ECP 3703 Final

You are considering entry into a market in which there is currently only one producer (incumbent). If you enter, the incumbent can take one of two strategies, price low or price high. If they price high, then you expect a $60k profit per year. If they price low, then you expect a $20k loss per year. You should enter if:

You believe the probability that the incumbent will price low is less than 0.75. [To solve this, you need to find the minimum probability needed to breakeven. E(X)= (p(x1)) + ((1-p)*(x2)). Using ((p)*($60k))+((1-p)*($-20k))=0, you find 60p-20+20p=0 or 80p=20. Therefore, p (the probability of them pricing high) needs to be a minimum of 0.25 for you to breakeven. Therefore, you would only enter if you believed the probability of them pricing low (1-p) is less than 0.75]

The game of chicken has

a first-mover advantage. [the player who can commit to a course of action captures a majority of the gains from trade.]

The prisoners' dilemma is an example of:

a simultaneous game. [players do not observe their rival's decision before making their own.]

Airlines charge a ____________ price to business travelers compared to leisure travelers because business travelers have a ____________ demand than leisure travelers.

higher; less elastic customers with less elastic demand should be charged a higher price]

For products like parking lots and hotels, costs of building capacity are mostly fixed or sunk and firms in this industry typically face capacity constraints. Therefore,

if SRMR>SRMC at capacity, then the firms should price to fill capacity. [when MR>MC, it is optimal to reduce price to sell more, but one cannot sell more than capacity allows.]

Nash equilibrium is:

is where each player maximizes his own payoff given the action of the other player. [this is the definition of an equilibrium; each player is playing a best response to the other player.]

A good compensation scheme

anticipates how an agent will game the scheme. [agents may find ways to maximize their profit in ways not anticipated by the principal.]

Principal-agent relationships

are subject to moral hazard problems. [correct; principals may be unable to observe or monitor agents' actions.]

Restrictive covenants on loans are used to avoid

moral hazard. [restrictive covenants attempt to minimize excessive risk taking as a result of moral hazard.]

A shoe-producing firm decides to acquire a firm that produces shoe laces. This implies that the firm's aggregate demand (shoes + laces) will be:

more elastic than the individual demands. [shoes and laces are complements and aggregate demand of complements is more elastic than the individual demands.]

To combat the problem of adverse selection, ______ informed parties can employ _____ techniques.

more; signaling [signaling is a more informed party's effort to communicate her information to the less informed party]

​The formula for "expected value" may be written as

​(Probability of state A × Value in state A) + (Probability of state B × Value in state B)

Which of the following is an example of the "metering" strategy​?

​A doll company selling dolls at cost but charging high margins on doll accessories AND ​A cell phone company offers free locked in phones but charges high prices per call

​You are considering buying a store. In order to better assess your return on the investment, your expectations of the return should be based on

​A weighted average of days where sales are high, costs are low, days where sales are low and costs are high and days where both sales and costs are low

Once again, two ice cream truck vendors, A and B, are playing a simultaneous pricing game. If only one of the vendors prices low, he gets all the customers for a payoff of 12, while the other vendor gets no customers and a payoff of zero. If both vendors price high, they each get a payoff of 6. If both price low, they each get a payoff of 5. ​Suppose that the above game is repeated indefinitely, and together the vendors adopt a trigger strategy such that they would start charging the low price only if the other vendor charged a low price last time. Provided that the vendors stick to their new strategy, what would be the Nash equilibrium going forward?

​Both the vendors price high

Two ice cream truck vendors, A and B, are playing a simultaneous pricing game. If only one of the vendors prices low, he gets all the customers for a payoff of 12, while the other vendor gets no customers and a payoff of zero. If both vendors price high, they each get a payoff of 6. If both price low, they each get a payoff of 5. ​What is the Nash equilibrium of this game?

