Answers to the Problems and Applications
1.
One year ago, Jack and Jill set up a vinegar-bottling firm
(called JJVB). Use the following information to calculate
JJVB’s opportunity cost of production during its first year
of operation:
 Jack and Jill put $50,000 of their own money into the
firm.
 They bought equipment for $30,000.
 They hired one employee to help them for an annual wage of
$20,000.
 Jack gave up his previous job, at which he earned $30,000,
and spent all his time working for JJVB.
 Jill kept her old job, which paid $30 an hour, but gave up
10 hours of leisure each week (for 50 weeks) to work for
JJVB.
 JJVB bought $10,000 of goods and services from other
firms.
 The market value of the equipment at the end of the year
was $28,000.
 Jack and Jill have a $100,000 home loan on which they pay
an interest rate of 6 percent a year.
The wages paid, $20,000, and the goods and services bought from
other firms, $10,000, are opportunity costs to JJVB. Other
opportunity cost include the interest forgone on the $50,000 put
into the firm, which could have been used to pay part of the
mortgage, so the interest forgone is $3,000; the $30,000 income
forgone by Jack not working at his previous job; $15,000, which
is the value of 500 hours of Jill’s leisure (10 hours a week for
50 weeks); and the economic depreciation of $2,000 ($30,000
minus $28,000). JJVB’s total opportunity cost is the sum of all
these opportunity costs and is $80,000.
2.
Joe runs a shoeshine stand at the airport. With no skills and
no job experience, Joe has no alternative employment. Other
shoeshine stand operators that Joe knows earn $10,000 a year.
Joe pays the airport $2,000 a year for the space he uses, and
his total revenue from shining shoes is $15,000 a year. He
spent $1,000 on a chair, polish, and brushes and paid for
these items using his credit card. The interest on his credit
card balance is 20 percent a year. At the end of the year,
Joe was offered $500 for his business and all its equipment.
Calculate Joe’s opportunity cost of production and his
economic profit.
Joe’s opportunity costs are the $2,000 paid to the airport for
the space; the $200 for the interest paid on the $1,000 credit
card balance; the $10,000 of normal profit; and, the $500 for
the depreciation of his equipment (which equals the $1,000 paid
for the chair, polish, and brushes minus the $500 he was offered
for this equipment). Joe’s total opportunity cost is the sum of
these costs, which is $12,700. Joe’s economic profit is his
total revenue, $15,000, minus his total opportunity cost,
$12,700, for an economic profit of $2,300.
3.
Alternative ways of laundering
100 shirts are
a. Which methods are
technologically efficient?
All the methods are
technologically efficient.
Labor
Capital
Method (hours) (machines)
A
1
10
B
5
8
C
20
4
D
50
1
b. Which method is economically
efficient if the hourly wage rate and implicit rental rate
of capital are
(i) Wage rate $1, rental rate $100?
Method D is economically efficient because the total cost is
the least. Method D’s costs are 50  $1 + 1  $100, or $150.
(ii) Wage rate $5, rental rate $50?
Method D and Method C are economically efficient because the
total cost is the least. Method C’s costs are 20  $5 + 4 
$50, or $300.
(iii) Wage rate $50, rental rate $5?
Method A is economically efficient because the total cost is
the least. Method A’s costs are 1  $50 + 10  $5, or $100.
4.
Sales of the firms in the tattoo industry are
a. Calculate the four-firm
concentration ratio.
The four-firm concentration ratio is
Firm
60.49. The four-firm concentration
ratio equals the ratio of the total
Bright
sales of the largest four firms to the
Spots
total industry sales expressed as a
Freckles
percentage. The total sales of the
Love Galore
largest four firms is $450 + $325 +
Native
$250 + $200, which equals $1,225.
Birds
Total industry sales equal $1,225 +
Other 15
$800, which equals $2,025. The fourfirms
firm concentration ratio equals
($1,225/$2,025)  100, which is 60.49 percent.
Sales
(dollars
per
year)
450
325
250
200
800
b. What is the structure of the tattoo industry?
This industry is highly concentrated because the four-firm
concentration ratio exceeds 60 percent.
5.
In 2003 and 2004, Lego, the Danish toymaker that produces
colored plastic bricks, incurred economic losses. The firm
faced competition from low-cost copiers of its products and
faced a fall in the number of 5- to 9-year-old boys (its main
customers) in many rich countries. In 2004, Lego launched a
plan to restore profits. It fired 3,500 of its 8,000 workers;
closed factories in Switzerland and the United States; opened
factories in Eastern Europe and Mexico; and introduced
performance-based pay for its managers. Lego reported a
return to profit in 2005.
Based on Picking Up the Pieces,
The Economist, October 28, 2006.
a. Describe the problems that Lego faced in 2003 and 2004,
using the concepts of the three types of constraints that
all firms face.
Lego faced all of the three types of constraints: Technology,
information, and market.
The technology constraint that Lego faced was how it produced
its Legos. Before it made any changes, Lego used a relatively
large number of high-paid, presumably high-skilled workers in
the United States and Switzerland. After its changes, Lego
switched to using apparently fewer workers, who are lower-paid
and probably lower-skilled in Eastern Europe and Mexico.
