Deck 3: Markets, Organizations, and the Role of Knowledge

Question 1

Twin brothers, Tom and Bill, constantly fight over toys. For instance, Tom will argue it his turn to play with a toy, while Bill argues it is his turn. Their parents frequently have to intervene in these disputes. Their mom has conceived an idea that might reduce these conflicts. In particular, every toy in the house would be "owned" by one of the boys. The owner would have complete authority over the use of the toy. The mom reasons that ownership would cut down on disputes. Any time, there is an argument over a toy, the owner gets the final and immediate say. The boys' dad is concerned that this idea will prevent the boys from learning to "share." He envisions that under the new system, Tom will not allow Bill to play with his toys and Bill will not allow Tom to play with his toys. The current system forces them to figure out a way to share the toys. Do you think that their dad's concerns are valid Explain.

Answer 1

Assignment of property rights is essential for the working of markets. This is because market where property rights are not well defined or clear, experience conflicts of interest between economic agents. Everyone tries to use the resource for their own benefit, and they all end up over exploiting it.
In the given case, the concerns of the father are not valid because under the new system, property rights are clearly established. The owner of the toy can benefit from sharing in the same way partners benefit from trade. Note that the two brothers are now having separate set of toys that they own.
Due to this reason, there will be no dispute because both of them will play with their own toys. In addition, they can share each other's toys when one of them allows the other to play with his toys in exchange for the other's toys. In this way they will also experience a reduction in the number of disputes they had previously when no property rights were assigned.
However, it is the duty of the parents to enforce these rights. Therefore, father's concerns about the sharing aspect of the new system, are not valid.

Question 2

Critically evaluate the advice of the Providence Consulting Group, which recommended to your company:
"That you analyze all the business divisions in your company. Rank them on growth potential. Sell all the low-growth units and invest the money in the high-growth units. Make sure not to sell the high-growth units."

Answer 2

An economic agent is expected to behave rationally in that she should maximize her own utility. This also implies that when decision making is committed, the difference between willingness to pay and the price actually paid is maximized. Now willingness to pay reflects the value put on by the economic agents on the good they buy or sell.
In this case, there is a definite value posed by the business on the business units it has. The same, however, is not discussed indicating that some of the high growth units might not be valuable enough while some low growth units might be highly valuable. Given this, it is not economically rational to sell all low growth units when they are more valuable to the firm.
Similarly, it is not viable to keep high growth firms when they are more valued by some other business firms. Hence, ranking should not be done on the basis of growth but on the basis of valuation. Thus, the statement made by the consulting group is invalid.

Question 3

You are a manager of a division of a company that is responsible for the final assembly of two computer products, modems and keyboards. You manage two employees, Julio and Chenyu, who each work 8 hours per day. Currently you have assigned both Julio and Chenyu to spend the first 7 hours of the day assembling keyboards and the last hour assembling modems. Julio can assemble 2 modems per hour and 14 keyboards per hour. Chenyu is more highly skilled in both activities. She averages 3 modems per hour and 15 keyboards per hour.
What are potential reasons why you might not want to change the work assignments (assume that more assembly of either or both products is desirable)

Answer 3

Workers have different ability to produce or assemble a given good in terms of the time they spent on one unit. Some workers are more skilled than others which results in higher productivity and thus a greater compensation. This ability is measured by their opportunity cost, which is the amount of good sacrificed by producing the given good.
In the case, one employee is more skilled than the other, and this implies, he can assemble more units in the given time than the other. When this happens, the worker is said to have absolute advantage where a higher production (or assembly) takes places in a given time. Under the current assignment, both spend same amount of time in assembling two goods.
The manager may not be willing to change this assignment because he is skeptical of a reduction in productivity. An increase in the number of hours devoted to the assembly of one good may reduce overall production due to diminishing marginal productivity. The rule indicates that marginal product falls when more and more labor units are assigned.
In case one of the workers is assigned all eight hours in assembling keyboards and the other is assigned in assembling modems, they might experience a diminishing marginal product. Under that case, overall production will fall. Hence, the manager may not change the current assignment for the fear of reduced productivity.

