W H AT I S E C O N O M I C S ? 1 5 9
A n s w e r s t o t h e R e v i e w Q u i z z e s
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1. What is a rm’s fundamental goal and what happens if the rm doesn’t
pursue this goal?
2. Why do accountants and economists calculate a rm’s cost and prot in
di)erent ways?
Accountants and economists have di)erent reasons for computing a rm’s costs.
An accountant calculates a rm’s cost and prot to ensure that the rm pays the
3. What are the items that make opportunity cost di)er from the accountant’s
measure of cost?
A rm’s opportunity cost includes the cost of using resources bought in the market,
owned by the rm and supplied by the rm’s owner. Economists and accountants
both include the price of resources bought in the market as costs. But accountants
4. Why is normal prot an opportunity cost?
Normal prot is the return to a rm’s owner for the owner’s supply of
entrepreneurial ability and labor to the rm’s production process. Using the
5. What are the constraints that a rm faces? How does each constraint limit the
rm’s prot?
The three types of constraints a rm faces are technology constraints, information
constraints, and market constraints. Technology is any specic method of
1
0
ORGANIZING
PRODUCTION
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1. Is a rm technologically e5cient if it uses the latest technology? Why or why
not?
Technological e5ciency occurs when a rm produces a given level of output using
the least amount of inputs. Adopting the latest available technology does not
2. Is a rm economically ine5cient if it can cut its costs by producing less? Why
or why not?
Economic e5ciency occurs when the rm produces a given level of output at the
3. Explain the key distinction between technological e5ciency and economic
e5ciency.
The di)erence between technological and economic e5ciency is that technological
e5ciency concerns the quantity of inputs used in production for a given level of
4. Why do some rms use large amounts of capital and small amounts of labor
while others use small amounts of capital and large amounts of labor?
The mix of resources used, such as large amounts of capital versus small amounts
of capital, depends on economic e5ciency. Economic e5ciency is based on
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1. Explain the distinction between a command system and an incentive system.
A command system uses a managerial hierarchy, where commands pass
downward through the hierarchy and information (feedback) passes upward.
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W H A T I S E C O N O M I C S ? 1 6 1
2. What is the principal-agent problem? What are three ways in which rms try
to cope with it?
The principal-agent problem is the problem of devising compensation rules that
induce an agent to act in the best interests of a principal. There are three ways of
coping with this problem: Ownership, often o)ered to managers, gives the agents
an incentive to maximize the rm’s prots, which is the goal of the owners, the
3. What are the three types of rms? Explain the major advantages and
disadvantages of each.
The three main ways of organizing a rm have both advantages and
disadvantages:
Proprietorship. ADVANTAGES—easy to set up; managerial decision-making is
Partnership. ADVANTAGES—easy to set up; has diversied decision-making so
that more than one person’s expertise can be utilized; can survive the death or
Corporation. ADVANTAGES—perpetual life; limited liability for its owners; readily
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1. What are the four market types? Explain the distinguishing characteristics of
each.
Economists identify four market types:
1. Perfect competition is a market with many rms, each selling an identical
3. Oligopoly is a market in which a small number of rms compete and each rm
4. Monopoly is a market in which only one rm produces the entire output of the
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2. What are the two measures of concentration? Explain how each measure is
calculated.
Two measures of concentration have been developed and are in common use: the
four–rm concentration ratio and the Herndahl–Hirschman Index (HHI).
1. The four– rm concentration ratio is the percentage of the total industry sales
2. The Her ndahl–Hirschman Index (HHI) equals the sum of the squared market
3. Under what conditions do the measures of concentration give a good
indication of the degree of competition in a market?
Concentration measures give a good indication of the degree of competition in a
market if the following characteristics of the industry market are correct:
4. Is the U.S. economy competitive? Is it becoming more competitive or less
competitive?
The U.S. economy would be considered competitive since three-quarters of the
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1. What are the two ways in which economic activity can be coordinated?
2. What determines whether a rm or markets coordinate production?
Firms coordinate resources when they can do so at lower cost than can a market.
1. Firms may reduce transactions costs, which are the costs arising from nding
2. Firms can capture economies of scale, which occurs when the cost of
3. Firms can capture economies of scope, where one rm can use specialized
Firms coordinate economic activity when they can perform a task more e5ciently
3. What are the main reasons why rms can often coordinate production at a
lower cost than markets can?