Lego also faced information constraints. In particular, if Lego
had had full information about its market and its competitors’
plans, it is unlikely Lego would have suffered economic losses
in 2003 and 2004. And, of course, if Lego had had better
information, even after it started to suffer economic losses,
Lego would have more rapidly made changes to limit its losses.
In addition, Lego apparently faced information problems about
which managers were not working as hard as they should.
Finally, Lego faced significant market constraints. First Lego
suffered a fall in demand from its custmers, 5- to 9-year old
boys. Second other firms were making very similar but lowerpriced blocks. This competition lead Lego’s customers to switch
(some of) their purchases from Lego to Lego’s competitors,
thereby leaving Lego to suffer an economic loss.
b. Which of the actions that Lego took to restore profits
addressed an inefficiency? How did Lego seek to achieve
economic efficiency?
When Lego was suffering an economic loss, Lego was manufacturing
its blocks in Switzerland and the United States. These workers
were generally high-skilled and therefore high-paid. In an
effort to restore its profit, Lego changed its production method
by firing 3,500 workers and moving its factories to Eastern
Europe and Mexico, where it could use lower-skilled, and
therefore lower-paid workers. Apparently before the changes Lego
was using an economically inefficient production method, with
too many workers in general and too many high-skilled workers in
particular.
c. Which of the actions that Lego took to restore profits
addressed an information and organization problem? How did
Lego change the way in which it coped with the principalagent problem?
Lego faced an information and organization problem because Lego
apparently did not know which managers were shirking. To
overcome this important principal-agent problem, Lego changed
its compensation methods by introducing performance-based pay
for its managers. By basing its managers’ pay on their
performance, Lego gave its managers the incentive to work
diligently in their efforts to boost Lego’s profits.
d. In what type of market does Lego operate?
Lego operates in a monopolistically competitive market.
6.
John Deere’s Farm Team
Deere … opened up the Pune [India] center in 2001 as a way of
entering the Indian market. The move was unexpected: Deere is
known for its heavy-duty farm equipment and big construction
gear. Many of India’s 300 million-plus farmers still use
oxen-pulled plows …
Fortune, April 14, 2008
a. Why do many Indian farmers still use oxen-pulled plows? Are
they efficient or inefficient? Explain.
Many Indian farmers use oxen-pulled plows because the cost of
tractors is too high. Using oxen-pulled plows allows farmers to
produce at lower cost than if they used tractors. Because of the
lower cost, Indian farmers may well be economically efficient.
b. How might making John Deere farm equipment available to
Indian farmers change the technology constraint they face?
The presence of John Deere in the Indian market will increase
the supply of tractors and lower their price. By lowering their
cost so that using a tractor is now economically efficient,
Indian farmers will switch production methods. Their technology
constraint will change as a result of using the additional
capital equipment and the farmers will be able to produce more
output than before.
c. How do you expect John Deere’s move into the Indian farm
equipment market to influence the firm’s profit
opportunities?
John Deere is moving into India only because it expects the move
to be profitable. Hence Deere expects its decision to increase
its profit.
7.
Here It Is. Now, You Design It!
The idea is that the most successful companies no longer
invent new products and services on their own. They create
them along with their customers, and they do it in a way that
produces a unique experience for each customer. The important
corollary is that no company owns enough resources—or can
possibly own enough—to furnish unique experiences for each
customer, so companies must organize a constantly shifting
global web of suppliers and partners to do the job.
Fortune, May 26, 2008
a. Describe this method of organizing and coordinating
production: Does it use a command system or incentive
system?
This method uses an incentive system to organize and coordinate
production. The resources are not under the constant supervision
of the employer and so a command system of coordinating
production would not work. Instead the firm uses an incentive
system—giving the resources necessary for a project an incentive
to cooperate by paying them for their share of the project—to
organize the production.
b. How does this method of organizing and coordinating
production help firms achieve lower costs?
The design firm has lower costs because it uses different
resources with each project. If the design firm owned all the
resources, and therefore used a command system to organize
production, the firm would need to pay for all the resources for
each and every project. But for many of the projects some of the
resources would be unused. Hence the firm’s costs would be
significantly higher than if it paid for only the resources
actually used, as it does when it uses an incentive system of
organization.
8.
Rewarding Failure
Over the past 25 years CEO pay has risen … faster than
corporate profits, economic growth, or average workforce
compensation. … A more sensible alternative to the current
compensation system would require CEOs to own a lot of
company stock. If the stock is given to the boss, his salary
and bonus should be docked to reflect its value. As for
bonuses, they should be based on improving a company’s cash
earnings relative to its cost of capital, not to more easily
manipulated measures like earnings per share. ... [Bonuses]
should not be capped, but they should be unavailable to the
CEO for some period of years.
Fortune, April 28, 2008
a. What is the economic problem that CEO compensation schemes
are designed to solve?