Question 4

Suppose that the U.S. government begins charging a $1 sales tax to all consumers for each dress shirt they buy.
a. What is likely to happen to the price (not including the tax) and quantity demanded of dress shirts Show using supply and demand graphs.
b. What is likely to happen to the demand for sport shirts (not taxed) and undershirts (which are worn primarily with dress shirts) Explain.

Question 5

You are a manager of a division of a company that is responsible for the final assembly of two computer products, modems and keyboards. You manage two employees, Julio and Chenyu, who each work 8 hours per day. Currently you have assigned both Julio and Chenyu to spend the first 7 hours of the day assembling keyboards and the last hour assembling modems. Julio can assemble 2 modems per hour and 14 keyboards per hour. Chenyu is more highly skilled in both activities. She averages 3 modems per hour and 15 keyboards per hour.
How many modems and keyboards are being assembled under the current work assignments

Question 6

Since 1992, approximately 70,000 state-owned enterprises in Russia were privatized. Many of the private buyers were foreign companies and investors, for example from the United States and Western Europe. The idea was to move from a centrally planned economy to a market system.
Yet in the late 1990s a weak economy caused great concern among Russian voters. Politicians, such as Moscow's Mayor Yuri M. Luzhkov, began promoting "deprivatization" or, as the locals put it, deprivatizatsia. Under this policy certain past privatizations would be declared illegal and the transactions would be reversed. The company then would be either run as a state-owned enterprise or sold to another party. For example, in October 1999, a court stripped Wall Street's Kohlberg Kravis Roberts and the U.S.-Russia Investment Fund of their majority interest in the Lomonosov Porcelain Factory in St. Petersburg. These companies had purchased the factory in 1998, but the courts ruled that the company's initial privatization five years earlier was illegal. Sources suggested that the company was likely to be resold to Soviet-era managers who were set to lose their jobs when the new investors entered the picture. Politicians, such as Luzhkov, vow that not all privatizations will be reversed-only the illegal ones. But one current problem is that privatization legislation is nebulous about what could be termed a violation. Anything from a missing piece of paper in the original tender offer to investment requirements not being met might be ruled a violation. And virtually anyone could file a complaint to trigger an inquiry into a past deal.
Who gains from deprivatization Who loses

Question 7

Title-loan firms offer high-interest loans (the interest rate can exceed 200 percent per year) to high-risk customers. The title of a car is often used as collateral. If the borrower defaults on the loan, the company can repossess the car. Recently, the financial press has reported stories of poor people who have had their cars repossessed by title lending companies. Legislation is being proposed in some states to make this lending practice illegal. A proponent of the law made the following argument. "The market for loans is very competitive given all of the banks, savings and loans, and finance companies. Outlawing title lending will make poor people better off. It will motivate the lending companies to provide loans with less onerous terms. Thus low income people and people with bad credit histories will be able to obtain credit on more favorable terms." Do you agree with this argument Explain.

Question 8

Over the past few years the federal government has taken significant steps to encourage the development of ethanol and other fuels made from plants as a partial replacement for gasoline. These actions have been undertaken by politicians in the midst of public concerns about the dependence on foreign oil, war in the Middle East, and global warming. The primary input for ethanol production is corn. In 2006, the 5 billion gallons of ethanol produced in the United States consumed about 20 percent of the domestic corn supply. Under new legislation passed in late 2007, the production of corn ethanol would reach 15 billion gallons by 2015 and 21 billion gallons by 2022.
You manage the Hog Heaven restaurant chain. Your restaurant chain, which has about 300 outlets throughout the United States, specializes in barbecue pork dishes but also offers chicken, beef, and vegetarian meals. Currently about 80 percent of your revenue comes from your pork dishes. The price of pork has a major impact on your costs. You are concerned that the federal promotion of ethanol might have an impact on pork prices and the profitability of your restaurant chain. Feed cost is typically about 50-60 percent of the total cost of production of pork producers. About 80 percent of the feed that hogs consume is corn.
Use basic supply and demand analysis to illustrate the likely effect of the government's mandated increase of ethanol production on (1) corn prices and (2) pork prices.

Question 9

Find an event reported in today's business press that is likely to have an important effect on the cash flows for a given firm. Use Yahoo's finance Web site to produce a chart of the company's stock price around the time or day of the announcement of the event (http://finance.yahoo.com/). Explain why the market reacted the way it did.