Firms can often coordinate production at a lower cost than can markets because
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W H A T I S E C O N O M I C S ? 163
A nsw e r s t o t h e S t ud y P l a n Pr ob l e ms a nd
A p p l i c a t i o n s
1. One year ago, Jack and Jill set up a vinegar–bottling rm (called JJVB). Use the
following data to calculate JJVB’s opportunity cost of production during its rst
year of operation:
Jack and Jill put $50,000 of their own money into the rm and bought
equipment for $30,000.
They hired one worker at $20,000 a year.
Jack quit his old job, which paid $30,000 a year worked full-time for JJVB.
Jill kept her old job, which paid $30 an hour, but gave up 500 hours of
leisure a year to work for JJVB.
JJVB bought $10,000 of goods and services.
The market value of the equipment at the end of the year was $28,000.
Jack and Jill have a $100,000 home loan on which they pay interest of 6
percent a year.
The wages paid, $20,000, and the goods and services bought from other rms,
$10,000, are opportunity costs to JJVB. Other opportunity costs include the interest
2. Joe, who has no skills, no job experience, and no alternative employment,
runs a shoeshine stand. Other operators of shoeshine stands earn $10,000 a
year. Joe pays rent of $2,000 a year, and his total revenue is $15,000 a year.
Joe spent $1,000 on equipment, which he used his credit card to buy. The
interest on a credit card balance is 20 percent a year. At the end of the year,
Joe was o)ered $500 for his business and all its equipment. Calculate Joe’s
opportunity cost of production and his economic prot.
Joe’s opportunity costs are the $2,000 paid to the airport for the space; the $200
for the interest paid on the $1,000 credit card balance; the $10,000 of normal
3. Four ways of laundering 100 shirts are in the
table.
a. Which methods are technologically e5cient?
(i) Wage rate $1, rental rate $100?
Metho
d
Labor
(hours
)
Capital
(machine
s)
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1 6 4
(ii) Wage rate $5, rental rate $50?
Method D and Method C are economically e5cient because the total cost is the
(iii) Wage rate $50, rental rate $5?
4. Executive Pay
Executive compensation, based on performance, can theoretically constrain
pay, but companies are paying their top executives more and more. The
median compensation of a CEO in 2013 was $13.9 million, up 9 percent from
2012.
Source: CNBC, April 28, 2014
What is the economic problem that CEO compensation schemes are designed
to solve? Would paying executives with stock align their interests with
shareholders?
CEO compensation schemes are designed to overcome the principal–agent
problem. A CEO’s decisions can have large e)ects on the company’s protability.
The principals, the shareholders of the corporation, want the CEO, the agent, to
5. Sales of the rms in the tattoo industry are in
the table. Calculate the four-rm
concentration ratio. What is the structure of
the tattoo industry?
Firm
Sales
(dollars
per year)
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W H A T I S E C O N O M I C S ? 1 6 5
6. GameStop Racks Up the Points
No retailer has more cachet among gamers than GameStop. For now, only
Wal-Mart has a larger share—21.3% last year. GameStop’s share was 21.1%
last year, and may well overtake Wal-Mart this year. But if new women
gamers prefer shopping at Target to GameStop,Wal-Mart and Target might
erode GameStop’s market share.
Source: Fortune, June 9, 2008
Estimate a range for the four–rm concentration ratio and the HHI for the U.S.
game market based on the data provided in this news clip.
Wal-Mart is described as having the largest market share, 21.3 percent, and
GameStop is said to have the second largest market share, 21.1 percent. These
two rms have a market share of 42.4 percent. The market share of the next two
7. FedEx contracts with independent truck operators to pick up and deliver its
packages and pays them on the volume of packages carried. Why doesn’t
FedEx buy more trucks and hire more drivers? What incentive problems might
arise from this arrangement?
FedEx does not buy more trucks and hire more drivers because FedEx faces a
principal–agent problem. In particular, it is not easy to monitor its drivers and
insure that they are working hard to e5ciently deliver packages. FedEx overcomes
this problem by hiring independent contractors and then paying them based on
the amount of packages they deliver. Essentially, FedEx uses a piecework method
of payment.
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