SKETCH OF IDEAL ANSWERS

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Prosper Webb
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1 THE UNIVERSITY OF MELBOURNE MELBOURNE BUSINESS SCHOOL SKETCH OF IDEAL ANSWERS MANAGERIAL ECONOMICS John Asker This paper has 10 pages (Including this coversheet) Mid-Term Test: 10 th October 2006 Exam Duration: 90 Minutes + 5mins Reading Question 1 (two parts: a and b 20 points total) Your textiles firm is considering competing for the contract to design the uniform for the Australian soccer team. Competitors must develop preliminary drawings of the pattern, and the five competitors with the best preliminary drawings are selected. These five competitors then bid for the contract, in an auction; the lowest offer wins. You estimate that it would cost your firm $17,000 to develop these preliminary drawings. Your firm is the best textile design firm in Australia, so you are certain you can produce one of the 5 best drawings. If your firm won the contract, there would be costs of $80,000 in terms of foregone contracts (your designers could be working on other contracts) and of $2000 in materials. a) [10 points] Once you have reached the auction stage, what is your stopping price (that is, your Willingness to Sell)? The key to this question is that at the time of the decision (after the preliminary drawings have been made), the $17,000 cost to make the preliminary drawings is a sunck cost. As a consequence the WTS = $82,000 1

2 b) [10 points] This is a descending auction the price starts really high and slowing goes down: as the price drops bidders can either choose to drop out or stay in the auction. If the other competitors drop out at a price of $200,000, but you re still in, that s the price at which you win the contract. You think there is a 50% chance that the others will drop out at $110,000, and a 50% chance they ll drop out at $85,000. Do you enter the competition (that is, do you produce preliminary drawings and make a bid)? Show your calculations. There are several ways to set this question up. Given that here is one: First, since the WTS is $82,000 you are happy to win the auction at either $110,000 or at $85,000, conditional on being at the auction stage so you will always win the auction. The only uncertainty is at what price. Second, to get to this stage you have to fork out $17,000 Third, if you choose to do nothing, you do $80,000 of other work. Diagramatically the decision problem looks like: Note that you always continue, so expected gain from entering is: ½ [110,000-99,000] + ½[85,000-99,000] = ½ [110,000] + ½[85,000] 19,000 = ½ [110,000] + ½[85,000] 99,000 = 97,500 19,000 = 78,500 As opposed to 80,000 from staying out so you will not enter. As I said there are many ways to set this up this is by no means the only way. However, I did require that whatever you did in part (a), your answer in (b) be consistent with that. 2

3 Question 2 (two parts: a and b 20 points total) BHP is a company that owns a huge uranium ore deposit in the North-East region of South Australia. On the basis of present world prices and estimated costs of development and operations, the present value of this deposit is $1.5 billion. The Board of BHP has decided that it is leaning toward proceeding with the mining of the deposit. The only problem is that no one has worked out how to supply water to the mine site (which is in a desert). Indeed, it turns out that the estimate of the present value of the mine allowed for all cash flows except for the cost of supplying water to the mine. Veolia owns a desalination plant on the Eyre Peninsula which is ideal for producing water for the mine. Veolia currently pipes water to a township 5kms from the mine site. This pipeline has enough surplus capacity to carry all the water needed for the mine. The Veolia desalination plant and pipeline was built 10 years ago at a cost of $3 billion. BHP would like to use water supplied by Veolia using its desalination plant and pipeline. If BHP does not do a deal with Veolia it would have to either: 1. Use water from the Great Artesian Basin, which is very poor quality bore water. This would result in additional costs to BHP of $1.7 billion dollars in present value terms; or 2. Pump water from the Murray River, which is good quality but would result in a massive problem due to the environmental degradation that would occur to the river and would require the construction of a long pipeline. The estimated present value of these additional costs to BHP would be $2.1 billion. a) [10 points] Are BHP and Veolia likely to be able to do a deal? Explain. The likelihood is yes since the value of the mine is $1.5 billion and it is unlikely to cost this much to provide water to the mine. Every other option makes the NPV of the project negative, so unless the water comes from Violia the project will not go ahead. Most people got 10/10 in this question 3

4 b) [10 points] What is the price likely to be? Show your reasoning. (If extra information might be relevant, explain how you would use that extra information.) We don t know much about the costs incurred by Violia in providing the water. Water is pretty heavy so just pumping it along the pipe is likely to be expensive, also new infrastructure is required to extend the pipe from the town to the mine. Additionally we don t know what the opportunity cost of Violia is in entering the agreement. Sketching out these components of the cost side was important in getting full marks in this question. If the total cost of the project to violia is $x (assuming all costs are incurred by Violia) then in the absence of any infor about relative bargaining strength the price is likely to be Price = (1.5 billion x)/2 + x Question 3 (two parts: a and b 20 points in total) The luxury yacht market in the Mediterranean has collapsed after Fox News reported that the Loch Ness monster has migrated south for the summer. In one port, there are three individuals attempting to sell their yacht. Seller A has a reserve price of $400,000; seller B has a reserve price of $280,000, and Seller C has a reserve price of $220,000. Unfortunately, there is only one buyer, and she only wants to buy one yacht. She has the same WTP for all three yachts, of $800,000. a) [10 points] What will be the outcome in this market? In other words, who sells a yacht to the buyer? Justify your answer. The greatest surplus is created by Seller C and the buyer doing a deal so this is what we would expect to happen b) [10 points] What is the lowest price the yacht might sell for? The highest price? What is the price you expect? Show your reasoning. Seller C s value added is $60,000 so this is the greatest payoff they could get. Since the buyer is a monopsonist their value added is the total surplus, hence their payoff is essentially unrestricted. The lowest price is $220,000 (zero payoff for C), while the highest is $280,000 (C s payoff is equal to their value added). A reasonable guess for the price might be the average of these two $250,000 4

5 Question 4 (two parts: a and b 20 points in total) a) [10 points] Define opportunity cost The ideal answer would mention that the opp. Cost is the payoff created via the best opportunity forgone. b) [10 points] On August 2 nd 1990 Iraq invaded Kuwait. Over the following 2 days the price of petrol at the pump in Los Angeles went from $1.10 per gallon to $1.20. This lead to outrage from motorists, with one leading market commentator saying: It takes 2 weeks for oil to make its way from a well in the Middle East to the pump in LA so any price change now is crazy! In 2 weeks time there will definitely be less oil around and so you would expect the price to jump up then, but for the price to jump up now makes no sense at all. Explain how this commentator has completely misunderstood the concept of opportunity cost in formulating the station owners willingness to sell petrol. The key thing is to realize that the petrol station could hoard petrol and sell it in 2 weeks time. Hence the opportunity cost of selling know is the retrn from keeping and selling it when the supply shock hits. Given this, the price now should be the price in 2 weeks less and storage costs Points were awarded for other meaningfull economic justifications, particularly those involving some form of intertemporal tradeoff. 5

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ECON Microeconomics II IRYNA DUDNYK. Auctions.

ECON Microeconomics II IRYNA DUDNYK. Auctions. Auctions. What is an auction? When and whhy do we need auctions? Auction is a mechanism of allocating a particular object at a certain price. Allocating part concerns who will get the object and the price