Solution Manual for Managerial Economics A Problem Solving Approach, 6th Edition by Luke M. Froeb, B

Managerial Economics: A Problem-Solving Approach 6th Edition Solutions to End-of-Chapter Multiple Choice Questions

Table of Contents Chapter 1 ......................................................................................................................................... 2 Chapter 2 ......................................................................................................................................... 4 Chapter 3 ......................................................................................................................................... 7 Chapter 4 ......................................................................................................................................... 9 Chapter 5 ....................................................................................................................................... 13 Chapter 6 ....................................................................................................................................... 16 Chapter 7 ...................................................................................................................................... 19 Chapter 8 ...................................................................................................................................... 22 Chapter 9 ...................................................................................................................................... 25 Chapter 10.................................................................................................................................... 27 Chapter 11 ..................................................................................................................................... 29 Chapter 12 ..................................................................................................................................... 33 Chapter 14 (and 13) ...................................................................................................................... 35 Chapter 15 ..................................................................................................................................... 38 Chapter 16 ..................................................................................................................................... 41 Chapter 17 ..................................................................................................................................... 44 Chapter 18 ..................................................................................................................................... 47 Chapter 19 ..................................................................................................................................... 50 Chapter 20 ..................................................................................................................................... 53 Chapter 21 ..................................................................................................................................... 56 Chapter 22 ..................................................................................................................................... 59 Chapter 23 ..................................................................................................................................... 62

Chapter 1 1.

Why might performance compensation caps be bad? a. Different pay rates promote dissent. [A compensation cap is a maximum salary limit; it does not necessarily produce varied pay rates] b. Compensation caps can discourage employees from being productive after the cap.

[Correct; at least with regards to salary, the employee is not rewarded for further productivity beyond the amount that produces the cap value] c. Compensation caps can discourage employees from being productive before the cap.

[Employees are incentivized to reach the value of the cap, encouraging productivity prior to its achievement] d. Both b and c

2.

What is a possible consequence of a performance compensation reward scheme? a. It creates productive incentives. [As pay is tied directly to performance, such a policy may motivate workers to improve their performance for the additional compensation] b. It creates harmful incentives. [Such a policy may create incentives to manipulate the performance indicators or outputs, or view that performance metric exclusive from the overall interests of the firm] c. Both a and b [Correct; could produce productive or harmful incentives depending on the situation and the character of the person being rewarded] d. Neither a nor b [Performance compensation schemes will produce some kind of incentives]

3.

Which of the following is NOT one of the three problem solving principles laid out in Chapter 1? a. Under whose jurisdiction is the problem? [Correct; this is NOT one of the key problem solving principles]. b. Who is making the bad decision? [This is one of the key problem solving principles] c. Does the decision maker have enough information to make a good decision? [This is one of the key problem solving principles] d. Does the decision maker have the incentive to make a good decision? [This is one of the key problem solving principles]

4.

Why might it be bad for hotels to not charge higher prices when rooms are in higher demand? a. Arbitrageurs might establish a black market by reserving rooms and then selling the reservations to customers. [This black market allows the arbitrageurs to capture the value of the increased demand rather than the hotels who are providing the rooms as well as creating a less reliable system for the consumer] b. Rooms may be rationed. [If demand increases but prices do not, demand for rooms may exceed supply, forcing the hotel to ration the rooms and turn customers who would have been willing to pay higher rates away] c. Without the profit from these high demand times, hotels would have less of an incentive to build/expand, making the long run scarcity problem even worse. [Such a policy essentially creates a performance cap on the hotels, limiting their profitability to the number of rooms rather than overall demand]

d. All of the above. [Correct; all of these are potential negative impacts of hotels not adjusting prices to accommodate demand]

5.

The rational-actor paradigm assumes the people do NOT a. Act rationally. [The rational actor paradigm does assume that people act rationally] b. Act randomly. [Correct; the rational actor paradigm assumes people will act rationally, optimally and self-interestedly. Random actions are not one of the assumptions] c. Act optimally. [The rational actor paradigm does assume people will act optimally, selecting or creating the outcome that provides them with the most benefit] d. Act self-interestedly. [The rational actor paradigm does assume that people will act in their own best interest]

6.

The problem-solving principles analyze firm problems, a. from the organization’s point of view. [Correct; considering a problem from the view of the overall organization will help ensure all elements and impacts are considered.] b. from the manager’s point of view. [Managers are also employees of the organization, thinking of a problem from only their perspective may overlook its impact on the company as a whole] c. from the worker’s point of view. [Thinking about a problem only from the employee’s point of view risks missing the fundamental problem of goal alignment with the overall organization] d. from society’s point of view. [Society does not have the same goals and incentives as the firm.]

7.

Why might welfare for low income households reduce the propensity to work? a. It will not. [It can if working can only provide similar benefits to those that can be received from welfare without working] b. It reduces the incentive to work. [Correct; those receiving welfare may have less incentive to work if the benefits of working are similar to or worse than those that are received without it. Additionally, welfare may reduce the value of working for higher income workers who have to support the system, also reducing their incentives] c. It is unfair. [Perception of fairness alone will not alter the propensity to work unless it also impacts the value of that work for the individual, which would impact his overall incentives] d. It encourages jealousy. [Jealousy itself will not alter the propensity to work unless it also impacts the perceived value of that work, which changes the incentives]

8.

Why might a “bonus cap” for executives be a bad policy for the company? a. It isn’t. Executives shouldn’t make more than a certain amount. [Just like other types of employees, setting a maximum value for executives eliminates the ability to separate, reward and motivate them based on their performance] b. It would sow discontent. [Even if discontented, the rational actor paradigm indicates executives would still perform to reach the cap value in order to maximize their bonus]

c.

d.

9.

It would encourage shirking after the executives reached the cap. [Correct; limiting the bonus may reduce the incentive of executives to continue improving or performing once it is achieved] The cap could be set too high, so execs may work too hard and not reach it. [This is a problem not with the cap itself, but with the level, which can be adjusted as needed]

What might happen if a car dealership is awarded a bonus by the manufacturer for selling a certain number of its cars monthly, but the dealership is just short of that quota near the end of the month? a. It may sell the remaining cars at huge discounts to hit the quota. [Correct; the loss of income from the reduced rate will be offset by the manufacturer’s bonus] b. It creates an incentive to sell cars from different manufacturers. [The dealership is more inclined to sell cars from the manufacturer providing the bonus] c. It would ruin the relationship between dealer and manufacturer. [The dealer is working to meet the requirements of the manufacturer to achieve the bonus] d. Potential buyers will lose buying power at the dealer. [Potential buyers would gain buying power in this scenario since the dealership has incentive to lower prices]

10. Why might a supermarket advertise low prices on certain high profile items and sell them at a loss? a. It is a way for companies to be charitable. [The rational actor paradigm tells us the firm will act in its own self-interest] b. The store will sell other groceries to the same customers, often at a markup. [Correct; by using the discounted items to bring consumers into the stores, the supermarket can profit by increasing the prices on the other items they will purchase while they are there] c. They would not. [Actually, they do quite often. Can you think of why this may be?] d. This reduces the incentives of trade. [Trade incentives do not apply in this case]

Chapter 2 Multiple Choice Solutions:

1.

An individual’s value for a good or service is a. The amount of money he or she used to pay for a good. [Past payments do not necessarily indicate the current value of a good or service to an individual] b. The amount of money he or she is willing to pay for it. [Correct; to “value” a good means that you want it and can pay for it] c. The amount of money he or she has to spend on goods. [Total individual wealth does not reflect the value of a particular good or service] d. None of the above [To “value” a good means that you want it and can pay for it]

2.

The biggest advantage of capitalism is that a. it allows the market to self-regulate [Competition in the market results in self-regulation] b. it allows a person to follow his self-interest [Transactions will not be consummated unless both sides’ interests are met] c. it allows voluntary transactions which creates wealth [Wealth-creating transactions only occur when both buyer and seller see a surplus]

d. All of the above [Correct] 3.

Wealth creating transactions are more likely to occur a. with private property rights [Private property rights facilitate voluntary transactions] b. with strong contract enforcement [Contract enforcement helps facilitate voluntary transactions] c. with black markets [Black markets are often created from a wealth-generating arbitrage opportunity] d. All of the above [Correct; by making sure that buyers and sellers can keep the gains of trade, legal mechanisms such as private property and contract rights that facilitate voluntary transactions will help generate wealth; black markets also create wealth from seizing arbitrage opportunities that exist from inefficiencies in the market]

4.

Which of these actions creates value? a. Buying a struggling firm and selling off its assets for more than the purchase price. [Other firms value the sum of the individual assets more than they did when the firm was a collection of individual assets.] b. A baseball slugger drawing paying fans into the ballpark. [The baseball player increases the value of attending the game for ticket holders and potential ticket holders, thereby increasing ticket sales.] c. A student increasing his decision-making ability with an MBA. [The student is more valuable to firms with an MBA than without] d. All of the above [Correct]

5.

Which of the following are examples of a price floor? a. Minimum wages [Correct; by outlawing wages below a certain price, minimum wages are an example of a price floor] b. Rent controls in New York [This is an example of a price ceiling, in which the price of rent cannot go above a specified value] c. Both a and b [Of the two options, one is indeed an example of a price floor, while the other is a price ceiling] d. None of the above. [At least one of the answers above is an example of a price floor, which is defined as a regulation that outlaws trade at prices below the specified “floor” value]

6.

A price ceiling a. Is a government-set maximum price above market equilibrium. [A price ceiling is a regulation that outlaws trade above a specified price; it does not have to be above market equilibrium] b. Is an implicit tax on producers and an implicit subsidy to consumers. [Correct; Price ceilings prevent producers from selling at a higher price to consumers who would be willing to pay more, while consumers have the opportunity to purchase something they may not have been able to otherwise] c. Will create a surplus. [Likely, both the consumer (buyer) and producer (seller) will value the good at or above the specified ceiling. If the producer is forced to sell, any surplus for the consumer is a loss for the producer, so no net surplus is created from the transaction]

d.

7.

Causes an increase in consumer and producer surplus. [Both the consumer (buyer) and producer [seller] likely value the item at or above the specified ceiling, resulting in a benefit for the consumer but a loss of potential wealth for the producers]

Taxes a.

impede the movement of assets to higher valued uses. [This is the result of anything that deters a wealth creating transaction] b. reduce incentives to work. [By not allowing people to capture the full value of their labor and production, taxes reduce the incentive to work] c. decrease the number of wealth-creating transactions. [If a tax is larger than the total surplus created by a transaction, the transaction will not take place] d. All of the above. [Correct; when taxes are larger than the surplus of a transaction, that transaction will not take place, thus deterring a wealth creating transaction. Likewise, by not allowing people to keep the gains from their own trade, taxes can diminish the incentive to work]

8.

A consumer values a car at $20,000 and it costs a producer $15,000 to make the same car. If the transaction is completed at $18,000, the transaction will generate a. no surplus [A surplus is created from this transaction] b. $5,000 worth of seller surplus and unknown amount of buyer surplus [Seller surplus is $3,000, (Final price less seller value); Similarly, buyer surplus can be calculated by looking at the difference between the buyer value and the final price] c. $2,000 worth of buyer surplus and $3,000 of seller surplus [Correct; Buyer surplus is calculated by looking at the difference between the buyer value and the final price ($20,000$18,000=$2,000), while the seller surplus is calculated by looking at the difference between the final price and the seller’s value ($18,000-$15,000=$3,000)] d. $3,000 worth of buyer surplus and unknown amount of seller surplus. [Buyer surplus is $2,000, (Buyer value less final price); similarly, seller surplus can be calculated by looking at the difference between the final price and the seller value]

9.

A consumer values a car at $525,000 and a seller values the same car at $485,000. If sales tax is 8% and is levied on the seller, then the seller’s bottom line price is (rounded to the nearest thousand) a. $527,000 (Correct; $485,000/0.92 = $527,173.93, rounded to the nearest thousand is $527,000. (Note: as the seller requires a number at or above this value, $528,000 is arguably a better answer)] b. $524,000 [At a price of $524,000, the seller will only receive $482,080 ($524,000*0.92) which is below his bottom line] c. $525,000 [At a price of $525,000, the seller will only receive $483,000 ($525,000*0.92) which is below his bottom line] d. $500,000 [At a price of $500,000, the seller will only receive $460,000 ($500,000*0.92) which is below his bottom line]

10. Voluntary transactions a. Always produce gains for both parties [Correct; To be voluntary, both sides must see gains from consummating the transaction]

b.

Produce gains for at least one party [If one side does not see value in the transaction, they will choose to not consummate the deal. Both sides must see value] c. Always increase wealth for everyone [Voluntary transactions only create wealth for the parties involved] d. Are inefficient [Voluntary transactions move assets to their higher-value uses, a feature of an efficient market]

Chapter 3 Multiple Choice Solutions:

1.

A business owner makes 1000 items a day. Each day she contributes eight hours to produce those items. If hired elsewhere, she could have earned $250 an hour. The item sells for $15 each.

Production does not stop during weekends. If the explicit costs total $150,000 for 30 days, the firm’s accounting profit for the month equals: a. $300,000 [Correct; Revenue equals 1000 items per day * $15/item*30days = $450,000.

Explicit costs are given as $150,000. Therefore, accounting profit = $450,000-$150,000 = $300,000] b. $60,000 [This number represents the opportunity cost of her labor; $250/hr*8hrs/day*30 days = $60,000] c. $450,000 [This number represents the total revenue; 1000 items per day * $15/item*30days = $450,000.] d. $240,000 [For accounting profit, opportunity costs are not considered]

2.

If a firm is earning negative economic profits, it implies a. That the firm’s accounting profits are zero. [Not necessarily, it is impossible to determine the relationship between economic and accounting profit without information on the economic costs involved]. b. That the firm’s accounting profits are positive. [Not necessarily, it is impossible to determine the relationship between economic and accounting profit without information on the economic costs involved]. c. That the firm’s accounting profits are negative. [Not necessarily, it is impossible to determine the relationship between economic and accounting profit without information on the economic costs involved]. d. That more information is needed to determine accounting profits [Correct; it is impossible to determine the relationship between economic and accounting profit without information on the economic costs involved]

3.

Opportunity costs arise due to a. Resource scarcity [Correct; without scarce resources (time, labor, money, etc.), the pursuit of another alternative does not require one to give up anything in return. b. Lack of alternatives [ Opportunity costs come from foregoing alternatives. If there are no alternatives, there are no opportunity costs] c. Limited wants [Limited wants would not generate opportunity costs]

d.

Abundance of resources [ The pursuit of another alternative requires one to choose between allocation of resources. With abundant resources, this tradeoff does not occur]

4.

After graduating from college, Jim had three choices, listed in order of preference: (1) Move to Florida from Philadelphia, (2) work in a car dealership in Philadelphia, or (3) play soccer for a minor league in Philadelphia. His opportunity cost of moving to Florida includes a. The benefits he could have received from playing soccer [Opportunity cost represents the value of only the best foregone alternative] b. The income he could have earned at the car dealership [Correct; opportunity cost reflects the value of the best foregone alternative, in this case the car dealership salary] c. Both a and b. [Opportunity costs represent the value of only the best foregone alternative] d. Cannot be determined from the given information. [Opportunity costs reflect the value of the best foregone alternative, what is that for Jim in this case?]

5.

Economic Value Added helps firms avoid the hidden-cost fallacy a. by ignoring the opportunity costs of using capital [On the contrary, EVA makes the hidden cost of equity visible to the firm] b. by differentiating between sunk and fixed costs [EVA may help managers distinguish between the two, but it does so by looking at the cost of capital associated with each] c. by taking all capital costs into account, including the cost of equity [Correct; By taking all of the capital costs into account such as the cost of equity, firms can better gauge their economic profit and the opportunity costs associated with some of their current assets] d. None of the above. [It is one of the above]

6.

The fixed-cost fallacy occurs when a. A firm considers irrelevant costs [The sunk- or fixed-cost fallacy occurs when you make decisions using irrelevant costs or benefits. In other words, you consider costs and benefits that do not vary with the consequences of your decision. This is correct but so is another answer] b. A firm ignores relevant costs [This is the definition of the hidden cost fallacy] c. A firm considers overhead or depreciation costs to make short-run decisions [Overhead and depreciation are example of irrelevant or sunk costs that are not impacted by the outcome of a short term decision. This is correct but so is another answer] d. Both a and c. [Correct; The sunk or fixed cost fallacy occurs when costs (such as depreciation and overhead) are considered even when they do not vary with the consequences of the decision.

7.

Mr. D's Barbeque of Pickwick, TN, produces 10,000 dry-rubbed rib slabs per year. Annually Mr. D's fixed costs are $50,000. The average variable cost per slab is a constant $2. The average total cost per slab then is a. $7. [Correct; Total fixed costs are $5/slab ($50,000 Total Fixed Cost/10,000 units), and average variable cost is given as $2/slab. Therefore, average total cost (Fixed + Variable) per unit is $5+$2=$7] b. $2. [This represents the average variable cost per unit. Average total cost requires consideration of the fixed component] c. $5. [This represents the average fixed cost per unit, calculated as $50,000 Total Fixed cost/10,000 units]

d.

Impossible to determine. [Average total cost per unit can be determined by adding the average variable and fixed costs per unit of the rib slabs]

8.

All the following are examples of variable costs, except a. Hourly labor costs [Varies by the number of employees as well as their hours worked, which correlate with the total amount of output produced] b. Cost of raw materials [Cost of raw materials varies with the total amount of output produced] c. Accounting fees [Correct; accounting fees are paid regardless of total output. They do not vary with the amount that is produced] d. Electricity cost [Electricity, like other utilities varies by usage]

9.

The U.S. Government bought 112,000 acres of land in southeastern Colorado in 1968 for $17,500,000. The cost of using this land today exclusively for the reintroduction of the black-tailed prairie dog a. is zero, because they already own the land. [The cost of the land includes the cost of the best foregone option] b. is zero, because the land represents a sunk cost. [A cost is sunk when it does not vary with the outcome of the decision. In this case, there may be an opportunity cost associated with using the land for prairie dogs that should be considered] c. is equal to the market value of the land. [Correct; the cost of a decision includes the cost of the best foregone option. In this case, this is the amount the government could sell the land for if they did not use if for prairie dog introduction] d. is equal to the total dollar value the land would yield if used for farming and ranching. [This may be hard to determine, and also requires additional resources and labor. In this case, there may be a better alternative]

10. When a firm ignores the opportunity cost of capital when making investment or shutdown decisions, this is a case of a. Fixed-cost fallacy [Fixed-cost fallacy occurs when irrelevant fixed costs are considered.] b. Sunk-cost fallacy [ Sunk-cost fallacy occurs when irrelevant previous costs are considered] c. Hidden-cost fallacy [Correct; Ignoring relevant costs is an example of hidden-cost fallacy] d. None of the above [one of the above is correct]

Chapter 4 Multiple Choice Solutions:

1.

When economists speak of “marginal”, they mean a. opportunity [The opportunity cost of an alternative is the profit you give up to pursue it] b. scarcity [Scarcity refers to the limited availability of resources] c. incremental [Correct; marginal refers to additional cost or benefit created from producing each additional unit]

d.

unimportant [In economic terms, marginal does not imply unimportant. On the contrary, marginal analysis is a critical component of a wide variety of economic decisions]

2.

Managers undertake an investment only if a. Marginal benefits of the investment are greater than zero [When considering a decision, both the marginal benefits and marginal costs should be compared] b. MCs of the investment are greater than marginal benefits of the investment [If the marginal costs are greater than the marginal benefits of a decision, management will not make the investment] c. Marginal benefits are greater than MCs [Correct; managers should undertake an investment when the marginal benefits are greater than the marginal costs] d. Investment decisions do not depend on marginal analysis [Marginal analysis is critical in investment decisions]

3.

A firm produces 500 units per week. It hires 20 full-time workers (40 hours/week) at an hourly wage of $15. Raw materials are ordered weekly, and they cost $10 for every unit produced. The weekly cost of the rent payment for the factory is $2,250. How do the overall costs breakdown? a. Total variable cost is $17,000; total fixed cost is $2,250; total cost is $19,250 [Correct; both the $12,000 of labor costs (20 workers*40hrs/week*$15/hr) and the $5000 raw materials cost ($10/unit*500 units) are considered variable expenses. Factory rent is considered a fixed cost] b. Total variable cost is $12,000; total fixed cost is $7,250; total cost is $19,250 [Both labor and raw materials are considered variable costs as they both change as output levels change] c. Total variable cost is $5,000; total fixed cost is $14,250; total cost is $19.250 [Both labor and raw materials are considered variable costs as they change as output levels change] d. Total variable cost is $5,000; total fixed cost is $2,250; total cost is $7,250 [Both raw materials and labor should be considered as variable costs, which when added to the fixed rental cost will equal the total costs of production]

4.

Total costs increase from $1500 to $1800 when a firm increases output from 40 to 50 units. Which of the following is true if MC is constant? a. FC = $100 [We know that Total cost = FC + VC(Quantity). This means 1500 = FC+VC(40) and 1800=FC+VC(50). Using this information, we can solve for FC] b. FC = $200 [We know that Total cost = FC + VC(Quantity). This means 1500 = FC+VC(40) and 1800=FC+VC(50). Using this information, we can solve for FC] c. FC = $300 [Correct; We know that Total cost = FC + VC(Quantity). This means 1500 = FC+VC(40) and 1800=FC+VC(50). Using this information, we can solve for FC. For example, using the first equation we see VC(40)=1500-FC, hence VC=(1500-FC)/40. Plugging this value for VC into 1800=FC+VC(50) will give you 1800=FC+50((1500-FC)/40), which lets us find FC=300] d.

5.

FC = $400 [We know that Total cost = FC + VC(Quantity). This means 1500 = FC+VC(40) and 1800=FC+VC(50). Using this information, we can solve for FC]

A manager of a clothing firm is deciding whether to add another factory in addition to one already in production. The manager would compare

a.

b.

c.

d.

the total benefits gained from the two factories to the total costs of running the two factories.

[By combining the total costs and benefits of the two factories, the manager would not be able to determine the contribution of the second factory on its own] the incremental benefit expected from the second factory to the total costs of running the two factories. [The additional benefit of the second factory should only be compared to the additional costs of that factory, as the costs from the first factory will be incurred regardless] the incremental benefit expected from the second factory to the cost of the second factory [Correct; the manager will decide to add another factory when the incremental benefits of that factory are greater than its incremental costs] the total benefits gained from the two factories to the incremental costs of running the two factories. [The incremental costs of having a second factory should be compared only to its incremental benefit, as the benefits of the first factory will be produced regardless]

6.

A firm is thinking of hiring an additional worker to their organization who can increase total productivity by 100 units a week. The cost of hiring him is $1,500 per week. If the price of each unit is $12, a. the MR of hiring the worker is $1,500 [The MR of hiring the worker is $1200 (100 additional units produced*$12/unit)] b. The MC of hiring the worker is $1,200 [The MC of hiring the worker is his salary of $1500] c. The firm should not hire the worker since MR < MC [Correct; The MR of hiring the worker is $1200 (100 additional units*$12/unit), while his MC is his salary of $1500, indicating the company will lose $300/week by hiring the additional worker] d. All the above [Remember the marginal benefit is the additional revenue generated by the worker, while the marginal costs will be any additional costs that occur from hiring him]

7.

A retailer has to pay $9 per hour to hire 13 workers. If the retailer only needs to hire twelve workers, a wage rate of $7 per hour is sufficient. What is the MC of the 13th worker? a. $117. [This is the total cost of having 13 workers ($9*13)] b. $9. [This represents the wage of the additional worker, but does not take into consideration the additional costs of the wage increase for the rest of the employees associated with his hiring] c. $33. [Correct; The total cost of having twelve workers is $84 (12workers*$7hr) while the addition of the thirteenth worker brings the total cost up to $117 (13 workers*$9/hr).

Therefore, the marginal cost of the 13th worker is $33 ($117-$84)] d. $84. [This is the total cost of having 12 workers (12*$7/hr)]

8.

If a firm’s AC is rising then a. MC is less than AC. [If marginal cost is less that average cost, then its average cost will fall with each additional unit] b. MC is rising. [Average cost may still be falling even as marginal cost rises, provided the marginal cost still falls below the average] c. MC is greater than AC. [Correct; when the marginal cost is above the average, then the average will rise with output] d. the firm is making an economic profit. [Average cost trends cannot be determined by looking at average costs exclusively]

9.

A company is producing 15,000 units. At this output level, MR is $22 and the MC is $18. The firm sells each unit for $48 and average total cost is $40. What can we conclude from this information?

a.

The company is making a loss. [The company is making a profit of $120000. Total revenues equal $720000 ($48*15000units) while total costs are $600000 ($40*15000units)] b. The company needs to cut production. [You need to cut production when MC>MR] c. The company needs to increase production. [Correct; When MR>MC, you need to sell more. In this case MR=$22 is greater than MC=$18, therefore they should increase production] d. Not enough information is provided. [There is enough information provided to answer this question]

10. Food Fanatics caters meals where its costs of producing an extra meal is $25. Each of its meals sells for $20. At this rate, what should the company do? a. Produce more meals and increase its profit [MC is greater than MR] b. Produce fewer meals and increase its profit [Correct; MR=$20 and MC=$25; produce less when MR<MC] c. Not change production [Food Fanatics is not at the point where MR=MC] d. None of the above [See above]

Chapter 5 Multiple Choice Solutions

1.

Which of the following will increase the break-even quantity? a. A decrease in overall fixed costs [Breakeven is calculated as Q=F/(P-MC), Therefore a decrease in overall fixed costs would decrease the numerator and hence the Breakeven Quantity] b. A decrease in the marginal costs [Breakeven is calculated as Q = F/(P-MC). Therefore a decrease in the marginal costs will increase the denominator, and subsequently decreases the Breakeven Quantity] c. A decrease in the price level [Correct; Breakeven is calculated as Q= F/(P-MC). Therefore, a decrease in the price level will decrease the denominator, which will increase the Breakeven quantity] d. An increase in price level [Breakeven is calculated as Q= F/(P-MC). Therefore, an increase in the price level will increase the denominator, which will decrease the Breakeven Quantity.

2.

The higher the discount rate a. the more value individuals place on future dollars [a higher discount rate means future dollars are worth less relative to current dollars (present value of future dollars is lower)] b. the more value individuals place on current dollars [Correct; a higher discount rate means dollars today are value comparatively more relative to future dollars] c. the more investments will take place [the higher discount rate means the future value of current dollars is lower, which may lead to a decrease in investment] d. does not affect the investment strategy [interest rates are an important consideration of any investment strategy in terms of its impact on both the investing and borrowing rates]

3.

Assume a firm has the following cost and revenue characteristics at its current level of output: price=$10.00, average variable cost=$8.00 and average fixed cost =$4.00. This firm is a. incurring a loss of $2.00 per unit and should shut down. [In the short run, only variable costs are avoidable and should be considered in a shut down decision] b. realizing only a normal profit. [In this case, the firm is not making a profit] c. realizing an economic profit of $2.00 per unit. [In this case, the firm is not making a profit] d. incurring a loss per unit of $2.00 but should continue to operate in the short run.

[Correct; In the short run, only variable costs are avoidable and should be considered in a shutdown decision. As the current price ($10) is still higher than the variable costs ($8), the company should continue to operate in the short run until the fixed costs become avoidable]

4.

Sarah’s Machinery Company is deciding to dump their current technology A for a new technology B with smaller fixed costs but bigger MCs. The current technology has fixed costs of $500 and MCs of $50 whereas the new technology has fixed costs of $250 and MCs of $100. At what quantity is Sarah’s Machinery Company indifferent between two technologies? a. 5 [Correct; Total costs can be calculated as C=FC+VC(Q). Technology A has total costs of C=500+50(Q), while Technology B has C=250+100(Q). Sarah is indifferent at the quantity at which these two costs are the same. Therefore, setting these equations equal to each other gives us 500+50(Q) = 250 +100(Q), which allows us to solve for Q = 5]

b. c. d.

6 [Total costs can be calculated as C=FC+VC(Q). Sarah will be indifferent between the two technologies at the quantity where these two costs are the same] 7 [Total costs can be calculated as C=FC+VC(Q). Sarah will be indifferent between the two technologies at the quantity where these two costs are the same] 8 [Total costs can be calculated as C=FC+VC(Q). Sarah will be indifferent between the two technologies at the quantity where these two costs are the same]

5.

What is the net present value of a project that requires a $100 investment today and returns $50 at the end of the first year and $80 at the end of the second year? Assume a discount rate of 10%. a. $10.52 [To find Net Present Value, discount the future cash flows by the discount rate raised to the period in which it was received (for example, year one means k=1, etc) and then subtract the initial investment from the sum of those cash flows] b. $11.57 [Correct; Net present value is calculated by discounting the future cash flows from the period they were received and subtracting the initial investment from the sum of those cash flows. In this case, (50/1.1)+(80/1.12)=111.57. $111.57-$100 initial investment gives a NPV of $11.57] c. $18.18 [Remember that the cash inflows need to be discounted back to present value from the time period in which they occur (50 at the end of year 1, 80 at the end of year 2)] d. $30.00 [Don’t forget about the time value of money. To determine the net present value, the future cash flows will need to be discounted and the initial investment will be subtracted from the sum of those values]

6.

