Question

Homework 3

Managerial Economics – ECON 301

Instructions: Read each question carefully. If work is required, show your work to receive full or partial credit. Label all illustrations as necessary.

5 Points:    Your classmate argues that, all else being equal, if the price of ramen noodles increases the demand for ramen noodles decreases. Explain whether your classmate is correct or not?

5 Points:    Assume that ramen noodles are an inferior good. If the recently passed tax cut increase personal income, what impact might this have (all else being equal) on the demand for ramen noodles?

5 Points:    You are doing an analysis of a firm. When the firm’s production was 200 units, it generated 2000 in Total Benefits at a Total Cost of $500. When the firm ramped up production to 210 units, Total Benefits increased to 2200 and Total Cost to $600. What is the marginal benefit and marginal cost of producing 210 units?

5 Points:    Assume that you want to save so that you have $3000 in savings at the end of 5 years. The interest rate is 3%. How much do you have to save today to reach $5000 in savings at the end of 5 years?

5 Points:    Assume that you have won a prize that pays out $30,000 at the end of 5 years. Your classmate offers you $23,000 today for the prize. The opportunity cost of funds is 5%. Should you take your classmate’s offer? Why or why not?

5 Points:    Provide a brief example of the law of diminishing returns.

10 Points: Assume that your business has $15,000 today and wants to invest it to have $25,000 in 5 years. What is the interest rate necessary to make this happen?

10 Points: You receive $200 annually for a perpetual bond. Your classmate says the bond is worth $10,000. What is the assumed interest rate for the classmate>

20 Points: Assume that you are trying to value a firm that has current profits of $5 million. Assume that the opportunity cost of funds is 6% and the constant profit growth rate is 3%.

What is the present value of the firm if the firm does not issue a dividend?

What is the present value of the firm if it does issue a dividend?

30 Points: Given the table below, determine:

Net Benefits

Marginal Benefit

Marginal Cost

Marginal Net Benefits

What is the level of production that maximizes net benefits?

What is the level of marginal net benefits at this level of production?

What is the value of Marginal Benefit and Marginal Cost at this level of production?

What is the general principle (rule) with regards to Marginal Benefits, Marginal Costs, and the level of production that maximizes net benefits?

Q	Total Benefits	Total Cost
0	0	0
1	120	20
2	280	50
3	480	90
4	580	140
5	660	200
6	740	270
7	800	360
8	840	480

Answer 1

Solution:

a) All else being equal:

Yes, increase in the price of ramen noodles will decrease the demand for ramen noodles.

Explanation: Law od demand says that for a normal good, increase in price causes decrease in the demand of that good. i.e. price and quantity demanded has inverse / negative relationship.

b) Inferior goods:

Due to the tax cut, personal income has increased. We know that income has a negative relation with quantity demanded in case of an inferior good. So Increase in personal income will decrease the demand for ramen noodles (inferior good).

Explanation: Price effects = Substitution effect + income effects. The substitution effect is always negative. But in case of income effect, for a normal good, it has the positive effect and for an inferior good, it has the negative effect.

c) At firm production = 200 units

Total benefit = $ 2000 and Total cost = $ 500

At firm production = 210 units

Total benefit = $ 2200 and total cost = $ 600

For 10 unit extra production:

Change in total benefit = $ 200

Change in total cost = $ 100

So, Marginal benefit = 200/10 = $20

Marginal cost = 100/10 = $10

d) Amount in saving in the begning of 1st year = $3000

Interest rate = 3%

Years = 5

Total interest earned in 5 years = (3000 * 3 * 5)/100 = $450

So total amount in saving = $(3000 + 450) = $ 3450

So today's saving = $ (5000 - 3450) = $1550