Test Bank for Managerial Economics, 10th Edition William F. Samuelson, Stephen G. Marks, Jay L. Zagorsky Chapter 1-17
File: Ch01; CHAPTER 1: Introduction to Economic Decision Making MULTIPLE CHOICE 1. Managerial economics can best be defined as the: a) macroeconomics and microeconomics for managers. b) study of economic incentives on consumer behavior and demand. c) analysis of the labor market through the behavior of workers and managers. d) analysis of major management decisions using economic tools. e) study of the strategic interaction between firms in a market. ANSWER: d SECTION REFERENCE: Introduction DIFFICULTY LEVEL: Easy
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Which of the following is not one of the steps in managerial decision making? a) Predicting the consequences of a decision. b) Exploring the alternatives to the decision. c) Defining the problem and the objectives of the decision. d) Negotiating a consensus to implement the decision. e) Performing sensitivity analysis. ANSWER: d SECTION REFERENCE: Six Steps to Decision Making DIFFICULTY LEVEL: Easy
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Profit maximization is an ambiguous guide to decision making in the private sector because: a) firms in the private sector usually do not aim at profit maximization. b) the goal of profit maximization contradicts the goal of satisfying the firm’s shareholders. c) of the presence of risk and uncertainty. d) profit-maximization ignores social costs and benefits. e) None of the above answers is correct. ANSWER: c SECTION REFERENCE: Six Steps to Decision Making DIFFICULTY LEVEL: Easy
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Which of the following is true of economic models? a) Models are too theoretical to be applicable in real world decisions. b) Models are not useful because uncertainty prevents accurate forecasts. c) Models are simplified descriptions of processes, relationships, or other phenomena. d) Models describe real world situations in complete detail. e) Models are not useful because they do not take into account complicating and less important features of a problem. ANSWER: c SECTION REFERENCE: Six Steps to Decision Making DIFFICULTY LEVEL: Medium
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Which of the following correctly describes a deterministic economic model? a) A deterministic model is a model for which the outcome is predicted with certainty. b) A deterministic model can only be used to explain short-run economic phenomena. c) A deterministic model is most useful in identifying long-term trends. d) A deterministic model is used in the study of normative economics. e) The outcome of a deterministic model is random and has probabilities attached. ANSWER: a SECTION REFERENCE: Six Steps to Decision Making DIFFICULTY LEVEL: Easy
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Which of the following correctly explains a probabilistic model? a) A probabilistic model gives a description of real world economic phenomena. b) A probabilistic model shows the possibility of a range of outcomes. c) A probabilistic model examines the changes in economic variables over a period of time. d) A probabilistic model is based on value judgments. e) A probabilistic model is used to explain long-run economic phenomena ANSWER: b SECTION REFERENCE: Six Steps to Decision Making DIFFICULTY LEVEL: Easy
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Maximizing profit by enumerating the profit outcomes of different courses of action a) Is only applicable to problems with a small number of alternatives. b) Becomes increasingly costly as the number of choices increase. c) Always discovers the best possible choice. d) Provides a useful shortcut to finding the optimal choice. e) Answers b and c are both correct. 1-4
ANSWER: b SECTION REFERENCE: Six Steps to Decision Making DIFFICULTY LEVEL: Medium
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A beverages company wants to launch a new diet soda aimed at diabetics and healthconscious customers. It will use a economic model to identify its target customers. a) deterministic b) dynamic c) qualitative d) stochastic e) probabilistic ANSWER: a SECTION REFERENCE: Six Steps to Decision Making DIFFICULTY LEVEL: Medium
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Given that the market share of a firm depends on many unpredictable factors, a firm will use a economic model to estimate the market share for one of its products. a) deterministic b) dynamic c) qualitative d) probabilistic e) comparative statics ANSWER: d SECTION REFERENCE: Six Steps to Decision Making DIFFICULTY LEVEL: Medium
10. Sensitivity analysis is used by a firm to: a) analyze the impact of a change in the price of the good on the demand for the good. b) examine the static effects of an economic decision on the firm’s profitability. c) analyze the social costs and benefits of an economic decision. d) examine the opportunity costs of an economic decision. e) examine how an optimal decision is affected if key economic facts vary. ANSWER: e SECTION REFERENCE: Six Steps to Decision Making DIFFICULTY LEVEL: Easy
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11. A cosmetics company is conducting a second-year review of one of its newest products. The marketing department expects that the firm will continue to earn profits from the sale of the product in the third year as it did in the past two years. Senior management, however, feels that the profit projections would vary based on other factors such as the price of the competitor's products, the actual level of sales, and the possibility of cost reductions. In other words, the senior management is undertaking . a) a sensitivity analysis b) an enumeration study c) a benefit-cost analysis d) a contingent valuation study e) a strategic analysis ANSWER: a SECTION REFERENCE: Six Steps to Decision Making DIFFICULTY LEVEL: Medium
12. According to the satisficing model of management behavior, the goal of a firm is to: a) satisfy customers, employees, and shareholders. b) maximize the gain to society and not just to shareholders. c) achieve a satisfactory level of performance against a benchmark. d) maximize sales revenue and not necessarily the value of the firm. e) maximize its market share even at the cost of profit. ANSWER: c SECTION REFERENCE: Private and Public Decisions: An Economic View DIFFICULTY LEVEL: Easy
13. According to the theory of the firm, the management’s ultimate objective is to: a) maximize short-term profit, even if this sacrifices long-term profit. b) maximize the value of the firm. c) increase production to the highest possible level. d) increase the market share of the firm. e) diversify into as many product lines as the firm can. ANSWER: b SECTION REFERENCE: Private and Public Decisions: An Economic View DIFFICULTY LEVEL: Easy
14. A coffee shop decides that it will increase its market share to 55% by the end of the year by lowering the price of a cup of coffee. The price cut will certainly result in an increase in the
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firm’s share but will lower its profits. Which of the following best explains the firm’s decision? a) Satisficing behavior. b) Price discrimination. c) Social responsibility. d) A sensitivity analysis. e) Revenue maximization. ANSWER: e SECTION REFERENCE: Private and Public Decisions: An Economic View DIFFICULTY LEVEL: Medium
15. Ann is a manager at a private construction company. David works in the city planning department of the government. Based on this information, which of the following is most likely to be true? a) David will make decisions based on the value generated to shareholders. b) Ann will not have to factor in risk or uncertainty when making a decision. c) David will make decisions based on maximization of profit. d) Ann's decisions will be guided by the motive of social welfare. e) David will make decisions based on benefit-cost analysis. ANSWER: e SECTION REFERENCE: Private and Public Decisions: An Economic View DIFFICULTY LEVEL: Medium
16. A research study estimates that the direct cost of constructing a bridge connecting two boroughs in a city is $10 million. The revenue from the tolls on the bridge is estimated to be $8 million. The dollar value of pollution from the construction is estimated to be $5 million but the dollar value of the benefit to the city's residents is calculated to be $20 million. The construction of the bridge is most likely to be undertaken by: a) the government because revenues exceed costs. b) the government because the total benefits exceed total costs. c) a private firm because the total benefits exceed total costs. d) a private firm because revenues exceed direct costs. e) a private firm because the revenues exceed indirect costs. ANSWER: b SECTION REFERENCE: Private and Public Decisions: An Economic View DIFFICULTY LEVEL: Medium
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17. In evaluating public programs, benefit-cost analysis: a) takes into account only the benefits that society gains from public programs. b) states that a program should be undertaken only if it generates revenue. c) states that a program should be undertaken only if total benefits exceed total costs. d) takes into account only the direct costs of the program. e) states that a program should be undertaken only if there are no indirect costs. ANSWER: c SECTION REFERENCE: Private and Public Decisions: An Economic View DIFFICULTY LEVEL: Easy
18. The government is deciding whether it should build a veteran’s hospital in an urban area. It will choose to build the hospital only if: a) the hospital generates positive revenues. b) the cost of building the hospital is low. c) the profits from the hospital are positive. d) the opportunity cost of building the hospital is zero. e) the total benefits from the hospital exceed total costs. ANSWER: e SECTION REFERENCE: 4 DIFFICULTY LEVEL: Medium
