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Multiple-Choice Questions

1. Which of the following is an example of how the question of "what goods and services to
produce?" is answered by the command process?

A. government subsidies for affordable housing


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 industrial waste Answer:

2. Opportunity cost is best defined as

A. the amount given up when choosing one activity over all other alternatives.
B. the amount given up when choosing one activity over the next best alternative.
C. the opportunity to earn a profit that is greater than the one currently being made.
D. the amount that is given up when choosing an activity that is not as good as the next best alternative.

Answer:

3. In a market economy, which of the following is the most important factor affecting scarcity?

A. the needs and wants of consumers

B. the price of the product

C. the degree to which the government is involved in the allocation of resources.

D. All of the above are equally important.

Answer:

4. Which of the following is not considered by economists to be a basic resource or factor of


production?

A. money B) machinery and equipment

C) technology D) unskilled labor


Answer:

5. Select the group that best represents the basic factors of production.

A. land, labor, capital, entrepreneurship B) land, labor, money, management skills

C) land, natural resources, labor, capital D) land, labor, capital,

technology Answer:
6. Which of the statements below best illustrates the use of the market process in determining the
allocation of scarce resources?

A. "Let's make this product because this is what we know how to do best."
B. "Although we're currently making a profit on the products we make, we should consider shifting to
products where we can earn even more money."
C. "Everyone is opening video stores, why don't we?"
D. "We can't stop making this product. This product gave our company its start." Answer:
7. Which of the following is the best example of "what goods and services should be produced?"

A. the use of a capital intensive versus a labor intensive process of manufacturing textiles
B. the production of army helicopters versus the production of new commercial jet aircraft
C. the manufacturing of computer workstations in Hong Kong or in Germany
D. the leasing versus the purchasing of new capital equipment
Answer:
8. Which of the following is the best example of "how should goods and services be produced?"

A. adherence to technical specifications in the production of jet aircraft


B. the production of jet aircraft for the air force or for a commercial airline
C. the use of additional full-time workers versus the use of supplementary part-time workers
D. the production of a new manufacturing facility
Answer:

9. Which of the following is the best example of opportunity cost?

A. a company's expenditures on a training program for its employees


B. the rate of return on a company's investment
C. the amount of money that a company can earn by depositing excess funds in a money market fund
D. the amount of profit that a company forgoes when it decides to drop a particular product line in favor
of another one

Answer:
10. From the standpoint of a soft drink company the question of "What goods and services should
be produced?" is best represented by which of the following decisions?

A. whether or not to hire additional workers

B. whether or not to increase its advertising

C. whether or not to shut down selected manufacturing facilities

D. All of the above are examples.

E. None of the above are examples.

Answer:

11. Scarcity is a condition that exists when

A. there is a fixed supply of resources.

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.

Answer:

12. Managerial economics is best defined as

A. the study of economics by managers.

B. the study of the aggregate economic activity.

C. the study of how managers make decisions about the use of scarce resources.

D. All of the above are good definitions.


Answer:

13. In the text, the authors refer to "Stage II" of the process of changing economics as

A. demand management. B) cost management.

C) diminishing returns. D) profit taking.

Answer:

14. Which of the following is the best example of the "command" process?

A. MCI-Worldcom buys Sprint.


B. Striking auto workers force General Motors to shut down its factories.
C. Banks raise their fees on late payments by credit card holders.
D. The FCC requires local telephone companies to provide access to their local networks before being
able to offer long distance service.

Answer:

15. A critical element of entrepreneurship (as opposed to managerial skills) is

A. leadership skills. B) risk taking.

C) technology. D) political skills.

Answer:

16. In the text, a key factor in the changing "economics of a business" is

A. the need to grow revenues. B) increasing competition.

C) rising labor costs. D) the need to expand market share.


Answer:

17. In the "four-stage" model of change," Stage III is represented by

A. deciding how much to markup costs to set a profitable product price.

B. cost-cutting and restructuring to maintain and improve production.

C. narrowing product lines to those offering the greatest revenue potential.

D. focusing on markets with the greatest growth potential.

Answer:

18. 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

Answer:
19. Which of the following is the best example of the "traditional process"?

A. commercial bank mergers


B. minimum age limits for the purchase of alcoholic beverages

C. auctioning US Treasury bills


D. colleges and universities give admissions preferences to children of alumni Answer:
20. The best definition of economics is

A. how choices are made under conditions of scarcity.

B. how money is used.

C. how goods and services are produced.


D. how businesses maximize profits.

Answer:

21. 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.

Answer:

Analytical Questions
1. What economic conditions are relevant in managerial decision-making?

Answer: Such factors as market structure, supply and demand conditions, technology,
government regulations, international factors, expectations about the future, and the
macroeconomy are economic factors that play a role in managerial decision-making.

2. What factors lead to competitive advantage for a firm?

Answer: ost leadership (lower costs than competing firms), product differentiation, selection
and focus on a market niche, outsourcing and merger strategies, and international focus or
expansion are factors in the competitive advantage of the firm.

3. What are the typical types of risk faced by a firm?


Answer: anges in supply and demand conditions, changes in technology, increased
competition, changes in interest rates and inflation rates, exchange rate changes, and political
risk are typical types of risk faced by firms.

4. What are the four stages of change faced by firms?

Answer: Stage I: Market dominance, in which the only strategy required to earn a profit is

sufficient markup over cost. (Cost-plus)


Stage II: Technology and competition place pressures on the firm, often resulting in cost-
cutting, downsizing, restructuring, and reengineering. (Cost management)
Stage III: Focus on growth of top lines of business. (Revenue
management) Stage IV: Striving for continued profitable growth.
(Revenue plus)

5. How do the three basic economic questions relate to the firm?

Answer: rms must choose WHAT goods and services to produce, HOW to produce them
(through appropriate choice of resources and technology), and FOR WHOM they will be
provided (what segment of the market on which to focus).

6. What other business disciplines are related to Managerial Economics?

Answer: counting, Finance, Management Science (Quantitative Methods), Management


Strategies, Marketing

Chapter 2 The Firm and Its Goals

Multiple-Choice Questions

1. Transaction costs include

A. costs of negotiating contracts with other firms.


B. cost of enforcing contracts.

C. the existence of asset-specificity.

D. All of the above.

Answer:

2. 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.

Answer:

3. Company goals that are concerned with creating employee and customer satisfaction and
maintaining a high degree of social responsibility are
called objectives.

A. social B) noneconomic C) welfare D) public relations Answer:


4. risk involves variation in returns due to the ups and downs of the economy, the industry
and the firm.

A. Structural B) Fluctuational C) Business D) Financial Answer:


5. risk concerns the variation in returns that is induced by leverage.

A. Business B) Premium C) Business D) Financial Answer:

6. Unlike an accountant, an economist measures costs on a(n) basis.

A. implicit B) replacement C) historical D) conservative


Answer:
7. When a company manages its business in such a way that its cash flows over time, discounted at the
appropriate discount rate, will cause the value of the company's common stock to be at a maximum,
it is called maximization.
A. profit B) stockholder wealth

C) asset D) None of the


above.

Answer:

8. When a firm earns a normal profit, its revenue is just enough to cover both its cost and
its cost.

A. accounting; opportunity B) accounting; replacement

C) historical; replacement D) explicit;

accounting Answer:
9. 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.

Answer:

10. Accounting costs

A. are historical costs. B) are replacements costs.

C) usually include implicit costs. D) usually include normal profits.

Answer:

11. The calculation of stockholder wealth involves


A. the time-value of money concept. B) the cash flow stream.

C) business and financial risk. D) All of the above.

Answer:

12. As an objective, the maximization of profits ignores

A. the timing of cash flows B) the time-value of money concept.

C) the riskiness of cash flows. D) All of the above.

Answer:

13. Another name for stockholder wealth maximization is

A. profit maximization.

B. maximization of earnings per share.

C. maximization of the value of the common stock.

D. maximization of cash flows.

Answer:

14. MVA (Market Value Added)

A. will always be a positive number. B) may be a negative number.

C) measures the market value of the firm. D) None of the above.

Answer:
15. Opportunistic behavior is best described as a firm

A. gathering as much information as possible before dealing with another entity.


B. attempting to make a profit from its dealings with another entity.
C. firm trying to take advantage of another entity in its dealings with it.
D. selecting another entity to deal with.

Answer:

16. Firms are organized to keep their costs as low as possible by

A. comparing external transactions costs with internal operating cost.

B. analyzing supply and demand conditions.

C. minimizing their use of borrowed funds.

D. utilizing the latest technology.

Answer:

17. The best example of an economic goal of a firm is

A. providing good products/services to its customers.

B. improving its public image.

C. increasing employee morale.

D. increasing shareholder wealth.

Answer:

18. 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.

Answer:

19. 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.

Answer:

Analytical
Questions
1. a. If a stock is expected to pay an annual dividend of $20 forever, what is the approximate present
value of the stock, given that the discount rate is 5%?
b. If a stock is expected to pay an annual dividend of $20 forever, what is the approximate
present value of the stock, given that the discount rate is 8%?
c. If a stock is expected to pay an annual dividend of $20 this year, what is the approximate
present value of the stock, given that the discount rate is 8% and dividends are expected
to grow at a rate of 2% per year?

Answer:
a. P = D/k = 20/.05 = $400
b. P = 20/.08 = $250
c. P = D1/(k - g) = 20/(.08 - .02) = $333.33
2. If a stock is expected to pay a dividend of $40 for the current year, what is the approximate present
value of this stock, given at discount rate of 5% and a dividend growth rate of 3%?

Answer: P = $40/(0.05 - 0.03) = $40/0.02 = $2,000

3. Describe the difference between the Economic Value Added (EVA) and the Market Value Added
(MVA) approach to determining stockholder wealth.

Answer: VA is the difference between a firm's return on total capital and its cost of capital,
while MVA is the difference between the market value (equity plus debt) of a firm and
the amount of capital investors have paid into the company.

Chapter 3 Supply and Demand (Appendix 3A)

Multiple-Choice Questions
1. How long is the "short-run" time period in the economic analysis of the market?

A. three months or one business quarter


B. total time in which sellers already in the market respond to changes in demand and equilibrium
price
C. total amount of time it takes new sellers to enter the market
D. total amount of time it takes original sellers to leave the market Answer:
2. A new taco-making machine that is similar in size and cost to hot dog carts has encouraged more
street vendors to begin selling tacos. What short-run impact do you think this might have on the
market for hot dogs?

A. decrease in the demand for hot dogs B) increase in the demand for hot dogs

C) decrease in the supply of hot dogs D) increase in the supply of hot dogs

Answer:
3. Which of the following is not a nonprice determinant of demand?

A. tastes and preferences B) income


C) technology D) future expectations

Answer:
4. Which of the following is not a nonprice determinant of supply?
A. costs B) technology

C) income D) future expectations

Answer:
5. Which of the following statements is not true?
A. An increase in demand causes equilibrium price and quantity to rise.
B. A decrease in demand causes equilibrium price and quantity to fall.
C. An increase in supply causes equilibrium price to fall and quantity to rise.
D. A decrease in supply causes equilibrium price to rise and quantity to rise.

Answer:

6. A short-run time period is

A. the period of time in which sellers already in the market respond to a change in
equilibrium price by adjusting the amount of their fixed inputs.
B. the amount of time it takes for the market price to reach a new equilibrium as a result of some
initial change in supply or demand.
C. the amount of time it takes for sellers and buyers to decide on whether to enter a new market.
D. the amount of time it takes for buyers to change their purchasing habits as a result of a change in
market price.

Answer:

7. Which of the following would cause a decrease in the demand for fish?

A. The price of red meat increases. B) The price of fish increases.

C) The price of chicken decreases. D) The number of fishing boats


decreases.

Answer:

8. Which of the following would cause a short□run decrease in the quantity supplied of personal
computers?
A. The price of workstations decreases.

B. The price of PC software decreases.

C. The number of PC manufacturers decreases.

D. The cost of manufacturing PCs decreases.

Answer:

9. Which of the following will not cause a short-run shift in the supply curve?

A. a change in the number of sellers B) a change in the cost of resources

C) a change in the price of the product D) a change in future

expectations Answer:
10. In the short run, a change in the equilibrium price will

A. always lead to inflation.

B. cause a shift in the demand curve.

C. cause a shift in the supply curve.

D. cause a change in the quantity demanded or supplied.

Answer:

11. Which of the following applies most generally to supply in the long run?

A. Average cost must decline.

B. Sellers are able to make adjustments in all of their factors of production.

C. Sellers are only able to make adjustments in their variable factors of production.
D. All original sellers will leave the market.

Answer:

12. A movement along the demand curve may be caused by

A. a change in nonprice determinants of demand.

B. a change in consumer expectations.

C. a change in demand.

D. a change in supply.

Answer:

13. The rationing function of price

A. occurs when there is a movement of resources into or out of markets as a result of changes in
the equilibrium market price.
B. is also known as the guiding function of price.
C. occurs when consumers change their tastes and preferences.
D. occurs only when the market experiences severe shortages.

Answer:

14. The switch to the use of HFCS from sugar in soft drinks was prompted in large part by its relatively
lower price. Assuming a competitive market, what effect would this change have on the equilibrium
price and output for soft drinks?

A. Price rises, output falls. B) Price falls, output rises.

C) Price rises, output rises. D) Price falls, output falls.


Answer:

15. Which of the following best describes the "guiding function" of price?
A. In response to the surplus or shortage in two markets, price serves as a "guiding
function" by decreasing in one market and increasing in the other market in the short run.
B. The guiding function of price is the movement of resources into or out of markets in
response to a change in the equilibrium price of a good or service.
C. The guiding function of price occurs when the market price changes to eliminate the
imbalance between supply and demand caused by a shortage or surplus at the original
price.
D. The guiding function usually occurs in the short run while the rationing function usually
occurs in the long run.

Answer:

16. Which of the following best applies to the distinction between the "long run" and the "short run"?

A. The short run is a period of approximately 1-6 months while the long run is any time frame
longer.
B. In the short run, only new firms may enter, while in the long□run firms may either enter or exit the
market.
C. The rationing function of price is a short□run phenomenon whereas the guiding function is a long-
run phenomenon.
D. All of the above statements are correct.

Answer:

17. Which of the following would indicate that price is temporarily below its market
equilibrium?

A. There are a number of producers who are left with unwanted inventories.

B. There are a number of customers who must be placed on waiting lists for the product.

C. Firms decide to leave the market.

D. The government must step in and subsidize the product.

Answer:

R. Comparative statics analysis in economics is best illustrated as


A. the comparison of equilibrium points before and after changes in the market have
occurred.
B. a comparison of two types of markets.
C. the comparison of the percentage of change in the one variable divided by the percentage
change in the other variable.

D. an analytical technique used to show best case scenarios of demand and supply curves.

Answer:

19. The guiding function of price is

A. the movement of price to clear the market of any shortages or surpluses.

B. the use of price as a signal to guide government on the use of market subsidies.

C. a long-run function resulting in the movement of resources into or out of markets.

D. the movement of price as a result of changes in the demand for a product.

Answer:

20. If the price of a substitute product increases, which of the following is most likely to happen in the
market for the product under consideration in the short run?
A. Supply will increase.
B. Firms will leave the market.
C. Firms in the market will devote more of their variable inputs to the making of this
product.
D. Firms in the market will devote less of their variable inputs to the making of this product.

Answer:

21. Which of the following would lead to a short-run market surplus for fish?

A. The price of fish increases.


B. A new government study shows that fish have a greater risk of contamination from pollution.
C. An increase in the price of chicken.
D. A decrease in the number of fishing companies.
Answer:

22. Which of the following refers to a shift in the demand curve?

A. "This new advertising campaign should really increase our demand."


B. "Let's drop our price to increase our demand."
C. "We dare not raise our price because our demand will drop."
D. "If new sellers enter the market, the demand for the product is bound to increase." Answer:
23. In a perfectly competitive market, if the cost of production falls, we can expect

A. sellers to earn more profit.

B. sellers to earn less because price will fall.

C. consumers to buy more.

D. consumers to buy less.

Answer:

24. In 1998, the following event(s) caused a significant decline in the price of sugar:

A. favorable weather in important sugar growing countries.

B. economic conditions in Asia reduced sugar demand.

C. lowered demand for other products made of sugar.

D. All of the above.

Answer:

25. Which of the following will result in an increase in demand for residential housing in the short run?

A. a decrease in the price of lumber


B. an increase in the wages of carpenters
C. an increase in real household incomes
D. a decrease in the prices of residential housing
Answer:
26. Which of the following can result in an increase in the supply of residential housing in the short run?

A. a decrease in the price of lumber B) a decrease in real household incomes

C) an increase in the wages of electricians D) None of the above.

Answer:

27. Which of the following is a key determinant of both supply and demand?

A. income B) future expectations

C) tastes and preferences D) sales tax

Answer:
28. Which of the following could cause a long-run shift in demand as part of the "guiding function
of price"?

A. a change in tastes and preferences


B. an increase in price caused by a shift in supply
C. income shift caused by an economic recession
D. an increase in number of buyers
Answer:

29. A market is in equilibrium when

A. supply is equal to demand.

B. the price is adjusting upward.

C. the quantity supplied is equal to the quantity demanded.

D. tastes and preference remain constant.

Answer:
30. Which of the following indicates that there is a shortage in the market?

A. Demand is rising. B) Demand is falling.

C) Price is rising. D) Price is falling.

Answer:

31. Which of the following would cause a decreasing shift in the demand curve for a product?

A. an increase in income
B. an increase in the price of a complementary product
C. an increase in the price of a substitute product
D. the expectation that there will be a shortage in the availability of the product Answer:
32. Which of the following would cause a decrease in the price of a product?

A. an increasing shift in the supply of a product and no shift in demand


B. a decreasing shift in the supply of a product and no shift in demand
C. an increasing shift in the demand for product and no shift in supply
D. an increasing shift in the demand for product and a decreasing shift in supply Answer:
33. In the short-run if there is a surplus in the market for a product, the rationing function of price can
be expected to cause

A. an increasing shift in the demand for the product.

B. a decreasing shift in the supply of the product.

C. an increase in the market price of the product.

D. a decrease in the market price of the product.

Answer:

34. In the long-run if there is a shortage in the market for a product, the guiding (allocation) function
of price can be expected to cause
A. an increasing shift in the demand for the product.

B. a decreasing shift in the demand for the product.

C. an increasing shift in the supply of the product.

D. a decreasing shift in the supply of the product.

Answer:

35. The "law" of demand can be best described by

A. people will buy things that they enjoy.

B. if incomes rise, people will buy more.

C. a rise in price will cause shortages.

D. a fall in price will increase quantity demanded.

Answer:

Analytical Questions
1. For each of the following changes, show the effect on the demand curve, and state what will happen
to market equilibrium price and quantity in the short run.
a. Consumers expect that the price of the good will be higher in the future.
b. The price of a substitute good rises.
c. Consumer incomes fall, and the good is normal.
d. Consumer incomes fall, and the good is inferior.
e. A medical report is published showing that this product is hazardous to your health.
f. The price of the product rises.

Answer:

a. Demand increases (now); equilibrium price and quantity increase.


b. Demand increases; equilibrium price and quantity increase.
c. Demand decreases; equilibrium price and quantity fall.
d. Demand increases; equilibrium price and quantity increase.
e. Demand decreases; equilibrium price and quantity fall.
f. This is a movement along the demand curve, and the quantity demanded will decrease.

2. For each of the following changes, show the effect on the supply curve, and state what will happen
to market equilibrium price and quantity in the short run.
a. The government requires pollution control filters that raise production costs.
b. Wages of workers in this industry fall.
c. There is an improvement in technology.
d. The price of the product falls.
e. Producers expect that the price of the product will fall in the future.

Answer:

a. Supply decreases; equilibrium price rises and quantity falls.


b. Supply increases; equilibrium price falls and quantity rises.
c. Supply increases; equilibrium price falls and quantity rises.
d. This is a movement along the supply curve, and the quantity supplied will decrease.
e. Supply increases (now); equilibrium price falls and quantity rises.

3. Suppose that the demand for oranges increases. Carefully explain how the rationing function of
price will restore market equilibrium.

Answer: The increase in demand causes a shortage at the original equilibrium price; the
quantity supplied is less than the new quantity demanded at that price. The existence of the
shortage will cause the price to rise. As price rises, the quantity supplied will increase and the
quantity demanded will decrease (along the new demand curve) until equilibrium is reached at
a higher price (and quantity).

4. Suppose that the demand for oranges increase. Explain the long -run effects of the guiding
function of price in this scenario.

Answer: n the long run, the higher price of oranges will signal more firms to enter the orange
market, as it will seem more profitable than some other markets. As firms enter, supply
increases, causing the price to fall relative to the short-run price and quantity to increase
further. The higher short-run price has guided more resources into the market.

