ECO 550 Final Exam – New

ECO 550 Final Exam – Strayer New

ECO 550 Week 10 Chapter 9 through 17 Final Exam

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ECO 550 Final Exam Solution

Chapter 9—Applications of Cost Theory

MULTIPLE CHOICE

1. Evidence from empirical studies of short-run cost-output relationships lends support to the:
a. existence of a non-linear cubic total cost function
b. hypothesis that marginal costs first decrease, then gradually increase over the normal operating range of the firm
c. hypothesis that total costs increase quadratically over the ranges of output examined
d. hypothesis that total costs increase linearly over the range of output examined
e. none of the above

ANS: PTS: 1

2. The short-run cost function is:
a. where all inputs to the production process are variable
b. relevant to decisions in which one or more inputs to the production process are fixed
c. not relevant to optimal pricing and production output decisions
d. crucial in making optimal investment decisions in new production facilities
e. none of the above

ANS: PTS: 1

3. Theoretically, in a long-run cost function:
a. all inputs are fixed
b. all inputs are considered variable
c. some inputs are always fixed
d. capital and labor are always combined in fixed proportions
e. b and d

ANS: PTS: 1

4. 4. Break-even analysis usually assumes all of the following except:
a. a. in the short run, there is no distinction between variable and fixed costs.
b. b. revenue and cost curves are straight-lines throughout the analysis.
c. c. there appears to be perfect competition since the price is considered to remain the same regardless of quantity.
d. d. the straight-line cost curve implies that marginal cost is constant.
e. e. both c and d

ANS: PTS: 1

4. 5. What is another term meaning the degree of operating leverage?
a. a. The measure of the importance of fixed cost.
b. b. The operating profit elasticity.
c. c. The measure of business risk.
d. d. D.O.L.
e. e. All of the above.

ANS: PTS: 1

4. 6. In a study of banking by asset size over time, we can find which asset sizes are tending to become more prominent. The size that is becoming more predominant is presumed to be least cost. This is called:
a. a. regression to the mean analysis.
b. b. breakeven analysis.
c. c. survivorship analysis.
d. d. engineering cost analysis.
e. e. a Willie Sutton analysis.

ANS: PTS: 1

a. 7. George Webb Restaurant collects on the average $5 per customer at its breakfast & lunch diner. Its variable cost per customer averages $3, and its annual fixed cost is $40,000. If George Webb wants to make a profit of $20,000 per year at the diner, it will have to serve__________ customers per year.
b. a. 10,000 customers
c. b. 20,000 customers
d. c. 30,000 customers
e. d. 40,000 customers
f. e. 50,000 customers

ANS: PTS: 1

8. In determining the shape of the cost-output relationship only ____ depreciation is relevant.
a. direct
b. indirect
c. usage
d. time
e. scheduled

ANS: PTS: 1

9. Which of the following is not a limitation of the survivor technique for measuring the optimum size of firms within an industry?
a. since the technique does not employ actual cost data in the analysis, there is no way to assess the magnitude of the cost differentials between firms of varying size and efficiency.
b. the managerial and entrepreneurial aspects of the production process are not included in the analysis
c. because of legal factors, the long-run cost curve derived by this technique may be distorted and may not measure the cost curve postulated in economic theory
d. a and b
e. b and c

ANS: PTS: 1

10. The primary disadvantage of engineering methods for measuring cost functions is that they deal with the managerial and entrepreneurial aspects of the production process or plant.
a. true
b. false

ANS: PTS: 1

11. A linear total cost function implies that:
a. marginal costs are constant as output increases
b. average total costs are continually decreasing as output increases
c. a and b
d. none of the above

ANS: PTS: 1

12. A ____ total cost function implies that marginal costs ____ as output is increased.
a. linear; increase linearly
b. quadratic; increase linearly
c. cubic; increase linearly
d. a and b
e. none of the above

ANS: PTS: 1

13. A ____ total cost function implies that marginal costs ____ as output is increased.
a. linear; increase linearly
b. quadratic; are constant
c. cubic; increase linearly
d. linear; are constant
e. none of the above

ANS: PTS: 1

14. A ____ total cost function yields a U-shaped average total cost function.
a. cubic
b. quadratic
c. linear
d. a and b only
e. a, b, and c

ANS: PTS: 1

15. In the linear breakeven model, the difference between selling price per unit and variable cost per unit is referred to as:
a. variable margin per unit
b. variable cost ratio
c. contribution margin per unit
d. target margin per unit
e. none of the above

ANS: PTS: 1

16. Which of the following is not an assumption of the linear breakeven model:
a. constant selling price per unit
b. decreasing variable cost per unit
c. fixed costs are independent of the output level
d. a single product (or a constant mix of products) is being produced and sold
e. all costs can be classified as fixed or variable

ANS: PTS: 1

17. In the linear breakeven model, the breakeven sales volume (in dollars) is equal to fixed costs divided by:
a. unit selling price less unit variable cost
b. contribution margin per unit
c. one minus the variable cost ratio
d. a and b only
e. a, b, and c

ANS: PTS: 1

18. The degree of operating leverage is equal to the ____ change in ____ divided by the ____ change in ____.
a. percentage; sales; percentage; EBIT
b. unit; sales; unit; EBIT
c. percentage; EBIT; percentage; sales
d. unit; EBIT; unit; sales
e. none of the above

ANS: PTS: 1

19. The linear breakeven model excludes ____ from the analysis.
a. financing costs
b. taxes
c. contribution margin
d. a and b only
e. a, b, and c

ANS: PTS: 1

20. In the linear breakeven model, the relevant range of output is that range where the linearity assumptions of the model are assumed to hold.
a. true
b. false

ANS: PTS: 1

21. In the linear breakeven model, the breakeven sales volume (in dollars) can be found by multiplying the breakeven sales volume (in units) by:
a. one minus the variable cost ratio
b. contribution margin per unit
c. selling price per unit
d. standard deviation of unit sales
e. none of the above

ANS: PTS: 1

22. In the linear breakeven model, a firm incurs operating losses whenever output is less than the breakeven level.
a. true
b. false

ANS: PTS: 1

PROBLEMS

1. For each of the following cost-output relationships, describe the shape (U-shape, decreasing, increasing, constant) of the average total cost and marginal cost functions (C = total cost, Q = output):

(a) C = 42,500,000 + 2550Q
(b) C = 8.48 + 0.65Q + .00220Q2

ANS:

PTS: 1

2. Offshore Petroleum’s fixed costs are $2,500,000 and its debt repayment requirements are $1,000,000. Selling price per barrel of oil is $18 and variable costs per barrel are $10.

(a) Determine the breakeven output (in dollars).
(b) Determine the number of barrels of oil that offshore must produce and sell in order to earn a target (operating) profit of $1,500,000.
(c) Determine the degree of operating leverage at an output of 400,000 barrels.
(d) Assuming that sales of oil are normally distributed with a mean of 362,500 barrels and a standard deviation of 100,000 barrels, determine the probability that Offshore will incur an operating loss.

ANS:

PTS: 1 NOTE: Part (d) requires the use of statistical tables.

Chapter 10—Prices, Output, and Strategy: Pure and Monopolistic Competition

MULTIPLE CHOICE

1. The main difference between perfect competition and monopolistic competition is:
a. The number of sellers in the market
b. The ease of entry and exit in the industry
c. The degree of information about market price
d. The degree of product differentiation
e. Whether it is the short run or the long run

ANS: PTS: 1

2. Long distance telephone service has become a competitive market. The average cost per call is $0.05 a minute, and it’s declining. The likely reason for the declining price for long distance service is:
a. Governmental pressure to lower the price
b. Reduced demand for long distance service
c. Entry into this industry pushes prices down
d. Lower price for a barrel of crude oil
e. Increased cost of providing long distance service

ANS: PTS: 1

3. What is the profit maximization point for a firm in a purely competitive environment?
a. The output where P = MC
b. The output where P < MC c. The output where P > MC
d. The output where MR = MC
e. The output where AVC < P

ANS: PTS: 1

4. All of the following are true for both competition and monopolistic competition in the long run, except one of them. Which is it?
a. P = MC
b. P = AC
c. Economic profits become zero in the long-run
d. The barriers to entry and exit are relatively easy
e. None of the above is an exception

ANS: PTS: 1

5. Which of the following statements is (are) true concerning a pure competition situation?
a. Its demand curve is represented by a vertical line.
b. Firms must sell at or below market price.
c. Marginal revenue is equal to price.
d. both b and c
e. both a and b