19. The study of behavioral economics shows that decision makers: a) are not limited by cognitive constraints. b) are incapable of learning from their mistakes. c) are prone to biases, mistakes, and pitfalls. d) are guided solely by monetary incentives. e) make decisions in a highly calculative and rational manner. ANSWER: c SECTION REFERENCE: Private and Public Decisions: An Economic View DIFFICULTY LEVEL: Easy
SHORT ANSWERS 20. Carefully define managerial economics, and explain how it is useful in decision-making. ANSWER: Managerial economics is the analysis of major management decisions using the tools of economics. It applies familiar concepts such as demand, cost, market structure, and resource allocation. Managerial economics emphasizes the theory of the firm and employs
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quantitative analysis in making decisions. Simple models are used to emphasize the most important features of the decision problem. SECTION REFERENCE: Introduction DIFFICULTY LEVEL: Easy
21. How can the decision making process be structured to analyze complicated decisions? ANSWER: The decision making process can be summarized into a basic framework and used in economic analysis. Decision making can be structured into the following six steps: (1) Defining the problem: Since decisions are not made in a vacuum, the context of the decision, the problem itself, and the decision maker need to be identified. (2) Setting the objectives: The objectives that are set will determine the guiding rule for the decision. For example, if the objective is to maximize profit then the decision that is most likely to lead to profit-maximization will be chosen over a decision that might lead to maximization of market share. (3) Exploring the alternatives: All the alternative courses of action need to be listed and analyzed. (4) Predicting the consequences: Although the outcome of a decision cannot be predicted with certainty, predictive models can be used to predict outcomes with a reasonable level of certainty. (5) Choosing an option: The right choice should be made based on all the previous steps. If the decision is not immediately clear, various methods like marginal analysis, decision trees, game theory, benefit-cost analysis, and linear programming can be used to clarify the analysis. (6) Using sensitivity analysis: Once a choice is made, sensitivity analysis can be used to check whether and how the decision will be affected by changes in economic conditions or key assumptions. SECTION REFERENCE: Six Steps to Decision Making DIFFICULTY LEVEL: Easy
22. What are the two difficulties that may make profit maximization an ambiguous guide to decision making? Explain. ANSWER: The timing of benefits and costs and the presence of risk and uncertainty are the two difficulties that complicate the objective of profit maximization. Generally speaking, many decisions involve making costly investments “up front” in return for benefits or profits in the future. This requires the decision-maker to develop comparable measures of present and future monetary values. Uncertainty underscores the fact that some outcomes are not known with complete confidence. Costs may be far larger than expected, benefits far smaller, and delays in completion may diminish profits. The manager’s task is to foresee the range of possible outcomes and to estimate the likelihood of different consequences. SECTION REFERENCE: Six Steps to Decision Making
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DIFFICULTY LEVEL: Easy
23. One of the major steps in decision-making is to explore the alternatives. Do most managerial decisions have a few, limited number of options? Explain. Illustrate your answer with an appropriate example. ANSWER: Most decisions have several (often many) competing options. Even when the choices are limited, there are often more alternatives than first meet the eye. For example, suppose Disney is deciding whether to build a new theme park. It must choose the location, and the scale of operation, and when its opening should be scheduled. In addition, subsequent decisions will involve advertising and pricing strategies. Many managerial decisions involve more than a once-for-all choice from a set of options. Instead, managers face a sequence of decisions. For instance, whether a firm should attempt to develop a new product and if all goes well, when and how should it launch and promote the product. The firm will also have to decide how it should price the product and gear up capacity to supply the expected sales at its chosen price. SECTION REFERENCE: Six Steps to Decision Making DIFFICULTY LEVEL: Easy
24. Carefully define the term "model" and explain how models are used in managerial economics. ANSWER: A model is a simplified description of a process, relationship, or other phenomenon. The two main types of models are deterministic and probabilistic. Models select key features for analysis (and, therefore, they deliberately ignore less important features). Models are useful to managers because they show how the various options that a manager faces translate into outcomes. Models usually help in explaining past outcomes or in predicting future outcomes. SECTION REFERENCE: Six Steps to Decision Making DIFFICULTY LEVEL: Easy
25. Carefully define probabilistic and deterministic models, and explain how they differ. ANSWER: Deterministic models are predictive models in which the outcome of a decision is certain (or close enough that it doesn’t matter). In probabilistic models, there is no one certain outcome but, rather, many possible outcomes with a probability attached to each. SECTION REFERENCE: Six Steps to Decision Making DIFFICULTY LEVEL: Easy
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26. Value maximization is the main objective of top management. Briefly describe the alternative objectives. ANSWER: The three most important alternatives are: satisficing behavior, sales maximization, and pursuing the firm’s social responsibilities to all stakeholders. Satisficing behavior posits that firms will sometimes strive for second-best, or an acceptable level of performance as against the highest level of maximization. Sales targets may closely be linked to managers’ compensation and so firms may also strive to maximize sales subject to a certain level of profit. Firms that pursue social responsibility as their objective would aim to satisfy not only customers and investors but also society, the environment, and other stakeholders. All these objectives may be pursued at the expense of profits. SECTION REFERENCE: Private and Public Decisions: An Economic View DIFFICULTY LEVEL: Medium
27. Ecotopia is a developing country that is facing a growing need for energy to power its industries and fuel its development. The Ecotopian government's proposal to set up a nuclear energy plant has drawn widespread protests from environmental activists across the country. Since this is an issue that affects a large number of people, how would one weight the benefits and costs to make a decision that is best for the society as a whole? ANSWER: Setting up a nuclear plant in order to satisfy civilian energy needs affects the welfare of the society in general. In such a situation, since there are gains and losses for different groups of people, benefit-cost analysis should be used. Benefit-cost analysis weighs the total benefits and total costs of a decision (irrespective of who these benefits and losses accrue to). When setting up a nuclear plant, the benefits and costs need to be assigned a monetary value. If the value of the benefits is higher than the value of the costs, then the project should be undertaken. One of the possible benefits from nuclear energy is that Ecotopia can reduce its dependence on fossil fuels. Nuclear energy generation also does not emit greenhouse gases. Relevant costs include the high investment sum to build the plant, its ongoing operating costs, and safety-related costs including disposing of nuclear fuel. All these benefits and costs should be converted into a common measurable unit, usually dollars, and then compared. SECTION REFERENCE: Private and Public Decisions: An Economic View DIFFICULTY LEVEL: Medium
28. How does decision making in the private, for-profit sector differ from decision making in the public sector? ANSWER: In the private sector, managers seek maximum value for the firm. Managers focus primarily on the effects of a decision on the firm's profits. With an eye on profit, managers will not generally take into account the impacts (benefits and costs) on other
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parties. In the public sector, decisions are guided by benefit-cost analysis (not simply profit analysis). The benefits and costs to all affected parties (not just the program’s revenues and costs) are evaluated and totaled in order to make a sound decision. SECTION REFERENCE: Private and Public Decisions: An Economic View DIFFICULTY LEVEL: Medium
