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Managerial Economics: Theory, Applications, and Cases

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Brief
Table of Contents
Preface xix 13 Best-Practice Tactics: Game Theory 446
About the Authors xxiii 13A Entry Deterrence and Accommodation
Games 497
14 Pricing Techniques and Analysis 508
PART I 14A The Practice of Revenue Management 545
INTRODUCTION 1
1 Introduction and Goals of the Firm 2
PART V
2 Fundamental Economic Concepts 28
ORGANIZATIONAL ARCHITECTURE
AND REGULATION 557
PART II 15 Contracting, Governance, and
DEMAND AND FORECASTING 63 Organizational Form 558
15A Auction Design and Information
3 Demand Analysis 64
Economics 594
4 Estimating Demand 101
16 Government Regulation 623
4A Problems in Applying the Linear
17 Long-Term Investment Analysis 660
Regression Model 129
5 Business and Economic Forecasting 141
APPENDICES
6 Managing in the Global Economy 178
6A Foreign Exchange Risk Management 232 A The Time Value of Money A-1
B Differential Calculus Techniques
in Management B-1
PART III C Tables C-1
D Check Answers to Selected
PRODUCTION AND COST 235 End-of-Chapter Exercises D-1
7 Production Economics 236 Glossary G-1
7A Production Economics of Renewable and Index I-1
Exhaustible Natural Resources, Advanced Notes
Material 272
8 Cost Analysis 282 WEB APPENDICES
9 Applications of Cost Theory 307 A Consumer Choice Using Indifference
Curve Analysis
B International Parity Conditions
PART IV C Linear-Programming Applications
D Capacity Planning and Pricing against a
PRICING AND OUTPUT DECISIONS: Low-Cost Competitor: A Case Study of
STRATEGY AND TACTICS 333 Piedmont Airlines and People Express
10 Prices, Output, and Strategy: Pure and E Pricing of Joint Products and Transfer Pricing
Monopolistic Competition 334 F Decisions under Risk and Uncertainty
11 Price and Output Determination: G Maximization of Production Output Subject
Monopoly and Dominant Firms 384 to a Cost Constraint, Advanced Material
12 Price and Output Determination: H Long-Run Costs with a Cobb-Douglas
Oligopoly 411 Production Function, Advanced Material
vii
Contents
Preface xix Case Exercise: Designing a Managerial
About the Authors xxiii Incentives Contract 23
Case Exercise: Shareholder Value of Renewable
Energy from Wind Power at Hydro Co.:
PART I Is RE < C? 24
INTRODUCTION 1 2 Fundamental Economic Concepts 28

Chapter Preview 28
1 Introduction and Goals of the Firm 2 Managerial Challenge: Why Charge
Chapter Preview 2 $25 per Bag on Airline Flights? 28
Managerial Challenge: How to Achieve 2-1 Demand and Supply: A Review 29
Sustainability: Southern Company 2-1a The Diamond-Water Paradox and the
Electric Power Generation 2 Marginal Revolution 31
1-1 What Is Managerial Economics? 4 2-1b Marginal Utility and Incremental Cost
1-2 The Decision-Making Model 5 Simultaneously Determine Equilibrium
1-2a The Responsibilities of Management 5 Market Price 32
2-1c Individual and Market Demand Curves 33
What Went Right/What Went Wrong: 2-1d The Demand Function 34
Saturn Corporation 6 2-1e Import-Export Traded Goods 36
1-2b Moral Hazard in Teams 6
1-3 The Role of Profits 8 International Perspectives: Exchange Rate
1-3a Risk-Bearing Theory of Profit 8 Impacts on Demand: Cummins Engine
1-3b Temporary Disequilibrium Theory of Profit 9 Company 36
1-3c Monopoly Theory of Profit 9 2-1f Individual and Market Supply Curves 37
1-3d Innovation Theory of Profit 9 2-1g Equilibrium Market Price of Gasoline 38
1-3e Managerial Efficiency Theory of Profit 9 2-2 Marginal Analysis 43
1-4 Objective of the Firm 9 2-2a Total, Marginal, and Average Relationships 44
1-4a The Shareholder Wealth-Maximization 2-3 The Net Present Value Concept 48
Model of the Firm 10 2-3a Determining the Net Present Value of an
1-5 Separation of Ownership and Control: Investment 48
The Principal-Agent Problem 11 2-3b Sources of Positive Net Present Value
1-5a Divergent Objectives and Agency Conflict 11 Projects 50
1-5b Agency Problem 13 2-3c Risk and the NPV Rule 51
1-6 Implications of Shareholder Wealth 2-4 Meaning and Measurement of Risk 52
Maximization 15 2-4a Probability Distributions 52
2-4b Expected Values 53
What Went Right/What Went Wrong: Eli 2-4c Standard Deviation: An Absolute
Lilly Depressed by Loss of Prozac Patent 15 Measure of Risk 54
1-6a Caveats to Maximizing Shareholder Value 17 2-4d Normal Probability Distribution 54
1-6b Residual Claimants 19 2-4e Coefficient of Variation: A Relative
1-6c Goals in the Public Sector and Measure of Risk 56
Not-for-Profit Enterprises 19
What Went Right/What Went Wrong:
1-6d Not-for-Profit Objectives 20
1-6e The Efficiency Objective in Long-Term Capital Management (LTCM) 56
Not-for-Profit Organizations 20 2-5 Risk and Required Return 57
Summary 21 Summary 59
Exercises 22 Exercises 59
ix
x Contents
Case Exercise: Revenue Management at 4-2 A Simple Linear Regression Model 105
American Airlines 61 4-2a Assumptions Underlying the Simple
Linear Regression Model 106
4-2b Estimating the Population Regression
PART II Coefficients 107
4-3 Using the Regression Equation to Make
DEMAND AND FORECASTING 63 Predictions 110
4-3a Inferences about the Population
3 Demand Analysis 64 Regression Coefficients 112
Chapter Preview 64 4-3b Correlation Coefficient 115
4-3c The Analysis of Variance 116
Managerial Challenge: Health Care 4-4 Multiple Linear Regression Model 118
Reform and Cigarette Taxes 64 4-4a Use of Computer Programs 118
3-1 Demand Relationships 66 4-4b Estimating the Population Regression
3-1a The Demand Schedule Defined 66 Coefficients 118
3-1b Constrained Utility Maximization and 4-4c Using the Regression Model to Make
Consumer Behavior 67 Forecasts 118
What Went Right/What Went Wrong: 4-4d Inferences about the Population
Chevy Volt 71 Regression Coefficients 119
3-2 The Price Elasticity of Demand 72 4-4e The Analysis of Variance 121
3-2a Price Elasticity Defined 73 Summary 122
3-2b Interpreting the Price Elasticity: The Exercises 122
Relationship between the Price Elasticity Case Exercise: Soft Drink Demand Estimation 126
and Sales Revenue 76
3-2c The Importance of Elasticity-Revenue 4A Problems in Applying the Linear
Relationships 82 Regression Model 129
3-2d Factors Affecting the Price Elasticity of 4A-1 Introduction 129
Demand 84 4A-1a Autocorrelation 129
4A-1b Heteroscedasticity 131
International Perspectives: Free Trade 4A-1c Specification and Measurement Errors 132
and the Price Elasticity of Demand: 4A-1d Multicollinearity 133
Nestlé Yogurt 86 4A-1e Simultaneous Equation Relationships
3-3 The Income Elasticity of Demand 87 and the Identification Problem 133
3-3a Income Elasticity Defined 87 4A-2 Nonlinear Regression Models 136
3-4 Cross Elasticity of Demand 90 4A-2a Semilogarithmic Transformation 136
3-4a Cross Price Elasticity Defined 90 4A-2b Double-Log Transformation 136
3-4b Interpreting the Cross Price Elasticity 90 4A-2c Reciprocal Transformation 137
3-4c Antitrust and Cross Price Elasticities 90 4A-2d Polynomial Transformation 137
3-4d An Empirical Illustration of Price, Summary 138
Income, and Cross Elasticities 92 Exercises 138
3-5 The Combined Effect of Demand
Elasticities 92 5 Business and Economic Forecasting 141
Summary 93 Chapter Preview 141
Exercises 94 Managerial Challenge: Excess Fiber Optic
Case Exercise: Polo Golf Shirt Pricing 97 Capacity at Global Crossing Inc. 141
Case Exercise: Fifty Years of Sales 5-1 The Significance of Forecasting 143
Maximization at Volkswagen 98 5-2 Selecting a Forecasting Technique 143
5-2a Hierarchy of Forecasts 143
4 Estimating Demand 101 5-2b Criteria Used to Select a Forecasting
Chapter Preview 101 Technique 144
Managerial Challenge: Demand for 5-2c Evaluating the Accuracy of Forecasting
Models 144
Whitman’s Chocolate Samplers 101
4-1 Statistical Estimation of the Demand What Went Right/What Went Wrong:
Function 102 Crocs Shoes 144
Specification
4-1a Copyright of the Model 103 5-3 Alternative Forecasting Techniques
2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203
145
Contents xi
5-4 Deterministic Trend Analysis 145 6-5a Import-Export Flows and Transaction
5-4a Components of a Time Series 145 Demand for a Currency 192
5-4b Some Elementary Time-Series Models 146 6-5b The Equilibrium Price of the U.S. Dollar 193
5-4c Secular Trends 147 6-5c Speculative Demand, Government
5-4d Seasonal Variations 150 Transfers, and Coordinated Intervention 193
5-5 Smoothing Indicators 152 6-5d Short-Term Exchange Rate Fluctuations 194
5-5a Moving Averages 153 6-6 Determinants of Long-Run Trends in
5-5b First-Order Exponential Smoothing 155 Exchange Rates 195
5-6 Barometric Techniques 158 6-6a The Role of Real Growth Rates 195
5-6a Leading, Lagging, and Coincident 6-6b The Role of Real Interest Rates 198
Indicators 158 6-6c The Role of Expected Inflation 198
5-7 Survey and Opinion-Polling Techniques 159 6-7 Purchasing Power Parity 199
5-7a Forecasting Macroeconomic Activity 160 6-7a PPP Offers a Better Yardstick of
5-7b Sales Forecasting 161 Comparative Size of Business Activity 200
5-8 Macroeconometric Models 161 What Went Right/What Went Wrong:
5-8a Advantages of Econometric Forecasting Big Box U.S. Retailers in China 202
Techniques 161 6-7b Relative Purchasing Power Parity 202
5-8b Single-Equation Models 161 6-7c Qualifications of PPP 203
5-8c Multi-Equation Models 163 6-7d The Appropriate Use of PPP: An
5-8d Consensus Forecasts: Livingston and Overview 204
Blue Chip Forecaster Surveys 164
What Went Right/What Went Wrong: GM,
5-9 Forecasting with Input-Output Tables 165
Toyota, and the Celica GT-S Coupe 205
International Perspectives: Long-Term 6-7e Trade-Weighted Exchange Rate Index 206
Sales Forecasting by General Motors 6-8 International Trade: A Managerial
in Overseas Markets 165 Perspective 209
5-10 Advanced Material: Stochastic 6-8a Shares of World Trade and Regional
Time-series Analysis 166 Trading Blocs 209
Summary 169 6-8b Comparative Advantage and Free Trade 211
Exercises 169 6-8c Import Controls and Protective Tariffs 214
Case Exercise: Cruise Ship Arrivals in Alaska 173 6-8d The Case for Strategic Trade Policy 215
Case Exercise: Lumber Price Forecast 174 6-8e Increasing Returns 218
Case Exercise: Forecasting in the Global 6-8f Network Externalities 218
Financial Crisis 175 6-9 Free Trade Areas: The European Union
and NAFTA 219
6 Managing in the Global Economy 178 6-9a Optimal Currency Areas 219
Chapter Preview 178 6-9b Intraregional Trade 220
6-9c Mobility of Labor 220
Managerial Challenge: The Role of the 6-9d Correlated Macroeconomic Shocks 221
FX Rate in Assessing Foreign Business 6-10 Largest U.S. Trading Partners:
Opportunity 178 The Role of NAFTA 222
6-1 Introduction 181 6-10a A Comparison of the EU and NAFTA 224
What Went Right/What Went Wrong: 6-10b Gray Markets, Knockoffs, and Parallel
Export Market Pricing at Toyota 181 Importing 225
6-2 Import-Export Sales and Exchange What Went Right/What Went Wrong:
Rates 182 Ford Motor Co. and Exide Batteries:
6-2a Foreign Exchange Risk 183 Are Country Managers Here to Stay? 226
International Perspectives: Collapse 6-11 Perspectives on the U.S. Trade Deficit 227
of Export and Domestic Sales Summary 229
at Cummins Engine 184 Exercises 230
6-3 Outsourcing 185 Case Exercise: Predicting the Long-Term
6-4 China Trade Blossoms 187 Trends in Value of the U.S. Dollar and
6-4a China Today 189 the Euro 231
6-5 The Market for U.S. Dollars as Foreign Case Exercise: Elaborate the Debate on
Exchange 191 NAFTAin whole or in part. WCN 02-200-203
Copyright 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, 231
xii Contents
6A Foreign Exchange Risk Management 232 7-8d Empirical Studies of the Cobb-Douglas
International Perspectives: Toyota and Production Function in Manufacturing 263
Honda Buy U.S. Assembly Capacity 233 7-8e A Cross-Sectional Analysis of U.S.
Manufacturing Industries 263
Summary 266
PART III Exercises 267
Case Exercise: The Production Function
PRODUCTION AND COST 235 for Wilson Company 270
7 Production Economics 236 7A Production Economics of Renewable and