Question 10

Suppose that annual demand in the U.S. market for ice cream cones can be expressed as Q D = 800 + 0.2 I - 100 P , where Q D is the number of cones demanded in millions of cones, I equals average monthly income in dollars, and P is price in dollars per cone. Supply can be expressed as Q S = 200 + 150 P (with the same units for quantity and price).
a. Graph the demand and supply curves for ice cream cones, assuming that average monthly income is $2,000, and solve for the equilibrium price and quantity.
b. Now assume that average monthly income drops to $750 and supply is unchanged. Draw the new demand curve on the same graph as used in ( a ) above and solve for the new equilibrium price and quantity. How would you describe the shift in demand intuitively

Question 11

It is worth contemplating for a moment a very simple and commonplace instance of the action of the price system to see what precisely it accomplishes. Assume that somewhere in the world a new opportunity for the use of some raw material, say, tin, has arisen, or that one of the sources of supply of tin has been eliminated. It does not matter for our purpose-and it is significant that it does not matter-which of these two causes has made tin more scarce. All that the users of tin need to know is that some of the tin they used to consume is now more profitably employed elsewhere and that, in consequence, they must economize tin. There is no need for the great majority of them even to know where the more urgent need has arisen, or in favor of what other needs they ought to husband the supply. If only some of them know directly of the new demand and switch resources over to it, and if the people who are aware of the new gap thus created in turn fill it from still other sources, the effect will rapidly spread throughout the entire economic system. This influences not only all the uses of tin but also those of its substitutes and the substitutes of these substitutes, the supply of all things made of tin, and their substitutes, and so on. All this takes place without the great majority of those instrumental in bringing about these substitutions knowing anything at all about the original cause of these changes. The whole acts as one market, not because any of its members surveys the whole field, but because their limited individual fields of vision sufficiently overlap so that through many intermediaries the relevant information is communicated to all. The mere fact that there is one price for any commodity-or rather that local prices are connected in a manner determined by the cost of transport, etc.-brings about the solution which (if conceptually possible) might have been arrived at by one single mind possessing all the information which is in fact dispersed among all the people involved in the process.
Some people (for example, Hayek) argue that decentralization of economic decisions in the economy leads to an efficient resource allocation. What differences exist within the firm that make the link between decentralization and efficiency less clear
SOURCE: F. Hayek (1945), "The Use of Knowledge in Society," American Economic Review 35, 519-530.

Question 12

Many economists favor free trade between nations. They argue that free trade will increase total world output and make people of trading nations better off. Discuss how this argument relates to concepts presented in this chapter.

Question 13

The rent control agency of Rochester has found that aggregate demand is P = 500 - 5 Q D. Quantity, Q D , is measured in thousands of apartments. Price, P , equals the monthly rental rate in dollars. The city's board of realtors acknowledges that this is a good demand estimate and has shown that supply can be expressed as P = 5 Q S.
a. If the agency and the board are right about demand and supply, respectively, what is the free-market price How many apartments are rented
b. If we assume an average of 3 persons per apartment, what is the expected change in city population if the agency sets a maximum average monthly rent of $100 and all those who cannot find an apartment leave the city

Question 14

Since 1992, approximately 70,000 state-owned enterprises in Russia were privatized. Many of the private buyers were foreign companies and investors, for example from the United States and Western Europe. The idea was to move from a centrally planned economy to a market system.
Yet in the late 1990s a weak economy caused great concern among Russian voters. Politicians, such as Moscow's Mayor Yuri M. Luzhkov, began promoting "deprivatization" or, as the locals put it, deprivatizatsia. Under this policy certain past privatizations would be declared illegal and the transactions would be reversed. The company then would be either run as a state-owned enterprise or sold to another party. For example, in October 1999, a court stripped Wall Street's Kohlberg Kravis Roberts and the U.S.-Russia Investment Fund of their majority interest in the Lomonosov Porcelain Factory in St. Petersburg. These companies had purchased the factory in 1998, but the courts ruled that the company's initial privatization five years earlier was illegal. Sources suggested that the company was likely to be resold to Soviet-era managers who were set to lose their jobs when the new investors entered the picture. Politicians, such as Luzhkov, vow that not all privatizations will be reversed-only the illegal ones. But one current problem is that privatization legislation is nebulous about what could be termed a violation. Anything from a missing piece of paper in the original tender offer to investment requirements not being met might be ruled a violation. And virtually anyone could file a complaint to trigger an inquiry into a past deal.
What impact will the prospect of deprivatization have on investment by managers of privatized firms

