Macroeconomics, 11e (Parkin)
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1. What is a firm’s fundamental goal and what happens if the firm doesn’t pursue this goal?
A firm’s fundamental goal is to maximize its profit. If the firm fails to maximize profit it is either eliminated or bought out by other firms maximizing profit
2. Why do accountants and economists calculate a firm’s cost and profit in different ways?
Accountants and economists have different reasons for computing a firm’s costs. An accountant calculates a firm’s cost and profit to ensure that the firm pays the correct amount of income tax and to show its investors how their funds are being used. An economist calculates a firm’s cost and profit in a way that enables him or her to predict the firm's decisions.
3. What are the items that make opportunity cost differ from the accountant’s measure of cost?
A firm’s opportunity cost includes the cost of using resources bought in the market, owned by the firm and supplied by the firm's owner. Economists and accountants both include the price of resources bought in the market as costs. But accountants omit costs included by economists. For instance, use of a building the owner has already purchased has an opportunity cost that accountants do not include. Additionally the normal profit, interest foregone, and economic depreciation are other opportunity costs not recorded by an accountant.
4. Why is normal profit an opportunity cost?
Normal profit is the return to a firm’s owner for the owner’s supply of entrepreneurial ability and labor to the firm’s production process. Using the owner’s ability to run the business implies that the owner could have received a return for using it in another capacity, such as running another firm. This cost is an opportunity cost for the firm because it is the cost of a forgone alternative, which is running another firm, and must be included in calculating the firm’s opportunity cost of production
5. What are the constraints that a firm faces? How does each constraint limit the firm’s profit?
The three types of constraints a firm faces are technology constraints, information constraints, and market constraints. Technology is any specific method of producing a good or service and it advances
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over time. Using the available technology, the firm can produce more only if it hires more resources, which will increase its costs and limit the profit of additional output. Information is never complete, for the future or the present. A firm is constrained by limited information about the quality and effort of its work force, current and future buying plans of its customers, and the plans of its competitors. The cost of coping with limited information itself limits profit. Market constraints mean that what each firm can sell and the price it can obtain are constrained by its customers’ willingness to pay and by the prices and marketing efforts of other firms. The resources that a firm can buy and the prices it must pay for them are limited by the willingness of people to work for and invest in the firm. The expenditures a firm incurs to overcome these market constraints will limit the profit the firm can make.
1. Is a firm technologically efficient if it uses the latest technology? Why or why not?
Technological efficiency occurs when a firm produces a given level of output using the least amount of inputs. Adopting the latest available technology does not necessarily imply that a firm’s production process is technologically efficient. As long as the firm is getting the maximum possible output for a given combination of inputs, it is technologically efficient.
2. Is a firm economically inefficient if it can cut its costs by producing less? Why or why not?
Economic efficiency occurs when the firm produces a given level of output at the least cost. If a firm can decrease production costs by decreasing output, it is not necessarily economically inefficient. If it is producing the new level of output at the least possible cost, it is achieving economic efficiency.
3. Explain the key distinction between technological efficiency and economic efficiency. The difference between technological and economic efficiency is that technological efficiency concerns the quantity of inputs used in production for a given level of output, whereas economic efficiency concerns the value of the inputs used. Economic efficiency requires technological efficiency, but technological efficiency does not require economic efficiency.
4. Why do some firms use large amounts of capital and small amounts of labor while others use small amounts of capital and large amounts of labor?
The mix of resources used, such as large amounts of capital versus small amounts of capital, depends on economic efficiency. Economic efficiency is based on minimizing the value of the resources used, not the quantity. A firm will use the mix that produces output at the lowest possible cost, without regard to specific physical quantities or ratios of inputs. As the cost of capital decreases relative to the cost of other resources, capital-intensive production methods will become economically efficient and firms will avoid labor-intensive methods.
1. Explain the distinction between a command system and an incentive system. A command system uses a managerial hierarchy, where commands pass downward through the hierarchy and information (feedback) passes upward. These systems are relatively rigid and can have many layers of specialized management. Incentive systems use market-like mechanisms to induce workers to perform in ways that maximize the firm’s profit.
2. What is the principal-agent problem? What are three ways in which firms try to cope with it?
The principal-agent problem is the problem of devising compensation rules that induce an agent to act in the best interests of a principal. There are three ways of coping with this problem: Ownership, often offered to managers, gives the agents an incentive to maximize the firm’s profits, which is the goal of the owners, the principals; incentive pay links managers’ or workers’ pay to the firm’s performance and helps align the managers’ and workers’ interests with those of the owners, the principal; long-term
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contracts tie managers’ or workers’ long-term rewards to the long-term performance of the firm, encouraging the agents to work in the best long-term interests of the firm owners, the principals.
