Answers to the Problems and Applications

1.

One year ago, Jack and Jill set up a vinegar-bottling firm (called JJVB). Use the following
information to calculate JJVBs opportunity cost of production during its first year of
operation:
Jack and Jill put $50,000 of their own money into the firm.
They bought equipment for $30,000.
They hired one employee to help them for an annual wage of $20,000.
Jack gave up his previous job, at which he earned $30,000, and spent all his time working
for JJVB.
Jill kept her old job, which paid $30 an hour, but gave up 10 hours of leisure each week
(for 50 weeks) to work for JJVB.
JJVB bought $10,000 of goods and services from other firms.
The market value of the equipment at the end of the year was $28,000.
Jack and Jill have a $100,000 home loan on which they pay an interest rate of 6 percent a
year.
The wages paid, $20,000, and the goods and services bought from other firms, $10,000, are
opportunity costs to JJVB. Other opportunity cost include the interest forgone on the $50,000
put into the firm, which could have been used to pay part of the mortgage, so the interest
forgone is $3,000; the $30,000 income forgone by Jack not working at his previous job;
$15,000, which is the value of 500 hours of Jills leisure (10 hours a week for 50 weeks); and
the economic depreciation of $2,000 ($30,000 minus $28,000). JJVBs total opportunity cost is
the sum of all these opportunity costs and is $80,000.

2.

Joe runs a shoeshine stand at the airport. With no skills and no job experience, Joe has no
alternative employment. Other shoeshine stand operators that Joe knows earn $10,000 a
year. Joe pays the airport $2,000 a year for the space he uses, and his total revenue from
shining shoes is $15,000 a year. He spent $1,000 on a chair, polish, and brushes and paid
for these items using his credit card. The interest on his credit card balance is 20 percent a
year. At the end of the year, Joe was offered $500 for his business and all its equipment.
Calculate Joes opportunity cost of production and his economic profit.
Joes opportunity costs are the $2,000 paid to the airport for the space; the $200 for the interest
paid on the $1,000 credit card balance; the $10,000 of normal profit; and, the $500 for the
depreciation of his equipment (which equals the $1,000 paid for the chair, polish, and brushes
minus the $500 he was offered for this equipment). Joes total opportunity cost is the sum of
these costs, which is $12,700. Joes economic profit is his total revenue, $15,000, minus his total
opportunity cost, $12,700, for an economic profit of $2,300.

3.
Alternative ways of laundering 100 shirts are
a. Which methods are technologically efficient?
All the methods are technologically efficient.

b. Which method is economically efficient if the

hourly wage rate and implicit rental rate of
capital are
(i) Wage rate $1, rental rate $100?

Method
A
B
C
D

Labor
(hours)
1
5
20
50

Capital
(machines)
10
8
4
1

Method D is economically efficient because the total cost is the least. Method Ds costs are
50 $1 + 1 $100, or $150.

(ii) Wage rate $5, rental rate $50?

Method D and Method C are economically efficient because the total cost is the least.
Method Cs costs are 20 $5 + 4 $50, or $300.

(iii) Wage rate $50, rental rate $5?

Method A is economically efficient because the total cost is the least. Method As costs are 1
$50 + 10 $5, or $100.

4.
Sales of the firms in the tattoo industry are
a. Calculate the four-firm concentration ratio.
The four-firm concentration ratio is 60.49. The four-firm
concentration ratio equals the ratio of the total sales of the largest
four firms to the total industry sales expressed as a percentage.
The total sales of the largest four firms is $450 + $325 + $250 +
$200, which equals $1,225. Total industry sales equal $1,225 +
$800, which equals $2,025. The four-firm concentration ratio
equals ($1,225/$2,025) 100, which is 60.49 percent.

b. What is the structure of the tattoo industry?

Firm
Bright Spots
Freckles
Love Galore
Native Birds
Other 15 firms

Sales
(dollars per
year)
450
325
250
200
800

This industry is highly concentrated because the four-firm concentration ratio exceeds 60
percent.

5.

In 2003 and 2004, Lego, the Danish toymaker that produces colored plastic bricks,
incurred economic losses. The firm faced competition from low-cost copiers of its products
and faced a fall in the number of 5- to 9-year-old boys (its main customers) in many rich
countries. In 2004, Lego launched a plan to restore profits. It fired 3,500 of its 8,000
workers; closed factories in Switzerland and the United States; opened factories in Eastern
Europe and Mexico; and introduced performance-based pay for its managers. Lego
reported a return to profit in 2005.
Based on Picking Up the Pieces,
The Economist, October 28, 2006.
a. Describe the problems that Lego faced in 2003 and 2004, using the concepts of the three
types of constraints that all firms face.
Lego faced all of the three types of constraints: Technology, information, and market.
The technology constraint that Lego faced was how it produced its Legos. Before it made any
changes, Lego used a relatively large number of high-paid, presumably high-skilled workers in
the United States and Switzerland. After its changes, Lego switched to using apparently fewer
workers, who are lower-paid and probably lower-skilled in Eastern Europe and Mexico.
Lego also faced information constraints. In particular, if Lego had had full information about its
market and its competitors plans, it is unlikely Lego would have suffered economic losses in
2003 and 2004. And, of course, if Lego had had better information, even after it started to suffer
economic losses, Lego would have more rapidly made changes to limit its losses. In addition,
Lego apparently faced information problems about which managers were not working as hard as
they should.
Finally, Lego faced significant market constraints. First Lego suffered a fall in demand from its
custmers, 5- to 9-year old boys. Second other firms were making very similar but lower-priced
blocks. This competition lead Legos customers to switch (some of) their purchases from Lego
to Legos competitors, thereby leaving Lego to suffer an economic loss.

