ECO 550 Managerial Economics Complete Quiz Bank Week 1 – 11

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EC0 550 Complete Week 1 – 11 Quiz Test – A+ Graded Material – Strayer
Chapter 1 Quiz: Introduction and Goals of the Firm

1. The form of economics most relevant to managerial decision-making within the firm is:
a. macroeconomics
b. welfare economics
c. free-enterprise economics
d. microeconomics
e. none of the above

2. If one defines incremental cost as the change in total cost resulting from a decision, and incremental revenue as the change in total revenue resulting from a decision, any business decision is profitable if:
a. it increases revenue more than costs or reduces costs more than revenue
b. it decreases some costs more than it increases others (assuming revenues remain constant)
c. it increases some revenues more than it decreases others (assuming costs remain constant)
d. all of the above
e. b and c only

3. In the shareholder wealth maximization model, the value of a firm’s stock is equal to the present value of all expected future ____ discounted at the stockholders’ required rate of return.
a. profits (cash flows)
b. revenues
c. outlays
d. costs
e. investments

4. Which of the following statements concerning the shareholder wealth maximization model is (are) true?
a. The timing of future profits is explicitly considered.
b. The model provides a conceptual basis for evaluating differential levels of risk.
c. The model is only valid for dividend-paying firms.
d. a and b
e. a, b, and c

5. According to the profit-maximization goal, the firm should attempt to maximize short-run profits since there is too much uncertainty associated with long-run profits.
a. true
b. false

6. According to the innovation theory of profit, above-normal profits are necessary to compensate the owners of the firm for the risk they assume when making their investments.
a. true
b. false

7. According to the managerial efficiency theory of profit, above-normal profits can arise because of high-quality managerial skills.
a. true
b. false

8. Which of the following (if any) is not a factor affecting the profit performance of firms:
a. differential risk
b. innovation
c. managerial skills
d. existence of monopoly power
e. all of the above are factors

9. Agency problems and costs are incurred whenever the owners of a firm delegate decision-making authority to management.
a. true
b. false

10. Economic profit is defined as the difference between revenue and ____.
a. explicit cost
b. total economic cost
c. implicit cost
d. shareholder wealth
e. none of the above

11. Income tax payments are an example of ____.
a. implicit costs
b. explicit costs
c. normal return on investment
d. shareholder wealth
e. none of the above

12. Various executive compensation plans have been employed to motivate managers to make decisions that maximize shareholder wealth. These include:
a. cash bonuses based on length of service with the firm
b. bonuses for resisting hostile takeovers
c. requiring officers to own stock in the company
d. large corporate staffs
e. a, b, and c only

13. The common factors that give rise to all principal-agent problems include the
a. unobservability of some manager-agent action
b. presence of random disturbances in team production
c. the greater number of agents relative to the number of principals
d. a and b only
e. none of the above

14. The Saturn Corporation (once a division of GM) was permanently closed in 2009. What went wrong with Saturn?
a. Saturn’s cars sold at prices higher than rivals Honda or Toyota, so they could not sell many cars.
b. Saturn sold cars below the prices of Honda or Toyota, earning a low 3% rate of return.
c. Saturn found that young buyers of Saturn automobiles were very loyal to Saturn and GM.
d. Saturn implemented a change management view that helped make first time Saturn purchasers trade up to Buick or Cadillac.
e. all of the above

15. A Real Option Value is:
a. An option that been deflated by the cost of living index makes it a “real” option.
b. An opportunity cost of capital.
c. An opportunity to implement a new cost savings or revenue expansion activity that arises from business plans that the managers adopt.
d. An objective function and a decision rule that comes from it.
e. Both a and b.

16. Which of the following will increase (V0), the shareholder wealth maximization model of the firm:
V0·(shares outstanding) = ??t=1 (? t ) / (1+ke)t + Real Option Value.
a. Decrease the required rate of return (ke).
b. Decrease the stream of profits (?t).
c. Decrease the number of periods from ? to 10 periods.
d. Decrease the real option value.
e. All of the above.

17. The primary objective of a for-profit firm is to ___________.
a. maximize agency costs
b. minimize average cost
c. maximize total revenue
d. set output where total revenue equals total cost
e maximize shareholder value

18. Possible goals of Not-For-Profit (NFP) enterprises include all of the following EXCEPT:
a. maximize total costs
b. maximize output, subject to a breakeven constraint
c. maximize the happiness of the administrators of the NFP enterprise
d. maximize the utility of the contributors
e. a. and c.

19. The flat-screen plasma TVs are selling extremely well. The originators of this technology are earning higher profits. What theory of profit best reflects the performance of the plasma screen makers?
a. risk-bearing theory of profit
b. dynamic equilibrium theory of profit
c. innovation theory of profit
d. managerial efficiency theory of profit
e. stochastic optimization theory of profit

20. To reduce Agency Problems, executive compensation should be designed to:
a. create incentives so that managers act like owners of the firm.
b. avoid making the executives own shares in the company.
c. be an increasing function of the firm’s expenses.
d. be an increasing function of the sales revenue received by the firm.
e. all of the above

21. Recently, the American Medical Association changed its recommendations on the frequency of pap-smear exams for women. The new frequency recommendation was designed to address the family histories of the patients. The optimal frequency should be where the marginal benefit of an additional pap-test:
a. equals zero.
b. is greater than the marginal cost of the test
c. is lower than the marginal cost of an additional test
d. equals the marginal cost of the test
e. both a and b.
Chapter 2 Quiz Fundamental Economic Concepts

1. A change in the level of an economic activity is desirable and should be undertaken as long as the marginal benefits exceed the ____.
a. marginal returns
b. total costs
c. marginal costs
d. average costs
e. average benefits

2. The level of an economic activity should be increased to the point where the ____ is zero.
a. marginal cost
b. average cost
c. net marginal cost
d. net marginal benefit
e. none of the above

3. The net present value of an investment represents
a. an index of the desirability of the investment
b. the expected contribution of that investment to the goal of shareholder wealth maximization
c. the rate of return expected from the investment
d. a and b only
e. a and c only

4. Generally, investors expect that projects with high expected net present values also will be projects with
a. low risk
b. high risk
c. certain cash flows
d. short lives
e. none of the above

5. An closest example of a risk-free security is
a. General Motors bonds
b. AT&T commercial paper
c. U.S. Government Treasury bills
d. San Francisco municipal bonds
e. an I.O.U. that your cousin promises to pay you $100 in 3 months

6. The standard deviation is appropriate to compare the risk between two investments only if
a. the expected returns from the investments are approximately equal
b. the investments have similar life spans
c. objective estimates of each possible outcome is available
d. the coefficient of variation is equal to 1.0
e. none of the above

7. The approximate probability of a value occurring that is greater than one standard deviation from the mean is approximately (assuming a normal distribution)
a. 68.26%
b. 2.28%
c. 34%
d. 15.87%
e. none of the above

8. Based on risk-return tradeoffs observable in the financial marketplace, which of the following securities would you expect to offer higher expected returns than corporate bonds?
a. U.S. Government bonds
b. municipal bonds
c. common stock
d. commercial paper
e. none of the above

9. The primary difference(s) between the standard deviation and the coefficient of variation as measures of risk are:
a. the coefficient of variation is easier to compute
b. the standard deviation is a measure of relative risk whereas the coefficient of variation is a measure of absolute risk
c. the coefficient of variation is a measure of relative risk whereas the standard deviation is a measure of absolute risk
d. the standard deviation is rarely used in practice whereas the coefficient of variation is widely used
e. c and d

10. The ____ is the ratio of ____ to the ____.
a. standard deviation; covariance; expected value
b. coefficient of variation; expected value; standard deviation
c. correlation coefficient; standard deviation; expected value
d. coefficient of variation; standard deviation; expected value
e. none of the above

11. Sources of positive net present value projects include
a. buyer preferences for established brand names
b. economies of large-scale production and distribution
c. patent control of superior product designs or production techniques
d. a and b only
e. a, b, and c

12. Receiving $100 at the end of the next three years is worth more to me than receiving $260 right now, when my required interest rate is 10%.
a. True
b. False

13. The number of standard deviations z that a particular value of r is from the mean ? can be computed as z = (r – ?)/ ????Suppose that you work as a commission-only insurance agent earning $1,000 per week on average. Suppose that your standard deviation of weekly earnings is $500. What is the probability that you zero in a week? Use the following brief z-table to help with this problem.

Z value Probability
-3 .0013
-2 .0228
-1 .1587
0 .5000

a. 1.3% chance of earning nothing in a week
b. 2.28% chance of earning nothing in a week
c. 15.87% chance of earning nothing in a week
d. 50% chance of earning nothing in a week
e. none of the above

t

T
14. Consider an investment with the following payoffs and probabilities:
State of the Economy Probability Return
Stability .50 1,000
Good Growth .50 2,000
Determine the expected return for this investment.
a. 1,300
b. 1,500
c. 1,700
d. 2,000
e. 3,000

15. Consider an investment with the following payoffs and probabilities:
State of the Economy Probability Return
GDP grows slowly .70 1,000
GDP grow fast .30 2,000
Let the expected value in this example be 1,300. How do we find the standard deviation of the investment?
a. ? = ? { (1000-1300)2 + (2000-1300)2 }
b. ? = ? { (1000-1300) + (2000-1300) }
c. ??= ? { (.5)(1000-1300)2 + (.5)(2000-1300)2 }
d. ??= ? { (.7)(1000-1300) + (.3)(2000-1300) }
e. ??= ? { (.7)(1000-1300)2 + (.3)(2000-1300)2 }

16. An investment advisor plans a portfolio your 85 year old risk-averse grandmother. Her portfolio currently consists of 60% bonds and 40% blue chip stocks. This portfolio is estimated to have an expected return of 6% and with a standard deviation 12%. What is the probability that she makes less than 0% in a year? [A portion of Appendix B1 is given below, where z = (x – ???????with ??as the mean and ??as the standard deviation.]
a. 2.28%
b. 6.68%
c. 15.87%
d. 30.85%
e. 50%

17. Two investments have the following expected returns (net present values) and standard deviations:
PROJECT Expected Value Standard Deviation
Q $100,000 $20,000
X $50,000 $16,000
Based on the Coefficient of Variation, where the C.V. is the standard deviation dividend by the expected value.
a. All coefficients of variation are always the same.
b. Project Q is riskier than Project X
c. Project X is riskier than Project Q
d. Both projects have the same relative risk profile
e. There is not enough information to find the coefficient of variation.