Chapter Preview 236 Exhaustible Natural Resources, Advanced
Managerial Challenge: Green Power Material 272
Initiatives Examined: What Went 7A-1 Renewable Resources 272
Wrong in California’s Deregulation 7A-2 Exhaustible Natural Resources 276
of Electricity? 236 Exercises 281
7-1 The Production Function 238
7-1a Fixed and Variable Inputs 239 8 Cost Analysis 282
7-2 Production Functions with One Chapter Preview 282
Variable Input 241 Managerial Challenge: Can a Leaner
7-2a Marginal and Average Product Functions 241 General Motors Compete Effectively? 282
7-2b The Law of Diminishing Marginal 8-1 The Meaning and Measurement of Cost 283
Returns 242 8-1a Accounting versus Economic Costs 284
What Went Right/What Went Wrong: 8-1b Three Contrasts between Accounting
Factory Bottlenecks at a Boeing and Economic Costs 284
Assembly Plant 243 8-2 Short-Run Cost and Product Functions 288
7-2c Increasing Returns with Network Effects 243 8-2a Average and Marginal Cost Functions 288
7-2d Producing Information Services under 8-3 Long-Run Cost Functions 293
Increasing Returns 245 8-3a Optimal Capacity Utilization: Three
7-2e The Relationship between Total, Concepts 293
Marginal, and Average Product 246 8-4 Economies and Diseconomies of Scale 294
7-3 Determining the Optimal Use of the 8-4a The Percentage of Learning 295
Variable Input 248 8-4b Diseconomies of Scale 298
7-3a Marginal Revenue Product 249 8-4c The Overall Effects of Scale Economies
7-3b Marginal Factor Cost 249 and Diseconomies 298
7-3c Optimal Input Level 249 International Perspectives: How Japanese
7-4 Production with Multiple Variable Inputs 250 Companies Deal with the Problems
7-4a Production (Output Constant) Isoquants 250 of Size 299
7-4b The Marginal Rate of Technical Summary 301
Substitution 252 Exercises 302
7-5 Determining the Optimal Combination Case Exercise: Cost Analysis of Patio Furniture 304
of Inputs 254 Case Exercise: Profit Margins on the
7-5a Isocost Lines 255
Amazon Kindle 306
7-5b Minimizing Cost Subject to an Output
Constraint 256
9 Applications of Cost Theory 307
7-6 A Fixed Proportions Optimal
Chapter Preview 307
Production Process 257
7-6a Production Processes and Process Rays 258 Managerial Challenge: How Exactly Have
7-7 Measuring the Efficiency of a Computerization and Information
Production Process 259 Technology Lowered Costs at Chevron,
7-8 Returns to Scale 260 Timken, and Merck? 307
7-8a Measuring Returns to Scale 261 9-1 Estimating Cost Functions 308
7-8b Increasing and Decreasing Returns to 9-1a Issues in Cost Definition and
Scale 262 Measurement 309
The Cobb-Douglas
7-8c Copyright Production
2017 Cengage Learning. Function
All Rights Reserved. 262 9-1b orControlling
May not be copied, scanned, for Other
duplicated, in whole Variables
or in part. WCN 02-200-203 309
Contents xiii
9-1c The Form of the Empirical Cost-Output 10-3c The Power of Buyers and Suppliers 346
Relationship 310 10-3d The Intensity of Rivalrous Tactics 347
What Went Right/What Went Wrong: 10-3e The Myth of Market Share 351
Boeing: The Rising Marginal Cost 10-4 A Continuum of Market Structures 351
10-4a Pure Competition 352
of Wide-Bodies 311 10-4b Monopoly 353
9-1d Statistical Estimation of Short-Run 10-4c Monopolistic Competition 354
Cost Functions 312 10-4d Oligopoly 354
9-1e Statistical Estimation of Long-Run 10-5 Price-Output Determination under
Cost Functions 313 Pure Competition 355
9-1f Determining the Optimal Scale of an 10-5a Short Run 355
Operation 313 10-5b Profit Maximization under Pure
9-1g Economies of Scale versus Economies Competition (Short Run): Adobe
of Scope 316 Corporation 358
9-1h Engineering Cost Techniques 316 10-5c Long Run 359
9-1i The Survivor Technique 318 10-6 Price-Output Determination under
9-1j A Cautionary Tale 318
Monopolistic Competition 362
9-2 Break-Even Analysis 319
9-2a Graphical Method 320 What Went Right/What Went Wrong:
9-2b Algebraic Method 320 The Dynamics of Competition at
9-2c Some Limitations of Break-Even Analysis 323 Amazon.com 363
9-2d Doing a Break-Even versus a 10-6a Short Run 363
Contribution Analysis 323 10-6b Long Run 363
9-2e A Limitation of Contribution Analysis 325 10-7 Selling and Promotional Expenses 365
9-2f Operating Leverage 325 10-7a Determining the Optimal Level
9-2g Inherent Business Risk 327 of Selling and Promotional Outlays 366
Summary 327 10-7b Optimal Advertising Intensity 367
10-7c The Net Value of Advertising 368
Exercises 328
10-8 Competitive Markets under
Case Exercise: Cost Functions 329
Asymmetric Information 369
Case Exercise: Charter Airline Operating
10-8a Incomplete versus Asymmetric
Decisions 330 Information 369
10-8b Search Goods versus Experience Goods 370
PART IV 10-8c Adverse Selection and the Notorious
Firm 370
PRICING AND OUTPUT DECISIONS: 10-8d Insuring and Lending under Asymmetric
STRATEGY AND TACTICS 333 Information: Another Lemons Market 372
10-9 Solutions to the Adverse Selection
10 Prices, Output, and Strategy: Pure and Problem: Advanced Material 373
Monopolistic Competition 334 10-9a Mutual Reliance: Hostage Mechanisms
Chapter Preview 334 Support Asymmetric Information
Managerial Challenge: Resurrecting Exchange 373
10-9b Brand-Name Reputations as Hostages 374
Apple in the Tablet World 334
10-9c Price Premiums with Non-Redeployable
10-1 Introduction 335 Assets 376
10-2 Competitive Strategy 336
Summary 378
What Went Right/What Went Wrong: Exercises 379
Xerox 337 Case Exercise: Netflix and Redbox Compete
10-2a Generic Types of Strategies 338 for Movie Rentals 381
10-2b Product Differentiation Strategy 338 Case Exercise: Saving Sony Music 382
10-2c Cost-Based Strategy 338
10-2d Information Technology Strategy 339 1 1 Price and Output Determination:
10-2e The Relevant Market Concept 341 Monopoly and Dominant Firms 384
10-3 Porter’s Five Forces Strategic Chapter Preview 384
Framework 341 Managerial Challenge: Dominant
10-3a The Threat of Substitutes 342 Microprocessor Company Intel
10-3b2017The
Copyright Threat
Cengage of Entry
Learning. All Rights Reserved. May not be343 Adapts intowhole
copied, scanned, or duplicated, Next
or inTrend
part. WCN 02-200-203 384
xiv Contents
11-1 Monopoly Defined 385 12-2 Interdependencies in Oligopolistic

