Please answer the following short answer questions (5 pts each):
18. As a budding entrepreneur, you have purchased a small bagel shop. You have engaged in a market study to categorize your customers’ willingness to pay for a meal (coffee+bagel) into 8 equal sized groups: ($5.00, $4.50, $4.00, $3.50, $3.00, $2.50, $2.00, $1.50). All of your costs are fixed except labor and materials, which cost $2.25
per meal sold.

a. What price should you charge for a meal? Does your answer depend on the total number of consumers?
b. Suppose your market research tells you that the four lowest value groups are all students. Should you offer a student discount? If so, how much?
19. Concert price have increased coincidentally with illegal downloading of music off the internet. What is the causal link?
20. VetPharm has historically produced and sold drugs for animals; however, one of its products developed for animal use has recently been approved for a similar use in humans. Market research has revealed that that at the current per dose price, the elasticity of demand on the part of animal owners is -2.0. The research also estimates
that at this price the elasticity of demand for human use would be -.2. The current price is $5.00 per dose. If the MC of production is $1, what should the company do?
a. reduce animal price; reduce human price.
b. raise animal price; raise human price.
c. reduce animal price; raise human price.
d. raise animal price; reduce human price.

21. Ivan loves classical music, and his favorite composer wrote nine symphonies. Ivan just happens to the 9 symphonies in exactly the order in which they were written. The table below shows the values that Ivan places on
having these symphonies which he does not currently yet own:

Rank Total Personal Value
1_______________19 2_______________36 3_______________51
4_______________64 5_______________75 6_______________84
7_______________91 8_______________96 9_______________99 You can interpret the above to mean, for example, that Ivan values her favorite Symphony at $19, and that the total value of the first Symphony plus Symphony # 2 (his second favorite) is $36, etc. If the symphonies were sold individually on CDs – one symphony per disc – and the price per CD was $10.00, how many CDs would he buy?

22. Referring to the question above: If the symphonies were also offered as a complete set of 9 CDs and the price of the entire set was $79.00, would he rather buy the individual CDs or the box set? HINT: WHICH OPTION GIVES HIM MORE CONSUMER SURPLUS?

34. The following represents the potential outcomes of your first salary negotiation after graduation:
Employer
Low Salary Offer
Employee Walks
Employer gets 0
Employee gets 0
Employee Accepts
Employer gets 100
Employee gets 75
High Salary Offer
Employee Walks
Employer gets 0
Employee gets 0
Employee Accepts
Employee gets 100
Employer gets 75
Assuming this is a sequential move game with the employer moving first, circle the most likely outcome. Does the ability to move first give the employer an advantage? If so, how? As the employee, is there anything you could do to realize a higher payoff?
35. You are considering launching a strategic alliance with a competitor to join your separate skills to develop a new jointly owned technology. Both you and your partner have the option of fully or partially supporting
the alliance.
Complete the payoff diagram to make this a Prisoner’s Dilemma. You fully support alliance Partner fully
supports alliance Partner partially supports alliance

You partially support alliance

You: 100
Partner: 100
You: 50
Partner: 150

You: 150
Partner: 50
You:
Partner:

37. Suppose that you are a seller bargaining with a buyer. Your bottom line is zero, and you think the buyer’s top dollar is either $5 with probability .25, or $6 with probability .
75. Suppose further that you can commit to a posted price. What is the price that maximizes expected profitability?
39. You take a position with a large real estate development company as your first job after graduation. Your first big assignment is to sell an office building – you have been informed the company’s cost into the building (and the bottom line price it is willing to accept) is $400,000. You have identified a likely buyer and you assess that his top price is either $500,000 with a probability of .3, $600,000 with a probability of .5, or $1,000,000 with a probability of .2. You have to commit to a posted price – what price will maximize your profitability?
40. You start an insurance company as your first entrepreneurial venture after graduation. Your main product line is malpractice insurance for dentists. After exhaustive research, you learn that settling malpractice claims against careful dentists costs $2,000 and settling malpractice claims against reckless dentists costs $7,500.
Individual dentists know whether they are reckless or careful, and your research shows that approximately 20% of dentists are reckless. How much do should you charge for malpractice insurance to break even? Why?
41. Research has shown that the majority of strategic alliance joint ventures between companies are not successful. Provide an adverse selection and moral hazard explanation for this lack of success.
42. Botulinum toxin, marketed under the brand name “Botox” is a drug that paralyzes muscles into which it is injected. It is one of the few promising treatments for migraine headaches, which affect about 10% of the population. Migraine headaches are debilitating, but there is no objective way to diagnose them. Thus migraine headaches are relatively easy to fake. Botox is also very popular as a cosmetic treatment to get rid of wrinkles. If you are a small business, should you offer insurance coverage for Botox treatments for migraine headaches? (HINT: moral hazard.)

