eco204_summer_2009_practice_problem_18

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Unformatted text preview: University of Toronto, Department of Economics, ECO 204. Summer 2009. S. Ajaz Hussain ECO 204 Summer 2009 S. Ajaz Hussain Practice Problems 18 Please help improve the course by sending me an email about typos or suggestions for improvements Note: Please don't memorize these solutions in the expectation that similar questions will appear on tests and exams. Instead, try to understand how to derive the answer as you'll be tested on techniques and applications, not on memorization. Moreover, tests and exams will cover topics and techniques that may not be in these practice problems. You are urged to go over all lectures, class notes and HWs thoroughly. Question 1 (20082009 Test Question) Spurred by the success of major sports leagues such as the NBA, NHL, NFL and UFC you start a new sports league BED: "Battle of Economists unto Death". This profit maximizing league organizes gladiator style fights between prominent economists. BED's costs stem from printing tickets only. Suppose Q is measured in thousands. A typical match hall has a capacity of 2,000 or Q = 2. (a) In March 2009, Professor Peasando will battle Lord Maynard Keynes. Suppose demand for March 2009 is estimated to be P = 25 5Q and MC is estimated to be MC = 5. How many tickets will you print and sell? At what price? (b) In April 2009, Professor Hussain will battle Ecoman. Suppose demand for April 2009 is estimated to be P = 25 5Q and MC is estimated to be MC = 5. However, before any tickets are printed, the MC estimate changes to MC = 10. How many tickets should you print and sell? At what price? (c) In May 2009, Professor GIndart will battle Milton Friedman. Suppose demand for May 2009 is estimated to be P = 25 5Q and MC is estimated to be MC = 5. However, after all tickets are printed, the demand forecast is revised to P = 10 Q. How many tickets should you sell? What is the price of the tickets? 1 University of Toronto, Department of Economics, ECO 204. Summer 2009. S. Ajaz Hussain Question 2 Ajax computers manufactures, distributes and retails computers for microeconomic computing. It estimates demand to be P = 100 25Q, where P is in $ and Q is in `000s. The MC of manufacturing, distributing and retailing 1,000 machines is given by: MC = MCmanufacture + MCdistribution + MCretail = 25 + 5 + 20 (a) Calculate the revenue maximizing output and price. (b) Calculate the profit maximizing output and price. (c) Suppose after the machines have been produced, the MC of distribution increases from $5 to $10. How will this impact Ajax computers? Question 3 "Hee Haw" sells farm equipment and faces demand given by P = 3,000 Q, where P is the price in dollars and Q is output sold per month. In its East Coast factory, the firm's fixed costs are $250,000 per month, and its marginal cost of manufacturing the equipment is $1,000 per unit. (a) Find the firm's profit maximizing output and price. What are its profits? (b) Over the last year, the US dollar has appreciated against the Japanese yen (i.e., it takes fewer dollars to buy one Yen, or takes more Yen to buy a dollar). As a result, Japanese imports of farm equipment to the US have become more competitive. Hee Haw's marketing department judges that it would now have to cut price by $500 in order to sell the same output as in part (a): this is to say, that the demand curve has fallen by $500. Is such a pricecut part of a profit maximizing strategy? In this question suppose demand has fallen before actual production takes place. (c) Suppose that the firm has produced the optimal level of output in part (a). But before this quantity is sold, demand unexpectedly falls to: P = 2,800 2Q (or, Q = 1,400 0.5P). One manager recommends cutting price to sell the entire inventory; another favors maintaining the price in part (a) (and therefore selling less than the total inventory). Do you agree with either manager? What optimal price would you set? Question 4 The following page contains Exhibits 1 3 from the Prestige Telephone Company. In this case, commercial customers were being charged $800/hr. (a) Suppose management had chosen the price of $800/hr using the cost plus rule. What was their markup in March 2003? Show your calculations. Assume TFC is allocated to TFCCommercial on 2 University of Toronto, Department of Economics, ECO 204. Summer 2009. S. Ajaz Hussain the basis of volume (i.e. by the fraction of total hours billed to commercial customers 1 ). Hint: think carefully about "total hours". 