​Both the vendors price low

​Monitoring

​Gives the principle a better performance evaluation metric, allows the principle to better align the incentives of the agent with the goals of the principle and can be costly for the principle

​Jill, a bookkeeper, just received an attractive offer from an outside firm and so she asks for a raise from her current employer. She would be in a strong bargaining position because

​Her value for disagreement has increased

If advertising makes demand of a product less elastic, it makes sense for a firm to​

​Increase the price of the product

The following is an example of adverse selection​

​Individuals who eat lots of junk food opt to buy more insurance

​In a firm organized along functional lines, employee performance

​Is easily evaluated because supervisor and employee have similar skills

​If a car salesman is paid a fixed commission when he sells a car, the owner is most likely to see

​Low margins on sales

​In profit centers

​Managers are easy to evaluate because there is a simple metric of how well they performed

​Sam is responsible for ordering office supplies for a firm. As part of his compensation, he gets a bonus if the firm stays well-stocked at all times. The bonus implies that he is more likely to...

​Pay higher prices for the supplies

​Someone who values a lottery at an amount equal to its expected value is

​Risk neutral

​After acquiring closely substitutable product brands, a firm can successfully raise prices on both of the brands without losing much of its total sales because

​Some of these sales lost by one brand would be captured by the other

Your production line has recently been producing a serious defect. One of two possible processes, A and B, could be the culprit. From past experience you know that the probability that A is causing the problem is 0.8 but investigating A costs $100,000 while investigating B costs only $20,000. What are the expected error costs of shutting down process B first?

$16,000 [the expected error cost in this case comes from investigating B and having A be the culprit, in other words the probability the total money spent on B will be wasted, so (0.8)*($20,000)=$16,000.

Your software development company is considering investing in a new mobile app. If it goes viral (10% probability), you expect an NPV of $1,000,000; if it is moderately successful (20% probability), you expect an NPV of $200,000; and if it fails (70% probability), you expect an NPV of $-200,000. What is the expected NPV of the product?

$0 [((0.1)*($1,000,000))+((0.2)*($200,000))+((0.7)*(-$200,000))= $100,000+$40,000-$140,000 = $0]

Two hospitals are bargaining with a managed care organization (MCO) to get into its provider network. The MCO can earn $100 if it puts one of the hospitals in its network and $200 if it puts both hospitals in its network. If both hospitals merge and bargain jointly, how much more will they earn?

$0 [correct; each hospital is worth $100 whether or not the other hospital is included. Therefore, each earns $50 before the merger and they jointly earn $100 ($200/2) after the merger.]

In a bad economy, a CEO has a 4% chance of meeting earnings estimates at regular effort, and a 5% chance at extraordinary effort. Extraordinary effort costs the CEO $10,000. How large of a bonus should the CEO be paid for meeting estimates to encourage extraordinary effort?

$1,000,000 [extraordinary effort provides an extra 1% chance of meeting estimates. Therefore, the bonus must be at least $10,000/1%.]

A salesperson can put in regular effort (resulting in a 40% chance of sale) or high effort (60% chance of sale). If high effort costs the salesperson $20 more than regular effort, how large of a per-sale bonus is required to encourage high effort?

$100 [correct; high effort results in an extra 20% chance of earning a bonus and costs $20. Therefore, the bonus must at least satisfy (20%)b=$20.]

Fred is a salesman who can sell enough to generate $200,000/year worth of profit for his company. He earns only $110,000 in compensation. What is the value of his outside or next best alternative?

$20,000. [the players split the $180,000 gain from trade evenly.]

An all-you-can-eat buffet attracts two types of customers. Regular customers value the buffet at $20 and eat $5 of food in costs to the restaurant. Hungry customers value the buffet at $40 and eat $10 of food. If there are 100 of each type in the market for a buffet dinner, what is the restaurant's maximum profit?

$3,000 [by charging $40, the restaurant attracts only hungry customers.]

