6. In the early part of 1998, crude oil prices fell to a nine-year low at $13.28 a barrel.

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1 Questions 1. Delta Software earned $10 million this year. Suppose the growth rate of Delta's profits and the interest rate are both constant and Delta will be in business forever. Determine the value of Delta Software when a. The interest rate is 10 percent and profits grow by 4 percent per year. b. The interest rate is 10 percent and profits grow by 0 percent per year. c. The interest rate is 10 percent and profits decline by 4 percent per year. d. The interest rate is 10 percent and profits grow by 12 percent per year. (This part of the question is tricky.) 2. You are a strong advocate for a one-year investment project that would cost your firm $10,000 today, but generate virtually certain earnings of $15,000 at year-end. Those in your firm's financial group concur that the investment is virtually riskfree, but nonetheless your boss is concerned about the firm's cash flow problems. In fact, the problems are so severe that the firm's bank currently charges it 20 percent on one-year loans. Convince your boss to undertake the project. 3. A firm will maximize the present value of future profits by maximizing current profits when the: A. growth rate in profits is constant. B. growth rate in profits is larger than the interest rate. C. interest rate is larger than the growth rate in profits and both are constant. D. growth rate and interest rate are constant and equal. 4. You are the manager of a Fortune 500 hotel chain and must decide where to locate a new hotel. Based on tax considerations, your accounting department suggests that Atlantic City is the best choice, followed closely by Las Vegas. In particular, your current year tax savings from locating in Atlantic City are $4 million but only $3 million in Las Vegas. Your marketing department, on the other hand, has provided you with sales estimates that suggest that the present value of the gross (of taxes) operating profits from locating in Atlantic City are only $10 million but are $14 million for Las Vegas. It will cost $14 million to build the hotel in either location. Ignoring all other considerations, where should you build the hotel? What are your firm's economic profits if you locate the hotel in Atlantic City? 5. A potential entrepreneur is trying to decide whether to open a new health spa. She presently makes $35,000 per year as an aerobics instructor and will have to give up this job if she opens the new health spa. If she chooses to open the spa, it will cost her $200,000 per year in rent and other operating expenses. a. What are her accounting costs? b. What are her opportunity costs? c. How much would she need to make in revenues to earn positive accounting profits? Positive economic profits? 6. In the early part of 1998, crude oil prices fell to a nine-year low at $13.28 a barrel.

2 Falling crude oil prices were due in part to technological advances that made locating reservoirs and extraction cheaper. What impact will these lower crude oil prices have on the price of gasoline? 7. Apples and oranges are substitutes. A freeze in Florida destroys most of the orange crop. What would you expect to happen to the market for the following: a. Oranges? b. Apples? c. Orange juice? 8. The federal government recently decided to raise the excise tax on hard liquor. a. Graphically illustrate the effects of this tax on the market for hard liquor. b. Would a $1 increase in the excise tax on liquor increase the equilibrium price of liquor by $1? Explain. c. How would the excise tax on hard liquor affect a beer distributor? 9. The government decides that a specific scarce good should be provided for everyone who wants it at a price of zero and passes a law making it illegal to buy or sell the good. However, people can give the good away. This good is highly desirable for some of the population. What effect will this law have on the market? What would happen in this market if the law were removed? 10. Recently, the Brazilian Association of Citrus Exports (Abecitrus) announced that orange production would be down 25 percent this year because of poor weather conditions, disease, and tree stress resulting from three straight bumper crops. What effect will the decreased production of oranges have on the demand for tomato juice? 11. Assume that the price elasticity of demand is for a certain firm's product. If the firm lowers price, the firm's managers can expect total revenue to A. decrease B. increase C. remain constant D. either increase or remain constant depending upon the size of the price decrease.

