Managerial Economics: A Problem-Solving Approach 5th Edition Interactive HW Questions (solutions to end-of-chapter multiple choice questions) Table of Contents Chapter 1 ......................................................................................................................................... 3 Chapter 2 ......................................................................................................................................... 6 Chapter 3 ......................................................................................................................................... 9 Chapter 4 ....................................................................................................................................... 12 Chapter 5 ....................................................................................................................................... 15 Chapter 6 ....................................................................................................................................... 18 Chapter 7 ...................................................................................................................................... 22 Chapter 8 ...................................................................................................................................... 25 Chapter 9 ...................................................................................................................................... 28 Chapter 10.................................................................................................................................... 30 Chapter 11 ..................................................................................................................................... 32 Chapter 12..................................................................................................................................... 36 Chapter 14 (and 13) ...................................................................................................................... 38 Chapter 15..................................................................................................................................... 41 Chapter 16..................................................................................................................................... 44 Chapter 17..................................................................................................................................... 47 Chapter 18..................................................................................................................................... 50 Chapter 19.................................................................................................................................... 52 Chapter 20.................................................................................................................................... 55 Chapter 21.................................................................................................................................... 58 Chapter 22.................................................................................................................................... 61 Chapter 1 1. Why might performance compensation caps be bad? a. Different pay rates promote dissent. [A compensation cap is a maximum salary limit, it does not necessarily produce varied pay rates] b. Compensation caps can discourage employees from being productive after the cap. [correct; at least with regards to salary, the employee is not rewarded for further productivity beyond the amount that produces the cap value] c. Compensation caps can discourage employees from being productive before the cap. [employees are incentivized to reach the value of the cap, encouraging productivity prior to its achievement] d. Both b and c 2. What is a possible consequence of a performance compensation reward scheme? a. It creates productive incentives. [As pay is tied directly to performance, such a policy may motivate workers to improve their performance for the additional compensation] b. It creates harmful incentives. [Such a policy may create incentives to manipulate the performance indicators or outputs, or view that performance metric exclusive from the overall interests of the firm] c. Both a and b [correct; could produce productive or harmful incentives depending on the situation and the character of the person being rewarded] d. Neither a nor b [Performance compensation schemes will produce some kind of incentives] 3. Which of the following is NOT one of the three problem solving principles laid out in Chapter 1? a. Under whose jurisdiction is the problem? [correct; This is NOT one of the key problem solving principles]. b. Who is making the bad decision? [This is one of the key problem solving principles] c. Does the decision maker have enough information to make a good decision? [This is one of the key problem solving principles] d. Does the decision maker have the incentive to make a good decision? [This is one of the key problem solving principles] 4. Why might it be bad for hotels to not charge higher prices when rooms are in higher demand? a. Arbitrageurs might establish a black market by reserving rooms and then selling the reservations to customers. [This black market allows the arbitrageurs to capture the value of the increased demand rather than the hotels who are providing the rooms as well as creating a less reliable system for the consumer] b. Rooms may be rationed. [If demand increases but prices do not, demand for rooms may exceed supply, forcing the hotel to ration the rooms and turn customers who would have been willing to pay higher rates away] c. Without the profit from these high demand times, hotels would have less of an incentive to build/expand, making the long run scarcity problem even worse. [Such a policy essentially creates a performance cap on the hotels, limiting their profitability to the number of rooms rather than overall demand] d. All of the above. [correct; all of these are potential negative impacts of hotels not adjusting prices to accommodate demand] 5. The rational-actor paradigm assumes the people do NOT a. Act rationally. [The rational actor paradigm does assume that people act rationally] b. Use rules of thumb. [correct; the rational actor paradigm assumes people will act rationally, optimally and self-interestedly. Rules of thumb will only be used if they meet those three specific parameters] c. Act optimally. [The rational actor paradigm does assume people will act optimally, selecting or creating the outcome that provides them with the most benefit] d. Act self-interestedly. [The rational actor paradigm does assume that people will act in their own best interest] 6. The problem-solving principles analyze firm problems, a. from the organization’s point of view. [correct; considering a problem from the view of the overall organization will help ensure all elements and impacts are considered.] b. from the manager’s point of view. [Managers are also employees of the organization, thinking of a problem from only their perspective may overlook its impact on the company as a whole] c. from the worker’s point of view. [Thinking about a problem only from the employee’s point of view risks missing the fundamental problem of goal alignment with the overall organization] d. Both A and B [Think about problems from the perspective of the overall organization, not its employees] 7. Why might welfare for low income households reduce the propensity to work? a. It will not. [It can if working can only provide similar benefits to those that can be received from welfare without working] b. It reduces the incentive to work. [correct; those receiving welfare may have less incentive to work if the benefits of working are similar to or worse than those that are received without it. Additionally, welfare may reduce the value of working for higher income workers who have to support the system, also reducing their incentives] c. It is unfair. [Perception of fairness alone will not alter the propensity to work unless it also impacts the value of that work for the individual, which would impact his overall incentives] d. It encourages jealousy. [Jealousy itself will not alter the propensity to work unless it also impacts the perceived value of that work, which changes the incentives] 8. Why might a “bonus cap” for executives be a bad policy for the company? a. It isn’t. Executives shouldn’t make more than a certain amount. [Just like other types of employees, setting a maximum value for executives eliminates the ability to separate, reward and motivate them based on their performance] b. It would sew discontent. [Even if discontented, the rational actor paradigm indicates executives would still perform to reach the cap value in order to maximize their bonus] c. It would encourage laziness after the executives reached the cap. [correct; limiting the bonus may reduce the incentive of executives to continue improving or performing once it is achieved] d. The cap could be set too high, so execs may work too hard and not reach it. [This is a problem not with the cap itself, but with the level, which can be adjusted as needed] 9. What might happen if a car dealership is awarded a bonus by the manufacturer for selling a certain number of its cars monthly, but the dealership is just short of that quota near the end of the month? a. It may sell the remaining cars at huge discounts to hit the quota. [correct; the loss of income from the reduced rate will be offset by the manufacturer’s bonus] b. It creates an incentive to sell cars from different manufacturers. [the dealership is more inclined to sell cars from the manufacturer providing the bonus] c. It would ruin the relationship between dealer and manufacturer. [The dealer is working to meet the requirements of the manufacturer to achieve the bonus] 10. Why might a supermarket advertise low prices on certain high profile items and sell them at a loss? a. It is a way for companies to be charitable. [The rational actor paradigm tells us the firm will act in its own self-interest] b. The store will sell other groceries to the same customers, often at a markup. [correct; by using the discounted items to bring consumers into the stores, the supermarket can profit by increasing the prices on the other items they will purchase while they are there.] c. They would not. [Actually, they do quite often. Can you think of why this may be?] d. This reduces the incentives of trade. [Trade incentives do not apply in this case] Chapter 2 Multiple Choice Solutions: 1. An individual’s value for a good or service is a. The amount of money he or she used to pay for a good. [Past payments do not necessarily indicate the current value of a good or service to an individual] b. The amount of money he or she is willing to pay for it. [correct; to “value” a good means that you want it and can pay for it] c. The amount of money he or she has to spend on goods. [Total individual wealth does not reflect the value of a particular good or service] d. None of the above [To “value” a good means that you want it and can pay for it] 2. The biggest advantage of capitalism is a. generates wealth with the help of government intervention [Not all government intervention generates wealth, often it does the opposite. Rather, governments play a critical role in facilitating wealth generating transactions, particularly by enforcing property rights and contracts.] b. that prices assists in moving assets from high valued to low value uses [Wealth is created when assets move from lower to higher valued uses] c. it forces involuntary exchanges [Voluntary transactions create wealth] d. it creates wealth by letting a person follow his or her own self-interest [correct; a buyer willingly buys if the price is above her value, and a seller sells when the price is above her value, otherwise they would not transact] 3. Wealth creating transactions are more likely to occur a. with private property rights [private property rights facilitate voluntary transactions] b. with contract enforcement [contract enforcement helps facilitate voluntary transactions] c. with black markets [black markets are often created from a wealth-generating arbitrage opportunity] d. All of the above [correct; By making sure that buyers and sellers can keep the gains of trade, legal mechanisms such as private property and contract rights that facilitate voluntary transactions will help generate wealth; black markets also create wealth from seizing arbitrage opportunities that exist from inefficiencies in the market] 4. Government regulation a. provides incentives to conduct business in an illegal black market [correct; government regulation that impedes the movement of assets to higher valued uses destroys wealth. Black markets arise in part because of the arbitrage opportunities created in these situations] b. plays no role in generating wealth [governments play a critical role in the wealth creating process by enforcing property rights and contracts] c. is the best way to eliminate poverty [There are other opportunities beyond government regulation to address poverty, especially as often some regulations ultimately result in wealth destroying transactions] d. does not enforce property rights [One of governments most important roles is the enforcement of private property rights] 5. Which of the following are examples of a price floor? a. Minimum wages [correct; by outlawing wages below a certain price, minimum wages are an example of a price floor] b. Rent controls in New York [this is an example of a price ceiling, in which the price of rent cannot go above a specified value] c. Both a and b [Of the two options, one is indeed an example of a price floor, while the other is a price ceiling] d. None of the above. [At least one of the answers above is an example of a price floor, which is defined as a regulation that outlaws trade at prices below the specified “floor” value] 6. A price ceiling a. Is a government-set price above market equilibrium price. [A price ceiling is a regulation that outlaws trade above a specified price; it does not have to be above market equilibrium] b. Is the equivalent of an implicit tax on producers and an implicit subsidy to consumers. [correct; Price ceilings prevent producers from selling at a higher price to consumers who would be willing to pay more, while consumers have the opportunity to purchase something they may not have been able to otherwise] c. Will create a surplus. [Likely, both the consumer (buyer) and producer (seller) will value the good at or above the specified ceiling. If the producer is forced to sell, any surplus for the consumer is a loss for the producer, so no net surplus is created from the transaction] d. Causes an increase in consumer and producer surplus. [Both the consumer (buyer) and producer [seller] likely value the item at or above the specified ceiling, resulting in a benefit for the consumer but a loss of potential wealth for the producers] **NOTE of post-production change: the phrasing of answer a. should be changed to “is a government-set price above market equilibrium price.” 7. Taxes a. impede the movement of assets to higher valued uses. [This is the result of anything that deters a wealth creating transaction] b. reduce incentives to work. [By not allowing people to capture the full value of their labor and production, taxes reduce the incentive to work] c. decrease the number of wealth-creating transactions. [If a tax is larger than the total surplus created by a transaction, the transaction will not take place] d. All of the above. [correct; when taxes are larger than the surplus of a transaction, that transaction will not take place, thus deterring a wealth creating transaction. Likewise, by not allowing people to keep the gains from their own trade, taxes can diminish the incentive to work]. 8. A consumer values a car at $30,000 and a producer values the same car at $20,000. If the transaction is completed at $24,000, the transaction will generate a. no surplus [A surplus is created from this transaction] b. $4,000 worth of seller surplus and unknown amount of buyer surplus [Seller surplus is $4000, (Final price less seller value); Similarly, buyer surplus can be calculated by looking at the difference between the buyer value and the final price. c. $6,000 worth of buyer surplus and $4,000 of seller surplus [correct; Buyer surplus is calculated by looking at the difference between the buyer value and the final price ($30,000- d. 9. $24,000=$6,000), while the seller surplus is calculated by looking at the difference between the final price and the seller’s value ($24,000-$20,000=$4,000)] $6,000 worth of buyer surplus and unknown amount of seller surplus. [Buyer surplus is $6000, (Buyer value less final price); similarly, seller surplus can be calculated by looking at the difference between the final price and the seller value] A consumer values a car at $525,000 and a producer values the same car at $485,000. If sales tax is 8% and is levied on the seller, then the seller’s bottom line price is (rounded to the nearest thousand) a. $527,000 (correct; At a price of $527,000, the seller will receive $485,760 ($528,000*0.92) which is above his bottom line (For the exact value, look at $485,000/0.92 = $527,173.93. As the seller requires a number at or above this value, $528,000 is the best response)] b. $524,000 [at a price of $524,000, the seller will only receive $482,080 ($524,000*0.92) which is below his bottom line] c. $525,000 [at a price of $525,000, the seller will only receive $483,000 ($525,000*0.92) which is below his bottom line] d. $500,000 [at a price of $500,000, the seller will only receive $460,000 ($500,000*0.92) which is below his bottom line] 10. Efficiency implies opportunity a. always [In an efficient market, all assets are already employed in their highest valued uses] b. never [correct; by definition, wealth is generated from inefficiencies in the market, which allow for assets to be moved from lower to high valued uses] c. only if accompanied by secure property rights [Secure property rights assist in wealth generating transactions, which occur from the movement of assets from lower to higher valued uses] d. None of the above [It is one of the above] Chapter 3 Multiple Choice Solutions: 1. A business owner makes 1000 items a day. Each day he or she contributes 8 hours to produce those items. If hired, elsewhere he/she could have earned $250 an hour. The item sells for $15 each. Production does not stop during weekends. If the explicit costs total $150,000 for 30 days, the firm’s accounting profit for the month equals: a. $300,000 [correct; Revenue equals 1000 items per day * $15/item*30days = $450,000. Explicit costs are given as $150,000. Therefore, accounting profit = $450,000-$150,000 = $300,000] b. $60,000 [This number represents the opportunity cost of his labor; $250/hr*8hrs/day*30 days = $60,000] c. $450,000 [This number represents the total revenue; 1000 items per day * $15/item*30days = $450,000.] d. $240,000 [For accounting profit, opportunity costs are not considered] 2. A business owner makes 1000 items a day. Each day he/she contributes 8 hours to produce those items. If hired, elsewhere he/she could have earned $250 an hour. The item sells for $15 each. Production does not stop during weekends. If the explicit costs total $150,000 for 30 days, the economic profit for the month equals: a. $300,000 [This number represents the accounting profit. Revenue equals 1000 items per day * $15/item*30days = $450,000. Explicit costs are given as $150,000. Therefore, accounting profit = $450,000-$150,000 = $300,000] b. $60,000 [This number represents the opportunity cost of his labor; $250/hr*8hrs/day*30 days = $60,000] c. $450,000 [This number represents the total revenue; 1000 items per day * $15/item*30days = $450,000.] d. $240,000 [correct; When calculating economic profit, opportunity costs are considered. Total Revenue is $450,000 (1000 item/day*$15/item*30days), Explicit costs are given at $150,000 and the opportunity cost of labor is $60,000 ($250.hr*8hrs/day*30days). Therefore, economic profit is $450,000-$150,000-$60,000 = $240,000] 3. If a firm is earning negative economic profits, it implies a. That the firm’s accounting profits are zero. [Not necessarily, it is impossible to determine the relationship between economic and accounting profit without information on the economic costs involved]. b. That the firm’s accounting profits are positive. [Not necessarily, it is impossible to determine the relationship between economic and accounting profit without information on the economic costs involved]. c. That the firm’s accounting profits are negative. [Not necessarily, it is impossible to determine the relationship between economic and accounting profit without information on the economic costs involved]. d. More information is needed to conclude about accounting profits [correct; it is impossible to determine the relationship between economic and accounting profit without information on the economic costs involved] 4. Opportunity costs arise due to a. Resource scarcity [correct; without scarce resources (time, labor, money, etc), the pursuit of another alternative does not require one to give up anything in return. b. Interest rates [interest is an economic cost that reflects what creditors charge for use of their capital] c. Limited wants [Limited wants would not generate opportunity costs] d. Unlimited scarcity [Unlimited scarcity does not generate opportunity costs] 5. After graduating from college, Jim had three choices, listed in order of preference: (1) Move to Florida from Philadelphia, (2) work in a car dealership in Philadelphia, or (3) play soccer for a minor league in Philadelphia. His opportunity cost of moving to Florida includes a. The benefits he could have received from playing soccer [Opportunity cost represents the value of only the best foregone alternative] b. The income he could have earned at the car dealership [correct; opportunity cost reflects the value of the best foregone alternative, in this case the car dealership salary] c. Both a and b. [Opportunity costs represent the value of only the best foregone alternative] d. Cannot be determined from the given information. [Opportunity costs reflect the value of the best foregone alternative, what is that for Jim in this case?] 6. Economic Value Added helps firms avoid the hidden-cost fallacy a. by ignoring the opportunity costs of using capital [On the contrary, EVA makes the hidden cost of equity visible to the firm] b. by differentiating between sunk and fixed costs [EVA may help managers distinguish between the two, but it does so by looking at the cost of capital associated with each] c. by taking all capital costs into account, including the cost of equity [correct; By taking all of the capital costs into account such as the cost of equity, firms can better gauge their economic profit and the opportunity costs associated with some of their current assets] d. None of the above. [It is one of the above] 7. The fixed-cost fallacy occurs when a. A firm considers irrelevant costs [The sunk or fixed cost fallacy occurs when you make decisions using irrelevant costs or benefits. In other words, you consider costs and benefits that do not vary with the consequences of your decision] b. A firm ignores relevant costs [This is the definition of the hidden cost fallacy] c. A firm considers overhead or depreciation costs to make short-run decisions [Overhead and depreciation are example of irrelevant or suck costs that are not impacted by the outcome of a short term decision] d. Both a and c. [correct; The sunk or fixed cost fallacy occurs when costs (such as depreciation and overhead) are considered even when they do not vary with the consequences of the decision. 