Self-EvaluationProblems

2-1.Suppose there are only two goods that Bob cares about(1) material welfare and

(2) leisure time that he "buys" from the outside world at $40 per unit and $20 per hour,re- spectively.He currently lives and works in Atlanta, has a budget totaling $1,000 per week for these two goods, and consumes 11 units of material welfare and 28 hours of leisure time.

1. ShowBob'sconsumptionchoiceonagraphusingtheactualbudgetlineandahypothet- ical indifference curve. (Label the axes and show the x and yintercepts.)
2. How will Bob's optimal consumption choice change if the government imposesa

$10/unit tax on the material welfare good?

1. Suppose Bob has a chance to move (at zero cost) to Saint Louis where material welfareand leisure time cost $50 and $10, respectively. His budget remains the same as before and the government has decided not to impose a tax on the material good. WouldBob move to Saint Louis? Why or why not?Explain.

2-2.Amiko is an investor in the stock market. She cares about both the expected value and stan- dard deviation of her investment. Currently she is invested in a security that has an expected value of $25,000 and a standard deviation of $10,000. This places her on an indifference curve with the following formula: Expected Value=$15,000+Standard Deviation

1. Is Amiko risk-averse?Explain.
2. WhatisAmiko's"certaintyequivalent"forhercurrentinvestment?Whatdoesthismean?
3. What is the risk premium on Amiko's currentinvestment?
   1. The city of Rochester is selling bonds at $90 per unit. The bonds pay $100 at the end ofone year when they mature (no other cashflows).

2-3.You have won a free ticket to see an Eric Clapton concert (which has no resale value). Bob Dylan is performing on the same night and is your next best alternative activity. Tickets to see Dylan cost $40. On any given day, you would be willing to pay up to $50 to see Dylan. Assume there are no other costs of seeing either performer. Based on this information, what is the opportunity cost of seeing Eric Clapton? (a) $0, (b) $10, (c) $40, or (d) $50²⁵

Review Questions

2-1.Which costs are pertinent to economic decision making? Which costs are notrelevant?

2-2.A noted economist was asked what he did with his "free time." He responded by saying that "time is not free." Explain this response.

2-3. The Solace Companyhas an inventoryof steel thatit originally purchasedfor $20,000. It currentlyhas an offerto sellthe steel for $30,000. ShouldSolace'smanagement agreeto sell? Explain.

2-4.Suppose that you have $900 and want to invest the money for one year. There are three ex- isting options.

1. Put the money under yourmattress.
2. The one-year interest rate of saving in the Chase Bank is 7percent.

Which one will you choose? What is the opportunity cost of your choice? Explain.

2-5.Suppose Juan's utility function is given by U=FC, where Fand Care the two goods avail- able for purchase: food and clothing.

1. Graph Juan's indifference curves for the following levels of utility: 100, 200, and300.
2. Are these curves convexor concave to the origin? What does this shape imply aboutJuan's willingness to trade food forclothing?
3. Suppose Juan's budget is $100 and the prices of Fand Care both $5. Graph the budgetconstraint.
4. How many units of food and clothing will Juan purchase at these prices andincome? Show graphically. What is his corresponding level ofutility?
5. TheJohnsonCompanyisthesoleproducerofclothing.Whatcanthecompanydotoin-duceJuantopurchasemoreclothing?Showgraphically.(Thegraphdoesnothavetobeexact.)

2-6.Suppose that Bob's indifference curves are straight lines (as opposed to being convex to the origin). What does this imply about Bob's willingness to trade one good for the other? Giveexamples of goods where this type of behavior might be expected?

2-7.SupposethatBob'sindifferencecurvesareperfectlyL-shapedwiththerightangleoccurring whenBobhasequalamountsofbothgoods.WhatdoesthisimplyaboutBob'swillingnessto trade one good for the other? Giveexamplesof goods where this type of behaviormight be expected?

2-8. a.Briefly describe the five models of behavior presented in this chapter.

b.What are the implications of these models for managers attempting to influence their employees' behavior?