Question 15

Since 1992, approximately 70,000 state-owned enterprises in Russia were privatized. Many of the private buyers were foreign companies and investors, for example from the United States and Western Europe. The idea was to move from a centrally planned economy to a market system.
Yet in the late 1990s a weak economy caused great concern among Russian voters. Politicians, such as Moscow's Mayor Yuri M. Luzhkov, began promoting "deprivatization" or, as the locals put it, deprivatizatsia. Under this policy certain past privatizations would be declared illegal and the transactions would be reversed. The company then would be either run as a state-owned enterprise or sold to another party. For example, in October 1999, a court stripped Wall Street's Kohlberg Kravis Roberts and the U.S.-Russia Investment Fund of their majority interest in the Lomonosov Porcelain Factory in St. Petersburg. These companies had purchased the factory in 1998, but the courts ruled that the company's initial privatization five years earlier was illegal. Sources suggested that the company was likely to be resold to Soviet-era managers who were set to lose their jobs when the new investors entered the picture. Politicians, such as Luzhkov, vow that not all privatizations will be reversed-only the illegal ones. But one current problem is that privatization legislation is nebulous about what could be termed a violation. Anything from a missing piece of paper in the original tender offer to investment requirements not being met might be ruled a violation. And virtually anyone could file a complaint to trigger an inquiry into a past deal.
Assuming more people are hurt by deprivatization than helped, why would a local politician support such a policy
SOURCE: M. Coker (1999). "That Russian Company You Bought Maybe You Didn't," BusinessWeek (December 13), 70.

Question 16

Assume that before the ice storm of 2003, the weekly demand and supply for ice in the Rochester Metro Area was given by the following equations:

a. Draw a graph representing the Rochester ice market before the storm and label it carefully. What was the equilibrium price for the Rochester ice market before the storm And the total quantity of ice traded
b. As a result of the ice storm, electricity went out in the Rochester area. The demand for ice increased due to the lack of electricity to power refrigerators. The lack of power also caused the supply to decrease. Ice producers were still able to produce some ice using electric generators. Other ice had to be imported from other areas with power. The relevant poststorm equations are the following:

Draw a graph representing the Rochester ice market after the storm and label it carefully. What is the new equilibrium price What is the quantity
c. An open-ad in a local newspaper, commenting on the dramatic increase in price of ice following the storm, stated:
Obviously, avarice and greed won out over decency and morality as ice-vendors took advantage
of the ice storm to increase prices and gouge their loyal customers.
Do you agree with this statement Explain.

Question 17

Suppose that you purchase a newly issued 10-year U.S. Treasury bond for $10,000. The bond has a promised interest rate of 5 percent ($250 every six months). The stated interest rate of 5 percent (annual payment of $500 divided by the initial face value of $10,000) does not change over the life of the bond. Do you expect that the market value of the bond will be constant or variable over the life of the bond Explain.

Question 18

What do you think will happen to the price and quantity of DVD players if
a. The availability of good movies to play on DVD players increases
b. Personal income increases
c. The price of inputs used to produce DVD players decreases
d. Ticket prices at local movie theaters decline substantially

Question 19

Suppose the supply and demand for wheat is given by:

Where P = the price per bushel of wheat and I = income. The current value of I is 100.
a. Find the current equilibrium price and quantity of wheat sold in the marketplace.
b. Find the equilibrium price and quantity if income increases to 150.
c. Show the change in equilibrium using a standard supply and demand graph. Make sure to label the axes and the curves. The graph does not need to be to scale. Just illustrate in a general way what is going on.

Question 20

What is Pareto efficiency Why do economists use this criterion for comparing alternative economic systems

Question 21

Suppose that the U.S. government caps the price of milk at $1.00/gallon. Prior to the cap milk sold for $1.00/gallon. Picture the effects of the price cap using a supply and demand graph. Explain how the cap affects consumers and producers.

