ECON B-251 EXAM 3 QUESTIONS &
SOLUTIONS
The Firm's Goal - ANSWER- To maximize profit
- If the firm fails to do this it is either eliminated or bought out
Explicit Cost - ANSWERCosts paid directly in money
Implicit Costs - ANSWER1. Uses its own capital.
•Economic depreciation is the change in the market value of capital over a given period.
•Interest forgone is the return on the funds used to acquire the capital.
2. Uses its owners' time or financial resources.
Normal Profit - ANSWERThe return to entrepreneurship is profit and the return that an
entrepreneur can expect to receive on the average
Economic Profit - ANSWERtotal revenue minus total cost,
To maximize profit, a firm must make five decisions: - ANSWERWhat goods and
services to produce and in what quantities
2. How to produce—the production technology to use
3. How to organize and compensate its managers and workers
4. How to market and price its products
5. What to produce itself and what to buy from other firms
Firm's Constraints - ANSWERTechnology, Information, and Market
Commands System - ANSWERA Managerial hierarchy
- Commands pass downwards through the hierarchy (feedback) passes upward
- Use when it's easy to monitor (perfect information)
Incentive System - ANSWERMarket-like mechanisms to induce workers to perform in
ways that maximize the firm's profit.
- Use when it's hard to monitor (imperfect information
Perfect (full) information - ANSWEROccurs when all relevant information is known and
assumed in all perfectly competitive markets.
Imperfect Information - ANSWERHappens when all relevant information is not known.
Symmetric Information - ANSWEROccurs when both the seller and the buyer are well
informed about the goods and services and prices in the market.
, Asymmetric Information - ANSWERHappens when individuals have different amounts of
information available to them
Adverse Selection and Moral Hazard - ANSWERTwo types of asymmetric information
Adverse Selection - ANSWEROccurs when information is different (hidden) between
buyers and sellers.
- used car market for sellers
- health insurance for buyers
Moral Hazard - ANSWERHappens when individuals have more information about their
actions than others and have an incentive to behave or act differently (increase risk)
because they do not bear the full costs of their actions.
- The principal agent problem
Principal-agent problem - ANSWER-A problem of devising compensation rules that
induce an agent to act in the best interest of a principal.
- For example, the stockholders of a firm are the principals and the managers of the firm
are their agents.
- The problem occurs when wages increase, increases costs for the firm, decreasing
profit
solutions to principal-agent problem - ANSWERIncentive through ownership in the firm,
incentive pay, and long-term contracts
Proprietorship - ANSWERA business owned by one person.
- Adv: Owner answers to no one and receives all profits.
-Disadv: The owner has unlimited liability, meaning that he or she has complete legal
responsibility for all debts and damages
Partnership - ANSWERA firm with two or more owners.
- Adv: more than one person is available for specialized management, partners can pool
their financial capital in order to have a larger business base
- Disadv: partners have unlimited liability for debts incurred while in business. Partners
must agree on a management structure and how to divide up the profits (taxed as
personal income). If one partner cannot pay his or her share of a debt, the other
partners are responsible. When a partner decides to leave the partnership or dies, the
partnership normally ends.
Corporation - ANSWEROwned by one or more stockholders
- Largest revenue
- Advantage: By law, shareholders enjoy limited liability, which means the owners who
have legal liability only for the initial value of their investment.
-Disadvantage: Double taxation of corporate income.
SOLUTIONS
The Firm's Goal - ANSWER- To maximize profit
- If the firm fails to do this it is either eliminated or bought out
Explicit Cost - ANSWERCosts paid directly in money
Implicit Costs - ANSWER1. Uses its own capital.
•Economic depreciation is the change in the market value of capital over a given period.
•Interest forgone is the return on the funds used to acquire the capital.
2. Uses its owners' time or financial resources.
Normal Profit - ANSWERThe return to entrepreneurship is profit and the return that an
entrepreneur can expect to receive on the average
Economic Profit - ANSWERtotal revenue minus total cost,
To maximize profit, a firm must make five decisions: - ANSWERWhat goods and
services to produce and in what quantities
2. How to produce—the production technology to use
3. How to organize and compensate its managers and workers
4. How to market and price its products
5. What to produce itself and what to buy from other firms
Firm's Constraints - ANSWERTechnology, Information, and Market
Commands System - ANSWERA Managerial hierarchy
- Commands pass downwards through the hierarchy (feedback) passes upward
- Use when it's easy to monitor (perfect information)
Incentive System - ANSWERMarket-like mechanisms to induce workers to perform in
ways that maximize the firm's profit.
- Use when it's hard to monitor (imperfect information
Perfect (full) information - ANSWEROccurs when all relevant information is known and
assumed in all perfectly competitive markets.
Imperfect Information - ANSWERHappens when all relevant information is not known.
Symmetric Information - ANSWEROccurs when both the seller and the buyer are well
informed about the goods and services and prices in the market.
, Asymmetric Information - ANSWERHappens when individuals have different amounts of
information available to them
Adverse Selection and Moral Hazard - ANSWERTwo types of asymmetric information
Adverse Selection - ANSWEROccurs when information is different (hidden) between
buyers and sellers.
- used car market for sellers
- health insurance for buyers
Moral Hazard - ANSWERHappens when individuals have more information about their
actions than others and have an incentive to behave or act differently (increase risk)
because they do not bear the full costs of their actions.
- The principal agent problem
Principal-agent problem - ANSWER-A problem of devising compensation rules that
induce an agent to act in the best interest of a principal.
- For example, the stockholders of a firm are the principals and the managers of the firm
are their agents.
- The problem occurs when wages increase, increases costs for the firm, decreasing
profit
solutions to principal-agent problem - ANSWERIncentive through ownership in the firm,
incentive pay, and long-term contracts
Proprietorship - ANSWERA business owned by one person.
- Adv: Owner answers to no one and receives all profits.
-Disadv: The owner has unlimited liability, meaning that he or she has complete legal
responsibility for all debts and damages
Partnership - ANSWERA firm with two or more owners.
- Adv: more than one person is available for specialized management, partners can pool
their financial capital in order to have a larger business base
- Disadv: partners have unlimited liability for debts incurred while in business. Partners
must agree on a management structure and how to divide up the profits (taxed as
personal income). If one partner cannot pay his or her share of a debt, the other
partners are responsible. When a partner decides to leave the partnership or dies, the
partnership normally ends.
Corporation - ANSWEROwned by one or more stockholders
- Largest revenue
- Advantage: By law, shareholders enjoy limited liability, which means the owners who
have legal liability only for the initial value of their investment.
-Disadvantage: Double taxation of corporate income.
