Managerial Economics: Mid-Term Assignment

1. Opportunity costs equal the value of the next-available alternative. In addition to a dollar amount, opportunity costs include utility—or satisfaction—lost by foregoing the alternative (Brickley, Zimmerman, & Smith, 2008, p. 42). In Stella’s case, this means the cost of the new automobile should be compared to the cost of the next-available alternative, which we’ll say could be a used car plus whatever she would have bought with any excess money left over from the difference in price plus the amount of satisfaction/utility she would have gotten from that additional purchase (Brickley et al., 2008, p. 42). Stella’s opportunity cost of buying a new car then equals the cost of the used car plus the trip plus the satisfaction/happiness the trip would have provided.

2. Method 1: 20 x $10 = $200; 10 x $100 = $1,000; Total = $1,200

Method 2: 50 x $10 = $500; 2 x $100 = $200; Total = $700

Method 3: 100 x $10 = $1,000; 0 x $100 = $0; Total = $1,000

Method 4: 10 x $10 = $100; 12 x $100 = $1,200; Total = $1,300

The different methods show production substitutions representing the mixture of inputs required to come up with a given output: delivery to 50 spots. When different combinations of inputs come out with the same output, they are said to fall on the isoquant line or curve. Assuming all other things remain constant besides the cost of hiring drivers and the cost of the machines, the driver should utilize Method 2. He’ll pay the 50 truckers $500 total and the 2 machines will run him $200 total; this means he’ll be paying $700 for the month. The other methods will cost more for the month for the same output. This is a method of maximizing profits by reducing production costs and keeping output the same (Brickley et al., 2008, p. 66).

3. Enron’s problems arguably began with a flawed corporate architecture. A company’s organizational structure includes decision-making responsibilities, incentive systems, and evaluation systems measuring performance. In a well-planned business structure, decision-making functions are separated from decision-making oversight, which is performed by what are sometimes called “gatekeepers,” such as Boards of Directors, CEOs, regulators, investors, credit agencies, and financial analysts. Instead of utilizing these overseers to protect shareholder value, Enron used accounting tricks to mask risk and debts in its reporting, contributing to a lack of transparency. Enron delegated much of its decision management to local or lower-level employees and often designated the same employee or group of employees to provide oversight functions. Enron’s system of performance evaluation created conflicting interests within the organization, often incentivizing managers to engage in high-risk risk behaviors that provided high rewards for them at the expense of shareholder value in the long term. Different groups within the organization focused on the performance of small segments or business divisions, without respect to the effect on the company as a whole. Additionally, a decentralized legal department focused on small divisions and projects without being held accountable for the company’s overall well-being.

4. The very large fixed costs should perhaps not be ignored altogether when executives make output and pricing decisions, but companies should remember to price according to demand and rival pricing or they may go out of business. In the case of utility companies, the barriers to entry are so high that most have a monopoly or close to a monopoly in the market. They have the ability to charge higher prices without losing many customers. Electric companies should also remember the principles of economy of scale, however. The average cost per unit diminishes as the size gets large. Some companies use cost-plus pricing, in which they figure the cost of production into the price and then add a markup (Brickley et al., 2008, p. 212). Electric companies have the ability to do this because of the lack of competition in their market.

5. An oligopoly market is made up of only a few rival firms, usually because of significant barriers to entry and scale economies. Because the total number of competitors in an oligopoly is small, firms must strategically anticipate the responses of competitors when making decisions. For example, in an oligopoly, competitors commonly adjust prices in response to pricing changes by rival firms. Behavior can be described by the Nash equilibrium principle, which states that in an oligopoly, businesses will do the best they can to maximize profits when taking actions by rival companies into account. Wireless carriers, including Verizon, are part of an oligopoly market. There are only a few major cell phone providers in the United States. They change pricing in anticipation of or in response to competitors’ decisions. They often engage in pricing wars, though if they all colluded to increase prices to a certain amount, they would all experience much higher profits (though this behavior is forbidden by antitrust laws in the U.S.). Firms in oligopolistic markets generally earn less in total than the market would earn if it acted as a monopoly (Brickley et al., 2008, p. 193–196).

6. a.Demand elasticity equals the percent change in demand quantity divided by the percent change in price.

η = − (% change in Q) / (% change in P)

1.5 = − (+.30) / (% change in P)

% change in P = − .30/1.5

= − .20

= Price should drop by 20% to increase quantity by 30% (Brickley et al., 2008, p. 111)

b. Because price elasticity of demand is greater than 1.0, a decrease in price will lead to an increase in revenue. Total expenditures on a product change with price depend directly on elasticity. If demand is elastic, a small increase in price reduces revenue and a small decrease in price increases revenue. (This, of course, assumes that the 20% change in price is considered a small change.) (Brickley et al., 2008, pg. 112–113)

c .η xy1 = 0.5 is the cross elasticity of demand between DD glazed donuts and Krispy Kreme glazed donuts

If KK lowers its price by 20%, its demand will increase. DD’s demand will decrease, but only 0.5 per 1 percent increase in KK demand (or 10% decrease in DD demand) (Brickley et al., 2008, p. 116).

d. Because the cross elasticity is a negative number, this indicates that the two are complements to each other. An increase in the price of French Vanilla coffee will, therefore, cause an increase in demand for DD glazed donuts.

η xy2 = -0.5

15% increase in price

0.5 increase per every percent increase in price = 7.5% increase in price (Brickley, 2008, p. 118)

e. If average income increases by 5%, the demand for Dunkin Donuts will increase by 1.2 for every 1 percent increase in income. So, demand for DD glazed donuts will increase by 6%. DD glazed doughnuts are a normal good because they have a positive, as opposed to a negative income elasticity (Brickley et al., 2008, p. 118).

7.a. If both price High (at $4000), both would see $10,000,000 in profit. This could only happen if the firms work in a monopolistic way, which is regulated in market structures and forbidden by antitrust laws in the U.S. (Brickley et al., 2008, p. 249).

7.b. The dominant strategy takes into account the likely actions of the other party, as in the case of a prisoners’ dilemma (Brickley et al., 2008, p. 198). The dominant strategy for both is to price low, at $2000. Then, regardless of the other’s pricing, their firm will come out with profits.

7.c. The Nash equilibrium is for Westinghouse to set its price at _$2000___ and earn a profit of _$4,000,000___ and for General Electric to set its price at _$2000__ and earn a profit of _$4,000,000____.

7.d. The strategy that offers both players the best financial outcome would be for both companies to price high, but it is unlikely—barring collusion—that the companies would come together to act in concert. The U.S. has antitrust laws to protect consumers from collusion on the part of firms within a market. This means that the companies will strategically consider pricing decisions by anticipating potential responses by the competitor (Brickley et al., 2008, p. 249).

Reference

Brickley, J., Zimmerman, J., & Smith, C. W. (2009). Managerial economics and organizational structure (5th ed.). McGraw Hill-Irwin. Retrieved from www.mhhe.com/brickley5e