You expect to sell 500 cell phones a month, which have an MC of $50. If your fixed costs are $5,000 per month, what is the break-even price? a. $10 [Breakeven Q= FC/(P-MC). This means (P-MC)Q=FC, so P-MC= (FC/Q) and finally P= (FC/Q) + MC] b. $50 [Breakeven Q= FC/(P-MC). This means (P-MC)Q=FC, so P-MC= (FC/Q) and finally P= (FC/Q) + MC] c. $60 [Correct; Breakeven Q= FC/(P-MC). This means (P-MC)Q=FC, so P-MC= (FC/Q) and finally P= (FC/Q) + MC. This gives us P= (5000/500)+50 = 10+50 = $60] d. $100[Breakeven Q= FC/(P-MC). This means (P-MC)Q=FC, so P-MC= (FC/Q) and finally P= (FC/Q) + MC]

7.

You are considering opening a new business to sell dartboards. You estimate that your manufacturing equipment will cost $100,000, facility updates will cost $250,000, and on average it will cost you $80 (in labor and material) to produce a board. If you can sell dart boards for $100 each, what is your break-even quantity? a. 1,000 [Breakeven Q=FC/(P-MC). In this case, the Fixed costs include both the equipment and the updates, the price is given at $100, and the MC equals the average cost per board] b. 3,500 [Breakeven Q= FC/(P-MC). Don’t forget to consider the marginal costs!] c. 4,375 [Breakeven Q= FC/(P-MC). Don’t forget to consider the price!] d. 17,500 [Correct; Breakeven Q = FC/(P-MC). In this case, fixed costs are $350,000 ($100,000 equipment + $250,000 updates), the Price is given as $100 and the Marginal cost is the $80 cost per additional board. Putting these in the formula, we see that 350,000/(100-80) = 17,500]

8.

If GDP is expected to increase at a steady rate of 3% per year, how many years would it take for living standards to double?

a. b. c. d.

9.

10 [1.03^10=1.34] 20 [1.03^20=1.81] 24 [Correct; 1.03^24=2.03] 30 [1.03^30=2.42]

Break-even quantity is a point where a. the level of profit is maximized. [Profit occurs when sales exceed the break-even quantity] b. the level of cost is minimized. [Break-even quantity is the point at which costs are merely offset, not minimized] c. only variable costs are covered. [Both fixed and variable costs are covered at the break-even quantity] d. there are zero profits. [Correct; This is the definition of break-even quantity]

10. In the short run, a firm’s decision to shut down should not take into consideration a. avoidable costs. [Avoidable costs are relevant because they would be recovered in the short run] b. variable costs. [Variable costs are relevant because they would be recovered in the short run] c. fixed costs. [Correct; fixed costs are only avoidable in the long run] d. MCs [marginal costs are relevant because they would be recovered in the short run]

Chapter 6 Multiple Choice Questions

1.

Jim has estimated elasticity of demand for gasoline to be -0.7 in the short-run and -1.8 in the long run.

A decrease in taxes on gasoline would: a. lower tax revenue in both the short and long run. [Demand is inelastic in the short run, but elastic in the long run, indicating different effects in the short and long run from the price reduction that results from lower taxes] b. raise tax revenue in both the short and long run. [Demand is inelastic in the short run, but elastic in the long run, indicating different effects in the short and long run from the price reduction that results from lower taxes] c. raise tax revenue in the short run but lower tax revenue in the long run. [Inelastic demand in the short run means people initially will not change their consumption habits, which will lower revenue. What are the long-term effects?] d. lower tax revenue in the short run but raise tax revenue in the long run. [Correct; demand is inelastic in the short run, which means that initially the decrease in taxes will not alter people’s demand or consumption for gas, which will result in a decrease in the potential tax revenue as there is the same level of consumption at a lower price. However, in the long tax revenue will increase as the demand for gasoline becomes elastic, and the consumption of gasoline rises]

2.

It’s lunch time, you are hungry, and you would like to have some pizza. By the law of diminishing marginal value, a. You would pay more for your first slice of pizza than your second. [Correct; the marginal value of the second pizza slice is less than the first] b. You would pay more for your second slice of pizza than your first. [You value the second slice less because you have already eaten one slice] c. You would pay an equal amount of money for both the slices since they are identical. [You value the second slice less because you have already eaten one slice] d. None of the above [One of the above is correct]

3.

Teshi recently graduated from college. Her income increased tremendously from $5,000 a year to $60,000 a year. Teshi decided that instead of renting she will buy a house. This implies that a. houses are normal goods for Teshi [Correct; for normal goods, demand increases as income increases] b. houses are inferior goods for Teshi [For inferior goods, demand decreases as income increases] c. renting and owning are complementary for Teshi [Teshi’s decision to purchase a house was not reflective of a change in rental rates. If anything, renting and owning are substitutes for one another] d. we need information on the price of houses. [Not necessarily, Teshi’s behavior and purchasing decision here is more informative than the actual housing prices]

4.

Which of the following goods has a negative income elasticity of demand? a. Cars [Cars are a normal good; typically demand for cars increases with income]

b. c. d.

Items from Dollar stores [Correct; Dollar store items are typically considered inferior goods, hence their demand will decrease as the income of the user increases] Shoes [Typically, shoes are considered a normal good, with demand increasing with the income of the purchaser] Bread [Bread, like most food, is considered a normal good]

5.

An economist estimated the cross-price elasticity for peanut butter and jelly to be 1.5. Based on this information, we know the goods are a. inferior goods. [Cross price elasticity measures the change in the demand of one good with regard to the price of another in order to determine complements and substitutes. It does not reflect if a good is normal or inferior] b. complements. [Complements have negative cross price elasticity] c. inelastic. [With a cross price elasticity of 1.5>1, this relationship is elastic] d. substitutes. [Correct; Positive cross price elasticity means that Good A (Peanut Butter) is a substitute for Good B (Jelly)]

6.

Christine has purchased five bananas and is considering the purchase of a sixth. It is likely she will purchase the sixth banana if a. the marginal value she gets from the sixth banana is lower than its price. [Christine will not purchase an additional banana if the marginal value she receives is lower than her marginal cost (the price of the additional banana)] b. the marginal benefit of the sixth banana exceeds its price. [Correct; Christine will only purchase the banana when the marginal benefit she receives is greater than the marginal cost (or price) of the additional banana] c. the average value of the sixth bananas exceeds the price. [The marginal benefit, not the average value/benefit of the sixth banana is what is important to consider for this decision] d. the total personal value of six bananas exceeds the total expenditure to purchase six bananas. [Total values should not impact the decision to purchase an additional banana.

Rather, the marginal benefit of the sixth banana relative to its cost should be considered]

7.

Buyers consider Marlboro cigarettes and Budweiser beer to be complements. If Marlboro just increased its prices, what would you expect to occur in the Budweiser market? a. Demand would rise, and Budweiser would reduce price. [If two goods are complements, an increase in the price of one results in a decrease in demand for the other] b. Demand would fall, and Budweiser would reduce price. [Correct; when two goods are complements, an increase in the price of one results in a decrease in the demand for the other. To account for this decrease in demand, Budweiser would ultimately lower its prices as well] c. Demand would fall, and Budweiser would increase price. [As complements, demand for Budweiser would fall as a result of the increase in Marlboro prices. An increase in prices would only further decrease demand] d. Demand would rise, and Budweiser would increase supply. [If two goods are complements, and increase in the price of one results in a decrease in the demand for the other]

8.

Which of the following is the reason for the existence of consumer surplus? a. Consumers can purchase goods that they “want” in addition to what they “need.” [Wants and needs are both a reflection of how the consumer values an item, not necessarily an indication of consumer surplus]

b.

c.

d.

9.

Consumers can occasionally purchase products for less than their production cost.

[Production cost is less relevant to creating consumer surplus than the amount of value a consumer places on a final good (this could in fact be lower than the production cost as well)] Some consumers receive temporary discounts that result in below-market prices.

[Consumer surplus is a measure of the difference between the value a consumer places on an item and the amount they ultimately pay for it. If a consumer only purchases an item because of a discount, it indicates they likely value the item at the below-market price, so no surplus is created] Some consumers are willing to pay more than the price. [Correct; consumer surplus exists when the Value to the consumer is greater than the final (or market) price. It is when consumers pay market price for a good they place a higher value on that a consumer surplus is created]

A bakery currently sells chocolate chip cookies at a price of $16/dozen. The MC is $8/dozen. The cookies are becoming more popular with customers and so the bakery owner is considering raising the price to $20/dozen. What percentage of customers must be retained to ensure that the price increase is profitable? a. 28.0% [If the store only maintained 28% of its current customers, it would need to increase its prices to $36!] b. 33.3% [This is the number of customers the bakery can lose and still remain profitable] c. 66.6% [Correct; as the margin has increased from 8 (16-8) to 12(20-8), the bakery must maintain 66.6% (8/12) of its customers in order to get the same level of profitability] d. 72.0% [If the store maintained 72% of its current customers, it would only need to increase its prices to $19]

10. Suppose your firm adopts a technology that allows you to increase your output by 15%. If the elasticity of demand is -3, how should you adjust price if you want to sell all of your output? a. 5% lower. [Correct; %ΔQ= e(%ΔP). Therefore, an 15% increase in Q = -3(%ΔP), hence %ΔP = -5%] b. 0.5% lower. [Remember, %ΔQ= e(%ΔP)] c. 15% higher. [Remember, %ΔQ= e(%ΔP)] d. 15% lower. [Remember, %ΔQ= e(%ΔP)]

Chapter 7 Multiple Choice Questions

1.

Microsoft found that instead of producing a DVD player and a gaming system separately, it is cheaper to incorporate DVD playing capabilities in its new version of the gaming system. Microsoft is taking advantage of a. economies of scale [economies of scale mean average costs decline with output. There is no indication here that this is happening.] b. learning curve [learning curves mean that current production lowers future costs for the same product; that does not apply here] c. economies of scope [correct; the cost to produce the two products together is less than the sum of the costs of producing them separately] d. decreasing marginal costs [there is no indication that marginal costs are decreasing for either individual product]

2.

As a golf club production company produces more clubs, the average total cost of each club produced decreases. This is because: a. total fixed costs are decreasing as more clubs are produced [fixed costs by definition do not change with volume]. b. average variable cost is decreasing as more clubs are produced [there is no information to indicate that variable costs are declining]. c. there are scale economies. [correct; declining average total costs are indicative of economies of scale] d. total variable cost is decreasing as more clubs are produced [because variable cost will not be less than zero, total variable cost would not decrease as more units are produced]

3.

Average costs curves initially fall a. due to declining average fixed costs [correct; as output increases and fixed costs are distributed over more units, average fixed costs per unit fall] b. due to rising average fixed costs [average costs curves would increase if average fixed cost is increasing] c. due to declining accounting costs [accounting costs are not relevant here] d. due to rising marginal costs [rising marginal costs would cause the average costs curve to rise, not fall]

4.

At a startup, many of the employees must perform multiple tasks. Once the firm takes off, more employees are hired, and we expect: a. Each employee to be responsible for fewer tasks. [with more workers a firm can have employees specialize more.] b. The marginal cost to fall due to specialization. [greater scope for specialization can make a firm more efficient and lower marginal cost] c. The average fixed costs to fall. [workers specialize more lead to efficiencies that can lower average cost] d. All of the above. [correct; with more employees, each worker can perform fewer tasks which allows them to specialize more, increases productivity, and lowers marginal cost and average cost]

5.

A security system company’s total production costs depend on the number of systems produced according to the following equation: Total Costs = $20,000,000 + $4000*quantity produced. Given these data, which of the following is a false statement? a. There are economies of scale. [this statement is true; average costs fall with output]

b. c. d.

There are fixed costs associated with this business. [this statement is true; the $20,000,000 is a fixed cost] There are diseconomies of scale [correct; if average costs increased with output, there would be diseconomies. That is not the case here] A firm that produces a larger output has a cost advantage over a smaller firm. [this statement is true; because average costs decrease with output(economies of scale), firms producing more will have lower average costs]

6.

Following are the costs to produce Product A, Product B, and Products A and B together. Which of the following exhibits economies of scope? a. 100, 150, 240 [correct; the cost of producing both products together (240) is less than the sum of the cost of producing them separately (250)] b. 100, 150, 250 [the cost of producing both products together (250) is NOT less than the sum of the cost of producing them separately (250)] c. 100, 150, 260 [the cost to produce the two products together (260) is NOT less than the sum of the costs of producing them separately(250)] d. All of the above [only one of the choices exhibits economies of scope]

7.

According to the law of diminishing marginal returns, marginal returns: a. diminish always prior to increasing. [marginal returns do not always diminish prior to increasing] b. diminish constantly. [there are cases where marginal returns increase] c. diminish never. [the law of diminishing marginal returns suggests some cases where returns will diminish]diminish eventually. [correct; The law of diminishing marginal returns states that as you try to expand output, your marginal productivity (the extra output associated with extra inputs) eventually declines.]

8.

It costs a firm $90 per unit to produce product A and $70 per unit to produce product B individually.

If the firm can produce both products together at $175 per unit of product A and B, this exhibits signs of a. economies of scale [economies of scale are not relevant here because the question refers to the cost of producing two separate products, not more of the same product] b. economies of scope [economies of scope indicate that the cost of producing the two products together is less than the sum of the cost of producing them separately. This is not the case here.] c. diseconomies of scale [economies of scale are not relevant here because the question refers to the cost of producing two separate products, not more of the same product] d. diseconomies of scope [correct; the cost to produce the two products together (175) is more than the sum of the costs of producing them separately(160)]

9.

A company faces the following costs at the respective production level in addition to its fixed costs of $50,000:

Quantity

Marginal Cost

Sale Price

Marginal Return

1

$10,000

$20,000

$10,000

2

$11,000

$20,000

$9,000

3

$12,000

$20,000

$8,000

4

$13,000

$20,000

$7,000

5

$14,000

$20,000

$6,000

[note to instructors: there is no question associated with #9; it was mistakenly numbered. Q10 refers to the information in the table above] 10. How would you describe the returns to scale for this company? a. Increasing [correct; average total costs are falling with output] b. Decreasing [average costs are falling with output, so returns are not decreasing] c. Constant [average costs are falling with output, so returns are not constant] d. Marginal [“marginal” returns to scale is not a meaningful phrase]

11. Once marginal cost rises above average cost, a. Average costs will increase [correct; the cost to produce an additional unit of output will be greater than the previous unit of output, which will increase average costs] b. Average costs are unaffected [average costs will be affected] c. Average costs will decrease [average costs will not decrease] d. None of the above [one of the answers is correct because marginal and average costs are related]

Chapter 8 1.

Changes in prices of a good causes a. movement along the demand curve [yes but this is not the only effect] b. movement along the supply curve [yes but this is not the only effect] c. no movement along either curve [changes in prices will result in movement along one or more of these curves d. Both a and b [correct; it causes movement along both curves]

2.

Imagine that the market for home exercise equipment experiences an increase in supply and a decrease in demand. Which of the following results is expected to occur? a. Both the equilibrium price and the equilibrium quantity could rise or fall. [increase in supply and decrease in demand both lead to a fall in price ] b. The equilibrium price would rise, and the equilibrium quantity could rise or fall. [increase in supply and decrease in demand both lead to a fall in price] c. The equilibrium price would fall, and the equilibrium quantity could rise or fall. [correct; increase in supply and decrease in demand both lead to lower price; net quantity change is unknown because the increase in supply would lead to higher quantity while the decrease in demand would lead to lower quantity] d. The equilibrium price would fall, and the equilibrium quantity would fall. [net quantity change is unknown because the increase in supply would lead to higher quantity while the decrease in demand would lead to lower quantity]

3.

When demand for a product falls, which of the following events would you NOT necessarily expect to occur? a. A decrease in the quantity of the product supplied. [equilibrium quantity will fall with a decrease in demand] b. A decrease in its price. [equilibrium price will fall with a decrease in demand] c. A decrease in the supply of the product. [correct; while a decrease in demand will be associated with a decrease in the quantity supplied at equilibrium, it will not cause a shift in the supply curve] d. A leftward shift of the demand curve. [falling demand means the demand curve shifts leftward]

4.

Suppose a recent and widely circulated medical article has reported new benefits of cycling for exercise. Simultaneously, the price of the parts needed to make bikes falls. If the change in supply is greater than the change in demand, the price will _________ and the quantity will _________. a. rise, rise [demand will increase because of the article while supply will also increase because of lower costs; if the supply shift (leading to lower prices) is greater than the change in demand (leading to higher prices), the net effect should not be a rise in both price and quantity] b. rise, fall [demand will increase because of the article while supply also increases because of lower costs; if the supply shift (leading to lower prices) is greater than the change in demand (leading to higher prices), the net effect should not be a fall in quantity.] c. fall, rise [correct; demand will increase because of the article while supply will also increase because of lower costs; if the supply shift (leading to lower prices) is greater than the change in demand (leading to higher prices), the net effect should be a fall in price while both shifts lead to a rise in quantity] d. fall, fall [demand will increase because of the article while supply will also increase because of lower costs; if the supply shift (leading to lower prices) is greater than the change in demand (leading to higher prices), the net effect should be a fall in price while both shifts lead to a rise in quantity]

5.

Suppose there are nine sellers and nine buyers in a competitive market, each willing to buy or sell one unit of a good, with values {$10, $9, $8, $7, $6, $5, $4, $3, $2}. Assuming there are no transactions costs, what is the equilibrium price in this market? a. $5 [at a price of $5, four suppliers are willing to sell but six buyers are willing to buy] b. $6 [correct; at a price of $6, five suppliers are willing to sell and five buyers are willing to buy] c. $7 [at a price of $7, six suppliers are willing to sell but four buyers are willing to buy] d. $8 [at a price of $8, seven suppliers are willing to sell but three buyers are willing to buy]

6.

If the government imposes a price floor at $9 (i.e., price must be $9 or higher) in the above market, how many goods will be traded? a. Five [at a price of $9, eight suppliers are willing to sell but only two buyers have values of $9 or more] b. Four [at a price of $9, eight suppliers are willing to sell but only two buyers have values of $9 or more] c. Three [at a price of $9, eight suppliers are willing to sell but only two buyers have values of $9 or more] d. Two [correct; at a price of $9, eight suppliers are willing to sell but only two buyers are willing to buy]

7.

Say the average price of a new home in Haaland City is $260,000. The local government has just passed new licensing requirements for housing contractors. Based on possible shifts in demand or supply and assuming that the licensing changes do not affect the quality of new houses, which of the following is a reasonable prediction for the average price of a new home in the future? a. $240,000 [the new licensing requirements lead to a reduction in supply, which will NOT lead to a lower equilibrium price] b. $250,000 [the new licensing requirements lead to a reduction in supply, which will NOT lead to a lower equilibrium price] c. $260,000 [the new licensing requirements lead to a reduction in supply, which will affect the equilibrium price] d. $270,000 [correct; the new licensing requirements lead to a reduction in supply, which will lead to a higher equilibrium price]

8.

Suppose a new employer is also re-locating to Haaland City and will be attracting many new people who will want to buy new houses. Assume that the change in licensing requirements mentioned above occurs at the same time. What do you think will happen to the equilibrium quantity of new homes bought and sold in Haaland City? a. It will decrease substantially [while quantity will decrease from the reduction in supply, the demand increase will cause quantity to rise] b. It will decrease but not by much [while quantity will decrease from the reduction in supply, the demand increase will cause quantity to rise] c. It will increase [while quantity will increase from the increase in demand, the supply decrease will cause quantity to fall] d. Not enough information [correct; the decrease in supply from the prior question will be associated with a lower quantity while the increase in demand mentioned here will be associated with higher quantity. Without knowing the magnitude of the shifts, it’s not possible to know the net effect (there is not enough information).]

9.

The price of peanuts increases. At the same time, we see the price of jelly (which is often consumed with peanut butter) rise. How does this affect the market for peanut butter? a. The demand curve will shift to the left; the supply curve will shift to the left [correct; the price of peanuts leads to higher peanut butter production costs meaning supply will shift left; a rise in the price of jelly, a complement to peanut butter, will cause peanut butter demand to shift left]

b. c. d.

The demand curve will shift to the left; the supply curve will shift to the right [the price of peanuts leads to higher peanut butter production costs meaning supply will shift left] The demand curve will shift to the right; the supply curve will shift to the left [a rise in the price of jelly, a complement to peanut butter, will cause peanut butter demand to shift left] The demand curve will shift to the right; the supply curve will shift to the right [the price of peanuts leads to higher peanut butter production costs meaning supply will shift left; a rise in the price of jelly, a complement to peanut butter, will cause peanut butter demand to shift left]

10. Holding other factors constant, an increase in the tax for producing coffee causes a. the supply curve to shift to the left, causing the prices of coffee to rise [correct; an increase in tax raises coffee production costs, leading to a decrease (shift left) in supply] b. the supply curve to shift to the right, causing the prices of coffee to rise [an increase in tax cause a shift left in supply] c. the supply curve to shift to the left, causing the prices of coffee to fall [a shift left in supply causes prices to rise not fall] d. the supply curve to shift to the right, causing the prices of coffee to fall [an increase in tax cause a shift left in supply]

Chapter 9 Multiple Choice Questions

1.

In the long-run, which of the following outcomes is most likely for a firm? a. Zero accounting profits but positive economic profits [ firms do not earn positive economic profit in the long-run] b. Zero accounting profits [zero accounting profit implies negative economic profit, and firms do not earn negative economic profit in the long-run] c. Positive accounting profits and positive economic profits [ firms do not earn positive economic profit in the long-run] d. Zero economic profits but positive accounting profits [correct; in the long-run economic profit is driven to zero]

2.

At the individual firm level, which of the following types of firms faces a downward-sloping demand curve? a. Both a perfectly competitive firm and a monopoly firm [the demand curve for the output of a perfectly competitive firm is flat] b. Neither a perfectly competitive firm nor a monopoly firm [one of the two types does face a downward-sloping demand curve] c. A perfectly competitive firm but not a monopoly firm [the demand curve for the output of a perfectly competitive firm is flat] d. A monopoly firm but not a perfectly competitive firm [correct; monopoly firms face a downward-sloping demand curve]

3.

Which of the following types of firms are guaranteed to make positive economic profit? a. Both a perfectly competitive firm and a monopoly [in the long-run, economic profit for both types of firms will be zero] b. Neither a perfectly competitive firm nor a monopoly [correct; no firm is guaranteed to make positive economic profit] c. A perfectly competitive firm but not a monopoly [in the long-run, economic profit for competitive firms will be zero] d. A monopoly but not a perfectly competitive firm [in the long-run, economic profit for monopoly firms will be zero]

4.

What is the main difference between a competitive firm and a monopoly firm? a. The number of customers served by the firm [competitive firms and monopoly firms may or may not have similar numbers of customers] b. Monopoly firms are more efficient and therefore have lower costs. [monopoly firms may or may not have lower costs] c. Monopoly firms can generally earn positive profits for a longer period of time. [correct; this profit is a reward for doing something unique, innovative, or creative—something that gives the firm less elastic demand.] d. Monopoly firms enjoy government protection from competition. [not necessarily; other factors can contribute to the lack of rivals]

5.

Which of the products below is closest to operating in a perfectly competitive industry? a. Nike shoes [branding of the shoes reduces the “closeness” of substitute products] b. Cotton [correct; agricultural commodities are close to perfectly competitive industries] c. Perdue Chicken [branding of the chicken reduces the “closeness” of substitute products]

d.

Restaurants [branding and other differentiation efforts reduce the “closeness” of substitute restaurants]

6.

A firm in a perfectly competitive market (a price taker) faces what type of demand curve? a. Unit elastic [a unit elastic demand curve is downward sloping; firms in perfectly competitive markets do not face unit elastic or downward sloping demand curves] b. Perfectly inelastic [demand is not inelastic for competitive firms] c. Perfectly elastic [correct; the demand curve for the output of a perfectly competitive firm is perfectly elastic (flat)] d. None of the above [one of the answers is correct]

7.

A competitive firm’s profit maximizing price is $18. At MC=MR, the output is 100 units. At this level of production, average total costs are $14. The firm’s profits are a. $400 in the short run and long run [long-run profit will be driven down to zero] b. $400 in the short-run and zero in the long run [correct; (18-14)*100. Long run profit is always driven to zero.] c. $1800 in the short-run and long-run [short-run profit will be price minus average cost times quantity; long-run profit will be driven down to zero] d. $1800 in the short-run and zero in the long run [short-run profit will be price minus average cost times quantity]

8.

What would happen to revenues if a firm in a perfectly competitive industry raised price? a. They would increase [a competitive firm can only sell at the industry price] b. They would increase but profit would decrease [a competitive firm can only sell at the industry price] c. They would increase along with profit [a competitive firm can only sell at the industry price] d. They would fall to zero [correct; a competitive firm can only sell at the industry price. If the firm raises price, it would sell nothing]

9.

If a firm in a perfectly competitive industry is experiencing average revenues greater than average costs, in the long-run a. some firms will leave the industry and price will rise [firms are unlikely to leave if revenues are greater than costs] b. some firms will enter the industry and price will rise [price is unlikely to increase if firms enter the industry] c. some firms will leave the industry and price will fall [firms are unlikely to leave if revenues are greater than costs; if they did leave, price would not fall] d. some firms will enter the industry and price will fall [correct; firms will be attracted to the higher-than-average revenues. As more firms enter the industry, supply will increase and price will fall.]

10. A sudden increase in the market demand in a competitive industry leads to a. above average profits in the short-run and average profits in the long-run [correct] b. losses in the short-run and average profits in the long-run [an increase in demand would lead to higher prices] c. firms looking to exit the industry [an increase in demand would lead to higher prices; higher prices would be unlikely to lead to exit] d. demand creating supply [demand does not create supply]

Chapter 10 Multiple Choice Questions

1.

An industry is defined as a. a group of firms producing the exact same products and services. [the products are not necessarily exactly the same] b. firms producing items that sell through the same distribution channels. [products within an industry may be sold through different distribution channels] c. firms that have the same resources and capabilities. [firms within an industry may have different resources and capabilities] d. a group of firms producing products that are close substitutes. [correct]

2.

Attractive industries have all the following, except a. high rivalry [correct; high rivalry would result in lower prices and reduced profit] b. low buyer power [low buyer power is positive for an industry; it means buyers capture less value] c. high entry barriers [high entry barriers help protect the industry from the threat of potential entrants] d. low supplier power [low supplier power is positive for an industry; it means suppliers capture less value]

3.

Which of the following is NOT an example of an entry barrier? a. Government protection through patents or licensing requirements [patents and licensing do slow entry into an industry] b. Strong brands [brands help deter entry because potential entrants will have to invest capital and time to build a competing brand] c. Low capital requirements for entry [correct; if capital requirements are low, it will be less costly (easier) to enter] d. Lower costs driven by economies of scale [this is an entry barrier as potential entrants know they will not be cost-competitive unless they can achieve scale]

4.

Buyers have higher power when a. their suppliers sell a highly differentiated product. [highly differentiated products mean buyers have lower power because it is more costly to switch to a rival product] b. they are not a significant purchaser of their supplier's output. [purchasing a large volume of a particular supplier’s output leads to higher negotiating power] c. switching costs are low. [correct; low switching costs put buyers in a better negotiating position because it is easier to buy a rival’s product] d. the buyer industry is highly fragmented (buyers are not concentrated) [fragmented buyers do not have more negotiating power].

5.

Which of the following is NOT a factor that contributes to higher rivalry in an industry? a. Numerous competitors. [more competitors generally leads to greater rivalry as cooperative outcomes are hard to achieve with many competitors] b. High fixed costs. [high fixed costs are associated with higher rivalry; when fixed costs are high and marginal costs are low, there is pressure to cut price to build volume in order to make some contribution to covering fixed costs] c. Fast industry growth. [correct; high growth reduces rivalry because firms are less worried about fighting over existing sources of demand given that demand is growing] d. Low switching costs for buyers. [low switching costs means firms have a high incentive to compete for buyers to get them to switch]

6.

The concept that describes firms possessing different bundles of resources is a. resource heterogeneity [correct] b. resource immobility [resource immobility describes the fact that resources resist transfer or copying] c. barriers to entry [barriers to entry are factors that reduce threat of entry to an industry] d. imitability [imitability refers to whether a resource can be copied]

7.

If a firm successfully adopts a product differentiation strategy, the elasticity of demand for its products should a. increase [increased elasticity means buyers would be more price sensitive; if the product is successfully differentiated, buyers should become less price sensitive] b. decrease [correct; decreased elasticity means buyers would be less price sensitive. If the product is more differentiated, buyers should be less price sensitive.] c. become marginal [marginal is not a term used to describe demand elasticity] d. be unaffected [elasticity should be affected]

8.

When a resource or capability is valuable and rare, a firm may gain a a. sustainable competitive advantage. [the resource or capability must also be difficult to imitate / substitute for the competitive advantage to be sustainable] b. competitive parity. [a valuable and rare resource or capability should help the firm do better than just achieve parity] c. cost advantage. [not necessarily; the advantage might be related to differentiation] d. temporary competitive advantage. [correct; valuable and rare resources lead to a temporary competitive advantage]

9.

Which of the following is critical for a firm adopting a long-term differentiation strategy? a. The firm must also reduce the costs of its product or service. [the firm does not necessarily have to reduce costs too] b. The strategy increases prices by at least 10%. [a price premium of less than 10% is still meaningful] c. The strategy is focused on innovation and not customer service. [the strategy could be focused on some other type of differentiation and still be successful] d. The methods of achieving differentiation are difficult to imitate. [correct; for the advantage to be sustainable, it must be difficult for rivals to imitate]

10. When a resource or capability is valuable, rare, hard to imitate, and non-substitutable firms may gain a. a temporary competitive advantage. [the advantage should be more than just temporary] b. a complex competitive advantage. [“complex” is not a word used to describe the nature of competitive advantage] c. competitive parity. [a resource or capability that is valuable, rare, hard to imitate, and nonsubstitutable should help the firm do better than just achieve parity] d. a sustainable competitive advantage. [correct]

Chapter 11 Multiple Choice Solutions:

1.