11-2 Sources of Market Power for a Industries 418
Monopolist 386 12-2a The Cournot Model 420
11-2a Increasing Returns from Network 12-3 Cartels and Other Forms of Collusion 421
Effects 386 12-3a Factors Affecting the Likelihood of
What Went Right/What Went Wrong: Successful Collusion 423
12-3b Cartel Profit Maximization and the
Pilot Error at Palm 389
Allocation of Restricted Output 424
11-3 Price and Output Determination for a
Monopolist 390 International Perspectives: The OPEC
11-3a Spreadsheet Approach: Profit versus Cartel 426
Revenue Maximization for Polo Golf 12-3c Cartel Analysis: Algebraic Approach 431
Shirts 390 12-4 Price Leadership 433
11-3b Graphical Approach 391 12-4a Barometric Price Leadership 433
11-3c Algebraic Approach 392 12-4b Dominant Firm Price Leadership 434
11-3d The Importance of the Price Elasticity 12-5 The Kinked Demand Curve Model 437
of Demand 393 12-6 Avoiding Price Wars 438
11-4 The Optimal Markup, Contribution What Went Right/What Went Wrong:
Margin, and Contribution Margin Good-Better-Best Product Strategy at
Percentage 395 Marriott Corporation and Kodak 441
11-4a Gross Profit Margins 397
Summary 443
11-4b Components of the Margin 397
11-4c Monopolists and Capacity Investments 398
Exercises 444
11-4d Limit Pricing 399 13 Best-Practice Tactics: Game Theory 446
11-4e Using Limit Pricing to Hamper the Chapter Preview 446
Sales of Generic Drugs 400
Managerial Challenge: Large-Scale Entry
What Went Right/What Went Wrong: Deterrence of Low-Cost Discounters:
Pfizer Sustains Sales of Off-Patent Southwest Airline/AirTran 446
Lipitor 401 13-1 Oligopolistic Rivalry and Game Theory 448
11-5 Regulated Monopolies 402
11-5a Electric Power Companies 402 What Went Right/What Went Wrong:
Nintendo’s Wii U 448
What Went Right/What Went Wrong: 13-1a A Conceptual Framework for Game
The Public Service Company of Theory Analysis 449
New Mexico 402 13-1b Components of a Game 450
11-5b Natural Gas Companies 403 13-1c Cooperative and Noncooperative Games 452
11-6 The Economic Rationale for Regulation 403 13-1d Other Types of Games 452
11-6a Natural Monopoly Argument 403 13-2 Analyzing Simultaneous Games 453
Summary 405 13-2a The Prisoner’s Dilemma 453
Exercises 405 13-2b Dominant Strategy Defined 455
Case Exercise: Differential Pricing of 13-3 Nash Equilibrium Strategy Defined 457
Pharmaceuticals: The HIV/AIDS Crisis 409 13-3a Mixed Nash Equilibrium Strategy 460
Case Exercise: Limit Pricing as Strategic 13-4 The Escape from Prisoner’s Dilemma 463
Entry Deterrence: Ace Inhibitor 410 13-4a Multiperiod Punishment and Reward
Schemes in Repeated Play Games 463
12 Price and Output Determination: 13-4b Unraveling and the Chain Store Paradox 464
Oligopoly 411 13-4c Mutual Forbearance and Cooperation
Chapter Preview 411 in Repeated Prisoner’s Dilemma Games 466
Managerial Challenge: Google’s Android 13-4d Winning Strategies in Evolutionary
Computer Tournaments: Tit for Tat 467
and Apple’s iPhone Displace Nokia in 13-4e Bayesian Reputation Effects 467
Smart phones? 411 13-4f Price-Matching Guarantees 469
12-1 Oligopolistic Market Structures 413 13-5 Analyzing Sequential Games 471
12-1a Oligopoly in the United States: 13-5a Industry Standards as Coordination
Relative Market Shares 413 Devices 471
Contents xv
13-5b Importance of the Order of Play 473 14-2c Multiple-Product Pricing Decision 516
13-5c A Sequential Coordination Game 474 14-2d Differential Pricing and the Price
13-5d Subgame Perfect Equilibrium in Elasticity of Demand 517
Sequential Games 476 What Went Right/What Went Wrong:
13-6 Business Rivalry as a Self-Enforcing Two-Part Pricing at Disney World 522
Sequential Game 477 14-3 Differential Pricing in Target Market
13-6a First-Mover and Fast-Second Segments 522
Advantages 478 14-3a Direct Segmentation with “Fences” 523
13-7 Credible Threats and Commitments 480 14-3b Optimal Two-Part Tariffs 526
13-8 Mechanisms for Establishing What Went Right/What Went Wrong:
Credibility 481 Unlimited Data at Verizon Wireless 526
13-9 Replacement Guarantees 483 14-3c Couponing 527
13-9a Hostages Support the Credibility of
Commitments 484 What Went Right/What Went Wrong:
13-9b Credible Commitments of Durable Price-Sensitive Customers Redeem 528
Goods Monopolists 485 14-3d Bundling 528
13-9c Planned Obsolescence 486 14-3e Price Discrimination 531
13-9d Post-Purchase Discounting Risk 487 14-4 Pricing in Practice 533
13-9e Lease Prices Reflect Anticipated Risks 489 14-4a Product Life Cycle Framework 533
14-4b Full-Cost Pricing versus Incremental
Summary 489 Contribution Analysis 535
Exercises 490 14-4c Pricing on the Internet 537
Case Exercise: International Perspectives: Summary 540
The Superjumbo Dilemma 495 Exercises 541
Case Exercise: Partitoning the Price of the
13A Entry Deterrence and Accommodation Chevy Volt 543
Games 497
13A-1 Excess Capacity as a Credible 14A The Practice of Revenue Management 545
Threat 497 14A-1 A Cross-Functional Systems
13A-2 Precommitments Using Non- Management Process 546
Redeployable Assets 497 14A-2 Sources of Sustainable Price
13A-3 Customer Sorting Rules 500 Premiums 548
13A-3a A Role for Sunk Costs in Decision 14A-3 Revenue Management Decisions,
Making 501 Advanced Material 548
13A-3b Perfectly Contestable Markets 502 14A-3a Proactive Price Discrimination 549
13A-3c Brinkmanship and Wars of Attrition 503 14A-3b Capacity Reallocation 550
13A-4 Tactical Insights about Slippery 14A-3c Optimal Overbooking 553
Slopes 505 Summary 556
Summary 506 Exercises 556
Exercises 507
PART V
14 Pricing Techniques and Analysis 508
ORGANIZATIONAL ARCHITECTURE
Chapter Preview 508
AND REGULATION 557
Managerial Challenge: Pricing the
Chevy Volt 508 15 Contracting, Governance, and
14-1 A Conceptual Framework for Proactive, Organizational Form 558
Systematic-Analytical, Value-Based Chapter Preview 558
Pricing 509 Managerial Challenge: Controlling the
What Went Right/What Went Wrong: Vertical: Microsoft WebTV versus
Zerex Anticorrosive Antifreeze 510 Google Fiber 558
14-2 Optimal Differential Price Levels 513 15-1 Introduction 559
14-2a Graphical Approach 513 15-2 The Role of Contracting in
14-2b Algebraic Approach 515 Cooperative Games 560
xvi Contents
15-2a Vertical Requirements Contracts 561 Case Exercise: Designing a Managerial

15-2b The Function of Commercial Incentive Contract 592
Contracts 562 Case Exercise: The Division of Investment
15-2c Incomplete Information, Incomplete Banking Fees in a Syndicate 593
Contracting, and Post-Contractual
Opportunism 565 15A Auction Design and Information
15-3 Corporate Governance and the Economics 594
Problem of Moral Hazard 565 15A-1 Optimal Mechanism Design 594
15A-1a Queue Service Rules 594
What Went Right/What Went Wrong:
15A-2 First-Come, First-Served versus
Forecasting the Great Recession with
Last-Come, First-Served 595
Workouts and Rollovers 567
15A-2a Stratified Lotteries for Concerts 596
15-3a The Need for Governance
Mechanisms 568 15A-3 Auctions 597
15A-3a Types of Auctions 597
What Went Right/What Went Wrong: 15A-3b Winner’s Curse in Asymmetric
Moral Hazard and Holdup at Enron Information Bidding Games 598
and WorldCom 569 15A-3c Information Revelation in
15-4 The Principal-Agent Model 569 Common-Value Auctions 600
15-4a The Efficiency of Alternative Hiring 15A-3d Bayesian Strategy with Open
Arrangements 569 Bidding Design 601
15-4b Creative Ingenuity and the Moral 15A-3e Strategic Underbidding in Private-
Hazard Problem in Managerial Value Auctions 603
Contracting 571 15A-3f Second-Highest Sealed-Bid
15-4c Formalizing the Principal-Agent Auctions: A Revelation Mechanism 605
Problem 573 15A-3g Revenue Equivalence of Alternative
15-4d Screening and Sorting Managerial Auction Types 607
Talent with Optimal Incentives 15A-3h Contractual Approaches to
Contracts 574 Asymmetric Information in Online
What Went Right/What Went Wrong: Auctions 609
Why Have Restricted Stock Grants 15A-4 Incentive-Compatible Revelation
Replaced Executive Stock Options at Mechanisms 611
Microsoft? 575 15A-4a Cost Revelation in Joint Ventures
15-5 Choosing the Efficient Organizational and Partnerships 611
15A-4b Cost Overruns with Simple
Form 577
Profit-Sharing Partnerships 612
What Went Right/What Went Wrong: 15A-4c Clarke-Groves Incentive-Compatible
Cable Allies Refuse to Adopt Microsoft’s Revelation Mechanism 614
WebTV as an Industry Standard 580 15A-4d An Optimal Incentives Contract 614
International Perspectives: Economies International Perspectives: Joint Venture
of Scale and International Joint in Memory Chips: IBM, Siemens, and
Ventures in Chip Making 581 Toshiba 615
15-6 Prospect Theory Motivates Full-Line 15A-4e Implementation of IC Contracts 616
Forcing 582 International Perspectives: Whirlpool’s
15-7 Vertical Integration 584 Joint Venture in Appliances Improves
What Went Right/What Went Wrong: upon Maytag’s Outright Purchase of
Dell Replaces Vertical Integration Hoover 617
with Virtual Integration 587 Summary 618
15-7a The Dissolution of Assets in a Exercises 619
Partnership 588 Case Exercise: Spectrum Auction 620
Summary 589 Case Exercise: Debugging Computer
Exercises 591 Software: Versioning at Intel 621
Case Exercise: Borders Books and
Amazon.com Decide to Do Business 16 Government Regulation 623
Together 592 Chapter Preview 623
Contents xvii
Managerial Challenge: Cap and Trade, What Went Right/What Went Wrong:
Deregulation, and the Coase Technology Licenses Cost Palm Its
Theorem 623 Lead in PDAs 652
16-1 The Regulation of Market Structure What Went Right/What Went Wrong:
and Conduct 624 Motorola: What They Didn’t Know
16-1a Market Performance 625
Hurt Them 653
16-1b Market Conduct 625
16-7b Conclusion on Licensing 653
16-1c Contestable Markets 626
Summary 654
16-2 Antitrust Statutes and Their
Exercises 655
Regulatory Enforcement 627
16-2a The Sherman Act (1890) 627
Case Exercise: Do Luxury Good
16-2b The Clayton Act (1914) 627 Manufacturers Have a Legitimate
16-2c The Robinson-Patman Act (1936) 628 Interest in Minimum Resale Price
16-2d The Hart-Scott-Rodino Antitrust Maintenance: Leegin v. Kay’s Kloset? 657
Improvement Act (1976) 629 Case Exercise: Microsoft Tying
16-3 Antitrust Prohibition of Selected Arrangements 658
Business Decisions 630 Case Exercise: Music Recording Industry
16-3a Collusion: Price Fixing 630 Consolidating 659
16-3b Mergers That Substantially Lessen
Competition 632 17 Long-Term Investment Analysis 660
16-3c Merger Guidelines (2010) 633 Chapter Preview 660
16-3d Monopolization 633 Managerial Challenge: Industrial
16-3e Wholesale Price Discrimination 635
Renaissance in America: Insourcing
16-3f Refusals to Deal 636
16-3g Resale Price Maintenance of GE Appliances 660
Agreements 636 17-1 The Nature of Capital Expenditure
16-4 Command and Control Regulatory Decisions 661
Constraints: An Economic Analysis 637 17-2 A Basic Framework for Capital
16-4a The Deregulation Movement 639 Budgeting 662
What Went Right/What Went Wrong: 17-3 The Capital Budgeting Process 662
The Need for a Regulated 17-3a Generating Capital Investment
Projects 663
Clearinghouse to Control Counterparty 17-3b Estimating Cash Flows 663
Risk at AIG 639 17-3c Evaluating and Choosing the
16-5 Regulation of Externalities 640 Investment Projects to Implement 665
16-5a Coasian Bargaining for Reciprocal
17-4 Estimating the Firm’s Cost of
Externalities 641
16-5b Qualifications of the Coase Theorem 642 Capital 668
16-5c Impediments to Bargaining 643 17-4a Cost of Debt Capital 669
16-5d Resolution of Externalities by 17-4b Cost of Internal Equity Capital 669
Regulatory Directive 644 17-4c Cost of External Equity Capital 671
16-5e Resolution of Externalities by Taxes 17-4d Weighted Cost of Capital 671
and Subsidies 645 17-5 Cost-Benefit Analysis 672
16-5f Resolution of Externalities by Sale of 17-5a Accept-Reject Decisions 673
Pollution Rights: Cap and Trade 647 17-5b Program-Level Analysis 674
16-6 Governmental Protection of Business 647 17-6 Steps in Cost-Benefit Analysis 674
16-6a Licensing and Permitting 647 17-7 Objectives and Constraints in
16-6b Patents 648 Cost-Benefit Analysis 676
16-7 The Optimal Deployment Decision: 17-8 Analysis and Valuation of Benefits
To License or Not 648 and Costs 677
16-7a Pros and Cons of Patent Protection 17-8a Direct Benefits 677
and Licensure of Trade Secrets 649 17-8b Direct Costs 677
What Went Right/What Went Wrong: 17-8c Indirect Costs or Benefits and
Intangibles 677
Delayed Release at Aventis 650
xviii Contents
17-8d The Appropriate Rate of Discount 678 D Check Answers to Selected