Question 22

Assume that the demand curve for sporting guns is described by

a. Compute the competitive equilibrium price and quantity. Draw a graph of a supply and demand curve and label it correctly. Compute the total value created in the market for sporting guns ( hint: total value = consumer surplus + producer surplus).
b. Suppose that the government views sporting guns as a luxury product and taxes the consumers $6 for each sporting gun they buy. Solve the new competitive equilibrium. What losses do consumers of sporting guns incur as a result of the tax What losses, if any, do the producers of sporting guns incur

Question 23

You are a manager of a division of a company that is responsible for the final assembly of two computer products, modems and keyboards. You manage two employees, Julio and Chenyu, who each work 8 hours per day. Currently you have assigned both Julio and Chenyu to spend the first 7 hours of the day assembling keyboards and the last hour assembling modems. Julio can assemble 2 modems per hour and 14 keyboards per hour. Chenyu is more highly skilled in both activities. She averages 3 modems per hour and 15 keyboards per hour.
What are Julio's opportunity costs for assembling modems and keyboards What are Chenyu's Does either employee have a comparative advantage in assembling one of the products

Question 24

What is an externality
b. Why might externalities lead a firm to discharge too much pollution into a river
c. Congress has passed a law that limits the level of cotton dust within textile factories. Why
might a textile firm allow too much cotton dust within its workplace

Question 25

Suppose there has been a storm in Nebraska that has destroyed part of the corn crop in the field. The demand curve for corn has not changed. As a result, the market clearing prices and quantities before and after the storm are:
(The subscripts a and b refer to "after the storm" and "before the storm.") subscripts a and b refer to "after the storm" and "before the storm.")

Question 26

Over the past few years the federal government has taken significant steps to encourage the development of ethanol and other fuels made from plants as a partial replacement for gasoline. These actions have been undertaken by politicians in the midst of public concerns about the dependence on foreign oil, war in the Middle East, and global warming. The primary input for ethanol production is corn. In 2006, the 5 billion gallons of ethanol produced in the United States consumed about 20 percent of the domestic corn supply. Under new legislation passed in late 2007, the production of corn ethanol would reach 15 billion gallons by 2015 and 21 billion gallons by 2022.
You manage the Hog Heaven restaurant chain. Your restaurant chain, which has about 300 outlets throughout the United States, specializes in barbecue pork dishes but also offers chicken, beef, and vegetarian meals. Currently about 80 percent of your revenue comes from your pork dishes. The price of pork has a major impact on your costs. You are concerned that the federal promotion of ethanol might have an impact on pork prices and the profitability of your restaurant chain. Feed cost is typically about 50-60 percent of the total cost of production of pork producers. About 80 percent of the feed that hogs consume is corn.
What actions might you consider given the results of your analysis

Question 27

What is the difference between general and specific knowledge How can specific knowledge motivate the use of decentralized decision making

Question 28

Since 1992, approximately 70,000 state-owned enterprises in Russia were privatized. Many of the private buyers were foreign companies and investors, for example from the United States and Western Europe. The idea was to move from a centrally planned economy to a market system.
Yet in the late 1990s a weak economy caused great concern among Russian voters. Politicians, such as Moscow's Mayor Yuri M. Luzhkov, began promoting "deprivatization" or, as the locals put it, deprivatizatsia. Under this policy certain past privatizations would be declared illegal and the transactions would be reversed. The company then would be either run as a state-owned enterprise or sold to another party. For example, in October 1999, a court stripped Wall Street's Kohlberg Kravis Roberts and the U.S.-Russia Investment Fund of their majority interest in the Lomonosov Porcelain Factory in St. Petersburg. These companies had purchased the factory in 1998, but the courts ruled that the company's initial privatization five years earlier was illegal. Sources suggested that the company was likely to be resold to Soviet-era managers who were set to lose their jobs when the new investors entered the picture. Politicians, such as Luzhkov, vow that not all privatizations will be reversed-only the illegal ones. But one current problem is that privatization legislation is nebulous about what could be termed a violation. Anything from a missing piece of paper in the original tender offer to investment requirements not being met might be ruled a violation. And virtually anyone could file a complaint to trigger an inquiry into a past deal.
What effect will deprivatization have on foreign investment in Russia

Question 29

Evaluate the following statement:
Using free markets and the price system always results in a more efficient resource allocation than central planning. Just look at what happened in Eastern Europe.

