Solutions To MC Problems, Froeb McCann, 5th Edition PDF

Managerial Economics:
A Problem-Solving Approach
5th Edition
Interactive HW Questions
(solutions to end-of-chapter multiple choice questions)
Table of Contents
Chapter 1 ......................................................................................................................................... 3
Chapter 2 ......................................................................................................................................... 6
Chapter 3 ......................................................................................................................................... 9
Chapter 4 ....................................................................................................................................... 12
Chapter 5 ....................................................................................................................................... 15
Chapter 6 ....................................................................................................................................... 18
Chapter 7 ...................................................................................................................................... 22
Chapter 8 ...................................................................................................................................... 25
Chapter 9 ...................................................................................................................................... 28
Chapter 10.................................................................................................................................... 30
Chapter 11 ..................................................................................................................................... 32
Chapter 12..................................................................................................................................... 36
Chapter 14 (and 13) ...................................................................................................................... 38
Chapter 15..................................................................................................................................... 41
Chapter 16..................................................................................................................................... 44
Chapter 17..................................................................................................................................... 47
Chapter 18..................................................................................................................................... 50
Chapter 19.................................................................................................................................... 52
Chapter 20.................................................................................................................................... 55
Chapter 21.................................................................................................................................... 58
Chapter 22.................................................................................................................................... 61
Chapter 1
1. Why might performance compensation caps be bad?

a. Different pay rates promote dissent. [A compensation cap is a maximum salary limit, it does
not necessarily produce varied pay rates]
b. Compensation caps can discourage employees from being productive after the cap.
[correct; at least with regards to salary, the employee is not rewarded for further
productivity beyond the amount that produces the cap value]
c. Compensation caps can discourage employees from being productive before the cap.
[employees are incentivized to reach the value of the cap, encouraging productivity prior to
its achievement]
d. Both b and c
2. What is a possible consequence of a performance compensation reward scheme?

a. It creates productive incentives. [As pay is tied directly to performance, such a policy may
motivate workers to improve their performance for the additional compensation]
b. It creates harmful incentives. [Such a policy may create incentives to manipulate the
performance indicators or outputs, or view that performance metric exclusive from the
overall interests of the firm]
c. Both a and b [correct; could produce productive or harmful incentives depending on the
situation and the character of the person being rewarded]
d. Neither a nor b [Performance compensation schemes will produce some kind of incentives]
3. Which of the following is NOT one of the three problem solving principles laid out in Chapter 1?
a. Under whose jurisdiction is the problem? [correct; This is NOT one of the key problem
solving principles].
b. Who is making the bad decision? [This is one of the key problem solving principles]
c. Does the decision maker have enough information to make a good decision? [This is one of
the key problem solving principles]
d. Does the decision maker have the incentive to make a good decision? [This is one of the key
problem solving principles]
4. Why might it be bad for hotels to not charge higher prices when rooms are in higher demand?
a. Arbitrageurs might establish a black market by reserving rooms and then selling the
reservations to customers. [This black market allows the arbitrageurs to capture the value of
the increased demand rather than the hotels who are providing the rooms as well as creating
a less reliable system for the consumer]
b. Rooms may be rationed. [If demand increases but prices do not, demand for rooms may
exceed supply, forcing the hotel to ration the rooms and turn customers who would have
been willing to pay higher rates away]
c. Without the profit from these high demand times, hotels would have less of an incentive to
build/expand, making the long run scarcity problem even worse. [Such a policy essentially
creates a performance cap on the hotels, limiting their profitability to the number of rooms
rather than overall demand]
d. All of the above. [correct; all of these are potential negative impacts of hotels not adjusting
prices to accommodate demand]
5. The rational-actor paradigm assumes the people do NOT
a. Act rationally. [The rational actor paradigm does assume that people act rationally]
b. Use rules of thumb. [correct; the rational actor paradigm assumes people will act
rationally, optimally and self-interestedly. Rules of thumb will only be used if they meet
those three specific parameters]
c. Act optimally. [The rational actor paradigm does assume people will act optimally, selecting
or creating the outcome that provides them with the most benefit]
d. Act self-interestedly. [The rational actor paradigm does assume that people will act in their
own best interest]
6. The problem-solving principles analyze firm problems,

a. from the organization’s point of view. [correct; considering a problem from the view of
the overall organization will help ensure all elements and impacts are considered.]
b. from the manager’s point of view. [Managers are also employees of the organization,
thinking of a problem from only their perspective may overlook its impact on the company
as a whole]
c. from the worker’s point of view. [Thinking about a problem only from the employee’s point
of view risks missing the fundamental problem of goal alignment with the overall
organization]
d. Both A and B [Think about problems from the perspective of the overall organization, not its
employees]
7. Why might welfare for low income households reduce the propensity to work?
a. It will not. [It can if working can only provide similar benefits to those that can be received
from welfare without working]
b. It reduces the incentive to work. [correct; those receiving welfare may have less incentive
to work if the benefits of working are similar to or worse than those that are received
without it. Additionally, welfare may reduce the value of working for higher income workers
who have to support the system, also reducing their incentives]
c. It is unfair. [Perception of fairness alone will not alter the propensity to work unless it also
impacts the value of that work for the individual, which would impact his overall incentives]
d. It encourages jealousy. [Jealousy itself will not alter the propensity to work unless it also
impacts the perceived value of that work, which changes the incentives]
8. Why might a “bonus cap” for executives be a bad policy for the company?
a. It isn’t. Executives shouldn’t make more than a certain amount. [Just like other types of
employees, setting a maximum value for executives eliminates the ability to separate,
reward and motivate them based on their performance]
b. It would sew discontent. [Even if discontented, the rational actor paradigm indicates
executives would still perform to reach the cap value in order to maximize their bonus]
c. It would encourage laziness after the executives reached the cap. [correct; limiting the
bonus may reduce the incentive of executives to continue improving or performing once it is
achieved]
d. The cap could be set too high, so execs may work too hard and not reach it. [This is a
problem not with the cap itself, but with the level, which can be adjusted as needed]
9. What might happen if a car dealership is awarded a bonus by the manufacturer for selling a certain
number of its cars monthly, but the dealership is just short of that quota near the end of the month?
a. It may sell the remaining cars at huge discounts to hit the quota. [correct; the loss of
income from the reduced rate will be offset by the manufacturer’s bonus]
b. It creates an incentive to sell cars from different manufacturers. [the dealership is more
inclined to sell cars from the manufacturer providing the bonus]
c. It would ruin the relationship between dealer and manufacturer. [The dealer is working to
meet the requirements of the manufacturer to achieve the bonus]
10. Why might a supermarket advertise low prices on certain high profile items and sell them at a loss?
a. It is a way for companies to be charitable. [The rational actor paradigm tells us the firm will
act in its own self-interest]
b. The store will sell other groceries to the same customers, often at a markup. [correct;
by using the discounted items to bring consumers into the stores, the supermarket can profit
by increasing the prices on the other items they will purchase while they are there.]
c. They would not. [Actually, they do quite often. Can you think of why this may be?]
d. This reduces the incentives of trade. [Trade incentives do not apply in this case]
Chapter 2
Multiple Choice Solutions:
1. An individual’s value for a good or service is

a. The amount of money he or she used to pay for a good. [Past payments do not necessarily
indicate the current value of a good or service to an individual]
b. The amount of money he or she is willing to pay for it. [correct; to “value” a good means
that you want it and can pay for it]
c. The amount of money he or she has to spend on goods. [Total individual wealth does not
reflect the value of a particular good or service]
d. None of the above [To “value” a good means that you want it and can pay for it]
2. The biggest advantage of capitalism is

a. generates wealth with the help of government intervention [Not all government intervention
generates wealth, often it does the opposite. Rather, governments play a critical role in
facilitating wealth generating transactions, particularly by enforcing property rights and
contracts.]
b. that prices assists in moving assets from high valued to low value uses [Wealth is created
when assets move from lower to higher valued uses]
c. it forces involuntary exchanges [Voluntary transactions create wealth]
d. it creates wealth by letting a person follow his or her own self-interest [correct; a
buyer willingly buys if the price is above her value, and a seller sells when the price is above
her value, otherwise they would not transact]
3. Wealth creating transactions are more likely to occur

a. with private property rights [private property rights facilitate voluntary transactions]
b. with contract enforcement [contract enforcement helps facilitate voluntary transactions]
c. with black markets [black markets are often created from a wealth-generating arbitrage
opportunity]
d. All of the above [correct; By making sure that buyers and sellers can keep the gains of
trade, legal mechanisms such as private property and contract rights that facilitate voluntary
transactions will help generate wealth; black markets also create wealth from seizing
arbitrage opportunities that exist from inefficiencies in the market]
4. Government regulation
a. provides incentives to conduct business in an illegal black market [correct;
government regulation that impedes the movement of assets to higher valued uses destroys
wealth. Black markets arise in part because of the arbitrage opportunities created in these
situations]
b. plays no role in generating wealth [governments play a critical role in the wealth creating
process by enforcing property rights and contracts]
c. is the best way to eliminate poverty [There are other opportunities beyond government
regulation to address poverty, especially as often some regulations ultimately result in
wealth destroying transactions]
d. does not enforce property rights [One of governments most important roles is the
enforcement of private property rights]
5. Which of the following are examples of a price floor?
a. Minimum wages [correct; by outlawing wages below a certain price, minimum wages are
an example of a price floor]
b. Rent controls in New York [this is an example of a price ceiling, in which the price of rent
cannot go above a specified value]
c. Both a and b [Of the two options, one is indeed an example of a price floor, while the other is
a price ceiling]
d. None of the above. [At least one of the answers above is an example of a price floor, which is
defined as a regulation that outlaws trade at prices below the specified “floor” value]
6. A price ceiling
a. Is a government-set price above market equilibrium price. [A price ceiling is a regulation
that outlaws trade above a specified price; it does not have to be above market equilibrium]
b. Is the equivalent of an implicit tax on producers and an implicit subsidy to consumers.
[correct; Price ceilings prevent producers from selling at a higher price to consumers who
would be willing to pay more, while consumers have the opportunity to purchase something
they may not have been able to otherwise]
c. Will create a surplus. [Likely, both the consumer (buyer) and producer (seller) will value the
good at or above the specified ceiling. If the producer is forced to sell, any surplus for the
consumer is a loss for the producer, so no net surplus is created from the transaction]
d. Causes an increase in consumer and producer surplus. [Both the consumer (buyer) and
producer [seller] likely value the item at or above the specified ceiling, resulting in a benefit
for the consumer but a loss of potential wealth for the producers]
**NOTE of post-production change: the phrasing of answer a. should be changed to “is a government-set
price above market equilibrium price.”
7. Taxes
a. impede the movement of assets to higher valued uses. [This is the result of anything that
deters a wealth creating transaction]
b. reduce incentives to work. [By not allowing people to capture the full value of their labor and
production, taxes reduce the incentive to work]
c. decrease the number of wealth-creating transactions. [If a tax is larger than the total surplus
created by a transaction, the transaction will not take place]
d. All of the above. [correct; when taxes are larger than the surplus of a transaction, that
transaction will not take place, thus deterring a wealth creating transaction. Likewise, by not
allowing people to keep the gains from their own trade, taxes can diminish the incentive to
work].
8. A consumer values a car at $30,000 and a producer values the same car at $20,000. If the transaction
is completed at $24,000, the transaction will generate
a. no surplus [A surplus is created from this transaction]
b. $4,000 worth of seller surplus and unknown amount of buyer surplus [Seller surplus is
$4000, (Final price less seller value); Similarly, buyer surplus can be calculated by looking at
the difference between the buyer value and the final price.
c. $6,000 worth of buyer surplus and $4,000 of seller surplus [correct; Buyer surplus is
calculated by looking at the difference between the buyer value and the final price ($30,000-
$24,000=$6,000), while the seller surplus is calculated by looking at the difference between
the final price and the seller’s value ($24,000-$20,000=$4,000)]
d. $6,000 worth of buyer surplus and unknown amount of seller surplus. [Buyer surplus is
$6000, (Buyer value less final price); similarly, seller surplus can be calculated by looking at
the difference between the final price and the seller value]
9. A consumer values a car at $525,000 and a producer values the same car at $485,000. If sales tax is
8% and is levied on the seller, then the seller’s bottom line price is (rounded to the nearest thousand)
a. $527,000 (correct; At a price of $527,000, the seller will receive $485,760 ($528,000*0.92)
which is above his bottom line (For the exact value, look at $485,000/0.92 = $527,173.93. As
the seller requires a number at or above this value, $528,000 is the best response)]
b. $524,000 [at a price of $524,000, the seller will only receive $482,080 ($524,000*0.92)
which is below his bottom line]
c. $525,000 [at a price of $525,000, the seller will only receive $483,000 ($525,000*0.92)
d. $500,000 [at a price of $500,000, the seller will only receive $460,000 ($500,000*0.92)
10. Efficiency implies opportunity

a. always [In an efficient market, all assets are already employed in their highest valued uses]
b. never [correct; by definition, wealth is generated from inefficiencies in the market, which
allow for assets to be moved from lower to high valued uses]
c. only if accompanied by secure property rights [Secure property rights assist in wealth
generating transactions, which occur from the movement of assets from lower to higher
valued uses]
d. None of the above [It is one of the above]
Chapter 3
1. A business owner makes 1000 items a day. Each day he or she contributes 8 hours to produce those
items. If hired, elsewhere he/she could have earned $250 an hour. The item sells for $15 each.
Production does not stop during weekends. If the explicit costs total $150,000 for 30 days, the firm’s
accounting profit for the month equals:
a. $300,000 [correct; Revenue equals 1000 items per day * $15/item*30days = $450,000.
Explicit costs are given as $150,000. Therefore, accounting profit = $450,000-$150,000 =
$300,000]
b. $60,000 [This number represents the opportunity cost of his labor; $250/hr*8hrs/day*30
days = $60,000]
c. $450,000 [This number represents the total revenue; 1000 items per day * $15/item*30days
= $450,000.]
d. $240,000 [For accounting profit, opportunity costs are not considered]
2. A business owner makes 1000 items a day. Each day he/she contributes 8 hours to produce those
items. If hired, elsewhere he/she could have earned $250 an hour. The item sells for $15 each.
Production does not stop during weekends. If the explicit costs total $150,000 for 30 days, the
economic profit for the month equals:
a. $300,000 [This number represents the accounting profit. Revenue equals 1000 items per
day * $15/item*30days = $450,000. Explicit costs are given as $150,000. Therefore,
accounting profit = $450,000-$150,000 = $300,000]
b. $60,000 [This number represents the opportunity cost of his labor; $250/hr*8hrs/day*30
days = $60,000]
c. $450,000 [This number represents the total revenue; 1000 items per day * $15/item*30days
= $450,000.]
d. $240,000 [correct; When calculating economic profit, opportunity costs are considered.
Total Revenue is $450,000 (1000 item/day*$15/item*30days), Explicit costs are given at
$150,000 and the opportunity cost of labor is $60,000 ($250.hr*8hrs/day*30days).
Therefore, economic profit is $450,000-$150,000-$60,000 = $240,000]
3. If a firm is earning negative economic profits, it implies

a. That the firm’s accounting profits are zero. [Not necessarily, it is impossible to determine the
relationship between economic and accounting profit without information on the economic
costs involved].
b. That the firm’s accounting profits are positive. [Not necessarily, it is impossible to determine
the relationship between economic and accounting profit without information on the
economic costs involved].
c. That the firm’s accounting profits are negative. [Not necessarily, it is impossible to
determine the relationship between economic and accounting profit without information on
the economic costs involved].
d. More information is needed to conclude about accounting profits [correct; it is
impossible to determine the relationship between economic and accounting profit without
information on the economic costs involved]
4. Opportunity costs arise due to
a. Resource scarcity [correct; without scarce resources (time, labor, money, etc), the pursuit
of another alternative does not require one to give up anything in return.
b. Interest rates [interest is an economic cost that reflects what creditors charge for use of their
capital]
c. Limited wants [Limited wants would not generate opportunity costs]
d. Unlimited scarcity [Unlimited scarcity does not generate opportunity costs]
5. After graduating from college, Jim had three choices, listed in order of preference: (1) Move to Florida
from Philadelphia, (2) work in a car dealership in Philadelphia, or (3) play soccer for a minor league
in Philadelphia. His opportunity cost of moving to Florida includes
a. The benefits he could have received from playing soccer [Opportunity cost represents the
value of only the best foregone alternative]
b. The income he could have earned at the car dealership [correct; opportunity cost
reflects the value of the best foregone alternative, in this case the car dealership salary]
c. Both a and b. [Opportunity costs represent the value of only the best foregone alternative]
d. Cannot be determined from the given information. [Opportunity costs reflect the value of the
best foregone alternative, what is that for Jim in this case?]
6. Economic Value Added helps firms avoid the hidden-cost fallacy

a. by ignoring the opportunity costs of using capital [On the contrary, EVA makes the hidden
cost of equity visible to the firm]
b. by differentiating between sunk and fixed costs [EVA may help managers distinguish
between the two, but it does so by looking at the cost of capital associated with each]
c. by taking all capital costs into account, including the cost of equity [correct; By taking
all of the capital costs into account such as the cost of equity, firms can better gauge their
economic profit and the opportunity costs associated with some of their current assets]
d. None of the above. [It is one of the above]
7. The fixed-cost fallacy occurs when

