economics for economic tutor

chapter 4 is Eastimating Demand

Chapter 5 is Business and Economic Forecasting

Chapter 6 is Managerial in the Global Economy

Chapter 7 is Production and Cost

Chapter 8 is Cost Analysis

PART

INTRODUCTION

ECONOMIC ANALYSIS AND
DECISIONS

1. Demand Analysis

. Production and Cost Analysis
3. Product, Pricing, and Output

Decisions
4. Capital Expenditure Analysis

ECONOMIC, POLITICAL, AND
SOCIAL ENVIRONMENT

1. Business Conditions (Trends,
Cycles, and Seasonal Effects)

2. Factor Market Conditions
(Capital, Labor, and Raw
Materials)

3. Competitors’ Reactions and
Tactical Response

4. Organizational Architecture
and Regulatory Constraints

Cash Flows Risk

Firm Value
(Shareholders’ Wealth)

1
CHAP T E R

Introduction and Goals
of the Firm
CHAPTER PREVIEW Managerial economics is the application of
microeconomics to problems faced by decision makers in the private, public, and
not-for-profit sectors. Managerial economics assists managers in efficiently
allocating scarce resources, planning corporate strategy, and executing effective
tactics. In this chapter, the responsibilities of management are explored.
Economic profit is defined and the role of profits in allocating resources in a
free enterprise system is examined. The primary goal of the firm, namely,
shareholder wealth maximization, is developed along with a discussion of how
managerial decisions influence shareholder wealth. The problems associated with
the separation of ownership and control and principal-agent relationships in large
corporations are explored.

MANAGERIAL CHALLENGE
How to Achieve Sustainability: Southern Company1

In the second decade of the twenty-first century, com-
panies all across the industrial landscape are seeking to
achieve sustainability. Sustainability is a powerful meta-
phor but an elusive goal. It means much more than
aligning oneself with environmental sensitivity, though
that commitment itself tests higher in opinion polling of
the latent preferences of American and European custo-
mers than any other response. Sustainability also im-
plies renewability and longevity of business plans that
are adaptable to changing circumstances without up-
rooting the organizational strategy. But what exactly
should management pursue as a set of objectives to
achieve this goal?

Management response to pollution abatement illus-
trates one type of sustainability challenge. At the insis-
tence of the Prime Minister of Canada during the
Reagan Administration, the U.S. Congress wrote a bi-
partisan cap-and-trade bill to address smokestack emis-
sions. Sulfur dioxide and nitrous oxide (SOX and NOX)
emissions precipitate out as acid rain, mist, and ice, im-

posing damage downwind over hundreds of miles to
painted and stone surfaces, trees, and asthmatics. The
Clean Air Act (CAA) of 1990, amended in 1997 and
2003, granted tradable pollution allowance assets
(TPAs) to known polluters. The CAA also authorized
an auction market for these TPA assets. The EPA
Web site (www.epa.gov) displays on a daily basis the
equilibrium, market-clearing price (e.g., $250 per ton
of soot) for the use of what had previously been an un-
priced common property resource—namely, acid-free
air and rainwater. Thereby, large point-source polluters
like power plants and steel mills earned an actual cost
per ton for the SOX and NOX–laden soot by-products
of burning lots of high sulfur coal. These amounts were
promptly placed in spreadsheets designed to find ways
of minimizing operating costs.2 No less importantly,
each polluter felt powerful incremental incentives to
mitigate compliance cost by reducing pollution. And
an entire industry devoted to developing pollution
abatement technology sprang up.

Cont.

The TPAs granted were set at approximately 80 per-
cent of the known pollution taking place at each plant in
1990. For example, Duke Power’s Belews Creek power
plant in northwestern North Carolina, generating
82,076 tons of sulfur dioxide acidic soot annually from
burning 400 train carloads of coal per day, was granted
62,930 tons of allowances (see Figure 1.1 displaying the
329 × 365 = 120,085 tons of nitrous oxide). Although
this approach “grandfathered” a substantial amount of

pollution, the gradualism of the 1990 cap-and-trade bill
was pivotally important to its widespread success. In-
dustries like steel and electric power were given five
years of transition to comply with the regulated emis-
sions requirements, and then in 1997, the initial allow-
ances were cut in half. Duke Power initially 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,
analyzed three compliance choices on a least-cost cash
flow basis: (1) buying allowances, (2) installing smoke-
stack scrubbers, or (3) adopting fuel switching technol-
ogy to burn higher-priced low-sulfur coal or even
cleaner natural gas. In a widely studied case, the South-
ern Company’s Bowen plant in North Georgia necessi-
tated a $657 million scrubber that after depreciation and
offsetting excess allowance revenue was found to cost
$476 million. Alternatively, continuing to burn high-
sulfur coal from the Appalachian Mountain region and
buying the requisite allowances was projected to cost

FIGURE 1.1 Nitrous Oxide from Coal-Fired Power Plants (Daily Emissions in Tons, pre Clean Air Act)

Asheville

CP&L

Cliffside
Duke

Duke
Allen

Marshall
Duke

Riverbend
Duke

Belews
Creek
Duke

Buck
Duke44

39
5924

164

329 tons
NOx

194

Cape
Fear

CP&L

Weatherspoon
CP&L

Sutton
CP&L

Lee
CP&L

Mayo
CP&L

Roxboro
CP&L

Dan
River
Duke

Source: NC Division of Air Quality.

MANAGERIAL CHALLENGE Continued

AP
Im
ag
es
/S
te
ph
en

M
or
to
n

Chapter 1: Introduction and Goals of the Firm 3

Cont.

WHAT IS MANAGERIAL ECONOMICS?
Managerial economics extracts from microeconomic theory those concepts and tech-
niques that enable managers to select strategic direction, to allocate efficiently the re-
sources available to the organization, and to respond effectively to tactical issues. All
such managerial 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:

$266 million. And finally, switching to low-sulfur coal
and adopting fuel switching technology was found to
cost $176 million. All these analyses were performed
on a present value basis with cost projections over
25 years.

Southern Company’s decision to switch to low-sulfur
coal was hailed far and wide as environmentally sensi-
tive. Today, such decisions are routinely described as a
sustainability initiative. Many electric utilities support
these sustainable outcomes of cap-and-trade policies
and even seek 15 percent of their power from renewable
energy (RE). In a Case Study at the end of the chapter,
we analyze several wind power RE alternatives to burn-
ing cheap high-sulfur large carbon footprint coal.

The choice of fuel-switching technology to abate smoke-
stack emissions was a shareholder value-maximizing
choice for Southern Company for two reasons. First,
switching to low-sulfur coal minimized projected cash
flow compliance costs but, in addition, the fuel-switching
technology created a strategic flexibility (a “real option”)
that created additional shareholder value for the Southern
Company. In this chapter, we will see what maximizing
capitalized value of equity (shareholder value) is and
what it is not.

Discussion Questions

� What’s the basic externality problem with acid
rain? What objectives should management
serve in responding to the acid rain problem?

� How does the Clean Air Act’s cap-and-trade
approach to air pollution affect the Southern
Company’s analysis of the previously unpriced
common property air and water resources
damaged by smokestack emissions?

� How should management comply with the
Clean Air Act, or should the Southern Com-
pany just pay the EPA’s fines? Why? How
would you decide?

� Which among Southern Company’s three
alternatives for compliance offered the most
strategic flexibility? Explain.

1Based on Frederick Harris, Alternative Energy Symposium, Wake Forest
Schools of Business (September 2008); and “Acid Rain: The Southern Com-
pany,” Harvard Business School Publishing, HBS: 9-792-060.
2EPA fines for noncompliance of $2,000 per ton have always far exceeded
the auction market cost of allowances ($131–$473 in recent years).

Example Capacity Expansion at Honda, N.A., and
Toyota Motors, N.A.
Honda and Toyota are attempting to expand their already substantial assembly op-
erations 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. 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

(Continued)

MANAGERIAL CHALLENGE Continued

4 Part 1: Introduction

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 establish
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 decreas-
ing. This could be caused by pricing errors, declining labor productivity, or the use of out-
dated retailing concepts. Once the source or sources of the problem are identified, the
manager can move to an examination of potential solutions. The choice between these al-
ternatives depends on an analysis of the relative costs and benefits, as well as other organi-
zational 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. This six-step decision-making process is illustrated in Figure 1.2.

The Responsibilities of Management
In a free enterprise system, managers are responsible for a number of goals. Managers are
responsible for proactively solving problems before they become crises and for selecting strat-
egies to assure the more likely success of the current business model. Managers create organi-
zational 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 monitor, motivate, and incentivize teamwork and
coordinate the integration of marketing, operations, and finance functions. In pursuing all
of these responsibilities, managers in a capitalist economy are ever conscious of their over-
arching goal to maximize returns to the owners of the business—that is, economic profits.

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 Ac-
cords. 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 sum-
marized 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 strat-
egies for growth while respecting all ethical, legal, and regulatory constraints.

Chapter 1: Introduction and Goals of the Firm 5

Economic profit is the difference between total sales revenue (price times units sold)
and total economic cost. The economic cost of any activity may be thought of as
the highest valued alternative opportunity that is forgone. To attract labor, capital,
intellectual property, land, and materiel, the firm must offer to pay a price that is suffi-
cient to convince the owners of these resources to forego other alternative activities and
commit their resources to this use. Thus, economic costs should always be thought of as
opportunity costs—that is, the costs of attracting a resource such as investment capital
from its next best alternative use.

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
indicate how this works.

FIGURE 1.2 The Decision-Making Process

Analyze
alternatives

and select the best

Implement and
monitor the

decision

Consider
societal

constraints

Consider
organizational and
input constraints

Establish objectives

Identify
the problem

Examine possible
alternative
solutions

Perform a
sensitivity analysis

economic profit The
difference between
total revenue and
total economic cost.
Economic cost
includes a “normal”
rate of return on the
capital contributions
of the firm’s partners.

6 Part 1: Introduction

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 or 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, the industry average return
on net worth for the hotel/gaming industry was 12.6 percent in 2005, compared with
9 percent for the water utility industry.

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 might earn 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 indus-
try 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 by late 2008, when oil market
conditions led to excess supplies and the price of crude oil fell to $45.

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 ad-
ditional units of 747 aircraft at a lower cost than can smaller firms), control of essential
natural resources (diamonds), 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.

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 Microsoft) are rewarded with
the potential for above-normal profits. Indeed, the U.S. patent system is designed to en-
sure that these above-normal return opportunities furnish strong incentives for contin-
ued innovation.

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 in-
variably the result of many factors, including differential risk, innovation, managerial
skills, the existence of monopoly power, and chance occurrences.

Chapter 1: Introduction and Goals of the Firm 7

OBJECTIVE OF THE FIRM
These theories of simple profit maximization as an objective of management are insight-
ful, but they ignore the timing and risk of profit streams. Shareholder wealth maximiza-
tion as an objective overcomes both these limitations.

The Shareholder Wealth-Maximization Model of the Firm
To maximize the value of the firm, managers should maximize shareholder wealth.
Shareholder wealth is measured by the market value of a firm’s common stock, which
is equal to the present value of all expected future cash flows to equity owners dis-
counted at the shareholders’ required rate of return plus a value for the firm’s embedded
real options:

V0 · ðShares OutstandingÞ = π1ð1+keÞ1
+

π2

ð1+keÞ2
+

π3

ð1+keÞ3
+ . . . +

π∞
ð1+keÞ∞

+ Real Option Value

V0 · ðShares OutstandingÞ = ∑
∞

t=1

πt
ð1+keÞt

+ Real Option Value [1.1]

where V0 is the current value of a share of stock (the stock price), πt represents the eco-
nomic profits expected in each of the future periods (from period 1 to ∞), and ke equals
the required rate of return.

A number of different factors (like interest rates and economy-wide business cycles)
influence the firm’s stock price in ways that are beyond the manager’s control, but many
factors (like innovation and cost control) are not. Real option value represents the cost
savings or revenue expansions that arise from preserving flexibility in the business plans
the managers adopt. For example, the Southern Company saved $90 million in comply-
ing with the Clean Air Act by adopting fuel-switching technology that allowed burning
of alternative high- and low-sulfur coals or fuel oil whenever the full cost of one input
became cheaper than another.

Note that Equation 1.1 does take into account the timing of future profits. By discount-
ing all future profits at the required rate of return, ke, Equation 1.1 shows that a dollar

Example Shareholder Wealth Maximization at Berkshire
Hathaway
Warren E. Buffett, chairman and CEO of Berkshire Hathaway, Inc., has described
the long-term economic goal of Berkshire Hathaway as follows: “to maximize the
average annual rate of gain in intrinsic business value on a per-share basis.”3 Berk-
shire’s book value per share has increased from $19.46 in 1964, when Buffett ac-
quired the firm, to $91,485 at the end of 2005, a compound annual rate of growth
of 21.5 percent. The Standard and Poor’s 500 companies experienced 10.3 percent
growth over this same time period.

Berkshire’s directors are all major stockholders. In addition, at least four of the di-
rectors have over 50 percent of their family’s net worth invested in Berkshire. Man-
agers and directors own over 47 percent of the firm’s stock. As a result, Buffet’s firm
has always placed a high priority on the goal of maximizing shareholder wealth.

3Annual Report, Berkshire Hathaway, Inc. (2005).

shareholder wealth
A measure of the value
of a firm. Shareholder
wealth is equal to the
value of a firm’s
common stock, which,
in turn, is equal to the
present value of all
future cash returns
expected to be
generated by the
firm for the benefit
of its owners.

8 Part 1: Introduction

received in the future is worth less than a dollar received immediately. (The techniques of
discounting to present value are explained in more detail in Chapter 2 and Appendix A at
the end of the book.) Equation 1.1 also provides a way to evaluate different levels of risk
since the higher the risk the higher the required rate of return ke used to discount the
future cash flows, and the lower the present value. In short, shareholder value is deter-
mined by the amount, timing, and risk of the firm’s expected future profits.

SEPARATION OF OWNERSHIP AND
CONTROL: THE PRINCIPAL-AGENT
PROBLEM
Profit maximization and shareholder wealth maximization are very useful concepts when
alternative choices can be easily identified and when the associated costs and revenues
can be readily estimated. Examples include scheduling capacity for optimal production
runs, determining an optimal inventory policy given sales patterns and available produc-
tion facilities, introducing an established product in a new geographic market, and
choosing whether to buy or lease a machine. In other cases, however, where the alterna-
tives are harder to identify and the costs and benefits less clear, the goals of owners and
managers are seldom aligned.

Example Resource-Allocation Decisions and Shareholder
Wealth: Apple Computer4

In distributing its stylish iMac personal computers and high tech iPods, Apple has
considered three distribution channels. On the one hand, copying Dell’s direct-
to-the-consumer approach would entail buying components from Motorola,
AMD, Intel, and so forth and then hiring third-party manufacturers to assemble
what each customer ordered just-in-time to fulfill Internet or telephone sales. In-
ventories and capital equipment costs would be very low indeed; almost all costs
would be variable. Alternatively, Apple could enter into distribution agreements
with an independent electronics retailer like Computer Tree. Finally, Apple could
retail its own products in Apple Stores. This third approach entails enormous cap-
ital investment and a higher proportion of fixed cost, especially if the retail chain
sought high visibility locations and needed lots of space.

Recently Apple opened its 147th retail store on Fifth Avenue in New York City.
The location left little doubt as to the allocation of company resources to this new
distribution strategy. Apple occupies a sprawling subterranean space topped by a
glass cube that Steve Jobs himself designed, across from Central Park, opposite
the famed Plaza Hotel. Apple’s profits in this most heavily trafficked tourist and
retail corridor will rely on several initiatives: (1) in-store theatres for workshop
training on iMac programs to record music or edit home movies, (2) numerous
technical experts available for troubleshooting with no waiting time, and (3) con-
tinuing investment in one of the world’s most valuable brands. In 2005, Apple
made $151 million in operating profits on $2.35 billion in sales at these Apple
Stores, a 6.4 percent profit margin relative to approximately a 2 percent profit mar-
gin company-wide.

4Based on Nick Wingfield, “How Apple’s Store Strategy Beat the Odds,” Wall Street Journal (May 17, 2006), p. B1.

Chapter 1: Introduction and Goals of the Firm 9

Divergent Objectives and Agency Conflict
As sole proprietorships and closely held businesses grow into limited liability corpora-
tions, the owners (the principals) frequently delegate decision-making authority to pro-
fessional managers (the agents). Because the manager-agents usually have much less to
lose than the owner-principals, the agents often seek acceptable levels (rather than a
maximum) of profit and shareholder wealth while pursuing their own self-interests.
This is known as a principal-agent problem or “agency conflict.”

For example, as oil prices subsided with the collapse of the OPEC cartel in the 1990s,
Exxon’s managers diversified the company into product lines like computer software
development—an area where Exxon had little or no expertise or competitive advantage.
The managers were hoping that diversification would smooth out their executive bonuses
tied to quarterly earnings, and it did. However, the decision to diversify ended up caus-
ing an extended decline in the value of Exxon’s stock.

Pursuing their own self-interests can also lead managers to focus on their own
long-term job security. In some instances this can motivate them to limit the amount
of risk taken by the firm because an unfavorable outcome resulting from the risk
could lead to their dismissal. Kodak is a good example. In the early 2000s, Kodak’s
executives didn’t want to risk developing immature digital photography products.
When the demand for digital camera products subsequently soared, Kodak was left
with too few markets for its traditional film products. Like Exxon, its stock value
plummeted.

Finally, the cash flow to owners erodes when the firm’s resources are diverted
from their most productive uses to perks for managers. In 1988, RJR Nabisco was a
firm that had become bloated with corporate retreats in Florida, an extensive fleet of
corporate airplanes and hangars, and an executive fixation on an awful-tasting new
product (the “smokeless” cigarette Premier). This left RJR Nabisco with substantially
less value in the marketplace than would have been possible with better resource
allocation decisions. Recognizing the value enhancement potential, Kohlberg Kravis
Roberts & Co. (KKR) initiated a hostile takeover bid and acquired RJR Nabisco for
$25 billion in early 1989. The purchase price offered to common stockholders by
KKR was $109 per share, much better than the $50 to $55 pre-takeover price. The
new owners moved quickly to sell many of RJR’s poorly performing assets, slash op-
erating expenses, and cancel the Premier project. Although the deal was heavily lev-
eraged with a large amount of debt borrowed at high interest rates, a much-improved
cash flow allowed KKR to pay down the debt within seven years, substantially ahead
of schedule.