ESSAYS 29. Amanda is a troubleshooter for a major manufacturing firm. A particular facility has experienced problems with quality for several years. In addition, there have been some major problems with the facility's labor union. A bitter strike, lasting six months, occurred prior to signing the current contract. Past management teams have visited and inspected the site but have been unable to achieve change, despite detailed study and recommendations. Recently, sales of the facility's product line have declined in the face of increased import competition from an East Asian country, and this is unlikely to change in the near future. Currently, the Board is considering two new courses of action. One is retooling the facility to manufacture a new line of products. This would involve capital costs of several millions of dollars. It would also mean that there would be no production from the facility while retooling and retraining takes place. The second option is closing down the facility. This would involve costs in the form of termination benefits, as well as funding some pension benefits of senior employees. There appear to be no buyers for the plant, and it would likely remain idle for some time, while continuing to be a tax drain on the company. How would Amanda use the steps of decision-making and the concept of value maximization to recommend a course of action to the Board? Explain. ANSWER: Management finds itself on the horns of a dilemma since it appears that any course of action – continuing current production, retooling, or closing the plant – will involve losses. Nonetheless, the tools of managerial economics still apply. Here, the firm seeks the course of action that minimizes its losses (If losses are minimized, then the value of the firm is maintained as far as possible). Thus, management must carefully estimate and compare the relative costs of its options. SECTION REFERENCE: Six Steps to Decision Making DIFFICULTY LEVEL: Medium
30. Carefully define sensitivity analysis, and provide three examples of how a manager might use it. ANSWER: Sensitivity analysis considers how an optimal decision would change if key economic facts or conditions were altered. Some examples of how to use it include: (1) predicting sales under different macroeconomic conditions (growth or recession) (2) the effects of escalating oil prices on energy costs (3) the effect on the sales of a product if a competitor cuts prices
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In each case, the changing factor not only affects the firm’s profit, it also implies changes in the firm’s production and pricing decisions. SECTION REFERENCE: Six Steps to Decision Making DIFFICULTY LEVEL: Medium
31. A company is thinking about significantly expanding its production capacity. What variables would it consider in making this decision? What might be useful sources of information for estimating the potential profit impact of the expansion? ANSWER: The most important variables are increased sales revenues and increased costs. Information on sales revenue would include current price and quantity data and the past growth rate of sales, and the impact of the firm’s advertising and promotional spending (and, of course anticipating the likely response of rival firms) on its sales. Information on costs would include the capital cost of building new facilities or expanding old ones (including borrowing costs influenced by interest rates) and annual fixed and variable costs (for equipment, labor and energy) needed to produce the greater level of output. Note that the expansion might bring the firm some reductions in average costs due to the use of new technology. SECTION REFERENCE: Private and Public Decisions: An Economic View DIFFICULTY LEVEL: Medium
32. Mike heads a new startup firm that decides to open a number of clinics that perform laser eye surgery to correct common vision problems. He hopes that over time his company can claim a substantial share of what is estimated to be an $18 billion per year market. Briefly describe the most important factors influencing his venture’s revenues and costs. Describe the most important risks. ANSWER: A complete answer should point out a number of obvious factors. On the demand side, the key question is the size of the total market willing and able to pay for the laser surgery (so as to dispense with glasses and contact lens). Because the procedure is not covered by insurance, demand will depend directly on the price (per eye) Mike’s company and others set for the procedure. Demand also depends upon the real and perceived risks of laser surgery. Demand issues raise a number of decision questions. How should the firm price and promote the clinics and procedures? Should it enlist elite physicians to oversee and endorse your firm’s services (as a means of differentiation)? Given current competitors and future entrants, what share of the total market can the firm reasonably expect to claim? Costs are equally important. Medical equipment and office space represent significant capital costs. Besides other operating costs, Mike’s company will pay a significant licensing fee (royalty) for each procedure to the laser’s patent holder. Of course, the ultimate average cost per patient will depend on the number of patients the firm attracts and on the scale of operation. Finally, there are significant risks – not only uncertainties on the revenue and cost
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sides already mentioned – but medical risks to patients and liability and regulatory risks to the company. SECTION REFERENCE: Private and Public Decisions: An Economic View DIFFICULTY LEVEL: Hard
33. A small nation is considering upgrading its air force to incorporate new technology. It faces two main choices. The first is to acquire a fleet of the latest fighter aircraft, with the newest electronics and weapons. The cost of the acquisition (assuming that the U.S. President and Congress agree to the sale) is $45 million per plane, including a stock of spare parts that should last five years. The second choice is to buy an electronic upgrade for existing aircraft, with a complete overhaul of the airframes. The cost of such an upgrade is $8 million per plane, with about a 10% loss of fleet because of damage beyond repair and “cannibalization” to obtain the highest number of flyable planes. The upgrading of existing planes results in aircraft with about 90% of the capability of the new aircraft. Top pilots in the small country's air force are concerned that they may not be flying the best aircraft, and could face a disadvantage in combat against newer planes flown by a potential enemy. However, they acknowledge that if a numerical superiority against the enemy can be obtained, an overall victory is still likely. Their theory is that three of the upgraded planes should be able to win against one of the newer planes flown by an enemy (although the pilots expect higher losses in combat). How would an economic consultant advise the defense ministry of the small country in deciding how best to spend its available budget for air defense? What objective(s) are important for this decision? What are the pros and cons of the available options? ANSWER: In this case, the objective is not maximum profit or operating revenue, but obtaining the best possible air force within the prescribed budget. The two main alternatives are to purchase new aircraft, or upgrade existing planes. Clearly, an important consideration is the difference in cost of the two possibilities. An upgrade is far cheaper, and results in 90% of the operational capability of the new plane. For $45 million spent on a single new plane, the country can upgrade between five and six existing aircrafts. Assuming that the air force pilots are correct that three of the older, upgraded planes can defeat a single, newer plane, upgrading provides a greater effective amount of firepower in a future air conflict. However, an additional issue should be taken into account: higher pilot losses can be expected with the upgrade. The cost of lives lost can be important for a country that places a high value on human life. A sound decision should indicate at least a third possible choice, that is, to order a small number of new planes in addition to upgrading most of the old planes. The new planes could accompany the older planes on missions and stand by to combat enemy fighters. While expensive, it is cheaper than buying an entirely new fleet, and could reduce overall pilot loss. SECTION REFERENCE: Private and Public Decisions: An Economic View DIFFICULTY LEVEL: Hard
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34. In striving to make the best possible decisions, a firm’s CEO always relies on a highly analytical approach. However, the firm’s Chairman of the Board argues that in his experience, the analytical approach can only go so far. He advocates analysis as only one of several decision approaches. What is your view? Discuss and explain. ANSWER: The virtue of the analytical approach is that it considers and analyzes the most important factors involved in a given decision. However, it is not infallible; managers may have the wrong incentives and/or pursue the wrong objectives. They might lack the necessary information to formulate a sound decision. Or they may fail to implement the decision – no matter how right it is. The key is to use the analytical approach flexibly. Different cases may require different degrees of analysis in each decision step. Certainly, the Chairman is right in insisting that there are other ways to make decisions, ranging from: company rules of thumb, invoking one’s experience, judgment and intuition, to “I’ll sleep on it”. These other means might provide useful insights and ingredients. Or to take an extreme case, sometimes, “flashes of genius” may offer decision solutions that are surprising and highly creative (and by no means irrational). For instance, a marketing plan might include radical elements constituting major changes in how a product is offered for sale. This approach is inspired, but it is also risky. It might spectacularly succeed, or just as spectacularly fail. In short, it remains the case that a sound analysis is required to articulate the logic of the decision (indeed, to convince others of its merits). SECTION REFERENCE: Things to Come DIFFICULTY LEVEL: Hard
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File: Ch02; CHAPTER 2: Optimal Decisions Using Marginal Analysis MULTIPLE CHOICE 1.