a. A firm considers irrelevant costs [The sunk or fixed cost fallacy occurs when you make
decisions using irrelevant costs or benefits. In other words, you consider costs and benefits
that do not vary with the consequences of your decision]
b. A firm ignores relevant costs [This is the definition of the hidden cost fallacy]
c. A firm considers overhead or depreciation costs to make short-run decisions [Overhead and
depreciation are example of irrelevant or suck costs that are not impacted by the outcome of
a short term decision]
d. Both a and c. [correct; The sunk or fixed cost fallacy occurs when costs (such as
depreciation and overhead) are considered even when they do not vary with the
consequences of the decision.
8. Mr. D's Barbeque of Pickwick, TN, produces 10,000 dry-rubbed rib slabs per year. Annually Mr. D's
fixed costs are $50,000. The average variable cost per slab is a constant $2. The average total cost per
slab then is
a. $7. [correct; Total fixed costs are $5/lab ($50,000Total Fixed Cost/10,000 units), and
average variable cost is given as $2/slab. Therefore average total cost (Fixed + Variable) per
unit equal $5+$2=$7]
b. $2. [This represents the average variable cost per unit. Average total cost requires
consideration of the fixed component]
c. $5. [This represents the average fixed cost per unit, calculated as $50,000 Total Fixed
cost/10,000 units]
d. Iimpossible to determine. [Average total cost per unit can be determined by adding the
average variable and fixed costs per unit of the rib slabs]
9. All the following are examples of variable costs, except

a. Labor costs [varies by the number of employees as well as their hours worked, which
correlate with the total amount of output produced]
b. Cost of raw materials [Cost of raw materials with the total amount of output produced]
c. Accounting fees [correct; accounting fees are paid regardless of total output. They do not
vary with the amount that is produced]
d. Electricity costs [Electricity, like other utilities varies by usage]
10. The U.S. Government bought 112,000 acres of land in southeastern Colorado in 1968 for
$17,500,000. The cost of using this land today exclusively for the reintroduction of the black-tailed
prairie dog
a. is zero, because they already own the land. [The cost of the land includes the cost of the best
foregone option]
b. is zero, because the land represents a sunk cost. [A cost is sunk when it does not vary with
the outcome of the decision. In this case, there may be an opportunity cost associated with
using the land for prairie dogs that should be considered]
c. is equal to the market value of the land. [correct; the cost of a decision includes the cost
of the best foregone option. In this case, this is the amount the government could sell the
land for if they did not use if for prairie dog introduction]
d. is equal to the total dollar value the land would yield if used for farming and ranching. [This
may be hard to determine, and also requires additional resources and labor. In this case,
there may be a better alternative]
e. depends on the value to society of black-tailed prairie dogs. [Regardless of the prairie dog
value, the cost would include that of the best foregone option and should still be considered.
If that cost is deemed less than the value of the prairie dogs, the project will move forward]
Chapter 4
1. When economists speak of “marginal”, they mean

a. opportunity [The opportunity cost of an alternative is the profit you give up to pursue it]
b. scarcity [Scarcity refers to the limited availability of resources]
c. incremental [correct; marginal refers to additional cost or benefit created from producing
each additional unit]
d. unimportant [In economic terms, marginal does not imply unimportant. On the contrary,
marginal analysis is a critical component of a wide variety of economic decisions]
2. Managers undertake an investment only if

a. Marginal benefits of the investment are greater than zero [when considering a decision, both
the marginal benefits and marginal costs should be compared]
b. Marginal costs of the investment are greater than marginal benefits of the investment [if the
marginal costs are greater than the marginal benefits of a decision, management will not
make the investment]
c. Marginal benefits are greater than marginal costs [correct; managers should undertake
an investment when the marginal benefits are greater than the marginal costs]
d. Investment decisions do not depend on marginal analysis [marginal analysis is critical in
investment decisions]
3. A firm produces 500 units per week. It hires 20 full-time workers (40 hours/week) at an hourly wage
of $15. Raw materials are ordered weekly and they costs $10 for every unit produced. The weekly
cost of the rent payment for the factory is $2,250. How do the overall costs breakdown?
a. Total variable cost is $17,000; total fixed cost is $2,250; total cost is $19,250 [correct;
both the $12,000 of labor costs (20 workers*40hrs/week*$15/hr) and the $5000 raw
materials cost ($10/unit*500 units) are considered variable expenses. Factory rent is
considered a fixed cost]
b. Total variable cost is $12,000; total fixed cost is $7,250; total cost is $19,250 [Both labor and
raw materials are considered variable costs as they both change as output levels change]
c. Total variable cost is $5,000; total fixed cost is $14,250; total cost is $19.250 [Both labor and
raw materials are considered variable costs as they change as output levels change]
d. Total variable cost is $5,000; total fixed cost is $2,250; total cost is $7,250 [Both raw
materials and labor should be considered as variable costs, which when added to the fixed
rental cost will equal the total costs of production]
4. Total costs increase from $1500 to $1800 when a firm increases output from 40 to 50 units. Which of
the following are true?
a. FC = $100 [We know that Total cost = FC + VC(Quantity). This means 1500 = FC+VC(40) and
1800=FC+VC(50). Using this information, we can solve for FC]
b. FC = $200 [We know that Total cost = FC + VC(Quantity). This means 1500 = FC+VC(40) and
c. FC = $300 [We know that Total cost = FC + VC(Quantity). This means 1500 = FC+VC(40) and
1800=FC+VC(50). Using this information, we can solve for FC. For example, using the first
equation we see VC(40)=1500-FC, hence VC=(1500-FC)/40. Plugging this value for VC into
1800=FC+VC(50) will give you 1800=FC+50((1500-FC)/40), which lets us find FC=300]
d. FC = $400 [We know that Total cost = FC + VC(Quantity). This means 1500 = FC+VC(40) and
5. A manager of a clothing firm is deciding whether to add another factory in addition to one already in
production. The manager would compare
a. the total benefits gained from the two factories to the total costs of running the two factories.
[By combining the total costs and benefits of the two factories, the manager would not be
able to determine the contribution of the second factory on its own]
b. the incremental benefit expected from the second factory to the total costs of running the
two factories. [The additional benefit of the second factory should only be compared to the
additional costs of that factory, as the costs from the first factory will be incurred regardless]
c. the incremental benefit expected from the second factory to the cost of the second
factory [correct; the manager will decide to add another factory when the incremental
benefits of that factory are greater than its incremental costs]
d. the total benefits gained from the two factories to the incremental costs of running the two
factories. [The incremental costs of having a second factory should be compared only to its
incremental benefit, as the benefits of the first factory will be produced regardless]
6. A firm is thinking of hiring an additional worker to their organization who can increase total
productivity by 100 units a week. The cost of hiring him is $1,500 per week. If the price of each unit is
$12,
a. the MR of hiring the worker is $1,500 [The MR of hiring the worker is $1200 (100 additional
units produced*$12/unit)]
b. The MC of hiring the worker is $1,200 [The MC of hiring the worker is his salary of $1500]
c. The firm should not hire the worker since MB < MC [correct; The MR of hiring the
worker is $1200 (100 additional units*$12/unit), while his MC is his salary of $1500,
indicating the company will lose $300/week by hiring the additional worker]
d. All the above [Remember the marginal benefit is the additional revenue generated by the
worker, while the marginal costs will be any additional costs that occur from hiring him]
7. A retailer has to pay $9 per hour to hire 13 workers. If the retailer only needs to hire twelve workers,
a wage rate of $7 per hour is sufficient. What is the marginal cost of the 13th worker?
a. $117. [This is the total cost of having 13 workers ($9*13)]
b. $9. [This represents the wage of the additional worker, but does not take into consideration
the additional costs of the wage increase for the rest of the employees associated with his
hiring]
c. $33. [correct; The total cost of having twelve workers is $84 (12workers*$7hr) while the
addition of the thirteenth worker brings the total cost up to $117 (13 workers*$9/hr).
Therefore, the marginal cost of the 13th worker is $33 ($117-$84)]
d. $84. [This is the total cost of having 12 workers (12*$7/hr)]
8. If a firm’s average cost is rising then

a. marginal cost is less than average cost. [If marginal cost is less that average cost, then its
average cost will fall with each additional unit]
b. marginal cost is rising. [Average cost may still be falling even as marginal cost rises, provided
the marginal cost still falls below the average]
c. marginal cost is greater than average cost [correct; when the marginal cost is above the
average, then the average will rise with output]
d. the firm is making an economic profit. [Average cost trends cannot be determined by looking
at average costs exclusively]
9. After the first week of his MBA Managerial Economics class, one of your pharmaceutical sales
representatives accuses you of committing the sunk cost fallacy by refusing to allow him to reduce
price to make what he considers to be a really tough sale. Which of the following suggest the sales
representative may be right?
a. Most of the costs of drug development are sunk, not fixed. [correct; in this case, he may
be correct. The costs of drug development have already been incurred, cannot be recovered,
and will not change with the outcome of the sale]
b. Sales representatives are paid a sales commission on revenue, so they don’t care about the
costs of drug development. [The fact that representatives are paid a commission on revenue
does not have anything to do with whether you are committing the sunk cost fallacy]
c. Sales representatives don’t worry that a low price today may make it more difficult for the
company’s other sales representatives to charge higher prices to their customers tomorrow.
[If true, this would be an example of a hidden cost]
d. Sales representatives think only about one thing, sales. [The fact that representatives think
only of sales does not have anything to do with whether you are committing the sunk cost
fallacy]
10. A company is producing 15,000 units. At this output level, marginal revenue is $22 and the marginal
cost is $18. The firm sells each unit for $48 and average total cost is $40. What can we conclude from
this information?
a. The company is making a loss. [The company is making a profit of $120000. Total revenues
equal $720000 ($48*15000units) while total costs are $600000 ($40*15000units)]
b. The company needs to cut production. [You need to cut production when MC>MR]
c. The company needs to increase production. [correct; When MR>MC, you need to sell
more. In this case MR=$22 is greater than MC=$18, therefore they should increase
production]
d. Not enough information is provided. [There is enough information provided to answer this
question]
Chapter 5
Multiple Choice Solutions
1. Which of the following will increase the break-even quantity?

a. A decrease in overall fixed costs [Breakeven is calculated as Q=F/(P-MC), Therefore a
decrease in overall fixed costs would decrease the numerator and hence the Breakeven
Quantity]
b. A decrease in the marginal costs [Breakeven is calculated as Q = F/(P-MC). Therefore a
decrease in the marginal costs will increase the denominator, and subsequently decreases
the Breakeven Quantity]
c. A decrease in the price level [correct; Breakeven is calculated as Q= F/(P-MC). Therefore,
a decrease in the price level will decrease the denominator, which will increase the
Breakeven quantity]
d. An increase in price level [Breakeven is calculated as Q= F/(P-MC). Therefore, an increase in
the price level will increase the denominator, which will decrease the Breakeven Quantity.
2. The higher the discount rates

a. the more value individuals place on future dollars [a higher discount rate means future
dollars are worth less relative to current dollars (present value of future dollars is lower)]
b. the more value individuals place on current dollars [correct; a higher discount rate
means dollars today are value comparatively more relative to future dollars]
c. the more investments will take place [the higher discount rate means the future value of
current dollars is lower, which may lead to an decrease in investment]
d. Does not affect the investment strategy [interest rates are an important consideration of any
investment strategy in terms of its impact on both the investing and borrowing rates]
3. Assume a firm has the following cost and revenue characteristics at its current level of output:
price=$10.00, average variable cost=$8.00 and average fixed cost =$4.00. This firm is
a. incurring a loss of $2.00 per unit and should shut down. [In the short run, only variable costs
are avoidable and should be considered in a shut down decision]
b. realizing only a normal profit. [In this case, the firm is not making a profit]
c. realizing an economic profit of $2.00 per unit. [In this case, the firm is not making a profit]
d. incurring a loss per unit of $2.00 but should continue to operate in the short run.
[correct; In the short run, only variable costs are avoidable and should be considered in a
shutdown decision. As the current price ($10) is still higher than the variable costs ($8), the
company should continue to operate in the short run until the fixed costs become avoidable]
4. Sarah’s Machinery Company is deciding to dump their current technology A for a new technology B
with smaller fixed costs but bigger marginal costs. The current technology has fixed costs of $500 and
marginal costs of $50 whereas the new technology has fixed costs of $250 and marginal costs of
$100. At what quantity is Sarah Machinery indifferent between two technologies?
a. 5 [correct; Total costs can be calculated as C=FC+VC(Q). Technology A has total costs of
C=500+50(Q), while Technology B has C=250+100(Q). Sarah is indifferent at the quantity at
which these two costs are the same. Therefore, setting these equations equal to each other
gives us 500+50(Q) = 250 +100(Q), which allows us to solve for Q = 5]
b. 6 [Total costs can be calculated as C=FC+VC(Q). Sarah will be indifferent between the two
technologies at the quantity where these two costs are the same]
c. 7 [Total costs can be calculated as C=FC+VC(Q). Sarah will be indifferent between the two
d. 8 [Total costs can be calculated as C=FC+VC(Q). Sarah will be indifferent between the two
5. What is the net present value of a project that requires a $100 investment today and returns $50 at
the end of the first year and $80 at the end of the second year? Assume a discount rate of 10%.
a. $10.52 [To find Net Present Value, discount the future cash flows by the discount rate raised
to the period in which it was received (for example, year one means k=1, etc) and then
subtract the initial investment from the sum of those cash flows]
b. $11.57 [correct; Net present value is calculated by discounting the future cash flows from
the period they were received and subtracting the initial investment from the sum of those
cash flows. In this case, (50/1.1)+(80/1.12)=111.57. $111.57-$100 initial investment gives a
NPV of $11.57]
c. $18.18 [Remember that the cash inflows need to be discounted back to present value from
the time period in which they occur (50 at the end of year 1, 80 at the end of year 2)]
d. $30.00 [Don’t forget about the time value of money. To determine the net present value, the
future cash flows will need to be discounted and the initial investment will be subtracted
from the sum of those values]
6. You expect to sell 500 cell phones a month, which have a marginal cost of $50. If your fixed costs are
$5,000 per month, what is the break-even price?
a. $10 [Breakeven Q= FC/(P-MC). This means (P-MC)Q=FC, so P-MC= (FC/Q) and finally P=
(FC/Q) – MC]
b. $50 [Breakeven Q= FC/(P-MC). This means (P-MC)Q=FC, so P-MC= (FC/Q) and finally P=
(FC/Q) – MC]
c. $60 [Breakeven Q= FC/(P-MC). This means (P-MC)Q=FC, so P-MC= (FC/Q) and finally P=
(FC/Q) – MC. This gives us P= (5000/500)+50 = 10+50 = $60]
d. $100[Breakeven Q= FC/(P-MC). This means (P-MC)Q=FC, so P-MC= (FC/Q) and finally P=
(FC/Q) – MC]
7. You are considering opening a new business to sell dartboards. You estimate that your
manufacturing equipment will cost $100,000, facility updates will cost $250,000, and on average it
will cost you $80 (in labor and material) to produce a board. If you can sell dart boards for $100
each, what is your break-even quantity?
a. 1,000 [Breakeven Q=FC/(P-MC). In this case, the Fixed costs include both the equipment and
the updates, the price is given at $100, and the MC equals the average cost per board]
b. 3,500 [Breakeven Q= FC/(P-MC). Don’t forget to consider the marginal costs!]
c. 4,375 [Breakeven Q= FC/(P-MC). Don’t forget to consider the price!]
d. 17,500 [correct; Breakeven Q = FC/(P-MC). In this case, fixed costs are $350,000 ($100,000
equipment + $250,000 updates), the Price is given as $100 and the Marginal cost is the $80
cost per additional board. Putting these in the formula, we see that 350,000/(100-80) =
17,500]
8. Which of the following is NOT true if a firm shuts down and produces zero output in the short run?
a. Variable costs will be zero. [This is true; variable costs relate directly to the amount of
output. With an output of zero, variable costs will also be zero]
b. Losses will be incurred. [This is true. Only variable costs are avoidable in the short run,
therefore the fixed costs will still be incurred even without any revenue produced which will
result in losses for the firm]
c. Fixed costs will be greater than zero. [This is true; only variable costs are avoidable in the
short run, which means the fixed costs will still be incurred]
d. Fixed costs will be less than zero. [correct; this is not true; fixed costs cannot be less than
zero]
9. What are some of the solutions for a hold-up problem?

a. Mergers [Mergers will help a hold-up problem by aligning the incentives of the two
organizations into one]
b. Contracts [When hold-up is anticipated, contracts can protect the potential victim]
c. Exchange of ‘hostages’ [The use of ‘hostages’ helps ensure both parties make appropriate
relationship specific investments, and provides either collateral or a means of escaping a
hold up situation]
d. All of the above [correct; all of these are potential solutions to hold up]
10. Which of the following is classified as a sunk cost?

