Managerial Economics Study Set 9

Business

Quiz 1 :

Managers, Profits, and Markets

Quiz 1 :

Managers, Profits, and Markets

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Explain why it would cost Rafael Nadal or Venus Williams more to leave the professional tennis tour and open a tennis shop than it would for the coach of a university tennis team to do so.
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The implicit cost of leaving the profession or job depends upon the earnings from profession or job. Generally players earn higher revenue than their coach, so that implicit cost would be higher for a player than a coach. It would be more comprehensive from the following inferences:
- The revenue from shop would be less than the total implicit cost of leaving the profession and explicit cost of running shop.
- However the implicit cost for the coach of university would be less and he/she can earn an economic profit by opening a shop.
- In other words the total opportunity cost for professional would be high than the coach of the university.

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Some managers are known for their reliance on "practical" decision-making rules and processes, and they can be quite skeptical of decision rules that seem too theoretical to be useful in practice. While it may be true that some theoretical methods in economics can be rather limited in their practical usefulness, there is an important corollary to keep in mind: "If it doesn't work in theory, then it won't work in practice." Explain the meaning of this corollary and give a real-world example ( Hint: see "Some Common Mistakes Managers Make").
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An article in The Wall Street Journal reported that large hotel chains, such as Marriott, are tending to reduce the number of hotels that they franchise to outside owners and increase the number the chain owns and manages itself. Some chains are requiring private owners or franchisees to make upgrades in their hotels, but they are having a difficult time enforcing the policy. Marriott says this upgrading is important because "we've built our name on quality." a. Explain the nature of the agency problem facing Marriott. b. Why would Marriott worry about the quality of the hotels it doesn't own but franchises? c. Why would a chain such as Marriott tend to own its hotels in resort areas, such as national parks, where there is little repeat business, and franchise hotels in downtown areas, where there is a lot of repeat business? Think of the reputation effect and the incentive of franchises to maintain quality.
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(a)
A " Classic Principal-agent " problem exists between hotel 'M' and its franchisees, because there exists a difference in the goals of both the principal (hotel) and the agent (franchise), while dealing with one problem.
The problem is that the private owners, who are supposed to make the decisions that would best serve hotel 'M', are motivated by self-interest which may differ from interests of the hotel.
Hotel 'M' likes to maintain a certain level of quality at each of its hotels. However, maintaining that level of quality requires additional capital investment by franchisees.
The franchisees are unwilling to invest their money in the hotel, because they do not have any interest in promotion of the brand image of hotel 'M'. They only care about their share of personal profits.
This problem could be less severe, if few provisions are added in the contract in terms of requirements issued by the hotel.
(b)
Since the hotel M is a big brand name in the hotel and hospitality industry, it does not like to compromise on its quality standards.
It has achieved this goodwill for itself only because of its high-quality standards, and compromising on it would mean a loss to its image/goodwill.
Even in the case of franchises, the brand name is still associated with the hotel and any negligence on the quality would make customers blame the brand only.
When a person has a bad stay at a hotel, he/she blames the hotel, but not the owners. Customers are not concerned with the ownership as much as they are more concerned with their services.
In addition, franchisees continue to pay premium for the name. iI they are not doing good, then the hotel will lose franchises along with customers, while gaining a tarnished name. A true snowball effect.
(c)
In cases like national parks where business is quite low, there is no/little incentive for hotels to provide quality services.
However, in case of a high repeat business like downtown areas, franchises have a higher incentive to maintain quality to attract customers.
Franchises will have a big incentive to maintain quality to attract business in down-town, where repeat business is the overarching goal.
Thus, it increases their profit and revenue shares.

