Managerial Economics
Foundations of Business Analysis and Strategy
14TH EDITION
Christopher R. Thomas
,CHAPTER 1: MANAGERS, PROFITS, AND MARKETS
ANSWERS TO APPLIED PROBLEMS
1. To say that a decision rule or process does not work in theory is to say that the answer
produced by the rule is not going to be the “correct” answer. In business decision making,
managers get the “correct” answer when their solutions are ones that lead to the greatest
level of profit.
For example, it is rather easy to calculate the profit margin for a good or service and to
make a pricing decision that will maximize the profit margin on the good or service. While
that may be a very practical method of determining price, pricing to maximize profit
margin does not in theory lead to the price that maximizes the profit or value of the firm—
except by accident in extremely rare circumstances. The same can be said for making
decisions that lead to the lowest possible unit or average cost of production. Unit cost is
easy to measure, and so it is useful in practice, yet unit cost is not theoretically the correct
measure of cost—that is, managers cannot, except by accident, find the profit-maximizing
price or output level by using average cost data. You will learn that the theoretically correct
cost measure is marginal cost for making profit-maximizing decisions.
Your training in managerial economics is designed to teach you the best and correct
ways to make business decisions, so that you do not settle for the numerous incorrect
methods that are still used in many businesses today. In other words, your goal should be
to devise ways to make the theoretically correct decision methods work for your company.
2.
a. Total explicit cost = $793,000 (= 555,000 + 45,000 + 28,000 + 165,000)
Total implicit cost = $190,000 (= 175,000 + 0.15 × 100,000)
Total economic cost = $983,000 (= 793,000 + 190,000)
b. Accounting profit = $177,000 (= 970,000 − 793,000)
c. Economic profit = −$13,000 (= 970,000 − 983,000)
, d. The owner’s accounting profit is $13,000 less than what he could have earned in salary
and return on investment of his $100,000, that is, his economic profit is −$13,000. Thus,
he would have made $13,000 more if he had kept his job and invested his $100,000 in
stocks of other businesses.
3. The $8,000 of lost income, even though not tax-deductible, is indeed part of the economic
cost the doctor incurs by going to Mexico to treat patients, and the doctor should consider
this $8,000 cost in making her decision to travel to Mexico.
4.
a. Burton’s explicit costs are $18,000 per month. His implicit costs are $20,000 per month
($15,000 + $5,000).
b. Opportunity cost = explicit + implicit costs = $18,000 + 20,000 = $38,000 per month
c. Burton Cummings’ costs of production (=$38,000/month) exceed his revenues by
$13,000 (= 38,000 −25,000). Rather than lose $13,000 per month, Burton could rent his
rig (and receive $15,000 per month) and drive trucks for another firm (and earn $5,000
per month). With this use of his resources he would earn $20,000 per month. Or, Burton
could try his luck as a singer in a rock band.
5. One cost of opening a tennis shop would be the forgone salary of the previous job. Given
that Nadal’s or Venus’ foregone income would be much larger than that of a university
coach, their opportunity cost would be higher.
6.
a. Linking the board of directors’ compensation to return on equity creates an incentive for
management to pursue profit maximization as a goal, thereby reducing the agency
problem between managers and shareholders.
b. Directors have better, easier, and cheaper access to information about the firm’s
revenues and costs. Shareholders are numerous and each one has only a relatively small
stake in the profitability of the firm. It is generally easier for a shareholder simply to sell
its shares and reinvest in another company.
, c. Accounting profit treats the cost of using shareholder equity capital as zero, and thus
CEOs and directors will have little incentive to use equity capital efficiently. With a
perceived cost of zero, equity capital will be overused and misallocated, which will drive
down the economic profit and the value of the firm. Shareholders own the firm and they
will suffer.
7.
a. Some Marriott franchises are shirking their responsibility to maintain high-quality hotels,
and this shirking damages the reputation of all Marriott franchises.
b. Poorly run franchises damage the Marriott reputation and reduce the profitability of
hotels owned by Marriott.
c. Where there is little repeat business, there is less incentive for a hotel to provide quality
service. Where there is a lot of repeat business, franchises will have an incentive to
maintain quality to attract repeat business.
8. Even though the financial arrangement with Delta and United limited the growth in
SkyWest’s economic profits in future years, the agreement decreased the risk associated
with SkyWest’s profits. In the Fortune article, one financial analyst states, “They (SkyWest)
shield themselves from the factors that lead to volatility in earnings—fuel prices, ticket
prices, and load factors—and bring investors the certainty they are looking for.” The lower
level of risk reduces the risk-adjusted discount rate, and, for a given stream of profits, the
value of the SkyWest rises.