8. Mr. D's Barbeque of Pickwick, TN, produces 10,000 dry-rubbed rib slabs per year. Annually Mr. D's fixed costs are $50,000. The average variable cost per slab is a constant $2. The average total cost per slab then is a. $7. [correct; Total fixed costs are $5/lab ($50,000Total Fixed Cost/10,000 units), and average variable cost is given as $2/slab. Therefore average total cost (Fixed + Variable) per unit equal $5+$2=$7] b. c. d. 9. $2. [This represents the average variable cost per unit. Average total cost requires consideration of the fixed component] $5. [This represents the average fixed cost per unit, calculated as $50,000 Total Fixed cost/10,000 units] Iimpossible to determine. [Average total cost per unit can be determined by adding the average variable and fixed costs per unit of the rib slabs] All the following are examples of variable costs, except a. Labor costs [varies by the number of employees as well as their hours worked, which correlate with the total amount of output produced] b. Cost of raw materials [Cost of raw materials with the total amount of output produced] c. Accounting fees [correct; accounting fees are paid regardless of total output. They do not vary with the amount that is produced] d. Electricity costs [Electricity, like other utilities varies by usage] 10. The U.S. Government bought 112,000 acres of land in southeastern Colorado in 1968 for $17,500,000. The cost of using this land today exclusively for the reintroduction of the black-tailed prairie dog a. is zero, because they already own the land. [The cost of the land includes the cost of the best foregone option] b. is zero, because the land represents a sunk cost. [A cost is sunk when it does not vary with the outcome of the decision. In this case, there may be an opportunity cost associated with using the land for prairie dogs that should be considered] c. is equal to the market value of the land. [correct; the cost of a decision includes the cost of the best foregone option. In this case, this is the amount the government could sell the land for if they did not use if for prairie dog introduction] d. is equal to the total dollar value the land would yield if used for farming and ranching. [This may be hard to determine, and also requires additional resources and labor. In this case, there may be a better alternative] e. depends on the value to society of black-tailed prairie dogs. [Regardless of the prairie dog value, the cost would include that of the best foregone option and should still be considered. If that cost is deemed less than the value of the prairie dogs, the project will move forward] Chapter 4 Multiple Choice Solutions: 1. When economists speak of “marginal”, they mean a. opportunity [The opportunity cost of an alternative is the profit you give up to pursue it] b. scarcity [Scarcity refers to the limited availability of resources] c. incremental [correct; marginal refers to additional cost or benefit created from producing each additional unit] d. unimportant [In economic terms, marginal does not imply unimportant. On the contrary, marginal analysis is a critical component of a wide variety of economic decisions] 2. Managers undertake an investment only if a. Marginal benefits of the investment are greater than zero [when considering a decision, both the marginal benefits and marginal costs should be compared] b. Marginal costs of the investment are greater than marginal benefits of the investment [if the marginal costs are greater than the marginal benefits of a decision, management will not make the investment] c. Marginal benefits are greater than marginal costs [correct; managers should undertake an investment when the marginal benefits are greater than the marginal costs] d. Investment decisions do not depend on marginal analysis [marginal analysis is critical in investment decisions] 3. A firm produces 500 units per week. It hires 20 full-time workers (40 hours/week) at an hourly wage of $15. Raw materials are ordered weekly and they costs $10 for every unit produced. The weekly cost of the rent payment for the factory is $2,250. How do the overall costs breakdown? a. Total variable cost is $17,000; total fixed cost is $2,250; total cost is $19,250 [correct; both the $12,000 of labor costs (20 workers*40hrs/week*$15/hr) and the $5000 raw materials cost ($10/unit*500 units) are considered variable expenses. Factory rent is considered a fixed cost] b. Total variable cost is $12,000; total fixed cost is $7,250; total cost is $19,250 [Both labor and raw materials are considered variable costs as they both change as output levels change] c. Total variable cost is $5,000; total fixed cost is $14,250; total cost is $19.250 [Both labor and raw materials are considered variable costs as they change as output levels change] d. Total variable cost is $5,000; total fixed cost is $2,250; total cost is $7,250 [Both raw materials and labor should be considered as variable costs, which when added to the fixed rental cost will equal the total costs of production] 4. Total costs increase from $1500 to $1800 when a firm increases output from 40 to 50 units. Which of the following are true? a. FC = $100 [We know that Total cost = FC + VC(Quantity). This means 1500 = FC+VC(40) and 1800=FC+VC(50). Using this information, we can solve for FC] b. FC = $200 [We know that Total cost = FC + VC(Quantity). This means 1500 = FC+VC(40) and 1800=FC+VC(50). Using this information, we can solve for FC] c. FC = $300 [We know that Total cost = FC + VC(Quantity). This means 1500 = FC+VC(40) and 1800=FC+VC(50). Using this information, we can solve for FC. For example, using the first equation we see VC(40)=1500-FC, hence VC=(1500-FC)/40. Plugging this value for VC into 1800=FC+VC(50) will give you 1800=FC+50((1500-FC)/40), which lets us find FC=300] d. FC = $400 [We know that Total cost = FC + VC(Quantity). This means 1500 = FC+VC(40) and 1800=FC+VC(50). Using this information, we can solve for FC] 5. A manager of a clothing firm is deciding whether to add another factory in addition to one already in production. The manager would compare a. the total benefits gained from the two factories to the total costs of running the two factories. [By combining the total costs and benefits of the two factories, the manager would not be able to determine the contribution of the second factory on its own] b. the incremental benefit expected from the second factory to the total costs of running the two factories. [The additional benefit of the second factory should only be compared to the additional costs of that factory, as the costs from the first factory will be incurred regardless] c. the incremental benefit expected from the second factory to the cost of the second factory [correct; the manager will decide to add another factory when the incremental benefits of that factory are greater than its incremental costs] d. the total benefits gained from the two factories to the incremental costs of running the two factories. [The incremental costs of having a second factory should be compared only to its incremental benefit, as the benefits of the first factory will be produced regardless] 6. A firm is thinking of hiring an additional worker to their organization who can increase total productivity by 100 units a week. The cost of hiring him is $1,500 per week. If the price of each unit is $12, a. the MR of hiring the worker is $1,500 [The MR of hiring the worker is $1200 (100 additional units produced*$12/unit)] b. The MC of hiring the worker is $1,200 [The MC of hiring the worker is his salary of $1500] c. The firm should not hire the worker since MB < MC [correct; The MR of hiring the worker is $1200 (100 additional units*$12/unit), while his MC is his salary of $1500, indicating the company will lose $300/week by hiring the additional worker] d. All the above [Remember the marginal benefit is the additional revenue generated by the worker, while the marginal costs will be any additional costs that occur from hiring him] 7. A retailer has to pay $9 per hour to hire 13 workers. If the retailer only needs to hire twelve workers, a wage rate of $7 per hour is sufficient. What is the marginal cost of the 13th worker? a. $117. [This is the total cost of having 13 workers ($9*13)] b. $9. [This represents the wage of the additional worker, but does not take into consideration the additional costs of the wage increase for the rest of the employees associated with his hiring] c. $33. [correct; The total cost of having twelve workers is $84 (12workers*$7hr) while the addition of the thirteenth worker brings the total cost up to $117 (13 workers*$9/hr). Therefore, the marginal cost of the 13th worker is $33 ($117-$84)] d. $84. [This is the total cost of having 12 workers (12*$7/hr)] 8. If a firm’s average cost is rising then a. marginal cost is less than average cost. [If marginal cost is less that average cost, then its average cost will fall with each additional unit] b. marginal cost is rising. [Average cost may still be falling even as marginal cost rises, provided the marginal cost still falls below the average] c. d. 9. marginal cost is greater than average cost [correct; when the marginal cost is above the average, then the average will rise with output] the firm is making an economic profit. [Average cost trends cannot be determined by looking at average costs exclusively] After the first week of his MBA Managerial Economics class, one of your pharmaceutical sales representatives accuses you of committing the sunk cost fallacy by refusing to allow him to reduce price to make what he considers to be a really tough sale. Which of the following suggest the sales representative may be right? a. Most of the costs of drug development are sunk, not fixed. [correct; in this case, he may be correct. The costs of drug development have already been incurred, cannot be recovered, and will not change with the outcome of the sale] b. Sales representatives are paid a sales commission on revenue, so they don’t care about the costs of drug development. [The fact that representatives are paid a commission on revenue does not have anything to do with whether you are committing the sunk cost fallacy] c. Sales representatives don’t worry that a low price today may make it more difficult for the company’s other sales representatives to charge higher prices to their customers tomorrow. [If true, this would be an example of a hidden cost] d. Sales representatives think only about one thing, sales. [The fact that representatives think only of sales does not have anything to do with whether you are committing the sunk cost fallacy] 10. A company is producing 15,000 units. At this output level, marginal revenue is $22 and the marginal cost is $18. The firm sells each unit for $48 and average total cost is $40. What can we conclude from this information? a. The company is making a loss. [The company is making a profit of $120000. Total revenues equal $720000 ($48*15000units) while total costs are $600000 ($40*15000units)] b. The company needs to cut production. [You need to cut production when MC>MR] c. The company needs to increase production. [correct; When MR>MC, you need to sell more. In this case MR=$22 is greater than MC=$18, therefore they should increase production] d. Not enough information is provided. [There is enough information provided to answer this question] Chapter 5 Multiple Choice Solutions 1. Which of the following will increase the break-even quantity? a. A decrease in overall fixed costs [Breakeven is calculated as Q=F/(P-MC), Therefore a decrease in overall fixed costs would decrease the numerator and hence the Breakeven Quantity] b. A decrease in the marginal costs [Breakeven is calculated as Q = F/(P-MC). Therefore a decrease in the marginal costs will increase the denominator, and subsequently decreases the Breakeven Quantity] c. A decrease in the price level [correct; Breakeven is calculated as Q= F/(P-MC). Therefore, a decrease in the price level will decrease the denominator, which will increase the Breakeven quantity] d. An increase in price level [Breakeven is calculated as Q= F/(P-MC). Therefore, an increase in the price level will increase the denominator, which will decrease the Breakeven Quantity. 2. The higher the discount rates a. the more value individuals place on future dollars [a higher discount rate means future dollars are worth less relative to current dollars (present value of future dollars is lower)] b. the more value individuals place on current dollars [correct; a higher discount rate means dollars today are value comparatively more relative to future dollars] c. the more investments will take place [the higher discount rate means the future value of current dollars is lower, which may lead to an decrease in investment] d. Does not affect the investment strategy [interest rates are an important consideration of any investment strategy in terms of its impact on both the investing and borrowing rates] 3. Assume a firm has the following cost and revenue characteristics at its current level of output: price=$10.00, average variable cost=$8.00 and average fixed cost =$4.00. This firm is a. incurring a loss of $2.00 per unit and should shut down. [In the short run, only variable costs are avoidable and should be considered in a shut down decision] b. realizing only a normal profit. [In this case, the firm is not making a profit] c. realizing an economic profit of $2.00 per unit. [In this case, the firm is not making a profit] d. incurring a loss per unit of $2.00 but should continue to operate in the short run. [correct; In the short run, only variable costs are avoidable and should be considered in a shutdown decision. As the current price ($10) is still higher than the variable costs ($8), the company should continue to operate in the short run until the fixed costs become avoidable] 4. Sarah’s Machinery Company is deciding to dump their current technology A for a new technology B with smaller fixed costs but bigger marginal costs. The current technology has fixed costs of $500 and marginal costs of $50 whereas the new technology has fixed costs of $250 and marginal costs of $100. At what quantity is Sarah Machinery indifferent between two technologies? a. 5 [correct; Total costs can be calculated as C=FC+VC(Q). Technology A has total costs of C=500+50(Q), while Technology B has C=250+100(Q). Sarah is indifferent at the quantity at which these two costs are the same. Therefore, setting these equations equal to each other gives us 500+50(Q) = 250 +100(Q), which allows us to solve for Q = 5] b. 6 [Total costs can be calculated as C=FC+VC(Q). Sarah will be indifferent between the two technologies at the quantity where these two costs are the same] c. d. 7 [Total costs can be calculated as C=FC+VC(Q). Sarah will be indifferent between the two technologies at the quantity where these two costs are the same] 8 [Total costs can be calculated as C=FC+VC(Q). Sarah will be indifferent between the two technologies at the quantity where these two costs are the same] 5. What is the net present value of a project that requires a $100 investment today and returns $50 at the end of the first year and $80 at the end of the second year? Assume a discount rate of 10%. a. $10.52 [To find Net Present Value, discount the future cash flows by the discount rate raised to the period in which it was received (for example, year one means k=1, etc) and then subtract the initial investment from the sum of those cash flows] b. $11.57 [correct; Net present value is calculated by discounting the future cash flows from the period they were received and subtracting the initial investment from the sum of those cash flows. In this case, (50/1.1)+(80/1.12)=111.57. $111.57-$100 initial investment gives a NPV of $11.57] c. $18.18 [Remember that the cash inflows need to be discounted back to present value from the time period in which they occur (50 at the end of year 1, 80 at the end of year 2)] d. $30.00 [Don’t forget about the time value of money. To determine the net present value, the future cash flows will need to be discounted and the initial investment will be subtracted from the sum of those values] 6. You expect to sell 500 cell phones a month, which have a marginal cost of $50. If your fixed costs are $5,000 per month, what is the break-even price? a. $10 [Breakeven Q= FC/(P-MC). This means (P-MC)Q=FC, so P-MC= (FC/Q) and finally P= (FC/Q) – MC] b. $50 [Breakeven Q= FC/(P-MC). This means (P-MC)Q=FC, so P-MC= (FC/Q) and finally P= (FC/Q) – MC] c. $60 [Breakeven Q= FC/(P-MC). This means (P-MC)Q=FC, so P-MC= (FC/Q) and finally P= (FC/Q) – MC. This gives us P= (5000/500)+50 = 10+50 = $60] d. $100[Breakeven Q= FC/(P-MC). This means (P-MC)Q=FC, so P-MC= (FC/Q) and finally P= (FC/Q) – MC] 7. You are considering opening a new business to sell dartboards. You estimate that your manufacturing equipment will cost $100,000, facility updates will cost $250,000, and on average it will cost you $80 (in labor and material) to produce a board. If you can sell dart boards for $100 each, what is your break-even quantity? a. 1,000 [Breakeven Q=FC/(P-MC). In this case, the Fixed costs include both the equipment and the updates, the price is given at $100, and the MC equals the average cost per board] b. 3,500 [Breakeven Q= FC/(P-MC). Don’t forget to consider the marginal costs!] c. 4,375 [Breakeven Q= FC/(P-MC). Don’t forget to consider the price!] d. 17,500 [correct; Breakeven Q = FC/(P-MC). In this case, fixed costs are $350,000 ($100,000 equipment + $250,000 updates), the Price is given as $100 and the Marginal cost is the $80 cost per additional board. Putting these in the formula, we see that 350,000/(100-80) = 17,500] 8. Which of the following is NOT true if a firm shuts down and produces zero output in the short run? a. Variable costs will be zero. [This is true; variable costs relate directly to the amount of output. With an output of zero, variable costs will also be zero] b. c. d. 9. Losses will be incurred. [This is true. Only variable costs are avoidable in the short run, therefore the fixed costs will still be incurred even without any revenue produced which will result in losses for the firm] Fixed costs will be greater than zero. [This is true; only variable costs are avoidable in the short run, which means the fixed costs will still be incurred] Fixed costs will be less than zero. [correct; this is not true; fixed costs cannot be less than zero] What are some of the solutions for a hold-up problem? a. Mergers [Mergers will help a hold-up problem by aligning the incentives of the two organizations into one] b. Contracts [When hold-up is anticipated, contracts can protect the potential victim] c. Exchange of ‘hostages’ [The use of ‘hostages’ helps ensure both parties make appropriate relationship specific investments, and provides either collateral or a means of escaping a hold up situation] d. All of the above [correct; all of these are potential solutions to hold up] 10. Which of the following is classified as a sunk cost? a. Cost of the next best alternative [this is the definition of an opportunity cost] b. Additional cost of producing an additional unit [this is the definition of a marginal cost] c. Research costs to determine the implementation of a technology [correct; research is often an example of a sunk cost as it is incurred before production and sale and cannot be recovered regardless of what happens with the final product] d. Total