Question 1- Is there any difference between profit maximization and value

maximization? Explain!
Answer
Value maximization is clearer and certain goal in with wealth maximization. Unlike profit

maximization (that measures the benefits of the project in terms of accounting profit)

value maximization measures the same in terms of cash flows rather than in terms of

accounting profit. It helps to reduce conflict and dispute among the stake holders and

corporations. According to wealth maximization, a good financial decision is that which

increases the net value of the corporation.

Question 2- Is it reasonable to expect firms to take actions that are in the public interest
but are detrimental to stockholders? Is regulation always necessary and appropriate to
induce firms to act in the public interest? Substantiate with real world examples

No, it will not a reasonable to expect firms to act on the idea of public interest when

they primarily came in to existence with the idea of earning it is illogical for firms to take

actions that are in the public interest if they are detrimental to stockholders. This is

because stockholders are the back bone of a company and taking actions that can be

detrimental to them might make them decide to leave, causing great loss of business.

Yes, government regulation is necessary in most cases and it is definitely appropriate to

make firms act to the public’s benefit. This is because, as we showed above, they do not

have an intrinsic drive to do so, especially when their stockholders’ rights or profits are

affected.

Question 3 - H&M has been selling 15,000 jackets per month for 355 ETB. When they
increased the price to 500ETB, they sold only 12,000 Jackets. What is the demand
elasticity? If the marginal cost is 250 per Jacket, what will be the desired markup price?
Was raising the price profitable?

Step1
- Initial price =355ETB
- New price = 500 ETB
- Initial quantity = 15,000
 - New quantity = 12,000
Now,
EP= %change in quantity /%change in quantity
%change in quantity=New quantity-Initial Quantity/ Initial Quantity
%change in quantity= (12,000-15000)/15,000*100
= -3000/15000*100
% change in quantity= -20%
% change in quantity= new price - Initial price/Initial price
% change in quantity =500-355/355*100
% change in quantity = 40.84%
Thus,
Price Elasticity of demand = -20%/40%
ED=0.49

Step 2

Marginal cost = 250

Now

Mark up price = price – marginal cost

When p =355 ETB

Mark up Price = 105 ETB

When p =500 ETB

Mark up =500-250

Mark up = 250 ETB

Step 3

When p= 355 ETB

Total revenue = price * Quantity

Total revenue = 355*15000

Total revenue = 5,325,000

When price = 500 ETB

Total revenue = 500*12,000

TR= 6,000,000

Thus, increasing price leads to an increase in total revenue by

675,000 = (6000, 000 - 5,325,000)

 Therefore Increasing price is profitable

Question 4- What is a “returns to scale”? Explain the different types of returns to scale
and their respective causes. Does it have relationship with economies of scale?
To scale describe what happens to long run returns as scale of production increases,

when all in put levels including physical capital usage are variable (able to be set by the

firm). The concept of returns to scale arises in the context of a firm’s production

function. It explains the long run linkage of the rate of increase in output (production)

relative to associated increase in the inputs (factors of production). In the long run, all

factors of production are variable and subject to change in response to a given

increased in production scale. While economies of scale show the effect of an increased

output level on unit costs, returns to scale focus only on the relation between input and

output quantities.

There are three possible types of returns to scale,

- increasing returns to scale

- Constant returns to scale and
- Diminishing (or decreasing) return to scale.

If output increases by the same proportional change as all inputs change then there are

constant returns to scale (CRS). If output increases by more than the proportional

change in all inputs there are decreasing returns to scale (DRS). If output increases by

more than the proportional change in all inputs, there are increasing returns to scale

(IRS). A firm’s production function could exhibit different types of returns to scale in

different range of output. Typically, there could be increasing returns at relatively low
output levels, decreasing returns at relatively high output levels, and consant returns at

some range of output levels between those extremes

In mainstreaming microeconomics, the returns to scale faced by affirm are purely

technologically imposed and are not influenced by economic decisions or by market

conditions (i.e., conclusions about returns to scale are derived from the specific

mathematical structure of the production function in isolation).

Question 5- The demand for Habesha beer in Addis Ababa is hypothesized to be

determined by price of beer (PRICE), Price of all other goods (OTHERSPR), Income
(INC) and per capita advertising (ADVERT). And the OLS estimation result is given by
DD=−5463+0.3643 PRICE−0.15439 OTHERPR+0.8892 INC+ 0.0831 ADVERT
( 11.2225 ) ( 1.7141 )( 1.0895 ) ( 6.7752 )( 2.6327 )
2
R =0.950
DW statistics=1.716

a. Interpret the estimation result

The long-linear demand functions for each product.

 Constant term
 Real price of the good
 Real income
 The coefficient of determination, or adjusted R2
 Coefficients for each independent variable.
 T-ratios for each variable.
 The Durbin- Watson statistic

The significant results found by duty (1983) include the following

 Changes in real income are significant for all three products and measured
income elasticity are positive for beer less than 1 ( 0.8) for sprite (1.6) and wine
( 2.8) it is greater than 1.
 Own price elasticity are negative for wines and spirits ( the expected sign ) but
less than 1 for wine ( - 0.6) and greater than 1 for sprite ( -1.18) for beer price
elasticity is positive rather than negative though the measured elasticity of ( 0.2)
is not significantly different from 0
 The elasticity for advertising is positive and significant, but small for beer (0.07)
and negative and insignificant for wine (0.01) and sprite (0.08). The results
advertising have a very small impact on the total sales of beer, wine and sprite.
 Statically, the adjusted R2 indicates that the models have significant explanatory
power, while the durbin-waston statistic indicates there were no problems with
autocorrelation as explained above.
 The studies by Duffy and others (see Brewster 1997, PP.153-154) show
that beer tends to have a very low price elasticity, a low cross elasticity of
demanded and low but positive income elasticity iof demand.
 More sophisticated models have been developed using demand systems to
estimate the elasticity’s. Duffy ( 1987 ) found the own price estimate of
the elasticity of demand for beer, using data from 1975 to 1983 to be -
0.36, for income to be +0.71 and for advertising +0.05.

b. What is the meaning of the R2?

The amount of variation explained by the independent variable included in the

model the adjusted R2 takes into account degree of freedom. Because otherwise
the value of R2 lan be improved by adding more independent variables
 In the model R2 accounted for 0.950 or 95% of the variation, or changes in the
independent variables. It also indicates that 0.05 or 5% variation is accounted the
closer the value of R2 is to 1 the better the fit. While the closer it is to 0 the poorer
the fit. So we see that 0.95 is closer to 1 and its better the fit.
c. What will happen to the demand of Habesha beer if the average income of
the community is increased by 1000 birr?

 If the average income of the community increased by 1000 the demand of Habesha increased
by 889.2 unit 0.8892*1000= 889.2