Chapter 3/4/5 managerial economics

Suppose you are advising a regional commercial printer, who is negotiating with a national magazine. For them, using a regional printer reduces shipping costs, but to take on the work, the regional printer must purchase a $12 million rotogravure printing press, which has no resale value. Assume $8 is the average cost of printing one million copies per year over a two year period. Now suppose that the magazine accepts your offer, and immediately hands you a purchase order for $8,000,000, for the first-year production. Do you accept the purchase order?

no

Hidden-Cost Fallacy

occurs when you ignore relevant costs. common one - to ignore the opportunity cost of capital when making investment or shutdown decisions

specific investment

one that is sunk or lacks value outside of a trading relationship

​A publisher is deciding whether or not to invest in a new printer. The printer would cost $900, and would increase the cash flows in year 1 by $500 and in year 3 by $800. (Assume that there would be zero increase in cash flows in year 2.) If the interest rate is 12%, what is the present value of the cash flows from the investment?

$1015.85

​Firm X is producing 1000 units, selling them at $15 each. Variable costs are $3 per unit and the firm is making an accounting profit of $3000. What is the firm's total costs?

$12,000

​Joe is planning on attending a football game. He spent $40 on the ticket. He will have to take the day off losing 8 hours of work. His hourly wage is $10. He estimates it will cost him around $20 for gas and parking at the game. Joe's total economic cost of attending the game equals

$140

Suppose you have won a free ticket to see a Bruce Springsteen concert. This ticket has no resale value. Also suppose that U2 has a concert the same night. The U2 concert represents your next-best alternative activity to the Springsteen concert. Tickets to the U2 concert cost $56, and on any particular day, you would be willing to pay up to $198 to see U2. Assume that there are no additional costs of seeing either show. Based on the information presented here, the opportunity cost of seeing Bruce Springsteen is __________

$142

Last year, a toy manufacturer introduced a new toy truck that was a huge success. The company invested $2.50 million in a plastic injection molding machine (which can be sold for $2 million immediately) and $100,000 in plastic injection molds specifically for the toy (not valuable to anyone else). The cost of labor and materials necessary to make each truck runs about $6. This year, a competitor has developed a similar toy, significantly reducing demand for the toy truck. Now, the original manufacturer is deciding whether it should continue production of the toy truck. If the estimated demand is 100,000 trucks, the break-even price is _________________ per truck.

$26

General formula for compounding

(Future value, k periods in the future) = (Present value)(1+r)^k

Compounding

(Future value, one period in the future) = (Present Value)(1+r)

Discounting formula

(Present Value) = (future value, k periods in the future)/(1+r)^k

​James withdrew $250,000 from his own savings account in order to purchase a hardware store. After one year, James sold the business for $320,000. Assuming that James' bank always pays its savings account holders an annual interest rate of 15%, what is his economic profit from the sale of the hardware store?

$32,500

You purchased two tickets to an upcoming concert for $129 apiece when the concert was first announced three months ago. Recently, you found that similar seats were selling for $214 apiece when purchased on QuickTickets, a website where people can resell their tickets to others. Based on the information presented here, the cost of attending the concert (for two persons) is

$428

​If the annual interest rate is 10%, the net present value of receiving $550 in the next year is:

$500

You expect to sell 500 cell phones a month, which have a marginal cost of $50. If your fixed costs are $5,000 per month, what is the break-even price?

$60

​With total fixed costs of $200, a firm has average total costs of $5 and average variable costs of $3. Its output must be: Hint: ATC minus AVC equals...

100 units

George's T-Shirt Shop produces 8,000 custom-printed T-shirts per month. George's fixed costs are $24,000 per month. The marginal cost per T-shirt is a constant $9. George's break-even price is _______________ per shirt. Suppose George sells 50% more T-shirts per month. At this quantity of shirts, George's break-even price is __________________ per shirt.