2-9.Employees in a plant in Minnesota are observed to be industrious and very productive.

Employees in a similar plant in southern California are observed to be lazy and unproduc- tive. Discuss how alternative views of human behavior and motivation might suggest differ- ent explanations for this observed behavior.

2-10. Employees at a department store are observed engaging in the following behavior: (a) they hide items that are on sale from the customers, and (b) they exert little effort in designing merchandise displays. They are also uncooperative with one another. What do you think might be causing this behavior, and what might you do to improve the situation?

2-11. One of the main tenets of economic analysis is that people act in their own narrow self- interest. Why then do people leave tips in restaurants? If a study were to compare the size of tips earned by servers in restaurants on interstate highways with those in restaurants near residential neighborhoods, what would you expect to find? Why?

2-12. Several school districts have attempted to increase teacher productivity by paying teachers based on the scores their students achieve on standardized tests (administered by outside testing agencies). The goal is to produce higher-quality classroom instruction. Do you think that this type of compensation scheme will produce the desired outcome? Explain.

2-13. A company recently raised the pay of employees by 20 percent. Employee productivity remained the same. The CEO of the company was quoted as saying, "It just goes to show that money does not motivate people." Provide a critical evaluation of this statement.

2-14.One physician who worked for a large health maintenance organization was quoted as saying:

One day I was listening to a patient's heart and realized there was an abnormal rhythm. My first thought was that I hoped that I did not have to refer the patient to a specialist.

Indeed, HMO physicians havebeen criticized for not making referrals when they are war- ranted. How do you think the physician was compensated by the HMO? Explain.

2-15.Insurancecompanieshavetogenerateenoughrevenuetocovertheircostsandmakeanormalprofitotherwise, theywill go out of business.This implies that the premiums chargedforinsurancepoliciesmustbegreaterthantheexpectedpayoutstothepolicyholders.Whywouldapersoneverbuyinsurance,knowingthatthepriceisgreaterthantheexpectedpayout?

2-16.Critically evaluate the following statement: "Risk-averse people never take gambles."

2-17.Suppose that an investment can yield three possible cash flows: $5,000; $1,000; or $0. The probability of each outcome is 1/3.

1. What is the expected value and standard deviation of theinvestment?
2. How much would a risk-neutral person be willing to pay for theinvestment?
3. How much would a risk-averse person be willing to pay for theinvestment?

2-18. In order to spur consumer spending in 1998, the Japanese governmentconsidered an $85 bil- lion vouchersystem whereby everyJapanese consumer would receivea shopping voucherthat could be used to purchase Japanese products. For simplicity,assume the following:Each consumer has wealth of 1 million yen, consumers must allocate this wealth between con- sumption now(c₁) and consumption later (c₂), the interest rate is zero, the voucheris worth100,000 yen, and it can be spent only in the current period. If it is not spent, it is lost.

1. Plot a budget line for a representative consumer both before and after the voucher pro-gram (c₁ and c₂ are on theaxes).
2. Do you expect that current consumption of a typical consumer will increase by the full100,000 yen of the voucher?Explain.
3. How does the impact of this 100,000-yen voucher differ from simply giving the individ-ual 100,000 yen?

2-19.People give to charity.

1. Is this action consistent with the "economic view of behavior"?Explain.
2. Suppose there is a big drop in charitable giving. At the same time there has been no de- cline in per capita income or total employment. Using the economic model, what poten-tial factors might have led to this decline ingiving?
3. Howmightthedeclineingivingbeexplainedbytheproduct-of-theenvironmentmodel?

2-20. The Japanese are very good at returning lost property to local police stations. If you lose a wallet filled with cash in Japan it is likely to be turned into the police. This is true even though the person finding it could keep it without anyone else knowing. This behavior isnotwhat you would find in New YorkCity.