b. Which of the actions that Lego took to restore profits addressed an inefficiency? How did
Lego seek to achieve economic efficiency?
When Lego was suffering an economic loss, Lego was manufacturing its blocks in Switzerland
and the United States. These workers were generally high-skilled and therefore high-paid. In an
effort to restore its profit, Lego changed its production method by firing 3,500 workers and
moving its factories to Eastern Europe and Mexico, where it could use lower-skilled, and
therefore lower-paid workers. Apparently before the changes Lego was using an economically
inefficient production method, with too many workers in general and too many high-skilled
workers in particular.

c. Which of the actions that Lego took to restore profits addressed an information and
organization problem? How did Lego change the way in which it coped with the
principal-agent problem?
Lego faced an information and organization problem because Lego apparently did not know
which managers were shirking. To overcome this important principal-agent problem, Lego
changed its compensation methods by introducing performance-based pay for its managers. By
basing its managers pay on their performance, Lego gave its managers the incentive to work
diligently in their efforts to boost Legos profits.

d. In what type of market does Lego operate?

Lego operates in a monopolistically competitive market.

6.

John Deeres Farm Team

Deere opened up the Pune [India] center in 2001 as a way of entering the Indian market.
The move was unexpected: Deere is known for its heavy-duty farm equipment and big
construction gear. Many of Indias 300 million-plus farmers still use oxen-pulled plows
Fortune, April 14, 2008
a. Why do many Indian farmers still use oxen-pulled plows? Are they efficient or
inefficient? Explain.
Many Indian farmers use oxen-pulled plows because the cost of tractors is too high. Using oxenpulled plows allows farmers to produce at lower cost than if they used tractors. Because of the
lower cost, Indian farmers may well be economically efficient.

b. How might making John Deere farm equipment available to Indian farmers change the
technology constraint they face?
The presence of John Deere in the Indian market will increase the supply of tractors and lower
their price. By lowering their cost so that using a tractor is now economically efficient, Indian
farmers will switch production methods. Their technology constraint will change as a result of
using the additional capital equipment and the farmers will be able to produce more output than
before.

c. How do you expect John Deeres move into the Indian farm equipment market to
influence the firms profit opportunities?
John Deere is moving into India only because it expects the move to be profitable. Hence Deere
expects its decision to increase its profit.

7.

Here It Is. Now, You Design It!

The idea is that the most successful companies no longer invent new products and services
on their own. They create them along with their customers, and they do it in a way that
produces a unique experience for each customer. The important corollary is that no
company owns enough resourcesor can possibly own enoughto furnish unique
experiences for each customer, so companies must organize a constantly shifting global
web of suppliers and partners to do the job.
Fortune, May 26, 2008
a. Describe this method of organizing and coordinating production: Does it use a command
system or incentive system?
This method uses an incentive system to organize and coordinate production. The resources are
not under the constant supervision of the employer and so a command system of coordinating
production would not work. Instead the firm uses an incentive systemgiving the resources
necessary for a project an incentive to cooperate by paying them for their share of the project
to organize the production.

b. How does this method of organizing and coordinating production help firms achieve
lower costs?
The design firm has lower costs because it uses different resources with each project. If the
design firm owned all the resources, and therefore used a command system to organize

production, the firm would need to pay for all the resources for each and every project. But for
many of the projects some of the resources would be unused. Hence the firms costs would be
significantly higher than if it paid for only the resources actually used, as it does when it uses an
incentive system of organization.

8.

