Managerial Economics
PRACTICE
Final Exam
ANSWER KEY
CONFIDENTIAL
Exam Organization:
25 Multiple Choice Questions
7 Short Answer Questions
2 Long Answer Questions
Total
50 points
35 points
15 points
100 points
Definitions:
Profit = Revenue - Cost (relevant to the decision)=Q*(P-AC)
Revenue = P * Q (non-price discrimination)
Total Cost = Fixed Costs + Total Variable Costs = AC * Q
Price elasticity of demand (e) = percent change in Quantity / percent change in Price
Factor elasticity of demand = percent change in Quantity / percent change in Factor
MR = P * (1 - 1 / | e |)
Current Markup = (P - MC) / P
Desired Markup = 1 / | e |
Break even quantity=F/(P-MC)
Break even price=Average Avoidable Cost
Multiple Choice – 2 Points Each
Instructions: Choose the best answer to each question.
1. When are parties likely to engage in transactions?
a. If they both gain from the transaction
b. If the sale price is above the seller’s value and below the buyer’s value
c. When the total gains from trade are greater than zero
d. All of the above
2. A business owner produces 2500 units during a typical eight hour day. The items sell for
$10 each and production does not stop on the weekend. If hired elsewhere, he would earn
$150 per hour. If the explicit costs total $300,000 for 30 days, the economic profit for the
month equals
a. $414,000
b. $450,000
c. $36,000
d. $750,000
3. If movie theatres decided to increase the price for the movie tickets, holding other factors
constant, what would happen to the demand for popcorn in the theatres?
a. the demand for popcorn would shift to the left because popcorn and movies are
substitute goods.
b. the demand for popcorn would shift to the left because popcorn and movies are
complementary goods.
c. the demand for popcorn would shift to the right because popcorn and movies are
substitute goods.
d. the demand for popcorn would shift to the right because popcorn and movies are
complementary goods.
4. You’ve just decided to add a new line to your manufacturing plant. Compute the expected
profit from the line addition if you estimate the following:
There is a 50% chance that profits will increase by $100,000.
There is a 30% chance that profits will increase by $15,000.
There is a 20% chance that profits will remain the same.
There is a 10% chance that profits will decrease by $15,000.
a. Gain of $100,000
b. Gain of $53,000
c. Loss of $15,000
d. Gain of $56,000
2
5. Which of the following will NOT cause the demand curve for fireworks to shift?
a. trade embargo on China.
b. sudden increase in price.
c. new study showing similarities in fireworks and improvised explosive devices.
d. Fourth of July.
6. Given that the own-price elasticity of demand for a brand of shoes is -2, if the price rises
by 8% what will happen to the quantity of shoes demanded?
a. It will decrease by 16%.
b. It will increase by 16%
c. It will decrease by 25%
d. It will increase by 25%
7. Which of the following conditions must be satisfied by a successful price discrimination
scheme?
a. The seller must have market power
b. The seller must be able to identify different customer groups with different
demand elasticities
c. The seller must be able to prevent arbitrage between the two groups
d. All of the above
8. If hiring the 4th worker increases total product by 50 units and the price of each unit is
$15,
Number
of
workers
Total Costs
0
$1,000
1
$2,200
$1,200
2
$3,200
$1,000
3
$4,000
$800
4
$4,600
$600
5
$5,000
$400
Marginal Cost
3
a.
b.
c.
d.
6
$5,200
$200
7
$5,600
$400
8
$6,200
$600
9
$7,000
$800
10
$8,000
$1,000
The firm should not hire the 4th worker as MR<MC
Marginal revenue equals $150
The firm should hire the 4th worker as MR>MC
The firm should not hire the 4th worker as MR<TC
9. Dr. Octavio is an Ophthalmologist who performs both cataract and Lasik surgeries.
Having no other competition in the area, high demand, and an inelastic Lasik market, Dr.
Octavio increase the price she charges for Lasik. This price increase
a. increases the opportunity cost of performing cataract surgeries.
b. increases the demand for Lasik surgery.
c. reduces the opportunity cost of performing cataract surgeries.
d. increases the demand for cataract surgeries, if cataract and Lasik surgeries are
substitutes.
10. A bookshelf manufacturer can produce 10 bookshelves for $2,500 and 12 bookshelves
for $2,760. What is the difference between the average cost per bookshelf for 12
bookshelves and the marginal cost of the 12th bookshelf?
a. $100
b. $130
c. $230
d. $260
11. You estimate that a pottery craftsman is debating attending the crafters fair. It costs $50
to set up the booth and $20 in transportation to get his pottery to the fair. He nets $5 for
each of his pieces, what is the minimum amount of sales would he have to make going to
the fair worth?
a. 10
b. 12
c. 14
d. 16
4
12. Two roommates John and Joe are playing a simultaneous game of cleaning the apartment.
If neither of them clean, the apartment gets filthy and both get a utility of 2. If John
cleans and Joe doesn’t, John gets a utility of 1 and Joe gets a utility of 4. If Joe cleans and
John doesn’t, Joe gets a utility of 1 and John gets a utility of 4 and if both clean up the
apartment, they each get a utility of 3.