To forge a closer alliance between the interests of shareholders and managers, some
companies structure a larger proportion of the manager’s compensation in the form of
performance-based payments. For example, in 2002, Walt Disney’s Michael Eisner re-
ceived over $20.2 million in long-term compensation (in addition to his $750,000 salary)
as a reward for increasing Walt Disney’s market value 10-fold from $2 billion to $23
billion during his first 10 years as CEO.5 Other firms like Hershey Foods, CSX, Union
Carbide, and Xerox require senior managers and directors to own a substantial amount
of company stock as a condition of employment. The idea behind this is to align the
pocketbook interests of managers directly with those of stockholders. In sum, how moti-
vated a manager will be to act in the interests of the firm’s stockholders depends on the
structure of his or her compensation package, the threat of dismissal, and the threat of
takeover by a new group of owners.

5J. Steiner, Business, Society, and Government (New York: McGraw-Hill, 2003), pp. 660–662.

10 Part 1: Introduction

Agency Problems
Two common factors that give rise to all principal-agent problems are the inherent un-
observability of managerial effort and the presence of random disturbances in team pro-
duction. The job performance of piecework garment workers is easily monitored, but the
work effort of salespeople and manufacturer’s trade representatives may not be observ-
able at less-than-prohibitive cost. Directly observing managerial input is even more prob-
lematic because managers contribute what one might call “creative ingenuity.” Creative
ingenuity in anticipating problems before they arise is inherently unobservable. Owners
know it when they see it, but often do not recognize when it is missing. As a result, in
explaining fluctuations in company performance, the manager’s creative ingenuity is
often inseparable from good and bad luck. Owners therefore find it difficult to know
when to reward managers for upturns and when to blame them for poor performance.

To an attempt to mitigate these agency problems, firms incur several agency costs,
which include the following:

1. Grants of restricted stock or deferred stock options to structure executive compensa-
tion in such a way as to align the incentives for management with shareholder interests.

Separation of ownership (shareholders) and control (management) in large cor-
porations permits managers to pursue goals, such as maximization of their own
personal welfare, that are not always in the long-term interests of shareholders. As a
result of pressure from large institutional shareholders, such as Fidelity Funds, from
statutes such as Sarbanes-Oxley mandating stronger corporate governance, and from
federal tax laws severely limiting the deductibility of executive pay, a growing num-
ber of corporations are seeking to assure that a larger proportion of the manager’s
pay occurs in the form of performance-based bonuses. They are doing so by (1) tying
executive bonuses to the performance of comparably situated competitor companies,
(2) by raising the performance hurdles that trigger executive bonuses, and (3) by
eliminating severance packages that provide windfalls for executives whose poor per-
formance leads to a takeover or their own dismissal.

In 2005, CEOs of the 350 largest U.S. corporations were paid $6 million in
median total direct compensation. The 10 companies with the highest shareholder
returns the previous five years paid $10.6 million in salary, bonus, and long-term

Example Agency Costs and Corporate Restructuring:
O.M. Scott & Sons6

The existence of high agency costs sometimes prompts firms to financially restruc-
ture themselves to achieve higher operating efficiencies. For example, the lawn pro-
ducts firm O.M. Scott & Sons, previously a subsidiary of ITT, was purchased by the
Scott managers in a highly leveraged buyout (LBO). Faced with heavy interest and
principal payments from the debt-financed LBO transaction and having the poten-
tial to profit directly from more efficient operation of the firm, the new owner-
managers quickly put in place accounting controls and operating procedures
designed to improve Scott’s performance. By monitoring inventory levels more
closely and negotiating more aggressively with suppliers, the firm was able to
reduce its average monthly working capital investment from an initial level of
$75 million to $35 million. At the same time, incentive pay for the sales force
caused revenue to increase from $160 million to a record $200 million.

6A more complete discussion of the Scott experience can be found in Brett Duval Fromson, “Life after Debt: How
LBOs Do It,” Fortune (March 13, 1989), pp. 91–92.

agency costs Costs
associated with
resolving conflicts
of interest among
shareholders,
managers, and lenders.
Agency costs include
the cost of monitoring
and bonding
performance, the cost
of constructing
contracts designed to
minimize agency
conflicts, and the loss
in efficiency resulting
from unresolved agent-
principal conflicts.

Chapter 1: Introduction and Goals of the Firm 11

incentives. The 10 companies with the lowest shareholder returns paid $1.6 million.
Figure 1.3 shows that across these 350 companies, CEO total compensation has
mirrored corporate profitability, spiking when profits grow and collapsing when
profits decline. In the global economic crisis of 2008–2009, CEO salaries declined in
63 percent of NYSE Euronext companies, and bonuses and raises were frozen, cut,
or eliminated in 47 percent and 52 percent, respectively.7

Example Executive Performance Pay: General Electric8

As a representative example of a performance-based pay package, General Electric
CEO Jeff Immelt had a 2006 salary of $3.2 million, a cash bonus of $5.9 million,
and gains on long-term incentives that converted to stock options of $3.8 million.
GE distributes stock options to 45,000 of its 300,000 employees, but decided that
one-half of CEO Jeff Immelt’s 250,000 “performance share units” should only con-
vert to stock options if GE cash flow grew at an average of 10 percent or more for
five years, and the other one-half should convert only if GE shareholder return ex-
ceeded the five-year cumulative total return on the S&P 500 index.

Basing these executive pay packages on demonstrated performance relative to in-
dustry and sector benchmarks has become something of a cause célèbre in the United
States. The reason is that by 2008 median CEO total compensation of $7.3 million
had grown to 198 times the $37,000 salary of the average U.S. worker. In Europe,
the comparable figure was $900,000, approximately 33 times the median worker sal-
ary of $27,000.9 And similar multipliers to those in Europe apply in Asia. So, what
U.S. CEOs get paid was the focus of much public policy discussion even before the
pay scandals at AIG and Merrill Lynch/Bank of America in the fall of 2009.

8Based on http://people.forbes.com/rankings/jeffrey-r-immelt/36126
9Mercer Human Resources Consulting, “Executive Compensation” (2006).

FIGURE 1.3 CEO Pay Trends

+25%

+15%

+5%

–15%

–25%

0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

2007 2009

–5%

Corporate profits CEO compensation

2008

Source: Mercer Human Resource Consulting.

7“NYSE Euronext 2010 CEO Report,” NYSEMagazine.com (September 2009), p. 27.

12 Part 1: Introduction

2. Internal audits and accounting oversight boards to monitor management’s actions.
In addition, many large creditors, especially banks, now monitor financial ratios and
investment decisions of large debtor companies on a monthly or even biweekly basis.
These initiatives strengthen the firm’s corporate governance.

3. Bonding expenditures and fraud liability insurance to protect the shareholders from
managerial dishonesty.

4. Lost profits arising from complex internal approval processes designed to limit
managerial discretion, but which prevent timely responses to opportunities.

IMPLICATIONS OF SHAREHOLDER WEALTH
MAXIMIZATION
Critics of those who want to align the interests of managers with equity owners often
allege that maximizing shareholder wealth focuses on short-term payoffs—sometimes to
the detriment of long-term profits. However, the evidence suggests just the opposite.
Short-term cash flows reflect only a small fraction of the firm’s share price; the first 5
years of expected dividend payouts explain only 18 percent and the first 10 years only
35 percent of the share prices of NYSE stocks.11 The goal of shareholder wealth maximi-
zation requires a long-term focus.

WHAT WENT RIGHT • WHAT WENT WRONG

Saturn Corporation

When General Motors rolled out their “different kind of
car company,” J.D. Powers rated product quality 8 per-
cent ahead of Honda, and customers liked the no-haggle
selling process. Saturn achieved the 200,000 unit sales en-
joyed by the Honda Civic and the Toyota Corolla in two
short years and caught the 285,000 volume of the Ford
Escort in Saturn’s fourth year. Making interpersonal as-
pects of customer service the number-one priority and
possessing superior inventory and MIS systems, Saturn
dealerships proved very profitable and quickly developed
a reputation for some of the highest customer loyalty in
the industry.

However, with pricing of the base Saturn model $1,200
below the $12,050 rival Japanese compact cars, the GM
parent earned only a $400 gross profit margin per vehicle.
In a typical year, this meant GM was recovering only about
$100 million of its $3 billion capital investment, a paltry 3
percent return. Netting out GM’s 11 percent cost of capital,
each Saturn was losing approximately $1,000. These figures
compare to a $3,300 gross profit margin per vehicle in
some of GM’s other divisions. Consequently, cash flow
was not reinvested in the Saturn division, products were
not updated, and the models stagnated. By 1997, sales

were slumping at −9 percent and in 1998 they fell an ad-
ditional 20 percent. In 2009, GM announced it was perma-
nently closing the Saturn division.

What problems appear responsible for Saturn’s mid-life
crisis? GM failed to adopt a change-management view of
what would be required to transfer the first-time Saturn
owners to more profitable GM divisions. The corporate
strategy was that price-conscious young Saturn buyers
would eventually trade up to Buick and Oldsmobile. In-
stead, middle-aged loyal Saturn owners sought to trade
up within Saturn, and finding no sporty larger models
available, they switched to larger Japanese imports like
the Honda Accord and Toyota Camry. Saturn has now
learned that companies whose products are exposed to
competition from foreign producers must plan product in-
troductions and marketing campaigns to account for this
global competitive environment. Recent product introduc-
tions have included a sport wagon, an efficient SUV, and a
high-profile sports coupe.

10Based on M. Cohen, “Saturn’s Supply-Chain Innovation,” Sloan Manage-
ment Review (Summer 2000), pp. 93–96; “Small Car Sales Are Back” and
“Why Didn’t GM Do More for Saturn?” BusinessWeek, September 22,
1997, pp. 40–42, and March 16, 1998, p. 62.

11J.R. Woolridge, “Competitive Decline: Is a Myopic Stock Market to Blame?” Journal of Applied Corporate
Finance (Spring 1988), pp. 26–36.

Chapter 1: Introduction and Goals of the Firm 13

Admittedly, value-maximizing managers must manage change—sometimes radical
changes in competition (free-wheeling electric power), in technology (Internet signal
compression), in revenue collection (music), and in regulation (cigarettes)—but they
must do so with an eye to the long-run sustainable profitability of the business. In short,
value-maximizing managers must anticipate change and make contingency plans.

Shareholder wealth maximization also reflects dynamic changes in the information
available to the public about a company’s expected future cash flows and foreseeable
risks. An accounting scandal at Krispy Kreme caused the stock price to plummet from
$41 to $20 per share in one month. Stock price also reflects not only the firm’s preexist-
ing positive net present value investments, but also the firm’s strategic investment oppor-
tunities (the “embedded real options”) a management team develops. Amgen, a
biotechnology company, had shareholder value of $42 million in 1983 despite no sales,
no cash flow, no capital assets, no patents, and poorly protected trade secrets. By 1993,
Amgen had sales of over $1.4 billion and cash flow of $408 million annually. Amgen had
developed and exercised enormously valuable strategic opportunities.

WHAT WENT RIGHT • WHAT WENT WRONG

Eli Lilly Depressed by Loss of Prozac
Patent12

Pharmaceutical giants like GlaxoSmithKline, Merck, Pfizer,
and Eli Lilly expend an average of $802 million to develop
a new drug. It takes 12.3 years to research and test for
efficacy and side effects, conduct clinical trials, and then
produce and market a new drug. Only 4 in 100 candidate
molecules or screening compounds lead to investigational
new drugs (INDs). Only 5 in 200 of these INDs display
sufficient efficacy in animal testing to warrant human
trials. Clinical failure occurs in 6 of 10 human trials, and
only half of the FDA-proposed drugs are ultimately ap-
proved. In sum, the joint probability of successful drug
discovery and development is just 0.04 × 0.025 × 0.4 ×
0.5 = 0.0002, two hundredths of 1 percent. Those few pat-
ented drugs that do make it to the pharmacy shelves, espe-
cially the blockbusters with several billion dollars in sales,
must contribute enough operating profit to recover the
cost of all these R & D failures.

In 2000, one of the key extension patents for Eli Lilly’s
blockbuster drug for the treatment of depression, Prozac,

was overturned by a regulator and a U.S. federal judge.
Within one month, Eli Lilly lost 70 percent of Prozac’s
sales to the generic equivalents. Although this company
has several other blockbusters, Eli Lilly’s share price plum-
meted 32 percent. CEO Sidney Taurel said he had made a
mistake in not rolling out Prozac’s successor replacement
drug when the patent extension for Prozac was first chal-
lenged. Taurel then moved quickly to establish a new man-
agement concept throughout the company. Now, each new
Eli Lilly drug is assigned a team of scientists, marketers,
and regulatory experts who oversee the entire life cycle of
the product from research inception to patent expiration.
The key function of these cross-functionally integrated
teams is contingency analysis and scenario planning to
deal with the unexpected.

12C. Kennedy, F. Harris, and M. Lord, “Integrating Public Policy and Public
Affairs into Pharmaceutical Marketing: Differential Pricing and the AIDS
Pandemic,” Journal of Public Policy and Marketing (Fall 2004), pp. 1–23;
and “Eli Lilly: Bloom and Blight,” The Economist (October 26, 2002), p. 60.

Example Amgen’s Potential Profitability Is Realized
Amgen, Inc. uses state-of-the-art biotechnology to develop human pharmaceutical
and diagnostic products. After a period of early losses during their start-up phase,
profits increased steadily from $19 million in 1989 to $355 million in 1993 to $670
million in 1996. On the strength of royalty income from the sale of its Epogen prod-
uct, a stimulator of red blood cell production, profits jumped to $900 million per year
by 1999. In 2009, Amgen was valued at $60 billion with revenues and cash flows hav-
ing continued to grow throughout the previous 10 years at 19 percent annually.

14 Part 1: Introduction

In general, only about 85 percent of shareholder value can be explained by even
30 years of cash flows.13 The remainder reflects the capitalized value of strategic flexibil-
ity to expand some profitable lines of business, to abandon others, and to retain but de-
lay investment in still others until more information becomes available. These additional
sources of equity value are referred to as “embedded real options.”

We need to address why NPV and option value are additive concepts. NPV was in-
vented to value bonds where all the cash flows are known and guaranteed by contract.
As a result, the NPV analysis adjusts for timing and for risk but ignores the value of
flexibility present in some capital budgeting projects but not others. These so-called em-
bedded options present the opportunity but not the obligation to take actions to maxi-
mize the upside or minimize the downside of a capital investment. For example,
investing in a fuel-switching technology in power plants allows Southern Company to
burn fuel oil when that input is cheap and burn natural gas when it is cheaper. Similarly,
building two smaller assembly plants, one in Japan and another in the United States, al-
lows Honda Camry production to be shifted as currency fluctuations cause costs to fall
in one plant location relative to the other. In general, a company can create flexibility in
their capital budgeting by: (1) facilitating follow-on projects through growth options, (2)
exiting early without penalty through abandonment options, or (3) staging investment
over a learning period until better information is available through deferral options.
The scenario planning that comes from such financial thinking compares the value of
expanding, leaving, or waiting to the opportunity loss from shrinking, staying, or imme-
diate investment. Flexibility of this sort expands upon the NPV from discounted cash
flow alone.

Value-maximizing behavior on the part of managers is also distinguishable from
satisficing behavior. Satisficers strive to “hit their targets” (for example, on sales growth,
return on investment, or safety rating targets). Not value maximizers. Rather than trying
to meet a standard like 97 percent, 99 percent, or 99.9 percent error-free takeoffs and
landings at O’Hare field in Chicago, or deliver a 9, 11, or 12.1 percent return on share-
holders’ equity, the value-maximizing manager will commit himself or herself to contin-
uous incremental improvements. Any time the marginal benefits of an action exceed its
marginal costs, the value-maximizing manager will just do it.

Example Real Option Value Attributable to Fuel-Switching
Technology at Southern Company
Ninety-six percent of all companies employ NPV analysis.14 Eighty-five percent
employ sensitivity analysis to better understand their capital investments. Only
66.8 percent of companies pursue the scenario planning and contingency analysis
that underlies real option valuation. A tiny 11.4 percent of companies formally cal-
culate the value of their embedded real options. That suggests an opportunity for
recently trained managers to introduce these new techniques of capital budgeting
to improve stockholder value. Southern Company found its embedded real option
from fuel switching technology was worth more than $45 million.

14Based on P. Ryan and G. Ryan, “Capital Budgeting Practices of the Fortune 1000: How Have Things Changed?”
Journal of Business and Management (Fall 2002).

13Woolridge, op. cit.

Chapter 1: Introduction and Goals of the Firm 15

Caveats to Maximizing Shareholder Value
Managers should concentrate on maximizing shareholder value alone only if three con-
ditions are met. These conditions require: (1) complete markets, (2) no significant asym-
metric information, and (3) known recontracting costs. We now discuss how a violation
of any of these conditions necessitates a much larger view of management’s role in firm
decision making.

Complete Markets To directly influence a company’s cash flows, forward or futures
markets as well as spot markets must be available for the firm’s inputs, output, and by-
products. For example, forward and futures markets for crude oil and coffee bean inputs
allow Texaco and Starbuck’s Coffeehouses to plan their costs with more accurate cash
flow projections. For a small 3 to 5 percent fee known in advance, value-maximizing
managers can lock in their input expense and avoid unexpected cost increases. This com-
pleteness of the markets allows a reduction in the cost-covering prices of gasoline and
cappuccino.

Example Tradable Pollution Permits at Duke Power

By establishing a market system for tradable air pollution permits, the Clean Air
Act set a price on the sulfur dioxide (SO2) by-product from burning high-sulfur
coal. SO2 emissions from coal-fired power plants in the Midwest raised the acidity
of rain and mist in eastern forests from Maine to Georgia to levels almost 100
times higher than the natural acidity of rainfall in the Grand Tetons in the far
northwestern United States. Dead trees, peeling paint, increased asthma, and stone
decomposition on buildings and monuments were the result.