ANS: PTS: 1

6. In pure competition:
a. the optimal price-output solution occurs at the point where marginal revenue is equal to price
b. a firm’s demand curve is represented by a horizontal line
c. a firm is a price-taker since the products of every producer are perfect substitutes for the products of every other producer
d. a and b only
e. a, b, and c

ANS: PTS: 1

7. In the short-run for a purely competitive market, a manufacturer will stop production when:
a. the total revenue is less than total costs
b. the contribution to fixed costs is zero or less
c. the price is greater than AVC
d. operating at a loss
e. a and b

ANS: PTS: 1

8. In the purely competitive case, marginal revenue (MR) is equal to:
a. cost
b. profit
c. price
d. total revenue
e. none of the above

ANS: PTS: 1

9. In long-run equilibrium, all firms in a pure competition market situation operating under a condition of certainty will have identical costs even though they may use different production and operation techniques.
a. true
b. false

ANS: PTS: 1

10. If price exceeds average costs under pure competition, ____ firms will enter the industry, supply will ____, and price will be driven ____.
a. more; decrease; down
b. more; decrease; up
c. more; increase; down
d. more; increase; up
e. none of the above

ANS: PTS: 1

11. A firm in pure competition would shut down when:
a. price is less than average total cost
b. price is less than average fixed cost
c. price is less than marginal cost
d. price is less than average variable cost

ANS: PTS: 1

12. In the long-run, firms in a monopolistically competitive industry will
a. earn substantial economic profits
b. tend to just cover costs, including normal profits
c. seek to increase the scale of operations
d. seek to reduce the scale of operations

ANS: PTS: 1

13. Uncertainty includes all of the following except ____.
a. unknown effects of deliberate actions
b. incomplete information as to the type of competitor
c. random disturbances
d. unverifiable claims
e. accidents due to weather hazards

ANS: PTS: 1

14. Experience goods are products or services
a. that the customer already knows
b. whose performance is highly unusual
c. whose quality is undetectable when purchased
d. not likely to cause repeat purchases
e. all of the above

ANS: PTS: 1

15. Buyers anticipate that the temporary warehouse seller of unbranded computer equipment will
a. deliver high quality products consistent with expectations
b. not attempt to establish any warranty enforcement mechanisms
c. offer several prices and qualities
d. produce only one quality
e. none of the above

ANS: PTS: 1

16. All of the following are mechanisms which reduce the adverse selection problem except ____.
a. warranties from established enterprises with non-redeployable assets
b. high interest rates
c. large collateral requirements
d. brand names and product-specific promotions and retail displays
e. higher prices in repeat customer transactions

ANS: PTS: 1

17. Asset specificity is largest when
a. value in first best use is large
b. value in second best use is large
c. customers choose their supplier at random
d. very valuable assets are non-redeployable
e. customers are loyal to a particular seller

ANS: PTS: 1

18. Under asymmetric information,
a. you never get what you pay for
b. you sometimes get cheated
c. you always get cheated
d. at best you get what you pay for
e. sellers make profits in excess of competitive returns

ANS: PTS: 1

19. To escape adverse selection and elicit high quality experience goods buyers can
a. offer price premiums to new firms in the market
b. seek out unbranded goods
c. buy from generic storefronts that have leased temporary space
d. secure warranties from warehouse retailers
e. none of the above

ANS: PTS: 1

20. The problems of asymmetric information exchange arise ultimately because
a. one party to the exchange possesses different information than another
b. one party has more information than another
c. one party knows nothing
d. one party cannot independently verify the information of another
e. information is scarce

ANS: PTS: 1

21. The market for “lemons” is one in which
a. the rational buyer discounts
b. the seller’s product claims are unverifiable at the point of purchase
c. “the bad apples drive out the good”
d. the problem of adverse selection is rampant
e. all of the above

ANS: PTS: 1

22. The fraudulent delivery of low quality experience goods at high prices is more likely if
a. interest rates decline
b. information about notorious firms is speedily disseminated
c. price premiums for allegedly high quality increase
d. sellers invest in non-transferable reputation
e. none of the above

ANS: PTS: 1

f. 23. An “experience good” is one that:
g. a. Only an expert can use
h. b. Has undetectable quality when purchased
i. c. Can be readily experienced simply by touching or tasting
j. d. Improves with age, like a fine wine
k. e. All of the above

ANS: PTS: 1
g. 24. A “search good” is:
h. a. One that depends on how the product behaves over time
i. b. A product whose quality is only found out over time by finding how durable it is
j. c. Like a peach that can be examined for flaws
k. d. Like a used car, since it is easy to determine its inherent quality
l. e. None of the above
ANS: PTS: 1

a. 25. The price for used cars is well below the price of new cars of the same general quality. This is an example of:
b. a. The Degree of Operating Leverage
c. b. A Lemon’s Market
d. c. Redeployment Assets
e. d. Cyclical Competition
f. e. The Unemployment Rate

ANS: PTS: 1

PROBLEMS

1. Sunrise Juice Company sells its output in a perfectly competitive market. The firm’s total cost function is given in the following schedule:

Output Total Cost
(Units) ($)
0 50
10 120
20 170
30 210
40 260
50 330
60 430

Total costs include a “normal” return on the time (labor services) and capital that the owner has invested in the firm. The prevailing market price is $7 per unit.

(a) Prepare (i) marginal cost and (ii) average total cost schedules for the firm.
(b) What is the firm’s profit maximizing output level?
(c) Is the industry in long-run equilibrium? Justify your answer.

ANS:

PTS: 1

2. Superior Metals Company has seen its sales volume decline over the last few years as the result of rising foreign imports. In order to increase sales (and hopefully, profits), the firm is considering a price reduction on luranium–a metal that it produces and sells. The firm currently sells 60,000 pounds of luranium a year at an average price of $10 per pound. Fixed costs of producing luranium are $250,000. Current variable costs per pound are $5. The firm has determined that the variable cost per pound could be reduced by $.50 if production volume could be increased by 10 percent (fixed costs would remain constant). The firm’s marketing department has estimated the arc elasticity of demand for luranium to be −1.5.

(a) How much would Superior Metals have to reduce the price of luranium in order to achieve a 10 percent increase in the quantity sold?
(b) What would the firm’s (i) total revenue, (ii) total cost, and (iii) total profit be before and after the price cut?

ANS:

PTS: 1

Chapter 11—Price and Output Determination: Monopoly and Dominant Firms

MULTIPLE CHOICE

5. 1. Unique Creations has a monopoly position in magnometers. If the marginal cost for a magnometer is $50 and the price elasticity for magnometers is -4, what is the optimal monopoly price?
Hint: P (1 +1/E) = MC.
a. $37.50
b. $41.25
c. $66.67
d. $75.00
e. $82.50

ANS: PTS: 1

2. Land’s End estimates a demand curve for turtleneck sweaters to be:
Log Q = .41 + 2.3 Log Y – 3 Log P
where Q is quantity, P is price, and Y is a measure on national income. If the marginal cost of imported turtleneck sweaters is $9.00. (Hint: P (1 +1/E) = MC). The optimal monopoly price would be:
a. P = $13.50
b. P = $26.50
c. P = $27.50
d. P = $34.50
e. P = $56.22

ANS: PTS: 1

3. Declining cost industries
l. a. have upward rising AC curves.
m. b. have upward rising demand curves.
n. c. have -shaped total costs.
o. d. have diseconomies of scale.
p. e. have marginal cost curves below their average cost curve.

