Managerial Economics and Business Strategy, 4e Page 1
Chapter 1: Answers to Questions and Problems
1. Consumer-consumer rivalry best illustrates this situation. Here, Levi Strauss & Co. is a
buyer competing against other bidders for the right to obtain the antique blue jeans.
2. The maximum you would be willing to pay for this asset is the present value, which is
( )
( ) ( ) ( ) ( )
2 3 4 5
150, 000 150, 000 150, 000 150, 000 150, 000
1 0.09
1 0.09 1 0.09 1 0.09 1 0.09
$583, 447.69.
PV = + + + +
+
+ + + +
=
3.
a. Net benefits are ( ) . 5 20 50
2
Q Q Q N + =
b. Net benefits when 1 = Q are ( ) 65 5 20 50 1 = + = N and when 5 = Q they are
( ) ( ) ( ) 25 5 5 5 20 50 5
2
= + = N .
c. Marginal net benefits are ( ) Q Q MNB 10 20 = .
d. Marginal net benefits when 1 = Q are ( ) ( ) 10 1 10 20 1 = = MNB and when 5 = Q they
are ( ) ( ) 30 5 10 20 5 = = MNB .
e. Setting ( ) 0 10 20 = = Q Q MNB and solving for Q, we see that net benefits are
maximized when 2 = Q .
f. When net benefits are maximized at 2 = Q , marginal net benefits are zero. That is,
( ) ( ) 0 2 10 20 2 = = MNB .
4.
a. The value of the firm before it pays out current dividends is
1 0.08
$550, 000
0.08 0.05
$19.8 million
firm
PV
+
| |
=
|
\
=
.
b. The value of the firm immediately after paying the dividend is
million 25 . 19 $
05 . 0 08 . 0
05 . 0 1
000 , 550 $
=
|
\
|
+
=
Dividend Ex
firm
PV
.
5. The present value of the perpetual stream of cash flows. This is given by
$75
1,875.
.04
Perpetuity
CF
PV
i
= = =
Page 2 Michael R. Baye
6. The completed table looks like this:
Control
Variable
Q
Total
Benefits
B(Q)
Total
Cost
C(Q)
Net
Benefits
N(Q)
Marginal
Benefit
MB(Q)
Marginal
Cost
MC(Q)
Marginal
Net
Benefit
MNB(Q)
100 1200 950 250 210 40 170
101 1400 1000 400 200 50 150
102 1590 1060 530 190 60 130
103 1770 1130 640 180 70 110
104 1940 1210 730 170 80 90
105 2100 1300 800 160 90 70
106 2250 1400 850 150 100 50
107 2390 1510 880 140 110 30
108 2520 1630 890 130 120 10
109 2640 1760 880 120 130 -10
110 2750 1900 850 110 140 -30
a. Net benefits are maximized at 108 = Q .
b. Marginal cost is slightly smaller than marginal benefit ( ) 130 , 120 = = MB MC . This is
due to the discrete nature of the control variable.
7.
a. The net present value of attending school is the present value of the benefits derived
from attending school (including the stream of higher earnings and the value to you of
the work environment and prestige that your education provides), minus the
opportunity cost of attending school. As noted in the text, the opportunity cost of
attending school is generally greater than the cost of books and tuition.
b. Since this increases the opportunity cost of getting an M.B.A., one would expect
fewer students to apply for admission into M.B.A. Programs.
8.
a. Her accounting profits are $180,000. These are computed as the difference between
revenues ($200,000) and explicit costs ($20,000).
b. By working as a painter, Jaynet gives up the $100,000 she could have earned under
her next best alternative. This implicit cost of $100,000 is in addition to the $20,000
in explicit costs. Since her economic costs are $120,000, her economic profits are
$200,000 - $120,000 = $80,000.
Managerial Economics and Business Strategy, 4e Page 3
9. First, recall the equation for the value of a firm:
|
|
\
|
+
=
g i
i
PV
firm
1
0
. Next, solve this
equation for g to obtain
( )
firm
PV
i
i g
0
1 +
= . Substituting in the known values implies a
growth rate of
( )
06 . 0
000 , 275
000 , 10 10 . 0 1
10 . 0 =
+
= g , or 6 percent. This would seem to be a
reasonable rate of growth: ( ) i g < < 10 . 0 06 . 0 .
10. Effectively, this question boils down to the question of whether it is a good investment to
spend an extra $100 on a refrigerator that will save you $25 at the end of each year for
five years. The net present value of this investment is
( ) ( ) ( ) ( )
2 3 4 5
$25 $25 $25 $25 $25
$100
1.05
1.05 1.05 1.05 1.05
$108.24 $100
$8.24.
NPV = + + + +
=
=
You should buy the energy efficient model, since doing so saves you $8.24 in present
value terms.
11. Under a flat hourly wage, employees have little incentive to work hard as working hard
will not directly benefit them. This adversely affects the firm, since its profits will be
lower than the $40,000 per store that is obtainable each day when employees perform at
their peak. Under the proposed pay structure, employees have a strong incentive to
increase effort, and this will benefit the firm. In particular, under the fixed hourly wage,
an employee receives $144 per day whether he or she works hard or not. Under the new
pay structure, an employee receives $264 per day if the store achieves its maximum
possible daily profit and only $64 if the stores daily profit is zero. This provides
employees an incentive to work hard and to exert peer pressure on employees who might
otherwise goof off. By providing employees an incentive to earn extra money by working
hard, both the firm and the employees will benefit.
