Answers to Additional Problems and Applications
Use the following data to work Problems 8 and 9.
Lee is a computer programmer who earned $35,000 in 2011. But on January 1,
2012, Lee opened a body board manufacturing business. At the end of the ‘rst
year of operation, he submitted the following information to his accountant:
He stopped renting out his cottage for $3,500 a year and used it as his
factory. The market value of the cottage increased from $70,000 to $71,000.
He spent $50,000 on materials, phone, etc.
He leased machines for $10,000 a year.
He paid $15,000 in wages.
He used $10,000 from his savings account, which earns 5 percent a year
interest.
He borrowed $40,000 at 10 percent a year.
He sold $160,000 worth of body boards.
Normal pro’t is $25,000 a year.
8. Calculate Lee’s opportunity cost of production and his economic pro’t.
Lee has costs of $50,000 paid for materials, phone, utilities, etc; $15,000 for
wages; $10,000 paid for the machine lease; $4,000 paid for interest expense on
the loan; $3,500 of forgone rent for the cottage plus $1,000 for the “depreciation”
9. Lee’s accountant recorded the depreciation on his cottage during 2012 as
$7,000. According to the accountant, what pro’t did Lee make?
Lee’s accountant will include costs of $50,000 paid for materials, phone, utilities,
etc; $15,000 for wages; $10,000 paid for the machine lease; $4,000 paid for
10. In 2011, Toni taught music and earned $20,000. She also earned $4,000 by
renting out her basement. On January 1, 2012, she quit teaching, stopped
renting out her basement, and began to use it as the o>ce for her new Web
site design business. She took $2,000 from her savings account to buy a
computer. During 2012, she paid $1,500 for the lease of a Web server and
$1,750 for high-speed Internet service. She received a total revenue from
Web site designing of $45,000 and earned interest at 5 percent a year on her
savings account balance. Normal pro’t is $55,000 a year. At the end of 2012,
Toni could have sold her computer for $500. Calculate Toni’s opportunity cost
of production and her economic pro’t in 2012.
Toni has costs of $1,500 for the lease of a Web server; $1,750 for high-speed
Internet service; $55,000 for normal pro’t; $20,000 of forgone earnings from
teaching; $4,000 of forgone rent from renting her basement; $100 of forgone
interest from her saving account; and $1,500 for the depreciation of her computer
11. The Colvin Interview: Chrysler
The key driver of pro’tability will be that the focus of the company isn’t on
pro’tability. Our focus is on the customer. If we can ‘nd a way to give
customers what they want better than anybody else, then what can stop us?
Source: Fortune, April 14, 2008
a. In spite of what Chrysler’s vice chairman and co-president claims, why is
Chrysler’s focus actually on pro’tability?
Chrysler’s actual focus is on its pro’t because if Chrysler continues to incur losses
b. What would happen to Chrysler if it didn’t focus on maximizing pro’t, but
instead focused their production and pricing decisions to “give customers
what they want”?
In general customers want very elaborate, very costly automobiles sold for an
exceptionally low price. In particular, customers want to pay the lowest price
12. Must Watches
Stocks too volatile? Bonds too boring? Then try an alternative investment—
one you can wear on your wrist.… [The] typical return on a watch over ‘ve to
ten years is roughly 10%. [One could] do better in an index fund, but… what
other investment is so wearable?
Source: Fortune, April 14, 2008
a. What is the cost of buying a watch?
b. What is the opportunity cost of owning a watch?
The opportunity cost of owning a watch is the annual forgone return, such as the
c. Does owning a watch create an economic pro’t opportunity?
Yes, owning a watch creates an economic pro’t opportunity. If the watch
appreciates at a rapid clip, so that the gain in the value of the watch over time
Use the following data to work Problems 13 and 14.
Four methods of completing a tax return and the time taken by each method are:
with a PC, 1 hour; with a pocket calculator, 12 hours; with a pocket calculator and
paper and pencil, 12 hours; and with a pencil and paper, 16 hours. The PC and its
software cost $1,000, the pocket calculator costs $10, and the pencil and paper
cost $1.
13. Which, if any, of the methods is technologically e>cient?
All methods other than “pocket calculator with paper and pencil” are
technologically e>cient. To use a pocket calculator with paper and pencil to
14. Which method is economically e>cient if the wage rate is
(i) $5 an hour?
The economically e>cient method is the technologically e>cient method that
(ii) $50 an hour?
When the wage rate is $50 an hour, total cost with a PC is $1,050, total cost with a
(iii) $500 an hour?
When the wage rate is $500 an hour, total cost with a PC is $1,500, total cost with
15. A Medical Sensation
Hospitals are buying da Vinci surgical robots. Surgeons, sitting comfortably at
a da Vinci console, can use various robotic attachments to perform even the
most complex procedures.
Source: Fortune, April 28, 2008
a. Assume that performing a surgery with a surgical robot requires fewer
surgeons and nurses. Is using the surgical robot technologically e>cient?
b. What additional information would you need to be able to say that switching
to surgical robots is economically e>cient for a hospital?