3 12. Several years ago the National Association of Broadcasters imposed restrictions on the amount of nonprogram material (commercials) that could be aired during children's television shows, effectively reducing the quantity of advertising allowed during children's viewing hours by 33 percent. Within four months, the price of a minute of advertising on network television increased by roughly 14 percent. What impact do you think this had on the revenues of the networks? 13. Which of the following goods would you expect to have the most inelastic demand? Why? a. Swiss cheese. b. Chesse. c. Dairy products. 14. The demand function for VCRs has been estimated to be, where is the quantity of VCRs, is the price of a videocassette, is the price of a movie, is the price of a VCR, and is income. Based on this information, answer the following questions. a. Are VCRs normal or inferior goods? b. Are movies substitutes or complements for VCRs? c. What additional information is needed to calculate the price elasticity of demand for VCRs? 15. The cross-price elasticity for textbooks and copies of old exams is If the price of copies of old exams increases by 10 percent, what will happen to the quantity demanded of textbooks? 16. Airlines give away millions of tickets each year through their frequent flyer programs, with the typical airline awarding a free ticket for each 25,000 miles flown on the airline. The average airline ticket costs $500 and is for a 2,500-mile round trip. Given this information, evaluate the following statement: Airlines could have the same effect on demand by eliminating their frequent flyer programs and simply lowering the average ticket price by 10 percent. 17. Clothing stores frequently run "sales" where they discount clothing prices by as much as 25 percent. What impact, if any, would you expect these "sales" to have on a store that specializes in selling shoes produced by Rockport?

4 18. Over the past decade medical costs have increased more rapidly than other prices. In order to illustrate how rising medical costs have affected consumer alternatives, let X represent the quantity of medical services, and let Y represent the quantity of other goods. Furthermore, let income (M) be measured in hundreds of dollars, the price of medical services and other goods in terms of dollars per minute, with and. a. Graph the budget line, and determine the market rate of substitution. b. Illustrate the budget set. c. Show in your graph what happens to the budget constraint if price of x increases to $10. d. What is the meaning of the slope of the two budget constraints? 19. Suppose you are the manager of a firm that produces Ultrasweet, a sugar substitute. Show graphically the effect of a reduction in the price of Sweet and Healthy, a competitor's product, on a typical consumer's consumption of Ultrasweet. 20. At a very basic level, food and shelter constitute the two most important goods needed to sustain human life. Accordingly, assume that a poor person must allocate his income solely between food and shelter. a. Show that if shelter is an inferior good, food must be a normal good. b. If food is a normal good, is shelter necessarily an inferior good? Explain, and show your answer graphically. 21. You are the manager of Telecall Inc., a small telemarketing company. Your company pays $10,000 per month for office space. A real estate agent has noticed that you are only using 75 percent of your available space and tells you that Telecall could add $800 per month to its bottom line by renting out the space it does not use. Telecall has been asked to do a new telemarketing campaign for a large credit card company, but this would require it to use the remaining office space. What is the opportunity cost of using the extra office space to handle the credit card company's promotion? 22. Suppose the production function of automobiles is given by a. Show that the marginal product of any given quantity of labor increases as capital is increased. b. Suppose Japanese and U.S. automakers produce on identical isoquants with this Cobb- Douglas production function and that labor costs are higher in Japan than in the United States. Do autoworkers in Japan have a higher marginal product than American autoworkers? Explain carefully. c. Now suppose Japanese automakers produce on a different isoquant from U.S. firms, but the prices of Japanese and American cars are identical. Do Japanese or American autoworkers have a higher marginal product? Why?

5 23. You are the manager of a firm that sells output at a price of $40 per unit. You are interested in hiring a new worker who will increase your firm's output by 2,000 units per year. Several other firms also are interested in hiring this worker. a. What is the most you should be willing to pay this worker to come to your firm? b. What will determine whether or not you actually have to offer this much to the worker to induce him to join your firm? 24. The maker of Turbotax produces software that prepares federal income tax returns. In addition, it produces software that prepares various state income tax returns. Why doesn't it pay for the firm to specialize in federal software? 25. In 1995 the U.S. Justice Department sued to block a merger between Microsoft and Intuit, the producer of the nation's best-selling business software. The Justice Department argued that the merger would lessen competition and raise prices of business software. Is there an economic argument that the merger might actually result in lower prices? Explain.

