Spring 2018

BUS 312 MANAGERIAL ECONOMICS

Study Questions

1. Consider a lottery with three possible outcomes:

- $100 will be received with probability 0.1
- $50 will be received with probability 0.2
- $10 will be received with probability 0.7

a) What is the expected value of the lottery?

b) What is the variance of the outcomes of the lottery?

2. Calculate the expected value and the expected utility of the following investment for George who
has a utility function of 𝑈 (𝐼) = 3𝐼2 .

Payoff Probability

$300 0.10
$250 0.80
$200 0.10

3. Richard is deciding whether to buy a state lottery ticket. Each ticket costs $1, and the probability
of the following winning payoffs is given as follows:

Probability Return

0.50 $0.00
0.25 $1.00
0.20 $2.00
0.05 $7.50

a) What is the expected value of Richard’s payoff if he buys a lottery ticket? What is the variance?
b) Richard’s nickname is “No-risk Rick.” He is an extremely risk-averse individual. Would he buy
the ticket?
c) Suppose Richard was offered insurance against losing any money. If he buys 1,000 lottery
tickets, how much would he be willing to pay to insure his gamble?

4. Suppose that two investments have the same three payoffs, but the probability associated with
each payoff differs, as illustrated in the table below:

Payoffs Probabilities for Inv. A Probabilities for Inv. B

$300 0.10 0.30

$250 0.80 0.40
$200 0.10 0.30
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a) Find the expected return and standard deviation of each investment.

b) Jill has the utility function 𝑈(𝐼) = 5𝐼, where I denotes the payoff. Which investment will she
choose?
c) Ken has the utility function 𝑈(𝐼) = (5𝐼)1/2. Which investment will he choose?
d) Laura has the utility function 𝑈(𝐼) = (5𝐼) 2. Which investment will she choose?

5. A shoe manufacturer tries to decide how many shoes to produce for next season. The demand for
shoes next year will be 100 units with 20% probability, 150 units with 50% probability and 200
units with 30% probability. Unit production costs are $50, $40 and $30 if the firm produces 100,
150 or 200 units, respectively.
If the firm sells 100 units, 150 units or 200 units, the sale prices will be $80, $75 and $70,
respectively. The shoe firm is negotiating with a market research company which will provide the
shoe firm with the exact demand for the next season. How much will the shoe company be willing
to pay for that information?

6. To absorb some short-term excess production capacity at its Arizona plant, Special Instrument
Products is considering a short manufacturing run for either of two new products, a temperature
sensor or a pressure sensor.
The market for each product is known if the products can be successfully developed. However,
there is some chance that it will not be possible to successfully develop them. Revenue of
$1,000,000 would be realized from selling the temperature sensor and revenue of $400,000 would
be realized from selling the pressure sensor. Both of these amounts are net of production cost but
do not include development cost.
If development is unsuccessful for a product, then there will be no sales, and the development cost
will be totally lost. Development cost would be $100,000 for the temperature sensor and $10,000
for the pressure sensor. The probability of development success is 0.5 for the temperature sensor
and 0.8 for the pressure sensor.

What should the company do?

7. Sam has an option to mine for gold on a certain piece of land. He has three choices of action:
- He can start mining immediately.
- He can conduct further tests to see whether there is a good promise of finding gold.
- He can drop the option.

The cost of the test would be $45,000, and the cost of mining would be $150,000. If he finds gold,
he expects to earn $600,000.

If he starts mining without further tests, he estimates that the probability of finding gold is 55
percent. He expects that the probability of the test being favorable is 60 percent. If the test is
favorable, the probability is 85 percent that there is gold in the ground, but if the test is
unfavorable, the probability of finding gold is only 10 percent.

What should Sam do?

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8. An oil exploration company has $100 million available in cash. It can invest the money in a bank at
10% yielding a return of $150 million over five years (ignore compound interest).
Alternatively it can invest in oil exploration Project A or B. If it invests in Project A there is a 0.5
chance of the project being a success, yielding $300 million, and a 0.5 chance of the project failing,
leading to a loss of $50 million (over the five-year period). If it invests in Project B there is a 0.6
chance of the project being a success, yielding $200 million and a 0.4 chance of the project failing,
leading to a loss of $20 million (over the five year period).
What should the company do?

9. There is large empty lot at the outskirts of İstanbul, owned by the municipal. The municipal is
willing to lease one-half of this lot for 5 years with an option to lease both it and the other half for
the next 5 years.
In return for charging you a reasonable rent, the city will take ownership of your equipment at the
end of the 5 or 10 years.
You have estimated your original investment to be $250,000. You expect your net cash flows (after
lease payments, all other expenses, and the taxes) to be $55,000 for each of the first 5 years. If
you exercise your option to continue with both parts of the property at the end of year 5, you will
need to invest another $150,000 (for additional equipment and a miniature golf course). Because
your cash flow estimates are now far into the future, you estimate a 50 percent probability that
your annual cash flows will remain the same ($55,000) and a 50 percent probability that they will
rise to $100,000 per year for the second 5 years. Your cost of capital is 12 percent.
a) Is the first 5-year project acceptable?
b) What is the value of the total project if you exercise your option? What is the value of your
option?

10. Scenario:
The demand for erasers (Q) is given as 𝑄 = 252 − 4𝑃 + 2𝐼, where P is the price of erasers and I is
the level of income. Suppose that Q = 240 and P = 10.

a) Given the information in Scenario, determine I (income).

b) Given the information in Scenario, what is the point price elasticity of demand?
c) Given the information in Scenario, it would be correct to say that demand is
- infinitely elastic.
- elastic, but not infinitely elastic.
- unit elastic (Ɛ p = -1).
- inelastic, but not completely inelastic.
- completely inelastic.

11. Company ABC reduces the price of one cup of coffee from $5 to $4 and the company is expecting
the price cut to boost the quantity of cups of coffee sold by 10%. Find the price elasticity of demand
for coffee? Determine the type of the elasticity? What should the company do to increase its
revenue?
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12. If the demand function for an item is 𝑄 = 500 − 3𝑃, find the point elasticity of demand at a price
of $100. Determine the type of the elasticity? What should the company do to increase its
revenue?

13. Suppose that a competitive firm has a total cost function 𝐶(𝑞) = 450 + 15𝑞 + 2𝑞 2n. If the market
price is P = $115 per unit, find the level of output produced by the firm. Find the level of profit.

14. The cost function of a firm is given in the following form: 𝐶 (𝑞) = 4𝑞 2 + 16.
a) Find variable cost, fixed cost, average cost, average variable cost, average fixed cost and
marginal cost.
b) Find the output that minimizes average cost.
c) At what range of prices will the firm produce a positive output?