A bidder' s value for a good may be low ($2), medium ($5), or high ($7). There is an equal number of potential bidders having each value. Suppose two bidders participate in a second-price auction. What is the best estimate of the expected revenue from the auction?

$3.56 [the price is $7 1/9 of the time, $5 3/9 of the time, and $2 5/9 of the time.]

An insurance company offers doctors malpractice insurance. Assume that malpractice claims against careful doctors cost $5,000 on average over the term of the policy and settling malpractice claims against reckless doctors costs $30,000. Doctors are risk-neutral and know whether they are reckless or careful, but the insurance company only knows that 10% of doctors are reckless. How much do insurance companies have to charge for malpractice insurance to break even?

$30,000 [only reckless doctors would purchase insurance at this price.]

A franchise restaurant chain is considering a new store in an unserved part of town. Its finance group estimates an NPV of $10 million if the population growth is 10% (40% probability), and NPV of $4 million of the population does not grow (30% probability), and an NPV of -$4 million if the population shrinks 5% (30% probability). What is the expected value of NPV (to the nearest dollar) for the following situation?

$4.0 million [((0.4)*(10m))+((0.3)*(4m))+((0.3)*(-4m))= 4m+1.2m-1.2m = 4 million]

In the above auction, if the bidders with the first- and third-highest values ($500 and $300) collude, which of these is closest to the winning price?

$400 [The second-highest value sets the price, so the collusion removing the third-highest value from active competition would not affect the price.]

Suppose that five bidders with values of $500, $400, $300, $200, and $100 attend an oral auction. Which of these is closest to the winning price?

$400 [as soon as the bidder with the value of $500 outbids the next highest bidder, the auction would end.]

50 percent of your potential customers would be willing to buy your product for $16 each, but the other 50 percent would be willing to pay no more than $10. Unfortunately, you cannot tell your customers apart. Your marginal cost per unit is $4. If you set the selling price of each unit at $16, the expected profit per unit is:

$6

​Half of all your potential customers would pay $16 for your product but the other half would only pay $10. You cannot tell them apart. Your marginal costs are $4. If you set the price at $16, the expected profit is:

$6

You own a retail establishment run by a store manager who receives a flat salary of $80,000. If you set up another store as a franchise with incentive compensation to the franchisee, what would be a reasonable total compensation range that the franchisee could earn?

$60,000- $100,000 [correct; this would allow the franchisee to earn an average salary similar to the manager but still allow it to vary with performance.]

You are bidding in a second-price auction for a painting that you value at $800. You estimate that other bidders are most likely to value the painting at between $200 and $600. Which of these is likely to be your best bid?

$800 [in a second-price auction, the optimal strategy is to bid exactly your value.]

An employer faces two types of employees. Regular workers are 70% of the population and generate $100,000 in productivity. Exceptional workers are 30% of the population, and generate $120,000 in productivity. Employees know their types, and reject salaries below their productivity. If the employer offers a salary equal to the average productivity in the population, what will be the employer's per-employee profit?

-$6,000 [the employer would offer $106,000 but hire only regular workers generating $100,000 in productivity.]

You are taking a multiple-choice test that awards you one point for a correct answer and penalizes you 0.25 points for an incorrect answer. If you have to make a random guess and there are five possible answers, what is the expected value of guessing?

0 points [((1/5)*(1)) + ((4/5)*(-0.25)) = 0.2 - 0.2 = 0]

Your company has a customer list that includes 3000 people. Your market research indicates that 90 of them responded to the coupon. If you send a coupon to one customer at random, what's the probability that he or she will use the coupon?

0.03 [the probability of using the coupon is 90/3000=0.03 or 3%]

Suppose an investment project has an NPV of $75 million if it becomes successful and an NPV of -$25 million if it is a failure. What is the minimum probability of success above which you should make the investment?