6 Answers 1.a. million. b. million. c. million. d. Since the profits grow faster than the interest rate, Delta Software's value is infinite. 2. The net present value of the investment. Since the net present value is positive, the investment should be undertaken. Cash flow considerations are irrelevant, in this case. Your firm could secure a $10,000 one-year loan from the bank at 20 percent. Since the net present value is positive, in one year the $15,000 generated from the investment will be more than enough to pay back the interest and principal on the loan. Thus, cash flow is not really an issue in this case, and in present value terms, your firm will pocket $2,500 from this investment. 3. C 4. Ignoring other considerations, if you build the hotel in Atlantic City your accounting profits are zero (computed as $4 million in tax savings, plus $10 million in operating profits, minus $14 in building costs). In contrast, if you build in Las Vegas your accounting profits are $3 million (computed as $3 million in tax savings, plus $14 million in operating profits, minus $14 million in building costs). Your best alternative is thus to build in Las Vegas to earn $3 million in accounting (and economic) profits. If you build the hotel in Atlantic City, your accounting profits are zero, but your implicit cost is the $3 million you give up by not building in Las Vegas - your best alternative. Thus, your economic profits of building in Atlantic City are -$3 million. 5. a. Accounting costs equal $200,000 per year in rent plus other operating expenses. b. Opportunity costs equal $235,000 per year plus other operating expenses. c. In order to earn positive accounting profits, the revenues per year should be greater than $200,000 plus other operating expenses per year. In order to earn positive economic profits, the revenues per year should be greater than $235,000 plus other operating expenses per year. 6. Since crude oil is an input to producing gasoline, lower crude prices will reduce the cost of producing gasoline. Gasoline producers will now be willing to produce more gas at any given price. That is, the supply curve will shift to the right. The equilibrium price and quantity combination moves from point A to point B in Figure: The equilibrium price of gasoline falls, while the equilibrium quantity rises.

7 7. a. The demand for oranges does not change, but supply shifts left. This implies an increase in price and a decrease in quantity sold in the orange market. b. Since apples are a substitute for oranges, an increase in the price of oranges increases the demand for apples. As the supply of apples does not change, this implies an increase in both price and quantity sold in the apple market. c. Oranges are the main input for the production of orange juice. An increase in the price of oranges decreases the supply curve for orange juice. On the other hand, the demand does not change. This results in an increase in price and a decrease in quantity sold in the orange juice market. 8. a. As can be seen from Figure, the market supply for hard liquor will decrease by the amount of the excise tax. This results in higher prices (from P1 to P2) and smaller quantities sold in the market for hard liquor (from Q1 to Q2). b. No, a $1 increase in the excise tax on liquor shifts the initial supply up (leftward) by $1. This reduces the equilibrium quantity exchanged in the market. While the equilibrium price increases to P2 (which is less than the P1 plus the excise tax), it must pay Uncle Sam $1 (the difference between the initial and final supply curve). The firm ends up

8 keeping the price associated with Q2 on the initial supply curve, which is less than the initial equilibrium price, P1. Alternatively, note that adding a $1 excise tax to the initial equilibrium price P1, is greater than the post-tax equilibrium price, P2. c. Since hard liquor and beer are substitutes in consumption, an increase in price in hard liquor shifts the demand curve for beer to the right. Hence, both the equilibrium price and quantity of beer will increase. Anticipating this, a beer distributor should increase its production.

9 9. The new legislation is essentially a price ceiling. This price ceiling will have two effects. First it will result in a shortage in the market since quantity demanded will now exceed quantity supplied. This shortage will be accompanied by a full economic price that is greater than the previous equilibrium price. The second effect will be the emergence of a black market, where the good will be traded illegally. Since there exists a positive cost associated with possibly being caught selling the good, the black market price will be higher than the previous equilibrium price. If the law were removed, the full economic price would decrease and the equilibrium quantity would increase. Also, the black market would disappear. 10. A 25% reduction in the production of oranges shifts the supply curve for oranges leftward, raising orange prices and decreasing the quantity demanded. Since oranges are inputs in production for orange juice, an increase in orange prices, decreases the supply curve for orange juice, which causes orange juice prices to increase and the quantity demanded to decrease. Assuming orange juice and tomato juice are substitutes in consumption, higher orange juice prices cause consumers to switch from drinking orange juice to tomato juice. Thus, demand for tomato juice increases. 11. A 12. The own-price elasticity of demand for advertising time is the percentage change in quantity demanded (- 33 percent) divided by the percentage change in price (+ 14 percent), which is Thus, the demand for advertising minutes by those who sell children's products is elastic. By the total revenue test, we would expect this to decrease network revenues. 13. Dairy products are expected to have the most inelastic demand because it is the most broadly defined group, followed by cheese and then swiss cheese. A more specifically defined category has more substitutes and, therefore, more elastic demand. 14a. Since the coefficient associated with income is negative, an increase in income leads to a reduction in demand for VCRs. Hence, VCRs are inferior goods. b. Movies are substitutes for VCRs, since the coefficient associated with the price of a movie is positive. c. The actual values of prices and income are needed to calculate the price elasticity of demand for VCRs.

