Managerial Economics Flashcards

Question 1

Q

What is the fundamental concept behind economics?

Answer

A

social science
allocate scarce resources in the most efficient way possible to satisfy as many of societies wants as possible

Scarcity:

all resources (natural, human, capital goods) are limited in comparison to society’s infinite wants
decision making is therefore important

Question 2

Q

What are opportunity costs?

Answer

A

Related to a decision

- benefits to the society of what is sacrificed or given up when a choice is made

Question 3

Q

What is the difference between Micro and Macroeconomics?

Why are they important?

Answer

A

Microeconomics:

branch of economics that studies the behaviour of individual economic units
focus on firm, consumers, specific markets

Important for managers: pricing, output, strategies and the potential of impacting cost, demand, revenue and profit

Macroeconomics:

study of the economy as a whole
focus on aggregate (total) expenditure and aggregate (total) consumption
international trade, government spending, taxation and money supply

Important for managers: estimate current market situation, understand politic environment, predict economic cycles

Question 4

Q

What are normative economics?

Answer

A

Normative = opinion about what the government “ought to” or “should do” or how the economy “should be”

Question 5

Q

What are positive economics?

Answer

A

Positive = facts and statements that can be tested in practice

Question 6

Q

What the difference between deductive and inductive methods?
What are the purposes of them?

Answer

A

Deductive
- hypotheses are made, tested and then rejected or approved based on quantitive analysis of data

Inductive:
- economics create theories based on facts which have been determined after the analysis of data

–> Economists use both methods to find support for their economic theories, build theories or create new theories

Question 7

Q

What is ceteris paribus?

What does it mean?

Answer

A

Economists build models on the relationship between a few variables and assume other variables that influence the study are unchanged

Ceteris paribus = other things being equal assumption

Question 8

Q

Describe the idea of economic optimisation.

Answer

A

Idea of optimisation:

economic agent (household, government, firm) aims to maximize their utility, profits and social welfare respectively
subject to certain constraints
act rationally based on the marginal cost and marginal benefit of a good

Question 9

Q

What is the assumption of the rational expectation school of thought?

Answer

A

Economic agents are able to understand the future effects of government policy decisions to the point that such policies may become ineffective

Question 10

Q

What is the criticism regarding the scientific methodological approach used by many economists?

Answer

A

Often difficult to realistically build models of the economy and the behaviour of its economic agents using structural equations and optimisation theory
many models are based on assumptions that are unrealistic
many models do not represent the real world
critic: if policy prescriptions are based on these models it could lead to inaccurate and potentially hazardous courses of action regarding the economic well being

Question 11

Q

List different economic schools of thought.

Answer

A

Classical
New Classical
Neo Classical
Austrian
Keynesian
New Keynesian
Post Keynesian
institutional
evolutionary
radical
Marxist
feminist
behavioural

Question 12

Q

What are categories of economic schools of thought?
How are the different from each other?
What is the criticised?

Answer

A

Mainstream:

classical, new classical, Neo classical, austrian
limited government intervention in the economy
promote the idea that markets by themselves can correct any imbalances
government intervention create inefficiencies

Heterodox:

Keynesian, etc.
markets are inefficient and they do bot correct themselves
governments need to intervene to correct market failures arising from imperfect competition and imperfect information

Question 13

Q

What are implications for managers regarding the different economic schools of thought? Which analytical tools should they rely on?

Answer

A

- Understand underlying economic framework which an analytical tool is based
- Are the assumptions realistic?
- Are the assumptions relevant?
- Are they relevant to the Marco environment of the firm?

2
- understand the limitations of the data at the disposal

3

be aware to only rely on quantitative data when making decisions
focus on instincts as well
Challenge: mix gut feeling with quantitive data

Question 14

Q

What is the critic of the main schools of thought in economics?

Answer

A

Critic with Mainstream:

creating economic models are too simplistic and unrealistic
models cannot describe how the economy works
models are very useless at best and potentially dangerous if governments follow the prescriptions at worst

Critic with Heterodox:

thinking lacks credibility because of its non-scientific methodology approach
does not use mathematical equilibrium optimisation models
qualitative research alone cannot explain the behaviour of firms, governments and individuals on a basis for valid recommendations

Question 15

Q

What is a business cycle?

Which phases are there?

Answer

A

regular fluctuations in the economic activity
represent macroeconomic instability
economic prosperity tends to be followed by economic downturns

Recession
- aggregate expenditure falls and unemployment rises
- GDP in two consecutive quarters are decreasing
Trough
- economic activity at the lowest point
Growth
- economic activity rises / recovers
Peak
- highest point right before it begins to fall

Question 16

Q

How can mangers deal with the business cycle?

Answer

A

1: Understand the terminology used to describe the macro conditions
2: Look for signs suggesting economic changes
3: economic indications that governments, central banks, and firms follow to gauge upcoming changes
4: Challenge of interpreting them correctly

Question 17

Q

What are economic indicators?

List them.

Answer

A

Economic indicators reflect the health of an economy

1 Labor market conditions

initial claims for unemployment benefits
employment rate and unemployment rate
labor force participation rate
long-term unemployment rate

2 Government finances

budget deficit / surplus
government debt

3 Surveys

Surveys of Consumer Expectations (SCE)
ECB Surverys
Business Leader surveys

4 Inflation

HICP (Harmonized index of consumer prices)
CPI (Consumer Price Index)
PPI (Producer Price Index)

5 National Income and trade

GDP
personal income
BOP (Balance of Payments - Import/Export)
exchange rates

6 Key expenditures

construction spending
motor vehicle sales

7 Manufacturing and inventories

industrial production and capacity utilisation
manufacturers shipments, inventories and orders
wholesale and retail inventories

Question 18

Q

What policies should governments use to create conditions of macroeconomic stability?

Answer

A

1 Sustainable economic growth
2 Price stability (low inflation)
3 Full employment (low unemployment)
4 Balance of Payment equilibrium 
6 Sustainable national debt (including low budget deficit)
7 More equitable distribution of income

Question 19

Q

What is monetary policy?

Answer

A

Focus on:

supply of money
interest rates
availability of credit

Done by the central banks (FED, ECB, etc.)

Tool = OMO (Open Market Operations):

buying and selling of securities –> changes in money supply
changing the discount rate –> change interest rates of credit
changing the reserve ration –> affect availability of credit

Question 20

Q

Describe OMO.
Who uses it?
What’s the underlying policy?

Answer

A

Tool = OMO (Open Market Operations):

buying and selling of securities –> changes in money supply
changing the discount rate –> change interest rates of credit
changing the reserve ration –> affect availability of credit

Used by central banks such as ECB, FED, etc.