cost of producing a product [Production costs are more than likely not sunk, as they tend to be impacted by output decisions] Chapter 6 Multiple Choice Questions 1. Jim has estimated elasticity of demand for gasoline to be -0.7 in the short-run and -1.8 in the long run. A decrease in taxes on gasoline would: a. lower tax revenue in both the short and long run. [Demand is inelastic in the short run, but elastic in the long run, indicating different effects in the short and long run from the price reduction that results from lower taxes] b. raise tax revenue in both the short and long run. [Demand is inelastic in the short run, but elastic in the long run, indicating different effects in the short and long run from the price reduction that results from lower taxes] c. raise tax revenue in the short run but lower tax revenue in the long run. [Inelastic demand in the short run means people initially will not change their consumption habits, which will lower tax run. What are the long term effects?] d. lower tax revenue in the short run but raise tax revenue in the long run. [correct; demand is inelastic in the short run, which means that initially the decrease in taxes will not alter people’s demand or consumption for gas, which will result in a decrease in the potential tax revenue as there is the same level of consumption at a lower price. However, in the long tax revenue will increase as the demand for gasoline becomes elastic, and the consumption of gasoline rises] **NOTE of post-production change: the word “tax” should be removed from each of the multiplechoice answers a. lower revenue in both the short and long run. [Demand is inelastic in the short run, but elastic in the long run, indicating different effects in the short and long run from the price reduction that results from lower taxes] b. raise revenue in both the short and long run. [Demand is inelastic in the short run, but elastic in the long run, indicating different effects in the short and long run from the price reduction that results from lower taxes] c. raise revenue in the short run but lower revenue in the long run. [Inelastic demand in the short run means people initially will not change their consumption habits much, so revenue will decrease. What are the long term effects?] d. lower revenue in the short run but raise revenue in the long run. [correct; demand is inelastic in the short run, meaning a price decrease will decrease revenue. However, in the long revenue, demand is elastic so revenue will increase due to the price decrease] 2. Which one of the following is true? a. Nike has a more inelastic demand curve than shoes [False; Demand for an individual brand is more elastic than industry aggregate demand] b. The demand curve for gas is more elastic in the short run than in the long run. [False; In the long run, demand curves become more elastic] c. Cigarettes have a more elastic demands than televisions [False; As price increases, demand becomes more elastic]. d. Salt has a more inelastic demand than meat [correct; This is true, not only is salt less expensive than meat (as price increases, price becomes more elastic), but salt also has many complements (it is a staple in most households with every meal), which would indicate a less elastic demand than meat] 3. Jim recently graduated from college. His income increased tremendously from earning $5000 a year to $60,000 a year. Jim decided that instead of renting he will buy a house. This implies that a. houses are normal goods for Jim [correct; for normal goods, demand increases as income increases] b. houses are inferior goods for Jim [for inferior goods, demand decreases as income increases] c. renting and owning are complementary for Jim [Jim’s decision to purchase a house was not reflective of a change in rental rates. If anything, renting and owning are substitutes for one another] d. need information on the price of houses. [Not necessarily, Jim’s behavior and purchasing decision here is more informative than the actual housing prices] 4. Which of the following goods have a negative income elasticity of demand? a. Cars [cars are a normal good; typically demand for cars increases with income] b. Items from Dollar stores [correct; Dollar store items are typically considered inferior goods, hence their demand will decrease as the income of the user increases] c. Shoes [typically, shoes are considered a normal good, with demand increasing with the income of the purchaser] d. Bread [Bread, like most food is considered a normal good] 5. An economist estimated the cross-price elasticity for peanut butter and jelly to be +1.5. Based on this information, we know the goods are a. inferior goods. [Cross price elasticity measures the change in the demand of one good with regard to the price of another in order to determine complements and substitutes. It does not reflect if a good is normal or inferior] b. complements. [Complements have negative cross price elasticity] c. inelastic. [With a cross price elasticity of 1.5>1, this relationship is elastic] d. substitutes. [correct; Positive cross price elasticity means that Good A (Peanut Butter) is a substitute for Good B (Jelly)] 6. Christine has purchased five bananas and is considering the purchase of a sixth. It is likely she will purchase the sixth banana if a. the marginal value she gets from the sixth banana is lower than its price. [Christine will not purchase an additional banana if the marginal value she receives is lower than her marginal cost (the price of the additional banana)] b. the marginal benefit of the sixth banana exceeds its price. [correct; Christine will only purchase the banana when the marginal benefit she receives is greater than the marginal cost (or price) of the additional banana] c. the average value of the sixth bananas exceeds the price. [The marginal benefit, not the average value/benefit of the sixth banana is what is important to consider for this decision] d. the total personal value of six bananas exceeds the total expenditure to purchase six bananas. [Total values should not impact the decision to purchase an additional banana. Rather, the marginal benefit of the sixth banana relative to its cost should be considered] 7. Buyers consider Marlboro cigarettes and Budweiser beer to be complements. If Marlboro just increased its prices, what would you expect to occur in the Budweiser market? a. b. c. d. Demand would rise, and Budweiser would reduce price. [If two goods are complements, an increase in the price of one results in a decrease in demand for the other] Demand would fall, and Budweiser would reduce price. [correct; when two goods are complements, an increase in the price of one results in a decrease in the demand for the other. To account for this decrease in demand, Budweiser would ultimately lower its prices as well] Demand would fall, and Budweiser would increase price. [As complements, demand for Budweiser would fall as a result of the increase in Marlboro prices. An increase in prices would only further decrease demand] Demand would rise, and Budweiser would increase supply. [If two goods are complements, and increase in the price of one results in a decrease in the demand for the other] 8. Which of the following is the reason for the existence of consumer surplus? a. Consumers can purchase goods that they “want” in addition to what they “need.” [Wants and needs are both a reflection of how the consumer values an item, not necessarily an indication of consumer surplus] b. Consumers can occasionally purchase products for less than their production cost. [Production cost is less relevant to creating consumer surplus than the amount of value a consumer places on a final good (this could in fact be lower than the production cost as well)] c. Some consumers receive temporary discounts that result in below-market prices. [Consumer surplus is a measure of the difference between the value a consumer places on an item and the amount they ultimately pay for it. If a consumer only purchases an item because of a discount, it indicates they likely value the item at the below-market price, so no surplus is created] d. Some consumers are willing to pay more than the market price. [correct; consumer surplus exists when the Value to the consumer is greater than the final (or market) price. It is when consumers pay market price for a good they place a higher value on that a consumer surplus is created] 9. A bakery currently sells chocolate chip cookies at a price of $16 per dozen. The marginal cost per dozen is $8. The cookies are becoming more popular with customers and so the bakery owner is considering raising the price to $20/dozen. What percentage of customers must be maintained to ensure that the price increase is profitable? a. 28.0% [if the store only maintained 28% of its current customers, it would need to increase its prices to $36!] b. 33.3% [this is the number of customers the bakery can lose and still remain profitable] c. 66.6% [correct; as the margin has increased from 8 (16-8) to 12(20-8), the bakery must maintain 66.6% (8/12) of its customers in order to get the same level of profitability] d. 72.0% [if the store maintained 72% of its current customers, it would only need to increase its prices to $19] 10. A firm adopts a technology that allows you to increase your output by 15%. If the elasticity of demand in the US is -3, how should you adjust your price if you want to sell all of your output? a. 5% lower. [correct; %ΔQ= e(%ΔP). Therefore, an 15% increase in Q = -3(%ΔP), hence %ΔP = -5%] b. 0.5% lower. [Remember, %ΔQ= e(%ΔP)] c. 15% higher. [Remember, %ΔQ= e(%ΔP)] d. 15% lower. [Remember, %ΔQ= e(%ΔP)] Chapter 7 Multiple Choice Questions 1. Microsoft found that instead of producing a DVD player and a gaming system separately, it is cheaper to incorporate DVD playing capabilities in its new version of the gaming system. Microsoft is taking advantage of a. economies of scale [economies of scale mean average costs decline with output. There is no indication here that this is happening.] b. learning curve [learning curves mean that current production lowers future costs for the same product; that does not apply here] c. economies of scope [correct; the cost to produce the two products together is less than the sum of the costs of producing them separately] d. decreasing marginal costs [there is no indication that marginal costs are decreasing for either individual product] 2. As a golf club production company produces more clubs, the average total cost of each club produced decreases. This is because: a. total fixed costs are decreasing as more clubs are produced [fixed costs by definition do not change with volume]. b. average variable cost is decreasing as more clubs are produced [there is no information to indicate that variable costs are declining]. c. there are scale economies. [correct; declining average total costs are indicative of economies of scale] d. total variable cost is decreasing as more clubs are produced [because variable cost will not be less than zero, total variable cost would not decrease as more units are produced] 3. Average costs curves initially fall a. due to declining average fixed costs [correct; as output increases and fixed costs are distributed over more units, average fixed costs per unit fall] b. due to rising average fixed costs [average costs curves would increase if average fixed cost is increasing] c. due to declining accounting costs [accounting costs are not relevant here] d. due to rising marginal costs [rising marginal costs would cause the average costs curve to rise, not fall] 4. What might you reasonably expect of an industry in which firms tend to have economies of scale? a. Exceptional competition among firms [economies of scale means average cost falls with output; it does not necessarily imply a high level of competition] b. A large number of firms [given the importance of volume in gaining economies of scale, we would expect few firms, each with a large volume] c. Highly diversified firms [given the importance of volume in gaining economies of scale, we would expect a few firms that concentrate on building volume of individual products and concentrate less on diversifying into other product areas] d. A small number of firms [correct; a few firms with large volume could be expected to capture the economies of scale] 5. A security system company’s total production costs depend on the number of systems produced according to the following equation: Total Costs = $20,000,000 + $4000*quantity produced. Given these data, which of the following is a false statement? a. There are economies of scale. [this statement is true; average costs fall with output] b. There are fixed costs associated with this business. [this statement is true; the $20,000,000 is a fixed cost] c. d. There are diseconomies of scale [correct; if average costs increased with output, there would be diseconomies. That is not the case here] A firm that produces a larger output has a cost advantage over a smaller firm. [this statement is true; because average costs decrease with output(economies of scale), firms producing more will have lower average costs] 6. Following are the costs to produce Product A, Product B, and Products A and B together. Which of the following exhibits economies of scope? a. 100, 150, 240 [correct; the cost of producing both products together (240) is less than the sum of the cost of producing them separately (250)] b. 100, 150, 250 [the cost of producing both products together (250) is NOT less than the sum of the cost of producing them separately (250)] c. 100, 150, 260 [the cost to produce the two products together (260) is NOT less than the sum of the costs of producing them separately(250)] d. All of the above [only one of the choices exhibits economies of scope] 7. According to the law of diminishing marginal returns, marginal returns: a. diminish always prior to increasing. [marginal returns do not always diminish prior to increasing] b. diminish constantly. [there are cases where marginal returns increase] c. diminish never. [the law of diminishing marginal returns suggests some cases where returns will diminish]diminish eventually. [correct; The law of diminishing marginal returns states that as you try to expand output, your marginal productivity (the extra output associated with extra inputs) eventually declines.] 8. It costs a firm $90 per unit to produce product A and $70 per unit to produce product B individually. If the firm can produce both products together at $175 per unit of product A and B, this exhibits signs of a. economies of scale [economies of scale are not relevant here because the question refers to the cost of producing two separate products, not more of the same product] b. economies of scope [economies of scope indicate that the cost of producing the two products together is less than the sum of the cost of producing them separately. This is not the case here.] c. diseconomies of scale [economies of scale are not relevant here because the question refers to the cost of producing two separate products, not more of the same product] d. diseconomies of scope [correct; the cost to produce the two products together (175) is more than the sum of the costs of producing them separately(160)] 9. A company faces the following costs at the respective production level in addition to its fixed costs of $50,000: Quantity 1 2 3 4 5 Marginal Cost $10,000 $11,000 $12,000 $13,000 $14,000 Sale Price $20,000 $20,000 $20,000 $20,000 $20,000 Marginal Return $10,000 $9,000 $8,000 $7,000 $6,000 How would you describe the returns to scale for this company? a. Increasing [correct; average total costs are falling with output] b. Decreasing [average costs are falling with output, so returns are not decreasing] c. Constant [average costs are falling with output, so returns are not constant] d. Marginal [“marginal” returns to scale is not a meaningful phrase] 10. Once marginal cost rises above average cost, a. Average costs will increase [correct; the cost to produce an additional unit of output will be greater than the previous unit of output, which will increase average costs] b. Average costs are unaffected [average costs will be affected] c. Average costs will decrease [average costs will not decrease] d. None of the above [one of the answers is correct because marginal and average costs are related] Chapter 8 1. Changes in prices of a good causes a. movement along the demand curve [yes but this is not the only effect] b. movement along the supply curve [yes but this is not the only effect] c. no movement along either curve [changes in prices will result in movement along one or more of these curves d. Both a and b [correct; it causes movement along both curves] 2. If the market for a certain product experiences an increase in supply and a decrease in demand, which of the following results is expected to occur? a. Both the equilibrium price and the equilibrium quantity could rise or fall. [increase in supply and decrease in demand both lead to a fall in price ] b. The equilibrium price would rise, and the equilibrium quantity could rise or fall. [increase in supply and decrease in demand both lead to a fall in price] c. The equilibrium price would fall, and the equilibrium quantity could rise or fall. [correct; increase in supply and decrease in demand both lead to lower price; net quantity change is unknown because the increase in supply would lead to higher quantity while the decrease in demand would lead to lower quantity] d. The equilibrium price would fall, and the equilibrium quantity would fall. [net quantity change is unknown because the increase in supply would lead to higher quantity while the decrease in demand would lead to lower quantity] 3. When demand for a product falls, which of the following events would you NOT necessarily expect to occur? a. A decrease in the quantity of the product supplied. [equilibrium quantity will fall with a decrease in demand] b. A decrease in its price. [equilibrium price will fall with a decrease in demand] c. A decrease in the supply of the product. [correct; while a decrease in demand will be associated with a decrease in the quantity supplied at equilibrium, it will not cause a shift in the supply curve] d. A leftward shift of the demand curve. [falling demand means the demand curve shifts leftward] 4. Suppose a recent and widely circulated medical article has reported new benefits of cycling for exercise. Simultaneously, the price of the parts needed to make bikes falls. If the change in supply is greater than the change in demand, the price will _________ and the quantity will _________. a. rise, rise [demand will increase because of the article while supply will also increase because of lower costs; if the supply shift (leading to lower prices) is greater than the change in demand (leading to higher prices), the net effect should not be a rise in both price and quantity] b. rise, fall [demand will increase because of the article while supply also increases because of lower costs; if the supply shift (leading to lower prices) is greater than the change in demand (leading to higher prices), the net effect should not be a fall in quantity.] c. fall, rise [correct; demand will increase because of the article while supply will also increase because of lower costs; if the supply shift (leading to lower prices) is greater than the change in demand (leading to higher prices), the net effect should be a fall in price while both shifts lead to a rise in quantity] d. fall, fall [demand will increase because of the article while supply will also increase because of lower costs; if the supply shift (leading to lower prices) is greater than the change in demand (leading to higher prices), the net effect should be a fall in price while both shifts lead to a rise in quantity] 5. Suppose there are nine sellers and nine buyers in a competitive market, each willing to buy or sell one unit of a good, with values {$10, $9, $8, $7, $6, $5, $4, $3, $2}. Assuming there are no transactions costs, what is the equilibrium price in this market? a. $5 [at a price of $5, four suppliers are willing to sell but six buyers are willing to buy] b. $6 [correct; at a price of $6, five suppliers are willing to sell and five buyers are willing to buy] c. $7 [at a price of $7, six suppliers are willing to sell but four buyers are willing to buy] d. $8 [at a price of $8, seven suppliers are willing to sell but three buyers are willing to buy] 6. If the government imposes a price floor at $9 (i.e., price must be $9 or higher) in the above market, how many goods will be traded? a. Five [at a price of $9, eight suppliers are willing to sell but only two buyers have values of $9 or more] b. Four [at a price of $9, eight suppliers are willing to sell but only two buyers have values of $9 or more] c. Three [at a price of $9, eight suppliers are willing to sell but only two buyers have values of $9 or more] d. Two [correct; at a price of $9, eight suppliers are willing to sell but only two buyers are willing to buy] 7. Say the average price of a new home in Lampard City is $160,000. The local government has just passed new licensing requirements for housing contractors. Based on possible shifts in demand or supply and assuming that the licensing changes do not affect the quality of new houses, which of the following is a reasonable prediction for the average price of a new home in the future? a. $140,000 [the new licensing requirements lead to a reduction in supply, which will NOT lead to a lower equilibrium price] b. $150,000 [the new licensing requirements lead to a reduction in supply, which will NOT lead to a lower equilibrium price] c. $160,000 [the new licensing requirements lead to a reduction in supply, which will affect the equilibrium price] d. $170,000 [correct; the new licensing requirements lead to a reduction in supply, which will lead to a higher equilibrium price] 8. Suppose a new employer is also re-locating to Lampard City and will be attracting many new people who will want to buy new houses. Assume that the change in licensing requirements mentioned above occurs at the same time. What do you think will happen to the equilibrium quantity of new homes bought and sold in Lampard City? a. It will decrease substantially [while quantity will decrease from the reduction in supply, the demand increase will cause quantity to rise] b. It will decrease but not by much [while quantity will decrease from the reduction in supply, the demand increase will cause quantity to rise] c. It will increase [while quantity will increase from the increase in demand, the supply decrease will cause quantity to fall] d. Not enough information [correct; the decrease in supply from the prior question will be associated with a lower quantity while the increase in demand mentioned here will be associated with higher quantity. Without knowing the magnitude of the shifts, it’s not possible to know the net effect (there is not enough information).] 