MANAGERIAL ECONOMICS

1. Describe the effects of each of the following managerial decisions or economic influences on the
value of the firm:
A.

The firm is required to install new equipment to reduce air pollution.

Answer:
The most direct effect of a requirement to install new pollution control equipment
would be an increase in the operating cost component of the valuation model.
Secondary effects might be expected in the discount rate due to an increase in
regulatory risk, and in the revenue function if consumers react positively to the
installation of the pollution control equipment in production facilities.

B.

Through heavy expenditures on advertising, the firm's marketing department

increases sales substantially.
Answer:
All three major components of the valuation model-the revenue function, cost
function, and the discount rate--are likely to be affected by an increase in advertising.
Revenues and cost will both increase as output is expanded. The discount rate may
be affected if the firm's profit outlook changes significantly because of increased
demand (growth) or if borrowing is necessary to fund a rapid expansion of plant and
equipment to meet increased demand.

C.

The production department purchases new equipment that lowers manufacturing

costs.
Answer:
The primary effect of newer and more efficient production equipment is a reduction
in the total cost component of the valuation model. Secondary effects on firm
revenues could also be important if lower costs make price reductions possible and
result in an increase in the quantity demanded of the firm's products. Likewise, the
capitalization rate or discount factor can be affected by the firm's changing prospects.

D.

The firm raises prices. Quantity demanded in the short run is unaffected, but in the
longer run, unit sales are expected to decline.
Answer:
The time pattern of revenues is affected by such a pricing decision to raise prices in
the near term. This will alter production relationships and investment plans, and
affect the valuation model through the cost component and capitalization factor.

E.

The Federal Reserve System takes actions that lower interest rates dramatically.
Answer:
A general lowering of interest rates leads to a reduction in the cost of capital or
discount rate in the valuation model.
2. How is the popular notion of business profit different from the economic profit concept? What
role does the idea of normal profits play in this difference?
Answer:
The key distinction is that business or accounting profit provides a measure of the total
return on capital investment, whereas economic profit refers to the return on capital in
excess of that required (expected) by investors. Normal profit refers to the risk-adjusted rate
of profit required by investors to attract and retain funds for capital investment. Many of the
profit theories described in the chapter actually confound the business and economic profit
concepts.

(Which concept--the business profit concept or the economic profit concept--provides the more
appropriate basis for evaluating business operations? Why?
ANSWER: The economic profit concept provides the most appropriate basis for evaluating the operations
of a business since it allows for a risk-adjusted normal rate of return on all capital devoted to the
enterprise. Even when business profits are substantial, economic profits can sometimes be negative given
the effects of risk, inflation, and other factors. Substantial business profits are no guarantee to the growth,
or even maintenance, of capital investment. In actual practice, investors adjust reported accounting data
to account for additional factors that must be considered.)
3. Characterize each of the following statements as true or false, and explain your answer.
A. If marginal revenue is greater than average revenue, the demand curve is downward sloping.
Answer:
False. Since average revenue is falling along a downward sloping demand curve, marginal
revenue must be less than average revenue for the demand curve to slope downward.
B. Profit is minimized when total revenue equals total cost.
Answer:
False. Profits are maximized when marginal revenue equals marginal cost. Profits equal zero at
the breakeven point where total revenue equals total cost. Profits are minimized when the
difference between total revenue and total cost is at a maximum.
C. Given a downward-sloping demand curve and positive marginal costs, profit-maximizing firms
always sell more output at lower prices than revenue-maximizing firms.
Answer:
False. Profit maximization involves setting marginal revenue equal to marginal cost. Revenue
maximization involves setting marginal revenue equal to zero. Given a downward sloping
demand curve and positive marginal costs, revenue maximizing firms charge lower prices and
offer greater quantities of output than profit maximizers.
D. Marginal cost must be less than average cost for average cost to decline as output expands.
Answer:
True. Average cost falls as output expands so long as marginal cost is less than average cost. If
this condition is met, average costs decline whether marginal costs are falling, rising or constant.
E. Marginal profit is the difference between marginal revenue and marginal cost, and always
exceeds zero at the profit-maximizing activity level.

