Principles of Macroeconomics 11th Edition by Karl E. Case , Ray C. Fair , Sharon E. Oster – Test Bank

$20.00

Description

INSTANT DOWNLOAD COMPLETE TEST BANK WITH ANSWERS

 

Principles of Macroeconomics 11th Edition by Karl E. Case , Ray C. Fair , Sharon E. Oster – Test Bank

 

Sample  Questions

 

 

Chapter 6

 

 

Household Behavior and Consumer Choice

 

Household Choice in Output Markets

 

  1. What role do households play in output markets? What role do households play in factor

markets?

 

Households are the buyers in output markets and are the sellers in factor markets.

 

Diff: 1       Skill: Conceptual         Topic: households

AACSB:

 

  1. What role do firms play in output markets? What role do firms play in factor markets?

 

Firms are the sellers in output markets and are the buyers in factor markets.

 

Diff: 1       Skill: Conceptual         Topic: firms

AACSB:

 

  1. What does the assumption of perfect knowledge include?

 

It is assumed that households possess knowledge of the qualities and prices of all goods available in the market and that firms have all available information concerning wage rates, capital costs, and output prices.

 

Diff: 1       Skill: Conceptual         Topic: perfect knowledge

AACSB:

 

  1. List the characteristics of a perfectly competitive market.

 

(1.)       Many firms, each small relative to the size of the market.

(2.)       Homogeneous products.

(3.)       Many households, each small relative to the market.

(4.)       Households and firms possess all the information they need to make market choices.

 

Diff: 1       Skill: Definition          Topic: perfectly competitive market

AACSB:

 

  1. What is meant by the term homogeneous products? Give an example.

 

Homogeneous products are products that are identical to or indistinguishable from

one another.  An example would be a grade A, large egg.  It is impossible to tell one

farmer’s eggs from another.

 

Diff: 1       Skill: Definition          Topic: homogeneous product

AACSB:

 

  1. What are the three basic decisions that any household must make.

 

Every household must make three basic decisions: (1) how much of each product, or output, to demand; (2) how much labor to supply; and (3) how much to spend today and how much to save for the future.

 

Diff: 1       Skill: Definition          Topic: homogeneous product

AACSB:

 

  1. Why do firms in perfectly competitive markets have no control over the price of their products?

 

Firms in competitive markets are price takers, because all firms in the market

produce identical products and each firm is small relative to the size of the market.  Raising prices above this price would result in losing all its sales because consumers perceive the products to be identical. Setting a price below this level would not increase the number of consumers but only result in a decline in revenue.

 

Diff: 1       Skill: Conceptual         Topic: perfectly competitive markets

AACSB:

 

  1. What are the three basic economic decisions each household must make?

 

(1.) How much of each product to demand.

(2.) How much labor to supply.

(3.) How much to spend today and how much to save for the future.

 

Diff: 1       Skill: Conceptual         Topic: households

AACSB:

 

  1. What are the three factors that define a household budget constraint. Explain.

 

Income, wealth, and prices define household budget constraint. The budget constraint separates those combinations of goods and services that are available from those that are not. All the points below and to the left of a graph of a household budget constraint make up the choice set, or opportunity set.

 

Diff: 1       Skill: Definition          Topic: homogeneous product

AACSB:

 

  1. List six factors that influence the quantity of a good or service demanded by a household.

 

(1.) The price of the product.

(2.) The income available to the household.

(3.) The household’s level of accumulated wealth.

(4.) The prices of other products available.

(5.) The tastes and preferences of the members of the household.

(6.) The household’s expectations concerning future income, prices, and wealth.

 

Diff: 1       Skill: Conceptual         Topic: determinants of demand

AACSB:

 

  1. What is a budget constraint?

 

A budget constraint is the limit imposed on household choices by income, wealth, and product prices.

 

Diff: 1       Skill: Definition          Topic: budget constraint

AACSB:

 

  1. Assume you have an income of $200 and you can only purchase two goods – good A and good B. If the price of good A and B are $1 and $2 how much of each good can purchase? Assume that the price of good A falls why would you now consider not only consuming more of good A but also more of good B? What’s going on that might cause this behavioral response?

 

You can purchase 200 units of good A and 100 units of good B. If the price of good A fell you not only would be interested in buying more of good A but you may also wish to purchase more of good B as well since you now have more real income because of  good A’s price decline.

 

Diff: 1       Skill: Definition          Topic: substitution and income effect

AACSB: Analytic Skills

 

  1. What is a household’s choice set or opportunity set?

 

A choice set is the set of options that is defined and limited by a budget constraint.

 

Diff: 1       Skill: Definition          Topic: choice set

AACSB:

 

 

 

 

 

 

 

 

 

 

 

 

  1. Use the budget constraint below to identify economic meaning of each of the choice points: A, B, C, D, and E.

 

 

Points A, B and C exhaust all the consumer’s income. Point D involves saving and point E is simply not attainable given current prices and income.

 

Diff: 1       Skill: Definition          Topic: choice set

AACSB:

 

 

 

 

 

 

 

 

 

 

 

 

  1. Susie receives an allowance from her parents of $10 per week. She spends her entire allowance on two goods: cans of hairspray and bubble gum. The price of a can of hairspray is $2 and the price of a pack of bubble gum is $1.  Draw Susie’s budget constraint.

 

The budget constraint is drawn below.

 

 

Diff: 1       Skill: Conceptual         Topic: budget constraint

AACSB:

 

  1. Susie receives an allowance from her parents of $10 per week. She spends her entire allowance on two goods: cans of hairspray and bubble gum. The price of a can of hairspray is $2 and the price of a pack of bubble gum is $1.  What is the opportunity cost of a can of hairspray?  What is the opportunity cost of a pack of bubble gum?

 

The opportunity cost of a can of hairspray is 2 packs of bubble gum.  The opportunity cost of a pack of bubble gum is 1/2 can of hairspray.

 

Diff: 1       Skill: Analytic             Topic: opportunity cost

AACSB: Analytic Skills

 

 

 

 

 

 

 

 

 

 

 

 

  1. Mike is a college student who works part time and earns $100 per week. He spends his entire income on two goods: pepperoni pizzas and bottles of soda. The price of a pepperoni pizza is $10 and the price of a bottle of soda is $2.  Draw Mike’s budget constraint.

 

The budget constraint is drawn below.

 

 

 

Diff: 1                   Skill: Conceptual         Topic: budget constraint

AACSB:

 

  1. Mike is a college student who works part time and earns $100 per week. He spends his entire income on two goods: pepperoni pizzas and bottles of soda. The price of a pepperoni pizza is $10 and the price of a bottle of soda is $2.  What is the opportunity cost of a pepperoni pizza?  What is the opportunity cost of a bottle of soda?

 

The opportunity cost of a pepperoni pizza is 5 bottles of soda.  The opportunity cost of a bottle of soda is 1/5 of a pepperoni pizza.

 

Diff: 1                   Skill: Analytic             Topic: opportunity cost

AACSB: Analytic Skills

 

 

 

 

 

 

 

 

 

Scenario 1

 

Let’s say that you only have enough time to take two college courses in a semester. You also only have 15 hours per week to devote to both courses – French and Economics. Assume that you could earn a “70” in both courses even if you didn’t study at all for either course. If you study for either course your productivity is such that each hour spent studying for a course earns you 2 points for your grade in that course.

 

  1. Using Scenario 1 what is the maximum grade you could earn in any one course? If you wanted to earn a grade of 90 in French but no better than a 70 in economics are you operating on your budget constraint? Why or why not?

 

The maximum grade you could earn in either course is a 100. Fifteen hours times 2 points is 30 points plus the original 70 that you were going to get without studying.  If you only care about making a 90 in French and no better than a 70 in economics then you are not operating on the budget constraint. Why? It would only require 10 hours of your time to earn the 90. You would have 5 hours left over.

 

Diff: 1                   Skill: Analytic             Topic: budget constraint

AACSB: Analytic Skills

 

  1. Using Scenario 1 what would happen to your budget constraint if you came up with a study technique that allowed you to earn 3 points for every hour spent studying economics and still only 2 points for every hour spent studying French? What has happened to the relative price of one hour of studying French?

 

The budget constraint would pivot out. The relative price of studying French would actually rise since every hour you spend studying French is costing your 3 points towards your economics grade rather than the previous 2 points.

 

Diff: 1       Skill: Analytic             Topic: budget constraint

AACSB: Analytic Skills

 

  1. Using Scenario 1 what would happen to your budget constraint if suddenly you discovered an extra 10 hours in your schedule that you could use to study. What would happen to the slope of the budget constraint? What would happen to the positioning of the budget constraint?

 

The slope of the budget constraint would remain unchanged. However the budget constraint would shift outward and to the right.

 

Diff: 1       Skill: Analytic             Topic: budget constraint

AACSB:

 

 

 

 

  1. Lance earns $500 per week. He spends his entire income on two goods: movies and bottles of wine. The price of a movie is $10 and the price of a bottle of wine is $10.  Draw Lance’s budget constraint and identify his opportunity set.

 

The budget constraint is drawn below.  The opportunity set is the area on and inside the triangle.

Diff: 1       Skill: Analytic                         Topic: opportunity set

AACSB:

 

  1. Lisa has an income of $250 per week, which she spends entirely on milk and eggs. The price of milk is $2 per gallon and the price of a dozen eggs is $1. What is the opportunity cost of a gallon of milk?  If the price of a dozen eggs rises to $1.50, what happens to the opportunity cost of a gallon of milk?

 

The opportunity cost of a gallon of milk is 2 dozen eggs.  If the price of eggs rises to $1.50 per dozen, the opportunity cost of a gallon of milk falls to 1.33 dozen eggs.

 

Diff: 1                   Skill: Analytic             Topic: budget constraint

AACSB:

 

  1. Misty spends her entire weekly allowance of $15 on two goods: T-shirts (which cost $10 each) and lipstick (which costs $5). What is the opportunity cost of a T-shirt? If her parents raise her allowance to $20 per week, what happens to the opportunity cost of a T-shirt?

The opportunity cost of a T-shirt is 2 lipsticks.  If her parents change her allowance, the opportunity cost of a T-shirt is unaffected.

Diff: 1                   Skill: Analytic             Topic: budget constraint

AACSB:

  1. Justin has a part-time job and earns $50 per week. He spends his entire income on two goods: Hamburgers (which cost $2 each) and movie rentals (which cost $3 each). Draw Justin’s budget constraint.  Suppose that Justin decides to purchase 10 hamburgers and rent 10 movies this week.  Is this choice within Justin’s opportunity set?  Show this choice on your graph.

 

Yes, Justin is able to purchase 10 hamburgers and rent 10 movies.  That is one point on his budget constraint.

 

Diff: 1                   Skill: Analytic             Topic budget constraint

AACSB:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  1. Joseph earns $200 per week and spends his entire income on cheese (which costs $5 per pound) and crackers (which cost $2 per box). Draw Joseph’s budget constraint. If the price of cheese increases to $8 per pound, what will happen to Joseph’s budget constraint?

 

After the price of cheese rises, the budget constraint will tilt down and become

flatter.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Diff: 1                   Skill: Analytic             Topic: budget constraint

AACSB:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  1. Connor receives a weekly allowance of $20 from his parents that he uses to purchase two goods: Pokemon cards (which cost $5 per pack) and comic books (which cost $4 each). Draw Connor’s budget constraint.  Show what would happen if Connor’s parents lower his allowance to $15 per week.  Does the opportunity cost of a comic book change?

 

The budget constraints are shown below.  When Connor’s allowance falls, the budget constraint shifts in but keeps the same slope. The opportunity cost of a comic book is unaffected.  It is equal to 4/5 of a pack of Pokemon cards both before and after the change in Connor’s allowance.

 

 

 

 

 

 

 

 

 

 

 

 

3.75
5
Comic books

 

 

 

 

Diff: 1                  Skill: Analytic             Topic: budget constraint

AACSB:

 

Scenario 2

 

Assume that a poor person has an income of $500. There are only two goods that he can consume – food and “all other goods”. Food prices are $2 and “all other goods” are $1. Assume that the government is considering two possible way to help this person. Plan A involves providing $100 in cash. Plan B involves providing $100 in food coupons that can only be spent on food.

 

  1. What happens to the budget constraint of the recipient when he receives the $100 cash under Plan A? What is likely to happen to his consumption of both food and “all other goods” if they are both normal goods?

 

The budget constraint will shift out and to the right under the cash plan. His consumption of both goods are likely to rise if they are normal goods.

 

Diff: 1                   Skill: Analytic             Topic: budget constraint

AACSB: Analytic Skills

 

 

  1. What happens to the maximum amount of “all other goods” that this person can buy if instead he receives the $100 in food coupons? What’s the maximum amount of food he can buy under this plan?

 

He still can only purchase 500 units of “all other goods”. The maximum amount of food is 300 units.

 

Diff: 1                   Skill: Analytic             Topic: budget constraint

AACSB:

 

  1. Heather earns $100 per week that she uses to purchase two goods: trips to a day spa (which cost $100 each) and shoes (which cost $50 per pair). Draw Heather’s budget constraint.  Show what would happen if Heather receives a raise and begins earning $200 per week.  If trips to the day spa and shoes are both normal goods, what will happen to the amount of spa trips and pairs of shoes that Heather buys?

 

The budget constraints are shown below.  When Heather’s income rises, the budget constraint shifts out but keeps the same slope.  Since trips to the day spa and shoes are both normal goods, Heather will purchase more of each of them.

 

           

2
4
pairs of shoes
Trips to Day Spa

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Diff: 1                   Skill: Analytic             Topic: budget constraint

AACSB: Analytic Skills

 

 

 

 

 

 

 

  1. Graph the budget constraint for Px= 2, Py=4, and I = 1000. What is the slope of the budget constraint? Measure units of X along the horizontal axis and units of Y along the vertical axis. Answer:

 

Diff: 2       Skill: Analytic             Topic: budget constraint
AACSB:

 

  1. Graph the budget constraint for Px= 2, Py= 3, and I = 1000. What is the slope of the budget constraint? Measure units of X along the horizontal axis and units of Y along the vertical axis. Answer:

 

Diff: 2      Skill: Analytic             Topic: budget constraint
AACSB:

 

 

  1. Sketch the budget constraint under the condition that Py= 3, Px= 4 for the first 100 units and Px = 2 for all units purchased greater than 100. Assume I = 1000.  Graph the effect of a reduction in the price of Y to 2.