17-9 Cost-Effectiveness Analysis 679 End-of-Chapter Exercises D-1
17-9a Least-Cost Studies 679 Glossary G-1
17-9b Objective-Level Studies 680 Index I-1
Summary 680 Notes
Exercises 681
Case Exercise: Industrial WEB APPENDICES
Development Tax Relief and A Consumer Choice Using Indifference Curve
Incentives 684 Analysis
Case Exercise: Multigenerational Effects B International Parity Conditions
of Ozone Depletion and Greenhouse C Linear-Programming Applications
Gases 685 D Capacity Planning and Pricing against a Low-Cost
Case Exercise: Can Tidal Power Be Competitor: A Case Study of Piedmont Airlines
Harnessed in the Bay of Fundy 688 and People Express
E Pricing of Joint Products and Transfer Pricing
APPENDICES F Decisions under Risk and Uncertainty
A The Time Value of Money A-1 G Maximization of Production Output Subject to a
B Differential Calculus Techniques in Cost Constraint, Advanced Material
Management B-1 H Long-Run Costs with a Cobb-Douglas Production
C Tables C-1 Function, Advanced Material
Preface
ORGANIZATION OF THE TEXT
The 14th edition has been thoroughly updated with 45 new applications and dozens of new
figures and tables.
We continue to expand the review of microeconomic fundamentals in Chapters 2 and
3, employing a wide-ranging discussion of the equilibrium price of crude oil and gasoline
as well as the marginal analysis of long-lasting lightbulbs. This new emphasis supports
the use of the book for pre-experience MA in Management and specialized MS programs
in business schools.
The text is structured, like many others, around demand, production, cost and pric-
ing theory in context, but the difference here is the context. We believe students are
motivated to learn analytical tools by first becoming immersed in and motivated by
deep fact situation contexts. Consequently, in each of the first 12 chapters we teach
the students why a new technique is important by first demonstrating what it can be
used to accomplish in business practice. Only then, do we delve into the theory that
applies.
Another distinctive feature of the book is the extensive treatment in Chapter 6 of
global business, import-export trade, exchange rates, free trade areas, and trade policy.
There is more comprehensive material on applied game theory in Chapters 13, 13A, 15,
15A, and the Web Appendix Case Study than in any other managerial economics text-
book. And a unique treatment of revenue (yield) management appears in Chapter 14A.
Part V includes the hot topics of corporate governance, information economics, auction
design, and the choice of organizational architecture. Chapter 16 on Regulation includes
an extensive discussion of market mechanisms for addressing externalities. Chapter 17
now leads off with a capital budgeting decision by GE to return appliance manufacturing
to the United States.
By far the most distinctive feature of the book is its 300 boxed examples, Managerial
Challenges, What Went Right/What Went Wrong explorations of corporate practice,
and mini-case examples on every other page demonstrating what each analytical concept
is used for in practice. This list of concept applications is highlighted on the inside front
and back covers.
STUDENT PREPARATION
The text is designed for use by upper-level undergraduates and first-year graduate stu-
dents in business schools, departments of economics, and professional schools of man-
agement, public policy, and information science as well as in executive training
programs. Students are presumed to have a background in the basic principles of micro-
economics, although Chapter 2 offers an extensive review of those topics. No prior
work in statistics is assumed; development of all the quantitative concepts employed is
self-contained. The book makes occasional use of elementary concepts of differential
xix
xx Preface
calculus. In all cases where calculus is employed, at least one alternative approach, such as
graphical, algebraic, or tabular analysis, is also presented. Spreadsheet applications have
become so prominent in the practice of managerial economics that we now address
optimization in that context.
PEDAGOGICAL FEATURES OF THE

14TH EDITION
The 14th edition of Managerial Economics makes extensive use of pedagogical aids to
enhance individualized student learning. The key features of the book are:
1. Managerial Challenges. Each chapter opens with a Managerial Challenge (MC) illumi-
nating a real-life problem faced by managers that is closely related to the topics covered
in the chapter. Instructors can use the discussion questions following each MC to
“hook” student interest at the start of the class or in conjunction with MindTap preclass
preparation assignments.
2. What Went Right/What Went Wrong. This feature allows students to relate
business mistakes and triumphs to what they have just learned, and helps build
that elusive goal of managerial insight.
3. Extensive Use of Boxed Examples. More than 300 real-world applications and
examples derived from actual corporate practice are highlighted throughout the
text. These applications help the analytical tools and concepts to come alive
and thereby enhance student learning. They are listed on the inside front and
back covers to highlight the prominence of this feature of the book.
4. Sustainability and the Environment Symbol. A wind vane symbol highlights
numerous passages that address environmental effects and sustainability issues
throughout the book.
5. Exercises. Each chapter contains a large problem analysis set. Check answers to
selected problems color-coded in blue type are provided in Appendix D at the
end of the book. Problems that can be solved using Excel are highlighted with an
Excel icon. The book’s Web site (www.cengage.com/economics/mcguigan) has
answers to all the other textbook problems.
6. Case Exercises. Most chapters include mini-cases that extend the concepts and
tools developed into a deep fact situation context of a real-world company, allow-
ing the students to practice what they encounter on every other page in the 300
boxed examples and applications.
7. Chapter Glossaries. In the margins of the text, new terms are defined as they are
introduced. The placement of the glossary terms next to the location where the
term is first used reinforces the importance of these new concepts and aids in
later studying.
8. International Perspectives. Throughout the book, special International Perspec-
tives sections that illustrate the application of managerial economics concepts
to an increasingly global economy are provided. A globe symbol highlights this
internationally relevant material.
9. Point-by-Point Summaries. Each chapter ends with a detailed, point-by-point
summary of important concepts from the chapter.
10. Diversity of Presentation Approaches. Important analytical concepts are
presented in several different ways, including tabular, spreadsheet, graphical, and
algebraic analysis to individualize the learning process.
Preface xxi
ANCILLARY MATERIALS
A complete set of ancillary materials is available to adopters to supplement the text,
including the following:
Instructor’s Manual and Test Bank

The instructor’s manual and test bank that accompany the book contain suggested
answers to the end-of-chapter exercises and cases. The authors have taken great care to
provide an error-free manual for instructors to use. The manual is available to instruc-
tors on the book’s Web site. The test bank, containing a large collection of true-false,
multiple-choice, and numerical problems, is available to adopters and is also available
on the Web site in Word format, as well as on the IRCD.
MindTap
MindTap is an extensive online learning system that includes the ebook, assignments
that bring course concepts to life, supplemental readings, video and discussions ques-
tions, and practice and apply exercises. This cloud-based platform integrates learning
applications (“apps”) into an easy-to-use and easy-to-access tool that supports a person-
alized learning experience. MindTap combines student learning tools—readings, multi-
media, activities and assessments—into a singular Learning Path that guides students
through the course.
Mindtap Support Web Site

When you adopt Managerial Economics: Applications, Strategy, and Tactics, 14e, you and
your students will have access to a rich array of teaching and learning resources that you
won’t find anywhere else. Located at www.CengageBrain.com, this outstanding site features
additional instructor and student resources.
PowerPoint Presentation
Available on the product companion Web site, this comprehensive package provides an
excellent lecture aid for instructors. These slides cover many of the most important
topics from the text, and they can be customized by instructors to meet specific course
needs.
ACKNOWLEDGMENTS
A number of reviewers, users, and colleagues have been particularly helpful in providing
us with many worthwhile comments and suggestions at various stages in the development
of this and earlier editions of the book. Included among these individuals are:
William Beranek, J. Walter Elliott, William J. Kretlow, William Gunther, J. William
Hanlon, Robert Knapp, Robert S. Main, Edward Sussna, Bruce T. Allen, Allen Moran,
Edward Oppermann, Dwight Porter, Robert L. Conn, Allen Parkman, Daniel Slate, Richard
L. Pfister, J. P. Magaddino, Richard A. Stanford, Donald Bumpass, Barry P. Keating, John
Wittman, Sisay Asefa, James R. Ashley, David Bunting, Amy H. Dalton, Richard D. Evans,
Gordon V. Karels, Richard S. Bower, Massoud M. Saghafi, John C. Callahan, Frank Falero,
Ramon Rabinovitch, D. Steinnes, Jay Damon Hobson, Clifford Fry, John Crockett, Marvin
Frankel, James T. Peach, Paul Kozlowski, Dennis Fixler, Steven Crane, Scott L. Smith,
Edward Miller, Fred Kolb, Bill Carson, Jack W. Thornton, Changhee Chae, Robert
B. Dallin, Christopher J. Zappe, Anthony V. Popp, Phillip M. Sisneros, George Brower,
xxii Preface
Carlos Sevilla, Dean Baim, Charles Callahan, Phillip Robins, Bruce Jaffee, Alwyn du Plessis,
Darly Winn, Gary Shoesmith, Richard J. Ward, William H. Hoyt, Irvin Grossack, William
Simeone, Satyajit Ghosh, David Levy, Simon Hakim, Patricia Sanderson, David P. Ely, Albert
A. O’Kunade, Doug Sharp, Arne Dag Sti, Walker Davidson, David Buschena, George
M. Radakovic, Harpal S. Grewal, Stephen J. Silver, Michael J. O’Hara, Luke M. Froeb, Dean
Waters, Jake Vogelsang, Lynda Y. de la Viña, Audie R. Brewton, Paul M. Hayashi, Lawrence
B. Pulley, Tim Mages, Robert Brooker, Carl Emomoto, Charles Leathers, Marshall Medoff,
Gary Brester, Stephan Gohmann, L. Joe Moffitt, Christopher Erickson, Antoine El Khoury,
Steven Rock, Rajeev K. Goel, Lee S. Redding, Paul J. Hoyt, Bijan Vasigh, Cheryl A. Casper,
Semoon Chang, Kwang Soo Cheong, Barbara M. Fischer, John A. Karikari, Francis
D. Mummery, Lucjan T. Orlowski, Dennis Proffitt, and Steven S. Shwiff.
People who were especially helpful in the preparation of the 14th edition include
Robert F. Brooker, Kristen E. Collett-Schmitt, Simon Medcalfe, Dr. Paul Stock, Shahab
Dabirian, James Leady, Stephen Onyeiwu, and Karl W. Einoff. A special thanks to
B. Ramy Elitzur of Tel Aviv University for suggesting the exercise on designing a manage-
rial incentive contract and to Bob Hebert, Business Librarian at Wake Forest School of
Business, for his tireless pursuit of reference material.
We are also indebted to Wake Forest University and the University of Louisville for the
support they provided and owe thanks to our faculty colleagues for the encouragement and
assistance provided on a continuing basis during the preparation of the manuscript. We wish
to express our appreciation to the members of the Cengage Learning staff for their help in
the preparation and promotion of this book, especially Chris Rader. We are grateful to the
Literary Executor of the late Sir Ronald A. Fisher, F.R.S.; to Dr. Frank Yates, F.R.S.; and to
Longman Group, Ltd., London, for permission to reprint Table III from their book Statistical
Tables for Biological, Agricultural, and Medical Research (6th ed., 1974).
James R. McGuigan
R. Charles Moyer
Frederick H. deB. Harris
About the Authors
James R. McGuigan
James R. McGuigan owns and operates his own numismatic investment firm. Prior to this
business, he was Associate Professor of Finance and Business Economics in the School of
Business Administration at Wayne State University. He also taught at the University of
Pittsburgh and Point Park College. McGuigan received his undergraduate degree from
Carnegie Mellon University. He earned an M.B.A. at the Graduate School of Business at
the University of Chicago and his Ph.D. from the University of Pittsburgh. In addition to
his interests in economics, he has coauthored books on financial management.
His research articles on options have been published in the Journal of Financial and
Quantitative Analysis.
R. Charles Moyer
R. Charles Moyer earned his B.A. in Economics from Howard University and his M.B.A.
and Ph.D. in Finance and Managerial Economics from the University of Pittsburgh.
Professor Moyer is Dean Emeritus and Professor of Finance and Entrepreneurship at
the College of Business, University of Louisville. Previously, he was GMAC Chair of
Finance and Dean, Babcock Graduate School of Management, Wake Forest University.
He was also Professor of Finance and Chairman of the Department of Finance at Texas
Tech University. Professor Moyer also has taught at the University of Houston, Lehigh
University, and the University of New Mexico, and spent a year at the Federal Reserve
Bank of Cleveland. Professor Moyer has taught extensively abroad in Germany, France,
and Russia. In addition to this text, Moyer has coauthored two other financial management
texts. He has been published in many leading journals, including Financial Management,
Journal of Financial and Quantitative Analysis, Journal of Finance, Financial Review, Journal
of Financial Research, International Journal of Forecasting, Strategic Management Journal and
Journal of Economics and Business. Professor Moyer is a member of the Board of Directors
of Capitala Finance Corporation, US WorldMeds, and Summit Biosciences.
Frederick H. deB. Harris

