Economics 401Hartmann

Spring 2009Worksheet 1

Announcements:

  • Assignment is due Friday, February 20thby 5:00 p.m.
  • Either submit homework through Blackboard or drop off the assignment in my mailbox in room OEC 436. Do not send homework electronically to my email account.
  • If you decide to submit your work electronically, you will either have to scan your mathematical work into an Adobe file or you will have to type up all of your mathematical work.
  • You will be assigned to a group of 4 students for the purpose of completing homework assignments.
  • Each group should turn in one assignment with the names of each group member; individual papers will not be accepted. Your homework grade will comprise of the cumulative score on homework assignments plus your participation that is in part determined by your fellow group members.
  • While completing homework assignments, you may only consult with the other members of your assigned group (or me) on how to answer the questions. You may, however, discuss the class notes with anyone in the class, just not how to answer or interpret a question.
  1. Review of Microeconomics - Each state has established its own set of regulations for the day care industry. For example, in Virginia there must be one adult for every four kids under age 15 months. ( Thus, for every four kids you watch you need to hire another employee. Assume Kids-R-Us operates in Virginia and only watches kids that fall into this age category. Also assume that the day care’s production costs only depend on the number of children they watch, X1, and the number of employees they hire, X2. More specifically, it costs them W1 to watch each child and W2 in wages for each employee hired. The mathematical representation of the total cost function is

TC = W1X1 + W2X2

where X2 = 1/4X1.

(Aside: X2 is a function of X1, i.e., dependent on X1, but the reverse is not true.)

  1. What is the marginal cost of hiring another employee?

ii. What is the marginal cost of watching another child?

iii. Explain in words what the MC of watching another child is. (Ignore discreteness of humans.)

  1. The chief economist for Argus Corporation, a large appliance manufacturer, estimated the firm’s short-run cost function for vacuum cleaners using an average variable cost function of the form

AVC = a +bQ +cQ2

where AVC = dollars per vacuum cleaner and Q = number of vacuum cleaners produced each month. Total fixed cost each month is $180,000. The following results were obtained:

AVC = 191.93 + -0.0305Q + 0.0000024Q2

So for example, if Q = 100, then AVC equals 188.904. (Sum of 191.93 + -3.05 +0.024).

  1. If Argus Corporation produces 8,000 vacuum cleaners per month, what is the estimated average variable cost? Total variable cost? Total cost? Marginal cost? Show work.
  1. At what level of output will average variable cost be at a minimum? What is average variable cost associated with this output? Show work.
  1. The manager of a sports shoe company is engaged in a debate over what strategy would lead to the greatest profit. The company is currently producing women’s and boys’ shoes. Management wants to know if production of boys’ shoes be increased, cut back, or discontinued? The correct answers to these questions depend on a careful analysis of relevant costs. To clarify the situation, management has gathered the following information about different sales quantities of boys’ shoes.

Boy's / Direct / Allocated / Total
Pairs of / Price / Revenue / Costs / Costs / Average
Shoes / (VC) / (FC) / Cost
1600 / $40 / $64,000 / $66,400 / $15,000 / $50.88
2400 / $36 / $86,400 / $74,400 / $20,769 / $39.65
3200 / $32 / $102,400 / $85,600 / $25,714 / $34.79
3600 / $30 / $108,000 / $92,400 / $27,931 / $33.43
4000 / $28 / $112,000 / $100,000 / $30,000 / $32.50

Assume fixed costs are $90,000. Allocate fixed costs based in proportion to number of pairs produced. Assume production of women’s shoes is fixed at 8,000. Thus, if the volume of boy’s shoes is 4,000, then its production is 1/3 of the total; hence its allocation of fixed costs is (1/3)($90,000) =$30.000. Allocations for other output levels are computed in the same manner. Total average cost for boys’ shoes is the sum of direct and allocated costs divided by total output.

The firm is currently selling 2,400 pairs of boys’ shoes per week and charging $36 per pair (which is below ATC). What productionstrategy should management pursue with respect to boys’ shoes: a) shut down, b) increase production by what amount, or c) decrease production by what amount? Explain. Provide evidence for your conclusion. Show work.