43. In the Oct 29, 2005 NY Times Article, Wal-mart’s Health Care Struggle is Corporate America’s too, an internal Wal-Mart Memo, suggested redefining jobs to require physical activity, and to offer health care insurance plans that allowed workers who have low medical costs to spend the unused benefits on other items, like housing or
education. Give an adverse selection explanation and a moral hazard explanation of how these actions can help reduce Wal-Mart’s health care costs.

44. Assume you paid $3,000 for your notebook computer. The probability of the computer being stolen is .02 if you are careful and .05 if you are not. How much (in dollar terms) are you willing to expend in caring for the computer? If you had purchased insurance that replaced the computer if it were stolen, how much would you be willing
to spend in taking care of it (ignore the “costs” of lost data and time in getting a replacement)? Why?

6. You have an opportunity to invest in a new plant. The fixed costs are $100,000 per year. The marginal cost of production is $2 for a quantity up to 10,000 units per year. The marginal cost of production is $4 for a quantity between 10,001 and 30,000 units per year (an additional 20,000 units per year) and $10 for production above 30,000 per year. What is the break even quantity if the market is competitive and the market price
is $8 per unit? Show all calculations.
7. According to a study of U.S. cigarette sales between 1955 and 1985, when the price of cigarettes was 1% higher, consumption would be 0.4% lower in the short run and 0.75% lower in the long run (Becker et al., 1994)
a. Calculate the short-and long-run price elasticities of the demand for
cigarettes.
b. Is demand more or less elastic in the long run than in the short run? Explain your answer.
c. If the government were to impose a tax that raised the price of cigarettes by 5 percent, would total consumer expenditure on cigarettes rise or fall in the short run? What about in the long run?
8. Your company manufactures a high-efficiency natural gas furnace. The current price is $2000 per unit. The price elasticity of demand is -2.5 for prices between $1500 and $2500. Your CEO has asked you to predict the net effect on demand for various scenarios. You have determined that there are three major factors that will affect your demand: the price of competitors’ products, income, and the price of natural gas. You have hired a consulting company to estimate the effects of these factors. The results are as follows: (1) the cross price
elasticity of demand between your product and your competitors’ products is constant at +.5, (2) income elasticity of demand for your products is constant at +1.6, and (3) the cross price elasticity of demand between your product and natural gas is constant at +.3.
a) By what percent would your demand change if you increased price by 5% and all other factors remained constant?
b) By what percent would your demand change if you did not increase price but your competitors increased their prices by 8% and all other factors remained constant?
c) By what percent would your demand change if you did not increase price but income decreased by 2% and all other factors remained constant?
d) By what percent would your demand change if you did not increase price but the price of natural gas fell by 20% and all other factors remained constant?
e) What is the net effect on your demand of all changes taken together (you increased price by 5% and competitors increased price by 8% and income decreased by 2% and the price of natural gas fell by 20%)? Assume the effects
of each change are independent and cumulative.
9. Suppose the chairman and chief executive officer of General Motors has decided to a) raise the company’s auto prices by 5%. In addition, suppose that the following events have been forecast for the next year: b) the price of
competitors cars are due to rise by 8%; d) consumers’ incomes will rise by 2%; and d) the price of gasoline is due to fall by 20%. You, as head of production, must decide what all of these events mean for GM’s car sales so that you can plan production accordingly. You hire an economics consulting firm that provides you with these estimates based on econometric studies:
Price elasticity of demand for GM cars is 2.0 (in absolute value terms)