Part of monetary policy to affect money supply, interest rates and availability of credit.

Question 21

Q

What is tight/contractionary monetary policy?

Answer

A

Executed as part of the OMO of the central banks:

Aims to decrease inflationary pressures by:

decreasing money supply growth
increasing interest rates
Decreasing money supply by selling securities to commercial banks or the general public
Increasing interest rates = more expensive to borrow money

Question 22

Q

What is loose/expansionary monetary policy?

Answer

A

Executed as part of the OMO of the central banks:

Aims to increase or accommodate aggregate spending:

increasing money supply
decreasing interest rates
Increasing money supply by buying securities from commercial banks or the general public
Decrease interest rates = cheaper to borrow money
Adopt non-traditional methods such as QE (quantitative easing) to stimulate bank lending and spending

Question 23

Q

Describe the term fiscal policy.

Answer

A

Fiscal policy is the government’s policy with respect to the government spending and taxation

Government can

increase spending and/or
decrease taxes

Expansionary fiscal policy:

Decreasing income and/or corporate taxes:
- leaves households with more money
- more profits for companies to reinvest
focus on aggregate expenditure
used to pull economy out of a recession
mainstream economists: increase aggregate expenditure = short-term effect only since long-term results in higher inflation
results in higher budget deficits = government borrowing + cloud out (reduce) private sector and business spending (reducing the effectiveness)
Heterodox economists:
strong disagree with the view of mainstream regarding expansionary fiscal policy
will result in higher tax revenue + lower government spending on unemployment benefits
help to minimise budget deficit
interest rates do not have an effect on crowding out

Question 24

Q

Describe the supply-side policies.

Name six examples.

Answer

A

Fiscal and monetary policies focus on the demand-side to influence aggregate spending
Alternative approach to increase the supply-side
Aims to increase aggregate supply by increasing efficiency in the product and resource market

Examples:
1 lowering the size and duration of unemployment benefits to motivate the unemployed to search for work
2 reducing minimum wages to create greater incentive for employers to hire workers
3 reducing marginal income tax to create incentive for works to work more hours
4 reduce trade union power
5 making information about jobs more accessible to unemployed
6 increase competition in the product markets

Question 25

Q

What is the macro goal that policy makers perceive as the most important?

Answer

A

Does not exist and depends on the country
If unemployment is high –> Employment rates
If inflation is high –> inflation

Mainstream view:

focused more on long-term growth that requires price stability and fiscal discipline
full employment or low unemployment is not explicitly stated
price stability ensures competitiveness which contributes to economic growth and smaller levels of unemployment
appropriate monetary and fiscal policies to avoid excessively expansive fiscal policy

Heterodox view:
+ keeping inflation and fiscal deficits low will not lead to high growth and falling unemployment
+ inflation and sound fiscal finance counties can have high unemployment rates
+ effectiveness of monetary policy without expensionary fiscal policy will not work

Question 26

Q

What is demand?

Answer

A

Demand is the amount (quantity) of a good or service that buyers are willing and able to buy at different prices over a given period of time in a given market.

Question 27

Q

Describe the law of demand.

Answer

A

As the price rises the demanded quantity falls and vice versa
relationship between price and demand is inverse
negative sloping curve

Income effect:

effect on demand due to changes in the purchasing power of income that arises from a change in price
if price of a good falls, an individual can afford to buy more

Substitution effect:

if a price of a good changes, it becomes more expensive or cheaper compared to other products and services
consumers will substitute the more expensive for a cheaper product

Question 28

Q

What are Non-Price determinants of demand?

Describe them.

Answer

A

1 Changes in tastes and preferences

seasonal changes
trends in fashion and technology
advertising or publicity

2 Income levels

people become unemployed = lower demand
higher payments = higher demand = more buying power

3 Expectation of the future

bleak future outlook; worried people = lower demand
demand based on good: normal goods, inferior goods, superior goods

4 Prices of related goods

substitutes = satisfy the same want
demand for a product is positively related to the price of a substitute product
price of substitute rises = demand for the other substitute good rises
goods consumed together = complementary good
demand for complementary goods are inversely related

5 Number of buyers in a market
- more buyers = more demand

Question 29

Q

What is the demand function?

Answer

A

Qd = f ( 
price of good, 
tastes and preferences,
income levels,
expectations,
prices of related goods,
number of buyers)

Question 30

Q

What is the difference between changes in demand vs. changes in quantity demanded?

Answer

A

Changes in Quantity demanded:

changes when price changes
changes in price (ceteris paribus) = change along the demand curve

Demand changes:

tastes/preferences, income, expectations, number of buyers, related product changes
shift of the whole demand curve (right or left)
shift to right = increase in demand at any given price
shift to right = decrease in demand at any given price

Question 31

Q

What is price elasticity of demand?

What is the result?

Answer

A

PED = measures how much the quantity demanded for a good changes when its price changes

PED = % change in Qd / % change in P

Result is always absolute

Result:

PED > 1: percentage change in Qd is greater than the percentage change in price –> demand is price elastic
PED < 1: percentage change in price is greater than the percentage change in Qd –> demand is price inelastic

Question 32

Q

What are factors influencing the PED?

Give an example for each.

Answer

A

1 Availability of close substitutes
- if price rises, some buyers will switch to substitutes
- if there are no substitutes it is difficult to switch = price inelastic
Example: demand for petrol = the same for each price = price inelastic due to the lack of substitutes

2 Proportion of income spent on the good
- if proportion of income spent is small = customers are less likely to significantly decrease the amount they buy
Example: Salt, butter, milk = very small amount of income = price inelastic goods

3 Luxury vs. necessities

demand for necessities are price inelastic (people do not need to buy more or less of it)
demand for luxury goods are price elastic (people could not go on holiday for a season and still survive)
Habit or addition demand: very price inelastic since people buy the product anyways

4 Time
- demand for products tend to be inelastic in the short-term
- long term = elastic
Example: People need to buy petrol in the short-term; however long-term they could purchase alternative fuel tech

Question 33

Q

What types of goods can be differentiated regarding their relation to demand?

Answer

A

Inferior goods:

negatively related to demand
e.g. bus tickets: as income increases demand decreases and vice versa

Normal goods:

positive relationship
e.g. vacation/luxury items: as income decreases the demand decreases

Question 34

Q

Why is it important for managers to be aware of price elasticity of demand?

Answer

A

Knowledge about product being inelastic means prices can be raised without worrying that demand will fall very much
quantity demanded will be lower but total revenue will increase
Knowledge about product being ELASTIC means prices can NOT be raised because quantity demanded will be lower than the price gain and total revenue will decrease

Question 35

Q

What is income elasticity of demand?
How is it calculated?
What does the results mean?