3. What are the three types of firms? Explain the major advantages and disadvantages of each. The three main ways of organizing a firm have both advantages and disadvantages:
Proprietorship. ADVANTAGES easy to set up; managerial decision-making is simple and rapid; and profits are taxed only once. DISADVANTAGES bad decisions on the part of the owner are not subject to review; the owner’s entire wealth is at stake because of unlimited liability; the firm dies with the owner; and acquiring capital and labor is expensive.
Partnership. ADVANTAGES easy to set up; has diversified decision-making so that more than one person’s expertise can be utilized; can survive the death or withdrawal of a partner; and profits are taxed only once. DISADVANTAGES all the owners’ wealth is at risk because of unlimited liability; if there are many partners, gaining a consensus about managerial decisions may be difficult; the withdrawal of partner may create capital shortage; labor costs are high compared to corporations; and capital costs can be high.
Corporation. ADVANTAGES perpetual life; limited liability for its owners; readily available, large-scale, and low-cost capital; can rely on professional managers rather than the talents of the owners; and reduced costs from long-term labor contracts. DISADVANTAGES potentially complex management structure may lead to slow and expensive decision-making; and profits are taxed twice, once as corporate profit and once as income to the stockholders.
1. What are the four market types? Explain the distinguishing characteristics of each. Economists identify four market types:
1. Perfect competition is a market with many firms, each selling an identical product. There are many buyers and no restrictions on entry of new firms. Firms and buyers are all well informed of prices and products of all firms in the industry.
2. Monopolistic competition is a market with many firms that produce similar but slightly different goods.
3. Oligopoly is a market in which a small number of firms compete and each firm may produce almost identical or differentiated goods.
4. Monopoly is a market in which only one firm produces the entire output of the industry. There are no close substitutes for the monopolist’s product and there are barriers to entry that protect the firm from competition of entering firms.
2. What are the two measures of concentration? Explain how each measure is calculated. Two measures of concentration have been developed and are in common use: the four-firm concentration ratio and the Herfindahl–Hirschman Index (HHI).
1. The four-firm concentration ratio is the percentage of the total industry sales accounted for by the four largest firms in the industry.
2. The Herfindahl–Hirschman Index (HHI) equals the sum of the squared market shares of the 50 largest firms in the industry.
3. Under what conditions do the measures of concentration give a good indication of the degree of competition in a market?
Concentration measures give a good indication of the degree of competition in a market if the following characteristics of the industry market are correct:
1. The industry market is national in scope, rather than local or international.
2. There are no concerns about over-stating or under-stating the extent of barriers to entry.
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3. Firms are not misclassified with respect to their markets.
4. Is the U.S. economy competitive? Is it becoming more competitive or less competitive?
The U.S. economy would be considered competitive since three-quarters of the value of goods and services bought are in markets characterized as perfect competition or monopolistic competition. The U.S. economy has become increasingly competitive over the decades.
1. What are the two ways in which economic activity can be coordinated? Firms and markets both coordinate resources.
2. What determines whether a firm or markets coordinate production?
Firms coordinate resources when they can do so at lower cost than can a market.
1. Firms may reduce transactions costs, which are the costs arising from finding someone with whom to do business, reaching agreement on the price and other aspects of the exchange, and ensuring that the terms of the agreement are fulfilled.
2. Firms can capture economies of scale, which occurs when the cost of producing a unit falls as its output rate increases.
3. Firms can capture economies of scope, where one firm can use specialized inputs to produce a range of different goods at a lower cost than otherwise
4. Firms can engage in team production, in which the individuals specialize in mutually supportive tasks.
Firms coordinate economic activity when they can perform a task more efficiently than markets can. In such a situation, it is profitable to set up a firm. If markets can perform a task more efficiently than a firm can, firms will use markets, and any attempt to set up a firm to replace such market coordination will be doomed to failure.
3. What are the main reasons why firms can often coordinate production at a lower cost than markets can?
Firms can often coordinate production at a lower cost than can markets because firms lower transactions costs and achieve economies of scale, scope, and team production. These opportunities are not present when markets coordinate production.
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1. One year ago, Jack and Jill set up a vinegar-bottling firm (called JJVB). Use the following information to calculate JJVB’s opportunity cost of production during its first year of operation:
Jack and Jill put $50,000 of their own money into the firm.
They bought equipment for $30,000.
They hired one employee to help them for an annual wage of $20,000.
Jack gave up his previous job, at which he earned $30,000, and spent all his time working for JJVB.
Jill kept her old job, which paid $30 an hour, but gave up 10 hours of leisure each week (for 50 weeks) to work for JJVB.
JJVB bought $10,000 of goods and services from other firms.
The market value of the equipment at the end of the year was $28,000.