5. Suppose that macroeconomic forecasters predict that the economy will be expanding in the near
future. How might managers use this information?

Answer: conomic expansion increases consumer incomes, which will increase the demand for
normal goods and decrease the demand for inferior goods. Thus a producer of normal goods
might be anticipating a future increase in demand and thus considering expansion, while a
producer of inferior goods might be preparing for a decrease in demand and considering
contraction or a movement into a different product line.

6. For each of the following sets of supply and demand curves, calculate equilibrium price and
quantity.
a. QD = 2000 - 2P; QS = 2P
b. QD = 500 - P; QS = 50 +
P
c. QD = 5000 - 10P; QS = -1000 + 5P

Answer:
a. Q = 1000, P =
500 b. Q = 275, P
= 225 c. Q = 1000,
P= 400

7. Annual demand and supply for the Entronics company is given by:
QD = 5,000 + 0.5 I + 0.2 A - 100P, and QS = -5000 + 100P
where Q is the quantity per year, P is price, I is income per household, and A is
advertising expenditure.

a. If A = $10,000 and I = $25,000, what is the demand curve?


b. Given the demand curve in part a., what is equilibrium price and quantity?
c. If consumer incomes increase to $30,000, what will be the impact on equilibrium price and
quantity?

Answer:
a. QD = 19,500 - 100P
b. P = $122.50, Q =7,250
c. The new demand curve
is: QD = 22,000 - 100P
Thus the new equilibrium price is $135, and the new quantity is 8,500.

8. The market for milk is in equilibrium. Recent health reports indicate that calcium is absorbed better
in natural forms such as milk, and at the same time, the cost of milking equipment rises. Carefully
analyze the probable effects on the market.

Answer: The heath reports are likely to cause an increase in the demand for milk. Alone, this
would increase both the equilibrium price and quantity of milk. The increase in equipment
costs will cause a decrease in the supply of milk, and this alone would cause an increase in
equilibrium price and a decrease in equilibrium quantity. Taken together, both effects will lead
to an increase in price, and thus we can be certain that the equilibrium price will rise. The
effect on quantity is unclear as the supply and demand shifts move quantity in different
directions.
9. Industry supply and demand are given by: QD = 1000 - 2P and QS = 3P
a. What is the equilibrium price and quantity?
b. At a price of $100, will there be a shortage or a surplus, and how large will it be?
c. At a price of $300, will there be a shortage or a surplus, and how large will it be?

Answer:
a. P = $200, Q = 600.
b. At a price of $100, there will be a shortage. The quantity demanded will be 800, and the
quantity supplied will be 300, and thus there will be a shortage of 500 units.
c. At a price of $300, there will be a surplus. The quantity demanded will be 400, and the
quantity supplied will be 900, and thus there will be a surplus of 600 units.

10. A product's Demand Curve is: Qd = 50 - 2P, and its Supply Curve is: Qs = 40 + P.
a. When P = $10, what is the difference, if any, between Qd and Qs?
b. When P = $2, what is the difference, if any, between Qd and Qs?
c. What are the equilibrium values of P and Q?

Answer:

a. Qd = 30 and Qs = 50
b. Qd = 46 and Qs = 42

c. Q = 43.33 and P = $3.33

11. A product's Demand Curve is: Qd = 25 - P, and its Supply Curve is: Qs = 10 + 2P.
a. When P = $20, what is the difference, if any, between Qd and Qs?
b. When P = $3, what is the difference, if any, between Qd and Qs?
c. What are the equilibrium values of P and Q?

Answer:

a. Qd = 5 and Qs = 50
b. Qd = 22 and Qs = 16
c. Q = 20 and P = $5

12. List the major nonprice determinants of demand.


Answer: onsumer preferences (tastes), income, prices of related products (complements and
substitutes), future expectations, and number of buyers.

13. List the major nonprice determinants of supply.

Answer: nput costs, technology, prices of other products that can be sold by the firm
(complements and substitutes), future expectations, weather conditions, and number of
sellers.

Chapter 4 Demand Elasticity (Appendix 4A)

Multiple-Choice Questions

1. The sensitivity of the change in quantity demanded to a change in price is called

A. income elasticity. B) cross-elasticity.

C) price elasticity of demand. D) coefficient of elasticity.

Answer:

2. The sensitivity of the change in quantity consumed of one product to a change in the price of a
related product is called

A. cross-elasticity. B) substitute elasticity.

C) complementary elasticity. D) price elasticity of demand.

Answer:

3. The minimum wage is an example of a government imposed


A. price control.
B. price ceiling.
C. price floor.
D. Both A and B.

E. Both
A
and
C.
Answ
er:
4. A product that is similar to another, and can be consumed in place of it, is called

A. a normal good. B) an inferior good.

C) a complementary good. D) a substitute good.

Answer:

5. Two goods are if the quantity consumed of one increases when the price of the other
decreases.

A. normal B) superior

C) complementary D)

substitute Answer:

6. A tax that is imposed as a specific amount per unit of a product is a(n)

A. excise or specific tax. B) sales or ad valorem tax.

C) compound duty. D) income tax.

Answer:

7. The government unit that wants to achieve "revenue enhancement" will find it considerably more
favorable to enact an excise tax on products whose demand is

A. highly elastic. B) relatively elastic.

C) highly inelastic. D) unitary elastic.


Answer:

8. A product consumed in conjunction with another is called a(n)

A. inferior good. B) complementary good.

C) normal good. D) substitute good.

Answer:

9. Two products are if the quantity consumed of one increases when the price of the other
increases.

A. normal B) inferior

C) complementary D)

substitutes Answer:
10. When total revenue increases from $18,000 to $26,000 when quantity increases from eight to ten,
marginal revenue is equal to

A) $3,000. B) $4,000. C) $8,000. D)


$2,600.

Answer:

11. When total revenue reaches its peak (elasticity equals 1), marginal revenue reaches

A. 1.
B. zer
o.
C) -
1.
D) Cannot be determined from the information provided.

Answer:
12. The demand for items that go into the production of a final product is called

A. marginal demand. B) aggregate demand.

C) partial demand. D) derived demand.

Answer:

13. Remembering that demand elasticity is defined as the percentage change in quantity divided by the
percentage change in price, if price decreases and, in percentage terms, quantity rises more than price
has dropped, total revenue will

A. increase. B) decrease.

C) remain the same. D) either increase or decrease.

Answer:

14. When a one percent change in price results in a one percent change in quantity demanded in the
opposite direction, demand is

A. relatively inelastic. B) unitary elastic.

C) perfectly elastic. D) perfectly inelastic.

Answer:

15. The owner of a produce store found that when the price of a head of lettuce was raised from 50 cents
to $1, the quantity sold per hour fell from 18 to 8. The arc elasticity of demand for lettuce is

A) -0.56. B) -1.15. C) -0.8. D) -1.57.

Answer:

16. When purchases of tennis socks decline following an increase in the price of tennis sneakers (other
things remaining equal), the relationship between these two items can be described as

A. substitutable. B) complementary.
C) unique. D) ordinary.

Answer:

17. If the income elasticity coefficient equals 1, the proportion of a consumer's income spent on a given
product after a change in income will be _ the proportion of income spent
on that product prior to the income change.

A. greater than B) less than

C) equal to D) either greater than or equal

to Answer:
18. In general, if there are many good substitutes for a given product, the demand elasticity will be

A. high. B) low. C) indeterminate. D) zero.

Answer:

19. The derived demand curve for a product component will be more inelastic

A. the larger is the fraction of total cost going to this component.

B. the more inelastic is the demand curve for the final product.

C. the more elastic are the supply curves of cooperating factors.

D. the less essential is the component in question.

Answer:

20. As income rise and consumers feel "better off," they will shift consumption away from

goods toward goods more commensurate with their improved economic status.

A. inferior B) superior C) normal D) inelastic Answer:


21. If the consumption of sugar does not change at all following a price increase from 49 cents per
pound to 58 cents per pound, the demand for sugar is considered to be

A. relatively inelastic. B) perfectly elastic.

C) perfectly inelastic. D) unitary elastic.

Answer:

22. When the consumption of chicken (whose price has not changed) increases following an increase
in the price of beef, the two products can be considered to be

A. complements. B) substitutes. C) unrelated. D) correlated.

Answer:

23. If the income elasticity of a particular product is -0.2, it would be considered

A. a superior good. B) a normal good.

C) an inferior good. D) an elastic good.

Answer:

24. If a firm decreases the price of a product and total revenue decreases, then

A. the demand for this product is price elastic.

B. the demand for this product is price inelastic.

C. the cross elasticity is negative.

D. the income elasticity is less than 1.

Answer:
25. If the price of a product is increased and total revenue received from the sale of this product
increases, then the price elasticity of demand for the product is

A. elastic.

B. inelastic.

C. unitary.

D. None of the above.

Answer:

26. If there is an increase in consumer income and the demand for a product declines, then the
product is

A. a luxury good. B) a necessity good.

C) a normal good. D) an inferior good.

Answer:

27. If the price of Product A increases and this results in a decrease in the demand for Product B, then
Products A and B are

A. complements. B) substitutes. C) inferior. D) normal.

Answer:

BB. If the price of a product is decreased and total revenue received from the sale of this product does
not change, then the price elasticity of demand for the product is

A. elastic. B) inelastic. C) unitary. D) None of the above.

Answer:

29. If the demand for a product is price inelastic and the product price is increased, then the
marginal revenue (MR) received by the seller will
A. not change.

B. decrease.

C. increase.

D. Can't be determined from this information.

Answer:

30. If the price elasticity of supply of a product is elastic and the product price increases,
then the increase in the product supply should be

A. greater than the increase in price.


B. less than the increase in price.
C. the same as the increase in price.
D. Can't be determined from this information.

Answer:

31. Which of the following is not a determinant of price elasticity of demand?

A. product durability B) technology

C) ease of substitution D) proportion of total

expenditures Answer:
32. If government imposes a price ceiling on a product that is below the market equilibrium price,
then

A. a surplus will develop.

B. a shortage will develop.

C. producers will reduce their sales price.

D. consumers will reduce their demand for the product.


Answer:

33. If government imposes a price floor on a product that is above the market equilibrium price, then

A. a surplus will develop.

B. a shortage will develop.

C. producers will increase their sales price.

D. consumers will increase their demand for the product.

Answer:

34. If government imposes an excise tax on a product and the tax burden is borne equally by buyers
and sellers, then

A. price elasticity of demand is unitary.

B. price elasticity of supply is unitary.

C. the absolute values of price elasticities of demand and supply are equal.

D. None of the above.

Answer:

Analytical Questions
1. The initial price of a cup of coffee is $1, and at that price, 400 cups are demanded. If the price falls to
$0.90, the quantity demanded will increase to 500.

a. Calculate the (arc) price elasticity of demand for coffee.


b. Based on your answer, is the demand for coffee elastic or inelastic?
c. Based on your answer to a., if the price of coffee is increased by 10%, what will happen to the
revenues from coffee? Carefully explain how you know.

Answer:

a. Arc elasticity = -2.11


b. Elastic
c. Revenues will fall. Demand is elastic, and thus a 1% increase in price will lead to a greater
percentage decrease in quantity demanded. Revenues fall because the price increase does not
make up for the reduction in sales.

2. The demand curve is: QD = 500 - 1/2 P.

a. Calculate the (point) price elasticity of demand when price is $100. Is demand elastic or
inelastic?
b. Calculate the (point) price elasticity of demand when price is $700. Is demand elastic or
inelastic?
c. Find the point at which point elasticity is equal to -1.

Answer:

a. Elasticity = -1/2 (100/450) = -0.11, and is inelastic.


b. Elasticity = -1/2(700/150) = -2.5, and is elastic.
c. Elasticity is -1 at the midpoint of the demand curve, which is at a price of $500 and a
quantity of 250.

3. Suppose that the price elasticity of demand for wheat is known to be -0.75. Will a good wheat crop
(which increases the supply of wheat) be likely to increase or decrease the revenues of farmers?
Carefully explain.

Answer: good wheat crop that increases the supply of wheat will cause the equilibrium price

wheat to decrease (and quantity to increase). Since demand is inelastic, total revenues will fall,
as the percentage change in quantity will be less than the percentage change in price.

4. The income elasticity for most staple foods, such as wheat, is known to be between zero and one.

a. As incomes rise over time, what will happen to the demand for wheat?
b. What will happen to the quantity of wheat purchased by consumers?
c. What will happen to the percentage of their budgets that consumers spend on wheat?
d. All other things equal, are farmers likely to be relatively better off or relatively worse off in
periods of rising incomes?

Answer:
a. Demand will increase, since wheat has a positive income elasticity.
b. The quantity of wheat purchased will increase.
c. The percentage of consumer budgets spent on wheat and other staple goods will fall, since the
percentage change in the demand for wheat will be less than the percentage change in income.
d. Farmers are likely to be relatively worse off, since the demand for what they are selling will be rising
less rapidly than the demand for other goods that they are likely to purchase.

5. The demand for salt is relatively price inelastic, while the demand for pretzels is relatively price
elastic. How can you best explain why?

Answer: Salt has few substitutes, and takes up a small percentage of the consumer's budget,
and thus demand is likely to be inelastic. While pretzels are also a small part of the budget,
there are many substitutes available.

6. Unions have generally bee far more successful in organizing and raising wages in skilled trades such
as carpentry than in unskilled trades. Use the laws of derived demand to explain why.

Answer: There are at least two reasons. One is that the elasticity of substitution between
skilled workers and other factors of production is low; thus firms cannot substitute some other
factor of production if wages rise. Secondly, skilled labor is likely to be a relatively small
percentage of total costs, and thus raising wages does not cause a large increase in total costs
(which would lead to a reduction in supply, an increase in price, and a decrease in output).
Unskilled labor has more substitutes and is likely to be a larger share of costs for firms that
employ it, and thus if unions raise wages, firms employ other factors of production, and many
workers will be laid off.

7. Governments impose excise taxes on goods that have inelastic demand, such as cigarettes, more
often than in other cases. Why?

Answer: mposing an excise tax reduces the supply of the good, reducing equilibrium
quantity and raising the price. If demand is elastic, taxes will tend to reduce quantity by a
significant amount, and thus government tax revenues will be relatively small. However, if
demand is inelastic, the reduction in quantity will be small, and government tax revenues
will be higher. (Governments may also impose taxes to deter consumption, but this is likely
to be ineffective if elasticity is low.)

8. Demand and supply in the wheat market are given by:


QD = 2000 - 1000 P and QS = -500 + 1000 P,
where Q is millions of bushels and P is price per bushel.

a. Find the equilibrium price and quantity.


b. Suppose that the government wishes to support farm income and thus sets a price floor of

$1.50/bushel. Find the size of the farm surplus.


c. What is the cost of this program to the government?

Answer:
a. P = $1.25, Q = 750
b. If P = $1.50, QD = 500 and QS = 1000. The surplus is 500 (million)
bushels. c. $1.50□500 = $750 million.

9. Demand is given by: QD = 6000 - 50P, Domestic supply is: QS = 25P, and Foreign producers can
supply any quantity at a price of $40.
a. If foreign producers can sell in the domestic market, what is the equilibrium price? What is the
equilibrium quantity? How much is sold by domestic and foreign producers, respectively?
b. Under domestic government pressure, foreign producers voluntarily agree to restrict their goods.
What will happen to the price and quantity? What will happen to the amount that domestic
producers supply? What will happen to revenues of domestic and foreign producers?

Answer:
a. P = $40. Q = 4,0000. Of that, domestic producers supply 1,000 units, and foreign producers
supply 3,000 units.
b. The quantity restriction will cause equilibrium price to rise and quantity to decrease. Domestic
producers will sell more, and foreign producers will sell less. Revenues of domestic producers will
rise. The effect on the revenues of foreign producers is unclear; if demand is inelastic, they may rise.

10. You are told that the price elasticity of demand for widgets is -0.75, the income elasticity of
widgets is 2, and the cross-price elasticity of widgets and gadgets is 4. Carefully explain what
information you can gather from each of these figures.

Answer: mand for this good is inelastic with respect to price. This is a normal good as income
elasticity is greater than zero, and it is a luxury/superior good as income elasticity is greater
than one. Widgets and gadgets are substitutes, and they are good substitutes because cross-
price elasticity is elastic (large).

11. If a product's demand function is: Q = 30 - 3P, then calculate the price elasticity of demand when

a. product price is $3 using the point elasticity formula


b. product price is $4 using the point elasticity formula
c. product price decreases from $4 to $3, using the arc elasticity formula

d. product price is $5, using the point elasticity formula


e. product price increases from $4 to $5, using the arc elasticity formula
Answer: (a) -0.429 (b) -0.667 (c) -0.538 (d) -1.000 (e) -0.818
12. If a price of corn is $3.00 a bushel, 5,000 bushels would be demanded. If the price rises to
$4.00
a bushel, 4,000 bushels would be demanded.
a. What is the (arc) price elasticity of demand?
b. Based on this answer if the price of corn rose to $5.00 a bushel, what would be the demand for corn?
c. If the price of corn decreased from $4.00 to $3.00 a bushel, what would be the change in total
revenue for sellers of corn?
d. If the price of corn increased from $4.00 to $5.00 a bushel, what would be the change in total
revenue for sellers of corn?

Answer: (a) -0.778 (b) 3,309 (c) -$1,000 (d) +$545

13. Domestic demand for a product is: Qd = 3000 - 25P, the domestic supply of the product is: Qs =
20P, and foreign producers can supply any quantity at a price (P) of $30.

a. What is the domestic equilibrium price and quantity?


b. At this domestic equilibrium price, how much of the product will be supplied by domestic
producers and how much by foreign producers?

Answer:
a. P = $30 and Q = 2250
b. Domestic producers supply 600 units and foreign producers supply 1650 units.

Chapter 5 Demand Estimation and Forecasting

Multiple-Choice Questions

1. If a regression coefficient passes the t-test, it means that

A. the regression equation is valid.

B. the regression coefficient is significantly different from zero.

C. the regression coefficient can be used for forecasting.

D. the regression coefficient should be included in the regression equation.

Answer:

2. Which of the following is a test of the statistical significance of the entire regression equation?
A. t-test B) R2 C) F-test D) Durbin-Watson test Answer:
3. Which of the following is a test of the statistical significance of a particular regression
coefficient?

A. t-test B) R2 C) F-test D) Durbin-Watson test Answer:


4. Which of the following is a measure of the explanatory power of the regression model?

A. t-test B) R2 C) F-test D) Durbin-Watson test Answer:


5. When a regression coefficient is significant at the .05 level, it means that

A. there is only a five percent chance that there will be an error in a forecast.
B. there is 95 percent chance that the regression coefficient is the true population coefficient.
C. there is a five percent chance or less that the estimated coefficient is zero.
D. there is a five percent chance or less that the regression coefficient is not the true
population coefficient.

Answer:

Answer the following question(s) based on the following regression equation. (Standard
errors in parentheses,n = 150.):
QD = 1000 - 50PA + 10PB + .05I, (20) (7) (.04)
where QD = quantity demanded of product A, PA = price of product A, PB = price of
a competing product B and I = per capita income.

6. Using the "rule of 2," which of the following variables can be deemed statistically significant?

A. PA

B. PB

C. I

D. All of the above.

E. None of the above.

Answer:
7. For which of the following variables should a "two tail" t-test be applied?

A. P B) I C) PC D) Should be applied for all.

Answer:

8. Which of the following refers to a relatively high correlation among the independent variables of a
regression equation?

A. autocorrelation
B. the identity problem
C. statistically insignificant regression coefficients
D. multicollinearity
Answer:
9. When the R2 of a regression equation is very high, it indicates that

A. all the coefficients are statistically significant.


B. the intercept term has no economic meaning.
C. a high proportion of the variation in the independent variable can be accounted for by the variation
in the independent variables.
D. there is a good chance of serial correlation and so the equation must be discarded.

Answer:

10. The coefficient of a linear regression equation indicates

A. the change in the dependent variable relative to a unit change in the independent variable.
B. the change in the independent variable relative to a unit change in the dependent

variable.
C. the percentage change in the dependent variable relative to a unit change in the
independent variable.
D. the percentage change in the independent variable relative to a unit change in the dependent
variable.

Answer:
11. For the regression equation Q = 100 - 10X1 + 25X2, which of the following statements is true?

A. X2 is the more important variable because it is positive.

B. When X1 decreases by one unit, Q decreases by 10 units.

C. When X1 increases by 10 units, Q decreases by 1 unit.

D. When X1 increases by one unit, Q decreases by 10 units.

Answer:

12. When using regression analysis for forecasting, the confidence interval indicates

A. the degree of confidence that one has in the equation's R2.


B. the range in which the value of the dependent variable is expected to lie with a given degree of
probability.
C. the degree of confidence that one has in the regression coefficients.
D. the range in which the actual outcome of a forecast is going to lie.