According to the model of the firm, the management’s main goal is to: a) increase revenue from sales. b) maximize profit. c) maximize its market share. d) minimize its variable cost per unit. e) maintain a steady and predictable growth in earnings. ANSWER: b SECTION REFERENCE: A Simple Model of the Firm DIFFICULTY LEVEL: Easy
2.
According to the law of demand, if a firm reduces the price of its good: a) consumers in the market will demand more units of the good. b) some consumers will exit the market. c) consumers will demand fewer units than before the price cut. d) the quantity of goods produced and sold by the firm will decline. e) competing firms will reduce prices. ANSWER: a SECTION REFERENCE: A Simple Model of the Firm DIFFICULTY LEVEL: Easy
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Which of the following is true of a firm facing a downward sloping demand curve? a) In order to sell more units, the firm needs to lower its price. b) A price cut will reduce total revenue. c) The firm's total revenue and price are directly correlated. d) The marginal revenue from each unit sold is constant. e) The firm faces a constant marginal cost curve. ANSWER: a SECTION REFERENCE: A Simple Model of the Firm DIFFICULTY LEVEL: Easy
4.
The demand for a product is given by Q = 600 – 30P. At P = $15, the firm sells: a) 100 units. b) 150 units. c) 300 units. d) 450 units. 2-1
Optimal Decisions Using Marginal Analysis
e) 600 units. ANSWER: b SECTION REFERENCE: A Simple Model of the Firm DIFFICULTY LEVEL: Medium
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The demand for a product is given by P = 1,750 – 25Q. If the firm wishes to sell 50 units, each unit should be priced at: a) $100. b) $200, c) $300. d) $400. e) $500. ANSWER: e SECTION REFERENCE: A Simple Model of the Firm DIFFICULTY LEVEL: Medium
6.
A firm’s demand curve is given by Q = 800 – 2P. Therefore, its inverse demand equation is: a) MR = 800 – 4P b) P = 800 – 2Q c) P = 400 – .5Q d) P = 800 – .5Q e) 800 = Q + 2P ANSWER: c SECTION REFERENCE: A Simple Model of the Firm DIFFICULTY LEVEL: Medium
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Suppose a firm's inverse demand function is P = 40 – 8Q. What is the firm's revenue function? a) R = 40Q – 8Q2 b) R = 40 – 16Q c) R = –8Q d) R = 40/Q – 8 e) R = 40Q – 4Q2 ANSWER: a SECTION REFERENCE: A Simple Model of the Firm DIFFICULTY LEVEL: Medium
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Chapter 2
The following table shows the total revenue and total cost (in dollars) from different sales volumes of the good. Table 2-1 Price 15 14 13 12 11 10
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Quantity 1 2 3 4 5 6
Total Revenue 15 28 39 48 55 60
Total Cost 3 7 12 18 25 33
Refer to Table 2-1. What is the firm’s profit from selling 3 units of the good? a) $13 b) $11 c) $12 d) $39 e) $27 ANSWER: e SECTION REFERENCE: A Simple Model of the Firm DIFFICULTY LEVEL: Easy
9.
Refer to Table 2-1. What is the marginal profit of the firm from the sale of the 3rd unit of the good? a) $9 b) $6 c) $2 d) $5 e) $21 ANSWER: b SECTION REFERENCE: Marginal Analysis DIFFICULTY LEVEL: Medium
10. Suppose, at its current output level, a firm’s marginal profit is positive. Therefore, to maximize profit, it should: a) decrease output until marginal profit is zero. b) increase output because MR is less than MC. c) increase both its output and its price. d) increase output because MR is greater than MC. e) increase output until it is producing at full capacity.
