BU5210 _ ECONOMIC ANALYSIS

Dr. Chen Wu

Problem Set 1
(KEAT CH1: Introduction to Managerial Economics
KEAT CH2: The Firm and Its Goals)
These questions are designed to facilitate your study of lecture notes, textbook and other course materials.
The problem set will be graded. You are encouraged to discuss them with your classmates and learn from
each other. Feel free to ask me questions during my office hours, and you should always consider me for
your primary source of help. Please be advised some questions in the problem set may appear in exams.

Part One: Multiple Choice Questions (2 points * 16 = 32 points)

__B__ 1) Managerial economics is best defined as the economic study of
A) how businesses can make the most profits.
B) how businesses can decide on the best use of scarce resources.
C) how businesses can operate at the lowest costs.
D) how businesses can sell the most products.
_D___ 2) Scarcity is a condition that exists when
A) there is a fixed supply of resources relative to the demand for the product.
B) there is a large demand for a product.
C) resources are not able to meet the entire demand for a product.
D) All of the above
__A__ 3) Which of the following is not considered as a factor of production?
A) money
B) machinery and equipment
C) land
D) unskilled labor
__A__ 4) Which of the following is the best example of how the question of "what goods and
services to produce?" is answered by the command process?
A) government subsidies for windmill energy production
B) laws regarding equal opportunity in employment
C) government allowance for the deduction of interest payments on private mortgages
D) government regulations concerning the dumping of hazardous waste
__C__ 5) Which of the following is the best example of "how goods and services should be
produced?"
A) complying with the technical specifications in the production of an aircraft
B) the production of jet aircraft for the air force or for a commercial airline
C) the use of additional workers versus the use of machines in the production of goods
D) the production of a new manufacturing facility
_D___ 6) Which of the following is the best example of the "command" process?
A) United Airlines buys Northwest Airlines.
B) Striking auto workers force General Motors to shut down its factories.
C) Banks raise their fees on late payments by credit card holders.
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BU5210 _ ECONOMIC ANALYSIS

Dr. Chen Wu

D) The FCC requires local telephone companies to provide access to their local networks before
being able to offer long distance service.
___B_ 7) In the text, the key question in the "economics of a business" is
A) whether the need to grow revenues is being met.
B) should the firm be in the business in which it is operating.
C) whether the firm faces rising labor costs.
D) can the firm affect its market share.
___b_ 8) The economic concept of "opportunity cost" is most closely associated with which of
the following management considerations?
A) market structure
B) resource scarcity
C) product demand
D) technology
_C___ 9) A company will strive to minimize
A) transaction costs.
B) costs of internal operations.
C) total costs of transactions and internal operations combined.
D) variable costs.
___D_ 10) A large corporation's profit objective may not be profit or wealth maximization,
because
A) stockholders have little power in corporate decision making.
B) management is more interested in maximizing its own income.
C) managers are overly concerned with their own survival and may not take all prudent risks.
D) All of the above
__B__ 11) Goals which are concerned with creating and maintaining employee and customer
satisfaction and social responsibility are referred to as ________ objectives.
A) social
B) noneconomic
C) welfare
D) public relations
__B__ 12) Financial risk is associated with changes in
A) the demand for a firm's products.
B) a firm's debt.
C) a firm's labor costs.
D) government regulations of a firm's activities.
_B___ 13) Unlike an accountant, an economist measures costs on a(n) ________ basis.
A) explicit
B) replacement
C) historical
D) conservative
__D__ 14) The calculation of stockholder wealth involves
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BU5210 _ ECONOMIC ANALYSIS

Dr. Chen Wu

A) the time-value of money concept.