The Nash equilibrium of this game is:
a.
b.
c.
d.
Both of them clean the apartment
John cleans, Joe doesn’t
Joe cleans, John doesn’t
Neither of them clean the apartment
13. From the blog: In the internet era, taking an online course (never seeing a professor at
all!) is becoming commonplace. Companies like “WeTakeYourClass” make it easy for
students to _______, which is an example of ___________.
a. signal, adverse selection
b. commit, bargaining
c. shirk, moral hazard
d. None of the above
14. Principal-agent relationships
a. reduce monitoring costs.
b. occur because managers have good information about employees.
c. are not related to asymmetric information.
d. are subject to moral hazard problems.
15. (From the blog) Which of the below strategies will improve your chances in a game of
chicken?
a.
b.
c.
d.
Accepting that you cannot guarantee victory
Develop a reputation as someone who will not back down
Make yourself appear larger and more imposing
All of the above
16. You’ve been asked to assist in negotiating pricing for implants. Which of the following
conditions would lead you to have more bargaining power?
a. a) Lots of substitutes for the vendor’s product are available.
b. b) There are relatively few buyers and many vendors.
c. c) Cost to switch vendors is low.
d. d) All of the above.
5
17. When a resource or capability is valuable and rare, a firm may gain a:
a. sustainable competitive advantage
b. competitive parity
c. cost advantage
d. permanent competitive advantage
18. If supply falls in a perfectly competitive market, we can expect ALL of the following
except
a. price to rise.
b. demand to fall.
c. the equilibrium bought and sold to fall.
d. quantity demanded to fall.
19. In the short run, certain of the firm's costs are fixed. This implies that,
a. if the firm were to expand output, average fixed costs would increase.
b. in the decision to change production levels in the short run, these costs are
irrelevant.
c. if the firm shut down and produced no output, these fixed costs could be avoided.
d. if the firm were to expand output, average fixed costs would remain the same.
20. The law of demand says that
a. when price falls, quantity demanded rises.
b. when demand rises, price goes up.
c. when supply rises, demand rises.
d. demand creates its own supply.
21. Many spouses complain that their partners tend to “let themselves go” after getting
married. This is an example of
a)
Moral hazard
b)
Adverse selection
c)
Terrible husbands
d)
None of the above
22. Both Nadia and Samantha are applying to insure their car against theft. Nadia lives in a secure
neighborhood, where the probability of theft is 10%. Samantha lives in a lesser secure
neighborhood where the probability of theft is 25%. Both Nadia and Samantha own cars worth
$10,000, and are willing to pay $100 over expected loss for insurance.
How much would Nadia be willing to pay for the insurance?
a. $900
b. $1000
c. $1100
d. $1200
6
Short Answer Questions (7 at 5pts each)
1. Frequent Flyers
Frequent flyer programs are targeted more toward business travelers (who do not pay for their
own tickets) than leisure travelers (who do). Explain their effect on each type of traveler. Why is
there a difference?
Answer: A leisure traveler must weigh the benefits of flying on a preferred airline and receiving
frequent flyer credit with the costs of the ticket. If another airline is sufficiently less expensive
for a particular flight, the leisure traveler might decide that the frequent flyer benefits are not
worth it. Conversely, a business traveler has only the benefits of being loyal to a single airline
but not the costs, since the ticket price is not paid by the traveler. Therefore, the business
traveler’s decision is an example of moral hazard. The flight decision is made comparing only
airline frequent flyer benefits without regard for the ticket prices.
2. Valentine's Day
On Valentine's Day, the price of roses increases by more than the price of greeting cards. Why?
(Hint: Consider what makes roses and cards different and how that difference might affect
supply's responsiveness to price.)
Answer:
Greeting cards can be stored, so manufacturers can easily step up production and prepare larger
stocks ahead of Valentine’s Day. This means that the supply of cards is relatively responsive to
price, flat, or elastic; hence, an increase in demand has little effect on price. By contrast, roses
are perishable. Only roses maturing around Valentine’s Day will be suitable for that day. It is
relatively costly to increase the quantity supplied on Valentine’s Day. This means that the supply
is relatively unresponsive to price, steep, or inelastic, and consequently, the increase in demand
causes the price to increase sharply.
3. Snacks, Beer, and Marijuana
Snack food venders and beer distributers earn some monopoly profits in their local markets but
see them slowly erode from various new substitutes. When California voted on legalizing
marijuana, which side would you think that California beer distributors were on? What about
snack food vendors?
Answer:
The potential legalization of marijuana would have different effects on different related markets.
In the category of recreational drugs, beer and marijuana are likely substitutes. Legalization
would shift demand away from beer sales and thus reduce the profits of beer distributors. We
would expect them to oppose legalization. On the other hand, marijuana and snack foods are
strong complements (or so we are told). Legalization would shift demand out for snack food
companies and thus increase their profits. We would expect them to support legalization.
