BADM 560 – FIRM AND INDUSTRY ANALYSIS

PROBLEM SET TWO QUESTIONS

1. Professors Comer, Dahiya and Pinkowitz (CDP) are deciding whether to open a Financial Services
consulting firm (PDC FinTech LLC). They each make $1.0MM a year as professors and will have to
give up this income if they open the firm. If they do choose to open the firm, it will cost them
$2.5MM a year in rent and other direct operating expenses.
a. If CDP opens the consulting firm, what are its accounting costs?
b. What is the opportunity cost of opening the consulting firm?
c. How much would CDP need to make in revenues to earn positive accounting profits? Positive
economic profits?
2. Suppose that you paid $5,000 to lease an electric bicycle. Under the terms of the lease, $1,000 of
this payment is refundable if the bicycle is returned within two months of signing the lease.
a. Upon signing the lease and paying $5,000, how large are your fixed costs? Your sunk costs?
b. One month after signing the lease, you choose to discontinue using the electric bicycle. A friend
offers to sublease the electric bicycle for $500. Should you accept this offer?
3. Given their international business research focus, Professors Jensen, Monte and Rivoli (JMR) are
considering opening a restaurant in the District of Columbia that specializes in Canadian cuisine. JMR
knows of a building that it could buy that would cost $100,000. It would require $30,000 in
improvements, however, to make it usable. Some of the improvements would be useful only to a
restaurant selling Canadian cuisine. JMR has already paid $5,000 for market research that indicates
a strong demand for Canadian cuisine. JMR has also already paid a consultant $10,000 to help with a
cost analysis. The cost and demand research indicate that JMR could more than cover expenses for
one year, but the Canadian cuisine craze will then die out and JMR will have to sell the building.
Since there are no other entrepreneurs with the skills to run Canadian-cuisine restaurants, the
building can be sold for $123,000 maximum, even after the improvements. JMR would also have to
pay a real estate agent $10,000 in order to sell the building. What is the minimum total profit that
JMR would have to earn in one year of business to justify proceeding with the restaurant?
4. You are considering hanging it all up and moving to Mooselookmeguntic, ME
to open up your own small brewery. You are considering “Flying Weasel,” as
this name would let you operate under the corporate umbrella of Weasel
TM
Breweries , the nano-brewery of The Monks of Ann Arbor Abby (see
http://www.weaselbreweries.com for more information). To start the
microbrewery, you will have to quit your current job of woodcarving lawn
gnomes, which pays $46,000 per year, and cash in your life savings of
$200,000, which is in a certificate of deposit earning five percent (5%) per year.
You will use the $200,000 to purchase equipment for your beer-making operations. You estimate
that you will have to spend $4,000 during the year to maintain the beer-making equipment so as to
preserve its market value at $200,000. Fortunately, you own a building suitable for the
microbrewery. However, you currently rent out this building on a month-to-month basis for $2,500
per month. You anticipate that you will spend $50,000 on raw materials (hops, barely, malt, water,
weasel flavoring, etc.), $40,000 on additional labor, and $14,000 for utilities during the first year of
operations. There are no other costs involved in this business. What minimum level of revenues will
you need to generate in the first year in order for economic profit to be positive?
5. Spinal Tap, Inc. manufactures amplifers that “go to 11.” Different quantities and total costs for
Spinal Tap, Inc. are summarized below.
Q FC VC(Q) TC(Q) ATC(Q) MC(Q)
0 1,000
1 2,000
2 2,500
3 4,000
4 6,000
5 10,000
6 15,000
a. Fill in the missing information in the table.
b. Over what range of quantities, if any, are there economies of scale?
c. Over what range of quantities, if any, are there diseconomies of scale?
6. A firm produces two products, X and Y. The production technology displays the following total costs,
where TC(i,j) represents the total cost of producing i units of X and j units of Y:
TC(0,50) = 100 TC(5,0) = 150
TC(0,100) = 210 TC(10,0) = 320
TC(5,50) = 240 TC(10,100) = 500
a. Does this production technology display economies of scale?
b. Does this production technology display economies of scope?
7. PB&J Inc. has two separate subsidiaries: P-IT produces peanut butter and J-IT produces jelly. Neither
subsidiary sells output to the external market. Instead, PB&J Inc. uses the output from each
subsidiary to produce peanut butter & jelly “kits” that it sells in the retail market. Although these
kits come in different sizes, each contains peanut butter and jelly in the “proper” ratio of 1:1 (i.e.,
one oz. of peanut butter for one oz. of jelly). P-IT’s cost function for peanut butter production is:
𝑇𝑇𝑇𝑇𝑃𝑃 = 150 + 80𝑃𝑃, where P represents oz. of peanut butter. J-IT’s cost function for jelly production
is: 𝑇𝑇𝑇𝑇𝐽𝐽 = 50 + 30𝐽𝐽, where J represents oz. of jelly. An in-house research scientist has come up with
a new process that produces one ounce of jelly as a byproduct of one ounce of peanut butter
produced. The cost function for the new production process is: 𝑇𝑇𝑇𝑇𝑃𝑃𝑃𝑃 = 1000 + 10𝑃𝑃.
a. Find a level of output (P) for which production exhibits economies of scope.
b. Find a level of output (P) for which production exhibits diseconomies of scope.