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Managerial Economics 3Rd Edition Froeb Solutions Manual Full Chapter PDF
Managerial Economics 3Rd Edition Froeb Solutions Manual Full Chapter PDF
Main Points
• Investments imply willingness to trade dollars in the present for dollars in the future. Wealth-
creating transactions occur when individuals with low discount rates (rate at which they value
future vs current dollars) lend to those with high discount rates.
• Companies, like individuals, have different discount rates, determined by their cost of capital. They
invest only in projects that earn a return higher than the cost of capital.
• The NPV rule states that if the present value of the net cash flow of a project is larger than zero,
the project earns economic profit (i.e., the investment earns more than the cost of capital).
• Although NPV is the correct way to analyze investments, not all companies use it. Instead, they
use break-even analysis because it is easier and more intuitive.
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• Break-even quantity is equal to fixed cost divided by the contribution margin. If you expect to
sell more than the break-even quantity, then your investment is profitable.
• Avoidable costs can be recovered by shutting down. If the benefits of shutting down (you recover
your avoidable costs) are larger than the costs (you forgo revenue), then shut down. The break-
even price is average avoidable cost.
• If you incur sunk costs, you are vulnerable to post-investment hold-up. Anticipate hold-up and
choose contracts or organizational forms that minimize the costs of hold-up.
• Once relationship-specific investments are made, parties are locked into a trading relationship with
each other, and can be held up by their trading partners. Anticipate hold-up and choose
organizational or contractual forms to give each party both the incentive to make relationship-
specific investments and to trade after these investments are made.
Teaching Note
Continuing with the theme that costs are related to decisions, this chapter identifies the relevant benefits
and costs of investment decisions. I begin with the anecdote of how TVA “held up” Mobil Oil after they
made a three month investment in an engineering audit of TVA’s lubrication needs, and tell students Mobil
did not “look ahead and reason back”, one of the main lessons of the chapter (this anecdote is at the
beginning of the Sunk Costs and Post-Investment Hold-Up section of the chapter).
Start by talking about NPV analysis as an “if and only if” proposition. Investments cover the (hidden?) cost
of capital if and only if they have a positive NPV. To set this up, talk about compounding and discounting
as the inverse of compounding. Talk about behavior of people with high discount rates (smoking,
uneducated, over weight), i.e., unwilling to undertake investments unless they return a lot of money.
Then talk about entry decisions, introduce break even quantities, and give an example. Then tell the story
of John Deere abandoning its large fixed cost but low MC factory in favor of buying Versatile, a company
that assembled off-the-shelf components in a large garage (low fixed cost, but high MC). If expected sales
were low, then this was a good decision. Get them to think of costs as related to the underlying technology.
Introduce break-even prices and give an example of how they are used in shut down decisions. Use the
cost taxonomy (long run: avoidable vs. unavoidable; short run: fixed vs. variable). Give an in-class
example, with fixed costs of $100/year, expected production of 100/year, and MC of $5. Ask them how
low price can go before they shut down. The answer is “it depends” on whether the fixed costs are avoidable
(long run) or not (short run).
Ask them what they would do if their firm received an RFP (request for proposal) on a wire harness from
GM with fixed costs of $1 million and MC of $1 with expected sales of 1 million units. The break even
price is $2. GM agrees to the price, and then hands you with a PO (purchase order) for .5 million units,
what do you say? Students will usually see the problem. Ask students whether this behavior is ethical?
Then tell them to anticipate self-interested behavior.
Go through the printer example to make them understand the importance of fixed vs. sunk (relationship-
specific) costs. Talk about the problem is that the investment will NOT be made unless the parties can
solve the hold-up problem. Ask how to do this. They will usually come up with the “rental” solution (the
magazine buys the printer, and rents it to the printing company).
Talk a little about contracts, hostage exchange, or vertical integration as a solution to the hold-up problem,
and then talk about hold-up problem in marriage but only with the older (executive) MBA students. The
younger students will not relate to a marriage example. Alternatively, talk about Patent Ambush as an
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example of post investment hold up. In 2003, the FTC sued Unocal for illegally obtaining market power
by suggesting the California Air Resources Board (CARB) adopt its formula for cleaner burning fuel. After
the oil refiners had sunk billions of dollars into modifying their refineries to produce the new formula
announced that it owned a patent on the formula that would cost them five cents/gallon to use.
When Chevron purchased Unocal, the FTC made them stop charging royalties on CARB gasoline.
In-class Problem
Run the Hold-up Game. This takes both setup time and time to run in class. But it demonstrates what
happens with the opportunity to hold-up your counter-party.
Supplementary Material
Blog Entries
ManagerialEcon.com (Chapter 5)
Auxiliary Slides
Project initiation from “The Hudsucker Proxy” (Save the material after the 5 minute mark for later.)
Readings
MBAprimer.com, Managerial Economics Module, Section 3. “Understanding Sellers’ Costs.”
http://mbaprimer.com
Interactive, online hypertext covers same material. At the end of the text there is a short, five question
quiz so that the students can “self test.”
Similar to the MBA Primer but with less attention to the graphic design aspects.
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Harvard Business School Note: "Basic Quantitative Analysis for Marketing", HBS 9-584-149.
Break even quantities, prices, and relevant costs for marketing decisions.
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