a. Cost of the next best alternative [this is the definition of an opportunity cost]
b. Additional cost of producing an additional unit [this is the definition of a marginal cost]
c. Research costs to determine the implementation of a technology [correct; research is
often an example of a sunk cost as it is incurred before production and sale and cannot be
recovered regardless of what happens with the final product]
d. Total cost of producing a product [Production costs are more than likely not sunk, as they
tend to be impacted by output decisions]
Chapter 6
Multiple Choice Questions
1. Jim has estimated elasticity of demand for gasoline to be -0.7 in the short-run and -1.8 in the long run.
A decrease in taxes on gasoline would:
a. lower tax revenue in both the short and long run. [Demand is inelastic in the short run, but
elastic in the long run, indicating different effects in the short and long run from the price
reduction that results from lower taxes]
b. raise tax revenue in both the short and long run. [Demand is inelastic in the short run, but
c. raise tax revenue in the short run but lower tax revenue in the long run. [Inelastic demand in
the short run means people initially will not change their consumption habits, which will
lower tax run. What are the long term effects?]
d. lower tax revenue in the short run but raise tax revenue in the long run. [correct;
demand is inelastic in the short run, which means that initially the decrease in taxes will not
alter people’s demand or consumption for gas, which will result in a decrease in the potential
tax revenue as there is the same level of consumption at a lower price. However, in the long
tax revenue will increase as the demand for gasoline becomes elastic, and the consumption
of gasoline rises]
**NOTE of post-production change: the word “tax” should be removed from each of the multiple-
choice answers
a. lower revenue in both the short and long run. [Demand is inelastic in the short run, but
b. raise revenue in both the short and long run. [Demand is inelastic in the short run, but elastic
in the long run, indicating different effects in the short and long run from the price reduction
that results from lower taxes]
c. raise revenue in the short run but lower revenue in the long run. [Inelastic demand in the
short run means people initially will not change their consumption habits much, so revenue
will decrease. What are the long term effects?]
d. lower revenue in the short run but raise revenue in the long run. [correct; demand is
inelastic in the short run, meaning a price decrease will decrease revenue. However, in the
long revenue, demand is elastic so revenue will increase due to the price decrease]
2. Which one of the following is true?

a. Nike has a more inelastic demand curve than shoes [False; Demand for an individual brand is
more elastic than industry aggregate demand]
b. The demand curve for gas is more elastic in the short run than in the long run. [False; In the
long run, demand curves become more elastic]
c. Cigarettes have a more elastic demands than televisions [False; As price increases, demand
becomes more elastic].
d. Salt has a more inelastic demand than meat [correct; This is true, not only is salt less
expensive than meat (as price increases, price becomes more elastic), but salt also has many
complements (it is a staple in most households with every meal), which would indicate a less
elastic demand than meat]
3. Jim recently graduated from college. His income increased tremendously from earning $5000 a year
to $60,000 a year. Jim decided that instead of renting he will buy a house. This implies that
a. houses are normal goods for Jim [correct; for normal goods, demand increases as income
increases]
b. houses are inferior goods for Jim [for inferior goods, demand decreases as income increases]
c. renting and owning are complementary for Jim [Jim’s decision to purchase a house was not
reflective of a change in rental rates. If anything, renting and owning are substitutes for one
another]
d. need information on the price of houses. [Not necessarily, Jim’s behavior and purchasing
decision here is more informative than the actual housing prices]
4. Which of the following goods have a negative income elasticity of demand?

a. Cars [cars are a normal good; typically demand for cars increases with income]
b. Items from Dollar stores [correct; Dollar store items are typically considered inferior
goods, hence their demand will decrease as the income of the user increases]
c. Shoes [typically, shoes are considered a normal good, with demand increasing with the
income of the purchaser]
d. Bread [Bread, like most food is considered a normal good]
5. An economist estimated the cross-price elasticity for peanut butter and jelly to be +1.5. Based on this
information, we know the goods are
a. inferior goods. [Cross price elasticity measures the change in the demand of one good with
regard to the price of another in order to determine complements and substitutes. It does
not reflect if a good is normal or inferior]
b. complements. [Complements have negative cross price elasticity]
c. inelastic. [With a cross price elasticity of 1.5>1, this relationship is elastic]
d. substitutes. [correct; Positive cross price elasticity means that Good A (Peanut Butter) is a
substitute for Good B (Jelly)]
6. Christine has purchased five bananas and is considering the purchase of a sixth. It is likely she will
purchase the sixth banana if
a. the marginal value she gets from the sixth banana is lower than its price. [Christine will not
purchase an additional banana if the marginal value she receives is lower than her marginal
cost (the price of the additional banana)]
b. the marginal benefit of the sixth banana exceeds its price. [correct; Christine will only
purchase the banana when the marginal benefit she receives is greater than the marginal
cost (or price) of the additional banana]
c. the average value of the sixth bananas exceeds the price. [The marginal benefit, not the
average value/benefit of the sixth banana is what is important to consider for this decision]
d. the total personal value of six bananas exceeds the total expenditure to purchase six
bananas. [Total values should not impact the decision to purchase an additional banana.
Rather, the marginal benefit of the sixth banana relative to its cost should be considered]
7. Buyers consider Marlboro cigarettes and Budweiser beer to be complements. If Marlboro just
increased its prices, what would you expect to occur in the Budweiser market?
a. Demand would rise, and Budweiser would reduce price. [If two goods are complements, an
increase in the price of one results in a decrease in demand for the other]
b. Demand would fall, and Budweiser would reduce price. [correct; when two goods are
complements, an increase in the price of one results in a decrease in the demand for the
other. To account for this decrease in demand, Budweiser would ultimately lower its prices
as well]
c. Demand would fall, and Budweiser would increase price. [As complements, demand for
Budweiser would fall as a result of the increase in Marlboro prices. An increase in prices
would only further decrease demand]
d. Demand would rise, and Budweiser would increase supply. [If two goods are complements,
and increase in the price of one results in a decrease in the demand for the other]
8. Which of the following is the reason for the existence of consumer surplus?
a. Consumers can purchase goods that they “want” in addition to what they “need.” [Wants
and needs are both a reflection of how the consumer values an item, not necessarily an
indication of consumer surplus]
b. Consumers can occasionally purchase products for less than their production cost.
[Production cost is less relevant to creating consumer surplus than the amount of value a
consumer places on a final good (this could in fact be lower than the production cost as
well)]
c. Some consumers receive temporary discounts that result in below-market prices.
[Consumer surplus is a measure of the difference between the value a consumer places on an
item and the amount they ultimately pay for it. If a consumer only purchases an item because
of a discount, it indicates they likely value the item at the below-market price, so no surplus
is created]
d. Some consumers are willing to pay more than the market price. [correct; consumer
surplus exists when the Value to the consumer is greater than the final (or market) price. It
is when consumers pay market price for a good they place a higher value on that a consumer
surplus is created]
9. A bakery currently sells chocolate chip cookies at a price of $16 per dozen. The marginal cost per
dozen is $8. The cookies are becoming more popular with customers and so the bakery owner is
considering raising the price to $20/dozen. What percentage of customers must be maintained to
ensure that the price increase is profitable?
a. 28.0% [if the store only maintained 28% of its current customers, it would need to increase
its prices to $36!]
b. 33.3% [this is the number of customers the bakery can lose and still remain profitable]
c. 66.6% [correct; as the margin has increased from 8 (16-8) to 12(20-8), the bakery must
maintain 66.6% (8/12) of its customers in order to get the same level of profitability]
d. 72.0% [if the store maintained 72% of its current customers, it would only need to increase
its prices to $19]
10. A firm adopts a technology that allows you to increase your output by 15%. If the elasticity of
demand in the US is -3, how should you adjust your price if you want to sell all of your output?
a. 5% lower. [correct; %ΔQ= e(%ΔP). Therefore, an 15% increase in Q = -3(%ΔP), hence
%ΔP = -5%]
b. 0.5% lower. [Remember, %ΔQ= e(%ΔP)]
c. 15% higher. [Remember, %ΔQ= e(%ΔP)]

d. 15% lower. [Remember, %ΔQ= e(%ΔP)]
Chapter 7
1. Microsoft found that instead of producing a DVD player and a gaming system separately, it is cheaper
to incorporate DVD playing capabilities in its new version of the gaming system. Microsoft is taking
advantage of
a. economies of scale [economies of scale mean average costs decline with output. There is no
indication here that this is happening.]
b. learning curve [learning curves mean that current production lowers future costs for the
same product; that does not apply here]
c. economies of scope [correct; the cost to produce the two products together is less than the
sum of the costs of producing them separately]
d. decreasing marginal costs [there is no indication that marginal costs are decreasing for
either individual product]
2. As a golf club production company produces more clubs, the average total cost of each club produced
decreases. This is because:
a. total fixed costs are decreasing as more clubs are produced [fixed costs by definition do not
change with volume].
b. average variable cost is decreasing as more clubs are produced [there is no information to
indicate that variable costs are declining].
c. there are scale economies. [correct; declining average total costs are indicative of
economies of scale]
d. total variable cost is decreasing as more clubs are produced [because variable cost will not
be less than zero, total variable cost would not decrease as more units are produced]
3. Average costs curves initially fall

a. due to declining average fixed costs [correct; as output increases and fixed costs are
distributed over more units, average fixed costs per unit fall]
b. due to rising average fixed costs [average costs curves would increase if average fixed cost is
increasing]
c. due to declining accounting costs [accounting costs are not relevant here]
d. due to rising marginal costs [rising marginal costs would cause the average costs curve to
rise, not fall]
4. What might you reasonably expect of an industry in which firms tend to have economies of scale?
a. Exceptional competition among firms [economies of scale means average cost falls with
output; it does not necessarily imply a high level of competition]
b. A large number of firms [given the importance of volume in gaining economies of scale, we
would expect few firms, each with a large volume]
c. Highly diversified firms [given the importance of volume in gaining economies of scale, we
would expect a few firms that concentrate on building volume of individual products and
concentrate less on diversifying into other product areas]
d. A small number of firms [correct; a few firms with large volume could be expected to
capture the economies of scale]
5. A security system company’s total production costs depend on the number of systems produced
according to the following equation: Total Costs = $20,000,000 + $4000*quantity produced. Given
these data, which of the following is a false statement?
a. There are economies of scale. [this statement is true; average costs fall with output]
b. There are fixed costs associated with this business. [this statement is true; the $20,000,000
is a fixed cost]
c. There are diseconomies of scale [correct; if average costs increased with output, there
would be diseconomies. That is not the case here]
d. A firm that produces a larger output has a cost advantage over a smaller firm. [this
statement is true; because average costs decrease with output(economies of scale), firms
producing more will have lower average costs]
6. Following are the costs to produce Product A, Product B, and Products A and B together. Which of the
following exhibits economies of scope?
a. 100, 150, 240 [correct; the cost of producing both products together (240) is less than the
sum of the cost of producing them separately (250)]
b. 100, 150, 250 [the cost of producing both products together (250) is NOT less than the sum
of the cost of producing them separately (250)]
c. 100, 150, 260 [the cost to produce the two products together (260) is NOT less than the sum
of the costs of producing them separately(250)]
d. All of the above [only one of the choices exhibits economies of scope]
7. According to the law of diminishing marginal returns, marginal returns:

a. diminish always prior to increasing. [marginal returns do not always diminish prior to
increasing]
b. diminish constantly. [there are cases where marginal returns increase]
c. diminish never. [the law of diminishing marginal returns suggests some cases where returns
will diminish]diminish eventually. [correct; The law of diminishing marginal returns states
that as you try to expand output, your marginal productivity (the extra output associated
with extra inputs) eventually declines.]
8. It costs a firm $90 per unit to produce product A and $70 per unit to produce product B individually.
If the firm can produce both products together at $175 per unit of product A and B, this exhibits signs
of
a. economies of scale [economies of scale are not relevant here because the question refers to
the cost of producing two separate products, not more of the same product]
b. economies of scope [economies of scope indicate that the cost of producing the two products
together is less than the sum of the cost of producing them separately. This is not the case
here.]
c. diseconomies of scale [economies of scale are not relevant here because the question refers
to the cost of producing two separate products, not more of the same product]
d. diseconomies of scope [correct; the cost to produce the two products together (175) is more
than the sum of the costs of producing them separately(160)]
9. A company faces the following costs at the respective production level in addition to its fixed costs of
$50,000:
Quantity Marginal Cost Sale Price Marginal Return

1 $10,000 $20,000 $10,000
2 $11,000 $20,000 $9,000
3 $12,000 $20,000 $8,000
4 $13,000 $20,000 $7,000
5 $14,000 $20,000 $6,000
How would you describe the returns to scale for this company?
a. Increasing [correct; average total costs are falling with output]
b. Decreasing [average costs are falling with output, so returns are not decreasing]
c. Constant [average costs are falling with output, so returns are not constant]
d. Marginal [“marginal” returns to scale is not a meaningful phrase]
10. Once marginal cost rises above average cost,
a. Average costs will increase [correct; the cost to produce an additional unit of output will be
greater than the previous unit of output, which will increase average costs]
b. Average costs are unaffected [average costs will be affected]
c. Average costs will decrease [average costs will not decrease]
d. None of the above [one of the answers is correct because marginal and average costs are
related]
Chapter 8
1. Changes in prices of a good causes

a. movement along the demand curve [yes but this is not the only effect]
b. movement along the supply curve [yes but this is not the only effect]
c. no movement along either curve [changes in prices will result in movement along one or
more of these curves
d. Both a and b [correct; it causes movement along both curves]
2. If the market for a certain product experiences an increase in supply and a decrease in demand,
which of the following results is expected to occur?
a. Both the equilibrium price and the equilibrium quantity could rise or fall. [increase in supply
and decrease in demand both lead to a fall in price ]
b. The equilibrium price would rise, and the equilibrium quantity could rise or fall. [increase in
supply and decrease in demand both lead to a fall in price]
c. The equilibrium price would fall, and the equilibrium quantity could rise or fall. [correct;
increase in supply and decrease in demand both lead to lower price; net quantity change is
unknown because the increase in supply would lead to higher quantity while the decrease in
demand would lead to lower quantity]
d. The equilibrium price would fall, and the equilibrium quantity would fall. [net quantity
change is unknown because the increase in supply would lead to higher quantity while the
decrease in demand would lead to lower quantity]
3. When demand for a product falls, which of the following events would you NOT necessarily expect to
occur?
a. A decrease in the quantity of the product supplied. [equilibrium quantity will fall with a
decrease in demand]
b. A decrease in its price. [equilibrium price will fall with a decrease in demand]
c. A decrease in the supply of the product. [correct; while a decrease in demand will be
associated with a decrease in the quantity supplied at equilibrium, it will not cause a shift in
the supply curve]
d. A leftward shift of the demand curve. [falling demand means the demand curve shifts
leftward]
4. Suppose a recent and widely circulated medical article has reported new benefits of cycling for
exercise. Simultaneously, the price of the parts needed to make bikes falls. If the change in supply is
greater than the change in demand, the price will _________ and the quantity will _________.
a. rise, rise [demand will increase because of the article while supply will also increase because
of lower costs; if the supply shift (leading to lower prices) is greater than the change in
demand (leading to higher prices), the net effect should not be a rise in both price and
quantity]
b. rise, fall [demand will increase because of the article while supply also increases because of
lower costs; if the supply shift (leading to lower prices) is greater than the change in demand
(leading to higher prices), the net effect should not be a fall in quantity.]
c. fall, rise [correct; demand will increase because of the article while supply will also increase
because of lower costs; if the supply shift (leading to lower prices) is greater than the change
in demand (leading to higher prices), the net effect should be a fall in price while both shifts
lead to a rise in quantity]
d. fall, fall [demand will increase because of the article while supply will also increase because
of lower costs; if the supply shift (leading to lower prices) is greater than the change in
demand (leading to higher prices), the net effect should be a fall in price while both shifts
lead to a rise in quantity]
5. Suppose there are nine sellers and nine buyers in a competitive market, each willing to buy or sell
one unit of a good, with values {$10, $9, $8, $7, $6, $5, $4, $3, $2}. Assuming there are no transactions
costs, what is the equilibrium price in this market?
a. $5 [at a price of $5, four suppliers are willing to sell but six buyers are willing to buy]
b. $6 [correct; at a price of $6, five suppliers are willing to sell and five buyers are willing to
buy]
c. $7 [at a price of $7, six suppliers are willing to sell but four buyers are willing to buy]
d. $8 [at a price of $8, seven suppliers are willing to sell but three buyers are willing to buy]
6. If the government imposes a price floor at $9 (i.e., price must be $9 or higher) in the above market,
how many goods will be traded?
a. Five [at a price of $9, eight suppliers are willing to sell but only two buyers have values of $9
or more]
b. Four [at a price of $9, eight suppliers are willing to sell but only two buyers have values of $9
or more]
c. Three [at a price of $9, eight suppliers are willing to sell but only two buyers have values of
$9 or more]
d. Two [correct; at a price of $9, eight suppliers are willing to sell but only two buyers are
willing to buy]
7. Say the average price of a new home in Lampard City is $160,000. The local government has just
passed new licensing requirements for housing contractors. Based on possible shifts in demand or
supply and assuming that the licensing changes do not affect the quality of new houses, which of the
following is a reasonable prediction for the average price of a new home in the future?
a. $140,000 [the new licensing requirements lead to a reduction in supply, which will NOT lead
to a lower equilibrium price]
b. $150,000 [the new licensing requirements lead to a reduction in supply, which will NOT lead
to a lower equilibrium price]
c. $160,000 [the new licensing requirements lead to a reduction in supply, which will affect the
equilibrium price]
d. $170,000 [correct; the new licensing requirements lead to a reduction in supply, which will
lead to a higher equilibrium price]
8. Suppose a new employer is also re-locating to Lampard City and will be attracting many new people
who will want to buy new houses. Assume that the change in licensing requirements mentioned
above occurs at the same time. What do you think will happen to the equilibrium quantity of new
homes bought and sold in Lampard City?
a. It will decrease substantially [while quantity will decrease from the reduction in supply, the
demand increase will cause quantity to rise]
b. It will decrease but not by much [while quantity will decrease from the reduction in supply,
the demand increase will cause quantity to rise]
c. It will increase [while quantity will increase from the increase in demand, the supply
decrease will cause quantity to fall]
d. Not enough information [correct; the decrease in supply from the prior question will be
associated with a lower quantity while the increase in demand mentioned here will be
associated with higher quantity. Without knowing the magnitude of the shifts, it’s not
possible to know the net effect (there is not enough information).]
9. The price of peanuts increases. At the same time, we see the price of jelly rise. How does this affect
the market for peanut butter?
a. The demand curve will shift to the left; the supply curve will shift to the left [correct; the
price of peanuts leads to higher peanut butter production costs meaning supply will shift
left; a rise in the price of jelly, a complement to peanut butter, will cause peanut butter
demand to shift left]
b. The demand curve will shift to the left; the supply curve will shift to the right [the price of
peanuts leads to higher peanut butter production costs meaning supply will shift left]
c. The demand curve will shift to the right; the supply curve will shift to the left [a rise in the
price of jelly, a complement to peanut butter, will cause peanut butter demand to shift left]
d. The demand curve will shift to the right; the supply curve will shift to the right [the price of
peanuts leads to higher peanut butter production costs meaning supply will shift left; a rise
in the price of jelly, a complement to peanut butter, will cause peanut butter demand to shift
left]
10. Holding other factors constant, a decrease in the tax for producing coffee causes
a. the supply curve to shift to the left, causing the prices of coffee to rise [a decrease in tax
lowers coffee production costs, leading to an increase (shift right) in supply]
b. the supply curve to shift to the right, causing the prices of coffee to rise [an shift right in
supply means price will fall]
c. the supply curve to shift to the left, causing the prices of coffee to fall [a decrease in tax
lowers coffee production costs, leading to an increase (shift right) in supply]
d. the supply curve to shift to the right, causing the prices of coffee to fall [correct; a decrease
in tax lowers coffee production costs, leading to an increase (shift right) in supply which
means price will fall]
Chapter 9
1. In the long-run, which of the following outcomes is most likely for a firm?
a. Zero accounting profits but positive economic profits [ firms do not earn positive economic
profit in the long-run]
b. Zero accounting profits [zero accounting profit implies negative economic profit, and firms
do not earn negative economic profit in the long-run]
c. Positive accounting profits and positive economic profits [ firms do not earn positive
economic profit in the long-run]
d. Zero economic profits but positive accounting profits [correct; in the long-run economic
profit is driven to zero]
2. At the individual firm level, which of the following types of firms faces a downward-sloping demand
curve?
a. Both a perfectly competitive firm and a monopoly firm [the demand curve for the output of a
perfectly competitive firm is flat]
b. Neither a perfectly competitive firm nor a monopoly firm [one of the two types does face a
downward-sloping demand curve]
c. A perfectly competitive firm but not a monopoly firm [the demand curve for the output of a
perfectly competitive firm is flat]
d. A monopoly firm but not a perfectly competitive firm [correct; monopoly firms face a
downward-sloping demand curve]
3. Which of the following types of firms are guaranteed to make positive economic profit?
a. Both a perfectly competitive firm and a monopoly [in the long-run, economic profit for both
types of firms will be zero]
b. Neither a perfectly competitive firm nor a monopoly [correct; no firm is guaranteed to make
positive economic profit]
c. A perfectly competitive firm but not a monopoly [in the long-run, economic profit for
competitive firms will be zero]
d. A monopoly but not a perfectly competitive firm [in the long-run, economic profit for
monopoly firms will be zero]
4. What is the main difference between a competitive firm and a monopoly firm?
a. The number of customers served by the firm [competitive firms and monopoly firms may or
may not have similar numbers of customers]
b. Monopoly firms are more efficient and therefore have lower costs. [monopoly firms may or
may not have lower costs]
c. Monopoly firms can generally earn positive profits over a longer period of time. [correct;
this profit is a reward for doing something unique, innovative, or creative—something that
gives the firm less elastic demand.]
d. Monopoly firms enjoy government protection from competition. [not necessarily; other
factors can contribute to the lack of rivals]
5. Which of the products below is closest to operating in a perfectly competitive industry?

