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major responsibility for acquiring the capital necessary to support the firm's investment
activities. There are many important overlaps among these functional areas--the
marketing department, for example, can help reduce the costs associated with a given
level of output by affecting the size and timing of customer orders. The production
department can stimulate sales by improving quality and making new products available
to sales personnel. Other departments within the firm--for example, accounting,
personnel, transportation, and engineering--provide information or services vital to both
continued sales growth and cost control. These activities all affect the risks of the firm
and thereby the discount rate used to determine present values. Thus, various decisions
in different departments of the firm can be appraised in terms of their effects on the
value of the firm as expressed in Equation 1.2. Therefore, the value maximization
model is useful in describing the integrated nature of managerial decision making across
the functional areas of business.
Q1.3 Describe the effects of each of the following managerial decisions or economic
influences on the value of the firm:
D. The firm raises prices. Quantity demanded in the short run is unaffected, but in
the longer run, unit sales are expected to decline.
E. The Federal Reserve System takes actions that lower interest rates dramatically.
Q1.3 ANSWER
A. The most direct effect of a requirement to install new pollution control equipment
would be an increase in the operating cost component of the valuation model.
Secondary effects might be expected in the discount rate due to an increase in
regulatory risk, and in the revenue function if consumers react positively to the
installation of the pollution control equipment in production facilities.
Nature and Scope of Managerial Economics 3
B. All three major components of the valuation model--the revenue function, cost
function, and the discount rate--are likely to be affected by an increase in
advertising. Revenues and cost will both increase as output is expanded. The
discount rate may be affected if the firm's profit outlook changes significantly
because of increased demand (growth) or if borrowing is necessary to fund a
rapid expansion of plant and equipment to meet increased demand.
D. The time pattern of revenues is affected by such a pricing decision to raise prices
in the near term. This will alter production relationships and investment plans,
and affect the valuation model through the cost component and capitalization
factor.
F. Higher rates of inflation, leading to an increase in the discount rate, cause the
present value of a constant income stream to decline. Unless the firm is able to
increase product prices in order to maintain profit margins, the value of the firm
falls as inflation and the discount rate increases. Of course, the economic effects
of inflation on the economic value of the firm are complex, involving both asset
and liability valuations, so determining the overall effect of inflation on the
economic value of individual firms is a difficult task.
Q1.4 In the wake of corporate scandals at Enron, Tyco, and WorldCom, some argue that
managers of large, publicly owned firms sometimes make decisions to maximize their
own welfare as opposed to that of stockholders. Does such behavior create problems in
using value maximization as a basis for examining managerial decision making?
Q1.4 ANSWER
Yes, like virtually all theory, the value maximization model involves some
simplification and abstraction from reality. The important question is whether or not
the model is realistic enough to provide useful insight into the managerial decision
making process. While managers undoubtedly do take their own welfare into account
when making decisions, evidence strongly indicates that market pressures provide a
4 Chapter 1
strong incentive for managers to act in accord with the dictates of economic efficiency.
Furthermore, managers who pursue policies detrimental to stockholder interests run the
risk of being replaced following stockholder "revolts" or unfriendly takeovers.
Q1.5 How is the popular notion of business profit different from the economic profit concept?
What role does the idea of normal profits play in this difference?
Q1.5 ANSWER
The key distinction is that business or accounting profit provides a measure of the total
return on capital investment, whereas economic profit refers to the return on capital in
excess of that required (expected) by investors. Normal profit refers to the risk-adjusted
rate of profit required by investors to attract and retain funds for capital investment.
Many of the profit theories described in the chapter actually confound the business and
economic profit concepts.
Q1.6 Which concept--the business profit concept or the economic profit concept--provides the
more appropriate basis for evaluating business operations? Why?
Q1.6 ANSWER
The economic profit concept provides the most appropriate basis for evaluating the
operations of a business since it allows for a risk-adjusted normal rate of return on all
capital devoted to the enterprise. Even when business profits are substantial, economic
profits can sometimes be negative given the effects of risk, inflation, and other factors.
Substantial business profits are no guarantee to the growth, or even maintenance, of
capital investment. In actual practice, investors adjust reported accounting data to
account for additional factors that must be considered.
Q1.7 Some argue that prescription drug manufacturers, like Pfizer, gouge consumers with
high prices and make excessive profits. Others contend that high profits are necessary
to give leading pharmaceutical companies the incentive to conduct risky research and
development. What factors should be considered in examining the adequacy of profits
for a firm or industry?
Q1.7 ANSWER
The primary factors one needs to include in an analysis of the adequacy of profits are
interest rate levels and risk. Normal profits must be large enough to fully compensate
investors for three costs: providing capital and the postponement of consumption,
sometimes called the pure or economic rate of interest, any potential loss of purchasing
power due to inflation, and the potential business risk inherent in any given investment.