9. The price of peanuts increases. At the same time, we see the price of jelly rise. How does this affect the market for peanut butter? a. The demand curve will shift to the left; the supply curve will shift to the left [correct; the price of peanuts leads to higher peanut butter production costs meaning supply will shift left; a rise in the price of jelly, a complement to peanut butter, will cause peanut butter demand to shift left] b. c. d. The demand curve will shift to the left; the supply curve will shift to the right [the price of peanuts leads to higher peanut butter production costs meaning supply will shift left] The demand curve will shift to the right; the supply curve will shift to the left [a rise in the price of jelly, a complement to peanut butter, will cause peanut butter demand to shift left] The demand curve will shift to the right; the supply curve will shift to the right [the price of peanuts leads to higher peanut butter production costs meaning supply will shift left; a rise in the price of jelly, a complement to peanut butter, will cause peanut butter demand to shift left] 10. Holding other factors constant, a decrease in the tax for producing coffee causes a. the supply curve to shift to the left, causing the prices of coffee to rise [a decrease in tax lowers coffee production costs, leading to an increase (shift right) in supply] b. the supply curve to shift to the right, causing the prices of coffee to rise [an shift right in supply means price will fall] c. the supply curve to shift to the left, causing the prices of coffee to fall [a decrease in tax lowers coffee production costs, leading to an increase (shift right) in supply] d. the supply curve to shift to the right, causing the prices of coffee to fall [correct; a decrease in tax lowers coffee production costs, leading to an increase (shift right) in supply which means price will fall] Chapter 9 Multiple Choice Questions 1. In the long-run, which of the following outcomes is most likely for a firm? a. Zero accounting profits but positive economic profits [ firms do not earn positive economic profit in the long-run] b. Zero accounting profits [zero accounting profit implies negative economic profit, and firms do not earn negative economic profit in the long-run] c. Positive accounting profits and positive economic profits [ firms do not earn positive economic profit in the long-run] d. Zero economic profits but positive accounting profits [correct; in the long-run economic profit is driven to zero] 2. At the individual firm level, which of the following types of firms faces a downward-sloping demand curve? a. Both a perfectly competitive firm and a monopoly firm [the demand curve for the output of a perfectly competitive firm is flat] b. Neither a perfectly competitive firm nor a monopoly firm [one of the two types does face a downward-sloping demand curve] c. A perfectly competitive firm but not a monopoly firm [the demand curve for the output of a perfectly competitive firm is flat] d. A monopoly firm but not a perfectly competitive firm [correct; monopoly firms face a downward-sloping demand curve] 3. Which of the following types of firms are guaranteed to make positive economic profit? a. Both a perfectly competitive firm and a monopoly [in the long-run, economic profit for both types of firms will be zero] b. Neither a perfectly competitive firm nor a monopoly [correct; no firm is guaranteed to make positive economic profit] c. A perfectly competitive firm but not a monopoly [in the long-run, economic profit for competitive firms will be zero] d. A monopoly but not a perfectly competitive firm [in the long-run, economic profit for monopoly firms will be zero] 4. What is the main difference between a competitive firm and a monopoly firm? a. The number of customers served by the firm [competitive firms and monopoly firms may or may not have similar numbers of customers] b. Monopoly firms are more efficient and therefore have lower costs. [monopoly firms may or may not have lower costs] c. Monopoly firms can generally earn positive profits over a longer period of time. [correct; this profit is a reward for doing something unique, innovative, or creative—something that gives the firm less elastic demand.] d. Monopoly firms enjoy government protection from competition. [not necessarily; other factors can contribute to the lack of rivals] 5. Which of the products below is closest to operating in a perfectly competitive industry? a. Nike shoes [branding of the shoes reduces the “closeness” of substitute products] b. Cotton [correct; agricultural commodities are close to perfectly competitive industries] c. Perdue Chicken [branding of the chicken reduces the “closeness” of substitute products] d. Restaurants [branding and other differentiation efforts reduce the “closeness” of substitute restaurants] 6. A firm in a perfectly competitive market (a price taker) faces what type of demand curve? a. Unit elastic [a unit elastic demand curve is downward sloping; firms in perfectly competitive markets do not face unit elastic or downward sloping demand curves] b. Perfectly inelastic [demand is not inelastic for competitive firms] c. Perfectly elastic [correct; the demand curve for the output of a perfectly competitive firm is perfectly elastic (flat)] d. None of the above [one of the answers is correct] 7. A competitive firm’s profit maximizing price is $15. At MC=MR, the output is 100 units. At this level of production, average total costs are $12. The firm’s profits are a. $300 in the short run and long run [long-run profit will be driven down to zero] b. $300 in the short-run and zero in the long run [correct; (15-12)*100. Long run profit is always driven to zero.] c. $500 in the short-run and long-run [short-run profit will be price minus average cost times quantity; long-run profit will be driven down to zero] d. $500 in the short-run and zero in the long run [short-run profit will be price minus average cost times quantity] 8. What would happen to revenues if a firm in a perfectly competitive industry raised prices? a. They would increase [a competitive firm can only sell at the industry price] b. They would increase but profit would decrease [a competitive firm can only sell at the industry price] c. They would increase along with profit [a competitive firm can only sell at the industry price] d. They would fall to zero [correct; a competitive firm can only sell at the industry price. If the firm raises price, it would sell nothing] 9. If a firm in a perfectly competitive industry is experiencing average revenues greater than average costs, in the long-run a. some firms will leave the industry and price will rise [firms are unlikely to leave if revenues are greater than costs] b. some firms will enter the industry and price will rise [price is unlikely to increase if firms enter the industry] c. some firms will leave the industry and price will fall [firms are unlikely to leave if revenues are greater than costs; if they did leave, price would not fall] d. some firms will enter the industry and price will fall [correct; firms will be attracted to the higher-than-average revenues. As more firms enter the industry, supply will increase and price will fall.] 10. A sudden decrease in the market demand in a competitive industry leads to a. losses in the short-run and average profits in the long-run [correct] b. above average profits in the short-run and average profits in the long-run [a decrease in demand would lead to lower prices] c. new firms being attracted to the industry [a decrease in demand would lead to lower prices; lower prices would not attract new firms to the industry d. demand creating supply [demand does not create supply] Chapter 10 Multiple Choice Questions 1. An industry is defined as a. a group of firms producing the exact same products and services. [the products are not necessarily exactly the same] b. firms producing items that sell through the same distribution channels. [products within an industry may be sold through different distribution channels] c. firms that have the same resources and capabilities. [firms within an industry may have different resources and capabilities] d. a group of firms producing products that are close substitutes. [correct] 2. Attractive industries have all the following, except a. high supplier power [correct; high supplier power would allow suppliers to capture more of the industry value] b. low buyer power [low buyer power is positive for an industry; it means buyers capture less value] c. high entry barriers [high entry barriers help protect the industry from the threat of potential entrants] d. low rivalry [low rivalry is positive for an industry; firms do not compete as aggressively] 3. Which of the following is NOT an example of an entry barrier? a. Government protection through patents or licensing requirements [patents and licensing do slow entry into an industry] b. Strong brands [brands help deter entry because potential entrants will have to invest capital and time to build a competing brand] c. Low capital requirements for entry [correct; if capital requirements are low, it will be less costly (easier) to enter] d. Lower costs driven by economies of scale [this is an entry barrier as potential entrants know they will not be cost-competitive unless they can achieve scale] 4. Buyers have higher power when a. their suppliers sell a highly differentiated product. [highly differentiated products mean buyers have lower power because it is more costly to switch to a rival product] b. they are not a significant purchaser of their supplier's output. [purchasing a large volume of a particular supplier’s output leads to higher negotiating power] c. switching costs are low. [correct; low switching costs put buyers in a better negotiating position because it is easier to buy a rival’s product] d. the buyer industry is highly fragmented (buyers are not concentrated) [fragmented buyers do not have more negotiating power]. 5. Which of the following is NOT a factor that contributes to higher rivalry in an industry? a. Numerous competitors. [more competitors generally leads to greater rivalry as cooperative outcomes are hard to achieve with many competitors] b. High fixed costs. [high fixed costs are associated with higher rivalry; when fixed costs are high and marginal costs are low, there is pressure to cut price to build volume in order to make some contribution to covering fixed costs] c. Fast industry growth. [correct; high growth reduces rivalry because firms are less worried about fighting over existing sources of demand given that demand is growing] d. Low switching costs for buyers. [low switching costs means firms have a high incentive to compete for buyers to get them to switch] 6. The concept that describes firms possessing different bundles of resources is a. b. c. d. resource heterogeneity [correct] resource immobility [resource immobility describes the fact that resources resist transfer or copying] barriers to entry [barriers to entry are factors that reduce threat of entry to an industry] imitability [imitability refers to whether a resource can be copied] 7. If a firm successfully adopts a product differentiation strategy, the elasticity of demand for its products should a. increase [increased elasticity means buyers would be more price sensitive; if the product is successfully differentiated, buyers should become less price sensitive] b. decrease [correct; decreased elasticity means buyers would be less price sensitive. If the product is more differentiated, buyers should be less price sensitive.] c. become marginal [marginal is not a term used to describe demand elasticity] d. be unaffected [elasticity should be affected] 8. When a resource or capability is valuable and rare, a firm may gain a a. sustainable competitive advantage. [the resource or capability must also be difficult to imitate / substitute for the competitive advantage to be sustainable] b. competitive parity. [a valuable and rare resource or capability should help the firm do better than just achieve parity] c. cost advantage. [not necessarily; the advantage might be related to differentiation] d. temporary competitive advantage. [correct; valuable and rare resources lead to a temporary competitive advantage] 9. Which of the following is critical for a firm adopting a long-term cost-reduction strategy? a. The firm must also differentiate its product or service. [the firm does not necessarily have to differentiate too] b. The strategy reduces costs by at least 10%. [a cost advantage of less than 10% is still meaningful] c. The strategy is focused on reducing internal production costs. [the strategy could be focused on some other type of cost and still be successful] d. The methods of achieving cost reductions are difficult to imitate. [correct; for the advantage to be sustainable, it must be difficult for rivals to imitate] 10. When a resource or capability is valuable, rare, hard to imitate, and non-substitutable firms may gain a. a temporary competitive advantage. [the advantage should be more than just temporary] b. a complex competitive advantage. [“complex” is not a word used to describe the nature of competitive advantage] c. competitive parity. [a resource or capability that is valuable, rare, hard to imitate, and nonsubstitutable should help the firm do better than just achieve parity] d. a sustainable competitive advantage. [correct] Chapter 11 Multiple Choice Solutions: 1. The intersection between demand for dollars and the supply of dollars is known as a. Inflation rate [the inflation rate is the rate that reflects the aggregate increase in price level] b. Exchange rate [correct; the exchange rate reflects the price point at which demand for dollars (those who want to buy dollars and sell the foreign currency) and supply of foreign exchange (those who want to sell dollars and buy the foreign currency) intersect] c. Price of US goods and services[Here “price” is the exchange rate] d. Quantity of US goods and services [quantity indicates the amount of dollars traded for the foreign currency in the market for foreign exchange.] 2. An individual in the US wants to buy office equipment from England that costs 2,800 pounds. If the exchange rate is $1.92/pound, how much will it cost him in dollar terms? a. $2,800 [This is what the cost would be if the currencies were equal, in other words if $1 = 1 pound] b. $5,376 [correct; If 1 pound = $1.92, then to purchase 2800 pounds worth of goods, you would need 2800*1.92 = $5,736] c. $1,458 [If 1 pound = $1.92, then you would need more than 2800 dollars to purchase equipment costing 2800 pounds. Think of it as if every pound is costing you $1.92] d. Need more information [There is enough information provided to answer the question] 3. If the Chinese yuan devalues relative to the US dollar, then a. US producers will benefit; Chinese consumers will benefit [A currency devaluation helps domestic firms by increasing demand but hurts domestic consumers by increasing domestic price. It also hurts foreign firms by decreasing demand but helps foreign consumers by decreasing price.] b. US producers will benefit; Chinese consumers will hurt [A currency devaluation helps domestic firms by increasing demand but hurts domestic consumers by increasing domestic price. It also hurts foreign firms by decreasing demand but helps foreign consumers by decreasing price.] c. US producers will be hurt; Chinese consumers will benefit [A currency devaluation helps domestic firms by increasing demand but hurts domestic consumers by increasing domestic price. It also hurts foreign firms by decreasing demand but helps foreign consumers by decreasing price.] d. US producers will be hurt; Chinese consumers will be hurt [Correct: A currency devaluation helps domestic firms by increasing demand but hurts domestic consumers by increasing domestic price. It also hurts foreign firms by decreasing demand but helps foreign consumers by decreasing price.] 4. Following a peso appreciation relative to the dollar, which of the following results is expected to occur? a. Prices in the United States would rise, and prices in Mexico would rise. [Since it takes fewer pesos for Mexicans to buy US goods and services, the peso appreciation increases demand for US goods and services. The depreciation also means that it takes more dollars for US consumers to buy Mexican goods and so decreases demand for Mexican goods and services. The former would increase prices for US goods and services, and the latter would decrease prices for Mexican goods and services] b. Prices in the United States would rise, and prices in Mexico would fall. [Correct: Since it takes fewer pesos for Mexicans to buy US goods and services, the peso appreciation increases demand for US goods and services. The depreciation also means that it takes more dollars for US consumers to buy Mexican goods and so decreases demand for Mexican goods c. d. and services. The former would increase prices for US goods and services, and the latter would decrease prices for Mexican goods and services] Prices in the United States would fall, and prices in Mexico would rise. [Since it takes fewer pesos for Mexicans to buy US goods and services, the peso appreciation increases demand for US goods and services. The depreciation also means that it takes more dollars for US consumers to buy Mexican goods and so decreases demand for Mexican goods and services. The former would increase prices for US goods and services, and the latter would decrease prices for Mexican goods and services] Prices in the United States would fall, and prices in Mexico would fall. [Since it takes fewer pesos for Mexicans to buy US goods and services, the peso appreciation increases demand for US goods and services. The depreciation also means that it takes more dollars for US consumers to buy Mexican goods and so decreases demand for Mexican goods and services. The former would increase prices for US goods and services, and the latter would decrease prices for Mexican goods and services] 5. Following a peso appreciation relative to the dollar, which of the following results is expected to occur? a. U.S. consumers would benefit, and Mexican producers would benefit. [A currency devaluation helps domestic firms by increasing demand but hurts domestic consumers by increasing domestic price. It also hurts foreign firms by decreasing demand but helps foreign consumers by decreasing price.] b. U.S. consumers would be hurt, and Mexican producers would benefit. [A currency devaluation helps domestic firms by increasing demand but hurts domestic consumers by increasing domestic price. It also hurts foreign firms by decreasing demand but helps foreign consumers by decreasing price.] c. U.S. consumers would benefit, and Mexican producers would be hurt. [A currency devaluation helps domestic firms by increasing demand but hurts domestic consumers by increasing domestic price. It also hurts foreign firms by decreasing demand but helps foreign consumers by decreasing price.] d. U.S. consumers would be hurt, and Mexican producers would be hurt. [correct; A currency devaluation helps domestic firms by increasing demand but hurts domestic consumers by increasing domestic price. It also hurts foreign firms by decreasing demand but helps foreign consumers by decreasing price.] 