Answers to Mathematical Exercises
1.
a. PV = NCF / (1 + r )t = $1, 000 / (1.065) = $938.97
b. PV = $1, 000 / (1.065) 2 = $881.66
c. PV = $1, 000 / (1.065)3 = $827.85
2. The following spreadsheet is used to answer Parts a, b, and c of this question.
Foundations of Business Analysis and Strategy
14TH EDITION
Christopher R. Thomas
,CHAPTER 1: MANAGERS, PROFITS, AND MARKETS
ANSWERS TO APPLIED PROBLEMS
1. To say that a decision rule or process does not work in theory is to say that the answer
produced by the rule is not going to be the “correct” answer. In business decision making,
managers get the “correct” answer when their solutions are ones that lead to the greatest
level of profit.
For example, it is rather easy to calculate the profit margin for a good or service and to
make a pricing decision that will maximize the profit margin on the good or service. While
that may be a very practical method of determining price, pricing to maximize profit
margin does not in theory lead to the price that maximizes the profit or value of the firm—
except by accident in extremely rare circumstances. The same can be said for making
decisions that lead to the lowest possible unit or average cost of production. Unit cost is
easy to measure, and so it is useful in practice, yet unit cost is not theoretically the correct
measure of cost—that is, managers cannot, except by accident, find the profit-maximizing
price or output level by using average cost data. You will learn that the theoretically correct
cost measure is marginal cost for making profit-maximizing decisions.
Your training in managerial economics is designed to teach you the best and correct
ways to make business decisions, so that you do not settle for the numerous incorrect
methods that are still used in many businesses today. In other words, your goal should be
to devise ways to make the theoretically correct decision methods work for your company.
2.
a. Total explicit cost = $793,000 (= 555,000 + 45,000 + 28,000 + 165,000)
Total implicit cost = $190,000 (= 175,000 + 0.15 × 100,000)
Total economic cost = $983,000 (= 793,000 + 190,000)
b. Accounting profit = $177,000 (= 970,000 − 793,000)
c. Economic profit = −$13,000 (= 970,000 − 983,000)
, d. The owner’s accounting profit is $13,000 less than what he could have earned in salary
and return on investment of his $100,000, that is, his economic profit is −$13,000. Thus,
he would have made $13,000 more if he had kept his job and invested his $100,000 in
stocks of other businesses.
3. The $8,000 of lost income, even though not tax-deductible, is indeed part of the economic
cost the doctor incurs by going to Mexico to treat patients, and the doctor should consider
this $8,000 cost in making her decision to travel to Mexico.
4.
a. Burton’s explicit costs are $18,000 per month. His implicit costs are $20,000 per month
($15,000 + $5,000).
b. Opportunity cost = explicit + implicit costs = $18,000 + 20,000 = $38,000 per month
c. Burton Cummings’ costs of production (=$38,000/month) exceed his revenues by
$13,000 (= 38,000 −25,000). Rather than lose $13,000 per month, Burton could rent his
rig (and receive $15,000 per month) and drive trucks for another firm (and earn $5,000
per month). With this use of his resources he would earn $20,000 per month. Or, Burton
could try his luck as a singer in a rock band.
5. One cost of opening a tennis shop would be the forgone salary of the previous job. Given
that Nadal’s or Venus’ foregone income would be much larger than that of a university
coach, their opportunity cost would be higher.
6.
a. Linking the board of directors’ compensation to return on equity creates an incentive for
management to pursue profit maximization as a goal, thereby reducing the agency
problem between managers and shareholders.
b. Directors have better, easier, and cheaper access to information about the firm’s
revenues and costs. Shareholders are numerous and each one has only a relatively small
stake in the profitability of the firm. It is generally easier for a shareholder simply to sell
its shares and reinvest in another company.
, c. Accounting profit treats the cost of using shareholder equity capital as zero, and thus
CEOs and directors will have little incentive to use equity capital efficiently. With a
perceived cost of zero, equity capital will be overused and misallocated, which will drive
down the economic profit and the value of the firm. Shareholders own the firm and they
will suffer.
7.
a. Some Marriott franchises are shirking their responsibility to maintain high-quality hotels,
and this shirking damages the reputation of all Marriott franchises.
b. Poorly run franchises damage the Marriott reputation and reduce the profitability of
hotels owned by Marriott.
c. Where there is little repeat business, there is less incentive for a hotel to provide quality
service. Where there is a lot of repeat business, franchises will have an incentive to
maintain quality to attract repeat business.
8. Even though the financial arrangement with Delta and United limited the growth in
SkyWest’s economic profits in future years, the agreement decreased the risk associated
with SkyWest’s profits. In the Fortune article, one financial analyst states, “They (SkyWest)
shield themselves from the factors that lead to volatility in earnings—fuel prices, ticket
prices, and load factors—and bring investors the certainty they are looking for.” The lower
level of risk reduces the risk-adjusted discount rate, and, for a given stream of profits, the
value of the SkyWest rises.
Answers to Mathematical Exercises
1.
a. PV = NCF / (1 + r )t = $1, 000 / (1.065) = $938.97
b. PV = $1, 000 / (1.065) 2 = $881.66
c. PV = $1, 000 / (1.065)3 = $827.85
2. The following spreadsheet is used to answer Parts a, b, and c of this question.
