BUSN 6120 Midterm Exam Answers
|Midterm Exam — ANSWER KEY
The Midterm Exam is a take-home exam and covers Chapters 1 – 7. Limit your answers to one page per question. Submit using the Assignments area.
- An article in the Wall Street Journal reported that large hotel chains, such as Marriott, are tending to reduce the number of hotels that they franchise to outside owners and increase the number the chain owns and manages itself. Some chains are requiring private owners or franchisees to make upgrades in their hotels, but they are having a difficult time enforcing the policy. Marriott says the upgrading is important because “we’ve built our name on quality.”
- What type of agency problem is involved here?
This is the classic principal-agent problem.
The problem is that the private owners who are supposed to make the decisions that would best serve Marriot are more motivated by self-interest, which may differ from Marriot’s interests. This could be alleviated if the provisions are spelled out in the contract in terms of requirements issued by Marriot.
- Why would Marriott worry about the quality of hotels it doesn’t own but franchises?
This answer has to do with reputation and name recognition.
When you have a bad stay at a hotel, no consumer ever says “I will never stay at another John Jones owned hotel again” They say, I’ll never stay at another Marriot again. Customers are not concerned with the ownership; they are concerned with the end result. In addition, franchisees continue to pay a premium for the name and if they are not doing well the principal will lose franchises along with customers,
while gaining a tarnished name. A true snowball effect.
- Why would a chain such as Marriott tend to own its hotels in resort areas, such as national parks, where there is little repeat business, and franchise in downtown areas, where there is a lot of repeat business? Think of the reputation effect and the incentive of franchises to maintain quality.
This has to do with repeat business.
In resort areas you are going to get many different customers. When there is little repeat business, there may be less incentive for a hotel to provide quality service. Down town where repeat business is the overarching goal — franchises will already have a big incentive to maintain quality to attract repeat business, thus increasing their profit and revenue share.
- Suppose you are the manager of a California winery. How would you expect the following events to affect the price you receive for a bottle of wine? Explain your answers.
- The price of a comparable French wine decreases.
When the price of a substitute good decreases, demand for our good decreases which will decrease the equilibrium price.
- One hundred new wineries open in California,
This will increase supply. An increase in supply will decrease equilibrium price.
- The unemployment rate in the United States decreases.
This will increase income, which is a determinant of demand – demand will increase. An increase in demand will increase equilibrium price.d. The price of cheese increases.
When the price of a complimentary good increases, demand for our good decreases which will decrease the equilibrium price.
- The price of a glass bottle increases significantly due to new government antishatter regulations.
This will increase costs, which is a determinant of supply. Supply will decrease with an increase in costs. A decrease in supply will increase equilibrium price.
- Researchers discover a new wine-making technology that reduces production costs.
An improvement in technoloby will decrease costs, which is a determinant of supply. Supply will increase with a decrease in costs. An increase in supply will decrease equilibrium price.
- The price of wine vinegar, which is made from the leftover grape mash, increases.
I’ll accept two answers on this one. Either no effect, or if we count the higher price for mash as a cost reduction for the company, then the higher price for mash will cause a decrease in costs, which is a determinant of supply. Supply will increase with a decrease in costs. An increase in supply will decrease equilibrium price.
- The average age of consumers increases, and older people drink less wine.
This could be considered either a change in tastes and preferences or number of buyers, both of which are determinants of demand. Demand for our good decreases which will decrease the equilibrium price.
- After Iraq invaded Kuwait, gasoline prices rose dramatically – up 50 percent. There were many effects of the increased price of gasoline. Explain the following effects in terms of the income effect, substitution effect, or both effects:
The substitution effect is simply the basic Law of Demand which states that as the price rises, the quantity demanded falls. The income effect has to do with the overall wealth of consumers. If consumers have more disposable income, they will purchase fewer inferior goods, and substitute higher priced normal goods.
- People drove less and purchased less gas.
This would be both effects. Consumers buy less due to the higher price. Driving less makes the consumers feel a bit wealthier, which could lead to some additional demand.
- People ate out less often.
This would be an income effect. Eating out less and driving less makes the consumers feel a bit wealthier, which could lead to some additional demand.
- People had more tune-ups done on their cars.
This would be an income effect. More tune-ups make consumers feel a bit less wealthy, which could lead to some decreased demand.
- Bike sales went up.
This could be both effects. If we consider bikes a substitute good for cars, then we could say the price of gasoline might fall a bit, and consumers buy more due to the lower price. Purchasing the bikes though would make consumers feel a bit less wealthy, which could lead to some decreased demand for gasoline.
- The sale of lottery tickets fell.
This would be an income effect. Less lottery tickets purchased would make consumers feel a bit wealthier, which could lead to some additional demand.
- People took vacations closer to home.
This could be both effects. If we consider consumers reacted to the higher price in taking vacations closer to home – then it’s a substitution effect. Taking the closer vacations would make consumers feel a bit wealthier, which could lead to some increased demand for gasoline.
- Recently, the House of Representatives passed legislation to increase the minimum wage in th nation from $5.15 to $7.50. What are the pros and cons of this proposal? Provide an analysis based on the demand and supply of labor.
Our Law of Demand not only applies to goods and services, but workers as well. When the price of labor increases, the quantity supplied of workers will increase (more workers want to work at the higher rate). The quantity demanded of labor (by employers) will decrease however at the higher price. This is why many economists believe that increases in the minimum wage actually work against the people that are intended to be helped – as fewer workers will be hired overall.
On the positive side, the workers who do receive the higher wage will be able to purchase more goods and services, and enjoy a higher standard of living.
- Assume the demand for plastic surgery is price inelastic. Are the following statements true of false? Explain.When a good or service is price inelastic, it means that the percentage change in quantity demanded will be smaller than the percentage change in price. If the price of the good or service is increased – it will result in an increase in total revenue / sales. Conversely, a decrease in price will result in a decrease in total revenue / sales.
- When the price of plastic surgery increases, the number of operations decreases.
True. This is the basic Law of Demand. The quantity demanded will decrease, but in this case by a smaller percentage than the percentage increase in price.
- The percentage change in the price of plastic surgery is less than the percentage change in quantity demanded.
False. That would be price elastic. The percentage change in the price is greater than the percentage change in quantity demanded when you have inelastic demand.
- Changes in the price of plastic surgery do not effect the number of operations.
False. That would be perfectly inelastic demand.
- Quantity demanded is quite responsive to changes in price.
False. That would be elastic demand. For inelastic demand, the quantity demanded is responsive, but not very responsive to changes in price.
- If more plastic surgery is performed, expenditures on plastic surgery will decrease.
True. This is the basic Law of Demand. If the quantity is increased that corresponds to a lower price on the demand curve, and you want to increase price to increase total revenue / sales. A lower price will decrease total revenue / sales / expenditures.
- The marginal revenue of another operation is negative.
True. Marginal Revenue is the change in Revenue when an additional unit is produced – or the change in revenue divided by the change in quantity produced. Again, by the basic Law of Demand, if the quantity is increased that corresponds to a lower price on the demand curve, and you want to increase price to increase total revenue / sales. A lower price will decrease total revenue / sales – so marginal revenue will be negative.
- Identify firms that periodically shut down their operations. What are the conditions that exist when they shut down their operations and the conditions that exist when they resume their operations? Explain your reasoning.
A shutdown is a short-run decision to reduce variable costs by reducing labor costs for a week or 2. The hope is that either the price will rise or variable costs will be reduced enough to increase profits. Think of this as similar to what some of the auto companies do (and others) when they close the factory for a couple of weeks because they’ve overproduced the product.
If the business is still losing money after every possible resource has been adjusted (meaning closing some plants, laying off workers, etc) then the business would most likely close permanently.
The key thing to recognize in the shutdown situation is that if you are losing less than total fixed costs, you keep operating. If you are losing more than total fixed costs, you shutdown temporarily.
- Recently there has be a drive to increase the production of alternative fuels from corn. The argument used by many is energy self sufficiency. In light of the desire to reduce our use of foreign produced oil, many have suggested we should subsidize this production and shift to alternative fuels. Is this a good or bad idea from and economic view? If you say “Yes” or “No”, why, explain your answer using sound economic theory.
Overall, the negatives seem to outweigh the positives. In an article a few years ago from business week it outlined the costs of ethanol. It’s subsidized by the U.S. government at a rate of 51 cents per gallon, and federal and state subsidies for the fuel added up to $6 billion last year (Herbst 2007). Then of course we have the rise in the price of corn, which boosts food prices. “Already, about 20% of the corn crop goes toward ethanol production that drove up corn prices 80% in 2006 alone. Ethanol lags gasoline in fuel efficiency” (Herbst 2007).
Think of all the mechanization and energy needed to harvest the corn. We use equipment that runs on gasoline which of course is counterproductive to the end result we desire with ethanol usage.
Now on the positive side the ethanol industry plays a crucial role for midwest farm regions. The higher corn prices are economically helping depressed rural areas and
new ethanol manufacturing plants bring jobs to areas that have higher unemployment (BusinessWeek.com 2007, “Who Profits from Corn’s Pop?”).
As a reaction to the higher corn prices we will see an increase in food prices. Economically this changes the budget constraints and consumer equilibrium when it comes to the purchase of normal goods. The higher costs of food and the higher costs of using ethanol removes income that can be utilized on other normal goods. This whole scenario lines right up with the increase in wages in terms of effects on consumer income, budget constraints, and demand for normal and inferior goods.