6. Following an increase in Mexican interest rates relative to U.S. interest rates, which caused Mexican investors to borrow abroad to invest domestically, which of the following is expected to occur? a. The dollar would appreciate relative to the peso, and Mexican prices would increase. [An increase in foreign borrowing means that Mexicans are borrowing dollars in the US, and then selling those dollars to buy pesos, which is an increase the supply of dollars in the market for foreign exchange. This decreases the price of a dollar measured in the foreign currency, also called a dollar depreciation. The dollar depreciation also means that it takes more dollars for US consumers to buy Mexican goods and services and so decreases demand for Mexican goods and services, which results in a decline in prices for Mexican goods and services.] b. The dollar would appreciate relative to the peso, and Mexican prices would decrease. [An increase in foreign borrowing means that Mexicans are borrowing dollars in the US, and then selling those dollars to buy pesos, which is an increase the supply of dollars in the market for foreign exchange. This decreases the price of a dollar measured in the foreign currency, also called a dollar depreciation. The dollar depreciation also means that it takes more dollars for US consumers to buy Mexican goods and services and so decreases demand for Mexican goods and services, which results in a decline in prices for Mexican goods and services.] c. The dollar would depreciate relative to the peso, and Mexican prices would increase. [An increase in foreign borrowing means that Mexicans are borrowing dollars in the US, and then selling those dollars to buy pesos, which is an increase the supply of dollars in the market for foreign exchange. This decreases the price of a dollar measured in the foreign currency, also called a dollar depreciation. The dollar depreciation also means that it takes more dollars d. for US consumers to buy Mexican goods and services and so decreases demand for Mexican goods and services, which results in a decline in prices for Mexican goods and services.] The dollar would depreciate relative to the peso, and Mexican prices would decrease. [An increase in foreign borrowing means that Mexicans are borrowing dollars in the US, and then selling those dollars to buy pesos, which is an increase the supply of dollars in the market for foreign exchange. This decreases the price of a dollar measured in the foreign currency, also called a dollar depreciation. The dollar depreciation also means that it takes more dollars for US consumers to buy Mexican goods and services and so decreases demand for Mexican goods and services, which results in a decline in prices for Mexican goods and services.] 7. Following an increase in Mexican interest rates relative to U.S. interest rates, which caused Mexican investors to borrow abroad to invest abroad, which of the following would occur? a. The dollar would appreciate relative to the peso, and Mexican prices would increase. [this foreign borrowing only impacts the exchange rate when those borrowed funds are then resold to purchase foreign currency (the peso) for use in Mexican domestic investment] b. The dollar would depreciate relative to the peso, and Mexican prices would decrease. . [this foreign borrowing only impacts the exchange rate when those borrowed funds are then resold to purchase foreign currency (the peso) for use in Mexican domestic investment] c. The dollar would depreciate relative to the peso, and Mexican prices would increase. . [this foreign borrowing only impacts the exchange rate when those borrowed funds are then resold to purchase foreign currency (the peso) for use in Mexican domestic investment] d. The exchange rate would not be affected, and neither would Mexican prices. [correct; the exchange rate is only affected when the borrowed funds are then resold and used to purchase foreign currency. If they continue to invest abroad, then exchange rate and foreign prices would not be affected] 8. In July 2014 the price of a Big Mac was $4.80 in the U.S. while in China it was only $2.73 at market exchange rates. So the "raw" Big Mac index says that the yuan was undervalued by 43% at that time. How would domestic inflation in China affect the Big Mac Index? a. The Big Mac Index would indicate that the Chinese currency is less under-valued. [Correct: If domestic inflation increased the Chinese price of a Big Mac to say, $4.80, then the Big Mac Index would say that the Chinese yuan and the dollar were in long run equilibrium, or that the yuan is less undervalued.] b. The Big Mac Index would indicate that the Chinese currency is more under-valued [If domestic inflation increased the Chinese price of a Big Mac to say, $4.80, then the Big Mac Index would say that the Chinese yuan and the dollar were in long run equilibrium, or that the yuan is less undervalued, not more.] c. The Big Mac Index is not affected by domestic inflation. [Domestic inflation would affect the price in yuan of the Big Mac in China, which would affect the value of the index.] d. The Big Mac Index would indicate that the Dollar is more under-valued. [The July 2014 index indicates that the dollar is over-valued; increases in the price in China would reduce not increase the indicated dollar over-valuation.] 9. If the U.S. economy strengthens, consumer income increase, and consumers buy more imported goods and services. How will this affect exchange rates? a. The dollar will appreciate relative to the yuan, and U.S. prices will increase. [To buy imports, US consumers have to exchange more dollars for yuan. This increase in the supply of dollars in the market for foreign exchange reduces the “price” of a dollar measured in yuan, which is a dollar depreciation.] b. The dollar will appreciate relative to the yuan, and U.S. prices will decrease. [To buy imports, US consumers have to exchange more dollars for yuan. This increase in the supply of dollars in the market for foreign exchange reduces the “price” of a dollar measured in yuan, which is a dollar depreciation.] c. The dollar will depreciate relative to the yuan, and U.S. prices will increase. [Correct: To buy imports, US consumers have to exchange more dollars for yuan. This increase in the supply of dollars in the market for foreign exchange reduces the “price” of a dollar measured in yuan, which is a dollar depreciation.] d. The dollar will depreciate relative to the yuan, and U.S. prices will decrease. [To buy imports, US consumers have to exchange more dollars for yuan. This increase in the supply of dollars in the market for foreign exchange reduces the “price” of a dollar measured in yuan, which is a dollar depreciation.] 10. If buyers expect future price increases, they will ___________ their purchases to avoid it. Similarly, sellers will __________ selling to take advantage of it. a. Accelerate; accelerate [buyers, anticipating the price increase, will accelerate their purchasing, hoping to pay less now, while sellers will delay purchasing, hoping to receive a higher price for the same good in the future.] b. Accelerate; delay [correct; buyers, anticipating the price increase, will accelerate their purchasing, hoping to pay less now, while sellers will delay purchasing, hoping to receive a higher price for the same good in the future.] c. Delay; accelerate [buyers, anticipating the price increase, will accelerate their purchasing, hoping to pay less now, while sellers will delay purchasing, hoping to receive a higher price for the same good in the future.] d. Delay; delay [buyers, anticipating the price increase, will accelerate their purchasing, hoping to pay less now, while sellers will delay purchasing, hoping to receive a higher price for the same good in the future.] Chapter 12 Multiple Choice Questions 1. After massive promotion of Justin Bieber’s latest music album, the producers reacted by raising prices for his albums. This implies that promotion expenditures made the album demand a. more elastic. [When demand becomes more elastic, the right response is to reduce price.] b. unitary elastic. [The question does not indicate any specific level of elasticity, only that it changed as a result of the promotion.] c. change due to psychological pricing. [This may or not be true, but the question is how does promotion expenditure changes demand elasticity.] d. less elastic. [correct; when promotion makes demand less elastic, the right response is to increase price.] 2. All of the following choices are examples of promoting a firm’s product, except a. celebrity endorsements. [This is a common component of product promotion.] b. pricing [correct; pricing often responds to changes in demand brought about by promotions] c. discount coupons. [These are a form of promotion designed to focus consumers on prices.] d. end-of-aisle displays. [These are a form of promotion designed to focus consumers on prices.] 3. A firm that acquires a substitute product can try and reduce cannibalization by a. doing nothing. [The prices charged prior to acquiring a substitute would no longer be optimal.] b. repositioning a product so that it does not directly compete with the substitute. [correct; If consumers do not perceive the products as substitutes, then cannibalization is reduced.] c. setting the same price on both products. [Substitute products usually have different prices (e.g., a manual and electric saw).] d. lowering prices on the low-margin products. [This is the opposite of the appropriate price response to acquiring a substitute product.] 4. A shoe-producing firm decides to acquire a firm that produces shoe laces. This implies that the firm’s aggregate demand (shoes + laces) will be: a. less elastic than the individual demands. [Aggregate demand of substitutes is less elastic than the individual demands. However, shoes and laces are likely complements.] b. more elastic than the individual demands. [correct; shoes and laces are complements and aggregate demand of complements is more elastic than the individual demands.] c. equally elastic as the individual demands. [shoes and laces are complements, and therefore the aggregate demand is not equal to the individual demands.] d. None of the above [common ownership of complements changes the elasticity of aggregate demand] 5. After firm A producing one good acquired another firm B producing another good, it raised the prices for both goods. One can conclude that the goods were a. substitutes. [correct; to prevent cannibalization, raise price on both goods after acquiring a substitute.] b. complements. [when acquiring a complement, prices on both goods should be lowered, not raised.] c. not related. [when goods are unrelated, common ownership does not affect the optimal price.] d. None of the above [one of the answers is correct.] 6. Firms tend to raise the price of their goods after acquiring a firm that sells a substitute good because a. b. c. d. they lose market power. [a loss of market power generally leads to lower prices] there is an increase in the overall demand for their products. [whether or not demand increases, firms still raise prices after acquiring a substitute good.] the bundle has a more elastic demand than individual goods. [when demand becomes more elastic, the correct response is to lower prices.] the bundle has a less elastic demand than individual goods. [correct; the aggregate demand for substitute products is less elastic than the individual demands.] 7. For products like parking lots and hotels, costs of building capacity are mostly fixed or sunk and firms in this industry typically face capacity constraints. Therefore, a. if SRMR>SRMC at capacity, then the firms should price to fill capacity. [correct; when MR>MC, it is optimal to reduce price to sell more, but one cannot sell more than capacity allows.] b. if SRMR<SRMC at capacity, then the firms should price to fill capacity. [when MR<MC, you are losing money and should increase price and sell less.] c. if LRMR>LRMC at capacity, then the firms should price to fill capacity. [long run costs and benefits help determine how much capacity to build, but not how to price once it is built.] d. if LRMR<LRMC at capacity, then the firms should price to fill capacity. [long run costs and benefits help determine how much capacity to build, but not how to price once it is built.] 8. A firm started advertising its product and this changed the product’s elasticity from -2 to -1.5. The firm should a. raise price from $10 to $15. [correct; using the formula (P-MC)/P=1/|e|, prices rise by 50%.] b. reduce price from $15 to $10. [since demand became less elastic, price should increase, not decrease.] c. raise price from $7.5 to $10. [using the formula (P-MC)/P=1/|e| would indicate that prices would have to rise by more than 33% following the change in elasticity.] d. reduce price from $10 to $7.5. [since demand became less elastic, price should increase, not decrease.] 9. After running a promotional campaign, the owners of a local shoe store decided to decrease the prices for the shoes sold in their store. One can infer that a. the promotional expenditures made the demand for their shoes more elastic. [correct; promotional activity that makes demand more elastic should be accompanied by a decrease in price.] b. the promotional expenditures made the demand for their shoes less elastic. [When demand becomes less elastic, the appropriate response is to increase price.] c. the promotional expenditures had no effect on the shoe demand elasticity. [If elasticity had not changed, then there would have been no reason to decrease prices.] d. the owners got it wrong. To cover the promotional expenses, they should have raised the prices. [promotional expenses are a fixed cost and do not directly impact the price except by changing the elasticity of demand.] 10. On average, if demand is unknown and costs of underpricing are _______ than the costs of overpricing, then _________. a. smaller; overprice [if the costs of underpricing are smaller, then one should not overprice.] b. smaller; underprice [correct; since the costs of underpricing are smaller, one should underprice.] c. larger; underprice [since the costs of underpricing are larger, one should avoid underpricing.] d. None of the above [one of the above combinations is correct.] Chapter 14 (and 13) Multiple Choice Questions 1. A software firm can offer a high-feature version of its software or a stripped down low-feature version, each with similar production costs. Which of the following cannot be an optimal segmentation strategy? a. Offer only the high-feature version aimed only at a high-value market segment. [This can be an optimal strategy if the risk of cannibalization is too great.] b. Offer only the low-feature version aimed at all market segments. [correct; this is not an optimal strategy, as the high-feature version has the same production costs but can likely be sold at a higher price.] c. Offer both versions targeted to different value segments. [This is a common form of indirect price discrimination.] d. Offer only the high-feature version aimed at all market segments. [This can be an optimal strategy if the risk of cannibalization is too great.] 2. Which of the following conditions must be satisfied by a successful price discrimination scheme? a. The seller must have a different product for each group of customers. [This is generally true for indirect price discrimination, but direct price discrimination schemes may charge different prices for the same product.] b. The seller must be able to identify each customer as having a high or low value. [Indirect price discrimination schemes like versioning can work even if the seller does not the value of each customer.] c. The seller must be able to prevent arbitrage between the two groups. [When offering different versions of products aimed at different market segments, arbitrage is not an issue.] d. None of the above [correct; Each of the above is necessary for a direct price discrimination scheme, but is not necessary for indirect price discrimination.] 3. Perfect price discrimination is when a firm can charge each customer exactly what they are willing to pay. In this case, a. the demand curve is very inelastic. [successful price discrimination does not depend on the elasticity of demand.] b. the marginal revenue is the demand curve [correct; the revenue from each consumer is equal to each consumer’s willingness to pay, which is given by the demand curve.] c. the demand curve is very elastic. [successful price discrimination does not depend on the elasticity of demand.] d. the marginal cost curve is the average cost curve. [nothing in the problem suggests this. Price discrimination can occur for different cost structures.] Use the following table to answer questions 4 – 6. Assume the cost of producing the goods is zero and that each consumer will purchase each good as long as the price is less than or equal to value. Consumer values are entries in the table. Consumer A Good 1 Good 2 Consumer B $2,300 $2,800 $1,700 $1,200 4. Suppose a monopolist only sold the goods separately. What price will the monopolist charge for Good 1 to maximize revenues for good 1? a. $2,300 [correct; this is more profitable than selling a single unit at $2,800.] b. $2,800 [at this price, the monopolist would sell only one unit to Consumer B.] c. $1,200 [this is not either consumer’s value of good 1.] d. $1,700 [this is not either consumer’s value of good 1.] 5. What is the total profit to the monopolist from selling the goods separately? a. $4,500 [the monopolist could increase profit by selling more than one unit of each good.] b. $6,300 [the monopolist could increase profit by selling more than one unit of good 2.] c. $7,000 [correct; the monopolist maximizes profit by selling each good to each consumer.] d. $6,200 [the monopolist can earn higher profit by setting prices optimally.] 6. What is a better pricing strategy for the monopolist? What is the resulting profit? a. Bundle the goods at $2,800; Profits=$5,600 [Both consumers value the bundle at more than $2,8000.] b. Bundle the goods at $4,000; Profits=$8,000 [correct; this charges both consumers exactly what each is willing to pay for the bundle.] c. Charge $2,800 for good 1 and charge $1,700 for good 2; Profits=$4,500 [bundling the two goods can increase profit in this case.] d. Charge $2,300 for good 1 and charge $1,200 for good 2; Profits = $7,000 [this is the maximum profit from selling the two goods separately but bundling the two goods can increase profit in this case.] 7. Assume that the price elasticity of demand for movie theatres is -.85 during all evening shows but for all afternoon shows the price elasticity of demand is -2.28. For the theatre to maximize total revenue, it should a. charge the same price for both shows, holding other things constant. [Since the two shows have very different elasticities of demand, they have different profit-maximizing prices.] b. charge a higher price for the afternoon shows and lower price for the evening shows, holding other things constant. [prices should be lower when demand is more elastic.] c. charge a lower price for the afternoon shows and higher price for the evening shows, holding other things constant . [correct; prices should be lower when demand is more elastic.] d. Need more information [there is sufficient information as prices vary with elasticity of demand.] 8. Arbitrage a. Is the act of buying low in one market and selling high in another market. [this is the definition of arbitrage, but is not the only correct answer.] b. Can force a seller to go back to uniform pricing. [arbitrage can lead a seller to abandon price discrimination, but this is not the only correct answer.] c. Can defeat direct price discrimination. [arbitrage can allow high-value consumers to purchase from low-value consumers, defeating the firm’s price discrimination. This is not the only correct answer.] d. All of the above [correct; the above both define arbitrage and identify its effects.] 9. Airlines charge a ____________ price to business travelers compared to leisure travelers because business travelers have a ____________ demand than leisure travelers. a. higher; more elastic [customers with more elastic demand should be charged a lower price.] b. higher; less elastic [correct; customers with less elastic demand should be charged a higher price]. c. lower; more elastic [business travelers generally pay a higher price than leisure travelers] d. lower; less elastic [business travelers generally pay a higher price than leisure travelers] 10. Metering is a. b. c. d. A type of indirect price discrimination [correct; metering identifies high-value customers by the intensity of their use of a related product such as paper for printers.] A type of direct price discrimination [direct price discrimination requires identifying the value of each individual consumer.] An evaluation of a product [metering is a type of price discrimination that identifies highvalue customers by how intensely they use a product.] An example of bundling [metering allows the purchase of individual products but identifies high-value customers by how many of them they buy.] Chapter 15 1. The prisoners’ dilemma is an example of: a. a sequential game [players in a prisoners’ dilemma do not observe the decisions of their rivals prior to acting.] b. a simultaneous game. [correct; players do not observe their rival’s decision before making their own.] c. a shirking game [a shirking game does not have a pure strategy equilibrium, but the prisoners’ dilemma does.] d. a dating game [the dating game also has the tension between conflict and cooperation that the prisoners’ dilemma has, but the two games are different.] 2. Nash equilibrium is: a. is where one player maximizes his payoff and the other doesn’t. [it is possible for both players to be maximizing their payoffs or for neither to be, as in the prisoners’ dilemma.] b. is where each player maximizes his own payoff given the action of the other player. [correct; this is the definition of an equilibrium; each player is playing a best response to the other player.] c. is where both players are maximizing their total payoff. [games like the prisoners’ dilemma show that players need not be maximizing their total payoff in equilibrium.] d. Is a unique prediction of the likely outcome of a game. [some games, like the game of chicken, have more than one equilibrium.] Use the following to answer question 3- 5 Consider the following information for a simultaneous-move game: two discount stores (megastore and superstore) are interested in expanding their market share through advertising. The table below depicts the profits of both stores with and without advertising. Payoffs for Megastore are in bold. Superstore Advertise Megastore Don’t Advertise Advertise $95, $80 $305, $55 Don’t Advertise $65, $285 $165, $115 3. The Nash equilibrium is a. For Megastore to advertise and for Superstore to advertise. [correct; advertise is a dominant strategy for each player.] b. For Megastore to advertise and for Superstore not to advertise. [If Megastore advertises, Superstore’s best response is to advertise.] c. For Megastore not to advertise and for Superstore to advertise. [If Superstore advertises, Megastore’s best response is to advertise.] d. For Megastore not to advertise and for Superstore not to advertise. [If either store does not advertise, the best response for the other store is to advertise.] 