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Optimal Decisions Using Marginal Analysis
ANSWER: d SECTION REFERENCE: Marginal Analysis DIFFICULTY LEVEL: Medium
11. Suppose a firm’s profit is given by the equation = –200 + 80Q – .2Q2. Which of the following is true? a) The firm’s marginal profit is given by the equation: M = 80 – .2Q. b) The firm’s profit-maximizing output is Q = 400. c) The firm’s profit-maximizing output is Q = 200. d) The firm’s marginal profit is given by the equation: M = 80 – 2Q. e) The firm’s profit-maximizing output is Q = 800. ANSWER: c SECTION REFERENCE: Marginal Analysis DIFFICULTY LEVEL: Medium
12. If a firm’s profit is given by = -150 + 360Q - 36Q2, then its optimal output is: a) 12 units. b) 5 units. c) 2 units. d) 20 units. e) 36 units. ANSWER: b SECTION REFERENCE: Marginal Analysis DIFFICULTY LEVEL: Medium
13. If a firm’s demand function is of the form P = a – bQ, what is its marginal revenue equation? a) MR = a – Q b) MR = a – 2bQ c) MR = a - 2Q d) MR = a – 2b e) MR = a + 2bQ ANSWER: b SECTION REFERENCE: Marginal Revenue and Marginal Cost DIFFICULTY LEVEL: Hard
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Chapter 2
14. A firm’s total revenue function is given by R = 100 + 100Q - 2Q2. At Q = 10, which of the following is true? a) The firm’s marginal revenue is $80. b) The firm’s marginal revenue is constant. c) The firm’s average revenue is $50. d) The firm’s total revenue is $500. e) The firm’s marginal revenue is $60. ANSWER: e SECTION REFERENCE: A Simple Model of the Firm DIFFICULTY LEVEL: Medium
15. Which of the following correctly defines marginal revenue? a) Marginal revenue is the price at which the firm sells the last unit of the good. b) Marginal revenue is the change in revenue from a unit increase in the price of the good. c) Marginal revenue is the additional revenue from a unit increase in output and sales. d) Marginal revenue is the additional revenue earned from an increase in demand for the good. e) Marginal revenue is the difference between price and marginal cost for the last unit sold. ANSWER: c SECTION REFERENCE: Marginal Revenue and Marginal Cost DIFFICULTY LEVEL: Easy
16. For a downward-sloping demand curve, the associated marginal revenue curve: a) coincides with the demand curve. b) lies below and is parallel to the demand curve. c) has twice the slope as the demand curve. d) is positive for all levels of sales. e) is parallel to the quantity axis. ANSWER: c SECTION REFERENCE: Marginal Revenue and Marginal Cost DIFFICULTY LEVEL: Easy
The following table shows the total revenue (in dollars) and total cost (in dollars) from the production and sale of different units of a product. Table 2-1
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Optimal Decisions Using Marginal Analysis
Price 15 14 13 12 11 10
Quantity 1 2 3 4 5 6
Total Revenue 15 28 39 48 55 60
Total Cost 3 7 12 18 25 33
17. Refer to Table 2-1. What is the marginal revenue associated with the sale of the 5th unit of the good? a) $55 b) $8 c) $7 d) $48 e) $4 ANSWER: c SECTION REFERENCE: Marginal Revenue and Marginal Cost DIFFICULTY LEVEL: Medium
18. Refer to Table 2-1. What is the profit-maximizing level of output for the firm? a) 3 units b) 2 units c) 1 unit d) 5 units e) 6 units ANSWER: d SECTION REFERENCE: Marginal Revenue and Marginal Cost DIFFICULTY LEVEL: Medium
19. Given that a firm's inverse demand function is P = 100 – 5Q and total cost is given by C = 550 + 10Q, what is the firm's profit-maximizing level of output? a) 10 units b) 15 units c) 9 units d) 8 units e) 5 units ANSWER: c SECTION REFERENCE: Marginal Revenue and Marginal Cost DIFFICULTY LEVEL: Medium
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20. Which of the following correctly defines marginal cost? a) Marginal cost is the addition made to fixed cost when an extra unit is produced. b) Marginal cost is the additional cost of producing an extra unit of output. c) Marginal cost is the additional cost of increasing the scale of production in the long run. d) Marginal cost is the difference between price and marginal revenue for the last unit sold. e) Marginal cost is the same as the firm’s variable cost at all levels of output. ANSWER: b SECTION REFERENCE: Marginal Revenue and Marginal Cost DIFFICULTY LEVEL: Easy
21. Given the total cost equation for a firm, the marginal cost equation can be derived by: a) dividing total cost by total output. b) taking the first derivative of the cost function with respect to quantity. c) dividing total variable cost by total output. d) subtracting variable cost from the fixed cost at all levels of output. e) multiplying the total cost equation by price. ANSWER: b SECTION REFERENCE: Marginal Revenue and Marginal Cost DIFFICULTY LEVEL: Easy
22. To maximize profit, the firm should set output at the level where: a) the average cost per unit is minimized. b) average revenue just equals average cost. c) marginal cost equals zero. d) marginal revenue is equal to marginal cost. e) marginal revenue equals zero. ANSWER: d SECTION REFERENCE: Marginal Revenue and Marginal Cost DIFFICULTY LEVEL: Easy
23. Assume that a firm is producing at its profit-maximizing level of output. A decrease in the price of raw materials used in production is most likely to lead to: a) an increase in quantity produced at an unchanged price. b) a fall in the price of the good and an increase in the quantity produced. c) a fall in both the price of the good and the quantity produced. d) an increase in both the price of the good and the quantity produced. e) a fall in the quantity produced of the good at an unchanged price. 2-7
Optimal Decisions Using Marginal Analysis
ANSWER: b SECTION REFERENCE: Sensitivity Analysis DIFFICULTY LEVEL: Medium
24. A firm negotiates a new labor contract with a higher average hourly wage. What is the most likely effect of the higher wage on the firm's price and output? a) Neither price nor output will be affected. b) Price will increase but output will not change. c) Both price and output will increase. d) Price will not change but output will decrease. e) Price will increase and output will decrease. ANSWER: e SECTION REFERENCE: Sensitivity Analysis DIFFICULTY LEVEL: Medium
25. Assume that a firm is producing at its profit-maximizing level of output. A decrease in fixed cost implies that: a) marginal revenue will increase but marginal cost will decrease. b) marginal revenue will not change but marginal cost will decrease. c) neither average total cost nor marginal cost will change. d) neither marginal revenue nor marginal cost will change. e) both marginal revenue and marginal cost will decrease. ANSWER: d SECTION REFERENCE: Sensitivity Analysis DIFFICULTY LEVEL: Medium
26. Due to an increase in the price of a competitor’s product, the demand for a firm’s product increases sharply. How is this most likely to affect the firm’s marginal revenue and marginal cost? a) Marginal revenue will increase but marginal cost will decrease. b) Both marginal revenue and marginal cost will not be affected. c) Both marginal revenue and marginal cost will increase. d) Marginal revenue will not change but marginal cost will increase. e) Marginal revenue will increase but marginal cost will not change. ANSWER: e SECTION REFERENCE: Sensitivity Analysis DIFFICULTY LEVEL: Medium
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27. Assume that Burger King, a fast food chain, enters into a franchise agreement. The royalty paid to Burger King by the franchisee is calculated as a percentage of the franchisee’s revenue. Given that the franchisee faces a downward-sloping demand curve, which of the following is likely to be true? a) The franchisee’s revenue-maximizing output will be greater than its profit-maximizing output. b) To maximize revenue, Burger King will want the franchisee to produce at the level where total revenue is positive but falling. c) The franchisee will produce at the level where the slope of the total revenue curve is zero in order to maximize profits. d) The profit-maximizing level of output for the franchisee will be at the level where marginal revenue is less than marginal cost. e) To maximize revenue, Burger King will want the franchisee to produce at the level where marginal revenue equals marginal cost. ANSWER: a SECTION REFERENCE: Sensitivity Analysis DIFFICULTY LEVEL: Hard