Answer:
False. Marginal profit equals marginal revenue minus marginal cost, and equals zero at the profit
maximizing activity level.
4. What is the difference between risk and uncertainty?
Answer: http://www.yourarticlelibrary.com/managerial-economics/uncertainty-risk-andprobability-analysis-in-economic-activity-managerial-economics/28362/

http://www.econlib.org/library/Knight/knRUP7.html
Uncertainty is a situation regarding a variable in which neither its probability distribution nor its
mode of occurrence is known. For instance, an oligopolist may be uncertain with respect to the
marketing strategies of his competitors. Uncertainty as defined in this way is extremely common
in economic activity.

The concept risk is a situation in which the probability distribution of a variable is known but its
actual value is not. Risk is an actuarial concept. Risk may be defined as an uncertainty of
financial loss on the occurrence of an unfortunate event. A risk is an uncertainty of loss. Risk is
an objectified uncertainty or a measurable misfortune. Every business involves some risk and
most people do not like being involved in any risky enterprise. The greater the risk, the higher
must be the expected gain in order to induce them to start the business.
To preserve the distinction which has been drawn in the last chapter between the measurable
uncertainty and an unmeasurable one we may use the term "risk" to designate the former and the
term "uncertainty" for the latter. The word "risk" is ordinarily used in a loose way to refer to any
sort of uncertainty viewed from the standpoint of the unfavorable contingency, and the term
"uncertainty" similarly with reference to the favorable outcome; we speak of the "risk" of a loss,
the "uncertainty" of a gain. But if our reasoning so far is at all correct, there is a fatal ambiguity in
these terms, which must be gotten rid of, and the use of the term "risk" in connection with the
measurable uncertainties or probabilities of insurance gives some justification for specializing the
terms as just indicated. We can also employ the terms "objective" and "subjective" probability to
designate the risk and uncertainty respectively, as these expressions are already in general use
with a signification akin to that proposed.

The practical difference between the two categories, risk and uncertainty, is that in the former the
distribution of the outcome in a group of instances is known (either through calculation a
priori or from statistics of past experience), while in the case of uncertainty this is not true, the
reason being in general that it is impossible to form a group of instances, because the situation
dealt with is in a high degree unique. The best example of uncertainty is in connection with the
exercise of judgment or the formation of those opinions as to the future course of events, which
opinions (and not scientific knowledge) actually guide most of our conduct. Now if the

distribution of the different possible outcomes in a group of instances is known, it is possible to

get rid of any real uncertainty by the expedient of grouping or "consolidating" instances. But that
it is possible does not necessarily mean that it will be done, and we must observe at the outset that
when an individual instance only is at issue, there is no difference for conduct between a
measurable risk and an unmeasurable uncertainty. The individual, as already observed, throws his
estimate of the value of an opinion into the probability form of "a successes in b trials" (a/b being
a proper fraction) and "feels" toward it as toward any other probability situation.

5. Confronted with a choice between Php5,000 today or Php10,000 a year from now, economic
experiments suggest that the vast majority of people will take the Php5,000 today. At the same
time, economic experiments show that most people will opt to take Php10,000 in 10 years over
Php5,000 in nine years. Is such behaviour rational? Explain.
Answer:
6. Following a price change for Diet Coke, explain how retailers use sales information to

learn if Doritos snack chips represent a complement or substitute for Diet Coke.
Answer:

Following a price change, companies use sales information to distinguish complements

from substitutes by noting the size and direction of effects on demand for related
products. Demand curves are downward sloping. As a result, when the price of a product
is decreased, sales of that product rise. At the same time, sales of substitutes fall as
customers switch to the now lower-priced alternative. When the price of a product rises,
sales of that product fall but sales of substitute products rise as customers switch to the
substitute=s relative bargain price. There is a positive correlation between price changes
and units sold when two products are substitutes. Sales of substitutes change in the same
direction of the price change for substitute products. Conversely, when the price of a
product is decreased, sales of that product and complements both rise. When the price of
a product rises, sales of that product fall as do sales of complementary products. There is
an inverse correlation between price changes and units sold when two products are
complements.