To elicit substantial pollution abatement at the least cost, the Clean Air Act of
1990 authorized the Environmental Protection Agency to issue tradable pollution
allowances (TPAs) to 467 known SO2 polluters for approximately 70 percent of the
previous year’s emissions. The utility companies doing the polluting then began to
trade the allowances. Companies that were able to abate their emissions at a low
cost (perhaps because they had smokestack scrubbing equipment) sold their allow-
ances to plants that couldn’t abate their emissions as cost effectively. In other
words, the low-cost abaters were able to cut their emissions cheaply and then sell
the permits they didn’t need to high-cost abaters. The result was that the nation’s
air got 30 percent cleaner at the least possible cost.

As a result of the growing completeness of this market, electric utilities like
Duke Power now know what expense line to incorporate in their cash flow projec-
tions for the SO2 by-products of operating with high-sulfur coal. TPAs can sell for
more than $100 per ton, and a single utility plant operation may require 15,000
tons of permits or more. The continuous tradeoff between installing 450-
million-dollar pollution abatement equipment, utilizing higher-cost alternative
fuels like low-sulfur coal and natural gas, or paying the current market price of
these EPA-issued pollution permits can now be explicitly analyzed and the least-
cost solutions found.

15Based on “Acid Rain: The Southern Company,” Harvard Business School Publishing, HBS: 9-792-060; “Cornering
the Market,” Wall Street Journal (June 5, 1995), p. B1; and Economic Report of the President, February 2000 (Washing-
ton, DC: U.S.G.P.O., 2000), pp. 240–264.

16 Part 1: Introduction

No Asymmetric Information Monitoring and coordination problems within the
corporation and contracting problems between sellers and buyers often arise because of
asymmetric information. Line managers and employees can misunderstand what senior
executives intend and miscommunicate these intentions to customers. A Food Lion
memo challenging employees to find a thousand different ways to save 1 percent of their
own costs elicited undesirable shortcuts in food preparation and storage. Dianne Sawyer
then secretly recorded seafood counter employees spraying old salmon with a light con-
centration of ammonia to restore the red appearance of fresh fish. Clearly, this was not
what the senior executives at Food Lion intended.

Building a good reputation with customers, workers, and the surrounding tax jurisdic-
tion is one way companies deal with the problem of asymmetric information, and man-
agers must attend to these reputational effects on shareholder value. We discuss the
implications of asymmetric information in competitive markets in Chapter 10.

Known Recontracting Costs Finally, to focus exclusively on the discounted pres-
ent value of future cash flows necessitates that managers obtain not only sales revenue and
expense estimates but also forecasts of future recontracting costs for pivotal inputs. Owners
of professional sports teams are acutely aware of how unknown recontracting costs with
star players can affect the value of their franchises. The same thing can occur with a piv-
otal corporate executive. A star CFO, COO, CMO, or CIO can often “hold up” the firm’s
owners when the time comes for contract renewals. In another arena, Westinghouse en-
tered into long-term supply contracts to provide fuel rods to nuclear power plants across
the country. Thereafter, when the market price of uranium quadrupled, Westinghouse re-
fused to deliver the promised fuel rods and recontracting costs skyrocketed. Value-
maximizing managers must anticipate and mitigate these recontracting problems.

To the extent markets are incomplete, information is asymmetric, or recontracting
costs are unknown, managers must attend to these matters in order to maximize share-
holder wealth rather than simply focus myopically on maximizing the net present value
of expected future cash flows.

Residual Claimants
Why is it that the primary duty of management and the board of directors of a company
is to the shareholders themselves? Shareholders have a residual claim on the firm’s net
cash flows after all expected contractual returns have been paid. All the other stake-
holders (employees, customers, bondholders, banks, suppliers, the surrounding tax juris-
dictions, the community in which plants are located, etc.) have contractual expected
returns. If expectations created by those contracts are not met, any of these stakeholders
has access to the full force of the contract law in securing what they are due. Share-
holders have contractual rights, too, but those rights simply entitle them to whatever is
left over, that is, to the residual. As a consequence, when shareholder owners hire a CEO
and a board, they create a fiduciary duty to allocate the company’s resources in such a
way as to maximize the net present value of these residual claims. This is what consti-
tutes the objective of shareholder wealth maximization.

Be very clear, however, that the value of any company’s stock is quite dependent on repu-
tation effects. Underfunding a pension plan or polluting the environment results in massive
losses of capitalized value because the financial markets anticipate (correctly) that such a com-
pany will have reduced future cash flows to owners. Labor costs to attract new employees will
rise; tax jurisdictions will reduce the tax preferences offered in new plant locations; customers
may boycott; and the public relations, lobbying, and legal costs of such a company will surely
rise. All this implies that wealth-maximizing managers must be very carefully attuned to
stakeholder interests precisely because it is in their shareholders’ best interests to do so.

Chapter 1: Introduction and Goals of the Firm 17

Goals in the Public Sector and Not-for-Profit Enterprises16
The value-maximization objective developed for private sector firms is not an appropri-
ate objective in the public sector or in not-for-profit (NFP) organizations. These organi-
zations pursue a different set of objectives because of the nature of the goods and services
they supply and the manner in which they are funded.

There are three characteristics of NFP organizations that distinguish them from for-
profit enterprises and influence their decision making. First, no one possesses a right to
receive profit or surpluses in an NFP enterprise. The absence of a profit motive can have
a serious impact on the incentive to be efficient. Second, NFP enterprises are exempt
from taxes on corporate income. Finally, donations to NFPs are tax deductible, which
gives NFP enterprises an advantage when competing for capital.

Not-for-profit organizations include performing arts groups, museums, libraries, hos-
pitals, churches, volunteer organizations, cooperatives, credit unions, labor unions, pro-
fessional societies, foundations, and fraternal organizations. Some of these organizations
offer services to a group of clients, such as the patients of a hospital. Others provide ser-
vices primarily to their members such as tennis clubs or credit unions. Finally, some
NFP organizations produce products to benefit the general public. Local symphony and
theater companies are examples.

Public sector (government) agencies tend to provide services that have significant
public-good characteristics. In contrast to private goods, like a bite-sized candy bar,
a public good can be consumed by more than one person. Moreover, excluding
those who do not pay can only be done at a prohibitively high cost. Examples of public
goods include national defense and flood control. If an antiballistic missile system or a
flood control levy is constructed, no one can be excluded from its protection even if they
refuse to contribute to the cost. Even if exclusion were feasible, the indivisibility of mis-
sile defense or flood control consumption makes the incremental cost (and therefore the
efficient price) of adding another participant quite low.

Some goods, such as recreational facilities and the performing arts, have both private-
good and public-good characteristics. For example, concerts and parks may be shared
(within limits) and are partially nonexcludable in the sense that they convey prestige and
quality-of-life benefits to the entire community.17 The more costly the exclusion, the
more likely the good or service will be provided by the public sector rather than the pri-
vate sector. Portrait artists and personal fitness trainers offer pay-as-you-go private fee
arrangements. Chamber music fans and tennis court users often organize in
consumption-sharing and cost-sharing clubs. At the end of the spectrum, open-air sym-
phony concerts and large parks usually necessitate some public financing.

Not-for-Profit Objectives
Several organizational objectives have been suggested for the NFP enterprise. These in-
clude the following:

1. Maximizing the quantity and quality of output subject to a break-even budget
constraint.

2. Maximizing the outcomes preferred by the NFP’s contributors.
3. Maximizing the longevity of the NFP’s administrators.

16This section draws heavily on Burton A. Weisbrod, The Nonprofit Economy (Cambridge, MA: Harvard Uni-
versity Press, 1988).

public goods Goods
that may be consumed
by more than one
person at the same
time with little or no
extra cost, and for
which it is expensive or
impossible to exclude
those who do not pay.

17William J. Baumol and W.G. Bowen, Performing Arts: The Economic Dilemma (Brookfield, VT: Ashgate
Publishing Co., 1993).

18 Part 1: Introduction

The Efficiency Objective in Not-for-Profit Organizations
Cost-benefit analysis has been developed to more efficiently allocate public and NFP
resources among competing uses. Because government and NFP spending is normally
constrained by a budget ceiling, the goals actually used in practice can be any one of
the following:

1. Maximize the benefits for given costs.
2. Minimize the costs while achieving a fixed level of benefits.
3. Maximize the net benefits (benefits minus costs).

Cost-benefit analysis is only one factor in the final decision, however. It does not in-
corporate many of the more subjective considerations or less easily quantifiable objec-
tives, like how fair it might be. Such matters must be introduced at a later stage in the
analysis, generally through the political process.

SUMMARY

� Managers are responsible for proactively solving
problems in the current business model, for setting
stretch goals, establishing the vision, and setting
strategy for future business, for monitoring team-
work, and integrating the operations, marketing,
and finance functions.

� Economic profit is defined as the difference between
total revenues and total economic costs. Economic
costs include a normal rate of return on the capital
contributed by the firm’s owners. Economic profits
exist to compensate investors for the risk they assume,
because of temporary disequilibrium conditions that
may occur in a market, because of the existence of
monopoly power, and as a reward to firms that are
especially innovative or highly efficient.

� As an overall objective of the firm, the shareholder
wealth-maximization model is flexible enough to
account for differential levels of risk and timing
differences in the receipt of benefits and the incur-
ring of future costs. Shareholder wealth captures
the net present value of future cash flows to owners
from positive NPV projects plus the value of em-
bedded real options.

� Managers may not always behave in a manner con-
sistent with the shareholder wealth-maximization ob-
jective. The agency costs associated with preventing
or at least mitigating these deviations from the
owner-principal’s objective are substantial.

� Changes in the firm’s performance, perhaps un-
related to a manager’s effort, combined with the
unobservable nature of their creative ingenuity pre-
sents a difficult principal-agent problem to resolve.
This combination makes it difficult for owner-
principals to know when to blame manager-
agents for weak performances versus giving them
credit for strong performances.

� Shareholder wealth maximization implies forward-
looking, long-run-oriented, dynamic strategies that
anticipate change in a risky market environment.
Managers can focus on maximizing the discounted
present value of the firm’s cash flows if three con-
ditions hold: complete markets, no asymmetric
information, and known recontracting costs. Oth-
erwise, they must attend to these complications as
well.

� Governance mechanisms (including internal moni-
toring by subcommittees appointed by boards
of directors and large creditors, internal/external
monitoring by large block shareholders, auditing
and variance analysis) can be used to mitigate
agency problems by limiting managerial discretion.

� Shareholder wealth maximization implies a firm
should be forward-looking, dynamic, and have a
long-term outlook; anticipate and manage change;
acquire strategic investment opportunities; and
maximize the present value of expected cash flows

cost-benefit analysis
A resource-allocation
model that can be used
by public sector and
not-for-profit
organizations to
evaluate programs or
investments on the
basis of the magnitude
of the discounted costs
and benefits.

Chapter 1: Introduction and Goals of the Firm 19

to owners within the boundaries of the statutory
law, administrative law, and ethical standards of
conduct.

� Shareholder wealth maximization will be difficult
to achieve when firms suffer from problems related
to incomplete markets, asymmetric information,
and unknown recontracting costs. In the absence
of these complications, managers should maximize
the present value of the discounted future net cash
flows to residual claimants—namely, equity own-
ers. If any of the complicating factors is present,
managers must first attend to those issues before
attempting to maximize shareholder wealth.

� Not-for-profit enterprises exist to supply a good or
service desired by their primary contributors.

� Public sector organizations often provide services
having significant public-good characteristics. Pub-
lic goods are goods that can be consumed by more
than one person at a time with little additional
cost, and for which excluding those who do not
pay for the goods is exceptionally difficult or pro-
hibitively expensive.

� Regardless of their specific objectives, both public
and private institutions should seek to furnish their
goods or services in the most efficient way, that is,
at the least cost possible.

Exercises 1. One of the approaches for the Southern Company to comply with the Clean Air
Act is to adopt fuel-switching technology. Do you think this strategic flexibility
would have value to Southern Company’s shareholders? Why?

2. Explain several dimensions of the shareholder-principal conflict with manager-
agents known as the principal-agent problem. To mitigate agency problems be-
tween senior executives and shareholders, should the compensation committee of
the board devote more to executive salary and bonus (cash compensation) or
more to long-term incentives? Why? What role does each type of pay play in
motivating managers?

3. Corporate profitability declined by 20 percent from 2008 to 2009. What perfor-
mance percentage would you use to trigger executive bonuses for that year?
Why? What issues would arise with hiring and retaining the best managers?

4. In the Southern Company Managerial Challenge, which alternative for complying
with the Clean Air Act creates the greatest real option value? How exactly does
that alternative save money? Why? Explain why installing a scrubber “burns” this
option.

5. In 2006, firms in the drug industry earned an average return on net worth of 22
percent, compared with an average return of 14 percent earned by over 1,400
firms followed by Value Line. Which theory or theories of profit do you think
best explain(s) the performance of the drug industry?

6. In the context of the shareholder wealth-maximization model of a firm, what
is the expected impact of each of the following events on the value of the firm?
Explain why.
a. New foreign competitors enter the market.
b. Strict pollution control requirements are enacted.
c. A previously nonunion workforce votes to unionize.
d. The rate of inflation increases substantially.
e. A major technological breakthrough is achieved by the firm, reducing its

costs of production.

Answers to the exercises
in blue can be found in
Appendix D at the back

of the book.

20 Part 1: Introduction

7. In 2008–2009, the price of jet and diesel fuel used by air freight companies de-
creased dramatically. As the CEO of FedEx, you have been presented with the fol-
lowing proposals to deal with the situation:
a. Reduce shipping rates to reflect the expense reduction.
b. Increase the number of deliveries per day in some markets.
c. Make long-term contracts to buy jet fuel and diesel at a fixed price for the

next two years and set shipping rates to a level that will cover these costs.
Evaluate these alternatives in the context of the decision-making model presented
in the text.

8. How would each of the following actions be expected to affect shareholder
wealth?
a. Southern Company adopts fuel-switching technology at its largest power

plants.
b. Ford Motor Company pays $2.5 billion for Jaguar.
c. General Motors offers large rebates to stimulate sales of its automobiles.
d. Rising interest rates cause the required returns of shareholders to increase.
e. Import restrictions are placed on the French competitors of Napa wineries.
f. There is a sudden drop in the expected future rate of inflation.
g. A new, labor-saving machine is purchased by Wonder Bread and results in

the layoff of 300 employees.

Case
Exercises DESIGNING A MANAGERIAL INCENTIVES

CONTRACT
Specific Electric Co. asks you to implement a pay-for-performance incentive contract
for its new CEO. The CEO can either work really hard with a personal opportunity
cost of $200,000 in reduced personal entrepreneurship and increased stress-related
health care costs or she can reduce her effort, thereby avoiding the personal costs.
The CEO faces three possible outcomes: the probability of her company experiencing
good luck is 30 percent, medium luck is 40 percent, and bad luck is 30 percent. Al-
though the management team can distinguish the three “states” of luck as the quarter
unfolds, the Compensation Committee of the Board of Directors (and the share-
holders) cannot do so. Once the board designs an incentive contract, the CEO decides
to expend high or low work effort, and soon thereafter the good, medium, or bad luck
occurs. One of the observable shareholder values listed below then results.

SHAREHOLDER VALUE

GOOD LUCK
(30%)

MEDIUM
LUCK (40%)

BAD LUCK
(30%)

High CEO Effort $1,000,000,000 $800,000,000 $500,000,000

Low CEO Effort $ 800,000,000 $500,000,000 $300,000,000

Chapter 1: Introduction and Goals of the Firm 21

Assume the company has 10 million shares outstanding offered at a $65 initial
share price, implying a $650,000,000 initial shareholder value. Since the CEO’s effort
and the company’s luck are unobservable to the owners and company directors, it is
not possible when the company’s share price falls to $50 and the company’s value to
$500,000,000 to distinguish whether the company experienced low CEO effort and
medium luck or high CEO effort and bad luck. Similarly, it is not possible to distin-
guish low CEO effort and good luck from high CEO effort and medium luck.

Answer the following questions from the perspective of a member of the Compen-
sation Committee of the board of directors who is aligned with shareholders’ interests
and is deciding on a performance-based pay plan (an “incentive contract”) for the
CEO.

Questions
1. What is the maximum amount it would be worth to shareholders to elicit high

CEO effort all of the time rather than low CEO effort all of the time?
2. If you decide to pay 1 percent of this amount (in Question 1) as a cash bonus,

what performance level (what share price or shareholder value) in the table
should trigger the bonus? Suppose you decide to elicit high CEO effort when,
and if, medium luck occurs by paying a bonus should the company’s value rise
to $800,000,000. What criticism can you see of this incentive contract plan?

3. Suppose you decide to elicit high CEO effort when, and if, good luck occurs by
paying a bonus only for an increase in the company’s value to $1,000,000,000.
What criticism can you see of this incentive contract plan?

4. Suppose you decide to elicit high CEO effort when, and if, bad luck occurs by
paying the bonus when the company’s value falls to $500,000. What criticism
can you see of this incentive contract plan?

5. In an effort to identify the share price that should trigger a bonus, the payment
for the CEO, and maximize shareholder value, how much would you, the Com-
pensation Committee, be willing to pay an auditor to examine the expense and
revenue flows in real time and deliver perfect forecasting information about the
“luck” the firm is experiencing? Compare shareholder value with this perfect in-
formation relative to the best choice among the cash bonus plans in Questions 2,
3, and 4.

6. Design a stock option-based incentive plan to elicit high effort. Show that 1 mil-
lion stock options at a $70 exercise price improves shareholder value relative to
the best of the cash bonus plans in Questions 2, 3, or 4.

7. Design an incentive plan that seeks to elicit high effort by granting restricted
stock. Show that one-half million shares granted at $70 improves shareholder
value relative to all prior alternatives.

8. Financial audits are basically sampling procedures to verify with a predetermined
accuracy the sources and uses of the company receipts and expenditures; the
larger the sample, the higher the accuracy. What’s the maximum amount the
Compensation Committee of the board will be willing to pay for a perfect forecast
if it were possible for the auditors to distinguish good from medium luck? What
about medium from bad luck?

22 Part 1: Introduction

SHAREHOLDER VALUE OF WIND POWER
AT HYDRO CO.:18 RE < C Wind farms and massive solar collector arrays are spreading across the globe. Wind produces enough electricity today in the United States to completely power 2 million homes. Wind and solar energy together provide less than 1 percent of the electric power worldwide, but already much more in some locations—for example, 19 percent in Denmark and 15 percent in Germany. Hydro, a Norwegian aluminum company, has established wind turbine pilot projects where entire communities are electricity self-sufficient. At 80 meters of elevation, class 3 wind energy (steady 22 kph breeze) is available almost everywhere on the planet, implying wind power potential world- wide of 72 million megawatts. Harvesting just the best 5 percent of this wind energy (3.6 million megawatts) would make it possible to retire several thousand coal-fired power plants, 617 of which operate in the United States today.19 Britain’s 2008 Re- newable Energy Strategy calls for renewable energy to account for 47 percent of total electricity output by 2020, 19 percent from offshore and 13 percent from onshore wind power.