Question 30

Calculate the present value of an investment with the following expected cash flows at a discount rate of 10 percent: year 1 = $500, year 2 = $600, and year 3 = $650. Recalculate the present value at discount rates of 15 percent and 5 percent.

Question 31

What are contracting costs
b. Give a few examples of contracting costs.
c. What effect does the existence of contracting costs have on market economies

Question 32

What is a property right What role do property rights play in a market economy

Question 33

If markets are so wonderful, why do firms exist

Question 34

You are a manager of a division of a company that is responsible for the final assembly of two computer products, modems and keyboards. You manage two employees, Julio and Chenyu, who each work 8 hours per day. Currently you have assigned both Julio and Chenyu to spend the first 7 hours of the day assembling keyboards and the last hour assembling modems. Julio can assemble 2 modems per hour and 14 keyboards per hour. Chenyu is more highly skilled in both activities. She averages 3 modems per hour and 15 keyboards per hour.
Devise a way of reassigning the work activities between the two employees that keeps the number of modems being assembled the same as before but increases the number of keyboards.

Question 35

In certain professional sports, team owners "own" the players. Owners can sell or trade players to another team. However, players are not free to negotiate with other team owners on their own behalf. The team owners initially obtain the rights to players through an annual draft that is used to allocate new players among the teams in the league. They can also obtain the rights to players by purchasing them from another team. Players do not like this process and often argue that they should be free to negotiate with all teams in the sporting league. In this case, they would be free to play for the team that offers the most desirable contract. Owners argue that this change in rights would have a negative effect on the distribution of talent across teams. In particular, they argue that all the good players would end up on rich, media-center teams such as New York or Los Angeles (because these teams could afford to pay higher salaries). The inequity of players across teams would make the sport less interesting to fans and thus destroy the league. Do you think the owners' argument is correct Explain.

Question 36

Since 1992, approximately 70,000 state-owned enterprises in Russia were privatized. Many of the private buyers were foreign companies and investors, for example from the United States and Western Europe. The idea was to move from a centrally planned economy to a market system.
Yet in the late 1990s a weak economy caused great concern among Russian voters. Politicians, such as Moscow's Mayor Yuri M. Luzhkov, began promoting "deprivatization" or, as the locals put it, deprivatizatsia. Under this policy certain past privatizations would be declared illegal and the transactions would be reversed. The company then would be either run as a state-owned enterprise or sold to another party. For example, in October 1999, a court stripped Wall Street's Kohlberg Kravis Roberts and the U.S.-Russia Investment Fund of their majority interest in the Lomonosov Porcelain Factory in St. Petersburg. These companies had purchased the factory in 1998, but the courts ruled that the company's initial privatization five years earlier was illegal. Sources suggested that the company was likely to be resold to Soviet-era managers who were set to lose their jobs when the new investors entered the picture. Politicians, such as Luzhkov, vow that not all privatizations will be reversed-only the illegal ones. But one current problem is that privatization legislation is nebulous about what could be termed a violation. Anything from a missing piece of paper in the original tender offer to investment requirements not being met might be ruled a violation. And virtually anyone could file a complaint to trigger an inquiry into a past deal.
Do you think that mass deprivatization is in the long-run best interests of Russia

Question 37

The guide at the Washington Monument tells your 10-year-old nephew, "Enjoy the monument. As a citizen you are one of its owners." Your nephew asks you if that is true. What do you say

Question 38

Is the discount rate used by investors to value a given stock necessarily constant over time Explain.

Question 39

Locust Hill Golf Club is a private country club. It charges an initiation fee of $23,000. When members quit the club, they receive no refund on their initiation fees. They simply lose their membership. Salt Lake Country Club is also a private golf course. At this club, members join by buying a membership certificate from a member who is leaving the club. The price of the membership is determined by supply and demand. Suppose that both clubs are considering installing a watering system. In each case, the watering system is expected to enhance the quality of the golf course significantly. To finance these systems, members would pay a special assessment of $2,000 per year for the next 3 years. The proposals will be voted on by the memberships. Do you think that the membership is more likely to vote in favor of the proposal at Locust Hill or for the one at Salt Lake Country Club Explain.