12; 11

You are considering opening a new business to sell dartboards. You estimate that your manufacturing equipment will cost $100,000, facility updates will cost $250,000, and on average it will cost you $80 (in labor and material) to produce a board. If you can sell dartboards for $100 each, what is your break-even quantity?

17,500

A university spent $1.8 million to install solar panels atop a parking garage. These panels will have a capacity of 300 kilowatts (kW) and have a life expectancy of 20 years. Suppose that the discount rate is 30%, that electricity can be purchased at $0.10 per kilowatt-hour (kWh), and that the marginal cost of electricity production using the solar panels is zero. Hint: It may be easier to think of the present value of operating the solar panels for 1 hour per year first. Approximately how many hours per year will the solar panels need to operate to enable this project to break even? If the solar panels can operate only for 16,286 hours a year at maximum, the project _____________ break even. Continue to assume that the solar panels can operate only for 16,286 hours a year at maximum. In order for the project to be worthwhile (i.e., at least break even), the university would need a grant of at least ___________________

18095.91; would not; $180,031.58

If GDP is expected to increase at a steady rate of 3% per year, how many years would it take for living standards to double?

24

A business incurs the following costs: •Labor: $115/unit •Materials: $35/unit •Rent: $150,000/month Assume the firm produces 2 million units per month. The total variable cost, per month, is ___________million. The total fixed cost, per month, is _____________-million. The total cost is _______________million.

300 million; 0.15 million; 300.15 million

In early 2008, you purchased and remodeled a 120-room hotel to handle the increased number of conventions coming to town. By mid-2008, it became apparent that the recession would kill the demand for conventions. Now, you forecast that you will be able to sell only 10,000 room-nights, which cost $60 per room per night to service. You spent $30.00 million on the hotel in 2008, and your cost of capital is 10%. The current going price to sell the hotel is $25 million. If the estimated demand is 10,000 room-nights, the break-even price is ___________________________ per room, per night. (Hint: Remember that the cost of capital is the opportunity cost, or true cost, of making an investment.)

310

In early 2008, you purchased and remodeled a 120-room hotel to handle the increased number of conventions coming to town. By mid-2008, it became apparent that the recession would kill the demand for conventions. Now, you forecast that you will be able to sell only 20,000 room-nights, which cost $80 per room per night to service. You spent $30.00 million on the hotel in 2008, and your cost of capital is 20%. The current going price to sell the hotel is $25 million. If the estimated demand is 20,000 room-nights, the break-even price is per room, per night. (Hint: Remember that the cost of capital is the opportunity cost, or true cost, of making an investment.)

330

A firm sells 1,000 units per week. Suppose the average variable cost is $35, and the average cost is $60. In the short run, the break-even price is _______________. In the long run, the break-even price is _______________________

35; 60

​A business produces 4,000 units per month which it sells at $20/unit. Costs include: $10,000 on raw materials, $15,000 in wages for operators and $10,000 in wages to sales people. If the business is just breaking even, how much is its total fixed cost?

45,000

Sarah's Machinery Company is deciding to dump its current technology A for a new technology B with smaller fixed costs but bigger MCs. The current technology has fixed costs of $500 and MCs of $50 whereas the new technology has fixed costs of $250 and marginal costs of $100. At what quantity is Sarah's Machinery Company indifferent between two technologies?

5

The expression "6/10, net 45" means that the customers receive a 6% discount if they pay within 10 days; otherwise, they must pay in full within 45 days. What would the seller's cost of capital have to be in order for the discount to be cost justified?

62.5714% 6%(265/25) = 62.5714

Your insurance firm processes claims through its two facilities: facility A and facility B. Each month, facility A handles 6,000 claims and incurs in $50,000 fixed costs and $54,000 in variable costs. Each month, facility B handles 5,000 and incurs $174,000 in fixed costs and $60,000 in variable costs. Hint: Be careful not to commit the sunk-cost fallacy in your analysis. If you anticipate a moderate decrease in the number of claims, you should lay off workers in facility ____________ in order to decrease costs.