So-called “alternative energy” is: (1) renewable, (2) in abundant local supply, and
(3) generates a low carbon footprint. Renewables are naturally replenishing sources
including wind, solar, hydro, biofuel, biomass, geothermal, tidal, ocean current, and
wave energy. Nuclear energy is not renewable because of the waste disposal issues.
To date, by far the most successful renewables are hydroelectric power plants and
ethanol-based biofuels, each accounting for about 2 percent of energy worldwide.
New sources of renewable energy such as wind and solar power are often judged
against fuel oil at $15, natural gas at $6, and coal at $4 per million BTUs (see Figure
1.4). One ton of plentiful high-sulfur-content coal generates approximately a mega-
watt of electricity and a ton of carbon dioxide (CO2). In 2008, the European Union’s
cap-and-trade legislation to reduce carbon emissions imposed a $23 per ton addi-
tional CO2 emissions charge atop the $85 purchase price of coal. Finding renewable
energy sources that have full costs lower than coal’s $23 + $85 = $108 for a megawatt
hour (RE < C) is a reasonable objective of energy policy.

Why pursue wind and solar power rather than other alternative energy sources? Nu-
clear energy has a decades-long timeline for construction and permitting especially of
nuclear waste disposal sites. Corn-based ethanol runs up the cost of animal feedstocks
and raises food prices. In addition, corn contains only one-eighth the BTUs of sugar-
cane, which is in abundant supply in the Caribbean and Brazil. Unfortunately, the U.S.
Congress has placed a $0.54 per gallon tariff on sugarcane-based ethanol. Natural gas is
80 percent cleaner than coal and extraordinarily abundant in the United States, the
world’s biggest energy user at 21 million barrels per day (mbd), 13 mbd being imported.

18Based on Frederick Harris, Alternative Energy Symposium, Wake Forest University (September 19,
2008).
19Older, smaller 500-megawatt coal-fired plants have adopted little pollution abatement technology. Nu-
clear power plants are much larger, generating typically 2,000 megawatts of electricity. Duke Power’s Be-
lews Creek plant at 2,200 megawatts is one of the largest coal-fired power plants in the United States (see
Figure 1.1). Following the installation of a $450-million smokestack scrubber, it is also one of the cleanest.
20France has added another €17 ($24) per ton of CO2 emissions tax on households and businesses using
coal-based and oil-based electricity. See “France Moves to Levy Carbon Tax on Fossil Fuels,” Wall Street
Journal (September 11, 2009), p. A10.

Chapter 1: Introduction and Goals of the Firm 23

The United States contains almost 30 percent of the known deposits worldwide of nat-
ural gas (and coal) but only 3 percent of the proven reserves of crude oil.

A 0.6 megawatt wind turbine that costs $1.2 million today will generate $4.4 mil-
lion in discounted net present value of electricity over a 15-year period, sufficient to
power 440 Western European or American households with 100 percent capacity uti-
lization and continuous 15 mph wind.21 Mechanical energy in the turbine is con-
verted directly into electrical potential energy with a magnetic coil generator. When
the wind does not blow, Hydro has demonstrated and patented a load-shifting tech-
nology that consists of a hydrolysis electrolyzer splitting water into oxygen and hydro-
gen, a hydrogen storage container, and a fuel cell to convert the hydrogen chemical
energy back to electrical current (see Figure 1.5). With the three extra pieces of equip-
ment, the capital investment rises from $1.2 million to $2.7 million. Even so, wind
power can be quite profitable with full cost recovery periods as short as seven years
under ideal operating conditions.

Of course, frequently the operating conditions with wind power are far less than
ideal. Despite the presence of wind at elevation across the globe, few communities
want 80+ meter wind turbines as tall as a football field in their backyard sight lines.
Lower installations result in less wind and therefore less electricity. In addition, the
conversion of one form of energy to another always burns energy. In Hydro’s load-
shifting process of converting mechanical energy from the turbine to chemical energy
in the electrolyzer and then to electrical energy in the hydrogen fuel cell, about 30
percent of the maximum energy coming directly to the electrical grid from the tur-
bine’s generator when the wind is blowing hard and steady is lost. Experiments in
many wind conditions at the Utsira site suggest that baseline output of Hydro’s pilot
project in Norway has a maximum energy conversion factor (CF) of 70 percent with
60 percent more typical. Even lower 45 percent CFs are expected in typical operating
conditions elsewhere. Seventy percent CF realizes $3.1 million of electricity.

FIGURE 1.4 RE < C? Renewable Energy Less Than Coal Cost?

1999 2001 2003 2005

Coal

Natural
gas

USD price per million BTU

Fuel oil

2007 2009
5
10
15
20

Source: Thomson Datastream; U.S. Energy Information Administration.

21600,000 kilowatt hours × $0.11 average electricity rates × 24 hours × 365 days equals $578,160 per year
for 15 years of expected working life of the turbine. Based on “Hydro: From Utsira to Future Energy Solu-
tions,” Ivey School of Business, Case #906M44, 2006.

24 Part 1: Introduction

Questions
1. Should Hydro as an aluminum producer invest in wind power in light of the

Utsira pilot project? Why or why not?
2. Should value-maximizing managers more generally invest in wind power? Why

or why not?
3. Larger-scale turbines increase the electricity more than proportionately to the in-

crease in costs. A 1 megawatt turbine costs $2.5 million, with the remaining
equipment costs unchanged, for a total required investment of $4 million to
power approximately 760 households. Electricity revenue over 15 years rises to
$7.2 million in discounted present value. What conversion factor allows cost re-
covery of this larger-scale turbine?

4. If the net present value of the Utsira project is negative, yet Hydro goes ahead
and funds the investment anyway, what ethical obligations does Hydro have to its
shareholders?

5. On what basis could shareholder value possibly rise if Hydro invests in wind
power? Would more or less disclosure to financial analysts improve the chances
of this outcome?

6. In 2009, 41 percent of all energy consumption in the United States comes from
electric power generation. Coal provides the preponderant fuel (51 percent), with
nuclear power (21 percent) and natural gas (17 percent) providing most of the
rest. Renewable energy provides only 9 percent. Recently, T. Boone Pickens pro-
posed converting the trucking fleet in the United States to liquefied natural
gas (LNG) and using wind power to replace the missing LNG in electric power
production. What issues do you see that must be resolved before the Pickens
plan could be adopted?

FIGURE 1.5 Wind Turbine Cost Recovery: Wind-to-H2 Load-Shift Technology

Wind
Turbine

(0.6 MWh)

Electrolyzer
H2O → H2 + O

H2 Fuel Cell
H2 + O → H2O

Hydro’s
Patented

Control &
Regulating

System

H2
Storage

Electric
Power
Grid

80%→ $3.5 mil
70% → $3.1 mil
60%→ $2.6 mil

$2.7 mil Investment

CF:

Chapter 1: Introduction and Goals of the Firm 25

2
C H A P T E R

Fundamental Economic
Concepts
CHAPTER PREVIEW A few fundamental microeconomic concepts provide
cornerstones for all of the analysis in managerial economics. Four of the most
important are demand and supply, marginal analysis, net present value, and the
meaning and measurement of risk. We will first review how the determinants of
demand and supply establish a market equilibrium price for gasoline, crude oil,
and hybrid electric cars. Marginal analysis tools are central when a decision
maker is seeking to optimize some objective, such as maximizing cost savings
from changing a lightbulb (e.g., from normal incandescent to compact
fluorescent [CFL]). The net present value concept makes directly comparable
alternative cash flows occurring at different points in time. In so doing, it
provides the linkage between the timing and risk of a firm’s projected profits
and the shareholder wealth-maximization objective. Risk-return analysis is
important to an understanding of the many trade-offs that managers must
consider as they introduce new products, expand capacity, or outsource overseas
in order to increase expected profits at the risk of greater variation in profits.

Two appendices elaborate these topics for those who want to know more analytica

details and seek exposure to additional application tools. Appendix C develops the
relationship between marginal analysis and differential calculus. Web Appendix F
shows how managers incorporate explicit probability information about the risk of
various outcomes into individual choice models, decision trees, risk-adjusted
discount rates, simulation analysis, and scenario planning.

MANAGERIAL CHALLENGE
Why Charge $25 per Bag on Airline Flights?

In May 2008, American Airlines (AA) announced that it
would immediately begin charging $25 per bag on all A

flights, not for extra luggage but for the first bag! Crude
oil had doubled from $70 to $130 per barrel in the previ-
ous 12 months, and jet fuel prices had accelerated even
faster. AA’s new baggage policy applied to all ticketed
passengers except first class and business class. On top
of incremental airline charges for sandwiches and snacks

introduced the previous year, this new announcement
stunned the travel public. Previously, only a few deep-
discount U.S. carriers with very limited route structures
such as People Express had charged separately for both
food and baggage service. Since American Airlines and
many other major carriers had belittled that policy as
part of their overall marketing campaign against deep
discounters, AA executives faced a dilemma.

Cont.

DEMAND AND SUPPLY: A REVIEW
Demand and supply simultaneously determine equilibrium market price (Peq).

Peq

equates the desired rate of purchase Qd/t with the planned rate of sale Qs/t. Both con-
cepts address intentions—that is, purchase intentions and supply intentions. Demand is
therefore a potential concept often distinguished from the transactional event of “units
sold.” In that sense, demand is more like the potential sales concept of customer traffic
than it is the accounting receivables concept of revenue from completing an actual sale.
Analogously, supply is more like scenario planning for operations than it is like actual

Jet fuel surcharges had recovered the year-over-yea

average variable cost increase for jet fuel expenses, but
incremental variable costs (the marginal cost) re-
mained uncovered. A quick back-of-the-envelope calcu-
lation outlines the problem. If total variable costs for a
500-mile flight on a 180-seat 737-800 rise from $22,00

in 2007 Q2 to $36,000 in 2008 Q2 because of $14,000 of
additional fuel costs, then competitively priced carriers
would seek to recover $14,000/180 = $78 per seat in
jet fuel surcharges. The average variable cost rise of
$78 would be added to the price for each fare class.
For example, the $188 Super Saver airfare restricted to
14-day advance purchase and Saturday night stay overs
would go up to $266. Class M airfares requiring 7-day
advance purchase but no Saturday stay overs would rise
from $289 to $367. Full coach economy airfares without
purchase restrictions would rise from $419 to $497, and
so on.

The problem was that by 2008 Q2, the marginal cost
for jet fuel had risen to approximately $1 for each
pound transported 500 miles. Carrying an additional
170-pound passenger in 2007 had resulted in $45 of
additional fuel costs. By May 2008, the marginal fuel
cost was $170 – $45 = $125 higher! So although the
$78 fuel surcharge was offsetting the accounting expense
increase when one averaged in cheaper earlier fuel pur-
chases, additional current purchases were much more
expensive. It was this much higher $170 marginal cost
that managers realized they should focus upon in decid-
ing upon incremental seat sales and deeply discounted
prices.

And similarly, this marginal $1 per pound for
500 miles became the focus of attention in analyzing bag-
gage cost. A first suitcase was traveling free under the
prior baggage policy as long as it weighed less than 42
pounds. But that maximum allowed suitcase imposed
$42 of marginal cost in May 2008. Therefore, in

mid-2008, American Airlines (and now other major car-
riers) announced a $25 baggage fee for the first bag in
order to cover the marginal cost of the representative
suitcase on AA, which weighs 25.4 pounds.

Discussion Questions

� How should the airline respond when
presented with an overweight bag (more than
42 pounds)?

� Explain whether or not each of the following
should be considered a variable cost that in-
creases with each additional airline seat sale:
baggage costs, crew costs, commissions on
ticket sales, airport parking costs, food costs,
and additional fuel costs from passenger
weight.

� If jet fuel prices reverse their upward trend and
begin to decline, fuel surcharges based on av-
erage variable cost will catch up with and sur-
pass marginal costs. How should the airlines
respond then?

MANAGERIAL CHALLENGE Continued

Chapter 2: Fundamental Economic Concepts 27

production, distribution, and delivery. In addition, supply and demand are explicitly
rates per unit time period (e.g., autos per week at a Chevy dealership and the aggregate
purchase intentions of the households in the surrounding target market). Hence, Peq is a
market-clearing equilibrium concept, a price that equates the flow rates of intended pur-
chase and planned sale.

When the order flow to buy at a given price (Qd/t) in Figure 2.1 just balances against
the order flow to sell at that price (Qs/t), Peq has emerged, but what ultimately deter-
mines this metric of “value” in a marketplace? Among the earliest answers can be found
in the Aristotelian concept of intrinsic use value. Because diamonds secure marriage
covenants and peace pacts between nations, they provide enormous use value and should
therefore exhibit high market value. The problem with this theory of value taken alone
arises when one considers cubic zirconium diamonds. No one other than a jewel mer-
chant can distinguish the artificial cubic zirconium from the real thing, and therefore
the intrinsic uses of both types are identical. Yet, cubic zirconium diamonds sell for
many times less than natural stones of like grade and color. Why? One clue arose at
the end of the Middle Ages, when Catholic monasteries produced beautiful hand-
copied Bibles and sold them for huge sums (i.e., $22,000 in 2010 dollars) to other mon-
asteries and the nobility. In 1455, Johannes Guttenberg offered a “mass produced”
printed facsimile that could be put to exactly the same intrinsic use, and yet, the market
value fell almost one-hundred-fold to $250 in 2010 dollars. Why?

Equilibrium market price results from the interaction of demanders and suppliers in-
volved in an exchange. In addition to the use value demanders anticipate from a product,
a supplier’s variable cost will also influence the market price observed. Ultimately, there-
fore, what minimum asking price suppliers require to cover their variable costs is just as
pivotal in determining value in exchange as what maximum offer price buyers are willing
to pay. Guttenberg Bibles and cubic zirconium diamonds exchange in a marketplace at
lower “value” not because they are intrinsically less useful than prior copies of the Bible

FIGURE 2.1 Demand and Supply Determine the Equilibrium Market Pri

Equilibrium
price ($/unit)

Peq

Planned rate
of sale

Desired rate
of purchase

Qdt = Q
s
t

Quantity (units/time)

28 Part 1: Introduction

or natural stones but simply because the bargain struck between buyers and sellers of
these products will likely be negotiated down to a level that just covers their lower vari-
able cost plus a small profit. Otherwise, preexisting competitors are likely to win the
business by asking less.

Even when the cost of production is nearly identical and intrinsic use value is nearly
identical, equilibrium market prices can still differ markedly. One additional determinant
of value helps to explain why. Market value depends upon the relative scarcity of re-
sources. Hardwoods are scarce in Japan but plentiful in Sweden. Even though the cost
of timber cutting and sawmill planing is the same in both locations, hardwood trees
have scarcity value as raw material in Japan that they do not have in Sweden where
they are plentiful. To take another example, whale oil for use in lamps throughout the
nineteenth and early twentieth centuries stayed at a nearly constant price until whale
species began to be harvested at rates beyond their sustainable yield. As whale resources
became scarcer, the whalers who expended no additional cost on better equipment or
longer voyages came home with less oil from reduced catches. With less raw material
on the market, the input price of whale oil rose quickly. Consequently, despite un-
changed other costs of production, the scarcer input led to a higher final product price.
Similar results occur in the commodity market for coffee beans or orange juice when
climate changes or insect infestations in the tropics cause crop projections to decline
and scarcity value to rise.

Example Discovery of Jojoba Bean Causes a Collapse of
Whale Oil Lubricant Prices

Until the last decade of the twentieth century, the best-known lubricant for high-
friction machinery with repeated temperature extremes like fan blades in aircraft
jet engines, contact surfaces in metal cutting tools, and gearboxes in auto transmis-
sions was a naturally occurring substance—sperm whale oil. In the early 1970s, the
United States placed sperm whales on the endangered species list and banned their
harvest. With the increasing scarcity of whales, the world market price of whale oil
lubricant approached $200 per quart. Research and development for synthetic oil
substitutes tried again and again but failed to find a replacement. Finally, a Califor-
nia scientist suggested the extract of the jojoba bean as a natural, environmentally
friendly lubricant. The jojoba bean grows like a weed throughout the desert of the
southwestern United States on wild trees that can be domesticated and cultivated
to yield beans for up to 150 years.

After production ramped up from 150 tons in 1986 to 700 tons in 1995,
solvent-extracted jojoba sold for $10 per quart. When tested in the laboratory,
jojoba bean extract exhibits some lubrication properties that exceed those of whale
oil (e.g., thermal stability over 400°F). Although 85 to 90 percent of jojoba bean
output is used in the production of cosmetics, the confirmation of this plentiful
substitute for high-friction lubricants caused a collapse in whale lubricant prices.
Sperm whale lubricant has the same cost of production and the same use value as
before the discovery of jojoba beans, but the scarcity value of the raw material in-
put has declined tenfold. Consequently, a quart of sperm whale lubricant now sells
for under $20 per quart.

1Based on “Jojoba Producers Form a Marketing Coop,” Chemical Marketing Reporter (January 8, 1995), p. 10.

Chapter 2: Fundamental Economic Concepts 29

The Diamond-Water Paradox and the Marginal Revolution
So equilibrium price in a marketplace is related to (1) intrinsic use value, (2) production
cost, and (3) input scarcity. In addition, however, most products and services have more
than one use and more than one method of production. And often these differences re-
late to how much or how often the product has already been consumed or produced. For
example, the initial access to e-mail servers or the Internet for several hours per day is
often essential to maintaining good communication with colleagues and business associ-
ates. Additional access makes it possible to employ search engines such as Google for
information related to a work assignment. Still more access affords an opportunity to
meet friends in a chat room. Finally, some households might purchase even more hours
of access on the chance that a desire to surf the Web would arise unexpectedly. Each of
these uses has its own distinct value along a continuum starting with necessities and end-
ing with frivolous non-essentials. Accordingly, what a customer will pay for another
hour of Internet access depends on the incremental hour in question. The greater the
utilization already, the lower the use value remaining.