The intersection between demand for dollars and the supply of dollars is known as the a. Inflation rate [The inflation rate is the rate that reflects the aggregate increase in price level] b. Exchange rate [Correct; the exchange rate reflects the price point at which demand for dollars (those who want to buy dollars and sell the foreign currency) and supply of dollars (those who want to sell dollars and buy the foreign currency) intersect] c. Price [Here “price” is the exchange rate] d. Quantity [Quantity indicates the amount of dollars traded for the foreign currency in the market for foreign exchange.]

2.

An individual in the United States wants to buy office equipment from England that costs 2,800 pounds. If the exchange rate is $1.92, how much will it cost him in dollar terms? a. $2,800 [This is what the cost would be if the currencies were equal, in other words if $1 = 1 pound] b. $5,376 [Correct; If 1 pound = $1.92, then to purchase 2800 pounds worth of goods, you would need 2800*1.92 = $5,736] c. $1,458 [If 1 pound = $1.92, then you would need more than 2800 dollars to purchase equipment costing 2800 pounds. Think of it as if every pound is costing you $1.92] d. Need more information [There is enough information provided to answer the question]

3.

If the Chinese yuan devalues relative to the US dollar, then a. US producers will benefit; Chinese consumers will benefit [A currency devaluation helps domestic firms by increasing demand but hurts domestic consumers by increasing domestic price. It also hurts foreign firms by decreasing demand but helps foreign consumers by decreasing price.] b. US producers will benefit; Chinese consumers will be hurt [A currency devaluation helps domestic firms by increasing demand but hurts domestic consumers by increasing domestic price. It also hurts foreign firms by decreasing demand but helps foreign consumers by decreasing price.] c. US producers will be hurt; Chinese consumers will benefit [A currency devaluation helps domestic firms by increasing demand but hurts domestic consumers by increasing domestic price. It also hurts foreign firms by decreasing demand but helps foreign consumers by decreasing price.] d. US producers will be hurt; Chinese consumers will be hurt [Correct; A currency devaluation helps domestic firms by increasing demand but hurts domestic consumers by increasing domestic price. It also hurts foreign firms by decreasing demand but helps foreign consumers by decreasing price.]

4.

Following a peso appreciation relative to the dollar, which of the following results is expected to occur? a. Prices in the United States would rise, and prices in Mexico would rise. [Since it takes fewer pesos for Mexicans to buy US goods and services, the peso appreciation increases demand for US goods and services. The depreciation also means that it takes more dollars for US consumers to buy Mexican goods and so decreases demand for Mexican goods and services.

The former would increase prices for US goods and services, and the latter would decrease prices for Mexican goods and services] b. Prices in the United States would rise, and prices in Mexico would fall. [Correct; Since it takes fewer pesos for Mexicans to buy US goods and services, the peso appreciation increases demand for US goods and services. The depreciation also means that it takes more

c.

d.

dollars for US consumers to buy Mexican goods and so decreases demand for Mexican goods and services. The former would increase prices for US goods and services, and the latter would decrease prices for Mexican goods and services] Prices in the United States would fall, and prices in Mexico would rise. [Since it takes fewer pesos for Mexicans to buy US goods and services, the peso appreciation increases demand for US goods and services. The depreciation also means that it takes more dollars for US consumers to buy Mexican goods and so decreases demand for Mexican goods and services.

The former would increase prices for US goods and services, and the latter would decrease prices for Mexican goods and services] Prices in the United States would fall, and prices in Mexico would fall. [Since it takes fewer pesos for Mexicans to buy US goods and services, the peso appreciation increases demand for US goods and services. The depreciation also means that it takes more dollars for US consumers to buy Mexican goods and so decreases demand for Mexican goods and services.

The former would increase prices for US goods and services, and the latter would decrease prices for Mexican goods and services]

5.

Following a peso appreciation relative to the dollar, which of the following results is expected to occur? a. U.S. consumers would benefit, and Mexican producers would benefit. [A currency devaluation helps domestic firms by increasing demand but hurts domestic consumers by increasing domestic price. It also hurts foreign firms by decreasing demand but helps foreign consumers by decreasing price.] b. U.S. consumers would be hurt, and Mexican producers would benefit. [A currency devaluation helps domestic firms by increasing demand but hurts domestic consumers by increasing domestic price. It also hurts foreign firms by decreasing demand but helps foreign consumers by decreasing price.] c. U.S. consumers would benefit, and Mexican producers would be hurt. [A currency devaluation helps domestic firms by increasing demand but hurts domestic consumers by increasing domestic price. It also hurts foreign firms by decreasing demand but helps foreign consumers by decreasing price.] d. U.S. consumers would be hurt, and Mexican producers would be hurt. [Correct; A currency devaluation helps domestic firms by increasing demand but hurts domestic consumers by increasing domestic price. It also hurts foreign firms by decreasing demand but helps foreign consumers by decreasing price.]

6.

Following an increase in Mexican interest rates relative to U.S. interest rates, which caused Mexican investors to borrow abroad to invest domestically, which of the following is expected to occur? a. The dollar would appreciate relative to the peso, and Mexican prices would increase. [An increase in foreign borrowing means that Mexicans are borrowing dollars in the US, and then selling those dollars to buy pesos, which is an increase the supply of dollars in the market for foreign exchange. This decreases the price of a dollar measured in the foreign currency, also called a dollar depreciation. The dollar depreciation also means that it takes more dollars for US consumers to buy Mexican goods and services and so decreases demand for Mexican goods and services, which results in a decline in prices for Mexican goods and services.] b. The dollar would appreciate relative to the peso, and Mexican prices would decrease. [An increase in foreign borrowing means that Mexicans are borrowing dollars in the US, and then selling those dollars to buy pesos, which is an increase the supply of dollars in the market for foreign exchange. This decreases the price of a dollar measured in the foreign currency, also called a dollar depreciation. The dollar depreciation also means that it takes more dollars for US consumers to buy Mexican goods and services and so decreases demand for Mexican goods and services, which results in a decline in prices for Mexican goods and services.] c. The dollar would depreciate relative to the peso, and Mexican prices would increase. [An increase in foreign borrowing means that Mexicans are borrowing dollars in the US, and then selling those dollars to buy pesos, which is an increase the supply of dollars in the market for foreign exchange. This decreases the price of a dollar measured in the foreign currency, also

d.

called a dollar depreciation. The dollar depreciation also means that it takes more dollars for US consumers to buy Mexican goods and services and so decreases demand for Mexican goods and services, which results in a decline in prices for Mexican goods and services.]

The dollar would depreciate relative to the peso, and Mexican prices would decrease.

[Correct; an increase in foreign borrowing means that Mexicans are borrowing dollars in the US, and then selling those dollars to buy pesos, which is an increase the supply of dollars in the market for foreign exchange. This decreases the price of a dollar measured in the foreign currency, also called a dollar depreciation. The dollar depreciation also means that it takes more dollars for US consumers to buy Mexican goods and services and so decreases demand for Mexican goods and services, which results in a decline in prices for Mexican goods and services.]

7.

Following an increase in Mexican interest rates relative to U.S. interest rates, which caused US investors to invest in Mexican Bonds. Which of the following would occur? a. The dollar would appreciate relative to the peso, and Mexican prices would increase. [This foreign borrowing only impacts the exchange rate when those borrowed funds are then resold to purchase foreign currency (the peso) for use in Mexican domestic investment] b. The dollar would depreciate relative to the peso, and Mexican prices would decrease. [This foreign borrowing only impacts the exchange rate when those borrowed funds are then resold to purchase foreign currency (the peso) for use in Mexican domestic investment] c. The dollar would depreciate relative to the peso, and Mexican prices would increase. [This foreign borrowing only impacts the exchange rate when those borrowed funds are then resold to purchase foreign currency (the peso) for use in Mexican domestic investment] d. The exchange rate would not be affected, and neither would Mexican prices. [Correct; the exchange rate is only affected when the borrowed funds are then resold and used to purchase foreign currency. If they continue to invest abroad, then exchange rate and foreign prices would not be affected]

8.

In July 2014 the price of a Big Mac was $4.80 in the United States while in China it was only $2.73 at market exchange rates. So, the "raw" Big Mac index says that the yuan was under-valued by 43% at that time. How would domestic inflation in China affect the Big Mac Index? a. The Big Mac Index would indicate that the Chinese currency is less under-valued.

[Correct; If domestic inflation increased the Chinese price of a Big Mac to say, $4.80, then the Big Mac Index would say that the Chinese yuan and the dollar were in long run equilibrium, or that the yuan is less undervalued.] b. The Big Mac Index would indicate that the Chinese currency is more under-valued [If domestic inflation increased the Chinese price of a Big Mac to say, $4.80, then the Big Mac Index would say that the Chinese yuan and the dollar were in long run equilibrium, or that the yuan is less undervalued, not more.] c. The Big Mac Index is not affected by inflation. [Domestic inflation would affect the price in yuan of the Big Mac in China, which would affect the value of the index.] d. The Big Mac Index would indicate that the Dollar is more under-valued. [The July 2014 index indicates that the dollar is over-valued; increases in the price in China would reduce not increase the indicated dollar over-valuation.]

9.

If the U.S. economy strengthens, consumer incomes increase, and consumers buy more imported goods and services. How will this affect exchange rates? a. The dollar will appreciate relative to the yuan, and U.S. prices will increase. [To buy imports, US consumers have to exchange more dollars for yuan. This increase in the supply of dollars in the market for foreign exchange reduces the “price” of a dollar measured in yuan, which is a dollar depreciation.] b. The dollar will appreciate relative to the yuan, and U.S. prices will decrease. [To buy imports, US consumers have to exchange more dollars for yuan. This increase in the supply

of dollars in the market for foreign exchange reduces the “price” of a dollar measured in yuan, which is a dollar depreciation.] c. The dollar will depreciate relative to the yuan, and U.S. prices will increase. [Correct; To buy imports, US consumers have to exchange more dollars for yuan. This increase in the supply of dollars in the market for foreign exchange reduces the “price” of a dollar measured in yuan, which is a dollar depreciation.] d. The dollar will depreciate relative to the yuan, and U.S. prices will decrease. [To buy imports, US consumers have to exchange more dollars for yuan. This increase in the supply of dollars in the market for foreign exchange reduces the “price” of a dollar measured in yuan, which is a dollar depreciation.]

10. If buyers expect future price increases, they will ___________ their purchases to avoid it. Similarly, sellers will __________ selling to take advantage of it. a. Accelerate; accelerate [Buyers, anticipating the price increase, will accelerate their purchasing, hoping to pay less now, while sellers will delay purchasing, hoping to receive a higher price for the same good in the future.] b. Accelerate; delay [Correct; buyers, anticipating the price increase, will accelerate their purchasing, hoping to pay less now, while sellers will delay purchasing, hoping to receive a higher price for the same good in the future.] c. Delay; accelerate [Buyers, anticipating the price increase, will accelerate their purchasing, hoping to pay less now, while sellers will delay purchasing, hoping to receive a higher price for the same good in the future.] d. Delay; delay [Buyers, anticipating the price increase, will accelerate their purchasing, hoping to pay less now, while sellers will delay purchasing, hoping to receive a higher price for the same good in the future.]

Chapter 12 Multiple Choice Questions

1.

After massive promotion of Olivia Rodrigo’s latest music album, the producers reacted by raising prices for her albums. This implies that promotion expenditures made the album demand a. more elastic. [When demand becomes more elastic, the right response is to reduce price.] b. unitary elastic. [The question does not indicate any specific level of elasticity, only that it changed as a result of the promotion.] c. change due to psychological pricing. [This may or not be true, but the question is how does promotion expenditure changes demand elasticity.] d. less elastic. [correct; when promotion makes demand less elastic, the right response is to increase price.]

2.

All of the following choices are examples of promoting a firm’s product, except a. celebrity endorsements. [This is a common component of product promotion.] b. pricing [correct; pricing often responds to changes in demand brought about by promotions] c. discount coupons. [These are a form of promotion designed to focus consumers on prices.] d. end-of-aisle displays. [These are a form of promotion designed to focus consumers on prices.]

3.

A firm that acquires a substitute product can reduce cannibalization by a. doing nothing. [The prices charged prior to acquiring a substitute would no longer be optimal.] b. repositioning a product so that it does not directly compete with the substitute. [correct; If consumers do not perceive the products as substitutes, then cannibalization is reduced.] c. setting the same price on both products. [Substitute products usually have different prices (e.g., a manual and electric saw).] d. lowering prices on the low-margin products. [This is the opposite of the appropriate price response to acquiring a substitute product.]

4.

A shoe-producing firm decides to acquire a firm that produces shoe laces. This action implies that the firm’s aggregate demand (shoes + laces) will be: a. less elastic than the individual demands. [Aggregate demand of substitutes is less elastic than the individual demands. However, shoes and laces are likely complements.] b. more elastic than the individual demands. [correct; shoes and laces are complements and aggregate demand of complements is more elastic than the individual demands.] c. equally elastic as the individual demands. [shoes and laces are complements, and therefore the aggregate demand is not equal to the individual demands.] d. none of the above [common ownership of complements changes the elasticity of aggregate demand]

5.

After firm A producing one good acquired firm B producing another good, it lowered the prices for both goods. One can conclude that the goods were a. substitutes. [when acquiring a substitute, prices on both goods should be raised, not lowered] b. complements. [correct; when acquiring a complement, prices on both goods should be lowered.] c. not related. [when goods are unrelated, common ownership does not affect the optimal price.] d. none of the above [one of the answers is correct.]

6.

Firms tend to raise the price of their goods after acquiring a firm that sells a substitute good because a. they lose market power. [a loss of market power generally leads to lower prices] b. there is an increase in the overall demand for their products. [whether or not demand increases, firms still raise prices after acquiring a substitute good.] c. the aggregate demand for both goods is more elastic than the demand for the individual goods. [when demand becomes more elastic, the correct response is to lower prices.] d. the aggregate demand for both goods is less elastic than the demand for the individual goods. [correct; the aggregate demand for substitute products is less elastic than the individual demands.]

7.

For products like parking lots and hotels, costs of building capacity are mostly fixed or sunk and firms in this industry typically face capacity constraints. Therefore, the firms should price to fill capacity if a. MR>MC at capacity. [correct; when MR>MC, it is optimal to reduce price to sell more, but one cannot sell more than capacity allows.] b. MR<MC at capacity. [when MR<MC, you are losing money and should increase price and sell less.] c. LRMR>LRMC at capacity. [long run costs and benefits help determine how much capacity to build, but not how to price once it is built.] d. LRMR<LRMC at capacity. [long run costs and benefits help determine how much capacity to build, but not how to price once it is built.]

8.

A firm started advertising its product, and this advertising changed the product’s elasticity from -2 to -1.5. If, prior to advertising, the firm charged $10, the firm should a. raise price from $10 to $15.00. [correct; using the formula (P-MC)/P=1/|e|, MC=5 and prices rise by 50%.] b. reduce price from $10 to $6.67. [since demand became less elastic, price should increase, not decrease.] c. raise price from $10 to $13.33. [using the formula (P-MC)/P=1/|e| would indicate that prices would have to rise by more than 33% following the change in elasticity.] d. reduce price from $10 to $7.50. [since demand became less elastic, price should increase, not decrease.]

9.

After running a promotional campaign, the owners of a local hardware store decided to decrease the prices for the advertised prices sold in their store. One can infer that a. the promotional expenditures made the demand for the advertised products more elastic. [correct; promotional activity that makes demand more elastic should be accompanied by a decrease in price.] b. the promotional expenditures made the demand for the advertised products less elastic.

[When demand becomes less elastic, the appropriate response is to increase price.] c. the promotional expenditures had no effect on demand elasticity. [If elasticity had not changed, then there would have been no reason to decrease prices.] d. the owners got it wrong. To cover the promotional expenses, they should have raised the prices. [promotional expenses are a fixed cost and do not directly impact the price except by changing the elasticity of demand.]

10. On average, if demand is unknown and costs of underpricing are _______ than the costs of overpricing, then _________. a. smaller; overprice [if the costs of underpricing are smaller, then one should not overprice.] b. smaller; underprice [correct; since the costs of underpricing are smaller, one should underprice.] c. larger; underprice [since the costs of underpricing are larger, one should avoid underpricing.] d. none of the above [one of the above combinations is correct.]

Chapter 14 (and 13) Multiple Choice Questions

1.

A software firm can offer a high-feature version of its software or a stripped-down low-feature version, each with similar production costs. Which of the following cannot be an optimal segmentation strategy? a. Offer only the high-feature version aimed only at a high-value market segment. [This can be an optimal strategy if the risk of cannibalization is too great.] b. Offer only the low-feature version aimed at all market segments. [correct; this is not an optimal strategy, as the high-feature version has the same production costs but can likely be sold at a higher price.] c. Offer both versions targeted to different value segments. [This is a common form of indirect price discrimination.] d. Offer only the high-feature version aimed at all market segments. [This can be an optimal strategy if the risk of cannibalization is too great.]

2.

Which of the following conditions must be satisfied for price discrimination to be successful? a. The seller must have a different product for each group of customers. [This is generally true for indirect price discrimination, but direct price discrimination schemes may charge different prices for the same product.] b. The seller must be able to identify each customer as having a high or low value. [Indirect price discrimination schemes like versioning can work even if the seller does not know the value of each customer.] c. The seller must be able to prevent arbitrage between the two groups. [When offering different versions of products aimed at different market segments, arbitrage is not an issue.] d. None of the above [correct; Each of the above is either necessary for a direct price discrimination scheme but not necessary for indirect price discrimination or vice versa.]

3.

Perfect price discrimination is when a firm can charge each customer exactly what they are willing to pay. In this case, a. the demand curve is very inelastic. [successful price discrimination does not depend on the elasticity of demand.] b. the marginal revenue is the demand curve [correct; the revenue from each consumer is equal to each consumer’s willingness to pay, which is given by the demand curve.] c. the demand curve is very elastic. [successful price discrimination does not depend on the elasticity of demand.] d. the marginal cost curve is the average cost curve. [nothing in the problem suggests this. Price discrimination can occur for different cost structures.]

Use the following table to answer Questions 4 – 6. Assume the cost of producing the goods is zero and that each consumer will purchase each good as long as the price is less than or equal to value.

Consumer values are given in the following table.

Consumer A

Consumer B

Good 1

$2,300

$2,800

Good 2

$1,700

$1,200

4.

Suppose a monopolist only sold the goods separately. What price will the monopolist charge for good 1 to maximize revenues for good 1? a. $2,300 [correct; this is more profitable than selling a single unit at $2,800.] b. $2,800 [at this price, the monopolist would sell only one unit to Consumer B.] c. $1,200 [this is not either consumer’s value of good 1.] d. $1,700 [this is not either consumer’s value of good 1.]

5.

What is the total profit to the monopolist from selling the goods separately? a. $4,500 [the monopolist could increase profit by selling more than one unit of each good.] b. $6,300 [the monopolist could increase profit by selling more than one unit of good 2.] c. $7,000 [correct; the monopolist maximizes profit by selling each good to each consumer.] d. $6,000 [the monopolist can earn higher profit by setting prices optimally.]

6.

What is a better pricing strategy for the monopolist? What is the resulting profit? a. Bundle the goods at $2,800; Profits=$5,600 [Both consumers value the bundle at more than $2,8000.] b. Bundle the goods at $4,000; Profits=$8,000 [correct; this charges both consumers exactly what each is willing to pay for the bundle.] c. Charge $2,800 for good 1 and charge $1,700 for good 2; Profits=$4,500 [bundling the two goods can increase profit in this case.] d. Charge $2,300 for good 1 and charge $1,200 for good 2; Profits = $7,000 [this is the maximum profit from selling the two goods separately but bundling the two goods can increase profit in this case.]

7.

Assume that the price elasticity of demand for movie theatres is -0.85 during all evening shows, but for all afternoon shows, the price elasticity of demand is -2.28. For the theatre to maximize total revenue, it should a. charge the same price for both shows, holding other things constant. [Since the two shows have very different elasticities of demand, they have different profit-maximizing prices.] b. charge a higher price for the afternoon shows and lower price for the evening shows, holding other things constant. [prices should be lower when demand is more elastic.] c. charge a lower price for the afternoon shows and higher price for the evening shows, holding other things constant. [correct; prices should be lower when demand is more elastic.] d. Gather more information. [there is sufficient information as prices should vary with elasticity of demand.]

8.

Arbitrage a. is the act of buying low in one market and selling high in another market. [this is the definition of arbitrage but is not the only correct answer.] b. can force a seller to go back to uniform pricing. [arbitrage can lead a seller to abandon price discrimination, but this is not the only correct answer.] c. can defeat direct price discrimination. [arbitrage can allow high-value consumers to purchase from low-value consumers, defeating the firm’s price discrimination. This is not the only correct answer.] d. All of the above. [correct; the above both define arbitrage and identify its effects.]

9.

Airlines attempt to charge a ____________ price to business travelers compared to leisure travelers because business travelers have a ____________ demand than leisure travelers.

a. b. c. d.

higher; more elastic [customers with more elastic demand should be charged a lower price.] higher; less elastic [correct; customers with less elastic demand should be charged a higher price]. lower; more elastic [business travelers generally pay a higher price than leisure travelers] lower; less elastic [business travelers generally pay a higher price than leisure travelers]

10. Metering is a. a type of indirect price discrimination [correct; metering identifies high-value customers by the intensity of their use of a related product such as paper for printers.] b. a type of direct price discrimination [direct price discrimination requires identifying the value of each individual consumer.] c. an evaluation of a product [metering is a type of price discrimination that identifies highvalue customers by how intensely they use a product.] d. an example of bundling [metering allows the purchase of individual products but identifies high-value customers by how many of them they buy.]

Chapter 15 1.

The prisoners’ dilemma is an example of a. a sequential-move game [players in a prisoners’ dilemma do not observe the decisions of their rivals prior to acting.] b. a simultaneous-move game. [correct; players do not observe their rival’s decision before making their own.] c. a shirking game. [a shirking game does not have a pure strategy equilibrium, but the prisoners’ dilemma does.] d. a tit-for-tat game. [tit-for-tat is a strategy for a repeated prisoners’ dilemma.]

2.

A Nash equilibrium a. is where one player maximizes his payoff, and the other doesn’t. [it is possible for both players to be maximizing their payoffs or for neither to be, as in the prisoners’ dilemma.] b. is where each player maximizes his own payoff given the action of the other player. [correct; this is the definition of an equilibrium; each player is playing a best response to the other player.] c. is where both players are maximizing their total payoff. [games like the prisoners’ dilemma show that players need not be maximizing their total payoff in equilibrium.] d. is a unique prediction of the likely outcome of a game. [some games, like the game of chicken, have more than one equilibrium.]

Use the following to answer Questions 3–5: Consider the following information for a simultaneous-move game: two discount stores (megastore and superstore) are interested in expanding their market share through advertising. The following table depicts the profits of both stores with and without advertising.

Superstore Advertise

Megastore

3.

Don’t Advertise

Advertise

$95, $80

$305, $55

Don’t Advertise

$65, $285

$165, $115

A Nash equilibrium is a. for Megastore to advertise and for Superstore to advertise. [correct; advertise is a dominant strategy for each player.] b. for Megastore to advertise and for Superstore not to advertise. [If Megastore advertises, Superstore’s best response is to advertise.] c. for Megastore not to advertise and for Superstore to advertise. [If Superstore advertises, Megastore’s best response is to advertise.]

d.

for Megastore not to advertise and for Superstore not to advertise. [If either store does not advertise, the best response for the other store is to advertise.]

4.

When the stores reach the Nash equilibrium, their profits will be a. Megastore $95 and Superstore $80. [correct; the equilibrium is for both stores to advertise.] b. Megastore $305 and Superstore $55. [Superstore is not best responding to Megastore.] c. Megastore $65 and Superstore $285. [Megastore is not best responding to Superstore.] d. Megastore $165 and Superstore $115. [Neither store is best responding to its rival’s strategy].

5.

If collusion were not illegal, then it would be optimal a. for Megastore to advertise and for Superstore to advertise. [This does not maximize firms’ profits individually or jointly.] b. for Megastore to advertise and for Superstore not to advertise. [correct; This maximizes joint profit.] c. for Megastore not to advertise and for Superstore to advertise. [This does not maximize joint profit.] d. for Megastore not to advertise and for Superstore not to advertise. [This is reasonable as each is earning higher profit than it would in equilibrium. However, if firms could reallocate profits or take turns, this does not maximize their joint profit.]

6.

In a Nash equilibrium, a. players are always maximizing their joint profit. [many games, such as the prisoners’ dilemma, reflect a tension between cooperation and conflict.] b. one player is always earning a higher profit than the other. [Nash equilibria do not say anything about the relative profits of the two players.] c. players must be playing the game sequentially. [simultaneous games also have Nash equilibria.] d. None of the above [correct; none of the above answers is correct.]

7.

In repeated games, all of the following make it easier to get out of bad situations except a. being nice, no first strikes. [you should cooperate as long as the other player does.] b. responding immediately to rivals. [you should be easily provoked and respond immediately to defection.] c. punishing uncooperative players as much as you can. [correct; this is bad advice. Instead, you should be forgiving and punish just enough to deter uncooperative behavior.] d. making sure your competitors can easily interpret your actions. [being clear means that your actions are understood by other players.]

Refer to the following strategic form game of price competition for Questions 8 and 9.

Firm B Low Price

High Price

Low Price

0, 0

50, -10

High Price

-10, 50

25, 25

Firm A

8.

If this game is played once, then a. firm A will charge a low price, and firm B will charge a low price. [correct; this is the equilibrium of the game.] b. firm A will charge a high price, and firm B will charge a low price. [in this case, firm A is not playing a best response and would prefer to charge a low price.] c. firm A will charge a low price, and firm B will charge a high price. [in this case, firm B is not playing a best response and would prefer to charge a low price.] d. firm A will charge a high price, and firm B will charge a high price. [this is not an equilibrium of the game as neither firm is playing a best response.]

9.

Suppose the game is infinitely repeated. What strategies will each firm utilize? a. firm A will charge a low price, and firm B will charge a low price. [the firms can earn higher profits by cooperating on a better outcome and using trigger strategies to support it.] b. firm A will charge a high price, and firm B will charge a low price. [firm A has no reason to lose money in each period as this is not a best response to firm B charging a low price.] c. firm A will charge a low price, and firm B will charge a high price. [firm B has no reason to lose money in each period as this is not a best response to firm A charging a low price.] d. firm A will charge a high price, and firm B will charge a high price. [correct; the firms can coordinate on the better payoffs by using trigger strategies, such as a tit-for-tat strategy.]

10. You, a real-estate developer, own a piece of land in Nassau, Bahamas, next to an equally sized piece of land owned by a competitor. Both of you have the choice of building a casino or a hotel. Your payoffs are as follows:

You Your competitor

Casino Hotel

Casino 3, 3 5 , 20

Hotel 20 , 5 2, 2

How much is it worth to you to get your casino building permit first? a. $2 million [If this game is played sequentially, the first mover would build a casino, earning $20 million in profits.] b. $3 million [If this game is played sequentially, the first mover would build a casino and the second mover would build a hotel.] c. $15 million [correct; the first mover earns $20 million and the second mover earns $5 million, so moving first is worth $15 million.] d. $17 million [$17 million is $20 million - $3 million, but both players earning $3 million occurs only if both build a casino, which is not an equilibrium.]

Chapter 16 Multiple Choice Questions

1.

For threats or commitments to be effective, they must be a. irrational. [There is no reason why a commitment needs to be “irrational” to be credible.] b. profitable. [Often, commitments and threats relate to courses of action that are contrary to one’s interests.] c. credible. [correct; The goal of a commitment or threat is to have your rival believe you.] d. none of the above. [One of the answers above is correct.]

2.

Fred and his employer both know that Fred can generate $200,000 of profit per year for his company. After negotiations, they agree that he will earn $110,000 in annual compensation. What does this imply for the value of his outside or next best alternative? a. $0. [According to the non-strategic view of bargaining, this would lead to $100,000 in compensation, halfway between $0 and $200,000.] b. $5,000. [According to the non-strategic view of bargaining, players split the gains to trade evenly. An outside alternative of $5,000 would provide Fred with $105,000 of the gains to trade which is more than his company receives.] c. $10,000. [According to the non-strategic view of bargaining, players split the gains to trade evenly. An outside alternative of $10,000 would provide Fred with $100,000 of the gains to trade which is more than his company receives.] d. $20,000. [correct; the players split the $180,000 gain from trade evenly.]

3.

How many pure-strategy Nash equilibria does the following game have? a. 0 [The game has pure strategy equilibria in which each player is playing a best response to the strategy of the other.] b. 1 [The game has more than one pure-strategy equilibrium.] c. 2 [correct; Both outcomes in which one player bargains hard and the other is nice are equilibria.] d. 3 [the best response to the other player bargaining hard is to be nice, and vice versa.]

Labor

Management

Bargain Hard

Be Nice

Bargain Hard

0,0

20, 10

Be Nice

12, 18

15, 15

4.

In the game in Question 3, how much does Labor earn if they can move first? a. 10 [Labor can do better by not being nice.] b. 15 [Both being nice is not an equilibrium of the game.] c. 18 [correct; if labor chooses to bargain hard, management would respond with being nice.] d. 20 [this is not a possible payoff for labor.]

5.

Consider a vendor-buyer relationship. Which of the following conditions would lead to the buyer having more bargaining power? a. Lots of substitutes for the vendor's product are available. [this would give the buyer better alternatives to an agreement with the vendor; this is not the only correct answer.]

b. c. d.

