METest - Practice Questions Answers Managerial Economics...

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Practice Questions : Answers Managerial Economics Weeks 1-4 Inclusive Question 1 a) - If the equipment can be resold for $50k in Sydney, your sunk costs are $250k ($200k + $100k - $50k); but the question says that there are NO smoothie shops in Sydney to sell the equipment to! - If the equipment can be resold for $50k in Europe only, your sunk costs are $300k, because it wouldn’t be worth it to spend $100k to send the equipment back. Î Your sunk costs are $300k b) At this point the investment costs are sunk, so you ignore them. You can write down a tree, or just think about each separate case: - if the SMH says it will be a success, you stay and earn $480k - if the SMH says it will be a medium success, you stay and earn $200k - if the SMH says it will be a failure, you leave the market and avoid losing $400k c) Now we are thinking of a decision at the beginning of a long tree. Let’s think about the events in words, then turn it into a tree: So that means that Nature plays when the Sydney Morning Herald reveals whether you’ll be a success or not. You have to decide whether or not to stay, after that. ( $ 1 8 0 ) YO U stay 1 / 3 good exit (-$300) NATURE stay (-$100) sink $300 to invest 1 / 3 medium (-$300) YOU 1 / 3 bad stay (-$700) don’t invest ($0) exit (-$300) Decide whether to invest If invest, you automatically buy and ship th Get reviewed & find out what the i Decide whether to stay in bi
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QUESTION: why are the sunk costs in the tree, now? Because in the first part of the tree, you haven’t yet invested, so they’re not sunk costs. Now solve by rollback: - First the stay/go decision: as you found in question (b), you will choose to stay in the top 2 cases, and to exit if the review says your shop is bad. ( $ 1 8 0 ) YO U stay 1 / 3 good NATURE stay (-$100) sink $300 to invest 1 / 3 medium YOU 1 / 3 bad don’t invest ($0) exit (-$300) - next solve the expected payoff: 1 / 3 good 180 NATURE sink $300 to invest 1 / 3 - 100 = 1 / 3 (180) + 1 / 3 (-100) + 1 / 3 (-300) YOU 1 / 3 bad = - 73.333 don’t invest ($0) - 300 Your expected payoff from entering the market is (- $73,333), so you don’t enter. d) Suppose your sunk costs are only $80k. ( $ 1 8 0 ) YO U stay 1 / 3 exit (-$80) NATURE stay (-$100) sink $80 to enter 1 / 3 (-$80) YOU 1 / 3 stay (-$700) don’t enter ($0) exit (-$80) Now you stay only if the review predicts you’ll do well and earn $180,000; you leave in the medium case. In the other cases you exit. Therefore your expected payoff is (180 – 80 – 80)/3 = 6,666.
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Î You decide to enter the market. e) Notice that if we leave out the decision to stay/go from this market, your expected earnings are exactly the same in each case: $180k with probability 1 / 3 , -$100k with probability 1 / 3 , and -$400k with probability 1 / 3 . But you have the option of leaving the market if things look bad, so your payoffs are different. In general, once costs are sunk you ignore them, but you’re much more likely to make an investment if a smaller share of the investment is sunk: it’s much easier to exit the market, if your business prospects get worse for some reason.
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This note was uploaded on 09/30/2010 for the course ECON 12345 taught by Professor Marquis during the Fall '10 term at Taylor University.

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METest - Practice Questions Answers Managerial Economics...

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