1. Does this observation about Japan imply that the economic model does not explain be-havior in Japan?Explain.
2. Police stations in Japan are filled with lost umbrellas. It used to be that the typical Japanese would make a trip to the local police station to search for a lost umbrella. Nowthey don't. Explain this behavior using the EconomicModel.
3. Do you think that the typical Japanese is more likely to come to a police station to finda lost cell phone or a lost umbrella? Explain using the Economic Model.

2-21.SomestatesintheUnitedStatesallowcitizenstocarryhandguns.Citizenscanprotectthem- selvesinthecaseofrobberiesbyusingtheseguns.Otherstatesdonotallowcitizenstocarry handguns.Criminals,however,tendtohavehandgunsinallstates.Useeconomicanalysisto predicttheeffectsofhandgunlawsonthebehaviorofthetypicalcriminal.Inparticular:

1. Do you think criminals will commit more or fewer robberies in the states with thelaws?
2. How do you think the laws will affect the types of robberiescriminals commit? Be sureto explain your economicreasoning.

2-22. Discuss the following statement: "Sunk costs matter. People who pay $20,000 to join a golf club play golf more frequently than people who play on public golf courses."

2-23. Jenny is an investor in the stock market. She cares about both the expected value and stan- dard deviation of her investment. Currently she is invested in a security that has anexpectedvalue of $15,000 and a standard deviation of $5,000. This places her on an indifference curve with the following formula: Expected Value =$10,000+StandardDeviation.

1. Is Jenny risk averse?Explain.
2. WhatisJenny's"certaintyequivalent"forhercurrentinvestment?Whatdoesthismean?
3. What is the risk premium on her currentinvestment?

2-24. Accounting problems at Enron ultimately led to the collapse of the large accounting firm ArthurAndersen.WhentheEnronscandalfirstbecamepublic,Andersen'stopmanagement blamed one "rogue partner" in the Houston office who they claimed was less honest than other partners at the firm. They fired the partner and asked that people not hold the remain- ingpartnersaccountablefor"onebadapple."WhatmodelofbehaviorwasAndersen'sman-agement using when it analyzed the source of the problem? According to the economic view of behavior, what was the more likely cause of theproblem?

2-25. According to a recent article in The Atlanta Journal-Constitution(January 29, 2004), "ma- terialism, not necessity, gave birth to dual-income families." In supporting the argument, the author cites the following figures from the Department of Commerce: In 1970 the average wage per job was $6,900, which in 2001 dollars (adjusting for inflation) amounts to

$31,500. In 2001, the average wage per job was $35,500. The main thesis of the article is that dual-income families are a result of a shift in consumer preferences towardconsump- tion as opposed to leisure time/time spent with thefamily.

1. Assume the average person worked 250 days during a year both in 1970 and 2001, and that, as reported in the article, only one person worked in the average family in 1970, while both parents did in 2001. Provide a graphical analysis of the typical family's choice between family income and combined parent leisure time that supports the au- thor's argument, relying on the tools presented in class. Be careful in labeling your graph(s), and provide a clear and concise explanation for your graph(s). Note that there are 365 days in a year so that the total parent leisure time that is possible is 730 days (assuming neither spouse works). Assume it is possible for each family member to workanywhere from 0 to 365 days a year (at the going salary rate) if they choose to doso.
2. Assume that in 1971 the average single person worked 220 days per year, while the same person worked 260 days per year in 2001. Moreover, suppose the average daily wage in 2001 dollars was $125 in 1970 and $140 in 2001. Show graphically how the au-thor's argument would not necessarily apply to the average single person (i.e., assume preferences are unchanged). Explain clearly and concisely why the average worker may be choosing to work more in 2001 and carefully label yourgraph.

2-26. Russell and Joe have hired Maria to help cook in their restaurant. Maria had previously owned her own breakfast business. Her speed in cooking was well-known. Russell and Joe have been surprised that her productivity has fallen significantly since she became their paid employee. Use the economic view of behavior and marginal analysis to provide a potential explanation for Maria's reduced productivity.