0.25 [you are looking for the breakeven- the minimum probability at which you would invest ((p)*($75m))+((1-p)*(-$25m)=0 Therefore 75p-25+25p=0 or 100p=25, so p=0.25]

To test the effectiveness of a two web advertising agencies, you increase your ad purchase with agency A by 50% without changing your purchase through agency B. The referrals to your website from agency A increased by only 34% but the referrals from agency B fell by 21%. What is the difference-in-difference estimate of the referrals per dollar through agency A?

1.1 referrals per dollar [ To construct a "difference-in-difference" estimate of referrals per dollar, you measure the change in referrals from Agency A (+34%) relative to the control group of Agency B (less -21%), for an estimate per dollar of ((55%)change in referrals/(50%)change in dollars) or 1.1. The difference between treatment (agency A) and control (agency B) referrals was 55% (=34%-(-21%). The difference in purchase amounts was 50% (=50%-0%). The diff-in-diff in referrals per dollar was 55%/50% or 1.1]

You have two types of buyers for your product. Forty percent of buyers value your product at $10 and sixty percent value it at $6. What price maximizes your expected revenue?

6 [in this case, all 100% of buyers will purchase your product]

Which of the following is true about different ways of conducting a private-value auction?

A second-price auction is strategically equivalent to an English auction. [in an English auction, bidders bid up to their value with the highest-value bidder winning at a price near the second-highest value.]

Metering is

A type of indirect price discrimination [metering identifies high-value customers by the intensity of their use of a related product such as paper for printers.]

​In a situation where a car salesman is selling cars on behalf of the dealer, the salesman is the

Agent

In the magazine Budget Travel , a hotel maid admits, " I cut corners everywhere I could. Instead of vacuuming, I found that just picking up the larger crumbs from the carpet would do. Rather than scrub the tub with hot water, sometimes it was just a spray and- wipe kind of day.... After several weeks on the job, I discovered that the staff leader who inspected the rooms couldn't tell the difference between a clean sink and one that was simply dry, so I would often just run a rag over the wet spots.... I apologize to you now if you ever stayed in one of my rooms." Which of the following organizational forms is more likely to have caused this kind of shirking?

Company-owned hotels [As managers do not share (as much) in the profits of the hotels, they have less incentive to monitor quality than the other two organizational forms.]

If a seller is concerned about collusion among bidders, which of the following changes to the auction should the seller make?

Conceal the amount of winning bids. [this makes it harder for the cartel to know if cheating occurred, which provides incentives for cartel members to cheat.]

​You own two different energy drink brands: "Blue Cow" and "600 minute energy." If you reduce the price on "Blue Cow", sales of "600 minute energy" would

Decrease

Decentralization of decision-making authority is consistent with which of the following?

Development of microcomputing resources at the corporate, division, and employee level. [this provides decision-making tools at each level of a corporation, reducing the need to centralize decision-making authority.]

Which of the following is an example of moral hazard?

Employees recently covered by the company health plan start going to the doctor every time they get a cold. [unlike the other answers, this is an example of moral hazard as each same individual takes a different levels of risk in the presence of insurance than in its absence.]

You've just decided to add a new line to your manufacturing plant. Compute the expected loss/profit from the line addition if you estimate the following:There's a 50% chance that profit will increase by $100,000.There's a 30% chance that profit will remain the same.There's a 20% chance that profit will decrease by $15,000.

Gain of $47,000 [((0.5)*($100,000))+((0.3)*(0))+((0.2)*(-$15,000))=$50,000+$0-$3000=$47,000]

George and KC have been working jobs that pay $60,000 and $30,000 per year, respectively. They are trying to decide whether to quit their jobs and jointly open up a taco stand on the beach, which they estimate can earn $150,000/year. How will the taco stand proceeds be split?

George gets $90,000 and KC gets $60,000 [Both George and KC will share the gains from trade generated from agreement equally. This provides each of them with $30,000 of the surplus.]