7
4. Boat Insurance
Maritime Insurance Company offers insurance policies for recreational boats. A typical policy
will pay the replacement cost of $25,000 if the boat is a total loss. If the boat is not a total loss
but the damage is more than $10,000, the policy pays $5,000. For damage under $10,000, no
coverage is offered. The company estimates the probability of no damage to be 0.60, the
probability of damage between $0 and $10,000 to be 0.25, and the probability of damage
between $10,000 and $25,000 to be 0.12. If the company wants to make a profit of $200 above
the expected cost, what should be the price of the policy?
5. Insurance Exchanges
The new health care law, by setting up "Insurance Exchanges" in which individuals can purchase
insurance, may change incentives for employers. Employers have always had an incentive to
drop employees who use a large amount of expensive health care because they affect the
insurance rates. Even before the law change, legal safeguards have prevented most selective
terminations and non-renewals. However, they do not prevent employees from selecting
themselves out of a health care plan. Once "Insurance Exchanges" exist, losing employer
provided insurance, while not good, is not as dire. Discuss how employers and insurance
companies are likely to revise their health insurance plans' coverage to take advantage of
employees opting for exchanges.
Answer:
This is an application of adverse selection. Employers would like to dump their high medical
cost employees so as to contain insurance costs. Workplace rules make this difficult currently.
But workplace rules do not prohibit employees from dropping insurance. If employers and their
insurance companies could design policies so that it is worth it for these high cost employees to
opt for the insurance exchanges, they will have shed a major cost. For example, an employer
with a self-insurance plan could simply exclude coverage for specific high-cost conditions – such
as AIDS, diabetes, and hemophilia. Employees who develop these conditions will find it
worthwhile to opt for the exchanges. This shifts the costs of these employees to the exchanges,
which will drive up their costs and, eventually, the premiums for individual plans.
5. Economic’s Top Chef (from the blog!)- this is one of the featured blog posts
Explain why many of the top restaurants in America prefer to serve several small portion courses
during a meal than one or two large plate options.
Answer: This is due to the law of diminishing returns. Take a steak for example. With the first
bite, you know what the steak will taste like, and with each additional bite, you know what to
expect and it becomes less “compelling” or desirable. In contrast, with several small courses, you
get the immediate benefit (burst of flavor) and then you move on to something different, creating
a more engaging and exciting meal experience and maximizing the “returns” for the meal6.
8
6. Hand Sanitizer
Due to the H1N1 flu outbreak, the demand for hand sanitizer has tripled. Should Johnson &
Johnson increase production of their Purell hand sanitizer? Should it invest in doubling
production capacity?
Answer:
An increase in demand will usually increase the price and, thus, greater production levels are
profitable. One way to do this is to increase manufacturing capacity. However, capacity will be
increased for many years and the H1N1 flu is likely to be a temporary phenomenon. That is,
demand for hand sanitizer is likely to return to pre-2009 levels in a year or two. In this case, the
extra capacity will likely be idle and unprofitable.
Long Answer Questions (2 questions totaling 15 pts)
1 Game Day Shuttle Service
You run a game day shuttle service for parking services for Texas Rangers games. Your total
costs for different customer loads are 1: $30, 2: $32, 3: $35, 4: $38, 5: $42, 6: $48, 7: $57, and 8:
$68. What are your marginal costs for each customer load level? If you are compensated $10 per
ride, what customer load would you want?
Answer: Marginal Cost is the change in costs due to the additional customer.
9
Q
TC
1
30
2
32
3
MC
Tot Rev
Profit
10
-20
2
20
-12
35
3
30
-5
4
38
3
40
-2
5
42
4
50
8
6
48
6
60
12
7
57
9
70
13
8
68
11
80
12
Since marginal revenue is the price of $10, you will serve customers up to the point where MC >
MR or you will serve 7 customers.
2. Nash Equilibrium (8 pts)
a) Given the following payoff matrix, what is the Nash Equilibrium? (circle the correct box)
Joe
GREEN
GREEN
Joe makes $40
Sally makes $20
YELLOW
Joe makes $80
Sally makes $60
10
Sally
YELLOW
Joe makes $90
Sally makes $30
Joe makes $100
Sally makes $40
Answer a):
Nash equilibrium identified:
Joe
GREEN
Sally
YELLOW
GREEN
Joe makes $40
Sally makes $20
Joe makes $90
Sally makes $30
YELLOW
Joe makes $80
Sally makes $60
Joe makes $100
Sally makes $40
b) Now, suppose Joe can move first (i.e. choosing his color before Sally), show what color Joe
would choose and how much Joe would be willing to pay to move first.
Answer b):
Joe
Green
Yellow
Sally: Green
Sally: Yellow
Sally: Green
Sally: Yellow
Joe gets 40
Sally gets 20
Joe gets 90
Sally gets 30
Joe gets 80
Sally gets 60
Joe gets 100
Sally gets 40
11
Joe would be willing to pay up to 10 (90 – 80) to move first.
12