2-27. Michael is a fan of the Rhinosthe local professional soccer team. At the beginning of the season, he purchased nonrefundable season tickets to their 10 home games for a total of

$100. Michael places equal value on each of the home games. His value for any given game is independent of how many other games he attended during the year. Michael would be willing to stay at home, which he derives no benefit from, and miss an individual game, if he could sell the ticket for one game for $20 or more.

Michael has attended three out of the last five home games. The sixth home game of the season is tomorrow night. Michael's friend Fred has offered to sell him an extra ticket to a sold-out concert for $50 that happens to be on the same night as the game. Normally, Michael would be willing to pay $70 to attend the concert. There is no way that Michael can attend both the Rhinos' game and the concert. Looking online, Michael finds that he can sell his ticket for tomorrow night's Rhinos' game for $5.

1. Whattype/typesofcostisthe$100thatMichaelpaidfortheseasontickets?Explainwhy.
2. Which event will Michael decide to attend? Explainwhy.

1. How much would Fred have to charge Michael for the concert ticket in order tomakeMichael not care which event he attended? Explainwhy.

2-28.An entrepreneur quits his job as a banker and invests $100,000 of his savings in a new busi- ness venture that he will manage. Discuss the two most obvious opportunity costs that he will incur from this decision.

2-29.In one hour, John can assemble either 20 telephones or 10 answering machines. It takes Sally two hours to assemble either 20 telephones or 10 answering machines. Does either person have an absolute advantage in assembling either product? What about acompetitive advantage? Explain (make sure you define absolute and competitive advantage andprovide the opportunity costs for each person). Draw the combined production possibilities curve for the two people assuming that they work eight hours. Put answering machines on the horizontal axis.

2-30.Youare trying to decide whether to fly or drive from Rochester to Boston during your sum- mer visit. The trip is approximately 400 miles. Youcan purchase a round-trip nonstop flightfor $230. The duration of each flight is 3.5 hours (seven hours in total). If you drive, it will take you approximately seven hours each way (14 hours in total). Yourcar gets 32 miles to the gallon and you expect gas will cost $3/gal. Tollsare $15 each way.Youvalue your time at $15 perhour.

1. Calculate the total cost of driving to Boston andback.
2. Under these conditions, will you drive orfly?
3. What if you value your time at $20, rather than $15, perhour?
4. You are offered a deal for $180 total airfare if you take a flight with a one hour layover in NYC (total flying time does not change). Do you take the deal? Will this change your flying versus driving decision? (Use the $15 per hour value of time in the calculation.)
5. What are some other costs you may want to consider in thisanalysis?
6. If you were expecting a snow storm, how might this change your analysis? Whataresome other costs you may want to take intoconsideration?

2-31. The school is having a happy hour on Friday. If you go, you will get two free drink tickets and snacks, for which you would normally pay $15. However, you will have to pay $10 for the cab fare home. You also have a free student ticket to the local profession team's soccer game. There is no resale value, as free tickets are still available.

1. What is the opportunity cost of going to the soccer game?
2. If you would not normally pay to go to the soccer game, which will youchoose?

2-32.Bill and Chris produce balls and bats. In one hour, Bill can produce two bats or four balls, while Chris can produce one bat or three balls. They each work 10 hours a day.

1. Which of the following, if any,is true? Explainwhy.
   1. Chris has an absolute advantage producing balls and a comparative advantage producingballs.
   2. Chris has an absolute advantage producing balls and Bill has a comparative advantage producingballs.
   3. Bill has an absolute advantage producing balls and a comparative advantage producingballs.
   4. Bill has an absolute advantage producing balls and Chris has a comparative advantage producingballs.
2. If Chris and Bill each split their time evenly between producing balls andproducing bats, what is the total number of bats and balls that will be produced in one day?
3. Can the combined production of balls be increased while holding the number of batsproduced constant?How?

d. GraphthecombinedproductionpossibilitiesfrontierforBillandChris.PlaceBatsontheverticalaxisandBallsonthehorizontalaxis.[Thegraphwouldshowthemaximumcom- binedamountofbatsthatcouldbeproducedbyBillandChrisforeachfeasiblecombined amount of balls that could beproduced.]