There are relatively few buyers and many vendors. [this would give the buyer better alternatives to an agreement with the vendor and would give the vendor worse alternatives to an agreement, both benefitting the buyer; this is not the only correct answer.]

It costs little for buyers to switch vendors. [this would increase the value of not reaching an agreement with the vendor; this is not the only correct answer.]

All of the above. [correct; each of the above improves the buyer’s alternatives to an agreement and thus reduces the buyer’s gains from reaching an agreement with this vendor.]

6.

Consider bargaining in which each party increases its outside option by $10,000. Which of the following is a likely result. a. The chance of a deal increases. [There is now less total surplus to divide, so each party has less to gain from an agreement.] b. Each party’s share of the bargaining surplus increases by $10,000. [There is now less total surplus to divide.] c. The bargaining split remains the same. [correct; since each surplus goes up by the same amount, the bargaining split does not change.] d. Each party share of the bargaining surplus increases by $5,000. [There is now less total surplus to divide.]

7.

Emmanuel and Fatima are entering into a bargaining situation in which Emmanuel stands to gain up to $5,000 and Fatima stands to gain up to $1,000, provided they reach agreement. Who is likely to have the stronger bargaining position? a. Emmanuel [Emmanuel has more to gain from reaching agreement and therefore will be a weaker bargainer.] b. Fatima [correct; Fatima has less to gain from agreement and therefore will be a stronger bargainer.] c. They will be equally effective. [The agreement reached depends on the gains for each party from reaching agreement.] d. These potential gains will have no impact on bargaining. [The gains for each party from reaching agreement directly relate to the agreement that will be reached.]

8.

Destiny and KC have been working jobs that pay $60,000 and $30,000 per year, respectively. They are trying to decide whether to quit their jobs and jointly open a taco stand on the beach, which they estimate can earn $150,000 per year. How will the taco stand proceeds be split? a. They won’t quit their jobs. [The gains from trade ($150,000-$60,000-$30,000) are positive.

Therefore, they will reach agreement to open the taco stand.] b. Destiny gets $90,000, and KC gets $60,000. [correct; Both Destiny and KC will share the gains from trade generated from agreement equally. This provides each of them with $30,000 of the surplus.] c. Destiny gets $75,000, and KC gets $75,000. [Destiny and KC have different alternatives to agreement, and therefore will receive different shares of the proceeds] d. Destiny gets $100,000, and KC gets $50,000. [This would provide Destiny with $40,000 of the gains from trade and KC with $20,000.]

9.

The game of chicken has a. a second-mover advantage. [the game of chicken favors the player who can commit to a position.] b. a first-mover advantage. [correct; the player who can commit to a course of action captures a majority of the gains from trade.] c. no sequential-move advantage. [the game of chicken provides an advantage for one of the players.] d. potential sequential-move advantages, depending on the players. [the outcome of the game of chicken has to do with the structure of the game and its payoffs, not the players.]

10. Two hospitals are bargaining with an insurance company to get into its provider network. The insurance company can earn $100 if it puts one of the hospitals in its network and $200 if it puts both hospitals in its network. If both hospitals merge and bargain jointly, how much more will they earn? a. $0 [correct; each hospital is worth $100 whether or not the other hospital is included.

Therefore, each earns $50 before the merger and they jointly earn $100 ($200/2) after the merger.] b. $50 [before the merger, the gains to trade for including each hospital is $100 whether or not the other hospital is included.] c. $100 [after the merger, the hospitals and the insurance company divide the gains from trade ($200) equally.] d. $200 [hospitals and the insurance company will share in the gains to trade equally before and after the merger.]

Chapter 17 1.

You are taking a multiple-choice test that awards you one point for a correct answer and penalizes you 0.25 points for an incorrect answer. If you have to make a random guess and there are five possible answers, what is the expected value of guessing? a. 0.5 points [the expected value of a random variable that can take on two values (x1,x2) with probabilities (p,1-p) is E(X)= (p*(x1)) + ((1-p)*(x2)). In this case, p represent the chance of getting a correct answer, while x1 and x2 refer to the possible points] b. 0.25 points [the expected value of a random variable that can take on two values (x1,x2) with probabilities (p,1-p) is E(X)= (p*(x1)) + ((1-p)*(x2)). In this case, p represent the chance of getting a correct answer, while x1 and x2 refer to the possible points] c. –0.25 points [the expected value of a random variable that can take on two values (x1,x2) with probabilities (p,1-p) is E(X)= (p*(x1)) + ((1-p)*(x2)). In this case, p represent the chance of getting a correct answer, while x1 and x2 refer to the possible points] d. 0 points [correct; ((1/5)*(1)) + ((4/5)*(-0.25)) = 0.2 – 0.2 = 0]

2.

A franchise restaurant chain is considering a new store in an unserved part of town. Its finance group estimates an NPV of $20 million if the population growth is 10% (40% probability), and NPV of $8 million of the population does not grow (30% probability), and an NPV of -$8 million if the population shrinks 5% (30% probability). What is the expected value of NPV (to the nearest dollar) of opening the store? a. $6.8 million [E(x)=((p1)*(x1))+((p2)*(x2))….+((pn)*(xn)). The probabilities are 0.4, 0.3 & 0.3 and the potential outcomes are $20, $8 & -$8 million in this case] b. $8.0 million [correct; ((0.4)*(20m))+((0.3)*(8m))+((0.3)*(-8m))= 8m+2.4m-2.4m = 8 million] c. $9.2 million [E(x)=((p1*)(x1))+((p2)*(x2))….+((pn)*(xn)). The probabilities are 0.4, 0.3 & 0.3 and the potential outcomes are $20, $8 & -$8 million in this case] d. $10.4 million [E(x)=((p1)*(x1))+((p2)*(x2))….+((pn)*(xn)). The probabilities are 0.4, 0.3 & 0.3 and the potential outcomes are $20, $8 & -$8 million in this case]

3.

You’ve just decided to add a new line to your manufacturing plant. Compute the expected loss/profit from the line addition if you estimate the following:  There’s a 50% chance that profit will increase by $100,000.  There’s a 30% chance that profit will remain the same.  There’s a 20% chance that profit will decrease by $15,000. a. Gain of $100,000 [E(x)=((p1)*(x1))+((p2)*(x2))….+((pn)(xn)). The probabilities are 0.5, 0.3 & 0.2 and the profits are $10,000, $0 & -$15,000 in this case] b. Gain of $70,000 [E(x)=((p1*)(x1))+((p2)*(x2))….+((pn)(xn)). The probabilities are 0.5, 0.3 & 0.2 and the profits are $10,000, $0 & -$15,000 in this case] c. Loss of $53,000 [E(x)=((p1)*(x1))+((p2)*(x2))….+((pn)(xn)). The probabilities are 0.5, 0.3 & 0.2 and the profits are $10,000, $0 & -$15,000 in this case] d. Gain of $47,000 [correct; ((0.5)*($100,000))+((0.3)*(0))+((0.2)*(-$15,000))=$50,000+$0$3000=$47,000]

4.

Your software development company is considering investing in a new mobile app. If it goes viral (10% probability), you expect an NPV of $2,000,000; if it is moderately successful (20% probability), you expect an NPV of $400,000; and if it fails (70% probability), you expect an NPV of $-400,000.

What is the expected NPV of the product?

a. b. c. d.

$0 [correct; ((0.1)*($2,000,000))+((0.2)*($400,000))+((0.7)*(-$400,000))= $200,000+$80,000-$280,000 = $0] $560,000 [E(x)=((p1)(x1))+((p2)(x2))….+((pn)(xn)). The probabilities are 0.1, 0.2 & 0.7 and the NPVs are $2,00,000, $400,000 & -$400,000 in this case] $667,000 [E(x)=((p1)(x1))+((p2)(x2))….+((pn)(xn)). The probabilities are 0.1, 0.2 & 0.7 and the NPVs are $2,00,000, $400,000 & -$400,000 in this case] None of the above [It is one of the above-In cases where you have the probability of different occurrences and their outcomes, you can determine the total expected outcome]

5.

Suppose an investment project has an NPV of $75 million if it becomes successful and an NPV of –$25 million if it is a failure. What is the minimum probability of success above which you should make the investment? a. 0.5 [the expected value of a random variable that can take on two values (x 1,x2) with probabilities (p,1-p) is E(X)= (p(x1)) + ((1-p)*(x2)). In this case, you are looking for the value of p that will allow you to breakeven (i.e., where E(X) = 0)] b. 1/3 [the expected value of a random variable that can take on two values (x 1,x2) with probabilities (p,1-p) is E(X)= (p(x1)) + ((1-p)*(x2)). In this case, you are looking for the value of p that will allow you to breakeven (i.e., where E(X) = 0)] c. 0.25 [correct; you are looking for the breakeven- the minimum probability at which you would invest ((p)*($75m))+((1-p)*(-$25m)=0 Therefore 75p-25+25p=0 or 100p=25, so p=0.25] d. 0.1 [the expected value of a random variable that can take on two values (x 1,x2) with probabilities (p,1-p) is E(X)= (p(x1)) + ((1-p)*(x2)). In this case, you are looking for the value of p that will allow you to breakeven (i.e., where E(X) = 0)]

6.

To test the effectiveness of a two web advertising agencies, you increase your ad purchase with agency A by 50% without changing your purchase through agency B. The referrals to your website from agency A increased by only 34% but the referrals from agency B fell by 21%. What is the difference-in-difference estimate of the referrals per dollar through agency A? a. 1.2 referrals per dollar [To construct a "difference-in-difference" estimate of referrals per dollar, measure the difference in referral percent changes from Agency A to Agency B over the difference in percent purchase amount changes] b. 1.1 referrals per dollar [correct; To construct a "difference-in-difference" estimate of referrals per dollar, you measure the change in referrals from Agency A (+34%) relative to the control group of Agency B (less -21%), for an estimate per dollar of ((55%)change in referrals/(50%)change in dollars) or 1.1. The difference between treatment (agency A) and control (agency B) referrals was 55% (=34%-(-21%). The difference in purchase amounts was 50% (=50%-0%). The diff-in-diff in referrals per dollar was 55%/50% or 1.1] c. 1.0 referrals per dollar [To construct a "difference-in-difference" estimate of referrals per dollar, measure the difference in referral percent changes from Agency A to Agency B over the difference in percent purchase amount changes] d. 0.9 referrals per dollar [To construct a "difference-in-difference" estimate of referrals per dollar, measure the difference in referral percent changes from Agency A to Agency B over the difference in percent purchase amount changes]

7.

Your company has a customer list that includes 3000 people. Your market research indicates that 90 of them responded to the coupon. If you send a coupon to one customer at random, what’s the probability that he or she will use the coupon? a. 0.03 [correct; the probability of using the coupon is 90/3000=0.03 or 3%]

b. c. d.

0.09 [the probability the coupon will be used is equal to the chance a customer will respond, in other words, the number of potential positive responses over total customers] 0.30 [the probability the coupon will be used is equal to the chance a customer will respond, in other words, the number of potential positive responses over total customers] 0.90 [the probability the coupon will be used is equal to the chance a customer will respond, in other words, the number of potential positive responses over total customers]

8.

Your production line has recently been producing a serious defect. One of two possible processes, A and B, could be the culprit. From past experience you know that the probability that A is causing the problem is 0.8 but investigating A costs $100,000 while investigating B costs only $20,000. What are the expected error costs of shutting down process B first? a. $80,000 [this is the expected cost of shutting down process A first] b. $20,000 [the expected error cost in this case comes from investigating B and having A be the culprit. In other words, it is the probability the total money spent on B will be wasted] c. $16,000 [correct; the expected error cost in this case comes from investigating B and having A be the culprit, in other words the probability the total money spent on B will be wasted, so (0.8)*($20,000)=$16,000. d. $4,000 [this is the expected cost of shutting down process B first]

9.

You have two types of buyers for your product. Forty percent of buyers value your product at $10 and 60% value it at $6. What price maximizes your expected revenue? a. $10 [In this case, only forty percent of buyers will purchase your product for expected revenue per customer of $4] b. $6 [correct; in this case, all 100% of buyers will purchase your product] c. $7.60 [This price still only appeals to the top 40% of buyers, and for less than they are willing to pay for expected revenue per customer of $3.04] d. $8 [This price still only appeals to the top 40% of buyers, and for less than they are willing to pay for expected revenue per customer of $3.2]

10. You are considering entry into a market that currently has only one producer (incumbent). If you enter, the incumbent can take one of two strategies, price low or price high. If the incumbent prices high, then you expect a $60K profit per year. If the incumbent prices low, then you expect a $20K loss per year. You should enter if you believe a. demand is inelastic. [if demand is inelastic, price will not impact the demand for your product] b. the probability that the incumbent will price low is greater than 0.75. [To solve this, you need to find the minimum probability needed to breakeven. E(X)= (p(x1)) + ((1-p)*(x2)).

Once you solve for p, determine what p is of the incumbent pricing low] c. the probability that the incumbent will price low is less than 0.75. [Correct; To solve this, you need to find the minimum probability needed to breakeven. E(X)= (p(x 1)) + ((1p)*(x2)). Using ((p)*($60k))+((1-p)*($-20k))=0, you find 60p-20+20p=0 or 80p=20.

Therefore, p (the probability of them pricing high) needs to be a minimum of 0.25 for you to breakeven. Therefore, you would only enter if you believed the probability of them pricing low (1-p) is less than 0.75] d. the market size is growing. [If market size is growing, demand may accommodate the addition of a competitor]

Chapter 18

1.

You are bidding in a second-price auction for a painting that you value at $800. You estimate that other bidders are most likely to value the painting at between $200 and $600. Which of these is likely to be your best bid? a. $1,000 [you should never bid above your value as you might end up paying more than the painting is worth to you.] b. $800 [correct; in a second-price auction, the optimal strategy is to bid exactly your value.] c. $600 [If you are wrong and some other bidder values the painting at $700, you would end up losing the auction even though you would have been willing to pay $700.] d. $400 [You are unlikely to win a t a price this low.]

2.

Which of the following is true about different ways of conducting a private-value auction? a. A first-price auction is strategically equivalent to a second-price auction. [Bidding behavior is very different in a first-price auction, where you bid below your value, and a second-price auction, where you bid equal to your value.] b. A first-price auction is strategically equivalent to an oral English auction. [In an English auction, bidders are willing to bid up to their values, but first price auctions involve bid shading.] c. A second-price auction is strategically equivalent to an oral English auction. [correct; in an English auction, bidders bid up to their value with the highest-value bidder winning at a price near the second-highest value.] d. None of the above. [One of the above answers is correct.]

3.

Suppose that five bidders with values of $500, $400, $300, $200, and $100 attend an oral auction.

Which of these is closest to the winning price? a. $500 [You need at least two bidders actively competing to drive the price up.] b. $400 [correct; as soon as the bidder with the value of $500 outbids the next highest bidder, the auction would end.] c. $300 [since multiple bidders value the item more than $300, they would continue to compete, driving the price higher.] d. $200 [since multiple bidders value the item more than $200, they would continue to compete, driving the price higher.]

4.

In the above auction, if the bidders with the first- and third-highest values ($500 and $300) collude, which of these is closest to the winning price? a. $500 [You need at least two bidders actively competing to drive the price up.] b. $400 [correct; The second-highest value sets the price, so the collusion removing the thirdhighest value from active competition would not affect the price.] c. $300 [despite the collusion, multiple bidders value the item more than $300, they would continue to compete, driving the price higher.] d. $200 [despite the collusion, multiple bidders value the item more than $200, they would continue to compete, driving the price higher.]

5.

In a common-value auction, you should a. bid more aggressively the more competitors you face. [The more competitors you face, the more you should be wary of winning as this implies that every other bidder believes the item to be worth less than you do.] b. bid less aggressively the more competitors you face. [correct; The more bidders there are, the more winning is potentially “bad news.”] c. bid the same regardless of the number of competitors. [In common-value auctions, beating out competitors reveals that they all think that the object is worth less than your bid.]

d.

bid more aggressively when others have better information than you. [The winner’s curse is especially bad when rivals have better information than you do.]

6.

If a seller is concerned about collusion among bidders, which of the following changes to the auction should the seller make? a. Hold frequent, small auctions instead of infrequent large auctions. [frequent auctions allow bidders to take turns whereas a single large auction provides a greater incentive for cartel members to cheat.] b. Conceal the amount of winning bids. [correct; this makes it harder for the cartel to know if cheating occurred, which provides incentives for cartel members to cheat.] c. Publicly announce the name of each auction’ s winner. [announcing the name of each winner allows the cartel to monitor cheating, thus helping the cartel.] d. Hold an English auction instead of a sealed-bid first-price auction. [collusion is easier in second-price auctions.]

7.

You’ re holding an auction to license a new technology that your company has developed. One of your assistants raises a concern that bidders’ fear of the winner’s curse may encourage them to shade their bids. How might you address this concern? a. Release your analyst’s positive scenario for the technology’s future profitability. [Revealing information reduces the winner’s curse, but this is not the only correct answer] b. Release your analyst’s negative scenario for the technology’ s future profitability. [Revealing information reduces the winner’s curse, but this is not the only correct answer] c. Use an oral auction. [Oral auctions reveal information about other bidders’ values, but this is not the only correct answer.] d. All of the above. [correct; in common value auctions, the auctioneer should reveal as much information as possible, both good and bad, to bidders so that they do not fear the winner’s curse.]

8.

Which of the following is true about the winner’s curse? a. The winner’s curse occurs primarily in private-value auctions. [Each bidder knows his or her value in private value auctions, so there is no winner’s curse.] b. You successfully avoided the winner’ s curse if you made money in the auction. [This is merely good luck. Avoiding the winner’s curse implies making money on average, not just in a single auction.] c. The winner’s curse means that you bid incorrectly. [correct; the winner’s curse happens when bids do not account for the fact that only the highest (and most optimistic) bid wins, and that the most optimistic estimate is likely to be wrong.] d. The winner’s curse means that you lost money in an auction. [This is merely bad luck and can happen even when you bid correctly.]

9.

A bidder’s value for a good may be low ($2), medium ($5), or high ($7). There is an equal number of potential bidders having each value. Suppose two bidders participate in a second-price auction. What is the best estimate of the expected revenue from the auction? a. $4.11 [Draw a table of the nine possible outcomes. The second-highest value sets the price in each auction. For example, the price is $7 only 1/9 of the time.] b. $3.99 [Draw a table of the nine possible outcomes. The second-highest value sets the price in each auction.] c. $3.56 [correct; the price is $7 1/9 of the time, $5 3/9 of the time, and $2 5/9 of the time.] d. $5.00 [The price can be as high as $7 or as low as $2. Draw a table of the nine possible outcomes.]

10. In a first-price auction, you bid __________ your value, and in a second-price auction you bid _______ your value. a. at; above [you should never bid above your value in either type of auction.] b. below; above [you should never bid above your value in either type of auction.]

c.

below; at [correct; bid at your value in second-price auctions and shade your bid (bid below your value) in first-price auctions.] d. below; below [In a second-price auction, you should not bid below your value.]

Chapter 19 Multiple Choice Questions

1.

An insurance company offers doctors malpractice insurance. Assume that malpractice claims against careful doctors cost $5,000 on average over the term of the policy and settling malpractice claims against reckless doctors costs $30,000. Doctors are risk-neutral and know whether they are reckless or careful, but the insurance company only knows that 10% of doctors are reckless. How much do insurance companies have to charge for malpractice insurance to break even? a. $5,000 [Both reckless and careful doctors would purchase insurance at this price.] b. $7,500 [Because careful doctors are risk-neutral, they would not purchase insurance at this price, leaving the insurance company only with reckless doctors.] c. $27,500 [The insurance company would insure only reckless doctors, losing $2,500 on each insured.] d. $30,000 [Correct; only reckless doctors would purchase insurance at this price.]

2.

An employer faces two types of employees. Regular workers are 70% of the population and generate $100,000 in productivity. Exceptional workers are 30% of the population, and generate $120,000 in productivity. Employees know their types, and reject salaries below their productivity. If the employer offers a salary equal to the average productivity in the population, what will be the employer’s per-employee profit? a. -$10,000 [The average productivity is $100,000(70%)+$120,000(30%)=$106,000 b. -$6,000 [Correct; the employer would offer $106,000 but hire only regular workers generating $100,000 in productivity.] c. $0 [This answer ignores the adverse selection problem.] d. $4,000 [Adverse selection implies that profits would be negative, not positive]

3.

An all-you-can-eat buffet attracts two types of customers. Regular customers value the buffet at $20 and eat $5 of food in costs to the restaurant. Hungry customers value the buffet at $40 and eat $10 of food. If there are 100 of each type in the market for a buffet dinner, what is the restaurant’s maximum profit? a. $2,500 [This is obtained by charging $20, but the restaurant can do better.] b. $3,000 [Correct; by charging $40, the restaurant attracts only hungry customers.] c. $4,500 [This level of profit is unobtainable as the restaurant can attract at most 100 customers at $40 or 200 customers at $20.] d. $6,500 [This level of profit is unobtainable and exceeds the total value of all customers.]

4.

To combat the problem of adverse selection, ______ informed parties can employ _____ techniques. a. more; signaling [Correct; signaling is a more informed party’s effort to communicate her information to the less informed party] b. less; signaling [The less-informed party’s effort to learn the information that the more informed party has is called screening.] c. equally; screening [Adverse selection arises because parties are not equally informed] d. equally; signaling [Adverse selection arises because parties are not equally informed]

5.

Which of the following can be an example of a signal?

a.

b.

c. d.

An air-conditioning manufacturer offers a 50-year warranty. [This signals quality as the warranty is more expensive to honor for an inferior product; this is not the only correct answer] A lawyer offers to be paid only if the client wins. [This signals a higher likelihood of winning as the contingent fee is less a risk if the chance of winning is high; this is not the only correct answer A student pursues an MBA. [This can signal dedication, willingness to work hard, or other traits.]

All of the above [Correct; all of the above are possible signals]

6.

Which of the following is not an example of adverse selection? a. A business bets the proceeds of a bank loan on the next NFL game. [Correct; this is an example of moral hazard rather than adverse selection.] b. An accident-prone driver buys auto insurance. [This is adverse selection as drivers who are more expensive to insure are more likely to buy insurance.] c. A patient suffering from a terminal disease buys life insurance. [This is adverse selection as patients who are more expensive to insure are more likely to buy insurance.] d. A really hungry person decides to go to the all-you-can-eat buffet for dinner. [This is adverse selection as customers who are more expensive to serve are more likely to buy the buffet.]

7.

The demand for insurance arises primarily from people who are a. risk-seeking. [Risk-seeking individuals are less willing to pay a premium in order to eliminate a risk.] b. risk-averse. [Correct; risk-averse individuals are willing to pay more to avoid risks and thus are most likely to purchase insurance.] c. risk-neutral. [Risk-neutral individuals are willing to insure only when the premium costs less than the expected loss.] d. None of the above [Willingness to pay for insurance depends on one’s risk tolerance.]

8.

Which of the following is a potential solution to the adverse selection problem faced by insurance companies? a. Offer plans with different deductibles so that higher-risk customers accept higher deductibles. [The deductible is a signal that reveals each insured’s risk, reducing adverse selection; this is not the only correct answer.] b. Create a national database of customers that allows companies to look up each person’s historical risk. [This provides information about each insured’s risk, reducing information asymmetry.] c. Mandate that every person purchase insurance. [This eliminates adverse selection by prohibiting low-risk individuals from exiting the insurance market.] d. All of the above [Correct; each of the above is a potential solution to the adverse selection problem.]

9.

An insurance company suffers from adverse selection if a. safe customers are less likely to insure than risky customers. [Correct; adverse selection occurs when only the most expensive customers buy insurance.] b. customers know their willingness to pay for insurance but the company does not. [This is a common feature of most pricing decisions and does not necessarily lead to adverse selection.]

c. d.

a customer takes on much greater risk because he is insured. [This is moral hazard, but it does not suggest that different customers take different actions.] its customers are risk averse. [Insurance company customers are often risk averse whether the insurance company faces adverse selection or not.]

10. Which of the following is an example of adverse selection? a. A safe driver taking greater risk in a rental car than his own car. [This answer does not suggest that there are different types of drivers, with some posing a higher risk than others.] b. A terminally ill person purchasing life insurance. [Correct; a higher-cost patient purchasing insurance while, presumably, a lower-cost patient choosing not to purchase, is adverse selection.] c. An employment contract encourages little effort on the part of employees. [This answer does not suggest that there are different types of employees.] d. All of the above [Only one of the above is an example of adverse selection, rather than moral hazard.]

Chapter 20 Multiple Choice Questions 1.

Which of the following is an example of moral hazard? a. Reckless drivers are the ones most likely to buy automobile insurance. [This is an example of adverse selection as it relates to different types of drivers.] b. Retail stores located in high-crime areas tend to buy theft insurance more often than stores located in low-crime areas. [This is an example of adverse selection as it relates to different types of stores.] c. Drivers who have many accidents prefer to buy cars with air bags. [This is an example of adverse selection as it relates to different types of drivers.] d. Employees recently covered by the company health plan start going to the doctor every time they get a cold. [Correct; unlike the other answers, this is an example of moral hazard as each same individual takes a different levels of risk in the presence of insurance than in its absence.]

2.

In a bad economy, a CEO has a 4% chance of meeting earnings estimates at regular effort, and a 5% chance at extraordinary effort. Extraordinary effort costs the CEO $10,000. How large a bonus should the CEO be paid for meeting estimates to encourage extraordinary effort? a. $100,000 [$100,000 earned 5% of the time is worth less than the cost of extraordinary effort.] b. $200,000 [This is insufficient since the CEO has an almost equal chance of meeting estimates at regular effort as at extraordinary effort.] c. $250,000 [The answer should account for the additional likelihood of meeting estimates from extraordinary effort.] d. $1,000,000 [Correct; extraordinary effort provides an extra 1% chance of meeting estimates. Therefore, the bonus must be at least $10,000/1%.]

3.

A salesperson can put in regular effort (resulting in a 40% chance of sale) or high effort (60% chance of sale). If high effort costs the salesperson $20 more than regular effort, how large a per-sale bonus is required to encourage high effort? a. $12 [This is less than the extra cost of effort and therefore would not be worth it for the salesperson.] b. $20 [A $20 bonus earned 60% of the time does not offset a $20 cost of effort.] c. $33.33 [This would exactly compensate for the extra cost of effort (60% x $33.33 = $20), but does not account for the fact that the salesperson has a good chance of earning the bonus at regular effort as well.] d. $100 [Correct; high effort results in an extra 20% chance of earning a bonus and costs $20.

Therefore, the bonus must at least satisfy (20%)b=$20.]

4.

Which of the following is not an example of a process designed to combat moral hazard problems? a. Banks include restrictive covenants in loan agreements. [This prevents bank customers from taking excessive risks with the bank’s capital.] b. Universities have students complete evaluations of professor performance at the end of a class. [This helps prevent shirking by faculty]

c. d.

Insurance companies require applicants to provide medical history information as part of the application process. [Correct; this combats adverse selection rather than moral hazard.]

Employers regularly monitor employee performance. [Employees have less incentive to work hard than employers want since part of the generated profits go to the employer.]

5.

Which of the following is an example of moral hazard? a. High-quality products being driven out of a market by low-quality products. [This is an example of adverse selection.] b. A local charity raising insufficient funds because no one contributes, expecting that their neighbors will. [This is an example of free riding] c. A bakery defaults on its loan because of a new consumer fear of carbohydrates. [This is the result of the usual risk of lending and is not due to the bakery taking excessive risk.] d. A corporation uses a business loan secured for one investment on another, higher-risk investment. [Correct; the corporation takes excessive risks because the lender bears the downside.]

6.

Which of the following is not an example of moral hazard? a. People are more likely to lock their own car than a rental car. [People exercise less care with a rental car as they do not bear the downside to the same degree as with their own car.] b. Skateboarders attempt more difficult maneuvers when wearing a helmet. [The helmet “insures” partially against risk, leading to greater risk-taking behavior.] c. Bad salespeople are less drawn to commission-based jobs. [Correct; this is an example of adverse selection, as it differentiates types of people, not their actions.] d. People with fire insurance are less likely to install smoke alarms. [People with insurance take less care.]

7.

Which of the following is true? a. Moral hazard is primarily an issue prior to a transaction. [Moral hazard arises when people take different actions because of the transaction (such as purchasing insurance).] b. Adverse selection is primarily an issue after a transaction. [Adverse selection results from different willingness to enter into a transaction.] c. Moral hazard is the result of an information asymmetry. [Correct; moral hazard arises from hidden actions.] d. Resolving adverse selection also resolves moral hazard. [While related, these are different types of information asymmetry.]

8.

Restrictive covenants on loans are used to avoid a. moral hazard. [Correct; restrictive covenants attempt to minimize excessive risk taking as a result of moral hazard.] b. adverse selection. [Restrictive covenants attempt to control hidden actions.] c. free riding. [Restrictive covenants exist to make sure that loans are used for their intended purposes, which is unrelated to free riding.] d. None of the above [One of the above answers is correct.]

9.

Loan applications require a lot of information from applicants to avoid a. moral hazard. [Moral hazard is an issue of hidden actions.] b. adverse selection. [Correct; the information reveals something about the type of borrower.] c. free riding. [Free riding is not the result of an information asymmetry.]

d.

None of the above [One of the above answers is correct.]

