1. Some managers are known for their reliance on "practical" decision-making rules and

processes, and they can be quite skeptical of decision rules that seem too theoretical to

be useful in practice. While it may be true that some theoretical methods in economics

can be rather limited in their practical usefulness, there is an important corollary to

keep in mind: "If it doesn't work in theory, then it won't work in practice." Explain the

meaning of this corollary and give a real-world example (Hint: see "Some Common

Mistakes Managers Make").

2. At the beginning of the year, an audio engineer quit his job and gave up a salary of

$175,000 per year in order to start his own business, Sound Devices, Inc. The new

company builds, installs, and maintains custom audio equipment for businesses that

require high-quality audio systems. A partial income statement for the first year of

operation for Sound Devices, Inc., is shown below:

Revenues

Revenue from sales of product and services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$970,000

Operating costs and expenses

Cost of products and services sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .355,000

Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .155,000

Administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45,000

Total operating costs and expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$555,000

Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$415,000

Interest expense (bank loan) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45,000

Legal expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28,000

Corporate income tax payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .165,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$177,000

To get started, the owner of Sound Devices spent $100,000 of his personal savingsto pay for some of the capital equipment used in the business. During the first year of operation, the owner of Sound Devices could have earned a 15 percent return by investing in stocks of other new businesses with risk levels similar to the risk level at Sound Devices.

a. What are the total explicit, total implicit, and total economic costs for the year?

b. What is accounting profit?

c. What is economic profit?

d. Given your answer in part c, evaluate the owner's decision to leave his job to start

Sound Devices.

3. A doctor spent two weeks doing charity medical work in Mexico. In calculating her taxable income for the year, her accountant deducted as business expenses her roundtrip airline ticket, meals, and a hotel bill for the two-week stay. She was surprised to learn that the accountant, following IRS rules, could not deduct as a cost of the trip the $8,000 of income she lost by being absent from her medical practice for two weeks.

She asked the accountant, "Since lost income is not deductible as an expense, should I ignore it when I make my decision next year to go to Mexico for charity work?" Can you give the doctor some advice on decision making?

4. When Burton Cummings graduated with honors from the Canadian Trucking Academy, his father gave him a $350,000 tractor-trailer rig. Recently, Burton was boasting to some fellow truckers that his revenues were typically $25,000 per month, while his operating

costs (fuel, maintenance, and depreciation) amounted to only $18,000 per month. Tractortrailer rigs identical to Burton's rig rent for $15,000 per month. If Burton was driving trucks for one of the competing trucking firms, he would earn $5,000 per month.

a. How much are Burton Cummings's explicit costs per month? How much are his

implicit costs per month?

b. What is the dollar amount of the opportunity cost of the resources used by Burton

Cummings each month?

c. Burton is proud of the fact that he is generating a net cash flow of $7,000 (5 $25,000

$18,000) per month, since he would be earning only $5,000 per month if he were

working for a trucking firm. What advice would you give Burton Cummings?

MATHEMATICAL EXERCISES

1. Using a discount rate of 6.5 percent, calculate the present value of a $1,000 profit

payment to be received at the end of

a. One year

b. Two years

c. Three years

2. What is the present value of a firm with a five-year life span that earns the following

stream of expected profit? (Treat all profits as being received at year-end.) Use a riskadjusted

discount rate of 12 percent.

Year Expected profit

1 $10,000

2 20,000

3 50,000

4 75,000

5 50,000