Answer

A

YED (income elasticity of demand) measures how much the demand changes when income levels change

YED = % change in demand / % change in income

YED < 1: Percentage change in demand is smaller than percentage change in income therefore demand is income inelastic

Results:

Normal goods: YED = 0 bis 1 (demand increases when income increases)
Inferior goods: YED < 1 (demand decreasing when income increases - e.g. bus ticket)
Superior goods: YED > 1 (luxury good: demand increases a lot when income increases)

Question 36

Q

What is the implication for managers regarding the YED?

Answer

A

important to understand the income elasticities of the products
YED that are highly elastic (luxury goods) ca be affected significantly by a recession and decreases in buying power
companies with YED elastic goods can diversify as part of preparation for a recession

Question 37

Q

What is XED?
How is it calculated?
What are the results?

Answer

A

Cross-price elasticity of demand (XED) measures how much the demand for one product changes when the price of another product changes

XED ab = % change in demand for good A / % change in price of good B

Result:
XED < 0: Two goods are substitute products (the higher the more substitutable)
XED > 0: Two goods are complementary products

Question 38

Q

Why is XED important for managers?

Answer

A

understand how XED affects substitutes and complementary products
if XED for a product is elastic with respect to competitors product = more attention needs to be paid to competitors pricing strategies
if XED is elastic and competitor lowers prices, it will significantly influence the demand for the product
price cuts, ads, promos, etc. can be an option

Question 39

Q

What is cross-sectional data?

Answer

A

Information obtained about variables for a specific time period

Question 40

Q

What is time-series data?

Answer

A

Information about a variable over a period of time

Question 41

Q

How can a Demand estimation be performed?

Answer

A

- Regression analysis
appropriate data:
- accurate
- reliable
- valid
- data must be collected in a way to avoid potential issues (e.g. surveys, biases)

Question 42

Q

What data is required to properly estimate demand?

Answer

A

dependant variable: e.g. demand for hotel rooms

independent variables:

price per room
income levels of potential customers
preferences and tastes
perceived safety and advertisement
prices charged by other hotels

Question 43

Q

What is the coefficient of determination in a regression analysis?

Answer

A

R2 indicates the proportion of variations in the dependant variable that is explained by the explanatory (independent) variables in the regression equation.

e.g. R2 = 0.75
means 75 percent of the variations in the demand for hotels rooms can be account for by the variations in the independent variables

Question 44

Q

What is the F-value in a regression analysis?

Answer

A

F-Value is compared to a critical value to determine whether the entire regression equation is statistically significant based on the degrees of freedom and the designed significant level

F-value measures the significance of R2 (coefficient of determination)

Question 45

Q

What is the F-value in a regression analysis?

Answer

A

F-Value is compared to a critical value to determine whether the entire regression equation is statistically significant based on the degrees of freedom and the designed significant level

F-value measures the significance of R2 (coefficient of determination)

Question 46

Q

What are t-statistics in a regression analysis?

Answer

A

t-statistics (value) are determined by a t-test to determine the statistical significance of each regression coefficient

t-value = estimated coefficient / standard error of the coefficient

significance level of .05 is considered acceptable
= 95% confidence that the results obtained from the sample are representative

Question 47

Q

What could be potential issues in a regression analysis?

Answer

A

1 Misspecification of equation

regression analysis is incorrectly specifying the form of the regression equation
e.g. linear equation used when dependant and independent variables are not linearly related
regression may also be inadequate in t hat It does not include important predictors (e.g. missing variables that are important for the outcome)

2 Multicollinearity

two or ore independent variables are related to each other in a systematic way
difficult to know if the independent variable affects the dependent variable
biases the standard error reducing the t-values and making it more difficult to identify statistically significant independent variables and reject the null hypothesis

3 Identification problem

equilibrium price and quantity in the market are simultaneously determined by demand and supply
difficult to know if supply or demand had a bigger effect
not identifying and resolving will lead to biased estimates

4 Problems with random errors

every regression has random terms
random term is assumed to have a normal distribution, a zero mean, and a constant variance
variance of the random error is not constant and changes over time
leads to prediction errors due to repeated overestimations or underestimations

Question 48

Q

What’s the definition of supply?

Answer

A

Supply is the amount (quantity) of a good or service that firms/producers/sellers are willing and able to offer for sale at different prices over a given period of time in a given market.

Question 49

Q

Describe the law of supply.

What is the implication for firms?

Answer

A

Supply represents a positive relationship between to price and quantity supplied.
Upward slowing curve of supply.
As prices increase, a firm has a greater incentive and ability to produce and offer more for sale.
Higher prices may allow to cover additional costs that it may have to incur in order to produce and sell more.
higher prices = opportunity to earn higher profits, thus creating an incentive for firms to take on the risk associated with expansion and increasing output

Question 50

Q

What is meant by “extension of supply” and “contraction of supply”?

Answer

A

Expansion of supply:

move up along the supply curve as prices rise (e.g. form 200$ to 250$)
quantity of supply increases

Contraction of supply:

move down along the supply curve as prices decrease (e.g. form 250$ to 200$)
quantity of supply decreases

Question 51

Q

What are non-price determents of supply?

Answer

A

1 Weather

agricultures output is highly affected by weather conditions
good weather = higher output = shift of supply curve to the right
bad weather = lower output = shift of supply curve to the left

2 Cost of production

higher raw material prices (e.g. wages, electricity, etc.) will increase the total cost of production = firm needs to sell at higher prices = shift of supply curve to the left
Advances in technology = more output = shift to right
lower taxes or subsidies = lower cost for production = more output = shift to right

3 Expectations of the future

optimistic outlook = more willing to invest to expand and produce more = shift to right
negative outlook/expectations = produce less / reduce inventory = shift to left

4 Prices of other products or services by the seller

if firm produces more than one product using the same inputs, it will have an incentive to produce more of the products that are in higher demand
e.g. farmers = carrots are more profitable than potatoes = lower supply for potatoes = shift to the left of potatoes = shift to the right of carrots

5 Number of sellers in the market

firms enter the market to produce and compete = more output = shift to the right
existing firms go bankrupt = shift to the left

Question 52

Q

What is Price elasticity of supply?
How is it calculated?
How can the results be interpreted?

Answer

A

Price elasticity of supply measures how much the quantity supplied of a good changes when its prices change.

PES = % change in quantity supplied / % change in Price

Results:

PES < 1 = percentage change in Qs smaller than percentage change in P = supply is inelastic
PES > 1 = percentage change in Qs greater than percentage change in P = supply is elastic

Question 53

Q

Why is it important for managers to understand the price elasticity of supply?

Answer

A

PES of their products and inputs very important
- if demand rises but supply is relatively inelastic = firm will not be able to increase the output fast enough to satisfy the demand = loss of customers, sales and profits

Question 54

Q

What are determinants of price elasticity of supply?

Answer

A

1 Storage and costs of storage

prices rise = use stocked quantity = more profit = elastic supply
if products cannot be stored (e.g. vegetables = supply is relatively price inelastic (short term)

2 Production capacity

if company is not producing at full production capacity = fast increase in supply possible = elastic supply
firm at fully production capacity already = inelastic supply = no increases possible in the short term

3 Time

short term: if prices rise firms may not be able to increase supplied amount
long term: increases in supply are much more likely (new machines, facilities, production capacities)

Question 55

Q

How are prices determined?

Answer

A

Price mechanisms based on supply and demand
Equilibrium between Qs and Qd is the price

Supply surplus:

supplied quantity is higher than demanded quality
firms will lower the price
lower price will lead to increase in Qd
lower price will reduce incentive to produce as much = lower Qs

Supply shortage:

quantity demanded in greater than quantity supplied
excess demand = higher prices for sellers possible
increase of sellers in the market = higher Qs

Question 56

Q

How can changes in non-price determinants affect demand and the market equilibrium?

Answer

A

1 Successful advertising
2 changes in tastes and preferences in favor of a good
3 increase in income (effect on normal goods)
4 increase in the price of a substitute good
5 increase in the number of potential buyers
6 consumer expectations are optimistic / expected price increase

-> Demand increases
-> Demand curve shifts right
-> Price Equilibrium and Quantity Equilibrium RISE

Question 57

Q

What happens to the market equilibrium (Qe and Pe) if the following happens?

1 The customers changed the preferences and now prefer another good of the good of the company

2 Economy is in a recession and the income decreases (normal good)

3 The company produces swimwear and winter is approaching

Answer

A

1 Lower demand for the product of the company = shift of demand to the left = Pe decreases; Qe decreases

2 Lower overall demand of the customers due to lower income (cannot afford as much as before) = shift of demand to the left = Pe decreases; Qe decreases

3 seasonal business = demand temporarily shifts to the left = Pe decreases; Qe decreases

Question 58

Q

How can changes in non-price determinants affect supply and the market equilibrium?

Answer

A

1 Favourable weather (mainly agricultural)
2 Decreases in the input costs (price of raw materials; rent, etc)
3 Advances in technology
4 Decreases in indirect taxes
5 Increase in government subsidies
6 Increase in the number of sellers
7 Business managers expect prices to fall and want to sell more now
8 Decrease in the price of another good the company produces

-> Supply increases
-> Supply curve shifts to the right
-> Pe FALLS ; Qe RISES

Question 59

Q

What is production?

Answer

A

Process during which inputs such as raw materials are transformed into outputs using other inputs such as labor, land, and capital goods such as machines, tools, factories, and offices.

Question 60

Q

What is the production function?

Answer

A

Shows the relationship between input and output
maximum level of output that can be produced within a given period using given combinations of inputs and level of technology

Q = f (X1, X2, X3, …, Xn)

Question 61

Q

What is the difference between short run and long run production?
Give an example for each.

Answer

A

Short run:
- period of time during which at least one factor of the production cannot be changed
- in this period, if a firm wants to increase its output, one of its input factors is fixed in quantity or size and cannot be varied
Example: Pizzeria produces certain amount of Pizze that cannot be increase with adding more Pizzaioli because only one oven is available

Long run:
- period of time during which the quantity or size of all input factors including capital and land can be increased
Example: Pizzeria produces certain amount of Pizze. Over the long run it can purchase more ovens, open more than one shop and increase output.

Question 62

Q

What is MP(L)?

What is AP(L)?

Answer

A

MP (L) = Marginal product of labor:
The additional (extra) output that is created from using one more unit of labor.

AP (L) = Average product of labor:

Represents labor productivity and is calculated by dividing total product by quantity of labor
Result does not mean that each unit of labor produces AP(L) but together in average they product AP(L)

Question 63

Q

In the short run MP(L) initially rises and begins to fall.

Explain the cause.

Answer

A

When there is only one worker, adding another worker increases the productivity
Workers can specialise and divide labor effectively
Cooperation increases output MP(L)
both MP(L) and AP(L) rise
due to limitations in input factors (e.g. kitchen space) the addition of more labor units will not increase efficiency anymore
addition of more workers will increase the output but at an decreasing rate since the workers could get in each others way
diminishing marginal returns

Question 64

Q

Describe the law of diminishing marginal returns.

Give an example.

Answer

A

As more and more units of variable input are added to a fixed amount of another input, eventually the marginal product will start to decrease and thus output will begin to rise at a diminishing rate.

Example:

two cooks are working in a kitchen
adding a third will increase the output
adding a forth will still increase the output but at a slower rate due to limited ovens
adding a fifth will increase the output very little
adding a sixth will decrease the output (they get in each others way)

Answer 65

A

Stage 1:

average product of labor rises
specialisation and cooperation of workers allows for greater use of underutilised fixed capital resulting in MP(L) being greater than AP(L)
MP(L) cuts AP(L) when APL(L) is at the max level

Stage 2:
- diminishing marginal returns; TP continues to rise since MP(L) is positive

Stage 3:
- TP begins to fall as MP(L) becomes negative

Answer 66

A

Managers engage in careful capacity planning to avoid operating in stages I and III in the short run
During stage 1 they would underutlize the fixed inputs
During stage 3 they would be operating ineffectively
Level of output is determined by customer demand - managers must try to estimate future demand in order to have the right amount of fixed and variable inputs to operate in stage 2

Answer 67

A

firm can vary the size and quantity of all factors in an effort to increase output
all factors of input are changed by the same proportion, there is a change in the scale of production

1 Increasing returns to scale

output increases proportionally more than its input
Increase input by 30% increases output by 40%

2 Decreasing returns to scale

output increases proportionally less than its input
Increase input by 30% increases output by 20%

3 Constant returns to scale

output increases proportionally with input
Increase input by 30% increases output by 30%

Answer 68

A

Relevant cost are the incremental costs explicit and implicit for a decision.

Explicit cost:
- actual costs incurred in producing goods or services such as wages, rental payments for office space, advertising expenses, interest on loans, and payments for raw materials

Implicit costs:
- are not actually paid but represent the opportunity costs of resources used

Opportunity costs:
- costs in terms of the benefits foregone of the next best alternative due to a particular choice

Incremental costs:

managers must compare the potential incremental benefits of courses of actions with the incremental costs
incremental costs = total current and future costs associated with a decision (thus all implicit costs including opportunity costs)

Answer 69

A

Expanses that cannot be recovered
They are irrelevant for a decision of a manager and not considered
Managers focus only on relevant costs and not sunk costs
Sunk costs do not change because of a decision

Answer 70

A

Expresses costs as a function of output
total cost of producing any level of output

Determined by the production function

one factor is fixed and cannot be varied in size or quantity
short run: at least one fixed cost

Short run cost function:
TC = TVC + TFC

Answer 71

A

Fixed costs are costs that do not vary with output - they remain the same whether the output increases or decreases

Variable costs are costs that vary with output - as output increases the variable costs rise accordingly

Answer 72

A

MC = additional cost of producing one more unit of output

MC = change in total cost / change in total quantity
MC = change in total variable cost / change in quanity

-> increasing marginal returns (MP(L) is rising), MC falls
-> when diminishing marginal returns set in (MP(L) begins to fall), MC begins to rise

Answer 73

A

Short run firms try to increase the output by using more labor = initially increasing marginal returns to labor
This causes MC of production to decrease which in turn causes AVC to fall
As firms add more and more workers to a fixed amount of capital or land, diminishing returns begin to set in = MC of production begins to rise
once MC rises above AVC, AVC begins to rise causing ATC to rise

Answer 74

A

Long run, all factors of production can be varied and there are no fixed cost
no fixed cost = law of diminishing returns does not apply in the long run
average cost curve is not determined by diminishing marginal returns but by internal economies and diseconomies of scale that lead to increasing and decreasing returns to scale respectively

Internal economies of scale = when firms long run average costs (LRAC) falls as output increases

Internal diseconomies of scale = when firms LRAC rises as output increases

Answer 75

A

1 Commercial Economies
- discounted prices on bulk purchases of supplies

2 Financial Economies
- arise if large firm is able to obtain a loan at a lower interest rate (less risky)

3 Managerial Economies
- larger firms using more specialized managers for different functions of the company (marketing, finance, etc.)

4 Marketing Economies
- lower average ad cost

5 Technical economies
- increased specialisation and division of labor e.g. container principle (larger containers on same surface area)

6 R&D economies
- large firms spread costs of R&D over a greater level of output

–> Occur in the long run where no fixed costs are present because LRAC falls as output increases

Answer 76

A

When firm becomes too big
Managerial diseconomies: effective and timely communication and coordination between departments, divisions, and orga level becomes slow and more difficult
decreased productivity
alienation of work
workers feel not heard and cared for

Answer 77

A

1 Profit maximization
2 Revenue maximization
3 Sales (output) maximisation
4 Profit satisficing

Answer 78

A

Neoclassical economics assume that the goal of a firm is to maximize profits.
Important: Higher prices or more output does not result in high profits
Profit maximisation is the level of output where MR = MC
As long as MR is greater than MC associated with producing that unit a firm can increase the profit by producing more

Real world:

Neoclassical economics: Rational managers use all relevant info when making decisions
Critics argue:
most business managers do not aim to maximise profits due to incomplete knowledge of a firms production function and potential search cost
Focus on making decisions based on heuristics and gut feeling

Answer 79

A

Revenue maximisation:

TR = Q*P
As long as MR is greater than 0, a firm can increase its TR by selling more
most cases a firm must lower prices to sell more

Sales Maximisation:

sell as much output as possible without making a loss
output level where price is equal to average total cost (P=ATC)

Answer 80

A

Normal profit

minimum amount of profit that a person is willing to earn to remain in business
represents opportunity cost of resources employed incl. minimum amount that the person could earn using his human capital elsewhere
Minimum profit constraint: firm could increase its output as much as possible and up to the point where it would still be able to earn a certain level of profit that had been previously determined as minimum acceptable level

Answer 81

A

Minimum profit constraint:
firm could increase its output as much as possible and up to the point where it would still be able to earn a certain level of profit that had been previously determined as minimum acceptable level

Answer 82

A

Principle-agent problem: Who makes the decisions for a firm?
CEO is hired to serve the interest of the shareholders
CEO is incentivised by year bonus (e.g. focus on stock price)
CEO has incentive to make decisions regarding the stock price (e.g. expansion or M&A) that focuses on increasing revenue, output but not profit
Todays bonus plans are more oriented towards long term performance and profitability

Answer 83

A

insufficient info, uncertainty and complexity regarding many decisions = difficult for managers to make right decisions regarding profit maximisation
aim to achieve a certain profit level that will be satisfactory for the board of directors and shareholders
satisficing reflects the need to satisfy shareholder (principle) demands

Answer 84

A

4 Pure Competition
3 Monopolistic competition
2 Oligopoly
1 Monopoly

Answer 85

A

1 Perfect (pure) competition
Number of firms: very large >100
Size of firms: very small
Control over price: none; price takers
Differentiated or homogenous product: homogenous, perfect substitutes
Price competition or non-price competition: compete on price, no-non price competition
Barriers to entry and exit: none
Example: farming and currency market

2 Monopolistic competition
Number of firms: many (e.g. 50)
Size of firms: small
Control over price: some control
Differentiated or homogenous product: differentiated, close substitutes 
Price competition or non-price competition: many compete on price but also non-price competition
Barriers to entry and exit: weak if any
Example: café and restaurant market

3 Oligopol
Number of firms: few (e.g. 3-5)
Size of firms: large
Control over price: control but interdependent on other firms
Differentiated or homogenous product: differentiated but homogenous in some markets
Price competition or non-price competition: mainly non-price competition but also price competition in some markets
Barriers to entry and exit: strong barriers and large exit costs
Example: airplane manufacturing industry

4 Monopoly
Number of firms: one
Size of firms: large
Control over price: large, price maker
Differentiated or homogenous product: no close substitutes
Price competition or non-price competition: many engage in PR activities or restrictive trade practices
Barriers to entry and exit: entry is blocked
Example: electricity provider

Answer 86

A

Production efficiency:

P = minimum ATC
Example: firm produces ice cream at the cost of 5$ and sells the ice cream on the market for 5$

Allocation efficiency:

P = MC
firm produces cars. Each car they produce more costs 10.000$. The price on the market for the car is 10.000$
Productive and allocative efficiency only under conditions of pure (perfect) competition
no barriers to entry
many small firms that sell homogenous products which have no control over the market or price

Answer 87

A

monoploy where internal economies of scale are very large and extend over a large range of output
one firm cannot satisfy the whole market demand and maximise all internal economy of scale effects
firm can satisfy the whole market but does not sell t the lowest possible costs

Characteristics are strong barriers to entry

existence of high capital costs
strong brand names
patents and copyrights
ownership of scarce resources
restrictive trade practices (charge limit prices to discourage competitor)

Answer 88

A

monopoly power is not a monopoly
monopoly power > 40% market share and dominant in the industry
market power firms are price makers
greater the power the more inelastic the demand curve
profit maximsing firms will charge a price and product a level of output that will result in MC = MR
price it charges is above ATC (=supernormal profits)

Answer 89

A

at the loss minimizing output where Q = MR, ATC is greater that the price charged
ATC is above the firms/market demand resulting in a loss at any demanded quantity
usually happens for state own monopolies
inefficiencies of state firms can be covered with tax revenue

Reasons:

state firms did not have incentive to produce effectively due to lack of competition (organisational slack)
Orga slack = costs are higher than what they should be
more employees that a firm needs
salaries being higher that what employees are willing to work for
inadequate control over quality or production oversight
extravagant spending of managers

Answer 90

A

Kinked-demand curve model in a Oligopol market

Oligopol firms are reluctant to change prices due to anticipated responses from competitors
prices will tend to be sticky (do not change often)
Kinked-demand curve = MR curve
lowering the price in an oligopol market when competitors do the same results in inelastic quantity demanded (unchanged)
decrease of revenue in Qd from lower prices = lower revenue (kinked)
demand is price elastic above P, demand is price inelastic below P

Answer 91

A

Kinked-demand curve model in a Oligopol market

Oligopol firms are reluctant to change prices due to anticipated responses from competitors
prices will tend to be sticky (do not change often)
Kinked-demand curve = MR curve
lowering the price in an oligopol market when competitors do the same results in inelastic quantity demanded (unchanged)
decrease of revenue in Qd from lower prices = lower revenue (kinked)
demand is price elastic above P, demand is price inelastic below P

Answer 92

A

Oligopol market has often one firm bigger than the rest
leader raises prices; others follow
managers are not worried about losing customers due to pricing strategies
key: buyers must still be willing to buy at different prices (demand must be inelastic)
if PED is inelastic and prices can rise = higher profit for the companies

How to ensure that firms will actually follow the leader’s price?

price leader usually sends messages to rival companies in form of press speeches
other firms (smaller) need to follow to avoid revenge by big leader
price leader could drop prices below the AC levels of competitors (price them out) but above the own AC to avoid losses

Answer 93

A

firms agree to behave in a certain way that will benefit them
often in oligopol markets
companies raise prices on purpose to increase profit
companies divide markets geographically or do not compete in each other’s market
Illegal in the US, EU and many other countries
more likely in oligopol market due to interdependency

Answer 94

A

no dominant market leader (e.g. in oligopol market)
price changes are initiated by any firm in the industry
price change acts as barometer and other firms follow (price leadership)
other firms pricing strategy may follow and adapt

Answer 95

A

Collusion can be overt (formal and known) or cartels/covert (tacit)

most often cartels are covert since collusion is illegal
most-well known example of overt collusion is the OPEC cartel (biggest oil producers worldwide)
OPEC influences the world price of oil setting production quotas for its members
demand tends to be inelastic so the supply controls the price

Answer 96

A

Firms in contestable markets always face the threat of potential entrants to the industry
arrival of new competitors will decrease the demand, revenue and profit of the existing firm
to prevent this existing firms use limit pricing: charge a price lower that the one that will maximise profits in order to discourage new arrivals entering the market
set prices lower than new firms AC but higher than own firms AC
firms accept lower profits in short run but keep market share in long run

Answer 97

A

Predator pricing

practise of charging a price that is low enough to drive competitor out of business
adopted by existing firms to eliminate a competitor
charge a lower price than the competitors AC
firms engaging in these strategies might make losses in the short run
difficult: if successful new competitors might enter

Answer 98

A

Limit pricing:

Firms in contestable markets always face the threat of potential entrants to the industry
arrival of new competitors will decrease the demand, revenue and profit of the existing firm
to prevent this existing firms use limit pricing: charge a price lower that the one that will maximise profits in order to discourage new arrivals entering the market
set prices lower than new firms AC but higher than own firms AC
firms accept lower profits in short run but keep market share in long run

Answer 99

A

Predator pricing

practise of charging a price that is low enough to drive competitor out of business
adopted by existing firms to eliminate a competitor
charge a lower price than the competitors AC
firms engaging in these strategies might make losses in the short run
difficult: if successful new competitors might enter
very difficult if new competitor has financial strength to engage in penetration pricing

Answer 100

A

Occurs when a firm charges a low price in order to gain market share and establish itself in an industry.

Enter with low prices and increase price once market share goal is reached

Answer 101

A

Buyers willing to pay a higher price for a product bestows upon them some level of prestige

Firm will be able to earn high profits if it is able to make people believe that the product conveys the prestige

Answer 102

A

Price discrimination (price strategy)

goal is to increase profits
charge different prices for the same good when differences in price are not due to differences in costs

1st degree Price discrimination: charge maximum price that each buyer is willing to pay for each unit of a good/service

2nd degree price discrimination: occurs when a firm charges buyers different according to how much they purchase.

3rd degree Price discrimination: occurs when the sellers divide or segment buyers into distinct markets (age, income, geography) and charges a different price in each market

Answer 103

A

Charge different prices to those who are more/less sensitive to higher prices

goal is to increase profits
charge different prices for the same good when differences in price are not due to differences in costs

1st degree Price discrimination: charge maximum price that each buyer is willing to pay for each unit of a good/service

2nd degree price discrimination: occurs when a firm charges buyers different according to how much they purchase.

3rd degree Price discrimination: occurs when the sellers divide or segment buyers into distinct markets (age, income, geography) and charges a different price in each market

Other forms:

peak-load pricing
price skimming
intertemporal pricing
two-tariff pricing

Answer 104

A

1 buyers must have different price elasticities of demand
2 firm must be able to determine PED differences amongst buyers
3 price discriminating firm must be able to keep the segmented markets segmented at low cost (avoid reselling customers that undercut prices)
4 firm must have control over prices (market power)

Answer 105

A

1st degree: difficult to know maximum price that buyers want to pay for

2nd degree: more common; buy one get a third at 50%; as long as price is above the ATC company can increase quantity and generate additional revenue and profit

3rd degree: very common, fares for busses differ based on retirement or student as those groups tend to be more price elastic

Answer 106

A

if costs differ, price discrimination (e.g. 3rd degree for bus fares) are not sufficient
customers are charged a higher price during peak demand (e.g. rush hour) and lower at off-peak times (evening/night)
strategy acknowledges importance of PED but at different peak demand levels to cover higher marginal costs

Answer 107

A

Firm introduces a new product/service without any close substitutes
demand is relatively price inelastic
firm can charge more until new competitors arise
decrease prices over long run to avoid too much competition

Intertemporal pricing:

different prices in two different time periods that span over weeks, months or years.
e.g. Apple with new iPhone as customers have waited for the new model (inelastic)

Two-part tariff:

determine price based on fixed and variable cost
charge customers a base rate to cover FC and variable fee to cover VC
e.g. electricity, water or other utility firms

Answer 108

A

also called mark-up cost
average costs of production is defined + certain percentage (mark-up) for profit to define final price
mark-up cost differs depending on product line, etc.
can respect different PEDs in markets
lower mark-up when prices are elastic

Answer 109

A

firms sell more than one product
prices should be defined how the products are related on demand side and supply (cost) side
demand side = products might be supplements or complementary

Full range pricing:
- determine the prices of all their complementary and substitute products jointly so they can set prices to maximise profits form all its sales

Example:

Lidl charges very low prices for certain products to attract people into the market
product generates losses because prices are higher than ATC
however: customers tend to buy more than one products
high mark-up for other product cover the costs and generate additional profit
full range pricing can justify loss leader products

Answer 110

A

many large orgas divide and operate within profit centers
each profit center aims to maximise profits and reach targets
incentive to set prices that will increase profit in their profit center
however: profit of one PC will affect input prices of other PC so final price is also affected by this
conflict of interest should be solved by setting divisional targets regarding the MC of intermediate products
focus on efficiency to keep MC low

Answer 111

A

MSC = MSB is the socially optimal level of output
if MSB > MSC net value gain for society of producing additional units
if MSC > MSB, MSB is lower than MSC; additional value to society of consuming the last unit of the good is lower than the additional cost to the economy of producing that unit (society is allocating too many resources to the production)

Answer 112

A

social benefits from the production and consumption of a good
positive spillover effects to third parties who did not pay for the inoculation also benefit
Usually MSB = MPB
for Positive Externalities: MSB is greater than MPB
MSB = MPB + positive externalities
society is undervaluing the good that is creating the external benefit
society is producing less than would be socially optimal (market failure/inefficiency)
external benefit is larger for lower levels of output
prices for these goods are (perceived) too high because people do not understand the full benefit to the society (difference between MPB and MSB)

Example:
Education/training
health care

Answer 113

A

Education and healthcare are merit goods

merit good would be under consumed if provided by a private sector
people do not understand true value of merit goods
people perceive good too expensive
MPB is lower than MSB (gap is a positive externality)

Answer 114

A

production and/or consumption of a good creates external costs
costs for third parties not directly involved
price did not factor negative effect of third party in
MPC to MSC gap increases with increased output
too many resources are allocated to producing the good (price too low)
net welfare (deadweight) loss

Example:
Firm produces tires and has toxic fumes that affect farmers nearby. Their crops cannot grow like they would and these effects are not priced into the “production cost” of the tire producer.

Answer 115

A

Firms aim for profit maximisation, profit satisfying or some other goals to make profit
some markets suffer from “free rider” issues: people who will not want to pay for a good but cannot be excluded from consuming it
firms cannot make a profit will depend on legal rights to charge tolls for free riders
inefficient allocation of resources = market failure
necessity to provide public goods: street lights or national defence otherwise these would not be provided by private firms = missing market

Answer 116

A

Good is provided by the government because it would otherwise not be provided by the private sector due to free rider issues
Non-excludability: once a good/service has been provided, it is difficult or too costly to exclude non-payers from benefiting
non-rivalry: consumption of a good does not result in less of the good for other people

Answer 117

A

pure monopoly: market demand is firms demand
monopoly produces less and charges a higher price than optimal (allocative inefficiency)
MC of the company = supply curve of the market in a pure monopoly (at MC = P there would be an allocative efficiency)
monopoly maximises profits by charging MC = MR at ATC min which is lower than P resulting in allocative inefficiency and productive inefficiency
producer surplus: difference between minimum price the firm is willing to sell for one more unit and price it actually receives
producer surplus is part of consumer surplus but some of the producer surplus is also lost (deadweight welfare loss to society)

Example:
Electricity provider charges a very high price per kW/h and costumers do not have an alternative = deadweight welfare loss

Answer 118

A

lack of perfect information
asymmetric information between parties engaging in transaction
advantage for one party at the expense of the other
two main issues: additional cost + efficiency reduction in the economy

Example:
Company requires a bank credit; company is hiding potential sales losses but requires the credit to survive. Bank does not know about this and thinks the company is successful.

Answer 119

A

externalities (positive or negative)
monopoly power
missing information (asymmetric information)

Answer 120

A

Positive externalities = under-allocation of resources and under consumption resulting in a price being too high for the true benefit

Governments can:

1 provide subsidies to firms:

reduce production costs and incentives to produce more
subsidies must be large enough to lower the price to the level MPC = MSB

2 provide subsidies to the buyers

e.g. by tax deductions to increase consumption of the good
subsidies must be large enough to increase MPB (demand) to the level MSB = MSC

3 providing the good itself

e.g. public education, public hospitals
costs are covered by tax revenue
resolves positive externalities and reduces missing markets due to the free rider problems

Answer 121

A

Negative externalities = over-allocation of resources and over-consumption
Problem is not the amount of the good but the negative spillover effects

Prices of the good should increase

Governments can:

1 Internalise the negative externality

third parties negatively affected can sue for damages
Farmers affected can sue the production factory for the pollution (cover their costs and internalise the true costs to society for the producer)

2 Regulations

regulate the maximum level of pollution and charge fines if exceeded
incentive to pollute less to avoid fines
difficult to set the right max. level where MSB = MSC

3 Taxes

general tax (e.g. green tax for pollution) on damages that create external costs
higher costs = higher prices
MPC must be raised to equal MSC (MSC = MSB) socially efficient output

4 Tradable permits

permits are handed to companies by determined maximum amount (e.g. of pollution)
each firm can use these permits to exchange for negative spillover effects
similar to regulation but tradable (if firm does not have any more permits, it needs to buy more from competitors)
permits cost money and incentivise lower negative effects

Answer 122

A

Monopoly markets = prices are too high and quantity is too low

governments can pass anti-trust laws that prohibit firms from exploiting customers
reducing barriers to entry in the market to allow competitors in the market (price reduction due to output increase)
regulate natural monopolies to reduce the exploitation by focusing on price and quality e.g. customer service

Answer 123

A

regulations to provide clear and accurate information to make informed decisions
laws to require a risk and cost analysis
laws to force firms to promote negative effects from their products (fatty foods, cigarettes, etc.)
provide informations (e.g. to unemployed people) about opportunities to reduce regional failures (e.g. labor market)

Answer 124

A

helps to analyse how individuals make decisions when they know that their decision affect others while at the same time the decisions of others affect them
mutual interdependence
better understanding of strategy and pricing (e.g. how competitors would respond to price changes)
predict potential behaviour of firms based on assumptions the managers make to adopt the appropriate strategy
predefine strategies based on potential strategy by competitors, payoffs and outcomes

zero-sum game: one player’s loss is the other player’s gain and vice versa.

non-zero-sum game: both players (e.g. firms) may lose or gain depending on each player’s actions.

Answer 125

A

Nash equilibrium is the outcome that results from the players making their best decision based on what they believe will be the other players’ decision.
Stable equilibrium because once players adopt the strategy that is best for them, they do not have an incentive to change it (=dominant strategy)

Example:
Hansel and Gretel are both interrogated for committing a crime.
Hansel will opt for the strategy based on what he think’s Gretel’s strategy will be.
If Hansel thinks Gretel will confess, he will also confess.
If Hansel thinks Gretel will not confess, he will still chose to confess.
(prisoner dilemma = non-zero sum game)

Answer 126

A

competing firms will not find it acceptable to continue to charge low prices and they may agree to cooperate to both charge high prices and make higher profits = cooperative equilibrium
repeated games = less incentive to cheat = better understanding how they will react to each other

Example:
One company decides to lower prices the other company will react and lower prices even more. The new equilibrium is way lower and companies decide to increase prices again. The next “game” they will be more or less cooperating because they know each others reactions.

Answer 127

A

Asymmetric info = parties not having the same info for decision making

often a problem for insurance companies and banks

1 Adverse selection

occurs before an agreement is made
selection to give a loan to someone who says to use it for renovation. After receiving the load the person uses it for vacation (= person lied and is not trustworthy) and is less likely to pay it back

2 Moral hazard

occurs after an agreement is made
selection to give a loan to someone who says to use it for renovation. After the loan was provided the person engages in a hazardous business opportunity and loses all the money while gambling. (even though the person intended to pay it back, now it is not possible anymore)

Answer 128

A

Adverse selection:

bank could carry out a screening test to increase the likelihood of identifying potentially bad borrowers
background check: credit score, asset ownership, credit history, income statement, etc.
bank can require a collateral
sealed-bid-auction

Moral hazard:

approve loan only after receiving invoices for the intended purpose
require collateral to reduce likelihood of careless behaviour
restrictive clause to avoid certain behaviour
insurance companies often make clauses void if certain behaviour is different than previously stated

Answer 129

A

bids are usually secretly submitted in a sealed envelope
often used for conducting competitive procurements
helps to reduce some of the uncertainty regarding prices
increases chances to make better decisions and reduce adverse selection

Answer 130

A

typically used by private individuals to get best price for a good
auctioneer calls out for the higher and higher bids
last and highest bid obtains the product
helps to gain max price

Answer 131

A

occurs when managers or employees have an incentive not to behave in the best entrust of their employer
slack off at work / wrong decisions
incentive programs should be used to avoid this

Answer 132

A

determining which capital project a firm should invest in
how much this investment will cost the company
how the investment will be financed
profitable and alignment with long term strategic goals
not an easy choice: cash outflow early; cash inflow much later

Example:

purchase of new capital to produce new product
construction of new facilities, factories, warehouses
deciding whether to buy or lease
deciding whether to product or outsource a product
deciding whether to replace obsolete equipment

Answer 133

A

money today is worth more than in the future

- possibility to earn interest

Answer 134

A

PV = CF / ( 1+i )^n

Answer 135

A

NPV (net present value)
IRR (internal rate of return)

Both discount future cash flows and respect the time value of money principle.

Answer 136

A

NPV = sum(CF/ (1+i)^n )

NPV > 0 = project generates a surplus
NPV = 0 = project does not generate surplus nor loss –> still good to increase output/sales and potentially affect market share
NPV < 0 = project generates losses and should be avoided

Answer 137

A

1 other investments might have a higher NPV and firms needs to prioritise the limited funds accordingly

2 value of NPV is based on expected discount rate over the duration of the expected future cash flow (discount rate = opportunity cost; if higher could lower overall NPV)

3 expected future cash flows may not be risk free (no guarantee regarding size or timing)

Answer 138

A

internal rate of return
NPV = 0 (investment is earning just enough to cover the cost of capital)
higher IRR = beneficial since IRR > opportunities cost (cost of capital)
IRR is higher when most of the cash flow happens early

Answer 139

A

NPV of the difference can be calculated:
e. g. initial cost is 500$ higher and annual surplus is 135$ higher over 5 years (NPV = 84$ and IRR = 11%)

IRR is greater than the cost of capital of 5%
NPV is positive and 84$

–> Project can generate a positive result and should be preferred to the other

Answer 140

A

two mutually exclusive project: choice has to be made
choose can not be based only on NPV (the highest should be chosen) otherwise only large projects will be chosen at the expense of small projects with small NPV
smaller projects with small NPV combined can result in large NPV
helpful to calculate PI (profitability index):
PI = present value of future streams of income / initial investment outlay
PI can help to rank and prioritise projects regardless of the size

PI > 1 = project should be accepted (the higher the better)
PI < 1 = project should be rejected

Answer 141

A

Risk can be assigned with a probability based on historic data or macroeconomic data
Uncertainty cannot be predicted = is unknown

Answer 142

A

Average of all possible outcomes (factoring in risk associated)
Average is weighted according to probability of each outcome occurring

Probability 30%: NPV (2-3%) = 300.000
Probability 50%: NPV (1-2%) = 200.000
Probability 20%: NPV (<1%) = -40.000

EV = (300.000 * 0,3) + (200.000 * 0,5) + (-40.000 * 0,2)
EV = 182.000€

EV can be compared to alternative to choose the best option

Risk:
1 Absolute:
- standard deviation reflect variation of possible outcomes from EV
- can only be used if EV are very similar

2 Relative:

coefficient of variation is used (cov = standard deviation / EV * 100)
the lower risk the better

Answer 143

A

Both are used for factors that can influence the future cash flows of an investment.
Help with risk analysis

Sensitivity analysis:

creates two forecasts (optimistic and pessimistic)
optimistic: higher future cashflow
pessimistic: lower future cashflow
can also be used for discount rate instead of CF
one factor or variable is changed to show how sensitive the expected NPV would be

Scenario analysis:

more variables are changed at the same time
discount rate, CF, prices, demand, etc.
state of economy of a country

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