10. Which of the following is true about moral hazard? a. Moral hazard arises from actions that cannot be observed. [Moral hazard is an issue of hidden action, but is not the only correct answer.] b. Shirking is a form of moral hazard. [This is true, but is not the only correct answer.] c. Moral hazard refers to the taking of excessive risk. [This is true, but is not the only correct answer.] d. All of the above [Correct; all of the above are examples of hidden actions and a reduced incentive to take precautions.]

Chapter 21 1.

Your notebook computer’s hard drive recently crashed, and you decide to take it to a local repair technician to have it fixed. In this relationship, a. you are the agent. [The agent typically is the party actually performing the work.] b. the technician is the principal. [The principal typically is the party contracting an agent to perform the work.] c. the technician is the agent. [correct; the technician is being contracted by you, the principal, to do the work.] d. no principal-agent relationship exists. [Assuming that the repair technician has any interests that are not identical to yours, a principal-agent relationship exists.]

2.

A good incentive-compensation scheme a. maximizes the agent's utility. [the goal of a compensation scheme is to maximize the principal’s profit.] b. anticipates how an agent will game the scheme. [correct; agents may find ways to maximize their profit in ways not anticipated by the principal.] c. does not subject a risk-averse agent to risk. [incentive compensation usually involves some risk for the agent, for which he or she has to be compensated.] d. accompanies centralized decision-making authority. [compensation schemes are especially important when decision-making authority is decentralized.]

3.

Principal-agent relationships a. reduce monitoring costs. [Principal-agent relationships are often characterized by high monitoring costs and thus often rely on incentive pay.] b. occur because managers have good information about employees. [Principal-agent relationships exist in many environments, including ones where principals have very little information about their employees.] c. are not related to asymmetric information. [Agents having better information about their capabilities and actions is typical of principal-agent problems.] d. are subject to moral hazard problems. [correct; principals may be unable to observe or monitor agents’ actions.]

4.

All of the costs associated with a principal interacting with an agent are called a. opportunity costs. [These are the costs of foregone opportunities.] b. agency costs. [correct; these include the costs of combatting moral hazard and adverse selection] c. monitoring costs. [This is just one type of cost associated with principal-agent relationships.] d. sunk costs. [These are costs that do not vary with the consequences of your decision.]

5.

Principal-agent problems a. occur when firm managers have more incentive to maximize profit than shareholders do.

[The problem generally occurs because the manager has less incentive to maximize profit.] b. would be reduced if firm owners had better information about the actions of the firm’s managers. [correct; the cost of controlling incentive conflict from agency problems goes down if the principal can gather information]

c. d.

are made worse when executives own stock in their companies. [This provides incentives for executives to maximize stock price, which presumably is in the interest of shareholders.] are increased as more information is shared between the parties. [Reducing information asymmetry also reduces principal-agent problems.]

6.

To create an effective incentive-compensation scheme, you must have a. adequate performance measures. [correct; compensation schemes tie rewards to performance and therefore require that performance be reliably measured.] b. unlimited funds. [Incentive compensation schemes align the incentives of the agent with that of the principal, but this does not require unlimited funds.] c. a flat management structure. [A specific management structure is not a precondition for an effective compensation scheme.] d. none of the above. [One of the above answers is correct;]

7.

Decentralization of decision-making authority is consistent with which of the following? a. A trend of stronger, more active CEOs. [This would be consistent with centralization of authority] b. Shrinking costs of computing bandwidth, which allows information to be inexpensively aggregated from geographically diverse business units. [When information is easier to aggregate, centralized decision-making authority becomes easier to sustain.] c. Development of computing resources at the corporate, division, and employee level. [correct; this provides decision-making tools at each level of a corporation, reducing the need to centralize decision-making authority.] d. Reduction in the use of incentive compensation. [Decentralization of authority is generally accompanied with increased reliance on incentive compensation.]

8.

A firm faces two kinds of employees, those able to sell 10 units/year, and those able to sell 5 units/year. High-productivity employees are willing to work for $100K/year, while low-productivity employees are willing to work for only $50K/year. To screen out the low-productivity employees, the firm should offer a. a salary of $100K. [Both kinds of employees would accept this salary.] b. a salary of $75K plus $5K/unit commission. [Low-productivity employees would not be screened out as they would earn more than $50.] c. a sales commission of $10K/unit. [Low-productivity employees would not be screened out as they would earn $10K on each of five units.] d. offer a sales commission of $20K/unit on sales above 5 units. [correct; This would sufficiently reward high-productivity employees but pay low-productivity employees only $20K, screening them out.]

9.

You own a retail establishment run by a store manager who receives a flat salary of $80,000. If you set up another store as a franchise with incentive compensation to the franchisee, what would be a reasonable total compensation range that the franchisee could earn? a. $80,000 [The franchisee’s compensation should vary with performance.] b. $40,000–$80,000 [This range would result in expected compensation below $80,000 and thus would be insufficient to entice the franchisee to participate.] c. $60,000–$100,000 [correct; this would allow the franchisee to earn an average salary similar to the manager but still allow it to vary with performance.]

d.

$80,000–$100,000 [If a manager requires total compensation of $80,000, then the franchisee should earn roughly $80,000 on average.]

10. In the magazine Budget Travel, a hotel maid admits, “I cut corners everywhere I could. Instead of vacuuming, I found that just picking up the larger crumbs from the carpet would do. Rather than scrub the tub with hot water, sometimes it was just a spray-and-wipe kind of day. … After several weeks on the job, I discovered that the staff leader who inspected the rooms couldn’t tell the difference between a clean sink and one that was simply dry, so I would often just run a rag over the wet spots. … I apologize to you now if you ever stayed in one of my rooms.” Which of the following organizational forms is more likely to have caused this kind of shirking? a. Franchising: where the hotel managers are the owners of the hotel (franchisee) and pay a fixed franchise fee [As owners, hotel managers receive the profit of the hotel as earnings and thus have a lot of incentive to maintain the quality of the hotel.] b. Company-owned hotels [correct; As managers do not share (as much) in the profits of the hotels, they have less incentive to monitor quality than the other two organizational forms.] c. Franchising with a sharing contract, where the hotel managers are the owners of the hotel (franchisee), pay a small fixed fee but share revenue with the franchisor [As owners, hotel managers’ earnings vary with the profit of the hotel, providing a lot of incentive to maintain the quality of the hotel.] d. None of the above [incentives to shirk vary with organizational form.]

Chapter 22 Multiple Choice Questions 1.

A computer manufacturer has two divisions: one serving residential customers and one serving business customers. If an incentive conflict arises between the two divisions, how will overall company profits be affected? a. Profits will definitely fall. [While profit often falls due to division conflict, it is not definite] b. Profits will definitely rise. [Profit is unlikely to increase due to a divisional conflict] c. Profits may fall, but it depends on the nature of the conflict. [Correct] d. The conflict has no potential to affect overall profit. [While the conflict is not guaranteed to affect profit, you should definitely be worried about the potential to affect profit]

2.

Which of the following changes might help solve a divisional conflict regarding a decision? a. Change who has authority to make the decision [Yes, this might help but are there other options?] b. Transfer information to the decision makers so they are better informed [Yes, this might help but are there other options?] c. Change the performance evaluation and associated compensation of the decision makers [Yes, this might help but are there other options?] d. All of the above [Correct; all of the above are potential solutions to consider]

3.

Joe runs the Service Division for a car dealership. The overall dealership has profit of $10 million on sales of $100 million and costs of $90 million. Joe’ s division contributed $9 million in sales and $7 million in costs. If the Service Division is evaluated as a profit center, what dollar amount is most relevant to Joe? a. $2 million [Correct; this is the profit of the Service Division] b. $7 million [While the $7 million in cost is important, other figures matter too] c. $9 million [While the $9 million in sales is important, other figures matter too] d. $10 million [Because Joe’s incentives are likely tied to Service Division profit, he is unlikely to consider overall dealership profit as most relevant]

4.

If you were a manager of a cost center, which of the following areas would be of most interest to you? a. Capturing potential economies of scale. [Correct] b. Increasing the quality of your product. [Cost centers are normally rewarded for producing at the lowest cost; increasing quality would likely increase cost rather than reduce it] c. Hiring more marketing staff to figure out how to increase prices. [Cost centers are normally rewarded for producing at the lowest cost; adding marketing staff would likely increase cost rather than reduce it] d. Adding additional features to your product. [Cost centers are normally rewarded for producing at the lowest cost; adding features would likely increase rather than reduce cost]

5.

Transfer prices should be set at a. the marginal cost of the selling division plus a reasonable profit amount. [This could lead to a double mark-up problem] b. the marginal cost of the selling division unless it is evaluated as a profit center. [Whether the division is evaluated as a profit center should not impact the transfer price]

c. d.

the opportunity cost of the asset being transferred. [Correct] at whatever price is negotiated between the selling and buying divisions. [This may or may not result in the right price being negotiated]

6.

Which type of organizational form has the benefit of closer coordination to serve a particular product or geographic area? a. Profit centers. [A profit center means that the group or division is evaluated based on profit; this is not directly related to coordination to serve a product group or geographic area] b. Functional organizations. [A lack of coordination is one of the challenges not benefits of a functional structure] c. M-form organizations. [Correct] d. Functional and M-form organizations have the same benefits. [These two structures have different types of benefits]

7.

Which of the following provides an example of divisions based on a functional organizational structure? a. Americas, Africa, Asia, Europe [This would be an example of an M-form based on region] b. Research and development, production, finance, marketing [Correct] c. Youth products, teen products, senior products [This would be an example of an M-form based on product] d. Business users, home users, educational users [This would be an example of an M-form based on customer type]

8.

Which of the following organizational forms requires the strongest management oversight to ensure coordination of functions? a. Profit centers [Treating a division as a profit center refers to how it is evaluated not to the company’s organizational form] b. Functional organizations [Correct] c. M-form organizations [One of the benefits of the M-form is the higher level of coordination of functional areas, so it is not as likely to need strong management oversight] d. Functional and M-form organizations likely require similar oversight [The two forms differ in the amount of oversight needed to foster coordination]

9.

Which of the following actions is consistent with a manager whose compensation depends on meeting a budget goal and who does not believe he can make that goal? a. Asking a vendor to pre-ship and invoice materials for the following year. [Yes, this action is consistent but are there other actions?] b. Discovering a “problem” in the order taking process, thereby forcibly pushing sales into the ensuing year. [Yes, this action is consistent but are there other actions?] c. Increasing accounting reserve estimates, leading to higher recognized expenses. [Yes, this action is consistent but are there other actions?] d. All of the above [Correct; all of these actions are consistent with this type of compensation scheme]

10. One of the basic functions of the budgeting process is a. assigning decision rights. [Assigning decision rights is part of organization design]

b. c. d.

transferring information. [Correct] evaluating managerial performance. [While performance evaluation is sometimes related to achieving budgets, a basic function of the budgeting process is not to evaluate performance] implementing structural change. [Budgeting and implementing structural change are separate activities]

Chapter 23 Multiple Choice Questions 1.

Alpha Industries is considering acquiring Foxtrot Flooring. Foxtrot is worth $20 million to its current owners under its existing operational methods. Because there are some opportunities for synergies between the two companies, Alpha believes that Foxtrot is worth $25 million as part of Alpha Industries. What do you predict for a sales price of Foxtrot? a. Less than $20 million or Alpha will not buy [According to the rational actor paradigm Alpha will purchase at any value below $25 million] b. More than $25 million or Foxtrot will not sell [According to the rational actor paradigm Foxtrot will sell at any value above $20 million] c. Something between $20 and $25 million [Correct; the rational actor paradigm indicates that Foxtrot will be willing to sell at anything above their value of $20m, while Alpha is willing to purchase at anything below their valuation of $25 million; a value between $20 and $25 million satisfies both of these requirements] d. The different valuations make a sale very unlikely. [Not true, the rational actor paradigm indicates that Foxtrot will be willing to sell at anything above their value, while Alpha will be willing to purchase at anything under theirs]

2.

All of the following provide a motive for vertical agreements EXCEPT a. effective execution of price discrimination [True; with vertical integration, retailers are able to defeat upstream price discrimination schemes designed by a manufacturer] b. elimination of free-riding among retailers [True; vertical contracts such as exclusive territories can overcome the problem of free riding by discount retailers] c. quality control [True; vertically integrating can allow a manufacturer to have greater control over the final product] d. diversification [Correct; this is false. Diversification represents a company expanding its reach horizontally rather than vertically]

3.

Which of the following is an example of vertical integration? a. A custom software company purchasing a competing software firm [This is a form of expansion, not vertical integration] b. A soft drink producer buying a brand of iced tea [This is an example of horizontal integration, not vertical integration] c. A coal producer purchasing a nuclear power plant [This is an example of diversification, not vertical integration] d. A gourmet cheese company purchasing a dairy [Correct; dairy is an input into the cheese production process]

4.

Why are contact lens manufacturers reluctant to sell their lenses through the Internet? a. The Internet price is too high due to double marginalization [Double marginalization is more likely to occur with retailers than online]

b. c.

d.

Search costs are lower, so the Internet sales are too competitive [Competition alone is not the reason for their reluctance, there are other factors involved] Doing so reduces the incentives of retailers to provide point-of-sale services [Correct; in order to compete with online prices, retailer would likely be forced to eliminate their point of sale services, which could affect customer's overall experience with the brand] They are afraid of antitrust lawsuits [Antitrust laws don't apply to a company selling its own product through a different channel]

5.

In which of the following instances would an acquisition make the most sense? a. The target is a very profitable company [Don't just acquire a company because it is profitable] b. Synergies exist between the acquirer and the target [Synergies are worthless unless you are the one capturing the value] c. Integration costs are low between the two [Even if integration costs are low, you would only purchase if there was value to you] d. Synergy benefits outweigh the costs of integration [Correct; the value of the synergy should outweigh the cost of acquiring it!]

6.

Why do vertical agreements typically pose less antitrust risk than horizontal agreements? a. Vertical agreements occur less often than horizontal agreements [Frequency of occurrence does not contribute to antitrust risk] b. Vertical agreements often result in lower prices, which are beneficial to the consumer [Correct; the purpose of antitrust laws are to protect the consumers, who often benefit from vertical integrations] c. Vertical agreements are rarely profitable [Vertical agreements can be very profitable if done correctly] d. Vertical agreements do not pose less antitrust risk than horizontal agreements [Actually, they do. Consider the different impacts each of these agreements have on the consumers]

7.

CUS Pharmacy wishes to carry Pepgro blue pills. But Daisy Pharmaceuticals, the maker of Pepgro, will not supply CUS unless CUS agrees to carry other medications that Daisy makes. This is an example of a. Exclusion [Exclusion is the practice of blocking competitors from participating in a market.

CUS is only impacting their participation in their stores, not the market as a whole] b. Tying [Correct; tying is the practice of making the sale of one good conditional on the purchase of an additional, separate good, as you see here] c. territory restriction [CUS is not dividing products by territory in this case] d. bundling [Bundling refers to offering multiple goods for sale as one product. CUS is not mandating the products be sold together but rather at the same store]

8.

A multinational firm acquires many of its components pre-assembled from suppliers. One of these suppliers operates in a country with a much lower corporate income tax rate. How does this affect the vertical relationship between this supplier and the multinational?

a. b. c.

d.

9.

This will not affect the relationship [Tax is an important consideration between multinationals and suppliers] The multinational should stop working with the supplier [Not necessarily, there are other ways the multinational can benefit from their relationship with the supplier] The multinational should consider purchasing this supplier [Correct; The multinational can evade regulation by “realizing” a larger portion of the combined profits in the low tax jurisdiction without substantively altering its operations] The multinational should move all its operations to the supplier’s home country [Possibly, but then it could bear substantial increases in operation and reorganization costs]

In which of the following cases might you expect to find a manufacturer granting exclusive territories? a. A pet supply chain that requires heavy local advertising to drive sales [True- is it the only one?] b. Custom computer sales that require a good deal of consultation [True- is it the only one?] c. A submarine sandwich chain that relies on its nationwide brand reputation [True- is it the only one?] d. All of the above [Correct]

10. Local Spanish TV markets cater to individual cities by producing local content. This content can be produced in-house by a network or they can also purchase rights to third-party produced content.

Recently, Spanish cities have erected barriers to entry in television content production that allows content producers more market power. How would this have affected vertical integration between content providers and TV networks? a. There is more vertical integration to limit arbitrage by price discriminating content producers [Contracting effectively prohibits TV networks from reselling purchased content to another TV network] b. There is less vertical integration because point-of-sale services are less important [TV broadcasting involves few opportunities for direct customer point-of-sale services] c. There is more vertical integration to reduce the double marginalization problem [Correct; TV networks place a second margin on top of the first content producer’s margin.

The new barriers to entry increase content producers’ initial margins which makes the double marginalization problem more severe] d. There is less vertical integration because evading regulation is less important [Firms vertically integrate so as to engage in regulatory evasion]

Managerial Economics: A Problem-Solving Approach 6th Edition

Solutions to End-of-Chapter Individual Problems

Table of Contents Chapter 1 ....................................................................................................................................... 71 1-1 Goal Alignment at a Small Manufacturing Concern .......................................................... 71 1-2 Goal Alignment at a Small Manufacturing Concern (cont.) ............................................... 72 1-3 Goal Alignment at a Small Manufacturing Concern (cont.) ............................................... 72 1-4 Goal Alignment at New York City Schools ....................................................................... 72 1-5 Goal Alignment between Airlines and Flight Crews .......................................................... 72 1-6 Goal Alignment between Hospitals and the British Government ....................................... 73 Chapter 2 ....................................................................................................................................... 74 2-1 Airline Delays ..................................................................................................................... 74 2-2 Selling Used Cars ................................................................................................................ 74 2-3 Flood Insurance ................................................................................................................... 74 2-4 France’s Labor Unions Force Early Closing Times ........................................................... 74 2-5 Kraft and Cadbury............................................................................................................... 75 2-6 Price of Breast Reconstruction Versus Breast Augmentation ............................................ 75 Chapter 3 ....................................................................................................................................... 76 3-1 Concert Opportunity Cost ................................................................................................... 76 3-2 Concert Opportunity Cost 2 ................................................................................................ 76 3-3 Housing Bubble .................................................................................................................. 76 3-4 Opportunity Cost ................................................................................................................. 77 3-5 Starbucks ............................................................................................................................. 77 3-6 Dropping University Courses ............................................................................................. 77 3-7 Business Costs .................................................................................................................... 78 Chapter 4 ....................................................................................................................................... 79 4-1 Extent Versus Discrete Problems........................................................................................ 79 4-2 Game Day Shuttle Service .................................................................................................. 79 4-3 Paid for Grades ................................................................................................................... 80 4-4 Supplier Bids ....................................................................................................................... 80 4-5 Processing Insurance Claims .............................................................................................. 80 4-6 Copier Company ................................................................................................................. 81 Chapter 5 ....................................................................................................................................... 82 5-1 George’s T-Shirt Shop ........................................................................................................ 82

5-2 Net Present Value ............................................................................................................... 82 5-3 Doctor’s Human Capital ..................................................................................................... 82 5-4 Solar Panel Installation ....................................................................................................... 82 5-5 Toy Trucks .......................................................................................................................... 83 5-6 Running a Hotel During a Recession .................................................................................. 83 5-7 Short Run versus Long Run ................................................................................................ 84 Chapter 6 ....................................................................................................................................... 85 6-1 Elasticity of T-Shirt Sales ................................................................................................... 85 6-2 Increasing Movie Ticket Prices .......................................................................................... 85 6-3 Promotional Pricing ............................................................................................................ 85 6-4 Bar Nuts .............................................................................................................................. 86 Chapter 7 ....................................................................................................................................... 87 7-1 Scale and Scope .................................................................................................................. 87 7-2 Pre-prepared Meals ............................................................................................................. 87 7-3 Rangers’ T-Shirts ................................................................................................................ 87 7-4 Average and Marginal Costs ............................................................................................... 88 7-5 Learning Curves .................................................................................................................. 88 7-6 Multiconcept Restaurants Are a Growing Trend ................................................................ 89 Chapter 8 ....................................................................................................................................... 90 8-1 Widget Market .................................................................................................................... 90 8-2 Cotton Prices ....................................................................................................................... 90 8-3 Hand Sanitizer..................................................................................................................... 91 8-4 Chocolate Candy Bars Market ............................................................................................ 91 8-5 Demand Shifts ..................................................................................................................... 92 8-6 Valentine’s Day .................................................................................................................. 92 Chapter 9 ....................................................................................................................................... 93 9-1 Faculty Housing Benefits .................................................................................................... 93 9-2 Snacks, Beer, and Marijuana .............................................................................................. 93 9-3 Competition or Monopoly .................................................................................................. 93 9-4 Competitive Industries ........................................................................................................ 93 9-5 Economic Profit .................................................................................................................. 94 9-6 Economics Versus Business ............................................................................................... 94

Chapter 10 ..................................................................................................................................... 95 10-1 High Rivalry...................................................................................................................... 95 10-2 Increasing Customer Value ............................................................................................... 95 10-3 Intangible Resources ......................................................................................................... 95 10-4 Five Forces and the Airline Industry ................................................................................ 96 10-5 Barriers to Entry................................................................................................................ 97 10-6 Salons and Teeth Whitening ............................................................................................. 97 Chapter 11 ..................................................................................................................................... 98 11-1 The Carry Trade ................................................................................................................ 98 11-2 Brexit Fears ....................................................................................................................... 98 11-3 Effects of the Pound Devaluation on Tourism and Bank Profits ...................................... 98 11-4 The Effects of a Pound Depreciation on Whirlpool.......................................................... 99 11-5 Domestic Content.............................................................................................................. 99 11-6 Dollar Devaluation ............................................................................................................ 99 11-7 Effect of Expectations on the Exchange Rate ................................................................. 100 Chapter 12 ................................................................................................................................... 101 12-1 Parking Lot Optimization ............................................................................................... 101 12-2 Parking at Cowboys Stadium .......................................................................................... 101 12-3 Product Store Locations .................................................................................................. 102 12-4 Macintosh Versus iPhone ............................................................................................... 102 12-5 Concert Prices ................................................................................................................. 102 12-6 Radio Stations and Rock Concerts .................................................................................. 102 Chapter (13)-14 ........................................................................................................................... 104 14-1 Barbie Dolls and Accessories ......................................................................................... 104 14-2 Vape Shops ..................................................................................................................... 104 14-3 Dojo Pricing .................................................................................................................... 104 14-4 Fitness Trackers .............................................................................................................. 104 14-5 Music Pricing .................................................................................................................. 105 14-6 Bundling.......................................................................................................................... 106 Chapter 15 ................................................................................................................................... 107 15-1 To Vote or Not to Vote ................................................................................................... 107 15-2 To Vote or Not to Vote Part II ........................................................................................ 107

15-3 Compatibility .................................................................................................................. 107 15-4 Salary Negotiation .......................................................................................................... 108 15-5 Renegotiating Employment Contracts ............................................................................ 108 15-6 Entry Game with Withdrawal ......................................................................................... 109 Chapter 16 ................................................................................................................................... 111 16-1 Streamer Bargaining ....................................................................................................... 111 16-2 Airline Merger ................................................................................................................ 111 16-3 House Closing ................................................................................................................. 111 16-4 A City and Its Unions ..................................................................................................... 112 16-5 Entering International Markets ....................................................................................... 112 16-6 PBMs............................................................................................................................... 113 Chapter 17 ................................................................................................................................... 114 17-1 Global Expansion ............................................................................................................ 114 17-2 Game Show Uncertainty ................................................................................................. 114 17-3 Ad Agencies .................................................................................................................... 115 17-4 Disposing of Used Assets ............................................................................................... 116 17-5 Saint Petersburg Gambles ............................................................................................... 116 17-6 Hiring .............................................................................................................................. 116 Chapter 18 ................................................................................................................................... 118 18-1 Effects of Collusion ........................................................................................................ 118 18-2 Reserve Prices ................................................................................................................. 118 18-3 Reserve Prices II ............................................................................................................. 119 18-4 Asset Auctions in Sweden .............................................................................................. 119 18-5 Art Auctions .................................................................................................................... 120 18-6 Contractor Bidding.......................................................................................................... 120 Chapter 19 ................................................................................................................................... 121 19-1 Leasing Residuals ........................................................................................................... 121 19-2 College Degrees Required for Police Officers................................................................ 121 19-3 Bicycle Insurance and Information Asymmetry ............................................................. 121 19-4 Job Auction ..................................................................................................................... 122 19-5 “Soft Selling” and Adverse Selection ............................................................................. 122 19-6 Hiring Employees ........................................................................................................... 122

Chapter 20 ................................................................................................................................... 124 20-1 Extended Warranties ....................................................................................................... 124 20-2 Business Loan ................................................................................................................. 124 20-3 Kitchen Remodel Costs .................................................................................................. 124 20-4 Auto Insurance ................................................................................................................ 125 20-5 BPO Services .................................................................................................................. 125 20-6 Frequent Flyers ............................................................................................................... 125 Chapter 21 ................................................................................................................................... 127 21-1 Real Estate Agents .......................................................................................................... 127 21-2 Airline Departures ........................................................................................................... 127 21-3 Incentive Conflicts .......................................................................................................... 127 21-4 Public School Principals ................................................................................................. 128 21-5 Venture Capital ............................................................................................................... 128 21-6 Meeting Milestones ......................................................................................................... 128 Chapter 22 ................................................................................................................................... 130 22-1 Transfer Pricing .............................................................................................................. 130 22-2 Transfer Prices Set by Headquarters ............................................................................... 131 22-3 Chargebacks .................................................................................................................... 131 22-4 Divisional Profit Measure ............................................................................................... 131 22-5 Furniture Forecasting ...................................................................................................... 132 22-6 Jet Turbine Design .......................................................................................................... 132 Chapter 23 ................................................................................................................................... 134 23-1 Telephone Pole Attachments .......................................................................................... 134 23-2 Integration of Physician Groups and Testing Services ................................................... 134 23-3 Online Cosmetics ............................................................................................................ 134 23-4 Wedding Dresses ............................................................................................................ 135 23-5 Herbicide Integration ...................................................................................................... 135 23-6 Loyalty Payments............................................................................................................ 135

Chapter 1 Short Answer Key:

1-1 Goal Alignment at a Small Manufacturing Concern The owners of a small manufacturing concern have hired a manger to run the company with the expectation that he will buy the company after five years. Compensation of the new Vice President is a flat salary plus 75% of the first $150,000 profit, then 10% of profit over $150,000. Purchase price for the company is set at 4.5 times earnings (profit), computed as average annual profitability over the next five years.

a. Plot the annual compensation of the vice president as a function of annual profit.

Assume for now the VP has a base salary of 50,000. If so, when P≤$150000, his compensation can be determined by the equation C = 50000+0.75(P). When P≥150000, compensation is determined by the equation C=(50000+0.75(150000)) + 0.1P, which means C=162500+0.1P. The plot for compensation can be seen below.

Company Profit VP Compensation 0 50000 50000 87500 100000 125000 150000 162500 175000 180000 200000 182500 250000 187500 300000 192500

b. Assume the company will be worth $10million in five years. Plot the profit of buying the company as a function of annual profit.

The purchase price will be 4.5x earnings, calculated as 4.5x average annual profitability. Therefore, the profitability of the purchase can be seen by the equation Ppurchase = 10,000,000 – 4.5(Pannual). The plot of this equation can be seen below.

Annual Profit Purchase Profit 125000 9437500 250000 8875000 500000 7750000 750000 6625000 1000000 5500000 1250000 4375000 1500000 3250000 2000000 1000000

1-2 Goal Alignment at a Small Manufacturing Concern (cont.)

Does this contract align the incentives of the new vice president with the profitability goals of the owners?

No. Both the purchase price and the profit sharing create perverse incentives. The VP keeps $0.75 of each dollar earned up to $150,000, but only $0.10 of each dollar earned after $150K. Since earning more requires more effort (increasing marginal effort), he has little incentive to earn more than $150,000. And every dollar the VP earns raises the price that he will eventually pay for the company by $4.50, effectively penalizing him for increasing company profitability.

1-3 Goal Alignment at a Small Manufacturing Concern (cont.)

Re-design the contract to better align the incentives of the new vice president with the profitability goals of the owners.

One approach would be to establish a purchase price at the initiation of the contract. This would encourage the VP to make the company as profitable as possible, as the increases to his marginal wealth of 10% above 150000 are not offset by the dramatic increases in purchase price. Also, this encourages him to make the company as profitable as possible as it will ultimately be his once the 5 years have passed.

[note to instructors: the material in red in Q1-4, along with all of Q1-6 and Q1-6 were inadvertently deleted from the final version of the text]

1-4 Goal Alignment at New York City Schools 1,800 New York City teachers who lost their jobs earlier this year have yet to apply for another job despite the fact that there are 1,200 openings. Why not?

New York is the only city in the U.S. where teachers are guaranteed pay for life even if their school closes and they no longer have a permanent job. The policy costs DOE more than $100 million per year in salary and benefits. Those teachers go into the Absent Teacher Reserve pool, where they can be used as substitutes. The average salary for an ATR pool teacher? $82,000, with some making $100,000. Some teachers have been in the pool since 2006.

1-5 Goal Alignment between Airlines and Flight Crews Planes frequently push back from the gate on time, but then wait 2 feet away from the gate until it is time to queue up for take-off. This increases fuel consumption and increases the time that passengers must sit in a cramped plane awaiting take-off. Why does this happen?

Airlines are often evaluated and measured by their “on time” performance metrics. As this refers to boarding times rather than the time of actual departure, airlines would rather board the planes on time and wait on the tarmac than leaves passengers waiting at the gate.

1-6 Goal Alignment between Hospitals and the British Government In 2008, the Labour party in Britain promised that patients would have to wait for no more than four hours to be seen in an emergency room. How is the National Health Service meeting this performance goal?