PROBLEMS

1. Suppose that the firm’s cost function is given in the following schedule (where Q is the level of output):

Output Total
Q (units) Cost
0 7
1 25
2 37
3 45
4 50
5 53
6 58
7 66
8 78
9 96
10 124

Determine the (a) marginal cost and (b) average total cost schedules

2. Complete the following table.

Total Marginal Average
Output Profit Profit Profit

0 ?48 0 ______
1 ?26 ______ ______
2 ?8 ______ ______
3 6 ______ ______
4 16 ______ ______
5 22 ______ ______
6 24 ______ ______
7 22 ______ ______
8 16 ______ ______
9 6 ______ ______
10 ?8 ______ ______

3. A firm has decided to invest in a piece of land. Management has estimated that the land can be sold in 5 years for the following possible prices:

Price Probability

10,000 .20
15,000 .30
20,000 .40
25,000 .10

(a) Determine the expected selling price for the land.
(b) Determine the standard deviation of the possible sales prices.
(c) Determine the coefficient of variation.
Chapter 3 Quiz: Demand Analysis

1. Suppose we estimate that the demand elasticity for fine leather jackets is .7 at their current prices. Then we know that:
a. a 1% increase in price reduces quantity sold by .7%.
b. no one wants to buy leather jackets.
c. demand for leather jackets is elastic.
d. a cut in the prices will increase total revenue.
e. leather jackets are luxury items.

2. If demand were inelastic, then we should immediately:
a. cut the price.
b. keep the price where it is.
c. go to the Nobel Prize Committee to show we were the first to find an upward sloping demand curve.
d. stop selling it since it is inelastic.
e. raise the price.

3. In this problem, demonstrate your knowledge of percentage rates of change of an entire demand function (Hint: %?Q = EP•%?P + EY•%?Y). You have found that the price elasticity of motor control devices at Allen-Bradley Corporation is -2, and that the income elasticity is a +1.5. You have been asked to predict sales of these devices for one year into the future. Economists from the Conference Board predict that income will be rising 3% over the next year, and AB’s management is planning to raise prices 2%. You expect that the number of AB motor control devices sold in one year will:
a. fall .5%.
b. not change.
c. rise 1%r.
d. rise 2%.
e. rise .5%.

4 A linear demand for lake front cabins on a nearby lake is estimated to be: QD = 900,000 – 2P. What is the point price elasticity for lake front cabins at a price of P = $300,000? [Hint: Ep = (?Q/?P)(P/Q)]
a. EP = -3.0
b. EP = -2.0
c. EP = -1.0
d. EP = -0.5
e. EP = 0

5. Property taxes are the product of the tax rate (T) and the assessed value (V). The total property tax collected in your city (P) is: P = T•V. If the value of properties rise 4% and if Mayor and City Council reduces the property the tax rate by 2%, what happens to the total amount of property tax collected? [hint: the percentage rate of change of a product is approximately the sum of the percentage rates of change.}
a. It rises 6 %.
b. It rises 4 %.
c. It rises 3 %.
d. It rises 2 %
e. If falls 2%.

6. Demand is given by QD = 620 10•P and supply is given by QS = 100 + 3•P. What is the price and quantity when the market is in equilibrium?
a. The price will be $30 and the quantity will be 132 units.
b. The price will be $11 and the quantity will be 122 units.
c. The price will be $40 and the quantity will be 220 units.
d. The price will be $35 and the quantity will be 137 units
e. The price will be $10 and the quantity will be 420 units.

7. Which of the following would tend to make demand INELASTIC?
a. the amount of time analyzed is quite long
b. there are lots of substitutes available
c. the product is highly durable
d. the proportion of the budget spent on the item is very small
e. no one really wants the product at all

8. Which of the following best represents management’s objective(s) in utilizing demand analysis?
a. it provides insights necessary for the effective manipulation of demand
b. it helps to measure the efficiency of the use of company resources
c. it aids in the forecasting of sales and revenues
d. a and b
e. a and c

9. Identify the reasons why the quantity demanded of a product increases as the price of that product decreases.
a. as the price declines, the real income of the consumer increases
b. as the price of product A declines, it makes it more attractive than product B
c. as the price declines, the consumer will always demand more on each successive price reduction
d. a and b
e. a and c

10. An increase in the quantity demanded could be caused by:
a. an increase in the price of substitute goods
b. a decrease in the price of complementary goods
c. an increase in consumer income levels
d. all of the above
e. none of the above

11. Iron ore is an example of a:
a. durable good
b. producers’ good
c. nondurable good
d. consumer good
e. none of the above

12. If the cross price elasticity measured between items A and B is positive, the two products are referred to as:
a. complements
b. substitutes
c. inelastic as compared to each other
d. both b and c
e. a, b, and c

13. When demand is ____ a percentage change in ____ is exactly offset by the same percentage change in ____ demanded, the net result being a constant total consumer expenditure.
a. elastic; price; quantity
b. unit elastic; price; quantity
c. inelastic; quantity; price
d. inelastic; price; quantity
e. none of the above

14. Marginal revenue (MR) is ____ when total revenue is maximized.
a. greater than one
b. equal to one
c. less than zero
d. equal to zero
e. equal to minus one

15. The factor(s) which cause(s) a movement along the demand curve include(s):
a. increase in level of advertising
b. decrease in price of complementary goods
c. increase in consumer disposable income
d. decrease in price of the good demanded
e. all of the above

16. An increase in each of the following factors would normally provide a subsequent increase in quantity demanded, except:
a. price of substitute goods
b. level of competitor advertising
c. consumer income level
d. consumer desires for goods and services
e. a and b

17. Producers’ goods are:
a. consumers’ goods
b. raw materials combined to produce consumer goods
c. durable goods used by consumers
d. always more expensive when used by corporations
e. none of the above

18. The demand for durable goods tends to be more price elastic than the demand for non-durables.
a. true
b. false

19. A price elasticity (ED) of ?1.50 indicates that for a ____ increase in price, quantity demanded will ____ by ____.
a. one percent; increase; 1.50 units
b. one unit; increase; 1.50 units
c. one percent; decrease; 1.50 percent
d. one unit; decrease; 1.50 percent
e. ten percent; increase; fifteen percent

20. Those goods having a calculated income elasticity that is negative are called:
a. producers’ goods
b. durable goods
c. inferior goods
d. nondurable goods
e. none of the above

21. An income elasticity (Ey) of 2.0 indicates that for a ____ increase in income, ____ will increase by ____.
a. one percent; quantity supplied; two units
b. one unit; quantity supplied; two units
c. one percent; quantity demanded; two percent
d. one unit; quantity demanded; two units
e. ten percent; quantity supplied; two percent

22. When demand elasticity is ____ in absolute value (or ____), an increase in price will result in a(n) ____ in total revenues.
a. less than 1; elastic; increase
b. more than 1; inelastic; decrease
c. less than 1; elastic; decrease
d. less than 1; inelastic; increase
e. none of the above

23. Empirical estimates of the price elasticity of demand [in Table 3.4] suggest that the demand for household consumption of alcoholic beverages is:
a. highly price elastic
b. price inelastic
c. unitarily elastic
d. an inferior good
e. none of the above

PROBLEM

1. The manager of the Sell-Rite drug store accidentally mismarked a shipment of 20-pound bags of charcoal at $4.38 instead of the regular price of $5.18. At the end of a week, the store’s inventory of 200 bags of charcoal was completely sold out. The store normally sells an average of 150 bags per week.

(a) What is the store’s arc elasticity of demand for charcoal?
(b) Give an economic interpretation of the numerical value obtained in part (a)

2. The Future Flight Corporation manufactures a variety of Frisbees selling for $2.98 each. Sales have averaged 10,000 units per month during the last year. Recently Future Flight’s closest competitor, Soaring Free Company, cut its prices on similar Frisbees from $3.49 to $2.59. Future Flight noticed that its sales declined to 8,000 units per month after the price cut.

(a) What is the arc cross elasticity of demand between Future Flight’s and Soaring Free’s Frisbees?
(b) If Future Flight knows the arc price elasticity of demand for its Frisbees is ?2.2, what price would they have to charge in order to obtain the same level of sales as before Soaring Free’s price cut?

3. The British Automobile Company is introducing a brand new model called the “London Special.” Using the latest forecasting techniques, BAC economists have developed the following demand function for the “London Special”:

QD = 1,200,000 ? 40P

What is the point price elasticity of demand at prices of (a) $8,000 and (b) $10,000?

4. Hanna Corporation markets a compact microwave oven. In 2010 they sold 23,000 units at $375 each. Per capita disposable income in 2010 was $6,750. Hanna economists have determined that the arc price elasticity for this microwave oven is ?1.2.

(a) In 2011 Hanna is planning to lower the price of the microwave oven to $325. Forecast sales volume for 2011 assuming that all other things remain equal.
(b) However, in checking with government economists, Hanna finds that per capita disposable income is expected to rise to $7,000 in 2011. In the past the company has observed an arc income elasticity of +2.5 for microwave ovens. Forecast 2011 sales given that the price is reduces to $325 and that per capita disposable income increases to $7,000. Assume that the price and income effects are independent and additive.

Chapter 4 Quiz: Estimating Demand

1. Using a sample of 100 consumers, a double-log regression model was used to estimate demand for gasoline. Standard errors of the coefficients appear in the parentheses below the coefficients.

Ln Q = 2.45 -0.67 Ln P + . 45 Ln Y – .34 Ln Pcars
(.20) (.10) (.25)

Where Q is gallons demanded, P is price per gallon, Y is disposable income, and Pcars is a price index for cars. Based on this information, which is NOT correct?
a. Gasoline is inelastic.
b. Gasoline is a normal good.
c. Cars and gasoline appear to be mild complements.
d. The coefficient on the price of cars (Pcars) is insignificant.
e. All of the coefficients are insignificant.

2. In a cross section regression of 48 states, the following linear demand for per-capita cans of soda was found: Cans = 159.17 – 102.56 Price + 1.00 Income + 3.94Temp

Coefficients Standard Error t Stat
Intercept 159.17 94.16 1.69
Price -102.56 33.25 -3.08
Income 1.00 1.77 0.57
Temperature 3.94 0.82 4.83

R-Sq = 54.1% R-Sq(adj) = 51.0%

From the linear regression results in the cans case above, we know that:
a. Price is insignificant
b. Income is significant
c. Temp is significant
d. As price rises for soda, people tend to drink less of it
e. All of the coefficients are significant

3. A study of expenditures on food in cities resulting in the following equation:
Log E = 0.693 Log Y + 0.224 Log N
where E is Food Expenditures; Y is total expenditures on goods and services; and N is the size of the family. This evidence implies:
a. that as total expenditures on goods and services rises, food expenditures falls.
b. that a one-percent increase in family size increases food expenditures .693%.
c. that a one-percent increase in family size increases food expenditures .224%.
d. that a one-percent increase in total expenditures increases food expenditures 1%.
e. that as family size increases, food expenditures go down.