a. Nike shoes [branding of the shoes reduces the “closeness” of substitute products]
b. Cotton [correct; agricultural commodities are close to perfectly competitive industries]
c. Perdue Chicken [branding of the chicken reduces the “closeness” of substitute products]
d. Restaurants [branding and other differentiation efforts reduce the “closeness” of substitute
restaurants]
6. A firm in a perfectly competitive market (a price taker) faces what type of demand curve?
a. Unit elastic [a unit elastic demand curve is downward sloping; firms in perfectly competitive
markets do not face unit elastic or downward sloping demand curves]
b. Perfectly inelastic [demand is not inelastic for competitive firms]
c. Perfectly elastic [correct; the demand curve for the output of a perfectly competitive firm is
perfectly elastic (flat)]
d. None of the above [one of the answers is correct]
7. A competitive firm’s profit maximizing price is $15. At MC=MR, the output is 100 units. At this level of
production, average total costs are $12. The firm’s profits are
a. $300 in the short run and long run [long-run profit will be driven down to zero]
b. $300 in the short-run and zero in the long run [correct; (15-12)*100. Long run profit is
always driven to zero.]
c. $500 in the short-run and long-run [short-run profit will be price minus average cost times
quantity; long-run profit will be driven down to zero]
d. $500 in the short-run and zero in the long run [short-run profit will be price minus average
cost times quantity]
8. What would happen to revenues if a firm in a perfectly competitive industry raised prices?
a. They would increase [a competitive firm can only sell at the industry price]
b. They would increase but profit would decrease [a competitive firm can only sell at the
industry price]
c. They would increase along with profit [a competitive firm can only sell at the industry price]
d. They would fall to zero [correct; a competitive firm can only sell at the industry price. If the
firm raises price, it would sell nothing]
9. If a firm in a perfectly competitive industry is experiencing average revenues greater than average
costs, in the long-run
a. some firms will leave the industry and price will rise [firms are unlikely to leave if revenues
are greater than costs]
b. some firms will enter the industry and price will rise [price is unlikely to increase if firms
enter the industry]
c. some firms will leave the industry and price will fall [firms are unlikely to leave if revenues
are greater than costs; if they did leave, price would not fall]
d. some firms will enter the industry and price will fall [correct; firms will be attracted to the
higher-than-average revenues. As more firms enter the industry, supply will increase and
price will fall.]
10. A sudden decrease in the market demand in a competitive industry leads to

a. losses in the short-run and average profits in the long-run [correct]
b. above average profits in the short-run and average profits in the long-run [a decrease in
demand would lead to lower prices]
c. new firms being attracted to the industry [a decrease in demand would lead to lower prices;
lower prices would not attract new firms to the industry
d. demand creating supply [demand does not create supply]
Chapter 10
1. An industry is defined as
a. a group of firms producing the exact same products and services. [the products are not
necessarily exactly the same]
b. firms producing items that sell through the same distribution channels. [products within an
industry may be sold through different distribution channels]
c. firms that have the same resources and capabilities. [firms within an industry may have
different resources and capabilities]
d. a group of firms producing products that are close substitutes. [correct]
2. Attractive industries have all the following, except

a. high supplier power [correct; high supplier power would allow suppliers to capture more of
the industry value]
b. low buyer power [low buyer power is positive for an industry; it means buyers capture less
value]
c. high entry barriers [high entry barriers help protect the industry from the threat of potential
entrants]
d. low rivalry [low rivalry is positive for an industry; firms do not compete as aggressively]
3. Which of the following is NOT an example of an entry barrier?

a. Government protection through patents or licensing requirements [patents and licensing do
slow entry into an industry]
b. Strong brands [brands help deter entry because potential entrants will have to invest capital
and time to build a competing brand]
c. Low capital requirements for entry [correct; if capital requirements are low, it will be less
costly (easier) to enter]
d. Lower costs driven by economies of scale [this is an entry barrier as potential entrants know
they will not be cost-competitive unless they can achieve scale]
4. Buyers have higher power when

a. their suppliers sell a highly differentiated product. [highly differentiated products mean
buyers have lower power because it is more costly to switch to a rival product]
b. they are not a significant purchaser of their supplier's output. [purchasing a large volume of
a particular supplier’s output leads to higher negotiating power]
c. switching costs are low. [correct; low switching costs put buyers in a better negotiating
position because it is easier to buy a rival’s product]
d. the buyer industry is highly fragmented (buyers are not concentrated) [fragmented buyers
do not have more negotiating power].
5. Which of the following is NOT a factor that contributes to higher rivalry in an industry?
a. Numerous competitors. [more competitors generally leads to greater rivalry as cooperative
outcomes are hard to achieve with many competitors]
b. High fixed costs. [high fixed costs are associated with higher rivalry; when fixed costs are
high and marginal costs are low, there is pressure to cut price to build volume in order to
make some contribution to covering fixed costs]
c. Fast industry growth. [correct; high growth reduces rivalry because firms are less worried
about fighting over existing sources of demand given that demand is growing]
d. Low switching costs for buyers. [low switching costs means firms have a high incentive to
compete for buyers to get them to switch]
6. The concept that describes firms possessing different bundles of resources is

a. resource heterogeneity [correct]
b. resource immobility [resource immobility describes the fact that resources resist transfer or
copying]
c. barriers to entry [barriers to entry are factors that reduce threat of entry to an industry]
d. imitability [imitability refers to whether a resource can be copied]
7. If a firm successfully adopts a product differentiation strategy, the elasticity of demand for its
products should
a. increase [increased elasticity means buyers would be more price sensitive; if the product is
successfully differentiated, buyers should become less price sensitive]
b. decrease [correct; decreased elasticity means buyers would be less price sensitive. If the
product is more differentiated, buyers should be less price sensitive.]
c. become marginal [marginal is not a term used to describe demand elasticity]
d. be unaffected [elasticity should be affected]
8. When a resource or capability is valuable and rare, a firm may gain a

a. sustainable competitive advantage. [the resource or capability must also be difficult to
imitate / substitute for the competitive advantage to be sustainable]
b. competitive parity. [a valuable and rare resource or capability should help the firm do better
than just achieve parity]
c. cost advantage. [not necessarily; the advantage might be related to differentiation]
d. temporary competitive advantage. [correct; valuable and rare resources lead to a temporary
competitive advantage]
9. Which of the following is critical for a firm adopting a long-term cost-reduction strategy?
a. The firm must also differentiate its product or service. [the firm does not necessarily have to
differentiate too]
b. The strategy reduces costs by at least 10%. [a cost advantage of less than 10% is still
meaningful]
c. The strategy is focused on reducing internal production costs. [the strategy could be focused
on some other type of cost and still be successful]
d. The methods of achieving cost reductions are difficult to imitate. [correct; for the advantage
to be sustainable, it must be difficult for rivals to imitate]
10. When a resource or capability is valuable, rare, hard to imitate, and non-substitutable firms may gain
a. a temporary competitive advantage. [the advantage should be more than just temporary]
b. a complex competitive advantage. [“complex” is not a word used to describe the nature of
competitive advantage]
c. competitive parity. [a resource or capability that is valuable, rare, hard to imitate, and non-
substitutable should help the firm do better than just achieve parity]
d. a sustainable competitive advantage. [correct]
Chapter 11
1. The intersection between demand for dollars and the supply of dollars is known as
a. Inflation rate [the inflation rate is the rate that reflects the aggregate increase in price level]
b. Exchange rate [correct; the exchange rate reflects the price point at which demand for
dollars (those who want to buy dollars and sell the foreign currency) and supply of foreign
exchange (those who want to sell dollars and buy the foreign currency) intersect]
c. Price of US goods and services[Here “price” is the exchange rate]
d. Quantity of US goods and services [quantity indicates the amount of dollars traded for the
foreign currency in the market for foreign exchange.]
2. An individual in the US wants to buy office equipment from England that costs 2,800 pounds. If the
exchange rate is $1.92/pound, how much will it cost him in dollar terms?
a. $2,800 [This is what the cost would be if the currencies were equal, in other words if $1 = 1
pound]
b. $5,376 [correct; If 1 pound = $1.92, then to purchase 2800 pounds worth of goods, you
would need 2800*1.92 = $5,736]
c. $1,458 [If 1 pound = $1.92, then you would need more than 2800 dollars to purchase
equipment costing 2800 pounds. Think of it as if every pound is costing you $1.92]
d. Need more information [There is enough information provided to answer the question]
3. If the Chinese yuan devalues relative to the US dollar, then