CEO compensation schemes are designed to overcome the principalagent problem. A CEO’s decisions can have large effects on the
company’s profitability. The principals, the shareholders of the
corporation, want the CEO, the agent, to carefully consider the
decisions and make decisions that boost the firm’s profit. The
CEO, however, has the incentive to shirk and to make decisions
that boost his or her well-being rather than the company’s
profit.
b. How do the proposed changes to CEO compensation outlined in
the news clip address the problem you described in a?
The changes proposed in the news clip are designed to link the
CEO’s pay to the company’s profit. If the profit rises, then the
company’ stock price will rise. If the CEO’s pay is largely
determined by changes in the stock price, then the CEO’s
decisions are directly linked to the company’s fortunes. By
making the bonuses unavailable for a period of time, the schemes
attempt to guarantee that the CEO’s decisions are in the
company’s long-term best interest rather than trying to quickly
boost the company and its stock price but at the cost of its
long-term performance.
9.
GameStop Racks Up the Points
No retailer has more cachet among gamers than GameStop, and
only Wal-Mart has a larger share of the market—for now. …
Wal-Mart had a 21.3% market share last year. GameStop’s share
was 21.1%, and may well overtake Wal-Mart this year … but
[new women gamers] may prefer shopping at Target to GameStop.
… A chance for Wal-Mart and Target to erode GameStop’s market
share. …
Fortune, June 9, 2008
a. According to the news clip, what is the structure of the
U.S. retail video game market?
The market described is an oligopoly. There are only a few
firms, three in particular, described as comprising the market.
b. Estimate a range for the four-firm concentration ratio and
the HHI for the game market in the United States based on
the information provided in this news clip.
Wal-Mart is described as having the largest market share, 21.3
percent, and GameStop is said to have the second largest market
share, 21.1 percent. These two firms have a market share of 42.4
percent. The market share of the next two largest firms must be
less than 42.4 percent. As a result the four-firm concentration
ratio ranges from 42.4 percent to 84.7 percent.
The HHI equals the sum of the squared market shares of the 50
largest firms. Wal-Mart’s contribution to the HHI is 21.32 which
is 453.7 and GameStop’s contribution to the HHI is 21.12 which
is 445.2. Based on the two largest firms, the HHI is at least
898.9. If there are two other firms each with a market share of
21.0 percent and one other firm with a market share of 13.6
percent, the HHI attains its maximum of 2,024.26. So the HHI can
range from about 900 to about 2,025.
10. 6 Steps to Creating a Super Startup
But starting a business is a complicated, risky, allconsuming effort. Indeed, just two-thirds of new small
businesses survive at least two years, and only 44 percent
survive at least four years. … You have to be willing to take
calculated risks. … Most entrepreneurs start their businesses
by dipping into their savings, and hitting up friends and
family. Perhaps half of all startups, in fact, are funded
initially by the founder’s credit cards … Getting a bank loan
is tough unless you have assets—and that often means using
your home as collateral.
CNN, October 18, 2007
a. When starting a business, what are the risks and potential
rewards associated with a proprietorship identified in the
news clip?
Organizing a business a proprietorship is easy, an advantage of
this form of business organization. The potential reward is the
(economic) profit the business might earn. The news clip points
out that proprietorships have a difficult time raising the
necessary funds.
b. How might a partnership help to overcome the risks
identified in the news clip?
The advantages of a partnership are that it is easier to raise
capital. All the partners can help raise the necessary funds. In
addition partnerships have diversified decision making which can
save the business from making an uncontested bad decision, which
can occur in a proprietorship.
c. How might a corporation help to overcome the risks
identified in the news clip?
Raising funds for a corporation by selling stock to the many
owners might well be easier than raising funds for a
proprietorship. First, there can be many shareholders rather
than just one person raising the funds. Second the owners of a
corporation have limited liability for the firm’s debts, which
makes them more willing to supply funds to the business. Finally
a corporation can hire professional management.
11. Federal Express enters into contracts with independent truck
operators who offer FedEx service and who are rewarded by the
volume (cubic meters) of packages they carry.
a. Why doesn’t FedEx buy more trucks and hire more drivers?
FedEx faces a principal-agent problem. In particular, it is not
easy to monitor its drivers and insure that they are working
hard to efficiently deliver packages. FedEx overcomes this
problem by hiring independent contactors and then paying them
based on the amount of packages they deliver. Essentially, FedEx
uses a piecework method of payment.
b. What incentive problems might arise from the arrangement
that FedEx uses?
FedEx pays its drivers based on the volume of packages they
deliver. This method of payment creates a few potential problems
for FedEx. First, FedEx must worry about the quality of its
service. In particular, unless FedEx bases part of the payment
on quality, its drivers have an incentive to drop the package
and race off to the next delivery with no concern for how the
packages are handled. Second, FedEx must take care that drivers
do not attempt to select only packages that are close to the
FedEx location and avoid packages that have a greater than
average driving time. Finally, FedEx also must worry that its
drivers do not take undue risks while driving (in order) to
deliver as many packages as possible. If FedEx trucks were
involved in too many accidents, FedEx would suffer bad publicity
and, presumably, would lose some business.