ECON 491 Midterm: Spring 2018 (In-Class Portion) - Choose 4 Out of 7 Topics

1.

Relative Prices of Stuff Over Time

(a)

(2 points) According to Nordhaus, approximately how much has the price of light declined, in

terms of hours of labor required to generate an hour of light, from prehistoric times until the

invention of the compact fluorescent (CFL) bulb?

(b)

(2 points) The price of ice was $6 to $8 per ton in the North, but up to $125 in the South until

1868, when a New Orleans plant sold ice for $35 per ton. What accounts for this price

difference?

(c)

(1 point) The CPI (Consumer Price Index) in 1868 was 40 in 1967 constant dollars (meaning that

stuff that cost $100 in 1967 cost approximately $40 100 years earlier.) In the absence of

innovation, changes in demand, or different levels of competition, how much would we expect

ice to cost in New Orleans in 1967? How does this figure compare to the actual price of $35 per

ton?

(d)

(1 point) According to data collected at Meijer in 2017 (fifty years after 1967), ice in perfectly

clear cubes is now $0.20 per pound (10 pounds for $1.99). The CPI for 2017 is approximately

735 in 1967 dollars. In real terms (e.g., 1967 constant dollars), how much does ice cost now

compared to 1868?

(e)

(1 point) Employer cost for employer compensation averaged $35.64 per hour worked in

September 2017. How much does 20 pounds of ice cost in terms of an hour of labor in 2017?

(f)

(1 point) A skilled carpenter earned approximately $0.30 per hour in 1868. How much did 10

pounds of ice cost, in terms of an hour of labor, in 1868?

(g)

(2 points) Give two explanations,

other than innovations in ice-making

, why the answers to (e)

and (f) are not the same.

(1 point extra credit) What's the name of the oily bird that Shetland Islanders used to stick a wick into

and light like a candle?

ECON 491 Midterm: Spring 2018 (In-Class Portion) - Choose 4 Out of 7 Topics

2. Scaling Up/KLEM

Consider the following cost structure to make umbrellas:

Capital

10% (e.g., $1 per umbrella)

Labor

20% (e.g,, $2 per umbrella)

Energy

30% (e.g., $3 per umbrella)

Materials

40% (e.g., $4 per umbrella)

(a)

(1 point) The production operation creates a second shift using the same plant. Labor, energy, and

materials are all variable costs which go into an umbrella, whereas capital is a fixed cost (for the building,

etc.) If the new operation has the same productivity as the old operation in terms of umbrellas per

employee per shift, what is the new breakdown of cost percentages?

Hint: Capital cost percentage goes

down and the others go up.

(a)

(1 point) If the new operation achieves double the labor productivity as the old operation (that is, not only

are twice as many umbrellas made per day, twice as many are made per shift), what is the new cost

breakdown?

(b)

(2 points) OK, so now we're running two shifts. If half the energy required to make an umbrella is a direct

marginal cost (for example, heating up the aluminum to make the interior struts) and half of it is a cost of

operating the business (e.g., heating up the plant so the workers don't freeze solid in the winter), how

would moving to two shifts affect the cost structure? Hint: Start with your answer to (a) and think on a

per-umbrella basis.

(c)

(2 points) These umbrellas don't need to be made 100% by hand, however, and the company is

considering an investment in automation so that many parts can be made by machine, with the final

product simply assembled by hand (like Dell does). Starting off with the original 10/20/30/40 cost

structure, if automation increases capital costs by one-quarter (that is, to 125% of their previous level) but

reduces labor costs by half (that is, 50% of their previous level), how much will moving to automation

reduce total cost on a percentage basis? (You may find Sutton's Law to be useful here.)

(d)

(1 point) In a general sense, will investing in automation be more valuable to a factory that runs

two

shifts

per day or one that runs only

one

shift? Why? (No calculation is required.)

(e)

(3 points) The new operation now

both

runs two shifts per day

and

automates the production. Including

all

the changes in capital, labor, and energy costs, how does the new total cost compare to original total

cost? (You will find computing the new breakdown to be useful, but your answer should be in terms of

percentage of original cost.)

ECON 491 Midterm: Spring 2018 (In-Class Portion) - Choose 4 Out of 7 Topics

3. Incentives to make high-end goods/innovations in the market

Monty Verdi has invented a better umbrella, for which monthly demand is given by Q = 100 - 2P. (Q is

in umbrellas per month and P is in dollars, but you probably already knew that.)

(a)

(1 point) How much quantity is demanded at P = $15?

(b)

(2 points) If you got (a) correct, you should be able to figure out that the monthly revenue (P*Q)

is $1,050. If the per-unit variable costs (which you might think of as "marginal cost") are $5 per

unit, how much are monthly profits at a price of $15?

(c)

(2 points) How many umbrellas must eventually be manufactured and sold at $15, over time, to

break even against a fixed cost of $5,000 to design and create the prototype while supporting

Monty during the invention process?