 

Diff: 2                   Skill: Analytic            Topic: budget constraint
AACSB:

 

  1. Sketch the budget constraint under the condition that Py= 3, Px= 4 for the first 100 units and Px = 2 for all units purchased greater than 100. Assume I = 1000. Graph the effect of income rising to 1500. Answer:

 

 

Diff: 2                         Skill: Analytic             Topic: budget constraint

AACSB:

 

  1. Assume that income in year 1 is 1000 and 1200 in year 2 and the individual can against his future income or lend his current income at zero cost. Graph the budget constraint. Measure consumption in year 1 along the horizontal axis and consumption in year 2 along the vertical axis. Answer:

 

Diff: 2                   Skill: Analytic             Topic: budget constraint
AACSB:

 

Refer to the information provided in Scenario 3 below to answer the following questions.

 

SCENARIO 3: Consider the budget allocation decision of a family of four on vacation in a beach resort. The family has $300 budgeted for entertainment for the weekend and two options: Renting bicycles for $10 an hour per bicycle or playing miniature golf for $4 a game per person. Consider each question separately, and place golfing on the vertical axis and bicycling on the horizontal axis. Assume that all four family members must do everything together.

 

  1. Refer to Scenario 3. Graph the budget constraint.

 

Diff: 2       Skill: Analytic            Topic: budget constraint
AACSB:

 

 

 

 

 

 

 

  1. Refer to Scenario 3. Graph the effect of a “Rent 3  Get 1 Bicycle Free” promotion.

 

Diff: 2       Skill: Analytic            Topic: budget constraint
AACSB:

 

 

  1. Refer to Scenario 3. Graph the effect of a 100% increase in the price of miniature golf.

 

Diff: 2       Skill: Analytic             Topic: budget constraint
AACSB:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  1. Refer to Scenario 3. Graph the effect of a promotion of two free hours of bicycling for each family of four. Answer:

 

Diff: 2       Skill: Analytic             Topic: budget constraint
AACSB:

 

 

  1. Graph the budget constraint for Px= 2, Py= 3, and I = 1500. Measure units of X along the horizontal axis and units of Y along the vertical axis. Answer:

 

 

Diff: 2                   Skill: Analytic             Topic: budget constraint
AACSB:

 

 

 

 

 

 

  1. Graph the budget constraint for Px= 2, Py= 3, and I = 1500 with the additional condition that X is free for the first 250 units. Measure units of X along the horizontal axis and units of Y along the vertical axis. Answer:

 

This graph indicates that the consumer may consume up to 250 units of X for free while spending his/her income entirely on good Y.

 

Diff: 2       Skill: Analytic            Topic: budget constraint
AACSB:

 

  1. Graph the budget constraint for a worker who earns 5 dollars an hour and can, theoretically, work 24 hours a day. Measure units of leisure along the horizontal axis. Now graph the budget constraint for a worker who makes 6 dollars an hour and can, theoretically, work 24 hours a day. Compare the two graphs. Answer:

 

The budget constraint pivots when the wage increases. The slope increases to reflect the fact that the opportunity cost of leisure has increased.

 

Diff: 2       Skill: Analytic             Topic: budget constraint
AACSB:

 

 

 

 

 

 

 

 

  1. Assume that Paula can buy gum or candy. A pack of gum costs $.30 and a candy bar costs $.50. Paula has $3.00 a day to spend on gum and candy bars. Draw Paula’s budget constraint. Shade in Paula’s choice set. On the graph show how Paula’s budget constraint will be affected if the price of gum increases to $.50. Answer:

 

 

The budget constraint will intersect the gum axis at 10 and the candy axis at 6. The area to the left of the budget constraint is the consumer’s choice set. If the price of gum increases to $.50, the budget constraint will now intersect the gum axis at 6.

 

Diff: 2       Skill: Analytic            Topic: budget constraint
AACSB:

 

 

  1. What is a household’s choice set defined as?

Choice set is defined as the set of options that is characterized and limited by the budget constraint.

 

Diff: 2       Skill: Definition          Topic: choice set
AACSB:

 

 

  1. Tony spends $36 per month on cookies. For him, chocolate chip cookies and peanut butter cookies are perfect substitutes. Chocolate chip cookies are $4 per dozen and peanut butter cookies are $3 per dozen. How many dozen of each type of cookie will Tony buy in a given month if he wants to maximize his utility?

 

Tony will by no chocolate chip cookies and 12 dozen peanut butter cookies.

 

Diff: 2       Skill: Analytic                         Topic: perfect substitutes

AACSB:

 

 

 

The Basis of Choice: Utility

 

  1. What is meant by utility?

 

Utility is the satisfaction (or reward) a product yields relative to its alternatives.  It is the basis of choice.

 

Diff: 1                   Skill: Definition          Topic: utility

AACSB:

 

  1. What problems are implicit in the concept of utility?

 

(1.) It is impossible to measure utility.

(2.) It is impossible to compare the utility of different people.

 

Diff: 1                   Skill: Conceptual         Topic: utility

AACSB:

 

  1. What is the difference between total utility and marginal utility?

 

Total utility is the total amount of satisfaction obtained from the consumption of a

good or a service.  Marginal utility is the additional satisfaction gained by the

consumption of one more unit of a good or service.

 

Diff: 1       Skill: Definition                      Topic: utility

AACSB:

 

 

 

 

 

  1. Below represents a total utility function for someone that goes to the gym. Add a second column in which you calculate the marginal utility of each visit to the gym. Use this information to determine when diminishing marginal utility sets in.

 

 

 

 

Diminishing marginal utility sets in with the second trip to the gym.

 

Diff: 1       Skill: Definition                      Topic: utility

AACSB:

 

  1. Explain how it is possible for marginal utility to fall while total utility is still on the rise?

 

Total utility is the sum of the marginal utilities of all previous units. Even if marginal utility is falling as long as it is still positive that will allow total utility to continue to rise.

 

Diff: 1       Skill: Conceptual         Topic: marginal utility

AACSB:

 

  1. When total utility is rising but at a decreasing rate what must be happening to marginal utility? When will total utility stop rising?

 

Marginal utility is still positive but it is becoming smaller. Total utility will stop rising when marginal utility reaches zero.

 

Diff: 2       Skill: Conceptual         Topic: marginal and total utility

AACSB:

 

  1. When total utility is at its maximum what must be the value of marginal utility?

 

Total utility is maximized when marginal utility is zero.

 

Diff: 1       Skill: Conceptual         Topic: marginal and total utility

AACSB:

 

  1. Use the total utility function below to construct a marginal utility function.

 

 

 

 

Diff: 1       Skill: Conceptual         Topic: marginal and total utility

AACSB:

 

 

 

  1. Observe the difference in vending machines between canned soda and newspapers. Typically, if you insert coins into a newspaper vending machine and open it you will see available all of the copies of the newspaper within one’s reach. However, soda machines are very different. They work such that only one can is dispensed at a time. The rest of the canned soda is well out of reach. Explain in terms of marginal utility why the newspaper distributor is relatively unconcerned about the rest of the newspapers being taken without payment while the soda distributor uses a machine that goes to great lengths to insure that only one can of soda is dispensed at a time.

 

The answer is fairly straightforward. A second or third newspaper probably has close to a zero marginal utility for the typical consumer. The second copy doesn’t really provide him with any net gain in satisfaction. However, the rest of the canned soda in all likelihood would still have a positive marginal utility for most consumers. Therefore, it is worth it to spend a little extra money on a machine that keeps the rest of the product away from prying hands. By contrast, the low incidence of theft of newspapers provides no justification for a more complex vending machine.

 

Diff: 3       Skill: Conceptual         Topic:  diminishing marginal utility

AACSB: Analytic Skills

 

  1. What is the law of diminishing marginal utility?

 

The law of diminishing marginal utility states that the more of any one good consumed in a given period the less satisfaction generated by consuming each additional unit of the good.

 

Diff: 1       Skill: Definition          Topic: law of diminishing marginal utility

AACSB:

 

  1. Using the consumer equilibrium condition which is expressed in algebraic form below prove that this is the same thing as saying that consumer equilibrium occurs when the ration of the marginal utilities per dollar are equal for both goods.

 

Answer: By multiplying both sides of this equation by MUY and dividing both sides by PX, we can rewrite this utility-maximizing rule as follows:

 

 

Diff: 2       Skill: Analytic            Topic: utility-maximizing rule
AACSB:

  1. Evaluate the following statement. “As long as I am still enjoying this candy I am going to keep buying and eating more of it”.

 

This confuses marginal and total utility. While it might be true that he is still receiving positive marginal utility from eating more of the candy it might not be the most rational thing for him to do in order to maximize his total utility. That is, he might be better off redirecting some of this expenditures toward another good that has a higher marginal utility per dollar.

 

Diff: 2       Skill: Conceptual         Topic: marginal and total utility

AACSB: Analytic Skills

 

  1. Comment on the following statement: “Diminishing marginal utility means that total utility falls when an additional unit of a good is consumed.”

 

That statement is not true.  Diminishing marginal utility means that marginal utility falls when an additional unit of a good is consumed.

 

Diff: 1       Skill: Conceptual         Topic: law of diminishing marginal utility

AACSB:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  1. The table below shows how the total utility that Zach derives from eating candy bars changes as he consumes more and more candy bars each day:

 

Candy Bars Total Utility Marginal Utility
1 20
2 30
3 38
4 44
5 48
6 50

 

Fill in the table above.  Do the numbers in the table support the law of diminishing marginal utility?  Explain.

 

Yes, the numbers in the table show diminishing marginal utility.  Marginal utility falls as each additional candy bar is consumed.

 

Candy Bars Total Utility Marginal Utility
1 20 20
2 30 10
3 38 8
4 44 6
5 48 4
6 50 2

 

Diff: 1             Skill: Analytic             Topic: diminishing marginal utility

AACSB:

 

 

 

 

 

 

 

 

 

 

  1. Kylie spends her income of $150 per week on two goods: movies (which cost $5 each) and books (which cost $10 each). At her current level of consumption, the marginal utility from the last movie consumed is 20 and the marginal utility from the last book consumed is 30. Is Kylie maximizing her utility?  Why or why not?  If not, what should Kylie do to achieve a higher level of utility?

 

No, she is not maximizing utility.  She should be consuming such that the marginal utility per dollar spent on movies is equal to the marginal utility per dollar spent on books.  In this case, the marginal utility per dollar spent on movies is higher. Therefore, she should increase her consumption of movies and lower her consumption of books.

 

Diff: 2                   Skill: Analytic             Topic: utility maximization

AACSB: Analytic Skills

 

  1. The table below shows how the total utility that Alan derives from watching basketball games changes as he watches more and more games each week:

 

Basketball Games Total Utility Marginal Utility
1 55
2 85
3 110
4 130
5 145
6 155

Fill in the table above.  Do the numbers in the table support the law of diminishing marginal utility?  Explain.

Yes, the numbers in the table show diminishing marginal utility. Marginal utility falls as each additional basketball game is watched.

Basketball Games Total Utility Marginal Utility
1 55 55
2 85 30
3 110 25
4 130 20
5 145 15
6 155 10

Diff: 1                   Skill: Analytic             Topic: diminishing marginal utility

AACSB:

  1. Colin spends his income of $100 per week on two goods: pizzas (which cost $8 each) and milk (which costs $1 per gallon). At his current level of consumption, the marginal utility from the last pizza consumed is 32 and the marginal utility from the last gallon of milk is 4. Is Colin maximizing his utility?  Why or why not?  If not, what should Colin do to achieve a higher level of utility?

 

Yes, he is maximizing utility.  He is consuming such that the marginal utility per dollar spent on pizza is equal to the marginal utility per dollar spent on milk.

 

Diff: 1                   Skill: Analytic             Topic: utility maximization

AACSB: Analytic Skills

 

  1. What is the utility-maximizing rule?

 

A consumer is maximizing utility when the marginal utility derived from the last unit of good X consumed divided by the price of good X is equal to the marginal utility derived from the last unit of good Y consumed divided by the price of good Y.

 

Diff: 1                   Skill: Definition          Topic: utility maximization

AACSB:

 

  1. What is the diamond-water paradox?

 

The diamond-water paradox is a paradox stating that (1) the things with the greatest value in use frequently have little or no value in exchange, and (2) the things with the greatest value in exchange often have little or no value in use.

 

Diff: 1                   Skill: Definition          Topic: consumer surplus

AACSB:

 

 

  1. What does diminishing marginal utility imply about the shape of a person’s demand curve? Explain.

 

Demand curves will be downward sloping because of the law of diminishing marginal utility.  Individuals will compare the value of the marginal utility they receive from a good with its price: if the value of the good is higher or equal to the price, the individual will purchase it.  Thus, a person will buy more of a good at a low price than at a high price.

 

Diff: 1                   Skill: Conceptual         Topic: diminishing marginal utility

AACSB:

 

 

 

 

Income and Substitution Effects

 

  1. Suppose that Jeanna’s income rises. If tomatoes are a normal good, what will happen to the quantity of tomatoes purchased by Jeanna? Is this an income effect, a substitution effect, or both?  Explain.

 

Jeanna will purchase more tomatoes if her income rises because tomatoes are a normal good.  This is an income effect.  Her income has increased, so she is better off.  There is no substitution effect in this case because there is no change in relative prices.

 

Diff: 2                   Skill: Analytic             Topic: income and substitution effects

AACSB:

 

  1. When the price of corn increases, the quantity of corn demanded falls. Explain this change in terms of income and substitution effects.

 

When the price of corn rises, households have less purchasing power than before.  If corn is a normal good, this means that they will consume less of it.  This is the income effect.  Also, an increase in the price of corn makes corn relatively more expensive.  Thus, households will shift away from purchasing corn to purchase relatively cheaper goods.  This is the substitution effect.  Both effects imply that the quantity of corn demanded will fall as the price of corn rises.

 

Diff: 2                   Skill: Analytic             Topic: income and substitution effects

AACSB: Reflective Thinking

 

  1. When the price of raisins falls, the quantity of raisins demanded rises. Explain this change in terms of income and substitution effects.