To determine if the production technique is economically e>cient, information
16. Wal-Mart has more than 3,700 stores, more than one million employees, and
total revenues of close to a quarter of a trillion dollars in the United States
alone. Sarah Frey-Talley runs the family-owned Frey Farms in Illinois and
supplies Wal-Mart with pumpkins and other fresh produce.
a. How does Wal-Mart coordinate its activities? Is it likely to use mainly a
command system or also to use incentive systems? Explain.
Wal-Mart is a huge organization. As such, it uses both command and incentive
systems. At the lower, store level, command is the system that is most commonly
b. How do you think Sarah Frey–Talley coordinates the activities of Frey Farms?
Is she likely to use mainly a command system or also to use incentive
systems? Explain.
Ms. Frey–Talley probably uses a command system signi’cantly more often than an
incentive system. Her farm has few employees and so it is easy to tell each
c. Describe, compare, and contrast the principal–agent problems faced by
Wal-Mart and Frey Farms. How might these ‘rms cope with their
principal–agent problems?
Wal-Mart faces many more principal-agent problems than does Ms. Frey-Talley. For
Ms. Frey–Talley’s farm, it is relatively straightforward to monitor each employee so
employees will ‘nd it di>cult to shirk. Plus Ms. Frey–Talley owns the farm herself,
and so there is no principal-agent problem associated with a diBerence between
the owners and the managers. Wal-Mart, however, has more than one million
17. Where Does Google Go Next?
Google gives its engineers one day a week to work on whatever project they
want. A couple of colleagues did what many of the young geniuses do at
Google: They came up with a cool idea. At Google, you often end up with a
laissez-faire mess instead of resource allocation.
Source: Fortune, May 26, 2008
a. Describe Google’s method of organizing production with their software
engineers.
In some sense Google is using a command system because Google “orders” its
engineers to use one day a week to work on their own projects. But in a larger
b. What are the potential gains and opportunity costs associated with this
method?
The potential gain is that the creative people working for Google will apply their
creativity to develop new and better products for Google. The potential drawback
18. Market shares of chocolate makers are in the
table.
Calculate the Her’ndahl-Hirschman Index. What
is the structure of the chocolate industry?
Firm
Market
share
(percent)
Use the following information to work Problems 19 to 21.
Two leading design ‘rms, Astro Studios of San Francisco and Hers Experimental
Design Laboratory, Inc. of Osaka, Japan, worked with Microsoft to design the Xbox
360 video game console. IBM, ATI, and SiS designed the Xbox 360’s hardware.
Three ‘rms—Flextronics, Wistron, and Celestica—manufacture the Xbox 360 at
their plants in China and Taiwan.
19. Describe the roles of market coordination and coordination by ‘rms in the
design, manufacture, and marketing of the Xbox 360.
Microsoft entered the market to hire various ‘rms, Astro Studios and Hers
Experimental Design Laboratory to design the Xbox 360 and then entered the
20.a. Why do you think Microsoft works with a large number of other ‘rms, rather
than performing all the required tasks itself?
Microsoft works with a large number of ‘rms rather than doing everything in-house
because it is less expensive for Microsoft to work with other ‘rms. These other
b. What are the roles of transactions costs, economies of scale, economies of
scope, and economies of team production in the design, manufacture, and
marketing of the Xbox?
Microsoft needed to determine what part of designing, building, and marketing the
Xbox would take place inside of Microsoft and what would take place in other
companies that Microsoft hired. Hiring other companies means that Microsoft
incurs the transactions costs of using markets. However, other companies that
21. Why do you think the Xbox is designed in the United States and Japan but
built in China?
The Xbox is designed in America and Japan because America and Japan have a
large number of highly–skilled workers who can successfully design the Xbox. With
Economics in the News
22. After you have studied Economics in the News on pp. 240–241, answer the
following questions.
a. What products do Facebook and Google sell?
Facebook sells social networking services; that is, it allows its users to keep up with
b. In what types of markets do Facebook and Google compete?
Both markets have many other providers of similar services. But in each case
c. How do social networks and Internet search providers generate revenue?
d. What is special about social network sites that make them attractive to
advertisers?
Social network sites have millions of users. Users typically provide the social
network site information about the user’s interests. Therefore these sites are
e. What is special about Internet search providers that make them attractive to
advertisers?
Users of Internet search providers often are searching for either a particular
product or else a product to ‘ll a particular need. Often users are searching with
f. What technological changes might increase the pro’tability of social
networks compared to Internet search providers?
Technological change that enables the social networking site to more precisely
target the preferences of individual consumers—such as past buying history from
23. Long Reviled, Merit Pay Gains Among Teachers
School districts in many states experiment with plans that compensate
teachers partly based on classroom performance, rather than their years on
the job and coursework completed. Working with mentors to improve their
instruction and getting bonuses for raising student achievement encourages
eBorts to raise teaching quality.
Source: The New York Times, June 18, 2007
How does “merit pay” attempt to cope with the principal-agent problem in
public education?
The principal-agent problem with teachers in public education is the concern that
teachers will not work hard in the classroom. Teachers’ eBorts are di>cult to