4. All of the following are reasons why an association relationship may not imply a causal relationship except:
a. the association may be due to pure chance
b. the association may be the result of the influence of a third common factor
c. both variables may be the cause and the effect at the same time
d. the association may be hypothetical
e. both c and d

5. In regression analysis, the existence of a significant pattern in successive values of the error term constitutes:
a. heteroscedasticity
b. autocorrelation
c. multicollinearity
d. nonlinearities
e. a simultaneous equation relationship

6. In regression analysis, the existence of a high degree of intercorrelation among some or all of the explanatory variables in the regression equation constitutes:
a. autocorrelation
b. a simultaneous equation relationship
c. nonlinearities
d. heteroscedasticity
e. multicollinearity

7. When using a multiplicative power function (Y = a X1b1 X2b2 X3b3) to represent an economic relationship, estimates of the parameters (a, and the b’s) using linear regression analysis can be obtained by first applying a ____ transformation to convert the function to a linear relationship.
a. semilogarithmic
b. double-logarithmic
c. reciprocal
d. polynomial
e. cubic

8. The correlation coefficient ranges in value between 0.0 and 1.0.
a. true
b. false

9. The coefficient of determination ranges in value between 0.0 and 1.0.
a. true
b. false

10. The coefficient of determination measures the proportion of the variation in the independent variable that is “explained” by the regression line.
a. true
b. false

11. The presence of association between two variables does not necessarily imply causation for the following reason(s):
a. the association between two variables may result simply from pure chance
b. the association between two variables may be the result of the influence of a third common factor
c. both variables may be the cause and the effect at the same time
d. a and b
e. a, b, and c

12. The estimated slope coefficient (b) of the regression equation (Ln Y = a + b Ln X) measures the ____ change in Y for a one ____ change in X.
a. percentage, unit
b. percentage, percent
c. unit, unit
d. unit, percent
e. none of the above

13. The standard deviation of the error terms in an estimated regression equation is known as:
a. coefficient of determination
b. correlation coefficient
c. Durbin-Watson statistic
d. standard error of the estimate
e. none of the above

14. In testing whether each individual independent variables (Xs) in a multiple regression equation is statistically significant in explaining the dependent variable (Y), one uses the:
a. F-test
b. Durbin-Watson test
c. t-test
d. z-test
e. none of the above

15. One commonly used test in checking for the presence of autocorrelation when working with time series data is the ____.
a. F-test
b. Durbin-Watson test
c. t-test
d. z-test
e. none of the above

16. The method which can give some information in estimating demand of a product that hasn’t yet come to market is:
a. the consumer survey
b. market experimentation
c. a statistical demand analysis
d. plotting the data
e. the barometric method

17. Demand functions in the multiplicative form are most common for all of the following reasons except:
a. elasticities are constant over a range of data
b. ease of estimation of elasticities
c. exponents of parameters are the elasticities of those variables
d. marginal impact of a unit change in an individual variable is constant
e. c and d

18. The Identification Problem in the development of a demand function is a result of:
a. the variance of the demand elasticity
b. the consistency of quantity demanded at any given point
c. the negative slope of the demand function
d. the simultaneous relationship between the demand and supply functions
e. none of the above

19. Consider the following linear demand function where QD = quantity demanded, P = selling price, and Y = disposable income:

QD = ?36 ?2.1P + .24Y

The coefficient of P (i.e., ?2.1) indicates that (all other things being held constant):
a. for a one percent increase in price, quantity demanded would decline by 2.1 percent
b. for a one unit increase in price, quantity demanded would decline by 2.1 units
c. for a one percent increase in price, quantity demanded would decline by 2.1 units
d. for a one unit increase in price, quantity demanded would decline by 2.1 percent
e. none of the above

20. Consider the following multiplicative demand function where QD = quantity demanded, P = selling price, and Y = disposable income:

The coefficient of Y (i.e., .2) indicates that (all other things being held constant):
a. for a one percent increase in disposable income, quantity demanded would increase by .2 percent
b. for a one unit increase in disposable income, quantity demanded would increase by .2 units
c. for a one percent increase in disposable income quantity demanded would increase by .2 units
d. for a one unit increase in disposable income, quantity demanded would increase by .2 percent
e. none of the above

21. One shortcoming of the use of ____ in demand analysis is that the participants are generally aware that their actions are being observed and hence they may seek to act in a manner somewhat different than normal.
a. market experiments
b. consumer clinics
c. statistical (econometric) methods
d. a and b
e. none of the above

22. The constant or intercept term in a statistical demand study represents the quantity demanded when all independent variables are equal to:
a. 1.0
b. their minimum values
c. their average values
d. 0.0
e. none of the above

23. Novo Nordisk A/S, a Danish firm, sells insulin and other drugs worldwide. Activella, an estrogen and progestin hormone replacement therapy sold by Novo-Nordisk, is examined using 33 quarters of data
Y = -204 + . 34X1 – .17X2
(17.0) (-1.71)
Where Y is quarterly sales of Activella, X1 is the Novo’s advertising of the hormone therapy, and X2 is advertising of a similar product by Eli Lilly and Company, Novo-Nordisk’s chief competitor. The parentheses contain t-values. Addition information is: Durbin-Watson = 1.9 and R2 = .89.

Using the data for Novo-Nordisk, which is correct?
a. Both X1 and X2 are statistically significant.
b. Neither X1 nor X2 are statistically significant.
c. X1 is statistically significant but X2 is not statistically significant.
d. X1 is not statistically significant but X2 is statistically significant.
e. The Durbin-Watson statistic shows significant problems with autocorrelation

24. In which of the following econometric problems do we find Durbin-Watson statistic being far away from 2.0?
a. the identification problem
b. autocorrelation
c. multicollinearity
d. heteroscedasticity
e. agency problems

25. When there is multicollinearity in an estimated regression equation,
a. the coefficients are likely to be small.
b. the t statistics are likely to be small even though the R2 is large.
c. the coefficient of determination is likely to be small.
d. the problem of omitted variables is likely.
e. the error terms will tend to have a cyclical pattern.

26. When two or more “independent” variables are highly correlated, then we have:
a. the identification problem
b. multicollinearity
c. autocorrelation
d. heteroscedasticity
e. complementary products

27. Which is NOT true about the coefficient of determination?
a. As you add more variables, the R-square generally rises.
b. As you add more variables, the adjusted R-square can fall.
c. If the R-square is above 50%, the regression is considered significant.
d. The R-square gives the percent of the variation in the dependent variable that is explained by the independent variables.
e. The higher is the R-square, the better is the fit.

PROBLEMS

1. Phoenix Lumber Company uses the number of construction permits issued to help estimate demand (sales). The firm collected the following data on annual sales and number of construction permits issued in its market area:

No. of Construction Sales
Year Permits Issued (000) (1,000,000)

2003 6.50 10.30
2004 6.20 10.10
2005 6.60 10.50
2006 7.30 10.80
2007 7.80 11.20
2008 8.20 11.40
2009 8.30 11.30

(a) Which variable is the dependent variable and which is the independent variable?
(b) Determine the estimated regression line.
(c) Test the hypothesis (at the .05 significance level) that there is no relationship between the variables.
(d) Calculate the coefficient of determination. Give an economic interpretation to the value obtained.
(e) Perform an analysis of variance on the regression including an F-test (at the .05 significance level) of the overall significance of the results.
(f) Suppose that 8,000 construction permits are expected to be issued in 2010. What would be the point estimate of Phoenix Lumber Company’s sales for 2010?

2. Lenny’s, a national restaurant chain, conducted a study of the factors affecting demand (sales). The following variables were defined and measured for a random sample of 30 of its restaurants:

Y = Annual restaurant sales ($000)
X1 = Disposable personal income (per capita) of residents within 5 mile radius
X2 = License to sell beer/wine (0 = No, 1 = Yes)
X3 = Location (within one-half mile of interstate highway–0 = No, 1 = Yes)
X4 = Population (within 5 mile radius)
X5 = Number of competing restaurants within 2 mile radius

The data were entered into a computerized regression program and the following results were obtained:

MULTIPLE R .889
R-SQUARE .79
STD. ERROR OF EST. .40

ANALYSIS OF VARIANCE

DF Sum Squares Mean Sqr. F-Stat
Regression 5 326.13 65.226 18.17
Error 24 86.17 3.590
Total 29 412.30

Variable Coefficient Std. Error T-Value

Constant .363 .196 1.852
X-1 .00275 .00104 2.644
X-2 76.65 93.70 .818
X-3 164.3 235.4 .698
X-4 .00331 .00126 2.627
X-5 46.2 12.1 ?3.818

Questions:

(a) Give the regression equation for predicting restaurant sales.
(b) Give an interpretation of each of the estimated regression coefficients.
(c) Which of the independent variables (if any) are statistically significant at the .05 level in “explaining” restaurant sales?
(d) What proportion of the variation in restaurant sales is “explained” by the regression equation?
(e) Perform an F-test (at the .05 significance level) of the overall explanatory power of the regression model.

3. The following demand function has been estimated for Fantasy pinball machines:

QD = 3,500 ? 40P + 17.5Px + 670U + .0090A + 6,500N

where P = monthly rental price of Fantasy pinball machines
Px = monthly rental price of Old Chicago pinball machines (their largest competitor)
U = current unemployment rate in the 10 largest metropolitan areas
A = advertising expenditures for Fantasy pinball machines
N = fraction of the U.S. population between ages 10 and 30

(a) What is the point price elasticity of demand for Fantasy pinball machines when P = $150, Px = $100, U = .12, A = $200,000 and N = .35?
(b) What is the point cross elasticity of demand with respect to Old Chicago pinball machines for the values of the independent variables given in part (a)?

4. Given the following demand function:
Q = 2.0 P?1.33 Y2.0 A.50

where Q = quantity demanded (thousands of units)
P = price ($/unit)
Y = disposable income per capita ($ thousands)
A = advertising expenditures ($ thousands)

determine the following when P = $2/unit, Y = $8 (i.e., $8000), and A = $25 (i.e., $25,000)

(a) Price elasticity of demand
(b) The approximate percentage increase in demand if disposable income percentage increases by 3%.
(c) The approximate percentage increase in demand if advertising expenditures are increased by 5 percent.