Frederick H. deB. Harris is Professor of Managerial Economics and Finance at the School of
Business, Wake Forest University. His specialties are pricing tactics and capacity planning.
Professor Harris has taught managerial economics core courses and B.A., B.S., M.S., M.B.A.,
and Ph.D. electives in business schools and economics departments in the United States,
Germany, France, Italy, and Australia. He has won two school-wide Professor of the Year
teaching awards and two Researcher of the Year awards. Other recognitions include Out-
standing Faculty by Inc. magazine (1998), Most Popular Courses by Business Week Online
2000–2001, and Outstanding Faculty by BusinessWeek’s Guide to the Best Business Schools,
5th to 9th eds., 1997–2004.
Professor Harris has published widely in leading journals, including the Review of Eco-
nomics and Statistics, Journal of Financial and Quantitative Analysis, Journal of Operations
Management, Journal of Industrial Economics, Journal of Banking and Finance, Journal of
Business Ethics, and Journal of Financial Markets. From 1988 through 1993, Professor
Harris served on the Board of Associate Editors of the Journal of Industrial Economics.
xxiii
xxiv About the Authors
His path breaking work on price discovery has been frequently cited in leading academic
journals, and several articles with practitioners have been published in the Journal of
Trading from Institutional Investor Journals. In addition, he often benchmarks the pricing,
order processing, and capacity planning functions of large companies against state-of-the-
art techniques in revenue management and writes about his findings in journals such as
the AMA’s Marketing Management and INFORMS’s Journal of Revenue and Pricing
Management.
PART I
Introduction
ECONOMIC ANALYSIS AND ECONOMIC, POLITICAL, AND

DECISIONS SOCIAL ENVIRONMENT
1. Demand Analysis 1. Business Conditions (Trends,
2. Production and Cost Analysis Cycles, and Seasonal Effects)
3. Product, Pricing, and Output 2. Factor Market Conditions
Decisions (Capital, Labor, and Raw
4. Capital Expenditure Analysis Materials)
3. Competitors’ Reactions and
Tactical Response
4. Organizational Architecture
and Regulatory Constraints
Cash Flows Risk
Firm Value
(Shareholders’ Wealth)
1
CHAPTER
1 Introduction and Goals

of the Firm
CHAPTER PREVIEW
Managerial economics is the application of microeconomics to decision problems faced in the private and
public sectors. Managerial economics assists managers in efficiently allocating scarce resources, planning
organizational strategy, and executing effective tactics. In this chapter, the meaning of economic profit is
explored, and the role of profits in allocating resources in a free enterprise system is examined. The
primary goal of the firm to maximize shareholder wealth is developed along with a full discussion of
critical resources and feedback effects attributable to stakeholders. Management’s role in resolving
problems associated with the separation of ownership and control, moral hazard in teams, and principal-
agent relationships is explored.
MANAGERIAL CHALLENGE
How to Achieve Sustainability: Southern Company Electric
Power Generation1
In the second decade of the twenty-first century, compa- downwind hundreds of miles away to trees, painted and
nies all across the industrial landscape are seeking to stone surfaces, and asthmatics. The Clean Air Act
achieve sustainability. Sustainability is a powerful meta- (CAA) of 1990, amended in 1997 and 2003, granted
phor but an elusive goal. It means much more than tradable pollution allowances (TPAs) to known pollu-
aligning oneself with a commitment to environmental ters. The CAA also authorized an auction market for
sensitivity, which tests higher in opinion polling of the these TPA assets. The Environmental Protection Agency
latent preferences of Americans and Europeans than any Web site (www.epa.gov) displays on a daily basis the
other response. Sustainability also implies renewability equilibrium, market-clearing price of these new TPAs
and longevity of business plans that are adaptable to on the balance sheet. Most importantly, the cap-
changing circumstances. But what exactly should man- and-trade system literally identified for the first time a
agement pursue as a set of objectives to achieve this price for the use of what had previously been unpriced
goal? common property resources—namely, acid-free air and
Management response to pollution abatement illus- rainwater. As a result, large point-source polluters like
trates one type of sustainability challenge. At the insis- power plants and steel mills now incur an actual cost
tence of the prime minister of Canada during the Reagan per ton for the SOx and NOx–laden soot by-products
Administration, the U.S. Congress enacted a bipartisan of burning lots of high sulfur coal. These amounts
cap-and-trade bill to address smokestack emissions. Sul- were promptly placed in spreadsheets designed to find
fur dioxide and nitrous oxide (SOx and NOx) emissions ways of minimizing the sum of operating plus pollution
precipitate as acid rain, mist, and ice, imposing damage by-product costs.2 Thereafter, each polluter felt powerful
Cont.
2 Copyright 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203
Chapter 1: Introduction and Goals of the Firm 3
MANAGERIAL CHALLENGE Continued

Figure 1.1). Although TPAs “grandfathered” a substan-
tial amount of pollution, the gradual transition provided
by cap-and-trade legislation was pivotally important to
its widespread success. Industries such as steel and elec-
tric power were given five years to comply with the reg-
ulated emissions requirements, and then in 1997, the
initial allowances were cut in half. Duke Power initially
AP Images/Stephen Morton
bought 19,146 allowances for Belews Creek at prices
ranging from $131 to $480 per ton and then in 2003
built two 30-story smokestack scrubbers that reduced
the NOx emissions by 75 percent.
Another major electric utility, Southern Company, ana-
incremental incentives to reduce compliance cost by abat- lyzed three compliance choices on a least-cost cash flow
ing pollution. And an entire industry devoted to develop- basis: (1) buying allowances, (2) installing smokestack
ing pollution abatement technology sprang up. scrubbers, or (3) adopting fuel-switching technology to
The TPAs granted were set at approximately 80 per- burn low-sulfur coal or even cleaner natural gas. In a widely
cent of the known pollution taking place at each plant in studied case, the Southern Company found its huge Bowen
1990. For example, Duke Power’s Belews Creek power plant in North Georgia would require a $657 million scrub-
plant, generating 120,085 tons of nitrous oxide acidic ber that after tax deductions for capital equipment depreci-
soot annually from burning 400 train carloads of coal ation and offsets from excess allowance revenue implied
every day, was granted 96,068 tons of allowances (see a $476 million cost. Alternatively, continuing to burn
FIGURE 1.1 Nitrous Oxide from Coal-Fired Power Plants (Daily Emissions in Tons, pre Clean Air Act)
329 tons
NOx
194
164 Mayo
55 CP&L
13
Buck
Duke 14 Dan Roxboro
44 River CP&L
59 24 17
Asheville 39 Duke 27
Marshall Cape
CP&L Duke Belews
Fear Lee
Riverbend Creek CP&L CP&L
Duke Duke
Cliffside 13 55
Allen
Duke Duke Weatherspoon
CP&L
Sutton
CP&L
Source: NC Division of Air Quality.
Cont.
4 Part I: Introduction
MANAGERIAL CHALLENGE Continued

high-sulfur coal from the nearby Appalachian Mountains
and purchasing the requisite allowances in the cap- Discussion Questions
and-trade market was projected to cost $266 million. And n What is the basic externality problem with
finally, switching to low-sulfur coal while adopting fuel- acid rain? What objectives should manage-
switching technology was found to cost $176 million. All ment serve in responding to the acid rain
these analyses were performed on a present value basis problem?
with cost projections over 25 years. Chapter 2 offers a n How did the Clean Air Act’s cap-and-trade
quick primer on the net present value concept. approach to air pollution affect the Southern
Southern Company’s decision to switch to low-sulfur Company’s analysis of the previously unpriced
coal was hailed far and wide as environmentally sensitive common property air and water resources
and sustainable. Many electric utilities support cap- damaged by smokestack emissions?
and-trade policies and actively pursue the mandate of n How should management comply with the
the states in which they operate to derive 15 percent of Clean Air Act, or should the Southern Com-
their power from renewable energy (RE). In a Case pany simply pay the EPA’s fines? Why? How
Study at the end of the chapter, we analyze wind and would you decide?
tidal power RE alternatives for generating electricity. n Which among Southern Company’s three
The choice of fuel-switching technology to abate alternatives for compliance offered the most
smokestack emissions was a shareholder value- strategic flexibility? Explain.
maximizing choice for Southern Company for two rea-
sons. First, switching to low-sulfur coal minimized their
projected cash flow compliance costs under the CAA
1
but, in addition, the fuel-switching technology created Based on Frederick Harris, Alternative Energy Symposium, Wake Forest
Schools of Business (September 2008); and “Acid Rain: The Southern Com-
a strategic flexibility (a “real option”) and that in itself pany,” Harvard Business School Publishing, HBS: 9-792-060.
created additional shareholder value. In this chapter, we 2
EPA fines for noncompliance of $2,000 per ton often exceed the auction
will see what maximizing capitalized value of equity market price of tradeable pollution allowances by a factor of 10.
(shareholder value) entails and what is does not.
1-1 WHAT IS MANAGERIAL ECONOMICS?