a. US producers will benefit; Chinese consumers will benefit [A currency devaluation helps
domestic firms by increasing demand but hurts domestic consumers by increasing domestic
price. It also hurts foreign firms by decreasing demand but helps foreign consumers by
decreasing price.]
b. US producers will benefit; Chinese consumers will hurt [A currency devaluation helps
decreasing price.]
c. US producers will be hurt; Chinese consumers will benefit [A currency devaluation helps
decreasing price.]
d. US producers will be hurt; Chinese consumers will be hurt [Correct: A currency
devaluation helps domestic firms by increasing demand but hurts domestic consumers by
increasing domestic price. It also hurts foreign firms by decreasing demand but helps
foreign consumers by decreasing price.]
4. Following a peso appreciation relative to the dollar, which of the following results is expected to
occur?
a. Prices in the United States would rise, and prices in Mexico would rise. [Since it takes fewer
pesos for Mexicans to buy US goods and services, the peso appreciation increases demand
for US goods and services. The depreciation also means that it takes more dollars for US
consumers to buy Mexican goods and so decreases demand for Mexican goods and services.
The former would increase prices for US goods and services, and the latter would decrease
prices for Mexican goods and services]
b. Prices in the United States would rise, and prices in Mexico would fall. [Correct: Since
it takes fewer pesos for Mexicans to buy US goods and services, the peso appreciation
increases demand for US goods and services. The depreciation also means that it takes more
dollars for US consumers to buy Mexican goods and so decreases demand for Mexican goods
and services. The former would increase prices for US goods and services, and the latter
would decrease prices for Mexican goods and services]
c. Prices in the United States would fall, and prices in Mexico would rise. [Since it takes fewer
d. Prices in the United States would fall, and prices in Mexico would fall. [Since it takes fewer
5. Following a peso appreciation relative to the dollar, which of the following results is expected to
occur?
a. U.S. consumers would benefit, and Mexican producers would benefit. [A currency
b. U.S. consumers would be hurt, and Mexican producers would benefit. [A currency
c. U.S. consumers would benefit, and Mexican producers would be hurt. [A currency
d. U.S. consumers would be hurt, and Mexican producers would be hurt. [correct; A
currency devaluation helps domestic firms by increasing demand but hurts domestic
consumers by increasing domestic price. It also hurts foreign firms by decreasing demand
but helps foreign consumers by decreasing price.]
6. Following an increase in Mexican interest rates relative to U.S. interest rates, which caused Mexican
investors to borrow abroad to invest domestically, which of the following is expected to occur?
a. The dollar would appreciate relative to the peso, and Mexican prices would increase. [An
increase in foreign borrowing means that Mexicans are borrowing dollars in the US, and then
selling those dollars to buy pesos, which is an increase the supply of dollars in the market for
foreign exchange. This decreases the price of a dollar measured in the foreign currency, also
called a dollar depreciation. The dollar depreciation also means that it takes more dollars
for US consumers to buy Mexican goods and services and so decreases demand for Mexican
goods and services, which results in a decline in prices for Mexican goods and services.]
b. The dollar would appreciate relative to the peso, and Mexican prices would decrease. [An
c. The dollar would depreciate relative to the peso, and Mexican prices would increase. [An
d. The dollar would depreciate relative to the peso, and Mexican prices would decrease.
[An increase in foreign borrowing means that Mexicans are borrowing dollars in the US, and
then selling those dollars to buy pesos, which is an increase the supply of dollars in the
market for foreign exchange. This decreases the price of a dollar measured in the foreign
currency, also called a dollar depreciation. The dollar depreciation also means that it takes
more dollars for US consumers to buy Mexican goods and services and so decreases demand
for Mexican goods and services, which results in a decline in prices for Mexican goods and
services.]
7. Following an increase in Mexican interest rates relative to U.S. interest rates, which caused Mexican
investors to borrow abroad to invest abroad, which of the following would occur?
a. The dollar would appreciate relative to the peso, and Mexican prices would increase. [this
foreign borrowing only impacts the exchange rate when those borrowed funds are then
resold to purchase foreign currency (the peso) for use in Mexican domestic investment]
b. The dollar would depreciate relative to the peso, and Mexican prices would decrease. . [this
c. The dollar would depreciate relative to the peso, and Mexican prices would increase. . [this
d. The exchange rate would not be affected, and neither would Mexican prices. [correct;
the exchange rate is only affected when the borrowed funds are then resold and used to
purchase foreign currency. If they continue to invest abroad, then exchange rate and foreign
prices would not be affected]
8. In July 2014 the price of a Big Mac was $4.80 in the U.S. while in China it was only $2.73 at market
exchange rates. So the "raw" Big Mac index says that the yuan was undervalued by 43% at that time.
How would domestic inflation in China affect the Big Mac Index?
a. The Big Mac Index would indicate that the Chinese currency is less under-valued.
[Correct: If domestic inflation increased the Chinese price of a Big Mac to say, $4.80, then the
Big Mac Index would say that the Chinese yuan and the dollar were in long run equilibrium,
or that the yuan is less undervalued.]
b. The Big Mac Index would indicate that the Chinese currency is more under-valued [If
domestic inflation increased the Chinese price of a Big Mac to say, $4.80, then the Big Mac
Index would say that the Chinese yuan and the dollar were in long run equilibrium, or that
the yuan is less undervalued, not more.]
c. The Big Mac Index is not affected by domestic inflation. [Domestic inflation would affect the
price in yuan of the Big Mac in China, which would affect the value of the index.]
d. The Big Mac Index would indicate that the Dollar is more under-valued. [The July 2014
index indicates that the dollar is over-valued; increases in the price in China would reduce
not increase the indicated dollar over-valuation.]
9. If the U.S. economy strengthens, consumer income increase, and consumers buy more imported
goods and services. How will this affect exchange rates?
a. The dollar will appreciate relative to the yuan, and U.S. prices will increase. [To buy imports,
US consumers have to exchange more dollars for yuan. This increase in the supply of dollars
in the market for foreign exchange reduces the “price” of a dollar measured in yuan, which is
a dollar depreciation.]
b. The dollar will appreciate relative to the yuan, and U.S. prices will decrease. [To buy
imports, US consumers have to exchange more dollars for yuan. This increase in the supply
of dollars in the market for foreign exchange reduces the “price” of a dollar measured in
yuan, which is a dollar depreciation.]
c. The dollar will depreciate relative to the yuan, and U.S. prices will increase. [Correct:
To buy imports, US consumers have to exchange more dollars for yuan. This increase in the
supply of dollars in the market for foreign exchange reduces the “price” of a dollar measured
in yuan, which is a dollar depreciation.]
d. The dollar will depreciate relative to the yuan, and U.S. prices will decrease. [To buy imports,
US consumers have to exchange more dollars for yuan. This increase in the supply of dollars
in the market for foreign exchange reduces the “price” of a dollar measured in yuan, which is
a dollar depreciation.]
10. If buyers expect future price increases, they will ___________ their purchases to avoid it. Similarly,
sellers will __________ selling to take advantage of it.
a. Accelerate; accelerate [buyers, anticipating the price increase, will accelerate their
purchasing, hoping to pay less now, while sellers will delay purchasing, hoping to receive a
higher price for the same good in the future.]
b. Accelerate; delay [correct; buyers, anticipating the price increase, will accelerate their
purchasing, hoping to pay less now, while sellers will delay purchasing, hoping to receive a
higher price for the same good in the future.]
c. Delay; accelerate [buyers, anticipating the price increase, will accelerate their purchasing,
hoping to pay less now, while sellers will delay purchasing, hoping to receive a higher price
for the same good in the future.]
d. Delay; delay [buyers, anticipating the price increase, will accelerate their purchasing, hoping
to pay less now, while sellers will delay purchasing, hoping to receive a higher price for the
same good in the future.]
Chapter 12
1. After massive promotion of Justin Bieber’s latest music album, the producers reacted by raising
prices for his albums. This implies that promotion expenditures made the album demand
a. more elastic. [When demand becomes more elastic, the right response is to reduce price.]
b. unitary elastic. [The question does not indicate any specific level of elasticity, only that it
changed as a result of the promotion.]
c. change due to psychological pricing. [This may or not be true, but the question is how does
promotion expenditure changes demand elasticity.]
d. less elastic. [correct; when promotion makes demand less elastic, the right response is to
increase price.]
2. All of the following choices are examples of promoting a firm’s product, except
a. celebrity endorsements. [This is a common component of product promotion.]
b. pricing [correct; pricing often responds to changes in demand brought about by
promotions]
c. discount coupons. [These are a form of promotion designed to focus consumers on prices.]
d. end-of-aisle displays. [These are a form of promotion designed to focus consumers on
prices.]
3. A firm that acquires a substitute product can try and reduce cannibalization by
a. doing nothing. [The prices charged prior to acquiring a substitute would no longer be
optimal.]
b. repositioning a product so that it does not directly compete with the substitute. [correct; If
consumers do not perceive the products as substitutes, then cannibalization is reduced.]
c. setting the same price on both products. [Substitute products usually have different prices
(e.g., a manual and electric saw).]
d. lowering prices on the low-margin products. [This is the opposite of the appropriate price
response to acquiring a substitute product.]
4. A shoe-producing firm decides to acquire a firm that produces shoe laces. This implies that the firm’s
aggregate demand (shoes + laces) will be:
a. less elastic than the individual demands. [Aggregate demand of substitutes is less elastic
than the individual demands. However, shoes and laces are likely complements.]
b. more elastic than the individual demands. [correct; shoes and laces are complements and
aggregate demand of complements is more elastic than the individual demands.]
c. equally elastic as the individual demands. [shoes and laces are complements, and therefore
the aggregate demand is not equal to the individual demands.]
d. None of the above [common ownership of complements changes the elasticity of aggregate
demand]
5. After firm A producing one good acquired another firm B producing another good, it raised the prices
for both goods. One can conclude that the goods were
a. substitutes. [correct; to prevent cannibalization, raise price on both goods after acquiring a
substitute.]
b. complements. [when acquiring a complement, prices on both goods should be lowered, not
raised.]
c. not related. [when goods are unrelated, common ownership does not affect the optimal
price.]
d. None of the above [one of the answers is correct.]
6. Firms tend to raise the price of their goods after acquiring a firm that sells a substitute good because
a. they lose market power. [a loss of market power generally leads to lower prices]
b. there is an increase in the overall demand for their products. [whether or not demand
increases, firms still raise prices after acquiring a substitute good.]
c. the bundle has a more elastic demand than individual goods. [when demand becomes more
elastic, the correct response is to lower prices.]
d. the bundle has a less elastic demand than individual goods. [correct; the aggregate demand
for substitute products is less elastic than the individual demands.]
7. For products like parking lots and hotels, costs of building capacity are mostly fixed or sunk and
firms in this industry typically face capacity constraints. Therefore,
a. if SRMR>SRMC at capacity, then the firms should price to fill capacity. [correct; when
MR>MC, it is optimal to reduce price to sell more, but one cannot sell more than capacity
allows.]
b. if SRMR<SRMC at capacity, then the firms should price to fill capacity. [when MR<MC, you
are losing money and should increase price and sell less.]
c. if LRMR>LRMC at capacity, then the firms should price to fill capacity. [long run costs and
benefits help determine how much capacity to build, but not how to price once it is built.]
d. if LRMR<LRMC at capacity, then the firms should price to fill capacity. [long run costs and
benefits help determine how much capacity to build, but not how to price once it is built.]
8. A firm started advertising its product and this changed the product’s elasticity from -2 to -1.5. The
firm should
a. raise price from $10 to $15. [correct; using the formula (P-MC)/P=1/|e|, prices rise by
50%.]
b. reduce price from $15 to $10. [since demand became less elastic, price should increase, not
decrease.]
c. raise price from $7.5 to $10. [using the formula (P-MC)/P=1/|e| would indicate that prices
would have to rise by more than 33% following the change in elasticity.]
d. reduce price from $10 to $7.5. [since demand became less elastic, price should increase, not
decrease.]
9. After running a promotional campaign, the owners of a local shoe store decided to decrease the
prices for the shoes sold in their store. One can infer that
a. the promotional expenditures made the demand for their shoes more elastic. [correct;
promotional activity that makes demand more elastic should be accompanied by a decrease
in price.]
b. the promotional expenditures made the demand for their shoes less elastic. [When demand
becomes less elastic, the appropriate response is to increase price.]
c. the promotional expenditures had no effect on the shoe demand elasticity. [If elasticity had
not changed, then there would have been no reason to decrease prices.]
d. the owners got it wrong. To cover the promotional expenses, they should have raised the
prices. [promotional expenses are a fixed cost and do not directly impact the price except by
changing the elasticity of demand.]
10. On average, if demand is unknown and costs of underpricing are _______ than the costs of overpricing,
then _________.
a. smaller; overprice [if the costs of underpricing are smaller, then one should not overprice.]
b. smaller; underprice [correct; since the costs of underpricing are smaller, one should
underprice.]
c. larger; underprice [since the costs of underpricing are larger, one should avoid
underpricing.]
d. None of the above [one of the above combinations is correct.]
Chapter 14 (and 13)
1. A software firm can offer a high-feature version of its software or a stripped down low-feature
version, each with similar production costs. Which of the following cannot be an optimal
segmentation strategy?
a. Offer only the high-feature version aimed only at a high-value market segment. [This can be
an optimal strategy if the risk of cannibalization is too great.]
b. Offer only the low-feature version aimed at all market segments. [correct; this is not an
optimal strategy, as the high-feature version has the same production costs but can likely be
sold at a higher price.]
c. Offer both versions targeted to different value segments. [This is a common form of indirect
price discrimination.]
d. Offer only the high-feature version aimed at all market segments. [This can be an optimal
strategy if the risk of cannibalization is too great.]
2. Which of the following conditions must be satisfied by a successful price discrimination scheme?
a. The seller must have a different product for each group of customers. [This is generally true
for indirect price discrimination, but direct price discrimination schemes may charge
different prices for the same product.]
b. The seller must be able to identify each customer as having a high or low value. [Indirect
price discrimination schemes like versioning can work even if the seller does not the value of
each customer.]
c. The seller must be able to prevent arbitrage between the two groups. [When offering
different versions of products aimed at different market segments, arbitrage is not an issue.]
d. None of the above [correct; Each of the above is necessary for a direct price discrimination
scheme, but is not necessary for indirect price discrimination.]
3. Perfect price discrimination is when a firm can charge each customer exactly what they are willing to
pay. In this case,
a. the demand curve is very inelastic. [successful price discrimination does not depend on the
elasticity of demand.]
b. the marginal revenue is the demand curve [correct; the revenue from each consumer is
equal to each consumer’s willingness to pay, which is given by the demand curve.]
c. the demand curve is very elastic. [successful price discrimination does not depend on the
elasticity of demand.]
d. the marginal cost curve is the average cost curve. [nothing in the problem suggests this. Price
discrimination can occur for different cost structures.]
Use the following table to answer questions 4 – 6. Assume the cost of producing the goods is zero and that
each consumer will purchase each good as long as the price is less than or equal to value. Consumer values
are entries in the table.
Consumer A Consumer B
$2,300 $2,800
Good 1
$1,700 $1,200
Good 2
4. Suppose a monopolist only sold the goods separately. What price will the monopolist charge for Good
1 to maximize revenues for good 1?
a. $2,300 [correct; this is more profitable than selling a single unit at $2,800.]
b. $2,800 [at this price, the monopolist would sell only one unit to Consumer B.]
c. $1,200 [this is not either consumer’s value of good 1.]
d. $1,700 [this is not either consumer’s value of good 1.]
5. What is the total profit to the monopolist from selling the goods separately?
a. $4,500 [the monopolist could increase profit by selling more than one unit of each good.]
b. $6,300 [the monopolist could increase profit by selling more than one unit of good 2.]
c. $7,000 [correct; the monopolist maximizes profit by selling each good to each consumer.]
d. $6,200 [the monopolist can earn higher profit by setting prices optimally.]
6. What is a better pricing strategy for the monopolist? What is the resulting profit?
a. Bundle the goods at $2,800; Profits=$5,600 [Both consumers value the bundle at more than
$2,8000.]
b. Bundle the goods at $4,000; Profits=$8,000 [correct; this charges both consumers exactly
what each is willing to pay for the bundle.]
c. Charge $2,800 for good 1 and charge $1,700 for good 2; Profits=$4,500 [bundling the two
goods can increase profit in this case.]
d. Charge $2,300 for good 1 and charge $1,200 for good 2; Profits = $7,000 [this is the
maximum profit from selling the two goods separately but bundling the two goods can
increase profit in this case.]
7. Assume that the price elasticity of demand for movie theatres is -.85 during all evening shows but for
all afternoon shows the price elasticity of demand is -2.28. For the theatre to maximize total revenue,
it should
a. charge the same price for both shows, holding other things constant. [Since the two shows
have very different elasticities of demand, they have different profit-maximizing prices.]
b. charge a higher price for the afternoon shows and lower price for the evening shows, holding
other things constant. [prices should be lower when demand is more elastic.]
c. charge a lower price for the afternoon shows and higher price for the evening shows, holding
other things constant . [correct; prices should be lower when demand is more elastic.]
d. Need more information [there is sufficient information as prices vary with elasticity of
demand.]
8. Arbitrage
a. Is the act of buying low in one market and selling high in another market. [this is the
definition of arbitrage, but is not the only correct answer.]
b. Can force a seller to go back to uniform pricing. [arbitrage can lead a seller to abandon price
discrimination, but this is not the only correct answer.]
c. Can defeat direct price discrimination. [arbitrage can allow high-value consumers to
purchase from low-value consumers, defeating the firm’s price discrimination. This is not the
only correct answer.]
d. All of the above [correct; the above both define arbitrage and identify its effects.]
9. Airlines charge a ____________ price to business travelers compared to leisure travelers because
business travelers have a ____________ demand than leisure travelers.
a. higher; more elastic [customers with more elastic demand should be charged a lower price.]
b. higher; less elastic [correct; customers with less elastic demand should be charged a higher
price].
c. lower; more elastic [business travelers generally pay a higher price than leisure travelers]
d. lower; less elastic [business travelers generally pay a higher price than leisure travelers]
10. Metering is
a. A type of indirect price discrimination [correct; metering identifies high-value customers by
the intensity of their use of a related product such as paper for printers.]
b. A type of direct price discrimination [direct price discrimination requires identifying the
value of each individual consumer.]
c. An evaluation of a product [metering is a type of price discrimination that identifies high-
value customers by how intensely they use a product.]
d. An example of bundling [metering allows the purchase of individual products but identifies
high-value customers by how many of them they buy.]
Chapter 15
1. The prisoners’ dilemma is an example of:
a. a sequential game [players in a prisoners’ dilemma do not observe the decisions of their
rivals prior to acting.]
b. a simultaneous game. [correct; players do not observe their rival’s decision before making
their own.]
c. a shirking game [a shirking game does not have a pure strategy equilibrium, but the
prisoners’ dilemma does.]
d. a dating game [the dating game also has the tension between conflict and cooperation that
the prisoners’ dilemma has, but the two games are different.]
2. Nash equilibrium is:

a. is where one player maximizes his payoff and the other doesn’t. [it is possible for both
players to be maximizing their payoffs or for neither to be, as in the prisoners’ dilemma.]
b. is where each player maximizes his own payoff given the action of the other player. [correct;
this is the definition of an equilibrium; each player is playing a best response to the other
player.]
c. is where both players are maximizing their total payoff. [games like the prisoners’ dilemma
show that players need not be maximizing their total payoff in equilibrium.]
d. Is a unique prediction of the likely outcome of a game. [some games, like the game of
chicken, have more than one equilibrium.]
Use the following to answer question 3- 5
Consider the following information for a simultaneous-move game: two discount stores (megastore and
superstore) are interested in expanding their market share through advertising. The table below depicts
the profits of both stores with and without advertising. Payoffs for Megastore are in bold.
Superstore
Don’t
Advertise Advertise
Advertise $95, $80 $305, $55

Megastore
Don’t $165, $115
$65, $285
Advertise
3. The Nash equilibrium is

a. For Megastore to advertise and for Superstore to advertise. [correct; advertise is a dominant
strategy for each player.]
b. For Megastore to advertise and for Superstore not to advertise. [If Megastore advertises,
Superstore’s best response is to advertise.]
c. For Megastore not to advertise and for Superstore to advertise. [If Superstore advertises,
Megastore’s best response is to advertise.]
d. For Megastore not to advertise and for Superstore not to advertise. [If either store does not
advertise, the best response for the other store is to advertise.]
4. When the stores reach the Nash equilibrium, their profits will be
a. Megastore $95 and Superstore $80. [correct; the equilibrium is for both stores to advertise.]
b. Megastore $305 and Superstore $55. [Superstore is not best responding to Megastore.]
c. Megastore $65 and Superstore $285. [Megastore is not best responding to Superstore.]
d. Megastore $165 and Superstore $115. [Neither store is best responding to its rival’s
strategy].
5. If collusion were not illegal, then it would be optimal

a. for Megastore to advertise and for Superstore to advertise. [This does not maximize firms’
profits individually or jointly.]
b. for Megastore to advertise and for Superstore not to advertise. [correct; This maximizes
joint profit.]
c. for Megastore not to advertise and for Superstore to advertise. [This does not maximize joint
profit.]
d. for Megastore not to advertise and for Superstore not to advertise. [This is reasonable as
each is earning higher profit than it would in equilibrium. However, if firms could reallocate
profits or take turns, this does not maximize their joint profit.]
6. In a Nash equilibrium,
a. players are always maximizing their joint profit. [many games, such as the prisoners’
dilemma, reflect a tension between cooperation and conflict.]
b. one player is always earning a higher profit than the other. [Nash equilibria do not say
anything about the relative profits of the two players.]
c. players must be playing the game sequentially. [simultaneous games also have Nash
equilibria.]
d. None of the above [correct; none of the above answers is correct.]
7. In repeated games, all of the following make it easier to get out of bad situations except
a. be nice, no first strikes. [you should cooperate as long as the other player does.]
b. respond immediately to rivals. [you should be easily provoked and respond immediately to
defection.]
c. punish uncooperative players as much as you can. [correct; this is bad advice. Instead, you
should be forgiving and punish just enough to deter uncooperative behavior.]
d. make sure your competitors can easily interpret your actions. [being clear means that your
actions are understood by other players.]
Refer to the following strategic form game of price competition for questions 8 and 9.
Firm B
High Price
Low Price
Low 0, 0 50, -10

