Chapter 2/Fundamental Economic Concepts

Chapter 2

Fundamental Economic Concepts
Solutions to Exercises
1. The number of checked bags should fall, as individuals internalize the external cost of added weight. However, the average weight should rise, as those checking bags would in all likelihood pack as much as possible to make up for the cost. 2. The wage in the market for oil spill cleanup efforts should rise, thanks to an increase in demand for labor. The wage in the market for similarly-skilled labor should also fall, as the relevant labor supply falls in response to the previous increase in wage. We would expect an increase in migration, as long as the wage of the home market was less than the wage that could be received in the Gulf region. 3. Projects A, C, G and B require a total of $875 million in investment. Project B, the lowest return project of this group is expected to generate an 18 percent rate of return. Ajax can raise up to $1,050 million, with the highest cost being 18 percent for the last $200 million. If Ajax were to choose any project beyond A, C, G, and Bsuch as project D (the next best project after B)that project would generate a marginal rate of return (16 percent), which is less than the marginal cost of funds needed to finance it, in this case 18 percent for the last $200 million up to a total of $1,050. Thus, the optimal capital budget is to invest in projects A, C, G, B, for a total of $875 million. 4. This question examines expected values, standard deviations, and risk measures for MICHTEC’s products with probabilities of .2, .5, and .3 for boom, recession, and normal growth. a. Expected annual revenues = $90(.2) + $75(.5) + $85(.3) = $77.175, or as this is expressed in millions of dollars, the expected annual revenues are $77,175,000. b. Standard deviation of annual revenues = [(90 – 77.175)2(.2) + (75 – 77.175)2(.5) + (85 –