ECO 110 – Introduction to Economics
Professor Mike Rizzo
Second COLLECTED Problem Set – This is an assignment that WILL be collected and
graded. Please feel free to talk about the assignment with your friends or with your group
and I strongly encourage you to submit your assignment as a group.
Assigned:
Due:
Monday, April 4th
Monday, April 11th
COMPLETE ANY 10 of the 15
1. Why do insurance policies with deductibles cost less? Give two reasons.
2. Suppose the laws against sale of marijuana are weakened (for example, by paroling
drug-dealers after only 3 years), while laws against use of marijuana are
strengthened (for example, by imposing a 3-year mandatory minimum sentence for
use). What happens to the market for marijuana?
3. Suppose that you can buy a baseball franchise for $100 million, and its annual net
revenues (revenues minus expenses) are $5 million. The interest rate is 10 percent
per year.
a. What are net revenues as a percent of the purchase price? This is the "rental
rate" for the baseball franchise.
b. If the appreciation rate of the franchise is 8 percent per year, use the
profitability formula to calculate the profitability for the franchise. Should you
buy the franchise?
c. If your cash flow is equal to net revenues minus interest expense, calculate
the first year cash flow from owning the franchise.
d. Explain the difference between rent-buy analysis and cash flow analysis for
this franchise.
4. You can buy a share of stock for $100. The stock pays a dividend of $1 per year.
The ratio of the dividend to the price is the "rental income" from the stock. If the
interest rate is 5 percent and the rate at which dividends and share prices appreciate
is 3 percent, is the stock a good buy?
5. You deposit $3000 in the bank and earn 5 percent interest, compounded
continuously.
a. How much will you have in the bank after one year? after four years?
b. How long will it take to have $10,000 in the bank?
6. If you deposit $C in the bank every year, for n years, at an interest rate of r
compounded annually, after you make your deposit at the start of the nth year you
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will have: B = C[(1+r)n-1] /r in the bank.
a.
Suppose that you deposit $1000 a year for 10 years at an interest rate of 6
percent (r = .06). How much will you have after you make your deposit at
the start of the tenth year?
b. Suppose that you want to have $100,000 after 10 years, and the interest rate
is 6 percent. How much will you have to deposit each year?
c. Suppose that you want to have $1 million after 30 years, and the interest
rate is 7 percent. How much will you have to deposit each year?
7. Remember that the formula for an annuity is: C = rB/[1-(1+r)-n]; where C is the
annuity payment, B is the initial balance, r is the interest rate, and n is the number
of years that the annuity will run. Suppose that you have $500,000 and the interest
rate is 6 percent, and the annuity runs for 20 years.
a. What is the annuity payment?
b. Suppose that the inflation rate is 2 percent per year. What is the real
interest rate that would be used to calculate a real annuity payment?
c. Calculate the real annuity payment assuming that inflation is 2 percent per
year.
d. The annuity payment in the first year is equal to the real annuity payment.
In the second year, the annuity payment is the real annuity payment times (1
+ .02). In the third year, the annuity payment is the real annuity payment
times (1 + .02)2. Calculate the annuity payment for the second year and for
the third year.
8. Suppose that you have $100,000, the interest rate is 8 percent, and the annuity runs
for 4 years. If the inflation rate is 5 percent, calculate the real annuity. Calculate
the actual annuity payments for each of the four years. Show that the annuity
works. That is, for each year, fill out a table with the beginning balance, interest
earned, annuity paid, and ending balance. Show that after four years the ending
balance is exactly zero.
9. The formula for finding the monthly payment on a mortgage or an auto loan is the
same as the formula for an annuity. However, the interest rate is the annual
interest rate divided by 12, and the number of periods, n, is the number of years
times 12.
a. Find the monthly payment on a 30-year mortgage with a $100,000 initial
balance and an interest rate of 12 percent.
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b. Find the monthly payment on a 5-year auto loan with a $20,000 initial
balance and an interest rate of 5 percent.
10. Daniel Kahneman, Jack L. Knetsch and Richard Thaler have done research on the
notions of fairness that people apply to market transactions. One of their articles,
titled, “Fairness as a Constraint on Profit Seeking: Entitlements in the Market,”
reports the results of a public opinion survey designed to determine the rules of
fairness people use in evaluating actions by business firms. Here is one hypothetical
situation that was described in the survey:
A grocery store has several months’ supply of peanut butter in stock which it has
on the shelves and in the storeroom. The owner hears that the wholesale price
of peanut butter has increased and immediately raises the price on his current
stock of peanut butter.
Of the 147 respondents surveyed, only 21% thought this was acceptable behavior
while 79% deemed it unfair.
a. The wholesale price of peanut butter in stock is a sunk cost. Is it relevant to
pricing decisions for a seller who shares the majority view on fairness in
pricing?
b. How could it be relevant to a seller who personally holds the minority view
but also knows that his customers will find out what he has done if he raises
the price on “old” stock?
c. The economic way of thinking does not usually distinguish a sum of money
paid out from a sum of money not received: both are equally costs. The
majority of the public apparently does distinguish, because it holds that
sellers may raise their prices to cover higher wholesale cost payments but
may not do so merely because consumers are willing to pay the higher
prices. Can you defend the popular distinction, or do you think it is simply
the product of failure to understand what’s going on?
11. “When lenders extend credit to high-risk borrowers, they must raise the interest rate
that may be charged low-risk borrowers in order to cover their losses from defaults.”
Does this claim make any sense?
12. About half of all new restaurants fail within a year, and 85% close within five years.
What do these figures indicate about the profitability of the restaurant business?
Why do so many entrepreneurs nonetheless start up new restaurants every year?
13. Before 1980, the Interstate Commerce Commission rarely granted new permits to
trucking firms to haul goods interstate, and operating rights were often extremely
valuable. They were listed as assets on the books of trucking companies and made
up a significant portion of the purchase price whenever such companies were sold.
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a. What factors established the market value of such operating rights?
b. When the Motor Carrier Act of 1980 took effect, allowing much easier entry
into interstate trucking, the market value of operating rights fell. Why?
c. Was this fall a loss?
d. Losses as well as profits are the consequences of uncertainty. What was the
uncertainty that produced this loss for trucking companies in 1980?
e. What would have happened to the value of operating rights in the 1970s if
everyone had known 10 years in advance that Congress was going to ease
restrictions on entry into interstate trucking after 1980?
f.
The Motor Carrier Act of 1980 was a change in the rules of the game. Which
were the principal property rights affected, and with what consequences?
14. “Everybody knows” that laborers receive wages and only owners receive profits. But
is this true?
a. If employees agree to continue working for an employer who is currently
unable to pay them, because they don’t want the firm to fail, are they
working for wages or profits?
b. If you agree to loan your lawn-mower to someone who wants to start a
lawn-care business, on condition that he pay you $2 each time he borrows it,
are you a capitalist? If your $2 properly called profit? Would your answers
differ if he agreed to pay you 20% of his gross receipts?
15. Take a look at the yellow pages of your local phone book, or surf the web for a little
while. Can you provide a list of three entrepreneurial firms in each of the categories
below, and provide reasons for your placement? Do some of the firms fall into more
than one category?
a. Firms that primarily engage in arbitrage activity
b. Firms that primarily engage in innovative activity
c. Firms that primarily engage in entrepreneurial imitation
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