B) the cash flow stream.
C) business and financial risk.
D) All of the above
__A__ 15) Accounting costs
A) are historical costs.
B) are replacements costs.
C) usually include implicit costs.
D) usually include normal profits.
__C__ 16) A firm's "normal profit" is best characterized by the
A) average of a firm's profits over the past five years.
B) amount of profit necessary to keep the price of a firm's stock from changing.
C) amount of profit a firm could earn in its next best alternative activity.
D) the average amount of profit earned in the firm's industry.
Part Two: Analytical Questions (6 points * 3 = 18 points)
Question 1 (Introduction to Managerial Economics)
Elaborate on the basic economic questions of what, how and for whom. Following are examples
of typical economic decisions made by the managers of a firm. Determine whether each is an
example of what, how, or for whom.
a. Should the company make its own spare parts or buy them from an outside vendor?
b. Should the company continue to service the equipment that it sells or ask customers to
use independent repair companies?
c. Should a company expand its business to international markets or concentrate on the
domestic market?
d. Should the company replace its own communications network with a virtual private
network that is owned and operated by another company?
e. Should the company buy or lease the fleet of trucks that is uses to transport its products to
market?
Question 2 (The Firm and Its goals)
Discuss the meaning of the term principal-agent problem. Why does this problem exist? What
are some of the forces that cause managers to act in the interest of shareholders?
Question 3 (The Firm and Its Goals)
A company has 2 million shares outstanding. It paid a dividend of $2 during the past year, and
expects that dividends will grow at 6 percent annually in the future. Stockholders require a rate
of return of 13 percent. What would you expect the price of each share to be today, and what is
the value of the companys common stock?

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BU5210 _ ECONOMIC ANALYSIS

Dr. Chen Wu

Question 1
a) How, it is one of the important managerial decisions for a company decide how it is
going to produce goods , it can range from buying raw material to build something from
scratch or buying spare parts from a vendor as stated in the example. Option that is more
viable and the one that keeps the transaction costs down is the best one to choose
b) What, is one of the first questions a company has to answer as to what goods the
company wants to produce or similarly what services. And when it is going to
discontinue production of a good /service and begin producing a new and different
product.
c) Whom , this question helps managers decide what segment of market to focus on
,analysis of current and future market demands helps in finding out a target market which
has a demand for a product that is being produced as it is essential for maximization of
profit.
d) How, another part of the question as to how a company should produce goods , is hiring
staffing , procurement and capital budgeting , as long as it is more economically feasible
it can be a good decision to outsource some functions of the company as in the example.
e) How, this also an example of how a company decides to produce goods and supply to the
market
Question 2
Principal-agent is a term that is used to describe a problem that arises due to the
difference in objectives between the owner that are the stockholders and the management of a
company /business. It is a complimentary relationship. This problem arises because the Agent
(management) sometimes may not act in the best interest of the principal (stockholder) even
though that that might be a good decision from managements point of view.
There are few factors that can cause managers to act in favor of stockholders.
As Banks , insurance companies and mutual funds buy large amounts of stock of big
corporations as suggested by their expert analysts . If such a corporation and its management
underperform, they might not show signs of future growth , that can lead these institutions to sell
these stocks and the corporations stock prices will fall. This can result in takeovers and change of
management. This is something the management would want to avoid.
Other large stockholders play a vital role in such situations similar to one described above
and can influence management through proxy if they dont perform up to the mark. Competitive
pressure from other companies also stimulates management to perform and if they dont a
common average stockholders sells off his share as its value and the dividends he receives
decrease. This can lead to fall in stock prices.
Now shareholders have more say in functioning of a corporation for example in electing
directors and how much pay executives get since the passing of Sarbanes-Oxley 2002
Another motivational factor for Managers is that mangers who perform well have a higher
demand in Manager labor market and will have more value than managers who underperform.
In Addition to all this managements remunerations and compensation packages are tied to
the objectives of stockholders in a way that if the corporations perform well their profits and
stock value increases their remunerations and compensation packages further improve.
These are some of the forces that cause mangers to act in favor of stockholders.
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Question 3
P = D / (k g)
P = 2 / (0.13 0.06)
P = 28.57
Value Of company stock = 28.57 x 2 = $57.14 million

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Dr. Chen Wu