SHORT ANSWERS 28. Are there any types of goods or situations where the law of demand does not hold? Explain. ANSWER: The law of demand states that all other factors held constant, the higher the unit price of a good, the fewer the number of units demanded by consumers and, consequently, sold by firms. For certain goods, a high price is associated with a higher status or luxury, for example, a fancy wine or a designer bag. For such goods, a high price is seen as a sign of exclusivity, which means that the demand for these goods might increase as price increases. These are called Veblen goods. SECTION REFERENCE: A Simple Model of the Firm DIFFICULTY LEVEL: Medium
29. What is the law of demand? How do managers use it in decision-making? ANSWER: The law of demand states that all other factors held constant, the higher the unit price of a good, the fewer the number of units demanded by consumers and, consequently, sold by the firm. Managers use the demand curve as the basis for predicting the revenue consequences of alternative output and pricing policies. SECTION REFERENCE: A Simple Model of the Firm DIFFICULTY LEVEL: Easy
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Optimal Decisions Using Marginal Analysis
30. Carefully define marginal analysis, and explain how it is useful in managerial economics. ANSWER: Marginal analysis is the process of considering small changes in a decision and determining whether such a change will improve the ultimate objective. The manager can follow a clear rule: Make a small move to a nearby alternative if and only if the move will improve one's objective. Keep moving until no further move will help. SECTION REFERENCE: Marginal Analysis DIFFICULTY LEVEL: Easy
31. Suppose that a firm operates in a competitive market where the commodity price is $15 per unit. The firm’s cost equation is C = 25 + .25Q2, where C = total cost and Q = quantity. (a) Find the profit-maximizing level of output for the firm. Determine its level of profit. ANSWER: In a competitive market, R = P × Q = 15Q implying MR = dR/dQ = $15. In turn, marginal cost is: MC = dC/dQ = .5Q. Setting MR = MC implies 15 = .5Q, or Q = 30 units. At Q = 30 units, R = $450, C =$250, and profit = $200. SECTION REFERENCE: Marginal Revenue and Marginal Cost DIFFICULTY LEVEL: Medium (b) Suppose that fixed costs increase to $75. Verify that this change in fixed costs does not affect the firm's optimal output. ANSWER: The increase in fixed cost has no effect on MR or MC, so setting MR = MC, again implies Q* = 30 units. The firm's optimal level of output is unaffected. However, with the $50 rise in fixed cost, the firm's profit falls to $150. SECTION REFERENCE: Sensitivity Analysis DIFFICULTY LEVEL: Medium
32. The demand for a firm’s product is given by the equation: P = 36 – .2Q. The firm’s cost equation is given by C = 200 + 20Q. (a) Determine the firm’s optimal quantity and price. ANSWER: MR = dR/dQ = 36 – .4Q and MC = dC/dQ = $20. Setting MR = MC implies Q* = 40 units, as the optimal output. From the price equation, it follows that the optimal price is: P* = 36 – (.2)(40) = $28. Finally, profit is given by: = $1,120 – 1,000 = $120. SECTION REFERENCE: Marginal Revenue and Marginal Cost DIFFICULTY LEVEL: Medium (b) Suppose that the firm’s costs change to C = 100 + 24Q. Determine the new optimal quantity and price. Explain why the results differ from the previous case.
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ANSWER: With the new cost function, MC = $24. Setting MR = MC implies 36 – .4Q = 24, or Q* = 30 units. In turn, P* = 36 – (.2)(30) = $30. Finally, profit is given by: = $900 – $820 = $80. Here, the reduction in fixed cost has no impact on output, but the increase in marginal cost induces a smaller output quantity and a greater price. SECTION REFERENCE: Sensitivity Analysis DIFFICULTY LEVEL: Medium
33. A firm faces the demand curve, P = 80 – 3Q, and has the cost equation: C = 200 + 20Q, where P = price, C = total cost, and Q = quantity. (a) Find the optimal quantity and price for the firm. ANSWER: Profit is maximized by setting MR = MC. From the price equation, MR = 80 – 6Q. Equating this with MC = $20 implies 80 – 6Q = 20, so the optimal level of output is: Q* = 10 units. In turn, the optimal price is: P* = 80 – (3)(10) = $50. SECTION REFERENCE: Marginal Revenue and Marginal Cost DIFFICULTY LEVEL: Medium (b) Now suppose that the demand for the firm’s product changes to: P = 110 – 3Q. Find the new optimal quantity and price. Has there been an increase or a decrease in demand? Explain. ANSWER: Given the new price equation, P = 110 – 3Q, it follows that MR = 110 – 6Q. Setting MR = MC implies 110 – 6Q = 20, or Q* = 15 units. In turn, P* = 110 – (3)(15) = $65. The increase in demand (in this case a parallel outward shift of the demand curve) has induced the firm to increase both its price and quantity. SECTION REFERENCE: Sensitivity Analysis DIFFICULTY LEVEL: Medium
34. Suppose the inverse demand curve of a firm is given by the equation: P = 2,500 – 10Q. Compute the firm’s total revenue and marginal revenue, and determine the quantity that maximizes total revenue. ANSWER: R = P × Q = 2,500Q – 10Q2. In turn, MR = 2,500 – 20Q. Revenue is maximized when MR equal to 0. Therefore, 2,500 – 20Q = 0 implies Q = 125. SECTION REFERENCE: Marginal Revenue and Marginal Cost DIFFICULTY LEVEL: Medium
35. Suppose that a firm sells in a competitive market at a fixed price of $12 per unit. The firm's cost function is: C = 200 + 4Q. In this case, how can the firm use marginal revenue and marginal cost to maximize its profit? 2-11
Optimal Decisions Using Marginal Analysis
ANSWER: Here, total revenue = 12Q so that MR = $12. In turn, MC = $4. Since MR > MC, the firm gains additional profit by continuing to increase output. It should do so until it reaches the capacity limit of its production facility. SECTION REFERENCE: Marginal Revenue and Marginal Cost DIFFICULTY LEVEL: Medium
36. In each case below, find the profit-maximizing level of output. Verify that each output level is a maximum by checking the second derivative. (a) = –50 + 200Q – 10Q2 ANSWER: M = 200 – 20Q. Setting M = 0 implies: Q* = 10. The second derivative is equal to –20, which is negative implying that Q* = 10 is the profit-maximizing level of output. SECTION REFERENCE: Calculus and Optimization Techniques (Appendix) DIFFICULTY LEVEL: Medium (b) = –100 + 300Q – 4Q3 ANSWER: M = 300 – 12Q2. Setting M = 0 implies: Q* = 5. The second derivative is equal to –24Q, which is negative implying that Q* = 5 is the profit-maximizing level of output. SECTION REFERENCE: Calculus and Optimization Techniques (Appendix) DIFFICULTY LEVEL: Medium
37. Carefully explain the economic importance of the Lagrange multiplier. How might a manager use it in decision making? ANSWER: The Lagrange multiplier measures the marginal change in the objective function at the constrained optimum. Thus, it measures the cost to the firm (in terms of lost profit) of the binding constraint. Managers can use the value of the Lagrange multiplier to determine whether it is worthwhile to relax or shift the constraint. For example, suppose that the cost of relaxing a constraint (for instance, increasing the firm’s limited production capacity) is larger than the increase in profits that would result from the change. In this case, it does not pay to expand capacity. Management should accept the constrained level of profit as the optimal outcome. SECTION REFERENCE: Calculus and Optimization Techniques (Appendix) DIFFICULTY LEVEL: Medium