The question of profit adequacy or inadequacy can only be answered in terms of the
Nature and Scope of Managerial Economics 5
requirements for meeting each of these return criteria. In terms of empirical evidence, if
entry is eager and widespread, it is likely that entrants see excessive profits. However,
if entry is slow or nonexistent, then it seems difficult to argue that incumbents are
reaping economic profits. The pharmaceutical industry is indeed risky, but entry from
the biotechnology industry suggests that opportunities for above-normal profits are
present.
Q1.8 ANSWER
The concept of self-interest is important because it provides the underlying rationale for
economic decisions. Consumers and producers make economic decisions in such a
manner as to further their own material well-being. Consumers make purchase
decisions when goods and services represent a relative bargain in terms of the benefits
they provide. Firms and other producers make the decision to supply output when
doing so is profitable. In both cases, furthering the self-interest of each decision maker
provides the underlying rationale for economic decisions. Interestingly, the desire to
further each decision maker's own self-interest results in voluntary economic exchange
that is mutually beneficial. A business or consumer transaction takes place if and only
if both parties benefit.
Q1.9 "In the long run, a profit-maximizing firm would never knowingly market unsafe
products. However, in the short run, unsafe products can do a lot of damage." Discuss
this statement.
Q1.9 ANSWER
Q1.10 Is it reasonable to expect firms to take actions that are in the public interest but are
detrimental to stockholders? Is regulation always necessary and appropriate to induce
firms to act in the public interest?
Q1.10 ANSWER
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will allow. Hold all these folds flat and close, and with a small
pinching cord give one turn round the middle of the cracker and
pinch it close; bind it with pack thread as tight as you can, then in the
place where it was pinched prime one end and cap it with touch-
paper.
When these crackers are fired they will give a loud report at every
turn of the paper: if you want a great number of these, you have only
to cut the paper longer, or join it on to a greater length; but if they are
made very long you must have a piece of wood with a groove in it
deep enough to let in half the cracker, which will hold it straight while
you are pinching it.
Rockets.
There are several recipes for making rockets, the best of which is 3
ounces of charcoal, 6 of sulphur, 8 of niter, 32 of meal powder.
Another very good one is, 3 ounces of iron filings, 4 of powdered
charcoal, 8 of sulphur, 16 of niter, and 64 of meal powder. If a
smaller quantity is wanted divide each proportion by 2, if a still
smaller divide by 4.
Rains.
Sometimes gold or silver rains are added to rockets, which give them
a very beautiful appearance. A gold rain is made of 2 parts sawdust,
4 sulphur, 4 meal powder, 6 glass dust, 16 niter, in all 32 parts. A
silver rain may be made of 2 parts salt prunella, 8 sulphuret of
antimony, 8 sulphur, 8 meal powder, and 14 niter, in all 32 parts.
Catherine Wheels.
These are very pretty fireworks, and are made to turn on a pivot.
There are many recipes for the composition of which they are
formed; 1 part camphor, 1 sulphur, 1 niter, 2 meal powder. Another
is, 3 parts iron filings, 4 sulphur, 12 niter, 16 meal powder. This
composition is to be rammed into small cases, and bound round a
small wheel having a hole for a pivot in the center.
Crimson Fire.
The principal ingredient in this is nitrate of strontium, of which 40
parts are taken, with 13 of sulphur, 15 of chlorate of potass, 4 of
sulphuret of antimony, and 2 of lamp-black. These, as all the
ingredients for the other fires, should be rubbed in a ladle, and they
may be used in a ladle or iron dish set on the ground.
Blue Fire.
The ingredients of blue fire are 20 parts; 12 of niter, 4 of sulphur, 2 of
sulphuret of antimony, and 2 of lamp-black.
Green Fire.
The ingredients for green fire are in 54 parts; 42 of nitrate of barytes,
8 of sulphur, 3 of chlorate of potass, and 1 of lamp-black.
Purple Fire.
The best recipe for purple fire is of 60 parts; 25 of niter, 25 of nitrate
of strontium, 7 of sulphur, 2 of realgor, and 1 of lamp-black.
White Fire.
The best and purest white fire is made of 24 parts of niter, 7 of
sulphur, 2 of red arsenic, and one of lamp-black.
Spur Fire.
9 parts of niter, 4 of sulphur, and 3 of lamp-black, well rubbed
together.
Blue Lights.
These are made of 4 parts of sulphur, 2 of niter, and 1 of powder,
and are rammed into squib-cases the contrary way.
Port or Wildfires.
Saltpeter 4 parts, meal powder 6 parts, and sulphur 3 parts. The
composition to be moistened with linseed-oil.
[THE END.]
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Transcriber’s Notes:
The one footnote has been moved to the end of its section.
Punctuation has been made consistent.
Mathematical notation has been standardized to current conventions. For
example, the notation 1-2 for fractions has been changed to 1/2.
Variations in spelling and hyphenation were retained as they appear in the
original publication, except that obvious typographical errors have been
corrected.
p. 14: There is no illustration in the original book (This illustration represents)
The following change was made:
p. 7: 2 changed to 3 (No. 3, it)
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