To meet this performance goal, seriously ill patients are being kept in ambulances. Thousands of people a year are having to wait outside the emergency departments because the trusts will not let them in until they will be able to be treated within four hours in accordance with the Labour pledge and government targets. In addition to keeping people outside, this also has reduced the ability of the ambulances to respond to emergency calls, leading to serious problems throughout the region.

Chapter 2 Short Answer Key:

2-1 Airline Delays How will commercial airlines respond to the threat of new $27,500 fines for keeping passengers on the tarmac for more than three hours? What inefficiency will this create?

Carriers say that to avoid those fines, they will aggressively cancel flights before and during storms— even if the bad weather never materializes. The threats could foreshadow significant changes in air travel, making it even less reliable for millions of road warriors and vacationers. By canceling flights, it could take days for all travelers to get home when storms strike. [link].

2-2 Selling Used Cars I recently sold my used car. If no new production occurred for this transaction, how could it have created value?

The value of my willingness-to-sell was less than the buyer's willingness-to-pay. Any transaction price between these allows for a voluntary exchange in which we both benefit. Since we are both better off, value was created.

2-3 Flood Insurance The U.S. government subsidizes flood insurance because those who want to buy it live in the flood plain and cannot get it at reasonable rates. What inefficiency does this create?

Subsidies are like taxes in this case. Taxation will keep some efficient transactions from being consummated because potential transactions where the difference in buyer and seller valuation is positive will no longer cover the amount of the tax to be paid. This prevents the asset from moving to its highest valued use. With a subsidy, transactions in which the assets move from a higher valued use to a lower valued use can be consummated so long as the difference is less than the amount of the subsidy. This moves the asset to a lower valued use. With flood insurance worth an expected $20,000, homeowners would be willing to spend $120,000 to build a house that they value at only $100,000. Wealth is destroyed.

2-4 France’s Labor Unions Force Early Closing Times In 2013, France’s labor unions won a case against Sephora to prevent the retailer from staying open late and forcing its workers to work “antisocial hours”. The cosmetic store does about 20 percent of its business after 9 p.m., and the 50 sales staff who work the late shift are paid an hourly rate that is 25

percent higher than the day shift. Many of them are students or part time workers, who are put out of work by these new laws. Identify the inefficiency, and figure out a way to profit from it.

The inefficiency in this situation stems from the fact that the staff working the late shift valued the opportunity to work at the 25 percent increased wage more than not working during ―antisocial hours‖.

This regulation has not only diminished the value to the company, who is losing 20 percent of its business, but also the workers, who are now unemployed.

2-5 Kraft and Cadbury When Kraft recently bid $16.7 billion for Cadbury, Cadbury’s market value rose, but Kraft’s market value fell by more. What does this tell you about the value-creating potential of the deal?

It means that Kraft's shareholders, and potential shareholders, think that Kraft’s profits will fall. This would be the case if Kraft's $16.7 billion bid is greater than the present value of the expected future profits from the Cadbury unit. Essentially, the combined market value of the firms separately is greater than the market value of the firms together. The market thinks that combining these assets will destroy value.

2-6 Price of Breast Reconstruction Versus Breast Augmentation Two similar surgeries, breast reconstruction and breast augmentation, have different prices. Breast augmentation is cosmetic surgery not covered by health insurance. Patients who want the surgery must pay for it themselves. Breast reconstruction following breast removal due to cancer is covered by insurance. The price for one of the surgeries has increased by about 10% each year since 1995, whereas the other has increased by only 2%per year. Which of the surgeries has the lower inflation rate? Why?

Market pressure comes from two sources: consumers who can choose not to purchase, and competitors who can offer lower prices. Breast augmentation is subject to both of these forces, and thus has a lower price, while breast reconstruction is covered by insurance where the consumer pressure is weaker.

Chapter 3 3-1 Concert Opportunity Cost You won a free ticket to see a Bruce Springsteen concert (assume the ticket has no resale value). U2 has a concert the same night, and this represents your next-best alternative activity. Tickets to the U2 concert cost $80, and on any particular day, you would be willing to pay up to $100 to see this band. Assume that there are no additional costs of seeing either show. Based on the information presented here, what is the opportunity cost of seeing Bruce Springsteen?

$20. Opportunity cost is the value of your next best alternative. In this case, your next best alternative is attending the U2 concert. Your value for this alternative is $100 with a corresponding cost of $80 leaving a net value of $20.

Note: This question is adapted from Paul J. Ferraro and Laura O. Taylor (2005) "Do Economists Recognize an Opportunity Cost When They See One? A Dismal Performance from the Dismal Science", Contributions to Economic Analysis & Policy: Vol. 4: No. 1, Article 7.

3-2 Concert Opportunity Cost 2 You were able to purchase two tickets to an upcoming concert for $100 apiece when the concert was first announced three months ago. Recently, you saw that StubHub was listing similar seats for $225 apiece.

What does it cost you to attend the concert?

What you paid three months ago is irrelevant to your costs now. The decision you are facing is to attend the concert or not. If you do not attend, you can sell the tickets for $225 (ignoring any brokering fees and hassle costs). Thus, you forego $450 to attend the concert.

3-3 Housing Bubble Because of the housing bubble, many houses are now selling for much less than their selling price just two to three years ago. There is evidence that homeowners with virtually identical houses tend to ask for more if they paid more for the house. What fallacy are they making?

These two homeowners have virtually identical houses that should sell at virtually identical prices. The purchase price from years ago is a sunk cost and therefore irrelevant to the pricing decision. They are committing the sunk cost fallacy.

3-4 Opportunity Cost The expression “3/10, net 45” means that the customers receive a 3% discount if they pay within 10 days; otherwise, they must pay in full within 45 days. What would the seller’s cost of capital have to be in order for the discount to be cost justified? (Hint: Opportunity Cost)

The "opportunity cost" of receiving a late payment is the foregone benefit of receiving the money early. This is determined by a firm’s cost of capital. A 3% interest rate for 35 days corresponds to an annual rate of about 3%*(365/35)=31%.

3-5 Starbucks Starbucks is hoping to make use of its excess restaurant capacity in the evenings by experimenting with selling beer and wine. It speculates that the only additional costs are hiring more of the same sort of workers to cover the additional hours and costs of the new line of beverages. What hidden costs might emerge?

There could be many hidden costs. Here are a few examples:    

Some of Starbucks current baristas are underage and are not permitted to serve alcohol. Hiring new bartenders may raise the labor costs.

The storage and preparation of cold drinks, like beer and wine, differs considerably from the storage and preparation of hot drinks, like coffee. This suggests two separate ―production lines‖ at each store.

The Starbucks brand is known for signaling a quiet, comfy place to linger in small groups or alone. Serving alcohol may change the atmosphere enough that traditional coffee drinkers in the afternoon and early evening will be turned off.

The Starbucks brands is also known for high quality coffees that are high quality partly because of the care in choosing beans, roasting them and brewing on the premises. It is not clear that there is much scope for care in 'preparing' beer and wine beverages to add similar value. If not, this brand extension could dilute the signal of the brand.

3-6 Dropping University Courses Students doing poorly in courses often consider dropping the courses. Many universities will offer a refund before a certain date. Should this affect a student’s drop decision?

Before this date, the tuition is avoidable. After this date, it is sunk. Before this date, students compare the expected benefits to the tuition cost. After this date, they compare the expected benefits only to avoiding the hassle costs of continuing to participate in the course.

3-7 Business Costs A business incurs the following costs per unit: labor $125/unit, materials $45/unit, and rent $250,000/month. If the firm produces 1,000,000 units a month, calculate the following: a. Total variable costs b. Total fixed costs c. Total costs

a. Total variable costs = $170,000,000 per month (($125+$45) x 1,000,000) b. Total fixed costs = $250,000 per month (rent) c. Total costs = $170,250,000 per month

Chapter 4 4-1 Extent Versus Discrete Problems Identify which of the following are extent decisions. a. Decide whether to expand an existing product into a new region.

Discrete decision. b. What discount should be given on products during the upcoming holiday sale?

Extent decision. You must evaluate the marginal increase in sales for each level of discount. Is the profit generated from the price discount greater than the loss from the discount? c. Should the advertising budget be changed for the upcoming year?

Extent decision. If the increase in sales (revenue) is greater than the increase in budget (MR>MC), then the budget should be increased. You should also examine how sales would be affected if the budget is decreased. d. Should you develop a new product for an existing product line?

Discrete decision. You must decide whether the product should be developed (yes or no).

4-2 Game Day Shuttle Service You run a game day shuttle service for parking services for the local ball club. Your costs for different customer loads are 1: $30, 2: $32, 3: $35, 4: $38, 5: $42, 6: $48, 7: $57, and 8: $68. What are your marginal costs for each customer load level? If you are compensated $10 per ride, what customer load would you want?

Marginal Cost is the change in costs due to the additional customer. Since marginal revenue is the price of $10, you will serve customers up to the point where MC > MR or you will serve 7 customers.

Q

TC

1

30

2

32

3

MC

Tot Rev

Profit

10

-20

2

20

-12

35

3

30

-5

4

38

3

40

-2

5

42

4

50

8

6

48

6

60

12

7

57

9

70

13

8

68

11

80

12

4-3 Paid for Grades Children in poor neighborhoods have bleak outlooks on life and do not see much gain to studying. A recent experiment is paying children in poor neighborhoods $100 for each ―A‖ they earn in a six-week grade reporting cycle. How does this affect behavior?

The amount to study to earn good grades is an extent decision. For most of these children, the marginal costs exceeded the marginal benefits at low levels of effort. With the cash payment, the marginal benefit rises and so they will put in more effort.

4-4 Supplier Bids Your company is contemplating bidding on an RFP (Request For Proposal) for 100,000 units of a specialized part. Why might the amount be more than the requesting company actually wants?

It is likely that your chosen supplier will bear some fixed costs to setup for this specialized input and will bear a marginal cost per unit. His bid will be based on his average costs = FC/Q +MC. This is lower if he assumes a larger quantity. If you could get away with making him make this calculation for more than 100,000 units, you might get a lower bid price.

4-5 Processing Insurance Claims Your insurance firm processes claims through its newer, larger high-tech facility and its older, smaller low-tech facility. Each month, the high-tech facility handles 10,000 claims, incurs $100,000 in fixed costs and $100,000 in variable costs. Each month, the low-tech facility handles 2,000 claims, incurs $16,000 in fixed costs and $24,000 in variable costs. If you anticipate a decrease in the number of claims, where will you lay off workers?

What costs would be avoided under the two options? The fixed costs at each facility must be incurred (unless the reduction is so big that you can close a facility). Only the variable costs can be avoided. In the high-tech facility, the average variable cost per claim - an approximation of the marginal costs -is

$100,000/10,000 = $10 per claim. In the low-tech facility, the average variable cost per claim is $24,000/2,000 = $12 per claim. Therefore, by reducing the work apportioned to the low-tech facility will help you avoid more costs.

4-6 Copier Company A copy company wants to expand production. It currently has 20 workers who share eight copiers. Two months ago, the firm added two copiers, and output increased by 100,000 pages per day. One month ago, they added five workers, and productivity also increased by 50,000 pages per day. Copiers cost about twice as much as workers. Would you recommend they hire another employee or buy another copier?

This is an extent decision, so we have to measure the marginal benefit of adding a copier and the marginal benefit of adding a worker. The marginal productivity of a copier is 50,000 pages per day (100,000 pages/2 copiers). The marginal productivity of a worker is 10,000 pages per day (50,000 pages/5 workers). An extra copier will add five times much as an extra worker, but will cost less than five times as much. Buy a copier.

Chapter 5 5-1 George’s T-Shirt Shop George’s T-Shirt Shop produces 5,000 custom printed T-shirts per month. George’s fixed costs are $15,000 per month. The marginal cost per T-shirt is a constant $4. What is his break-even price? What would be George’s break-even price if he were to sell 50% more shirts?

The break-even price is the average unit cost which equals $15,000/5,000 + $4 = $7. If George sold 50% more, he would sell 7,500 units and the break-even price would be $15,000/7,500 + $4 = $6.

5-2 Net Present Value Suppose an initial investment of $100 will return $50/year for three years (assume the $50 is received each year at the end of the year). Is this a profitable investment if the discount rate is 20%?

Yes, the project has a positive NPV, so it is profitable NPV

= -$100 + 50/1.2 + 50/1.22 + 50/1.23 = -$100 + 41.67 + 34.72 + 28.94 = $5.33

5-3 Doctor’s Human Capital Probably the most important source of capital is human capital. For example, most medical doctors spend years learning to practice medicine. Doctors are willing to make large investments in their human capital because they expect to be compensated for doing so when they begin work. In Canada, the government nationalized the healthcare system and reduced doctors’ compensation. Is this a form of post-investment hold-up?

If the Canadian doctors can relocate to the United States or to another country where they can earn a competitive rate of return on their human capital, then the capital is fixed and cannot be expropriated by the Canadian government. But, if Canadian doctors are unwilling or unable to migrate to another country, then their human capital is sunk and can be expropriated by the Canadian government, at least in the short-run. In the long-run, the Canadian government will get exactly what they pay for, i.e. lowerquality medical care, because reducing the rewards for investing in human capital reduces investment in human capital. In the long-run we would expect Canadian doctors to have less human capital than those in the United States.

5-4 Solar Panel Installation A university spent $1.8 million to install solar panels atop a parking garage. These panels will have a

capacity of 500 kw, have a life expectancy of 20 years and suppose the discount rate is 10%.

a. If electricity can be purchased for costs of $0.10 per kwh, how many hours per year will the solar panels have to operate to make this project break even?

We need that the present value (PV) of the electricity generated by the solar panels be equal to the cost. The PV is the 20 year discounted value. Suppose it operates for one hour each of 20 years and thus generates 500kwh each year. For one hour of operation each year, it generates $50 worth of electricity (500kwh*$0.10/kwh) per year. The present value is: PV = $50/(1+10%) + $50/(1+10%)2 + + $50/(1+10%)3 + ... + + $50/(1+10%)20 PV = $468.25. (I would accept end of year accruing too.)

It would have to run for 3,844 hours per year ($1.8 million / $468.25) to break even.

b. If efficient systems operate for 2,400 hours per year, would the project break even?

It would have to run for 3,844 hours per year ($1.8 million / $468.25) to break even.

No, an efficient system (2,400 hours) is not efficient enough. c. The university is seeking a grant to cover capital costs. How big of a grant would make this project worthwhile (to the university)?

The electricity for an efficient system (2,400 hours) would have a PV of $468.25*2400 or just under $1,124,000. This is about $676,000 short of $1.8million. A grant of $676,000 would make it worthwhile. (In fact, the grant was for the whole $1.8million)

5-5 Toy Trucks Last year, a toy manufacturer introduced a new toy truck that was a huge success. The company invested $2.5 million for a plastic injection molding machine (which can be sold for $2.0 million) and $100,000 in plastic injection molds specifically for the toy (not valuable to anyone else). Labor and the cost of materials necessary to make each truck is about $3. This year, a competitor has developed a similar toy that has significantly reduced demand for the toy truck. Now, the original manufacturer is deciding whether they should continue production of the toy truck. If the estimated demand is 100,000 trucks, what is the break-even price for the toy truck? Should you shut down?

The break-even price is equal to the average avoidable cost of producing the trucks. The costs consist of $3 per truck plus $2.0 million (recoverable value). With a demand of 100,000, the break-even price is $23 [($2.0 million / 100,000) + $3]. If the manufacturer cannot sell 100,000 trucks for a minimum of $23, they should stop selling this product.

5-6 Running a Hotel During a Recession In early 2008, you purchased and remodeled a 120-room hotel to handle the increased number of conventions coming to town. By mid-2008, it became apparent that the recession would kill the demand for conventions. Now, you forecast that you will only be able to sell 20,000 room-nights that cost on

average $50 per room per night to service. You spent $20 million on the hotel in 2008, and your cost of capital is 10%. The current going price to sell the hotel is $15 million. What is your break-even price?

The breakeven price is the average avoidable cost. This is the annual cost of avoidable capital per room plus marginal costs. The fixed costs are avoidable only through a sale. That is, only $15million of the original $20million are still avoidable. So you have PBE = $15million*10%/20,000 + $50 = $125.

Another way to see this is by focusing on the costs of the decisions. The decision is to keep operating the hotel or not and you want to know which will earn you more money. If you stop running the hotel, you can sell it for $15million (the $20million initial cost is now irrelevant). If you keep running the hotel you earn the average hotel rate minus the average room cost on the expected number of room-nights into the foreseeable future. This must be larger than the alternative. That is: Opportunity cost < 20,000(PBE-50)/10% 10%($15million) < 20,000(PBE-50) PBE-50 > $75 PBE > $125 Either way, you run the hotel only if you can fetch an average $125 per room.

5-7 Short Run versus Long Run A firm sells 1,000 units per week. It charges $70 per unit, the average variable costs are $25, and the average costs are $65. a. What should the firm do in the short run? Why? b. What should the firm do in the long run? Why? c. At what price would the firm consider shutting down in the short run? d. At what price would the firm consider shutting down in the long run?

a. The firm should continue to operate, as the $70 price is greater than the $25 average variable costs, which are the only avoidable costs in the short run. b. The firm should continue to operate, as the $70 price is greater than the $65 average costs, all of which is avoidable in the long run. c. The short run shut-down price is $25, the same as the short run avoidable costs. d. The long run shut-down price is $65, the same as the long run avoidable costs.

Note to instructors: the above assumes that $65 represents total average cost (both fixed and variable)

Chapter 6 6-1 Elasticity of T-Shirt Sales Amari has been selling 5,000 T-shirts per month for $8.50. When Amari increased the price to $9.50, he sold only 4,000 T-shirts. What is the demand elasticity? If his MC is $4 per shirt, what is his desired markup and what is his initial actual markup? Was raising the price profitable?

The elasticity formula is e = (Q1-Q2)/(Q1+Q2) × (P1+P2)/(P1-P2). In this case, we have e = (5,0004,000)/(5,000+4,000) × (8.50+9.50)/(8.50-9.50) = (1/9) × (18/-1) = -2. The desired markup is -1/e = 0.5 and his initial actual markup was (P-MC)/P = (8.50-4)/8.5 ≈ 0.53. Since his actual margin was already greater than his desired margin, raising his price (and thus margin) would decrease profits

6-2 Increasing Movie Ticket Prices To conduct an experiment, AMC increased movie ticket prices from $9.00 to $10.00 and measured the change in ticket sales. Using the data over the following month, they concluded that the increase was profitable. However, over the subsequent months, they changed their minds and discontinued the experiment. How did the timing affect their conclusion about the profitability of increasing prices?

Demand is more elastic in the long run. By the long run, we mean enough time so that all the adjustments that are going to occur will have occurred. In this case, one month is most likely not long enough.

Customers who have already come to the theater will likely go through with the transaction. Once they become aware of the price increase, many will seek alternatives for their future entertainment. For some, these future transactions will occur many months later. After just the first month, demand did not fall much due to the price increase. Only after subsequent months did they get a truer view of just how elastic demand is. When it was revealed to be so much more elastic, the decrease in quantity demanded was so great that the fee increase was unprofitable.

6-3 Promotional Pricing An end-of-aisle price promotion changes the price elasticity of a good from –2 to –3. If the normal price is $10, what should the promotional price be?

The promotion has made consumers more price sensitive and has made demand more elastic. As demand becomes more elastic, the firm should decrease price. The exact price level will depend on the costs but the desired markup (which should be -1/e) will decrease from 1/2 to 1/3. If the $10 price were optimal at the previous elasticity, then (P-MC)/P=(10-MC)/10=1/2, so MC=5. Therefore, at the new elasticity, (P5)/P=1/3, so P=7.50.

6-4 Bar Nuts Why do bars offer free peanuts?

Peanuts are complements to the alcohol consumption and socializing that bars offer. By offering peanuts for free, the demand for purchased drinks increases. Bars earn higher profits from this increased demand in excess of the costs of the peanuts. (This is like free parking at retail outlets.)

Chapter 7 7-1 Scale and Scope What is the difference between economies of scale and economies of scope?

Scale economies arise from producing greater quantities of the same product. Average total costs fall as you produce more of the same product. Scope economies arise from producing different products together – total production cost of producing the two goods together is less than the cost of producing them separately.

7-2 Pre-prepared Meals Amazon is dominant in online book retailing and Wayfair is dominant in online furniture retailing.

However, the online pre-prepared meals segment includes competitors Blue Apron, Cornershop, Instacart, Fresh Direct, Hello Fresh, and Shipt. What cost conditions are consistent with these different market structures?

Online book and furniture retailing experience economies of scale in which a firm’s costs fall as it sells more. Economies of scale confers a competitive advantage on larger firms and can lead to a single dominant firm with a large market share.

In contrast, the existence of multiple online pre-prepared meals suggests that significant economies of scale in this industry cease to exist after some level of output, the minimum efficient scale (MES). Firms that reach this MES are on more equal competitive footing so that multiple suppliers can remain viable.

7-3 Rangers’ T-Shirts The variety of Riverside Ranger logo T-shirts includes 12 different designs. Setup between designs takes one hour (and $18,000), and, after setting up, you can produce 1,000 units of a particular design per hour (at a cost of $8,000). Does this production exhibit scale economies or scope economies?

Your marginal costs per shirt are MC = $8,000/1,000 = $8. Your total cost for a quantity (Q) is: TC = $18,000 + 8*Q

and average costs are AC=$18,000/Q + $8

This equation indicates average costs decline with quantity. Since average costs fall with output, there are scale economies for any one design.

7-4 Average and Marginal Costs Describe the change in average costs and the relationship between marginal and average costs under the following three conditions as quantities produced increase:

Average Cost Rising, Falling, Flat Rising, Falling, Flat Rising, Falling, Flat

Marginal Cost Versus Average Cost Higher, Lower, Equal Higher, Lower, Equal Higher, Lower, Equal

Average Cost

Marginal Cost versus Average Cost

Constant returns to scale

Rising Falling Flat

Higher Lower Equal

Decreasing returns to scale

Rising Falling Flat

Higher Lower Equal

Increasing returns to scale

Rising Falling Flat

Higher Lower Equal

Constant Returns to Scale Decreasing Returns to Scale Increasing Returns to Scale

7-5 Learning Curves Suppose you have a production technology that can be characterized by a learning curve. Every time you increase production by one unit, your costs decrease by $6. The first unit costs you $64 to produce. If you receive a request for proposal (RFP) on a project for four units, what is your break-even price? Suppose that if you get the contract, you estimate that you can win another project for two more units. Now what is your break-even price for those two units?

Quantity

Marginal Cost

Total Cost

Average Cost

1

$64

$64

$64

2

$58

$122

$61

3

$52

$174

$58

4

$46

$220

$55

5

$40

$260

$52

6

$34

$294

$49

Based on the table above, the break-even price for 4 units is $55. The extra cost of the fifth and sixth units is only $74 or $37/unit.

7-6 Multiconcept Restaurants Are a Growing Trend A multiconcept restaurant incorporates two or more restaurants, typically chains, under one roof. Sharing facilities reduces costs of both real estate and labor. The multiconcept restaurants typically offer a limited menu, compared with full-sized, stand-alone restaurants. For example, KMAC operates a combination Kentucky Fried Chicken (KFC)/Taco Bell restaurant. The food preparation areas are separate, but orders are taken at shared point-of-sale (POS) stations. If Taco Bell and KFC share facilities, they reduce fixed costs by 30%; however, sales in joint facilities are 20% lower than sales in two separate facilities. What do these numbers imply for the decision of when to open a shared facility versus two separate facilities?

If real estate is costly, or sales are low, then multiconcept restaurants are more profitable. If, however, real estate is cheap, or sales are big, then separate facilities are more profitable.

Chapter 8 8-1 Widget Market The widget market is competitive and includes no transaction costs. Five suppliers are willing to sell one widget at the following prices: $30, $29, $20, $16, and $12. Five buyers are willing to buy one widget at the following prices: $10, $12, $20, $24, and $29. What is the equilibrium price and quantity?

Equilibrium Price = $20 and Equilibrium Quantity = 3

Price

Demand

Supply

10

5

0

12

4

1

16

3

2

20

3

3

24

2

3

29

1

4

30

0

5

8-2 Cotton Prices The “A” index is a proxy for the world price of cotton. From January 2010 to December of 2021, the price reflected by the “A” index increased about 40%. a. Provide two separate explanations for this price increase using shifts in supply or demand.

b. What one piece of information would allow you to decide which of the two is a better explanation?

a. An increase in price could be explained by either  

An increase in demand A decrease in supply

b. Knowing whether quantity increased or not would allow you to distinguish between the two explanations. An increase in demand with no change in supply would result in higher quantity. A

decrease in supply with no change in demand would result in lower quantity.

It turns out that both explanations were actually contributing to the higher prices according to an article in the Wall Street Journal. ―Cotton prices have been driven higher by demand from developing countries, notably China and India, where rising wealth is boosting consumption patterns. Mother Nature is also to blame, with the deadly floods in Pakistan and heavy rains in China damaging many crops and limiting cotton supply.‖

8-3 Hand Sanitizer Due to the H1N1 flu outbreak, the demand for hand sanitizer tripled. Should Johnson & Johnson increase production of their Purell hand sanitizer? Should it invest in doubling production capacity?

An increase in demand will usually increase the price and, thus, greater production levels are profitable.

One way to do this is to increase manufacturing capacity. However, capacity will be increased for many years and the H1N1 flu is likely to be a temporary phenomenon. That is, demand for hand sanitizer is likely to return to pre-2009 levels in a year or two. In this case, the extra capacity will likely be idle and unprofitable.

8-4 Chocolate Candy Bars Market a. In the accompanying diagram (which represents the market for chocolate candy bars), the initial equilibrium is at the intersection of S1 and D1. Circle the new equilibrium if there is an increase in cocoa prices. b. In the same diagram, the initial equilibrium is at the intersection of S1 and D1. Circle the new equilibrium if there is rapid economic growth.

a. An increase in cocoa prices would cause a decrease in supply. The new equilibrium would be at the intersection of S2 and D1 (higher price and lower quantity)

b. Rapid economic growth would cause an increase in demand. The new equilibrium would be at the intersection of S1 and D3 (higher price and higher quantity)

8-5 Demand Shifts Indicate whether the following changes would cause a shift in the demand curve for Product A and, if so, the direction of the shift.

Change Increase in price of complementary product Increase in the price of the Product A Launch of effective advertising campaign for Product A

Demand Curve Shift?

Yes No

Direction of Shift?

Increase, Decrease, NA

Yes

No

Increase, Decrease, NA

Yes

No

Increase, Decrease, NA

Change

Demand Curve Shift?

Direction of Shift?

Increase in price of complementary product

Yes

No

Increase

Decrease

N/A

Increase in the price of the Product A Yes

No

Increase

Decrease

N/A

Launch of effective advertising

No

Increase

Decrease

N/A

Yes

campaign for Product A

8-6 Valentine’s Day On Valentine’s Day, the price of roses increases by more than the price of greeting cards. Why? (Hint: Consider what makes roses and cards different and how that difference might affect supply’s responsiveness to price.)

Greeting cards can be stored, so manufacturers can easily step up production and prepare larger stocks ahead of Valentine’s Day. This means that the supply of cards is relatively responsive to price, flat, or elastic; hence, an increase in demand has little effect on price. By contrast, roses are perishable. Only roses maturing around Valentine’s Day will be suitable for that day. It is relatively costly to increase the quantity supplied on Valentine’s Day. This means that the supply is relatively unresponsive to price, steep, or inelastic, and consequently, the increase in demand causes the price to increase sharply.

Chapter 9 9-1 Faculty Housing Benefits At a university faculty meeting in 2020, a proposal was made to increase the housing benefits for new faculty to keep pace with the high cost of housing. What will likely be the long-run effect of this proposal? (Hint: Think indifference principle.)

The proposal will likely have no net long-run effect. Higher housing benefits mean that schools do not have to offer as much in other incentives (e.g., pay) to new faculty members to induce them to come to the university. Consequently, the increased housing benefits will be offset with a compensating reduction in the wages of new Faculty members. Overall, any housing benefits, or lack thereof, will be capitalized in the salary package offered to the faculty member.

9-2 Snacks, Beer, and Marijuana Snack food venders and beer distributors earn some monopoly profits in their local markets but see them slowly erode from various new substitutes. When California voted on legalizing marijuana, which side would you think that California beer distributors were on? What about snack food venders? Why?

The potential legalization of marijuana would have different effects on different related markets. In the category of recreational drugs, beer and marijuana are likely substitutes. Legalization would shift demand away from beer sales and thus reduce the profits of beer distributors. We would expect them to oppose legalization.

On the other hand, marijuana and snack foods are strong complements (or so we are told). Legalization would shift demand out for snack food companies and thus increase their profits. We would expect them to support legalization.

9-3 Competition or Monopoly A fidget spinner manufacturer is producing 10,000 spinners selling them for $2.75 each. At this level of output, marginal revenue is $2.75. From this information, would you conclude that the fidget spinner manufacturer is a competitive firm or a monopolist? Why?

The fidget spinner manufacturer is a competitive firm. The information indicates that price=marginal revenue, which is the case for a perfectly competitive firm.

9-4 Competitive Industries Relative to managers in more monopolistic industries, are managers in more competitive industries more

likely to spend their time on reducing costs or on pricing strategies?

Competitive industries are those in which products have many close substitutes, firms have many rivals, and there are minimal entry and exit barriers. This implies very elastic demand and, therefore, not much ability to raise price. Therefore, the only way to increase profit is to reduce costs. Managers in these industries should spend more time on reducing costs.