This concept of a marginal use value that declines as the rate of consumption increases
leads to a powerful insight about consumer behavior. The question was posed: “Why
should something as essential to human life as water sell for low market prices while
something as frivolous as cosmetic diamonds sell for high market prices?” The initial an-
swer was that water is inexpensive to produce in most parts of the world while diamonds
require difficult search and discovery, expensive mining, and extensive transportation and
security expenses. In other words, diamonds cost more than water, so minimum asking
prices of suppliers dictate the higher market value observed for diamonds. However, recall
that supply is only one of what Alfred Marshall famously called “two blades of the scis-
sors” representing demand and supply. You can stab with one blade but you can’t cut
paper, and using supply alone, you can’t fully explain equilibrium market price.

The diamond-water paradox was therefore restated more narrowly: “Why should con-
sumers bid low offer prices for something as essential as water while bidding high offer
prices for something as frivolous as diamonds?” The resolution of this narrower paradox
hinges on distinguishing marginal use value (marginal utility) from total use value (total
utility). Clearly, in some circumstances and locales, the use value of water is enormous.
At an oasis in the desert, water does prevent you from thirsting to death. And even in
the typical city, the first couple of ounces of some liquid serve this same function, but
that’s the first couple of ounces. The next couple of dozen gallons per day remain at
high use value for drinking, flushing indoor plumbing, cooking, body washing, and so
forth. Thereafter, water is used for clothes washing, landscape watering, car washing,
and sundry lesser purposes. Indeed, if one asks the typical American household (which
consumes 80–100 gallons per person per day) to identify its least valuable use of water
each day, the answer may come back truly frivolous—perhaps something like the water
that runs down the sink drain while brushing teeth. In other words, the marginal use
value of water in most developed countries is the water that saves the consumer the in-
convenience of turning the water taps (on and off) twice rather than just once. And it is
this marginal use value at the relevant margin, not the total utility across all uses, that
determines a typical water consumer’s meager willingness to pay.

Marginal Utility and Incremental Cost Simultaneously

Determine Equilibrium Market Price
Alfred Marshall had it right: demand and supply do simultaneously determine market
equilibrium price. On the one hand, marginal utility determines the maximum offer

marginal use value The
additional value of the
consumption of one
more unit; the greater
the utilization already,
the lower the use value
remaining.

marginal utility The
use value obtained
from the last unit
consumed.

30 Part 1: Introduction

price consumers are willing to pay for each additional unit of consumption on the de-
mand side of the market. On the other hand, variable cost at the margin (an incremental
cost concept sometimes referred to as “marginal cost”) determines the minimum asking
price producers are willing to accept for each additional unit supplied. Water is both
cheaper to produce and more frivolous than diamonds at the relevant margin, and hence
water’s market equilibrium price is lower than that of diamonds. Figure 2.2 illustrates
this concept of marginal use value for water varying from the absolutely essential first
few ounces to the frivolous water left running while brushing one’s teeth.

At the same time, the marginal cost of producing water remains low throughout the 90-
gallon range of a typical household’s consumption. In contrast, diamonds exhibit steeply
rising marginal cost even at relatively small volume, and customers continue to employ cos-
metic diamonds for highly valuable uses even out to the relevant margin (one to three car-
ats) where typical households find their purchases occurring. Therefore, diamonds should
trade for equilibrium market prices that exceed the equilibrium market price of water.

Individual and Market Demand Curves
We have seen that the market-clearing equilibrium price (Peq) that sets the desired rate
of purchase (Qd/t) equal to the planned rate of sale (Qs/t) is simultaneously both the
maximum offer price demanders are willing to pay (the “offer”) and the minimum ask-
ing price sellers are willing to accept (the “ask”). But what determines the desired rate of
purchase Qd/t and planned rate of sales Qs/t? The demand schedule (sometimes called
the “demand curve”) is the simplest form of the demand relationship. It is merely a list
of prices and corresponding quantities of a commodity that would be demanded by
some individual or group of individuals at uniform prices. Table 2.1 shows the demand
schedule for regular-size pizzas at a Pizza Hut restaurant. This demand schedule

FIGURE 2.2 The Diamond-Water Paradox Resolved

Equilibrium
price ($/unit)

Offer
pricew = f(M.U.w)

P
d
eq

Pw
eq

Sdiamonds

Swater

Dwater

Ddiamonds

Quantity
(gallons/day)

(carats/lifetime)

2 carats 90 gallons

Asking
priced = g(M.C.d)

Chapter 2: Fundamental Economic Concepts 31

indicates that if the price were $9.00, customers would purchase 60 per night. Note that
the lower the price, the greater the quantity that will be demanded. This is the strongest
form of the law of demand—if a product or service is income superior, a household will
always purchase more as the relative price declines.

The Demand Function
The demand schedule (or curve) specifies the relationship between prices and quantity
demanded, holding constant the influence of all other factors. A demand function speci-
fies all these other factors that management will often consider, including the design and
packaging of products, the amount and distribution of the firm’s advertising budget, the
size of the sales force, promotional expenditures, the time period of adjustment for any
price changes, and taxes or subsidies. As detailed in Table 2.2, the demand function for
hybrid-electric or all-electric autos can be represented as

QD = f ðP, PS, PC, Y, A, AC, N, CP, PE, TA, T=S …Þ [2.1]
where QD = quantity demanded of (e.g., Toyota Prius or Chevy Volt)

P = price of the good or service (the auto)

PS = price of substitute goods or services (e.g., the popular gasoline-powered
Honda Accord or Chevy Malibu)

PC = price of complementary goods or services (replacement batteries)

Y = income of consumers

A = advertising and promotion expenditures by Toyota, Honda, and General
Motors (GM)

AC = competitors’ advertising and promotion expenditures

N = size of the potential target market (demographic factors)

CP = consumer tastes and preferences for a “greener” form of transportation

PE = expected future price appreciation or depreciation of hybrid autos

TA = purchase adjustment time period

T/S = taxes or subsidies on hybrid autos

The demand schedule or demand curve merely deals with the price-quantity relation-
ship itself. Changes in the price (P) of the good or service will result only in movement
along the demand curve, whereas changes in any of the other demand determinants in the
demand function (PS, PC, Y, A, AC, N, CP, PE, and so on) shift the demand curve. This is
illustrated graphically in Figure 2.3. The initial demand relationship is line DD 0. If the

TABLE 2.1 SIMPLIFIED DEMAND SCHEDULE: PIZZA HUT RESTAURANT

PRICE OF PIZZA

($/UNIT)

QUANTITY OF PIZZAS SOL

(UNITS PER TIME PERIOD)

100

demand function
A relationship between
quantity demanded and
all the determinants of
demand.

substitute goods
Alternative products
whose demand
increases when the
price of the focal
product rises.

complementary goods
Complements in
consumption whose
demand decreases
when the price of the
focal product rises.

32 Part 1: Introduction

FIGURE 2.3 Shifts in Demand

Price
($/unit)

Quantity (units)

Q1 Q2 Q3 Q

D�

D�2

D�1

TABLE 2.2 PARTIAL LIST OF FACTORS AFFECTING DEMAND

DEMAND FACTOR EXPECTED EFFECT

Increase (decrease) in price of substitute goodsa (PS) Increase (decrease) in demand (QD)

Increase (decrease) in price of complementary goodsb (PC)

Decrease (increase) in QD

Increase (decrease) in consumer income levelsc (Y)

Increase (decrease) in QD

Increase (decrease) in the amount of advertising
and marketing expenditures (A)

Increase (decrease) in QD

Increase (decrease) in level of advertising and marketing
by competitors (AC)

Decrease (increase) in QD

Increase (decrease) in population (N) Increase (decrease) in QD

Increase (decrease) in consumer preferences
for the good or service (CP)

Increase (decrease) in QD

Expected future price increases (decreases) for the good (PE) Increase (decrease) in QD

Time period of adjustment increases (decreases) (TA) Increase (decrease) in QD

Taxes (subsidies) on the good increase (decrease) (T/S) Decrease (increase) in QD

aTwo goods are substitutes if an increase (decrease) in the price of Good 1 results in an increase
(decrease) in the quantity demanded of Good 2, holding other factors constant, such as the price of
Good 2, other prices, income, and so on, or vice versa. For example, margarine may be viewed as a
rather good substitute for butter. As the price of butter increases, more people will decrease their con-
sumption of butter and increase their consumption of margarine.
bGoods that are used in conjunction with each other, either in production or consumption, are called
complementary goods. For example, DVDs are used in conjunction with DVD players. An increase in
the price of DVD players would have the effect of decreasing the demand for DVDs, ceteris paribus.
In other words, two goods are complementary if a decrease in the price of Good 1 results in an in-
crease in the quantity demanded of Good 2, ceteris paribus. Similarly, two goods are complements if an
increase in the price of Good 1 results in a decrease in the quantity demanded of Good 2.
cThe case of inferior goods—that is, those goods that are purchased in smaller total quantities as income
levels rise—will be discussed in Chapter 3.

Chapter 2: Fundamental Economic Concepts 33

original price were P1, quantity Q1 would be demanded. If the price declined to P2, the
quantity demanded would increase to Q2. If, however, changes occurred in the other deter-
minants of demand, we would expect to have a shift in the entire demand curve. If, for ex-
ample, a subsidy to hybrids were enacted, the new demand curve might become D1D

0
1. At

any price, P1, along D1D
0
1, a greater quantity, Q3, will be demanded than at the same price

before the subsidy on the original curve DD0. Similarly, if the prices of substitute products
such as the Honda Accord or Chevy Malibu were to decline sharply, the demand curve
would shift downward and to the left. At any price, P1, along the new curve D2

0D2, a smal-
ler quantity, Q4, would be demanded than at the same price on either DD

0 or D1D01.
In summary, movement along a demand curve is often referred to as a change in the

quantity demanded, while holding constant the effects of factors other than price that de-
termine demand. In contrast, a shift of the entire demand curve is often referred to as a
change in demand and is always caused by some demand determinant other than price.

Import-Export Traded Goods
In addition to the previous determinants of demand, the demand for goods traded in for-
eign markets is also influenced by external factors such as exchange rate fluctuations.
When Microsoft sells computer software overseas, it prefers to be paid in U.S. dollars.
This is because a company like Microsoft incurs few offshore expenses beyond advertising
and therefore cannot simply match payables and receivables in a foreign currency. To ac-
cept euros, Japanese yen, or Australian dollars in payment for software purchase orders
would introduce an exchange rate risk exposure for which Microsoft would want to be
compensated in the form of higher prices on its software. Consequently, the foreign ex-
ports of Microsoft are typically transacted in U.S. dollars and are therefore tied inextricably
to the price of the dollar against other currencies. As the value of the dollar rises, offshore
buyers must pay a larger amount of their own currency to obtain the U.S. dollars required
to complete a purchase order for Microsoft’s software, and this decreases the export
demand. Even in a large domestic market like the United States, companies often find
that these export demand considerations are key determinants of their overall demand.

Example Exchange Rate Impacts on Demand:
Cummins Engine Company
Cummins Engine Company of Columbus, Indiana, is the largest independent man-
ufacturer of new and replacement diesel engines for heavy trucks and for construc-
tion, mining, and agricultural machinery. Volvo and Daimler-Benz are their major
competitors, and 53 percent of sales occur offshore. The Cummins and Daimler-
Benz large diesel truck engines sell for approximately $40,000 and €35,000, respec-
tively. In the 2002 recession, Cummins suffered substantial declines in cash flow.
One reason was obvious: diesel replacement engines are not needed when fewer
goods are being delivered, and therefore fewer diesels are wearing out.

In addition, however, between 1999 and 2002, the value of the U.S. dollar (€ per $)
increased by 30 percent from €.85/$ to €1.12/$. This meant that a $40,000 Cummins
diesel engine that had sold for €34,000 in Munich in 1999 became €44,800, whereas
the €35,000 Mercedes diesel alternative that had been selling for $41,176 in Detroit
declined to $31,250 because of the stronger U.S. dollar. Cummins faced two unattrac-
tive options, either of which would reduce its cash flow. It could either cut its profit
margins and maintain unit sales, or maintain margins but have both offshore and

(Continued)

34 Part 1: Introduction

Individual and Market Supply Curves
What determines the planned rate of sale Qs/t? Like the demand schedule, the
supply schedule is a list of prices and corresponding quantities that an individual or
group of sellers desires to sell at uniform prices, holding constant the influence of all other
factors. A number of these other determinants of supply that management will often
need to consider are detailed in Table 2.3. The supply function can be represented as

QS = f ðP, PI, PUI, T, EE, F, RC, PE, T=S … Þ [2.2]

where Qs = quantity supplied (e.g., of domestic autos)

P = price of the autos

PI = price of inputs (e.g., sheet metal)

PUI = price of unused substitute inputs (e.g., fiberglass)

T = technological improvements (e.g., robotic welding)

EE = entry or exit of other auto sellers

F = accidental supply interruptions from fires, floods, etc.

RC = costs of regulatory compliance

PE = expected (future) changes in price

TA = adjustment time period

T/S = taxes or subsidies

TABLE 2.3 PARTIAL LIST OF FACTORS AFFECTING SUPPLY

SUPPLY FACTOR
EXPECTED EFFECT AT
EVERY PRICE

Increase (decrease) in the price of inputs (PI) Decrease (increase) in supply

Increase (decrease) in the price of unused substitute inputs (PUI) Decrease (increase) in supply

Technological improvements (T) Increase in supply

Entry (Exit) of other sellers (EE) Increase (decrease) in supply

Supply disruptions (F) Decrease in supply

Increase (decrease) in regulatory costs (RC) Decrease (increase) in supply

Expected future price increases (decreases) (PE) Decrease (increase) in supply

Time period of adjustment lengthens (shortens) (TA) Increase (decrease) in supply

Taxes (subsidies) (T/S) Decrease (increase) in supply

domestic sales collapse. The company chose to cut margins and maintain sales. By
2005, the dollar’s value had eroded, returning to €.85/$, and Cummins’ sales perfor-
mance markedly improved. In the interim, demand for Cummins engines was
adversely affected by the temporary appreciation of the U.S. dollar.

In 2009, with the U.S. dollar at a still lower value of €.64/$, the Cummins Engine
Co. could barely keep up with export demand since diesels to Europe were priced at
€25,600 versus Mercedes’ €32,000. Similarly, in Cleveland, St. Louis, and Atlanta,
Cummins $40,000 diesels were up against $54,688 Mercedes substitutes. What a great
time to be an American company competing against European manufacturers.

supply function
A relationship between
quantity supplied and
all the determinants
of supply.

Chapter 2: Fundamental Economic Concepts 35

Again, changes in the price (P) of the good or service will result only in movement
along the given supply curve, whereas changes in any of the other independent variables
(PS, PC, Y, A, AC, N, CP, PE, and so on) in the function shift the supply curve. As with
demand, a movement along a supply curve is referred to as a change in the quantity sup-
plied, while holding constant other determinants of supply. A shift of the entire supply
curve is often referred to as a change in supply and is always caused by some supply
determinant other than price.

Equilibrium Market Price of Gasoline
In April–July 2008, Americans woke up to a new reality about gasoline that markedly
affected their driving habits as well as U.S. public policy. The price of a gallon of regular
octane gasoline skyrocketed from $3.00 per gallon to $4.10 (see Figure 2.4). The previous
summer, when gas prices had hovered around $3 per gallon, Americans had cut back
only slightly on non-essential driving.

In the summer of 2008, with regular gasoline at $4.10 per gallon, not only summer driving
vacations but urban commuting itself changed in extraordinary ways. Overall, customer de-
mand by the typical two-person urban household shrank from 16 gallons per week to 11.5
gallons. As a result, for the first time in U.S. history, gasoline expenditure by U.S. households
declined despite a rising price at the pump—that is, 16 gallons/week at $3 in 2007 (Q3) =
$48 > 11.5 gallons per week at $4.10 in 2008 (Q3) = $47.15.

Several determinants of demand and supply were identified as possible explanations
for the spike in gasoline’s equilibrium market price. First, much was written about the
fact that no new refinery had been built in the United States in more than 30 years, sug-
gesting that refinery capacity shortages or pipeline bottlenecks might be responsible. De-
clining capacity does shift the supply curve in Figure 2.2 to the left, which would imply a
higher equilibrium price. But no refinery closings or pipeline disruptions could be iden-
tified that summer. And the U.S. Department of Energy found refineries command only
$0.36 per gallon of the final product price of gasoline for cost recovery plus profit and

Example NAFTA and the Reduced Labor Costs of Ford
Assembly Plants in Detroit
The North American Free Trade Agreement (NAFTA) made it possible to buy
subassemblies like axles and engine blocks from Mexican suppliers like Cifunsa,
SA, without paying any import tariff when the parts arrived in the United States.
Since United Auto Worker (UAW) labor in Detroit auto assembly plants also
makes axle subassemblies, the Mexican labor input can be thought about as an
unused substitute input from the point of view of Ford Motor Company.
NAFTA in effect lowered the input cost of substitute inputs for Ford. This
means fewer employers would pursue labor contracts with UAW labor in Detroit
and instead shift some of their production south across the Mexican border. Less
demand implies lower equilibrium wages would be offered and accepted by
UAW assembly line labor. Hence, the indirect effect of NAFTA was a reduction
in the input costs for UAW labor that the Ford Motor Co. did utilize. As usual,
lower input cost implies a shift of the supply curve down and to the right, an
increase in supply.

supply curve A
relationship between
price and quantity
supplied, holding
other determinants
of supply constant.

36 Part 1: Introduction

could not therefore be responsible for the $1.10 increase in the equilibrium price between
July 2007 and July 2008.

Second, retail gas station owners were accused of gouging the driving public. Higher
markups at retail also would shift the supply curve for gasoline back to the left, raising
the equilibrium market price. But again, retail markup and indeed all gasoline marketing
were found to add only $0.28 per gallon to the $4.10 price, much less than could be re-
sponsible for the $1.10 run-up in gasoline’s equilibrium market price. Third, excise taxes
on gasoline (earmarked for road building and maintenance) are levied by both the federal
and state governments. Gasoline taxes constitute $0.41 per gallon on average across the
United States. Any new excise taxes would have shifted the supply curve leftward, result-
ing in a higher equilibrium market price for gasoline. President George Bush’s Council of
Economic Advisors in 2007 did explore levying an additional $1 per gallon tax on gaso-
line to reduce the dependence of the United States on foreign oil, but no tax increase was
ever initiated. So what was responsible for the upward spike in gasoline prices?