Managerial economics extracts from microeconomic theory those concepts and techni-
ques that enable managers to select strategic direction, to allocate efficiently the resources
available to the organization, and to respond effectively to tactical issues. All such mana-
gerial decision making seeks to do the following:
1. identify the alternatives,
2. select the choice that accomplishes the objective(s) in the most efficient manner,
3. taking into account the constraints,
4. and the likely actions and reactions of rival decision makers.
For example, consider the following stylized decision problem:
Example
Capacity Expansion at Honda, N.A., and
Toyota Motors, N.A.
Honda and Toyota are attempting to expand their already substantial assembly opera-
tions in North America. Both companies face increasing demand for their
U.S.-manufactured vehicles, especially Toyota Camrys and Honda Accords. Camrys
and Accords rate extremely highly in consumer reports of durability and reliability.
(continued)
The demand for used Accords is so strong that they depreciate only 45 percent in their
first four years. Other competing vehicles may depreciate as much as 65 percent in the
same period. Toyota and Honda have identified two possible strategies (S1NEW and
S2USED) to meet the growing demand for Camrys and Accords. Strategy S1NEW
involves an internal expansion of capacity at Toyota’s $700 million Princeton, Indiana,
plant and Honda’s Marysville, Ohio, plant. Strategy S2USED involves the purchase and
renovation of assembly plants now owned by General Motors. The new plants will likely
receive substantial public subsidies through reduced property taxes. The older plants
already possess an enormous infrastructure of local suppliers and regulatory relief.
The objective of Toyota’s managers is to maximize the value today (present value)
of the expected future profit from the expansion. This problem can be summarized as
follows:
Objective function: Maximize the present value (P.V.) of profit
(S1NEW, S2USED)
Decision rule: Choose strategy S1NEW if P.V. (Profit S1NEW)
> P.V. (Profit S2USED)
Choose strategy S2USED if the reverse.
This simple illustration shows how resource-allocation decisions of managers

attempt to maximize the value of their firms across forward-looking dynamic strate-
gies for growth while respecting all ethical, legal, and regulatory constraints.
1-2 THE DECISION-MAKING MODEL

The ability to make good decisions is the key to successful managerial performance. All
decision making shares several common elements. First, the decision maker must estab-
lish the objectives. Next, the decision maker must identify the problem. For example, the
CEO of electronics retailer Best Buy may note that the profit margin on sales has been
decreasing. This could be caused by pricing errors, declining labor productivity, or the
use of outdated retailing concepts. Once the source or sources of the problem are identi-
fied, the manager can move to an examination of potential solutions. The choice between
these alternatives depends on an analysis of the relative costs and benefits, as well as other
organizational and societal constraints that may make one alternative preferable to
another.
The final step in the decision-making process, after all alternatives have been evalu-
ated, is to analyze the best available alternative under a variety of changes in the assump-
tions before making a recommendation. This crucial final step is referred to as a
sensitivity analysis. Knowing the limitations of the planned course of action as the deci-
sion environment changes, the manager can then proceed to an implementation of the
decision, monitoring carefully any unintended consequences or unanticipated changes
in the market. The case problem at the end of the chapter highlights the role of sensitiv-
ity analysis in analyzing wind turbines as a renewable energy source of electricity.
1-2a The Responsibilities of Management

In a free enterprise system, managers are responsible for a number of goals. Managers
are responsible for proactively solving problems in the current business model before
WHAT WENT RIGHT • WHAT WENT WRONG

Saturn Corporation3 other divisions. Consequently, cash flow was not reinvested
When General Motors (GM) rolled out their “different kind in the Saturn division, products were not updated, and the
of car company,” J.D. Powers rated product quality 8 percent models stagnated. By 1997, sales were slumping at −9 percent
ahead of Honda, and customers liked the no-haggle selling and in 1998 they fell an additional 20 percent. In 2009, GM
process. Saturn achieved the 200,000 unit sales enjoyed by announced it was permanently closing the Saturn division.
the Honda Civic and the Toyota Corolla in two short years GM managers had not established the next Saturn busi-
and caught the 285,000 volume of the Ford Escort in ness model which would have transferred young childless
Saturn’s fourth year. Making interpersonal aspects of cus- couples to more profitable GM divisions as their lifecycle
tomer service the number-one priority and possessing super- called for bigger sedans, minivans, and SUVs. Rather than
ior inventory and MIS systems, Saturn dealerships proved trading up to Buick, middle-aged loyal Saturn owners
very profitable and quickly developed a reputation for sought to trade up within Saturn, and finding no sporty
some of the highest customer loyalty in the industry. larger models available, they switched to larger Japanese
However, with pricing of the base Saturn model $1,200 imports like the Honda Accord and Toyota Camry. After
below the $12,050 rival Japanese compact cars, the GM parent almost collapsing, Saturn introduced a sport wagon, an
earned only a $400 gross profit margin per vehicle. In a typical efficient SUV, and a high-profile sports coupe. GM ulti-
year, this meant GM was recovering only about $100 million mately abandoned the brand in 2009.
of its $3 billion capital investment, a paltry 3 percent return. 3
Based on M. Cohen, “Saturn’s Supply-Chain Innovation,” Sloan Manage-
Netting out GM’s 11 percent cost of capital, each Saturn was ment Review (Summer 2000), pp. 93–96; “Small Car Sales Are Back” and
losing approximately $1,000. These figures compare to a “Why Didn’t GM Do More for Saturn?” BusinessWeek, September 22,
$3,300 gross profit margin per vehicle in some of GM’s 1997, pp. 40–42, and March 16, 1998, p. 62.
they become crises and for selecting strategies to assure the more likely success of the
next business model. Research In Motion built the world’s best international cell phone
(the Blackberry) but missed the market as customer demand evolved to web-enabled
smart phones with 500,000 and then millions of apps. In addition, managers create orga-
nizational structure and culture based on the organization’s mission. Senior management
especially is responsible for establishing a vision of new business directions and setting
stretch goals to get there. In addition, managers coordinate the integration of marketing,
operations, and finance functions. If plant managers don’t know the realized margins
from particular segments targeted by the sales team, then they will often expedite and
fulfill orders to the wrong customers. Finally, managers undertake the critical responsi-
bility of motivating and monitoring teamwork.
1-2b Moral Hazard in Teams

Teamwork skills and the ability to motivate teams is widely acknowledged as the single
most critical trait of effective managers. This applies equally to Navy Seal teams, factory
work cell teams, brand management teams, or consulting teams. Why is that? Why is
teamwork so important, and why is attaining good teamwork so hard? The essence of
teamwork is synergistic value creation in excess of the sum of the parts. As individuals
on a team, we can each “pull our own weight” or contribute more than that and com-
pound our extra effort with the extraordinary efforts of those around us. Just as in
sports, 110 percent effort on company teams often defeats more skilled opponents and
sometimes even those with better resources. But how does a manager attain the commit-
ment from a team to put forth 110 percent effort when doing less would not impose as
much personal sacrifice, and when individual shirking on one’s effort may not be trans-
parently obvious? This constitutes the so-called moral hazard problem in team-making.
If penalties and sanctions are few and far between, only a sense of moral duty induces
full-effort teamwork rather than the reduced effort associated with free-riding.
Consider the following example of the teamwork involved in bringing a product to
market. Mack and Myer are collaborating on a product launch. Each has specialized
skills that are required to achieve the maximum output and a gross profit of $100 if
they each “Pull Hard,” devoting their best effort to the project. In that event, $25 per-
sonal cost for each leaves $25 net profit available to each of them. If either shirks and
reduces effort unilaterally, the output is reduced and gross profit declines by 30 percent
to $70 to be divided between them, but the shirker reduces his or her personal cost to $0,
thereby yielding a $35 net profit to the free rider and only $10 to the dutiful teammate
who Pulled Hard. If both shirk and fail to provide best effort, then output collapses,
gross profit falls to $30, yielding each just $15 net profit. These payoffs are depicted in
the normal form game matrix Figure 1.2, Panel A.
What if this is a one-time-only situation, and each player must decide simultaneously
without knowing the choice of his or her teammate? One of the insights of game theory
is that in the absence of repeated games involving the same teammates, rational players
in such situations will ignore reputation effects and select the action whose payoff dom-
inates all others. In this case, that means each player will choose to Shirk since the $35
outcome exceeds $25, and the $15 outcome exceeds $10. In short, the outcomes from the
action Shirk in the right-hand column dominate those in the Pull Hard column (and so
too in the rows of the payoff matrix). Each team member therefore prefers to defect (by
choosing Shirk), whatever the choice of his or her teammate; Shirk is said to be a domi-
nant strategy. Therefore, {Shirk, Shirk} emerges as a dominant strategy outcome with
great predictability.
But if they both do so, a tragic dilemma arises. In the southeast {Shirk, Shirk} cell, the
payoff to each player is just $15, and total value added is only $30. Both teammates
FIGURE 1.2
Payoffs from Team
Panel A No Supervisor
Production with Mack
and without a
Pull Hard Shirk
Supervisor
Pull Hard
$25 $35
Meyer $25 $10
Shirk
$10 $15
$35 $15
Panel B Supervisor Present. A $10 Manager is Hired as a Monitor of Shirking for which
A $15 Penalty is Imposed.
Mack
Pull Hard Shirk
$20 $15
Pull Hard $20 $5
Meyer
Shirk $5 $–5
$15 $–5
realize, however, that if they had just found a way to elicit cooperation from one another,
$50 net profit would have been available in the northwest {Pull Hard, Pull Hard} cell.
Their individually optimal decision-making (reflected by the dominant strategy to defect
from cooperative arrangements) leaves $20 foregone profits until the players them-
selves organize their team-making differently. As a result, we might well expect that the
players would evolve mechanisms for contracting around the moral hazard problem in
order to capture the foregone value. How can this be accomplished?
What if the team hired a manager as project supervisor to monitor the teamwork and
punish shirking fairly? Splitting the cost of paying a manager $10 leaves $40 gross profit
in the {Pull Hard, Pull Hard} cell, to be divided evenly between Mack and Meyer. In the
diagonal cells, the manager now penalizes whichever teammate shirks their duty $15.
The payoff for this unilateral defector now becomes ð$70=2 ¼ $35Þ $15 $5 ¼ $15,
less than the ð$100=2 ¼ $50Þ $25 $5 ¼ $20 associated with the cooperative decision
to Pull Hard. And this is a symmetric payoff game, so both players now conclude the
same thing—that is, it pays to adopt mutually cooperative teamwork and deliver full
effort. Since each player will receive only ð$30=2 ¼ $15Þ $15 $5 ¼ $15 in the
event they both shirk their duties, and ð$70=2 ¼ $35Þ $25 $5 ¼ $5 in the event
their Hard Pull is unilaterally defected upon, each decides to Pull Hard. Indeed, examin-
ing the new payoff matrix in Figure 1.2, Panel B the choice pair {Pull Hard, Pull Hard}
has now become the dominant strategy. So, in conclusion, moral hazard in teams can be
avoided. What is needed is a manager as supervisor who imposes sanctions for the shirk-
ing behavior of teammates that decide to free ride.
Managers in a capitalist economy are motivated to monitor teamwork ultimately
because of their overarching goal to maximize returns to the owners of the business—
that is, economic profits.
economic profit The Economic profit is the difference between total sales revenue (price times units sold)
difference between and total economic cost. The economic cost of any activity may be thought of as the
total revenue and total highest valued alternative opportunity that is forgone. To attract labor, capital, intellec-
economic cost. Eco- tual property, land, and matériel, the firm must offer to pay a price that is sufficient to
nomic cost includes a convince the owners of these resources to forego other alternative activities and commit
“normal” rate of return
their resources to this use. Thus, economic costs should always be thought of as oppor-
on the capital contri-
butions of the firm’s
tunity costs—that is, the costs of attracting a resource such as investment capital from its
partners. next best alternative use.
1-3 THE ROLE OF PROFITS