B

Cost Taxonomy

Cost - Avoidable Costs & Unavoidable or "sunk" costs Avoidable costs breaks down into two - fixed costs (avoidable in the long run) or variable costs (avoidable in the short run)

Suppose an initial investment of $80 will return $40/year for three years (assume the $40 is received each year at the end of the year). At a discount rate of 30%, this investment ___________ profitable.

is not

Marginal Cost

is the additional cost incurred by producing and selling one more unit

Fixed costs

Do not vary with the amount of output

You pay $15 for a movie ticket. Halfway through the movie, you believe that the movie is awful and will only get worse in the second half of the film. In order to get your money's worth, you decide to stay for the remainder of the movie. True or False: This is not an example of the sunk-cost fallacy.

False

Your company is contemplating bidding on an RFP (Request For Proposal) to produce 100,000 units of a specialized part. Suppose, however, that the requesting company really needs only 90,000 units of the part. Also assume that, because the part is specialized, potential suppliers do not yet possess the machines and factories needed to produce it and that overhead expenses involved in production have yet to be incurred. Suppose the average costs of all potential suppliers are as follows: 90,000 units = 11 average total cost per unit 100,000 units = 10 average total cost per unit True or False: The requesting company can solicit lower bids by requesting 100,000 units as opposed to 90,000.

False

Which of the following is an example of an extent decision?

How much of a discount should be given on products during the upcoming holiday sale?

Incentive compensation schemes

If it increases MR or reduces MC, effort will increase

NPV rule

If the net present value of the sum of all discounted cash flows is larger than zero, then the project earns more than the cost of capital

Rule of 72

If you invest at a rate of return (r), divide 72 by r to get the number of years it takes to double your money

Average cost

is total cost (fixed and variable) divided by total units produced fixed cost portion of AC is irrelevant to an extent decision

MR & MC relationships

MR and MC are the relevant costs of an extent decision, like selling Sell more if MR > MC Sell less if MR < MC If MR = MC the right amount is being sold and maximizing profit

MR

Marginal Revenue

MC

Marginal cost

contribution margin

P-MC price minus variable/marginal cost

Break even equation

Q = F/(P-MC) where F is the annual fixed cost, P is price, and MC is marginal cost

A local coffee shop is hoping to make use of its excess restaurant capacity in the evenings by experimenting with selling beer and wine. It speculates that the only additional costs are hiring more of the same sort of workers to cover the additional hours and costs of the new line of beverages. Which of the following are examples of hidden costs that are likely to emerge from this decision? Check all that apply.

Training costs for new and existing employees on beer and wine serving procedures Increased insurance premiums due to the presence of alcohol at the coffee shop

Students doing poorly in courses often consider dropping the courses. Many universities will offer a refund if the student drops a course before a deadline. True or False: After the deadline, students should not take this refund option into account when deciding to drop the course.

True

A business owner makes 1,000 items a day. Each day she contributes eight hours to produce those items. If hired, elsewhere she could have earned $250 an hour. The item sells for $15 each. Production does not stop during weekends. If the explicit costs total $150,000 for 30 days, the firm's accounting profit for the month equals

a. 300,000

Fixed-Cost Fallacy/Sunk-Cost Fallacy

You consider irrelevant costs common one - to let overhead or depreciation costs influence short-run decisions

Mr. D's Barbeque of Pickwick, TN, produces 10,000 dry-rubbed rib slabs per year. Annually Mr. D's fixed costs are $50,000. The average variable cost per slab is a constant $2. The average total cost per slab then is

a. $7

Managers often have to decide between two competing strategies to achieve the same end. Which of the following statements is true?

a. The manager can use marginal analysis to compare the marginal cost of alternatives.

A firm produces 500 units per week. It hires 20 full-time workers (40 hours/week) at an hourly wage of $15. Raw materials are ordered weekly, and they cost $10 for every unit produced. The weekly cost of the rent payment for the factory is $2,250. How do the overall costs break down?

a. Total variable cost is $17,000; total fixed cost is $2,250; total cost is $19,250.