  1. Quasi-rents

Read question #10 on page 133 of Besanko et al. and answer the following.

a)What rent did BDS2 expect to earn if the contract was carried through? Show work.

b)What was BDS2 quasi-rent? State all assumptions made to compute this value. Show work.

c)Could BDS2 have held up GAS?Explain.

d)Provide an example in your life where someone tried to extract the quasi-rents from the relationship.

  1. Vertical Integration – Answer ONE of the following two essays.

a.)Universities tend to be highly integrated – many departments all belong to the same organization. There is not a technical reason why a university could not consist of freestanding departments linked together by contracts, much in the same way that a network organization links freestanding businesses. Why do you suppose that universities are not organized in this way (i.e., explain why universities are integrated)? Identify five reasons and provide evidence for your assertions.

b.)The owners of the Minnesota Twins and Vikings organizations wanted to backward integrate into cable and televise their games on the their own cable network, Vikings Sports. They did not want to pay profits to the local cable provider. (See attached article.) Critically evaluate (economically – compare the pros verses the cons) of the decision to maintain their own cable network. Specially go through each make-or-buy fallacy.

Other examples of vertical integration in sports:

Disney and Might Ducks (NHL) Anaheim Angels (MBL) – prior to 2005

Dolan Family and Cablevision and Rangers (NHL), Knicks (NBA), NY Liberty (WNBA)

Comcast and Philadelphia Flyers (NHL), Philadelphia 76ers (NBA)

  1. Here is an excerpt from the Wall Street Journal’s Business Bulletin.

TULIPS IN AUGUST and other garden fantasies bloom in competitive soil. … A bride-to-be in WashingtonState wanted tulips in the garden for her summer wedding. So, Molbak's Inc., in Woodinville, Washington, purchased and refrigerated 500 bulbs that would be planted in June to be ready in August.

Answer these questions based on this bulletin. Make sure answers incorporate economic analysis.

  1. If Molbakdesigns a garden for the wedding, whyMolbak cannot necessarilysell the design to another client? Explain.
  2. Can the bride and groom use Molbak’s design and purchase plants from another company? Explain.
  3. Given the answers to (a-b), then how does the design affect the negotiated price of the plants that Molbak can sell to the couple? That is, can the bride and groom “hold up" Molbak for the cost of the design?Explain.
  4. The article implies that Molbak is concerned only about the case in which the bride and groom use the design for free and then purchase plants from another supplier. Should Molbak also be concerned about the case in which the couple commits to purchase the plants from Molbak, but then back out?
  5. What canMolbakdo to protect itself from customers holding it up for its garden designs?Explain.
  1. Economies of Scale and Scope: Suppose an insurance company offers two products – life insurance and home insurance. Assume the production technology displays the following coststructure, where C(l, h) represents the cost of providing l units of life insurance and h units of home insurance:

C(0,50) = 100C(5,0) = 150

C(0,100) = 210C(10,0) = 320

C(5,50) = 240C(10,100) = 500

  1. Does this production technology display economies of scale? Explain.
  2. Does this production technology display economies of scope? Explain.
  3. From this data, can you conclude what is the profit maximizing output? Explain.
  4. If you answer to (i) is yes, then provide one reason for why an insurance company’s cost structure may exhibit economies of scale. If the answer is no, then leave this question blank.
  5. If you answer to (ii) is yes, then provide one reason for why an insurance company’s cost structure may exhibit economies of scope. If the answer is no, then leave this question blank.

Optional Problems (not to be turned in):

  1. In the past few years, several American and European firms open “hypermarts,” enormous stores that sell groceries, household goods, hardware, and other products under one roof. What are the possible economies of scale that might be enjoyed by hypermarts? What are the potential diseconomies of scale? Identify at least 2 sources for each. Provide justification for your answers.
  1. Best Buys redesigned their stores so that customers waiting to make purchases must stand in a single queue and wait for the next available cashier, rather than queue up at separate cashiers. How does this relate to inventory economies of scale? (Hint: what is being inventoried?)