In a free enterprise system, economic profits play an important role in guiding the deci-
sions made by the thousands of competing independent resource owners. The existence
of profits determines the type and quantity of goods and services that are produced and
sold, as well as the resulting derived demand for resources. Several theories of profit indi-
cate how this works.
1-3a Risk-Bearing Theory of Profit

Economic profits arise in part to compensate the owners of the firm for the risk they
assume when making their investments. Because a firm’s shareholders are not entitled
to a fixed rate of return on their investment—that is, they are claimants to the firm’s
residual cash flows after all other contractual payments have been made—they need to
be compensated for this risk in the form of a higher rate of return.
The risk-bearing theory of profits is explained in the context of normal profits, where
normal is defined in terms of the relative risk of alternative investments. Normal profits
for a high-risk firm, such as Las Vegas hotels and casinos, a biotech pharmaceutical
company, or an oil field exploration well operator, should be higher than normal profits
for firms of lesser risk, such as water utilities. For example, in 2005, the industry average
return on net worth for the casino hotel/gaming industry was 12.6 percent, compared to
9 percent for the water utility industry.
1-3b Temporary Disequilibrium Theory of Profit

Although there exists a long-run equilibrium normal rate of profit (adjusted for risk) that
all firms should tend to earn, at any point in time, firms may find themselves earning a
rate of return above or below this long-run normal return level. This can occur because
of temporary dislocations (shocks) in various sectors of the economy. Rates of return in
the oil industry rose substantially when the price of crude oil doubled from $75 in mid-
2007 to $146 in July 2008. However, those high returns declined sharply in 2014–2015,
when oil market conditions led to excess supplies and the price of crude oil fell to $45.
1-3c Monopoly Theory of Profit

In some industries, one firm is effectively able to dominate the market and persistently
earn above-normal rates of return. This ability to dominate the market may arise from
economies of scale (a situation in which one large firm, such as Boeing, can produce
additional units of 747 aircraft at a lower cost than can smaller firms), control of essen-
tial natural resources (crude oil), control of critical patents (biotech pharmaceutical
firms), or governmental restrictions that prohibit competition (cable franchise owners).
The conditions under which a monopolist can earn above-normal profits are discussed
in greater depth in Chapter 11.
1-3d Innovation Theory of Profit

The innovation theory of profit suggests that above-normal profits are the reward for
successful innovations. Firms that develop high-quality products (such as Porsche) or
successfully identify unique market opportunities (such as Apple) are rewarded with the
potential for above-normal profits. Indeed, the U.S. patent system is designed to ensure
that these above-normal return opportunities furnish strong incentives for continued
innovation.
1-3e Managerial Efficiency Theory of Profit

Closely related to the innovation theory is the managerial efficiency theory of profit.
Above-normal profits can arise because of the exceptional managerial skills of well-
managed firms. No single theory of profit can explain the observed profit rates in each
industry, nor are these theories necessarily mutually exclusive. Profit performance is
invariably the result of many factors, including differential risk, innovation, managerial
skills, the existence of monopoly power, and chance occurrences.
1-4 OBJECTIVE OF THE FIRM

These theories of simple profit maximization as an objective of management are insight-
ful, but they do not quantify the timing and risk of profit streams. Shareholder wealth
maximization as an objective overcomes both these limitations.
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Professor and Chairman of Design
University of Michigan
Ann Arbor, Mich.
Haight, Mary N.
Assistant Curator of Ancient Art
Yale University Art Gallery
New Haven, Conn.
Hamilton, George Heard
Curator of Paintings
New Haven, Conn.
Hamlin, Talbot F.
Librarian, Avery Architectural Library
Columbia University
New York, N.Y.
Hammett, Ralph W.
Professor of Architecture
Ann Arbor, Mich.
Hancock, Walter
Director of Sculpture
Pennsylvania Academy of the Fine Arts
Philadelphia, Pa.
Hayes, Bartlett H., Jr.
Director
Addison Gallery of American Art
Andover, Mass.
Hebran, Jean
Professor of Architecture
Ann Arbor, Mich.
Helm, Miss Florence
Old Merchant’s House
New York, N. Y.
Howe, Thomas Carr, Jr.
Director
California Palace of the Legion of Honor
San Francisco, Calif.
Hudnut, Joseph
Dean
Graduate School of Architecture
Harvard University
Cambridge, Mass.
Hume, Samuel J.
Director
Berkeley Art Association
Berkeley, Calif.
Ivins, William M., Jr.
Counselor and Curator of Prints
The Metropolitan Museum of Art
New York, N.Y.
Janson, H. W.
Assistant Professor
Department of Art and Archaeology
Washington University
St. Louis, Mo.
Jewell, Henry A.
Princeton University
Princeton, N. J.
Kaufmann, Edgar
Curator of Industrial Art
The Museum of Modern Art
New York, N.Y.
Keck, Sheldon
Restorer
The Brooklyn Museum
Brooklyn, N. Y.
Kirby, John C.
Assistant Administrator
Walters Gallery
Baltimore, Md.
Kirstein, Lincoln
New York, N. Y.
Kubler, Professor George
Yale University
New Haven, Conn.
Lee, Rensselaer W.
Princeton, N. J.
Marceau, Henri
Assistant Director
Philadelphia Museum of Art
Philadelphia, Pa.
Mcllhenny, Henry
Curator of Decorative Arts
Philadelphia, Pa.
McMahon, A. Philip
Chairman
Fine Arts Department
Washington Square College
New York University
New York, N. Y.
Meeks, Everett V.
Dean
Yale School of the Fine Arts
New Haven, Conn.
Meiss, Millard
Professor
Columbia University
New York, N. Y.
Miner, Miss Dorothy E.
Librarian
Walters Gallery
Baltimore, Md.
More, Hermon
Curator
Whitney Museum of American Art
New York, N. Y.
Morley, Dr. Grace McCann
Director
San Francisco Museum of Art
San Francisco, Calif.
Morse, John D.
Editor
Magazine of Art
New York, N. Y.
Myer, John Walden
Assistant Director
Museum of the City of New York
New York, N. Y.
Myers, George Hewitt
President
Textile Museum of the District of Columbia
Washington, D. C.
Nagel, Charles, Jr.
Director
The Brooklyn Museum
Brooklyn, N. Y.
O’Connor, John, Jr.
Assistant Director
Carnegie Institute
Pittsburgh, Pa.
Packard, Miss Elizabeth G.
Walters Gallery
Baltimore, Md.
Parker, Thomas C.
Director
American Federation of Arts
Washington, D. C.
Peat, Wilbur D.
Director
John Herron Art Institute
Indianapolis, Ind.
Phillips, John Marshall
Assistant Director and Curator of the Garvan
Collections
New Haven, Conn.
Poland, Reginald
Director
Fine Arts Society of San Diego
San Diego, Calif.
Porter, Allen
Secretary
New York, N. Y.
Porter, Vernon
Director
Riverside Museum
New York, N. Y.
Post, Chandler
Fogg Museum of Art
Harvard University
Cambridge, Mass.
Rathbone, Perry T.
Director
City Art Museum of St. Louis
St. Louis, Mo.
Reed, Henry Hope
New York, N. Y.
Rich, Daniel Catton
Director
The Art Institute of Chicago
Chicago, Ill.
Riefstahl, Mrs. Elizabeth
Librarian
Wilbour Egyptological Library
The Brooklyn Museum
Brooklyn, N. Y.
Ritchie, Andrew C.
Director
Albright Art Gallery
Buffalo, N. Y.
Robinson, Professor David M.
Johns Hopkins University
Baltimore, Md.
Ross, Marvin Chauncey
Curator of Medieval Art
Walters Gallery
Baltimore, Md.
Rowe, Margaret T. J.
Curator
Hobart Moore Memorial Collection
New Haven, Conn.
Saint-Gaudens, Homer
Director
Carnegie Institute
Pittsburgh, Pa.
Scholle, Hardinge
Director
Museum of the City of New York
New York, N.Y.
Setze, Josephine
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New Haven, Conn.
Sexton, Eric
Camden, Me.
Shelley, Donald A.
Curator of Paintings
New York Historical Society
New York, N. Y.
Sizer, Theodore
Director
New Haven, Conn.
Slusser, Jean Paul
Professor of Painting and Drawing
Ann Arbor, Mich.
Smith, Professor E. Baldwin
Princeton University
Princeton, N. J.
Soby, James Thrall
New York, N. Y.
Spinden, Dr. Herbert J.
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The Brooklyn Museum
Brooklyn, N. Y.
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Director
Department of Painting and Sculpture
New York, N. Y.
Sweet, Frederick
Associate Curator, Painting and Sculpture
The Art Institute of Chicago
Chicago, Ill.
Tee Van, John
Department of Tropical Research and Special
Events
New York Zoological Park
Bronx, N. Y.
Vail, R. W. G.
Director
New York, N. Y.
Walker, Hudson D.
President
American Federation of Arts
New York, N.Y.
Wall, Alexander J.
New York, N. Y.
Washburn, Gordon
Director
Museum of Art
Rhode Island School of Design
Providence, R. I.
Weissman, Miss Polaire
Museum of Costume Art
New York, N. Y.
Wissler, Dr. Clark
American Museum of Natural History
New York, N. Y.
Wind, Edgar
Smith College
Northampton, Mass.
York, Lewis E.
Chairman
Department of Painting
New Haven, Conn.
Zigrosser, Carl
Curator of Prints and Drawings
Philadelphia, Pa.
Stoddard, Whitney S.
Assistant Professor of History and Art
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Dr. Clapp and Mrs. Force subsequently announced that they had
received eight additional signatures which arrived too late to be
affixed to the original copy of the resolution. They included: Frances
A. Comstock, Donald Drew Egbert, Henry A. Judd, Sherley W.
Morgan, Richard Stillwell—all of Princeton University; Robert Tyler
Davis, Portland Museum, Portland, Maine; Frederick Hartt, Acting
Director, Smith College Museum of Art; and George Rowley,
Princeton Museum of Historic Art.
Statement by the American Commission for the