Opportunity costs arise due to

a. resource scarcity.

​Which of the following is most consistent with the concept of a "sunk cost"?

an asset with no scrap value

AC

average cost

Memorial Hospital's CEO conducted performance reviews of the hospital's departments and discovered that the average cost of deliveries ($5,000) was above their average revenue, and that the hospital was losing $700 on each delivery. From the information on how much the hospital is losing on deliveries, what is the change in profit for each extra delivery?

b. $1,300

What is the net present value of a project that requires a $100 investment today and returns $50 at the end of the first year and $80 at the end of the second year? Assume a discount rate of 10%.

b. $11.57

If you suspect that the magazine may try to hold you up during the second year of the contract, how much should you ask for in the first year?

b. $14 cost per million copies

Re Break-even analysis, which of the following statements is false?

b. Break-even analysis asks the question whether entry into an industry is profitable

Which of the following statements is correct?

b. If cost includes all your costs, including your opportunity cost of capital, you are earning zero profit when P=AC

Food Fanatics caters meals where their cost of producing an extra meal is $25. Each of their meals is standard and sells for $20. At this rate what should the company do?

b. Produce fewer meals and increase their profit

When might an effort-based incentive scheme not work?

b. When effort is tied to costs/benefits that are out of the worker's control

After graduating from college, Jim had three choices, listed in order of preference: (1) move to Florida from Philadelphia, (2) work in a car dealership in Philadelphia, or (3) play soccer for a minor league in Philadelphia. His opportunity cost of moving to Florida includes

b. the income he could have earned at the car dealership.

The higher the discount rates

b. the more value individuals place on current dollars.

A retailer has to pay $9 per hour to hire 13 workers. If the retailer only needs to hire 12 workers, a wage rate of $7 per hour is sufficient. What is the marginal cost of the 13th worker?

c. $33

What company would a rational actor rather work for?

c. A company who gives raises/bonuses based on a clear effort scale

Which of the following will increase the break-even quantity?

c. A decrease in the price level

Regarding accounting profit and economic profit, which of the following statements is/are true?Cost of capital= (4 billion Pounds*(1+green cell)- 4 billion Pound

c. A firm may have a negative economic profit and a positive accounting profit simultaneously.

Total costs increase from $1,500 to $1,800 when a firm increases output from 40 to 50 units. Which of the following is true if MC is constant?

c. FC = $300

Consider a football game. You buy a ticket for $20, but at game time, scalpers are selling tickets for $50 because your team is playing its cross-state rivals who have legions of fans willing to pay over $50 to go to the game. Even though you do not value the tickets at $50 (indeed - you value them for much less!), you go anyway because, you say, "These tickets cost me only $20." In this case, you should:

c. Go to the game if the benefit of going to the game is bigger than $50.

When a firm ignores the opportunity cost of capital when making investment or shutdown decisions, this is a case of

c. Hidden-cost fallacy

A company is producing 15,000 units. At this output level, marginal revenue is $22, and the marginal cost is $18. The firm sells each unit for $48 and average total cost is $40. What can we conclude from this information?

c. The company needs to increase production.

Regarding compounding, discounting and the rule of 72, which of the following statements is incorrect?

c. The rule of 72 is used to calculate compounding, but not discounting

All the following are examples of variable costs, except

c. accounting fees

Economic Value Added helps firms avoid the hidden-cost fallacy

c. by taking all capital costs into account, including the cost of equity.

When economists speak of "marginal," they mean

c. incremental.

The U.S. government bought 112,000 acres of land in southeastern Colorado in 1968 for $17,500,000. The cost of using this land today exclusively for the reintroduction of the black-tailed prairie dog

c. is equal to the market value of the land.

Managers undertake an investment only if

c. marginal benefits are greater than marginal costs.

If a firm's average cost is rising, then

c. marginal cost is greater than average cost.