9-5 Economic Profit Describe the difference in economic profit between a competitive firm and a monopolist in both the short and long run. Which should take longer to reach the long-run equilibrium?

In the short run, a monopolist should have higher economic profit than a competitive firm has. In the long run, both are expected to have zero economic profit. The monopolist will take longer to reach the long run.

9-6 Economics Versus Business Describe an important difference in the way an economist and a businessperson might view a monopoly.

An economist might likely view a monopoly in a negative light, as the monopoly power prevents the market from operating at full efficiency. A business person might instead view monopoly power as a goal for his or her business, as this power would allow the business to more easily generate positive economic profits.

Chapter 10 10-1 High Rivalry For each category, indicate which condition is associated with higher rivalry among competitors.

Number of Firms Fixed Costs Level of Product Differentiation Industry Growth Buyer Switching Costs

High High High High High

Low Low Low Low Low

The following are associated with higher rivalry: Number of firms

High

Low

Fixed costs

High

Low

Level of product differentiation

High

Low

Industry growth

High

Low

Buyer switching costs

High

Low

10-2 Increasing Customer Value To increase a company’s performance, a manager suggests that the company needs to increase the value of its product to customers. Describe three ways in which this advice might be incorrect (Hint: Think about what else might or might not change that affects profit.)

1. Value increases but price does not; consumer surplus increases but not profit 2. Value increases, price increases and cost increases all by the same amount– no change to profit 3. Value increases, price increases but cost increase is greater than price increase; profit is reduced.

10-3 Intangible Resources Why might intangible resources like human capital and intellectual assets be a more likely source of sustainable competitive advantage than tangible resources?

Intangible; they are likely to be harder to imitate

10-4 Five Forces and the Airline Industry Examine the U.S. passenger airline industry using the Five Forces. Is this an attractive industry? Why or why not?

Supplier power Labor unions: labor is a significant portion of cost, and unionization increases power. This is a significant concern Aircraft manufacturers: potentially high power given the relatively few number of suppliers but there is fierce competition among them so power is less significant.

Fuel: fuel is a commodity and its suppliers have little power Airports: can have significant power given limited supply of gates and landing rights, especially international expansion.

Buyer power Buyer power is moderately high; the product / service offered by the different airlines is relatively undifferentiated and switching costs are low.

Substitutes Alternate travel (car or train): can be a significant threat, especially for regional airlines.

Information technology alternative (e.g. videoconferencing): more threat for long distance, slows down industry growth

Rivalry Rivalry is high; there are many similarly situated airlines that tend to compete aggressively on price.

Fixed costs are high and industry growth is relatively low

Entry While there are some significant entry costs, these can be overcome (e.g., via leasing rather than purchasing jets)

Overall, this industry is not particularly attractive

10-5 Barriers to Entry How might a firm improve its position relative to the threat of entry in an industry with low barriers to entry? Provide at least three suggestions.

Possible approaches include:     

Build strong brand Increase customer loyalty Innovate and patent products Achieve economies of scale Lobby government for protective regulation(s)

10-6 Salons and Teeth Whitening Salon owners have recently started offering teeth-whitening services to clients in addition to their more standard services. In a number of states, regulators have ordered the salon owners to stop, claiming that this service constitutes the practice of illegal dentistry. What group would you expect to be behind the state’s efforts to ban salons from providing teeth-whitening services? Why?

Dentists because it restrains competition; indeed this practice has been opposed by the American Dental Association. See http://news.moneycentral.msn.com/provider/providerarticle.aspx?feed=AP&date=20090225&id=964126 4

Chapter 11 11-1 The Carry Trade In 2014, the euro was trading at $1.35 on the foreign exchange market. By 2015, the rate had fallen to $1.10, due to falling European interest rates. Explain the fall in the price of a euro using supply and demand curves, and in words.

A decline in European interest rates reduces the cost of borrowing in the EU. This increases the ―carry trade‖ where US consumers or businesses borrow euros from EU banks, sell euros to buy dollars, and spend or invest the dollars in the US. This increases demand for dollars which increases the price of a dollar. The dollar appreciates against the euro.

You can do the equivalent analysis in euros and say that this increases the supply of euros, which decreases the price of a euro. The euro depreciates against the dollar.

11-2 Brexit Fears When Great Britain voted to leave the Eurozone, the pound depreciated 17% against the dollar. It also raised fears that the Eurozone would fall apart. Explain how this fear would affect the dollar/euro exchange rate.

The fear of uncertainty causes a flight to safety, so Europeans sell euros to buy dollars. This increases demand for dollars which increases the price of a dollar. The dollar appreciates against the euro.

You can do the equivalent analysis in euros and say that this increases the supply of euros, which decreases the price of a euro. The euro depreciates against the dollar.

11-3 Effects of the Pound Devaluation on Tourism and Bank Profits Explain the effects of the pound devaluation on: (1) imports and tourism to Great Britain; and (2) profits of US banks with European trading subsidiaries in London (which earn profit in pounds).

1) A currency devaluation hurts foreign suppliers because it makes foreign goods (exports from foreign countries imported to Great Britain) more expensive to domestic consumers. The quantity of exports falls. This hurts domestic consumers and foreign suppliers but helps domestic suppliers and foreign consumers.

Tourism can be thought of as an ―export‖ in that tourists are foreign consumers, who have a demand for a domestic product (goods and services produced in Great Britain). A currency devaluation helps foreign consumers and domestic suppliers.

2) Profits for US banks with trading operations in London earn profit in pounds and then sell pounds to buy dollars to pay shareholders in the US. A pound devaluation would reduce the dollar profit of the Bank’s London trading operation.

11-4 The Effects of a Pound Depreciation on Whirlpool Most of the appliances that Whirlpool sells in the UK are built in the EU. What is the effect of a pound depreciation on Whirlpool’s profit margin?

Whirlpool incurs costs in euros but earns revenue in pounds. A currency devaluation would reduce revenue relative to cost so its profit margin would decrease.

11-5 Domestic Content Explain the effect of a dollar depreciation on domestic firms and domestic consumers for goods with less than 100% domestic content.

Domestic firms would still benefit on the whole, and domestic consumers would be harmed on the whole, but not as much as if the goods contained 100% domestic content. This is because firms that export heavily tend to import heavily as well. A devaluation would increase export demand but also increase the price of imported parts.

11-6 Dollar Devaluation How will a dollar devaluation affect businesses and consumers in the twin cities of El Paso, the United States, and Juarez, Mexico?

A dollar devaluation will increase the demand from Mexican consumers for US goods and services, raising the US price and quantity. This will benefit US producers, but hurt US consumers. A dollar devaluation will also reduce export demand for Mexican goods and services, reducing the Mexican price and reducing quantity. This will hurt Mexican producers in Juarez, but benefit Mexican consumers.

11-7 Effect of Expectations on the Exchange Rate If market participants expect the yuan to appreciate relative to the dollar, what will happen?

They will accelerate purchases of the yuan (an increase in demand for yuan), and delay purchases of dollars (a decrease in demand for dollars). Both of these factors cause the price of a yuan to increase, a kind of self-fulfilling expectation.

Chapter 12 12-1 Parking Lot Optimization Suppose your elasticity of demand for your parking lot spaces is –2, and price is $8 per day. If your MC is zero, and your lot is 80% full at 9 a.m. over the last month, are you optimizing?

Because demand is elastic, a decrease in price will likely increase revenues and (since marginal cost is zero) will increase profit. Therefore, it is unlikely that the lot is optimizing. However, one should investigate how variable is demand. If the lot is 80% full each day, then decreasing price will be optimal.

On the other hand, if the 80% capacity figure is because the lot is at capacity on weekdays but nearly empty on weekends, then prices might actually be too low. A price reduction would not increase the number of customers on weekdays, and a price increase may nevertheless keep the lot at capacity.

12-2 Parking at Cowboys Stadium What would efficient revenue management imply for the pricing of [parking at] the State Farm Stadium (home of the Arizona Cardinals football team) on typical game days? How about for the 2023 Super Bowl? How about for the many smaller events that fill less than half the lot?

The stadium parking lot has fixed capacity. This means that the marginal costs, after construction costs were sunk, are near zero up to capacity and extremely high once capacity is met. On typical game days, the marginal revenue at capacity is likely to be between these two values. This implies a simple strategy of pricing low enough to fill the lot but high enough that you do not have to turn away many customers.

For the Super Bowl, demand may be much higher as many fans will arrive to 'tailgate' during all of the planned activities with no intension of attending the game. The strategy is similar to game days, price low enough to fill the lot but high enough that very few people are turned away. However, the greater demand implies that this price is likely to be much higher than on regular game days.

For smaller events, demand will be so low that capacity will never be reached. Put differently, the only way to fill the lot is to set the price so low so that marginal revenue for the last few spots is likely to be negative. In this case, efficient yield management ignores the capacity constraint and focuses on equating marginal revenue with short-run marginal costs. Typically, this will mean that price is above short-run marginal costs.

One final consideration is that stadium parking and stadium tickets may be complements. That is, lower parking prices may increase demand for game tickets. If these are commonly owned, the optimal price for parking may be somewhat lower than indicated above.

12-3 Product Store Locations Some high-end retailers place their most expensive products right in the entryway of the store, where consumers will see them first, and place their more popular, better-selling items further back. Why?

They are likely trying to take advantage of psychological pricing. Since managing price expectations is as important as managing price, focusing consumers on higher prices initially allows consumers to perceive a discount, or a ―win,‖ when they later encounter the less expensive items. By setting the reference price higher, they are making consumers more likely to buy the items in the back when they do confront their prices.

12-4 Macintosh Versus iPhone When the Macintosh computer was introduced in 1982, Apple made it difficult for third party software developers to develop software for the platform. In contrast, Apple makes it relatively easy for third-party developers to make applications that run on the iPhone. Compare and contrast these two strategies.

When Apple made it difficult for third-party developers, it produced both hardware and software and profited both from the sale of the computers and from the sale of software for those computers. Since the hardware and software are complements, Apple priced each below its stand-alone profit-maximizing price.

With the iPhone, Apple encourages third party developers. As the software apps produced by these developers are complements to the iPhone, they make the iPhone more valuable, allowing Apple to raise its price.

The relative value of the two strategies depends on how complementary software is to the hardware and the relative ability of third-party developers relative to Apple.

12-5 Concert Prices Concert prices have increased coincidentally with illegal downloading of music off the Internet. Why?

Before illegal downloading, concert prices were kept low to help sell recorded music; concerts and recorded music were jointly priced complements in demand. After illegal downloading became more prevalent, profits from record sales fell dramatically, so performers’ profit calculus changed. It was as if they were pricing concerts independently of their effect on recorded music sales. Formally, the marginal revenue of concert sales fell due to illegal downloading, and concert prices increased in response.

12-6 Radio Stations and Rock Concerts In 2005, Liberty Media (a major owner of concert promoter Live Nation) spun off iHeartMedia, the

largest radio broadcaster in the United States. How would this spinoff affect prices for concert tickets or rates for radio programming?

Music radio stations and concerts tend to be complements in consumption. The radio station can easily promote the concert and the concert venue will advertise the station. When a firm owns complements, it tends to reduce prices for both. In this case, after spinning off a complement, the opposite should happen, and the prices of each should rise.

Chapter (13)-14 14-1 Barbie Dolls and Accessories Why might Mattel set a much lower margin on its Barbie dolls than on the accessories for the dolls?

This is a form of metering or ―giving away the razor to sell the blades.‖ Consumers differ in their willingness to pay for ―the Barbie experience.‖ Those who value it a lot are probably going to purchase more accessories than those who value it less. Purchases of accessories ―meter‖ consumers’ willingnessto-pay for the experience. A higher margin for the accessories allows Mattel to extract more of the surplus from the high types without losing the low types.

14-2 Vape Shops Some vape shops recently began offering a monthly subscription service instead of individual sales of pods or e-cigarette refills. If you wished to reduce the incidence of vaping, would you consider this pricing plan to be a desirable change?

This is a bundling mechanism. Traditionally, prices include a profit margin and price exceeds marginal cost. This means that there are unconsummated transactions that represent a value-creating opportunity.

By pricing each pod or refill at zero or marginal cost, you increase usage and, therefore, consumer surplus. The monthly subscription charge is meant to capture some of this additional consumer surplus.

The result of such a pricing scheme is that the use of vaping products increases, so those wishing to minimize incidence of vaping would not consider this desirable.

14-3 Dojo Pricing Your karate dojo has determined that students come only once a month if charged $50 per lesson, four times per month (once a week) at $40 per lesson, and 20 times at $10 per lesson. The marginal cost of another student is close to zero. How should your dojo price its lessons?

First, if you were to offer a per-lesson price, $10 is optimal since $10x20=$200 which is higher than $40x4 and $50x1. However, you might be able to do even better by charging a flat monthly fee and let people attend as many lessons as they wish. You could charge more than $200 a month (since the data indicates that students would come at least 20 times and value those visits at least $10 each) and thus do even better than setting a per-lesson price.

14-4 Fitness Trackers A manufacturer of a wearable fitness tracker has identified two groups of consumers for its product: occasional exercisers and competitive runners. Occasional exercisers, on average, have lower values for fitness trackers than competitive runners. Additionally, occasional exercisers attribute almost no extra value to a “friends” feature that lets you keep track of and compete with other users, while competitive runners, on average, value the friends feature. There is no additional cost to incorporating the friends

feature. The manufacturer is considering introducing two different models. The manufacturer has determined that occasional exercisers value a fitness tracker without the friends feature at $70 and one with the friends feature at $80, while competitive runners value the two versions at $80 and $150. If there is an equal number of occasional exercisers and competitive runners, what pricing strategy will yield the greatest revenue? What if competitive runners comprise the bulk of consumers?

There are three possibilities: -

First, we can market a single fitness tracker (with the friends feature) to both occasional exercisers and competitive runners at $80.

Second, we can market a fitness tracker (with the friends feature) only to competitive runners at $150.

Third, we can version by selling a simple tracker without the friends feature targeted to occasional exercisers for $70 and one with the friends feature targeted to competitive runners for $140 ($70 + $150 - $80). The existence of a simple tracker constrains our pricing on the one with the friends feature. Competitive runners value the friends feature at $70 ($150-$80), and therefore its price cannot exceed that of the simple one by more than $70.

If there is an equal number of occasional exercisers and competitive runners (say 1 of each), the revenue from each of our three strategies, respectively, is $80x2=$160, $150x1=$150, and $70x1+$140x1=$210.

Therefore, offering the two versions is best.

On the other hand, if almost all shoppers are competitive runners, the best strategy will be to sell only the fitness tracker with the friends feature at $150.

14-5 Music Pricing Vudu is a movie video-on-demand service that, until recently, was owned by Walmart. While most streaming services charge a monthly fee for unlimited use, Vudu charges for each movie watched. Would offering unlimited streaming for a monthly fee likely yield more or less profit for Vudu than charging for movies individually?

The per-movie pricing policy of Vudu does not capture the consumer surplus from people willing to pay more—sometimes much more—for some movies. It also does not capture the consumer surplus for movies that people value less than the price but more than marginal cost. Thus, this policy "leaves money on the table." It will leave more money on the table if the value that people attach to movies varies greatly across songs and people.

The monthly subscription fee pricing policy of most of Vudu’s competitors is an example of bundling and has the potential to capture this "money left on the table." For example, Netflix prices each movie at $0, which is very close to the marginal cost. This means that subscribers watch more movies than they would if they were being charged per movie, and this generates more potential consumer surplus. Netflix can capture this surplus by charging a subscription fee of just under the sum of the surplus for all movies watched. Of course, not all movie lovers have the same demand curve for movies. What matters is if the value of the bundle is more homogeneous across consumers than the values of the individual movies. This is likely to be true in this case.

14-6 Bundling At a student café, there are equal numbers of two types of customers with the following values. The café owner cannot distinguish between the two types of students because many students without early classes arrive early anyway (i.e., the owner cannot price discriminate).

Coffee Banana

Students with Early Classes $0.70 $0.50

Students without Early Classes $0.60 $1.00

The marginal cost of coffee is $0.10. The marginal cost of a banana is $0.40. Is bundling more profitable than selling separately? If so, what price should be charged for the bundle?

Mixed bundling is more profitable than only selling separately: Mixed bundle: Price bundle at 160, earn 160-50=110; price coffee at 70, earn 70-10=60. Total Profit is 170. Students with early classes don’t purchase a banana.

Price separately only: price coffee at 60, earn 120-20=100; price bananas at 100, earn 100-40=60 Total profit is 160. Students with early classes don’t purchase a banana.

Bundle only: coffee + banana at 120, earn 240 – 100 = 140; Total profit is 140.

Chapter 15 15-1 To Vote or Not to Vote Mr. and Mrs. Ward typically vote oppositely in elections and so their votes ―cancel each other out.‖ They each gain two units of utility from a vote for their positions (and lose two units of utility from a vote against their positions). However, the bother of actually voting costs each person one unit of utility.

Diagram a game in which they choose whether to vote or not to vote.

Mrs. Ward Vote

Don't Vote

Vote

-1, -1

1, -2

Don't Vote

-2, 1

0, 0

Mr. Ward

15-2 To Vote or Not to Vote Part II Suppose Mr. and Mrs. Ward agreed not to vote in tomorrow’s election. Would such an agreement improve utility? Would such an agreement be an equilibrium?

The Nash equilibrium of this game is for both to vote. This is the worst of all possibilities as total payoffs are minimized here (this game is a prisoners’ dilemma). In fact, the outcome with the highest total payoffs is for the couple not to vote. Therefore, an agreement not to vote would improve utility. However, because cheating is in each party’s best interest, it is difficult to maintain the agreement.

15-3 Compatibility Microsoft and a smaller rival often have to select from one of two competing technologies. The rival always prefers to select the same technology as Microsoft (because compatibility is important), while Microsoft always wants to select a different technology from its rival. Describe the equilibrium of this game.

This is a two-player, two-strategy, simultaneous move game. The actual payoffs could differ for different students but the game should look something like this one: Microsoft

A

B

Technology A

1,-1

-1, 1

Technology B

-1, 1

1, -1

Rival

There is no equilibrium in pure strategies. Therefore, we expect that both Microsoft and the rival will randomize.

15-4 Salary Negotiation The figure at the bottom of the page represents the potential outcomes of your first salary negotiation after graduation.

Assuming that this is a sequential-move game with the employer moving first, indicate the most likely outcome. Does the ability to move first give the employer an advantage? If so, how? As the employee, is there anything you could do to realize a higher payoff?

Employer

Low Salary Offer

High Salary Offer

Employee Walks

Employee Accepts

Employee Walks

Employee Accepts

Employer gets 0 Employee gets 0

Employer gets 100 Employee gets 75

Employer gets 0 Employee gets 0

Employee gets 100 Employer gets 75

Outcome = Low salary offer and employee accepts Employer has a first mover advantage; can force movement down low salary offer side.

Employee strategy: communicate a clear, credible commitment to walking if salary offer is low.

15-5 Renegotiating Employment Contracts Every year, management and labor renegotiate a new employment contract by sending their proposals to an arbitrator who chooses the best proposal (effectively giving one side or the other $1 million). Each side

can choose to hire, or not hire, an expensive labor lawyer (at a cost of $200,000) who is effective at preparing the proposal in the best light. If neither hires a lawyer or if both hire lawyers, each side can expect to win about half the time. If only one side hires a lawyer, it can expect to win three-quarters of the time. a. Diagram this simultaneous-move game. b. What is the Nash equilibrium of the game? c. Would the sides want to ban lawyers? a. You have to think in terms of expected payoffs. If neither side hires a lawyer, they each have a 50% chance of "winning" the $1 million yielding an expected payoff of $500,000. If they both hire lawyers, they have the same chance of winning the $1 million but they are each out $200,000 for a net of $300,000. However, if only one side hires a lawyer, its expected payoff is 75%($1million) - $200,000 or $550,000 and the non-hirer earns an expected $250,000.

Management No Lawyer

Lawyer

No Lawyer

$500,000, $500,000

$250,000, $550,000

Lawyer

$550,000, $250,000

$300,000, $300,000

Labor

b. This is a prisoner's dilemma game. Each side individually sees that hiring a lawyer dominates not hiring the lawyer and so they both do. Neither side would individually move aware from a strategy of hiring a lawyer. c. If they could set up rules that forbid the use of lawyers, both sides would be better off in the long run. This means that both would prefer changing the game to ban lawyers, perhaps through arbitration, or to make lawyers more costly.

15-6 Entry Game with Withdrawal In the text, we considered a sequential-move game in which an entrant was considering entering an industry in competition with an incumbent firm (Figure 15-1). Consider now that the entrant, if fought, has the possibility of withdrawing from the industry (at a loss of 1 for the entrant and a gain of 8 for the incumbent), or staying (at a loss of 5 for each player). What is the equilibrium of this game? Discuss if the entrant is better off with or without the ability to withdraw.

In the game represented in Figure 15.1, the equilibrium has the monopolist accommodate and therefore has the entrant choose ―In.‖ This question adds an option following Fight in which the entrant can withdraw at a loss of 1 rather than lose 5 by staying. Clearly, the entrant would choose to withdraw. But then, the monopolist would not choose to accommodate since accommodation yields the monopolist 5 while fighting (after the entrant withdraws) yields the monopolist 8. Knowing this, the entrant chooses to

stay out in the first place. Thus, the entrant is not better off with the ability to withdraw. In the original game, it is the fact that the monopolist cannot drive the entrant out that gives the monopolist incentive to accommodate.

Chapter 16 16-1 Streamer Bargaining Two equal-sized streaming services have a 10% overlap in subscribers (10% of the subscribers of each service subscribe to both). Advertisers are willing to pay $10 to advertise on one service but only $19 to advertise on both, because they’re unwilling to pay twice to reach the same subscriber. What’s the likely bargaining negotiation outcome if the advertisers bargain by telling each service that they’re going to reach an agreement with the other service, so the gains to reaching agreement are only $9? Suppose the two services merge. What is the likely post-merger bargaining outcome?

The Nash bargaining outcome tells us that parties split the gains from agreement. Pre-merger, each service splits the gains to agreement, which are $9. So each service receives $4.50. After the merger, the services bargain together and split $19. So the merged service gets $9.50, an increase of $0.50.

16-2 Airline Merger American Airlines and British Airways are proposing to merge. If British pilots and American pilots are represented by different unions, how would this merger affect airline costs?

After the merger, the airline could staff some flights with pilots from either union. That means that the disagreement value for management negotiating with any one union is higher. As a consequence, each union is in a worse negotiating position and we would expect salaries to fall thus reducing airline costs.

16-3 House Closing You’ve entered into a contract to purchase a new house, and the closing is scheduled for the next week.

It’s typical for some last-minute bargaining to occur at the closing table, where sellers often try to tack on extra fees. You have three options for the closing: (1) attend yourself, (2) send an attorney authorized to close only per the previously negotiated terms, or (3) pre-sign all the closing documents per the current terms and not attend the closing. Which of these would be most advantageous from a bargaining position?

Attending the closing yourself would probably be the least attractive option. The sellers would know that you have the authority to bargain over terms of the deal. Sending the attorney would be a better option serving as your commitment that you would walk away from the deal unless it is closed per the current terms. Pre-signing the papers would likely be the best option, as it is the most credible commitment to your unwillingness to negotiate the terms (the sellers might believe that the attorney would have some bargaining authority; pre-signed papers with no personal representative leaves little ambiguity regarding your commitment).

16-4 A City and Its Unions Robert G. Flanders Jr., the state-appointed receiver for Central Falls, RI, said his city’s declaration of bankruptcy had proved invaluable in helping it cut costs. Before the city declared bankruptcy, he said, he had found it impossible to wring meaningful concessions out of the city’s unions and retirees who were being asked to give up roughly half of the pensions they had earned as the city ran out of cash. Why does bankruptcy give the city bargaining power against its unions?

Remember that the alternatives to agreement determine the terms of agreement. Bankruptcy gives cities a much better alternative—they can abrogate pension obligations in bankruptcy—and this alternative allows them to gain a more favorable split of the proverbial pie, by extracting concessions from Unions.

Cities without this outside option have a more difficult time extracting concessions from Unions. [link].

16-5 Entering International Markets Your pharmaceutical firm is seeking to open up new international markets by partnering with various local distributors. The different distributors within a country are stronger with different market segments (hospitals, retail pharmacies, etc.) but also have substantial overlap. a. In Egypt, you calculate that the annual value created by one distributor is $60 million per year but would be $80 million if two distributors carried your product line. How much of the value can you expect to capture? b. Argentina also has two distributors with values similar to those in Egypt, but both are run by the government. How does this affect the amount you could capture? c. In Argentina, if you do not reach an agreement with the government distributors, you can set up a less efficient Internet-based distribution system that would generate $20 million in value to you. How does this affect the amount you could capture?

a. While two distributors allow you to reach more final customers, the marginal value of the second is less than the first. When negotiating with either, the assumption is that you already have the other. Therefore, they only add $20 million in value. In the nonstrategic view, parties tend to split the value that they bring to the negotiation. In this case, this means that each distributor gets about $10 million and you get $60 million. b. As before, the second distributor adds a smaller marginal value. However, since they are run by the government, you must negotiate with both simultaneously. It is both or none.

Now the margin is $80 million and you split it, keeping $40 million. c. Now your alternatives are contracting with the government or going alone. This raises your disagreement value from zero to $20 million. The marginal value of the government contract is now $80 million - $20 million or $60 million. You offer half, $30 million, and keep the remainder, $50 million. The Internet threat helps your bargaining position.

16-6 PBMs Pharmaceutical Benefits Managers or PBMs are intermediaries between upstream drug manufacturers and downstream insurance companies. They design formularies (list of drugs that insurance will cover) and negotiate prices with drug companies. PBMs want a wider variety of drugs available to their insured populations, but at low prices. Suppose that a PBM is negotiating with two nondrowsy allergy drugs, Claritin and Allegra, for inclusion on the formulary. The ―value‖ or ―surplus‖ created by including one nondrowsy allergy drug on the formulary is $100, but the value of including a second drug is only $30. a. What’s the likely bargaining negotiation outcome if the PBM bargains by telling each drug company that they’re going to reach agreement with the other drug company? b. Now suppose the two drug companies merge. What is the likely post-merger bargaining outcome?

a. The payoffs are $100 to the PBM, $15 to one drug company, and $15 to the other. b. The payoffs are $65 to the PBM, $65 to the merged drug company.

Chapter 17 17-1 Global Expansion You’re the manager of global opportunities for a U.S. Manufacturer, who is considering expanding sales into Asia. Your market research has identified the market potential in Malaysia, Philippines, and Singapore as described next:

Success Level

Malaysia

Philippines

Singapore

Probability

Units

Probability

Units

Probability

Units

Big

0.3

1,200,000

0.3

1,000,000

0.7

700,000

Mediocre

0.3

600,000

0.5

320,000

0.2

400,000

Failure

0.4

0

0.2

0

0.1

0

The product sells for $10 and has unit costs of $8.

If you can enter only one market, and the cost of entering the market (regardless of which market you select) is $250,000, should you enter one of these markets? If so, which one? If you enter, what is your expected profit?

Yes, you should enter. The market you should enter is Singapore. The expected profit is $890,000.

Malaysia:

Expected unit sales = 0.3*1,200,000+0.3*600,000+0.4*0 =

540,000

Philippines:

Expected unit sales = 0.3*1,000,000+0.5*320,000+0.2*0 =

460,000

Singapore:

Expected unit sales = 0.7*700,000+0.2*400,000+01*0 =

570,000

Expected profit of entering Singapore: 570,000*($10-$8) - $250,000 = $890,000

17-2 Game Show Uncertainty In the final round of a TV game show, contestants have a chance to increase their current winnings of $1 million dollars to $2 million dollars. If they are wrong, their prize is decreased to $500,000. The contestant thinks his guess will be right 50% of the time. Should he play? What is the lowest probability of a correct guess that would make playing profitable?

You should play the game.

You have a 50% chance of winning $1 million dollars and a 50% chance of losing $500,000. ($1,000,000*0.5 = 500,000). (0.5*$1,000,000 + 0.5*-$500,000) = $250,000

Alternative way to look at the problem: It costs $1 million to play; if you are right, you win $2 million, if you are wrong, you win $500,000. Expected value of playing is $1 million (0.5*2000000 + 0.5*500000) = $1,250,000 which is higher than the cost of playing

The minimum probability of a guess to make playing still profitable is 33.3%. $1,000,000(x) + (-$500,000)(1-x) = 0 $1,000,000x -$500,000 + $500,000x = 0 $1,500,000x = $500,000 X = ($500,000/$1,500,000) X = 1/3 = 33.3%

17-3 Ad Agencies The residential division of Prism’s high-speed internet service uses one advertising agency, while its commercial division uses another. Two analysts, Andy and Brad, are asked to test evaluate the effectiveness of the two agencies. Andy proposes an A/B test that compares the click-through rates per ad for the two agencies. Brad proposes a difference-in-difference test in which the budgets for both agencies are increased by 50% and the percent change in click-through rates are compared. What might be the sources of selection bias for the two proposals? Which is likely to be smaller?

Bias in Andy proposal: click-through rates in residential and commercial markets are likely different for a variety of reasons beyond the effectiveness of the advertising agencies (e.g., residential customers may simply be more likely to click on ads than commercial customers). As such, it wouldn’t make sense to just compare the two click-through rates.

Bias in Brad proposal: the potential to increase click-through rates likely differs in the residential and commercial markets, either due to the nature of the market or the amount of advertising already being done by the company in each market.

The second bias is likely to be smaller.