Jack and Jill have a $100,000 home loan on which they pay interest of 6 percent a year. The wages paid, $20,000, and the goods and services bought from other firms, $10,000, are opportunity costs to JJVB. Other opportunity costs include the interest forgone on the $50,000 put into the firm, which could have been used to pay part of the mortgage, so the interest forgone is $3,000; the $30,000 income forgone by Jack not working at his previous job; $15,000, which is the value of 500 hours of Jill’s leisure (10 hours a week for 50 weeks); and the economic depreciation of $2,000 ($30,000 minus $28,000). JJVB’s total opportunity cost is the sum of all these opportunity costs and is $80,000
2. Joe, who has no skills, no job experience, and no alternative employment, runs a shoeshine stand at the airport. Operators of other shoeshine stands earn $10,000 a year. Joe pays rent to the airport of $2,000 a year, and his total revenue from shining shoes is $15,000 a year. Joe spent $1,000 on a chair, polish, and brushes, using his credit card to buy them. The interest on a credit card balance is 20 percent a year. At the end of the year, Joe was offered $500 for his business and all its equipment. Calculate Joe’s opportunity cost of production and his economic profit. Joe’s opportunity costs are the $2,000 paid to the airport for the space; the $200 for the interest paid on the $1,000 credit card balance; the $10,000 of normal profit; and, the $500 for the depreciation of his equipment (which equals the $1,000 paid for the chair, polish, and brushes minus the $500 he was offered for this equipment). Joe’s total opportunity cost is the sum of these costs, which is $12,700. Joe’s economic profit is his total revenue, $15,000, minus his total opportunity cost, $12,700, for an economic profit of $2,300.
3. Alternative ways of laundering 100 shirts are in the table.
a. Which methods are technologically efficient?
All the methods are technologically efficient.
b. Which method is economically efficient if the hourly wage rate and the implicit rental rate of capital are as follows:
(i) Wage rate $1, rental rate $100?
Method D is economically efficient because the total cost is the least. Method D’s costs are 50 $1 + 1 $100, or $150.
(ii) Wage rate $5, rental rate $50?
Method D and Method C are economically efficient because the total cost is the least. Method C’s costs are 20 $5 + 4 $50, or $300 and Method D’s costs are 50 $5 + 1 $50, also $300
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(iii)Wage rate $50, rental rate $5?
Method A is economically efficient because the total cost is the least. Method A’s costs are 1 $50 + 10 $5, or $100.
4. John Deere’s Farm Team
Deere opened up the Pune [India] center in 2001. Deere’s move was unexpected: Deere is known for its heavy-duty farm equipment and big construction gear whereas many of India’s 300 million farmers still use oxen-pulled plows.
Source: Fortune, April 14, 2008
a. Why do many Indian farmers still use oxen-pulled plows? Are they efficient or inefficient?
Explain.
Many Indian farmers use oxen-pulled plows because the cost of tractors is too high. Using oxen-pulled plows allows farmers to produce at lower cost than if they used tractors. Because of the lower cost, Indian farmers may well be economically efficient.
b. How might making John Deere farm equipment available to Indian farmers change the technology constraint they face?
The presence of John Deere in the Indian market will increase the supply of tractors and lower their price. By lowering their cost so that using a tractor is now economically efficient, Indian farmers will switch production methods. Their technology constraint will change as a result of using the additional capital equipment and the farmers will be able to produce more output than before.
5. Here It
The idea is that the most successful companies no longer invent new products and services on their own. They create them along with their customers, and they do it in a way that produces a unique experience for each customer. The important corollary is that no company owns enough resources or can possibly own enough to furnish unique experiences for each customer, so companies must organize a constantly shifting global web of suppliers and partners to do the job.
Source: Fortune, May 26, 2008
a. Describe this method of organizing and coordinating production: Does it use a command system or incentive system?
This method uses an incentive system to organize and coordinate production. The resources are not under the constant supervision of the employer and so a command system of coordinating production would not work. Instead the firm uses an incentive system giving the resources necessary for a project an incentive to cooperate by paying them for their share of the project to organize the production.
b. How does this method of organizing and coordinating production help firms achieve lower costs?
The design firm has lower costs because it uses different resources with each project. If the design firm owned all the resources, and therefore used a command system to organize production, the firm would need to pay for all the resources for each and every project. But for many of the projects some of the resources would be unused. Hence the firm’s costs would be significantly higher than if it paid for only the resources actually used, as it does when it uses an incentive system of organization.
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Over the past 25 years CEO pay has risen faster than corporate profits, economic growth, or average wages. A more sensible alternative to the current compensation system would require CEOs to own a lot of company stock. If the stock is given to the boss, his salary and bonus should be docked to reflect its value. As for bonuses, they should be based on improving a company’s cash earnings relative to its cost of capital, not to manipulated measures like earnings per share. Bonuses should not be capped but be unavailable to the CEO for some period of years.
Source: Fortune, April 28, 2008
a. What is the economic problem that CEO compensation schemes are designed to solve?
CEO compensation schemes are designed to overcome the principal-agent problem. A CEO’s decisions can have large effects on the company’s profitability. The principals, the shareholders of the corporation, want the CEO, the agent, to carefully consider the decisions and make decisions that boost the firm’s profit. The CEO, however, has the incentive to shirk and to make decisions that boost his or her well-being rather than the company’s profit.
b. How do the proposed changes to CEO compensation outlined in the news clip address the problem you described in part (a)?
