Chapter 2 Economic Analysis For Managers

Economic analysis for managers
Chapter 2
1. A manager makes the statement that output should be expanded as long as

average revenue exceeds average cost. Does this strategy make sense? Explain.
Hide Solution
This statement confuses the use of average values and marginal values. The proper statement
is that output should be expanded as long as marginal revenue exceeds marginal cost. Clearly,
average revenue is not the same as marginal revenue, nor is average cost identical to marginal
cost. Indeed, if management followed the average-revenue/average-cost rule, it would expand
output to the point where AR = AC, in which case it is making zero profit per unit and,
therefore, zero total profit!
2.The original revenue function for the microchip producer is R = 170Q − 20Q2.
Derive the expression for marginal revenue, and use it to find the output level at
which revenue is maximized. Confirm that this is greater than the firm’s profit-
maximizing output, and explain why.#
The revenue function is R = 170Q -20Q2. Maximizing revenue means setting marginal
revenue equal to zero. Marginal revenue is: MR = dR/dQ = 170- 40Q. Setting 170- 40Q = 0
implies Q = 4.25 lots. By contrast, profit is maximized by expanding output orily to Q = 3.3
lots. Although the firm can increase its revenue by expanding output from 3.3 to 4.5 lots, it
sacrifices profit by doing so (since the extra revenue gained falls short of the extra cost
incurred. )
3.Because of changing demographics, a small, private liberal arts college predicts a

fall in enrollments over the next five years. How would it apply marginal analysis to
plan for the decreased enrollment? (The college is a nonprofit institution, so think
broadly about its objectives.)
In planning for a smaller enrollment, the college would look to answer many of the following
questions: How large is the expected decline in enrollment? (Can marketing measures be
taken to counteract the drop?) How does this decline translate into lower tuition revenue (and
perhaps lower alumni donations)? How should the university plan its downsizing? Via cuts in
faculty and administration? Reduced spending on buildings, labs, and books? Less
scholarship aid? How great would be the resulting cost savings? Can the university become
smaller (as it must) without compromising academic excellence?
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4. Suppose a firm’s inverse demand curve is given by P = 120 − .5Q and its cost
equation is C = 420 + 60Q + Q2.
a. Find the firm’s optimal quantity, price, and profit (1) by using the profit
and marginal profit equations and (2) by setting MR equal to MC. Also provide a graph
of MR and MC.
b. Suppose instead that the firm can sell any and all of its output at the fixed
market price P = 120. Find the firm’s optimal output.
4 a) Profit = PQ -C
= (120- .5Q)Q -(420 + 60Q + Q2)
= -420 + 60Q -1.5Q2.
Marginal Profit = d(Profit) /dQ = 60 -3Q = 0 Solving yields Q* = 20
Revenue = PQ = (120 -.5Q)Q = 120Q -.5Q2 and thus Marginal Revenue= 120 -Q
Cost = -420 + 60Q + Q2 and MC = 60 + 2Q
Equating marginal revenue and margina1 cost yields: 120 -Q = 60 + 2Q or Q* = 20
4. b. MR = 120
Equating marginal revenue and marginal cost yields 120 = 60 + 2Q or Q* = 30
5. As in Problem 4, demand continues to be given by P = 120, but the firm’s cost
equation is linear: C = 420 + 60Q. Graph the firm’s revenue and cost curves. At
what quantity does the firm break even, that is, earn exactly a zero profit?
a. In general, suppose the firm faces the fixed price P and has cost equation C = F + cQ,
where F denotes the firm’s fixed cost and c is its marginal cost per unit. Write down a
formula for the firm’s profit. Set this expression equal to zero and solve for the firm’s
break-even quantity (in terms of P, F, and c). Give an intuitive explanation for this break-
even equation.
b. In this case, what difficulty arises in trying to apply the MR = MC rule to maximize
profit? By applying the logic of marginal analysis, state the modified rule applicable to this
case.
a.The firm exactly breaks even at the quantity Q such that π = 120Q − [420 + 60Q] = 0
Solving for Q, we find 60Q = 420 or Q = 7 units.
b.In the general case, we set: π = PQ − [F + cQ] = 0. Solving for Q, we have: (P − c)Q = F
or Q = F/(P − c). This formula makes intuitive sense. The firm earns a margin (or
contribution) of (P − c) on each unit sold. Dividing this margin into the fixed cost reveals
the number of units needed to exactly cover the firm’s total fixed costs.
Here, MR = 120 and MC = dC/dQ = 60. Because MR and MC are both constant and distinct,
it is impossible to equate them. The modified rule is to expand output as far as possible (up to
capacity), because MR > MC.
6. A television station is considering the sale of promotional videos. It can have the
videos produced by one of two suppliers. Supplier A will charge the station a set-up
fee of $1,200 plus $2 for each DVD; supplier B has no set-up fee and will charge $4
per DVD. The station estimates its demand for the DVDs to be given by Q = 1,600 −
200P, where P is the price in dollars and Q is the number of DVDs. (The price
equation is P = 8 − Q/200.)
a. Suppose the station plans to give away the videos. How many DVDs
should it order? From which supplier?
b. Suppose instead that the station seeks to maximize its profit from sales of
the DVDs. What price should it charge? How many DVDs should it order
from which supplier? (Hint: Solve two separate problems, one with
supplier A and one with supplier B, and then compare profits. In each
case, apply the MR = MC rule.)
6. a) If videos are given away (P = $0), demand is predicted to be:

Q = 1600- (200)(0) = 1,600.
At this output, firm A's cost is
1,200 + (2)(1,600) =$4,400,
and firm B's cost is
(4)(1,600) = $6,400.
Firm A is the cheaper option and should be chosen. (In fact, firm A is cheaper as long as Q >
600. )
6 b) To maximize profit, we simply set MR = MC for each supplier and compare the
maximum profit attainable from each. We know that MR = 8- Q/100 and the marginal
costs are MCA = 2 and MCB = 4. Thus, for firm A, we find: 8 -QA/100 = 2, and so QA
= 600 and PA = $5 (from the price equation). For firm B, we find that QB = 400 and
PB = 6. The station's profit is: 3,000 -[1,200 + (2)(600)] = $600 with firm A. Its profit
is 2,400- 1,600 = $800 with firm B. Thus, an order of 400 videos from firm B (priced
at $6 each) is optimal.
7.The college and graduate-school textbook market is one of the most profitable
segments for book publishers. A best-selling accounting text—published by Old
School Inc (OS)—has a demand curve: P = 150 − Q, where Q denotes yearly sales (in
thousands) of books. (In other words, Q = 20 means 20 thousand books.) The cost of
producing, handling, and shipping each additional book is about $40, and the
publisher pays a $10 per book royalty to the author. Finally, the publisher’s overall
marketing and promotion spending (set annually) accounts for an average cost of
about $10 per book.
a. Determine OS’s profit-maximizing output and price for the accounting

