Prof.

Nico Voigtlnder FEMBA Program

Winter 2011 Managerial Economics

Problem Set 1
Problem 1. (10 points) Glenmorangie is a whisky distillery in Northern Scotland. It bottles three versions of its bourbon-casked single malt whiskey. These differ by virtue of the number of years they are aged in oak casks. The three are the 10, 15 and 25 year-old versions. It is commonly believed that aging whiskey adds quality to its taste, and therefore enhances the value placed on it by consumers. Why might the cost to the company of the various versions increase with their age when, after all, an older bottle is identical to a younger one except that it sits for longer in a warehouse? Hint: Can you think of an economic cost besides the obvious explicit one of storage space?

Problem 2. (10 points) The chickenpox (varicella) vaccine was first licensed in the United States in 1995. Since that time, the number of hospitalizations and deaths from varicella has declined more than 90%. The Center for Disease Control and Prevention (CDC) has recommended that children receive this vaccine. That recommendation was based on a cost-benefit study conducted by the US Office of Technology Assessment, an arm of the Federal government. Despite the strong evidence from this study that the vaccine was cost-beneficial, most health plans and insurance companies refused to cover the vaccines expense. Why might the health plans and insurance companies take a different view of the vaccines net benefits than would an agency of the Federal Government?

Problem 3. (20 points) Unilever, the multi-national consumer product company, has recently announced it is going to cull (sell to other companies) some of its less prominent and less successful brands. Some at Unilever have opposed the culling policy. The opponents have based their argument on the principle of contribution, invoking a discussion of fixed expenses. Advocates of the culling have based their argument on the principle of opportunity cost, citing specifically Unilever's potential to raise capital by selling the brands to other companies.

Prof. Nico Voigtlnder FEMBA Program

Winter 2011 Managerial Economics

A. Explain how the principle of contribution might be used to oppose the culling. Two or three sentences should suffice. B. Explain how the principle of opportunity cost might be used to favor the culling. Make sure you reference the information provided in the question. Two or three sentences should suffice.

Problem 4. (25 points) The fixed cost of Boeing's new aircraft, the 787, is $6 billion. The average variable cost is $100mio. The sales price is $140mio. A. What is the projected breakeven volume? B. Explain, using the concept of present value, why the calculation of the breakeven volume is actually more complicated than the simple equation presented in class would have you believe.

Problem 5. (35 points) At a recent meeting of the top management of the Merciful Samaritan Hospital, a for-profit organization that had been buffeted by the changes in the environment for medicine, a proposal was floated to expand more aggressively into the kidney transplant business. The hospital had already two staff surgeons who specialized in this activity. All of this activity was conducted under two existing separate contracts that Merciful Samaritan had signed with health care insurance organizations. Each contract called for Merciful Samaritan to provide transplants to a specific group of employees if the procedure was deemed necessary. The hospital was now considering an attempt to expand their business by 50% that would necessitate retaining the services of a third transplant surgeon. However, to lure the third surgeon from her current employer, Merciful Samaritan would need to offer her compensation of $400,000, or $50,000 more than the other two surgeons already on staff. The compensation policy developed by the Human Resource Director of the hospital was quite explicit on this issue: equal pay for equal work. That is, all three surgeons would receive the higher compensation were the third surgeon to come to Merciful Samaritan. Another issue that was raised at the meeting by the Marketing Manager of Merciful Samaritan was the impact of the planned expansion of the transplant business on the pricing of the two existing contracts the hospital already had. The Marketing Manager stated that if Merciful Samaritan were 2

Prof. Nico Voigtlnder FEMBA Program

Winter 2011 Managerial Economics

to compete successfully for more transplant business, then it would need to be more competitive in this market. Based upon the econometric work of the Director of Research for Merciful Samaritan, it was widely known that a contract price of $540,000 would be required to win a third contract. The Marketing Manager argued that if Merciful Samaritan got a third contract with a new insurance company for a price of $540,000, that lower price must also be offered immediately to the two, existing insurance companies currently under contract. He felt that to do otherwise was unethical. The existing contracts each were priced at $600,000. (Assume the contracts are each the same size, and that one surgeon is required for each.) The CEO of Merciful Samaritan ultimately was the one to decide whether it was worthwhile to expand further, or not, into this business. Help the CEO by answering the following questions about the situation.

You may (or may not) find the following information helpful: Fixed costs = $1,000,000 for Merciful Samaritan Variable Costs (does not include the surgeon) for each contract = $50,000

A. Calculate the marginal benefit of hiring the third surgeon. Hint: Compare total revenues from three vs. two contracts. B. Calculate the marginal cost of hiring the third surgeon. In addition to making the calculation, you need to give the specific name for each of the marginal cost components. C. Is it economically wise to expand from two to three contracts? Explain your response briefly. One or two sentences should be enough if carefully written.