The changes proposed in the news clip are designed to link the CEO’s pay to the company’s profit. If the profit rises, then the company’s stock price will rise. If the CEO’s pay is largely determined by changes in the stock price, then the CEO’s decisions are directly linked to the company’s fortunes. By making the bonuses unavailable for a period of time, the schemes attempt to guarantee that the CEO’s decisions are in the company’s long-term best interest rather than trying to quickly boost the company and its stock price but at the cost of its long-term performance.
Use the following news clip to work Problems 7 and 8.
Steps to Creating a Super Startup
Starting a business is a complicated and risky task. Just two-thirds of new small businesses survive at least two years, and only 44 percent survive at least four years. Most entrepreneurs start their businesses by dipping into their savings, borrowing from the family, and using the founder’s credit cards. Getting a bank loan is tough unless you have assets and that often means using your home as collateral.
Source: CNN, October 18, 2007
7 When starting a business, what are the risks and potential rewards identified in the news clip that are associated with a proprietorship?
Organizing a business as a proprietorship is easy, which is an advantage of this form of business organization. The potential reward is the (economic) profit the business might earn. The news clip points out that proprietorships have a difficult time raising the necessary funds.
8. How might (i) a partnership and (ii) a corporation help to overcome the risks identified in the news clip?
(i) The advantages of a partnership are that it is easier to raise capital. All the partners can help raise the necessary funds. In addition partnerships have diversified decision making which can save the business from making an uncontested bad decision, which can occur in a proprietorship.
(ii) Raising funds for a corporation by selling stock to the many owners might well be easier than raising funds for a proprietorship. First, there can be many shareholders rather than just one person raising the funds. Second the owners of a corporation have limited liability for the firm’s debts, which makes them more willing to supply funds to the business. Finally a corporation can hire professional management.
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9. Sales of the firms in the tattoo industry are in the table. Calculate the four-firm concentration ratio. What is the structure of the tattoo industry?
The four-firm concentration ratio is 60.49. The four-firm concentration ratio equals the ratio of the total sales of the largest four firms to the total industry sales expressed as a percentage. The total sales of the largest four firms is $450 + $325 + $250 + $200, which equals $1,225. Total industry sales equal $1,225 + $800, which equals $2,025. The four-firm concentration ratio equals ($1,225/$2,025) 100, which is 60.49 percent. This industry is highly concentrated because the four-firm concentration ratio exceeds 60 percent.
10. GameStop Racks Up the Points
No retailer has more cachet among gamers than GameStop. For now, only Wal-Mart has a larger market share 21.3% last year. GameStop’s share was 21.1% last year, and may well overtake Wal-Mart this year. But if new women gamers prefer shopping at Target to GameStop,Wal-Mart and Target might erode GameStop’s market share.
Source: Fortune, June 9, 2008
a. According to the news clip, what is the structure of the U.S. retail video-game market?
The market described is an oligopoly. There are only a few firms, three in particular, described as comprising the market.
b. Estimate a range for the four-firm concentration ratio and the HHI for the game market in the United States based on the information provided in this news clip. Wal-Mart is described as having the largest market share, 21.3 percent, and GameStop is said to have the second largest market share, 21.1 percent. These two firms have a market share of 42.4 percent. The market share of the next two largest firms must be less than 42.4 percent. As a result the four-firm concentration ratio ranges from 42.4 percent to 84.7 percent.
The HHI equals the sum of the squared market shares of the 50 largest firms. Wal-Mart’s contribution to the HHI is 21.32 which is 453.7 and GameStop’s contribution to the HHI is 21.12 which is 445.2. Based on the two largest firms, the HHI is at least 898.9. If there are two other firms each with a market share of 21.0 percent and one other firm with a market share of 15.6 percent, the HHI attains its maximum of 2,024.26. So the HHI can range from about 900 to about 2,025.
11. American automakers buy auto parts from independent suppliers rather than produce the parts themselves. In the 1980s, Chrysler got about 70 percent of its auto parts from independent suppliers, while Ford got about 60 percent and General Motors got 25 percent. A decade earlier, the proportions were 50 percent at Chrysler, 5 percent at Ford, and 20 percent at General Motors.
Source: The Cato Institute Policy Analysis, 1987
a. Why did American automakers decide to outsource most of their parts production?
Automakers decided to buy parts from suppliers because the automakers could obtain the parts from suppliers at lower cost than if they produced the parts themselves. Essentially auto makers, by outsourcing, are using the market to coordinate this aspect of their production.
b. Explain why independent producers of auto parts are more efficient than automakers.
The auto part suppliers are smaller than the large automakers. Therefore the part suppliers face fewer principal-agent problems. Because the firms are smaller it is significantly easier to monitor employees to be certain they are not shirking. With their specialization, the parts makers also can reap larger economies of scale of producing specific parts than could auto makers. Both these gains make part
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producers more efficient at producing parts than would be the case of the automaker itself produced the parts.