1 Accountants typically allocate fixed cost on the basis of volume: in this case they'd allocate TFC to commercial customers by the fraction of total revenue hours billed to commercial hours. This common practice is not correct. Nevertheless, assume it for this question. 3 University of Toronto, Department of Economics, ECO 204. Summer 2009. S. Ajaz Hussain Exhibit 1 Prestige Data Services Summary of Computer Utilization, First Quarter 2003 Revenue Hours Intercompany Commercial Total revenue hours Service hours Available hours Total hours January 206 123 329 32 199 560 February 181 135 316 32 164 512 March 223 138 361 40 143 544 Exhibit 2 Prestige Data Services Summary Results of Operations, First Quarter 2003 January Revenues Intercompany sales Commercial sales Computer use Other Total Revenue Expenses Space costs Rent Custodial services February March $ 82,400 98,400 9,241 190,041 $ 72,400 108,000 9,184 189,584 $ 89,200 110,400 12,685 212,285 $ 8,000 1,240 9,240 $ 8,000 1,240 9,240 $ 8,000 1,240 9,240 Equipment costs Computer leases Maintenance Depreciation: Computer equipment Office equipment and fixtures Power 95,000 5,400 25,500 680 1,633 128,213 95,000 5,400 25,500 680 1,592 128,172 95,000 5,400 25,500 680 1,803 128,383 Wages and salaries Operations Systems development and maintenance Administration Sales 29,496 12,000 9,000 11,200 61,696 9,031 7,909 15,424 $ 231,513 $ (41,472) 29,184 12,000 9,000 11,200 61,384 8,731 7,039 15,359 $ 229,925 $ (40,341) 30,264 12,000 9,000 11,200 62,464 10,317 8,083 15,236 $ 233,723 $ (21,438) Materials Sales promotions Corporate services Total expenses Net income/(loss) Exhibit 3 Prestige Data Services Standard Costs - Average Month, First Quarter 2003 Variable Costs Power per hour Operations wages Total variable expenses per hour Fixed Costs Rent Custodial Computer lease Computer maintenance Depreciation Power Wages and Salaries Operations Systems development Administration Sales $4 $24 $28 $8,000 $1,240 $95,000 $5,400 $26,180 $200 $21,600 $12,000 $9,000 $11,200 Total Wages & Salaries Fixed Costs $53,800 Total non-variable expenses Sales promotion $189,820 $8,000 $197,820 << Total Fixed Costs 4 University of Toronto, Department of Economics, ECO 204. Summer 2009. S. Ajaz Hussain (b) Critique Prestige Telephone Company's use of the cost plus rule. Please offer an explanation of whether and if the rule is being applied correctly. Hint: Part of the answer depends on the cost function or the fact that AVC is constant. Question 5 General Motors produces light trucks in several Michigan factories, where its annual fixed costs are $180m and marginal cost per truck is approximately $20,000. Regional demand for trucks is given by: P = 30,000 0.1Q, P is in $ and Q is annual sales of trucks. (a) What is GM's profit maximizing P and Q? What are light trucks profits? (b) GM is getting ready to export trucks to China. Based on marketing surveys, GM has found the elasticity of demand to be constant at E = 9. The additional cost of shipping is $800 per truck. A manager argues that the price in China should be at least $800 higher than the domestic price. Is this manager correct? (c) GM produces another version of the light truck at a marginal cost of $12,000 per truck. At the current price of $20,000, sales of the light truck have been disappointingly low with the result that GM has an inventory of 18,000 unsold trucks. The best estimate for the remaining trucks is: P = 30,000 Q One manager recommends keeping price at $20,000. Another favors cutting prices to clear the entire inventory. In your opinion, what should GM do? Question 6 A British Columbia resort offers yearround activities: in winter skiing and other cold weather activities and, in summer golf, tennis, and hiking. The resort's operating costs are essentially the same in winter and summer. Management charges higher rates in the winter resulting in average occupancy rates of 75% than in the summer when its average occupancy rate is 90%. Can this policy be consistent with profit maximization? Note what the question is asking: is it correct that management has 25% excess capacity in the winter compared to a 10% excess capacity in the summer? Should management drop prices in the winter to fill more rooms? Question 7 We've discussed the optimal price rule: P = {E/(1 + E)}MC. In real life, many small businesses use the cost plus rule to set prices: P = (1 + markup)AC. Discuss the correct way to set the markup. 