12.
a. Accounting costs equal $3,160,000 per year in overhead and operating expenses. Her
implicit cost is the $56,000 salary that must be given up to start the new business. Her
opportunity cost includes both implicit and explicit costs: $3,160,000 + $56,000 =
$3,216,000.
b. To earn positive accounting profits, the revenues per year should greater than
$3,160,000. To earn positive economic profits, the revenues per year must be greater
than $3,216,000.
Page 4 Michael R. Baye
13. First, note that the $170 million spent to date is irrelevant, as it will be lost regardless of
the decision. The relevant question is whether the incremental benefits (the present value
of the profits generated from the drug) exceed the incremental costs (the $30 million
needed to keep the project alive). Since these costs and benefits span time, it is
appropriate to compute the net present value. Here, the net present value of DASs R&D
initiative is
5 6 7 8 9
15, 000, 000 16, 500, 000 18, 150, 000 19, 965, 000 21, 961, 500
30, 000, 000
(1 0.07) (1 0.07) (1 0.07) (1 0.07) (1 0.07)
$26, 557, 759.86.
NPV = + + + +
+ + + + +
=
Since this is positive, DAS should spend the $30 million. Doing so adds about $26.6
million to the firms value.
14. Disagree. In particular, the optimal strategy is the high advertising strategy. To see this,
note that the present value of the profits from each advertising strategy are as follows:
( )
( ) ( )
2 3
$15, 000, 000 $90, 000, 000 $270, 000, 000
$290, 871, 525.17
1 0.10
1 0.10 1 0.10
High
PV = + + =
+
+ +
;
( )
( ) ( )
2 3
$30, 000, 000 $75, 000, 000 $150, 000, 000
$201, 953, 418.48
1 0.10
1 0.10 1 0.10
Moderate
PV = + + =
+
+ +
;
( ) ( ) ( )
10 . 888 , 078 , 245 $
10 . 0 1
000 , 000 , 126 $
10 . 0 1
000 , 000 , 105 $
10 . 0 1
000 , 000 , 70 $
3 2
=
+
+
+
+
+
=
low
PV .
Since the high advertising results in profit stream with the greatest present value, it is the
best option.
15.
a. Since the profits grow faster than the interest rate, the value of the firm would be
infinite. This illustrates a limitation of using these simple formulas to estimate the
value of a firm when the assumed growth rate is greater than the interest rate.
b.
1 1.08
$2.5 $54
0.05
firm
i
PV
i g
( +
(
= = =
(
(
billion.
c.
1 1.08
$2.5 $33.8
0.08
firm
i
PV
i g
( +
(
= = =
(
(
billion.
d.
1 1.08
$2.5 $24.5
0.11
firm
i
PV
i g
( +
(
= = =
(
(
billion.
Managerial Economics and Business Strategy, 4e Page 5
16. If she invests $1,500 in pre-tax money each year in a traditional IRA, at the end of 4
years the taxable value of her traditional IRA will be
( ) ( ) ( ) ( ) 90 . 299 , 7 $ 08 . 1 500 , 1 $ 08 . 1 500 , 1 $ 08 . 1 500 , 1 $ 08 . 1 500 , 1 $
1 2 3 4
= + + + .
She gets to keep only 83 percent of this (her tax rate is 17 percent), so her spendable
income when she withdraws her funds at the end of 4 years is
( )( ) 92 . 058 , 6 $ 90 . 299 , 7 $ 83 . 0 = . In contrast, if she has $1,500 in pre-tax income to devote
to investing in an IRA, she can only invest $1,245 in a Roth IRA each year (the
remaining $255 must be paid to Uncle Sam). Since she doesnt have to pay taxes on her
earnings, the value of her Roth IRA account at the end of 4 years represents her
spendable income upon retirement if she uses a Roth IRA. This amount is
( ) ( ) ( ) ( ) 92 . 058 , 6 $ 08 . 1 245 , 1 $ 08 . 1 245 , 1 $ 08 . 1 245 , 1 $ 08 . 1 245 , 1 $
1 2 3 4
= + + + .
Notice that, ignoring set-up fees, the Roth and traditional IRAs result in exactly the same
after-tax income at retirement. Therefore, she should adopt the plan with the lowest set-
up fees. In this case, this means choosing the Roth IRA, thus avoiding the $25 set-up fee
charged for the traditional IRA. In other words, the net present value of her after-tax
retirement funds if she chooses a Roth IRA,
( )
49 . 453 , 4 $ 0 $
08 . 1
92 . 058 , 6 $
4
= =
Roth
NPV
is $25 higher than under a traditional IRA.
17. No. Note first that your direct and indirect costs are the same regardless of whether you
adopt the project and therefore are irrelevant to your decision. In contrast, note that your
revenues increase by $9,807,700 if you adopt the project. This change in revenues
stemming from the adoption from the ad campaign represents your incremental revenues.
To earn these additional revenues, however, you must spend an additional $2,945,700 in
TV airtime and $1,179,100 for additional ad development labor. The sum of these costs
$4,124,800 represents the explicit incremental cost of the new advertising campaign. In
addition to these explicit costs, we must add $6,000,000 in implicit costs the profits lost
from foreign operations. Thus, based on the economically correct measure of costs
opportunity costs the incremental cost of the new campaign is $10,124,800. Since these
incremental costs exceed the incremental revenues of $9,807,700, you should not proceed
with the new advertising campaign. Going forward with the plan would reduce the firms
bottom line by $317,100. Expressed differently, the extra accounting profits earned in the
U. S. would not offset the accounting profits lost from foreign operations.