12. Federal Express enters into contracts with independent truck operators who offer FedEx service and who are rewarded by the volume of packages they carry. Why doesn’t FedEx buy more trucks and hire more drivers? What incentive problems might arise from this arrangement?
FedEx does not buy more trucks and hire more drivers because FedEx faces a principal-agent problem. In particular, it is not easy to monitor its drivers and insure that they are working hard to efficiently deliver packages. FedEx overcomes this problem by hiring independent contractors and then paying them based on the amount of packages they deliver. Essentially, FedEx uses a piecework method of payment.
FedEx pays its drivers based on the volume of packages they deliver. This method of payment creates a few incentive potential problems for FedEx. First, FedEx must worry about the quality of its service. In particular, unless FedEx bases part of the payment on quality, its drivers have an incentive to drop the package and race off to the next delivery with no concern for how the packages are handled. Second, FedEx must take care that drivers do not attempt to select only packages that are close to the FedEx location and avoid packages that have a greater than average driving time. Finally, FedEx also must worry that its drivers do not take undue risks while driving in order to deliver as many packages as possible. If FedEx trucks were involved in too many accidents, FedEx would suffer bad publicity and, presumably, would lose some business.
13. Lego, the Danish toymaker, incurred economic losses in 2003 and 2004. Lego faced competition from low-cost copiers of its products and a fall in demand. In 2004, to restore profits, Lego fired 3,500 of its 8,000 workers; closed factories in Switzerland and the United States; opened factories in Eastern Europe and Mexico; and introduced performance-based pay for its managers. Lego reported a return to profit in 2005.
Based on Picking Up the Pieces, The Economist, October 28, 2006
a. Describe the problems that Lego faced in 2003 and 2004, using the concepts of the three types of constraints that all firms face.
Lego faced all of the three types of constraints: Technology, information, and market.
The technology constraint that Lego faced was how it produced its Legos. Before it made any changes, Lego used a relatively large number of high-paid, presumably high-skilled workers in the United States and Switzerland. After its changes, Lego switched to using apparently fewer workers, who are lowerpaid and probably lower-skilled in Eastern Europe and Mexico.
Lego also faced information constraints. In particular, if Lego had full information about its market and its competitors’ plans, it is unlikely Lego would have suffered economic losses in 2003 and 2004. And, of course, if Lego had better information, even after it started to suffer economic losses, Lego would have more rapidly made changes to limit its losses. In addition, Lego apparently faced information problems about which managers were not working as hard as they should.
Finally, Lego faced significant market constraints. First Lego suffered a fall in demand from its customers, 5- to 9-year old boys. Second other firms were making very similar but lower-priced blocks. This competition lead Lego’s customers to switch (some of) their purchases from Lego to Lego’s competitors, thereby leaving Lego to suffer an economic loss
b. Which of the actions that Lego took to restore profits addressed an inefficiency? How did Lego seek to achieve economic efficiency?
When Lego was suffering an economic loss, Lego was manufacturing its blocks in Switzerland and the United States. These workers were generally high-skilled and therefore high-paid. In an effort to restore its profit, Lego changed its production method by firing 3,500 workers and moving its factories to Eastern Europe and Mexico, where it could use lower-skilled, and therefore lower-paid workers.
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Apparently before the changes Lego was using an economically inefficient production method, with too many workers in general and too many high-skilled workers in particular.
c. Which of Lego’s actions addressed an information and organization problem? How did Lego change the way in which it coped with the principal-agent problem?
Lego faced an information and organization problem because Lego apparently did not know which managers were shirking. To overcome this important principal-agent problem, Lego changed its compensation methods by introducing performance-based pay for its managers. By basing its managers’ pay on their performance, Lego gave its managers the incentive to work diligently in their efforts to boost Lego’s profits.
d. In what type of market does Lego operate?
Lego operates in a competitive market. If its competitors produced blocks that were perfect substitutes for Lego’s blocks, then Lego is in a perfectly competitive market. If its competitors produced blocks that were similar but were not perfect substitutes (as is perhaps more likely), then Lego is in a monopolistically competitive market.
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Use the following information to work Problems 14 and 15.
Lee is a computer programmer who earned $35,000 in 2011. But on January 1, 2012, Lee opened a body board manufacturing business. At the end of the first year of operation, he submitted the following information to his accountant:
He stopped renting out his cottage for $3,500 a year and used it as his factory. The market value of the cottage increased from $70,000 to $71,000.
He spent $50,000 on materials, phone, etc.
He leased machines for $10,000 a year.
He paid $15,000 in wages.
He used $10,000 from his savings account, which earns 5 percent a year interest.
He borrowed $40,000 at 10 percent a year
He sold $160,000 worth of body boards.
Normal profit is $25,000 a year.