​Jim is haggling with a car dealer on the price of a used car. If, in addition to the commission, the dealer is also getting a bonus per sale made, Jim is more likely to be able to

Get the car cheap

Arbitrage

Is the act of buying low in one market and selling high in another market, can force a seller to go back to uniform pricing and can defeat direct price discrimination.

After massive promotion of Justin Bieber's latest music album, the producers reacted by raising prices for his albums. This implies that promotion expenditures made the album demand

Less elastic. [when promotion makes demand less elastic, the right response is to increase price.]

​The management of a rental building faces a rent control situation, where it cannot charge more than $400 a month in rent on the apartment. The management knows that the apartments are high in demand and renters would be willing to be $1000 per month for them. The management will

Offer a bundle of both the apartment and furniture together for $1000 AND offer the controlled rent but force the tenants to rent furniture from the management

Which is true about the winner's curse?

The winner' s curse means that you bid incorrectly. [the winner's curse happens when bids do not account for the fact that only the highest (and most optimistic) bid wins, and that the most optimistic estimate is likely to be wrong.]

In order to create an effective incentive compensation scheme, you must have

adequate performance measures. [compensation schemes tie rewards to performance and therefore require that performance be reliably measured.]

Loan applications require a lot of information from applicants to avoid

adverse selection. [the information reveals something about the type of borrower.]

All of the costs associated with a principal interacting with an agent are called

agency costs [these include the costs of combating moral hazard and adverse selection]

In a first-price auction, you bid __________ your value, and in a second-price auction you bid _______ your value.

below; at [bid at your value in second-price auctions and shade your bid (bid below your value) in first-price auctions.]

In a common-value auction, you should

bid less aggressively the more competitors you face. [The more bidders there are, the more winning is potentially "bad news."]

Assume that the price elasticity of demand for movie theatres is -.85 during all evening shows but for all afternoon shows the price elasticity of demand is -2.28. For the theatre to maximize total revenue, it should

charge a lower price for the afternoon shows and higher price for the evening shows, holding other things constant . [prices should be lower when demand is more elastic.]

For threats or commitments to be effective, they must be

credible. [The goal of a commitment or threat is to have your rival believe you.]

A firm faces two kinds of employees, those able to sell 10 units/year, and those able to sell 5 units/year. High productivity employees are willing to work for $100/year while low productivity employees are willing to work for only $50/year. To screen out the low productivity employees, the firm should

offer a sales commission of $20/unit, on sales above 5 units. [correct; This would sufficiently reward high productivity employees but pay low productivity employees only $20, screening them out.]

In repeated games, all of the below make it easier to get out of bad situations except

punish uncooperative players as much as you can. [this is bad advice. Instead, you should be forgiving and punish just enough to deter uncooperative behavior.]

A firm started advertising its product and this changed the product's elasticity from -2 to -1.5. The firm should

raise price from $10 to $15. [using the formula (P-MC)/P=1/|e|, prices rise by 50%.]

A firm that acquires a substitute product can try and reduce cannibalization by

re positioning a product so that they do not directly compete with each other. [If consumers do not perceive the products as substitutes, then cannibalization is reduced.]

The demand for insurance arises primarily from people who are

risk-averse

An insurance company suffers from adverse selection if

safe customers are less likely to insure than risky customers. [correct; adverse selection occurs when only the most expensive customers buy insurance.]

On average, if demand is unknown and costs of underpricing are _______ than the costs of overpricing, then _________.

smaller; underprice [since the costs of underpricing are smaller, one should underprice.]

After firm A producing one good acquired another firm B producing another good, it raised the prices for both goods. One can conclude that the goods were

substitutes. [to prevent cannibalization, raise price on both goods after acquiring a substitute.]

Firms tend to raise the price of their goods after acquiring a firm that sells a substitute good because

the bundle has a more inelastic demand than individual goods. [the aggregate demand for substitute products is less elastic than the individual demands.]