 

When the price of raisins falls, households have more purchasing power than before.  If raisins are a normal good, this means that they will consume more of them.  This is the income effect.  Also, a decrease in the price of raisins makes raisins relatively less expensive.  Thus, households will shift toward purchasing raisins from purchasing relatively more expensive goods.  This is the substitution effect.  Both effects imply that the quantity of raisins demanded will rise as the price of raisins falls.

 

Diff: 2                   Skill: Analytic             Topic: income and substitution effects

AACSB:

 

 

 

 

 

  1. Suppose that macaroni and cheese is an inferior good and the price of macaroni and cheese rises. Explain the income and substitution effects of this price change.

 

When the price of macaroni and cheese rises, we have less purchasing power than before.  If macaroni and cheese is an inferior good, this means that we will consume more of it.  This is the income effect.  Also, an increase in the price of macaroni and cheese makes it relatively more expensive.  Thus, households will shift away from purchasing macaroni and cheese to purchase relatively cheaper goods.  This is the substitution effect.  Because these two effects work in opposite directions, the outcome (in terms of the quantity of macaroni and cheese demanded) will depend on which effect is larger. While it is theoretically possible, it is unlikely for this income effect to be larger than the substitution effect.

 

Diff: 3                   Skill: Analytic             Topic: income and substitution effects

AACSB: Reflective Thinking

 

  1. Differentiate between an income effect and a substitution effect.

 

Ceteris paribus, the income effect of a price decrease increases the opportunity to buy more of all goods, whereas the substitution effect of a price decrease makes the good become relatively cheaper. In the case of a price increase, the income effect reduces the opportunity to buy all goods, whereas the substitution effect makes the good become relatively more expensive.

 

Diff: 3                   Skill: Conceptual        Topic: income and substitution effects
AACSB:

 

  1. For a normal good, the income and substitution effect work in the same direction. For an inferior good, the income and substitution effects work in opposite directions. Does this imply that the demand curve for an inferior good is upward sloping? Explain.

No. As long as the income effect is smaller than the substitution effect the demand curve will still be downward sloping.

 

Diff:3                    Skill: Conceptual         Topic: income and substitution effects

AACSB:

 

 

 

 

 

 

 

 

 

 

  1. During the mid 1980s the price of gasoline fell. Americans purchased not only more gasoline but other goods as well. Use consumer theory to explain why this happened.

Essentially two effects are unleashed at the same time. The substitution effect induces people to consume more of the good whose relative price fell and the income effect from the lower-priced gasoline induces people to consumer more of all goods including gasoline.

 

Diff: 3                   Skill: Conceptual         Topic: income and substitution effects

AACSB:

 

  1. Using the concept of income and substitution effects, explain how you might react to each of the following:

(a) You currently work 20 hours a week at $10 per hour and your employer tells you he must reduce your wage to $8 per hour.

(b) The price of pizza doubles and the price of hamburgers remains constant.

 

(a) A reduction in the wage rate could either cause hours worked to increase or decrease, depending on whether the income or substitution effect is stronger.

(b)             If the price of pizza doubles, the consumer’s real income decreases, so the consumer would eat less pizza. Because the price of hamburgers remains constant, the consumer will substitute hamburgers for pizza

 

Diff: 3                  Skill: Conceptual         Topic: income and substitution effects

AACSB:

 

  1. Explain the income and substitution effects of an increase in the interest rate on savings.

If the interest rate rises, the substitution effect will lead to an increase in saving because the relative cost of current consumption increases. The income effect will cause a decrease in saving because it will require less saving today to reach the target consumption level in the future. Therefore, the effect of an increase in the interest rate on saving is indeterminate.

 

Diff: 3                   Skill: Conceptual        Topic: income and substitution effects
AACSB:

 

 

 

 

 

 

 

 

 

 

  1. Assume a distant tribe only harvests breadfruit and its entire livelihood depends on it. If the price of breadfruit were to rise suddenly how might it be possible that this tribe would actually consume more breadfruit?

The substitution effect would cause a decline in the consumption of bread fruit ceteris paribus. However, because breadfruit is the principle means by which the tribe earns its income there is also an income effect. If breadfruit is a normal good and the income effect is strong enough it can outweigh the substitution effect.

 

Diff: 3                    Skill: Conceptual        Topic: income and substitution effects

AACSB:

 

  1. In the 1970s there was a long draught in California that left a large section of Southern California parched. As water prices began to soar how do you think most residents changed their consumption of water? What kinds of water consumption probably did not change and why? Make sure to use utility in your explanation.

 

Most people probably either eliminated or reduced drastically the washing of cars, the watering of lawns and maybe even the filling of swimming pools. But the drought probably did not have much of an impact on internal consumption, bathing or the brushing of teeth. The items that were curtailed were no doubt those that provided the least amount of marginal utility.

 

Diff: 1                   Skill: Definition          Topic: consumer surplus

AACSB: Analytic Skills

 

  1. Explain the income effect and the substitution effect due to an increase in the wage rate.

An increase in income will lead to a higher demand for leisure. However, an increase in the wage rate will also make leisure more expensive. Since these two effects are moving in opposite directions of one another theory alone cannot tell us the net effect without knowing the absolute change of the income and substitution effects.

 

Diff: 3       Skill: Conceptual         Topic: income and substitution effects
AACSB: Reflective Thinking

 

  1. Explain the income effect and the substitution effects of a price change for a normal good.

For normal goods, the income and substitution effects work in the same direction. Higher prices lead to a lower quantity demanded, and lower prices lead to a higher quantity demanded.

 

Diff: 3       Skill: Conceptual         Topic: income and substitution effects
AACSB: Reflective Thinking

Household Choice in Input Markets

 

  1. List the three decisions that households face in the labor market.

 

(1.)       Whether to work.

      (2.)       How much to work.

      (3.)       What kind of a job to choose.

 

Diff: 1                   Skill: Fact                    Topic: labor market determinants

AACSB:

 

  1. Identify three things which affect the choices households make with respect to how much labor to supply?

 

The decision of how much labor to supply is affected by three things: the availability of jobs, market wage rates, and the skills possessed by members of the household.

 

Diff: 1                   Skill: Conceptual         Topic: labor market determinants

AACSB:

 

  1. How would you measure the price of an hour of leisure? Explain.

 

The price of an hour of leisure can be measured by the hourly wage.  The opportunity cost of enjoying an hour of leisure is the amount of foregone income that could have been earned at a job.

 

Diff: 1                   Skill: Conceptual         Topic: price of leisure

AACSB:

 

  1. Assume the government reduces your welfare check by $1 for every $2 that you earn on the job while on welfare. How will this tax affect your labor supply decisions? What is the implicit tax rate of such a policy?

 

The higher tax lowers the effective wage. The lower wage reduces the opportunity cost of leisure and discourages work. The implicit tax rate is 50%.

 

Diff: 1                   Skill: Conceptual         Topic: labor supply

AACSB:

 

  1. What does a labor supply curve represent? What does it look like?

 

A labor supply curve is a diagram that shows the quantity of labor supplied at different wage rates.  Its shape depends on how households react to changes in the wage rate. It will typically slope upwards as long as the substitution effect dominates. However, there is a possibility that the labor supply curve could bend backwards at higher wages if the income effect dominates the substitution effect.

 

Diff: 1                   Skill: Definition          Topic: labor supply

AACSB:

 

  1. Tyler’s wage rises and he chooses to increase the number of hours he supplies to the labor market. What does this imply about the relative sizes of the substitution effect and the income effect? Explain.

 

This must mean that the substitution effect outweighs the income effect.  The substitution effect of a wage increase implies that leisure is more expensive and the individual will work more.  The income effect suggests that since the worker is better off (and leisure is a normal good), the worker will work less.  Since Tyler chooses to work more, the substitution effect must be larger.

 

Diff: 2                   Skill: Analytic             Topic: labor supply

AACSB: Analytic Skills

 

  1. Refer to the figure below. What can we say about the relative sizes of the income and substitution effects?

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Because an increase in the wage leads to a decrease in the quantity of labor supplied, we can tell that the income effect is larger than the substitution effect.

 

Diff: 2                   Skill: Analytic             Topic: labor supply

AACSB:

 

  1. Comment on the following statement: “An increase in the wage always leads to an increase in the quantity of labor supplied.”

 

The statement is false.  If the substitution effect is larger than the income effect, a wage increase will lead to an increase in the quantity of labor supplied.  However, if the income effect is larger, an increase in the wage will actually lead to a decline in the quantity of labor supplied.

 

Diff: 2                   Skill: Analytic             Topic: labor supply

AACSB:

 

  1. What is the financial capital market?

 

The financial capital market is the complex set of institutions in which suppliers of capital (households that save) and the demand for capital (business firms wanting to invest) interact.

 

Diff: 1                   Skill: Definition          Topic: financial market

AACSB:

 

  1. Explain how income and substitution effects alter the saving behavior of households.

 

When the interest rate rises, the opportunity cost of spending income rises and therefore, individuals will be more likely to save.  This is the substitution effect.  However, because the interest rate increase makes households better off, they want to purchase more normal goods and save less.  This is the income effect.

 

Diff: 2                   Skill: Analytic             Topic: saving

AACSB:

 

  1. Empirical evidence suggests that saving tends to rise when there is an increase in interest rates. What does this imply about the relative sizes of the income and substitution effects? Explain.

 

The substitution effect must be larger.  The substitution effect of an interest rate increase suggests that households will save more because the opportunity cost of spending has increased.  The income effect suggests that an increase in the interest rate makes households better off and therefore they will want to spend more.  Because saving rises when the interest rate increases, the substitution effect must be larger.

 

Diff: 2                   Skill: Analytic             Topic: saving

AACSB:

 

 

 

Appendix: Indifference Curves

 

  1. Explain the four assumptions on which the theory of consumer choice is based. Select one of these assumptions and explain what would happen if this assumption did not hold true.

It is assumed that more is better. If more is not always better, the indifference curves would eventually have a positive slope. A diminishing marginal rate of substitution is assumed. If this assumption did not hold true, indifference curves would not be convex to the origin. Consumers can rank bundles so that they identify one bundle as being preferred to another or that they are indifferent between bundles. The last assumption is one of rationality. If consumers could not rank bundles or if consumers were not rational, it would be impossible to identify the point of utility maximization.

 

Diff: 2       Skill: Definition         Topic: consumer choice

AACSB:

 

  1. What is an indifference curve?

 

An indifference curve is a set of points, each representing a combination of goods that yield the same total utility.

 

Diff: 1                   Skill: Definition          Topic: indifference curve

AACSB:

 

  1. Why are indifference curves convex to the origin?

 

Indifference curves are convex because of diminishing marginal utility.  When a consumer has a large amount of good Y (and a small amount of good X), he will be willing to give up a great deal of good Y to receive a little more of good X.  However, if the individual has only a small amount of good Y and a large amount of good X, he will not be very willing to give up good Y to receive more of good X.

 

Diff: 2                   Skill: Conceptual         Topic: indifference curve

AACSB:

 

  1. Assume the properties of normal indifference curves. Where will a consumer maximize their utility?

The consumer will maximize their utility where the indifference curve is just tangent to the budget constraint.

 

Diff: 2       Skill: Definition          Topic: utility maximization

AACSB:

 

  1. If a consumer has a choice between only two goods and both of them are perfect substitutes what would the indifference curve look like and why?

The indifference curves would be downward-sloping and linear since the consumer would be willing to trade them at a fixed ratio.

 

Diff: 2       Skill: Definition         Topic: indifference curves
AACSB:

 

  1. If a consumer has a choice between only two goods and both of them are perfect complements what would the indifference curve look like and why?

The indifference curves would be “L-shaped”. The reasoning is that one good must be accompanied by the other good in order to give the first any utility. Having more of the second good however, doesn’t make the person any better off.

 

Diff: 2       Skill: Definition          Topic: indifference curves

AACSB:

 

  1. How can a consumer’s demand for a good be derived using indifference curve analysis?

 

As the price of a good changes the consumer’s budget constraint changes.  Thus, it is possible to see how the consumer changes his utility-maximizing choice.  This will give us his new quantity demanded at each price.

 

Diff: 2                   Skill: Analytic             Topic: indifference curves

AACSB:

 

 

  1. If an indifference curve were concave instead of convex to the origin, what implication would that have if the consumer reduces consumption of one good but still wants to enjoy the same level of utility in a two-good world?

Essentially it would mean that the consumer would not need as much of the second good to compensate him for his reduction in the consumption of the first good.

 

Diff: 2       Skill: Definition          Topic: indifference curves

AACSB:

 

 

  1. Using indifference curves and budget constraints, explain how a consumer maximizes utility. Show how this analysis can be used to derive a demand curve for a good. Answer:

 

 

The students need to identify utility maximization as the point of tangency between the budget constraint and the indifference curve. To derive demand they need to vary the price of X and show how consumption of X will change.

 

Diff: 2       Skill: Analytic             Topic: utility maximization
AACSB:

 

 

 

 

 

 

 

 

 

  1. Illustrate with a diagram a consumer in equilibrium with indifference curves and a budget constraint. Measure units of X on the horizontal axis and units of Y on the vertical axis. Provide intuitive and mathematical explanations for what must be true in equilibrium. Answer:

 

When utility is maximized the willingness of the individual to trade one good for the other (slope of the indifference curve) is equal to the relative value of the goods (price ratio, or the slope of the budget constraint) in the market or MUY/MUX=PY/PX.

 

Diff: 2       Skill: Analytic            Topic: utility maximization
AACSB:

 

  1. Explain the assumption of free disposal as it applies to indifference curve analysis.

 

In indifference curve analysis we  are restricted to goods that yield positive marginal utility, or,more simply, that “more is better.” One way to justify this assumption is to say that when more of something makes you worse off, you can simply throw it away at no cost.

 

Diff: 2       Skill: Analytic            Topic: utility maximization
AACSB:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  1. Graphically illustrate the effect of an increase in income on the budget constraint. Assuming that both X and Y are normal goods, graphically illustrate how equilibrium consumption will change with an increase in income.

 

 

 

 

Diff: 2                  Skill: Analytic             Topic: budget constraint shift
AACSB:

 

 

  1. Using the graph below explain why a consumer would not wish to consume at either points A or C even though he could afford to do so.