Answer:

13. Which of the following indicators will always improve when more variables are added to a
regression equation?

A. the magnitudes of the coefficients B) the t-test

C) R2 D) the standard errors of the coefficients

Answer:
14. The use of a dummy variable in regression analysis

A. indicates that a researcher does not really know what to include in the equation.
B. indicates that a variable is expected to either have or not have an impact on a dependent variable.
C. indicates that insufficient data is available for the analysis.
D. indicates the use of hypothetical data.
Answer:

15. In using regression analysis to estimate demand, which of the following problems is most directly
a result of insufficient data?

A. the identification problem B) the problem of a low R2

C) the problem of high standard errors D) the problem of insignificant F-

statistics Answer:
16. Regression analysis can best be described as

A. a statistical technique for estimating the best relationship between one variable and a set of other
selected variables.
B. a statistical technique for determining the true values of variables.
C. a statistical technique for creating functional relationships among variables.
D. None of the above.

Answer:

17. R2 is a statistical measure which

A. determines how important one variable is in explaining the value of another variable.
B. tests the true value of a variable.
C. determines how well an equation can estimate the relationship between one variable and a set of
other variables.
D. All of the above.

Answer:

18. The t-test is a statistical measure which

A. tests the true value of a variable.

B. tests the statistical significance of a regression coefficient.


C. tests the statistical significance of a regression equation.

D. None of the above.

Answer:

19. The problem of autocorrelation refers to


A. independent variables in a regression equation whose values are closely related to each
other.
B. insufficient data to estimate egression coefficient values.
C. regression coefficient values which are not significantly different from zero.
D. regression equation variables which exhibit a similar pattern in their values over a
number of time periods.

Answer:

20. A one-tail test of significance would be used to determine whether

A. demand for a product is price elastic.

B. two products are substitutes for each other in supply.

C. two products are unrelated to each other in demand.

D. supply of a product is price inelastic.

Answer:

21. The F-test is used to determine if

A. a regression coefficient is significant.


B. multicollinearity exists.
C. a regression equation significantly accounts for the variation in the value of a dependent variable.
D. an identification problem is present.

Answer:
22. In the estimation of demand, the "identification problem" refers to

A. the problem of selecting the proper level of significance.


B. the problem of deciding whether to use time series or cross sectional data.
C. the problem of separating out the effects of price on the quantity demanded when supply cannot be
not held constant.
D. the problem of having insufficient variation in prices.

Answer:

23. The t-statistic is computed by

A. dividing the regression coefficient by the standard error of the estimate.

B. dividing the regression coefficient by the standard error of the coefficient.

C. dividing the standard error of the coefficient by the regression coefficient.

D. dividing the R2 by the F-statistic.

Answer:

24. Which of the following is most likely to indicate a statistically significant regression
coefficient?

A) t > R2 B) R2 > .90 C) t >2 D) > 4

Answer:

Answer the following question(s) on the basis of the following regression equation.
(Standard errors in parentheses, n = 200):
Q = -500 - 100PA + 50PB + .3I + .2A; R2 =.12, (250) (50) (30) (.1) (.08)
where QD = 10,500, quantity demanded of product A, PA = $10, price of product A.
PB = $8, price of product B, I = $12,000, per capita income, and A = $20,000,
monthly advertising expenditures.
25. Which of the variables does not pass the t-test at the .05 level of significance?

A. PA

B. PB

C. A

D. I

E. All the variables pass the t-test.

Answer:

26. As a researcher, which aspect of the results would be of greatest concern?

A. the negative value of the constant (i.e., -500)


B. the relatively low impact of the competitor's price
C. the fact that not all of the variables are statistically significant
D. the poor fit of the regression line
Answer:
27. As the manager of Product A, which of the following would be of greatest concern (based on the
regression results above)?

A. None of the factors below would be of concern.


B. an impending recession
C. pressure on you by your salespersons to lower the price so that they can boost their sales
D. a price reduction by the makers of product B
Answer:
28. Which of the following cannot be determined on the basis of the above regression results?

A. the degree of price elasticity of product B

B. whether or not product A is "normal"

C. the degree of competition between A and B

D. All of the above can be determined.


Answer:

29. Which indicator shows how well a regression line fits through the scatter of data points?

A. F-test B) R2

C) t-test D) Durbin-Watson test

Answer:

30. A dummy variable is also called

A. an approximate variable. B) a discrete variable.

C) a zero-sum variable. D) an improper variable.

Answer:

31. A manager will have the least confidence in an explanatory variable that

A. does not pass the F-test. B) is expressed as a dummy variable.

C) does not pass the t-test. D) constitutes only a small part of R2.

Answer:

32. From a management policy perspective, which regression result is the most useful?

A. a regression equation that passes the F-test


B. a regression equation whose explanatory variables all pass the t-test
C. a regression equation that has the highest R2
D. a regression equation that has the least number of dummy variables
Answer:
33. The fact that a person with a forceful and persuasive personality but not necessarily the greatest
amount of knowledge and judgment can exercise a disproportionate amount of influence is a major
drawback of

A. the Delphi method of forecasting. B) the market research method.

C) opinion polling. D) the jury of executive opinion


approach.

Answer:

34. The forecasting technique, which predicts technological trends and is carried out by a
sequential series of written questions and answers is

A. the Delphi method. B) the market research method.

C) opinion polling. D) the jury of executive opinion


approach.

Answer:

35. Average weekly claims for unemployment insurance, money supply and the index of stock prices are
all examples of

A. leading indicators. B) coincident indicators.

C) lagging indicators. D) None of the above.

Answer:

36. One of the series included among the lagging indicators is

A. the change in sensitive material prices.

B. the index of industrial production.

C. employees on non-agricultural payrolls.

D. average duration of unemployment.


Answer:

37. The following is not one of the leading indicators:

A. index of consumer expectations, U. of Michigan.

B. change in consumer price index for services.

C. vendor performance, slower deliveries diffusion index.

D. manufacturers' new orders, nondefense capital goods.

Answer:

38. Which of the following is a leading economic indicator?

A. average hours, manufacturing B) money supply M2

C) stock prices, 500 common stocks D) All of the above.

Answer:

39. The method of forecasting with leading indicators can be criticized

A. for occasionally forecasting a recession when none ensues.


B. for forecasting the direction of the economy but not the size of the change in economic activity.
C. for frequent revisions of data after original publication.
D. All of the above.

Answer:

40. A general rule of thumb is that if, after a period of increases, the leading indicatorindex
sustains consecutive declines, a recession (or at least a slowing of the economy) will follow.
A. three B) four C) five D) six
Answer:
41. The forecasting technique which involves the use of the least squares statistical method to
examine trends, and takes into account seasonal and cyclical fluctuations, is known as

A. compound growth rate projection. B) the Delphi method.

C) time series projection. D) exponential smoothing projection.

Answer:

42. Quantitative forecasting that projects past data without explaining the reasons for future trends
is called

A. scientific forecasting. B) dumb forecasting.

C) empirical forecasting. D) naïve forecasting.

Answer:

43. The following is not a drawback of forecasting using the compound growth rate method:

A. only considers first and last observations.

B. considers only equal absolute changes.

C. disregards fluctuations between the original and terminal observations.

D. does not consider any trends in the data.

Answer:

44. Charting observations on a semi-logarithmic graph will help the analyst to ascertain whether

A. absolute changes from period to period are constant.


B. whether percentage changes from period to period are constant.
C. whether percentage changes from period to period are declining.
D. Both B and C.
Answer:

45. A major problem in projecting with a trend line is that

A. only straight-line projections can be accommodated.

B. it is valid only if the trend is upward.

C. it will not forecast turning points in activity.

D. it is a very complex method of forecasting.

Answer:

46. The following is the exponential trend equation to forecast sales (S):

A. S = a + b(t) B) S = a + bt

C) S = a + b(t) + c(t)2 D) None of the above.

Answer:

47. Among the advantages of the technique of forecasting are ease of calculation,
relatively little requirement for analytical skills, and the ability to provide the analyst with
information regarding the statistical significance of results and the size of statistical errors.

A. least-squares trend analysis B) compound growth rate

C) visual trend-fitting D) expert

opinion Answer:
48. Among the advantages of the least-squares trend analysis techniques is

A. the ease of calculation.

B. relatively little analytical skill required.


C. its ability to provide information regarding the statistical significance of the results.

D. All of the above.

Answer:

49. The forecasting method that involves using an average of past observations to predict the future (if
the forecaster feels that the future is a reflection of some average of past results) is the

A. moving average method.


B. econometric forecasting method.
C. exponential smoothing method.
D. Both A and B.

E. Both A
and C.
Answer
:

50. An explanatory forecasting technique in which the analyst must select independent variables that
help determine the dependent variable is called

A. exponential smoothing. B) regression analysis.

C) trend analysis. D) moving average method.

Answer:

51. When the more recent observations are more relevant to the estimate of the next period than
previous observations, the naive forecasting method to employ is

A. exponential smoothing. B) compound growth rate.

C) trend analysis. D) moving averages.

Answer:

52. Which of the following is a Leading Economic Indicator?


A. commercial and industrial loans outstanding

B. industrial production

C. average weekly duration of unemployment

D. None of the above.

Answer:

53. Which of the following is a Lagging Economic Indicator?

A. change in average labor costs in manufacturing

B. M2 measure of the money supply

C. industrial production

D. None of the above.

Answer:

54. The Delphi method is a

A. smoothing technique in forecasting.

B. consensual forecast based on expert opinions.

C. compound growth approach to forecasting.

D. naïve forecasting approach.

Answer:

55. The F-test is used in forecasting to


A. establish confidence intervals for testing regression coefficients.

B. examine the degree of multicollinearity among independent variables.

C. determine how well a regression equation can account for dependent variable values.

D. determine whether an identification problem exists.

Answer:

56. The Trend Projection approach to forecasting is represented by

A. time-series regressions. B) exponential smoothing.

C) opinion polls. D) All of the above.

Answer:

Analytical Questions
The following questions refer to this regression equation. (Standard errors in parentheses.)
QD = 15,000 - 10 P + 1500 A + 4 PX + 2 I, (5,234) (2.29) (525) (1.75) (1.5)
R2 = 0.65
N = 120
F = 35.25
Standard error of Y estimate =
565 Q = Quantity demanded
P = Price = 7,000
A = Advertising expense, in thousands =
54 PX = price of competitor's product =
8,000 I = average monthly income =
4,000

1. Calculate the elasticity for each variable and briefly comment on what information this gives you in
each case.

Answer: ased on the figures above, QD = 24,850


Price elasticity = -10(7,000/66,000) = -1.06. Demand is elastic (at this point).
Advertising elasticity = 1500(54/66,000) = 1.23. The product is elastic with respect to
advertising; a 1% increase in advertising expense will lead to a greater than 1% increase in
sales. Cross elasticity = 4(8000/66,000) = 0.48. Cross-elasticity is positive, implying that the
products are substitutes, but it is less than one, suggesting that they are not particularly good
substitutes and the competitor's price has little impact on the firm's sales.
Income elasticity = 2(4000/66,000) = 0.12. The product is income inelastic; thus it is a
normal good (necessity), and is not particularly responsive to income fluctuations.

2. Calculate t-statistics for each variable and explain what this tells you.

Answer: Price: 10/2.29 = 4.37


Advertising: 1500/525 = 2.86
Competitor's price: 4/1.75 =
2.29 Income: 2/1.5 = 1.33
All variables are statistically significant with the exception of income. Thus we can conclude
that the other variables do have an impact on the quantity demanded of this product.

3. How is the R2 value calculated, and what information does this give you?

Answer: R2 = RSS/TSS = 1 - (ESS/TSS), where TSS = sum of squared deviations of the


sample values of Y from their mean, RSS = sum of squared deviations of the estimated values
from their mean, and ESS = sum of the squared deviations of the sample values from their
estimated values. The R2 value tells you what percentage of the variation in the dependent
variable is explained by variation in the independent variables, or the "goodness of fit" of the
equation. In this case, 65% of the variation in quantity demanded is explained by variation in
the independent variables.

4. How would you evaluate the quality of this equation overall? Do you have any concerns?
Explain.

Answer: The overall equation is significant, as shown by the F-test. The R2 value is
reasonably high. One variable is not significant (might be desirable to re-estimate the
equation without it, although the inclusion of irrelevant variables does not affect the
properties of the OLS model). The sample size is sufficiently large. There are no significant
concerns. {Other answers are possible.}

5. When would you use a one-tailed rather than a two-tailed t-test when checking significance
levels?

Answer: You would use a one-tailed test when the sign of the variable is important. That
is, if you only want to know if the independent variable has a statistically significant effect
on the dependent variable, a two-tailed test should be used. If direction of effect is
important, then a one-tailed test should be used.

6. Should this firm be concerned if macroeconomic forecasters predict a recession? Explain.

Answer: ased income elasticity from this equation (0.12), no. The good is income inelastic, so
a recession should not cause a significant decrease in sales. Note also that income is not
statistically significant in this equation, making it even less of a concern.

7. The firm is considering changing its price to $9,000. Predict the quantity demanded at that price,
all other things equal, and develop a 95% confidence interval for your estimate.

Answer: t a price of $9,000, the point estimate of quantity demanded would be 46,000. With a
sample size of 120, the t-value is approximately 1.984. The standard error of the Y(Q) estimate
is
565. Thus we can predict with 95% confidence that quantity demanded will be between
44,879 and 47,120.

8. What is multicollinearity? In general, how would you know if you had a problem with
multicollinearity, and how could you correct it?

Answer: Multicollinearity occurs when the independent variables are correlated. One
indication of multicollinearity is that the equation will pass the F-test, but individual variables
will not have significant t values. Multicollinearity can sometimes be corrected by omitting
some of the correlated variables or by choosing proxy variable.

9. How could a manager use the information contained in this regression equation?

Answer: Many answers are possible. A manager might note that demand is elastic, and thus
that sales might respond to a price decrease. Likewise, sales should respond to increases in
advertising. Sales are less likely to be impacted by income changes or by changes in the price
of the competitor's product. The equation could be used to forecast expected sales based on
changes in one or more of the variables. The equation could be used to help in coordinating
production plans or with other parts of the firm.

10. Why is the identification problem more likely with time-series estimates of demand?
Answer: dentification problems occur when it is possible that both demand and supply are
shifting. Thus a series of observations is not identifying points along a single demand curve; it
is identifying a series of equilibrium points that may or may not be along a single curve. This
is most likely to be a problem in time series estimation of demand curves, simply because over
any reasonably long time period it is quite likely that both supply and demand will change
somewhat.

11) Qd = 5,000 - 15P + 50A + 3Px - 4I, (2, 117) (2.7) (15) (2) (3)

where Qd = Quantity Demanded, P = Product Price, A = Advertising Expenditures, Px =


Price of a Competitive Product, A = Advertising Expenditures, I = Average Monthly
Income, and the Standard Errors of the Regression Coefficients are shown in Parentheses.

Calculate the t-statistics for each variable and explain what inferences can be drawn
from them. If R2 of this equation is 0.25, what inference can be drawn from it.

Answer: P = 15/2.7 = 5.55, and Product Price is a very significant determinant of demand for
the product.
A = 50/15 = 3.33, and Advertising Expenditures also are a significant determinant of
demand. Px = 3/2 = 1.50, and Price of a Competitive Product is not a significant determinant
of demand. I = 4/3 = 1.33, and Average Monthly Income also is not a significant determinant
of demand.
R2 = 0.25 indicates that these variables collectively are not major determinants of demand.

12. What are the Key Steps for analyzing Demand functions based on Regression results?

Answer: eck signs and magnitudes; compute elasticity coefficients; determine statistical
significance.

13. Explain the difference between Cross-Section and Time-Series Regression Analysis.

Answer: ross-section analysis examines the relationships between given values of a


dependent variable and one or more independent variables at one moment in time (for one
time period only).

14. The demand equation for the Widget Company has been estimated to be:

QD = 20,000 + 10 I - 50P + 20
PC
where Q = monthly number of widgets sold, I = average monthly income, P = price of
widgets, and PC = average price of competing products.

a. If next month's income is forecast to be 2,000, the price of competing products is forecast to be

$20, and the price of widgets will be set at $30, forecast sales.

b. What will sales be if the price is dropped to $20?

Answer:

a. The forecast for sales is 38,900.


b. The forecast for sales will be 39,400.

15. The Gadget Company believes that sales are growing according to a linear trend.

Q = 50,000 + 200t
where t is time, and t=0 in 1990.

a. Forecast sales for 2003.


b. Do you see any problems with this forecasting method?

Answe
r: .
52,600
b. The equation was apparently estimated in 1990. The farther away from the
original year, the less likely the equation is to be correct, as there are many factors
that may disturb the trend.

16. If $1,000 is placed in an account earning 8% annually on January 1, 1999, how much would be in
this account on January 1, 2013?

Answer: $2,937

17. You are given the following straight-line trend equation: Sales = 1,275 + 89.3t, where 1990
represents t = 1. Project sales for 2000.

Answer: 2,257.3
18. The following are the sales achieved by Jensen Fabrics during the last 7 years:
1993 $116,000
1994 124,000
1995 127,000
1996 146,000
1997 155,000
1998 154,000
1999 162,000

Using the compound growth rate calculation, what would be your estimate for sales in 2000?

Answer: $171,200 (growth rate is 5.7%)


19. The following are the actual sales for the last six periods:
Period Sales
1 750
2 820
3 600
4 850
5 900
6 700

Using a 3-month moving average, what would be your prediction for period 7?

Answer: 817
20. The following are the actual sales for the last six periods:
Period Sales
1 750
2 820
3 600
4 850
5 900
6 700
If the exponential smoothing forecasting method is used, and the smoothing factor is .6, what
will be the forecast for period 7?
Answer: 761

21. What are the prerequisites of a good forecast?

Answer: forecast must be consistent with all aspects (parts) of a business. A forecast should be
based on knowledge of the relevant past, unless underlying conditions change or there is no past
to consider. A forecast must consider the economic and political environment in which
businesses operate. A forecast must provide information in a timely manner.

22. What are the four different characteristics that data exhibit when undertaking time-series
forecasts?

Answer: Trend; Cyclical Fluctuations; Seasonal Variation; Irregular Movements

23. Explain the difference between the Moving Average and Exponential Smoothing approaches to
forecasting.

Answer: The Moving Average approach assigns equal weights to each time period from
which data are obtained, and drops the oldest time period when a new time period is added
in calculating the average value.
The Exponential Smoothing approach assigns different weights to each time period
from which data are drawn, with the smallest weight given the oldest time period and the
greatest weight to the most recent period (all the weights are fractional, usually employing a
geometric progression, and must add up to one).

24. What are the four different characteristics that data exhibit when undertaking time-series
forecasts?

Answer: Trend; Cyclical Fluctuations; Seasonal Variation; Irregular Movements

25. Explain the difference between the Moving Average and Exponential Smoothing approaches to
forecasting.

Answer: The Moving Average approach assigns equal weights to each time period from
which data are obtained, and drops the oldest time period when a new time period is added
in calculating the average value.
The Exponential Smoothing approach assigns different weights to each time
period
from which data are drawn, with the smallest weight given the oldest time period and the
greatest weight to the most recent period (all the weights are fractional, usually employing a
geometric progression, and must add up to one).

Chapter 6 The Theory and


Estimation of Production (Appendices
6A and 6B)

Multiple-Choice Questions

1. The difference between the short-run and the long-run production function is

A. three months or one business quarter.

B. the time it takes for firms to change all production inputs.

C. the time it takes for firms to change only their variable inputs.

D. More information is required to answer this question.

Answer:

2. A firm using two inputs, X and Y, is using them in the most efficient manner when

A. MPX = MPY. B) PX = PY and MPX = MPY.

C) MPX/PY = MPY/PX. D) MPX/MPY = PX/PY.

Answer:
3. Which of the following is not true about the law of diminishing returns?
A. It is a short-run phenomenon.
B. It refers to diminishing marginal product.
C. It will have an impact on the firm's marginal cost.
D. It divides Stage I and II of the production process.
E. All of the above are true.

Answer:

4. Which of the following indicates when Stage II ends and Stage III begins in the short□run
production function?

A. when AP = 0 B) when MP = 0

C) when MP = AP D) when MP starts to diminish

Answer:

5. Which of the following indicate when Stage I ends and Stage II begins in the short□run
production?

A. when AP = 0 B) when MP = 0

C) when MP = AP D) when MP starts to diminish

Answer:
6. Which of the following statements about the short-run production function is true?