Chapter 5 Quiz: Business and Economic Forecasting

1. Time-series forecasting models:
a. are useful whenever changes occur rapidly and wildly
b. are more effective in making long-run forecasts than short-run forecasts
c. are based solely on historical observations of the values of the variable being forecasted
d. attempt to explain the underlying causal relationships which produce the observed outcome
e. none of the above

2. The forecasting technique which attempts to forecast short-run changes and makes use of economic indicators known as leading, coincident or lagging indicators is known as:
a. econometric technique
b. time-series forecasting
c. opinion polling
d. barometric technique
e. judgment forecasting

3. The use of quarterly data to develop the forecasting model Yt = a +bYt?1 is an example of which forecasting technique?
a. Barometric forecasting
b. Time-series forecasting
c. Survey and opinion
d. Econometric methods based on an understanding of the underlying economic variables involved
e. Input-output analysis

4. Variations in a time-series forecast can be caused by:
a. cyclical variations
b. secular trends
c. seasonal effects
d. a and b only
e. a, b, and c

5. The variation in an economic time-series which is caused by major expansions or contractions usually
of greater than a year in duration is known as:
a. secular trend
b. cyclical variation
c. seasonal effect
d. unpredictable random factor
e. none of the above

6. The type of economic indicator that can best be used for business forecasting is the:
a. leading indicator
b. coincident indicator
c. lagging indicator
d. current business inventory indicator
e. optimism/pessimism indicator

7. Consumer expenditure plans is an example of a forecasting method. Which of the general categories best described this example?
a. time-series forecasting techniques
b. barometric techniques
c. survey techniques and opinion polling
d. econometric techniques
e. input-output analysis

8. In the first-order exponential smoothing model, the new forecast is equal to a weighted average of the old forecast and the actual value in the most recent period.
a. true
b. false

9. Simplified trend models are generally appropriate for predicting the turning points in an economic time series.
a. true
b. false

10. Smoothing techniques are a form of ____ techniques which assume that there is an underlying pattern to be found in the historical values of a variable that is being forecast.
a. opinion polling
b. barometric forecasting
c. econometric forecasting
d. time-series forecasting
e. none of the above

11. Seasonal variations can be incorporated into a time-series model in a number of different ways, including:
a. ratio-to-trend method
b. use of dummy variables
c. root mean squared error method
d. a and b only
e. a, b, and c

12. For studying demand relationships for a proposed new product that no one has ever used before, what would be the best method to use?
a. ordinary least squares regression on historical data
b. market experiments, where the price is set differently in two markets
c. consumer surveys, where potential customers hear about the product and are asked their opinions
d. double log functional form regression model
e. all of the above are equally useful in this case

13. Which of the following barometric indicators would be the most helpful for forecasting future sales for an industry?
a. lagging economic indicators.
b. leading economic indicators.
c. coincident economic indicators.
d. wishful thinking
e. none of the above

14. An example of a time series data set is one for which the:
a. data would be collected for a given firm for several consecutive periods (e.g., months).
b. data would be collected for several different firms at a single point in time.
c. regression analysis comes from data randomly taken from different points in time.
d. data is created from a random number generation program.
d. use of regression analysis would impossible in time series.

15. Examine the plot of data.
Sales

? ? ?
? ? ? ? ?
? ?

Time
It is likely that the best forecasting method for this plot would be:
a. a two-period moving average
b. a secular trend upward
c. a seasonal pattern that can be modeled using dummy variables or seasonal adjustments
d. a semi-log regression model
e. a cubic functional form

16. Emma uses a linear model to forecast quarterly same-store sales at the local Garden Center. The results of her multiple regression is:

Sales = 2,800 + 200•T – 350•D

where T goes from 1 to 16 for each quarter of the year from the first quarter of 2006 (‘06I) through the fourth quarter of 2009 (‘09 IV). D is a dummy variable which is 1 if sales are in the cold and dreary first quarter, and zero otherwise, because the months of January, February, and March generate few sales at the Garden Center. Use this model to estimate sales in a store for the first quarter of 2010 in the 17th month; that is: {2010 I}. Emma’s forecast should be:
a. 5,950
b. 6,200
c. 6,350
d. 6,000
e. 5,850

17. Select the correct statement.
a. Qualitative forecasts give the direction of change.
b. Quantitative forecasts give the exact amount or exact percentage change.
c. Diffusion forecasts use the proportion of the forecasts that are positive to forecast up or down.
d. Surveys are a form of qualitative forecasting.
e. all of the above are correct.

18. If two alternative economic models are offered, other things equal, we would
a. tend to pick the one with the lowest R2.
b. select the model that is the most expensive to estimate.
c. pick the model that was the most complex.
d. select the model that gave the most accurate forecasts
e. all of the above

19. Mr. Geppetto uses exponential smoothing to predict revenue in his wood carving business. He uses a weight of ? = .4 for the naïve forecast and (1-?) = .6 for the past forecast. What revenue did he predict for March using the data below? Select closet answer.
MONTH REVENUE FORECAST
Nov 100 100
Dec 90 100
Jan 115 —-
Feb 110 —-
MARCH ? ?
a. 106.2
b. 104.7
c. 103.2
d. 102.1
e. 101.7

20. Suppose a plot of sales data over time appears to follow an S-shape as illustrated below.

Sales •



• •

Time

Which of the following is likely that the best forecasting functional form to use for sales data above?
a. A linear trend, Sales = a + b T
b. A quadratic shape in T, using T-squared as another variable, Sales = a + b T + cT2.
c. A semi-log form as sales appear to be growing at a constant percentage rate, Ln Sales = a + bT
d. A cubic shape in T, using T-squared and T-cubed as variables, Sales = a + b T + cT2 + d T3.
e. A quadratic shape in T and T-squared as variables, Sales = a + b T + cT2

PROBLEM

1. The Accuweather Corporation manufactures barometers and thermometers for weather forecasters. In an attempt to forecast its future needs for mercury, Accuweather’s chief economist estimated average monthly mercury needs as:

N = 500 + 10X

where N = monthly mercury needs (units) and X = time period in months (January 2008= 0). The following monthly seasonal adjustment factors have been estimated using data from the past five years:

Month Adjustment Factor
January 15%
April 10%
July ?20%
September 5%
December ?10%

(a) Forecast Accuweather’s mercury needs for January, April, July, September, and December of 2010.
(b) The following actual and forecast values of mercury needs in the month of November have been recorded:

Year Actual Forecast
2008 456 480
2009 324 360
2007 240 240

What seasonal adjustment factor should the firm use for November?

2. Milner Brewing Company experienced the following monthly sales (in thousands of barrels) during 2010:

Jan. Feb. Mar. Apr. May June
100 92 112 108 116 116

(a) Develop 2-month moving average forecasts for March through July.
(b) Develop 4-month moving average forecasts for May through July.
(c) Develop forecasts for February through July using the exponential smoothing method (with w = .5). Begin by assuming .

Chapter 6 Quiz: Managing Exports

MULTIPLE CHOICE

1. Using demand and supply curves for the Japanese yen based on the $/¥ price for yen, an increase in US INFLATION RATES would
a. Decrease the demand for yen and decrease the supply of the yen.
b. Increase the demand for yen and decrease the supply of the yen.
c. Increase the demand and increase the supply of yen.
d. Decrease both the supply and the demand of yen.
e. Have no impact on the demand or supply of the yen.

2. If the British pound (£) appreciates by 10% against the dollar:
a. both the US importers from Britain and US exporters to Britain will be helped by the appreciating pound.
b. the US exporters will find it harder to sell to foreign customers in Britain.
c. the US importer of British goods will tend to find that their cost of goods rises, hurting its bottom line.
d. both US importers of British goods and exporters to Britain will be unaffected by changes in foreign exchange rates.
e. all of the above.

3. Purchasing power parity or PPP says the ratios composed of:
a. interest rates explain the direction of exchange rates.
b. growth rates explain the direction of exchange rates.
c. inflation rates explain the direction of exchange rates.
d. services explain the direction exchange rates.
e. public opinion polls explain the direction of exchange rates.

4. If Ben Bernanke, Chair of the Federal Reserve Board, begins to tighten monetary policy by raising US interest rates next year, what is the likely impact on the value of the dollar?
a. The value of the dollar falls when US interest rates rise.
b. The value of the dollar rises when US interest rates rise.
c. The value of the dollar is not related to US interest rates.
d. This is known as Purchasing Power Parity or PPP.
e. The Federal Reserve has no impact at all on interest rates.

5. If the domestic prices for traded goods rises 5% in Japan and rises 7% the US over the same period, what would happened to the Yen/US dollar exchange rate? HINT: S1/S0 = (1+?h) / (1+ ?f) where S0 is the direct quote of the yen at time 0, the current period.
a. The direct quote of the yen ($/¥) rises, and the value of the dollar falls.
b. The direct quote of the yen ($/¥) falls, and the value of the dollar rises.
c. The direct quote of the yen would remain the same.
d. Purchasing power parity does not apply to inflation rates.
e. Both a and d.

6. US and Canada can both grow wheat and can do mining. Use the following table to look for which country has a comparative advantage in mining. (HINT: Find the cost of mining in terms of wheat in each country.)

Absolute Cost in US Absolute Cost in Canada
Wheat $5 C$8
Mining $10 C$12

a. Canada has a comparative advantage in mining.
b. The US has a comparative advantage in mining.
c. No comparative advantage in mining exists for either nation.
d. We must first know the exchange rate to be able to answer this question.
e. Both a and b.

7. The optimal currency area involves a trade-off of reducing transaction costs but the inability to use changes in exchange rates to help ailing regions. If the US, Canada, and Mexico had one single currency (the Peso-Dollar) we would tend to see all of the following EXCEPT:
a. Even more intraregional trade of goods across the three countries.
b. Lower transaction costs of trading within North America.
c. A greater difficulty in helping Mexico as you can no longer deflate the Mexican peso.
d. Less migration of workers across the three countries.
e. An elimination of correlated macroeconomic shocks across the countries.

8. If the value of the U.S. dollar rises from 1.0 per dollar to 1.3 per dollar,
a. imports of automobiles from Germany will decline
b. American inflation will increase
c. German exports of all traded goods will decline
d. American exports to Germany will decrease
e. sales by American manufacturers for the export markets will increase.

9. An appreciation of the U.S. dollar has what impact on Harley-Davidson (HD), a U.S. manufacturer of motorcycles?
a. domestic sales of HD motorcycles increase and foreign sales of HD motorcycles increase
b. domestic sales of HD motorcycles decrease and foreign sales of HD motorcycles increase
c. domestic sales of HD motorcycles increase and foreign sales of HD motorcycles decrease
d. domestic sales of HD motorcycles decrease and foreign sales of HD motorcycles decrease
e. only manufacturers who produce traded goods are affected

10. In the last twenty-five years, the Yen and German mark and now the Euro have
a. fluctuated widely against the dollar
b. appreciated against the dollar and then depreciated against the dollar
c. exchanged without restrictions
d. all of the above
e. none of the above

11. In an open economy with few capital restrictions and substantial import-export trade, a rise in interest rates and a decline in the producer price index of inflation will
a. raise the value of the currency
b. lower the nominal interest rate
c. increase the volume of trading in the foreign exchange market
d. lower the trade-weighted exchange rate
e. increase consumer inflation.