 

Graphically, the consumer will move along the budget constraint until the highest possible indifference curve is reached. At that point, the budget constraint and the indifference curve are tangent. This point of tangency occurs at X* and Y* (point B). Even though points A and C are possible for the consumer they don’t yield the highest possible level of utility that could be attained.

 

Diff: 2                  Skill: Analytic             Topic: budget constraint shift
AACSB:

 

Chapter 7

 

 

The Production Process: The Behavior of Profit-Maximizing Firms

 

 

The Behavior of Profit-Maximizing Firms

 

  1. What role do business firms play in output markets and in factor markets?

 

In output markets, firms supply goods and services.  In factor markets, firms demand factors of production.

 

Diff: 1                         Skill: Conceptual         Topic: business firms

AACSB:

 

  1. Explain what is meant by the term production.

 

Production is the process by which inputs are combined, transformed, and turned into outputs.

 

Diff: 1                         Skill: Definition          Topic: production

AACSB:

 

  1. What is a firm?

 

A firm is an organization that comes into being when an individual or a group of individuals decide to produce a good or service to meet a perceived demand.  Most firms exist to make a profit.

 

Diff: 1                         Skill: Definition          Topic: the firm

AACSB:

 

 

  1. How does a firm measure its profit?

 

Profit is measured as the difference between total revenue and total cost.

 

Diff: 1                         Skill: Definition          Topic: profit

AACSB:

 

  1. What are the three decisions that all firms must make?

 

(1.)                               How much output to supply.

(2.)                               How to produce that output.

(3.)                               How much of each input to demand.

 

Diff: 1                         Skill: Fact                    Topic: firm decisions

AACSB:

 

  1. A firm sells 150 units of output at a price of $8 each. The economic cost of producing the 150 units of output is $1,000.  Calculate the firm’s level of economic profit.

 

To calculate economic profit, we need to subtract total economic cost from total revenue.  Total revenue is calculated by multiplying the price of the good by the number of units sold ($8 ´ 150 = $1,200).  To calculate economic profit, we subtract economic cost ($1,000) from total revenue ($1,200) and we get $200.

 

Diff: 1                         Skill: Analytic             Topic: economic profit

AACSB:

 

  1. What is the difference between accounting cost and economic cost?

 

Accounting cost measures only the out-of-pocket costs of production.  Economic cost includes both out-of-pocket costs and the full opportunity costs of all the factors of production.  Economic cost includes a normal rate of return on capital.

 

Diff: 1                         Skill: Definition          Topic: economic cost

AACSB:

 

 

 

 

 

 

 

  1. A lawyer quits his job at a top legal firm where he was making $100,000 per year. He was just informed that his late aunt has bequeathed to him $1 million in cash. He decides to use all of the money to open and run his own hardware store. Assume at the end of the first year of business that his accountant has informed him that he earned a $90,000 accounting profit. Why would an economist not be quite as impressed? Explain.

 

An economist would not be impressed because he has not taken into account all his opportunity cost. The first one of course is the $100,000 that he could have been earning had not quit the law firm. That puts him $10,000 in the red right out of the starting gate. The second one of course is the forgone interest that could have been earned from the $1 million that could have been invested elsewhere. In short the economist would conclude that he has made a loss.

 

Diff: 2                         Skill: Definition          Topic: economic profit

AACSB:

 

  1. Suppose your neighbor owns a restaurant and boasts that he is able to turn a handsome accounting profit because of his low labor costs. He attributes this to the fact that he uses his sons and daughters as cooks and waiters. His point is that he offers them below-market wages. How would you respond to your neighbor’s statement? What would you tell him to expect as his children continue to work for him while they are in college and beyond?

 

Your neighbor might believe that he has low labor costs because of the low wages he is paying them. However, he must think carefully about their opportunity cost. If his children could earn higher wages at a job outside the restaurant than the extra-added profitability that they bring to the firm then their true cost must be taken into account. As his children go through college their opportunity cost will rise since they will become more valuable in the labor market.

 

Diff: 2                         Skill: Conceptual         Topic: economic costs

AACSB:

 

  1. Define the normal rate of return. If a business has fairly steady revenues and the future looks secure, what should the normal rate of return equal? Why?

The normal rate of return is the rate of profit that is just sufficient to keep owners and investors satisfied. The normal rate of return would be the return on risk-free government bonds because that would be the next best alternative.

 

Diff: 1                         Skill: Fact        Topic: normal rate of return
AACSB:

 

 

  1. What two things determine the cost of production?

 

(1.)                               The technologies which are available.

(2.)                               Input prices.

 

Diff: 1                                     Skill: Fact                    Topic: costs of production

AACSB:

 

  1. Using the table below explain why the economic profit and the accounting profit of this firm may be different.

 

Economic profit is calculated by taking total revenue and subtracting all economic costs including implicit costs or opportunity costs. In the above example this firm incurs total economic costs of $31,000 and therefore the firm would experience negative economic profit. Alternatively the accounting profit would be positive since only the explicit costs of $29,000 would be counted and the firm would enjoy an accounting profit of $1,000.

 

Diff: 1                         Skill: Fact        Topic: normal rate of return
AACSB:

 

  1. Fred’s Bar and Grill hires you to determine the company’s status. The data below provides information on the company’s annual costs and revenues.

 

Wages $85,000
Interest paid on loans 7,000
Other expenditures for factors of production 67,000
Total Revenue 250,000

 

Fred spends at least 40 hours a week at his place of business.  If he closed the bar, he could work for his competitor and earn $30,000 per year.  He also owns the building that houses the bar and could rent it out for $24,000 per year if he closes his business.  Calculate the economic cost and economic profit for Fred’s Bar and Grill.

 

Economic cost is equal to all costs of production including opportunity costs:

 

Wages                                     $85,000                      

Interest paid                               7,000                      

Other expenses                        67,000

Fred’s labor                             30,000

Fred’s building                        24,000

Total Costs                           $213,000

 

      Economic profit –total revenue – total costs – $250,000 – $213,000 = $37,000

 

Diff: 1                         Skill: Analytic             Topic: economic profit

AACSB:

 

  1. Evaluate the following statement. “I used my own money, my own land and my own equipment to start my business. Therefore I don’t have any costs associated with running my business”.

 

This is poor reasoning since all resources have an opportunity cost. Even though the money is the owner’s it could still have been used for another purpose that might make him even more money. The land and equipment also could have been rented to someone else. The fact that no money changes hands doesn’t make the cost of running the business go away.

 

Diff: 1       Skill: Definition    Topic: economic costs

AACSB:

 

  1. Why might a firm remain in operation even if it is earning zero economic profit?

 

If a firm is earning zero economic profit, it is earning a normal rate of return.  Thus, the opportunity costs of all factors of production have been covered.

 

Diff: 1                         Skill: Conceptual         Topic: economic profit

AACSB:

 

  1. Your friend Harry has quit his $20,000-a-year job to start a business that rents fishing boats. He asks you to lend him $50,000 and agrees to pay you a 10% return on your $50,000 if he earns a profit. During the first year Harry’s total revenue is $120,000 and his total cost for equipment and supplies are $100,000. Harry tells you that he cannot pay you any interest this year because he did not earn a profit. Is your friend Harry trying to cheat you?

The problem here is that profits are not strictly defined. Harry has made an accounting profit of $20,000, but an economic profit of zero. The $20,000 represents the opportunity cost of Harry’s time running the business.

 

Diff: 3                         Skill: Conceptual         Topic: economic profit
AACSB:

 

  1. Mitzi’s Pet Salon hires you to determine the company’s status. The data below provides information on the company’s annual costs and revenues.

 

Wages $25,000
Interest paid on loans 3,000
Other expenditures for factors of production 31,000
Total Revenue 90,000

 

 

Mitzi spends at least 40 hours a week at her place of business.  If she closed the salon, she could work for her competitor and earn $15,000 per year.  She also owns the building that houses the salon and could rent it out for $18,000 per year if she closes her business.  Calculate the economic cost and economic profit for Mitzi’s Pet Salon.  Would an accountant come to the same conclusion about the profitability of this firm?  Explain.

 

Economic cost is equal to all costs of production including opportunity

costs:

 

                                    Wages                           5,000

                                    Interest paid                 3,000

Other expenses          31,000

                                    Mitzi’s labor               15,000

                                    Mitzi’s building          18,000

                                    Total Costs              $92,000

 

Economic profit – total revenue – total costs = $90,000 – $92,000 = – $2,000

 

Accounting profit is calculated by taking total revenue and subtracting out-of-pocket costs.  It does not take account of opportunity costs.  Therefore, the accountant would calculate profit by taking total revenue ($90,000) and subtracting costs ($59,000) and would record a positive profit of $31,000.

 

Diff: 1                                     Skill: Analytic             Topic: accounting profit

AACSB:

 

 

  1. What assumptions do economists make about the time period known as the short run?

 

(1.)       The firm is operating under a fixed scale of production (some factor is fixed).

(2.)       Firms can neither enter nor exit the industry.

 

Diff: 1                         Skill: Definition          Topic: short run

AACSB:

 

  1. Why might certain industries have a long run and a short run that is not separated by very much time?

 

It may be that entry and exit can occur with relative ease if setting up the business and leaving it do not require much time.

 

Diff: 1                         Skill: Concept             Topic: short run

AACSB:

 

  1. How do economists define the time period known as the long run?

 

The long run is the period of time for which there are no fixed factors of production.  Firms can increase or decrease their scale of operation, and firms can enter or exit the industry.

 

Diff: 1                         Skill: Definition         Topic: long run

AACSB:

 

  1. What three pieces of information do firms need to know to make production decisions?

 

(1.)       The market price of the output.

(2.)       The techniques of production which are available.

(3.)       The prices of inputs.

 

Diff: 1                         Skill: Fact                    Topic: production

AACSB:

 

  1. How would a firm determine its optimal method of production?

 

The optimal method of production is the production method that minimizes cost.

 

Diff: 1                         Skill: Definition          Topic: optimal production method

AACSB:

 

 

 

The Production Process

 

  1. What is production technology?

 

Production technology is the quantitative relationship between inputs and outputs.  This relationship can be expressed using a production function.

 

Diff: 1                         Skill: Definition          Topic: technology

AACSB:

 

  1. Using an example, explain the difference between a labor-intensive technology and a capital-intensive technology.

 

The examples will vary, but students should describe a production process which involves using a large amount of labor with only a few tools or machines and a production process that uses a large number of machines with a small amount of labor.

 

Diff: 1                         Skill: Definition          Topic: technology

AACSB:

 

  1. Explain what is meant by marginal product.

 

Marginal product is the additional output that can be produced by adding one more unit of a specific input (all else equal).

 

Diff: 1                         Skill: Definition          Topic: marginal product

AACSB:

 

  1. Explain the law of diminishing returns.

 

The law of diminishing returns says that when additional units of a variable input are added to fixed inputs after a certain point, the marginal product of the variable input declines.

 

Diff: 1                         Skill: Definition          Topic: diminishing returns

AACSB:

 

  1. Assume that a company is producing at a point beyond where diminishing returns has already set in. If the firm cuts back on production what would you expect should happen to the marginal product of labor and why?

 

Marginal product should begin to rise. The reason is that if the firm is already operating beyond the point of diminishing returns this means that marginal product has already begun to fall. So it stands to reason that by cutting back on production the marginal product of labor would rise.

 

Diff: 2                         Skill: Conceptual         Topic: diminishing returns

AACSB:

 

  1. How is the average product of labor calculated?

 

The average product of labor is calculated by taking total output (or total product) and dividing by the level of labor.

 

Diff: 1                         Skill: Definition          Topic: average product of labor

AACSB:

 

  1. Explain how it is possible for marginal product to fall while average product is rising?

 

Average product can rise even if marginal product is falling as long as the marginal product is higher than the average product.

 

Diff: 2                         Skill: Analytic             Topic: marginal and average product

AACSB:

 

  1. Assume the marginal product for a particular good is constant. Describe the shape of the total product function that would accompany it.

 

The total product function would be upward-sloping and linear.

 

Diff: 2                         Skill: Analytic             Topic: total product

AACSB:

 

  1. Assume that a very unusual production process involves increasing marginal productivity that appears to have no end. What would the total productivity function look like? Comment on the likelihood of such a function in the real world.

 

The total product function would be upward-sloping and would be increasing at an increasing rate. In other words, the slope would keep getting progressively steeper as more labor is added. That doesn’t seem plausible in the real world because what we generally see is either constant marginal product or diminishing marginal product.

 

Diff: 2                         Skill: Conceptual         Topic: marginal product

AACSB:

 

  1. Suppose a manager of a company is told by his staff that marginal productivity has risen above the average productivity over the last six months of operation. What can this manager conclude is happening to the overall average productivity of the company? Explain.

 

The average productivity must also be rising. The reason is that if marginal productivity has risen above the average productivity this will simply pull up the average.

 

Diff: 2                         Skill: Analytic             Topic: average product

AACSB:

 

Scenario 1

 

Suppose your professor grades you on ten examinations, all carrying equal weight for the final grade in the course. Answer the following questions based on this information.

 

  1. Refer to Scenario 1. If you start the course in such a way that each exam score is better than your previous average what should happen to your average score? What would happen to your average if it was below your previous exam score? Explain.

 

Your average would continue to rise. If you received a score on one examination that was lower than the previous exam score there wouldn’t be any way to determine what would happen to your average unless you knew what this score was compared to your previous average, not your previous exam score.

 

Diff: 3                         Skill: Conceptual         Topic: average product

AACSB:

 

  1. Refer to Scenario 1. If you start the course in such a way that each exam score is worse than your previous average what should happen to your average score? What would happen to your average if the next exam score was larger than your previous exam score? Explain.

 

Your average would continue to fall. If you received a score on one examination that was higher than the previous exam score there wouldn’t be any way to determine what would happen to your average unless you knew what this score was compared to your previous average, not your previous exam score.

 

Diff: 3                         Skill: Conceptual       Topic: average product

AACSB:

 

  1. Refer to Scenario 1. The student has already taken 9 exams. His 9th exam was a 65 and his 10th exam was higher than the 9th exam. What can we conclude has happened to his average?

 

You can’t conclude anything unless you know whether the 10th exam score was higher than his previous average. The fact that it was higher than 65 which was his previous score is irrelevant.

