BA 6340
Economics
Michael Davis
Spring 2006
EMBA 2007
Final Exam
1.
You work for a chain of restaurants that is considering expanding into a new
market. You estimate that there is a 25% chance that the restaurant in the new
market will earn $200,000, a 25% chance that the new place will earn $100,000
and a 50% chance it will lose $80,000.
a. Calculate the expected value and the variance.
b. Suppose that your manager chooses not to open the new restaurant but
instead makes improvements at an existing location that he knows will
increase profits by $30,000. If these are really mutually exclusive
alternatives, what does this tell you about his attitude towards risk?
(Explain carefully.)
c. Suppose the author of your textbook, read the question above and made
the following comment: “good enough question, but it also provides an
opportunity to illustrate the difference in decisions made by managers at a
chain of restaurants and the decisions that might be made by the
owner/manager of a single restaurant.” In a two or three sentences,
explain what he might mean by this.
Answers:
a. Expected Value = P(X1)X1 + P(X2)X2 + P(X3)X3
= .25(200000) + .25(100000) + .50(-80000)
= 50000 + 25000 – 40000
= $35,000
Var = .25(200000-35000)^2 + .25(100000-35000)^2 + .50(-80000-35000)^2
= .25(165000)^2 + .25(65000)^2 + .50(-115000)^2
= .25(27225000000 + .25(4225000000) + .50(13225000000)
= 6806250000 + 1056250000 + 6612500000
= 14475000000
b. Choosing to make improvements that guarantee a return that is less than the
expected return tells us that the owner is attitudes towards risk averse.
Although we don’t know what it is, his certainty equivalent is below the
expected value of return which indicates that he is risk averse.
c. A restaurant chain owns a portfolio of restaurants. As long as the risks facing
any one restaurant are not correlated with the risks facing some other
restaurant, the chain can ignore the risks facing a single establishment. The
owner of a single restaurant or (maybe) the manager of a single restaurant in
the chain will likely be much or concerned with the risk
2. Six-Flags Over Texas is planning a special concert on July 4, the same day that
The Texas Rangers have a baseball game. Neither organization has set the time
for the event, but both would prefer to set up an evening event, capped off with
fireworks. They realize, however, that if the schedule at the same time, the
traffic will be terrible and their customers would be angry. The table below gives
payoffs for each outcome (the first entry is the payoff to the Rangers, the second
payoff is for Six-Flags.
Rangers
Afternoon Evening
Afternoon 3,4
5,3
Six-Flags
Evening 2,7
1,2
a. Identify any Nash equilibrium
b. Is this a prisoner’s dilemma (explain)?
c. Explain what you think will happen (both with and without coordination).
Answers:
Six
Flags
Afternoon
Evening
Six
Flags
Best
Choice
Rangers
Afternoon
Evening
R=3
S=4
R=2
S=7
R=5
S=3
R=1
S=2
Evening
Afternoon
Rangers
Best Choice
Evening
Afternoon
There are two Nash Equilibriums:
1. If Six Flags chooses Afternoon, then the optimal choice for the
Rangers is Evening. If the Rangers choose Evening, then the
optimal choice for Six Flags is the afternoon. In this case, both
players are following the optimal strategy given what the other is
doing.
2. If Six Flags chooses evening, then the optimal choice for the
Rangers is the Afternoon. If the Rangers choose afternoon, then
the optimal choice for Six Flags is the evening. In this case, both
players are following the optimal strategy given what the other is
doing.
2. b.
This is not a prisoner’s dilemma because a prisoner’s dilemma requires that
both participants have a dominant strategy. Here, neither participant has a
dominant strategy.
2.c. Without coordination it is difficult to know for sure what will happen.
It can be said that attitudes towards risk may be especially important. With
coordination, it is much easier to predicit, since Six-Flags going in the
evening and Rangers in the afternoon gives the highest combined payment.
3. The world of consumer electronics is apparently on the verge of another
battle between competing technologies, this time the format for the HD
DVD’s. (Here’s a link to a short article
http://www.pcworld.com/news/article/0,aid,116471,00.asp). The problem
resembles a very common game that we discussed in class. Explain the
analogy and also any insights the game might offer as to how the issue is
likely to be settled.
Answer:
Standards setting is a common example of the Battle of the Sexes game discussed
in class. In this case we have two clear players; Sony with Blu-Ray and NEC with HDDVD. It’s in both companies best interest to have a common standard because
consumers will more likely purchase with a standard across an industry. So two Nash
Equilibriums are defined but which is chosen? This problem maps directly to our B-of-S
game where Fred enjoys the opera and Wilma enjoys wrestling. They both have the
highest individual payoffs when they are together than in any other state.