text.
b. A rival publisher has raised the price of its best-selling accounting text by
$15. One option is to exactly match this price hike and so exactly preserve your level of
sales. Do you endorse this price increase? (Explain briefly why or why not.)
c. To save significantly on fixed costs, Old School plans to contract out the
actual printing of its textbooks to outside vendors. OS expects to pay a somewhat higher
printing cost per book (than in part a) from the outside vendor (who marks up price
above its cost to make a profit). How would outsourcing affect the output and pricing
decisions in part (a)?
Hide Solution
d. The marginal cost per book is MC = 40 + 10 = $50. (The marketing costs are
fixed, so the $10 figure mentioned is an average fixed cost per book.) Setting MR = MC, we
find MR = 150 −2Q = 50, implying Q* = 50 thousand books. In turn, P* = 150 −50 = $100
per book.
e. When the rival publisher raises its price dramatically, the firm’s demand curve
shifts upward and to the right. The new intersection of MR and MC now occurs at a greater
output. Thus, it is incorrect to try to maintain sales via a full $15 price hike. For instance, in
the case of a parallel upward shift, P = 165 − Q. Setting MR = MC, we find: MR = 165 −2Q
= 50, implying Q* = 57.5 thousand books, and in turn, P* = 165 −57.5 = $107.50 per book.
Here, OS should increase its price by only $7.50 (not $15).
f. By using an outside printer, OS is saving on fixed costs but is incurring a
higher marginal cost (i.e., printing cost) per book. With a higher marginal cost, the
intersection of MR and MC occurs at a lower optimal quantity. OS should reduce its targeted
sales quantity of the text and raise the price it charges per book. Presumably, the fixed cost
savings outweighs the variable cost increase.
8.Firm Z is developing a new product. An early introduction (beating rivals to market)
would greatly enhance the company’s revenues. However, the intensive development
effort needed to expedite the introduction can be very expensive. Suppose total revenues
and costs associated with the new product’s introduction are given by
R = 720 − 8t and C = 600 − 20t + .25t2,
where t is the introduction date (in months from now). Some executives have argued for
an expedited introduction date, 12 months from now (t = 12). Do you agree? What
introduction date is most profitable? Explain.
8 a) First note that if marginal cost and marginal benefit to consumers both increased by
$25, the optimal output would not change since MR(Q*) = MC(Q*) implies that MR(Q*) +
25 = MC(Q*) + 25. The price would rise by $25 but, since marginal costs rise by $25, the
total profits would remain the same. If marginal costs rose by than $25, profits would fall.
Thus the firm should not redesign if the increase in MC is $30.
8 b) If MC increases by $15 and MR increases by $25, the new intersection of the MR and
MC occurs at a higher output. Output and price would both rise. Price, however, would rise
by less than $25.
9. As the exclusive carrier on a local air route, a regional airline must determine the
number of flights it will provide per week and the fare it will charge. Taking into
account operating and fuel costs, airport charges, and so on, the estimated cost
per flight is $2,000. It expects to fly full flights (100 passengers), so its marginal
cost on a per passenger basis is $20. Finally, the airline’s estimated demand curve
is P = 120 − .1Q, where P is the fare in dollars and Q is the number of passengers
per week.
a. What is the airline’s profit-maximizing fare? How many passengers does
it carry per week, using how many flights? What is its weekly profit?
b. Suppose the airline is offered $4,000 per week to haul freight along the
route for a local firm. This will mean replacing one of the weekly passenger flights with
a freight flight (at the same operating cost). Should the airline carry freight for the local
firm? Explain.
Hide Solution
c. The MC per passenger is $20. Setting MR = MC, we find 120 −.2Q = 20, so Q
= 500 passengers (carried by 5 planes). The fare is $70 and the airline’s weekly profit is:
$35,000 −10,000 = $25,000.
d. If it carries the freight, the airline can fly only 4 passenger flights, or 400
passengers. At this lower volume of traffic, it can raise its ticket price to P = $80. Its total
revenue is (80) (400) + 4,000 = $36,000. Since this is greater than its previous revenue
($35,000) and its costs are the same, the airline should sign the freight agreement.
10.A producer of photocopiers derives profits from two sources: the immediate profit it
makes on each copier sold and the additional profit it gains from servicing its copiers
and selling toner and other supplies. The firm estimates that its additional profit from
service and supplies is about $300 over the life of each copier sold.
There is disagreement in management about the implication of this tie-in profit. One
group argues that this extra profit (though significant for the firm’s bottom line) should
have no effect on the firm’s optimal output and price. A second group argues that the
firm should maximize total profit by lowering price to sell additional units (even though
this reduces its profit margin at the point of sale). Which view (if either) is correct?
The latter view is correct. The additional post-sale revenues increase MR, effectively shifting
the MR curve up and to the right. The new intersection of MR and MC occurs at a higher
output. (Of course, one must discount the additional profit from service and supplies to take
into account the time value of money. )
11.Suppose the microchip producer discussed in this chapter faces demand and cost
equations given by Q = 8.5 − .05P and C = 100 + 38Q. Choosing to treat price as its
main decision variable, it writes profit as
Derive an expression for Mπ = dπ/dP. Then set Mπ = 0 to find the firm’s optimal price.
Your result should confirm the optimal price found earlier in the chapter.
Hide Solution
π = −423 + 10.4P −.05P2 implies Mπ = 10.4 −.1P. Setting Mπ = 0, we obtain: 10.4 −.1P = 0,
or P = $104 thousand. This is exactly the optimal price found earlier.
13. Suppose a firm’s inverse demand and cost equations are of the general forms P =
a − bQ and C = F + cQ, where the parameters a and b denote the intercept and
slope of the inverse demand function and the parameters F and c are the firm’s
fixed and marginal costs, respectively. Apply the MR = MC rule to confirm that
the firm’s optimal output and price are: Q = (a − c)/2b and P = (a + c)/2. Provide
explanations for the ways P and Q depend on the underlying economic
parameters.
Hide Solution
Setting MR = MC, one has: a −2bQ = c, so that Q = (a − c)/2b. We substitute this expression
into the price equation to obtain:
P = a − b[(a − c)/2b] = a − (a − c)/2 = a/2 + c/2 = (a + c)/.2
The firm’s optimal quantity increases after a favorable shift in demand—either an increase in
the intercept (a) or a fall in the slope (b). But quantity decreases if it becomes more costly to
produce extra units, that is, if the marginal cost (c) increases. Price is raised after a favorable
demand shift (an increase in a) or after an increase in marginal cost (c). Note that only $.50 of
each dollar of cost increase is passed on to the consumer in the form of a higher price.
15.Suppose a firm assesses its profit function as