 

Diff: 3                         Skill: Conceptual         Topic: average product

AACSB:

 

  1. Refer to Scenario 1. The student has already taken 9 exams and scored a 80 on the 9th one. His average is a 70 after the 9th exam. If he scores a 70 on the tenth exam what will happen to his average?

 

His average after the 10th exam will remain unchanged at 70. The reason is simple. Even though he scored lower than his previous exam score his score was equal to his average. This would have no impact on the average whatsoever.

 

Diff: 3                         Skill: Conceptual         Topic: average product

AACSB:

 

  1. As a manager of a fast-food restaurant, you estimate that the total product of labor used to make meals varies according to the following data:

 

Number of Workers (per day) Total Product of Labor

(meals per day)

APL MPL
0 0 —- —-
1 30
2 70
3 100
4 120
5 130

 

Fill in the table above.

 

Number of Workers (per day) Total Product of Labor

(meals per day)

APL MPL
0 0 —- —-
1 30 30 30
2 70 35 40
3 100 33.3 30
4 120 30 20
5 130 26 10

 

Diff: 1                                     Skill: Analytic             Topic: average product

AACSB:

 

 

 

 

 

 

 

 

 

 

 

 

 

  1. The data below shows the relationship between total output and the amount of labor hired at Jack’s Quick Lube Station:

 

Number of Workers

(per day)

Total Product

(oil changes per day)

0 0
1 25
2 45
3 60
4 70
5 75

 

Does the production function in the table above exhibit diminishing returns?  Explain.

 

Yes, the production function exhibits diminishing returns.  As the amount of labor hired increases, the marginal product of labor falls.

 

Diff: 1                                     Skill: Analytic             Topic: diminishing returns

AACSB:

 

  1. The data below shows the relationship between total output and the amount of labor hired at Papa’s Pizza Shop:

 

Number of Workers

(per day)

Total Product

(pizzas per day)

0 0
1 100
2 200
3 300
4 400
5 500

 

 

  1. Does the production function in the table above exhibit diminishing returns? Explain.

 

No, the production function does not exhibit diminishing returns.  As the amount of labor hired increases, the marginal product of labor is constant.  This violates the law of diminishing returns.

 

Diff: 1                         Skill: Analytic             Topic: law of diminishing returns

AACSB:

 

  1. If marginal product is decreasing what can we say about what is happening to average product? Explain.

 

You can’t actually say anything about it. If marginal product is above average product but still decreasing it will bring the average product up. If marginal product is below average product it will bring average product down.

 

Diff: 1                         Skill: Conceptual         Topic: marginal product

AACSB:

 

  1. Using the table below calculate the marginal product and the average product. Show where diminishing marginal productivity sets in.

 

 

 

Diminishing marginal productivity sets in at the third worker since this is the point where marginal product first falls.

 

Diff: 1                         Skill: Conceptual         Topic: marginal product

AACSB:

 

 

 

 

 

 

  1. As a manager of a dry-cleaning establishment, you estimate that the total product of labor used to clean shirts varies according to the following data:

 

Number of Workers (per day) Total Product of Labor

(shirts cleaned per day)

APL MPL
0 0 —- —-
1 50
2 95
3 135
4 170
5 200

 

Fill in the table above.

 

Number of Workers (per day) Total Product of Labor

(shirts cleaned per day)

APL MPL
0 0 —- —-
1 50 50 50
2 95 47.5 45
3 135 45 40
4 170 42.5 35
5 200 40 30

 

Diff: 1                         Skill: Analytic             Topic: marginal product

AACSB:

 

  1. Barney’s Beds currently hires 14 workers. The average product of labor is 2 beds per day, and the marginal product of a 15th worker is expected to be three beds per day.  If the firm hires the 15th worker, what will happen to the average product of labor?  Explain.

 

If the firm hires the 15th worker, the average product of labor will rise.  Whenever marginal product is greater than average product, average product will rise.

 

Diff: 2                         Skill: Analytic             Topic: average product

AACSB:

  1. Assume that for whatever reason there is a manufacturing firm exhibits a constant marginal product of labor over a certain range of production. Armed with only this information what would you be able to say about the average product and total product of labor curves of this firm.

 

The marginal product curve and the average product curve would be one and the same and would have a horizontal shape of the relevant production range. The total product function would be an upward-sloping linear function.

 

Diff: 2                         Skill: Conceptual         Topic: marginal product

AACSB:

 

  1. Use the two graphs below to explain the relationship between total product and marginal product.

 

 

A production function is a numerical representation of the relationship between inputs and outputs. In the figure on the left, total product is graphed as a function of labor inputs. In the figure on the right the marginal product of labor is the additional output that one additional unit of labor produces. The figure shows that the marginal product of the second unit of labor at the sandwich shop is 15 units of output; the marginal product of the fourth unit of labor is 5 units of output.

 

Diff: 2                         Skill: Analytic             Topic: average product

AACSB:

 

  1. What is the relationship between marginal product and average product?

 

When marginal product is greater than average product, average product rises.  When marginal product is lower than average product, average product falls.  When marginal product is equal to average product, average product is at its maximum.

 

Diff: 1                         Skill: Conceptual         Topic: average product

AACSB:

  1. Evaluate the following statement. “If marginal product is falling it will bring down the average product.”

 

This statement is not necessarily true. If marginal product is falling but still above average product then the average product will rise. However, if it is below average product then indeed it will bring average product down with it.

 

Diff: 2                         Skill: Conceptual         Topic: average product

AACSB:

 

  1. If marginal product is a constant what can we conclude about the shape of the average product function and why?

 

The average product function will be horizontal. Since the marginal product stays the same the average product will never change.

 

Diff: 2                         Skill: Conceptual         Topic: average product

AACSB:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  1. Label each of the three graphs below X, Y and Z as either the marginal product, average product or total product of labor and explain the relationship between each of them.

 

 

X is the total product of labor, Y is the marginal product of labor and Z is the average product of labor. Marginal and average product curves can be derived from total product curves. Marginal product is simply the additional total product that arises from hiring one more worker. Average product is total product divided by the units of labor required to produce a given amount of output. Average product is at its maximum at the point of intersection with marginal product.

 

Diff: 2                         Skill: Conceptual         Topic: average product

AACSB:

 

 

 

  1. Evaluate the following statement. “As the marginal product function falls it will eventually cut the average product function where average product is rising.”

 

This cannot be true. The reason is that when marginal product cuts the average product function the two will be equal. This point of equality will occur when average product is at its maximum. If the marginal product was declining and it cut the average product where it was rising this would imply that a marginal product that is below the average product would actually cause the average product to rise. This cannot be so.

 

Diff: 3                         Skill: Conceptual         Topic: marginal product

AACSB:

 

  1. As a manager of a shoe-repair shop, you estimated that the total product of labor used to repair shoes varies according to the following data but some of your figures were deleted by a clerk:

 

Number of Workers (per day) Total Product of Labor

(shoes repaired per day)

APL MPL
0 0 —- —-
1 25 25
2 24
3 66
4 13
5 87 8

 

Fill in missing data in the table above.

 

Number of Workers (per day) Total Product of Labor

(shoes repaired per day)

APL MPL
0 0 —- —-
1 25 25 25
2 48 24 23
3 66 22 18
4 79 19.75 13
5 87 17.4 8

 

Diff: 1                         Skill: Analytic             Topic: marginal product

AACSB:

 

 

  1. Wally’s Widgets currently hires 8 workers. The average product of labor is 15 widgets per day, and the marginal product of a 9th worker is expected to be 13 widgets per day.  If the firm hires the 9th worker, what will happen to the average product of labor?  Explain.

 

If the firm hires the 9th worker, the average product of labor will fall.  Whenever marginal product is lower than average product, average product will be falling.

 

Diff: 2                         Skill: Analytic             Topic: average product

AACSB:

 

  1. What is the relationship between the marginal product curve and the total product curve?

 

The marginal product curve is the slope of the total product curve.  Thus, marginal product is positive as long as total product is rising.

 

Diff: 1                         Skill: Conceptual         Topic: total product

AACSB:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  1. On the figure below, indicate the level of labor where diminishing returns set in.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Diminishing returns set in at the level of labor where the marginal product of labor begins to decline.  Since the marginal product of labor is the slope of the total product curve, diminishing returns can be seen once the slope of the total product curve begins to decline.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Diff: 1                         Skill: Conceptual         Topic: diminishing returns

AACSB:

 

 

 

 

 

 

 

 

  1. Referring to the table below, identify the unit of labor where diminishing returns has set in. Explain your answer.

 

Labor Output
0 0
1 5
2 11
3 18
4 24
5 29
6 33
7 35
8 35
9 33

 

Diminishing returns set in for the fourth worker. The reason that this is so is

that this is where marginal product first begins to fall.

 

Diff: 2                         Skill: Analytic             Topic: diminishing returns

AACSB:

 

  1. What does it mean when economists say that labor and capital are complementary inputs?

 

Additional capital increases the productivity of labor.  Likewise, capital is of very little use without labor to operate it.

 

Diff: 1                         Skill: Definition          Topic: complementary inputs

AACSB:

 

  1. What do economists mean when they say that capital can labor can be both complementary inputs and substitutes.

 

This is because capital enhances the productivity of labor, but it can also be substituted for labor.

 

Diff: 1                         Skill: Definition          Topic: complementary inputs

AACSB:

 

  1. Comment on the following statement: “When average product and marginal product are equal, marginal product is at its maximum.”

 

The statement is false.  If average product is equal to marginal product, average product is at its maximum.

 

Diff: 1                         Skill: Conceptual         Topic: marginal product

AACSB:

  1. A manager of a small company makes the following statement – “We need to keep hiring additional workers up to the point where the marginal productivity of the last worker we hire is at its maximum. This way we can maximize the total productivity of the firm.” Critically evaluate this statement.

 

This statement is false. The total product will be maximized when marginal productivity is zero. Even if the firm continues to hire workers long after the one with the maximum marginal productivity the firm will still see an increase in overall productivity if the additional workers still have a positive marginal productivity.

 

Diff: 1                         Skill: Conceptual         Topic: total product

AACSB:

 

  1. A corporate executive makes the following statement – “The company must keep hiring more workers up to the point where the marginal productivity of the last worker we hire is zero. This way we can maximize the total productivity of the firm.” Critically evaluate this statement. Also comment on whether this is the correct objective function for the firm.

 

This statement is true. If the company continues to hire all the way to the point where the marginal product of the last worker hired is zero then total product will be maximized. Hiring more workers than this will likely lead to negative marginal productivity and hiring fewer workers will lead to a positive marginal product. Either way, total product is maximized at a marginal product of zero. However, this may not be a wise policy since the objective function of a firm is to maximize profits not total productivity.

 

Diff: 2                         Skill: Conceptual         Topic: total product

AACSB:

 

  1. Comment on the following statement: “Diminishing returns occur when total output falls as additional units of labor are combined with fixed inputs in the production process.”

 

The statement is false.  Diminishing returns occurs when marginal product falls as additional units of labor are combined with fixed inputs in the production process.

 

Diff: 1                         Skill: Conceptual         Topic: diminishing returns

AACSB:

 

  1. There is a famous economics saying that argues “if diminishing marginal productivity never set in then the world could be fed from a flower pot.” Explain what this means economically.

 

What this is saying is if diminishing marginal productivity doesn’t hold then it would be possible to add more labor and more seed and fertilizer to the flower pot and one would be able to grow as much food as one desired without limit. Of course we know that the flower pot itself is a real limitation and that adding more labor, seed and fertilizer will quickly lead to diminishing returns.

 

Diff: 1                         Skill: Conceptual         Topic: diminishing returns

AACSB:

 

Choice of Technology

 

  1. Martha owns a factory which can produce 150 coffee mugs using the following five combinations of labor and capital:

 

Technology Units of Capital (K) Units of Labor (L)
A 3 20
B 5 15
C 8 11
D 12 8
E 17 6

 

If the price of capital is $5 per unit and the price of labor is $3 per unit, calculate the total cost of producing 150 coffee mugs under each technology.  Which technology would a profit-maximizing firm use?

 

Technology Units of Capital (K) Units of Labor (L) Total Cost
A 3 20 $75
B 5 15 70
C 8 11 73
D 12 8 84
E 17 6 103

 

The lowest cost technology is technology B, with 5 units of capital and 15 units of labor.

 

Diff: 2                                     Skill: Analytic             Topic: technology

AACSB:

  1. Rhonda’s Rug Company can produce 50 rugs using the following five combinations of labor and capital:

 

Technology Units of Capital (K) Units of Labor (L)
A 1 35
B 3 25
C 7 18
D 13 13
E 20 11

 

If the price of capital is $2 per unit and the price of labor is $1 per unit, calculate the total cost of producing 50 rugs under each technology.  Which is the cost-minimizing technology?

 

Technology Units of Capital (K) Units of Labor (L) Total Cost
A 1 35 $37
B 3 25 31
C 7 18 32
D 13 13 39
E 20 11 51

 

The lowest cost technology is technology B, with 3 units of capital and 25 units of labor.

 

Diff: 2                         Skill: Analytic             Topic: cost-minimizing technology

AACSB:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  1. Use the table below to answer the following questions. Calculate the total cost of production if labor and capital costs are equal at a $1 each. The recalculate the costs when only the price of labor rises to $5 but capital costs remain at $1. Identify the least cost technology in both cases.

 

 

 

The least cost technology is C at $8 when the input prices were both $1. But when labor costs rise to $5 the firm will shift to technology E at a total cost of $20 which is the lowest of the five.

 

Diff: 2                                     Skill: Analytical          Topic: least cost technology

AACSB:

 

 

ISOQUANTS and ISOCOSTS

 

  1. What is an isoquant?

 

An isoquant is a curve that shows all of the combinations of labor and capital that can be used to produce a given level of output.

 

Diff: 1                                     Skill: Definition          Topic: isoquant

AACSB:

 

 

 

 

 

 

  1. Comment on the following statement: “Isoquants must be downward sloping.”

 

The statement is true.  As we move from left to right, the amount of the input on the horizontal axis is increasing.  In order for output to remain constant, this must mean that the amount of the input on the vertical axis must be declining.  Thus, the isoquant will be downward sloping.