5 University of Toronto, Department of Economics, ECO 204. Summer 2009. S. Ajaz Hussain Question 8 (2008 2009 Final Exam Question) The following table reproduces portions of Exhibit 11 from the DHL case. Exhibit 11 Revenue and Cost Lane Examples: DOX and WPX U.K. to United States (1990) DOX WPX Revenue $5,723,000 $2,342,000 Outbound Cost 2,392,915 667,712 Hub Cost 596,608 490,436 Line Haul 2 1,121,882 647,915 Delivery 1,376,953 386,049 Gross Margin 234,642 149,888 Gross Margin % 4.1 6.4 Shipments 231,139 68,580 Revenue/Shipment $24.76 $34.15 Note: Please see footnote at the bottom of this page. (a) Calculate the AVC of DOX and WPX for this lane. Show all calculations. (b) Suppose DHL's headquarters in Brussels sets prices to maximize profits. If Brussels raises the price of a document from $24.76 to $25.01, how many documents will be sent from the U.K. to the U.S? State any assumptions. (c) Compute the price elasticity of the WPX segment. (d) Suppose DHL lowers the cost of shipping packages through learning by doing. Assuming the elasticity in part (c) is constant, what must the MC of packages be in order for the price of a document to be equal to the price of a package on the U.K. to U.S. lane? Show all calculations. Question 9 Kim Breweries is located in Markham. It brews beer on premises and ships to many locations all over Canada. The brewery's managers recommend pricing the beer by distance in order to cover transport costs (for example, the price in Montreal would be higher than Toronto). Evaluate this pricing strategy. Question 10 (20072008 Test Question) Sweet Ajax a Canadian company manufactures Halal maple syrup, sold in Canada and USA. Sweet Ajax's marketing group estimates demand for each month of 2009 to be: P = 3,000 Q 2 Line haul refers to the air segment of the shipment 6 University of Toronto, Department of Economics, ECO 204. Summer 2009. S. Ajaz Hussain Where P is in Canadian dollars and Q is units of output. Sweet Ajax's fixed costs are $250,000 per month and its marginal cost is $1,000. You're in charge of planning output and price each month. (a) Suppose you're planning output and prices for February 2009. What's your decision? Show all calculations and steps clearly. (b) Suppose that before production of the output in part (a) begins, your finance group informs you that the Canadian dollar has appreciated substantially against the US dollar (i.e., it takes more U.S dollars to buy a Canadian dollar). The marketing department estimates that the max WTP ("willingness to pay") has fallen by $500 and recommends that prices in February should be $500 less than the price in part (a). Do you think they are right? Show all calculations and steps clearly. (c) Now suppose that after production of the output in part (a) begins, your finance group informs you that the Canadian dollar has appreciated substantially against the US dollar (i.e., it takes more U.S dollars to buy a Canadian dollar). The marketing department estimates that the max WTP ("willingness to pay") has fallen by $500 and recommends that prices in February should be $500 less than the price in part (a). Do you think they are right? Show all calculations and steps clearly. (d) Return to the original question. Suppose MC decreases from $1,000 to $500 before production begins. What is the optimal price and output compared to part (a)? Question 11 In 1996, the drug Prilosec became the best selling antiulcer drug in the world. Prilosec's marginal cost (production and packaging) was only about $0.60 per daily dose. The manufacturer initially sets the price at $3 per daily dose. Research on demand for leading prescription drugs estimates price elasticities to be in the range 1.4 to 1.2. Does setting a price of $3 (or more) make sense? 7 ...
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This note was uploaded on 05/02/2011 for the course ECO 204 taught by Professor Hussein during the Fall '08 term at University of Toronto- Toronto.

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