Cross price elasticity between GM cars and those of its competitors is +.5
Cross price elasticity between GM cars and gasoline is -.3
Income elasticity of demand for GM cars is +1.6
Calculate the effect of each of these four changes on demand based on the estimates provided. What is the net effect of all the changes taken together?
a. Increase the company’s auto prices by 5%.
b. the price of competitors cars are due to rise by 8%;
c. consumers’ incomes will rise by 2%; and
d. the price of gasoline is due to fall by 20%.
e. Net effect to demand
10. Your company manufactures controllers used in the production of commercial air conditioning units. Your current price is $50 per controller. At that price the total quantity demanded is 4,000 spread over a large number of small customers. Fixed costs are $10,000 per month and marginal costs are $30 for production up to 10,000 units per month. Production cannot be pushed beyond 10,000 units per month. A hurricane has damaged the production facility of a company that produces a low-quality substitute controller. As a result that company has offered you a one-time $35,000 contract for 1,000 controllers to be delivered this month so they can  meet the demand of their customers. Within a month the damage to that company’s facility will be repaired and they will be
back to normal production. Hence this event will not cause your demand curve to shift.
a) Before deciding on the contract you want to analyze your current market.
What is the optimal price of your controller if the price elasticity of demand is estimated to be -2 for prices between $45 and $65 per controller?
b) Would you recommend setting your price to that determined in part (a)? Explain why or why not.
c) Would you recommend accepting the offered contract? Explain why or why not.
d) Does your answer to (c) change if your fixed costs are $12,000 per month? Explain why or why not.

11. An amusement park is considering changing its pricing system from a payper-ride system to a single entrance fee entitling the entrant to unlimited rides.
Assume that the park is not close to approaching the attendance capacity. The
marginal value for rides for the typical entrant is listed below:
Quantity Marginal value
1
2.50
2
2.00
3
1.50
4
1.00
5
0.50
6
0.10

7
0.00
a) Assuming that the marginal cost is zero to provide the rides to those in
attendance, what is the best pay-per-ride price (consider only 50 cent
increments)?
b) What is the profit maximizing entrance fee?
c) Under which system are profits higher?
d) Under which system is ride usage higher?
e) If, instead, the marginal cost of providing a ride were $0.30, what revision in the
pricing scheme, if any, would you suggest?
12. Suppose there are 9 sellers and 9 buyers in a market, each willing to buy or
sell one unit of a good. Their values are {$15, $14, $13, $12, $11, $10, $9, $8,
$7}. That is, there is one buyer and one seller each valuing the good at $15,
one buyer and one seller each valuing the market good at $14, etc.
a) Assuming no transactions costs and a competitive market, what is the
equilibrium price and quantity of goods traded in this market?
b) Suppose there is a single market maker in this market and no price controls.
Calculate the bid-ask prices that maximize the market maker’s profit when the
marginal cost of a transaction is $1.
c) If the government imposes a maximum spread of $2 (i.e., controlling the
market maker’s per transaction profit), what are the bid-ask prices that
maximize the market maker’s profit when the marginal cost of a transaction is
$1? What number of goods will be traded?
13. You are considering an investment that will enable you to produce a new product.
Your market research has indicated that the probability that the new product will be
extremely successful is .6 and the probability that it will only be moderately successful
is .4. The estimated demand curve if the product is extremely successful indicates 100
units per week at a price of $10 and 300 units per week at a price of $8. If it is only
moderately successful your demand curve indicates 50 units per week at a price of $10
and 70 units per week at a price of $8. Your fixed costs are $200 per week and your
marginal costs are constant at $5 in this production range. Should you invest in the new
product? If so, how should you price? What quantity do you expect to sell at that price?
What is the expected profit?
14. You are considering an investment that will enable you to produce a new product.
Your market research has indicated that the probability that the new product will be
extremely successful is .2 and the probability that it will only be moderately successful
is .8. The estimated demand curve if the product is extremely successful indicates 100
units per week at a price of $12 and 300 units per week at a price of $8. If it is only
moderately successful your demand curve indicates 50 units per week at a price of $12
and 80 units per week at a price of $8. Your fixed costs are $200 per week and your
marginal costs are constant at $5 in this production range. What is the expected profit
for each price? Should you make this investment assuming that you are risk neutral? If
so, which price would you select ($12 or $8)?
15. Doctors routinely ask patients about their occupation, employer, home
address, and scope of insurance coverage. How do the following factors affect
the ability of doctors to price discriminate?
a. Characteristics such as occupation and home address are quite fixed.