A firm is thinking of hiring an additional worker to their organization who can increase total productivity by 100 units a week. The cost of hiring him is $1,500 per week. If the price of each unit is $12,

c. the firm should not hire the worker since MR<MC.

A manager of a clothing firm is deciding whether to add another factory in addition to one already in production. The manager would compare

c. the incremental benefit expected from the second factory to the cost of the second factory.

Variable Costs

change as output changes

John Deere's choice of competing technologies teaches us that: a. The correct way to choose between competing technologies is to choose the one with lowest fixed costs b. The correct way to choose between competing technologies is to choose the one with lowest marginal costs c. The correct way to make the decision is to use break-even analysis to justify higher prices or greater output d. None of these is correct

d

Regarding compounding and discounting, which of the following statements is/are true? a. All investment decisions involve a trade-off between future sacrifice and current gain. b. Compounding utilizes the rule of 72. c. Both of these statements are true. d. None of these statements is true.

d

To test your understanding of the distinction between fixed and variable costs, designate which of the following statements is true. a. Payments to your accountants to prepare your tax returns are fixed b. Electricity to run the candy-making machines are variable. c. Fees to design the packaging of your candy bar are variable d. Both a and b are correct

d

The fixed-cost fallacy occurs when a. a firm considers irrelevant costs. b. a firm ignores relevant costs. c. a firm considers overhead or depreciation costs to make short-run decisions. d. Both a and c.

d.

To determine whether investments are profitable, follow these steps: a. Discount and add up the future benefits of an investment b. Compare the future benefits of an investment to the current cost of the investment c. If the difference is positive, then the investment is profitable d. All of these statements are correct

d. All of these statements are correct

Break-even quantity is a point where

d. There are zero profits

Assume a firm has the following cost and revenue characteristics at its current level of output: price = $10.00, average variable cost = $8.00, and average fixed cost = $4.00. This firm is

d. incurring a loss per unit of $2.00 but should continue to operate in the short run.

If a firm is earning negative economic profits, it implies

d. that more information is needed to determine accounting profits.

Accounting profit

does not necessarily correspond to economic profit

In the short-run, a firm's decision to shut-down should not take into consideration

fixed-costs

IRR

internal rate of return is the discount rate that sets NPV equal to zero

A copy company wants to expand production. It currently has 20 workers who share eight copiers. Two months ago, the firm added two copiers, and output increased by 200,000 pages per day. One month ago, the firm added five workers, and productivity also increased by 100,000 pages per day. A copier costs about twice as much as a worker. Assume these increases in productivity per worker and productivity per copier are good proxies for future increases in productivity when hiring additional workers or purchasing additional copiers. Based on this information, the copy company should _____________ in order to expand output.

purchase a copier

Marginal Revenue

the additional revenue gained from selling one more unit

Opportunity cost

the most desirable alternative given up as the result of a decision The opportunity cost of an alternative is the profit you give up to pursue it.

Perhaps the most important kind of capital is human capital. For example, most lawyers spend years learning to practice law. Lawyers are willing to make large investments in their human capital because they expect to be compensated for doing so when they begin work. Suppose the government nationalizes the market for legal services, resulting in lower compensation for lawyers. Assume lawyers cannot easily move to other countries. True or False: The investment in human capital for lawyers is subject to post-investment hold-up.

true

Decisions that change output change only

variable costs

WACC

weighted average cost of capital

Children in poor neighborhoods often have bleak outlooks on life and see little gain from studying. In a recent experiment, children in poor neighborhoods were paid $100 for each A they earned during a six-week grade reporting cycle. Suppose a participant in this experiment was expending $0 worth of effort in studying for each class before the experiment. Over the next 6 weeks, the student has a math class and an English class, where getting an A in math would require the student to exert $113 worth of effort, while getting an A in English would require the student to exert $93 worth of effort. In this experiment, the student ____________ increase time studying for math, and the student ___________ increase time studying for English.

would not; would

​Fixed costs are

​costs that do not vary with output