Protection and Salvage of Artistic and Historic
Monuments in War Areas, Owen J. Roberts, Chairman.
National Gallery of Art, Washington 25, D. C.
Washington, May 14, 1946: The members of the
Commission have received copies of a resolution signed by
Dr. Frederick M. Clapp, Director of the Frick Collection; Mrs.
Juliana Force, Director of the Whitney Museum of American
Art, and others who criticize the action of the United States
Government, taken at the Direction of the President and the
United States Army Command in Germany, in bringing to this
country certain paintings from German museums for
safekeeping until conditions in Germany warrant their return.
The Clapp resolution compares the action taken by the United
States Government to looting operations carried on by the
Nazis during the war.
The Commission has also noted the statements issued by
the White House on September 26, 1945, and by the War
Department on December 6, 1945, that the works of art of
bona fide German ownership, which may be brought to this
country for safekeeping, will be kept in trust for the German
people and will be returned to Germany when conditions
there warrant.
The Commission has also noted the statement issued by
the late Chief Justice Stone, Chairman of the Board of
Trustees of the National Gallery of Art, on December 14,
1945, that the Trustees of the National Gallery, at the request
of the Secretary of State, had agreed to arrange for the
storage space for such paintings as might be brought to this
country by the United States Army for safekeeping, and that
he felt the Army “deserved the highest praise for the care
exercised in salvaging these great works of art and in making
provisions for their safety until they can be returned to
Germany.”
The Commission accepts without reservation the promise
of the United States Government, as voiced by its highest
officials, that the works of art belonging to German museums
and brought to this country for safekeeping, will be returned to
Germany when conditions there warrant.
The Commission is strongly of the opinion that the
resolution sponsored by Dr. Clapp, Mrs. Force, and others is
without justification and is to be deplored.
Hon. Owen J. Roberts, Chairman
Philadelphia, Pennsylvania
David E. Finley, Vice Chairman
Director, National Gallery of Art
Washington, D.C.
Huntington Cairns, Secretary
Secretary, National Gallery of Art
Washington, D.C.
Dr. William Bell Dinsmoor
Columbia University, New York
Hon. Herbert H. Lehman
New York
Paul J. Sachs
Professor of Fine Arts, Harvard University
Cambridge, Massachusetts
Francis Cardinal Spellman
Archbishop of New York
Francis Henry Taylor
Director, Metropolitan Museum of Art
New York
The following letters were released on June 10, 1946:
THE WHITE HOUSE

Washington
May 22, 1946
Dear Mrs. Force:
This is in acknowledgment of the letter to the President,
signed by yourself and Dr. Frederick M. Clapp, Director, The
Frick Collection, with which you enclosed a resolution signed
by ninety-five of your colleagues in connection with the two
hundred valuable paintings removed from Germany to this
country for safekeeping.
These paintings were removed to this country last year on
the basis of information to the effect that adequate facilities
and personnel to ensure their safekeeping did not exist in
Germany. Our military authorities did not feel that they could
take the responsibility of safeguarding them under such
conditions and it was therefore decided that they would have
to be shipped to this country until such time as they could
safely be returned to Germany. It was realized at the time that
this action might lead to criticism but it was taken,
nevertheless, because it was considered that the most
important aspect was to safeguard these priceless treasures.
It was hoped that the President’s pledge that they would be
returned to Germany, contained in a White House press
release on September 26, 1945, would satisfy those who
might be critical of this Government’s motives.
I know of no plans to make any further shipments of art
objects from Germany to the United States nor of any plans
for the exhibition of the two hundred paintings now in this
country. While a definite date for the return of these pictures
has not as yet been set, I can assure you that this
Government will honor its pledge to effect their return as soon
as conditions warrant.
Very sincerely yours,
(signed) William D. Hassett
Secretary to the President.
DEPARTMENT OF STATE
Washington
May 22, 1946
My dear Mrs. Force and Dr. Clapp:
I have received your letter of May 9, 1946, and its enclosed
resolution, signed by 95 of your colleagues, urging the
President to order the immediate safe return to Germany of
the 200 paintings which were brought to this country last year.
When these paintings were found by our forces in southern
Germany every effort was made to assure their preservation.
It soon became evident that adequate facilities and personnel
to ensure their safe keeping could not be guaranteed.
Consequently our military authorities, realizing the magnitude
of their responsibility in preserving these priceless treasures,
requested that they be relieved of this heavy responsibility
and that the paintings be shipped to this country where they
could be properly cared for. This Government reluctantly gave
its approval to this request, knowing that such action would
lead to criticism of its motives. The decision was taken
because there seemed no other way to ensure preservation
of these unique works of art. In order to dispel doubts as to
the reasons for this action the White House released a
statement to the press on September 26, 1945, which
explained the situation and included a pledge that the
paintings would be returned to their rightful owners. That
pledge still holds good and while a definite date for the return
of the paintings to Germany has not as yet been set, you may
rest assured that this will be done as soon as conditions
warrant.
The resolution also recommended that plans to exhibit
these paintings in this country be cancelled and that further
shipments of German works of art to this country be
countermanded. I have never heard of any plans to make
additional shipments of works of art from Germany to the
United States nor do I know of any plans to exhibit the
paintings which are now in this country.
Sincerely yours,
For the Secretary of State:
(signed) Dean Acheson
Under Secretary.
Following are Dr. Clapp’s and Mrs. Force’s replies, also released
on June 10:
June 3, 1946
My dear Mr. President:
Permit us to thank you for your kind attention to the
resolution, signed by us and ninety-five of our colleagues
prominent on the staffs of museums or experts in the history
and preservation of art, relative to the shipment to this country
of two hundred famous paintings formerly in the Kaiser
Friedrich and other museums of Berlin.
In addressing the resolution in question to you we felt that
we were following the time-honored American custom of
bringing to our government’s attention a consensus of opinion
on the part of those who have special practical familiarity with
old pictures and personal, sometimes long, acquaintance with
European history and culture in its emotional and intellectual
aspects.
Should you, in the course of events, undertake further
inquiries into the problem created by the shipment referred to
in our resolution, we shall be happy to be so informed.
Respectfully yours,
June 3, 1946
Dear Mr. Hassett:
In reply to your letter of the twenty-second permit us to say
that should the President make further inquiries into the
subject covered by our resolution with reference to two
hundred pictures selected chiefly from the collections of the
Kaiser Friedrich Museum and brought to this country, we
should be pleased to be kept informed.
We, and our ninety-five colleagues in museums and
universities who have had long experience with old paintings
and are interested in the history and preservation of works of
art, would also be glad to know when the pictures referred to
are returned to Germany since we are as yet uninformed
whether the conditions which are held not to warrant their
return are of a practical or a political nature.
This question obviously cannot but be uppermost in our
minds in view of the fact that present conditions in Germany
are apparently such as to warrant leaving there thousands of
German-owned works of art of great moment which belong
not only to the Kaiser Friedrich Museum but to the museums
of other cities in the American zone, including the great
collection of the Alte Pinakothek in Munich, where under
satisfactory conditions and auspices an exhibition of early
German art, including masterpieces by Dürer, Grünewald and
others, is now being held.
It is in fact one of our perplexities that we have never been
told why our officials discriminated against important pictures
and art objects (many times the number of those urgently
transported to this country for safekeeping) which were also
formerly in the Kaiser Friedrich and other museums, not
forgetting those which were in South German churches. Were
they just left to their fate?
If it were convenient at any time to pass on to the President
our continued anxieties on these important points we should
be happy to have you do so.
Sincerely yours,
June 3, 1946
Dear Mr. Acheson:
In reply to your letter of the twenty-second with reference to
our resolution supported by the signatures of ninety-five of our
colleagues prominent in museums or experts in the history
and preservation of old masters and other works of art, permit
us to say that, in the absence of Secretary Byrnes, we took
the liberty of sending you the resolution.
We are aware of the statement released by the White
House on September 26, 1945 explaining the situation and
promising to return the pictures to Germany when conditions
there should warrant such action. We are, however, still
uninformed why the unanimous advice of the monuments
officers, who had special training and technical knowledge not
only of the conditions required for the preservation of old
masters but of the certain dangers to which journeys subject
them, was disregarded.
We have also never been told whether the conditions
believed to jeopardize the safety of these important pictures
were of a practical or of a political nature. Neither do we know
why, out of the great and extensive collections of the Kaiser
Friedrich only two hundred pictures were selected nor by
whom the selection was made. More serious still no official
mention has ever been made of the fact that there were in the
possession of the other museums of Berlin and other cities,
including the famous collection of the Alte Pinakothek in
Munich, as well as in the churches of the American Zone, art
objects and pictures many times more numerous than the
paintings actually brought to this country for safekeeping. One
cannot but ask: Were satisfactory conditions found for them or
were they merely left to their fate?
These are questions that have given and still give rise to
rumors, unhappy conjectures and ambiguous interpretations
which we deplore. Unreasonably or otherwise the whole
situation is confused by implications that we feel will not be
laid until the pictures deposited in Washington have been sent
back with the least possible delay to their rightful owners on
whom devolves an unequivocable responsibility for their care
and preservation.
Sincerely yours,
FOOTNOTES
[1] E(insatzstab) R(eichsleiter) R(osenberg)—Reichsleiter
meaning realm leader. The Rosenberg Task Force was commonly
referred to by these initials.
[2] See article “German Paintings in the National Gallery: A
Protest,” by Charles L. Kuhn, in College Art Journal, January
1946. This and subsequent references printed by permission.
[3] See article “German Paintings in the National Gallery: A
Protest,” by Charles L. Kuhn, in College Art Journal, January
1946.
[4] As printed by Kuhn in College Art Journal, January 1946, p.
81; also in Magazine of Art, February 1946, and New York Times,
February 7, 1946.
[5] See in this connection the statements released to the press
by the White House on September 26, 1945, and by the War
Department on December 6, 1945. They are printed in Magazine
of Art for February, 1946.
[6] These letters are printed on pages 83 and 84 of College Art
Journal for January 1946; in Magazine of Art for February 1946,
and in the New York Times of February 7, 1946.
INDEX
INDEX
Aachen crown jewels, 119

Abbey of Monte Cassino, 152
Adams, Capt. Edward, 240
Adcock, Maj. Gen. C. L, 272
Administration Building, 64, 65
Adoration of the Magi, Master of the Holy Kinship, 206
Adoration of the Mystic Lamb, The, van Eyck, 144, 146, 243,
291.
See also Ghent altarpiece
Adulteress, The, see “Vermeer” fake
Akhnaton, 287
Allen, Maj., 125
Allied air attacks over Germany, 48
Allied Forces, 274
Allied Group Control Council for Germany, 15, 49
Almanach de Gotha, 27
Almelo, 195
“Alpine Specials,” 161
Alt Aussee, evacuation of pictures at, 130-170;
last ten days at, 171ff.;
other trips to, 178, 258;
Goudstikker pictures, 267;
mentioned, 58, 107, 118, 177, 184, 186, 192, 202, 204,
210, 213, 217, 225
Alt Aussee mine, evacuation of pictures, 65, 130-170, 240, 254,
269, 271, 277;
team arrives, 128;
mentioned, 176, 207, 244, 251
Altdorfer, Albrecht, 161
Altdorfer panels, 162, 165
Alte Pinakothek, 255
Alte Post, 237
Amalienburg, 215
American Embassy, London, 20
American Embassy, Paris, 265
American Fine Arts program, 235
American Military Government (AMG), 195, 259, 292
American Occupied Zone, 196, 243, 246, 260, 262, 268, 272,
275, 282, 291, 292, 293
Amsterdam, 149, 154, 257, 259, 261, 266, 267, 268, 269, 270
Anderson, Lt. George, 84, 85, 86, 102, 112, 190
Anderson, Maj. Harry, 180, 187, 188, 189, 190, 192, 222, 225
Angerer, ⸺, 219
Annunciation, Lippi, 152
Annunzio, Gabriele d’, 64
Arabian Nights, The, 20
Archival Collecting Point, Oberammergau, 282
Army Engineers, 38, 148
Army Museum at Prague, 271
Army redeployment program, 282
Arnhem, 266

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