Managerial Economics Exam #1

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Rational Actor Paradigm
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people act rationally, optimally, and self-interestedly and respond to incentives
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Performance Evaluation Metric
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Revenue, cost, profit, or similar outcome
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Reward Structure
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Commission, bonus, raise, or promotion
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Problem solving requires 2 steps:
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1. Figure out what is causing the problem 2. Figure out how to fix it For both steps, predict how people behave
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3 Questions to find the source of the problem
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1. who is making the bad decision? 2. Does the decision maker have enough information to make a good decision? 3. Does the decision maker have the incentive to make a good decision?
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Solutions to incentive problems:
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•Letting someone with better information or incentives make the decision •Giving the decision maker more information •Changing the decision maker’s incentives
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Deontologists
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actions are good or ethical if they conform to a set of principles (ex: the golden rule)
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Consequentialists
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actions are judged based on whether they lead to a good consequence
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Is economics more deontologist or consequentialist?
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• Economics is more consequentialist o Uses analysis to understand the consequences of different solutions
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Voluntary transactions create wealth by______
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moving assets from lower to higher valued uses (such as taxes, subsidies, or price controls
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Buyers surplus
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buyers value minus the price
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Seller surplus
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the price minus the sellers value
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Total surplus
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buyer + seller surplus = difference in values
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Wealth creating transaction corporate raider example:
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– see company is under-performing, gets rid of the whole management team
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What’s the governments role in wealth creation?
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o Enforcing property rights and contracts, legal tools that facilitate wealth creating transactions o Ensures that buyers and sellers keep gains from trade
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Why are some countries so poor?
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o No property rights o No rule of law
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Lesson of Economics
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an economy is efficient if all assets are employed in their highest-valued assets o This is an unattainable, but useful benchmark
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The one lesson of business:
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inefficiency implies the existence of unconsummated, wealth-creating transactions –make money by identifying unconsummated wealth-creating transactions and devise ways to profitably consummate them
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Destroying Wealth
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• Anything that stops assets from moving to higher valued uses is destroying wealth
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Taxes destroy wealth
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• By deterring wealth-creating transactions – when the tax is larger than the surplus for a transaction
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Price controls destroy wealth
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• Example: rent control (price ceiling) in NYC deters transactions between owners and renters
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Wealth Creation in Organizations
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• They buy raw materials (capital, labor, etc.) and create and sell higher-valued goods and services
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Buyer surplus
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– buyer is willing to pay more than the price for a product
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Costs are associated with ___
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decisions, not activities
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The opportunity cost of an alternative is
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the profit you give up to pursue it
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Fixed costs
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do not vary with the amount of output.
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Variable costs
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change as output changes.
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Explicit costs:
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• Costs paid to its suppliers for product inputs • General operating expenses, like salaries to factory managers and marketing expenses • Depreciation expenses related to investments in buildings and equipment • Interest payments on borrowed funds
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Implicit costs:
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• Payments to other capital suppliers (stockholders) • Stockholders expect a certain return on their money (they could have invested elsewhere)
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Relevant costs and relevant benefits of a decision
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Consider all costs and benefits that vary with the consequence of a decision and only costs and benefits that vary with the decision
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The fixed-cost/sunk-cost fallacy
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Hidden Cost Fallacy
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Psychological Biases:
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Not enough information or bad incentives are not the only causes for business mistakes. Often psychological biases get in the way of rational decision making.
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loss aversion
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confirmation bias
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anchoring bias
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overconfidence bias
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– the tendency to place too much confidence in the accuracy of your analysis
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Decision criteria
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keep engaging in the activity as long as the marginal benefit is larger than the marginal cost
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Average Cost =
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– the total cost divided by the number of units produced • AC = TC/Q • Average costs often decrease as quantity increases due to presence of fixed costs • Average costs are not relevant to extent decisions
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Marginal Cost
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– is the additional cost to make and sell one additional unit of output • Often lower than average cost (due to fixed costs) but not always • Marginal costs MATTER in extent decisions
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Marginal Revenue
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– is the additional revenue gained from producing and selling one more unit
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Extent Decision Examples:
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If the benefits of selling another unit (MR) are bigger than the costs (MC), then
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sell another unit
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Individuals with low discount rates would willingly lend to those with
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higher discount rates
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Compounding
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– if you invest a dollar today at a 10% r, then you would expect to have $1.10 in one year
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Rule of 72:
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if you invest at a rate of return r, divide 72 by r to get the number of years it takes to double your money
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Projects with a positive NPV create __________
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economic profit.
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Projects with negative NPV may create ________
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accounting profits, but not economic profit.
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Break even Quantity
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the break even quantity is the amount you need to sell to just cover your costs • At this sales level, profit is zero
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Long-run
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fixed costs become avoidable so they are included in the shutdown price
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Short run
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: they are unavoidable and should not be included in the shutdown price
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Vertical integration
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refers to the common ownership of two firms in separate stages of the vertical supply chain that connects raw materials to finished goods
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Decide whether to expand an existing product into a new region is an ________
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Discrete decision.
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What discount should be given on products during the upcoming holiday sale is an _______
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Extent decision.
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Should the advertising budget be changed for the upcoming year? is an _________
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Extent decision
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Should you develop a new product for an existing product line? is an________
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Discrete decision.

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