(d)

(1 point) Profit is maximized at a price of $27.50 rather than $15 (you can trust me on this for

now, but can check it out later.) How many units must be manufactured at $27.50, over time, to

break even against the fixed cost of $5,000 to create the prototype?

(e)

(1 point) OK, so you've figured out how many umbrellas it takes to break even. How many

months

does it take to break even at prices of $15 and $27.50, respectively? (You can ignore

discounting and the time value of money.)

(f)

(2 points) After you've broken even, what are the NPVs of the monthly profits at prices of $15

and $27.50 respectively? Use a discount rate of 1% per month. [Think of this as the income that

the inventor receives in their old age, once they've retired to the Costa Rican rain forest.]

(g)

(2 points) Jot down a few words about the relative importance of the economic sophistication of

pricing the umbrella correctly compared to the completely different skill required to invent the

umbrella.

ECON 491 Midterm: Spring 2018 (In-Class Portion) - Choose 4 Out of 7 Topics

4. Learning Curves and Costs, Over Time and Quantity

JP, Inc. makes one zeppelin per month in their Robert plant. The learning curve, showing their costs

based on their cumulative experience over time, results in a 10% reduction in costs every time

cumulative experience doubles. For ease of calculation, you can assume that this cost reduction

happens all at once, at the end of the month when they reach the critical quantity, and goes into effect

the next month.

1.

(1 point) After two such cost reductions, their new cost is 81% of their old cost, which happens

at the end of Month 3 and starts to take effect at the beginning of Month 4. Briefly explain why.

2.

(2 points) Fill in the missing values in the table. "Cumulative Experience" shows the amount of

product made

before

the beginning of the month.

Month

Cumulative Experience

At The Beginning of

This Month

Cost Per Zep Made

This Month

1

0

$100,000

2

1

$81,000

If you can't fill out this table, you should

really

choose another question.

3.

(2 points) How much is the average cost of the zeps made in the first

three

months?

4.

(1 point) How much is the average cost of the zeps made in the first

seven

months?

5.

(1 point) A little tricky: How much is the average cost of the zeps made in the first

twelve

months?

6.

(1 point) After

fifteen

months (that is, at the start of month sixteen), how much is the cost of the

zep compared to its original cost?

7.

(2 points) Why might we think that the rate of cost reduction would slow down over time?

ECON 491 Midterm: Spring 2018 (In-Class Portion) - Choose 4 Out of 7 Topics

5. R&D and Innovation

(a) (2 points) Consider a hypothetical industry. If firms that perform R&D make product innovations

five (5)

times as often compared to firms that don't, and 10% of the firms perform R&D, how much of

the overall product innovation in is achieved by firms that do perform R&D?

(b) (2 points) In this hypothetical industry, if performing R&D makes process innovation

nine (9) times as likely and 10% of the firms in the industry perform R&D, how much of the process innovation is

achieved by firms that perform R&D?

Enough hypotheticals! Now look at the "Other Chemicals" industry data from BRDIS,

omitting 3254:

New or significantly

improved product

Industry and NAICS code

Companies

(thousands)

a

Any good/

service

Any

process

Goods

Services

Yes

N

o

Ye

s

N

o

Ye

s

N

o

Yes

N

o

All industries, 21-33, 42-81

1,545.1

9

86

5

91

7

88

9

86

Manufacturing industries, 31-33

127.1

22

74

18

77

10

85

22

72

Food, 311

9.1

17

75

16

77

5

87

17

75

Beverage/tobacco products, 312

1.2

17

77

13

81

6

87

15

75

Textile/apparel/leather and allied products, 313-16

6.1

19

77

15

81

9

87

18

78

Wood products, 321

6.1

9

88

6

91

5

92

16

81

Chemicals, 325

5.9

41

52

33

60

18

75

34

59

Pharmaceuticals/medicines, 3254

1.5

45

51

24

72

27

69

42

53

Other 325

4.4

40

52

36

56

15

77

31

60

(b)

(1 point) As an easy start, if 10% of companies in NAICS 3250, 3251, 3252, 3253, 3255, 3256,

3257, 3258, and 3259 performed R&D over the survey period, how many companies would that

be?

ECON 491 Midterm: Spring 2018 (In-Class Portion) - Choose 4 Out of 7 Topics

(c)

(2 points) If performing product R&D makes any good or service

product

innovations five (5)

times as likely, how many companies in NAICS 325(0,1,2,3,5,6,7,8,9) performed

product

R&D

over this period? Show your work.

(e) (3 points) If exactly 100 companies performed

process

R&D over this period in NAICS

325(0,1,2,3,5,6,7,8,9), by what factor does investing in

process

R&D make generating a

process

innovation more likely? Show your work.

6. Rate of return on innovations in general (and process vs. product)

(6 points) Label the key features on the (updated and truncated to 32 periods) returns to R&D. You

should make sure to label all three arrows and all three time brackets.