Price
Firm A
High -10, 50 25, 25
Price
8. If this game is played once, then

a. firm A will charge a low price, and firm B will charge a low price. [correct; this is the
equilibrium of the game.]
b. firm A will charge a high price, and firm B will charge a low price. [in this case, firm A is not
playing a best response and would prefer to charge a low price.]
c. firm A will charge a low price, and firm B will charge a high price. [in this case, firm B is not
playing a best response and would prefer to charge a low price.]
d. firm A will charge a high price, and firm B will charge a high price. [this is not an equilibrium
of the game as neither firm is playing a best response.]
9. Suppose the game is infinitely repeated. What strategies will each firm utilize?
a. firm A will charge a low price, and firm B will charge a low price. [the firms can earn higher
profits by cooperating on a better outcome and using trigger strategies to support it.]
b. firm A will charge a high price, and firm B will charge a low price. [firm A has no reason to
lose money in each period as this is not a best response to firm B charging a low price.]
c. firm A will charge a low price, and firm B will charge a high price. [firm B has no reason to
lose money in each period as this is not a best response to firm A charging a low price.]
d. firm A will charge a high price, and firm B will charge a high price. [correct; the firms can
coordinate on the better payoffs by using trigger strategies, such as a tit-for-tat strategy.]
10. You, a real-estate developer, own a piece of land in Nassau, Bahamas, next to an equal size piece of
land owned by a competitor. Both of you have the choice of building a casino or a hotel. Your payoffs
are as follows:
You
Your
competitor Casino Hotel
Casino 3 , 3 20 , 5
Hotel 5 , 20 2 , 2
How much is it worth to you to get your casino building permit first?
a. $2 million [If this game is played sequentially, the first mover would build a casino, earning
$20,000 in profits.]
b. $3 million [If this game is played sequentially, the first mover would build a casino and the
second mover would build a hotel.]
c. $15 million [correct; the first mover earns $20 million and the second mover earns $5
million, so moving first is worth $15 million.]
d. $17 million [$17 million is $20 million - $3 million, but both players earning $3 million
occurs only if both build a casino, which is not an equilibrium.]
Chapter 16
1. For threats or commitments to be effective, they must be

a. irrational. [There is no reason why a commitment needs to be “irrational” to be credible.]
b. profitable. [Often, commitments and threats relate to courses of action that are contrary to
one’s interests.]
c. credible. [correct; The goal of a commitment or threat is to have your rival believe you.]
d. None of the above. [One of the answers above is correct.]
2. Fred and his employer both know that he can generate $200,000 of profit per year for his company.
After negotiations, they agree that he will earn $110,000 in annual compensation. What does this
imply for the value of his outside or next best alternative?
a. $0. [According to the non-strategic view of bargaining, this would lead to $100,000 in
compensation, halfway between $0 and $200,000.]
b. $5,000. [According to the non-strategic view of bargaining, players split the gains to trade
evenly. An outside alternative of $5,000 would provide Fred with $105,000 of the gains to
trade which is more than his company receives.]
c. $10,000. [According to the non-strategic view of bargaining, players split the gains to trade
evenly. An outside alternative of $10,000 would provide Fred with $100,000 of the gains to
trade which is more than his company receives.]
d. $20,000. [correct; the players split the $180,000 gain from trade evenly.]
3. How many pure strategy equilibria does the following game have?
a. 0 [The game has pure strategy equilibria in which each player is playing a best response to
the strategy of the other.]
b. 1 [The game has more than one pure-strategy equilibrium.]
c. 2 [correct; Both outcomes in which one player bargains hard and the other is nice are
equilibria.]
d. 3 [the best response to the other player bargaining hard is to be nice, and vice versa.]
LABOR
Bargain Hard Be Nice
MANAGEMENT Bargain Hard 0,0 20, 10

Be Nice 12, 18 15, 15
4. In the game in Question 3, how much does Labor earn if they can move first?
a. 10 [Labor can do better by not being nice.]
b. 15 [Both being nice is not an equilibrium of the game.]
c. 18 [correct; if labor chooses to bargain hard, management would respond with being nice.]
d. 20 [this is not a possible payoff for labor.]
5. Consider a vendor-buyer relationship. Which of the following conditions would lead to the buyer
having more bargaining power?
a. Lots of substitutes for the vendor's product are available. [this would give the buyer better
alternatives to an agreement with the vendor; this is not the only correct answer.]
b. There are relatively few buyers and many vendors. [this would give the buyer better
alternatives to an agreement with the vendor and would give the vendor worse alternatives
to an agreement, both benefitting the buyer; this is not the only correct answer.]
c. It costs little for buyers to switch vendors. [this would increase the value of not reaching an
agreement with the vendor; this is not the only correct answer.]
d. All of the above. [correct; each of the above improves the buyer’s alternatives to an
agreement and thus reduces the buyer’s gains from reaching an agreement with this
vendor.]
6. In the following game, how many pure strategy equilibria are there?
a. 0 [correct; management always wants to match labor’s strategy and labor always wants to
adopt a different strategy from management.]
b. 1 [an equilibrium requires that each player is playing a best response to the other player’s
strategy.]
c. 2 [For Labor, the best response to “Bargain Hard” is to be nice, and the best response to “Be
Nice” is to bargain hard.]
d. 3 [For Management, the best response to “Bargain Hard” is also to bargain hard, and the best
response to “Be Nice” is also to be nice.]
LABOR
Bargain Hard Be Nice

MANAGEMENT Bargain Hard 15,0 20, 10
Be Nice 10,20 30, 15
7. Pete and Lisa are entering into a bargaining situation in which Pete stands to gain up to $5,000 and
Lisa stands to gain up to $1,000, provided they reach agreement. Who is likely to be the stronger
bargainer?
a. Pete [Pete has more to gain from reaching agreement and therefore will be a weaker
bargainer.]
b. Lisa [correct; Lisa has less to gain from agreement and therefore will be a stronger
bargainer.]
c. They will be equally effective. [the agreement reached depends on the gains for each party
from reaching agreement.]
d. These potential gains will have no impact on bargaining. [the gains for each party from
reaching agreement directly relate to the agreement that will be reached.]
8. George and KC have been working jobs that pay $60,000 and $30,000 per year, respectively. They
are trying to decide whether to quit their jobs and jointly open up a taco stand on the beach, which
they estimate can earn $150,000/year. How will the taco stand proceeds be split?
a. They won’t quit their jobs. [The gains from trade ($150,000-$60,000-$30,000) are positive.
Therefore, they will reach agreement to open up the taco stand.]
b. George gets $90,000 and KC gets $60,000 [correct; Both George and KC will share the gains
from trade generated from agreement equally. This provides each of them with $30,000 of
the surplus.]
c. George gets $75,000 and KC gets $75,000 [George and KC have different alternatives to
agreement, and therefore will receive different shares of the proceeds]
d. George gets $100,000 and KC gets $50,000 [This would provide George with $40,000 of the
gains from trade and KC with $20,000.]
9. The game of chicken has

a. a second-mover advantage. [the game of chicken favors the player who can commit to a
position.]
b. a first-mover advantage. [correct; the player who can commit to a course of action captures
a majority of the gains from trade.]
c. no sequential-move advantage. [the game of chicken provides an advantage for one of the
players.]
d. potential sequential-move advantages, depending on the players. [the outcome of the game
of chicken has to do with the structure of the game and its payoffs, not the players.]
10. Two hospitals are bargaining with a managed care organization (MCO) to get into its provider
network. The MCO can earn $100 if it puts one of the hospitals in its network and $200 if it puts both
hospitals in its network. If both hospitals merge and bargain jointly, how much more will they earn?
a. $0 [correct; each hospital is worth $100 whether or not the other hospital is included.
Therefore, each earns $50 before the merger and they jointly earn $100 ($200/2) after the
merger.]
b. $50 [before the merger, the gains to trade for including each hospital is $100 whether or not
the other hospital is included.]
c. $100 [after the merger, the hospitals and the MCO divide the gains from trade ($200)
equally.]
d. $200 [hospitals and the MCO will share in the gains to trade equally before and after the
merger.]
Chapter 17
1. You are taking a multiple-choice test that awards you one point for a correct answer and penalizes
you 0.25 points for an incorrect answer. If you have to make a random guess and there are five
possible answers, what is the expected value of guessing?
a. 0.5 points [the expected value of a random variable that can take on two values (x 1,x2) with
probabilities (p,1-p) is E(X)= (p*(x1)) + ((1-p)*(x2)). In this case, p represent the chance of
getting a correct answer, while x1 and x2 refer to the possible points]
b. 0.25 points [the expected value of a random variable that can take on two values (x 1,x2) with
probabilities (p,1-p) is E(X)= (p*(x1)) + ((1-p)*(x2)). In this case, p represent the chance of
getting a correct answer, while x1 and x2 refer to the possible points]
c. –0.25 points [the expected value of a random variable that can take on two values (x1,x2)
with probabilities (p,1-p) is E(X)= (p*(x1)) + ((1-p)*(x2)). In this case, p represent the chance
of getting a correct answer, while x1 and x2 refer to the possible points]
d. 0 points [correct; ((1/5)*(1)) + ((4/5)*(-0.25)) = 0.2 – 0.2 = 0]
2. A franchise restaurant chain is considering a new store in an unserved part of town. Its finance group
estimates an NPV of $10 million if the population growth is 10% (40% probability), and NPV of $4
million of the population does not grow (30% probability), and an NPV of -$4 million if the
population shrinks 5% (30% probability). What is the expected value of NPV (to the nearest dollar)
for the following situation?
a. $3.4 million [E(x)=((p1)*(x1))+((p2)*(x2))….+((pn)*(xn)). The probabilities are 0.4, 0.3 & 0.3
and the potential outcomes are $10, $4 & -$4 million in this case]
b. $4.0 million [correct; ((0.4)*(10m))+((0.3)*(4m))+((0.3)*(-4m))= 4m+1.2m-1.2m = 4
million]
c. $4.6 million [E(x)=((p1*)(x1))+((p2)*(x2))….+((pn)*(xn)). The probabilities are 0.4, 0.3 & 0.3
d. $5.2 million [E(x)=((p1)*(x1))+((p2)*(x2))….+((pn)*(xn)). The probabilities are 0.4, 0.3 & 0.3
3. You’ve just decided to add a new line to your manufacturing plant. Compute the expected loss/profit
from the line addition if you estimate the following:
 There’s a 50% chance that profit will increase by $100,000.
 There’s a 30% chance that profit will remain the same.
 There’s a 20% chance that profit will decrease by $15,000.
a. Gain of $100,000 [E(x)=((p1)*(x1))+((p2)*(x2))….+((pn)(xn)). The probabilities are 0.5, 0.3 &
0.2 and the profits are $10,000, $0 & -$15,000 in this case]
b. Gain of $70,000 [E(x)=((p1*)(x1))+((p2)*(x2))….+((pn)(xn)). The probabilities are 0.5, 0.3 &
c. Loss of $53,000 [E(x)=((p1)*(x1))+((p2)*(x2))….+((pn)(xn)). The probabilities are 0.5, 0.3 &
d. Gain of $47,000 [correct; ((0.5)*($100,000))+((0.3)*(0))+((0.2)*(-$15,000))=$50,000+$0-
$3000=$47,000]
4. Your software development company is considering investing in a new mobile app. If it goes viral
(10% probability), you expect an NPV of $1,000,000; if it is moderately successful (20% probability),
you expect an NPV of $200,000; and if it fails (70% probability), you expect an NPV of $-200,000.
What is the expected NPV of the product?
a. $0 [correct; ((0.1)*($1,000,000))+((0.2)*($200,000))+((0.7)*(-$200,000))=
$100,000+$40,000-$140,000 = $0]
b. $280,000 [E(x)=((p1)(x1))+((p2)(x2))….+((pn)(xn)). The probabilities are 0.1, 0.2 & 0.7 and
the NPVs are $1,00,000, $200,000 & -$200,000 in this case]
c. $333,000 [E(x)=((p1)(x1))+((p2)(x2))….+((pn)(xn)). The probabilities are 0.1, 0.2 & 0.7 and
the NPVs are $1,00,000, $200,000 & -$200,000 in this case]
d. None of the above [It is one of the above-In cases where you have the probability of different
occurrences and their outcomes, you can determine the total expected outcome]
5. Suppose an investment project has an NPV of $75 million if it becomes successful and an NPV of –$25
million if it is a failure. What is the minimum probability of success above which you should make the
investment?
a. 0.5 [the expected value of a random variable that can take on two values (x1,x2) with
probabilities (p,1-p) is E(X)= (p(x1)) + ((1-p)*(x2)). In this case, you are looking for the value
of p that will allow you to breakeven (i.e., where E(X) = 0)]
b. 1/3 [the expected value of a random variable that can take on two values (x1,x2) with
c. 0.25 [correct; you are looking for the breakeven- the minimum probability at which you
would invest ((p)*($75m))+((1-p)*(-$25m)=0 Therefore 75p-25+25p=0 or 100p=25, so
p=0.25]
d. 0.1 [the expected value of a random variable that can take on two values (x 1,x2) with
6. To test the effectiveness of a two Web advertising agencies, you increase your ad purchase with
agency A by 50% without changing your purchase through agency B. The referrals to your website
from agency A increased by only 34% but the referrals from agency B fell by 21%. What is the
difference-in-difference estimate of the referrals per dollar through agency A?
a. 1.2 referrals per dollar [To construct a "difference-in-difference" estimate of referrals per
dollar, measure the difference in referral percent changes from Agency A to Agency B over
the difference in percent purchase amount changes]
b. 1.1 referrals per dollar [correct; To construct a "difference-in-difference" estimate of
referrals per dollar, you measure the change in referrals from Agency A (+34%) relative to
the control group of Agency B (less -21%), for an estimate per dollar of ((55%)change in
referrals/(50%)change in dollars) or 1.1. The difference between treatment (agency A) and
control (agency B) referrals was 55% (=34%-(-21%). The difference in purchase amounts
was 50% (=50%-0%). The diff-in-diff in referrals per dollar was 55%/50% or 1.1]
c. 1.0 referrals per dollar [To construct a "difference-in-difference" estimate of referrals per
d. 0.9 referrals per dollar [To construct a "difference-in-difference" estimate of referrals per
7. Your company has a customer list that includes 3000 people. Your market research indicates that 90
of them responded to the coupon. If you send a coupon to one customer at random, what’s the
probability that he or she will use the coupon?
a. 0.03 [correct; the probability of using the coupon is 90/3000=0.03 or 3%]
b. 0.09 [the probability the coupon will be used is equal to the chance a customer will respond,
in other words, the number of potential positive responses over total customers]
c. 0.30 [the probability the coupon will be used is equal to the chance a customer will respond,
d. 0.90 [the probability the coupon will be used is equal to the chance a customer will respond,
8. Your production line has recently been producing a serious defect. One of two possible processes, A
and B, could be the culprit. From past experience you know that the probability that A is causing the
problem is 0.8 but investigating A costs $100,000 while investigating B costs only $20,000. What are
the expected error costs of shutting down process B first?
a. $80,000 [this is the expected cost of shutting down process A first]
b. $20,000 [the expected error cost in this case comes from investigating B and having A be the
culprit. In other words, it is the probability the total money spent on B will be wasted]
c. $16,000 [correct; the expected error cost in this case comes from investigating B and
having A be the culprit, in other words the probability the total money spent on B will be
wasted, so (0.8)*($20,000)=$16,000.
d. $4,000 [this is the expected cost of shutting down process B first]
9. You have two types of buyers for your product. Forty percent of buyers value your product at $10
and sixty percent value it at $6. What price maximizes your expected revenue?
a. $10 [In this case, only forty percent of buyers will purchase your product for expected
revenue per customer of $4]
b. $6 [correct; in this case, all 100% of buyers will purchase your product]
c. $7.60 [This price still only appeals to the top 40% of buyers, and for less than they are
willing to pay for expected revenue per customer of $3.04]
d. $8 [This price still only appeals to the top 40% of buyers, and for less than they are willing to
pay for expected revenue per customer of $3.2]
10. You are considering entry into a market in which there is currently only one producer (incumbent). If
you enter, the incumbent can take one of two strategies, price low or price high. If he prices high,
then you expect a $60K profit per year. If he prices low, then you expect a $20K loss per year. You
should enter if
a. you believe demand is inelastic. [if demand is inelastic, price will not impact the demand for
your product]
b. you believe the probability that the incumbent will price low is greater than 0.75. [To solve
this, you need to find the minimum probability needed to breakeven. E(X)= (p(x 1)) + ((1-
p)*(x2)). Once you solve for p, determine what p is of the incumbent pricing low]
c. you believe the probability that the incumbent will price low is less than 0.75.
[Correct; To solve this, you need to find the minimum probability needed to breakeven.
E(X)= (p(x1)) + ((1-p)*(x2)). Using ((p)*($60k))+((1-p)*($-20k))=0, you find 60p-20+20p=0
or 80p=20. Therefore, p (the probability of them pricing high) needs to be a minimum of
0.25 for you to breakeven. Therefore, you would only enter if you believed the probability of
them pricing low (1-p) is less than 0.75]
d. you believe the market size is growing. [If market size is growing, demand may
accommodate the addition of a competitor]
Chapter 18
1. You are bidding in a second-price auction for a painting that you value at $800. You estimate that
other bidders are most likely to value the painting at between $200 and $600. Which of these is likely
to be your best bid?
a. $1,000 [you should never bid above your value as you might end up paying more than the
painting is worth to you.]
b. $800 [correct; in a second-price auction, the optimal strategy is to bid exactly your value.]
c. $600 [If you are wrong and some other bidder values the painting at $700, you would end up
losing the auction even though you would have been willing to pay $700.]
d. $400 [You are unlikely to win a t a price this low.]
2. Which of the following is true about different ways of conducting a private-value auction?
a. A first-price auction is strategically equivalent to a second-price auction. [Bidding behavior
is very different in a first-price auction, where you bid below your value, and a second-price
auction, where you bid equal to your value.]
b. A first-price auction is strategically equivalent to an English auction. [In an English auction,
bidders are willing to bid up to their values, but first price auctions involve bid shading.]
c. A second-price auction is strategically equivalent to an English auction. [correct; in an
English auction, bidders bid up to their value with the highest-value bidder winning at a
price near the second-highest value.]
d. None of the above [One of the above answers is correct.]
3. Suppose that five bidders with values of $500, $400, $300, $200, and $100 attend an oral auction.
Which of these is closest to the winning price?
a. $500 [You need at least two bidders actively competing to drive the price up.]
b. $400 [correct; as soon as the bidder with the value of $500 outbids the next highest bidder,
the auction would end.]
c. $300 [since multiple bidders value the item more than $300, they would continue to
compete, driving the price higher.]
d. $200 [since multiple bidders value the item more than $200, they would continue to
compete, driving the price higher.]
4. In the above auction, if the bidders with the first- and third-highest values ($500 and $300) collude,
which of these is closest to the winning price?
a. $500 [You need at least two bidders actively competing to drive the price up.]
b. $400 [correct; The second-highest value sets the price, so the collusion removing the third-
highest value from active competition would not affect the price.]
c. $300 [despite the collusion, multiple bidders value the item more than $300, they would
continue to compete, driving the price higher.]
d. $200 [despite the collusion, multiple bidders value the item more than $200, they would
continue to compete, driving the price higher.]
5. In a common-value auction, you should

a. bid more aggressively the more competitors you face. [The more competitors you face, the
more you should be wary of winning as this implies that every other bidder believes the item
to be worth less than you do.]
b. bid less aggressively the more competitors you face. [correct; The more bidders there are,
the more winning is potentially “bad news.”]
c. bid the same regardless of the number of competitors. [In common-value auctions, beating
out competitors reveals that they all think that the object is worth less than your bid.]
d. bid more aggressively when others have better information than you. [The winner’s curse is
especially bad when rivals have better information than you do.]
6. If a seller is concerned about collusion among bidders, which of the following changes to the auction
should the seller make?
a. Hold frequent, small auctions instead of infrequent large auctions. [frequent auctions allow
bidders to take turns whereas a single large auction provides a greater incentive for cartel
members to cheat.]
b. Conceal the amount of winning bids. [correct; this makes it harder for the cartel to know if
cheating occurred, which provides incentives for cartel members to cheat.]
c. Publically announce the name of each auction’ s winner. [announcing the name of each
winner allows the cartel to monitor cheating, thus helping the cartel.]
d. Hold a second-price instead of a first price auction. [collusion is easier in second-price
auctions.]
7. You’ re holding an auction to license a new technology that your company has developed. One of your
assistants raises a concern that bidders’ fear of the winner’s curse may encourage them to shade
their bids. How might you address this concern?
a. Release your analyst’ s positive scenario for the technology’ s future profitability. [revealing
information reduces the winner’s curse, but this is not the only correct answer]
b. Release your analyst’ s negative scenario for the technology’ s future profitability. [revealing
information reduces the winner’s curse, but this is not the only correct answer]
c. Use an oral auction. [oral auctions reveal information about other bidders’ values.]
d. All of the above [correct; in common value auctions, the auctioneer should reveal as much
information as possible, both good and bad, to bidders so that they do not fear the winner’s
curse.]
8. Which of the following is true about the winner’s curse?

a. The winner’s curse occurs primarily in private-value auctions. [each bidder knows his or her
value in private value auctions, so there is no winner’s curse.]
b. You successfully avoided the winner’ s curse if you made money in the auction. [this is
merely good luck. Avoiding the winner’s curse implies making money on average, not just in
a single auction.]
c. The winner’ s curse means that you bid incorrectly. [correct; the winner’s curse happens
when bids do not account for the fact that only the highest (and most optimistic) bid wins,
and that the most optimistic estimate is likely to be wrong.]
d. The winner’ s curse means that you lost money in an auction. [this is merely bad luck and
can happen even when you bid correctly.]
9. A bidder’ s value for a good may be low ($2), medium ($5), or high ($7). There is an equal number of
potential bidders having each value. Suppose two bidders participate in a second-price auction. What
is the best estimate of the expected revenue from the auction?
a. $4.11 [draw a table of the nine possible outcomes. The second-highest value sets the price in
each auction. For example, the price is $7 only 1/9 of the time.]
b. $3.99 [draw a table of the nine possible outcomes. The second-highest value sets the price in
each auction.]
c. $3.56 [correct; the price is $7 1/9 of the time, $5 3/9 of the time, and $2 5/9 of the time.]
d. $5.00 [the price can be as high as $7 or as low as $2. Draw a table of the nine possible
outcomes.]
10. In a first-price auction, you bid __________ your value, and in a second-price auction you bid _______ your
value.
a. at; above [you should never bid above your value in either type of auction.]
b. below; above [you should never bid above your value in either type of auction.]
c. below; at [correct; bid at your value in second-price auctions and shade your bid (bid below
your value) in first-price auctions.]
d. below; below [In a second-price auction, you should not bid below your value.]
Chapter 19
1. An insurance company offers doctors malpractice insurance. Assume that malpractice claims against
careful doctors cost $5,000 on average over the term of the policy and settling malpractice claims
against reckless doctors costs $30,000. Doctors are risk-neutral and know whether they are reckless
or careful, but the insurance company only knows that 10% of doctors are reckless. How much do
insurance companies have to charge for malpractice insurance to break even?
a. $5,000 [both reckless and careful doctors would purchase insurance at this price.]
b. $7,500 [because careful doctors are risk-neutral, they would not purchase insurance at this
price, leaving the insurance company only with reckless doctors.]
c. $27,500 [the insurance company would insure only reckless doctors, losing $2,500 on each
insured.]
d. $30,000 [correct; only reckless doctors would purchase insurance at this price.]
2. An employer faces two types of employees. Regular workers are 70% of the population and generate
$100,000 in productivity. Exceptional workers are 30% of the population, and generate $120,000 in
productivity. Employees know their types, and reject salaries below their productivity. If the
employer offers a salary equal to the average productivity in the population, what will be the
employer’s per-employee profit?
a. -$10,000 [the average productivity is $100,000(70%)+$120,000(30%)=$106,000
b. -$6,000 [correct; the employer would offer $106,000 but hire only regular workers
generating $100,000 in productivity.]
c. $0 [this answer ignores the adverse selection problem.]
d. $4,000 [adverse selection implies that profits would be negative, not positive]
3. An all-you-can-eat buffet attracts two types of customers. Regular customers value the buffet at $20
and eat $5 of food in costs to the restaurant. Hungry customers value the buffet at $40 and eat $10 of
food. If there are 100 of each type in the market for a buffet dinner, what is the restaurant’s
maximum profit?
a. $2,500 [this is obtained by charging $20, but the restaurant can do better.]
b. $3,000 [correct; by charging $40, the restaurant attracts only hungry customers.]
c. $4,500 [this level of profit is unobtainable as the restaurant can attract at most 100
customers at $40 or 200 customers at $20.]
d. $6,500 [this level of profit is unobtainable and exceeds the total value of all customers.]
4. To combat the problem of adverse selection, ______ informed parties can employ _____ techniques.
a. more; signaling [correct; signaling is a more informed party’s effort to communicate her
information to the less informed party]
b. less; signaling [the less-informed party’s effort to learn the information that the more
informed party has is called screening.]
c. equally; screening [adverse selection arises because parties are not equally informed]
d. equally; signaling [adverse selection arises because parties are not equally informed]
5. Which of the following can be an example of a signal?

a. An air-conditioning manufacturer offers a 50-year warranty. [this signals quality as the
warranty is more expensive to honor for an inferior product; this is not the only correct
answer]
b. A lawyer offers to be paid only if the client wins. [this signals a higher likelihood of winning
as the contingent fee is less a risk if the chance of winning is high; this is not the only correct
answer
c. A student pursues an MBA. [this can signal dedication, willingness to work hard, or other
traits.]
d. All of the above [correct; all of the above are possible signals]
6. Which of the following is not an example of adverse selection?

a. A business bets the proceeds of a bank loan on the next NFL game. [correct; this is an
example of moral hazard rather than adverse selection.]
b. An accident-prone driver buys auto insurance. [this is adverse selection as drivers who are
more expensive to insure are more likely to buy insurance.]
c. A patient suffering from a terminal disease buys life insurance. [this is adverse selection as
patients who are more expensive to insure are more likely to buy insurance.]
d. A really hungry person decides to go to the all-you-can-eat buffet for dinner. [this is adverse
selection as customers who are more expensive to serve are more likely to buy the buffet.]
7. The demand for insurance arises primarily from people who are
a. risk-seeking. [risk-seeking individuals are less willing to pay a premium in order to eliminate
a risk.]
b. risk-averse. [correct; risk-averse individuals are willing to pay more to avoid risks and thus
are most likely to purchase insurance.]
c. risk-neutral. [risk-neutral individuals are willing to insure only when the premium costs less
than the expected loss.]
d. None of the above [willingness to pay for insurance depends on one’s risk tolerance.]
8. Which of the following is a potential solution to the adverse selection problem faced by insurance
companies?
a. Offer plans with different deductibles so that higher-risk customers accept higher
deductibles. [the deductible is a signal that reveals each insured’s risk, reducing adverse
selection; this is not the only correct answer.]
b. Create a national database of customers that allows companies to look up each person’s
historical risk. [this provides information about each insured’s risk, reducing information
asymmetry.]
c. Mandate that every person purchase insurance. [this eliminates adverse selection by
prohibiting low-risk individuals from exiting the insurance market.]
d. All of the above [correct; each of the above is a potential solution to the adverse selection
problem.]
9. An insurance company suffers from adverse selection if

a. safe customers are less likely to insure than risky customers. [correct; adverse selection
occurs when only the most expensive customers buy insurance.]
b. customers know their willingness to pay for insurance but the company does not. [this is a
common feature of most pricing decisions and does not necessarily lead to adverse
selection.]
c. a customer takes on much greater risk because he is insured. [this is moral hazard, but does
not suggest that different customers take different actions.]
d. its customers are risk averse. [insurance company customers are often risk averse whether
the insurance company faces adverse selection or not.]
10. Which of the following is an example of adverse selection?

a. A safe driver taking greater risk in a rental car than his own car. [this answer does not
suggest that there are different types of drivers, with some posing a higher risk than others.]
b. A terminally ill person purchasing life insurance. [correct; a higher-cost patient purchasing
insurance while, presumably, a lower-cost patient choosing not to purchase, is adverse
selection.]
c. An employment contract encourages little effort on the part of employees. [this answer does
not suggest that there are different types of employees.]
d. All of the above [only one of the above is an example of adverse selection, rather than moral
hazard.]
Chapter 20
1. Which of the following is an example of moral hazard?
a. Reckless drivers are the ones most likely to buy automobile insurance. [this is an example of
adverse selection as it relates to different types of drivers.]
b. Retail stores located in high-crime areas tend to buy theft insurance more often than stores
located in low-crime areas. [this is an example of adverse selection as it relates to different
types of stores.]
c. Drivers who have many accidents prefer to buy cars with air bags. [this is an example of
adverse selection as it relates to different types of drivers.]
d. Employees recently covered by the company health plan start going to the doctor every time
they get a cold. [correct; unlike the other answers, this is an example of moral hazard as
each same individual takes a different levels of risk in the presence of insurance than in its
absence.]
2. In a bad economy, a CEO has a 4% chance of meeting earnings estimates at regular effort, and a 5%
chance at extraordinary effort. Extraordinary effort costs the CEO $10,000. How large a bonus should
the CEO be paid for meeting estimates to encourage extraordinary effort?
a. $100,000 [$100,000 earned 5% of the time is worth less than the cost of extraordinary
effort.]
b. $200,000 [This is insufficient since the CEO has an almost equal chance of meeting estimates
at regular effort as at extraordinary effort.]
c. $250,000 [The answer should account for the additional likelihood of meeting estimates
from extraordinary effort.]
d. $1,000,000 [correct; extraordinary effort provides an extra 1% chance of meeting estimates.
Therefore, the bonus must be at least $10,000/1%.]
3. A salesperson can put in regular effort (resulting in a 40% chance of sale) or high effort (60% chance
of sale). If high effort costs the salesperson $20 more than regular effort, how large a per-sale bonus
is required to encourage high effort?
a. $12 [this is less than the extra cost of effort and therefore would not be worth it for the
salesperson.]
b. $20 [a $20 bonus earned 60% of the time does not offset a $20 cost of effort.]
c. $33.33 [this would exactly compensate for the extra cost of effort (60% x $33.33 = $20), but
does not account for the fact that the salesperson has a good chance of earning the bonus at
regular effort as well.]
d. $100 [correct; high effort results in an extra 20% chance of earning a bonus and costs $20.
Therefore, the bonus must at least satisfy (20%)b=$20.]
4. Which of the following is not an example of a process designed to combat moral hazard problems?
a. Banks include restrictive covenants in loan agreements. [this prevents bank customers from
taking excessive risks with the bank’s capital.]
b. Universities have students complete evaluations of professor performance at the end of a
class. [This helps prevent shirking by faculty]
c. Insurance companies require applicants to provide medical history information as part of
the application process. [correct; this combats adverse selection rather than moral hazard.]
d. Employers regularly monitor employee performance. [employees have less incentive to
work hard than employers want since part of the generated profits go to the employer.]
5. Which of the following is an example of moral hazard?
a. High-quality products being driven out of a market by low-quality products. [this is an
example of adverse selection.]
b. A local charity raising insufficient funds because no one contributes, expecting that their
neighbors will. [this is an example of free riding]
c. A bakery defaults on its loan because of a new consumer fear of carbohydrates. [this is the
result of the usual risk of lending and is not due to the bakery taking excessive risk.]
d. A corporation uses a business loan secured for one investment on another, higher-risk
investment. [correct; the corporation takes excessive risks because the lender bears the
downside.]
6. Which of the following is not an example of moral hazard?

a. People are more likely to lock their own car than a rental car. [people exercise less care with
a rental car as they do not bear the downside to the same degree as with their own car.]
b. Skateboarders attempt more difficult maneuvers when wearing a helmet. [the helmet
“insures” partially against risk, leading to greater risk-taking behavior.]
c. Bad salespeople are less drawn to commission-based jobs. [correct; this is an example of
adverse selection, as it differentiates types of people, not their actions.]
d. People with fire insurance are less likely to install smoke alarms. [people with insurance
take less care.]
7. Which of the following is true?

a. Moral hazard is primarily an issue prior to a transaction. [moral hazard arises when people
take different actions because of the transaction (such as purchasing insurance).]
b. Adverse selection is primarily an issue after a transaction. [adverse selection results from
different willingness to enter into a transaction.]
c. Moral hazard is the result of an information asymmetry. [correct; moral hazard arises from
hidden actions.]
d. Resolving adverse selection also resolves moral hazard. [while related, these are different
types of information asymmetry.]
8. Restrictive covenants on loans are used to avoid

a. moral hazard. [correct; restrictive covenants attempt to minimize excessive risk taking as a
result of moral hazard.]
b. adverse selection. [restrictive covenants attempt to control hidden actions.]
c. free riding. [restrictive covenants exist to make sure that loans are used for their intended
purposes, which is unrelated to free riding.]
d. None of the above [one of the above answers is correct.]
9. Loan applications require a lot of information from applicants to avoid

a. moral hazard. [moral hazard is an issue of hidden actions.]
b. adverse selection. [correct; the information reveals something about the type of borrower.]
c. free riding. [free riding is not the result of an information asymmetry.]
d. None of the above [one of the above answers is correct.]
10. Which of the following is true about moral hazard?

a. Moral hazard arises from actions that cannot be observed. [moral hazard is an issue of
hidden action, but is not the only correct answer.]
b. Shirking is a form of moral hazard. [this is true, but is not the only correct answer.]
c. Moral hazard refers to the taking of excessive risk. [this is true, but is not the only correct
answer.]
d. All of the above [correct; all of the above are examples of hidden actions and a reduced
incentive to take precautions.]
Chapter 21
1. Your notebook computer’ s hard drive recently crashed, and you decide to take it to a local repair
technician to have it fixed. In this relationship,
a. you are the agent. [the agent typically is the party actually performing the work.]
b. the technician is the principal. [the principal typically is the party contracting an agent to
perform the work.]
c. the technician is the agent. [correct; the technician is being contracted by you, the principal,
to do the work.]
d. no principal-agent relationship exists. [assuming that the repair technician has any interests
that are not identical to yours, a principal-agent relationship exists.]
2. A good compensation scheme

a. maximizes the agent's utility. [the goal of a compensation scheme is to maximize the
principal’s profit.]
b. anticipates how an agent will game the scheme. [correct; agents may find ways to maximize
their profit in ways not anticipated by the principal.]
c. does not subject a risk-averse agent to risk. [incentive compensation usually involves some
risk for the agent, for which he or she has to be compensated.]
d. accompanies centralized decision-making authority. [compensation schemes are especially
important when decision-making authority is decentralized.]
3. Principal-agent relationships
a. reduce monitoring costs. [principal-agent relationships are often characterized by high
monitoring costs and thus often rely on incentive pay.]
b. occur because managers have good information about employees. [principal-agent
relationships exist in many environments, including ones where principals have very little
information about their employees.]
c. are not related to asymmetric information. [agents having better information about their
capabilities and actions is typical of principal-agent problems.]
d. are subject to moral hazard problems. [correct; principals may be unable to observe or
monitor agents’ actions.]
4. All of the costs associated with a principal interacting with an agent are called
a. opportunity costs [these are the costs of foregone opportunities.]
b. agency costs [correct; these include the costs of combatting moral hazard and adverse
selection]
c. monitoring costs [this is just one type of cost associated with principal-agent relationships.]
d. sunk costs [these are costs that do not vary with the consequences of your decision.]
5. Principal-agent problems
a. occur when firm managers have more incentive to maximize profit than shareholders do.
[the problem generally occurs because the manager has less incentive to maximize profit.]
b. would be reduced if firm owners had better information about the actions of the firm’s
managers. [correct; the cost of controlling incentive conflict from agency problems goes
down if the principal can gather information]
c. help explain why equity investments from outside owners are an important financing source
for firms. [equity investments from outside owners actually create agency relationships]
d. are increased as more information is shared between the parties. [reducing information
asymmetry also reduces principal-agent problems.]
6. In order to create an effective incentive compensation scheme, you must have

a. adequate performance measures. [correct; compensation schemes tie rewards to
performance and therefore require that performance be reliably measured.]
b. unlimited funds. [incentive compensation schemes align the incentives of the agent with that
of the principal, but this does not require unlimited funds.]
c. a flat management structure. [a specific management structure is not a precondition for an
effective compensation scheme.]
d. None of the above [one of the above answers is correct;]
7. Decentralization of decision-making authority is consistent with which of the following?

a. A trend of stronger, more active CEOs. [this would be consistent with centralization of
authority]
b. Shrinking costs of computing bandwidth, which allows information to be inexpensively
aggregated from geographically diverse business units. [When information is easier to
aggregate, centralized decision making authority becomes easier to sustain.]
c. Development of microcomputing resources at the corporate, division, and employee level.
[correct; this provides decision-making tools at each level of a corporation, reducing the
need to centralize decision-making authority.]
d. Reduction in the use of incentive compensation. [decentralization of authority is generally
accompanied with increased reliance on incentive compensation.]
8. A firm faces two kinds of employees, those able to sell 10 units/year, and those able to sell 5
units/year. High-productivity employees are willing to work for $100/year while low-productivity
employees are willing to work for only $50/year. To screen out the low-productivity employees, the
firm should
a. offer a salary of $100. [Both kinds of employees would accept this salary.]
b. offer a salary of $75 plus $5/unit commission. [Low-productivity employees would not be
screened out as they would earn more than $50.]
c. offer sales commission of $10/unit. [Low-productivity employees would not be screened out
as they would earn $10 on each of five units.]
d. offer a sales commission of $20/unit, on sales above 5 units. [correct; This would
sufficiently reward high-productivity employees but pay low-productivity employees only
$20, screening them out.]
9. You own a retail establishment run by a store manager who receives a flat salary of $80,000. If you
set up another store as a franchise with incentive compensation to the franchisee, what would be a
reasonable total compensation range that the franchisee could earn?
a. $80,000 [the franchisee’s compensation should vary with performance.]
b. $40,000– $80,000 [this range would result in expected compensation below $80,000 and
thus would be insufficient to entice the franchisee to participate.]
c. $60,000– $100,000 [correct; this would allow the franchisee to earn an average salary
similar to the manager but still allow it to vary with performance.]
d. $80,000– $100,000 [If a manager requires total compensation of $80,000, then the
franchisee should earn roughly $80,000 on average.]
10. In the magazine Budget Travel , a hotel maid admits, “ I cut corners everywhere I could. Instead of
vacuuming, I found that just picking up the larger crumbs from the carpet would do. Rather than
scrub the tub with hot water, sometimes it was just a spray-and-wipe kind of day.… After several
weeks on the job, I discovered that the staff leader who inspected the rooms couldn’t tell the
difference between a clean sink and one that was simply dry, so I would often just run a rag over the
wet spots.… I apologize to you now if you ever stayed in one of my rooms.” Which of the following
organizational forms is more likely to have caused this kind of shirking?
a. Franchising: where the hotel managers are the owners of the hotel (franchisee) and pay a
fixed franchise fee [As owners, hotel managers receive the profit of the hotel as earnings and
thus have a lot of incentive to maintain the quality of the hotel.]
b. Company-owned hotels [correct; As managers do not share (as much) in the profits of the
hotels, they have less incentive to monitor quality than the other two organizational forms.]
c. Franchising with a sharing contract, where the hotel managers are the owners of the hotel
(franchisee); they pay a smaller fixed fee to the franchisor but share revenue with the
franchisor. [As owners, hotel managers’ earnings vary with the profit of the hotel, providing
a lot of incentive to maintain the quality of the hotel.]
d. None of the above [incentives to shirk vary with organizational form.]
Chapter 22
1. A computer manufacturer has two divisions: one serving residential customers and one serving
business customers. If an incentive conflict arises between the two divisions, how will overall
company profits be affected?
a. Profits will definitely fall. [while profit often falls due to division conflict, it is not definite]
b. Profits will definitely rise. [profit is unlikely to increase due to a divisional conflict]
c. Profits may fall, but it depends on the nature of the conflict. [correct]
d. The conflict has no potential to affect overall profit. [while the conflict is not guaranteed to
affect profit, you should definitely be worried about the potential to affect profit]
2. Which of the following changes might help solve a divisional conflict regarding a decision?
a. Change who has authority to make the decision [yes, this might help but are there other
options?]
b. Transfer information to the decision makers so they are better informed [yes, this might help
but are there other options?]
c. Change the performance evaluation and associated compensation of the decision makers
[yes, this might help but are there other options?]
d. All of the above [correct; all of the above are potential solutions to consider]
3. Joe runs the Service Division for a car dealership. The overall dealership has profit of $10 million on
sales of $100 million and costs of $90 million. Joe’ s division contributed $9 million in sales and $7
million in costs. If the Service Division is evaluated as a profit center, what dollar amount is most
relevant to Joe?
a. $2 million [correct; this is the profit of the Service Division]
b. $7 million [while the $7 million in cost is important, other figures matter too]
c. $9 million [while the $9 million in sales is important, other figures matter too]
d. $10 million [because Joe’s incentives are tied to Service Division profit, he is unlikely to
consider overall dealership profit as most relevant]
4. If you were a manager of a cost center, which of the following areas would be of most interest to you?
a. Capturing potential economies of scale. [correct]
b. Increasing the quality of your product. [cost centers are normally rewarded for producing at
the lowest cost; increasing quality would likely increase cost rather than reduce it]
c. Hiring more marketing staff to figure out how to increase prices. [cost centers are normally
rewarded for producing at the lowest cost; adding marketing staff would likely increase cost
rather than reduce it]
d. Adding additional features to your product. [cost centers are normally rewarded for
producing at the lowest cost; adding features would likely increase rather than reduce cost]
5. Transfer prices should be set at

a. marginal cost of the selling division plus a reasonable profit amount. [this could lead to a
double mark-up problem]
b. marginal cost of the selling division unless it is evaluated as a profit center. [whether the
division is evaluated as a profit center should not impact the transfer price]
c. the opportunity cost of the asset being transferred. [correct]
d. at whatever price is negotiated between the selling and buying divisions. [this may or may
not result in the right price being negotiated]
6. Which type of organizational form has the benefit of closer coordination to serve a particular product
or geographic area?
a. Profit centers. [a profit center means that the group or division is evaluated based on profit;
this is not directly related to coordination to serve a product group or geographic area]
b. Functional organizations. [a lack of coordination is one of the challenges not benefits of a
functional structure]
c. M-form organizations. [correct]
d. Functional and M-form organizations have the same benefits. [these two structures have
different types of benefits]
7. Which of the following provides an example of divisions based on a functional organizational

structure?
a. Americas, Africa, Asia, Europe [this would be an example of an M-form based on region]
b. Research and development, production, finance, marketing [correct]
c. Youth products, teen products, senior products [this would be an example of an M-form
based on product]
d. Business users, home users, educational users [this would be an example of an M-form based
on customer type]
8. Which of the following organizational forms requires the strongest management oversight to ensure
coordination of functions?
a. Profit centers [treating a division as a profit center refers to how it is evaluated not to the
company’s organizational form]
b. Functional organizations [correct]
c. M-form organizations [one of the benefits of the M-form is the higher level of coordination of
functional areas, so it is not as likely to need strong management oversight]
d. Functional and M-form organizations likely require similar oversight [the two forms differ in
the amount of oversight needed to foster coordination]
9. Which of the following actions is consistent with a manager whose compensation depends on
meeting a budget goal and who does not believe he can make that goal?
a. Asking a vendor to pre-ship and invoice materials for the following year. [yes, this action is
consistent but are there other actions?]
b. Discovering a “problem” in the order taking process, thereby forcibly pushing sales into the
ensuing year. [yes, this action is consistent but are there other actions?]
c. Increasing accounting reserve estimates, leading to higher recognized expenses. [yes, this
action is consistent but are there other actions?]
d. All of the above [correct; all of these actions are consistent with this type of compensation
scheme]
10. One of the basic functions of the budgeting process is

a. assigning decision rights. [assigning decision rights is part of organization design]
b. transferring information. [correct]
c. evaluating managerial performance. [while performance evaluation is sometimes related to
achieving budgets, a basic function of the budgeting process is not to evaluate performance]
d. implementing structural change. [budgeting and implementing structural change are
separate activities]
Chapter 23
1. Alpha Industries is considering acquiring Foxtrot Flooring. Foxtrot is worth $20 million to its current
owners under its existing operational methods. Because there are some opportunities for synergies
between the two companies, Alpha believes that Foxtrot is worth $25 million as part of Alpha
Industries. What do you predict for a sales price of Foxtrot?
a. Less than $20 million or Alpha will not buy [According to the rational actor paradigm Alpha
will purchase at any value below $25 million]
b. More than $25 million or Foxtrot will not sell [According to the rational actor paradigm
Foxtrot will sell at any value above $20 million]
c. Something between $20 and $25 million [correct; the rational actor paradigm indicates
that Foxtrot will be willing to sell at anything above their value of $20m, while Alpha is
willing to purchase at anything below their valuation of $25 million; a value between $20
and $25 million satisfies both of these requirements]
d. The different valuations make a sale very unlikely. [Not true, the rational actor paradigm
indicates that Foxtrot will be willing to sell at anything above their value, while Alpha will be
willing to purchase at anything under theirs]
2. All of the following provide a motive for vertical agreements EXCEPT

a. effective execution of price discrimination [true; with vertical integration, retailers are able
to defeat upstream price discrimination schemes designed by a manufacturer]
b. elimination of free-riding among retailers [true; vertical contracts such as exclusive
territories can overcome the problem of free riding by discount retailers]
c. quality control [true; vertically integrating can allow a manufacturer to have greater control
over the final product]
d. diversification [correct; this is false. Diversification represents a company expanding its
reach horizontally rather than vertically]
3. Which of the following is an example of vertical integration?

a. A custom software company purchasing a competing software firm [this is a form of
expansion, not vertical integration]
b. A soft drink producer buying a brand of iced tea [this is an example of horizontal integration,
not vertical integration]
c. A coal producer purchasing a nuclear power plant [this is an example of diversification, not
vertical integration]
d. A gourmet cheese company purchasing a dairy [correct; dairy is an input into the cheese
production process]
4. Why are contact lens manufacturers reluctant to sell their lenses through the Internet?
a. The Internet price is too high due to double marginalization [double marginalization is more
likely to occur with retailers than online]
b. Search costs are lower, so the Internet sales are too competitive [competition alone is not
the reason for their reluctance, there are other factors involved]
c. Doing so reduces the incentives of retailers to provide point-of-sale services [correct;
in order to compete with online prices, retailer would likely be forced to eliminate their
point of sale services, which could affect customer's overall experience with the brand]
d. They are afraid of antitrust lawsuits [antitrust laws don't apply to a company selling its own
product through a different channel]
5. In which of the following instances would an acquisition make the most sense?
a. The target is a very profitable company [don't just acquire a company because it is
profitable]
b. Synergies exist between the acquirer and the target [synergies are worthless unless you are
the one capturing the value]
c. Integration costs are low between the two [even if integration costs are low, you would only
purchase if there was value to you]
d. Synergy benefits outweigh the costs of integration [correct; the value of the synergy
should outweigh the cost of acquiring it!]
6. Why do vertical agreements typically pose less antitrust risk than horizontal agreements?
a. Vertical agreements occur less often than horizontal agreements [frequency of occurrence
does not contribute to antitrust risk]
b. Vertical agreements often result in lower prices, which are beneficial to the consumer
[correct; the purpose of antitrust laws are to protect the consumers, who often benefit from
vertical integrations]
c. Vertical agreements are rarely profitable [vertical agreements can be very profitable if done
correctly]
d. Vertical agreements do not pose less antitrust risk than horizontal agreements [actually,
they do. Consider the different impacts each of these agreements have on the consumers]
7. CUS Pharmacy wishes to carry Pepgro blue pills. But Daisy Pharmaceuticals, the maker of Pepgro,
will not supply CUS unless CUS agrees to carry other medications that Daisy makes. This is an
example of
a. Exclusion [exclusion is the practice of blocking competitors from participating in a market.
CUS is only impacting their participation in their stores, not the market as a whole]
b. Tying [correct; tying is the practice of making the sale of one good conditional on the
purchase of an additional, separate good, as you see here]
c. territory restriction [CUS is not dividing products by territory in this case]
d. bundling [Bundling refers to offering multiple goods for sale as one product. CUS is not
mandating the products be sold together but rather at the same store]
8. A multinational firm acquires many of its components pre-assembled from suppliers. One of these
suppliers operates in a country with a much lower corporate income tax rate. How does this affect
the vertical relationship between this supplier and the multinational?
a. This will not affect the relationship [Tax is an important consideration between
multinationals and suppliers]
b. The multinational should stop working with the supplier [not necessarily, there are other
ways the multinational can benefit from their relationship with the supplier]
c. The multinational should consider purchasing this supplier [correct; The multinational
can evade regulation by “realizing” a larger portion of the combined profits in the low
tax jurisdiction without substantively altering its operations.]
d. The multinational should move all its operations to the supplier’s home country [Possibly,
but then it could bear substantial increases in operation and reorganization costs.]
9. In which of the following cases might you expect to find a manufacturer granting exclusive
territories?
a. A pet supply chain that requires heavy local advertising to drive sales [true- is it the only
one?]
b. Custom computer sales that require a good deal of consultation [true- is it the only one?]
c. A submarine sandwich chain that relies on its nationwide brand reputation [true- is it the
only one?]
d. All of the above [correct]
10. Local Spanish TV markets cater to individual cities by producing local content. This content can be
produced in-house by a network or they can also purchase rights to third-party produced content.
Recently, Spanish cities have erected barriers to entry in television content production that allows
content producers more market power. How would this have affected vertical integration between
content providers and TV networks?
a. There is more vertical integration to limit arbitrage by price discriminating content
producers [Contracting effectively prohibits TV networks from reselling purchased content
to another TV network.]
b. There is less vertical integration because point-of-sale services are less important [TV
broadcasting involves few opportunities for direct customer point-of-sale services]
c. There is more vertical integration to reduce the double marginalization problem [correct,
TV networks place a second margin on top of the first content producer’s margin. The
new barriers to entry increase content producers’ initial margins which makes the
double marginalization problem more severe.]
d. There is less vertical integration because evading regulation is less important [Firms
vertically integrate so as to engage in regulatory evasion]

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Managerial Economics:

1. Why might performance compensation caps be bad?

2. What is a possible consequence of a performance compensation reward scheme?

6. The problem-solving principles analyze firm problems,

Multiple Choice Solutions:

1. An individual’s value for a good or service is

2. The biggest advantage of capitalism is

3. Wealth creating transactions are more likely to occur

10. Efficiency implies opportunity

Multiple Choice Solutions:

3. If a firm is earning negative economic profits, it implies

6. Economic Value Added helps firms avoid the hidden-cost fallacy

7. The fixed-cost fallacy occurs when

9. All the following are examples of variable costs, except

Multiple Choice Solutions:

1. When economists speak of “marginal”, they mean

2. Managers undertake an investment only if

8. If a firm’s average cost is rising then

Multiple Choice Solutions

1. Which of the following will increase the break-even quantity?

2. The higher the discount rates

9. What are some of the solutions for a hold-up problem?

10. Which of the following is classified as a sunk cost?

Multiple Choice Questions

2. Which one of the following is true?

4. Which of the following goods have a negative income elasticity of demand?

c. 15% higher. [Remember, %ΔQ= e(%ΔP)]

3. Average costs curves initially fall

7. According to the law of diminishing marginal returns, marginal returns:

Quantity Marginal Cost Sale Price Marginal Return

1. Changes in prices of a good causes

5. Which of the products below is closest to operating in a perfectly competitive industry?

10. A sudden decrease in the market demand in a competitive industry leads to

2. Attractive industries have all the following, except

3. Which of the following is NOT an example of an entry barrier?

4. Buyers have higher power when

6. The concept that describes firms possessing different bundles of resources is

8. When a resource or capability is valuable and rare, a firm may gain a

Multiple Choice Solutions:

3. If the Chinese yuan devalues relative to the US dollar, then

2. Nash equilibrium is:

Use the following to answer question 3- 5

Advertise $95, $80 $305, $55

3. The Nash equilibrium is

5. If collusion were not illegal, then it would be optimal

Low 0, 0 50, -10

8. If this game is played once, then

1. For threats or commitments to be effective, they must be

Bargain Hard Be Nice

MANAGEMENT Bargain Hard 0,0 20, 10

Bargain Hard Be Nice

9. The game of chicken has

5. In a common-value auction, you should

8. Which of the following is true about the winner’s curse?

5. Which of the following can be an example of a signal?

6. Which of the following is not an example of adverse selection?

9. An insurance company suffers from adverse selection if

10. Which of the following is an example of adverse selection?

6. Which of the following is not an example of moral hazard?

7. Which of the following is true?

8. Restrictive covenants on loans are used to avoid

9. Loan applications require a lot of information from applicants to avoid