12. When a manufacturer’s home currency appreciates substantially,
a. domestic sales decline
b. foreign sales decline
c. company-owned foreign plant and equipment will increase
d. margins often decline
e. all of the above

13. An increase in the exchange rate of the U.S. dollar relative to a trading partner can result from
a. higher anticipated costs of production in the U.S.
b. higher interest rates and higher inflation in the U.S.
c. higher growth rates in the trading partner’s economy
d. a change in the terms of trade
e. lower export industry productivity

14. The purchasing power parity hypothesis implies that an increase in inflation in one country relative to another will over a long period of time
a. increase exports
b. reduce the competitive pressure on prices
c. lower the value of the currency in the country with the higher inflation rate
d. increase foreign aid
e. increase the speculative demand for the currency

15. Trading partners should specialize in producing goods in accordance with comparative advantage, then trade and diversify in consumption because
a. out-of-pocket costs of production decline
b. free trade areas protect infant industries
c. economies of scale are present
d. manufacturers face diminishing returns
e. more goods are available for consumption

16. European Union labor costs exceed U.S. and British labor costs primarily because
a. worker productivity is lower in the EU
b. union wages are higher in the EU
c. layoffs and plant closings are more restrictive in the U.S. and Britain
d. the amount of paid time off is higher in the EU
e. labor-management relations are better in the EU

17. Companies that reduce their margins on export products in the face of appreciation of their home currency may be motivated by a desire to
a. sacrifice market share abroad but build market share at home
b. increase production volume to realize learning curve advantages
c. sell foreign plants and equipment to lower their debt
d. reduce the costs of transportation
e. all of the above

18. In a recession, the trade balance often improves because
a. service exports exceed manufactured good exports
b. banks sell depressed assets
c. fewer households can afford luxury imports
d. direct investment abroad declines
e. the capital account exceeds the current account

PROBLEM

1. Suppose nominal interest rates in the U.S. rise from 4.6% to 5% and decline in Britain from 6% to 5.5%, while U.S. consumer inflation remains unchanged at 1.9% and British inflation declines from 4% to 3%. In addition suppose, real growth in the U.S. is forecasted for next year at 4% and in Britain real growth is forecasted at 5%. Finally, suppose producer price inflation in the U.S. is declining from 2% to 1% while in Britain producer price inflation is rising from 2% to 3.2%. Explain what effect each of these factors would have on the long-term trend exchange rate ( per $) and why?

Chapter 7 Quiz: Production Economics

1. What’s true about both the short-run and long-run in terms of production and cost analysis?
a. In the short-run, one or more of the resources are fixed
b. In the long-run, all the factors are variable
c. The time horizon determines whether or not an input variable is fixed or not
d. The law of diminishing returns is based in part on some factors of production being fixed, as they are in the short run.
e. All of the above

2. The marginal product is defined as:
a. The ratio of total output to the amount of the variable input used in producing the output
b. The incremental change in total output that can be produced by the use of one more unit of the variable input in the production process
c. The percentage change in output resulting from a given percentage change in the amount
d. The amount of fixed cost involved.
e. None of the above

3. Fill in the missing data to solve this problem.

Variable Total Average Marginal
Input Product Product Product
4 ? 70 —-
5 ? ? 40
6 350 ? ?
What is the total product for 5 units of input, and what is the marginal product for 6 units of input?
a. 320 and 30
b. 350 and 20
c. 360 and 15
d. 400 and 10
e. 430 and 8

4. The following is a Cobb-Douglas production function: Q = 1.75K0.5·L0.5. What is correct here?
a. A one-percent change in L will cause Q to change by one percent
b. A one-percent change in K will cause Q to change by two percent
c. This production function displays increasing returns to scale
d. This production function displays constant returns to scale
e. This production function displays decreasing returns to scale

5. Suppose you have a Cobb-Douglas function with a capital elasticity of output (a) of 0.28 and a labor elasticity of output (ß) of 0.84. What statement is correct?
a. There are increasing returns to scale
b. If the amount of labor input (L) is increased by 1%, the output will increase by 0.84%
c. If the amount of capital input (K) is decreased by 1%, the output will decrease by 0.28%
d. The sum of the exponents in the Cobb-Douglas function is 1.12.
e. All of the above

6. The Cobb-Douglas production function is: Q = 1.4*L0.6*K0.5. What would be the percentage change in output (%?Q) if labor grows by 3.0% and capital is cut by 5.0%?
[HINT: %?Q = (EL * %?L) + (EK * %?K)]
a. %?Q = + 3.0%
b. %?Q = + 5.0%
c. %?Q = – 0.70%
d. %?Q = – 2.50%
e. %?Q = – 5.0%

7. If the marginal product of labor is 100 and the price of labor is 10, while the marginal product of capital is 200 and the price of capital is $30, then what should the firm?
a. The firm should use relatively more capital
b. The firm should use relatively more labor
c. The firm should not make any changes – they are currently efficient
d. Using the Equimarginal Criterion, we can’t determine the firm’s efficiency level
e. Both c and d

8. The marginal rate of technical substitution may be defined as all of the following except:
a. the rate at which one input may be substituted for another input in the production process, while total output remains constant
b. equal to the negative slope of the isoquant at any point on the isoquant
c. the rate at which all combinations of inputs have equal total costs
d. equal to the ratio of the marginal products of X and Y
e. b and c

9. The law of diminishing marginal returns:
a. states that each and every increase in the amount of the variable factor employed in the production process will yield diminishing marginal returns
b. is a mathematical theorem that can be logically proved or disproved
c. is the rate at which one input may be substituted for another input in the production process
d. none of the above

10. The combinations of inputs costing a constant C dollars is called:
a. an isocost line
b. an isoquant curve
c. the MRTS
d. an isorevenue line
e. none of the above

11. In a relationship among total, average and marginal products, where TP is maximized:
a. AP is maximized
b. AP is equal to zero
c. MP is maximized
d. MP is equal to zero
e. none of the above

12. Holding the total output constant, the rate at which one input X may be substituted for another input Y in a production process is:
a. the slope of the isoquant curve
b. the marginal rate of technical substitution (MRTS)
c. equal to MPx/MPy
d. all of the above
e. none of the above

13. Which of the following is never negative?
a. marginal product
b. average product
c. production elasticity
d. marginal rate of technical substitution
e. slope of the isocost lines

14. Concerning the maximization of output subject to a cost constraint, which of the following statements (if any) are true?
a. At the optimal input combination, the slope of the isoquant must equal the slope of the isocost line.
b. The optimal solution occurs at the boundary of the feasible region of input combinations.
c. The optimal solution occurs at the point where the isoquant is tangent to the isocost lines.
d. all of the above
e. none of the above

15. In a production process, an excessive amount of the variable input relative to the fixed input is being used to produce the desired output. This statement is true for:
a. stage II
b. stages I and II
c. when Ep = 1
d. stage III
e. none of the above

16. Marginal revenue product is:
a. defined as the amount that an additional unit of the variable input adds to the total revenue
b. equal to the marginal factor cost of the variable factor times the marginal revenue resulting from the increase in output obtained
c. equal to the marginal product of the variable factor times the marginal product resulting from the increase in output obtained
d. a and b
e. a and c

17. The isoquants for inputs that are perfect substitutes for one another consist of a series of:
a. right angles
b. parallel lines
c. concentric circles
d. right triangles
e. none of the above

18. In production and cost analysis, the short run is the period of time in which one (or more) of the resources employed in the production process is fixed or incapable of being varied.
a. true
b. false

19. Marginal revenue product is defined as the amount that an additional unit of the variable input adds to ____.
a. marginal revenue
b. total output
c. total revenue
d. marginal product
e. none of the above

20. Marginal factor cost is defined as the amount that an additional unit of the variable input adds to ____.
a. marginal cost
b. variable cost
c. marginal rate of technical substitution
d. total cost
e. none of the above

21. The isoquants for inputs that are perfect complements for one another consist of a series of:
a. right angles
b. parallel lines
c. concentric circles
d. right triangles
e. none of the above

22. Given a Cobb-Douglas production function estimate of Q = 1.19L.72K.18 for a given industry, this industry would have:
a. increasing returns to scale
b. constant returns to scale
c. decreasing returns to scale
d. negative returns to scale
e. none of the above

23. The primary purpose of the Cobb-Douglas power function is to:
a. allow one to make estimates of cost-output relationships
b. allow one to make predictions about a resulting increase in output for a given increase in the inputs
c. aid one in gaining accurate empirical values for economic variables
d. calculate a short-run linear total cost function
e. a and b

24. The original Cobb-Douglas function was given as . It was subsequently rewritten as . What benefit was derived in the revision?
a. the function becomes a non-linear relationship so it would fit to production curves having an “S” shape
b. returns to scale can be shown in the revision
c. returns to scale become constant
d. a and b only
e. a, b, and c

25. The Cobb-Douglas production function has which of the following properties?
a. output is a linear increasing function of each of the inputs
b. it provides a good fit to the traditional S-shaped production function
c. the elasticity of production is constant and equal to 1 minus the exponent of the appropriate variable
d. all of the above
e. none of the above

26. In the Cobb-Douglas production function ( ):
a. the marginal product of labor (L) is equal to ?1
b. the average product of labor (L) is equal to ?2
c. if the amount of labor input (L) is increased by 1 percent, the output will increase by ?1 percent
d. a and b
e. a and c

PROBLEMS

1. Emco Company has an assembly line of fixed size A. Total output is a function of the number of workers (crew size) as shown in the following schedule:

Crew Size Total Output
(No. of Workers) (No. of Units)

0 0
1 10
2 35
3 50
4 56
5 59
6 60
7 60
8 58

Determine the following schedules:

(a) marginal productivity of labor
(b) average productivity of labor
(c) elasticity of production with respect to labor

2. A certain production process employs two inputs–labor (L) and raw materials (R). Output (Q) is a function of these two inputs and is given by the following relationship:

Q = 6L2 R2???.10L3 R3

Assume that raw materials (input R) are fixed at 10 units.

(a) Determine the total product function (TPL) for input L.
(b) Determine the marginal product function for input L.
(c) Determine the average product function for input L.
(d) Find the number of units of input L that maximizes the total product function.
(e) Find the number of units of input L that maximizes the marginal product function.
(f) Find the number of units of input L that maximizes the average product function.
(g) Determine the boundaries for the three stages of production.