A. MP always equals AP at the maximum point of MP.

B. MP always equals zero when TP is at its maximum point.

C. TP starts to decline at the point of diminishing returns.

D. When MP diminishes, AP is at its minimum point.

E. None of the above is true.

Answer:
7. Assume a firm employs 10 workers and pays each $15 per hour. Further assume that the MP of the
10th worker is 5 units of output and that the price of the output is $4. According to economic theory,
in the short run,

A. the firm should hire additional workers.

B. the firm should reduce the number of workers employed.

C. the firm should continue to employ 10 workers.

D. More information is required to answer this question.

Answer:

8. Which of the following is the best example of two inputs that would exhibit a constant
marginal rate of technical substitution?

A. trucks and truck drivers


B. natural gas and oil
C. personal computers and clerical workers
D. company employed computer programmers and temporary supplemental computer
Programmers

Answer:

9. Decreasing returns to scale

A. indicates that an increase in all inputs by some proportion will result in a decrease in output.
B. must always occur at some point in the production process.
C. is directly related to the law of diminishing returns.
D. All of the above are true.

E. None of the above is true.

Answer:

10. A firm that operates in Stage III of the short□run production function

A. has too much fixed capacity relative to its variable inputs.


B. has too little fixed capacity relative to its variable inputs.

C. has greatly overestimated the demand for its output.

D. should try to increase the amount of variable input used.

Answer:

11. Which of the following combination of inputs is most closely reflective of decreasing marginal
rate of technical substitution (MRTS)?

A. oil and natural gas B) sugar and high fructose corn syrup

C) computers and clerks D) keyboards and computers

Answer:
12. In the short run, finding the optimal amount of variable input involves which relationship?

A. MP = MC B) AP = MP C) MP = 0 D) MRP = MFC Answer:


13. The perfect substitution of two inputs implies that

A. two inputs can be substituted at a ratio of 1 to 1.

B. one input can be substituted for another up to some point.

C. two inputs can be substituted at some constant ratio.

D. one input can be substituted for another.

Answer:

14. If a firm finds itself operating in Stage I, it implies that

A. variable inputs are extremely expensive.

B. it overinvested in fixed capacity.

C. it underinvested in fixed capacity.

D. fixed inputs are extremely expensive.


Answer:

15. If MRP > MLC, it means that a firm should

A. use less labor. B) use more labor.

C) increase its fixed capacity. D) decrease its fixed capacity.

Answer:

16. In the long run, a firm is said to be experiencing decreasing returns to scale if a 10 percent increase
in inputs results in

A. an increase in output from 100 to 110. B) a decrease in output from 100 to 90.

C) an increase in output from 100 to 105. D) a decrease in output from 100 to 85.

Answer:

17. When is it not in the best interest of a company to hire additional workers in the short run?

A. when the average product of labor is decreasing


B. when the firm is in Stage II of the production process
C. when the marginal revenue product equals zero
D. when the wage rate is equal to or greater than labor's marginal revenue product Answer:
18. When the law of diminishing returns takes effect

A. firms must add increasingly more input if they are to maintain the same extra amount of output.
B. firms must add decreasingly more input if they are to maintain the same extra amount of output.
C. more input must be added in order to increase its output.
D. a firm must always try to add the same amount of input to the production process.

Answer:

S. An isoquant indicates
A. different combinations of two inputs that can be purchased for the same amount of
money.
B. different combinations of two inputs that can produce the same amount of output.
C. different combinations of output that can be produced with the same amount of input.

D. different combinations of output that cost the same amount to produce.

Answer:

20. If a firm used a combination of inputs that was to the left of its isocost line, it would indicate that

A. it is exceeding its budget.

B. it is not spending all of its budget.

C. it is operating at its optimal point because it is saving money.

D. None of the above.

Answer:

21. In economic theory, if an additional worker adds less to the total output than previous
workers hired, it is because

A. there may be less that this person can do, given the fixed capacity of the firm.

B. he/she is less skilled than the previously hired workers.

C. everyone is getting in each other's way.

D. the firm is experiencing diminishing returns to scale.

Answer:

22. In a call center, which of the following could be considered to be a variable input in the short run?

A. the level of computer-telephony software being utilized


B. the number of call center representatives on duty at the center
C. the number of call center managers or supervisors
D. the size (e.g., square footage) of the call center
Answer:
23. A major advantage of the production function is that it can be easily transformed into a
linear function, and thus can be analyzed with the linear regression method.

A. cubic B) power C) quadratic D) None of the above.

Answer:

24. functions are very useful in an analyzing production functions, which exhibit both
increasing and decreasing marginal products.

A. Cobb-Douglas B) Straight-line

C) Quadratic D) Cubic

Answer:

25. The following Cobb-Douglas production function, Q = 1.8L0.74K0.36, exhibits

A. increasing returns. B) constant returns.

C) decreasing returns. D) Both A and

B. Answer:
26. The following is not one of the strengths of the Cobb-Douglas production function:

A. Both marginal product and returns to scale can be estimated from it.
B. It can be converted into a linear function for ease of calculation.
C. It shows a production function passing through increasing returns to constant returns and then
to decreasing returns.
D. The sum of the exponents indicates whether returns to scale are increasing, constant or
decreasing.

Answer:

27. An advantage of using the cross-sectional regression method in estimating production is that
A. the problem of technological change over time is overcome.

B. there is no need to adjust data, which are in monetary terms for geographical differences.

C. we can assume that all plants operate at their most efficient input combinations.

D. All of the above.

Answer:

28. When the exponents of a Cobb-Douglas production function sum to more than 1, the
function exhibits

A. constant returns. B) increasing returns.

C) decreasing returns. D) either increasing or decreasing returns.

Answer:

29. A Production Function represents

A. the method used to convert inputs into outputs.


B. the amounts of output that can be created by various amounts of inputs.
C. the optimum mix of inputs to maximize output.
D. All of the above.

Answer:

30. Stage III of the short-run Production Function is

A. the most efficient mix of inputs.


B. the least costly level of output.
C. where additional units of inputs will lead to less output.
D. where additional units of inputs will lead to more output.
Answer:

31. The "Law of Diminishing Returns" states that

A. additional inputs will reduce output.

B. additional inputs will decrease average productivity.

C. the supply of inputs is becoming scarce.

D. additional inputs will lead to less additional output.

Answer:

32. Increasing Returns to Scale results when

A. in the long-run, an increase in inputs will lead to an increase in the average products of inputs.
B. in the long run, an increase in inputs will lead to an equivalent increase in output.
C. labor becomes more skilled.
D. All of the above.

Answer:

33. Output (Total Product) is maximized when

A. input average productivity is at its maximum.

B. the "law of diminishing returns" sets in.

C. input marginal productivity is zero.

D. input marginal productivity is at its maximum.


Answer:

34. Isoquants represent

A. combinations of inputs that produce the same output.

B. combinations of inputs that yield the greatest output.

C. inputs that are perfect substitutes for each other.

D. least costly combinations of inputs.

Answer:

35. Marginal rates of technical substitution (MRTS) represent

A. the optimum combinations of inputs.

B. cost minimizing combinations of inputs.

C. the degree to which one input can replace another without output changing.

D. All of the above.

Answer:

36. Isocost curves represent

A. least cost combinations of inputs.

B. combinations of inputs that can be purchased given their prices and the funds available.

C. a producers cost function.

D. None of the above.


Answer:

Analytical Questions
Number Of Output
Workers
0 0
1 50
2 110
3 300
4 450
5 590
6 665
7 700
8 725
9 710
10 705

1. The table above shows the weekly relationship between output and number of workers for a factory
with a fixed size of plant.

a. Calculate the marginal product of labor.


b. At what point does diminishing returns set in?
c. Calculate the average product of labor.
d. Find the three stages of production.

Answer:

Number Of Output MPL APL


Workers
0 0 -- --
1 50 50 50
2 110 60 55
3 300 190 100
4 450 150 112.5
5 590 140 118
6 665 75 110.83
7 700 35 100
8 725 25 90.63
9 710 15 78.89
10 705 -5 70.5

a. See table.
b. Diminishing returns sets in after the third worker is hired.
c. See table.
d. Stage I is between the first and approximately the 5th worker (until APL is 55 maximized); Stage II
is from the 5th worker to the 9th worker (MPL still positive), and Stage III begins with the hiring of
the 10th worker (MPL becomes negative).

2. Based on the table above, if the wage rate is $500 and the price of output is $5, how many
workers should the firm hire?

Answer:

Number Of Output MPL APL


Workers

0 0 -- --
1 50 50 $250
2 110 60 $300
3 300 190 $950
4 450 150 $750
5 590 140 $700
6 665 75 $375
7 700 35 $175
8 725 25 $100
9 710 15 $75
10 705 -5 --

The firm should hire 5 workers. At the 6th worker, MRPL < MLC.

3. A firm has two plants, one in the United States and one in Mexico, and it cannot change the size of
the plants or the amount of capital equipment. The wage in Mexico is $5. The wage in the
U.S. is $20. Given current employment, the marginal product of the last worker in
Mexico is 100, and the marginal product of the last worker in the U.S. is 500.

a. Is the firm maximizing output relative to its labor cost? Show how you know.
b. If it is not, what should the firm do?

Answer: . Maximizing output between plants requires that (MPL/w)U.S. =


(MPL/w)MEXICO. Since 100/5 (=20) is not equal to 500/20 (=25), the firm is not
maximizing output relative to its labor cost.
b. The firm should hire more U.S. workers and fewer Mexican workers, all
other things equal.

4. A firm is making a long-run planning decision. It wants to decide on the optimal size of plant and
labor force. It is considering building a medium-sized plant and hiring 100 workers. Engineering
estimates suggest that at those levels, the marginal product of capital will be 100 and the marginal
product of labor will be 75. If the wage rate is $5 and the rental rate on capital is $10, is the firm
making the right decision? Support your answer.

Answer: No, the firm is not making the right decision. Minimizing cost (maximizing output)
requires that (MPL/w) = (MPK/r). 100/10 < 75/5, so the firm should plan to build a smaller
plant and employ more workers, all other things equal.

5. For each of the following functions, describe returns to scale.


a. Q = K + L
b. Q = K1/2L1/4
c. Q = K2L

Answer:

a. Constant returns to scale.


b. Decreasing returns to scale.
c. Increasing returns to scale.

6. How would you choose to estimate a production function for a single plant? How
would you choose to estimate a production function for a number of firms in an industry? Explain.
Answer: stimating a production function for a single plant generally uses time-series analysis,
because it is possible to know if technology and other variables have remained constant over
time. To estimate a production function for a number of firms in an industry, it is customary
to use cross-sectional analysis because it is unlikely that technology and other relevant factors
have remained constant for all firms in the industry over time, and cross-sectional analysis
removes this problem.

7. What are the major issues that must be considered in measuring inputs for regression analysis of
production functions?

Answer: ow is labor to be measured? Can it be measured in hours, and if not, how can the
labor of labor actually used in production be expressed? How are materials to be measured?
How are capital assets, which have different rates of depreciation and input intensity, to be
measured?

8. What does the expansion path represent?

Answer: The expansion path represents the cost-minimizing choice of inputs, given
constant input prices, for different levels of output.

9) Q = K1/2L1/2
w = $2, r = $2
The firm would like to know the minimum cost of producing 2000 units of output. Find
the combination of inputs that minimizes the cost of producing 2000 units, the total cost,
and identify the expansion path.

Answer: MPL = ½
K1/2L-1/2 MPK = ½ K-
1/2L1/2
Optimization
requires: MPL/w =
MPK/r
This results in K=L, which is the equation of the expansion
path. Q = K1/2L1/2 = 2000
Substitute the expansion path relationship to
yield: K* = L* = 2000
Then total cost = TC = 2*2000 + 2*2000 = $8,000
10) Q = K1/2L1/2
w = $2, r = $2
The firm would like to know the maximum output that can be produced for $8,000. Find
the combination of inputs that maximizes output for a cost of $8,000, the amount of
output that can be produced, and identify the expansion path.

Answer: MPL = ½
K1/2L-1/2 MPK = ½ K-
1/2L1/2
Optimization
requires: MPL/w =
MPK/r
This results in K=L, which is the equation of the expansion
path. TC = 8,000 = 2L + 2K
Substitute the expansion path relationship to
yield: K* = L* = 2000
Then Q = K1/2L1/2 = 2000.

11. If the price of capital is $24, the price of labor is $15, and the marginal product of capital is 16, the
least costly combination of capital and labor requires that the marginal product of labor be .

Answer: MPcapital/MPlabor = Price of capital/Price of Labor, or marginal product of labor =


10.
12. If a production function is given by the equation: Q = 12X + 10X2 - X3, where Q =
Output and X = Input, then calculate the equations for

a. average product
b. marginal product
c. point of diminishing average returns
d. point of diminishing marginal returns

Answer:

a. AP = Q/X, or 12 +10X - X2
b. MP = dQ/dX, or 12 + 20X - 3X2
c. DAR occurs where AP at a maximum, or dAP/dX = 0, or 10 - 2X = 0, X = 5
d. DMR occurs where MP at a maximum, or dMP/dX = 0, or 20 - 6X = 0, X = 3.33

13. Given the Production Function: Q = 72X + 15X2 - X3, where Q = Output and X = Input

a. What is the Marginal Product (MP) when X = 8?


b. What is the Average Product (AP) when X = 6?
c. At what value of X will Q be at its maximum?
d. At what value of X will Diminishing Returns set in?

Answer:
a. MP = 30X -3X2, MP =120 when X=8;
b. AP = 72 + 15X - X2, AP=126 when X=6;

c. Q at a maximum when MP is 0, or X =12 [-2 has no meaning;]

d. diminishing returns sets in when MP at a maximum value, or X =5

Chapter 7 The Theory and


Estimation of Cost
(Appendices 7A and 7B)

Multiple-Choice Questions
1. Which of the following cost functions indicates that the law of diminishing returns takes effect as
soon as production begins?

A) 1000 + 2.5Q +
.05Q2 B) 1000 + 2.5Q
C) 1000 + 2.5Q - 1.2Q2 + .03Q3
D) Not enough information to determine this.

Answer:

2. Which of the following relationships is correct?

A. When marginal product starts to decrease, marginal cost starts to decrease.


B. When marginal cost starts to increase, average cost starts to increase.

C. When marginal cost starts to increase, average variable cost starts to increase.

D. When marginal product starts to decrease, marginal cost starts to increase.

Answer:

3. The law of diminishing returns begins first to affect a firm's short-run cost structure when

A. average variable cost begins to increase.

B. marginal cost begins to increase.

C. average cost begins to increase.

D. average fixed cost begins to decrease.

Answer:

4. Which of the following statements best represents a difference between short-run and
long-run cost?

A. Less than one year is considered the short run; more than one year the long run.
B. There are no fixed costs in the long run.
C. In the short-run labor must always be considered the variable input and capital the fixed input.
D. All of the above are true.

Answer:

5. The relationship between MC and AC can best be described as follows:

A. when AC increases, MC starts to increase.

B. when MC increases, AC starts to increase.

C. when MC decreases, AC decreases.


D. when MC exceeds AC, AC starts to increase.

Answer:

6. Average fixed cost is

A. AC minus AVC. B) TC divided by Q.

C) AVC minus MC. D) TC minus TVC.

Answer:
7. Which of the following cost relationships is not true?

A. AFC = AC - MC
B. TVC = TC - TFC
C. The change in TVC/the change in Q = MC.
D. The change in TC/ the change in Q = MC.
Answer:
8. Economists consider which of the following costs to be irrelevant to a short-run business decision?

A. opportunity cost B) out-of-pocket cost

C. historical cost D) replacement cost


Answer:
9. Which of the following is a relevant cost?

A. replacement cost

B. sunk cost

C. historical cost

D. fixed cost

E. All of the above are relevant.

Answer:

10. Which of the following is a reason for economies of scale?


A. Fixed costs are spread out as volume increases.

B. The law of diminishing returns does not take effect.

C. Input productivity increases as a result of greater specialization.

D. There is greater savings in transportation costs.

Answer:

11. Diseconomies of scale can be caused by

A. the law of diminishing returns.

B. bureaucratic inefficiencies.

C. increasing advertising and promotional costs.

D. All of the above.

Answer:

12. When a firm increased its output by one unit, its AC rose from $45 to $50. This implies that its MC is

A) $5.

B. between $45 and $50.

C. greater than $50.

D. Cannot be determined from the above information.

Answer:

13. When a firm increased its output by one unit, its AC decreased. This implies that
A. MC < AC.

B. MC = AC.

C. MC < AFC.

D. the law of diminishing returns has not yet taken effect.

Answer:

14. When a firm increased its output by unit, its AFC decreased. This is an indication that

A. the law of diminishing returns has taken effect.

B. MC < AFC.

C. AVC < AFC.

D. the firm is spreading out its total fixed cost.

Answer:

15. The main factor that explains the difference between accounting cost and economic cost is

A. opportunity cost.

B. fixed cost.

C. variable cost.

D. All of the above help to explain the difference.

Answer:

16. Economies of scale is indicated by


A. declining long-run AVC. B) declining long-run AFC.

C) declining long-run AC. D) declining long-

run TC. Answer:


17. Which of the following distinctions helps to explain the difference between relevant and
irrelevant cost?

A. accounting cost vs. direct cost B) historical cost vs. replacement cost

C) sunk cost vs. fixed cost D) variable cost vs. incremental

cost Answer:
18. Which of the following distinctions does not help to explain the difference between relevant and
irrelevant cost?

A. historical vs. replacement cost

B. sunk vs. incremental cost

C. variable vs. fixed cost

D. out-of-pocket vs. opportunity cost

E. All help to explain the difference.

Answer:

19. Which of the following actions has the best potential for experiencing economies of scope?

A. producing a product that has appeal to a wider segment of the market


B. producing computers and software
C. producing spaghetti and soft drinks
D. producing cars and trucks
Answer:

20. The learning curve indicates that


A. economies of scale is taking effect.

B. repetition of various production tasks cause unit costs to decrease.

C. workers must learn new skills in order to improve.

D. it takes time to learn a new skill.

Answer:

21. When a firm's MC curve shifts to the right, it implies that

A. new firms are entering the market.

B. labor productivity is decreasing.

C. labor productivity is increasing.

D. the firm's overhead costs are decreasing.

Answer:

22. When a firm experiences increasing returns to scale

A. its AFC will decrease. B) its AFC will increase.

C) its AC will increase. D) its AC will decrease.

Answer:

23. If a firm's rent increases, it will affect its cost structure in the following way:

A. AVC will increase. B) MC will increase.

C) TFC will increase. D) All of the above will increase.


Answer:

24. Assuming the existence of economies of scale, if a firm finds that it can reduce its unit cost by
decreasing its scale of production, it means that

A. it has too much production capacity relative to its demand.

B. it should try to produce less.

C. the law of diminishing returns has not taken effect.

D. it has too much fixed overhead relative to its variable cost.

Answer:

25. Which of the following relationships implies that a firm's short-run cost function is linear?

A. MC = AC B) MC = AVC

C) AC = AFC + AVC D) MC > AC

Answer:
26. The marginal cost will intersect the average variable cost curve

A. when the average variable cost curve is rising.

B. where average variable cost curve equals price.

C. at the minimum point of the average variable cost curve.

D. the two will never intersect.

Answer:

27. Which of the following cost functions will exhibit both decreasing and increasing marginal costs?

A. a cubic cost function B) a quadratic cost function


C) a linear cost function D) All of the above.

Answer:

28. If total cost equals $2,000 and quantity produced is 100 units,

A. then fixed cost is $200 and average variable cost is $18.

B. then fixed cost is $600 and average variable cost is $14.

C. then fixed cost is $500 and marginal cost is $15.

D. then either A or B can be correct.

Answer:

29. The learning curve

A. is really no different from a marginal cost curve.

B. calculates average cost at a particular point in time.

C. shows the decrease in unit cost as more of the same product is produced over time.

D. None of the above.

Answer:

30. Which level indicates the point of maximum economic efficiency?

A. lowest point on AC curve B) lowest point on AVC curve

C) lowest point on MC curve D) None of the above.