b. It is physically impossible to transfer medical treatment from one person to
another.
c. Doctors treat patients on an individual basis.
16. You have 10 individuals with values {$1, $2, $3, $4, $5, $6, $7, $8, $9, $10},
and suppose you find a way to charge one price to the consumers whose
values are {$1, $2, $3, $4, $5}, and a different price to those consumers whose
values are {$6, $7, $8, $9, $10}. MC of production is $2.50.
a. What price should you charge to the second group?
b. What are your expected profits from selling to the second group?
c. What price should you charge to the first group?
d. If it costs $5 to implement this price-discrimination scheme (to identify the two
groups and prevent arbitrage between them), should you do it?
17. Your company has developed a drug called Matrox that is an effective treatment for
migraine headaches. You have just discovered that it can also be used for organ
transplant patients to reduce the risk of organ rejection. The demand for migraine
medications is considerably more elastic than the demand for drugs to reduce the risk of
organ rejections. A study has indicated that the elasticity of demand for Matrox as a
migraine medication is -4.0 but as a transplant drug it is -1.5. The current price of
Matrox is $10 per dose; the marginal cost is $5 per dose. Should you use a price
discrimination scheme for this product in these two markets? If so, how should you
price Matrox in each market? If not, why not? Show all calculations.
18. Read the following summary for the article from the Wall Street Journal titled
“How Detroit is Ruining Your Car’s Value”
The zero percent financing deals and rebates on domestic new car purchases
have triggered sharp declines in the values of both these cars the minute they
drive off the lot and used cars in general. There are two reasons for the decline
in the price of used cars. The first is the increase in the supply of used cars.
With more people trading in used cars, there are more used cars on the market.
The second is the decrease in demand for used cars. With financing deals on
new cars, more people are buying new cars instead of used cars. The article
nicely describes a cascade effect in the prices of used cars. “The financing
deals are accelerating the rate cars lose their value as they age. It works like
this: Buying a $20,000 car with a $2,000 rebate lowers your out-of-pocket cost
to $18,000. But the rebate instantly shrinks the new car’s value by the same
amount. It also lowers the trade-in price of the previous year’s model. The effect
then cascades through older versions of the vehicle.” The article notes that a
one-year old car loses in value somewhere between 70 and 85 percent of the
amount of the rebate on the new model of the car.
a. Use supply and demand to analyze the effect of a $2000 new-car rebate on
the price and quantity of used cars. Explain in words the effects of the rebate on
supply and/or demand and its effects on quantity and price.
b. Why does a rebate reduce the value of a one-year old used car by only 7085% of the amount of the rebate? That is, why not the full amount of the rebate?

c. Suppose the owner of a one-year old Ford sedan is going to purchase a new Toyota
SUV. Is the Taurus owner better off if he goes to purchase the Toyota after Ford
introduces a rebate on the purchase of a new sedan?
19. There are two niches in a market of electronic sensors, one is SIZE
(where smaller sensors are preferred) and the other is PERFORMANCE
(where high performance sensors are preferred). Two firms, A and B,
must simultaneously choose which niche to target their product to. The
payoff matrix is shown below, where profits are listed in millions of
dollars.
Company B
PERFORMAN SIZE
CE
Company A
PERFORMAN A makes $3
A makes $10
CE
B makes $2
B makes $3
SIZE

