SECTION REFERENCE: Private and Public Decisions: An Economic View
DIFFICULTY LEVEL: Medium
- 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 on 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) are evaluated and totaled in order to make a sound decision.
SECTION REFERENCE: Private and Public Decisions: An Economic View
DIFFICULTY LEVEL: Medium
ESSAYS
- Amanda is a troubleshooter for a major manufacturing firm. 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 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, while continuing to be a tax drain on the company. How would Amanda 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 REFERENCE: Six Steps to Decision Making
DIFFICULTY LEVEL: Medium
- 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 macroeconomic conditions (growth or recession)
(2) the effects of escalating oil prices on energy costs
(3) the effect on the sales of a product if a competitor cuts prices
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 REFERENCE: Six Steps to Decision Making
DIFFICULTY LEVEL: Medium
- 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 for 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 of the firm’s advertising and promotional spending (and, of course anticipating the likely response of rival firms) on its sales. 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 and energy) 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.