As we have seen, the variables in the demand and supply functions in Equations 2.1
and 2.2 determining equilibrium market price may be grouped into three broad sets
of factors affecting use value, cost of production, and resource scarcity.2 Since crude
oil inputs account for $2.96 of the $4.10 final product price of gasoline, resource scar-
city was a likely candidate to explain the increase in gasoline prices from $3 to $4.10.
Higher crude oil input prices shift the supply curve leftward, leading to higher final
product prices for gasoline. Figure 2.5 shows that the previous three times crude oil
input prices shot up, supply disruptions in the crude oil input market were involved
(i.e., during the first Gulf War in Kuwait in 1991, during an especially effective era
for the OPEC cartel 1999–2001, and during the Iraq War in 2004).

In contrast, the crude oil input price rise from $40 to $80 per barrel in 2006–2007
reflected demand-side increased usage especially by India and China. India and China
are only 9 percent of the 85 million barrels per day (mbd) worldwide crude oil market
but these two countries have been growing very quickly. A 2 to 3 percent additional

FIGURE 2.4 Average Gas Prices in the United States

2005

0.50

1.00

1.50

2.00

2.50

3.00

3.50

$4.00

$2.90 $2.80 $3.00

$4.

2006 2007 2008

Source: AAA Carolinas.

2Two additional factors are speculation and government intervention in the form of taxes, subsidies, and
regulations.

Chapter 2: Fundamental Economic Concepts 37

demand can significantly raise equilibrium prices for crude oil resources because at any
point in time there is a very thin inventory (8–10 days supply) working its way through
the distribution network from wells to pumps to terminals to tankers to refineries. By
late 2007, crude oil input prices were rising beyond $80 per barrel. As gasoline headed
toward $4.10 per gallon in the United States, $9.16 per gallon in Germany, and $8.80 per
gallon in Great Britain, Western drivers substantially cut back consumption. Brazil
approached $6.40 per gallon and pursued a successful energy independence campaign
focused on sugar cane-based ethanol plants.

Was the $80 price in late 2007 the highest price ever in the crude oil input market
prior to that time? The answer is “no.” In 1981, the equilibrium crude oil price reached
$36 per barrel. Using the U.S. consumer price index (CPI), since crude oil transactions
worldwide are denominated in U.S. dollars, cumulative price increases between 1981 and
2007 total 228.8 percent, so $36 × a 2.288 inflation-adjustment multiplier equals $82
in 2007, and $80/2.288 equals $35 in 1981. Consequently, the $80 crude oil price in late
2007 was in fact lower than the inflation-adjusted $36 crude price in 1981 at the height
of the influence of the OPEC II oil cartel. However, in early 2008, the equilibrium price
of crude continued to spike upward.

When the crude price climbed above $100, large numbers of speculators acquired
long positions in the crude oil futures market betting on a further price rise. Speculative

FIGURE 2.5 Supply Disruptions and Developing Country Demand Fuel Crude Oil Price Spikes

1990

Gulf
War OPEC III

Iraq
War

Indian,
Chinese
demand

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

50
60
70
80
90
100

110

40
30
20
10
0

O
il

p
ri

ce
,

in
c

o
n

st
an

t
2

0
0

0
U

.S
.$

1990–2010 Real price per barrel, mean (standard deviation)

Mean
+/– 2

Standard deviations

Source: Federal Reserve Bank, St. Louis, National Economics Trends, September 2000;
FedDallas, Regional Economic Data, 2006.

38 Part 1: Introduction

demand (supply) is always motivated by the anticipation of equilibrium market prices
being higher (lower) tomorrow. Those who “go long” and buy futures contracts to take
delivery at prices agreed on today are betting the price will go up, and those who “sell
short” and write futures contracts promising to deliver in the future at prices agreed on
today are betting the other way. The net long direction of speculative trading in the first
half of 2008 added to the growing market demand from India and China and drove the
crude oil equilibrium price still higher, eventually reaching $146 per barrel in July 2008.

Faced with $4.10 per gallon gasoline, as ExxonMobil and Shell sought to recover their
extraordinary input costs for crude, American consumers decided to vacate their SUVs,
join carpools, and ride the buses and trains to work. Urban mass transit system ridership
shot up 20 percent in a matter of months. Other Americans purchased fuel-efficient hy-
brids like the Toyota Prius. Still others mobilized behind T. Boone Pickens’s plan to con-
vert the federal trucking fleet to natural gas. Fearing an onslaught of feasible substitutes
like hybrid electric cars and natural gas-powered trucks, the Saudis ramped up crude oil
production from their average 8.5 mbd 1990–2006 all the way to 10.5 and 10.9 mbd in
2007 and 2008 (see Figure 2.6).

FIGURE 2.6 Saudi Arabia Crude Oil Production

1970

M
il
li
o
n
s

o
f

b
ar

re
l/

d
ay

10.9

8.5

1975 1980 1985 1990 1995 2000 2005 2010

Source: U.S. Energy Information Administration.

Chapter 2: Fundamental Economic Concepts 39

With U.S. demand for gasoline declining and capacity to extract and refine expand-
ing, the equilibrium price of crude finally turned and began to decline. The late 2008
crude oil price reversal was caused by a combination of increasing supply fundamentals
(shifting the supply curve to the right), slowing demand growth, and a speculative expec-
tation that in the near term crude prices would be lower (not higher). Consequently, the
supply of crude oil (and especially of highly leveraged crude oil futures contracts) mush-
roomed. Angola doubled production capacity to 2.1 mbd, and Saudi capacity grew to
12.5 mbd. Saudi Arabia and Kuwait also broke ground on two giant new refining
facilities.

Example Speculation Sends Crude Oil Input Price on a
Roller-Coaster Ride at ExxonMobil and Shell
With reversed expectations of lower crude prices in the near term, the speculative
bubble in crude oil quickly burst. Despite 5 percent higher market demand over the
last four months of 2008 (again primarily from China and India), the equilibrium
price of crude oil plummeted more than $100 a barrel from $146 in September
2008 to a low of $40 by January 2009 (see Figure 2.7). By 2009 (Q3), the crude
price stood again at $75 per barrel, and gasoline was selling for $2.74 per gallon.
Although North American import demand for crude oil has been flat in recent
years, OPEC members clearly believe that the spectacular 22 percent demand
growth from Asian developing countries in 2000–2008 will continue. Over a two-
year period, rising Asian demand, massive capacity expansions, a worldwide finan-
cial boom, then collapse, and speculative buying followed by speculative selling had
taken oil companies and gasoline buyers on quite a roller-coaster ride.

FIGURE 2.7 Crude Oil Price, West Texas Intermediate

1999 2001 2003 2005 2007 2009
0

$
p

er
b

ar
re

l
50

100

125

150

Source: Thomson Datasteam.

40 Part 1: Introduction

MARGINAL ANALYSIS
Marginal analysis is one of the most useful concepts in microeconomics. Resource-
allocation decisions typically are expressed in terms of the marginal equilibrium
conditions that must be satisfied to attain an optimal solution. The familiar profit-
maximization rule for the firm of setting output at the point where “marginal cost equals
marginal revenue” is one such example. Long-term investment decisions (capital expen-
ditures) also are made using marginal analysis decision rules. Only if the expected return
from an investment project (that is, the marginal return to the firm) exceeds the cost of
funds that must be acquired to finance the project (the marginal cost of capital), should
the project be undertaken. Following this important marginal decision rule leads to the
maximization of shareholder wealth.

More generally, a change in the level of an economic activity is desirable if the mar-
ginal benefits exceed the marginal (that is, the incremental) costs. If we define net mar-
ginal return as the difference between marginal benefits and marginal costs, then an
equivalent optimality condition is that the level of the activity should be increased to
the point where the net marginal return is zero.

In summary, marginal analysis instructs decision makers to determine the additional
(marginal) costs and additional (marginal) benefits associated with a proposed action.
Only if the marginal benefits exceed the marginal costs (that is, if net marginal benefits
are positive) should the action be taken.

Total, Marginal, and Average Relationships
Revenue, cost, profit, and many other economic relationships can be presented using tab-
ular, graphic, and algebraic frameworks. Let us first use a tabular presentation. Suppose

Example Tenneco Shipyard Marginal Analysis
Resource-allocation decisions should be made by comparing the marginal (or
incremental) benefits of a change in the level of an activity with the incremental
costs of the change. For example, the marginal revenue benefit derived from
producing and selling one more supertanker is equal to the difference between
total revenue, assuming the additional unit is not sold, and total revenue includ-
ing the additional sale. Similarly, marginal cost is defined as the change in total
costs that occurs from undertaking some economic activity, such as the produc-
tion of an additional ship design including the opportunity costs, and therefore
may not necessarily always be equal to the cash outlays alone. Perhaps the Ten-
neco design team has an opportunity for higher net profit as subcontractors on
Boeing projects. If so, Tenneco’s routine ship-design work should be contracted
out to other shipbuilding design firms who can become a trusted subcontractor
to Tenneco.

marginal analysis
A basis for making
various economic
decisions that analyzes
the additional
(marginal) benefits
derived from a
particular decision
and compares them
with the additional
(marginal) costs
incurred.

Chapter 2: Fundamental Economic Concepts 41

Example Marginal Analysis and Capital Budgeting Decisions:
Sara Lee Corporation
The capital budgeting decision problem facing a typical firm, such as Sara Lee Cor-
poration, can be used to illustrate the application of marginal analysis decision
rules. Sara Lee has the following schedule of potential investment projects (all
assumed to be of equal risk) available to it:

PROJECT

INVESTMENT
REQUIRED
($ MILLION)

EXPECTED
RATE OF
RETURN

CUMULATIVE
INVESTMENT
($ MILLION)

A $25.0 27.0% $ 25.0

B 15.0 24.0 40.0

C 40.0 21.0 80.0

D 35.0 18.0 115.0

E 12.0 15.0 127.0

F 20.0 14.0 147.0

G 18.0 13.0 165.0

H 13.0 11.0 178.0

I 7.0 8.0 185.0

Sara Lee has estimated the cost of acquiring the funds needed to finance these
investment projects as follows:

BLOCK OF
FUNDS
($ MILLION)

COST OF
CAPITAL

CUMULATIVE FUNDS
RAISED ($ MILLION)

First $50.0 10.0% $ 50.0

Next 25.0 10.5 75.0

Next 40.0 11.0 115.0

Next 50.0 12.2 165.0

Next 20.0 14.5 185.0

The expected rate of return on the projects listed above can be thought of as the
marginal (or incremental) return available to Sara Lee as it undertakes each addi-
tional investment project. Similarly, the cost-of-capital schedule may be thought of
as the incremental cost of acquiring the needed funds. Following the marginal
analysis rules means that Sara Lee should invest in additional projects as long as
the expected rate of return on the project exceeds the marginal cost of capital funds
needed to finance the project.

Project A, which offers an expected return of 27 percent and requires an out-
lay of $25 million, is acceptable because the marginal return exceeds the mar-
ginal cost of capital (10.0 percent for the first $50 million of funds raised by
Sara Lee). In fact, an examination of the tables indicates that projects A through
G all meet the marginal analysis test because the marginal return from each of
these projects exceeds the marginal cost of capital funds needed to finance these
projects. In contrast, projects H and I should not be undertaken because they
offer returns of 11 percent and 8 percent, respectively, compared with a marginal
cost of capital of 14.5 percent for the $20 million in funds needed to finance
those projects.

42 Part 1: Introduction

that the total profit πT of a firm is a function of the number of units of output produced
Q, as shown in columns 1 and 2 of Table 2.4.

Marginal profit, which represents the change in total profit resulting from a one-unit
increase in output, is shown in column 3 of the table. (A Δ is used to represent a
“change” in some variable.) The marginal profit Δπ(Q) of any level of output Q is calcu-
lated by taking the difference between the total profit at this level πT(Q) and at one unit
below this level πT(Q − 1).

3 In comparing the marginal and total profit functions, we

Example Marginal Analysis of Driving a Mini Cooper versus a
Chevy Volt
Urban sprawl and flight to the suburbs have now resulted in the mean commuter
trip in the United States rising to 33 miles one way. With the housing density in
most American cities well below what would be required to support extensive light
rail and subway lines, the typical household must find economical ways to get at
least one worker from a suburban home to the central business district and back
each day. A fuel-efficient, small commuter car like the Mini Cooper is one alterna-
tive. Others have recently been proposed—the Chevy Volt and Nissan Leaf, both
all-electric vehicles that are recharged at the end of each 40-mile commuting trip.
Technically, the Leaf and the Volt are e-REVs, extended-range electric vehicles.
Each contains a small gasoline-driven internal combustion engine that runs an
electric generator, but unlike hybrids such as the Ford Fusion and Toyota Prius,
these e-REVs have no mechanical connection between the gasoline engine and
the drivetrain. Instead, the Chevy Volt goes 40 miles on the charge contained in
220 lithium ion (L-ion) batteries which are plugged in for a recharging cycle of
8 hours at 220 volts (or 3 hours at 110 volts) at work and at home. When the
battery pack falls to a 30 percent state of charge (SOC), the gasoline engine comes
on to turn the generator and maintain battery power above 25 percent SOC.

Automotive engineers calculate that each mile traveled in the Chevy Volt’s all-
electric mode “burns” 0.26 kilowatt hours of electricity. So, the mean commuter
trip of 33 miles requires 8.58 kWh of electricity. The price of electricity in the United
States varies from a peak period in the afternoon and evening to a much cheaper off-
peak period late at night, and from a low of $0.07 per kWh in Washington state to
$0.12 in Rhode Island. On average, a representative nighttime rate is $0.10, and a
representative daytime rate is $0.13. This means that each nighttime charge will
run the household $0.86, and the comparable daytime charge downtown at work will
be $1.12 for a total operating cost per day of just under $2. For 300 days of work,
that’s $600 per year. In contrast, the gasoline-powered Mini Cooper gets 32 mpg, so
at $3.00 per gallon, the Mini’s operating cost is approximately $6 per day or $1,800
per year. The typical commuter use of e-Rev vehicles will save $4 per day or $1,200
per year relative to popular fuel-efficient gasoline-powered cars.

At an EPA-measured 41 mpg throughout a range of driving conditions, the
hybrid-electric Ford Fusion qualifies for a federal tax credit of $3,400. In contrast,
at an EPA-measured 238 mpg, the Chevy Volt qualifies for a $7,500 tax credit to
offset the $12,000 additional cost of the L-ion battery pack over the cost of a con-
ventional battery. Because the Chevy Volt’s battery pack is expected to last 10 years,
the $1,200 annual capital cost for the battery pack is equal to the $1,200 energy
cost savings even without the federal tax credit.

3Web Appendix A expands upon the idea that the total profit function can be maximized by identifying the
level of activity at which the marginal profit function goes to zero.

Chapter 2: Fundamental Economic Concepts 43

note that for increasing output levels, the marginal profit values remain positive as long
as the total profit function is increasing. Only when the total profit function begins de-
creasing—that is, at Q = 10 units—does the marginal profit become negative. The
average profit function values πA(Q), shown in column 4 of Table 2.4, are obtained by
dividing the total profit figure πT(Q) by the output level Q. In comparing the marginal
and the average profit function values, we see that the average profit function πA(Q) is
increasing as long as the marginal profit is greater than the average profit—that is, up to
Q = 7 units. Beyond an output level of Q = 7 units, the marginal profit is less than the
average profit and the average profit function values are decreasing.

By examining the total profit function πT(Q) in Table 2.4, we see that profit is maxi-
mized at an output level of Q = 9 units. Given that the objective is to maximize total
profit, then the optimal output decision would be to produce and sell 9 units. If the mar-
ginal analysis decision rule discussed earlier in this section is used, the same (optimal)
decision is obtained. Applying the rule to this problem, the firm would expand produc-
tion as long as the net marginal return—that is, marginal revenue minus marginal cost
(marginal profit)—is positive. From column 3 of Table 2.4, we can see that the marginal
profit is positive for output levels up to Q = 9. Therefore, the marginal profit decision
rule would indicate that 9 units should be produced—the same decision that was ob-
tained from the total profit function.

The relationships among the total, marginal, and average profit functions and the
optimal output decision also can be represented graphically. A set of continuous profit
functions, analogous to those presented in Table 2.4 for discrete integer values of out-
put (Q), is shown in Figure 2.8. At the break-even output level Q1, both total profits
and average profits are zero. The marginal profit function, which equals the slope of
the total profit function, takes on its maximum value at an output of Q2 units. This
point corresponds to the inflection point. Below the inflection point, total profits are
increasing at an increasing rate, and hence marginal profits are increasing. Above the
inflection point, up to an output level Q4, total profits are increasing at a decreasing
rate, and consequently marginal profits are decreasing. The average profit function,
which represents the slope of a straight line drawn from the origin 0 to each point on

TABLE 2.4 TOTAL, MARGINAL, AND AVERAGE PROFIT RELATIONSHIPS

(1) (2) (3) (4)

NUMBER OF UNITS OF
OUTPUT PER UNIT OF

TIME Q
TOTAL PROFIT

πT(Q) ($)

MARGINAL PROFIT
Δπ(Q) = πT(Q) − πT(Q − 1)

($/UNIT)

AVERAGE PROFIT
πA(Q) = πT(Q)/Q

($/UNIT)

0 −200 0 —

1 −150 50 −150.00

2 −25 125 −12.50

3 200 225 66.67

4 475 275 118.75

5 775 300 155.00

6 1,075 300 179.17

7 1,325 250 189.29

8 1,475 150 184.38

9 1,500 25 166.67

10 1,350 −150 135.00

44 Part 1: Introduction

the total profit function, takes on its maximum value at an output of Q3 units. The
average profit necessarily equals the marginal profit at this point. This follows because
the slope of the 0A line, which defines the average profit, is also equal to the slope of
the total profit function at point A, which defines the marginal profit. Finally, total
profit is maximized at an output of Q4 units where marginal profit equals 0. Beyond
Q4 the total profit function is decreasing, and consequently the marginal profit function
takes on negative values.