Answer:
31. MC increases because

A. MC naturally increases as firm nears capacity.

B. labor is paid overtime wages when volume increases.

C. in the short run, MC always increases.

D. the law of diminishing returns takes effect.

Answer:

32. Which of the following is the best example of economies of scope?

A. Coca-Cola expands its global operations to sub-Sahara Africa.

B. Alcohol for car fuel is produced from corn.

C. Amazon.com decides to rent out its Web site to independent e-commerce companies.

D. A company reduces its cost by getting bigger discounts for bulk purchases.

Answer:

33. The distinction between sunk and incremental costs is most helpful in answering which question?

A. How many more people should be added to the production process?

B. What is the correct price to charge?

C. Should we begin to build a new factory?

D. Should we continue developing a new software application that we began last year?

Answer:
34. A Production Function represents

A. the method used to convert inputs into outputs.

B. the amounts of output that can be created by various amounts of inputs.

C. the optimum mix of inputs to maximize output.

D. All of the above.

Answer:

35. Stage III of the short-run Production Function is

A. the most efficient mix of inputs.

B. the least costly level of output.

C. where additional units of inputs will lead to less output.

D. where additional units of inputs will lead to more output.

Answer:

36. The "Law of Diminishing Returns" states that

A. additional inputs will reduce output.

B. additional inputs will decrease average productivity.

C. the supply of inputs is becoming scarce.

D. additional inputs will lead to less additional output.

Answer:
37. Increasing Returns to Scale results when

A. in the long-run, an increase in inputs will lead to an increase in the average products of inputs.
B. in the long run, an increase in inputs will lead to an equivalent increase in output.
C. labor becomes more skilled.
D. All of the above.

Answer:

38. Output (Total Product) is maximized when

A. input average productivity is at its maximum.

B. the "law of diminishing returns" sets in.

C. input marginal productivity is zero.

D. input marginal productivity is at its maximum.

Answer:

39. The results of many empirical studies of short-run cost functions have shown that total costs conform
to

A. a quadratic total cost function. B) a power cost function.

C) a linear cost function. D) a cubic cost function.

Answer:

40. Among the problems encountered when time series analysis is used to estimate cost
functions is

A. that technological changes may have occurred.


B. that accounting changes may have occurred during the period analyzed.
C. that some costs are recorded on the books of account at a time other than when they are incurred.
D. All of the above.
Answer:

41. The method of estimating long-run costs in which knowledgeable professionals familiar with
production facilities and processes calculate optimal combination of inputs to produce given
quantities and then estimate costs is known as

A. engineering cost estimating. B) the survivorship method.

C) regression analysis. D) None of the above.

Answer:

42. When the survivorship method of cost estimating is used, an increase, over time, in the
proportion of industry product produced by medium size firms indicates the existence of

A. continuing economies of scale.

B. continuing diseconomies of to scale.

C. a U-shaped long-run average cost curve.

D. large technological changes.

Answer:

43. The major advantages of using cross-sectional analysis for long-run costs studies include

A. the inclusion in the sample of different plants of different sizes.

B. the avoidance of having to adjust for inflationary trends.

C. the avoidance of having to account for interregional cost differences.

D. All of the above.

E. A and B above.
Answer:

44. A short-run total cost function of the following form: TC = 100 + 32Q - 4Q2 + 0.4Q3, indicates
the existence of

A. a linear total cost curve. B) a constant average variable cost curve.

C) a U-shaped average total cost curve. D) a constant marginal cost curve.

Answer:

45. Isoquants represent

A. combinations of inputs that produce the same output.

B. combinations of inputs that yield the greatest output.

C. inputs that are perfect substitutes for each other.

D. least costly combinations of inputs.

Answer:

46. Marginal rates of technical substitution (MRTS) represent

A. the optimum combinations of inputs.

B. cost minimizing combinations of inputs.

C. the degree to which one input can replace another without output changing.

D. All of the above.

Answer:
47. Isocost curves represent

A. least cost combinations of inputs.

B. combinations of inputs that can be purchased given their prices and the funds available.

C. a producers cost function.

D. None of the above.

Answer:

48. Short-run cost functions are estimated using

A. time-series regression analysis. B) cross-sectional regression analysis.

C) nominal cost data. D) present value cost data.

Answer:

49. In estimating short-run cost functions, one must adjust for

A. price level changes. B) accounting procedure changes.

C) product heterogeneity. D) All of the above.

Answer:

50. Long-run cost functions are estimated using

A. time-series regression analysis. B) cross-sectional regression analysis.

C) cost accounting data. D) None of the above.

Answer:
Analytical Questions
1. You have opened your own word-processing service. You bought a personal computer, and paid
$5,000 for it. However, due to the cost changes in the computer industry, the current price of an
equivalent machine is $2,500. You could sell any used machine for $1,000. If you were not word
processing, you could earn $20,000 per year at an alternative job. Assume that the interest rate is
10%. You can also hire an assistant who can do everything that you can do for $20,000 per year (you
would still continue to do word processing).
One person using one computer can produce 11,000 typed pages per year, and the
price per page for your service is $2.
You are considering three options: (1) expand your business by hiring an assistant.
(2) leave your business the way it is (3) shut down. Based on the costs and revenues above,
which should you do? Explain and show any relevant calculations.

Answer
: Optio
n 1:
Revenue = $22,000
Opportunity cost of your time = 20,000
Opportunity cost of interest on salvage value of existing computer =
100 Economic profit = $1,900
Option 2:
You still earn $1,900 as above.
Revenue from additional worker =
22,000 Wages = 20,000
Opportunity cost of interest on purchase of new computer =
250 Depreciation = 1,500
Economic profit from additional worker =
$250 Total economic profit = $2,150
Option
3: Revenu
e=0
No costs, since opportunity costs no longer apply, and fixed costs are
sunk. Economic profit = 0

(Could possibly view the $1,000 you get from selling the used computer as revenue,
but makes no difference to final solution of problem.)

Option 2, expand your business, is the best option.

2. Fred's Widget Company has purchased $500,000 in equipment, which can be sold for a salvage value
of $300,000 at any time. The best interest rate on alternative investments is 5%. What is the cost of
using this machinery for one year? How would your answer be different if the machinery had not yet
been purchased?

Answer: Short-run cost = $15,000


Cost if the machinery was not purchased = $200,000 + $25,000 = $225,000
Explanation: The short-run cost is just the forgone interest. The short-run depreciation is
sunk, and the salvage value doesn't change. The long-run cost (if the machine has not been
purchased is the depreciation cost plus the foregone interest on the whole $500,000.

3. The following table shows the relationship between output and number of workers in the short
run. If the wage is $50/day, find marginal cost of production.

Number Of Output
Workers
0 0
1 50
2 110
3 300
4 450
5 590
6 665
7 700
8 725
9 710
10 705

Answer:
Number
Of Workers Output MPL MC
(=w/MPL)
0 0 -- --
1 50 50 1.00
2 110 60 0.91
3 300 190 0.26
4 450 150 0.33
5 590 140 0.36
6 665 75 0.67
7 700 35 1.43
8 725 25 2.00
9 710 15 3.33
10 705 -5 --
4. Consider
a firm that has just built a plant, which cost $20,000. Each worker costs $5.00 per
hour. Based on this information, fill in the table below.

Number Avera Avera


of Work ge ge
Outp Margin Fix Variab Tot Margin
er Hours Variab Total
ut al ed le al al
le Cost Cost
Product Co Cost Co Cost
st st
0 0 -- 20,00 -- -- --
0
50 400 20,25
0
100 900 20,50
0
150 1300 20,75
0
200 1600 21,00
0
250 1800 21,25
0
300 1900 21,50
0
350 1950 21,75
0

Answer:
Number Avera Avera
of Work ge ge
Outp Margin Fix Variab Tot Margin
er Hours Variab Total
ut al ed le al al
le Cost Cost
Product Co Cost Co Cost
st st
0 0 -- 20,00 0 20,00 -- -- --
0 0
50 400 8 20,00 250 20,25 .625 .625 50.625
0 0
100 900 10 20,00 500 20,50 .50 .56 22.78
0 0
150 1300 8 20,00 750 20,75 .625 .58 15.96
0 0
200 1600 6 20,00 1000 21,00 .833 .625 13.125
0 0
250 1800 4 20,00 1250 21,25 1.25 .69 11.81
0 0
300 1900 2 20,00 1500 21,50 2.50 .79 11.32
0 0
350 1950 1 20,00 1750 21,75 5.00 .90 11.15
0 0

5. How would each of the following affect the firm's marginal, average, and average variable cost
curves?

a. An increase in wages
b. A decrease in material costs
c. The government imposes a fixed amount of tax.
d. The rent that the firm pays on the building that it leases decreases.

Answer:

a. Wages are a variable cost, so MC, AVC, and ATC increase.


b. Materials are a variable cost, so MC, AVC, and ATC decrease.
c. A fixed or lump-sum tax increases ATC but not MC or AVC.
d. Rent is generally viewed as a fixed cost, so ATC decreases, but MC and AVC are unchanged.

6. A firm experiences increasing returns to scale; that is, doubling all its inputs more than
doubles its output. What can be inferred about the firm's short-run costs?

Answer: Returns to scale is a long-run phenomenon because all inputs must be changed. Thus
we can infer little about the firm's short-run costs from this information, other than the firm is
likely to experience diminishing marginal returns in the short run due to the fact that it will
have a fixed factor of production (and thus short-run marginal costs will rise with output).

7. Carefully explain if the following statements are true, false, or uncertain.


a. If average cost is increasing, marginal cost must be increasing.
b. If there are diminishing returns, the marginal cost curve must be positively sloped.
c. Marginal costs decrease as output increases because the firm can spread fixed costs over more units.

Answer:
a. True. If average cost is increasing, marginal cost must be above average cost, so marginal cost must
be increasing.
b. True. If there are diminishing returns, each worker produces less than the one before him. Thus
each unit must be getting more expensive (because you pay workers the same amount but they
produce less).
c. False. Marginal costs have nothing to do with fixed costs. The statement would be correct if it was
about average costs.

8. Carefully explain the difference between diseconomies of scale and diminishing returns.

Answer: seconomies of scale means that, in the long run, average costs are rising, usually due
to coordination problems or decreasing returns to scale. Diminishing returns means that, in the
short run, marginal product is falling (or marginal cost is rising) because each worker is
producing less than the one before him, due to the fact that capital (or some other factor of
production) is fixed. There is no connection between these things.

9. For each of the following cost functions, find MC, AC, and AVC.
a. TC = 20,000 + 10 Q
b. TC = 18,000 + Q + 0.2 Q2

Answer:
a. MC = 10
AC = (20,000/Q) +
10 AVC = 10
b. MC = 1 + 0.4Q
AC = (18,000/Q) + 1 +
0.2Q AVC = 1 + 0.2Q

10. For each of the following cost functions, if possible, find minimum AC and minimum AVC. a. TC =
20,000 + 10 Q
b. TC = 18,000 + Q + 0.2 Q2

Answer:

a. Set MC = AC.

10 = (20,000/Q) + 10
In this case, AC is decreasing everywhere, and thus there is no minimum average cost
(although it will approach $10).
Set MC =
AVC. 10 = 10
Q = 0, and at that point, AVC = $10.

b. Set MC = AC.

1 + 0.4Q = (18,000/Q) + 1 + 0.2Q


Q = 300, and at that point, AC =
$121. Set MC = AVC.
1 + 0.4Q = 1 + 0.2Q
Q = 0, and at that point, AVC = $1.

11. Given the Production Function: Q = 72X + 15X2 - X3, where Q = Output and X = Input

a. What is the Marginal Product (MP) when X = 8?


b. What is the Average Product (AP) when X = 6?
c. At what value of X will Q be at its maximum?
d. At what value of X will Diminishing Returns set in?

Answer:
a. MP = 30X -3X2, MP =120 when X=8;
b. AP = 72 + 15X - X2, AP=126 when X=6;

c. Q at a maximum when MP is 0, or X =12 [-2 has no meaning;]

d. diminishing returns sets in when MP at a maximum value, or X =5

12. Given the Production Function: Q = 21X + 9X2 - X3, where Q = Output, and X = Input

a. At what value of X does Stage II of the production function begin?


b. At what value of X does Stage III of the production function begin?
c. At what value of X does diminishing returns set in?

Answer:

a. Stage II begins when AP is at a maximum, or X = 4.5


b. Stage III begins where MP = 0, or X = 7 [-1 has no meaning]
c. diminishing returns set in when MP at a maximum, or dMP/dQ = 0, or X = 3

13. If the price of capital is $24, the price of labor is $15, and the marginal product of capital is 16, the
least costly combination of capital and labor requires that the marginal product of labor be .

Answer: MPcapital/MPlabor = Price of capital/Price of Labor, or marginal product of labor =


10.

14. If a production function is given by the equation: Q = 12X + 10X2 - X3, where Q = Output and X
= Input, the calculate the equations for

a. average product
b. marginal product
c. point of diminishing average returns
d. point of diminishing marginal returns

Answer:

a. AP = Q/X, or 12 +10X - X2
b. MP = dQ/dX, or 12 + 20X - 3X2
c. DAR occurs where AP at a maximum, or dAP/dX = 0, or 10 - 2X = 0, X = 5
d. DMR occurs where MP at a maximum, or dMP/dX = 0, or 20 - 6X = 0, X = 3.33

15. Given the total cost function: TC = 100 + 40Q - 15Q2 + 5Q3, calculate the

a. average fixed cost function (AFC)


b. average variable cost function (AVC)
c. marginal cost function (MC)

Answer:
a. AFC = 100/Q
b. AVC = 40 -15Q +
5Q2 c. MC = 40 - 30Q
+ 15Q2

Chapter 8 Pricing and Output


Decisions: Perfect Competition and
Monopoly (Appendices 8A and
8B)

Multiple-Choice Questions

1. Which of the following products is the best example of perfect competition?

A. automobiles B) apples

C) soap D) video cassettes

Answer:

2. Which of the following is not characteristic of perfect competition?

A. a differentiated product B) no barriers to entry or exit

C. large number of buyers D) complete knowledge of market price Answer:


3. Which of the following conditions would definitely cause a perfectly competitive company to shut
down in the short run?

A. P < MC B) P = MC < AC C) P < AVC D) P = MR Answer:


4. In economic analysis, any amount of profit earned above zero is considered "above normal"
because

A. normally firms are supposed to earn zero profit.


B. this would indicate that the firm's revenue exceeded both its accounting and opportunity cost.
C. this would indicate that the firm was at least earning a profit equal to its opportunity cost.
D. this would indicate that the firm's revenue exceeded its accounting cost.

Answer:
5. If a perfectly competitive firm incurs an economic loss, it should

A. shut down immediately.

B. try to raise its price.

C. shut down in the long run.

D. shut down if this loss exceeds fixed cost.

Answer:

6. At the point at which P=MC, suppose that a perfectly competitive firm's MC = $100, its AVC
= $80 and its AC = $110. This firm should

A. shut down immediately.

B. continue operating in the short run.

C. try to take advantage of economies of scale.

D. try to increase its advertising and promotion.

Answer:

7. A perfectly competitive firm sells 15 units of output at the going market price of $10. Suppose its
average cost is $15 and its average variable cost is $8. Its contribution margin (i.e., contribution to
fixed cost) is

A)
$30.
B)
$150.
C)
$105.

D. Cannot be determined from the above information.


Answer:

8. When a firm produces at the point where MR = MC, the profit that it is earning is considered to be

A. maximum. B) normal.

C) above normal. D) Not enough information is provided.

Answer:

9. When a firm has the power to establish its price,

A. P = MR. B) P = MC. C) P > MR. D) P < MR.


Answer:
10. When MR = MC,

A. marginal profit is maximized. B) total profit is maximized.

C) marginal profit is positive. D) total profit is zero.

Answer:

11. In the short run, which of the following would indicate that a perfectly competitive firm is
producing an output for which it is receiving a normal profit?

A. P > AC B) AVC < P < AC C) P = AC D) P = AVC Answer:


12. A firm that seeks to maximize its revenue is most likely to adhere to which of the following?

A. MR = MC B) MR =0 C) MR =P D) MR < MC
Answer:
13. Which of the following is true for a monopoly?

A. P = MC B) P = MR C) P > MR D) P < MR Answer:


14. Which of the following characteristics is most important in differentiating between perfect
competition and all other types of markets?

A. whether or not the product is standardized

B. whether or not there is complete market information about price


C. whether or not firms are price takers

D. All of the above are equally important.

Answer:

15. Suppose a firm is currently maximizing its profits (i.e., following the MR=MC rule). Assuming
that it wants to continue maximizing its profits, if its fixed costs increase, it should

A. maintain the same price.

B. raise its price.

C. lower its price.

D. Not enough information to answer this question.

Answer:

16. Suppose a firm is currently maximizing its profits (i.e., following the MR=MC rule). Assuming
it wants to continue maximizing its profits, if its variable costs decrease, it should

A. lower its price in response to the lower costs.

B. raise its price in order to earn more profits.

C. maintain the same price.

D. Not enough information to answer this question.

Answer:

17. Which of the following is true about a monopoly?

A. Its demand curve is generally less elastic than in more competitive markets.
B. It will always earn economic profit.
C. It will try to charge the highest possible price.
D. It will always be subject to government regulation.
E. None of the above is true.

Answer:

18. Assume a profit maximizing firm's short-run cost is TC = 700 + 60Q. If its demand curve is P = 300
- 15Q, what should it do in the short run?

A. shut down

B. continue operating in the short run even though it is losing money

C. continue operating because it is earning an economic profit

D. Cannot be determined from the above information.

Answer:

19. Assume a perfectly competitive firm's short□run cost is TC = 100 + 160Q + 3Q2. If the market
price is $196, what should it do?

A. produce 5 units and continue operating

B. produce 6 units and continue operating

C. produce zero units (i.e., shut down)

D. Cannot be determined from the above information.

Answer:

20. A monopoly will usually produce

A. where its demand curve is inelastic.

B. where its demand curve is elastic.


C. where its demand curve is either elastic or inelastic.

D. only when its demand curve is perfectly inelastic.

Answer:

21. The main difference between the price-quantity graph of a perfectly competitive firm and a
monopoly is

A. that the competitive firm's demand curve is horizontal, while that of the monopoly is
downward sloping.
B. that a monopoly always earns an economic profit while a competitive company always earns
only normal profit.
C. that a monopoly maximizes its profit when marginal revenue is greater than marginal cost.
D. that a monopoly does not incur increasing marginal cost.

Answer:

22. When the slope of the total revenue curve is equal to the slope of the total cost curve

A. monopoly profit is maximized.


B. marginal revenue equals marginal cost.
C. the marginal cost curve intersects the total average cost curve.
D. the total cost curve is at its minimum.

E. Both
A
and
B
Ans
wer:
23. A feature of Perfect Competition is

A. use of nonprice competition by firms. B) mutual interdependence among firms.

C) unique products. D) standardized products.

Answer:

24. Monopoly is characterized by


A. unique products.

B. market entry and exit difficult or impossible.

C. nonprice competition not necessary.

D. All of the above.

Answer:

Y. The fact that a perfectly competitive firm has a perfectly elastic demand curve means

A. there is no limit to the firm's profits. B) there is no limit to the firm's revenues.

C) that it can sell all it wants at any price. D) None of the

above Answer:

26. In the short run a firm should shut down if it cannot

A. make normal profits. B) make economic profits.

C) cover its variable costs. D) cover its fixed costs.

Answer:

27. Firms are 'price makers" if they

A. have sufficient market power to set their product price.

B. make the market price their product price.

C. make their product price competitive.

D. None of the above.


Answer:

28. If a monopoly wants to maximize it profit, it should

A. produce in the range where its average costs are declining.

B. produce in the range where its demand curve is elastic.

C. produce in the range where its marginal costs are declining.

D. produce in the range where its marginal costs are less than its average costs.

Answer:

Analytical Questions
1. A perfectly competitive firm has total revenue and total cost curves given by:

TR = 100Q
TC = 5,000 + 2Q + 0.2 Q2
a. Find the profit-maximizing output for this firm.
b. What profit does the firm make?

Answ
er: .
MR = 100
MC = 2 +
.4Q 100 =
2 + .4Q
Q* = 245
b. Profit = 100*245 – 5,000 – 2(245) – 0.2 (245)2 = $7,005

2. What does it mean to say that a perfectly competitive firm is a price taker? Can't a firm set any price
it chooses?

Answer: firm can set any price it chooses, but it a perfectly competitive industry, it will do no
good to choose anything but the market price. At a higher price, no one will buy (since
products are assumed to be identical) and at a lower price, you lose revenue without gaining
sales, since you can presumably sell all you want to at the market price. Thus the firm is said
to be a price taker.

3. Why would a firm choose to remain in an industry in which it makes an economic profit of zero?

Answer: Making an economic profit of zero does not mean that the firm is not making any
money. It means that it is covering all its costs, including opportunity costs. This means that
all resources employed are earning just as much as they would in their next-best use, and
thus that there is no gain from moving them to their next -best use.

4. You've been hired by an unprofitable firm to determine whether it should shut down its operation.
The firm currently uses 70 workers to produce 300 units of output per day. The daily wage (per
worker) is $100, and the price of the firm's output is $30. The cost of other variable inputs is $500
per day. Although you don't know the firm's fixed cost, you know that it is high enough that the
firm's total costs exceed its total revenue. You know that the marginal cost of the last unit is $30.
Should the firm continue to operate at a loss? Carefully explain your answer.