π = −10 − 48Q + 15Q2 − Q3.
a. Compute the firm’s profit for the following levels of output: Q = 2, 8, and 14.
b. Derive an expression for marginal profit. Compute marginal profit at Q = 2, 8,
and 14. Confirm that profit is maximized at Q = 8. (Why is profit not maximized at Q =
2?)
Hide Solution
c. The profit function is π = −10 −48Q + 15Q2 − Q3. At outputs of 0, 2, 8, and 14, the
respective profits are −10, −54, 54, and −486.
d. Marginal profit is Mπ = dπ/dQ = −48 + 30Q −3Q2 = −3(Q −2)(Q −8), after factoring.
Thus, marginal profit is zero at Q = 2 and Q = 8. From part (a) we see that profit achieves a
local minimum at Q = 2 and a maximum at Q = 8.
14. Modifying a product to increase its “value added” benefits customers and can
also enhance supplier profits. For example, suppose an improved version of a
product increases customer value added by $25 per unit. (In effect, the demand
curve undergoes a parallel upward shift of $25.)
a. If the redesign is expected to increase the item’s marginal cost by $30,
should the company undertake it?
b. Suppose instead that the redesign increases marginal cost by $15. Should
the firm undertake it, and (if so) how should it vary its original output
and price?
15. Under the terms of the current contractual agreement, Burger Queen (BQ) is entitled
to 20 percent of the revenue earned by each of its franchises. BQ’s best-selling item is
the Slopper (it slops out of the bun). BQ supplies the ingredients for the Slopper (bun,
mystery meat, etc.) at cost to the franchise. The franchisee’s average cost per Slopper
(including ingredients, labor cost, and so on) is $.80. At a particular franchise
restaurant, weekly demand for Sloppers is given by P = 3.00 − Q/800.
a. If BQ sets the price and weekly sales quantity of Sloppers, what quantity and price
would it set? How much does BQ receive? What is the franchisee’s net profit?
b. Suppose the franchise owner sets the price and sales quantity. What price and quantity
will the owner set? (Hint: Remember that the owner keeps only $.80 of each extra dollar of
revenue earned.) How does the total profit earned by the two parties compare to their total
profit in part (a)?
c. Now, suppose BQ and an individual franchise owner enter into an agreement in which
BQ is entitled to a share of the franchisee’s profit. Will profit sharing remove the conflict
between BQ and the franchise operator? Under profit sharing, what will be the price and
quantity of Sloppers? (Does the exact split of the profit affect your answer? Explain briefly.)
What is the resulting total profit?
d. Profit sharing is not widely practiced in the franchise business. What are its
disadvantages relative to revenue sharing?
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Chapter 2 Economic Analysis For Managers

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Economic analysis for managers

1. A manager makes the statement that output should be expanded as long as

3.Because of changing demographics, a small, private liberal arts college predicts a

= -420 + 60Q -1.5Q2.

Marginal Profit = d(Profit) /dQ = 60 -3Q = 0 Solving yields Q* = 20

Cost = -420 + 60Q + Q2 and MC = 60 + 2Q

Equating marginal revenue and margina1 cost yields: 120 -Q = 60 + 2Q or Q* = 20

Equating marginal revenue and marginal cost yields 120 = 60 + 2Q or Q* = 30

6. a) If videos are given away (P = $0), demand is predicted to be:

1,200 + (2)(1,600) =$4,400,

and firm B's cost is

a. Determine OS’s profit-maximizing output and price for the accounting

15.Suppose a firm assesses its profit function as

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