THE NET PRESENT VALUE CONCEPT
When costs and benefits occur at approximately the same time, the marginal decision
rule (proceed with the action if marginal benefit exceeds marginal cost) applies. But,
many economic decisions require that costs be incurred immediately to capture a
stream of benefits over several future time periods. In these cases, the net present value
(NPV) rule replaces the marginal decision rule and provides appropriate guidance for
longer-term decision makers. The NPV of an investment represents the contribution of
that investment to the value of the firm and, accordingly, to shareholder wealth
maximization.

FIGURE 2.8 Total, Average, and Marginal Profit Functions

Total profit
($) (πT(Q))

Inflection
point

Maximum total profit

Total profit πT(Q)

Break-even
point

Average profit
(πA(Q))
Marginal profit
(Δπ(Q))
($/unit)

Units of output (Q)

Units of output (Q)Q1 Q2 Q3 Q

Marginal profit Δπ(Q)

Average profit πA(Q)

Maximum average profit point

Maximum marginal profit point

Chapter 2: Fundamental Economic Concepts 45

Determining the Net Present Value of an Investment
To understand the NPV rule, consider the following situation. You are responsible for
investing $1 million to support the retirement of several family members. Your financial
advisor has suggested that you use these funds to purchase a piece of land near a
proposed new highway interchange. A trustworthy state road commissioner is certain
that the interchange will be built and that in one year the value of this land will increase
to $1.2 million. Hence, you believe initially that this is a riskless investment. At the end
of one year you plan to sell the land. You are being asked to invest $1 million today in
the anticipation of receiving $1.2 million a year from today, or a profit of $200,000. You
wonder whether this profit represents a sufficient return on your investment.

You feel it is important to recognize that a return of $1.2 million received one year
from today must be worth less than $1.2 million today because you could invest your
$1 million today to earn interest over the coming year. Therefore, to compare a dollar
received in the future with a dollar in hand today, it is necessary to multiply the future
dollar by a discount factor that reflects the alternative investment opportunities that are
available.

Instead of investing $1 million in the land venture, you are aware that you could also
invest in a one-year U.S. government bond that currently offers a return of 3 percent.
The 3 percent return represents the return (the opportunity cost) forgone by investing
in the land project. The 3 percent rate also can be thought of as the compensation to
an investor who agrees to postpone receiving a cash return for one year. The discount
factor, also called a present value interest factor (PVIF), is equal to

PVIF =
1

1 + i

where i is the compensation for postponing receipt of a cash return for one year. The
present value (PV0) of an amount received one year in the future (FV1) is equal to that
amount times the discount factor, or

PV0 = FV1 × ðPVIFÞ [2.3]

In the case of the land project, the present value of the promised $1.2 million
expected to be received in one year is equal to

PV0 = $1:2 million
1

1 + 0:03

� �
= $1,165,049

If you invested $1,165,049 today to earn 3 percent for the coming year, you would
have $1.2 million at the end of the year. You are clearly better off with the proposed
land investment (assuming that it really is riskless like the U.S. government bond invest-
ment). How much better off are you?

The answer to this question is at the heart of NPV calculations. The land investment
project is worth $1,165,049 today to an investor who demands a 3 percent return on
this type of investment. You, however, have been able to acquire this investment for
only $1,000,000. Thus, your wealth has increased by undertaking this investment by
$165,049 ($1,165,049 present value of the projected investment opportunity payoffs
minus the required initial investment of $1,000,000). The NPV of this investment is
$165,049. In general, the NPV of an investment is equal to

NPV = Present value of future returns − Initial outlay [2.4]

This example was simplified by assuming that the returns from the investment were
received exactly one year from the date of the initial outlay. If the payoff from the land

present value The
value today of a future
amount of money or
a series of future
payments evaluated
at the appropriate
discount rate.

46 Part 1: Introduction

investment had been not one but two years away, the PVIF would have been 1/(1.03)2 =
0.942596, and the NPV would have been 1.2 million (.942596) – 1.0 million = $131,115.
The NPV rule can be generalized to cover returns received over any number of future
time periods with projected growth or decay and terminal values as salvage or disposal
costs. In Appendix A at the end of the book, the present value concept is developed in
more detail so that it can be applied in these more complex investment settings.

Example Changing a Lightbulb Saves $40 and May
Save the Planet

Incandescent lightbulbs replaced oil lamps for interior lighting more than 100 years
ago. Thomas Edison himself improved on some basic designs running electric cur-
rent through a carbonized filament in an oxygen-free vacuum tube, producing less
combustion and more light. General Electric had its origins selling long-lasting
tungsten filament incandescent bulbs. Today, the new compact fluorescent light
(CFL) bulb uses 75 percent less electricity to heat an argon vapor that emits ultra-
violet light. The UV light excites a fluorescent phosphor coating on the inside of
the tube, which then emits visible light. The U.S. Department of Energy estimates
that if all 105 million U.S. households replaced just one heavily used incandescent
bulb with a CFL bulb yielding comparable light, the electricity saved could light
3 million homes. In addition, the energy saved would remove from the environ-
ment an amount of greenhouse gases from coal-burning power plants equal to the
CO2 emitted by 800,000 cars. The U.K. Department of Business, Enterprise, and Reg-
ulatory Reform estimates that replacing the three most frequently used lightbulbs in
U.K. households would save the electricity used by all the street lamps in Britain.

The magnitude of these energy savings is certainly staggering, but at what cost?
Bought for $1.19 per bulb, 1,000-hour incandescent 75-watt bulbs cost much less to
install than CFL bulbs that create the same 1,250 lumens of light, last 8,000 hours,
burn only 18 to 22 watts of electricity, but cost $14. So, the lifetime cost comparison
hinges on whether the extra $12.81 acquisition cost of the CFL bulb is worth the
extended lifetime of energy savings. Net present value techniques are designed to
answer just such questions of the time value of money (savings) that are delayed.

Table 2.5 shows the initial net investments of $14 and $1.19 per bulb, the
55 kilowatt hours (kWh) of power saved on average by the CFL bulb each year, the
$0.10 per kWh representative cost of the electricity,5 and the additional $1.19 in-
candescent bulb replacement every 1,000 hours (the typical U.S. household’s an-
nual usage). Assuming a 6 percent discount rate, the net present value of the
$5.50 annual energy savings plus the $1.19 replacement cost for incandescent bulbs
avoided each year for seven years yields a net present value cost savings of $40.79,
which exceeds the differential $12.81 acquisition cost for the CFL bulb by $27.98.
The European Union has found this $28 net present value of the cost savings from
switching to CFL bulbs (plus their CO2 abatement) so compelling that incandes-
cent bulbs are no longer approved for manufacture or import into the EU. More
gradual U.S. phaseout of incandescent bulbs will begin in 2012.

4Based on “DOE Launches Change a Light, Change the World Campaign” (October 3, 2007), www.energy.gov
and www.energystar.gov.
5Electric rates for incremental power vary by region from $.06 per kWh in the state of Washington to $.08 in the
Carolinas, to $.12 in California, New York, and across New England.

Chapter 2: Fundamental Economic Concepts 47

Sources of Positive Net Present Value Projects
What causes some projects to have a positive NPV and others to have a negative NPV?
When product and factor markets are other than perfectly competitive, it is possible for a
firm to earn above-normal profits (economic rents) that result in positive net present value
projects. The reasons why these above-normal profits may be available arise from condi-
tions that define each type of product and factor market and distinguish it from a perfectly
competitive market. These reasons include the following barriers to entry and other factors:

1. Buyer preferences for established brand names
2. Ownership or control of favored distribution systems (such as exclusive auto dealer-

ships or airline hubs)
3. Patent control of superior product designs or production techniques
4. Exclusive ownership of superior natural resource deposits
5. Inability of new firms to acquire necessary factors of production (management,

labor, equipment)
6. Superior access to financial resources at lower costs (economies of scale in attracting

capital)
7. Economies of large-scale production and distribution arising from

a. Capital-intensive production processes
b. High initial start-up costs

These factors can permit a firm to identify positive net present value projects for internal
investment. If the barriers to entry are sufficiently high (such as a patent on key technology)
so as to prevent any new competition, or if the start-up period for competitive ventures is
sufficiently long, then it is possible that a project may have a positive net present value.
However, in assessing the viability of such a project, the manager or analyst must consider
the likely period of time when above-normal returns can be earned before new competitors
emerge and force cash flows back to a more normal level. It is generally unrealistic to expect
to be able to earn above-normal returns over the entire life of an investment project.

Risk and the NPV Rule
The previous land investment example assumed that the investment was riskless. There-
fore, the rate of return used to compute the discount factor and the net present value
was the riskless rate of return available on a U.S. government bond having a one-year
maturity. What if you do not believe that the construction of the new interchange is a cer-
tainty, or you are not confident about of the value of the land in one year? To compensate

TABLE 2.5 LIFETIME COST SAVINGS OF COMPACT FLUORESCENT LIGHT (CFL) BULBS

t=0 t=1 t=2 t=3 t=4 t=5 t=6 t=7 t=8

(END OF PERIOD
VALUES)

Incandescent −$1.19 −$1.19 −$1.19 −$1.19 −$1.19 −$1.19 −$1.19 −$1.19 0

CFL −$14.00 55 kWh × $.10 = $5.50 $5.50 $5.50 $5.50 $5.50 $5.50 $5.50 $5.50

Cost difference −$12.81 NPV (8 years of $5.50 energy savings at d=6%) = $34.15

NPV (7 years of $1.19 incandescent replacement cost at d=6%) = $6.64

NPV (Lifetime cost savings) − Cost difference

($34.15 + $6.64) $40.79 $12.81

= $27.98

48 Part 1: Introduction

for the perceived risk of this investment, you decide that you require a 15 percent rate of
return on your investment. Using a 15 percent required rate of return in calculating
the discount factor, the present value of the expected $1.2 million sales price of the
land is $1,043,478 ($1.2 million times [1/1.15]). Thus, the NPV of this investment declines
to $43,478. The increase in the perceived risk of the investment results in a dramatic
$121,571 decline from $165,049 in the NPV on a $1 million investment.

A primary problem facing managers is the difficulty of evaluating the risk associated
with investments and then translating that risk into a discount rate that reflects an ade-
quate level of risk compensation. In the next section of this chapter, we discuss the risk
concept and the factors that affect investment risk and influence the required rate of
return on an investment.

MEANING AND MEASUREMENT OF RISK
Risk implies a chance for some unfavorable outcome to occur—for example, the possibility
that actual cash flows will be less than the expected outcome. When a range of potential
outcomes is associated with a decision and the decision maker is able to assign probabilities
to each of these possible outcomes, risk is said to exist. A decision is said to be risk free if
the cash flow outcomes are known with certainty. A good example of a risk-free investment
is U.S. Treasury securities. There is virtually no chance that the Treasury will fail to redeem
these securities at maturity or that the Treasury will default on any interest payments owed.
In contrast, US Airways bonds constitute a risky investment because it is possible that US
Airways will default on one or more interest payments and will lack sufficient funds at ma-
turity to redeem the bonds at face value. In summary, risk refers to the potential variability
of outcomes from a decision. The more variable these outcomes are, the greater the risk.

Probability Distributions
The probability that a particular outcome will occur is defined as the relative frequency
or percentage chance of its occurrence. Probabilities may be either objectively or subjec-
tively determined. An objective determination is based on past outcomes of similar
events, whereas a subjective determination is merely an opinion made by an individual
about the likelihood that a given event will occur. In the case of decisions that are fre-
quently repeated, such as the drilling of developmental oil wells in an established oil
field, reasonably good objective estimates can be made about the success of a new well.
In contrast, for totally new decisions or one-of-a-kind investments, subjective estimates
about the likelihood of various outcomes are necessary. The fact that many probability
estimates in business are at least partially subjective does not diminish their usefulness.

Using either objective or subjective methods, the decision maker can develop a
probability distribution for the possible outcomes. Table 2.6 shows the probability
distribution of net cash flows for two sample investments. The lowest estimated annual

TABLE 2.6 PROBABILITY DISTRIBUTIONS OF THE ANNUAL NET CASH

FLOWS (NCF) FROM TWO

INVESTMENTS

INVESTMENT I INVESTMENT II

POSSIBLE NCF PROBABILITY POSSIBLE NCF PROBABILITY

$200 0.2 $100 0.2

300 0.6 300 0.6

400 0.2 500 0.2

1.0 1.0

risk A decision-making
situation in which there
is variability in the
possible outcomes,
and the probabilities
of these outcomes can
be specified by the
decision maker.

probability The
percentage chance
that a particular
outcome will occur.

Chapter 2: Fundamental Economic Concepts 49

net cash flow (NCF) for each investment—$200 for Investment I and $100 for Investment
II—represents pessimistic forecasts about the investments’ performance; the middle values—
$300 and $300—could be considered normal performance levels; and the highest values—
$400 and $500—are optimistic estimates.

Expected Values
From this information, the expected value of each decision alternative can be calculated.
The expected value is defined as the weighted average of the possible outcomes. It is the
value that is expected to occur on average if the decision (such as an investment) were
repeated a large number of times.

Algebraically, the expected value may be defined as

r = ∑
n

j = 1
rjpj [2.5]

where r is the expected value; rj is the outcome for the jth case, where there are n possible
outcomes; and pj is the probability that the jth outcome will occur. The expected cash
flows for Investments I and II are calculated in Table 2.8 using Equation 2.5. In this exam-
ple, both investments have expected values of annual net cash flows equaling $300.

Example Probability Distributions and Risk: US Airways Bonds
6

Consider an investor who is contemplating the purchase of US Airways bonds. That
investor might assign the probabilities associated with the three possible outcomes
from this investment, as shown in Table 2.7. These probabilities are interpreted to
mean that a 30 percent chance exists that the bonds will not be in default over their
life and will be redeemed at maturity, a 65 percent chance of interest default during
the life of the bonds, and a 5 percent chance that the bonds will not be redeemed at
maturity. In this example, no other outcomes are deemed possible.

6The annual report for the US Airways Corporation can be found at http://investor.usairways.com

TABLE 2.7 POSSIBLE OUTCOMES FROM INVESTING IN US

AIRWAYS BONDS

OUTCOME PROBABILITY

No default, bonds redeemed at maturity 0.30

Default on interest for one or more periods 0.65

No interest default, but bonds not redeemed at maturity 0.05

1.00

TABLE 2.8 COMPUTATION OF THE EXPECTED RETURNS FROM TWO

INVESTMENTS
INVESTMENT I INVESTMENT II

rj pj rj × pj rj pj rj × pj

$200 0.2 $ 40 $100 0.2 $ 20

300 0.6 180 300 0.6 180

400 0.2 80 500 0.2 100

Expected value: rI = $300 rII = $300

expected value The
weighted average of
the possible outcomes
where the weights are
the probabilities of the
respective outcomes.

50 Part 1: Introduction

Standard Deviation: An Absolute Measure of Risk
The standard deviation is a statistical measure of the dispersion of a variable about its
mean. It is defined as the square root of the weighted average squared deviations of in-
dividual outcomes from the mean:

σ =

ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
∑
n

j = 1
ðrj − rjÞ2pj

s
[2.6]

where σ is the standard deviation.
The standard deviation can be used to measure the variability of a decision alter-

native. As such, it gives an indication of the risk involved in the alternative. The
larger the standard deviation, the more variable the possible outcomes and the riskier
the decision alternative. A standard deviation of zero indicates no variability and thus
no risk.

Table 2.9 shows the calculation of the standard deviations for Investments I and II.
These calculations show that Investment II appears to be riskier than Investment
I because the expected cash flows from Investment II are more variable.

Normal Probability Distribution
The possible outcomes from most investment decisions are much more numerous
than in Table 2.6 but their effects can be estimated by assuming a continuous proba-
bility distribution. Assuming a normal probability distribution is often correct or
nearly correct, and it greatly simplifies the analysis. The normal probability distribu-
tion is characterized by a symmetrical, bell-like curve. A table of the standard normal
probability function (Table 1 in Appendix B at the end of this book) can be used to
compute the probability of occurrence of any particular outcome. From this table, for
example, it is apparent that the actual outcome should be between plus and minus 1

TABLE 2.9 COMPUTATION OF THE STANDARD DEVIATIONS FOR TWO INVESTMENTS

j rj r rj − r ðrj − rÞ2 pj ðrj − rÞ2pj
Investment I 1 $200 $300 −$100 $10,000 0.2 $2,000

2 300 300 0 0 0.6 0

3 400 300 100 10,000 0.2 2,000

∑
3

j = 1
ðrj − rÞ2pj = $4,000

σ =
ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
∑
n

j = 1
ðrj − rÞ2pj

r
=

ffiffiffiffiffiffiffiffiffiffiffi
4,000

p
=

$63:25

Investment II 1 $100 $300 −$200 $40,000 0.2 $8,000

2 300 300 0 0 0.6 0

3 500 300 200 40,000 0.2 8,000

∑
3

j = 1
ðrj − rÞ2pj = $16,000

σ =
ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
∑
n
j = 1
ðrj − rÞ2pj
r
=

ffiffiffiffiffiffiffiffiffiffiffiffiffi
16,000

p
= $126:49

standard deviation
A statistical measure of
the dispersion or
variability of possible
outcomes.

Chapter 2: Fundamental Economic Concepts 51

standard deviation from the expected value 68.26 percent of the time,7 between plus
and minus 2 standard deviations 95.44 percent of the time, and between plus and
minus 3 standard deviations 99.74 percent of the time (see Figure 2.9). So a “3 sigma
event” occurs less than 1 percent of the time with a relative frequency 0.0026 (i.e., 1.0
− 0.9974), and a “9 sigma event” occurs almost never, with a relative frequency less
than 0.0001. Nevertheless, such extraordinary events can and do happen (see following
box on LTCM).

The number of standard deviations z that a particular value of r is from the mean r
can be computed as

z =
r − r
σ

[2.7]

Table 1 in Appendix B and Equation 2.5 can be used to compute the probability of
an annual net cash flow for Investment I being less than some value r—for example,
$205. First, the number of standard deviations that $205 is from the mean must be cal-
culated. Substituting the mean and the standard deviation from Tables 2.8 and 2.9 into
Equation 2.7 yields

z =
$205 − $300

$63:25

= −1:50

In other words, the annual cash flow value of $205 is 1.5 standard deviations below
the mean. Reading from the 1.5 row in Table 1 gives a value of 0.0668, or 6.68 percent.

