File: Ch01; CHAPTER 1: Introduction to Economic Decision Making

Each question contains a code showing the section of the chapter text from which it was taken. The codes for this chapter are:

Code	Section
 1	Introduction
 2	Seven Examples of Managerial Decisions
 3	Six Steps to Decision Making
 4	Private and Public Decisions

MULTIPLE CHOICE

1.  A sensible decision should incorporate a
a)  List of alternative courses of action.
b)  Complete prediction of the future.
c)  Statement of goals and objectives.
d)  Summary list of pros and cons.
e)  Answers a and c are both correct.

ANSWER: e.  
SECTION: 1

2.  Managerial economics can best be defined as the
a)  Economic analysis of internal management functions.
b)  Study of economic incentives in organizations and markets.
c)  Impact of global economic factors on business.
d)  Analysis of major management decisions using economic tools.
e)  None of the above answers is correct.

ANSWER: d   
SECTION: 2     

3.  Is profit maximization an unambiguous guide to decision making in the private sector?
a)  Yes. This is clear and results in sound decisions.
b)  Yes, although profit is of no concern at all to non-profit agencies.
c)  No, because of risk and uncertainty about future events.
d)  No, because managers may disagree as to the best means of maximizing profits.
e)  No, top management’s real financial incentives are usually at odds with profit maximization.

ANSWER: c   
SECTION: 3     

4.  Are models helpful in predicting the outcomes of decisions?
a)  No, models are too theoretical to be applicable in real world decisions.
b)  No, because there is too much uncertainty to ever forecast outcomes accurately.
c)  Yes, even though they simplify the analysis and omit some features of the problem.
d)  Yes, models can describe situations in complete detail.
e)  Yes, but large-scale models tend to be prohibitively expensive.

ANSWER: c   
SECTION: 3

5.  The two main kinds of models are
a)  Short run and long run.
b)  Deterministic and probabilistic.
c)  Theoretical and pragmatic.
d)  Simple and complex.
e)  Mathematical and graphical.

ANSWER: b   
SECTION: 3  

6.  Sensitivity analysis can best be defined as
a)  Being sensitive to the impact of the firm’s decisions on other variables.
b)  Analyzing tradeoffs among multiple objectives.
c)  Measuring results against objectives.
d)  Examining the reliability of key data used to make a decision.
e)  Examining how a decision would change if key economic facts were changed.

ANSWER: e   
SECTION: 3   

7.  According to the theory of the firm, what is management's ultimate objective?
a)  Short-term profit, even if this sacrifices long-term profit.
b)  Maximizing the value of the firm.
c)  Long-term profit, even if this sacrifices short-term profit.
d)  Being responsive to all of the firm’s stakeholders.
e)  Maximizing market share.

ANSWER: b   
SECTION: 4     

8.  The example of a multinational car maker
a)  Offers a good case for the use of risk management models.
b)  involves multiple pricing and production decisions.
c)  Shows how a firm might respond to trade restrictions.
d)  Provides a clear case for limited government regulation.
e)  None of the above answers is correct.

ANSWER: b   
SECTION: 3     

9.  Which of the following is NOT one of the suggested steps in decision making?
a)  Predicting the consequences
b)  Implementing the decision.
c)  Defining the problem.
d)  Negotiating a decision consensus.
e)  Neither answer b nor d is a decision step.

ANSWER: e   
SECTION: 3   

10.  Which of the following might cause managers to fail to maximize the value of the firm?
a)  They have other objectives that conflict with value maximization.
b)  They may have incomplete information upon which to act.
c)  They may make mistakes in analysis.
d)  They may fail to implement decisions that lead to value maximization.
e)  All of the above.

ANSWER: e   
SECTION: 4     

11.  According to the satisficing model of management behavior, firms seek
a)  Some satisfactory level of performance rather than maximization.
b)  To satisfy all stakeholders: customers, workers, shareholders, and local constituents.
c)  To satisfy corporate shareholders.
d)  To maximize sales revenue rather than maximizing the value of the firm.
e)  A satisfactory level of market share.

ANSWER: a   
SECTION: 4     

12.  Which of the following is sometimes suggested as an alternative model of management behavior? 
a)  Sales maximization.
b)  Satisfying multiple stakeholders.
c)  Maximizing net present value.
d)  Maximizing the personal wealth and compensation of top management.
e)  Minimizing the risk of firm bankruptcy.

ANSWER: a   
SECTION: 4     

13.  In evaluating public programs, benefit-cost analysis 
a)  Considers only measurable benefits and costs.
b)  Insists that public projects should be profitable, i.e., pay for themselves.
c)  States that a program should be undertaken if and only if its total benefits exceed its total costs. 
d)  Attempts to impute monetary values to all benefits and costs.
e)  Answers c and d are both correct.

ANSWER: e   
SECTION: 4

14.  Making decisions based on overall judgment and experience
a)  Is especially suited for devising long-term corporate strategy.
b)  Is the overwhelming norm for top corporate executives.
c)  Is problematic because the logic of one’s judgment is uncheckable.
d)  Offers a sound alternative to analytical decision making.
e)  Answers a and c are both correct.

ANSWER: c   
SECTION: 4

SHORT ANSWER

15.  Carefully define managerial economics, and explain how it is useful in decision-making.

ANSWER: Managerial economics is the analysis of major management decisions using the tools of economics. It applies familiar concepts such as demand, cost, market structure, resource allocation, and the like. Managerial economics emphasizes the theory of the firm and employs quantitative analysis in making decisions. Simple models are used to emphasize the most important features of the decision problem.
SECTION: 1

16.  Carefully define the term "model" and explain how models are used in managerial economics.

ANSWER: A model is a simplified description of a process, relationship, or other phenomenon. The two main types of models are deterministic and probabilistic. Models are used primarily to explain and to predict economic events. They are useful in selecting key features for analysis (and, therefore, they deliberately ignore less important features).
SECTION: 3

17.  Carefully define probabilistic and deterministic models, and explain how they differ.

ANSWER: Deterministic models are predictive models in which the outcome of a decision is certain (or close enough that it doesn’t matter). In probabilistic models, there is no one certain outcome but, rather, many possible outcomes with a probability attached to each.
SECTION: 3

18.  How does decision making in the private, for-profit sector differ from decision making in the public sector?

ANSWER: In the private sector, managers seek maximum value for the firm. Managers focus primarily on the effects of a decision on the firm's profits. With an eye to profit, managers will not generally take into account the impacts (benefits and costs) on other parties. In the public sector, decisions are guided by benefit-cost analysis (not simply profit analysis). The benefits and costs to all affected parties (not just the program’s revenues and costs) must be evaluated and totaled in order to make a sound decision.
SECTION: 4

19.  What are the two difficulties that may make profit maximization an ambiguous guide to decision making? Explain why they complicate the analysis.

ANSWER: The two difficulties are (1) the timing of benefits and costs and (2) the presence of risk and uncertainty. Generally speaking, many decisions involve making costly investments “up front” in return for benefits or profits in the future.  This requires the decision-maker to develop comparable measures of present and future monetary values. Uncertainty underscores the fact that some outcomes are not known with complete confidence. Costs may be far larger than expected, benefits far smaller, and delays in completion may diminish profits. The manager’s task is to foresee the range of possible outcomes and to estimate the likelihood of different consequences.
SECTION: 4

20.  One of the major steps in decision-making is to explore the alternatives. Do most managerial decisions have a few, limited number of options? Explain. Illustrate your answer with an appropriate example.

ANSWER: Most decisions have several (often many) competing options. Even when the choices are limited, there are often more alternatives than first meet the eye.  For example, Disney had to decide whether to build a new theme park, and if so, where, and what at what scale. In addition, subsequent decisions involved advertising and pricing strategies.
Many managerial decisions involve more than a once-for-all choice from a set of options. Instead, managers face a sequence of decisions. For instance, should a firm (1) attempt to develop a new product, (2) if all goes well, when and how should it launch and promote it, and (3) how should it price it (and gear up capacity to supply the expected sales at its chosen price)?
SECTION: 3

21. Value maximization is the main objective of top management. Briefly describe alternative objectives.

ANSWER: The three most important alternatives are: satisficing behavior, sales maximization, and pursuing the firm’s social responsibilities to all stakeholders. (See the discussion in the text.)
SECTION: 4

ESSAY

22.  A company is thinking about significantly expanding its production capacity. What variables would it consider in making this decision? What might be useful sources of information to use in estimating the potential profit impact of the expansion?

ANSWER: The most important variables are increased sales revenues and increased costs. Information on sales revenue would include current price and quantity data and the past growth rate of sales, and the impact the firm’s advertising and promotional spending (and, of course anticipating the likely response of rival firms). Information on costs would include the capital cost of building new facilities or expanding old ones (including borrowing costs influenced by interest rates) and annual fixed and variable costs (for equipment, labor, energy costs) needed to produce the greater level of output. Note that the expansion might bring the firm some reductions in average costs due to the use of new technology. 
SECTION: 2

23.  You head a new startup firm with a business plan calling for opening a number of clinics that perform laser eye surgery to correct common vision problems. You hope that over time your company can claim a substantial share of what you estimate to be a $8 billion per year market.
Briefly describe the most important factors influencing your venture’s revenues and costs. Describe the most important risks.

ANSWER: A complete answer should point out a number of obvious factors. On the demand side, the key question is the size of the total market willing and able to pay for the laser surgery (so as to dispense with glasses and contact lens). Because the procedure is not covered by insurance, demand will depend directly on the price (per eye) your company and others set for the procedure. Demand also depends upon the real and perceived risks of laser surgery. Demand issues raise a number of decision questions. How should your firm price and promote the clinics and procedures? Should it enlist elite physicians to oversee and endorse your firm’s services (as a means of differentiation). Given current competitors and future entrants, what share of the total market can your firm reasonably expect to claim?
Costs are equally important. Medical equipment and office space represent significant capital costs. Besides other operating costs, your company will pay a significant licensing fee (royalty) for each procedure to the laser’s patent holder. Of course, the ultimate average cost per patient will depend on the number of patients you attract and on your scale of operation. Finally, there are significant risks – not only uncertainties on the revenue and cost sides already mentioned – but medical risks to patients and liability and regulatory risks to your company.
SECTION 2

24.  Carefully define sensitivity analysis, and provide three examples of how a manager might use it.

ANSWER: Sensitivity analysis considers how an optimal decision would change if key economic facts or conditions were altered. Some examples of how to use it include: (1) predicting sales under different macro economic conditions (growth or recession), (2) the effects of escalating oil prices on energy costs, or (3) the effect of a close competitor cutting its price. In each case, the changing factor not only affects the firm’s profit, it also implies changes in the firm’s production and pricing decisions. 
SECTION: 3

25.  You are the troubleshooter for a major manufacturing firm. It seems that a particular facility has experienced problems with quality for several years. In addition, there have been some major problems with the facility's labor union. A bitter strike, lasting six months, occurred prior to signing the current contract. Past management teams have visited and inspected the site but have been unable to achieve change, despite detailed study and recommendations. Recently, sales of the facility's product line have declined in the face of increased import competition from an East Asian country, and this is unlikely to change in the near future.
Currently, the Board is considering two new courses of action. One is retooling the facility to manufacture a new line of products. This would involve capital costs of several millions of dollars. It would also mean that there would be no production from the facility while retooling and retraining takes place. The second option is closing down of the facility. This would involve costs in the form of termination benefits, as well as funding some pension benefits of senior employees.  There appear to be no buyers for the plant, and it would likely remain idle for some time. Possibly, no buyer could be found for it, and the plant might be vacant for years, while continuing to be a tax drain on the company.
How would you use the steps of decision-making and the concept of value maximization to recommend a course of action to the Board? Explain.

ANSWER: Management finds itself on the horns of a dilemma since it appears that any course of action – continuing current production, retooling, or closing the plant –  will involve losses. Nonetheless, the tools of managerial economics still apply. Here, the firm seeks the course of action that minimizes its losses (If losses are minimized, then the value of the firm is maintained as far as possible). Thus, management must carefully estimate and compare the relative costs of its options.
SECTION: 3

26.  In striving to make the best possible decisions, a firm’s CEO always relies on a highly analytical approach. However, the firm’s Chairman of the Board argues that in his experience, the analytical approach can only go so far. He advocates analysis as only one of several decision approaches. What is your view? Discuss and explain.
 
ANSWER: The virtue of the analytical approach is that it considers and analyzes the most important factors involved in a given decision. However, it is not infallible for many of the reasons noted in the chapter.  (Managers may have the wrong incentives and/or pursue the wrong objectives. They might lack the necessary information to formulate a sound decision. Or they may fail to implement the decision – no matter how right it is.) As the text notes, “The key is to use the analytical approach flexibly.” Different cases may require different degrees of analysis in each decision step. 
Certainly, the Chairman is right in insisting that there are other ways to make decisions, ranging from: company rules of thumb, gut checks, invoking one’s experience, judgment and intuition, to “I’ll sleep on it.” These other means might provide useful insights and ingredients. Or to take an extreme case, sometimes, “flashes of genius” may offer decision solutions that are surprising and highly creative (and by no means irrational). For instance, a marketing plan might include radical elements constituting major changes in how a product is offered for sale. This approach is inspired, but it is also risky. It might spectacularly succeed, or just as spectacularly fail. In short, it remains the case that a sound analysis is required to articulate the logic of the decision (indeed, to convince others of its merits).
SECTION: 4

27.  A small nation is considering upgrading its air force to incorporate new technology. It faces two main choices. The first is to acquire a fleet of the latest fighter aircraft, with the newest electronics and weapons. The cost of the acquisition (assuming that the U.S. President and Congress agree to the sale) is $45 million per plane, including a stock of spare parts that should last five years. The second choice is to buy an electronic upgrade for existing aircraft, with a complete overhaul of the airframes. The cost of such an upgrade is $8 million per plane, with about a 10% loss of fleet because of damage beyond repair and “cannibalization” to obtain the highest number of flyable planes. The upgrading of existing planes results in aircraft with about 90% of the capability of the new aircraft.
Top pilots in the small country's air force are concerned that they may not be flying the best aircraft, and could face a disadvantage in combat against newer planes flown by a potential enemy. However, they acknowledge that if a numerical superiority against the enemy can be obtained, an overall victory is still likely. Their theory is that three of the upgraded planes should be able to win against one of the newer planes flown by an enemy (although the pilots expect higher losses in combat). 
As an economic consultant, how would you advise the defense ministry of the small country in deciding how best to spend its available budget for air defense? What objective(s) are important for this decision? What are the pros and cons of the available options?

ANSWER: In this case, the objective is not maximum profit or operating revenue, but obtaining the best possible air force within the prescribed budget.  The two main alternatives are to purchase new aircraft, or upgrade existing planes. Clearly, an important consideration is the difference in cost of the two possibilities. An upgrade is far cheaper, and results in 90% of the operational capability of the new plane. For $45 million spent on a single new plane, the country can upgrade between five and six existing aircraft. Assuming that the air force pilots are correct that three of the older, upgraded planes can defeat a single, newer plane, upgrading provides a greater effective amount of firepower in a future air conflict. However, an additional issue should be taken into account: higher pilot losses can be expected with the upgrade.  The cost of lives lost can be important for a country that places a high value on human life.
A sound decision should indicate at least a third possible choice, that is, to order a small number of new planes in addition to upgrading most of the old planes. The new planes could accompany the older planes on missions and stand by to combat enemy fighters. While expensive, it is cheaper than buying an entirely new fleet, and could reduce overall pilot loss.
SECTION: 4