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Chapter 1-5

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Economics 2163A/B

Econ 101 Practice Questions Prof. Dan Friedman Managerial Economics Chapters 1-5 (Baye, 7e) Winter 2012 Questions 1. Delta Software earned $10 million this year. Suppose the growth rate of Delta's profits and the interest rate are both constant and Delta will be in business forever. Determine the value of Delta Software when a. The interest rate is 10 percent and profits grow by 4 percent per year. b. The interest rate is 10 percent and profits grow by 0 percent per year. c. The interest rate is 10 percent and profits decline by 4 percent per year. d. The interest rate is 10 percent and profits grow by 12 percent per year. (This part of the question is tricky.) 2. You are a strong advocate for a one-year investment project that would cost your firm $10,000 today, but generate virtually certain earnings of $15,000 at year-end. Those in your firm's financial group concur that the investment is virtually risk- free, but nonetheless your boss is concerned about the firm's cash flow problems. In fact, the problems are so severe that the firm's bank currently charges it 20 percent on one-year loans. Convince your boss to undertake the project. 3. A firm will maximize the present value of future profits by maximizing current profits when the: A. growth rate in profits is constant. B. growth rate in profits is larger than the interest rate. C. interest rate is larger than the growth rate in profits and both are constant. D. growth rate and interest rate are constant and equal. 4. You are the manager of a Fortune 500 hotel chain and must decide where to locate a new hotel. Based on tax considerations, your accounting department suggests that Atlantic City is the best choice, followed closely by Las Vegas. In particular, your current year tax savings from locating in Atlantic City are $4 million but only $3 million in Las Vegas. Your marketing department, on the other hand, has provided you with sales estimates that suggest that the present value of the gross (of taxes) operating profits from locating in Atlantic City are only $10 million but are $14 million for Las Vegas. It will cost $14 million to build the hotel in either location. Ignoring all other considerations, where should you build the hotel? What are your firm's economic profits if you locate the hotel in Atlantic City? 5. A potential entrepreneur is trying to decide whether to open a new health spa. She presently makes $35,000 per year as an aerobics instructor and will have to give up this job if she opens the new health spa. If she chooses to open the spa, it will cost her $200,000 per year in rent and other operating expenses. a. What are her accounting costs? b. What are her opportunity costs? c. How much would she need to make in revenues to earn positive accounting profits? Positive economic profits? 6. In the early part of 1998, crude oil prices fell to a nine-year low at $13.28 a barrel. Econ 101 Practice Questions Prof. Dan Friedman Managerial Economics Chapters 1-5 (Baye, 7e) Winter 2012 Falling crude oil prices were due in part to technological advances that made locating reservoirs and extraction cheaper. What impact will these lower crude oil prices have on the price of gasoline? 7. Apples and oranges are substitutes. A freeze in Florida destroys most of the orange crop. What would you expect to happen to the market for the following: a. Oranges? b. Apples? c. Orange juice? 8. The federal government recently decided to raise the excise tax on hard liquor. a. Graphically illustrate the effects of this tax on the market for hard liquor. b. Would a $1 increase in the excise tax on liquor increase the equilibrium price of liquor by $1? Explain. c. How would the excise tax on hard liquor affect a beer distributor? 9. The government decides that a specific scarce good should be provided for everyone who wants it at a price of zero and passes a law making it illegal to buy or sell the good. However, people can give the good away. This good is highly desirable for some of the population. What effect will this law have on the market? What would happen in this market if the law were removed? 10. Recently, the Brazilian Association of Citrus Exports (Abecitrus) announced that orange production would be down 25 percent this year because of poor weather conditions, disease, and tree stress resulting from three straight bumper crops. What effect will the decreased production of oranges have on the demand for tomato juice? 11. Assume that the price elasticity of demand is -0.75 for a certain firm's product. If the firm lowers price, the firm's managers can expect total revenue to A. decrease B. increase C. remain constant D. either increase or remain constant depending upon the size of the price decrease. Econ 101 Practice Questions Prof. Dan Friedman Managerial Economics Chapters 1-5 (Baye, 7e) Winter 2012 12. Several years ago the National Association of Broadcasters imposed restrictions on the amount of nonprogram material (commercials) that could be aired during children's television shows, effectively reducing the quantity of advertising allowed during children's viewing hours by 33 percent. Within four months, the price of a minute of advertising on network television increased by roughly 14 percent. What impact do you think this had on the revenues of the networks? 13. Which of the following goods would you expect to have the most inelastic demand? Why? a. Swiss cheese. b. Chesse. c. Dairy products. 14. The demand function for VCRs has been estimated to be , where is the quantity of VCRs, is the price of a videocassette, is the price of a movie, is the price of a VCR, and is income. Based on this information, answer the following questions. a. Are VCRs normal or inferior goods? b. Are movies substitutes or complements for VCRs? c. What additional information is needed to calculate the price elasticity of demand for VCRs? 15. The cross-price elasticity for textbooks and copies of old exams is -3.5. If the price of copies of old exams increases by 10 percent, what will happen to the quantity demanded of textbooks? 16. Airlines give away millions of tickets each year through their frequent flyer programs, with the typical airline awarding a free ticket for each 25,000 miles flown on the airline. The average airline ticket costs $500 and is for a 2,500-mile round trip. Given this information, evaluate the following statement: Airlines could have the same effect on demand by eliminating their frequent flyer programs and simply lowering the average ticket price by 10 percent. 17. Clothing stores frequently run "sales" where they discount clothing prices by as much as 25 percent. What impact, if any, would you expect these "sales" to have on a store that specializes in selling shoes produced by Rockport? Econ 101 Practice Questions Prof. Dan Friedman Managerial Economics Chapters 1-5 (Baye, 7e) Winter 2012 18. Over the past decade medical costs have increased more rapidly than other prices. In order to illustrate how rising medical costs have affected consumer alternatives, let X represent the quantity of medical services, and let Y represent the quantity of other goods. Furthermore, let income (M) be measured in hundreds of dollars, the price of medical services and other goods in terms of dollars per minute, with and . a. Graph the budget line, and determine the market rate of substitution. b. Illustrate the budget set. c. Show in your graph what happens to the budget constraint if price of x increases to $10. d. What is the meaning of the slope of the two budget constraints? 19. Suppose you are the manager of a firm that produces Ultrasweet, a sugar substitute. Show graphically the effect of a reduction in the price of Sweet and Healthy, a competitor's product, on a typical consumer's consumption of Ultrasweet. 20. At a very basic level, food and shelter constitute the two most important goods needed to sustain human life. Accordingly, assume that a poor person must allocate his income solely between food and shelter. a. Show that if shelter is an inferior good, food must be a normal good. b. If food is a normal good, is shelter necessarily an inferior good? Explain, and show your answer graphically. 21. You are the manager of Telecall Inc., a small telemarketing company. Your company pays $10,000 per month for office space. A real estate agent has noticed that you are only using 75 percent of your available space and tells you that Telecall could add $800 per month to its bottom line by renting out the space it does not use. Telecall has been asked to do a new telemarketing campaign for a large credit card company, but this would require it to use the remaining office space. What is the opportunity cost of using the extra office space to handle the credit card company's promotion? 22. Suppose the production function of automobiles is given by a. Show that the marginal product of any given quantity of labor increases as capital is increased. b. Suppose Japanese and U.S. automakers produce on identical isoquants with this Cobb- Douglas production function and that labor costs are higher in Japan than in the United States. Do autoworkers in Japan have a higher marginal product than American autoworkers? Explain carefully. c. Now suppose Japanese automakers produce on a different isoquant from U.S. firms, but the prices of Japanese and American cars are identical. Do Japanese or American autoworkers have a higher marginal product? Why? Econ 101 Practice Questions Prof. Dan Friedman Managerial Economics Chapters 1-5 (Baye, 7e) Winter 2012 23. You are the manager of a firm that sells output at a price of $40 per unit. You are interested in hiring a new worker who will increase your firm's output by 2,000 units per year. Several other firms also are interested in hiring this worker. a. What is the most you should be willing to pay this worker to come to your firm? b. What will determine whether or not you actually have to offer this much to the worker to induce him to join your firm? 24. The maker of Turbotax produces software that prepares federal income tax returns. In addition, it produces software that prepares various state income tax returns. Why doesn't it pay for the firm to specialize in federal software? 25. In 1995 the U.S. Justice Department sued to block a merger between Microsoft and Intuit, the producer of the nation's best-selling business software. The Justice Department argued that the merger would lessen competition and raise prices of business software. Is there an economic argument that the merger might actually result in lower prices? Explain. Econ 101 Practice Questions Prof. Dan Friedman Managerial Economics Chapters 1-5 (Baye, 7e) Winter 2012 Answers 1.a. million. b. million. c. million. d. Since the profit
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