4. When the stores reach the Nash equilibrium, their profits will be a. Megastore $95 and Superstore $80. [correct; the equilibrium is for both stores to advertise.] b. Megastore $305 and Superstore $55. [Superstore is not best responding to Megastore.] c. d. Megastore $65 and Superstore $285. [Megastore is not best responding to Superstore.] Megastore $165 and Superstore $115. [Neither store is best responding to its rival’s strategy]. 5. If collusion were not illegal, then it would be optimal a. for Megastore to advertise and for Superstore to advertise. [This does not maximize firms’ profits individually or jointly.] b. for Megastore to advertise and for Superstore not to advertise. [correct; This maximizes joint profit.] c. for Megastore not to advertise and for Superstore to advertise. [This does not maximize joint profit.] d. for Megastore not to advertise and for Superstore not to advertise. [This is reasonable as each is earning higher profit than it would in equilibrium. However, if firms could reallocate profits or take turns, this does not maximize their joint profit.] 6. In a Nash equilibrium, a. players are always maximizing their joint profit. [many games, such as the prisoners’ dilemma, reflect a tension between cooperation and conflict.] b. one player is always earning a higher profit than the other. [Nash equilibria do not say anything about the relative profits of the two players.] c. players must be playing the game sequentially. [simultaneous games also have Nash equilibria.] d. None of the above [correct; none of the above answers is correct.] 7. In repeated games, all of the following make it easier to get out of bad situations except a. be nice, no first strikes. [you should cooperate as long as the other player does.] b. respond immediately to rivals. [you should be easily provoked and respond immediately to defection.] c. punish uncooperative players as much as you can. [correct; this is bad advice. Instead, you should be forgiving and punish just enough to deter uncooperative behavior.] d. make sure your competitors can easily interpret your actions. [being clear means that your actions are understood by other players.] Refer to the following strategic form game of price competition for questions 8 and 9. Firm B Low Price Firm A 8. High Price Low Price 0, 0 50, -10 High Price -10, 50 25, 25 If this game is played once, then a. firm A will charge a low price, and firm B will charge a low price. [correct; this is the equilibrium of the game.] b. firm A will charge a high price, and firm B will charge a low price. [in this case, firm A is not playing a best response and would prefer to charge a low price.] c. d. 9. firm A will charge a low price, and firm B will charge a high price. [in this case, firm B is not playing a best response and would prefer to charge a low price.] firm A will charge a high price, and firm B will charge a high price. [this is not an equilibrium of the game as neither firm is playing a best response.] Suppose the game is infinitely repeated. What strategies will each firm utilize? a. firm A will charge a low price, and firm B will charge a low price. [the firms can earn higher profits by cooperating on a better outcome and using trigger strategies to support it.] b. firm A will charge a high price, and firm B will charge a low price. [firm A has no reason to lose money in each period as this is not a best response to firm B charging a low price.] c. firm A will charge a low price, and firm B will charge a high price. [firm B has no reason to lose money in each period as this is not a best response to firm A charging a low price.] d. firm A will charge a high price, and firm B will charge a high price. [correct; the firms can coordinate on the better payoffs by using trigger strategies, such as a tit-for-tat strategy.] 10. You, a real-estate developer, own a piece of land in Nassau, Bahamas, next to an equal size piece of land owned by a competitor. Both of you have the choice of building a casino or a hotel. Your payoffs are as follows: You Your competitor Casino Hotel Casino 3 , 3 20 , Hotel 5 , 2 20 , 5 2 How much is it worth to you to get your casino building permit first? a. $2 million [If this game is played sequentially, the first mover would build a casino, earning $20,000 in profits.] b. $3 million [If this game is played sequentially, the first mover would build a casino and the second mover would build a hotel.] c. $15 million [correct; the first mover earns $20 million and the second mover earns $5 million, so moving first is worth $15 million.] d. $17 million [$17 million is $20 million - $3 million, but both players earning $3 million occurs only if both build a casino, which is not an equilibrium.] Chapter 16 Multiple Choice Questions 1. For threats or commitments to be effective, they must be a. irrational. [There is no reason why a commitment needs to be “irrational” to be credible.] b. profitable. [Often, commitments and threats relate to courses of action that are contrary to one’s interests.] c. credible. [correct; The goal of a commitment or threat is to have your rival believe you.] d. None of the above. [One of the answers above is correct.] 2. Fred and his employer both know that he can generate $200,000 of profit per year for his company. After negotiations, they agree that he will earn $110,000 in annual compensation. What does this imply for the value of his outside or next best alternative? a. $0. [According to the non-strategic view of bargaining, this would lead to $100,000 in compensation, halfway between $0 and $200,000.] b. $5,000. [According to the non-strategic view of bargaining, players split the gains to trade evenly. An outside alternative of $5,000 would provide Fred with $105,000 of the gains to trade which is more than his company receives.] c. $10,000. [According to the non-strategic view of bargaining, players split the gains to trade evenly. An outside alternative of $10,000 would provide Fred with $100,000 of the gains to trade which is more than his company receives.] d. $20,000. [correct; the players split the $180,000 gain from trade evenly.] 3. How many pure strategy equilibria does the following game have? a. 0 [The game has pure strategy equilibria in which each player is playing a best response to the strategy of the other.] b. 1 [The game has more than one pure-strategy equilibrium.] c. 2 [correct; Both outcomes in which one player bargains hard and the other is nice are equilibria.] d. 3 [the best response to the other player bargaining hard is to be nice, and vice versa.] LABOR MANAGEMENT Bargain Hard Be Nice Bargain Hard Be Nice 0,0 12, 18 20, 10 15, 15 4. In the game in Question 3, how much does Labor earn if they can move first? a. 10 [Labor can do better by not being nice.] b. 15 [Both being nice is not an equilibrium of the game.] c. 18 [correct; if labor chooses to bargain hard, management would respond with being nice.] d. 20 [this is not a possible payoff for labor.] 5. Consider a vendor-buyer relationship. Which of the following conditions would lead to the buyer having more bargaining power? a. Lots of substitutes for the vendor's product are available. [this would give the buyer better alternatives to an agreement with the vendor; this is not the only correct answer.] b. There are relatively few buyers and many vendors. [this would give the buyer better alternatives to an agreement with the vendor and would give the vendor worse alternatives to an agreement, both benefitting the buyer; this is not the only correct answer.] c. It costs little for buyers to switch vendors. [this would increase the value of not reaching an agreement with the vendor; this is not the only correct answer.] d. 6. All of the above. [correct; each of the above improves the buyer’s alternatives to an agreement and thus reduces the buyer’s gains from reaching an agreement with this vendor.] In the following game, how many pure strategy equilibria are there? a. 0 [correct; management always wants to match labor’s strategy and labor always wants to adopt a different strategy from management.] b. 1 [an equilibrium requires that each player is playing a best response to the other player’s strategy.] c. 2 [For Labor, the best response to “Bargain Hard” is to be nice, and the best response to “Be Nice” is to bargain hard.] d. 3 [For Management, the best response to “Bargain Hard” is also to bargain hard, and the best response to “Be Nice” is also to be nice.] LABOR MANAGEMENT Bargain Hard Be Nice Bargain Hard 15,0 10,20 Be Nice 20, 10 30, 15 7. Pete and Lisa are entering into a bargaining situation in which Pete stands to gain up to $5,000 and Lisa stands to gain up to $1,000, provided they reach agreement. Who is likely to be the stronger bargainer? a. Pete [Pete has more to gain from reaching agreement and therefore will be a weaker bargainer.] b. Lisa [correct; Lisa has less to gain from agreement and therefore will be a stronger bargainer.] c. They will be equally effective. [the agreement reached depends on the gains for each party from reaching agreement.] d. These potential gains will have no impact on bargaining. [the gains for each party from reaching agreement directly relate to the agreement that will be reached.] 8. George and KC have been working jobs that pay $60,000 and $30,000 per year, respectively. They are trying to decide whether to quit their jobs and jointly open up a taco stand on the beach, which they estimate can earn $150,000/year. How will the taco stand proceeds be split? a. They won’t quit their jobs. [The gains from trade ($150,000-$60,000-$30,000) are positive. Therefore, they will reach agreement to open up the taco stand.] b. George gets $90,000 and KC gets $60,000 [correct; Both George and KC will share the gains from trade generated from agreement equally. This provides each of them with $30,000 of the surplus.] c. George gets $75,000 and KC gets $75,000 [George and KC have different alternatives to agreement, and therefore will receive different shares of the proceeds] d. George gets $100,000 and KC gets $50,000 [This would provide George with $40,000 of the gains from trade and KC with $20,000.] 9. The game of chicken has a. a second-mover advantage. [the game of chicken favors the player who can commit to a position.] b. a first-mover advantage. [correct; the player who can commit to a course of action captures a majority of the gains from trade.] c. no sequential-move advantage. [the game of chicken provides an advantage for one of the players.] d. potential sequential-move advantages, depending on the players. [the outcome of the game of chicken has to do with the structure of the game and its payoffs, not the players.] 10. Two hospitals are bargaining with a managed care organization (MCO) to get into its provider network. The MCO can earn $100 if it puts one of the hospitals in its network and $200 if it puts both hospitals in its network. If both hospitals merge and bargain jointly, how much more will they earn? a. $0 [correct; each hospital is worth $100 whether or not the other hospital is included. Therefore, each earns $50 before the merger and they jointly earn $100 ($200/2) after the merger.] b. $50 [before the merger, the gains to trade for including each hospital is $100 whether or not the other hospital is included.] c. $100 [after the merger, the hospitals and the MCO divide the gains from trade ($200) equally.] d. $200 [hospitals and the MCO will share in the gains to trade equally before and after the merger.] Chapter 17 1. You are taking a multiple-choice test that awards you one point for a correct answer and penalizes you 0.25 points for an incorrect answer. If you have to make a random guess and there are five possible answers, what is the expected value of guessing? a. 0.5 points [the expected value of a random variable that can take on two values (x 1,x2) with probabilities (p,1-p) is E(X)= (p*(x1)) + ((1-p)*(x2)). In this case, p represent the chance of getting a correct answer, while x1 and x2 refer to the possible points] b. 0.25 points [the expected value of a random variable that can take on two values (x 1,x2) with probabilities (p,1-p) is E(X)= (p*(x1)) + ((1-p)*(x2)). In this case, p represent the chance of getting a correct answer, while x1 and x2 refer to the possible points] c. –0.25 points [the expected value of a random variable that can take on two values (x1,x2) with probabilities (p,1-p) is E(X)= (p*(x1)) + ((1-p)*(x2)). In this case, p represent the chance of getting a correct answer, while x1 and x2 refer to the possible points] d. 0 points [correct; ((1/5)*(1)) + ((4/5)*(-0.25)) = 0.2 – 0.2 = 0] 2. A franchise restaurant chain is considering a new store in an unserved part of town. Its finance group estimates an NPV of $10 million if the population growth is 10% (40% probability), and NPV of $4 million of the population does not grow (30% probability), and an NPV of -$4 million if the population shrinks 5% (30% probability). What is the expected value of NPV (to the nearest dollar) for the following situation? a. $3.4 million [E(x)=((p1)*(x1))+((p2)*(x2))….+((pn)*(xn)). The probabilities are 0.4, 0.3 & 0.3 and the potential outcomes are $10, $4 & -$4 million in this case] b. $4.0 million [correct; ((0.4)*(10m))+((0.3)*(4m))+((0.3)*(-4m))= 4m+1.2m-1.2m = 4 million] c. $4.6 million [E(x)=((p1*)(x1))+((p2)*(x2))….+((pn)*(xn)). The probabilities are 0.4, 0.3 & 0.3 and the potential outcomes are $10, $4 & -$4 million in this case] d. $5.2 million [E(x)=((p1)*(x1))+((p2)*(x2))….+((pn)*(xn)). The probabilities are 0.4, 0.3 & 0.3 and the potential outcomes are $10, $4 & -$4 million in this case] 3. You’ve just decided to add a new line to your manufacturing plant. Compute the expected loss/profit from the line addition if you estimate the following: ï‚· There’s a 50% chance that profit will increase by $100,000. ï‚· There’s a 30% chance that profit will remain the same. ï‚· There’s a 20% chance that profit will decrease by $15,000. a. Gain of $100,000 [E(x)=((p1)*(x1))+((p2)*(x2))….+((pn)(xn)). The probabilities are 0.5, 0.3 & 0.2 and the profits are $10,000, $0 & -$15,000 in this case] b. Gain of $70,000 [E(x)=((p1*)(x1))+((p2)*(x2))….+((pn)(xn)). The probabilities are 0.5, 0.3 & 0.2 and the profits are $10,000, $0 & -$15,000 in this case] c. Loss of $53,000 [E(x)=((p1)*(x1))+((p2)*(x2))….+((pn)(xn)). The probabilities are 0.5, 0.3 & 0.2 and the profits are $10,000, $0 & -$15,000 in this case] d. Gain of $47,000 [correct; ((0.5)*($100,000))+((0.3)*(0))+((0.2)*(-$15,000))=$50,000+$0$3000=$47,000] 4. Your software development company is considering investing in a new mobile app. If it goes viral (10% probability), you expect an NPV of $1,000,000; if it is moderately successful (20% probability), you expect an NPV of $200,000; and if it fails (70% probability), you expect an NPV of $-200,000. What is the expected NPV of the product? a. b. c. d. $0 [correct; ((0.1)*($1,000,000))+((0.2)*($200,000))+((0.7)*(-$200,000))= $100,000+$40,000-$140,000 = $0] $280,000 [E(x)=((p1)(x1))+((p2)(x2))….+((pn)(xn)). The probabilities are 0.1, 0.2 & 0.7 and the NPVs are $1,00,000, $200,000 & -$200,000 in this case] $333,000 [E(x)=((p1)(x1))+((p2)(x2))….+((pn)(xn)). The probabilities are 0.1, 0.2 & 0.7 and the NPVs are $1,00,000, $200,000 & -$200,000 in this case] None of the above [It is one of the above-In cases where you have the probability of different occurrences and their outcomes, you can determine the total expected outcome] 5. Suppose an investment project has an NPV of $75 million if it becomes successful and an NPV of –$25 million if it is a failure. What is the minimum probability of success above which you should make the investment? a. 0.5 [the expected value of a random variable that can take on two values (x1,x2) with probabilities (p,1-p) is E(X)= (p(x1)) + ((1-p)*(x2)). In this case, you are looking for the value of p that will allow you to breakeven (i.e., where E(X) = 0)] b. 1/3 [the expected value of a random variable that can take on two values (x1,x2) with probabilities (p,1-p) is E(X)= (p(x1)) + ((1-p)*(x2)). In this case, you are looking for the value of p that will allow you to breakeven (i.e., where E(X) = 0)] c. 0.25 [correct; you are looking for the breakeven- the minimum probability at which you would invest ((p)*($75m))+((1-p)*(-$25m)=0 Therefore 75p-25+25p=0 or 100p=25, so p=0.25] d. 0.1 [the expected value of a random variable that can take on two values (x 1,x2) with probabilities (p,1-p) is E(X)= (p(x1)) + ((1-p)*(x2)). In this case, you are looking for the value of p that will allow you to breakeven (i.e., where E(X) = 0)] 6. To test the effectiveness of a two Web advertising agencies, you increase your ad purchase with agency A by 50% without changing your purchase through agency B. The referrals to your website from agency A increased by only 34% but the referrals from agency B fell by 21%. What is the difference-in-difference estimate of the referrals per dollar through agency A? a. 1.2 referrals per dollar [To construct a "difference-in-difference" estimate of referrals per dollar, measure the difference in referral percent changes from Agency A to Agency B over the difference in percent purchase amount changes] b. 1.1 referrals per dollar [correct; To construct a "difference-in-difference" estimate of referrals per dollar, you measure the change in referrals from Agency A (+34%) relative to the control group of Agency B (less -21%), for an estimate per dollar of ((55%)change in referrals/(50%)change in dollars) or 1.1. The difference between treatment (agency A) and control (agency B) referrals was 55% (=34%-(-21%). The difference in purchase amounts was 50% (=50%-0%). The diff-in-diff in referrals per dollar was 55%/50% or 1.1] c. 1.0 referrals per dollar [To construct a "difference-in-difference" estimate of referrals per dollar, measure the difference in referral percent changes from Agency A to Agency B over the difference in percent purchase amount changes] d. 0.9 referrals per dollar [To construct a "difference-in-difference" estimate of referrals per dollar, measure the difference in referral percent changes from Agency A to Agency B over the difference in percent purchase amount changes] 7. Your company has a customer list that includes 3000 people. Your market research indicates that 90 of them responded to the coupon. If you send a coupon to one customer at random, what’s the probability that he or she will use the coupon? a. 0.03 [correct; the probability of using the coupon is 90/3000=0.03 or 3%] b. 0.09 [the probability the coupon will be used is equal to the chance a customer will respond, in other words, the number of potential positive responses over total customers] c. d. 0.30 [the probability the coupon will be used is equal to the chance a customer will respond, in other words, the number of potential positive responses over total customers] 0.90 [the probability the coupon will be used is equal to the chance a customer will respond, in other words, the number of potential positive responses over total customers] 8. Your production line has recently been producing a serious defect. One of two possible processes, A and B, could be the culprit. From past experience you know that the probability that A is causing the problem is 0.8 but investigating A costs $100,000 while investigating B costs only $20,000. What are the expected error costs of shutting down process B first? a. $80,000 [this is the expected cost of shutting down process A first] b. $20,000 [the expected error cost in this case comes from investigating B and having A be the culprit. In other words, it is the probability the total money spent on B will be wasted] c. $16,000 [correct; the expected error cost in this case comes from investigating B and having A be the culprit, in other words the probability the total money spent on B will be wasted, so (0.8)*($20,000)=$16,000. d. $4,000 [this is the expected cost of shutting down process B first] 9. You have two types of buyers for your product. Forty percent of buyers value your product at $10 and sixty percent value it at $6. What price maximizes your expected revenue? a. $10 [In this case, only forty percent of buyers will purchase your product for expected revenue per customer of $4] b. $6 [correct; in this case, all 100% of buyers will purchase your product] c. $7.60 [This price still only appeals to the top 40% of buyers, and for less than they are willing to pay for expected revenue per customer of $3.04] d. $8 [This price still only appeals to the top 40% of buyers, and for less than they are willing to pay for expected revenue per customer of $3.2] 10. You are considering entry into a market in which there is currently only one producer (incumbent). If you enter, the incumbent can take one of two strategies, price low or price high. If he prices high, then you expect a $60K profit per year. If he prices low, then you expect a $20K loss per year. You should enter if a. you believe demand is inelastic. [if demand is inelastic, price will not impact the demand for your product] b. you believe the probability that the incumbent will price low is greater than 0.75. [To solve this, you need to find the minimum probability needed to breakeven. E(X)= (p(x 1)) + ((1p)*(x2)). Once you solve for p, determine what p is of the incumbent pricing low] c. you believe the probability that the incumbent will price low is less than 0.75. [Correct; To solve this, you need to find the minimum probability needed to breakeven. E(X)= (p(x1)) + ((1-p)*(x2)). Using ((p)*($60k))+((1-p)*($-20k))=0, you find 60p-20+20p=0 or 80p=20. Therefore, p (the probability of them pricing high) needs to be a minimum of 0.25 for you to breakeven. Therefore, you would only enter if you believed the probability of them pricing low (1-p) is less than 0.75] d. you believe the market size is growing. [If market size is growing, demand may accommodate the addition of a competitor] Chapter 18 1. You are bidding in a second-price auction for a painting that you value at $800. You estimate that other bidders are most likely to value the painting at between $200 and $600. Which of these is likely to be your best bid? a. $1,000 [you should never bid above your value as you might end up paying more than the painting is worth to you.] b. $800 [correct; in a second-price auction, the optimal strategy is to bid exactly your value.] c. $600 [If you are wrong and some other bidder values the painting at $700, you would end up losing the auction even though you would have been willing to pay $700.] d. $400 [You are unlikely to win a t a price this low.] 2. Which of the following is true about different ways of conducting a private-value auction? a. A first-price auction is strategically equivalent to a second-price auction. [Bidding behavior is very different in a first-price auction, where you bid below your value, and a second-price auction, where you bid equal to your value.] b. A first-price auction is strategically equivalent to an English auction. [In an English auction, bidders are willing to bid up to their values, but first price auctions involve bid shading.] c. A second-price auction is strategically equivalent to an English auction. [correct; in an English auction, bidders bid up to their value with the highest-value bidder winning at a price near the second-highest value.] d. None of the above [One of the above answers is correct.] 