Answer: VC = $7,000 + 500. Thus AVC = 7500/300 = $25. Since P > AVC, the firm
should continue to operate in the short run.

5. Suppose that a perfectly competitive industry is in long-run equilibrium, and demand


increases. Explain the short- and long-run effects on the firm and the industry.

Answer: Short run: An increase in demand raises equilibrium price and quantity. Existing
firms produce more (because the higher price means that MR=MC at a higher quantity) and
earn positive economic profits.
Long run: Positive profits attract new firms into the industry. The increase in supply
reduces price and further increases quantity. Firms continue to enter until economic profits
return to zero, and there is no further incentive for entry.

6. Market price is $50. The firm's marginal cost curve is given by:

MC = 10 + 2Q

a. Find the profit-maximizing output for the firm.


b. At this output, is the firm making a profit? Explain your answer.

Answer:
50 = 10 + 2Q
Q* = 20
b. It is impossible to say without further information. We know that at a quantity of 20, the
firm will maximize profit or minimize loss, but without information on total costs, we cannot
tell if there is a profit or loss.

7. A monopolist has demand and cost curves


given by: QD = 1000 - 2P
TC = 5,000 + 50Q

a. Find the monopolist's profit-maximizing quantity and price.


b. Find the monopolist's profit.

Answer:
a. MR = 500 –
Q MC = 50
50 = 500 – Q
Q* =
450 P*
= $275
b. Profit = 275*450 – 5,000 – 50*450 = $96,250

8. A monopolist has demand and cost curves given by:

QD = 10,000 – 20P
TC = 1,000 + 10Q + .05Q2

a. Find the monopolist’s profit-maximizing quantity and price.


b. Find the monopolist’s profit.

Answer:
a. MR = 500 – 0.1 Q
MC = 10 + 0.1Q
10 + 0.1Q = 500 – 0.1 Q
Q* = 2,450
P* =
$377.50
b. Profit = (377.50)*2450 – 1,000 – 10*2450 – 0.05(2450)2 = $599,250

9. True, false, or uncertain? Any firm that is not covering fixed costs should shut down in the short
run.

Answer: alse. Fixed costs are sunk and should have no effect on short-run decisions. If a firm
is not covering variable costs, it should shut down, because those costs are avoidable.
10. A perfectly competitive firm has the cost function: TC = 1000 + 2Q + 0.1 Q2 What
is the lowest price at which this firm can break even?

Answer:
MC = 2 + 0.2Q
AC = (1000/Q) + 2 + 0.1Q
Set MC = AC. for minimum AC, or 2 + 0.2Q = (1000/Q) + 2 + 0.1Q,, or Q = 100, and at that
point, AC = $22. This is the lowest price at which the firm can break even.

11. Describe the difference in market structure between Monopoly and Oligopoly.

Answer: Monopoly has only one producer because the product is unique, or has no
close substitutes, or government gives it the exclusive authority to produce and sell
that

product.
Oligopoly has relatively few large firms producing standardized or
differentiated products, but for which entry into or exit from the industry is very
difficult, so that they are mutually interdependent in their pricing-output decisions.

12. Explain the difference between Economic and Normal profits.

Answer: Normal profit is the amount of profit necessary to insure that a firm continues to
operate in the long run, and it is based on the profit that could be earned in its next best
alternative activity. It is equal to the sum of its accounting cost and opportunity cost.
Economic profit is the amount of profit above normal profit: profit in excess of what could be
earned in its next best alternative activity.

13. Describe the process by which the competitive market establishes a price at which all firms are just
earning normal profits.

Answer: ove normal profits will entice new firms to enter the industry, thereby driving down
market price and firm profits until they reach the normal level, after which no additional
firms enter the industry. Below normal profits will cause some firms to exit the industry,
thereby raising market price and firm profits until the normal level is reestablished, and no
further firms exit the industry.
14. A monopolist’s Demand function is P = 1624 - 4Q, and its Total Cost function is TC =
22,000 + 24Q -4Q2 + ⅓Q3, where Q is output produced and sold.

a. At what level of output and sales (Q) and price (P) will Total Profits be maximized?
b. At what level of output and sales (Q) and price (P) will Total Revenue be maximized?
c. At what price (P) should the monopolist shut down?

Answer:
a. Total Profits are maximized where MR = MC, and MR = dTR/dQ, with TR = P(Q), and MC
= dTC/dQ. TR = 1624Q -4Q2, so MR = 1624 - 8Q. MC = 24 - 8Q + Q2.
MR = MC is 1624 - 8Q = 24 - 8Q + Q2, or 1600 = Q2, and Q = 40. With Q = 40, P = 1464.

b. Total Revenue is maximized when MR = 0, or 1624 - 8Q = 0, or Q = 203 with P = 203.

c. Shut down would occur whenever price(P) is less than average variable cost (AVC), or below P =
AVC, or 1624 - 4Q = 24 - 4Q + ⅓Q2, or 1600 = ⅓Q2, or Q2 = 4800, or Q = 69
(approximately). When Q = 69, P = 1348, so any price below 1348 would cause the firm to
shut down since it is not covering its variable costs.

15. What are the limitations in using Break-Even analysis?

Answer: t requires the use of linear cost and revenue functions; it isn't applicable if the
functions are non-linear. It assumes that there are fixed costs, which means the analysis can
applied only to short-run operations. It can't handle multiple product situations, unless the
product mixes are constant. It can't be used to determine profit maximizing levels of
operations.

16. What is the Degree of Operating Leverage?

Answer: t is an elasticity formula which calculates the percentage change in profit


resulting from some percentage change in the level of operation (output and sales).

17. How can break-even analysis be used to project the level of operation needed to achieve a
targeted profit level?

Answer: The targeted level of profit can be factored into the break-even equation as a fixed
cost, and then determine the level of output and sales at which the operating costs plus fixed
costs plus desired profit would just equal sales revenue: Q = (TFC + Desired Profit)/(P -
AVC), where Q = output, TFC = total fixed cost, P = sales price, and AVC = average variable
cost.
Chapter 9 Pricing and
Output Decisions: Perfect
Competition and Monopoly

Multiple-Choice Questions
1. Which of the following industries is most likely to represent the Monopolistic Competition market
structure?

A. pharmaceuticals B) tobacco products

C) hair salons D) farm equipment

Answer:

2. The Kinked-Demand Curve model best reflects

A. mutual interdependence among sellers.

B. a game theory approach to price-output decisions.

C. price rigidities in oligopolistic markets.

D. All of the above.

Answer:

3. The Herfindahl-Hirschman (HH) Index is used to

A. measure the degree of nonprice competition.


B. measure the degree of market concentration in an industry.

C. measure the extent of price leadership.

D. None of the above.

Answer:

4. If firms are earning economic profit in a monopolistically competitive market, which of the
following is most likely to happen in the long run?

A. Some firms will leave the market.

B. Firms will join together to keep others from entering.

C. New firms will enter the market, thereby eliminating the economic profit.

D. Firms will continue to earn economic profit.

Answer:

5. Mutual interdependence means that

A. all firms are price takers.

B. each firm sets its own price based on its anticipated reaction by its competitors.

C. all firms collaborate to establish one price.

D. all firms are free to enter or leave the market.

Answer:

6. In which of these markets would the firms be facing the least elastic demand curve?

A. perfect competition B) pure monopoly


C) monopolistic competition D)

oligopoly Answer:
7. In the long run, the most helpful action that a monopolistically competitive firm can take to
maintain its economic profit is to

A. continue its efforts to differentiate its product.

B. raise its price.

C. lower its price.

D. do nothing, because it will inevitably experience a decline in profits.

Answer:

8. The main difference between perfect competition and monopolistic competition is

A. the number of sellers in the market.

B. the ease of exit from the market.

C. the degree of information about market price.

D. the degree of product differentiation.

Answer:

9. The demand curve, which assumes that competitors will follow price decreases but not price
increases, is called

A. an industry demand curve. B) an inelastic demand curve.

C) a kinked demand curve. D) a competitive demand curve.

Answer:
10. The existence of a kinked demand curve under oligopoly conditions may result in

A. price flexibility. B) price rigidity.

C) competitive pricing. D) None of the above.

Answer:

11. When a company is faced by a kinked demand curve, the marginal revenue curve

A. will be upward sloping.

B. will be horizontal.

C. will always be zero at the quantity produced.

D. will be discontinuous.

Answer:

12. Porter's "Five Forces Model" is based on

A. the laws of supply and demand.

B. the law of diminishing returns.

C. the Structure-Conduct-Performance model.

D. the key factors affecting demand.

Answer:

13. The four-firm concentration ratio


A. indicates the total profitability among the top four firms in an industry.

B. is an indicator of the degree of monopolistic competition.

C. indicates the presence and intensity of an oligopoly market.

D. is used by the government as a basis for anti-trust cases.

Answer:

Analytical Questions
1. Convenience stores with gas stations tend to sell an essentially identical variety of goods and
services. Yet this is generally considered to be a monopolistically competitive industry selling
differentiated products. How can this be considered a differentiated product?

Answer: These stores are differentiated by location.

2. Describe the transition from short-run to long-run equilibrium in a monopolistically


competitive industry.

Answer: n the short run, firms in a monopolistically competitive industry may make a positive

profit. However, since there are assumed to be no significant barriers to entry, positive
profits attract entry. As more firms (or varieties) enter, the demand for each firm (or variety)
decreases, and thus prices and profits fall until there is no further incentive for entry.

3. How is a monopolistically competitive industry like perfect competition? How is it like


monopoly?

Answer: Monopolistic competition is like perfect competition in that there are many firms
and no barriers to entry (and thus long-run economic profits will be zero). It is like monopoly
in that firms sell products that are not perfect substitutes for each other, and thus firms have
some market power, and prices will be above marginal cost.

4. Why might a concentration ratio be a poor measure of actual industry competition? Answer:
oncentration ratios measure national competition within a line of goods that are substitutes in
production. Where there is much international competition, where competition is regional rather
than national, where there is competition from goods that are substitutes in
consumption but not production, and for other reasons listed in the text, competition ratios
may be poor measures of competition.
5. When one automaker begins offering low cost financing or rebates, others tend to do the same. What
two oligopoly models might offer an explanation of this behavior?

Answer: (1) Kinked demand curve: the assumption behind the kinked demand curve model
is that rivals follow price decreases but not price increases. One automaker offering rebates,
etc., is essentially a price cut, and so others will follow. (2) Price leadership: This could also
be viewed as a price leader setting a new price and others following.

6. Fast food restaurants tend to cluster together. That is, on one corner, there may be four similar fast-
food restaurants. How can this be explained using a location game theory model?

Answer: Similar to the beach kiosk model, restaurants cluster because they attract the most
customers that way. One explanation might be: assume that customers have identical
transportation costs, are distributed uniformly, and have no preference for one restaurant
over another. Then they will always go to the closest restaurant. If one located far away
from the other, it would attract customers on the other side of it, but only half of the ones
between it and its rival. If it locates next to its rival, it gets all the customers on that side,
and thus maximizes profit.

7. The following matrix shows the payoffs for an advertising game between Coke and Pepsi. The firms
can choose to advertise or to not advertise. Numbers in the matrix represent profits; the first number
in each cell is the payoff to Coke. (Numbers in millions.)
Coke (rows)/Pepsi (columns) Advertise Don’t Advertise
Advertise (10, 10) (500, -50)
Don’t Advertise (-50, 500) (100, 100)

a. Explain why this would be described as a Prisoner's Dilemma game.

b. Explain the probable outcome of this game.

Answer:
a. The joint profit-maximizing outcome is for neither to advertise. But there is a temptation to cheat,
the dilemma, and thus the firms are likely to end up where they are collectively worst off.
b. The dominant strategy for each firm is to advertise, and thus the probable outcome is that each will
earn $10 million.

8. Some countries, such as Israel, have absolute policies of not negotiating with terrorists if they take
hostages. How does this relate to sequential games and the idea of credible commitment?
Answer: Prior to the taking of hostages, it is desirable to "play tough" and state that you will
not deal with terrorists. But once hostages are taken, you have an incentive to try to free
them.
However, the terrorists can figure your incentives, too, so your threat is not credible. Absolute
policies that are publicly announced and followed through may create reputation effects that
make the policies credible, and thus countries may reach the desired outcome□hostages are
not taken because terrorists believe that they will not negotiate.

9. a. What is the grim trigger strategy, and how does it solve the Prisoner's Dilemma in
repeated games?
b. Under what circumstances is it likely to fail?

Answer: . The grim trigger refers to the threat to price low (or whatever the competitive
strategy is) forever if the cartel member(s) deviate from the cartel strategy. It may solve the
Prisoner's Dilemma because it can make the potential future loss from cheating greater than
the one-period gain.
b. If the one-period gain from cheating is sufficiently high relative to the discounted present
value of future profits received by a cartel member, or if the firm does not value profits
received in the future, the grim trigger will not be a deterrent. (It also may not be a credible
threat.)

10. Microsoft has integrated many components into its Windows operating systems, such as a web
browser, media player, etc. How might this be an example of nonprice competition?

Answer: There are a number of possible answers, including enhancing the attributes of the
product (increasing demand), increasing switching costs to increase customer loyalty
(reduce elasticity), etc.

11. Describe the factors in Michael Porter's "Five Forces Model" that affect the ability of any firm
in an industry to earn a profit.

Answer: Threats of new entrants into the industry, bargaining power of a firm's customers,
bargaining power of a firm's suppliers, threats of substitute products from other industries,
and intramarket rivalry from other firms in the industry.

12. Describe the structure-conduct-performance (S-C-P) paradigm.

Answer: n analytical approach to examining the structure of an industry and how it affects firm
profitability. It holds that the types of products being sold, their price elasticities of demand,
the methods use to produce them (especially the role of technology and the existence of scale
economies), and the degree to which there are related products (complements and substitutes)
will determine the number of firms in the industry, conditions of firm entry and exit, and the
extent of product differentiation. The resultant industry structure determines firm pricing-
output strategies which, in turn, determine the degree of firm profitability.

13. Explain why the "kinked-demand curve" model of oligopoly represents a game theory
approach to oligopolistic behavior.

Answer: ame theory usually is defined as studying how individuals form strategies when they
are aware that their decisions affect the decisions of other which, in turn, will affect the
outcome of their decisions. The "kinked-demand curve" model is based on how firms perceive
their competitors will react to any changes they make in their product prices, and how the
expected reactions by competitive firms will affect firm profitability.
The typical assumption is that if the firm raises its product price, competitors will not
raise their prices so that the firm will experience such a decrease in quantity sold that their
total revenue and profit will decline. However, if the firm lowers its product price, competitors
will match the price decrease so that the firm gains little or no increase in quantity sold,
resulting in a decline in total revenue and profit. Under this expected behavior by competitors,
firms should not alter their product prices in response to small changes in product costs.

Chapter 10 Special Pricing Practices

Multiple-Choice Questions

1. All of the following are conditions which are favorable to the formation of cartels, except

A. the existence of a small number of firms.

B. geographic proximity of firms.

C. homogeneity of the product.

D. easy entry into the industry.

Answer:

2. Prices under an ideal cartel situation will be equal to


A. monopoly prices. B) competitive prices.

C) prices under monopolistic competition. D) marginal cost.

Answer:

3. A cartel price will be established at the quantity where

A. total cost equals the industry total revenue.

B. average cost equals the industry revenue.

C. the sum of the members' marginal costs equals industry marginal revenue.

D. marginal cost equals industry price.

Answer:

4. Cartel agreements tend to break down

A. during economic downturns.

B. because of price "chiseling" by one or more members.

C. when there is overcapacity in the industry.

D. because of all of the above.

Answer:

5. Barometric price leadership exists when

A. one firm in the industry initiates a price change and the others may or may not follow.

B. one firm imposes its best price on the rest of the industry.
C. when all firms agree to change prices simultaneously.

D. when one company forms a price umbrella for all others.

Answer:

6. Dominant price leadership exists when

A. one firm drives the others out of the market.


B. the dominant firm decides how much each of its competitors can sell.
C. the dominant firm establishes the price at the quantity where its MR = MC, and permits all other
firms to sell all they want to sell at that price.
D. the dominant firm charges the lowest price in the industry.

Answer:

7. The oligopolistic situation in which a company's objective is to maximize revenue subject to a


minimum profit requirement is usually referred to as

A. the aggregate model. B) the Baumol model.

C) the aggressive model. D) the Marshall model.

Answer:

8. In the Baumol model, the total quantity sold will usually be larger than

A. if perfect competition prevailed. B) if total costs were minimized.

C) if profit were maximized. D) if companies were interdependent.

Answer:

9. In the Baumol model, a change in fixed costs will


A. increase total quantity sold. B) have no effect on total quantity sold.

C) decrease total quantity sold. D) have an effect on total quantity sold.

Answer:

10. In order that price discrimination can exist,

A. markets must be capable of being separated.


B. markets must be interdependent.
C. different demand price elasticities must exist in different markets.
D. demand price elasticities must be identical in all markets.

E. Both
A and
C.
Answ
er:

11. Third-degree price discrimination exists when

A. the seller knows exactly how much each potential customer is willing to pay and will charge
accordingly.
B. different prices are charged by blocks of services.
C. when the seller can separate markets by geography, income, age, etc., and charge different
prices to these different groups.
D. when the seller will bargain with buyers in each of the markets to obtain the best possible price.

Answer:

12. The result for the seller of being able to practice price discrimination will be

A. higher profits. B) lower demand elasticity.

C) lower quantity sold. D) cost minimization.

Answer:
13. The practice by a monopolist of charging each buyer the highest price he/she is willing to pay is
called

A. first-degree discrimination. B) second-degree discrimination.

C) third-degree discrimination. D) fourth-degree discrimination.

Answer:

14. When state universities charge higher tuition fees to out-of-state students than to local
students, the universities are practicing

A. first-degree discrimination. B) second-degree discrimination.

C) third-degree discrimination. D) fourth-degree discrimination.

Answer:

15. The following are possible examples of price discrimination, except

A. prices in export markets are lower than for identical products in the domestic market.
B. senior citizens pay lower fares on public transportation than younger people at the same time.
C. a product sells at a higher price at location A than at location B, because transportation costs are
higher from the factory to A.
D. subscription prices for a professional journal are higher when bought by a library than when
bought by an individual.

Answer:

16. Under conditions of first-degree price discrimination

A. production may equal that which would exist under perfect competition.

B. production may exceed that which would prevail under perfect competition.

C. prices will be lower than under perfect competition.

D. production will always be lower than under perfect competition.


Answer:
17. If a product which costs $8 is sold at $10, the profit margin is A)
$2. B) 25%.
C) 20%. D) None of the above.

Answer:
18. If a product which costs $8 is sold at $10, the mark-up is A)
$2. B) 25%.
C) 20%. D) None of the above.

Answer:

19. The correct expression for cost plus pricing is

A. Price = Cost (1 + profit margin). B) Price = Cost + profit margin.

C) Price = Cost (1 + mark-up). D) Price = Cost + (1 + mark-up).

Answer:

20. If the demand elasticity for a product is -2, and a profit-maximizing firm sells the product for

$10, its marginal cost must be

A) $5. B) $10. C) $15. D) $8.

Answer:

21. When mark-up equals 50%, then demand elasticity will be

A) -1. B) -1.5. C) -2. D) -3.

Answer:

22. The pricing of a product at each stage of production as the product moves through several stages
is called
A. transfer pricing. B) cost plus pricing.

C) penetration pricing. D) monopolistic pricing.

Answer:

23. A company which charges a lower price than may be indicated by economic analysis to gain a
foothold in the market is practicing

A. price skimming. B) psychological pricing.

C) penetration pricing. D) prestige pricing.

Answer:

24. Assume that a multinational company produces components in country A, and ships them to a
subsidiary in country B. In order to increase its profits,

A. the company should charge a high transfer price for the components if income taxes in country B
are higher than in country A.
B. the company should charge a low transfer price for the components if income taxes in country B
are higher than in country A.
C. the company should charge a high transfer price for the components if income taxes in country A
are higher than in country B.
D. None of the above.

Answer:

25. Barometric price leadership can occur when oligopolistic firms

A. compete on the basis of differentiated products.

B. want to avoid price competition and violating antitrust laws.

C. try to enforce cartel agreements.

D. All of the above.

Answer:
26. Revenue maximization occurs when a firm sells at a price

A. that is equal to its minimum average variable cost.


B. where its marginal revenue is equal to its marginal cost.
C. where its marginal revenue is zero.
D. None of the above

.
Answer:

27. Second-degree price discrimination occurs when

A. different prices are charged for different blocks of services.


B. different groups of buyers are charged different prices based on their price elasticities of demand.
C. a different price is charged is charged for each amount of a product purchased.
D. None of the above.