ESSAY 2-12
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38. How will an increase in price affect the quantity of output sold by a firm? What are the reasons for this change? ANSWER: According to the law of demand, a change in price will lead to a drop in the quantity of output sold by a firm. There are three sources of the decrease in demand: (1) decreased sales to the firm's current customers, as they choose to buy less at the higher price; (2) sales lost to competing suppliers; and (3) decrease in new customers, who choose to buy from competing suppliers. In particular circumstances, these factors will be important to a greater or lesser degree. SECTION REFERENCE: A Simple Model of the Firm DIFFICULTY LEVEL: Easy
39. Assume that Turbo is a firm that produces two kinds of flash-memory drives. Its deluxe model has the inverse demand equation: PD = 70 – .05QD, where QD is the number of units sold per week. For its economy model, the price equation is: PE = 30 – .05QE. Turbo’s marginal cost is $10 per unit for either drive, and it produces both on a single assembly line that has a maximum capacity of 875 drives per week. (a) Determine the profit-maximizing outputs and prices of the drives. ANSWER: Setting the marginal profit from the sale of the deluxe model equal to zero implies MD = 60 – .1QD = 0 or QD = 600 drives. For the economy version, ME = 20 – .1QE = 0, so QE = 200 drives. The corresponding prices are: PD = $40 and PE = $20. The total output (600 + 200 < 857) is within the firm’s capacity. SECTION REFERENCE: Marginal Analysis DIFFICULTY LEVEL: Medium (b) Suppose demand for the economy drive increases to: PE = 50 – .04QE. What are the profit-maximizing outputs and prices of the drives? ANSWER: Given the increase in demand for the economy drives, Turbo’s new optimal output becomes QE = 500 drives, so total output would exceed total capacity. The constrained optimization problem (using the Lagrangian approach) must satisfy the optimality condition: MD = ME, or 60 – .1QD = 40 – .08QE, as well as the capacity constraint, QD + QE = 875. Solving these two equations in two unknowns implies QD = 500 drives and QE = 375 drives. The new prices are: PD = $45 and PE = $35. SECTION REFERENCE: Calculus and Optimization Techniques (Appendix) DIFFICULTY LEVEL: Hard
40. War Game, Inc. produces games that simulate historical battles. The market is small but loyal, and War Game is the largest manufacturer. It is thinking about introducing a new game in honor of the sixtieth anniversary of the end of World War II. Based on historical data regarding sales, War Game management forecasts demand for this game to be P = 50 – 2-13
Optimal Decisions Using Marginal Analysis
.002Q, where Q denotes unit sales per year, and P denotes price in dollars. The cost of manufacturing (based on royalty payments to the designer of the game, and the costs of printing and distributing) is C = 140,000 + 10Q. (a) If the goal of War Game is to maximize profit, calculate the optimal output and price. ANSWER: The company's profit equation is: = (50Q – .002Q2) – 10Q – 140,000. To maximize profit, set marginal profit equal to 0. Therefore, M = 40 – .004Q = 0, implying optimal output, Q* = 10,000 units. In turn, P = 50 – (.002)(10,000) = $30 per unit of the game. SECTION REFERENCE: Marginal Analysis DIFFICULTY LEVEL: Medium (b) If instead the company's goal is to maximize sales revenue, what is its optimal price and quantity? ANSWER: The company's revenue equation is given by: R = P × Q = 50Q – .002Q2. To maximize revenue, set marginal revenue equal to 0. Therefore, 50 – .004Q = 0, implying optimal output, Q*= 12,500 units. In turn, P = 50 – (.002)(12,500) = $25 per unit of the game. SECTION REFERENCE: Marginal Revenue and Marginal Cost DIFFICULTY LEVEL: Medium
41. A manufacturing company produces and sells small farm tractors. Its annual fixed costs are $15 million, and its marginal cost per tractor is $20,000. Demand for small tractors is given by: P = 30,000 – Q, where P denotes price in dollars and Q is annual sales. (a) Find the firm's profit-maximizing output, price, and annual profit. ANSWER: To maximize profit, marginal revenue should be equal to marginal cost Therefore, MR = 30,000 – 2Q = 20,000, implying optimal output, Q* = 5,000 tractors and P = 30,000 – 5000 = $25,000 per tractor. The firm’s total profit is: ($25,000 – $20,000)(5,000) – $15,000,000 = $10,000,000. SECTION REFERENCE: Marginal Revenue and Marginal Cost DIFFICULTY LEVEL: Medium (b) Assume that agriculture prices fall and the farming sector faces a mild recession. The demand for the small tractors drops to: P = 26,000 – Q. Suppose the recession is only temporary, and demand will recover soon. What price and output adjustment should the firm make during the recession? ANSWER: With the fall in demand, the firm’s new optimal output can be obtained by setting MR = MC: MR = 26,000 – 2Q = 20,000, implying Q* = 3,000 tractors and P* = 26,000 – 3,000 = $23,000 per tractor. The firm’s total profit is: ($23,000 – $20,000)(3,000) –
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$15,000,000 = -$6,000,000. In the short run, the firm is minimizing its losses while waiting for sales to recover. SECTION REFERENCE: Marginal Revenue and Marginal Cost DIFFICULTY LEVEL: Medium
42. KopyKat is a firm that specializes in printing business cards and résumé’s, using the latest laser technology. The manager has estimated that weekly demand can be approximated by P = 25 – .001Q, where P is price and Q is output per week. The firm’s cost function is C = 25,000 + 13Q + .002Q2, where C is total cost. (a) Determine the firm’s profit maximizing price and output. ANSWER: The firm’s inverse demand function is P = 25 – .001Q which implies MR = 25 – .002Q. Also MC = dC/dQ = 13 + .004Q. Setting MR = MC, yields: 25 – .002Q = 13 + .004Q, or .006Q = 12. Thus, the profit-maximizing output is 2,000 units per week. The optimal price is: P = 25 – (.001)(2,000) = $23 per unit. SECTION REFERENCE: Marginal Revenue and Marginal Cost DIFFICULTY LEVEL: Medium (b) The night supervisor believes that extending KopyKat’s hours by two hours in the evening would substantially increase volume. The manager is willing to stay open for two hours over the next three months as an experiment. What results would lead the manager to decide if the store can remain open later in the evening on a permanent basis? ANSWER: Keeping KopyKat open for additional hours means incurring some additional labor costs (If volume increases, production cost will increase as well). As always, the decision for the manager hinges on whether the increased volume from longer hours generates enough additional revenue to cover the increased cost of longer hours. An experiment for three months should presumably provide enough data to let the manager decide if the move is worth it in terms of the increased revenues and increased cost. SECTION REFERENCE: Sensitivity Analysis DIFFICULTY LEVEL: Hard (c) A former employee decides to sue KopyKat, alleging employment discrimination. Although management claims innocence, they agree to settle out of court. The settlement requires KopyKat to pay the employee $10,000 per month for the next year. Determine the optimal price and output for the firm under these new conditions. ANSWER: The payment of $10,000 per month represents an increase in the firm's fixed costs and has no impact on marginal revenue or marginal cost. Thus, the firm should not alter its pricing or production decisions. SECTION REFERENCE: Sensitivity Analysis DIFFICULTY LEVEL: Hard
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Optimal Decisions Using Marginal Analysis