Obviously to agree on a standard, there will need to be a compromise.
From Sony’s perspective, they have experience with this having gone through it before
with the BetaMax vs. VHS battle. Their poor positioning of a superior technology
ultimately cost them the standard and consumers got an inferior technology.
Coming back to the article, this may be why Sony is moving fast to get Blu-ray into the
market. With market prices on these machines falling coupled with the Blu-ray based
Playstation 3 poised to release this calendar year, Blu-Ray will get mass market
penetration internationally. Sony should move swiftly to position Blu-ray with the
studios, selling the technology and increased space per disc for multimedia distribution.
Sony should also entice NEC with shared profits in the studio industry’s new production
lines as well as introducing products based on Blu-ray technology.
NEC will have a difficult time getting mass penetration of their product unless
they can come in as a second mover and offer a cheaper or technically more advanced
system. They should approach the studios to seal conversion deals of their equipment to
produce HD-DVD based movies. They should also try to convince Microsoft to use HDDVD technology in the Xbox and media PC systems to compete with Sony on a mass
international scale.
4. A well-known economist recently wrote in favorable terms about the
French economy stating “it's true that France's G.D.P. per person is
well below that of the United States but…”. Describe precisely what is
being measured by GDP and what might follow the “but”. (That is, why
GDP might not fully describe the economic conditions in the country.)
Answer:
Generally, GDP measures the final market value of goods and services produced
by a nation. It does not measure overall economic activity. The components used to
measure GDP are:
a. Public consumption of goods and services
Durable, non-durable, and services
b. Gross private domestic investments
New accumulated capital goods; not financial investments
c. Net exports of goods and services
Make sure to remove items built elsewhere and consumed here. What is built
in the nation and exported is counted.
d. Federal government spending/gross investment.
There may be non-economic forces that drive down the GDP per capita
measurement for France. European’s have more holiday and generally prefer to not keep
the same hours of employment year round as US workers. This would naturally lower
personal income and thus GDP measurements. Additionally, France’s overall unemployment rate may be much higher further contributing to lower GDP per capita than
the US.
5. If the Chinese were to allow the yuan to freely float against the U.S.
dollar it is widely expected that the dollar will fall in value in relation to
the yuan, making Chinese goods more expensive in America and
American goods less expensive in China. However, there would be other
consequences, both desirable and undesirable, as well. Discuss these, both
from the American and Chinese perspective.
Answer:
Desirable Effects:
- The change in exchange rates would likely reduce imports from China, possibly
creating some jobs in some American industries.
- Floating the yuan would allow the Chinese more flexibility in the conduct of
monetary policy since they would no longer have to buy dollars to support the
exchange rate.
- Floating the yuan may prevent a catastrophic devaluation such as happened in
Thailand in 1997.
- Floating the yuan may prevent the U.S. from imposing trade barriers on China.
- Floating the yuan reduces the Chinese investment in U.S. financial assets and thus
reduces their financial interest in the U.S.
Undesirable Effects: (notice how some of these are dark-side of those things
considered advantages).
- More expensive Chinese imports to America would drive up product costs in the US
for toys, clothes, electronics, and other cheaply made Chinese commodities.
- Floating the yuan would give the Chinese the flexibility to engage in irresponsible
monetary policy.
- Floating the yuan would create exchange rate risk for those doing business in China
and for Chinese businesses doing business outside China.
-
Floating the yuan reduces the Chinese investment in U.S. financial assets and thus
reduces their integration and interest in the U.S.
6. Your company is thinking about opening large manufacturing operation
and also to capture a significant market share in The Kingdom of Elbonia.
At a recent board meeting one of the members made the following
statement. ”Sure, Elbonia has long had a stable, prosperous economy
with GDP growth rates of more than 4%, but they also have a huge
current account deficit. This deficit must indicate that there is some real
underlying weakness.” Criticize this statement.
Answer:
Having a current account deficit is not necessarily bad. In fact, combined with
Elbonia’s GDP growth, it may actually indicate an even stronger economy than
measuring GDP alone.
A current account deficit occurs because capital is flowing into Elbonia. Opening a
manufacturing company there would be a wise move. You have foreign investors who
are investing heavily into Elbonia to create the capital account surplus. As an added
benefit, Elbonian’s are becoming more and wealthier through a stable and prosperous
economy. These Elbonian’s will be investing more in everything both domestic and
abroad. One possible weakness is sustainability. How long will foreign investors hold
Elbonia’s financial instruments? What happens when they sell everything and pull out?