FIGURE 2.9 A Sample Illustration of Areas under the Normal Probability Distribution Curve

0
Standard deviations

–1σ–2σ–3σ +1σ +2σ +3σ

95.44%
99.74%

68.26%

P
ro

b
ab

il
it

y
o

f
o

cc
u

rr
en

15.87%

7For example, Table 1 indicates a probability of 0.1587 of a value occurring that is greater than +1σ from the
mean and a probability of 0.1587 of a value occurring that is less than −1σ from the mean. Hence the proba-
bility of a value between +1σ and −1σ is 68.26 percent—that is, 1.00 − (2 × 0.1587).

52 Part 1: Introduction

Thus, a 6.68 percent probability exists that Investment I will have annual net cash flows
less than $205. Conversely, there is a 93.32 percent probability (1 − 0.0668) that the in-
vestment will have a cash flow greater than $205.

Coefficient of Variation: A Relative Measure of Risk
The standard deviation is an appropriate measure of risk when the decision alternatives
being compared are approximately equal in size (that is, have similar expected values
of the outcomes) and the outcomes are estimated to have symmetrical probability
distributions. Because the standard deviation is an absolute measure of variability,

WHAT WENT RIGHT • WHAT WENT WRONG

Long-Term Capital Management (LTCM)
8

LTCM operated from June 1993–September 1998 as a
hedge fund that invested highly leveraged private capital
in arbitrage trading strategies on the financial derivative
markets. LTCM’s principal activity was examining interest
rate derivative contracts throughout the world for evidence
of very minor mispricing and then betting enormous sums
on the subsequent convergence of those contracts to pre-
dictable equilibrium prices. Since the mispricing might be
only several cents per thousand dollars invested, LTCM
often needed to risk millions or even billions on each bet
to secure a nontrivial absolute dollar return. With some-
times as many as 100 independent bets spread across doz-
ens of different government bond markets, LTCM
appeared globally diversified.

In a typical month, 60 such convergence strategies with
positions in several thousand counterparty contracts would
make money and another 40 strategies with a similar num-
ber of counterparties would lose money. Steadily, the prof-
its mounted. From approximately $1 billion net asset value
(equity) in February 1994, LTCM reached $7 billion of net
asset value in January 1998. LTCM then paid out $2.4 bil-
lion in a one-time distribution to non-partners, which
equaled a 40 percent annual compound return on their
investment (ROI). Shortly thereafter, in August 1998, the
remaining $4.6 billion equity shrank by 45 percent, and
then one month later shrank by another 82 percent to
less than $600 million. In September 1998, the hedge
fund was taken over by 14 Wall Street banks who, in ex-
change for inserting $3.6 billion to cover the firm’s debts,
acquired 90 percent of the equity ownership. What went
wrong?

One potential explanation is that such events are fully
expected in an enterprise so risky that it returns a
40 percent ROI. Anticipated risk and expected return
are highly positively correlated across different types of
investments. However, LTCM’s annual return had a
standard deviation from June 1993 to June 1998 of only

11.5 percent per year as compared to 10 percent as the
average for all S&P 500 stocks. In this respect, LTCM’s
return volatility was quite ordinary. Another potential ex-
planation is that LTCM’s $129 billion on the June 1998
balance sheet was overwhelmed by excessive off-balance
sheet assets and liabilities. Although the absolute size of
the numbers is staggering (e.g., $1.2 trillion in interest
rate swaps, $28 billion in foreign exchange derivatives,
and $36 billion in equity derivatives), LTCM’s 9 percent
ratio of on-balance sheet to off-balance sheet assets was
similar to that of a typical securities firm (about 12 per-
cent). Even LTCM’s high financial leverage ($129 billion
assets to $4.7 billion equity = 26 to 1) was customary
practice for hedge funds.

What appears to have gone wrong for LTCM was that
a default of the Russian government on debt obligations in
August 1998 set in motion a truly extraordinary “flight to
quality.” General turmoil in the bond markets caused in-
terest rate volatility to rise to a standard deviation of
36 percent when 3 percent would have been typical.
LTCM was caught on the wrong side of many interest
rate derivative positions for which no trade was available
at any price. Although LTCM had “stress tested” their
trading positions against so-called “3 sigma events”
(a one-day loss of $35 million), this August–September
1998 volatility proved to be a 9 sigma event (i.e., a one-
day loss of $553 million).

With massive investments highly leveraged and ex-
posed to a 9 sigma event, LTCM hemorrhaged $2 billion
in one month. Because liquidity risk exposure of an other-
wise fully diversified portfolio was to blame, many invest-
ment houses have concluded that leverage should be
substantially reduced as a result of the events at LTCM.

8R. Lowenstein, When Genius Failed (New York: Random House, 2000);
remarks by Dave Modest, NBER Conference, May 1999; and “Case Study:
LTCM,” eRisk, (2000).

Chapter 2: Fundamental Economic Concepts 53

however, it is generally not suitable for comparing alternatives of differing size. In these
cases the coefficient of variation provides a better measure of risk.

The coefficient of variation (v) considers relative variation and thus is well suited for
use when a comparison is being made between two unequally sized decision alternatives.
It is defined as the ratio of the standard deviation σ to the expected value r, or

ν =
σ

r
[2.8]

RISK AND REQUIRED RETURN
The relationship between risk and required return on an investment can be defined as

Required return = Risk-free return + Risk premium [2.9]

The risk-free rate of return refers to the return available on an investment with no
risk of default. For debt securities, no default risk means that promised interest and prin-
cipal payments are guaranteed to be made. The best example of risk-free debt securities
are short-term government securities, such as U.S. Treasury bills. The buyer of a U.S.
government debt security always is assured of receiving the promised principal and inter-
est payments because the U.S. government always can print more money. The risk-free
return on T-bills equals the real rate of interest plus the expected rate of inflation. The
second term in Equation 2.9 is a potential “reward” that an investor can expect to receive

Example Relative Risk Measurement: Arrow Tool Company
Arrow Tool Company is considering two investments, T and S. Investment T has ex-
pected annual net cash flows of $100,000 and a standard deviation of $20,000, whereas
Investment S has expected annual net cash flows of $4,000 and a $2,000 standard de-
viation. Intuition tells us that Investment T is less risky because its relative variation is
smaller. As the coefficient of variation increases, so does the relative risk of the deci-
sion alternative. The coefficients of variation for Investments T and S are computed as

Investment T:

ν =
σ
r

=
$20,000
$100,000

= 0:20

Investment S:

ν =
σ
r

=
$2,000
$4,000

= 0:5

Cash flows of Investment S have a larger coefficient of variation (0.50) than do
cash flows of Investment T (0.20); therefore, even though the standard deviation is
smaller, Investment S is the more risky of the two alternatives.

coefficient of variation
The ratio of the
standard deviation to
the expected value.
A relative measure
of risk.

54 Part 1: Introduction

from providing capital for a risky investment. This risk premium may arise for any
number of reasons. The borrower firm may default on its contractual repayment
obligations (a default risk premium). The investor may have little seniority in presenting
claims against a bankrupt borrower (a seniority risk premium). The investor may be un-
able to sell his security interest (a liquidity risk premium as we saw in the case of
LTCM), or debt repayment may occur early (a maturity risk premium). Finally, the re-
turn the investor receives may simply be highly volatile, exceeding expectations during
one period and plummeting below expectations during the next period. Investors gener-
ally are considered to be risk averse; that is, they expect, on average, to be compensated
for any and all of these risks they assume when making an investment.

Example Risk-Return Trade-Offs in Stocks, Bonds,
Farmland, and Diamonds
Investors require higher rates of return on debt securities based primarily on their
default risk. Bond-rating agencies, such as Moody’s, Standard and Poor’s, and
Fitch, provide evaluations of the default risk of many corporate bonds. Moody’s,
for example, rates bonds on a 9-point scale from Aaa through C, where Aaa-
rated bonds have the lowest expected default risk. As can be seen in Table 2.10,
the yields on bonds increase as the risk of default increases, again reflecting the
positive relationship between risk and required returns.

Table 2.10 also shows investment in diamonds has returned 3 percent whereas
farmland has returned 6.5 percent, U.S. stocks have returned 10 percent, biotech
stocks have returned 12.6 percent, and emerging market stocks have returned 16
percent compounded annually from 1970 to 2010. These compound annual returns
mirror the return variance of diamonds (lowest), farmland, U.S. stocks, biotech
stocks, and emerging market stocks (highest).

TABLE 2.10 RELATIONSHIP BETWEEN RISK AND REQUIRED RETURNS

DEBT SECURITY YIELD

U.S. Treasury bill 3.8%

U.S. Treasury bonds (25 year +) 5.06

Aaa-rated corporate bonds 6.49

Aa-rated bonds 6.93

A-rated bonds 7.18

Baa-rated corporate bonds 7.80

Other investments

Diamonds 3.0

Farmland 6.5

Stocks

All U.S. stocks 10.1

Biotech stocks 12.6

Emerging market stocks 16.0

Source: Board of Governors of the Federal Reserve System, Federal Reserve Bulletin.

Chapter 2: Fundamental Economic Concepts 55

SUMMARY

� Demand and supply simultaneously determine
equilibrium market price. The determinants of de-
mand (supply) other than price shift the demand
(supply) curve. A change in price alone leads to a
change in quantity demanded (supplied) without
any shift in demand (supply).

� The offer price demanders are willing to pay is
determined by the marginal use value of the pur-
chase being considered. The asking price suppliers
are willing to accept is determined by the variable
cost of the product or service being supplied.

� The equilibrium price of gasoline fluctuates pri-
marily because of spikes and collapses in crude
oil input prices caused at various times by supply
disruptions and gluts, increasing demand in devel-
oping countries, and speculation.

� Changes in price result in movement along the de-
mand curve, whereas changes in any of the other
variables in the demand function result in shifts of
the entire demand curve. Thus “changes in quan-
tity demanded along” a particular demand curve
result from price changes. In contrast, when one
speaks of “changes in demand,” one is referring
to shifts in the entire demand curve.

� Some of the factors that cause a shift in the entire
demand curve are changes in the income level of
consumers, the price of substitute and complemen-
tary goods, the level of advertising, competitors’

advertising expenditures, population, consumer
preferences, time period of adjustment, taxes or
subsidies, and price expectations.

� The marginal analysis concept requires that a deci-
sion maker determine the additional (marginal)
costs and additional (marginal) benefits associated
with a proposed action. If the marginal benefits
exceed the marginal costs (that is, if the net mar-
ginal benefits are positive), the action should be
taken.

� The net present value of an investment is equal to
the present value of expected future returns (cash
flows) minus the initial outlay.

� The net present value of an investment equals the
contribution of that investment to the value of the
firm and, accordingly, to the wealth of share-
holders. The net present value of an investment
depends on the return required by investors (the
firm), which, in turn, is a function of the perceived
risk of the investment.

� Risk refers to the potential variability of outcomes
from a decision alternative. It can be measured ei-
ther by the standard deviation (an absolute mea-
sure of risk) or coefficient of variation (a relative
measure of risk).

� A positive relationship exists between risk and re-
quired rates of return. Investments involving
greater risks must offer higher expected returns.

Exercises
1. For each of the determinants of demand in Equation 2.1, identify an example

illustrating the effect on the demand for hybrid gasoline-electric vehicles such as
the Toyota Prius. Then do the same for each of the determinants of supply in
Equation 2.2. In each instance, would equilibrium market price increase or de-
crease? Consider substitutes such as plug-in hybrids, the Nissan Leaf and Chevy
Volt, and complements such as gasoline and lithium ion laptop computer
batteries.

2. Gasoline prices above $3 per gallon have affected what Enterprise Rental Car Co.
can charge for various models of rental cars. SUVs are $37 with one-day return
and subcompacts are $41 with one-day return. Why would the equilibrium price
of SUVs be lower than the equilibrium price of subcompacts?

Answers to the exercises
in blue can be found in
Appendix D at the back

of the book.

56 Part 1: Introduction

3. The Ajax Corporation has the following set of projects available to it:

PROJECT*
INVESTMENT REQUIRED

($ MILLION)
EXPECTED RATE

OF RETURN

A 500 23.0%

B 75 18.0

C 50 21.0

D 125 16.0

E 300 14.0

F 150 13.0

G 250 19.0

*Note: All projects have equal risk.

Ajax can raise funds with the following marginal costs:

First $250 million 14.0%

Next 250 million 15.5

Next 100 million 16.0

Next 250 million 16.5

Next 200 million 18.0

Next 200 million 21.0

Use the marginal cost and marginal revenue concepts developed in this chapter to
derive an optimal capital budget for Ajax.

4. The demand for MICHTEC’s products is related to the state of the economy. If
the economy is expanding next year (an above-normal growth in GNP), the com-
pany expects sales to be $90 million. If there is a recession next year (a decline in
GNP), sales are expected to be $75 million. If next year is normal (a moderate
growth in GNP), sales are expected to be $85 million. MICHTEC’s economists
have estimated the chances that the economy will be either expanding, normal,
or in a recession next year at 0.2, 0.5, and 0.3, respectively.
a. Compute expected annual sales.
b. Compute the standard deviation of annual sales.
c. Compute the coefficient of variation of annual sales.

5. Two investments have the following expected returns (net present values) and
standard deviation of returns:

PROJECT EXPECTED RETURNS STANDARD DEVIATION

A $ 50,000 $ 40,000

B $250,000 $125,000

Which one is riskier? Why?
6. The manager of the aerospace division of General Aeronautics has estimated the

price it can charge for providing satellite launch services to commercial firms. Her
most optimistic estimate (a price not expected to be exceeded more than 10 per-
cent of the time) is $2 million. Her most pessimistic estimate (a lower price than
this one is not expected more than 10 percent of the time) is $1 million. The
expected value estimate is $1.5 million. The price distribution is believed to be
approximately normal.

Chapter 2: Fundamental Economic Concepts 57

a. What is the expected price?
b. What is the standard deviation of the launch price?
c. What is the probability of receiving a price less than $1.2 million?

Case
Exercise REVENUE MANAGEMENT AT AMERICAN

AIRLINES
9

Airlines face highly cyclical demand; American reported profitability in the strong ex-
pansion of 2006–2007 but massive losses in the severe recession of 2008–2009. De-
mand also fluctuates day to day. One of the ways American copes with random
demand is through marginal analysis using revenue management techniques. Revenue
or “yield” management (RM) is an integrated demand-management, order-booking,
and capacity-planning process.

To win orders in a service industry without slashing prices requires that companies
create perceived value for segmented classes of customers. Business travelers on air-
lines, for example, will pay substantial premiums for last-minute responsiveness to
their flight change requests. Other business travelers demand exceptional delivery re-
liability and on-time performance. In contrast, most vacation excursion travelers want
commodity-like service at rock-bottom prices. Although only 15–20 percent of most
airlines’ seats are in the business segment, 65–75 percent of the profit contribution on
a typical flight comes from this group.

The management problem is that airline capacity must be planned and allocated
well in advance of customer arrivals, often before demand is fully known, yet unsold
inventory perishes at the moment of departure. This same issue faces hospitals, con-
sulting firms, TV stations, and printing businesses, all of whom must acquire and
schedule capacity before the demands for elective surgeries, a crisis management
team, TV ads, or the next week’s press run are fully known.

One approach to minimizing unsold inventory and yet capturing all last-minute
high-profit business is to auction off capacity to the highest bidder. The auction for
free-wheeling electricity works just that way: power companies bid at quarter ’til the
hour for excess supplies that other utilities agree to deliver on the hour. However, in
airlines, prices cannot be adjusted quickly as the moment of departure approaches.
Instead, revenue managers employ large historical databases to predict segmented cus-
tomer demand in light of current arrivals on the reservation system. They then ana-
lyze the expected marginal profit from holding in reserve another seat in business
class in anticipation of additional “last-minute” demand and compare that seat by
seat to the alternative expected marginal profit from accepting one more advance res-
ervation request from a discount traveler.

Suppose on the 9:00 A.M. Dallas to Chicago flight next Monday, 63 of American’s
170 seats have been “protected” for first class, business class, and full coach fares but
only 50 have been sold; the remaining 107 seats have been authorized for sale at a
discount. Three days before departure, another advance reservation request arrives in
the discount class, which is presently full. Should American reallocate capacity and

9Based on Robert Cross, Revenue Management (New York: Broadway Books, 1995); and Frederick Harris
and Peter Peacock, “Hold My Place Please: Yield Management Improves Capacity Allocation Guesswork,”
Marketing Management (Fall 1995), pp. 34–46.

58 Part 1: Introduction

take on the new discount passenger? The answer depends on the marginal profit from
each class and the predicted probability of excess demand (beyond 63 seats) next
Monday in the business classes.

If the $721 full coach fare has a $500 marginal profit and the $155 discount fare
has a $100 marginal profit, the seat in question should not be reallocated from busi-
ness to discount customers unless the probability of “stocking out” in business is less
than 0.20 (accounting for the likely incidence of cancellations and no-shows). There-
fore, if the probability of stocking out is 0.25, the expected marginal profit from hold-
ing an empty seat for another potential business customer is $125, whereas the
marginal profit from selling that seat to the discount customer is only $100 with cer-
tainty. Even a pay-in-advance no-refund seat request from the discount class should
be refused. Every company has some viable orders that should be refused because ad-
ditional capacity held in reserve for the anticipated arrival of higher profit customers
is not “idle capacity” but rather a predictable revenue opportunity waiting to happen.

In this chapter, we developed the marginal analysis approach used in solving
American’s seat allocation decision problem. The Appendix to Chapter 14 discusses
further the application of revenue management to baseball, theatre ticketing, and
hotels.

Questions
1. Make a list of some of the issues that will need to be resolved if American Air-

lines decides to routinely charge different prices to customers in the same class of
service.

2. Would you expect these revenue management techniques of charging differential
prices based on the target customers’ willingness to pay for change order respon-
siveness, delivery reliability, schedule frequency, and so forth to be more effective
in the trucking industry, the outpatient health care industry, or the hotel indus-
try? Why or why not?

3. Sometimes when reservation requests by deep discount travelers are refused, de-
manders take their business elsewhere; they “balk.” At other times, such deman-
ders negotiate and can be “sold up” to higher fare service like United’s Economy
Plus. If United experiences fewer customers balking when reservation requests for
the cheapest seats are refused, should they allocate preexisting capacity to protect
fewer seats (or more) for late-arriving full-fare passengers?

Chapter 2: Fundamental Economic Concepts 59

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