3. An industry can be characterized by the following production function:

Q = 2.5L.60 C.40

(a) What is the algebraic expression for the marginal productivity of labor?
(b) What is the algebraic expression for the average productivity of labor?
(c) How would you characterize the returns-to-scale in the industry?

Chapter 8 Quiz: Cost Analysis

1. Economies of Scope refers to situations where per unit costs are:
a. Unaffected when two or more products are produced
b. Reduced when two or more products are produced
c. Increased when two or more products are produced
d. Demonstrating constant returns to scale
e. Demonstrating decreasing returns to scale

2. Economies of scale exist whenever long-run average costs:
a. Increase as output is increased
b. Remain constant as output is increased
c. Decrease as output is increased
d. Decline and then rise as output is increased
e. None of the above

3. Which of the following is true with regards to a long-run cost function?
a. The shape of the firm’s long-run cost function is important in decisions to expand the scale of operations
b. The long-run average cost curve is U-shaped
c. The long-run average cost curve is flatter than the short-run average cost curve.
d. The curve consists of the lower boundary of all the short-run cost curves
e. All of the above

4. If TC = 321 + 55Q – 5Q2, then average total cost at Q = 10 is:
a. 10.2
b. 102
c. 37.1
d. 371
e. 321

5. Suppose that total cost is cubic: TC = 200 + 5Q – 0.4Q2 + 0.001Q3
a. Fixed cost (FC) is $200
b. Variable cost (VC) is 5Q – 0.4Q2 + 0.001Q3
c. Average variable cost (AVC) is 5 – 0.4Q + 0.001Q2
d. Marginal cost (MC) is 5 – 0.8Q +.003Q2
e. All of the above are correct

6. What method of inventory valuation should be used for economic decision-making problems?
a. book value
b. original cost
c. current replacement cost
d. cost or market, whichever is lower
e. historical cost

7. According to the theory of cost, specialization in the use of variable resources in the short-run results initially in:
a. decreasing returns and declining average and marginal costs
b. increasing returns and declining average and marginal costs
c. increasing returns and increasing average and marginal costs
d. decreasing returns and increasing average and marginal costs
e. none of the above

8. For a short-run cost function which of the following statements is (are) not true?
a. The average fixed cost function is monotonically decreasing.
b. The marginal cost function intersects the average fixed cost function where the average variable cost function is a minimum.
c. The marginal cost function intersects the average variable cost function where the average variable cost function is a minimum.
d. The marginal cost function intersects the average total cost function where the average total cost function is a minimum.
e. b and c

9. The cost function is:
a. a means for expressing output as a function of cost
b. a schedule or mathematical relationship showing the total cost of producing various quantities of output
c. similar to a profit and loss statement
d. incapable in being developed from statistical regression analysis
e. none of the above

10. Which of the following statements about cost functions is true?
a. Variable costs will always increase in direct proportion to the quantity of output produced.
b. The less capital equipment employed in the production process relative to labor and other inputs, the longer will be the period of time required to increase significantly the scale of operation.
c. The shape of the firm’s long-run cost function is important in decisions to expand the scale of operations.
d. none of the above

11. Which of the following statements concerning the long-run average cost curve of economic theory is true?
a. It is L-shaped
b. It is ?-shaped
c. It is ?-shaped
d. It is ?-shaped
e. It is M-shaped

12. Possible sources of economies of scale (size) within a production plant include:
a. specialization in the use of capital and labor
b. imperfections in the labor market
c. transportation costs
d. a and b
e. a and c

13. The existence of diseconomies of scale (size) for the firm is hypothesized to result from:
a. transportation costs
b. imperfections in the labor market
c. imperfections in the capital markets
d. problems of coordination and control encountered by management
e. All of the above

14. The relevant cost in economic decision-making is the opportunity cost of the resources rather than the outlay of funds required to obtain the resources.
a. true
b. false

15. ____ are defined as costs which are incurred regardless of the alternative action chosen in a decision-making problem.
a. Opportunity costs
b. Marginal costs
c. Relevant costs
d. Sunk costs
e. None of the above

16. ____ include the opportunity costs of time and capital that the entrepreneur has invested in the firm.
a. Implicit costs
b. Explicit costs
c. a and b
d. None of the above

17. A cottage industry exists in the home-manufacture of ‘country crafts’. Especially treasured are handmade quilts. If the fourth completed quilt took 30 hours to make, and the eighth quilt took 28 hours. What is the percentage learning? Hint: Percentage learning = 100% – (c2/c1)•100%.
a. 5%
b. 6.7%
c. 10%
d. 100%
e. 122%

PROBLEMS

1. During the last few days the Superior Company has been running into problems with its computer system. The last run of the production cost schedule resulted in the incomplete listing shown below. From your knowledge of cost theory, fill in the blanks.

Q TC TFC TVC ATC AFC AVC MC
0 40 _____ _____ x x x x
1 _____ _____ _____ 52 _____ _____ _____
2 _____ _____ 20 _____ _____ _____ _____
3 _____ _____ _____ 21.33 _____ _____ _____
4 _____ _____ _____ _____ _____ _____ 4
5 _____ _____ 40 _____ _____ _____ _____
6 _____ _____ _____ 15.67 _____ _____ _____
7 _____ _____ _____ _____ _____ 10 _____
8 _____ _____ 96 _____ _____ _____ _____
9 _____ _____ _____ _____ _____ 15 _____
10 _____ _____ _____ _____ _____ _____ 45

2. The Jones Company has the following cost schedule:

Output Total Cost
(Units) ($)
0 3000
50 3750
100 4275
150 4675
200 5000
250 5300
300 5700
350 6250
400 7050
450 8225

Prepare (a) average total cost and (b) marginal cost schedules for the firm.

3. A firm has determined that its variable costs are given by the following relationship:

VC = .05Q3???5Q2 + 500Q

where Q is the quantity of output produced.

(a) Determine the output level where average variable costs are minimized.
(b) Determine the output level where marginal costs are minimized.

Chapter 9—Applications of Cost Theory

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

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

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

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

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

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. regression to the mean analysis.
b. breakeven analysis.
c. survivorship analysis.
d. engineering cost analysis.
e. a Willie Sutton analysis.

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.
a. 10,000 customers
b. 20,000 customers
c. 30,000 customers
d. 40,000 customers
e. 50,000 customers

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

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?

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

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

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

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

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)
a. Q = 10
b. Q = 15
c. Q = 22
d. Q = 37
e. Q = 41

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.
a. $206
b. $106
c. $56
d. $6
e. $3

6. A monopolist faces the following demand curve: P = 12 – .3Q with marginal costs of $3. What is the monopolistic PRICE?
a. P = $5.50
b. P = $6.50
c. P = $7.50
d. P = $8.50
e. P = $9.50

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

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

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

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

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

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

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

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

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

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

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

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.

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:

Chapter 12 Quiz: Price and Output Determination: Oligopoly

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.
c. all firms agree to change prices simultaneously.
d. one company forms a price umbrella for all others.
e. the firms are all colluding.

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

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.

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?

Chapter 13: Best Practice Tactics: Game Theory

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

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

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

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

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

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

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.

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.

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 co-operative 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.

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.

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

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. {expand output, restrict output}
b. {restrict output, expand output}
c. {restrict output, restrict output}
d. {expand output, expand output}

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

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

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)

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

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.

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

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

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

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

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

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

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

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

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?

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?

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

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

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

Chapter 13A Quiz: Entry Deterrence and Accommodation Games

MULTIPLE CHOICE

1. In deciding whether to invest in excess capacity in order to deter entry, incumbents should consider all of the following except
a. the order of play in pricing and capacity choice decisions
b. the customer sorting pattern
c. the sunk cost required to achieve excess capacity
d. the joint-profit-maximizing cartel output
e. the potential entrant’s projected profitability

2. An inverse intensity customer sorting rule is one in which
a. customers with high willingness to pay secure the discounted goods
b. customers are rationed randomly between the discounted and full price goods
c. no customers purchase below their willingness to pay
d. customers with the lowest willingness to pay secure the discounted goods
e. brand loyalty allows the incumbent to retain its regular customers

3. An efficient customer sorting rule is one in which
a. customers with high willingness to pay secure the discounted goods
b. customers are rationed randomly between the discounted and full price goods
c. no customer purchase below her willingness to pay
d. customers with the lowest willingness to pay secure the discount goods
e. brand loyalty allows the incumbent to retain its regular customers

4. All of the following are sunk cost investments that precommit an incumbent to aggressively defend market share and the cash flow prior to threatened entry except
a. reputational investments in company logos (e.g., Beatrice)
b. automobile showrooms
c. retail displays which hold only L’eggs egg-shaped hosiery packages
d. neon signage for an independently owned Krispy Kreme store
e. excess capacity in a declining industry

Chapter 14 Quiz: Pricing Techniques and Analysis

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

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

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

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

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

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

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

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

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

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

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.
a. True
b. False

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

13. The following are possible examples of price discrimination, EXCEPT:
a. prices in export markets are lower than for identical products in the domestic market.
b. senior citizens pay lower fares on public transportation than younger people at the same time.
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.
d. subscription prices for a professional journal are higher when bought by a library than when bought by an individual.

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

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?
a. Bundle both products (W and S) and sell them at $230.
b. Price product W at $170 and Product S at $135.
c. Price product W at $170 and Product S at $170.
d. Price product W at $95 and Product S at $105.
e. Bundle both products (W and S) and sell them at $275.

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:
a. the preference rankings of vacationers travelling together are negatively correlated.
b. a preference for cities is always higher than preferences for mountain vistas.
c. preference rankings of vacationers travelling together are positively correlated.
d. preference for the seaside is always higher than preferences for city excursions.
e. no one wants to take a European vacation package to cities, mountains, and the seaside.

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:
a. -1
b. -1.5
c. -2
d. -3

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:
a. They could consider increasing the capacity of each theater to be able to seat more customers.
b. They could lower the price at the peak times to reduce the problem of spoilage.
c. They could stop showing blockbuster movies and select more critically acclaimed art films to decrease spoilage.
d. They could stop showing movies at night.

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. Spoilage increases
b. Spillage increases
c. Overbooking increases

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

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. make them reduce the amount of overbooking.
b. cause them to increase the amount of overbooking.
c. let them keep the same amount of overbooking.

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?

Chapter 15 Quiz: Contracting, Governance, and Organizational Form

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.

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.

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

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

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

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

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

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

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

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

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

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

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

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

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.

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.
c. Employees sometime take items from the store in which they work.
d. 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.
e. Firm managers sometime want to relax on the job.

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 15A Quiz: Auction Design and Information Economics

1. Common value auctions with open bidding necessarily entail
a. asymmetric information
b. ascending prices
c. more than two bidders
d. amendment of bids
e. sealed final offers.