3. Suppose that five bidders with values of $500, $400, $300, $200, and $100 attend an oral auction. Which of these is closest to the winning price? a. $500 [You need at least two bidders actively competing to drive the price up.] b. $400 [correct; as soon as the bidder with the value of $500 outbids the next highest bidder, the auction would end.] c. $300 [since multiple bidders value the item more than $300, they would continue to compete, driving the price higher.] d. $200 [since multiple bidders value the item more than $200, they would continue to compete, driving the price higher.] 4. In the above auction, if the bidders with the first- and third-highest values ($500 and $300) collude, which of these is closest to the winning price? a. $500 [You need at least two bidders actively competing to drive the price up.] b. $400 [correct; The second-highest value sets the price, so the collusion removing the thirdhighest value from active competition would not affect the price.] c. $300 [despite the collusion, multiple bidders value the item more than $300, they would continue to compete, driving the price higher.] d. $200 [despite the collusion, multiple bidders value the item more than $200, they would continue to compete, driving the price higher.] 5. In a common-value auction, you should a. bid more aggressively the more competitors you face. [The more competitors you face, the more you should be wary of winning as this implies that every other bidder believes the item to be worth less than you do.] b. bid less aggressively the more competitors you face. [correct; The more bidders there are, the more winning is potentially “bad news.”] c. bid the same regardless of the number of competitors. [In common-value auctions, beating out competitors reveals that they all think that the object is worth less than your bid.] d. bid more aggressively when others have better information than you. [The winner’s curse is especially bad when rivals have better information than you do.] 6. If a seller is concerned about collusion among bidders, which of the following changes to the auction should the seller make? a. Hold frequent, small auctions instead of infrequent large auctions. [frequent auctions allow bidders to take turns whereas a single large auction provides a greater incentive for cartel members to cheat.] b. Conceal the amount of winning bids. [correct; this makes it harder for the cartel to know if cheating occurred, which provides incentives for cartel members to cheat.] c. Publically announce the name of each auction’ s winner. [announcing the name of each winner allows the cartel to monitor cheating, thus helping the cartel.] d. Hold a second-price instead of a first price auction. [collusion is easier in second-price auctions.] 7. You’ re holding an auction to license a new technology that your company has developed. One of your assistants raises a concern that bidders’ fear of the winner’s curse may encourage them to shade their bids. How might you address this concern? a. Release your analyst’ s positive scenario for the technology’ s future profitability. [revealing information reduces the winner’s curse, but this is not the only correct answer] b. Release your analyst’ s negative scenario for the technology’ s future profitability. [revealing information reduces the winner’s curse, but this is not the only correct answer] c. Use an oral auction. [oral auctions reveal information about other bidders’ values.] d. All of the above [correct; in common value auctions, the auctioneer should reveal as much information as possible, both good and bad, to bidders so that they do not fear the winner’s curse.] 8. Which of the following is true about the winner’s curse? a. The winner’s curse occurs primarily in private-value auctions. [each bidder knows his or her value in private value auctions, so there is no winner’s curse.] b. You successfully avoided the winner’ s curse if you made money in the auction. [this is merely good luck. Avoiding the winner’s curse implies making money on average, not just in a single auction.] c. The winner’ s curse means that you bid incorrectly. [correct; the winner’s curse happens when bids do not account for the fact that only the highest (and most optimistic) bid wins, and that the most optimistic estimate is likely to be wrong.] d. The winner’ s curse means that you lost money in an auction. [this is merely bad luck and can happen even when you bid correctly.] 9. A bidder’ s value for a good may be low ($2), medium ($5), or high ($7). There is an equal number of potential bidders having each value. Suppose two bidders participate in a second-price auction. What is the best estimate of the expected revenue from the auction? a. $4.11 [draw a table of the nine possible outcomes. The second-highest value sets the price in each auction. For example, the price is $7 only 1/9 of the time.] b. $3.99 [draw a table of the nine possible outcomes. The second-highest value sets the price in each auction.] c. $3.56 [correct; the price is $7 1/9 of the time, $5 3/9 of the time, and $2 5/9 of the time.] d. $5.00 [the price can be as high as $7 or as low as $2. Draw a table of the nine possible outcomes.] 10. In a first-price auction, you bid __________ your value, and in a second-price auction you bid _______ your value. a. at; above [you should never bid above your value in either type of auction.] b. below; above [you should never bid above your value in either type of auction.] c. below; at [correct; bid at your value in second-price auctions and shade your bid (bid below your value) in first-price auctions.] d. below; below [In a second-price auction, you should not bid below your value.] Chapter 19 1. An insurance company offers doctors malpractice insurance. Assume that malpractice claims against careful doctors cost $5,000 on average over the term of the policy and settling malpractice claims against reckless doctors costs $30,000. Doctors are risk-neutral and know whether they are reckless or careful, but the insurance company only knows that 10% of doctors are reckless. How much do insurance companies have to charge for malpractice insurance to break even? a. $5,000 [both reckless and careful doctors would purchase insurance at this price.] b. $7,500 [because careful doctors are risk-neutral, they would not purchase insurance at this price, leaving the insurance company only with reckless doctors.] c. $27,500 [the insurance company would insure only reckless doctors, losing $2,500 on each insured.] d. $30,000 [correct; only reckless doctors would purchase insurance at this price.] 2. An employer faces two types of employees. Regular workers are 70% of the population and generate $100,000 in productivity. Exceptional workers are 30% of the population, and generate $120,000 in productivity. Employees know their types, and reject salaries below their productivity. If the employer offers a salary equal to the average productivity in the population, what will be the employer’s per-employee profit? a. -$10,000 [the average productivity is $100,000(70%)+$120,000(30%)=$106,000 b. -$6,000 [correct; the employer would offer $106,000 but hire only regular workers generating $100,000 in productivity.] c. $0 [this answer ignores the adverse selection problem.] d. $4,000 [adverse selection implies that profits would be negative, not positive] 3. An all-you-can-eat buffet attracts two types of customers. Regular customers value the buffet at $20 and eat $5 of food in costs to the restaurant. Hungry customers value the buffet at $40 and eat $10 of food. If there are 100 of each type in the market for a buffet dinner, what is the restaurant’s maximum profit? a. $2,500 [this is obtained by charging $20, but the restaurant can do better.] b. $3,000 [correct; by charging $40, the restaurant attracts only hungry customers.] c. $4,500 [this level of profit is unobtainable as the restaurant can attract at most 100 customers at $40 or 200 customers at $20.] d. $6,500 [this level of profit is unobtainable and exceeds the total value of all customers.] 4. To combat the problem of adverse selection, ______ informed parties can employ _____ techniques. a. more; signaling [correct; signaling is a more informed party’s effort to communicate her information to the less informed party] b. less; signaling [the less-informed party’s effort to learn the information that the more informed party has is called screening.] c. equally; screening [adverse selection arises because parties are not equally informed] d. equally; signaling [adverse selection arises because parties are not equally informed] 5. Which of the following can be an example of a signal? a. An air-conditioning manufacturer offers a 50-year warranty. [this signals quality as the warranty is more expensive to honor for an inferior product; this is not the only correct answer] b. c. d. A lawyer offers to be paid only if the client wins. [this signals a higher likelihood of winning as the contingent fee is less a risk if the chance of winning is high; this is not the only correct answer A student pursues an MBA. [this can signal dedication, willingness to work hard, or other traits.] All of the above [correct; all of the above are possible signals] 6. Which of the following is not an example of adverse selection? a. A business bets the proceeds of a bank loan on the next NFL game. [correct; this is an example of moral hazard rather than adverse selection.] b. An accident-prone driver buys auto insurance. [this is adverse selection as drivers who are more expensive to insure are more likely to buy insurance.] c. A patient suffering from a terminal disease buys life insurance. [this is adverse selection as patients who are more expensive to insure are more likely to buy insurance.] d. A really hungry person decides to go to the all-you-can-eat buffet for dinner. [this is adverse selection as customers who are more expensive to serve are more likely to buy the buffet.] 7. The demand for insurance arises primarily from people who are a. risk-seeking. [risk-seeking individuals are less willing to pay a premium in order to eliminate a risk.] b. risk-averse. [correct; risk-averse individuals are willing to pay more to avoid risks and thus are most likely to purchase insurance.] c. risk-neutral. [risk-neutral individuals are willing to insure only when the premium costs less than the expected loss.] d. None of the above [willingness to pay for insurance depends on one’s risk tolerance.] 8. Which of the following is a potential solution to the adverse selection problem faced by insurance companies? a. Offer plans with different deductibles so that higher-risk customers accept higher deductibles. [the deductible is a signal that reveals each insured’s risk, reducing adverse selection; this is not the only correct answer.] b. Create a national database of customers that allows companies to look up each person’s historical risk. [this provides information about each insured’s risk, reducing information asymmetry.] c. Mandate that every person purchase insurance. [this eliminates adverse selection by prohibiting low-risk individuals from exiting the insurance market.] d. All of the above [correct; each of the above is a potential solution to the adverse selection problem.] 9. An insurance company suffers from adverse selection if a. safe customers are less likely to insure than risky customers. [correct; adverse selection occurs when only the most expensive customers buy insurance.] b. customers know their willingness to pay for insurance but the company does not. [this is a common feature of most pricing decisions and does not necessarily lead to adverse selection.] c. a customer takes on much greater risk because he is insured. [this is moral hazard, but does not suggest that different customers take different actions.] d. its customers are risk averse. [insurance company customers are often risk averse whether the insurance company faces adverse selection or not.] 10. Which of the following is an example of adverse selection? a. A safe driver taking greater risk in a rental car than his own car. [this answer does not suggest that there are different types of drivers, with some posing a higher risk than others.] b. A terminally ill person purchasing life insurance. [correct; a higher-cost patient purchasing insurance while, presumably, a lower-cost patient choosing not to purchase, is adverse selection.] c. An employment contract encourages little effort on the part of employees. [this answer does not suggest that there are different types of employees.] d. All of the above [only one of the above is an example of adverse selection, rather than moral hazard.] Chapter 20 1. Which of the following is an example of moral hazard? a. Reckless drivers are the ones most likely to buy automobile insurance. [this is an example of adverse selection as it relates to different types of drivers.] b. Retail stores located in high-crime areas tend to buy theft insurance more often than stores located in low-crime areas. [this is an example of adverse selection as it relates to different types of stores.] c. Drivers who have many accidents prefer to buy cars with air bags. [this is an example of adverse selection as it relates to different types of drivers.] d. Employees recently covered by the company health plan start going to the doctor every time they get a cold. [correct; unlike the other answers, this is an example of moral hazard as each same individual takes a different levels of risk in the presence of insurance than in its absence.] 2. In a bad economy, a CEO has a 4% chance of meeting earnings estimates at regular effort, and a 5% chance at extraordinary effort. Extraordinary effort costs the CEO $10,000. How large a bonus should the CEO be paid for meeting estimates to encourage extraordinary effort? a. $100,000 [$100,000 earned 5% of the time is worth less than the cost of extraordinary effort.] b. $200,000 [This is insufficient since the CEO has an almost equal chance of meeting estimates at regular effort as at extraordinary effort.] c. $250,000 [The answer should account for the additional likelihood of meeting estimates from extraordinary effort.] d. $1,000,000 [correct; extraordinary effort provides an extra 1% chance of meeting estimates. Therefore, the bonus must be at least $10,000/1%.] 3. A salesperson can put in regular effort (resulting in a 40% chance of sale) or high effort (60% chance of sale). If high effort costs the salesperson $20 more than regular effort, how large a per-sale bonus is required to encourage high effort? a. $12 [this is less than the extra cost of effort and therefore would not be worth it for the salesperson.] b. $20 [a $20 bonus earned 60% of the time does not offset a $20 cost of effort.] c. $33.33 [this would exactly compensate for the extra cost of effort (60% x $33.33 = $20), but does not account for the fact that the salesperson has a good chance of earning the bonus at regular effort as well.] d. $100 [correct; high effort results in an extra 20% chance of earning a bonus and costs $20. Therefore, the bonus must at least satisfy (20%)b=$20.] 4. Which of the following is not an example of a process designed to combat moral hazard problems? a. Banks include restrictive covenants in loan agreements. [this prevents bank customers from taking excessive risks with the bank’s capital.] b. Universities have students complete evaluations of professor performance at the end of a class. [This helps prevent shirking by faculty] c. Insurance companies require applicants to provide medical history information as part of the application process. [correct; this combats adverse selection rather than moral hazard.] d. Employers regularly monitor employee performance. [employees have less incentive to work hard than employers want since part of the generated profits go to the employer.] 5. Which of the following is an example of moral hazard? a. High-quality products being driven out of a market by low-quality products. [this is an example of adverse selection.] b. A local charity raising insufficient funds because no one contributes, expecting that their neighbors will. [this is an example of free riding] c. A bakery defaults on its loan because of a new consumer fear of carbohydrates. [this is the result of the usual risk of lending and is not due to the bakery taking excessive risk.] d. A corporation uses a business loan secured for one investment on another, higher-risk investment. [correct; the corporation takes excessive risks because the lender bears the downside.] 6. Which of the following is not an example of moral hazard? a. People are more likely to lock their own car than a rental car. [people exercise less care with a rental car as they do not bear the downside to the same degree as with their own car.] b. Skateboarders attempt more difficult maneuvers when wearing a helmet. [the helmet “insures” partially against risk, leading to greater risk-taking behavior.] c. Bad salespeople are less drawn to commission-based jobs. [correct; this is an example of adverse selection, as it differentiates types of people, not their actions.] d. People with fire insurance are less likely to install smoke alarms. [people with insurance take less care.] 7. Which of the following is true? a. Moral hazard is primarily an issue prior to a transaction. [moral hazard arises when people take different actions because of the transaction (such as purchasing insurance).] b. Adverse selection is primarily an issue after a transaction. [adverse selection results from different willingness to enter into a transaction.] c. Moral hazard is the result of an information asymmetry. [correct; moral hazard arises from hidden actions.] d. Resolving adverse selection also resolves moral hazard. [while related, these are different types of information asymmetry.] 8. Restrictive covenants on loans are used to avoid a. moral hazard. [correct; restrictive covenants attempt to minimize excessive risk taking as a result of moral hazard.] b. adverse selection. [restrictive covenants attempt to control hidden actions.] c. free riding. [restrictive covenants exist to make sure that loans are used for their intended purposes, which is unrelated to free riding.] d. None of the above [one of the above answers is correct.] 9. Loan applications require a lot of information from applicants to avoid a. moral hazard. [moral hazard is an issue of hidden actions.] b. adverse selection. [correct; the information reveals something about the type of borrower.] c. free riding. [free riding is not the result of an information asymmetry.] d. None of the above [one of the above answers is correct.] 