Answer:

28. "Tying" is a form of price discrimination which involves a buyer

A. agreeing to purchase a product at a fixed price regardless of the amount purchased.

B. paying different prices based on the amounts of a product purchased.

C. required to buy one product in order to purchase some other product.

D. All of the above.

Answer:

29. Gasoline and heating oil are examples of products which are

A. joint products in fixed proportions. B) joint products in variable proportions.


C) joint products that are complements. D) unrelated to each other.

Answer:

30. Transfer pricing is a method used to

A. determine whether a firm should make or buy a component product.


B. determine the correct value of a product as it moves from one stage of production to another.
C. minimize a multinational firm's tax liabilities.
D. All of the above.

Answer:

Analytical Questions
1. Why does each of the following facilitate the creation and stability of a cartel?

a. High barriers to entry


b. An identical product
c. Similar costs

Answer:
a. A successful cartel implies positive profits. Positive profits attract entry, if it is
possible, and increasing the number of firms in the industry erodes the cartel's control and pricing
power (or makes it more difficult to negotiate with the larger number of firms in the industry).
b. If products are not identical, then consumers may have brand preferences, and thus it is
possible for firms to cheat on the cartel by promoting nonprice differences.
c. If costs are similar, profits are similar, and the incentives of each firm will be similar, all
other things equal. This makes it easier to agree on price and more "fair" in the sense that
firms will receive similar profits.

2. Industry demand is given by:

QD = 1000 - P
All firms in the industry have identical and constant marginal and average costs of $50/unit.
a. If the industry is perfectly competitive, what will industry output be? What will be the
equilibrium price? What profit will each firm earn?
b. Now suppose that there are five firms in the industry, and that they collude to set price. What price
will they set? What will be the output of each firm? What will be the profit of each firm?
Answer:

a. P = 50, so Q = 950. Each firm earns an economic profit of zero.


b. MR = 1000 - 2Q. Set MR =
MC 50 = 1000 - 2Q
Q=
475 P =
$525

Each firm produces 1/5 the output, or q =95. Profit for each firm is $45,125.

3. Why do cartels tend to break up?

Answer: There are many reasons, but one of the best is that there is an incentive to cheat.
While the cartel maximizes joint profits, individual profit could be increased if the firm could
sell more at the cartel price. If everyone does that, output increases and the price falls.

4. A monopolist sells to two consumer groups, students and non-students.


Demand for students: Q = 500 - 1/2P
Demand for non-students: Q = 750 -
2P MC = 20
Find the profit-maximizing price/quantity combination in each market if the groups can
be separated.

Answer:
Student
s:
P = 1000 - 2Q
MR = 1000 -
4Q
Set MR = MC. 20 = 1000 -
4Q 245 = Q, P = $510

Non-students:
P = 375 - 1/2
Q MR = 375 -
Q
Set MR = MC. 20 = 375 -
Q 355 = Q, P = $197.50
5. McDonald's charges a higher price for a Big Mac in New York City than it does in a small town
in Iowa. Is this an example of third degree price discrimination? Explain.

Answer: No, or not necessarily. Costs differ between the two markets, because land is
more expensive in New York City. Thus the higher price reflects that.

6. Some charge that third degree price discrimination is unfair or that it reduces social welfare. Why
does charging one group a lower price hurt anyone?

Answer: There's an equity issue about charging different prices to different people, but the
real social welfare issue is not about charging a lower price to one group; it's about charging
a higher price to the other. If the firm charged a single price, it would be somewhere
in between the two group prices, in most cases. So some customers who would be
able to buy at a lower price in the combined market pay more (or do not buy at all) in
the separated market.

7. Firms that make game systems like Playstation and Nintendo typically charge a price close to average
cost on the game system itself, and do not change that price even when the systems
are scarce or demand increases. Why might this be a profit-maximizing strategy?

Answer: These firms are selling two products, the systems and the games. These are
complementary products. If they increase the price of the systems, they reduce the demand
for games (and games are repeat purchases rather than one-time purchases). Additionally, the
system is the "hook", or the loss leader that draws customers in. Once you have the system,
the switching cost of moving to another system is significant. Thus the systems are cheap,
and the games are expensive.

8. In the Sunday newspaper, there are usually coupons that you can clip and take to the store to save
money on products. Anyone can buy a newspaper, and the value of the coupons easily exceeds the
price of the newspaper for most consumers. Is this an example of price discrimination? Explain.

Answer: Yes, it is. Consumers with more time are likely to have a more elastic demand for
products, and thus they are willing to clip the coupons (and may not buy except at the
lower price). Other consumers with less time won't deal with the coupons and thus will pay
a higher price. This is essentially the same idea as movie matinee pricing.

9. Would it ever make sense for a firm to charge a price at or below the cost of the product?

Answer: This might be an example of penetration pricing in which the firm is trying to
gain market share. (Two other reasons not discussed in the text: limit pricing to prevent
entry, and predatory pricing to drive out rivals.)
10. Superstar actors typically get contracts that specify that they get a percentage of "the gross", the total
revenues that the movie brings in. Why might actors want contracts structured that way? Why might
producers be willing to agree to that, and how does this make the goals of actors and producers
different?

Answer: tors want to maximize revenue with this sort of contract, while producers wish to
maximize profit. It is clearly advantageous to the actor, since cost overruns won't impact what
they receive. But it might also suit producers, because if actors are interested in maximizing
revenue, they have an incentive to promote the movie and try to increase sales (and to do a
good job). This might be more of an incentive than a cut of the profits, over which they have
less control.

11. A firm in an oligopolistic industry has the following demand and total cost equations: P =
600 - 20Q and TC = 700 + 160Q + 15Q2;
Calculate:

a. quantity at which profit is maximized.


b. maximum profit.
c. quantity at which revenue is maximized.
d. maximum revenue.
e. maximum quantity at which profit will be at least $580.
f. maximum revenue at which profit will be at least $580.

Answer: f revenue and cost schedules are


calculated: a. 6 b. 680 c. 15 d. 4500 e. 8 f. 3520
If results are calculated with equations:
a. 6.286 b. 682.86 c. 15 d. 4500 e. 8 f. 3520

12. A monopolistic firm operates in two separate markets. No trade is possible between market A and
market B. The firm has calculated the demand functions for each market as follows:
Market A p = 15 - Q; Market B p = 11 - Q
The company estimates its total cost function to be: TC = 4Q.
Calculate:
a. quantity, total revenue and profit when the company maximizes its profit and charges the same price
in both markets.
b. quantity, total revenue and profit when the company charges different prices in each market and
maximizes its total profit.

Answer: f revenue and cost schedules are


calculated: a. Q = 9; p = 8.5; TR = 76.5; TC = 36;
profit = 40.5
b. Market A:
Q = 5 to 6; p = 9 to 10; TR = 50 to 54; TC = 20 to 24; profit =
30 Market B:
Q = 3 to 4; p = 7 to 8; TR = 24 to 28; TC = 12 to 16; profit =
12 Combined profit = 42

If equations are used:


a. Q = 9; p = 8.5; TR = 76.5; TC = 36; profit = 40.5
b. Market A:
Q = 5.5; p = 9.5; TR = 52.25; TC = 22; profit = 30.25
Market B:
Q = 3.5; p = 7.5; TR = 26.25; TC = 14; profit = 12.25
Combined profit = 42.5

13. Briefly describe the conditions under which cartels will be formed.

Answer: n industry with relatively few firms selling identical or very similar products,
where entry is very difficult and cost structures are very similar. Also, geographic proximity
of the firms is very helpful.

14. Explain the reasons firms might follow the Baumol model of maximizing revenue subject to
achieving a minimum level of profits.

Answer: rms might wish to increase their market shares within the industry, managers' power
and prestige tend to grow with an increase in the size of a business' level of operations,
eschewing profit maximization might avoid new firms entering the industry and/or pressure
for government regulation, and increases in the scale of a firm's level of operation might
permit capturing cost economies of scale through greater market power to extract lower
prices from the firm's suppliers of inputs.

15. Describe the circumstances under which a producer of joint products in fixed proportions might
not sell all of one of the available joint products at the profit maximizing level of operations.

Answer: t the profit maximizing level of output, the demand for that joint product would be

such that the price at which it could be sold would involve negative marginal revenue and,
hence, a reduction in total profits. Thus sales would be limited to an amount where the last unit
sold brings in zero marginal revenue and the remaining units would not be sold (they could be
held for sale at a later date if the price might be expected to increase and if the costs of holding
the unsold product were less the present value of the expected revenue; otherwise the unsold
product would be destroyed).
Chapter 11 Game Theory and Asymmetric Information

Multiple-Choice Questions

1. Asymmetric information represents a market situation in which

A. all parties to a transaction possess less than full information.

B. one party in a transaction has more information than the other party.

C. some information possessed by the parties in a transaction may be false.

D. a zero-sum game exists.

Answer:

2. The Prisoner's Dilemma is an example of

A. market signaling.

B. a zero-sum game.

C. a non-zero sum, noncooperative game with a dominant strategy.

D. adverse selection.

Answer:

3. Moral hazard is the

A. outcome of a Prisoner's Dilemma.


B. result of market signaling.
C. risk associated with a Dutch auction.
D. risk that one party to a contract may alter its post-contract behavior to the detriment of another party.

Answer:

4. Market signaling

A. is a way of conveying information to other parties in a transaction where asymmetric information


exists.
B. represents a dominant strategy in a multi-player game.
C. results in an optimum solution to a beach kiosk scenario.
D. None of the above.

Answer:

Analytical Questions
1. What is the "market signaling"?

Answer: way of signaling information to other parties in situations where asymmetric


information exists so that their ability to make correct decisions is improved.

2. What is "moral hazard"?

Answer: The risk involved to one party when another party's behavior changes in a
detrimental manner after a contract has been entered into. Usually, this is the result of
asymmetric information.

3. What is "asymmetric information"?

Answer: market situation in which one party in a transaction possesses more complete
information than another party.

4. What is "adverse selection"?


Answer: situation in which the risk associated with the existence of asymmetric information
causes one party not to enter into a contractual relationship with another party.

5. What is "game theory"?

Answer: formal mathematical approach to examining the strategies used by individuals to


make decisions when they know that their actions will affect the decisions of other individuals,
and the other individuals take this into account in their decision making. It is particularly
useful in analyzing business decision making in oligopolistic markets where firms are
mutually interdependent.

6. What is a "payoff matrix"?

Answer: tabular presentation of various outcomes to each player, in a two-player situation,


based on the various simultaneous decisions made by the players.

7. In game theory analysis, what is a "dominant strategy"?

Answer: strategy that would be the best one for a player in a non-cooperative game no matter
what strategies are adopted by the other players in the game.

Chapter 12 Capital Budgeting, Risk, and Uncertainty

Multiple-Choice Questions

1. The term "capital budgeting" refers to decisions

A. which are made in the short run.


B. which concern the spreading of expenditures over a period lasting less than one year.
C. where expenditures and receipts for a particular undertaking will continue over a relatively
long period of time.
D. where a receipt of cash will occur simultaneously with an outflow of cash.
Answer:

2. Capital budgeting projects include all of the following with the exception of

A. the purchase of a six-month treasury bill.


B. the expansion of a plant.
C. the development of a new product.
D. the replacement of a piece of equipment.

Answer:

3. If $1,000 is placed in an account earning 8% annually, the balance at the end of seven years will be

A) $1,080. B) $1,560. C) $2,000. D) $1,714.

Answer:

4. The payback period for a project, requiring an initial outlay of $10,000 and producing ten uniform
annual cash inflows of $1,500, is

A. six years. B) six years and eight months.

C) six years and six months. D) seven years.

Answer:

5. The net present value of a project is calculated as follows:

A. The future value of all cash inflows minus the present value of all outflows.

B. The sum of all cash inflows minus the sum of all cash outflows.

C. The present value of all cash inflows minus the present value of all cash outflows.

D. None of the above.

Answer:
6. A proposed project should be accepted if the net present value is

A. positive. B) negative.

C) larger than the internal rate of return. D) smaller than the internal rate of return.

Answer:

7. When future events cannot be assigned probabilities, we are talking about

A. risk. B) uncertainty.

C) a clouded future. D) financial risk.

Answer:

8. Probabilities, which can be obtained by repetition or are based on general mathematical


principles are called

A. statistical. B) empirical. C) a priori. D) subjective.

Answer:

9. Other things being equal, the higher the cost of capital,

A. the higher the NPV of a project.

B. the higher the IRR of the project.

C. the lower the NPV of the project.

D. the cost of capital has no effect on the NPV of the project.


Answer:

10. The internal rate of return of a project can be found

A. by discounting all cash flows at the cost of capital.


B. by averaging all cash inflows, and calculating the interest rate, which will make them equal to the
average investment.
C. by calculating the interest rate, which will equate the present value of all cash inflows to the present
value of all cash outflows.
D. None of the above.

Answer:

11. In finance, risk is most commonly measured by

A. the probability distribution.

B. the standard deviation.

C. the average deviation.

D. the square root of the standard deviation.

Answer:

12. A project whose acceptance eliminates another project from consideration is called

A. independent. B) mutually exclusive.

C) replacement D) complementary.

Answer:

13. The internal rate of return equals the cost of capital when
A. NPV = 0. B) NPV > 0.

C) NPV < 0. D) None of the above.

Answer:

14. When two mutually exclusive projects are considered, the NPV calculations and the IRR
calculations may, under certain circumstances, give conflicting recommendations as to which
project to accept. The reason for this result is that in the NPV calculation, cash inflows are assumed
to be reinvested at the cost of capital, while in the IRR solution, reinvestment takes place at

A. the hurdle rate. B) the accounting rate of return.

C) the prime rate. D) the project's internal rate of return.

Answer:

15. When analyzing a capital budgeting project, the analyst must include in his calculation all of the
following except

A. all revenues and costs in terms of cash flows.


B. only those cash flows that will change if the proposal is accepted (i.e., incremental cash flows).
C. interest payments on debt financing connected with the project.
D. any effect (impact) the acceptance of the project under consideration will have on other projects
now in operation.

Answer:

16. The use of the same cost of capital (risk adjusted discount rate) for all capital projects in a
corporation

A. is usually the correct procedure.


B. is incorrect since different divisions of the corporation may be faced with different levels of risk.
C. is incorrect since different capital projects, even in the same division, may be faced with different
levels of risk.
D. Both B and C.
Answer:
17. If a risky cash flow of $10,000 is equivalent to a riskless cash flow of $9,300, the certainty
equivalent factor is
A) 0.93. B) 0.07. C) 1.07. D) 1.93.

Answer:

18. If, at the end of the project life, a piece of equipment having a book value of $4,000 is expected to
bring $3,000 upon resale, and the income tax rate is 40%, how much will be the cash flow?

A) $2,800 B) $3,000 C) $3,400 D) $4,000

Answer:

19. If the risk adjusted discount rate method and the certainty equivalent methods are to give the same
results, then the certainty equivalent factor (at) must equal (where rf is the risk-free interest rate, and
k is the risk adjusted cost of capital)

A. (1 + rf)t times (1 + k) t B) (1 + k) t divided by (1 + rf) t

C) (1 + rf) t divided by (1 + k) t D) (1 + k) t minus (1


+ rf) t

Answer:

20. Two projects have the following NPV's and standard deviations:

Project A Project B
NPV 200 200
Standard deviation 75 100

A person who selects project A over project B is

A. risk seeking. B) risk indifferent.

C) risk averse. D) None of the above.


Answer:

21. An increase in net working capital required at the beginning of an expansion project must be
considered to be

A. a cash inflow. B) a reallocation of assets.

C) a cash outflow. D) None of the above.

Answer:

22. Usually, the cost of capital for newly issued stock is the cost of retained earnings.

A. lower than B) higher than

C) same as D) either higher or lower

than Answer:
23. A stock whose rate of return fluctuates less than the rate of return of a market portfolio will have a
beta that equals

A. 1. B) less than 1.

C) more than 1. D) Either A or C above.

Answer:

24. The use of sensitivity analysis will generally result in

A. the calculation of a certainty equivalent NPV.

B. the calculation of a best case, a base case and a worst case.

C. the calculation of the coefficient of variation.

D. the calculation of the probability of the maximum profit.

Answer:
25. A company's capital structure is made up of 40% debt and 60% common equity (both at market
values). The interest rate on bonds similar to those issued by the company is 8%. The cost of equity
is estimated to be 15%. The income tax rate is 40%. The company's weighted cost of capital is

A) 11.5%. B) 12.2%. C) 10.9%. D) 8.9%.

Answer:

26. Capital rationing

A. exists when a company sets an arbitrary limit on the amount of investment it is willing to undertake,
so that not all projects with an NPV higher than the cost of capital will be accepted.
B. generally does not permit a company to achieve maximum value.
C. seems to occur quite frequently among corporations.
D. All of the above.

Answer:

27. The time value of money can be best described as

A. a dollar to day is worth more than a dollar tomorrow.

B. the basis on which net present values are calculated.

C. the basis on which internal rates of return are calculated.

D. All of the above.

Answer:

28. Net present value and internal rate of return capital budgeting decisions can differ because

A. the initial costs of the capital outlays differ.


B. the cash flow streams differ.

C. the discount rates differ for different time periods.

D. All of the above.

Answer:

29. Simulation analysis

A. permits the calculation of expected value and standard deviation.

B. does not permit the calculation of expected value and standard deviation.

C. is too complex to ever be used in actual business situations.

D. does not consider probabilities.

Answer:

30. The expected value is

A. the total of all possible outcomes.

B. the arithmetic average of all possible outcomes.

C. the average of all possible outcomes weighted by their respective probabilities.

D. the total of all possible outcomes divided by the number of different possible outcomes.

Answer:

31. An advantage of the decision tree is that

A. it eliminates the need for calculating the cost of capital.


B. it eliminates the need for calculating probabilities.
C. it causes the analyst to consider important events that may occur in the course of the project, and
decisions and actions that may have to be undertaken.
D. All of the above.

Answer:

32. A real option can present management with the opportunity to

A. vary output. B) abandon a project.

C) postpone a project. D) All of the above.

Answer:

33. A source of business risk is a change in

A. technology. B) consumer preferences.

C) input prices. D) All of the above.

Answer:

34. The certainty equivalent approach to accounting for risk in capital budgeting involves

A. adjusting the discount rate used to calculate net present values.

B. adjusting the expected cash flows.

C. estimating the coefficient of variation.

D. estimating the standard deviation of the net present values.

Answer:

35. A drawback in the use of sensitivity analysis in capital budgeting decisions is that it doesn't
A. permit evaluating alternative outcomes.

B. provide estimates of net present values.

C. assign probability values to outcomes.

D. consider different possible rates of discount.

Answer:

36. The following is an example of risk in capital budgeting on a global basis:

A. exchange rate changes B) tariff changes

C) expropriation D) All of the above.

Answer:

37. The risk adjusted discount rate

A. is the sum of the risk-free rate and the risk premium.

B. includes risk in the denominator of the present value calculation.

C. includes risk in the numerator of the present value calculation.

D. All of the above.

Answer:

38. A drawback in using the payback approach to capital budgeting decisions is

A. it doesn't account for the time value of money.


B. it ignores cash flows beyond the payback period.

C. it doesn't adjust for differences in the stream of cash flows.

D. All of the above.

Answer:

39. The cost of capital is best described as the

A. opportunity cost of financing a capital outlay.

B. funds that must be acquired to finance a capital outlay.

C. decrease in stockholder equity due to a capital outlay.

D. All of the above.

Answer:

40. Capital rationing refers to

A. setting a minimum acceptable rate of return for a capital outlay.


B. selecting among profitable capital outlays when there are constraints on the funds available.
C. determining the maximum price to pay for a capital good.
D. None of the above.

Answer:

41. In evaluating the required rate of return for equity financing of a capital project, the Beta value
is(a) the expected rate of growth in a firm's profits.

A. the expected future value of a firm's stock.


B. the volatility in the rate of return on a firm's stock compared with the volatility in the rate of return
on a market portfolio of stocks.
C. None of the above.
Answer:

42. When future events cannot be assigned probabilities, we are talking about

A. risk. B) uncertainty.

C) a clouded future. D) financial risk.

Answer:

43. Probabilities, which are based on past data or experience, are called

A. a priori. B) objective. C) uncertain. D) statistical.

Answer:

44. The use of real options in capital budgeting

A. may raise the NPV of a capital project.

B. makes the analysis of the project considerably easier.

C. allows management to make decisions more quickly.

D. eliminates the need for calculating the project's risk adjusted discount rate.

Answer:

45. The difference between sensitivity analysis and scenario analysis is

A. sensitivity analysis is a method for evaluating risk while scenario analysis is not.
B. sensitivity analysis is based on regression analysis while scenario analysis is not.
C. sensitivity analysis examines the impact on the overall results of a change in one variable while
scenario analysis examines the impacts on overall results of changes in several variables at the same
time.
D. None of the above.

