EC 101: Microeconomics Term I, 2010

ARIJIT SEN IIM Calcutta

PROBLEM SET I

Numerical Exercises 1. When the Haas School of Business (at UC Berkeley) moved to its new building in 1995, each classroom was equipped with a podium that contained a computer and other hardware to allow anything that could be displayed on the computer's screen to also be projected onto a large screen at the front of the class. The computers installed in the podiums were, at the time, the state of the art Mac/PC compromise machines, "swing-Macs" made by Apple. Unfortunately, the swing-Macs didn't "swing" as well as had been hoped. Faculty who used PC software on them frequently were faced with computer crashes and freeze-ups in the middle of a class. Someone suggested that, since nearly all of the faculty use PCs, it would be better to install PC fully compatible machines instead. As a faculty member put it, "I bet we could replace the "swing-Macs" for $1,500 per classroom." To which another faculty member replied: "Those swing-Macs cost $5,000 each. I don't know what it would cost to replace them with cheap PCs, but that's not the point. We can't just scrap twelve $5,000 computers." What is the correct way to formulate the cost-benefit analysis given that the swing-Macs have already been installed?

2. A young chef in New York City, tired of working for others, wants to open his own restaurant and run it for one year. He has a pretty good sense of what his yearly sales revenues are going to be, but needs your help in calculating economic costs. He provides you with the following information: To run his restaurant, he has to quit his job, which has been paying $28,000 per year; cash in a $10,000 certificate of deposit that pays interest of 5% p.a. and buy capital equipments with the money; take over a store owned by his wife that has been rented out for $1000 per month. In addition, his yearly running expenses will add up to $50,000 ($20,000 for raw materials and $30,000 for hired help). Can you calculate his yearly economic costs? Do you need any additional information?

3. On June 30, 1992, the Wall Street Journal reported the following story: Solomon Keith, a 55-year-old bank custodian, won the $5 million New York lottery in 1987, but unfortunately died in an auto accident 15 months later after collecting only the first two installments of $240245 each. His estate collected three more payments, leaving 16 annual payments to be made. Then, primarily because of various taxes and administrative costs associated with the estate, the remaining payments were put up for bid. The Prudential Life Insurance Company (PLI) made the winning bid of $2,075,000. Suppose that the annual risk-free nominal interest rate in the US stayed unchanged at 8% and that PLI perfectly foresaw this, did it bid too much or too little? 1

4. Today is 1-1-2010. Julia started a boutique at the beginning of 2009 after quitting her job as a salesperson, where her annual income was $25,000. Before starting the business, she paid $2,000 to take a course on How to run your own boutique. For the year 2009, Julia paid $10,000 in rent for shop-space and $15,000 for raw materials. [Assume that there is no inflation, and that there are no taxes.] (i) What has been her sunk expenditure to enter the business and what has been her annual economic cost in 2009? (ii) Julia generated $50,000 in sales revenue over the year 2009. If she had expected to have this sales revenue figure at the beginning of the year, should she have started the boutique? (iii) Julia expects to have the same sales revenue and raw materials cost in the future, but has been successful in negotiating a $1,000 dollar reduction in her yearly rent. Should she remain in business if she has the opportunity of getting her old sales-job back at the same salary as before?

Thought Exercises A. Can you identify firms in an industry who are/were competitors and complementors at the same time? B. A brand manager who has just introduced a new detergent in the market tells you: Focusing on profit-maximization is nonsense. My aim is to enhance market share and brand loyalty for my product. Thats the way to succeed in an industry. I am perfectly willing to sacrifice profits in order to achieve such success. Is the managers proposed business strategy inconsistent with the profit maximization hypothesis? Contrast the above view with what Herb Kelleher, the founder and CEO of Southwest Airlines, had to say about market-share focus: Market share has nothing to do with profitability. Market share says we just want to be big, we dont care if we make money doing it. That is really incongruous if profitability is your purpose. Confusing the two concepts increasing profits and increasing market share has derailed many firms that were otherwise on track in fulfilling their fundamental purpose maximizing shareholder value. C. You have been blind-folded and taken to a particular point on a hill, where you have been tied to a pole. You can only extend your foot by one step in all directions. What can you determine regarding whether or not you are positioned at the top of the hill?