10. Which of the following is true about moral hazard? a. b. c. d. Moral hazard arises from actions that cannot be observed. [moral hazard is an issue of hidden action, but is not the only correct answer.] Shirking is a form of moral hazard. [this is true, but is not the only correct answer.] Moral hazard refers to the taking of excessive risk. [this is true, but is not the only correct answer.] All of the above [correct; all of the above are examples of hidden actions and a reduced incentive to take precautions.] Chapter 21 1. Your notebook computer’ s hard drive recently crashed, and you decide to take it to a local repair technician to have it fixed. In this relationship, a. you are the agent. [the agent typically is the party actually performing the work.] b. the technician is the principal. [the principal typically is the party contracting an agent to perform the work.] c. the technician is the agent. [correct; the technician is being contracted by you, the principal, to do the work.] d. no principal-agent relationship exists. [assuming that the repair technician has any interests that are not identical to yours, a principal-agent relationship exists.] 2. A good compensation scheme a. maximizes the agent's utility. [the goal of a compensation scheme is to maximize the principal’s profit.] b. anticipates how an agent will game the scheme. [correct; agents may find ways to maximize their profit in ways not anticipated by the principal.] c. does not subject a risk-averse agent to risk. [incentive compensation usually involves some risk for the agent, for which he or she has to be compensated.] d. accompanies centralized decision-making authority. [compensation schemes are especially important when decision-making authority is decentralized.] 3. Principal-agent relationships a. reduce monitoring costs. [principal-agent relationships are often characterized by high monitoring costs and thus often rely on incentive pay.] b. occur because managers have good information about employees. [principal-agent relationships exist in many environments, including ones where principals have very little information about their employees.] c. are not related to asymmetric information. [agents having better information about their capabilities and actions is typical of principal-agent problems.] d. are subject to moral hazard problems. [correct; principals may be unable to observe or monitor agents’ actions.] 4. All of the costs associated with a principal interacting with an agent are called a. opportunity costs [these are the costs of foregone opportunities.] b. agency costs [correct; these include the costs of combatting moral hazard and adverse selection] c. monitoring costs [this is just one type of cost associated with principal-agent relationships.] d. sunk costs [these are costs that do not vary with the consequences of your decision.] 5. Principal-agent problems a. occur when firm managers have more incentive to maximize profit than shareholders do. [the problem generally occurs because the manager has less incentive to maximize profit.] b. would be reduced if firm owners had better information about the actions of the firm’s managers. [correct; the cost of controlling incentive conflict from agency problems goes down if the principal can gather information] c. help explain why equity investments from outside owners are an important financing source for firms. [equity investments from outside owners actually create agency relationships] d. are increased as more information is shared between the parties. [reducing information asymmetry also reduces principal-agent problems.] 6. In order to create an effective incentive compensation scheme, you must have a. adequate performance measures. [correct; compensation schemes tie rewards to performance and therefore require that performance be reliably measured.] b. unlimited funds. [incentive compensation schemes align the incentives of the agent with that of the principal, but this does not require unlimited funds.] c. a flat management structure. [a specific management structure is not a precondition for an effective compensation scheme.] d. None of the above [one of the above answers is correct;] 7. Decentralization of decision-making authority is consistent with which of the following? a. A trend of stronger, more active CEOs. [this would be consistent with centralization of authority] b. Shrinking costs of computing bandwidth, which allows information to be inexpensively aggregated from geographically diverse business units. [When information is easier to aggregate, centralized decision making authority becomes easier to sustain.] c. Development of microcomputing resources at the corporate, division, and employee level. [correct; this provides decision-making tools at each level of a corporation, reducing the need to centralize decision-making authority.] d. Reduction in the use of incentive compensation. [decentralization of authority is generally accompanied with increased reliance on incentive compensation.] 8. A firm faces two kinds of employees, those able to sell 10 units/year, and those able to sell 5 units/year. High-productivity employees are willing to work for $100/year while low-productivity employees are willing to work for only $50/year. To screen out the low-productivity employees, the firm should a. offer a salary of $100. [Both kinds of employees would accept this salary.] b. offer a salary of $75 plus $5/unit commission. [Low-productivity employees would not be screened out as they would earn more than $50.] c. offer sales commission of $10/unit. [Low-productivity employees would not be screened out as they would earn $10 on each of five units.] d. offer a sales commission of $20/unit, on sales above 5 units. [correct; This would sufficiently reward high-productivity employees but pay low-productivity employees only $20, screening them out.] 9. You own a retail establishment run by a store manager who receives a flat salary of $80,000. If you set up another store as a franchise with incentive compensation to the franchisee, what would be a reasonable total compensation range that the franchisee could earn? a. $80,000 [the franchisee’s compensation should vary with performance.] b. $40,000– $80,000 [this range would result in expected compensation below $80,000 and thus would be insufficient to entice the franchisee to participate.] c. $60,000– $100,000 [correct; this would allow the franchisee to earn an average salary similar to the manager but still allow it to vary with performance.] d. $80,000– $100,000 [If a manager requires total compensation of $80,000, then the franchisee should earn roughly $80,000 on average.] 10. In the magazine Budget Travel , a hotel maid admits, “ I cut corners everywhere I could. Instead of vacuuming, I found that just picking up the larger crumbs from the carpet would do. Rather than scrub the tub with hot water, sometimes it was just a spray-and-wipe kind of day.… After several weeks on the job, I discovered that the staff leader who inspected the rooms couldn’t tell the difference between a clean sink and one that was simply dry, so I would often just run a rag over the wet spots.… I apologize to you now if you ever stayed in one of my rooms.” Which of the following organizational forms is more likely to have caused this kind of shirking? a. Franchising: where the hotel managers are the owners of the hotel (franchisee) and pay a fixed franchise fee [As owners, hotel managers receive the profit of the hotel as earnings and thus have a lot of incentive to maintain the quality of the hotel.] b. Company-owned hotels [correct; As managers do not share (as much) in the profits of the hotels, they have less incentive to monitor quality than the other two organizational forms.] c. Franchising with a sharing contract, where the hotel managers are the owners of the hotel (franchisee); they pay a smaller fixed fee to the franchisor but share revenue with the franchisor. [As owners, hotel managers’ earnings vary with the profit of the hotel, providing a lot of incentive to maintain the quality of the hotel.] d. None of the above [incentives to shirk vary with organizational form.] Chapter 22 1. A computer manufacturer has two divisions: one serving residential customers and one serving business customers. If an incentive conflict arises between the two divisions, how will overall company profits be affected? a. Profits will definitely fall. [while profit often falls due to division conflict, it is not definite] b. Profits will definitely rise. [profit is unlikely to increase due to a divisional conflict] c. Profits may fall, but it depends on the nature of the conflict. [correct] d. The conflict has no potential to affect overall profit. [while the conflict is not guaranteed to affect profit, you should definitely be worried about the potential to affect profit] 2. Which of the following changes might help solve a divisional conflict regarding a decision? a. Change who has authority to make the decision [yes, this might help but are there other options?] b. Transfer information to the decision makers so they are better informed [yes, this might help but are there other options?] c. Change the performance evaluation and associated compensation of the decision makers [yes, this might help but are there other options?] d. All of the above [correct; all of the above are potential solutions to consider] 3. Joe runs the Service Division for a car dealership. The overall dealership has profit of $10 million on sales of $100 million and costs of $90 million. Joe’ s division contributed $9 million in sales and $7 million in costs. If the Service Division is evaluated as a profit center, what dollar amount is most relevant to Joe? a. $2 million [correct; this is the profit of the Service Division] b. $7 million [while the $7 million in cost is important, other figures matter too] c. $9 million [while the $9 million in sales is important, other figures matter too] d. $10 million [because Joe’s incentives are tied to Service Division profit, he is unlikely to consider overall dealership profit as most relevant] 4. If you were a manager of a cost center, which of the following areas would be of most interest to you? a. Capturing potential economies of scale. [correct] b. Increasing the quality of your product. [cost centers are normally rewarded for producing at the lowest cost; increasing quality would likely increase cost rather than reduce it] c. Hiring more marketing staff to figure out how to increase prices. [cost centers are normally rewarded for producing at the lowest cost; adding marketing staff would likely increase cost rather than reduce it] d. Adding additional features to your product. [cost centers are normally rewarded for producing at the lowest cost; adding features would likely increase rather than reduce cost] 5. Transfer prices should be set at a. marginal cost of the selling division plus a reasonable profit amount. [this could lead to a double mark-up problem] b. marginal cost of the selling division unless it is evaluated as a profit center. [whether the division is evaluated as a profit center should not impact the transfer price] c. the opportunity cost of the asset being transferred. [correct] d. at whatever price is negotiated between the selling and buying divisions. [this may or may not result in the right price being negotiated] 6. Which type of organizational form has the benefit of closer coordination to serve a particular product or geographic area? a. Profit centers. [a profit center means that the group or division is evaluated based on profit; this is not directly related to coordination to serve a product group or geographic area] b. Functional organizations. [a lack of coordination is one of the challenges not benefits of a functional structure] c. M-form organizations. [correct] d. Functional and M-form organizations have the same benefits. [these two structures have different types of benefits] 7. Which of the following provides an example of divisions based on a functional organizational structure? a. Americas, Africa, Asia, Europe [this would be an example of an M-form based on region] b. Research and development, production, finance, marketing [correct] c. Youth products, teen products, senior products [this would be an example of an M-form based on product] d. Business users, home users, educational users [this would be an example of an M-form based on customer type] 8. Which of the following organizational forms requires the strongest management oversight to ensure coordination of functions? a. Profit centers [treating a division as a profit center refers to how it is evaluated not to the company’s organizational form] b. Functional organizations [correct] c. M-form organizations [one of the benefits of the M-form is the higher level of coordination of functional areas, so it is not as likely to need strong management oversight] d. Functional and M-form organizations likely require similar oversight [the two forms differ in the amount of oversight needed to foster coordination] 9. Which of the following actions is consistent with a manager whose compensation depends on meeting a budget goal and who does not believe he can make that goal? a. Asking a vendor to pre-ship and invoice materials for the following year. [yes, this action is consistent but are there other actions?] b. Discovering a “problem” in the order taking process, thereby forcibly pushing sales into the ensuing year. [yes, this action is consistent but are there other actions?] c. Increasing accounting reserve estimates, leading to higher recognized expenses. [yes, this action is consistent but are there other actions?] d. All of the above [correct; all of these actions are consistent with this type of compensation scheme] 10. One of the basic functions of the budgeting process is a. assigning decision rights. [assigning decision rights is part of organization design] b. transferring information. [correct] c. evaluating managerial performance. [while performance evaluation is sometimes related to achieving budgets, a basic function of the budgeting process is not to evaluate performance] d. implementing structural change. [budgeting and implementing structural change are separate activities] Chapter 23 1. Alpha Industries is considering acquiring Foxtrot Flooring. Foxtrot is worth $20 million to its current owners under its existing operational methods. Because there are some opportunities for synergies between the two companies, Alpha believes that Foxtrot is worth $25 million as part of Alpha Industries. What do you predict for a sales price of Foxtrot? a. Less than $20 million or Alpha will not buy [According to the rational actor paradigm Alpha will purchase at any value below $25 million] b. More than $25 million or Foxtrot will not sell [According to the rational actor paradigm Foxtrot will sell at any value above $20 million] c. Something between $20 and $25 million [correct; the rational actor paradigm indicates that Foxtrot will be willing to sell at anything above their value of $20m, while Alpha is willing to purchase at anything below their valuation of $25 million; a value between $20 and $25 million satisfies both of these requirements] d. The different valuations make a sale very unlikely. [Not true, the rational actor paradigm indicates that Foxtrot will be willing to sell at anything above their value, while Alpha will be willing to purchase at anything under theirs] 2. All of the following provide a motive for vertical agreements EXCEPT a. effective execution of price discrimination [true; with vertical integration, retailers are able to defeat upstream price discrimination schemes designed by a manufacturer] b. elimination of free-riding among retailers [true; vertical contracts such as exclusive territories can overcome the problem of free riding by discount retailers] c. quality control [true; vertically integrating can allow a manufacturer to have greater control over the final product] d. diversification [correct; this is false. Diversification represents a company expanding its reach horizontally rather than vertically] 3. Which of the following is an example of vertical integration? a. A custom software company purchasing a competing software firm [this is a form of expansion, not vertical integration] b. A soft drink producer buying a brand of iced tea [this is an example of horizontal integration, not vertical integration] c. A coal producer purchasing a nuclear power plant [this is an example of diversification, not vertical integration] d. A gourmet cheese company purchasing a dairy [correct; dairy is an input into the cheese production process] 4. Why are contact lens manufacturers reluctant to sell their lenses through the Internet? a. The Internet price is too high due to double marginalization [double marginalization is more likely to occur with retailers than online] b. Search costs are lower, so the Internet sales are too competitive [competition alone is not the reason for their reluctance, there are other factors involved] c. d. Doing so reduces the incentives of retailers to provide point-of-sale services [correct; in order to compete with online prices, retailer would likely be forced to eliminate their point of sale services, which could affect customer's overall experience with the brand] They are afraid of antitrust lawsuits [antitrust laws don't apply to a company selling its own product through a different channel] 5. In which of the following instances would an acquisition make the most sense? a. The target is a very profitable company [don't just acquire a company because it is profitable] b. Synergies exist between the acquirer and the target [synergies are worthless unless you are the one capturing the value] c. Integration costs are low between the two [even if integration costs are low, you would only purchase if there was value to you] d. Synergy benefits outweigh the costs of integration [correct; the value of the synergy should outweigh the cost of acquiring it!] 6. Why do vertical agreements typically pose less antitrust risk than horizontal agreements? a. Vertical agreements occur less often than horizontal agreements [frequency of occurrence does not contribute to antitrust risk] b. Vertical agreements often result in lower prices, which are beneficial to the consumer [correct; the purpose of antitrust laws are to protect the consumers, who often benefit from vertical integrations] c. Vertical agreements are rarely profitable [vertical agreements can be very profitable if done correctly] d. Vertical agreements do not pose less antitrust risk than horizontal agreements [actually, they do. Consider the different impacts each of these agreements have on the consumers] 7. CUS Pharmacy wishes to carry Pepgro blue pills. But Daisy Pharmaceuticals, the maker of Pepgro, will not supply CUS unless CUS agrees to carry other medications that Daisy makes. This is an example of a. Exclusion [exclusion is the practice of blocking competitors from participating in a market. CUS is only impacting their participation in their stores, not the market as a whole] b. Tying [correct; tying is the practice of making the sale of one good conditional on the purchase of an additional, separate good, as you see here] c. territory restriction [CUS is not dividing products by territory in this case] d. bundling [Bundling refers to offering multiple goods for sale as one product. CUS is not mandating the products be sold together but rather at the same store] 8. A multinational firm acquires many of its components pre-assembled from suppliers. One of these suppliers operates in a country with a much lower corporate income tax rate. How does this affect the vertical relationship between this supplier and the multinational? a. This will not affect the relationship [Tax is an important consideration between multinationals and suppliers] b. The multinational should stop working with the supplier [not necessarily, there are other ways the multinational can benefit from their relationship with the supplier] c. d. 9. The multinational should consider purchasing this supplier [correct; The multinational can evade regulation by “realizing” a larger portion of the combined profits in the low tax jurisdiction without substantively altering its operations.] The multinational should move all its operations to the supplier’s home country [Possibly, but then it could bear substantial increases in operation and reorganization costs.] In which of the following cases might you expect to find a manufacturer granting exclusive territories? a. A pet supply chain that requires heavy local advertising to drive sales [true- is it the only one?] b. Custom computer sales that require a good deal of consultation [true- is it the only one?] c. A submarine sandwich chain that relies on its nationwide brand reputation [true- is it the only one?] d. All of the above [correct] 10. Local Spanish TV markets cater to individual cities by producing local content. This content can be produced in-house by a network or they can also purchase rights to third-party produced content. Recently, Spanish cities have erected barriers to entry in television content production that allows content producers more market power. How would this have affected vertical integration between content providers and TV networks? a. There is more vertical integration to limit arbitrage by price discriminating content producers [Contracting effectively prohibits TV networks from reselling purchased content to another TV network.] b. There is less vertical integration because point-of-sale services are less important [TV broadcasting involves few opportunities for direct customer point-of-sale services] c. There is more vertical integration to reduce the double marginalization problem [correct, TV networks place a second margin on top of the first content producer’s margin. The new barriers to entry increase content producers’ initial margins which makes the double marginalization problem more severe.] d. There is less vertical integration because evading regulation is less important [Firms vertically integrate so as to engage in regulatory evasion]