17-4 Disposing of Used Assets Your company has a customer who is shutting down a production line, and it is your responsibility to dispose of the extrusion machine. The company could keep it in inventory for a possible future product and estimates that the reservation value is $350,000. Your dealings on the secondhand market lead you to believe that there is a 0.4 chance a random buyer will pay $400,000, a 0.25 chance the buyer will pay $450,000, a 0.1 chance the buyer will pay $500,000, and a 0.25 chance it will not sell. If you must commit to a posted price, what price maximizes expected profit?

Price $500,000 $450,000 $400,000

Prob. of sale 10% 35% 75%

Expected profit .1(500-250)=$25,000 .35(450-250)=$70,000 .75(400-250)=$112,500

A price of $400,000 yields the highest expected profit.

17-5 Saint Petersburg Gambles You are offered the following gamble based on coin flips. If the first heads occurs on the first flip, you get $2. If the first heads occurs on the second flip you get $4, and so on so that if the first head is on the Nth flip, you get $2^N. The game continues until there is a heads. What is the expected value of this gamble?

When offered, most people say they would only pay less than $10 to play this game. What are two reasons why people are willing to pay so much less than the expected value?

In this case, the expected monetary value of this gamble is infinite; (1/2)($2) + (1/4)($4) + (1/8)($8)…… = Σ (1/2N)(2^N).

Individuals may be willing to pay so little for two reasons. 1) There may be diminishing utility to monetary winnings (you ―value‖ $2 billion in winnings less than twice as much as $1 billion). 2) Individuals correctly deduce that the game will not actually pay off for high enough values. For example, for N>30 the actual probability is likely to be 0 not the 1/N claimed. After all, the one making the offer does not have the infinite dollars required to run the game.

17-6 Hiring The HR department is trying to fill a vacant position for a job with a small talent pool. Valid applications arrive every week or so, and the applicants all seem to bring different levels of expertise. For each

applicant, the HR manager gathers information by trying to verify various claims on resumes, but some doubt about fit always lingers when a decision to hire or not is to be made.   

What are the two types of decision error costs?

Which decision error is more likely to be discovered by the CEO? How does this affect the HR manager’s hiring decisions?

There are two types of errors you can make when hiring applicants: Type I: you can hire a bad worker; or Type II: you can fail to hire a good worker. The Type I error is more likely to be recognized and discovered, so the HR manager will ―shade‖ his decisions, to try to avoid hiring bad workers. This will likely cause him to commit more Type II errors, failing to hire good applicants.

Chapter 18 18-1 Effects of Collusion You hold an auction among three bidders. You estimate that each bidder has a value of either $16 or $20 for the item, and you attach probabilities to each value of 50%. What is the expected price? If two of the three bidders collude, what is the price?

There are eight possible value combinations for the three bidders, and each is equally likely. These are given in the first three columns of the table below. The fourth column (equal to the second highest value) is the resulting auction price without collusion. The expected price is (4/8)$16+(4/8)$20=$18.

Imagine that bidders 1 and 2 collude. They would be willing to bid up to the maximum of either of their values, but will not bid against each other. Effectively, the auctioneer faces two bidders represented in the right three columns of the table below. The only time the collusion impacts price is when the two colluding bidders have the two highest values ($20 and $20) and both are higher than the next highest value ($16). In this case, by not competing against each other, they drive the price down from $20 to $16.

The expected price is (5/8)$16+(3/8)$20=$17.50

Bidder 1

Bidder 2

Bidder 3

Price

$16 $16 $16 $16 $20 $20 $20 $20

$16 $16 $20 $20 $16 $16 $20 $20

$16 $20 $16 $20 $16 $20 $16 $20

$16 $16 $16 $20 $16 $20 $20 $20

Maximum of 1 and 2 $16 $16 $20 $20 $20 $20 $20 $20

Bidder 3 Value $16 $20 $16 $20 $16 $20 $16 $20

Collusion Price $16 $16 $16 $20 $16 $20 $16 $20

18-2 Reserve Prices A reserve price is a minimum price set by the auctioneer. If no bidder is willing to pay the reserve price, the item is unsold at a profit of $0 for the auctioneer. If only one bidder values the item at or above the reserve price, that bidder pays the reserve price. An auctioneer faces two bidders, each with a value of either $30 or $80, with both values equally probable. What reserve price should the auctioneer set, and what is the expected revenue from auctioning the item with and without a reserve price?

If bidders have values of either $30 or $80, a reserve price below $30 would have no effect (the bidders will always bid the price up to at least $30), and a reserve price between $30 and $80 makes little sense.

Therefore, we need to compare the auction without a reserve price to one with an $80 reserve price. The table below shows the possible values and outcomes. Without a reserve price, the auction yields expected revenues of ($30+$30+$30+$80)/4=$42.50. With a reserve price, the auctioneer earns $80 whenever either bidder values the good at least $80, but does not sell if neither bidder does. The expected revenue is $80x3/4=$60.

Bidder 1

Bidder 2

Price without Reserve

$30 $30 $80 $80

$30 $80 $30 $80

$30 $30 $30 $80

Price with $80 Reserve $0 $80 $80 $80

18-3 Reserve Prices II Consider the problem above, but now each bidder has a value of either $60 or $80. What reserve price should the auctioneer set, and what is the expected revenue from auctioning the item with and without a reserve price?

Bidder 1

Bidder 2

Price without Reserve

$60 $60 $80 $80

$60 $80 $60 $80

$60 $60 $60 $80

Price with $80 Reserve $0 $80 $80 $80

Without a reserve price, the expected revenue is ($60+$60+$60+$80)/4=$65. With a reserve price, the expected revenue is $80x3/4=$60. In this case, a reserve price is not desirable as the cost of no sale is too high relative to the higher price obtained when only one bidder values the good at $80.

18-4 Asset Auctions in Sweden In Sweden, firms that fail to meet their debt obligations are immediately auctioned off to the highest bidder. (There is no reorganization through Chapter 11 bankruptcy.) The current managers are often the high bidders for the company. Why?

An auction for a company is often a common-value auction, where bidders have similar values for the company but do not have perfect information about its value. Current company managers are likely to have better information about the company than other bidders. This keeps other bidders out of the market (or unwilling to bid high) since outbidding existing managers is bad news: it indicates that they think the company is worth less than you do!

18-5 Art Auctions When a famous painting becomes available for sale, it is often known which museum or collector will be the likely winner. Yet, representatives of other museums that have no chance of winning are actively wooed by the auctioneer to attend anyway. Why?

One of the maxims of the chapter is that ―strong losing bidders lead to higher winning bids.‖ In fact, it is usually the bidder with the second-highest value who has the greatest impact on price. Even when the identity of the eventual winner is known, competition determines the price that the winner will pay.

18-6 Contractor Bidding Moe Green estimates the cost of future projects for a large contracting firm. Mr. Green uses precisely the same techniques to estimate the costs of every potential job and formulates bids by adding a standard profit markup. For some companies to whom the firm offers its services, no competitors exist, so they are almost certain to get them as clients. For these jobs, Mr. Green finds that his cost estimates are right, on average. For jobs where competitors are also vying for the business, Mr. Green finds that they almost always end up costing more than he estimates. Why does this occur?

This is precisely the winner’s curse. When no competition exists, Moe receives every job and his estimates can average out. The estimates that are a little high offset those that are a little low. When competition exists, Moe is more likely to win the jobs that he underestimates (since he will likely be the lowest-cost bidder) and is less likely to win the jobs that he overestimates (since a rival bidder likely bids less). Thus, the fact that he wins suggests that he likely underestimated the true cost of the job.

Chapter 19 19-1 Leasing Residuals In the late 1990s, car leasing was very popular in the United States. A customer would lease a car from the manufacturer for a set term, usually two years, and then have the option of keeping the car. If the customer decided to keep the car, the customer would pay a price to the manufacturer, the ―residual value,‖ computed as 60% of the new car price. The manufacturer would then sell the returned cars at auction. In 1999, the manufacturer lost an average of $480 on each returned car (the auction price was, on average, $480 less than the residual value). a. Why was the manufacturer losing money on this program? b. What should the manufacturer do to stop losing money?

a. Adverse selection [not necessary to use the jargon]. Customers are keeping the good cars (those worth more than the residual value) and returning the bad cars (those worth less than the residual value). b. Set a more accurate residual value. The company hired an appraiser to set the residual value two weeks before the car was returned. By setting a more accurate residual value (closer to the car’s value), most consumers were indifferent between returning and keeping their cars. The value of the returned cars was very close to the auction price.

19-2 College Degrees Required for Police Officers Many police officer positions require the applicant to have a college degree even though the tasks of a police officer rarely call upon college course material. Why don’t police departments increase their applicant pool by dropping this requirement?

The college degree may serve as a screening device. Police departments make considerable investments in officers and so want to avoid high turnover. The college degree requirement means that applicants will have to make a considerable investment before being considered. This eliminates casual applicants who may not be committed to policing as a career.

19-3 Bicycle Insurance and Information Asymmetry You sell bicycle theft insurance. If bicycle owners do not know whether they are high- or low-risk consumers, is there an adverse selection problem?

No. Since consumers are all willing to purchase insurance at some average price, say $35, the insurance company can offer a single policy to all consumers, and they will all purchase. There is no information asymmetry in this case, so the problem disappears.

19-4 Job Auction When China reformed state-owned enterprises, it tried a new approach to choosing managers: it put managerial jobs up for auction. The bids for the jobs consisted of promises of future profit streams that the managers would generate and then deliver to the state. In cases where the incumbent manager was the winning bidder, firm productivity tended to increase dramatically. When outside bidders won, there was little productivity improvement. If incumbent managers were not generally more qualified, how can you explain this result?

Adverse selection: Outside bidders will win only when the informed bidders (incumbent managers) think the job is not worth very much. Thus, winning is really bad news. This is analogous to the winner’s curse—in fact the winner’s curse can be thought of as a type of adverse selection.

19-5 “Soft Selling” and Adverse Selection Soft selling occurs when a buyer is skeptical of the usefulness of a product and the seller offers to set a price that depends on realized value. For example, suppose you’re trying to sell a company a new accounting system that will reduce costs by 10%. Instead of naming a price, you offer to give them the product in exchange for 50% of their cost savings. Describe the information asymmetry, the adverse selection problem, and why soft selling is a successful signal.

The seller of the product knows whether the product works; the buyer does not. The buyer is worried that the seller has an incentive to lie—to tell him that the product will reduce costs regardless of whether they will. The buyer ―signals‖ the quality of his product by offering to be paid only if it works. A seller who knew his product didn’t work would not find it profitable to offer this kind of contract.

19-6 Hiring Employees You need to hire some new employees to staff your start-up venture. You know that potential employees are distributed throughout the population as follows, but you can’t distinguish among them:

Employee Value

Probability

$50,000

0.25

$60,000

0.25

$70,000

0.25

$80,000

0.25

What is the expected value of five employees you hire?

Expected value = $50,000 Without adverse selection, you would expect to hire an equal number of each type of employee and your expected value would be $65,000 (E(v) = .25(50,000) + .25(60,000) + .25(70,000) + .25(80,000) = $65,000) But with adverse selection, you will not realize this value. If you initially assume an expected value of $65,000 and therefore offer that as your salary, only the $50,000 and $60,000 employees will accept.

This drives your expected value down to $55,000. If you lower your offer to $55,000, only the $50,000 employees will accept.

The only reasonable offer you can make is $50,000.

Chapter 20 20-1 Extended Warranties Your product fails about 2% of the time, on average. Some customers purchase the extended warranty you offer in which you will replace the product if it fails. Would you want to price the extended warranty at 2% of the product price? Discuss both moral hazard and adverse selection issues.

Your product fails about 2% of the time but this probability rate is probably affected by user care. You could face adverse selection in that those who tend to use the product inappropriately are more likely to purchase. You could face moral hazard in that, once users know they are insured, they will tend to use the product less carefully. In either case, the claim rate will exceed 2% and you will lose money.

20-2 Business Loan A colleague tells you that he can get a business loan from the bank, but the rates seem very high for what your colleague considers a low-risk loan. a. Give an adverse selection explanation for this, and offer advice to your friend on how to solve the problem. b. Give a moral hazard explanation for this, and offer advice to your friend on how to solve the problem.

a. Consider two types of borrowers, ones likely to pay back loans and ones less likely to pay back. If the bank cannot tell them apart, the bank can only attract bad borrowers. Your friend must signal that he is a good borrower and is likely to pay back the loan. To do this, he has to do something that a bad borrower would be unwilling to do, like pledge his personal property, or house, as collateral on the loan. b. Once you have a loan, you are more likely to engage in risky behavior, and banks probably offer loans anticipating that you will engage in risky behavior. Your friend must show the bank that he is unlikely to engage in risky behavior. To do this, he can sign contracts limiting his behavior after getting the loan.

20-3 Kitchen Remodel Costs Suppose you are hiring a contractor to remodel your kitchen. One contractor offers a fixed price for the complete job, while a competing contractor offers a cost-plus offer where you are billed a multiple of the contractor’s cost of materials. Which contractor has an incentive to incur cost overruns? Which contractor has an incentive to use substandard materials and less competent labor?

The second contractor (cost-plus) has an incentive to incur cost overruns, as the contractor earns an additional markup on each additional cost item. The first contractor (fixed price) has an incentive to use substandard materials and less competent labor. The contractor earns additional profit by incurring lower costs.

20-4 Auto Insurance Suppose that every driver faces a 1% probability of an automobile accident every year. An accident will, on average, cost each driver $10,000. Suppose there are two types of individuals: those with $60,000 in the bank and those with $5,000 in the bank. Assume that individuals with $5,000 in the bank declare bankruptcy if they get in an accident. In bankruptcy, creditors receive only what individuals have in the bank. What is the actuarially fair price of insurance? What price are individuals with $5,000 in the bank willing to pay for the insurance? Will those with $5,000 in the bank voluntarily purchase insurance? What is the effect of state laws forcing individuals to purchase auto liability insurance?

The actuarially fair price of insurance is 1% x $10,000=$100. Individuals with only $5,000 in the bank are only willing to pay 1% x $5,000=$50 for the insurance. They have fewer assets to protect, and therefore have lower demand for insurance. At the actuarially fair price of $100, they will not voluntarily purchase insurance.

20-5 BPO Services BPO Services is in the business of digitizing information from forms that are filled out by hand. In 2006, a big client gave BPO a distribution of the forms that it digitized in house last year, and BPO estimated how much it would cost to digitize each form.

FORM TYPE

Mix of Forms

Form Cost

A

25%

$0.25

B

25%

$0.10

C

25%

$0.15

D

25%

$0.50

a. Compute the average cost of digitizing a form. b. The client agreed to pay the average cost computed in A for each form that BPO processed, but BPO lost money on the contract. How much did BPO lose, on average, for each form that it processed?

a. $0.25 b. The client outsourced only Forms A and D (Average cost=$0.375, average loss=$0.125), and decided to digitize Forms B and C in house. BPO lost money on the contract by not anticipating moral hazard (post contractual change in behavior). [Note, some students may not anticipate that Form A would be outsourced, but the client’s costs are likely higher than BPO’s.]

20-6 Frequent Flyers Frequent flyer programs are targeted more toward business travelers (who do not pay for their own

tickets) than leisure travelers (who do). Explain their effect on each type of traveler. Why is there a difference?

A leisure traveler must weigh the benefits of flying on a preferred airline and receiving frequent flyer credit with the costs of the ticket. If another airline is sufficiently less expensive for a particular flight, the leisure traveler might decide that the frequent flyer benefits are not worth it. Conversely, a business traveler has only the benefits of being loyal to a single airline but not the costs since the ticket price is not paid by the traveler. Therefore, the business traveler’s decision is an example of moral hazard. The flight decision is made comparing only airline frequent flyer benefits without regard for the ticket prices.

Chapter 21 21-1 Real Estate Agents When real estate agents sell their own, rather than clients’, houses, they leave the houses on the market for a longer time (10 days longer on average) and wind up with better prices (2% higher on average).

Why?

This is a classic principal-agent conflict. Real estate agents are compensated with a percentage of the purchase price, typically three percent. Waiting longer for a better offer will result in a higher price, but the bulk of this additional gain goes to the owner of the house (97%), while the costs of additional selling effort fall on the real estate agent. When real estate agents sell their own houses, they get all of the extra profit from waiting, so they waits longer.

21-2 Airline Departures Planes frequently push back from the gate on time, but then wait 2 feet away from the gate until it is time to queue up for take-off. This practice increases fuel consumption and increases the time that passengers must sit in a cramped plane awaiting take-off. Why does this practice occur? What can be done to fix it?

Consider the incentives of the pilots who decide whether to wait at the gate or 2 feet away from the gate.

Pilot wages vary depending on whether the plane is parked at the gate or if the flight is ―underway.‖ Holding pay for a representative airplane captain is about $20 per hour while flight pay, which starts once the plane pushes back from the gate, is $184 per hour. This represents a principal (airline)-agent (pilot) conflict. Another reason is to game on-time departure stats if they depend on pushback rather than takeoff.

Fixing the problem could involve changing decision rights or changing incentives. One solution would be to no longer allow the captain to decide when to push back. Alternatively, one could redesign the way the captain is paid.

21-3 Incentive Conflicts Which of the following are characteristic of principal-agent conflicts that often exist in a firm? a. Managers do not always operate in the best interest of owners because owners are generally more risk averse than managers. b. Managers generally have a shorter time horizon than owners; thus, managers do not fully consider the firm’s future long-run profitability. c. Managers do not always operate in the best interest of owners because managers care about the noncash benefits of their jobs. d. Firms can usually find solutions that reduce agency costs without increasing monitoring or incentive costs.

b. and c. are correct

21-4 Public School Principals Each year, many public schools are rewarded with bigger budgets for achieving a rating of ―excellent‖ or ―recommended‖ and are punished for rating ―needs improvement.‖ These ratings are based on meeting thresholds on a broad set of measures such as attendance rates, graduation rates, standardized test scores, SAT scores, and so on. Discuss the incentives for school principals (who are the agents, in this case) under this scheme and how you might improve them.

The effect of stronger incentives to meet benchmarks is that principals now work harder to achieve these goals. Ideally, this would mean improving teaching methods so that students learn more. However, the predominant fear seems to be ―teaching to the test‖ at the expense of actual learning. This is a bigger problem when benchmarks are poorer measures of actual learning. This scheme also incentivizes principals to alter the composition of the school’s students. Principals now have an incentive to avoid enrolling poor performing students and to seek out better performing students. The consequence may be that the poorer performing students become less well served.

21-5 Venture Capital Venture capital (VC) firms are pools of private capital that typically invest in small, fast-growing companies, which usually can’t raise funds through other means. In exchange for this financing, the VCs receive a share of the company’s equity, and the founders of the firm typically stay on and continue to manage the company. a. Describe the nature of the incentive conflict between VCs and the managers, identifying the principal and the agent. b. VC investments have two typical components: (1) managers maintain some ownership in the company and often earn additional equity if the company performs well; (2) VCs demand seats on the company’s board. Discuss how these two components help address the incentive conflict.

a. The incentive conflict is between the venture capitalists (the principals) and the managers (agents).

The VCs want the manager to take actions to increase firm value while the manager is more likely concerned with taking actions that increase personal well-being. b. Manager ownership is a form of incentive compensation that helps align the incentives of the agent with the principal. As owners of the firm, managers become more concerned with taking actions that increase firm value. Board representation serves two functions. First, it is a form of monitoring where the VCs can watch managers’ actions more closely. Second, it centralizes decision-making authority for certain high-level decisions at the principal (VC) level.

21-6 Meeting Milestones A convenience store manager earns a base salary plus small bonuses for each of 10 different possible

monthly milestones met. Typical managers can meet half of these milestones. Do they miss the others by a little or a lot?

For any one task, there is a lump-sum payment upon completion. Accomplishing 99% of the task has the same reward as accomplishing 1%. But accomplishing each task might take effort away from other tasks.

The manager earns no bonus for accomplishing 50% of all milestones but earns multiple bonuses from fully meeting the milestones on 50% of the tasks. They have an incentive to ignore some tasks so as to assure that that would complete others. On the ignored tasks, they will miss by a lot. (Also, for the tasks they complete, they should not waste their time by greatly exceeding the goal.)

Chapter 22 22-1 Transfer Pricing Suppose that a paper mill ―feeds‖ a downstream box mill. For the downstream mill, the marginal profitability of producing boxes declines with volume. For example, the first unit of boxes increases earnings by $10, the second $9, the third $8, and so on, until the tenth unit increases profit by just $1. The cost the upstream mill incurs for producing enough paper to make one unit of boxes is $3.50. a. If the two companies are separate profit centers, and the upstream paper mill sets a single transfer price (the price the box company pays the paper mill), what price will it set, and how much money will the company make? b. If the paper mill were forced to transfer at marginal cost, how much money would the company make?

Price

Quantity

Revenue

MR

MC

Profit

10

1

10

10

3.5

6.50

9

2

18

8

3.5

11.00

8

3

24

6

3.5

13.50

7

4

28

4

3.5

14.00

6

5

30

2

3.5

12.50

5

6

30

0

3.5

9.00

4

7

28

-2

3.5

3.50

3

8

24

-4

3.5

-4.00

2

9

18

-6

3.5

-13.50

1

10

10

-8

3.5

-25.00

[note that the marginal profitability of boxes represents the price that the box division would be willing to pay the paper division for boxes; this allows the creation of the above chart from the paper division perspective; paper division will set price where MR>MC] The upstream paper mill will price at $7, sell four units and earn $14. Company-wide profits are (10+9+8+7)-4*3.50 = 34-14 =20.

If the upstream firm transfers at marginal cost, then the downstream box plant will consume seven units, and company-wide profit is (10+9+8+7+6+5+4)-7*3.50 = 49-24.50 = 24.50.

22-2 Transfer Prices Set by Headquarters List three reasons why might it be a bad idea to have corporate headquarters set transfer prices.

Three reasons why it may be a bad idea:    

Corporate managers may not have good information about the best transfer price.

It may lead division managers to provide misinformation about costs related to the transfer price.

It distracts corporate managers from concentrating on larger problems.

(Could also mention costs associated with division managers lobbying HQ for favorable transfer price)

22-3 Chargebacks Your local fast-food chain with two dozen stores uses the company’s internal corporate marketing department to produce signage, print ads, in-store displays, and so forth. When placing an order, store managers are assessed a chargeback (transfer price) that reduces store profitability but increases marketing department profitability. Lately, the store managers have been ordering more and more marketing services; the marketing department is swamped, and it cannot afford to hire more staff. What does this indicate about the chargeback rates?

―Customers‖ of the marketing department want to "buy" ever more services at the current transfer price.

This indicates the transfer price is below the alternative, ordering these services from outside from an outside vender. This might be OK because the optimal transfer price equals the marginal cost, which could be below the market price if there is a margin in place. Yet, the additional transfers to the marketing department are not sufficient to cover the additional costs of fulfilling the orders. This indicates that the transfer price is set below the marginal cost in the marketing department. The transfer price is too low.

22-4 Divisional Profit Measure Discuss the advantages and disadvantages of using divisional profit as the basis of incentive compensation for division managers compared to using company profit as the basis.

 

Divisional profit – focuses division managers on divisional performance (advantage) but perhaps at the expense of overall company performance (disadvantage) Company profit – focuses division managers on overall corporate performance (advantage) but exposes them to a lot of uncontrollable risk, for which they must be compensated (disadvantage); also may lead to some free-riding (disadvantage)

22-5 Furniture Forecasting Futura Furniture Products manufactures upscale office furniture for the ―Office of the Future.‖ The sales division comprises regionally based sales offices made up of sales representatives and regional managers.

Sales representatives—who report to the regional managers—conduct direct sales efforts with customers in their regions. As part of the sales process, representatives gather information about likely future orders and convey that information back to the regional managers. Regional managers use that information to create sales forecasts, which are then used as the basis for manufacturing schedules. Sales representatives and regional managers are both compensated on a salary plus commission (percentage of revenue as pricing is centrally controlled). However, a regional manager’s commission is adjusted based on regional sales that exceed the forecasted budget. Corporate managers are concerned with one of Futura’s key products, the ―DeskPod.‖ They worry that DeskPod forecasts are inaccurate, causing extreme havoc in the manufacturing process. How are the forecasts likely to be inaccurate? What do you think is driving this inaccuracy? How might this problem be solved?

Sales forecasts are most likely understated. This is driven by the compensation structure of the regional managers, who are compensated for exceeding budget. Their incentive is to understate forecasts to ensure they can exceed budget.

A number of solutions are possible. The compensation scheme could be changed so regional sales managers are not paid simply for exceeding budget (institute compensation without kinks). Information could be transferred to corporate managers to allow them to set budgets. Finally, part of the sales managers’ compensation could be based on the accuracy of forecasts.

22-6 Jet Turbine Design This problem is mentioned in the text (see the section on “Organizational Alternatives”). Your task is to propose an organizational solution. To briefly recap, a manufacturer is trying to design the next generation of turbine engines for jet airplanes. The company is divided along functional lines.

Engineering designs the engine, production manufactures it, and finance figures out how much to charge for it. The engineers invented a radical new design that used hollow fan blades. The award-winning design used less fuel than conventional engines, but the hollow fan blades were very difficult to build.

When the Finance Division computed the marginal cost of an engine, it discovered that the new engines were much more expensive than rival engines, even accounting for the expected fuel savings. No one purchased the engine. How would you make sure that this problem does not recur?

Use the three questions:   

The problem is that engineering made a poor decision to build hollow fan blades.

They had information about the feasibility of different types of designs.

They were not compensated based on whether designs were profitable to build.

The firm changed its organizational architecture to:

  

Reorganize the firms around the process of creating a new turbine engine. This meant replacing the functional divisions with a turbine division that included engineers, manufacturing; and finance capability.

Compensate the turbine division according to the profitability of engine sales.

Evaluate individuals according to their contribution to division profitability.

Chapter 23 23-1 Telephone Pole Attachments To further the deployment of broadband services, many jurisdictions require owners of utility poles and telephone poles to accept wires attachments from other companies. Some telephone companies already offer broadband services over the lines already installed on telephone poles.

Third-party companies seeking to attach their own lines to existing poles complain that telephone maintenance crews put peanut butter on their lines to encourage rats to eat the lines. If true, why is this a profitable strategy? Would this be an Issue for poles owned by the electric company and not the telephone company?

The owners of telephone poles would be willing to negotiate a rental rate for broadband companies to attach additional cables to the poles. However, if the owner is the local telephone company already supplying broadband service, the rate would have to include the potential lost profits from a lost customer. The state requirement implies that the rental rate would be lower than what the phone company would accept. Instead, the incumbent provider would like to exclude any rivals. In can do this by sabotaging the rival cables whenever it has a chance to.

In contrast, the electric company does not have this issue with the poles it owns. Since electric companies typically do not provide broadband service, the new attachment does not represent a rival (and may be a complement). It is more willing to accept the regulated price and it gains no benefit from excluding the entrant.

23-2 Integration of Physician Groups and Testing Services Under a proposed healthcare reform, doctors’ fees will be capped at 80% of their current rate, but doctors can order blood tests that will be reimbursed at 90% of the current rate. How does vertical integration of physician groups into testing services increase profits?

With different reimbursement rates, doctors can cross-subsidize the more severe regulation of their fees with less severely regulated testing services. Vertically integration into testing services facilitates this strategy.

23-3 Online Cosmetics Australian cosmetics maker, Eternal Beauty Products, pressures online retailers to either sell goods at prices charged by brick and mortar stores or risk being cutoff. If online retailers are paying the same wholesale prices, why would Eternal not want online retailers to charge lower prices?

Cosmetic sales benefit from point-of-sales services for a customer to determine the best product for her and how to apply it most effectively. Brick & mortar stores offer these services and set retail prices high enough over wholesale prices to cover these costs. Online retailers do not and so prefer lower prices that do not cover these costs. However, if they did, customers would get the point-of-sale services from brick

& mortar stores and make purchases online. If this happened, it would undermine the delivery of the point-of-sale services by the brick & mortar stores.

23-4 Wedding Dresses Stores that sell wedding dresses do not typically permit photos, and do not have tags in the dresses that would identify the manufacturer and style type. What is the purpose of these rules? Suggest one other way of accomplishing the same objective.

These retail stores want to prevent customers from "free riding" on their fitting and display services. Here is an example of such free riding: ―I just spoke with someone who had all her bridesmaids sized in the store only to go online and buy them from a discount site. I would assume many of the brides are doing this as well.‖

23-5 Herbicide Integration Suppose the herbicide manufacturer mentioned in the chapter can vertically integrate only into home gardening retailing. Would this allow the manufacturer to price discriminate?

Enter the low value business, farming. To see why this allows price discrimination, consider the alternative, entering the high value business of home gardening. If you continue to sell 200 liter barrels to a rival downstream retailer of farming pesticide for $3/liter, what would prevent the farming retailer from trying to enter the home gardening business and undercut your $5/liter price?

23-6 Loyalty Payments Intel made large loyalty payments to HP in exchange for HP buying most of their chips from Intel instead of rival AMD. AMD sued Intel under the antitrust laws, and Intel settled the case by paying $1.25 billion to AMD. What incentive conflict was being controlled by these loyalty payments? What advice did Intel ignore when they adopted this practice?

If you have some significant market power, consider the effect on competitors of any planned action. If the planned action is likely to hurt your competitors badly, be sure that such harm is a byproduct of moves that have a sound business justification. [extra credit if they get the reason why] In this case, even though Intel had some justifications for the loyalty payments, the loyalty payments also reduced demand for AMD chips, which drove them up their

average cost curve (chip manufacturers exhibit economies of scale) which made it difficult for them to compete.