 

Diff: 2                         Skill: Conceptual                     Topic: isoquant

AACSB:

 

 

  1. What is the marginal technical rate of substitution?

 

The marginal rate of technical substitution is the slope of the isoquant.  It is the ratio of the marginal product of labor to the marginal product of capital. It is the negative of the slope of the isoquant.

 

Diff: 1             Skill: Definition          Topic: marginal technical rate of substitution

AACSB:

 

  1. If the marginal product of labor is equal to 5 and the marginal product of capital is 2, what is the marginal technical rate of substitution?

 

The marginal rate of technical substitution is the ratio of the marginal product of labor to the marginal product of capital.  Thus, the marginal rate of technical substitution would be 5/2 or 2.5.

 

Diff: 1             Skill: Analytic             Topic: marginal technical rate of substitution

AACSB:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  1. Which isoquant represents a higher level of output? Explain.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Isoquant B represents a higher level of output.  At any level of capital, the level of labor is higher on Isoquant B.  Likewise, at any level of labor, the level of capital is higher on Isoquant B.  Thus, output must be greater.

 

Diff: 1                         Skill: Conceptual         Topic: isoquant

AACSB:

 

  1. What is an isocost line? Write the equation used for an isocost line.

 

An isocost line is a line that shows all of the combinations of capital and labor that are available for a given cost.  The equation used for an isocost line is
(PK
´ K) +  (PL ´ L)

= TC.

 

Diff: 1                         Skill: Definition          Topic: isocost

AACSB:

 

  1. Suppose that the price of capital is $10 per unit and the price of labor is $8 per unit. Write an equation for an isocost line using this information.  What would be the slope of this isocost line?

 

The equation for the isocost line would be (10 ´ K) + (8 ´ L) = TC.  The slope of the isocost line would be (-PL/PK) or -8/10.

 

Diff: 1                         Skill: Analytic             Topic: isocost

AACSB:

 

 

 

 

 

  1. What is the cost-minimizing equilibrium condition?

 

The cost-minimizing equilibrium condition is for the slope of the isoquant (-MPL/MPK) to be equal to the slope of the isocost line (-PL/PK).

 

Diff: 2             Skill: Conceptual         Topic: cost-minimizing equilibrium condition

AACSB:

 

  1. A firm is employing capital and labor such that the marginal product of capital is 30 and the marginal product of labor is 10. If the price of a unit of capital is $50 and the price of a unit of labor is $10, is the firm minimizing its costs?  If not, can you recommend a change for the firm to make in its relative amounts of labor and capital used?  Explain.

 

No, the firm is not minimizing costs.  The slope of its isoquant is -10/30 (-1/3) and the slope of its isocost line is -10/50 (-1/5).  In order to minimize costs, the firm needs to produce where these slopes would be equal.  In other words, the firm needs to produce where the slope of its isoquant is equal to -1/5.  If the firm was to increase its use of labor or decrease its use of capital, the slope of the isoquant will fall.

 

Diff: 2             Skill: Analytic             Topic: cost-minimizing equilibrium condition

AACSB:

 

  1. A firm is employing capital and labor such that the marginal product of capital is 80 and the marginal product of labor is 20. If the price of a unit of capital is $30 and the price of a unit of labor is $15, is the firm minimizing its costs?  If not, can you recommend a change for the firm to make in its relative amounts of labor and capital used?  Explain.

 

No, the firm is not minimizing costs.  The slope of its isoquant is -20/80 (-1/4) and the slope of its isocost line is -15/30 (-1/2).  In order to minimize costs, the firm needs to produce where these slopes would be equal.  In other words, the firm needs to produce where the slope of its isoquant is -1/2.  If the firm was to decrease its use of labor or increase its use of capital, the slope of the isoquant will rise.

 

Diff: 2             Skill: Analytic             Topic: cost-minimizing equilibrium condition

AACSB:

 

  1. On the graph below, draw an isoquant that shows the least-cost combination of capital and labor to produce 100 units of output. Assume that the price of a unit of capital is $1 and the price of a unit of labor is $1.  What is the slope of the isoquant at the least-cost combination of labor and capital?  Explain.
Capital
q = 100

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The least-cost combination occurs where the isoquant and isocost line are tangent.  This means that their slopes are equal.  Since the slope of the isocost line is -1/1 (-1), we know that the slope of the isoquant must also be -1.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Diff: 2                                     Skill: Analytic             Topic: least-cost combination

AACSB:

 

 

 

 

 

  1. If two inputs were perfect substitutes, what would their isoquants look like? Explain.

 

 

The reason they are drawn this way is that if the price of one of them rises by any amount at all   consumers will just turn to the other, and consumption of first input will drop to zero.

 

Diff: 2                         Skill: Analytic             Topic: isoquant

AACSB:

 

  1. How would you expect an improvement in technology to affect a set of isoquants? Use appropriate graphs to explain your answer. Explain.

 

 

Diff: 2                         Skill: Definition          Topic: isoquant

AACSB:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  1. Using an isocost and isoquant diagram, explain how a firm chooses the least costly combination of inputs. On a separate diagram show how to derive a total cost curve from isoquants and isocost lines.

 

The least costly combination would be the point of tangency between the isoquant and the isocost line. The student must change the expenditure level to trace out the total cost curve.

 

 

Diff: 3                         Skill: Analytic             Topic: isoquants and isocosts

AACSB:

 

Chapter 11

 

 

Input Demand: The Capital Market and the Investment Decision

 

 

Capital, Investment, and Depreciation

 

  1. What role do households play in capital markets?

 

Households indirectly supply the financial resources necessary for firms to purchase capital.

 

Diff: 1                                    Skill: Conceptual                     Topic: capital markets

AACSB:

 

  1. Comment on the following statement: “Capital investment decisions always involve risk.”

 

The statement is true.  When firms make capital investment decisions, they must do so based on expectations about the future.  Therefore, because the future is uncertain, these decisions will always involve some amount of risk.

 

Diff: 1                                    Skill: Conceptual                     Topic: capital investment

AACSB: Reflective Thinking

 

  1. Explain what is meant by capital.

 

Capital is a good produced by the economic system which is used as an input to produce other goods and services in the future.

 

Diff: 1                                    Skill: Definition                      Topic: capital

AACSB:

  1. What is the most important dimension of capital and how does that relate to its value?

 

The most important dimension of capital is that it exists through time. Therefore, its value is only as great as the value of the services it will render over time.

 

Diff: 1                                    Skill: Definition                      Topic: capital

AACSB:

 

  1. What is the difference between tangible and intangible capital?

 

Tangible capital is a material thing used to produce future goods and services.  Intangible capital is a nonmaterial thing used to produce future goods and services.

 

Diff: 1                                    Skill: Definition                      Topic: intangible capital

AACSB:

 

  1. What is the most common measure of a firm’s capital stock, and why is it not the most important to focus on?

 

The most common measure of a firm’s capital stock is the current market value of its plant, equipment, inventories, and intangible assets. However, in thinking about capital, it is important to focus on the actual capital stock instead of its simple monetary value.

 

Diff: 1                                    Skill: Definition                      Topic: capital

AACSB:

 

  1. Assume an attorney who has worked with a large law firm decides to leave to establish his own practice. Even though he is not leaving the company with any physical assets what might be his most important asset? What factors might impede his ability to use this asset and why?

 

Even though he is not leaving the law firm with any physical assets he has certainly gained experience with the firm in the form of human capital. He also has contacts with his previous clients. One factor that might impede his ability to use this asset would be if he signed a non-compete contract with his previous employer or otherwise promised not to solicit business from their clients for a certain period of time.

 

 Diff: 1                                    Skill: Definition                      Topic: intangible capital

AACSB: Analytic Skills

 

  1. List the major categories of tangible capital.

 

(1.)     Nonresidential structures.

(2.)     Durable equipment.

(3.)     Residential structures.

(4.)     Inventories.

 

Diff: 1                                    Skill: Definition                      Topic: tangible capital

AACSB:

 

  1. What is social capital? Give an example.

 

Social capital is capital that provides services to the public.  Examples include public works such as roads and bridges or public services such as police protection.

 

Diff: 1                                    Skill: Definition                      Topic: social capital

AACSB:

 

  1. What is human capital?

 

Human capital is a form of intangible capital that includes the knowledge and skills that workers have acquired through education and training.

 

Diff: 1                                    Skill: Definition                      Topic: human capital

AACSB:

 

  1. Why is knowledge considered a type of capital?

 

Knowledge is human capital.  Knowledge is considered capital because it yields valuable services to a firm over time in the same way that other types of capital (such as machinery) do.

 

Diff: 2                                    Skill: Conceptual                     Topic: human capital

AACSB:

 

  1. How is capital valued?

 

The value of capital is measured by the value of services that it will render the firm over time.

 

Diff: 1                                    Skill: Conceptual                     Topic: capital

AACSB:

 

  1. What is meant by capital stock?

 

For a single firm, its capital stock is equal to the current market value of the firm’s plant, equipment, inventories, and intangible assets.

 

Diff: 1                                    Skill: Definition                      Topic: capital stock

AACSB:

 

  1. What is the difference between stock and flow measures?

 

Stock measures are valued at a particular point in time, while flow measures are valued over a period of time.

 

Diff: 1                                    Skill: Definition                      Topic: capital stock and flow

AACSB:

 

  1. In economics, what is meant by investment?

 

Investment is new capital additions to a firm’s capital stock.

 

Diff: 1                        Skill: Definition                      Topic: investment

AACSB:

 

  1. Before investing what should investors evaluate first?

 

Before investing, investors must evaluate the expected flow of future productive services that an    investment project will yield.

 

Diff: 1                        Skill: Definition                      Topic: investment

AACSB:

 

  1. Comment on the following statement: “In economics, investment means a wide variety of things including purchases of stocks, bonds, and other financial assets.”

 

The statement is false.  In economics, investment refers only to an increase in capital.  Purchasing stocks or bonds is a form of saving.

 

Diff: 2                                    Skill: Definition                      Topic: investment

AACSB: Analytic Skills

 

  1. What is depreciation?

 

Depreciation is the decline in an asset’s economic value over time.

 

Diff: 1                                    Skill: Definition                      Topic: depreciation

AACSB:

 

  1. Explain why a computer might depreciate rapidly just in one year even if it is in just as good of a condition as the day it was purchased?

 

The reason is that newer, faster and more capable computers are being manufactured at a fairly rapid pace. This serves to make older computers more obsolete even more quickly than they otherwise would.

 

Diff: 1                                    Skill: Conceptual                     Topic: depreciation

AACSB: Reflective Thinking

 

  1. Why does capital depreciate?

 

Capital can depreciate because it wears out physically or because it becomes obsolete.

 

Diff: 1                         Skill: Conceptual                     Topic: depreciation

AACSB:

 

  1. Typically when firms talk about depreciation they are usually referring to the deprecation of physical capital assets. However, how any why might it be possible for there to be deprecation in human capital?

 

Just like physical capital human capital can also become obsolete. If a worker studies and trains to improve his human capital then he or she is adding to his or her own human capital stock. Likewise, if workers do not keep up with changes in the labor market by acquiring new skills and knowledge then it is very possible than the human capital that ehy have acquired can decline in value over time.

 

Diff: 1                         Skill: Conceptual                     Topic: depreciation

AACSB: Reflective Thinking.

 

 

  1. Define capital. Explain the relationship between investment and capital.

Capital is those goods produced by the economic system that are used as inputs in the production of future goods and services. Investment is a flow and capital is stock. Investment increases the stock of capital.

 

Diff: 2                                    Skill: Definition                      Topic: investment and capital

AACSB:

 

 

 

 

 

  1. How can lack of investment in social capital affect private firms’ profits?

Most social capital is in the form of roads, transit systems, fire services, police services, water, and sewer systems. All businesses use some combination of these services to conduct their business. For example, when transportation systems are inadequate, labor may be prevented from producing goods and services, or goods and services may be prevented from being sold. Either scenario will reduce a firm’s overall profits by reducing quantity sold and therefore total revenue.

 

Diff: 2                                    Skill: Conceptual        Topic: social capital

AACSB:

 

  1. Suppose a firm is considering locating a manufacturing facility in a poorer country where wage rates are much lower than in the United States. Why would social capital be a factor in their decision to relocate? Explain in terms of the impact that a lack of social capital may have on the marginal revenue product

Social capital refers to the infrastructure of a particular region or country. If the country in question has inadequate social infrastructure like poor roads or schools then it might not be a good decision to relocate because the firms’ workers will have a hard time getting to work and won’t be as well educated because of the lack of good schools.

 

Diff: 1                                    Skill: Conceptual        Topic: social capital

AACSB: Analytic Skills

 

  1. A government wants to build a hydroelectric dam to reduce flooding in a region and provide electricity to its people. What type of investment is this? In order to make a decision about whether or not to make the investment, how should the government evaluate this project?

A dam is an infrastructure or social investment. The government should estimate the expected returns from the dam over its lifetime and compare them to the expected construction costs by calculating a return on investment. If the return is greater than the opportunity cost, the government should build the dam.

 

Diff: 3                                    Skill: Conceptual         Topic: social capital

AACSB: Analytic Skills

 

  1. Name two conditions that can cause a capital asset to depreciate.

Capital assets can depreciate due to physical wear and/or the asset becomes obsolete due to a change in technology or consumer tastes and preferences.

 

Diff: 1                                    Skill: Fact                   Topic: depreciation

AACSB:

 

  1. An Internet start-up company consists of three people with an idea that they wish to use in pursuing a patent for a product. What type of capital does this company have and what is its value?

The company’s capital is mainly human capital. Unfortunately, this is very difficult to measure and therefore value.

 

Diff: 2                                    Skill: Conceptual         Topic: human capital

AACSB:

 

  1. Why does it seem to be more difficult for investors to measure the capital stock of a firm like eBay rather than a firm like Ford Motor Company? Explain.

Ford Motor Company is likely to have more physical assets like factories, machines and equipment that are easy to measure in market terms. However, a company like eBay may have few such physical assets since a large part of the value of their business is their good will – their reputation for conducting honest transactions and minimizing fraud.

 

Diff: 1                                    Skill: Conceptual        Topic: capital valuation

AACSB: Reflective Thinking

 

 

The Capital Market

 

  1. Explain what occurs in the capital market.

 

The capital market is where households supply their savings to firms that demand funds in order to buy capital goods.