Perfect price discrimination is when a firm can charge each customer exactly what they are willing to pay. In this case,

the marginal revenue is the demand curve [correct; the revenue from each consumer is equal to each consumer's willingness to pay, which is given by the demand curve.]

After running a promotional campaign, the owners of a local shoe store decided to decrease the prices for the shoes sold in their store. One can infer that

the promotional expenditures made the demand for their shoes more elastic. [promotional activity that makes demand more elastic should be accompanied by a decrease in price.]

Your notebook computer' s hard drive recently crashed, and you decide to take it to a local repair technician to have it fixed. In this relationship,

the technician is the agent. [the technician is being contracted by you, the principal, to do the work.]

​Scatterbrain Samantha often forgets to lock her house, which contains $100,000 of valuable property. This has caused the probability of a burglary to be 30%. If her house gets broken into, she faces a property loss of $10,000, otherwise she gets to keep her $100,000. What is her expected loss?

​$3000

​Five possibilities are equally likely and have payoffs of $2, $4, $6, $8, and $10. The expected value is:

​$6

​If the bidders at a second-price auction have true values of $8, $7, $6, and $5, the item will sell for

​$7

​Anna's Antiques expects to get two bidders for the unique china teacup it sells. Each of the bidders can either have a high-value of $100 or a low-value of $70 with equal probability. What is the expected revenue from setting the price at $100?

​$75

A thief and a security guard are playing a simultaneous game. The thief will choose whether or not to steal, while the guard will choose whether or not to be vigilant. If the thief steals and the security guard is vigilant, the thief gets caught and suffers a loss of 20, while the security guard gets a bonus worth 15. However, if the thief steals and the security guard is not vigilant, the thief does not get caught and gains 15, while the guard loses 5. On the other hand, if the thief does not steal and the guard is vigilant, the guard loses 3 for the effort, while the thief gains nothing. Finally, if the thief does not steal and the guard is not vigilant, neither one of them gain anything. ​What is the Nash equilibrium of this simultaneous game?

​The game has no Nash equilibrium

​Suppose that during the negotiations between management and a union, a strike occurs. This outcome might be because

​The union is trying to convince the management that it will stick to its strategy AND The management didn't believe the union's threat was credible

​The optimal bidding strategy for an oral auction is

​To drop out when the bidding exceeds your true value

​Tom & Jerry are running Hanna Barbera's lemonade stand as two profit centers. Tom makes the lemonade while Jerry sells it. Jerry argues that Tom is transferring the lemonade to him priced too high, which forces him to charge the customers a high price, losing sales. What could be a profitable solution to this transfer-pricing problem?

​Turn Tom's division into a cost center

​The key distinction between risk and uncertainty is

​Uncertainty refers to not knowing possible outcomes or their probabilities

​A "false positive" is

​When you incorrectly conclude that your hypothesis is true

Tom wants to avoid any accidents on the work floor of his factory. If an accident does occur, it would cost him $500,000 in damages. Installing safety equipment would decrease the probability of an accident occurring from 20% to 10%. However, the equipment costs $20,000 to install. ​Would Tom install the safety equipment?

​Yes because it costs him less than it is worth

​Experiencing the winner's curse in a common-value auction means

​Your estimate of the value of the good being auctioned was too optimistic

​You offer an extended warranty for your product that is purchased by a few customers. If the product typically fails 2% of the time, the claim rate will exceed 2% of warranty purchasers because

​adverse selection will lead those who are more reckless to purchase the warranty AND moral hazard will lead those who purchase to be more reckless

​To attract more bidders, and more aggressive bidders, to your common-value auction

​allow potential bidders ample time to examine the object being sold

​Bid-rigging is more likely when

​auctions are frequent

​For a firm to maximize total profits through price discrimination, it should

​charge a high price to high-value consumers and a low price to low-value consumers

​Vertical relationships can increase profits through

​eliminating a double-markup problem

​The difference between moral hazard and adverse selection is

​moral hazard has to do with unobservable actions of individuals