14. Calculate Lee’s opportunity cost of production and his economic profit.
Lee has costs of $50,000 paid for materials, phone, utilities, etc; $15,000 for wages; $10,000 paid for the machine lease; $4,000 paid for interest expense on the loan; $3,500 of forgone rent for the cottage plus $1,000 for the “depreciation” of the cottage (the cottage actually appreciated); $500 in forgone interest from the savings account; wages forgone of $35,000; and, $25,000 for normal profit. These give a total opportunity cost of $142,000. Lee’s economic profit is the total revenue, $160,000, minus the total opportunity cost, $142,000, for an economic profit of $18,000.
15. Lee’s accountant recorded the depreciation on his cottage during 2012 as $7,000. According to the accountant, what profit did Lee make?
Lee’s accountant will include costs of $50,000 paid for materials, phone, utilities, etc; $15,000 for wages; $10,000 paid for the machine lease; $4,000 paid for interest expense on the loan; and, $7,000 of depreciation expense for a total opportunity cost of $86,000. The total profit according to the accountant will equal total revenue, $160,000, minus total cost, $86,000, for a profit of $74,000.
16. In 2011, Toni taught music and earned $20,000. She also earned $4,000 by renting out her basement. On January 1, 2012, she quit teaching, stopped renting out her basement, and began to use it as the office for her new Web site design business. She took $2,000 from her savings account to buy a computer. During 2012, she paid $1,500 for the lease of a Web server and $1,750 for high-speed Internet service. She received a total revenue from Web site designing of $45,000 and earned interest at 5 percent a year on her savings account balance. Normal profit is $55,000 a year. At the end of 2012, Toni could have sold her computer for $500. Calculate Toni’s opportunity cost of production and her economic profit in 2012.
Toni has costs of $1,500 for the lease of a Web server; $1,750 for high-speed Internet service; $55,000 for normal profit; $20,000 of forgone earnings from teaching; $4,000 of forgone rent from renting her basement; $100 of forgone interest from her saving account; and $1,500 for the depreciation of her computer (which equals the $2,000 paid for it minus the $500 for which she could have sold it). These various costs sum to a total opportunity cost of $83,850. Toni’s economic profit is her total revenue, $45,000, minus her total opportunity cost, $83,850, for an economic loss of $38,850.
17.
The key driver of profitability will be that the focus of the company isn’t on profitability. Our focus is on the customer. If we can find a way to give customers what they want better than
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anybody else, then what can stop us?
Source: Fortune, April 14, 2008
a. In spite of what Chrysler’s vice chairman and co-president claims, why is Chrysler’s focus actually on profitability?
Chrysler’s actual focus is on its profit because if Chrysler continues to incur losses Chrysler eventually will shut down. This statement is correct even in an era of government bailouts because the government will eventually stop offering bailouts if the company does not return to profitability.
b. What would happen to Chrysler if it didn’t focus on maximizing profit, but instead focused their production and pricing decisions to “give customers what they want”?
In general customers want very elaborate, very costly automobiles sold for an exceptionally low price. In particular, customers want to pay the lowest price possible regardless of the company’s profit. If Chrysler focused on only giving customers want they want, Chrysler would continue to incur a loss and ultimately would either close or be purchased by another company.
18. Must Watches
Stocks too volatile? Bonds too boring? Then try an alternative investment one you can wear on your wrist.… [The] typical return on a watch over five to ten years is roughly 10%. [One could] do better in an index fund, but… what other investment is so wearable?
Source: Fortune, April 14, 2008
a. What is the cost of buying a watch?
The (opportunity) cost of buying a watch is the loss of whatever else would have been purchased with the funds.
b. What is the opportunity cost of owning a watch?
The opportunity cost of owning a watch is the annual forgone return, such as the forgone interest from buying a watch rather than placing the funds in a savings account, and the depreciation of the watch.
c. Does owning a watch create an economic profit opportunity?
Yes, owning a watch creates an economic profit opportunity. If the watch appreciates at a rapid clip, so that the gain in the value of the watch over time exceeds the normal profit from the funds used to purchase the watch, then owning the watch has lead to an economic profit. Use the following information to work Problems 19 and 20.
Four methods of completing a tax return and the time taken by each method are: with a PC, 1 hour; with a pocket calculator, 12 hours; with a pocket calculator and paper and pencil, 12 hours; and with a pencil and paper, 16 hours. The PC and its software cost $1,000, the pocket calculator costs $10, and the pencil and paper cost $1.
19. Which, if any, of the methods is technologically efficient?
All methods other than “pocket calculator with paper and pencil” are technologically efficient. To use a pocket calculator with paper and pencil to complete the tax return is not a technologically efficient method because it takes the same number of hours as it would with a pocket calculator but it uses more capital.
20. Which method is economically efficient if the wage rate is (i) $5 an hour?
The economically efficient method is the technologically efficient method that allows the task to be done at least cost. When the wage rate is $5 an hour, total cost with a PC is $1,005, total cost with a pocket calculator is $70, and total cost with paper and pencil is $81. Total cost is least with a pocket calculator.