 

Diff: 1                                    Skill: Definition          Topic: capital market

AACSB:

 

  1. What role do households play in the capital market? What role do firms play?

 

In the capital market households are the suppliers of funds.  Firms demand these funds in order to purchase capital goods.

 

Diff: 1                                    Skill: Conceptual                     Topic: capital market

AACSB:

 

  1. What is a bond?

 

A bond is a contract between a borrower and a lender, in which the borrower agrees to pay the loan at some time in the future, along with interest payments along the way.

 

Diff: 1                         Skill: Definition                      Topic: bonds

AACSB:

 

  1. Why do school districts sell bonds to the public when they are financing a new school building program rather than sell stock?

 

School districts sell bonds for these types of expenditures because the assets will have a long life and the bond can be paid back over time. They don’t sell stock because school districts are typically not corporate entities but rather run by the government. Selling stock would imply that the holders of the stock have ownership in the “company” and a claim on its profits. Since school districts are not companies and don’t make profits it is more appropriate to sell bonds to finance these expenditures.

 

Diff: 1                                    Skill: Definition                      Topic: bonds

AACSB: Analytic Skills

 

  1. Why might two Fortune 500 companies borrow the same amount of money for the same term at the same time yet both pay a very different interest rate even when the same banks makes both loans?

 

The reasons that interest rates are different have to do with many other factors than the ones mentioned. Most notably the credit-worthiness of the firm will play a role and the expected ability of the firm to be able to satisfactorily pay back the loan.

 

Diff: 1                        Skill: Definition                      Topic: loans

AACSB: Analytic Skills

 

  1. When economists say that mortgages are “securitized” what do they mean by this description?

 

It means that the mortgage documents are pooled and then mortgage-backed securities are sold to investors who want to take different degrees of risk.

 

Diff: 1                                    Skill: Definition                      Topic: mortgages

AACSB:

 

  1. Why do mortgage companies begin to require larger down payments from their borrowers when housing prices begin to fall?

 

The primary risk that a mortgage company makes when it loans money on a house is default on the part of the borrower. Even though the house is typically the largest part of the collateral of the loan the mortgage company could stand to lose a significant amount of money if it had to sell the repossessed home in a declining market. Making borrowers put up a larger down payment helps make up for the deficiency in the value of the collateral.

 

Diff: 1                        Skill: Definition                      Topic: mortgages

AACSB: Analytic Skills

 

  1. Many reporters in the media were critical of the high interest rates that many banks charged to lenders in the so-called sub-prime market. Using economic reasoning what was the likely justification for these high interest rates.

The sub-prime market served borrowers who otherwise would not have been able to get credit because of their poor credit history or low income or combination of the two. In order for banks and mortgage companies to find it in their interest to serve these clients they charged a premium above and beyond what they would typically charge clients with better credit histories since there was a greater chance of their defaulting.

 

Diff: 1                                   Skill: Fact                    Topic: loans

AACSB: Analytic Skills

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  1. Is each of the following situations an example of savings, investment, or neither? In each case explain your choice.

 

(a)       A savings and loan association lends money for the purchase of “junk” (not backed) bonds.

(b)      John’s income is $25,000 per year; $22,000 is spent on consumer goods and the remaining money is used purchase stock in the local electric company.

(c)       Just before retirement a couple sells their shares of Pacific Bell stock and puts the proceeds in a bank savings account.

(d)      The city of Los Angeles rebuilds highways after an earthquake.

(e)       In order to improve the income earning potential of current welfare recipients, the federal government increases the size of income transfers.

 

(a)      This example is neither savings nor investment because it is a financial transaction.

(b)      This is an example of savings to John because it is foregone consumption.

(c)       This example is neither savings nor investment because it is a financial transaction.

(d)      This is an example of social investment because the city is building a product that is useful for future and current residents.

(e)       This example is neither savings nor investment because it is a transfer from taxpayers to welfare recipients.

 

Diff: 3                                    Skill: Conceptual                    Topic: investment and saving

AACSB:

 

  1. What is an entrepreneur?

 

An entrepreneur is an individual who organizes, manages, and assumes the risk of a new firm.

 

Diff: 1            Skill: Definition          Topic: entrepreneur

AACSB:

 

  1. Why is the manager of a company typically not the same person as an entrepreneur?

 

An entrepreneur is usually the one that assumes the risk of the firm. Often the management of the company can be someone that the entrepreneur can hire who does not have to exhibit risk-taking qualities.

 

Diff: 1            Skill: Definition          Topic: entrepreneur

AACSB: Reflective Thinking

 

 

 

  1. What is the financial capital market? Who are the suppliers in the market?  Who are the demanders?

 

The financial capital market is the part of the capital market in which savers and investors interact through intermediaries.  Households are the savers and thus are the suppliers in the market.  The demanders are firms wishing to borrow funds to purchase new capital.

 

Diff: 1             Skill: Definition          Topic: financial capital market

AACSB:

 

  1. What is capital income?

 

Capital income is income earned on savings that have been put to use through financial capital markets.  Interest is the most common form of capital income.

 

Diff: 1             Skill: Definition          Topic: capital income

AACSB:

 

  1. List and define two types of capital income.

 

(1.)       Interest represents the payments made for the use of money.

     (2.)       Profit is the excess of revenues over cost in a given period.

 

Diff: 1                         Skill: Definition                      Topic: capital income

AACSB:

 

  1. What is the primary source for capital available to businesses? Name four methods of channeling these funds.

 

Households. Loans from financial institutions, Venture capital, stock issuance and retained earnings.

 

Diff: 1                                    Skill: Fact                               Topic: capital

AACSB:

 

  1. Why do U.S. government loans generally pay a low interest rate?

 

U.S. government bonds pay a low interest rate because the U.S. government is considered to be the safest borrower and most individuals believe that there is very little risk that the government will not repay its loans.

 

Diff: 1                                    Skill: Conceptual                     Topic: loans

AACSB:

 

 

  1. Why might a country like Brazil have to offer a much higher interest rate on its government bonds than those offered by the Great Britain?

 

Potential bond holders perceive that Brazil is a greater credit risk than Great Britain and therefore must be compensated for taking on that risk.

 

            Diff: 1                         Skill: Conceptual                     Topic: bonds

AACSB:

 

  1. List and define the two categories of after-tax corporate profits.

 

(1.) Dividends are the after-tax profits distributed to shareholders.

(2.) Retained earnings are the after-tax profits retained by the corporation.

 

Diff: 1                                    Skill: Definition                      Topic: after-tax corporate profit

AACSB:

 

  1. Explain why some small start-up companies choose not to pay dividends even though they make very large profits. Why might investors still be happy with this arrangement?

 

Small start-up companies may choose to take the profit and use it to reinvest in the company rather than pay it out as dividends. This can be a cheaper way of borrowing financial capital versus borrowing from banks. Investors are likely to be happy with this arrangement is they believe that the company can make a higher rate of return on the profit than the investors could on their own in an alternative use.

 

Diff: 2             Skill: Definition                      Topic: dividends and retained earnings

AACSB: Reflective Thinking

 

  1. Suppose that Fred’s Bed Company was started in 1999 and 100 percent of the $500,000 needed to start up the company was raised by selling shares of stock. In 2000, the company distributed its entire profit of $35,000 to shareholders.  If the market interest rate is 8 percent, what is the level of economic profit earned by the firm’s stockholders?

 

If the market rate of interest is 8 percent, then the opportunity cost of capital is $40,000 ($500,000 ´ 0.08).  Therefore, the shareholders are earning a negative economic profit (loss) of $5,000.

 

Diff: 2                                    Skill: Analytic                         Topic: economic profits

AACSB:

 

 

  1. Oftentimes when a company’s share price is very “high” it will choose to split the stock price and offer each shareholder one share for each they currently hold. Explain why companies might do this and what the effect is on shareholder wealth.

 

Companies might do this if they believe that the “high” price of their stock is discouraging many investors from buying. The stock split does not have any impact on shareholder wealth because even though the price has fallen in half the number of shares each stockholder has in their possession has doubled. This leaves the net worth of their holdings in the company the same.

 

Diff: 1                                    Skill: Analytic                         Topic: stocks

AACSB: Analytic Skills

 

  1. Suppose that Mighty Mike’s Sandwich Shop was started in 1998 and 100 percent of the $250,000 needed to start up the company was raised by selling shares of stock. In 2000, the company distributed its entire profit of $15,000 to shareholders.  If the market interest rate is 5 percent, what is the level of economic profit earned by the firm’s stockholders?

 

If the market rate of interest is 5 percent, then the opportunity cost of capital is $12,500 ($250,000 ´ 0.05).  Therefore, the shareholders are earning an economic profit of $2,500.

 

Diff: 2                                    Skill: Analytic                         Topic: economic profit

AACSB:

 

  1. Give three examples of ways in which financial markets channel household savings into investment projects.

 

(1.)     Banks make loans to businesses using funds saved by households.

      (2.)     A corporation uses its retained earnings to purchase new equipment.

      (3.)     A new firm issues stock to get funds to set up its business.

(4.)     Venture capital

 

Diff: 1                                    Skill: Conceptual                     Topic: financial markets

AACSB:

 

  1. What is venture capital?

 

Venture capital funds take household savings and put them into high-risk ventures in exchange for a share of the profits if the new businesses succeed.

 

Diff: 1                                    Skill: Definition                      Topic: venture capital

AACSB:

  1. An engineer with a major power company decides to leave his job because he believes he has found a way to deliver Internet service across the electrical grid and he wants to start up his own business. He doesn’t have very much cash or collateral. Which method of financing do you believe he will most likely use and why?

 

Venture capital is his most likely source. The reason is that bank financing is not likely to work because the bank will perceive the venture as being too risky. Also, since he doesn’t have any collateral this would be another reason that the loan would not likely be approved. The venture capitalist is still taking on the same risk but is able to spread that risk over a diversified portfolio of different projects.

 

            Diff: 1                         Skill: Conceptual                     Topic: venture capital

AACSB: Analytic Skills

 

  1. What functions does capital income serve in the economy?

 

Interest serves as an incentive to postpone gratification.  Profit serves as a reward for innovation and risk taking.

 

Diff: 1                                    Skill: Conceptual                     Topic: capital income

AACSB:

 

  1. Comment on the following statement: “When a firm retains earnings for investment purposes, it is actually saving on behalf of its shareholders.”

 

The statement is true.  If the firm did not retain its profits, it would distribute them to shareholders in the form of dividends.  Households could then decide whether to save these funds or spend them.  Thus, by making the decision to hold onto a portion of its profits, it is making the decision to save these profits on behalf of its shareholders.

 

Diff: 2                                    Skill: Conceptual                     Topic: retained earnings

AACSB: Reflective Thinking

 

  1. Why might stockholders be upset to find out that their company’s profits that otherwise would have been distributed as dividends are instead invested in U.S. Treasury bonds?

 

They would be upset because those same investors could have taken those profits and done the same thing with them on their own or better. The only instance when it would be appropriate for the company to retain the earnings is when the rate of return on the profit is likely to be higher than what investors could reasonably be expected to earn on their own had the profits been distributed as dividends instead.

 

            Diff: 2                         Skill: Conceptual                     Topic: retained earnings

AACSB: Reflective Thinking

 

  1. Who makes investment decisions in most modern industrial societies? Discuss the roles played by firms, households, and the capital market.

 

In most modern societies, firms primarily make investment decisions.  Households decide how much to save, and the level of saving limits the amount of investment which firms can undertake.  The capital market directs household savings into profitable investment projects.

 

Diff: 1                                    Skill: Conceptual                     Topic: investment

AACSB:

 

  1. Suppose that you are an analyst working for a venture capital firm. An individual contacts you about backing his brand new Internet company.  What information would you want before making this decision?

 

You would want information that would allow you to calculate an expected rate of return on your investment.  Therefore, you would need information on projected costs and revenues for the firm.

 

Diff: 1                                    Skill: Conceptual                     Topic: venture capital

AACSB:

 

 

 

The Demand for New Capital and the Investment Decision

 

  1. You start your own business selling boating equipment. To start the business you sell 5,000 shares of stock at $50 each. This year the revenues from the business are $300,000, and total costs of operating the business are $200,000. All profits are paid out as dividends to the shareholders. If the current interest rate is 20%, what is the economic profit being earned by the shareholders? What will happen to the amount of economic profits earned if the interest rate decreases? Explain your answer.

The shareholders are earning an economic profit of $10 per share. We get this by adding up the total costs of the firm: $200,000 plus the opportunity cost of the initial $250,000 which is $50,000 of lost interest income. That gives us a total of $250,000 in total costs. Since revenues are $300,000 the total profit is $50,000 with profit per share of $50,000/5,000 = $10. If the interest rate decreases, the shareholders’ economic profit will increase. The shareholder will still receive $20 in dividends, if they had put their $50 in an interest-bearing account the return would fallen below $10. Therefore, their economic profit would increase.

 

Diff: 2                                    Skill: Analytic                        Topic: expected rate of return

AACSB: Analytic Skills

 

  1. Explain why using a firm’s profits to reinvest in the company is really not “free borrowing”?

The profits that the company is using could have alternative uses. Whatever those are determines the cost of using them to reinvest in the company. Therefore, the funds are really not free to use.

 

Diff: 2                                    Skill: Analytic                        Topic: retained earnings

AACSB:

 

  1. What does the investment demand curve show?

 

The investment demand curve shows the demand for capital in the economy as a function of the market interest rate. Only those investment projects that are expected to yield a rate of return higher than the market interest rate will be funded. Lower interest rates should stimulate investment.

 

Diff: 1                        Skill: Definition                      Topic: investment

AACSB:

 

  1. Explain how a firm makes an investment decision.

A firm will decide whether or not to invest on the basis of expected rates of return. If the expected rate of return is greater than the interest rate, the firm should make the investment. Another way to consider investment is that the firm should invest up to the point where the marginal revenue product of capital equals the price of capital.

 

Diff: 2                                    Skill: Conceptual                    Topic: investment

AACSB:

 

  1. Up to which point will a perfectly competitive firm continue to invest? Explain carefully.

A perfectly competitive profit-maximizing firm will keep investing in new capital up to the point at which the expected rate of return is equal to the interest rate. This is equivalent to saying that the firm will continue investing up to the point at which the marginal revenue product of capital is equal to the price of capital, or MRPK = PK.