2. An incentive-compatible mechanism for revealing true willingness to pay in a private value auction is
a. impossible
b. a Dutch auction
c. a second-highest sealed bid auction
d. a sequential auction with open bidding
e. a discriminatory price all-or-nothing auction.

3. In comparing rules for serving a queue, last-come first-served has all of the following effects except
a. reduces the waiting time
b. causes few customers to arrive and depart more than once
c. increases the side payments among those yet to be served
d. hastens the adoption of a lottery system for deciding who should get the tickets

4. The principal advantage of an open bidding system for allocating telecommunications spectrum licenses was
a. the pooling of asymmetric information by the bidders
b. the reconfiguring of cell phone license areas
c. the substitute value of adjacent service areas
d. reduced cost

5. A Dutch auction implies all of the following except
a. more than one unit sale available
b. higher prices later in the auction
c. identical expected seller revenue for common value items
d. greater expected seller revenue in estate sales with risk-averse bidders

6. Each partner in a simple profit-sharing contract that splits the independently verifiable sales revenue minus unobservable cost has an incentive
a. to reject an automatic renewal of the contract
b. to understate fixed cost
c. to overstate avoidable cost
d. to understate customer loyalty for repeat purchases
e. to renew the partnership contract

7. An optimal incentives contract can induce the revelation of true costs in a partnership by
a. imposing penalties when costs are overstated
b. offering bonus payments when costs are verified
c. renewing the reliance relationship
d. linking revealed cost to the partner’s foregone expected profits
e. enlisting third-party enforcement

8. An incentive-compatible revelation mechanism is
a. self-enforcing
b. always multi-period
c. too complicated to influence decisions
d. prevalent in vertically integrated businesses
e. not adopted by franchise businesses

9. Incentive-compatible revelation mechanisms attempt to
a. induce an employee to reject the next best alternative employment opportunity
b. elicit privately-held information
c. secure enforcement primarily by third parties
d. reject voluntary contracting with third parties
e. impose similar risk premiums on all employees

10. Revenue equivalence theorem refers to equal seller revenue in which of the following pairs:
a. sealed bid auctions and English auctions
b. second highest wins and pays auctions and Dutch auctions
c. English highest wins and pays auctions and sealed bid Dutch auctions
d. highest wins and pays auctions and second highest wins and pay auctions

11. In Dutch auctions, the bidding
a. starts low and rises until the highest bidder wins.
b. is done in secret “sealed bids” which are opened at a specified time.
c. begins with a very high price, and is reduced until the first person takes it.
d. is accomplished by giving the price of the second highest bid to the highest bidder.

12. Winning an auction can be exhilarating, but it can also lead to doubt as to whether you did the right thing or not. This is called:
a. The regret effect.
b. Moral hazard.
c. Second wind.
d. The winner’s curse.

13. Suppose that a private firm wants to go public to give the owners a chance to retire. It follows the lead of the Google IPO by using a modified Vickrey (or uniform price) auction. The owners of the firm plans to sell 1 million shares and hope to raise at least $10 million from the auction. The following bids were submitted.
Bob 250,000 shares at $12
Sam 350,000 shares at $13
Mary 300,000 shares at $9
Sue 100,000 shares at $10
Ravi 450,000 shares at $11
a. The market clearing price is $13, and the sellers of the firm get $13 million.
b. The market clearing price is $12, and the sellers of the firm get $13 million.
c. The market clearing price is $11, and the sellers of the firm get $11 million.
d. The market clearing price is $10, and the sellers of the firm get $10 million.
e. The market clearing price is $9, and the sellers of the firm get$9 million

14. Auctions are used in place of markets when the items traded are unique (e.g., a Ming vase or a right to drill for oil). Which of the following examples are typically sold using Vickrey auction methods?
a. For-sale-by-owner houses
b. Household furnishings
c. Items sold in Filene’s Basement, with the price discounted after a certain date
d. Vintage postage stamps

15. Sealed bids can be used in multiple rounds. How is this done?
a. The winner of the first round automatically wins all future rounds.
b. The winner’s price in the first round is the reservation price in the next round. If higher prices come in the next round, the highest price is the new reservation price for round three, and so forth.
c. The second best price in the first round is the winner.
d. Bidding continues in more and more rounds until someone yells “uncle.”

16. Research suggests that an auction for a private value item will yield the HIGHEST payout if:
a. we use a Dutch auction
b. we use an English auction
c. we use only cash, and not allow credit cards
d. use a fixed price

Problems

1. If two art dealers bidding for a Picasso receive the following forecast information about the chance of a forgery which with previously unknown Picasso paintings is present 8 times in 10 historically, what is the amount by which strategic underbidding could be reduced if ten bidders were attracted to the auction?

Forecast Received: Not a forgery, Actual Picasso is Forecast

Forecast Accuracy: Prob(This Forecast/Actual Forgery) = 0.4
Prob(Forgery Forecast/Actual Forgery) = 0.6
Prob(This Forecast/Actual Picasso) = 0.9
Prob(Forgery Forecast/Actual Picasso) = 0.1

Exhibit 15A-1
Suppose GM and Nucor Steel seek to develop jointly a new sheet metal and auto body stamping machine, and each party knows the payoffs in the following table of equi-probable outcomes but cannot independently verify one another’s costs. Both GM and Nucor can cancel the project and both will then earn $0 if the cost revelations give early warning of losses.

JOINT PROFITS
Nucor Steel
Low Costs High Costs
($40) ($60)
Low Costs
($100) $40 $20
GM

High Costs
($130) $10 ?$10

Note: The figures in parentheses represent costs associated with the Low and High cost realizations, and all figures are in millions. The joint profit payoffs are the difference between $180 and the sum of the cost realizations.

2. Refer to Exhibit 15A-1.

Part A: What is the incentive-compatible revelation mechanism that will induce true revelation of the asymmetric cost information and maximize the value of the partnership?

3. Refer to Exhibit 15A-1.

Part B: What are the expected net profits to each partner under the incentives contract?

4. Refer to Exhibit 15A-1.

Part C: What is the expected net profit under the simple profit sharing contract, and why would the partners adopt an incentive-compatible revelation mechanism (i.e., an optimal incentives contract)?

5. What are the expected net profits to Johnson & Johnson in a pharmaceutical R&D joint venture with Amgen given the following joint profit payoffs. The joint profit payoffs are the difference between $180 and the sum of the cost realizations. Assume that the three columns are equally likely to occur, each row is equally likely to occur. Both Johnson and Johnson and Amgen can cancel the project and both will then earn $0 if the cost revelations give early warning of losses.

JOINT PROFITS

Johnson and Johnson
Low Costs Moderate Costs High Costs
($30) ($50) ($60)
Low Costs
($100) $50 $30 $20
Amgen

High Costs
($140) $10 ?$10 ?$20

The figures in parentheses represent costs associated with the Low, Moderate and High cost realizations, and all figures are in millions.

Chapter 16 Quiz Government Regulation :

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

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

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

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

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

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

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

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

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

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

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.

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

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

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.

Chapter 17 Quiz Longterm Investment Analysis:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

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?

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.

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.

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.

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.

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.

Appendix C:

1. Differentiate the following TC function: TC = 150 + 200 Q – 4 Q2 + .6 Q3
a. dTC/dQ = 200 – 8Q + 1.8 Q2
b. dTC/dQ =-8 + 1.8 Q2
c. dTC/dQ = 200
d. dTC/dQ = 200 – 4Q + .6Q2
e. dTC/dQ = 1.8 Q2

2. The total revenue function (where Q = output), is: TR = 400 Q – 4 Q2
a. TR is maximized at Q = 20
b. TR is maximized at Q = 30
c. TR is maximized at Q = 40
d. TR is maximized at Q = 50
e. TR is maximized at Q = 60

3. The following is a cubic demand function in P. Find the derivative dQ/dP of: Q= 4+3P-.5P2 + .02P3.
a. dQ/dP = 4 + 3P – P + .06P2
b. dQ/dP = 3
c. dQ/dP = 3 – P + .06P2
d. dQ/dP = .06P2
e. dQ/dP = .06

4. If the first derivative of Y with respect to X is: dY/dX = -4•X2, then the second derivative is:
a. -4
b. -8•X
c. -4•X
d. -8•X2
e. -8

5. The second derivative of the function (d2Y/dX2 ) is negative at the optimal solution of X=22. Therefore, we know that the solution X=22, where the first derivative equals zero…
a. must be a minimum.
b. must be a maximum.
c. may be either a maximum or a minimum.
d. would be nothing, because the second derivative is negative.

Web Appendix C:

1. The fixed per-unit profit contribution coefficients of the objective function in a linear programming problem imply the following economic assumptions except:
a. selling prices per unit of the products (outputs) are constant
b. constant returns to scale in the production process
c. buying prices per unit of the resources (inputs) are proportional to the amount purchased
d. both b and c
e. both a and c

2. Which of the following statements concerning dual variables is (are) true?
a. Dual variables are obtained automatically in an algebraic solution of a linear programming problem.
b. Dual variables are similar to the artificial variables used in the LaGrange Multiplier technique.
c. A dual variable indicates how much the objective function will change if one additional unit of a given resource is made available, provided that the increase in the resource does not shift the optimal solution to another corner of the feasible solution space.
d. a and c
e. a, b, and c

3. If the primal linear programming problem has two variables and four constraints (excluding the non-negativity constraints), the corresponding dual linear programming problem will have ____.
a. two variables and four constraints
b. four variables and two constraints
c. two variables and two constraints
d. four variables and four constraints
e. none of the above

4. A dual variable equal to zero in the optimal solution to a profit-maximization linear programming problem indicates that the objective function will not increase if an additional unit of the given resources is made available.
a. true
b. false

5. An optimal solution of a linear programming problem always lies on the boundary of the feasible solution space.
a. true
b. false

6. A primal linear programming problem has multiple optimal solutions if it contains two or more variables.
a. true
b. false

7. An optimal solution of a linear programming problem always occurs at one (or more) of the corner points of the feasible solution space.
a. true
b. false

8. Slack variables are given coefficients of ____ in the objective function.
a. +1
b. 0
c. ?1
d. +.00001
e. none of the above

9. In a maximization linear programming problem, the ____ variables represent the difference between the right-hand sides and left-hand sides of less than or equal to (?) inequality constraints.
a. dual
b. slack
c. primal
d. both a and b
e. none of the above

10. In a minimization linear programming problem, the ____ variables are subtracted from the greater than or equal to (?) inequality constraints in order to convert these constraints to equalities.
a. dual
b. primal
c. surplus
d. both a and b
e. both a and c

11. A computer solution of large-scale linear programming problems typically employs a procedure (or variation of the procedure) known as the ____ method.
a. least squares
b. analysis of variance
c. simplex
d. primal/dual
e. none of the above

12. ____ variables are given coefficients of zero in the objective function of a minimization linear programming problem.
a. Primal
b. Dual
c. Surplus
d. Dummy
e. none of the above

PROBLEM

1. The Value-Pack Canning Company buys fresh fruits and vegetables from farmers, processes and cans them, and sells the output to various supermarket chains. The company is trying to determine the optimal mix of peas and green beans to process during the forthcoming period at its Fresno plant. Output is limited by the capacity of the plant and the firm’s financial resources. The plant can process 4,000,000 pounds of peas or green beans (or any linear combination thereof) during the forthcoming period. The company buys peas and green beans for $.10 and $.20 per pound respectively. Purchases must be paid for at the time of delivery and the firm’s current cash balance limits purchases to $600,000 during the forthcoming period. As part of long-term contracts with several supermarket chains, the firm is required to process at least 800,000 pounds of peas and 1,200,000 pounds of green beans during the period. The profit contribution of peas and green beans are $.015 and $.025 respectively. The firm desires to find the mix of peas and green beans to produce in order to maximize the total profit contribution of the plant during the forthcoming period. Let X1 be the number of pounds of peas processed and X2 be the number of pounds of green beans processed.