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(ii) $50 an hour?
When the wage rate is $50 an hour, total cost with a PC is $1,050, total cost with a pocket calculator is $610, and the total cost with paper and pencil is $801. The pocket calculator is economically efficient.
(iii)$500 an hour?
When the wage rate is $500 an hour, total cost with a PC is $1,500, total cost with a pocket calculator is $6,010, and total cost with pencil and paper is $8,001. The PC is economically efficient.
21. A Medical Sensation
Hospitals are buying da Vinci surgical robots. Surgeons, sitting comfortably at a da Vinci console, can use various robotic attachments to perform even the most complex procedures.
Source: Fortune, April 28, 2008
a. Assume that performing a surgery with a surgical robot requires fewer surgeons and nurses. Is using the surgical robot technologically efficient?
Using the surgical robot is technologically efficient because the production technique uses less labor (and more capital) than the non-robotic technique.
b. What additional information would you need to be able to say that switching to surgical robots is economically efficient for a hospital?
To determine if the production technique is economically efficient, information about the cost of the robot and the cost of the nurses and doctors and about the number of doctors and nurses each production technique uses is needed.
22. Wal-Mart has more than 3,700 stores, more than one million employees, and total revenues of close to a quarter of a trillion dollars in the United States alone. Sarah Frey-Talley runs the family-owned Frey Farms in Illinois and supplies Wal-Mart with pumpkins and other fresh produce.
a. How does Wal-Mart coordinate its activities? Is it likely to use mainly a command system or also to use incentive systems? Explain.
Wal-Mart is a huge organization. As such, it uses both command and incentive systems. At the lower, store level, command is the system that is most commonly used. (For instance, an associate is told that he or she will help unload a delivery and stack the packages against the South wall.) At the higher, corporate level, incentive is the system most commonly used. (For instance, regional directors have part of their income tied to their region’s performance.) However, even at the store level some incentive systems are used (associates can enroll in a profit sharing plan) and even at the corporate level some command systems are used (regional directors are told that they must report to their supervisors on a weekly basis).
b. How do you think Sarah Frey-Talley coordinates the activities of Frey Farms? Is she likely to use mainly a command system or also to use incentive systems? Explain.
Ms. Frey-Talley probably uses a command system significantly more often than an incentive system. Her farm has few employees and so it is easy to tell each employee what to do, when to do it, and where to do it. Possibly the only use of an incentive system might be if Ms. Frey-Talley has some higher-ranking family members on a profit-sharing program.
c. Describe, compare, and contrast the principal–agent problems faced by Wal-Mart and Frey Farms. How might these firms cope with their principal–agent problems?
Wal-Mart faces many more principal-agent problems than does Ms. Frey-Talley. For Ms. Frey-Talley’s farm, it is relatively straightforward to monitor each employee so employees will find it difficult to shirk. Plus Ms. Frey-Talley owns the farm herself, and so there is no principal-agent problem associated with a difference between the owners and the managers. Wal-Mart, however, has more than one million employees. Each of these employees realizes that if he or she shirks, it will make little
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difference to Wal-Mart’s overall performance. So Wal-Mart’s managers must be constantly alert to this problem. Wal-Mart also faces the principal-agent problem that results because its owners are not its managers. As a result, the owners must try to create incentives for the managers to behave in the best interests of the owners. Wal-Mart has a number of ways that it can try to overcome the principal-agent problems it faces. Its top management is given stock options. Regional managers, store managers, and top level store management are given profit-sharing packages that depend on the performance of the region or a particular store. Buyers for Wal-Mart people employed by Wal-Mart to determine which products Wal-Mart will purchase are often given profit-sharing packages that increase the buyer’s income depending on how well the products the buyer purchased perform in the stores. All of these are designed to give the recipient the incentive to make decisions that boost Wal-Mart’s profit and thereby its stock price, which benefit the owners.
23. Where Does Google Go Next?
Google gives its engineers one day a week to work on whatever project they want. A couple of colleagues did what many of the young geniuses do at Google: They came up with a cool idea. At Google, you often end up with a laissez-faire mess instead of resource allocation.
Source: Fortune, May 26, 2008
a. Describe Google’s method of organizing production with their software engineers. In some sense Google is using a command system because Google “orders” its engineers to use one day a week to work on their own projects. But in a larger sense Google is using an incentive system. If one of the engineers comes up with a wildly profitable idea, the engineer will benefit by gaining stature and probably income within Google.
b. What are the potential gains and opportunity costs associated with this method?
The potential gain is that the creative people working for Google will apply their creativity to develop new and better products for Google. The potential drawback is the principal-agent problem. The engineers might use their time for on-the-job leisure rather than for new, cutting edge research.
24. Market shares of chocolate makers are in the table. Calculate the Herfindahl-Hirschman Index. What is the structure of the chocolate industry?