Rewarding Failure
Over the past 25 years CEO pay has risen faster than corporate profits, economic
growth, or average workforce compensation. A more sensible alternative to the current
compensation system would require CEOs to own a lot of company stock. If the stock is
given to the boss, his salary and bonus should be docked to reflect its value. As for
bonuses, they should be based on improving a companys cash earnings relative to its cost
of capital, not to more easily manipulated measures like earnings per share. ... [Bonuses]
should not be capped, but they should be unavailable to the CEO for some period of years.
Fortune, April 28, 2008
a. What is the economic problem that CEO compensation schemes are designed to solve?
CEO compensation schemes are designed to overcome the principal-agent problem. A CEOs
decisions can have large effects on the companys profitability. The principals, the shareholders
of the corporation, want the CEO, the agent, to carefully consider the decisions and make
decisions that boost the firms profit. The CEO, however, has the incentive to shirk and to make
decisions that boost his or her well-being rather than the companys profit.

b. How do the proposed changes to CEO compensation outlined in the news clip address the
problem you described in a?
The changes proposed in the news clip are designed to link the CEOs pay to the companys
profit. If the profit rises, then the company stock price will rise. If the CEOs pay is largely
determined by changes in the stock price, then the CEOs decisions are directly linked to the
companys fortunes. By making the bonuses unavailable for a period of time, the schemes
attempt to guarantee that the CEOs decisions are in the companys long-term best interest rather
than trying to quickly boost the company and its stock price but at the cost of its long-term
performance.

9.

GameStop Racks Up the Points

No retailer has more cachet among gamers than GameStop, and only Wal-Mart has a larger
share of the marketfor now. Wal-Mart had a 21.3% market share last year.
GameStops share was 21.1%, and may well overtake Wal-Mart this year but [new
women gamers] may prefer shopping at Target to GameStop. A chance for Wal-Mart
and Target to erode GameStops market share.
Fortune, June 9, 2008
a. According to the news clip, what is the structure of the U.S. retail video game market?
The market described is an oligopoly. There are only a few firms, three in particular, described
as comprising the market.

b. Estimate a range for the four-firm concentration ratio and the HHI for the game market in
the United States based on the information provided in this news clip.
Wal-Mart is described as having the largest market share, 21.3 percent, and GameStop is said to
have the second largest market share, 21.1 percent. These two firms have a market share of 42.4
percent. The market share of the next two largest firms must be less than 42.4 percent. As a
result the four-firm concentration ratio ranges from 42.4 percent to 84.7 percent.
The HHI equals the sum of the squared market shares of the 50 largest firms. Wal-Marts
contribution to the HHI is 21.32 which is 453.7 and GameStops contribution to the HHI is 21.12
which is 445.2. Based on the two largest firms, the HHI is at least 898.9. If there are two other
firms each with a market share of 21.0 percent and one other firm with a market share of 13.6
percent, the HHI attains its maximum of 2,024.26. So the HHI can range from about 900 to
about 2,025.

10.

6 Steps to Creating a Super Startup

But starting a business is a complicated, risky, all-consuming effort. Indeed, just two-thirds
of new small businesses survive at least two years, and only 44 percent survive at least four
years. You have to be willing to take calculated risks. Most entrepreneurs start their
businesses by dipping into their savings, and hitting up friends and family. Perhaps half of
all startups, in fact, are funded initially by the founders credit cards Getting a bank loan
is tough unless you have assetsand that often means using your home as collateral.
CNN, October 18, 2007
a. When starting a business, what are the risks and potential rewards associated with a
proprietorship identified in the news clip?
Organizing a business a proprietorship is easy, an advantage of this form of business
organization. The potential reward is the (economic) profit the business might earn. The news
clip points out that proprietorships have a difficult time raising the necessary funds.

b. How might a partnership help to overcome the risks identified in the news clip?
The advantages of a partnership are that it is easier to raise capital. All the partners can help
raise the necessary funds. In addition partnerships have diversified decision making which can
save the business from making an uncontested bad decision, which can occur in a
proprietorship.

c. How might a corporation help to overcome the risks identified in the news clip?
Raising funds for a corporation by selling stock to the many owners might well be easier than
raising funds for a proprietorship. First, there can be many shareholders rather than just one
person raising the funds. Second the owners of a corporation have limited liability for the firms
debts, which makes them more willing to supply funds to the business. Finally a corporation can
hire professional management.

11.

Federal Express enters into contracts with independent truck operators who offer FedEx
service and who are rewarded by the volume (cubic meters) of packages they carry.
a. Why doesnt FedEx buy more trucks and hire more drivers?
FedEx faces a principal-agent problem. In particular, it is not easy to monitor its drivers and
insure that they are working hard to efficiently deliver packages. FedEx overcomes this problem
by hiring independent contactors and then paying them based on the amount of packages they
deliver. Essentially, FedEx uses a piecework method of payment.

b. What incentive problems might arise from the arrangement that FedEx uses?
FedEx pays its drivers based on the volume of packages they deliver. This method of payment
creates a few potential problems for FedEx. First, FedEx must worry about the quality of its
service. In particular, unless FedEx bases part of the payment on quality, its drivers have an
incentive to drop the package and race off to the next delivery with no concern for how the
packages are handled. Second, FedEx must take care that drivers do not attempt to select only
packages that are close to the FedEx location and avoid packages that have a greater than
average driving time. Finally, FedEx also must worry that its drivers do not take undue risks
while driving (in order) to deliver as many packages as possible. If FedEx trucks were involved
in too many accidents, FedEx would suffer bad publicity and, presumably, would lose some
business.