(a) Formulate the problem algebraically in the linear programming framework.
(b) Using graphical methods, determine the optimal mix of vegetables to process.

ANS:

(a) max .015X1 + .025X2 (objective function)
s.t. X1 + X2 ? 4,000,000 (Constraint 1)
.10X 1 + .20X2 ? 600,000 (Constraint 2)
X1 ? 800,000 (Constraint 3)
X2 ? 1,200,000 (Constraint 4)
X1, X2 ? 0

(b)
The optimal solution occurs at one of the corner points of the feasible solution space (shaded area). Evaluating the objective function at each corner point, one obtains:

Corner Point Value of Objective Function
(.8, 1.2) .015(800,000) + .025(1,200,000) = $42,000
(.8, 2.6) .015(800,000) + .025(2,600,000) = $77,000
(2.0, 2.0) .015(2,000,000) + .025(2,000,000) = $80,000
(2.8, 1.2) .015(2,800,000) + .025(1,200,000) = $72,000

The maximum value of the objective function lies at the (2.0, 2.0) corner point. Therefore, the optimal product mix is 2,000,000 pounds of peas and 2,000,000 pounds of green beans.

Web Appendix E:

1. Transfer pricing:
a. is typical of a centralized firm
b. assumes no external sources available
c. should maximize a division’s profits, rather than the firm’s
d. can exist with or without an external competitive market
e. none of the above

2. Transfer prices in a multiproduct divisionalized firm:
a. serve as a measure of the marginal value of resources employed when making price-output decisions that will maximize profits
b. cannot be determined whenever one division sells its products both internally to another division and externally in a perfectly competitive market
c. serves as a measure of the overall value of the resources employed in the division when analyzing the performance of the division
d. a and c only
e. a, b, and c

3. In the pricing of multiple products with independent demands, the Equal Marginal Revenue (EMR) line is determined by the intersection of a firm’s MC curve and:
a. the marginal cost curve for the first product profitably produced
b. the marginal revenue curve for the last product profitably produced
c. the marginal revenue curve for the first product profitably produced
d. the marginal cost curve for the last product profitably produced
e. none of the above

4. The solution for an optimum combination of joint products produced in variable proportions requires a point of tangency between the ____.
a. isocost and marginal revenue curves
b. isocost and isorevenue curves
c. isorevenue and marginal cost curves
d. marginal cost and marginal revenue curves
e. none of the above

5. Joint products are:
a. products which are technically independent in the production process
b. exemplified by beef and hide from cattle
c. products whose production processes are interdependent
d. a and b
e. b and c

6. With a perfectly competitive external market for an intermediate product, the optimal transfer price for intracompany transfers of the intermediate product (between the production and marketing departments) is equal to the ____.
a. production department’s marginal cost
b. production department’s total cost
c. competitive market price
d. competitive market price plus cost of capital
e. none of the above

7. ____ products are technically ____ in the production process.
a. Alternative; independent
b. Joint; interdependent
c. a and b
d. none of the above

8. Transfer pricing can cause unhappiness within a firm because:
a. the internal sellers want to sell items internally at low prices.
b. the internal buyers want to buy items internally at high prices.
c. the internal sellers want to sell items at higher prices than the internal buyers want to pay.
d. only government workers are happy.

9. Economists argue that the optimal transfer price is one that represents:
a. the average cost of the item based on standard costing.
b. the competitive price that would be available without a vertically integrated firm.
c. the optimal monopoly price based on P (1 + 1/E) = MC.
d. the total cost, including coverage of some of the overhead costs.

10. Universal Foods sells can goods to grocery stores and uses some of the can goods at the corporate cafeteria. The cafeteria is a profit center. Canned green beans are sold to Kroger’s Grocery Stores at 90¢ for a 32-oz. can. The Universal Foods cafeteria wants to ‘pay’ only 30¢ for the can. As the arbitrator in this dispute, you decide to:
a. pretend to be Solomon and split the difference, because that is optimal.
b. decide to go with 30¢, because it is critical that the cafeteria shows as much profit as possible.
c. decide to go with 90¢, because that reflects the closest to a competitive market price for canned green beans.

11. Buster Brown shoes and McAn Shoes is a vertically integrated shoe manufacturer and shoe retail firm. Shoe retail is highly competitive. The optimal transfer price of shoes from Buster Brown to McAn Shoes is:
a. whatever the shoe manufacturer could sell shoes to other retail shoe stores
b. a price that is somewhat lower that the price it could sell shoes to other retail shoe stores
c. a price that is somewhat higher than the price it could sell to other retail shoe shore

12. A vertically integrated firm produces both a specialized computer chip and the consumer toy that uses this chip. No external market exists for the computer chip. The management teams of both divisions receive bonuses that are dependent on the internal profits generated within their respective divisions. The toy division prefers a ________ transfer price, while the computer chip division prefers a _________ transfer price.
a. low, low
b. low, high
c. high, low
d. high, high

13. If the IRS didn’t keep a good watch on transfer pricing, international transfer pricing could lead to loss of corporate profits taxes in the US are much higher than the Cayman Islands. If a firm owns a Cayman Island distributorship, it can buy US products and resell them from the Cayman Islands. To minimize firm-wide corporate taxation (and if it were not required to use arm’s length pricing), then:
a. Use a high transfer price to sell products to the Cayman Island to minimize US taxes.
b. Use a low transfer price to sell products to the Cayman Island to minimize US taxes.
c. It will not matter what transfer price it uses to minimize US taxes.

PROBLEM

1. Washington Instrument produces various electronic products including electronic calculators. The marketing division (m) of the company purchases the integrated circuits used in the calculators, manufactures the various other components (e.g., case, batteries, buttons, etc.), and then assembles and distributes the final calculators under its own brand name (MBA-Whiz). The integrated circuits are produced by a separate production (p) division of the firm. The production division can sell the integrated circuits in the competitive open market at a standard price of $1.50/unit. Likewise, the marketing division can purchase integrated circuits in this market at $1.50/unit. The demand function for this particular calculator is:

Qm = 1350???50Pm

where Qm is quantity sold per month and Pm is the price per unit. The marginal cost function of the calculators (excluding the cost of the integrated circuit) is:

MCm = .0025Qm

The marginal cost function of the production division for these integrated circuits is:

MCP = .00375Qp

where Qp is the quantity of integrated circuits produced per month.

(a) Determine the profit-maximizing price and outlet level of calculators for the marketing division.
(b) Determine the profit-maximizing price and output level of integrated circuits for the production division.
(c) Determine the optimal intracompany transfer price for integrated circuits.
(d) Determine the number of integrated circuits the production division should sell
(i) internally to the marketing division and (ii) externally on the open market.
(e) Determine the number of integrated circuits the marketing division should buy
(i) internally from the production division and (ii) externally on the open market.

Web Appendix F:

1. Simulation techniques used in risk analysis are:
a. cheap to apply
b. widely used
c. mostly beneficial for large projects
d. limited by their inability to consider the probability distribution of the components of a project’s cash flows
e. all of the above

2. Which of the following statements concerning marginal utility is (are) true?
a. marginal utility measures the satisfaction the individual receives from a given incremental change in wealth
b. marginal utility is given by the reciprocal of the slope
c. a and b
d. none of the above

3. Diminishing marginal utility:
a. indicates that the slope of the utility function is increasing as wealth increases
b. means that, as one’s wealth increases, the individual receives more additional satisfaction from each equal increment of wealth
c. a and b
d. none of the above

4. For an individual having a utility function characterized by a(n) ____, the maximization of expected monetary value criterion will, in general, yield the same decisions as the maximization of expected utility criterion.
a. diminishing marginal utility for money
b. linear utility for money
c. increasing marginal utility for money
d. inverse marginal utility for money
e. converse marginal utility for money

5. In the risk-adjusted discount rate approach, the cash flows for each project are discounted at the:
a. risk-free rate
b. cost of capital
c. risk-adjusted discount rate
d. certainty-equivalent rate
e. none of the above

6. The ____ of a portfolio of two or more securities is equal to the weighted average of the ____ of each of the individual securities in the portfolio.
a. standard deviation; standard deviation
b. variance; variance
c. risk; risk
d. expected return; expected return
e. none of the above

7. A(n) ____ creates the legal obligation for the buyer (seller) to purchase (sell) a commodity specified in the contract at the agreed upon price at some future point in time.
a. futures contract
b. forward contract
c. option
d. a and b only
e. a, b, and c

8. A ____ is a transaction that limits the risk associated with market price fluctuations for a particular investment position.
a. minimax position
b. maximin position
c. hedge
d. fence
e. none of the above

9. The Economist Frank Knight and others sometimes make a distinction between risk and uncertainty:
a. Risk involves the huge volatility, whereas uncertainty is more like a feeling of queasiness.
b. Risk involves probabilities that are unknown and outcomes that are unknown, whereas uncertainty involves probabilities that are known and outcomes that are known.
c. Uncertainty uses standard deviations and expected values, whereas we can compute these in situations involving risk.
d. Uncertainty involves probabilities that are unknown and outcomes that are unknown, whereas risk involves probabilities that are known and outcomes that are known.

PROBLEM

1. Consider the two following common stocks:

Standard
Expected Deviation
Return of Return

MGA 15% 16%
MGB 10% 10%

The correlation coefficient between the returns for the two common stocks is .50. An investor plans to put 60% of his wealth in MGA common stock and 40% in MGB common stock.

(a) Determine the expected return for this portfolio.
(b) Determine the standard deviation of the portfolio’s returns.