 

Diff: 2                                    Skill: Conceptual                    Topic: investment

AACSB:

 

 

 

 

 

  1. Explain why lower interest rates can stimulate investment by businesses. Show this on a graph.

As the interest rate decreases, there are more projects whose expected rate of return will exceed the interest rate. Thus firms will find it profitable to invest in more projects.

 

 

Diff: 2                                     Skill: Conceptual                     Topic: investment

AACSB:

 

 

  1. Explain the difference between financing investment with a business loan versus with venture capital. What are the pros and cons of each?

Financing with a loan involves accepting an obligation to repay a debt. Financing with venture capital involves accepting funds in exchange for a portion of ownership of the company. With a loan a business owner retains control of her company but must generate enough profit to cover operating costs and loan payments. This may not be possible for a new company. With venture capital there is no obligation to repay the funds. However, a business owner must forfeit some profits and control of her company to the venture capitalist.

 

Diff: 3                        Skill: Conceptual                     Topic: venture capital

AACSB:

 

  1. What is meant by the expected rate of return?

 

The expected rate of return is the annual rate of return that a firm expects to obtain through a capital investment.

 

Diff: 1                                    Skill: Definition                      Topic: expected rate of return

AACSB:

  1. Suppose that you are the president of a small printing company and you are considering the purchase of new machinery. What factors must you consider in making this decision?

 

You must first consider the expected flow of future productive services that the machinery will yield.  The expected costs must be considered as well.  These costs should include a look at the possible alternative uses of the funds required to purchase the machinery.

 

Diff: 1                                    Skill: Conceptual                     Topic: expected rate of return

AACSB:

 

  1. Suppose that you and your four siblings are given an opportunity to purchase a video rental store. Each of you would put up $50,000.  The revenue from the store is expected to remain $350,000 per year for the next several years.  The costs (not including the opportunity costs of your investment) of operating the store are expected to remain steady at $320,000 for the next several years.  The current market rate of interest is 5 percent per year.  Should you go in on this deal?

 

The expected profit from the store is $30,000 per year.  If the profits are divided equally among the five partners, this amounts to $6,000 per year.  This is a 12 percent rate of return on the initial $50,000 investment.  Since the expected rate of return is greater than the market rate of interest, you should go in on the deal.

 

Diff: 2                                    Skill: Analytic                         Topic: expected rate of return

AACSB: Analytic Skills

 

  1. Suppose that you and two friends have an opportunity to purchase a pizza restaurant. Each of you would put up $75,000.  The revenue from the restaurant is expected to remain $200,000 per year for the next several years.  The costs (not including the opportunity costs of your investment) of operating the restaurant are expected to remain steady at $185,000 for the next several years.  The current market rate of interest is 7 percent per year.  Should you go in on this deal?

 

The expected profit from the restaurant is $15,000 per year.  If the profits are divided equally among the three partners, this amounts to $5,000 per year.  This is a 6.67 percent rate of return on the initial $75,000 investment.  Since the expected rate of return is less than the market rate of interest, you should not go in on the deal.

 

Diff: 2                                    Skill: Analytic                         Topic: expected rate of return

AACSB: Analytic Skills

 

  1. In the 1980s the CEO of Coca Cola corporation found out that its core business was making roughly 15% rate of return on investor capital. However, he also discovered that some of the newly acquired subsidiaries were not making anywhere near that amount. He decided to ask each of these companies to come up with a plan to push the rate of return closer to the 15% mark or he warned that these companies might be sold. Why would the CEO sell off companies or operations that are still profitable?

 

The opportunity cost of holding on to companies or operations that are making less than the core business is the difference in the profitability. Therefore, Coca Cola and its executive probably reasoned correctly that it could take sell those companies that were not hitting the 15% mark and reinvest the money in the areas of the company that were hitting the target rate of return.

 

            Diff: 1                         Skill: Analytic                         Topic: expected rate of return

AACSB: Analytic Skills

 

 

Refer to the information provided in Scenario 1 below to answer the questions that follow.

 

SCENARIO 1: The Ajax corporation is considering investing in a series of projects to help improve the quality of life in the city. Following are the projects and their expected rate of return percentages.

 

 

  1. Refer to Scenario 1. If Ajax can borrow at an interest rate of 5%, which projects should be considered? If Ajax can borrow at an interest rate of 11%, which projects should be considered? What is the level of total investment if the interest rate is 10%?

At an interest rate of 5%, every project except the jet-ski facility should be considered because they will all offer a greater rate of return. At an interest rate of 11%, the water pipeline and the amphitheater should be considered, as they are the only ones that offer a greater rate of return. At an interest rate of 10%, $17,500,000 is the level of total investment because the new water pipeline, amphitheater, and roads will all be undertaken.

 

Diff: 2                                    Skill: Analytic                         Topic: investment

AACSB:

 

 

  1. The table below represents potential investment projects for R.L. Clark and Company, based on forecasts of future profits attributable to the investment:

 

Project Total Investment ($) Expected Rate of Return (%)
A    250,000 15
B 1,300,000 13
C    575,000 10
D    140,000  8
E    980,000  5

 

With the interest rate on the y-axis, draw the firm’s total investment as a function of the interest rate.  If the market rate of interest is 9 percent, how much will the firm spend on investment projects?  Explain.

 

If the market rate of interest is 9 percent, the firm will invest in only projects A, B, and C.  Therefore, the firm will spend $2,125,000 on investment projects.  Projects D and E have a rate of return lower than the market rate of interest and thus the firm will not choose to invest in them.

 

 

Diff: 2                         Skill: Analytic                         Topic: expected rate of return

AACSB:

 

 

 

 

 

 

 

 

 

 

  1. The table below represents potential investment projects for ABC Corporation, based on forecasts of future profits attributable to the investment:

 

Project Total Investment ($) Expected Rate of Return (%)
A 350,000 23
B 785,000 18
C 200,000 12
D 690,000 9
E 345,000 6

 

If the market rate of interest is 8 percent, how much will ABC Corporation spend on investment projects?  What happens if the market rate of interest rises to 10 percent?  Explain.

 

If the market rate of interest is 8 percent, ABC Corporation will invest in projects A, B, C, and D.  Thus, they will spend $2,025,000.  Project E has an expected rate of return below the market rate of interest so ABC Corporation will not choose to invest in it.  If the interest rate rises to 10 percent, project D becomes unprofitable.  Therefore, ABC Corporation will spend $1,335,000 on investment projects.

 

Diff: 2                         Skill: Analytic                         Topic: expected rate of return

AACSB:

 

  1. Why is the demand curve for new capital downward sloping?

 

The demand for new capital is downward sloping because there is an inverse relationship between the interest rate and the amount of new capital purchased.  As the interest rate rises, some projects will become unprofitable (because their expected rate of return is lower than the market interest rate).  Thus, as the interest rate rises, the quantity of new capital demanded will fall.

 

Diff: 1             Skill: Conceptual                     Topic: demand for capital

AACSB:

 

  1. List four factors that may affect the demand for capital.

 

Answers to this question will vary, but they may include:

           (1.)       The interest rate.

           (2.)       Government policy.

           (3.)       Global affairs.

           (4.)       Inflation.

           (5.)       Currency exchange rates.

 

Diff: 1                        Skill: Conceptual                     Topic: demand for capital

AACSB:

 

  1. How is the market demand curve for new capital derived?

 

The market demand curve for new capital is the sum of all of the individual demand curves for new capital in the economy.  It represents the level of total investment undertaken by all firms at every interest rate.

 

Diff: 1                         Skill: Conceptual                     Topic: demand for capital

AACSB:

 

  1. Frank Banks manufactures and sells piggy banks in a perfectly competitive market. The firm recently purchased new equipment with an expected rate of return of 7 percent.  If the market rate of interest is 8 percent, was the firm’s decision to purchase the equipment a wise one?

 

No.  A perfectly competitive firm should keep investing in capital up to the point where the expected rate of return is equal to the interest rate.  In this case, the interest rate is higher.  This implies that the opportunity cost of the funds used to purchase the equipment is greater than the expected revenues from the equipment.  Thus, it was a bad decision.

 

Diff: 1                         Skill: Analytic             Topic: expected rate of return

AACSB:

 

  1. Boyd Manufacturing operates in a perfectly competitive market. The firm recently purchased a new structure with an expected rate of return of 18 percent.  If the market rate of interest is 10 percent, was the firm’s decision to purchase the structure a wise one?

 

Yes.  A perfectly competitive firm should keep investing in capital up to the point where the expected rate of return is equal to the interest rate.  In this case, the expected rate of return on the investment is higher than the market rate of interest.  This implies that the opportunity cost of the funds used to purchase the structure is lower than the expected revenues from the structure.  Thus, it was a good decision.

 

Diff: 1                                    Skill: Conceptual         Topic: expected rate of return

AACSB:

 

  1. Explain the relationship between the market interest rate and the amount of investment a firm will undertake.

 

There is an inverse relationship between the market interest rate and the amount of investment a firm will undertake.  As the interest rate falls, investment projects that were not previously profitable may become profitable and the firm’s expenditure on investment projects will rise.

 

Diff: 1                        Skill: Conceptual                     Topic: investment demand

AACSB:

 

CALCULATING PRESENT VALUE

 

  1. What is the formula for the present value of $1 one year from now? If the rate of interest is 5 percent, what is the present value of $10 to be paid one year from now?

 

The formula for the present value of $1 one year from now is $1/(1 + r) where r is the market rate of interest.  If the interest rate is 5 percent, the present value of $10 to be paid one year from now is $9.52.

 

Diff: 2                         Skill: Analytic                         Topic: present value

AACSB:

 

  1. What happens to the present value of $1 one year from now if the market rate of interest falls?

 

If the interest rate falls, the present value of $1 one year from now will increase.  If the interest rate is lower, the amount you would have to set aside today to end up with $1 one year from now would be higher.

 

Diff: 2             Skill: Analytic                         Topic: present value

AACSB:

  1. How is the concept of present value useful in deciding whether or not to undertake an investment project?

 

If the present value of the income stream associated with an investment is less than the full cost of the investment project, the investment should not be undertaken.  If the present value of the income stream is greater than or equal to the full cost of the investment project, it should be undertaken.

 

Diff: 2             Skill: Conceptual                     Topic: present value

AACSB:

 

  1. Which is larger: the present value of $1 two years from now or the present value of $1 one year from now?

 

The present value of $1 one year from now is greater than the present value of $1 two years from now.  At the same interest rate, a individual would have to put a greater amount aside if he wanted to end up with $1 after one year than he would have to if he put the money aside for two years.

 

            Diff: 2             Skill: Analytic                         Topic: present value

AACSB:

 

  1. Assume that you are a plaintiff and have won a structured settlement from a lawsuit that entitles you to $1 million each year over the next ten years. An attorney from the defense team approaches you afterward and offers you $6 million in exchange for your settlement. How would you go about evaluating whether this is a good deal for you or not?

 

You would first have to determine what the present value of each $1 million installment is worth by figuring out what rate of return you could reasonable expected to earn. This becomes your discount rate. Once you have calculated the present value of each of these $1 million installments over the next ten years you simply add them up. If they sum to less than $6 million then you should take the cash payment. If not then you should stay with your structured settlement.

 

Diff: 2                         Skill: Analytic                         Topic: present valueAACSB: Analytic Skills

 

  1. The lottery this evening is worth $50 million dollars in your state. There are two people in your neighborhood that are buying lottery tickets. One is a student with little financial knowledge or business acumen. The other is a successful entrepreneur that is earning 20% rate of return on his business. Which of these people is likely to check off the “cash” option on the ticket and which is likely to choose the structured payout and why?

 

It is more likely that the entrepreneur will choose the cash option because he can invest this money in his business and earn a handsome return. The present discounted value of the structured payout is likely to be less than the cash option. Just the opposite is likely to be true for the student.

 

              Diff: 2                        Skill: Analytic                         Topic: present value

AACSB: Analytic Skills

 

  1. As the president of your firm, you are considering the purchase of a new piece of machinery. The machine is expected to increase profits by $5,000 per year for five years.  After that, the machine will have no value.  If the machine costs $22,000 and the market rate of interest is 5 percent, should your firm purchase the machine?

 

No.  The present value of the income stream is ($5,000/1.05) + ($5,000/1.1025) + ($5,000/1.157625) + ($5,000/1.2155063) + ($5,000/1.2762816) = $4,761.90 + $4,535.15 + $4,319.19 + $4,113.51 + $3,917.63 = $21,647.38.  Since the cost of the machine is greater than the present value of the income stream, the machine should not be purchased.

 

Diff: 3                                    Skill: Analytic                         Topic: present value

AACSB:

 

  1. The president of XYZ, Incorporated is considering the purchase of new equipment. The equipment is expected to increase profits by $25,000 per year for four years.  After that, the equipment will have no value.  If the machine costs $80,000 and the market rate of interest is 6 percent, should your firm purchase the machine?

 

Yes.  The present value of the income stream is ($25,000/1.06) + ($25,000/1.1236) + ($25,000/1.191016) + ($25,000/1.262477) = $23,584.91 + $22,249.91 + $20,990.48 + $19,802.34  = $86,627.64.  Since the cost of the equipment is less than the present value of the income stream, the equipment should be purchased.

 

Diff: 3                                    Skill: Analytic                         Topic: present value

AACSB:

 

  1. Use the concept of present value to explain the inverse relationship between the interest rate and the amount of investment a firm undertakes.

 

As the interest rate falls, the present value of the income stream from an investment rises.  Firms should undertake an investment project only if the present value of the income stream is higher than the full cost of the investment.  Thus, the lower the interest rate, the greater the likelihood that this will be true.  As the interest rate falls, projects that were not previously profitable will become profitable, and the firm’s level of investment will rise.

 

Diff: 3                                    Skill: Conceptual                     Topic: investment demand

AACSB:

 

  1. What is the most an individual would be willing to pay on January 1st for a bond that promises to pay $500 at the end of the year for the next three years if the market rate of interest is 5 percent?

 

The individual would be willing to pay no more than the present value of the income stream which is ($500/1.05) + ($500/ 1.1025) + ($500/1.157625) = $476.19 + $453.51 + $431.92 = $1,361.62.

 

Diff: 3                                    Skill: Analytic                         Topic: present value

AACSB: