Managerial Economics

Mr. Upton

Final Examination

Name:

Directions: do all work on the exam itself, answering the question in the space provided. If you require extra space, use the back of the exam, indicating that you have done so.

First part (6 Point Questions).

1. A firm in Silicon Valley develops a new technology that allows broadcasters to target specific commercials to specific houses. For example, during a commercial break in an Indians Game, the Smith household could receive one commercial, while the Jones household received another more suited to their interests, thus effectively reducing the cost of mass advertising. It is expected that this new system will reduce the incentives for resale price maintenance. Explain whether you agree or disagree with this statement.

I agree. If advertising becomes cheaper the advantages of special selling become less, as does the need for retail price maintenance.

2. It is often difficult for students to find a space in the parking lot at the College of Business Administration. There are some unreserved metered spaces, but there is often a queue to get one of those spaces. A proposal was recently made to raise the rate for using those meters. Both undergraduates and MBA students were surveyed on this plan. One group voted in favor; the other opposed. Assuming that both groups acted rationally, which one favorer and which one opposed? Why?

The MBA students have a higher value of time. They will favor the proposal, for it makes rationing by price and not by time.

3. If the price of a good falls, then - in general - there will be a decrease in demand. Explain whether you agree or disagree with this statement.

This is a double trick question. First, a fall in price usually leads to an increase in the quantity demanded. Second, it does not lead to an increase in demand but a movement along the demand curve.

4. Two firms locked in a Bertrand Duopoly will oppose a regulations limiting the size of each firm. Explain whether you agree or disagree with this statement.

Disagree. That is the only way they can earn profits.

5. Saks Fifth Avenue routinely marks down its high priced fashion clothing, while Wall Mart does not engage in many markdowns over the course of the year. This shows that Saks has an inept pricing policy and that it would do much better if it priced things reasonably in the first place. Explain whether you agree or disagree with this statement.

Disagree. Saks faces greater demand uncertainty. This is a sensible response.

6. Joe's Barber Shop is located in a quiet Cleveland Suburb. Joe's customers come primarily from men who work in downtown Cleveland and who are home only on the weekends, and residents of Happy Days Retirement Home. Joe has determined the amount each would be willing to pay for a haircut, depending on the time of week.

	Weekdays	Saturday
Commuters	$7	$15
Denizens of Happy Days	$6	$14

`

If Joe must charge one price for weekend haircuts and another for Saturday cuts, regardless of the customer's age, what prices should Joe charge? (Joe will be able to handle his customers whenever they come.). Explain your answer.

$5.99 for weekday cuts and $13.98 for Saturdays

7. At a recent meeting of the association of Manufacturing Plants of Ohio (MOP), a survey of small plants revealed that the small plants owned and operated by the managers had generally installed big screen television sets in the manager's offices. Such frills were missing from similar plants operated for large corporations. This provides some, albeit limited, proof that corporate governance does work and that corporations are not installing wasteful fringes. Explain whether you agree or disagree with this statement.

I disagree. Individual owners pay for the sets out of their own profits. They have concluded that the benefits exceed the costs. Employee-managers and owner-managers have similar tastes. Thus, when big firms skimp on this fringe, they will pay more in salary to their managers than they will save on the TV sets.

8. Cashiers at a restaurant should earn no more than do waitresses. The hours are the same, and the stress if anything is less. All they have to do is sit there and watch over the cash resister. Explain whether you agree or disagree with this statement.

Disagree. How do you deal with the problem of monitoring their performance?

9. John Smith has the following utility as a function of wealth:

Wealth Utility

$900 1250

$1000 1400

$1100 1570

He has $1000 and is offered the chance to bet $100 on a coin toss. Will he take the bet? Why or why not?

Yes. His marginal utility of income is increasing. He is a risk taker and will take the bet.

10. If a firm can achieve economies of scope, it can cut costs. Explain whether you agree or disagree with this statement.

Agree, but remember that economics of scope are very different than economies of scale.

Second Part (20 point questions)
Answer four of the five.

I did not work problem ________

1. Jones now works 40 yours a week for a salary of $400. He seems quite happy in the position. He is now offered a new position where he is paid entirely only on commission. Specifically, he will be paid five percent of sales over $1,000 a week. He earns no commission on the first $1,000. He can work as many or as few hours as he chooses. In checking out the new job, he comes across the following data on current employees:

Employee	Average Weekly Hours	Average Weekly Sales
Wilson	40	$9,000
Smith	50	$11,400
Brown	30	$6,600

Jones believes [and so should you] that he is no better or worse as a salesman than Wilson, Smith or Brown. Will he take the new job? And, if he did, would he work more or fewer hours than he does now? Explain your answer.

He will take the job. If he works 40 hours a week he will earn the same $400 (5% on $8,000 worth of sales). If he works 50 hours, he earns another $120 an hour, which seems to be pay of $12 an hour. He will take advantage of the new position to increase his hours of work.

2. You have just been hired at the new production manager of XYZ Steel Enterprises. They have three plants currently producing 1/2-inch sheet steel of identical quality. The plants have the following cost functions:

TC₁ = 1 + 4 Q₁

TC₂ = 10 + Q₂² + 2 Q₂

TC₃ = 5 + Q₃²

where Qi measures the production of plant i in tons and TC_i the total cost in thousands of dollars.

(a) Traditionally, ten tons of sheet steel has been produced each period. Plant 1 has produced 2 tons. Plant 2 has produced 4 tons, and Plant 3 has produced 4 tons. You have been assigned the task of developing ways to reschedule production among plants so as to reduce costs, given that the output level remains at 10 tons. What changes do you suggest? Why?

(b) You begin to question whether an output of ten tons is profit maximizing. If the output market is competitive and the output price (in thousands of dollars) is $2, are there further changes that you could suggest to increase profits?

(c) Is this long run equilibrium? Why or why not?

(a) You want the Marginal cost of the three plants equal. Set Q¹ = 7, Q₂ = 1 and Q₃ = 2. Then MC = 4 at all plants.

(b) Shut plants one and two down. Its MC is always greater than 2. Set Q₃ = 1.

(c) No. You want to get out completely.

3. Ethyl's Pizzeria is considering introducing a new style of pizzas. She thinks the customers will prefer them to the old style. Right now her profits are running $2000 per week. If she introduces the new style pizza, her profits will increase to $3000 per week, even after paying the $1000 per week rental on the new oven. Yes, this is a very expensive pizza oven. But this seems like a no-brainer.

Alas, there is a catch. For years, Ethyl has competed with Vesuviuo Pizzeria, located down the street. While both boast of the best pizza in town, the truth is that the two Pizzerias are essentially the same, with the same cost, sales and profit structure. If Vesuviuo installs the same oven, then their situation changes. If both have the new ovens, their profits will go down to $1000 per week, after paying for the new ovens. If Ethyl does not install and Vesuviuo does, then her profits will rise to $2200 per week.

Ethyl asks you for advice. She has heard you muttering about "game theory" and thinks this might be applicable to this situation. She wants you to evaluate two strategies:

• Doing nothing for the moment and seeing what Vesuviuo does
• Going ahead and signing the contract for the new ovens. The contract cannot be cancelled once signed. If Sally does this, she is not sure whether she should make a big announcement or just wait and surprise everyone when the ovens start working.

Help her out. Show how, with your mastery of game theory, how to answer her problem. Explain your answer. (Hint: you do have the numbers on Vesuviuo.) Certainly, you will want to set up the payoff matrix and explain its meaning and implications carefully.

Here is the payoff matrix:

		Vesuviuo
		Install New Oven	Stay
Ethyl	Install New Oven	p V =1000 p E = 1000	p V = 2200 p E = 3000
	Stay	p V = 3000 p E = 2200	p V = 2000 p E = 2000

There are actually three Nash Equilibria, involving one of both of them installing the new oven. Once Sally has committed herself, Vesuviuo will not install and vice versa. Sally should install and make a big splash about signing the contract.

1. As you know, I provide copies of my lecture notes on the Web for this course. Working with two colleagues, I also provide lecture notes for Principles of Macroeconomics, where we routinely draw over 200 students a semester. (To make life easy, assume we draw exactly 200 students per semester). When we first started doing this, all the students would print out the lecture notes. Since then, Kent State University has sensibly begun charging for printing from computer labs, and it now costs about $10 to print out a copy of the lecture notes. Now, only about half of the students print the notes out.

While we do not know exactly what would have happened if the University had only charged $5 for each copy, it seems quite reasonable to assume that the response would have been proportional. That is, only a quarter rather than a half would have stopped printing out the lecture notes. Given this assumption, answer the following questions:

1. How much consumer surplus was generated the semester when there was not charge for printing out notes?
2. I believe I could produce a copy of the notes for $6 each to hand out to students. Assuming that is correct, and if my objective is to maximize my profit, how much should I charge for the notes?
3. You will notice that I said KSU "sensibly" began charging for printing in the computer labs. Why is this sensible?
4. Suppose I believe the cost per semester of producing the notes, my time included is twice your answer given in "a". And instead of maximizing my personal profit, I want to maximize social benefit. Should I conclude that the benefits from my efforts to put the notes on the web are less than the costs to me and stop doing it? Why or why not?

Warning: this is a straightforward question in economics. Let us skip the jokes, comments about your perceptions of the value of the notes, and concentrate on what we can learn from actual student responses.

And we can learn a lot.

1. When p=0, Q =200. When p = 10, Q = 100. This suggests a demand curve Q = 200 – 10P. The consumer surplus is thus the area under this demand curve, or (1/2)(200)(20) = $2000.
2. The inverse demand curve is P = 20 – 0.1Q, so revenue is 20Q – 0.1Q2. MR =20 – 0.2Q, and that equals 6 when Q = 70. I should thus charge $13
3. Resources are misallocated when they are given away free. When I first started doing this, the reaction of the computer labs was first elation at the high use and then dismay at the paper bill. My reaction was that I was helping them learn some basic economics.
4. No. This gives the benefit of a printed out copy. There is also benefit from having a copy on the web, and that is not included in the analysis.

1. The industry demand curve for widgets is given by

Q = 600 - 10 P

There is one and only one way of producing widgets. The cost varies with the number produced at each plant. Specifically, the cost of production for a given plant is:

Quantity	Total Cost
1	22
2	28
3	36
4	52
5	70

At the moment, Acme Widgets has a monopoly on production?

1. What level of output per plant minimizes average cost? Explain your answer.

(a) A quick calculation shows the output to be 3 per plant. LRAC is $12.

2. How many widgets will Acme produce at each plant?

(b) 3

3. How much will Acme charge for each widget?

If the demand curve is 600-10P, the inverse demand curve is P = 60 –0lQ. Thus the revenue function is 60Q – 0.1Q². The Marginal Revenue function is then 60 – 0.2Q. Acme will operate where MR = MC, in this case $12. Thus Q =240 and P = $36

4. How many will be sold?

240

5. How many plants will Acme operate?

80

6. Now suppose the monopoly is broken up, and other firms can build plants just like Acme's to compete with it. What will happen to the price of widgets ?

The price will drop to $12

7. How many will be sold?

480

8. And how many will be sold by Acme, assuming it builds no new plants?

240