profit-maximizing advertising-to-sales ratio for your product? Do you
have any concern about the precision of this estimate?

SELECTED READINGS
Gal-Or, Esther, and Spiro, Michael H., “Regulatory Regimes of Economic Education 25(3), Summer 1994,
in the Electric Power Industry: Implications for pp. 235–50.
Capacity.” Journal of Regulatory Economics 4(3), Nguyen, Dung, “Advertising, Random Sales Response, and
September 1992, pp. 263–78. Brand Competition: Some Theoretical and Econometric
Gius, Mark Paul, “The Extent of the Market in the Liquor Implications.” Journal of Business 60(2), April 1987,
Industry: An Empirical Test of Localized Brand Rivalry, pp. 259–79.
1970–1988.” Review of Industrial Organization 8(5), Simon, Herbert A., “Organizations and Markets.” Journal of
October 1993, pp. 599–608. Economic Perspectives 5(2), Spring 1991, pp. 25–44.
Lamdin, Douglas J., “The Welfare Effects of Monopoly versus Stegeman, Mark, “Advertising in Competitive Markets.”
Competition: A Clarification of Textbook Presentations.” American Economic Review 81(1), March 1991,
Journal of Economic Education 23(3), Summer 1992, pp. 210–23.
pp. 247–53. Zupan, Mark A., “On Cream Skimming, Coase, and the
Malueg, David A., “Monopoly Output and Welfare: The Sustainability of Natural Monopolies.” Applied
Role of Curvature of the Demand Function.” Journal Economics 22(4), April 1990, pp. 487–92.

APPENDIX
THE CALCULUS OF PROFIT MAXIMIZATION

PERFECT COMPETITION or
The profits of a perfectly competitive firm are P = MC
The second-order condition for maximizing profits requires
! = PQ ! C(Q)
that
The first-order conditions for maximizing profits require d2! = ! ____
____ d2C = ! _____
dMC < 0
2
that marginal profits be zero: dQ dQ2 dQ
dC(Q)
d! = P ! ______
___ This means that d(MC)"dQ > 0, or that marginal cost
=0 must be increasing in output.
dQ dQ
Thus, we obtain the profit-maximizing rule for a firm in MONOPOLY AND MONOPOLISTIC COMPETITION
perfect competition: MR = MC RULE
dC The profits for a firm with market power are
P = ___
dQ ! = R(Q) ! C(Q)
!"!
where R(Q) = P(Q)Q is total revenue. To maximize prof- which means that
its, marginal profits must be zero:
dMC
dMR < _____
_____
___ dR(Q) ______
d" = _____ dC(Q) dQ dQ
! =0
dQ dQ dQ
But this simply means that the slope of the marginal reve-
or
nue curve must be less than the slope of the marginal cost
MR = MC
curve.
The second-order condition requires that
2 2
d 2" = _______
____ d R(Q) _______
!
d C(Q)
<0
2 2
dQ dQ dQ 2

APPENDIX
THE ALGEBRA OF PERFECTLY COMPETITIVE SUPPLY FUNCTIONS

This appendix shows how to obtain the short-run firm and to each other and solve for qi. When we do this for the
industry supply functions from cost data. Suppose there given equations, we find that the quantity at which mar-
are 500 firms in a perfectly competitive industry, with ginal cost equals average variable cost is qi = 0.
each firm having a cost function of Next, we recognize that an individual firm maximizes
C(qi) = 50 + 2qi + 4qi2 profits by equating P = MCi, so

The corresponding average total cost (ATC), average vari- P = 2 + 8qi

able cost (AVC), and marginal cost (MC) functions are Solving for qi gives us the individual firm’s supply
50 + 2 + 4q
ATCi = ___ function:
qi i
2 + __
qi = ! __ 1P
AVCi = 2 + 4qi 8 8
and To find the supply curve for the industry, we simply sum
MCi = 2 + 8qi the above equation over all 500 firms in the market:

Q = ∑ qi = 500(!__ )
Recall that a firm’s supply curve is the firm’s marginal 500 1,000 ____
2 + __
1 P = ! _____ + 500 P
cost curve above the minimum of average variable cost. i=1 8 8 8 8
Since AVC is at its minimum where it equals marginal
or
cost, to find the quantity where average variable cost
equals marginal cost, we must set the two functions equal Q = !125 + 62.5P

Design Credit: Spreadsheet design icon: Botond1977/Shutterstock

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