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When Burton Cummings graduated with honors from the Canadian Trucking Academy, his father gave him a $350,000 tractor-trailer rig. Recently, Burton was boasting to some fellow truckers that his revenues were typically $25,000 per month, while his operating costs (fuel, maintenance, and depreciation) amounted to only $18,000 per month. Tractor-trailer rigs identical to Burton's rig rent for $15,000 per month. If Burton was driving trucks for one of the competing trucking firms, he would earn $5,000 per month. a. How much are Burton Cummings's explicit costs per month? How much are his implicit costs per month? b. What is the dollar amount of the opportunity cost of the resources used by Burton Cummings each month? c. Burton is proud of the fact that he is generating a net cash flow of $7,000 (5 $25,000 ? $18,000) per month, since he would be earning only $5,000 per month if he were working for a trucking firm. What advice would you give Burton Cummings?
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You are considering the purchase of a piece of land that can be leased to the government for 100 years. The annual lease payment is $20,000 and the appropriate discount rate for your situation is 4 percent. What is the (approximate) present value of this stream of constant lease payments?
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Using a discount rate of 6.5 percent, calculate the present value of a $1,000 payment to be received at the end of a. One year b. Two years c. Three years
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Suppose that, in their divorce settlement, Ashton Kutcher offers Demi Moore $10 million spread evenly over 10 years, but she instead demands $5 million now. If the appropriate discount rate is 8 percent, which alternative is better for Ashton and which for Demi? What if the discount rate is 20 percent?
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What is the present value of a firm with a five-year life span that earns the following stream of expected profit? (Treat all profits as being received at year-end.) Use a risk-adjusted discount rate of 12 percent. img
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Fortune magazine reported that SkyWest, an independent regional airline, negotiated a financial arrangement with Delta and United to provide regional jet service for the two major airlines. For its part of the deal, SkyWest agreed to paint its jets the colors of Delta Connection and United Express and to fly routes specified by the two airlines. In return, Delta and United agreed to pay SkyWest a predetermined profit margin and to cover most of the regional airline's costs. Fortune explained that while the deal limited the amount of profit SkyWest could earn, it also insulated the smaller airline from volatility in earnings since Delta and United covered SkyWest's fuel costs, increased its load factor (the percentage of seats occupied), and managed its ticket prices. Fortune suggested that Wall Street liked the deal because SkyWest's market valuation increased from $143 million to $1.1 billion after it began its service with the two major airlines. Explain carefully how this arrangement with Delta and United could have caused the value of SkyWest to increase dramatically even though it limited the amount of profit SkyWest could earn.
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At the beginning of the year, an audio engineer quit his job and gave up a salary of $175,000 per year in order to start his own business, Sound Devices, Inc. The new company builds, installs, and maintains custom audio equipment for businesses that require high-quality audio systems. A partial income statement for the first year of operation for Sound Devices, Inc., is shown below: img To get started, the owner of Sound Devices spent $100,000 of his personal savings to pay for some of the capital equipment used in the business. During the first year of operation, the owner of Sound Devices could have earned a 15 percent return by investing in stocks of other new businesses with risk levels similar to the risk level at Sound Devices. a. What are the total explicit, total implicit, and total economic costs for the year? b. What is accounting profit? c. What is economic profit? d. Given your answer in part c, evaluate the owner's decision to leave his job to start Sound Devices.
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A doctor spent two weeks doing charity medical work in Mexico. In calculating her taxable income for the year, her accountant deducted as business expenses her roundtrip airline ticket, meals, and a hotel bill for the two-week stay. She was surprised to learn that the accountant, following IRS rules, could not deduct as a cost of the trip the $8,000 of income she lost by being absent from her medical practice for two weeks. She asked the accountant, "Since lost income is not deductible as an expense, should I ignore it when I make my decision next year to go to Mexico for charity work?" Can you give the doctor some advice on decision making?
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An article in The Wall Street Journal discusses a trend among some large U.S. corporations to base the compensation of outside members of their boards of directors partly on the performance of the corporation. "This growing practice more closely aligns the director to the company. [Some] companies link certain stock or stock-option grants for directors to improved financial performance, using a measure such as annual return on equity." How would such a linkage tend to reduce the agency problem between managers and shareholders as a whole? Why could directors be more efficient than shareholders at improving managerial performance and changing their incentives?
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