Answer:

Analytical Questions
1. You deposit $10,000 in a savings account today. If the interest rate is 3%, what is the value in 20
years?

Answer: V = PV(1+i)n = 10,000(1.03)20 = $18,061

2. You start working at age 20 and you plan to deposit $5,000 in a savings account every year for the
next 45 years.

a. At the end of this time, how much money will you have if the interest rate is 5%?
b. You decide that's not enough money. How much will you have to save every year if you wish to
have $1,000,000 when you retire?

Answer:
a. FV = 5,000 {((1+ i)n – 1)/i} = $798,500
b. You will have to save $6,261 per year.

3. An aircraft company has signed a contract to deliver a plane 3 years from now. The price they will
receive at the end of 3 years is $20 million. If the firm's cost of capital is 6%, what is the present
value of this payment?

Answer: PV = 20/(1.06)3 = $16.79 million

4. An aircraft company has signed a contract to sell a plane for $20 million. The firm buying the plane
will pay for it in 5 annual payments (at year end) of $4 million. If the firm's cost of capital is 6%,
what is the net present value of this payment?

Answer: PV = $16.85 million

5. A firm must spend $10 million today on a project that is expected to bring in annual revenues of
$1.5 million for the next 10 years (beginning at the end of year 1).
a. If the firm's cost of capital is 5%, what is the NPV of this project?
b. If the firm's cost of capital is 10%, what is the NPV of this project?
c. What is the internal rate of return?

Answer:

a. Present value of the revenues = $11.58 million, so NPV = $1.58 million.


b. Present value of the revenues = $9.22 million, so NPV = -$0.78 million. c.
8.15%

6. If an expansion proposal is accepted, allowing an otherwise idle (and useless) machine with a
market value and book value of $2,000 to be utilized, should it be recorded as a cash outflow, and if
so, how much?

Answer: Yes, $2,000

7. You win the $20 million state lottery, and you have a choice of taking an amount of money per year
for the next 20 years or a flat payment now. The flat payment that the state offers you is
$9.82 million.

a. What discount rate is the state using?


b. Should you take the money or the annuity?

Answer:

a. 8% (This is essentially the internal rate of return on the project.)


b. In general, it depends on what return you think you can get on the money. If you think you can do
better than 8%, you're better off with the cash.

8. If the interest rate is 7% and the tax rate is 15%, what is the after -tax cost of capital for the firm?

Answer: .07(1 - .15) = 5.95%

9. Inc.'s stock is currently $50. The last dividend that they paid was $1. If

dividends are expected to increase at a 10% annual rate, what is the firm's equity cost of

capital? Answer: ke = D1/P0 + g = 1.10/50 + .10 = 12.2%

10. If a company's stock is perceived to be more risky than average, what will happen to their equity
cost of capital? Explain using the capital asset pricing model.
Answer: stock that is more volatile (riskier) than the market average will have a beta of
greater than 1. This means that the return that stockholders will require will be greater than
average
[kj = Rf + b(km – Rf)]. In other words, the company will have to pay stockholders more
since they must take a greater risk, and the equity cost of capital will rise.

11. Explain what is meant by the "weighted cost of capital" and how it is used in capital
budgeting.

Answer: The proportion of each type of financing (debt, equity and retained earnings) in the
firm's capital structure, and applying these percentages to the opportunity costs of capital
associated with financing a prospective capital outlay. This weighted average of the
opportunity cost of capital then is used to discount projected cash flows back to a net present
value.

12. Describe the Capital Asset Pricing Model (CAPM) and how it is used in capital budgeting
decisions.

Answer: APM is a procedure for adjusting a measure of the required rate of return on a firm's
stock for risk. This risk-adjusted measure of the required rate of return on a firm's stock is
used as the opportunity cost of capital in equity financing of a capital project. The projected
cash flows from the project are discounted back to a net present value using this risk-adjusted
rate of return. The risk adjustment is based on the Beta value of a firm's stock: the ratio of the
volatility in the rate of return on a firm's stock to the volatility in the rate of return on a market
portfolio of stocks.

13. What additional complexities arise when multinational corporations consider capital projects on a
global basis?

Answer: onsiderations must be given to the impact on projected cash flows from differences
in tax laws and tax rates, exchange rate controls and changes, limitations on repatriation of
profits, tariffs and quotas on imported products, and special licensing fees. In addition, rates
used to discount cash flows back to present values must be adjusted for differences in rates of
inflation and taxes, and risks associated with expropriation of assets and political-social
instability.

14. A firm's most recent annual dividend was $2 per share; its shares sell for $40 in the stock market,
and the company expects its dividend to grow at a constant rate of 5% in the foreseeable future.
Using the dividend growth (Gordon) model, what would you estimate its equity cost of capital to
be?

Answer: 10.25% = [(2)(1.05)/(40 + .05)]


15. What are the major sources of risk for the firm?

Answer: conomic uncertainty, competition (actions of competitors), changes in


demand, changes in technology, changes in input costs

16. You buy a lottery ticket for $1. If you win, you receive $3 million. The odds of your numbers coming
up are 1:10,000,000. What is the expected value of this gamble?

Answer: xpected value = (3 million)(0.0000001) + (-1)(0.9999999) = -$0.69, or you expect


to lose 69 cents.

17. Project A and Project B both have expected values of $5,000. Project A has a standard
deviation of $1,000, while Project B has a standard deviation of $3,000. Comment on the
desirability of these projects.

Answer: oth have the same expected value, but A has a lower standard deviation. It is
99% certain that the return from A will be between $2,000 and $8,000. However, for B, it
is
99% certain that the return will be between $-4,000 and $14,000. Project B is more
risky and thus less desirable.

18. Project C has an expected value of $500 and a standard deviation of 50. Project D has an
expected value of $300 and a standard deviation of 10. Comment on the desirability of these
projects.

Answer: VC = 50/500 =
0.10 CVD = 10/300 = 0.03
Project D has a lower coefficient of variation and thus is more desirable. Even though its
expected value is lower, it's lower standard deviation (and thus lower risk) makes up for
this.

19.
100 0.15
150 0.20
220 0.30
290 0.20
310 0.15
The Widget Company has estimated the following revenue possibilities for the
year: Sales Probability

a. Find expected revenue.


b. Find the standard deviation.
c. Find the coefficient of variation.

Answer:

a. Expected revenue is $215.50.


b. Standard deviation = 72.90
c. Coefficient of variation = 0.34

20. Savings accounts pay very low rates of interest. The average return on the stock market is about
10-12%, in the long run. Why would anyone put money into a savings account?

Answer: The stock market gives a higher return for higher risk. Particularly if you are
very averse to risk, you might find the savings account to be an attractive alternative.

21. A two-period project has the following probabilities and cash flows:

Probability Cash flow


Period 1: .25 500

.50 600
.25 700

Period 2: .30 300


.50 500
.20 700
The discount rate is 7%, and the initial investment is $1,000. How much is the expected NPV
of this project?

Answer: $-20.

22. Two projects have the following NPV's and standard deviations:

Project A Project B
NPV 200 300
Standard deviation 75 100

Which of the two projects is more risky?

Answer: Since the two projects have different NPV's and different standard deviations,
relative risk can be measured by the coefficient of variation. Project A has a CV of.375,
project B .333. Thus, the relative risk of project B is less.

23. In terms of capital budgeting, explain the difference between risk and uncertainty.

Answer: Uncertainty involves possible future events to which no probability values can be
assigned, while risk involves such events to which probabilities can be attached to their
outcome. Thus, risk adjustments can be made to expected cash flow values and/or opportunity
cost rates of discount. With uncertainty, no such adjustments can be made.

24. Describe the real option approach to risk-adjusted capital budgeting.

Answer: Real options involve the contractional ability to make changes in capital projects,
particularly once they are underway. Such options involve the ability to alter outputs (expand,
contract, shutdown), alter inputs (both input types and processes using them), and postpone or
abandon projects. These options give the holder the right, but not the obligation, to exercise
them

and usually require the holder to pay an extra amount for this privilege. To determine whether
such options are worthwhile, one would calculate the difference in the expected net present
values of the capital projects with and without the option and compare it to the cost of paying
for the option.
25. Explain why risk can be insured against but uncertainty cannot.

Answer: The provider of insurance policies can assign probabilities to the occurrences of
insurable events and calculate premium rates to charge. With uncertainty, no probabilities can
be attached to such events and it isn't possible to construct the appropriate premium rates.

26. You are given risky cash flow data for a three-year project:

Year Cash flow


1 $2,000
2 3,000
3 4,000

The initial cash outflow is $6,000; the risk-free interest rate is 6%, and the risk-adjusted
discount rate is 10%.

Calculate the NPV by both the risk-adjusted discount rate method and the certainty
equivalent method in such a way that the NPV will be the same using either method.

Answer:
Riskless Risky
Cash Flow Cash Flow
CE Discounted Discounted
Year Cash Flow Factor* Riskless at 6% at 10%
Cash Flow
1 2000 0.963636 1927 1818 1818
2 3000 0.928595 2786 2479 2479
3 4000 0.894828 3579 3005 3005

Total 7303 7303


Less initial investment 6000 6000
NPV 1303 1303
*CE factors:
1.06/1.1 = 0.963636
1.06²/1.1² = 0.928595
1.063/1.13 = 0.894828

27. What additional sources of risk come from international investments?

Answer: xchange rate risk, and political risks such as regulation, discrimination,
and expropriation

28. The XYZ Company has estimated expected cash flows for 1996 to be as follows:

Probability Cash flow


.10 $120,000
.15 140,000
.50 150,000
.15 180,000
.10 210,000

Calculate:

a. expected value
b. standard deviation
c. coefficient of variation
d. the probability that the cash flow will be less than $100,000.

Answer: . $156,000
b. $23,749
c. 0.152
d. 0.91% (z-statistic is 2.36)

29. You are given the following risky cash flows and certainty equivalent factors for a four-year project:

Certainty Cash Flow Equivalent


Period Factor
1 $2,500 .95
2 3,000 .92
3 4,000 .88
4 3,000 .84

The initial investment for this project is $8,000, and the risk-free interest rate is 6%.
Calculate the net present value of the project.

Answer: $1,648

Chapter 13 Multinational Corporation and Globalization

Multiple-Choice Questions

1. Which of the following are risks for multinational corporations but not risks for domestic
corporations?

A. changes in government rules and regulations


B. capital controls
C. changes in tax laws
D. government red tape and corruption
Answer:
2. Which of the following represent ways in which multinational corporations can protect
themselves from exchange rate risks?

A. forward markets B) futures markets

C) currency options D) All of the above.

Answer:

3. Which of the following represent capital budgeting problems for multinational corporations but not
for domestic corporations?

A. determining the cost of capital

B. calculating after-tax cash flows

C. selecting the appropriate risk-adjusted rates of return

D. None of the above.


Answer:

4. Which of the following are not arguments in favor of the globalization of business?

A. more efficient use of resources lowers operating costs and selling prices
B. more products are made available and new markets are opened
C. economic and political security is enhanced
D. technology transfers improve living standards in poorer countries Answer:

Analytical Questions
1. What are the major risks facing multinational corporations?

Answer: Sudden and unexpected changes in exchange rates; capital controls; expropriation of
property; ownership and human resource restrictions; lack of protection for intellectual
property; non-enforcement of contracts and business laws; civil unrest and wars; corruption;
discriminatory policies against foreign personnel and businesses (including red tape and
special fees and other charges); and sudden changes in governments.

2. What are the major ways that the risks of exchange rate changes can be hedged against?

Answer: Offsetting transactions in the same currency; buying or selling currency in the
forward or futures markets; call or put options; and currency swaps.

3. What are the major reasons a multinational corporation would engage in Foreign Direct
Investment (FDI)?

Answer: reater profit earning opportunities in other markets; take advantage of economies of
scale and/or scope; have direct access to natural resources; operate within a currency
union and avoid restrictions and other discriminatory policies against
foreign businesses operating within a country.

4. What are the ways a multinational corporation can reposition its funds to increase its profits?
Answer: Transfer pricing to take advantage of differences in tax rates among countries;
royalty payments, license fees and dividends to transfer funds to other more profitable
entities while avoiding income taxes or to take advantage expected changes in exchange
rates.

Chapter 14 Government and


Industry: Challenges and
Opportunities for Today's Manager

Multiple-Choice Questions
1. Which of the following is not considered a rationale for the intervention of government in the market
process in the United States?

A. the redistribution of income

B. the reallocation of resources

C. the long-run planning of scarce resources

D. the short-run stabilization of prices

E. All of the above.

Answer:

2. Which of the following is the best example of a good or service that provides a benefit
externality?

A. the construction of a private road that allows vehicles if a toll is paid

B. a public library

C. a bookstore that is open to everyone


D. All of the above.

E. None of the above.

Answer:

3. Which of the following is not an example of a cost externality?

A. the dumping of industrial waste into a lake

B. unsightly billboards

C. a neighbor that blasts his stereo system

D. the building of a new type of jet fighter bomber

E. All of the above.

Answer:

4. The demand for products that provide benefit externalities is generally _ the demand for
products that do not.

A. greater than
B. less than
C. the same as
D. greater or less (depending on the market) than

Answer:

5. The supply for products that exhibit cost externalities is generally the supply for
products that do not.

A. greater than
B. less than
C. the same as
D. greater or less (depending on the market) than
Answer:
6. Which of the following is an example of a government action to internalize a cost externality?

A. a fine imposed on a company that pollutes a stream


B. the closing of a public library
C. a sales tax on jewelry
D. the increase on bridge tolls
Answer:
7. When cost externalities exist, an optimal equilibrium can be attained if the government

A. restricts production.
B. levies a tax for the difference between private costs and social costs.
C. prohibits production.
D. All three above.

E. Both
A
and
B.
Ans
wer:
8. The Coase theorem states that, in the presence of cost externalities, an optimal equilibrium can be
attained

A. with government taxation.

B. by prohibiting production.

C. by correctly defining property rights and through negotiation between the parties.

D. None of the above.

Answer:

9. Tying arrangements that lessen competition were made illegal by

A. the Sherman Anti-Trust Act. B) the Clayton Act.

C) the Celler-Kefauver Act. D) the Robinson-Patman Act.

Answer:
10. One school of anti-trust thought argues that, rather than ensuring efficiency, anti-trust laws are really
aimed at

A. protecting small independent firms against large corporations.

B. outlawing all monopolies whether they perform "bad acts" or not.

C. price differentiation due to differences in quality and cost.

D. restricting interlocking directorates.

Answer:

11. Which of the following would NOT be considered a synergistic benefit from a merger?

A. an improvement in distribution systems


B. economies of scale in production
C. decreased cost of capital
D. None of the above.

Answer:

12. A merger between two companies in unrelated fields of business

A. will always lead to economies of scale.


B. will generally increase the value of the unified firm compared to the value of the two companies
before the merger because of the benefits of diversification.
C. may not have any synergistic effects.
D. will necessarily lead to an increase in the market power of the merged company.

Answer:

Analytical
Questions
1. What are the five major reasons for government involvement in a market economy?

Answer: Provide the legal, monetary and social framework necessary for markets to operate.
Insure that markets operate in a competitive manner. Redistribute income and wealth in a more
desired (equitable) fashion. Guarantee a more efficient use of resources when there are benefit
and cost externalities. Stabilize the overall level of economic activity to counteract undesirable
levels of price inflation and unemployment.

2. A function of government is to regulate "natural monopolies." Explain what is a natural


monopoly and why it requires government regulation.

Answer: Natural monopolies occur when there are large cost economies of scale such that one
producer can operate in the declining range of average cost while meeting the entire market
demand for a product. In these situations it is more economical to have only one producer of
the product, since production costs will be lower and the product can be profitably sold at
lower price prices than if there were several or more producers. Thus, the economy would
benefit from having only one producer, but this would permit the producer to earn monopoly
profits from lack of competition. Therefore, government should permit only one producer but
regulate its operations, including selling prices, so that it doesn't exploit its monopoly position.

3. Describe the basic motives for businesses to merge.

Answer: Take advantages of synergies in operations: increase overall sales, reduce operating
costs, lower costs of capital. Mutual acquisition of skilled managers, as each of the
businesses may have skilled personnel that the other doesn't possess. Take advantage of
favorable tax consequences. Increase market power so as to enhance economic profits.
Diversify to reduce business risk. Increase the compensation of top executives, although this
often is at the expense of stockholders and other employees.

Chapter 15 Managerial Economics in


Action: The Case of the Semiconductor
Industry

Multiple-Choice Questions
1. Which of the following is not a feature of the semiconductor market structure?

A. high concentration of market power among the firms


B. capital intensity
C. technology driven
D. cyclical swings in market demand
Answer:
2. Semiconductor firms tend to be multinational because

A. cost considerations lead to production and distribution taking place in different countries.
B. labor force differences result in research and development being conducted in different countries
than are manufacturing.
C. marketing tends to be on a worldwide basis.
D. All of the above.

Answer:

3. Multinational subcontracting is very common in the semiconductor industry because

A. exchange rate fluctuations are frequent.

B. specialization in manufacturing and distribution is a major cost-saving consideration.

C. market demand keeps shifting.

D. None of the above.

Answer:

Analytical Questions
1. Describe the market structure of the semiconductor industry.
Answer: The semiconductor industry is a highly competitive one, which has experienced
rapid rates of growth but which also has been plagued by dramatic upswings and
downswings in market demand on a rather regular basis. In addition, it's very capital
intensive, technology driven, with research and development expenditures being its most
important component.
Further, the individual firms have very little market power and experience long lead times in
production. All these characteristics make this industry a very unstable and highly risky
capital venture.

2. Cite the major factors that affect the degree of competitiveness in the semiconductor industry.

Answer: Rapidly changing technology makes equipment and processes quickly obsolete,
thereby requiring large expenditures on research and development. In order to control costs
there has been increased outsourcing on a global basis of the packaging, warehousing and
shipping of the end products. Also, both the demands for and supply of the products have
become more global especially with the rapid economic growth in the Asia/Pacific region
(most notably China). As a business-to-business industry, semiconductor firms are dealing
with highly knowledgeable and cost conscious customers, which has promoted fierce
competition among firms on both the demand and supply side of the market. Many analyst
forecast a slowing down in both the rate of technological change and the markets for
semiconductor products. If so, this probably will lead to a shakeout in the industry with fewer
firms and a more oligopolistic market structure. As a result, price competition may lessen but
there still should be intensive competition in product development with attendant research and
development outlays. There also is the danger, as has already occurred, that governments will
intervene in international trade to protect domestic firms through the use of tariffs, quotas,
export subsidies and licensing restrictions.

(Online only) Review of Mathematical


Concepts Used in Managerial
Economics

Analytical Questions

1. The demand curve is given by:

QD = 5000 - 10 P
Find equations for:

a. Total revenue
b. Marginal revenue

Answer:
a. TR = P*Q = (500 – 1/10 Q)Q = 500Q – 1/10
Q2 b. MR = 500 – 1/5Q

2. The demand curve is given by:

QD = 5000 - 10 P
Find the price and quantity at which total revenue is maximized and the maximum revenue.

Answer: MR = 500 - 1/5Q


0 = 500 - 1/5Q
Q = 2500
P = 250
TR = $625,000

3. For each of the following sets of supply and demand curves, calculate equilibrium price and quantity.
a. QD = 1000 - P; QS = P
b. QD = 1500 - 2P; QS = 100 + 2P
c. QD = 2000 - 3P; QS = -300 + 3P

Answer:
a. Q = 500, P = 500
b. Q = 800, P = 350
c. Q = 850, P = 383.33

4. For each of the following cost functions, find MC, AC, and AVC. a.
TC = 40,000 + 20 Q
b. TC = 1000 + 2Q + 0.1 Q2

Answer:
a. MC = 20
AC = (40,000/Q) +
20 AVC = 20
b. MC = 2 + 0.2Q
AC = (1000/Q) + 2 +
0.1Q AVC = 2 + 0.1Q
5. For each of the following cost functions, if possible, find minimum AC and minimum AVC. a. TC
= 40,000 + 20 Q
b. TC = 1000 + 2Q + 0.1 Q2

Answer:

a. Set MC = AC.

20 = (40,000/Q) + 20
In this case, AC is decreasing everywhere, and thus there is no minimum average cost
(although it will approach $20).
Set MC =
AVC. 20 = 20
Q = 0, and at that point, AVC = $20.

b. Set MC = AC.

2 + 0.2Q = (1000/Q) + 2 + 0.1Q


Q = 100, and at that point, AC =
$22. Set MC = AVC.
2 + 0.2Q = 2 + 0.1Q
Q = 0, and at that point, AVC = $2.

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