43. Max Whitley, manager of Whitley Construction, builds new homes in a booming community in the Midwest. Although sales have slowed because of a national recession, it now looks as if the recession is about to end. Max wants to be ready with material, labor, and foremen to meet the demand for housing. Last year, Max built and sold 40 starter homes which is the most popular model. Max thinks that his sales will increase to 50 units over the current year. The going market price for this model (which Max and his numerous competitors have charged) has been $275,000. In addition, Whitley Construction's marginal cost of building this model averages $245,000. (a) Based on these facts, recommend a course of action for Max. ANSWER: Since Max can expect to make $30,000 marginal profit on each home, he should attempt to build and sell a maximum number of units. He should monitor market demand and examine whether home sales really robust enough to justify building 50 units. If the price is truly market determined (note that he has many competitors), Max may not be able to increase his sale price considerably. However, he should take advantage of every opportunity to sell more homes, since marginal revenue is above marginal cost. SECTION REFERENCE: Marginal Revenue and Marginal Cost DIFFICULTY LEVEL: Medium (b) Suppose that the economic boom raises the cost of labor and raw materials, so that the additional cost of a starter house rises to $265,000. What is Max's most profitable course of action? Explain. ANSWER: If the market price is competitively determined, Max will have little opportunity to pass on such a cost increase in the form of a higher price (Whitley's new home sales would dwindle quickly if it charged a price above the competitive level). The most profitable course of action is to sell new homes at the lower profit margin of $10,000 per house. An alternative choice is to reduce construction of starter homes and increase production of larger, more expensive homes, assuming that the profit margins are greater on these. SECTION REFERENCE: A Simple Model of the Firm DIFFICULTY LEVEL: Hard
44. Night Timers is a small company manufacturing glow-in-the-dark products. One of the hottest items the engineering department has developed is adhesive tape that can be applied to walls and floors. Night Timers' chief engineer anticipates that the product will be sold in ten-foot rolls. At present, the company's maximum production capacity is 140,000 rolls per year. The engineer believes the cost function to be described by C = $50,000 + 0.25Q, where C is total cost and Q is number of rolls (The high fixed costs represent development cost and tooling to prepare coating equipment). Night Timers' president seeks to establish a price that maximizes profit (since she is the chief stockholder). She thinks that the firm should be able to sell at least 125,000 rolls of tape per year. (a) If Night Timers plans to sell 125,000 rolls per year, what is the necessary price if the firm is to break even? What if it can only sell 100,000? 2-16
Chapter 2
ANSWER: Break even implies R = C, or P × Q = 50,000 + .25Q at the level of output indicated. To find the break-even price, substitute Q = 125,000 and solve for P. Thus P = $.65 per unit. If Q = 100,000, the break-even price rises to P = $.75 per unit. SECTION REFERENCE: Marginal Revenue and Marginal Cost DIFFICULTY LEVEL: Medium (b) The marketing manager forecasts demand for the tape to be: Q = 350,000 - 200,000P. Find the firm's profit-maximizing output and price. ANSWER: The demand equation can be rearranged as: P = 1.75 – Q/200,000. Thus, MR = 1.75 – Q/100,000. From the cost function, MC = $.25. Setting MR = MC implies: 1.75 – Q/100,000 = 0.25. Therefore, Q = (1.5)(100,000) = 150,000 rolls. However, maximum capacity is 140,000 rolls. Thus, an output of 140,000 is the maximum the company can expect to sell. The requisite price is: P = 1.75 – 140,000/200,000 = $1.05. The firm's projected profit is: (1.05 – 0.25)(140,000) – 50,000 = $62,000. SECTION REFERENCE: Marginal Analysis, Marginal Revenue and Marginal Cost DIFFICULTY LEVEL: Medium (c) If the estimated demand as given by Q = 350,000 - 200,000P is realized in the first year of production, should the company consider expanding capacity? Explain. ANSWER: The relevant question is whether the increased profit of expanding capacity exceeds the increased cost of doing so. If the firm could produce and sell 150,000 rolls (by lowering price to $1), the company's profit would increase very slightly to ($1 – $0.25)(150,000) – $50,000 = $62,500. The extra $500 in profit is clearly not worth the cost of expansion. SECTION REFERENCE: Marginal Analysis DIFFICULTY LEVEL: Hard
45. (a) How will an increase in overhead costs affect the demand and supply curves for a firm? Will an increase in the price of a raw material used in production have the same effect? ANSWER: An increase in the overhead cost is the same as an increase in the fixed cost of a firm. An increase in fixed cost will shift the total cost line upward, parallel to the previous total cost line. At every level of output, the difference between revenue and cost will reduce by the amount of the overhead cost. The level of output will be the same; at the point of intersection of the marginal revenue and marginal cost curves. When the price of a raw material increases, the fixed cost remains the same but the marginal cost of producing each unit of the good increases. The marginal cost curve will shift upward in a parallel manner. Since it intersects the marginal revenue curve, the level of output produced will fall and the price will increase. SECTION REFERENCE: Sensitivity analysis DIFFICULTY LEVEL: Medium
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Optimal Decisions Using Marginal Analysis
(b) Given that the output in the market is supplied by both domestic and foreign firms, how would a depreciation of the domestic currency in terms of the foreign currency affect the domestic firm? ANSWER: A depreciation of the domestic currency which is valued in terms of the foreign currency, will increase the price of imports for domestic consumers. This means that the demand curve facing the foreign firms will shift inward. Correspondingly, the domestic demand curve facing domestic firms will shift outward. With an outward shift of the demand curve, domestic firms will increase their output and price. SECTION REFERENCE: Sensitivity analysis DIFFICULTY LEVEL: Hard
46. The current manager of a small bicycle shop estimates the demand curve for a child’s starter bike to be: P = 80 – 2Q. Costs are given by: C = 200 + 20Q. The former owner of the shop (now retired) urges the manager to keep prices low so as to increase sales and maximize revenue. (The shop pays the former owner 5% of each dollar of earned revenue). If current management follows the former owner’s goal, what sales output and price should it set? What strategy would you recommend to maximize profits? ANSWER: If the manager obeys the wishes of the former owner and maximizes revenue, she would set output at the point where marginal revenue equals 0. The total revenue can be obtained from the firm’s demand curve as: R = price × quantity = (80 – 2Q)Q = 80Q – 2Q2‚ so that MR = dR/dQ = 80 – 4Q. Setting MR = 0 implies Q = 20 bikes. In turn, P = $40 per bike and = R - C = 800 – 600 = $200. However, the firm’s real goal should be to maximize profit. Thus, the manager should follow the optimal MR = MC rule. It follows that 80 - 4Q = 20, or Q = 15 bikes. In turn, P = $50 per bike, and = R - C = 750 – 500 = $250. With an optimal output and pricing policy, the shop can increase its profit by 25% compared to the revenue-maximizing outcome. SECTION REFERENCE: Sensitivity Analysis DIFFICULTY LEVEL: Medium
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