A makes $4
B makes $4

A makes $11
B makes $2

20. Suppose two companies, Rosencrantz and Guildenstern, are both selling
the same software technology, Alpha. They have an equal share in the market,
which is worth a total of $100,000. However, both companies are deciding
whether to develop the next generation software, Beta, which has huge market
potential. Beta’s probability of success is 0.60. If only one company enters the
Beta market, the entire market is worth $250,000. On the other hand, if both
companies introduce Beta, the successful market value would be only $150,000
since competition would reduce the price. If both succeed, both would hold an
equal share in the Beta market as well.
If Beta fails, the total market would only be $20,000 regardless of how many
companies enter the market.
In addition, the company not entering the Beta market could capture Alpha’s
market all to themselves (launching Beta means a loss of all Alpha sales)
Should either company continue to develop Beta? How could one company gain an
advantage?
21. Two
companies, A
and B, are
considering entry
into the same
two markets:
Asia or
Australia. Due to
financial
constraints each
company can
only enter one of
the two markets.

The expected
payoffs to each
company for
each possible
entry scenario
are as follows:
Company A
Decision
Enter Asia
Enter Asia
Enter Australia
Enter Australia

Company B
Decision

Payoff to A

Payoff to B

Enter Asia
Enter Australia
Enter Asia
Enter Australia

$35M
$50M
$85M
$40M

$50M
$90M
$60M
$45M

22. Given payoff matrix: Joe
GREEN
YELLOW
Sally
GREEN
YELLOW

Joe makes $40 Joe makes $80
Sally makes
Sally makes
$20
$60
Joe makes $90
Joe makes $100
Sally makes $30
Sally makes $40

23. An insurance company would like to offer theft insurance for renters. The
policy would pay the full replacement value of any items that were stolen from
the apartment. Some apartments have security alarms installed. Such systems
detect a break-in and ring an alarm within the apartment. The insurance
company estimates that the probability of a theft in a year is .05 if there is no
security system and .01 if there is a security system (there cannot be more than
one theft in any year). An apartment with a security system costs the renter an
additional $50 per year. Assume that the dollar loss from a theft is $10,000 and
that the insurance company is risk neutral and the renter would be willing to pay
more than the expected loss to insure against the loss of theft.
a. What is the insurance company’s breakeven price for a one year theft
insurance policy for an apartment without a security system?
b. Does a renter have incentive to pay for a security system if he does not have
insurance? To answer this question you must calculate the expected cost to the
renter with and without a security system.
c. For a security system to be effective the renter must turn it on whenever he or
she leaves the apartment. Suppose it costs the renter $10 per year in expended
effort to turn on the alarm system. What is the insurance company’s breakeven
price for a one year theft insurance policy for an apartment with a security
system? (HINT: Moral Hazard)

d. What deductible amount would provide sufficient incentive for the renter to
turn on the alarm system each time he or she leaves the apartment?
e. What is the insurance company’s breakeven price for a one year theft insurance policy
with that deductible amount for an apartment with a security system?

24. A corn farmer is considering two alternatives for selling his crop. The first is
a contract where he can sell the rights to the future crop at planting. The second
is to sell the crop after harvest. At harvest the farmer estimates that the price of
corn will be $10 per bushel with probability .5 and $12 per bushel with
probability .5. The farmer is averse to risk, and is willing to pay $50,000 to avoid
the risk of damage to the crop while it is growing (e.g., from a tornado or flood).
If the farmer uses pesticides he expects a crop of 60,000 bushels; if he does not
use pesticides he expects a crop of 55,000 bushels. The cost of pesticides is
$20,000. The other costs associated with planting and harvesting the crop total
$450,000.
a. If the farmer decides to sell the crop at harvest will he be better off using
pesticides or not using them? What is the farmer’s expected profit in each case?
b. What is the maximum a purchaser would be willing to pay to the farmer for
the rights to the future corn crop assuming they cannot monitor the farmer after
purchasing the contract? Defend your answer.
c. Which alternative: (1) sale of rights prior to planting or (2) selling the crop
after harvest yields the maximum expected benefit for the farmer considering
his level of risk aversion?