The Herfindahl-Hirschman Index is 1,800. The HerfindahlHirschman Index equals the sum of the squares of the market shares of the 50 largest firms or of all firms if there are less than 50 firms. The Herfindahl-Hirschman Index equals 152 + 102 + 202 + 152 + 252 + 152, which equals 1,800. This industry is moderately competitive because the Herfindahl-Hirschman Index lies in the range 1,000 to 1,800. Use the following information to work Problems 25 to 27
Two leading design firms, Astro Studios of San Francisco and Hers Experimental Design Laboratory, Inc. of Osaka, Japan, worked with Microsoft to design the Xbox 360 video game console. IBM, ATI, and SiS designed the Xbox 360’s hardware. Three firms Flextronics, Wistron, and Celestica manufacture the Xbox 360 at their plants in China and Taiwan
25. Describe the roles of market coordination and coordination by firms in the design, manufacture, and marketing of the Xbox 360.
Microsoft entered the market to hire various firms, Astro Studios and Hers Experimental Design Laboratory to design the Xbox 360 and then entered the market again to hire IBM, ATI, and SiS to design the hardware of the Xbox 360. Finally, Microsoft once again entered the market to hire
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Flextronics and Wistron, and Celestica to produce the Xbox 360. Once Microsoft had contracted with these firms, the design, manufacture, etc. takes place within the firm.
26. a. Why do you think Microsoft works with a large number of other firms, rather than performing all the required tasks itself?
Microsoft works with a large number of firms rather than doing everything in-house because it is less expensive for Microsoft to work with other firms. These other firms have specialized in various tasks and so have gained economies of scale that Microsoft does not possess. Therefore it is cheaper for Microsoft to enter the market and hire the expertise it needs than to do it all itself.
b What are the roles of transactions costs, economies of scale, economies of scope, and economies of team production in the design, manufacture, and marketing of the Xbox?
Microsoft needed to determine what part of designing, building, and marketing the Xbox would take place inside of Microsoft and what would take place in other companies that Microsoft hired. Hiring other companies means that Microsoft incurs the transactions costs of using markets. However, other companies that specialized in different tasks have economies of scale, economies of scope, and/or economies of team production that lower the cost to Microsoft of hiring them. So Microsoft had to determine which parts of the Xbox 360 would be cheaper to undertake inside of Microsoft and which parts would be cheaper to enter the market to contract with other firms.
27 Why do you think the Xbox is designed in the United States and Japan but built in China?
The Xbox is designed in America and Japan because America and Japan have a large number of highly-skilled workers who can successfully design the Xbox. With a large number of technically adept workers, it is less expensive to design the Xbox in these countries. Manufacturing the Xbox, however, takes place in China because China has a large number of lower-skilled workers and so it is less expensive to build the Xbox in China.
28 After you have studied Reading Between the Lines on pp. 240–241, answer the following questions
a. What products do Facebook and Google sell?
Facebook sells social networking services; that is, it allows its users to keep up with their friends. Google sells search services; that is, it helps its users search the Internet for the topics in which they are interested.
b. In what types of markets do Facebook and Google compete?
Both markets have many other providers of similar services. But in each case there are a few that are much larger than the many competitors. So both markets are oligopolies.
c. How do social networks and Internet search providers generate revenue?
Both social network Internet sites and Internet search providers generate revenue from sale of advertisements.
d. What is special about social network sites that make them attractive to advertisers?
Social network sites have millions of users. Users typically provide the social network site information about the user’s interests. Therefore these sites are attractive to advertisers because an advertiser gains a large audience of people who have a tendency to be interested in the advertiser’s product.
e. What is special about Internet search providers that make them attractive to advertisers?
Users of Internet search providers often are searching for either a particular product or else a product to fill a particular need. Often users are searching with an intention to buy. Advertisers are attracted to these web sites because they allow the advertiser to target an audience that is frequently going to purchase the product the advertiser has for sale.
f. What technological changes might increase the profitability of social networks compared to
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Technological change that enables the social networking site to more precisely target the preferences of individual consumers such as past buying history from the social networking website or better information about preferences via the consumer’s past web browsing on the social network site or on other web sites would make Internet advertising on the social website more profitable because the ads would more precisely reflect the potential buyer's interests. This change would enable the social networking website to set a higher price for each advertisement, thereby increasing its profitability compared to Internet search providers.
School districts in many states experiment with plans that compensate teachers partly based on classroom performance, rather than their years on the job and coursework completed. Working with mentors to improve their instruction and getting bonuses for raising student achievement encourages efforts to raise teaching quality
Source: The New York Times, June 18, 2007
How does “merit pay” attempt to cope with the principal-agent problem in public education?
The principal-agent problem with teachers in public education is the concern that teachers will not work hard in the classroom. Teachers’ efforts are difficult to monitor and so teachers have the incentive to shirk by working less diligently and teaching their students less. Merit pay links the teachers’ pay to their students’ achievement, presumably performance on standardized exams. With this linkage teachers will be paid more the better their students’ performance which gives the teachers the selfinterested incentive to work diligently to instruct their students.
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