10 15. By definition, Substitute E Q,P = -3.5 and = 10 into the equation to get = The statement is false. The frequent flyer programs are, in effect, a "buy 10 tickets, get one free" deal. The price of the first 10 tickets remains unchanged under the deal, while the price of the 11th ticket is zero. 17.Since shoes and clothing are probably complements, "sales" at clothing stores most likely lead to increased shoe purchases at Rockport shoe stores. 18a. See Figure below. b. The budget set is the area above the x-axis, to the left of the y-axis, and below the budget line when M = 100, P x = 4, and P y = 5. c. See Figure below. d. The slopes reflect the market rate of substitutions under two different sets of prices. A steeper slope means you have to give up a larger amount of Y in order to obtain one more unit of X. 19.A reduction in the price of Sweet and Healthy rotates the budget constraint, and consumer equilibrium will change. Since Sweet and Healthy and Ultrasweet are substitutes, a typical consumer will consume more Sweet and Healthy and less Ultrasweet.

11 20. Let the quantities of food and shelter be denoted by F and S. Then the budget constraint implies P f F + P s S = M. Differentiating this equation, holding P s and P f constant, reveals P f df/dm + P s ds/dm = 1. If shelter is an inferior good, ds/dm < 0, then df/dm must be positive; food is a normal good if shelter is inferior. b. It need not be the case, as Figure below reveals. The movement from A to B means that demand for both shelter and food increased due to the increase in income. 21. The $800 per month that could be earned by renting out the excess office space. 22. a. Notice that MP L can be written as.75(k/l) 1/4, which increases as K increases. b. Since the higher labor costs in Japan induces a higher K/L ratio, the result in part (a) implies that the marginal product of Japanese workers is higher than that of American workers. c. Since the price of American and Japanese cars are assumed to be identical, the ratio of the value marginal product of American workers to Japanese workers is simply the ratio of the marginal products. Since this ratio equals the ratio of the wages - which is higher in Japan - our conclusion in part (b) is obtained again. Japanese workers have higher marginal products than do American workers. 23a. The extra revenue you will earn by hiring the worker is 2,000 x $40 = $80,000 per year. The most you should pay the worker is an annual salary of $80,000. b. It depends on how much the worker can get from other firms. For instance, if his opportunity cost is $60,000, you will only have to pay $60, to get him.

12 24. There are cost complementarities and economies of scope in producing software for Federal returns (Q F ) and State returns (Q S ). When the multiproduct cost function, C(Q F,Q S ), for producing federal and state tax preparation software exhibits economies of scope, it will be cheaper to produce both types of software jointly than to produce them separately. When there are cost complementarities in production, the marginal cost of producing state software (Q S ) will be lower when Federal software is produced (Q F ). The economies of scope and cost complementarities are due to similarities in the programs and user interfaces that comprise Federal and State income tax preparation software. Once a basic program and interface is written to compute Federal taxes, the marginal cost of producing software for State purposes is much lower (effectively, it is the cost of entering details about each particular state's tax code). If the maker of Turbotax specialized, then another firm that produced both types of software could do so at lower cost, and undermine Turbotax's position in the market. 25.If there are economies of scope or cost complementarities in producing operating systems like DOS and Windows in conjunction with business software, then the merger might lower costs and therefore prices to consumers.

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