ANS: PTS: 1

m. 4. A monopolist seller of Irish ceramics faces the following demand function for its product: P = 62 – 3Q. The fixed cost is $10 and the variable cost per unit is $2. What is the maximizing QUANTITY for this monopoly? Hint: MR is twice as steep as the inverse demand curve: MR = 62 – 6 Q. (Pick closest answer)
n. a. Q = 10
o. b. Q = 15
p. c. Q = 22
q. d. Q = 37
r. e. Q = 41

ANS: PTS: 1

g. 5. Globo Public Supply has $1,000,000 in assets. Its demand curve is: P = 206 – .20•Q and its total cost function is: TC = 20,000 + 6•Q where TC excludes the cost of capital. If Globo Public Supply is UNREGULATED, find Globo’s optimal price.
h. a. $206
i. b. $106
j. c. $56
k. d. $6
l. e. $3

ANS: PTS: 1

a. 6. A monopolist faces the following demand curve: P = 12 – .3Q with marginal costs of $3. What is the monopolistic PRICE?
b. a. P = $5.50
c. b. P = $6.50
d. c. P = $7.50
e. d. P = $8.50
f. e. P = $9.50
g. 7.
h. 8.
i. 9.
j. 10.
k. 11.
l. 12.
ANS: PTS: 1

a. 7. In natural monopoly, AC continuously declines due to economies in distribution or in production, which tends to found in industries which face increasing returns to scale. If price were set equal to marginal cost, then:
a. price would equal average cost.
b. price would exceed average cost.
c. price would be below average cost.
d. price would be at the profit maximizing level for natural monopoly
e. all of the above

ANS: PTS: 1

8. The profit-maximizing monopolist, faced with a negative-sloping demand curve, will always produce:
a. at an output greater than the output where average costs are minimized
b. at an output short of that output where average costs are minimized
c. at an output equal to industry output under pure competition
d. a and c
e. none of the above

ANS: PTS: 1

9. In the case of pure monopoly:
a. one firm is the sole producer of a good or service which has no close substitutes
b. the firm’s profit is maximized at the price and output combination where marginal cost equals marginal revenue
c. the demand curve is always elastic
d. a and b only
e. a, b, and c

ANS: PTS: 1

10. A monopoly will always produce less than a purely competitive industry, ceteris paribus.
a. true
b. false

ANS: PTS: 1

11. The demand curve facing the firm in ____ is the same as the industry demand curve.
a. pure competition
b. monopolistic competition
c. oligopoly
d. pure monopoly
e. none of the above

ANS: PTS: 1

12. When the cross elasticity of demand between one product and all other products is low, one is generally referring to a(n) ____ situation.
a. oligopoly
b. monopoly
c. pure competition
d. substitution
e. monopolistic competition

ANS: PTS: 1

14. Of the following, which is not an economic rationale for public utility regulation?
a. production process exhibiting increasing returns to scale
b. constant cost industry
c. avoidance of duplication of facilities
d. protection of consumers from price discrimination
e. none of the above

ANS: PTS: 1

15. The practice by telephone companies of charging lower long-distance rates at night than during the day is an example of:
a. inverted block pricing
b. second-degree price discrimination
c. peak-load pricing
d. first-degree price discrimination
e. none of the above

ANS: PTS: 1

16. In the electric power industry, residential customers have relatively ____ demand for electricity compared with large industrial users. But contrary to price discrimination, large industrial users generally are charged ____ rates.
a. similar, similar
b. elastic, lower
c. elastic, higher
d. inelastic, lower
e. inelastic, higher

ANS: PTS: 1

17. ____ as practiced by public utilities is designed to encourage greater usage and therefore spread the fixed costs of the utility’s plant over a larger number of units of output.
a. Peak load pricing
b. Inverted block pricing
c. Block pricing
d. First degree price discrimination
e. none of the above

ANS: PTS: 1

18. Regulatory agencies engage in all of the following activities except _______.
a. controlling entry into the regulated industries
b. overseeing the quality of service provided by the firms
c. setting federal and state income tax rates on regulated firms
d. setting prices that consumers will pay
e. none of the above

ANS: PTS: 1

PROBLEMS

1. The Zinger Company manufactures and sells a line of sewing machines. Demand per period (Q) for a particular model is given by the following relationship:

Q = 400−.5P

where P is price. Total costs (including a “normal” return to the owners) of producing Q units per period are:

TC = 20,000 + 50Q + 3Q2

(a) Express total profits () in terms of Q.
(b) At what level of output are total profits maximized? What price will be charged? What are total profits at this output level?
(c) What model of market pricing has been assumed in this problem? Justify your answer.

ANS:

PTS: 1

2. Zar Island Gas Company is the sole producer of natural gas in the remote island country of Zar. The company’s operations are regulated by the State Energy Commission. The demand function for gas in Zar has been estimated as:

P = 1,000−.2Q

where Q is output (measured in units) and P is price (measured in dollars per unit). Zar Island’s cost function is:

TC = 300,000 + 10Q

This total cost function does not include a “normal” return on the firm’s invested capital of $4 million.

(a) In the absence of any government price regulation, determine Zar Island’s optimal (i) output level, (ii) selling price, (iii) total profits, and (iv) rate of return on its asset base.
(b) The State Energy Commission has ordered the firm to charge a price which will provide it with no more than a 12 percent return on its total assets. Determine Zar Island’s (i) output level, (ii) selling price, and (iii) total profits under this constraint.
Hint: The roots of the quadratic equation:

ANS:

PTS: 1

Chapter 12—Price and Output Determination: Oligopoly

MULTIPLE CHOICE

1. “Conscious parallelism of action” among oligopolistic firms is an example of ____.
a. intense rivalry
b. a formal collusive agreement
c. informal, or tacit, cooperation
d. a cartel
e. none of the above

ANS: PTS: 1

2. The kinked demand curve model was developed to help explain:
a. fluctuations of prices in pure competition
b. rigidities observed in prices in oligopolistic industries
c. fluctuations observed in prices in oligopolistic industries
d. all of the above
e. none of the above

ANS: PTS: 1

3. An oligopoly is characterized by:
a. a relatively small number of firms
b. either differentiated or undifferentiated products
c. actions of any individual firm will affect sales of other firms in the industry
d. a and b
e. a, b, and c

ANS: PTS: 1

4. Which of the following is an example of an oligopolistic market structure?
a. public utilities
b. air transport industry
c. liquor retailers
d. wheat farmers
e. none of the above

ANS: PTS: 1

5. In the Cournot duopoly model, each of the two firms, in determining its profit-maximizing price-output level, assumes that the other firm’s ____ will not change.
a. price
b. output
c. marketing strategy
d. inventory
e. none of the above

ANS: PTS: 1

6. If a cartel seeks to maximize profits, the market share (or quota) for each firm should be set at a level such that the ____ of all firms is identical.
a. average total cost
b. average profit
c. marginal profit
d. marginal cost
e. marginal revenue

ANS: PTS: 1

7. In the absence of any legally binding enforcement mechanism, individual cartel producers may find it advantageous to cheat on the agreements and engage in secret price concessions.
a. true
b. false

ANS: PTS: 1

8. A(n) ____ is characterized by a relatively small number of firms producing a product.
a. monopoly
b. syndicate
c. cooperative
d. oligopoly
e. none of the above

ANS: PTS: 1

9. The distinctive characteristic of an oligopolistic market structure is that there are recognizable interdependencies among the decisions of the firms.
a. true
b. false

ANS: PTS: 1

10. Factors that affect the ability of oligopolistic firms to successfully engage in cooperation include ____.
a. number and size distribution of sellers
b. size and frequency of orders
c. product heterogeneity
d. a and b only
e. a, b, and c

ANS: PTS: 1

11. Effective oligopolistic collusion is more likely to occur when customer orders are small, frequent, and received on a regular basis as compared with large orders that are received infrequently at irregular intervals.
a. true
b. false

ANS: PTS: 1

12. Effective collusion generally is more difficult as the number of oligopolistic firms involved increases.
a. true
b. false

ANS: PTS: 1

13. The largest problem faced in cartel pricing agreements such as OPEC is:
a. detecting violations of quota barriers by cartel participants
b. arriving at a profit maximizing price
c. attracting participants in the cartel
d. none of the above

ANS: PTS: 1

6. 14. Some market conditions make cartels MORE likely to succeed in collusion. Which of the following will make collusion more successful?
a. The products are heterogeneous
b. The orders are small and frequent
c. The firms are all about the same size
d. Costs differ across the firms
e. Firms are geographically widely scattered

ANS: PTS: 1

15. Even ideal cartels tend to be unstable because
a. firms typically prefer competition to collusion as competition, because it leads to more profits.
b. collusion leads to lowest possible overall profits in the industry.
c. oligopolistic managers are extremely risk loving.
d. firms can benefit by secretly selling more than they promised the other firms
e. all of the above

ANS: PTS: 1

16. Suppose that in a perfectly competitive industry the equilibrium industry quantity is 10,000 units. Suppose that the monopoly output is 5,000. For a 2-firm Cournot Oligopoly (N =2) known as a duopoly, what is a likely Cournot QUANTITY for the industry?
a. 3,000 units
b. 5,000 units
c. 6,667 units
d. 10,000 units
e. 15,000 units

ANS: PTS: 1

17. A cartel is a situation where firms in the industry
a. have an agreement to restrict output.
b. agree to produce identical products.
c. obey the rules of dominant firm price leadership.
d. experience the pain of a kinked demand curve.
e. have a barometric price leader

ANS: PTS: 1
q. 18. In a kinked demand market, whenever one firm decides to lower its price,
r. a. other firms will automatically follow.
s. b. none of the other firms will follow.
t. c. one half of the firms follow and one half of the firms don’t follow the price cut.
u. d. other firms all decide to exit the industry
v. e. all of the other firms raise their prices.

ANS: PTS: 1

s. 19. The existence of a kinked demand curve under oligopoly conditions may result in
t. a. volatile prices
u. b. competitive pricing.
v. c. prices above the monopoly price.
w. d. an increase in the coefficient of variation of prices.
x. e. price rigidity

ANS: PTS: 1

20. Barometric price leadership exists when
a. one firm in the industry initiates a price change and the others follow it as a signal of changes in cost or demand in the industry.
b. one firm imposes its best price on the rest of the industry.
m. c. all firms agree to change prices simultaneously.
n. d. one company forms a price umbrella for all others.
o. e. the firms are all colluding.

ANS: PTS: 1

21. Some industries that have rigid prices. In those industries, we tend to
m. a. find that output is also rigid over the business cycle
n. b. find that output varies greatly over the business cycle
o. c. find the employment in these industries is quite stable over the business cycle
p. d. find that the rate of return is negative in boom times
q. e. all of the above.

ANS: PTS: 1

PROBLEMS

1. Two companies (A and B) are duopolists that produce identical products. Demand for the products is given by the following demand function:

P = 10,000−QA−QB

where QA and QB are the quantities sold by the respective firms and P is the selling price.

Total cost functions for the two companies are:

TCA = 500,000 + 200QA + .5QA2
TCB = 200,000 + 400QB + QB2

Assume that the two firms act independently as in the Cournot model (that is, each firm assumes that the other firm’s output will not change). Determine the long-run equilibrium output and selling price for each firm.

ANS:

PTS: 1

2. Two companies (A and B) are duopolists that produce identical products. Demand for the products is given by the following demand function:

P = 10,000−QA−QB

where QA and QB are the quantities sold by the respective firms and P is the selling price.

Total cost functions for the two companies are:

TCA = 500,000 + 200QA + .5QA2
TCB = 200,000 + 400QB + QB2

Assume that the firms form a cartel to maximize total industry profits (sum of Firm A and Firm B profits). Determine the optimum output and selling price for each firm.

3. The Winston Tobacco Company feels that it is faced with the following segmented demand function for its cigarettes:

where Q is the number of cartons sold and P is the price per carton.

(a) Why is such a segmented demand function likely to exist? What type of industry structure is indicated by this relationship?
(b) Determine Winston’s marginal revenue function.
(c) Given that Winston’s total cost function (including a “normal” return to the owners) is

TC1 = 80 + 2.6Q + .05Q2

determine Winston’s profit maximizing price and output level.
(d) Given that Winston’s total cost function increases to

TC2 = 90 + 3.4Q + .05Q2

what is their profit maximizing price and output level?

ANS:

PTS: 1

Chapter 13—Best Practice Tactics: Game Theory

MULTIPLE CHOICE

1. In ____ 2-person, nonzero-sum games there is no communication between the participants and no way to enforce agreements.
a. noncooperative
b. cooperative
c. a and b
d. none of the above

ANS: PTS: 1

2. A strategy game is
a. any pricing competition among firms
b. a situation arising from independent decision making among economic participants
c. interpendent choice behavior by individuals or groups who share a common goal
d. none of the above

ANS: PTS: 1

3. Essential components of a game include all of the following except:
a. players
b. payoffs
c. actions
d. an information set
e. cooperation

ANS: PTS: 1

4. In a zero-sum game
a. all players receive a $0 payoff
b. all players can simultaneously win
c. the gains to the winners equal the losses of the losers
d. none of the above

ANS: PTS: 1

5. When airlines post prices on an electronic bulletin board at 8:00 a.m. each morning, the decision-makers are engaged in
a. a single play game
b. a sequential game
c. an entry decision
d. a simultaneous game
e. an infinite repetition game

ANS: PTS: 1

6. The starting point of many methods for predicting equilibrium strategy in sequential games is
a. designing proactive reactions to rival actions
b. information sets
c. uncertain outcomes
d. backwards induction based on an explicit order of play
e. endgame analysis

ANS: PTS: 1

7. 7. Consider the game known as the Prisoner’s Dilemma. What’s the dilemma?
a. By both not confessing, both get to the cooperative solution and minimize time in prison.
b. By both confessing, both get to the noncooperative solution and both serve significant time in prison.
c. As a group, they are better off cooperating by not confessing, but each player has an incentive to be first to confess in a double cross.
d. The problem is that the spies should never have been caught; they should move to Rio.

ANS: PTS: 1

8. When there is an Equilibrium (or a Nash Equilibrium), we expect that:
a. once the firm’s get there, no one will change their strategy.
b. firms will tend to select a randomized strategy.
c. neither firm will care what it does.
d. this is always a dominated strategy.

ANS: PTS: 1

9. The Prisoner’s Dilemma involves two spies who are held in separate soundproof rooms. But even if the two spies could communicate, what makes it difficult for them to achieve the cooperative solution (both not confessing)?
a. The problem is their lack of information.
b. The problem is that it is a nonzero sum game.
c. The problem is that both spies have incentives to double cross each other.
d. The problem is that all the outcomes are not particularly good for either player.

ANS: PTS: 1

w. 10. When there is no Equilibrium (or no Nash Equilibrium), we expect that:
a. the firms end up in the cooperative strategy.
b. a firm will follow a randomized strategy.
c. a firm will not care what it does.
d. a firm will very likely have a dominant strategy.

ANS: PTS: 1

11. In a game, a dominated strategy is one where:
a. It is always the best strategy
b. It is always the worst strategy
c. It is the strategy that is the best among the group of worst possible strategies.
d. Is sometimes the best and sometimes the worst strategy

ANS: PTS: 1

12. If two firms operate in a market that is characterized as being a Prisoner’s Dilemma, and the two strategies given them are to restrict output or expand output, which of the following strategy pairs would represent the cooperative solution in a duopoly for firm 1 and firm 2, and firm 1 given first in each pair?
a. a. {expand output, restrict output}
b. b. {restrict output, expand output}
c. c. {restrict output, restrict output}
d. d. {expand output, expand output}

ANS: PTS: 1

13. A key to analyzing subgame perfect equilibrium strategy in sequential games is
a. predictable behavior
b. an explicit order of play for at least some participants
c. information sets that are known with certainty
d. credible threats clearly communicated
e. randomness

ANS: PTS: 1

14. Credibility in threats and commitments in sequential games is based on
a. randomizing one’s actions so they are unpredictable
b. explicit communications with competitors
c. effective scenario planning
d. analyzing best reply responses
e. none of the above

ANS: PTS: 1

15. In making promises that are not guaranteed by third parties and in imposing penalties that are not enforced by third parties, all of the following are credibility-enhancing mechanisms except
a. establishing a bond forfeited by violating the commitment
b. investing in a non-redeployable reputational asset tied to the promise or threat
c. interrupting the communication of negotiated compromises
d. offering a warranty
e. delivering a hostage (e.g., a patent license triggered by violating the promise)

ANS: PTS: 1

16. The difference between cooperative and non-cooperative games is
a. cooperative games allow side payments to support collusion
b. non-cooperative games encourage communication of sensitive information between arms-length competitors
c. cooperative games involve randomized behavior
d. cooperative games necessitate an explicit order of play
e. inconsequential except when players have contractual relationships

ANS: PTS: 1

17. An illustration of a non-credible commitment is the promise
a. to not increase capacity in a declining industry
b. to match a new entrant’s discount price
c. to enter a profitable industry
d. to restrain output to the quota assigned by a cartel
e. to exit in the face of projected losses.

ANS: PTS: 1

18. A dominant strategy differs from a Nash equilibrium strategy in that
a. Nash equilibrium strategy does not assume best reply responses
b. dominant strategy assumes best reply responses
c. only Nash strategy applies to simultaneous games
d. one dominant strategy is sufficient to predict behavior in a multi-person game
e. Nash strategy is often unique

ANS: PTS: 1

19. In adopting mixed Nash equilibrium strategy, a player is attempting to
a. randomize his or her own behavior
b. make the opponent favor a course of action preferred by the first player
c. randomize the outcome of actions
d. make the opponent indifferent between one action and another
e. none of the above

ANS: PTS: 1

20. To trust a potential cooperator until the first defection and then never cooperate thereafter is
a. a dominant strategy
b. an irrational strategy
c. a grim trigger strategy
d. a non-cooperative finite game strategy
e. a subgame imperfect strategy

ANS: PTS: 1

21. Non-cooperative sequential games can incorporate all the following features except
a. a single decision-maker in the endgame
b. no communication
c. finite or infinite time periods
d. third-party enforceable agreements
e. an explicit order of play

ANS: PTS: 1

22. If one-time gains from defection are always less than the discounted present value of an infinite time stream of cooperative payoffs at some given discount rate, the decision-makers have escaped
a. the Folk Theorem
b. the law of large numbers
c. the Prisoner’s dilemma
d. the paradox of large numbers
e. the strategy of recusal

ANS: PTS: 1
23. The chain store paradox of an incumbent who accommodates a finite stream of potential entrants threatening to enter sequentially numerous markets illustrates
a. backwards induction
b. the unraveling problem
c. subgame perfect equilibrium
d. best reply responses
e. all of the above

ANS: PTS: 1

24. Cooperation in repeated prisoner’s dilemma situations seems to be enhanced by all of the following except
a. limited punishment schemes
b. clarity of conditional rewards
c. grim trigger strategy
d. provocability–i.e., credible threats of punishment
e. tit for tat strategy

ANS: PTS: 1

25. Credible promises and hostage mechanisms can support a continuous stream of cooperative exchanges except when
a. the promisor is better off fulfilling than ignoring his promise
b. neither party has a prior dominant strategy
c. the hostage can be revoked for just causes
d. the hostage is more valuable than any given exchange
e. the hostage is difficult to replace

ANS: PTS: 1

PROBLEMS

Exhibit 13-1
Consider the information below when answering the following question(s):

PIZZA SPINNERS’ CHOICE
SIX SEVEN
Harry’s $550 $750
SIX $700 $100

Harry’s $120 $370
SEVEN $640 $350

(Note: Payoffs in the upper right corner go to Pizza Spinners and payoffs in the lower left go to Harry’s).

1. In choosing whether to deliver to six or seven neighborhoods, Pizza Spinners has to take into account not only its own costs, but also the delivery area response of its competitor Harry’s Pizzeria. If the payoffs per week from delivering in six and seven neighborhoods are as displayed in the exhibit above, what will Pizza Spinner’s choose and why?

ANS:

2. In choosing whether to deliver to six or seven neighborhoods, Harry’s Pizzeria has to take into account not only its own costs but the delivery area response of its competitor Pizza Spinners. If the payoffs per week from delivering in six and seven neighborhoods are as displayed in Exhibit 13-1, what will Harry’s Pizzeria choose and why?

ANS:

PTS: 1

3. If the city-pair route from Orlando to New Orleans is served by only two air carriers, Northwest and Delta, and if the payoffs from discounting or maintaining high prices are as below, what behavior would you predict for Delta in a one-play game and why?

DELTA’S CHOICES
MAINTAIN DISCOUNT
Northwest’s $26,000 $32,000
MAINTAIN $24,000 $18,000

Northwest’s $21,000 $16,000
DISCOUNT $28,000 $12,000

ANS:

4. Retailers A and B anticipate many repetitions of the following pricing game in which they must choose between discounting or maintaining higher prices. Under what circumstances will store A resist discounting and choose MAINTAIN?

STORE A’s CHOICES
MAINTAIN DISCOUNT
STORE B $550 $950
MAINTAIN $700 $100

STORE B $120 $370
DISCOUNT $640 $350

ANS:

PTS: 1

5. Suppose a new low cost discount firm must decide in advance between introducing LARGE or SMALL capacity in a licensed cable TV market where the incumbent then will decide on a HIGH or MATCHING pricing response. If the following table describes the payoffs from various combinations of these strategies, what capacity will the new entrant choose and why?

Incumbent Profit Entrant Profit

With LARGE Capacity HIGH Prices $50 $10
MATCHING Prices $70 $3

With SMALL Capacity HIGH Prices $90 $5
MATCHING Prices $60 $1

ANS:

Chapter 14—Pricing Techniques and Analysis

MULTIPLE CHOICE

1. The segmenting of customers into several small groups such as household, institutional, commercial, and industrial users, and establishing a different rate schedule for each group is known as:
a. first-degree price discrimination
b. market penetration
c. third-degree price discrimination
d. second-degree price discrimination
e. none of the above

ANS: PTS: 1

2. Which of the statements about price discrimination is (are) false?
a. It must be possible to segment the market.
b. It must be difficult to transfer the seller’s product from one market segment to another.
c. Public utilities practice first-degree price discrimination.
d. There must be differences in the elasticity of demand from one segment to another.
e. c and d

ANS: PTS: 1

3. Which of the following pricing policies best identifies when a product should be expanded, maintained, or discontinued?
a. full-cost pricing policy
b. target-pricing policy
c. marginal-pricing policy
d. market-share pricing policy
e. markup pricing policy

ANS: PTS: 1

4. Second-degree price discrimination:
a. is also known as block rate setting
b. is imperfect in the eyes of a monopolist
c. is regularly practiced by public utilities
d. is effective only in the case of services or products which are sold in easily metered units
e. all of the above

ANS: PTS: 1

5. In ____ price discrimination, the entire consumer surplus is captured by the producer.
a. first-degree
b. second-degree
c. third-degree
d. a and b
e. none of the above

ANS: PTS: 1

6. In ____ price discrimination, the monopolist charges each consumer the highest price that purchaser is willing to pay for each unit purchased (provided that this price exceeds the marginal cost of production).
a. first-degree
b. second-degree
c. third-degree
d. a and b
e. none of the above

ANS: PTS: 1

7. ____ is a new product pricing strategy which results in a high initial product price. This price is reduced over time as demand at the higher price is satisfied.
a. Prestige pricing
b. Price lining
c. Skimming
d. Incremental pricing
e. None of the above

ANS: PTS: 1

8. ____ is the price at which an intermediate good or service is transferred from the selling to the buying division within the same firm.
a. Incremental price
b. Marginal price
c. Full-cost price
d. Transfer price
e. none of the above

ANS: PTS: 1

9. For a monopolist that engages in price discrimination, when the price elasticity in market 1 is less (in absolute value) than in market 2, the optimal price in market 1 will exceed the optimal price in market 2.
a. true
b. false

ANS: PTS: 1

10. To maximize profits, a monopolist that engages in price discrimination must allocate output in such a way as to make identical the ____ in all markets.
a. ratio of price to marginal cost
b. ratio of marginal cost to marginal utility
c. ratio of price to elasticity
d. marginal revenue
e. none of the above

ANS: PTS: 1

11. Barbers give a price discount to kids. According to price discrimination, if barbers use price discrimination, this implies demand for hair cuts by kids is more elastic.
8. True
9. False

ANS: PTS: 1

12. Third-degree price discrimination exists whenever:
f. a. the seller knows exactly how much each potential customer is willing to pay and will charge accordingly.
g. b. different prices are charged by blocks of services.
h. c. the seller can separate markets by geography, income, age, etc., and charge different prices to these different groups.
i. d. the seller will bargain with buyers in each of the markets to obtain the best possible price.

ANS: PTS: 1

13. The following are possible examples of price discrimination, EXCEPT:
5. a. prices in export markets are lower than for identical products in the domestic market.
6. b. senior citizens pay lower fares on public transportation than younger people at the same time.
7. c. a product sells at a higher price at location A than at location B, because transportation costs are higher from the factory to A.
8. d. subscription prices for a professional journal are higher when bought by a library than when bought by an individual.

ANS: PTS: 1

14. Firms that have a cover charge for their customers and charge for each item they purchase as well are exhibiting
f. a. universal access price discrimination
g. b. declining block price discrimination.
h. c. mixed bundling price discrimination.
i. d. two-part price discrimination.
j. e. uniform pricing

ANS: PTS: 1

5. 15. A manufacturer produces two types of computer software, Word processing (W) and Spreadsheet (S), which is offered to two different retail outlets (#1 and #2). The following table shows the maximum price each retail outlet is willing to pay for each individual software product.
Product W Product S
Retail #1 $170 $105
Retail #2 $95 $135
What is the optimal pricing strategy that will maximize revenue for the manufacturer, given the maximum the retail outlets are willing to pay?
y. a. Bundle both products (W and S) and sell them at $230.
z. b. Price product W at $170 and Product S at $135.
aa. c. Price product W at $170 and Product S at $170.
bb. d. Price product W at $95 and Product S at $105.
cc. e. Bundle both products (W and S) and sell them at $275.

ANS: PTS: 1

16. Vacation tours to Europe invariably package visits to disparate regions: cities, mountains, and the seaside. Bundling, a type of second degree price discrimination, is most profitable when:
p. a. the preference rankings of vacationers travelling together are negatively correlated.
q. b. a preference for cities is always higher than preferences for mountain vistas.
r. c. preference rankings of vacationers travelling together are positively correlated.
s. d. preference for the seaside is always higher than preferences for city excursions.
t. e. no one wants to take a European vacation package to cities, mountains, and the seaside.

ANS:
17. The optimal mark-up is: m = -1/ (E+1). When the mark-up on cookware equals 50%, then demand elasticity (E) for cookware is:
r. a. -1
s. b. -1.5
t. c. -2
u. d. -3

ANS: PTS: 1

18. [Advanced Material] Cross functional revenue management examines capacity, pricing, and customer account management in order to maximize revenue.

Capacity Planning

Pricing Customer Account Management

If the MegaPlex Movie Theater finds that too often they have to turn customers away from their theaters at peak movie times for blockbusters creating too much slippage, cross functional revenue management suggests:
b. a. They could consider increasing the capacity of each theater to be able to seat more customers.
c. b. They could lower the price at the peak times to reduce the problem of spoilage.
d. c. They could stop showing blockbuster movies and select more critically acclaimed art films to decrease spoilage.
e. d. They could stop showing movies at night.

ANS: PTS: 1

b. 19. [Advanced Material] Restaurants try to buy just enough fish to match the expected walk-ins and reservations. If they buy a lot more fish, in the language of revenue management:
a. a. Spoilage increases
b. b. Spillage increases
c. c. Overbooking increases

ANS: PTS: 1

a. 20. [Advanced Material] If an airline company decides to buy smaller jets with fewer seats, then the problem of:
a. a. spillage and spoilage both increase.
b. b. spillage decreases, but spoilage increases.
c. c. spillage and spoilage both decrease.
d. d. spoilage decreases, but spillage increases.

ANS: PTS: 1

a. 21. [Advanced Material] If airlines found that the number of no-shows starts to increase, then its policy for optimal overbooking would tend to:
a. a. make them reduce the amount of overbooking.
b. b. cause them to increase the amount of overbooking.
c. c. let them keep the same amount of overbooking.

ANS: PTS: 1

PROBLEM

1. Consolidated Salt Company sells table salt to both retail grocery chains and commercial users (e.g., bakeries, snack food makers, etc.). The demand function for each of these markets is:

Retail grocery chains: P1 = 180−8Q1
Commercial users: P2 = 100−4Q2

where P1 and P2 are the prices charged and Q1 and Q2 are the quantities sold in the respective markets. Consolidated’s total cost function (which includes a “normal” return to the owners) for salt is:

TC = 50 + 20(Q1 + Q2)

(a) Determine Consolidated’s total profit function.
(b) Assuming that Consolidated is effectively able to charge different prices in the two markets, what are the profit-maximizing price and output levels for the product in the two markets? What is Consolidated’s total profit under this condition?
(c) Assuming that Consolidated is required to charge the same price in each market, what are the profit-maximizing price and output levels? What is Consolidated’s total profit under this condition?

ANS:

PTS: 1

Chapter 15—Contracting, Governance, and Organizational Form

MULTIPLE CHOICE

1. Non-redeployable durable assets that are dependent upon unique complementary and perfectly redeployable assets to achieve substantial value-added will typically be organized as
a. an export trading company
b. a spot market contract
c. a vertically integrated firm
d. an on-going relational contract
e. a joint stock company.

ANS: PTS: 1

2. Vertical integration may be motivated by all of the following except:
a. Upstream market power
b. Economies of ever wider spans of managerial control
c. Technological interdependencies
d. Reduced search and bargaining cost
e. The hold-up problem.

ANS: PTS: 1

3. Contracts are distinguished from tactical alliances by which of the following characteristics:
a. involve sequential responses
b. require third-party enforcement
c. raise shareholder value
d. elicit diminished reactions from competitors

ANS: PTS: 1

4. When manufacturers and distributors establish credible commitments to one another, they often employ
a. vertical requirements contracts
b. third-party monitoring
c. credible threat mechanisms
d. non-price tactics

ANS: PTS: 1

5. Which of the following is not among the functions of contract?
a. to provide incentives for efficient reliance
b. to reduce transaction costs
c. to discourage the development of asymmetric information
d. to provide risk allocation mechanisms

ANS: PTS: 1

6. Buying electricity off the freewheeling grid at one quarter ’til the hour for delivery on the hour illustrates:
a. relational contracts with distributors
b. vertical requirements contracts
c. spot market transactions
d. variable price agreements

ANS: PTS: 1

7. When someone contracts to do a task but fails to put full effort into the performance of an agreement, yet the lack of effort is not independently verifiable, this lack of effort constitutes a
a. breach of contractual obligations
b. denial of good guarantee
c. loss of reputation
d. moral hazard

ANS: PTS: 1

8. When retail bicycle dealers advertise and perform warranty repairs but do not deliver the personal selling message that Schwinn has designed as part of the marketing plan but cannot observe at less than prohibitive cost, the manufacturer has encountered a problem of ____.
a. reliance relationships
b. uncertainty
c. moral hazard
d. creative ingenuity
e. insurance reliance

ANS: PTS: 1

9. Which of the following are not approaches to resolving the principal-agent problem?
a. ex ante incentive alignment
b. deferred stock options
c. ex post governance mechanism
d. straight salary contracts
e. monitoring by independent outside directors

ANS: PTS: 1

10. To accomplish its purpose a linear profit-sharing contract must
a. induce the employee to moonlight
b. communicate a code of conduct that will be monitored and enforced
c. meet either the participation or the incentive compatibility constraint
d. establish a separating equilibrium
e. not realign incentives

ANS: PTS: 1

11. Mac trucks and their dealers would likely have an organizational form of
a. fixed profit sharing franchise contracts
b. spot market recontracting
c. alliances
d. vertical integration

ANS: PTS: 1
12. Reliant assets are always all of the following except:
a. durable
b. have substantially less value in second best use
c. dependent on unique complementary inputs
d. pivotal in designing strategy

ANS: PTS: 1

13. Governance mechanisms are designed
a. to increase contracting costs
b. to resolve post-contractual opportunism
c. to enhance the flexibility of restrictive covenants
d. to replace insurance
e. none of the above

ANS: PTS: 1

14. When borrowers who do not intend to repay are able to hide their bad credit histories, a lender’s well-intentioned borrowers should
a. complain to regulatory authorities
b. withdraw their loan applications
c. offer more collateral in exchange for lower interest charges
d. divulge still more information on their loan applications
e. hope for a pooling equilibrium

ANS: PTS: 1

15. Each of the following is an example of moral hazard in which people modify their behavior in an opportunistic way, often frustrating the intent of governmental or management policies. Which is NOT an example of moral hazard?
a. After a firm gets a loan from a bank to purchase inventory, the borrower instead decides to use it to invest in call options on stocks.
b. Based on motorcycle accident data, a state passes a law requiring motorcyclists to wear helmet, but then the motorcyclist wearing helmets start to drive faster and more recklessly.
c. Bank and nonbank mortgage lenders make money granting loans. But the Government through Freddie Mac and Fannie Mae decides to purchase these loans. The mortgage lenders find that they earn a fee for each mortgage that they grant and then sell to Freddie Mac or Fannie Mae. Since they never intended on holding on to the mortgage, the mortgage granters are not too particular on whether the customer can really pay it back. The lowest quality loans are sold to the Government.
d. A fellow buys a $1 million life insurance policy and then travels to Nepal to climb Mount Everest.
e. A student learns that if he or she reads the chapter and studies lecture notes, the student does better on the next test.

ANS: PTS: 1

16. Agency problems appear in many settings within a firm. All of the following are examples, except which is NOT a good example of this problem?
a. Diversified stockholders are more enthusiastic on accepting business risks than are firm managers.
b. Firm managers receive cash bonuses based on the performance of the firm.
10. Employees sometime take items from the store in which they work.
11. Lenders to firms want the managers to invest in safe projects to protect their collateral in the project but managers want to invest in projects that will make a name for them and warrant promotion.
12. Firm managers sometime want to relax on the job.
ANS: PTS: 1

PROBLEMS

1. Cooperative agreements between manufacturers and retailers concerning retail promotion and manufacturer advertising are often the key to the success of new products. Analyze the following sequential product promotion game, and then predict 1) whether the product will be updated by the manufacturer (Man), 2) whether the retail distributor (RET) will promote the product, and 3) whether the manufacturer will advertise the product. No explanation necessary.

2. In the following sequential marketing game, is a threat by the manufacturer (Man) not to advertise a newly updated product unless the retailer (RET) promotes it a credible threat?

Chapter 16—Government Regulation

MULTIPLE CHOICE

1. Patents have been defended by some on the grounds that they stimulate inventive activity. Others have argued for changes in current patent laws because:
a. resources are misallocated by the grant of a patent monopoly
b. patents may not be necessary to encourage inventive activity
c. the current patent monopoly period (17 years) is too short to encourage any inventive activity.
d. a and b only
e. all of the above

ANS: PTS: 1

2. The Sherman Act prohibits:
a. contracts in restraint of commerce
b. monopolization of an industry
c. price discrimination
d. a and b
e. a, b, and c

ANS: PTS: 1

3. The sentiment for increased deregulation in the late 1970’s and early 1980’s has been felt most significantly in the price regulation of
a. coal
b. grain
c. transportation
d. automobiles
e. electric power generation

ANS: PTS: 1

4. Which of the following public policies has (have) the effect of restricting competition?
a. licensing
b. patents
c. import quotas
d. a and b only
e. a, b, and c

ANS: PTS: 1

5. The concept of market structure refers to three main characteristics of buyers and sellers in a particular market. These include ____.
a. the degree of seller and buyer concentration in the market
b. the degree of actual or imagined differentiation between the products or services of competing producers
c. the pricing behavior of the firms
d. a and b
e. a, b, and c

ANS: PTS: 1
6. The concept of market conduct includes such things as ____.
a. pricing behavior of the firm or group of firms
b. product policy of the firm or group of firms
c. the degree of seller and buyer concentration in the market
d. a and b only
e. a, b, and c

ANS: PTS: 1

7. ____ yields the same results as the theory of perfect competition, but requires substantially fewer assumptions than the perfectly competitive model.
a. Baumol’s sales maximization hypothesis
b. The Pareto optimality condition
c. The Cournot model
d. The theory of contestable markets
e. none of the above

ANS: PTS: 1

8. The lower the barriers to entry and exit, the more nearly a market structure fits the ____ market model.
a. monopolistic competition
b. perfectly contestable
c. oligopoly
d. monopoly
e. none of the above

ANS: PTS: 1

9. The Herfindahl-Hirschman index (also shortened to just the Herfindahl index) is a measure of ____.
a. market concentration
b. income distribution
c. technological progressiveness
d. price discrimination
e. none of the above

ANS: PTS: 1

10. The ____ is equal to the some of the squares of the market shares of all the firms in an industry.
a. market concentration ratio
b. Herfindahl-Hirschman index
c. correlation coefficient
d. standard deviation of concentration
e. none of the above

ANS: PTS: 1

11. Industry A has market shares of 50, 30, and 20. Industry B has market shares of 45, 40, and 15. Hint: HHI = (si2), where si is the market shares of the i-th firm in the industry.
a. The Herfindahl index for A is 100.
b. The Herfindahl index for A is 3,800.
c. The Herfindahl index for B is 3,600
d. The Herfindahl index for A is greater than for B.
e. The Herfindahl index is for B is 4,000.

ANS: PTS: 1
12. The antitrust laws regulate all of the following business decisions except ____.
a. collusion
b. mergers
c. monopolistic practices
d. price discrimination
e. wage levels

ANS: PTS: 1

13. ____ occurs whenever a third party receives or bears costs arising from an economic transaction in which the individual (or group) is not a direct participant.
a. Pecuniary benefits and costs
b. Externalities
c. Intangibles
d. Monopoly costs and benefits
e. none of the above

ANS: PTS: 1

14. The Coase Theorem works best in places that transaction costs for contracts among people is low. Often in the world of torts and externalities both parties can claim that they have rights to impose on others. One case is that of a railroad that is noisy and scares the cattle and the rancher whose cattle sometimes wander in front of moving trains causing damage to them and the train. What does the Coase say would happen?
a. The train should have property right to be safe from wandering cattle, and the rancher should be liable for train damage of rampaging cattle.
b. The rancher should have the property right to be safe from noisy trains, and the railroad should be liable for weight loss of cattle from train whistles and rumbling noise.
c. If transaction costs are low, the efficient activity will occur, either the rancher or railroad installing fences to protect from rampaging cattle and/or sound insulation with trees, or if it is cheaper, fewer train trips per day. The cheapest or most efficient solution will happen, regardless of who is assigned the original property right.

ANS: PTS: 1

Chapter 17—Long-Term Investment Analysis

MULTIPLE CHOICE

1. Capital expenditures:
a. are easily reversible
b. are forms of operating expenditures
c. Affect long-run future profitability
d. Involve only money, not machinery
e. none of the above

ANS: PTS: 1

2. Any current outlay that is expected to yield a flow of benefits beyond one year in the future is:
a. a capital gain
b. a wealth maximizing factor
c. a capital expenditure
d. a cost of capital
e. a dividend reinvestment

ANS: PTS: 1

3. If the acceptance of Project A makes it impossible to accept Project B, these projects are:
a. contingent projects
b. complementary projects
c. mutually inclusive projects
d. mutually exclusive projects
e. none of the above

ANS: PTS: 1

4. Which of the following is (are) a guideline(s) to be used in the estimation of cash flows?
a. cash flows should be measured on an incremental basis
b. cash flows should be measured on an after-tax basis
c. all the indirect effects of the project should be included
d. all of the above
e. none of the above

ANS: PTS: 1

5. In order to help assure that all relevant factors will be considered, the capital-expenditure selection process should include the following steps except:
a. generating alternative capital-investment project proposals
b. estimating cash flows for the project proposals
c. reviewing the investment projects after they have been implemented
d. allocate manpower to the various divisions within the firm
e. a and d

ANS: PTS: 1

6. Which of the following would not be classified as a capital expenditure for decision-making purposes?
a. purchase of a building
b. investment in a new milling machine
c. purchase of 90-day Treasury Bills
d. investment in a management training program
e. all of the above are capital expenditures

ANS: PTS: 1

7. The decision by the Municipal Transit Authority to either refurbish existing buses, buy new large buses, or to supplement the existing fleet with mini-buses is an example of:
a. independent projects
b. mutually exclusive projects
c. contingent projects
d. separable projects
e. none of the above

ANS: PTS: 1

8. Which of the following is (are) a basic principle(s) when estimating a project’s cash flows?
a. cash flows should be measured on a pre-tax basis
b. cash flows should ignore depreciation since it is a non-cash charge
c. only direct effects of a project should be included in the cash flow calculations
d. cash flows should be measured on an incremental basis
e. all of the above

ANS: PTS: 1

9. Which of the following items is (are) not considered as part of the net investment calculation?
a. installation and shipping charges
b. acquisition cost of new asset
c. salvage value of old equipment that is being replaced
d. first year’s net cash flow
e. c and d

ANS: PTS: 1

10. The relationship between NPV and IRR is such that :
a. both approaches always provide the same ranking of alternatives
b. the IRR of a project is equal to the firm’s cost of capital when the NPV of a project is $0
c. if the NPV of a project is negative, then the IRR must be greater than the cost of capital
d. all of the above
e. none of the above

ANS: PTS: 1

11. Project post-audit reviews are rarely of practical value because capital investments are sunk, irreversible costs.
a. true
b. false

ANS: PTS: 1

12. The cost of capital can be thought of as the rate of return required by investors in the firm’s securities.
a. true
b. false

ANS: PTS: 1

13. In cost of capital calculations, the flotation cost on new debt is usually ignored because the flotation cost percentage for large debt issues is relatively low.
a. true
b. false

ANS: PTS: 1

14. The cost of internal equity (retained earnings) is ____ the cost of external equity (new common stock).
a. greater than
b. equal to
c. less than

ANS: PTS: 1

15. The expected rate of return from a share of stock consists of:
a. a dividend return
b. capital appreciation (or depreciation)
c. interest
d. a and b only
e. a, b, and c

ANS: PTS: 1

16. The weights used in calculating the firm’s weighted-average cost of capital are equal to the proportion of debt and equity ____.
a. used to finance the project
b. used to finance the projects undertaken last year
c. in the industry average capital structure
d. in the firm’s target capital structure
e. none of the above

ANS: PTS: 1

17. In determining the optimal capital budget, one should choose those project’s whose ____ exceeds the firm’s ____ cost of capital.
a. internal rate of return, average
b. internal rate of return, marginal
c. internal rate of return, historic
d. average rate of return, marginal
e. none of the above

ANS: PTS: 1

18. In the constant-growth dividend valuation model, the required rate of return on common stock (i.e., cost of equity capital) can be shown to be equal to the sum of the dividend yield plus the ____.
a. yield-to-maturity
b. present value yield
c. risk-free rate
d. dividend growth rate
e. none of the above

ANS: PTS: 1

19. The ____ depicts the risk-return relationship in the market for all securities:
a. characteristic line
b. security market line
c. investment opportunity curve
d. marginal cost of capital schedule
e. none of the above

ANS: PTS: 1

20. Beta in the CAPM is ____.
a. one measure of the systematic risk of a stock
b. estimated as the slope of a regression line between an individual security’s returns and returns for the market index.
c. useful in estimating the firm’s cost of debt capital
d. a and b only
e. a, b, and c

ANS: PTS: 1

21. The effect of changes in the level of interest rates on security returns is an example of ____.
a. systematic risk
b. unsystematic risk
c. nondiversifiable risk
d. a and c only
e. b and c only

ANS: PTS: 1

22. The ____ method assumes that the cash flows over the life of the project are reinvested at the ____.
a. net present value; computed internal rate of return
b. internal rate of return; firm’s cost of capital
c. net present value; firm’s cost of capital
d. net present value; risk-free rate of return
e. none of the above

ANS: PTS: 1

23. All of the following except ____ are shortcomings of cost-benefit analysis.
a. difficulty in measuring third-party costs
b. difficulty in measuring third-party benefits
c. failure to consider the time value of benefits and costs
d. difficulty of accounting for program interactions
e. a and b

ANS: PTS: 1

24. Which of the following should not be counted in a cost-benefit analysis?
a. direct benefits and costs
b. real secondary benefits
c. technological secondary costs
d. pecuniary benefits
e. intangibles

ANS: PTS: 1

25. The social rate of discount is best approximated by:
a. the cost of government borrowing
b. the opportunity cost of resources taken from the private sector
c. 3 percent
d. 30 percent
e. none of the above

ANS: PTS: 1

26. In cost-effectiveness analysis, constant cost studies:
a. are rarely used
b. attempt to specify the output which may be achieved from a number of alternative programs, assuming all are funded at the same level
c. are useless because they fail to adequately evaluate program benefits
d. try to find the least expensive way of achieving a certain objective
e. none of the above

ANS: PTS: 1

27. Cost-benefit analysis is the public sector counterpart to ____ used in private, profit-oriented firms.
a. ratio analysis
b. break-even analysis
c. capital budgeting techniques
d. economic forecasting
e. none of the above

ANS: PTS: 1

28. Direct costs of a public sector investment project are generally easier to measure than the direct benefits.
a. true
b. false

ANS: PTS: 1

29. In calculating the benefit-cost ratio, social benefits and costs are discounted at the
a. internal rate of return
b. federal funds rate
c. Treasury Bill rate
d. long-term government bond rate
e. none of the above

ANS: PTS: 1

30. The discount rate utilized in public sector budgeting performs the functions of:
a. allocating funds between the public and private sectors
b. allocating funds between present consumption and investment (i.e., future consumption)
c. allocating funds between debt and equity securities
d. a and b only
e. none of the above

ANS: PTS: 1

31. In cost-benefit analysis, a low discount rate tends to favor projects with relatively ____ lives.
a. short
b. long

ANS: PTS: 1

32. The social discount rate used in cost-benefit analysis is equal to a weighted average of the Treasury Bill rate and the long-term government borrowing rate.
a. true
b. false

ANS: PTS: 1

33. Public sector investment projects are economically justifiable only when:
a. the discounted social benefits exceed the discounted social costs
b. the internal rate of return exceeds the social discount rate
c. the benefit-cost ratio exceeds zero
d. a and b only
e. a, b, and c

ANS: PTS: 1

34. In cost-benefit analysis, intangibles include such factors as:
a. quality of life considerations
b. changes in land values resulting from a project
c. aesthetic contributions
d. a and b only
e. a and c only

ANS: PTS: 1

PROBLEMS

1. RCB Corporation is considering the purchase of a machine for which the initial cash outlay will be $100,000. Predicted net cash inflows before depreciation and taxes are $25,000 per year for the next five years. The machine will be depreciated (using the straight-line method) over the 5-year period with a zero estimated salvage value at the end of the period. The corporation’s marginal tax rate is 40 percent and its cost of capital is 12 percent.

(a) Determine the annual net cash flow after depreciation and taxes for years 1-5.
(b) Determine the internal rate of return.
(c) Determine the net present value.
(d) Should RCB purchase the machine? Why or why not?

NOTE: This problem requires the use of present value tables or a financial calculator.

ANS:

PTS: 1

2. The capital structure of Wildcat Wells, an independent petroleum exploration and drilling company, consists of 40 percent debt and 60 percent equity capital. Debt capital consists of a bond (which matures in 10 years) issued five years ago at an interest rate of 10 percent. Since then market interest rates have risen substantially. The firm has been advised by its investment banker that additional debt financing (bonds) could be obtained at a rate of 12 percent. In the last six years of operations, Wildcat Wells has averaged a 12 percent compound rate of growth in earnings and dividends. This rate is expected to continue for the foreseeable future. Next year’s dividend is projected to be $.75 per share. The firm’s stock is currently selling for $25 per share. Wildcat Wells has a 40 percent marginal income tax rate.

(a) What is the firm’s after-tax cost of debt financing?
(b) What is the firm’s after-tax cost of internal equity capital?
(c) Assuming that Wildcat Wells plans to maintain its present capital structure, what is the firm’s weighted cost of capital?

ANS:

PTS: 1

3. The production superintendent of the Holloway Company has proposed that the firm purchase a new $40,000 grinding machine for use in the plant. The machine is expected to generate $10,000 per year in pre-tax cash savings (labor and spoilage) for the next 10 years. At the end of 10 years the salvage value of the machine is estimated to be $5,000. Holloway uses straight-line depreciation and its marginal income tax rate is 40 percent. The firm’s cost of capital is 12 percent.

(a) What are the net cash inflows after depreciation and taxes for the machine in years 1-10?
(b) What is the net present value for the machine?
(c) What is the internal rate of return for the machine?
(d) Would you recommend purchasing the machine? Why or why not?

NOTE: This problem requires the use of present value tables or a financial calculator.

ANS:

PTS: 1

4. Aspen Industries currently pays an annual common stock dividend of $5.00 per share. The company’s dividend has grown steadily over the past 10 years at a 7 percent rate and this rate is expected to continue for the foreseeable future. The company’s stock currently sells for $70 per share. The company can issue new common stock at a net price of $65 per share.

(a) Determine the firm’s cost of internal equity capital using the dividend capitalization (constant-growth) model.
(b) Determine the firm’s cost of external equity capital using the dividend capitalization (constant-growth) model.

ANS:

PTS: 1

5. Piedmont Power Company’s common stock has a beta, ß, estimated to be .85. The risk-free rate is 8 percent and the expected market return is 14 percent. Compute Peidmont’s cost of equity capital.

PTS: 1

6. The Jackson Company has the following capital expenditure projects available for possible investment next year:

Investment Internal
Project (Million) Rate of Return

A $10 22%
B 25 14
C 20 18
D 40 12
E 15 10
F 10 13
G 50 15
H 30 11

The company has developed the following costs of various increments of capital needed to finance its capital budget for next year:

Amount of
Capital Raised Cost of
(Million) Capital

Up to $50 11.0
$50-$125 12.5
Over $125 14.5

Determine the optimal capital budget for the company.

ANS:

7. The Ministry of Recreation has decided to consider a proposal to build a new regional park. A piece of land is available which can be purchased, after condemnation proceedings, for $1,000,000. A private developer has offered the owner of the land $2 million. The value of direct recreational benefits from the park is estimated at $175,000 per year for 25 years. In addition, indirect benefits of $12,500 per year for 25 years have been projected. Increased values in land surrounding the project will provide immediate, one-time pecuniary benefits to the land-owners of $1,000,000.

The direct cost to operate and maintain the park is estimated at $50,000 per year. The Ministry believes a 10% discount rate is appropriate to evaluate projects of this sort. Should the park be built? Justify your answer using cost benefit analysis.

ANS: