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Economics Study Guide

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Question 1
Among the reasons economists consider economic profit to be the best measure of a company's performance is

Accounting profit is difficult to measure.
Explicit costs are fully accounted for in economic but not accounting profit.
Estimating income for tax purposes only includes explicit costs.
The opportunity costs of all resources are subtracted from total revenue.

Question 2

Linda gave up her job paying $60,000 a year to start Frozen Yogurt Express. The first year of operation, Frozen Yogurt Express generated $70,000 in revenues and $20,000 in explicit costs, not including any payment to Linda for her time. What is Linda's economic profit?

-$10,000
$10,000
$50,000
$70,000

Question 3

When comparing the risk between two investments

The standard deviation is appropriate even if the expected returns differ significantly.
The one with the greater expected value is always riskier.
Those with shorter life spans tend to be riskier.
The standard deviation is appropriate if the expected returns are close in value.

Question 4

Among common factors that give rise to principal-agent problems is

Information is shared equally by managers and agents.
Common goals are shared by managers and owners.
Asymmetric information is present.
A greater number of agents relative to the number of principals.

Question 5

If accounting profit is negative, economic profit must be

Zero.
Positive.
Negative.
Greater than accounting profit.

Question 6

The Soup Kitchen, a local charity, was given the gift of a building by a local philanthroper. The charity's board voted to remodel the building and use it to expand its services. The economic cost to the charity of using the building includes

Only the cost of remodeling.
The cost of remodeling and maintaining it.
The cost of remodeling, maintenance, and loss of revenue if the building had been rented/sold.
Only the value of lost revenue if the building had been rented or sold.

Question 7

Net benefits (profits) are maximized when

The additional benefit from the last unit of activity exceeds the additional cost of the last unit by the largest amount.
The difference between total benefit and total cost is maximized.
Total benefit is maximized.
Total benefit equals total cost.

Question 8

Assuming the supply curve remains constant, a decrease in demand can be expected to

Reduce equilibrium price and increase equilibrium quantity.
Increase equilibrium price and reduce equilibrium quantity.
Decrease equilibrium price and quantity.
Not result in a change in either equilibrium price or quantity.

Question 9

In which of the following examples will it NOT be possible to determine the effect (increase or decrease) on equilibrium price of hamburgers without knowing more about the magnitude of the shifts in supply and demand?

The demand for hamburgers decreases and the supply of hamburgers increases.
The demand for hamburgers increases and the supply of hamburgers decreases.
The demand for hamburgers increases while the cost of meat increases.
The demand for hamburgers increases and the supply of hamburgers increases.

Question 10

Suppose that the market for diamonds is in equilibrium. If political unrest shuts down several major diamond mines, which of the follow is most likely to happen?

The equilibrium quantity of diamonds decreases.
The supply of diamonds increases.
The equilibrium price of diamond decreases.
The demand for diamonds decreases.

Question 11

Assume that more people want Super Bowl tickets than are available through the ticket office at the current price. Select the statement that best represents the situation.

There is a shortage of Super Bowl tickets at the current price.
The current price is higher than the equilibrium price for Super Bowl tickets.
If the current price is lowered, the excess demand for Super Bowl tickets would decrease.
There is a surplus of Super Bowl tickets at the current price.

Question 12

Assume that a decrease in the price of product X results in fewer units of product Y being sold. You can conclude that X and Y are

Complementary goods.
Normal goods.
Inferior goods.
Substitute goods.

Question 13

The equilibrium price and quantity of tea both rise. Which of the following best fits the observed data?

a decrease in demand with supply constant
an increase in supply with demand constant
a decrease in demand coupled with an increase in supply
an increase in demand with supply constant

Question 14

When Napa Winery reduces the price of its chardonnay from $20 a bottle to $15 a bottle, the result is an increase in

The demand for its chardonnay.
The supply of its chardonnay.
The quantity demanded of its chardonnay.
The quantity of its chardonnay supplied.

Question 15

If the market price of milk decreases at the same time the market quantity of milk purchased rises, a possible factor influencing this change is

An increase in demand for milk with no change in supply.
An increase in supply of milk with no change in demand.
A decrease in supply of milk and an increase in demand.
An increase in supply of milk and an increase in demand for milk.

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The answers with the rationale for each of the questions has been provided.

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Case study #1: The NY Fashion Company: What is the financial/economic explanation for the difference between the unit profits found in parts (d) and (e).

Case Study#1

The NY Fashion Company

From the tenth floor of her office building, Diana Ricks watches her swarms of New Yorkers watching stores along streets. On this hot July day, she pays particular attention to the fashions worn by the various women and wonders what they will choose to wear in the fall. Her thoughts are not simply random thoughts; they are rooted of her work since she owns and manages the NY Fashion Company, a leader of women's clothing company.

She usually meets her production manger, Ted Wallace, during this month to decide upon next month's production plan for the fall line. Specifically, she must determine the quantity of each clothing item she should produce given the plant's production capacity, limited resources, and demand forecasts. Diana relies upon the sales department forecasts because the items produced next month will appear in stores during September. Women generally buy the majority of the fall fashions when the clothing items first appear in department stores.

She turns back to her desk and looks at the clothing patterns designed almost six months ago, papers listing the of materials requirements for each pattern, and the demand forecasts for each pattern. She remembers the hectic and sometimes terrifying days of designing the fall line and presenting it at fashion shows in New York, Milan, and Paris. Ultimately, she paid her team of six designers a total of $500,000 for their work on her fall line. With the cost of hiring runway models and the renting the conference hall, each of the three fashions show costs her an additional of $500,000. She also paid the following overhead costs on her fall line.

Material Handling $280,000
Production Planning Dept. $260,000
Set-up Indirect Cost $260,000
Shipping Department $200,000

Total $1,000,000

Her fall line consists of both professional and casual fashions. She has determined the prices for each clothing item by taking into account the item and the prestige of her company's brand name.

The fall professional fashions include tailored wool slack, silk blouse, silk camisole, tailored skirt, and wool blazer. Price, material requirements, labor hours, and machine hours are shown in Table 1. The fall casual fashions include velvet pants, cotton sweater, cotton miniskirt, velvet shirt and button-down blouse. The other pertinent information regarding price, material requirements, labor hours and machine hours are shown in Table 2.

Table 1. Professional clothing items with price, labor hours, and machine hours requirements.
Clothing
Items Price Materials Requirements Labor hrs @$20/hr Machine hrs @$10/hr
Tailored wool slacks $300 3 yard of wool
2 yards of acetate for lining 5 6
Silk blouse $180 1.5 yards of silk 3 4
Silk camisole $120 0.5 yard of silk 2 2
Tailored skirt $270 2 yards of rayon
1.5 yards of acetate for lining 4 4
Wool blazer $320 2.5 yards of wool
1.5 yards of acetate for lining 5 4

Table 2. Causal clothing items with price, labor hours, and machine hours requirements.
Clothing Item Price Materials Requirements Labor hrs @$20/hr Machine hrs @$10/hr
Velvet pants $350 3 yard of velvet
2 yards of acetate for lining 5 7.5
Cotton sweater $130 1.5 yards of cotton 2 2
Cotton miniskirt $75 0.5 yard of cotton 1 2
Velvet shirt $200 1.5 yards of velvet 5 6
Button-down blouse $120 1.5 yards of rayon 3 3

Ted has told Diana that he ordered 45,000 yards of wool, 28,000 yards of acetate, 18,000 yards of silk, 30,000 yards of rayon, 20,000 yards of velvet, and 30,000 yards of cotton for production. The prices of the materials are listed in Table 3.

Table 3. Cost of materials
Materials Cost per yard, $
Wool 9.00
Acetate 1.5
Silk 13.00
Rayon 2.25
Velvet 12.00
Cotton 2.5

Any material that is not used in production can be sent back to the textile wholesaler for full refund, although scrap material cannot be sent back to the wholesaler.

Ted also informs her that the production of both silk blouse and cotton sweater produces leftover scraps of material. Specifically, for the production of one silk blouse or one cotton sweater, 2 yards of silk and cotton, respectively, are needed. From these 2 yards, 1.5 yards are used for the silk blouse or the cotton sweater and 0.5 yard is left as scrap material. In order not to waste the material, she told Ted to use the rectangular scrap of silk or cotton to produce a silk camisole or cotton miniskirt, respectively. It means that whenever a silk blouse is produced, a silk camisole is also produced. Note that it is possible to produce a silk camisole without producing a silk blouse and a cotton miniskirt without producing a cotton sweater.

The demand forecasts indicate that some items have limited demand. Specifically, because the velvet pants and velvet shirts are fashion fads, sales department has forecasted that it can sell only 5,500 pairs of velvet pants and 6,000 velvet shirts. However, the company can produce less than the forecasted demand, since the company is not required to meet the demand. The silk blouses and camisoles have also limited demand because many women think silk is too hard to care for, and sales department projects that it can sell at most 12,000 silk blouses and 15,000 silk camisoles.

General hint: Make necessary assumption(s) if it is required to do a complete analysis.

a. Formulate and solve a linear programming problem to maximize total contribution margins given the production, resource, and demand constraints.
Hint: Compute unit contribution margin for each of the products as contribution margin = Sale price - direct costs. The calculated unit contribution will be used for the coefficient of the decision variables of your LP model. Interpret your computer results. The production plan that you obtain from the computer solution will be used for parts c through f.
b. The textile wholesaler informs Diana that since another textile customer canceled his order, she can be obtained an extra 10,000 yard of acetate. How many of each clothing item the company should now produce to maximize profit?
Hint: This is a sensitivity analysis. Make sure the acetate is a binding resource; otherwise the sensitivity analysis is not required.
c. Determine income statement (as of the end of Fall) based on the production plan developed in part a. Assume all clothing items planned in part (a) can be sold in the market. If a clothing item is not selected (determined by the LP model), it means it will not be produced.
d. Calculate the unit profit for each of the clothing items using the traditional volume-based costing method. Use the optimal production plan developed in part (a) and the following basis for allocating overhead costs.

Indirect cost Allocation Basis
Designer cost Direct material
Fashion show costs Direct labor hours
Material Handling Direct material
Production Planning Dept. Direct labor hours
Set-up Indirect Cost Direct labor hours
Shipping Department Direct material

e. Diana found that some of the clothing items are not competitive in the market. She consulted with an agency and found about the Activity-based costing method which would solve the problem. Determine the unit profit for each of the clothing items using the following cost drivers and activities.

Hint: If a product is excluded by the LP solution obtained in part (a), the corresponding activities for that item needs to be adjusted in the same category. For example, if one of the silk items is excluded by the LP solution, assign the corresponding activities to the other silk item. Use silk category for silk blouse and camisole items, cotton category for cotton sweater and miniskirt items, and last category for velvet pants and shirts, tailored slack and skirt, wool blazer and button down blouse items. You are free to do any necessary adjustment as long as you do not exceed the total unites indicated for each of the cost drivers.

Indirect Cost Cost Drivers Total Units
Designer cost # of patterns 100
Fashion Show costs Occupied space 10000
Material Handling # moves 500
Production Planning Dept. # of production orders 200
Set-up Indirect Cost # of set-ups 50
Shipping department # of shipments 200

Clothing items Designer cost Fashion Show costs Material Handling Production Planning Dept Set-up Indirect Cost Shipping department
Tailored wool slacks 5 1000 40 15 4 20
Silk blouse 8 900 40 20 6 20
Silk camisole 12 1200 50 15 6 20
Tailored skirt 15 800 80 30 3 15
Wool blazer 14 1300 60 20 7 25
Velvet pants 6 1200 30 30 5 30
Cotton sweater 15 600 50 20 4 25
Cotton miniskirt 10 1000 50 25 5 15
Velvet shirt 5 700 60 15 4 20
Button-down blouse 10 1300 40 10 6 10
Total 100 10000 500 200 50 200

f. What is the financial/economic explanation for the difference between the unit profits found in parts (d) and (e).

Note: assumptions might be required for each part as long as they are made realistically. Depending on what you assume, solutions will be different from one person to another. For example, if the optimal solution for any of the clothing items is equal to 2 units, you may impose a constraint to drop it from your solution mix.

REPORT FORMAT
The report will be a formal report complete with a Title Page, Summary of Case Study, and Answer to Questions, and Appendixes. Appendixes are used to include the computer outputs. Reports will be typed in a standard 12 point font and will be double-spaced on standard 8.5x11 papers with one inch margins on all four sides. The Reports will be retained by the department and will be normally considered to be a public document; it may be made available to others on request in the future.

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