Course: Business Economics

Short exam on 05th October 2021

Q1: Profit maximization criticisms

Profit maximization is one of the typical objectives of firms. However, there exists criticisms in
empirical perspectives. Clarify your understanding about these criticisms on the basis of relevant
research (you are encouraged to include more recent additional evidence in addition to the
papers of Shipley (1981) and Horby (1985)

Empirical studies of firm motives that are frequently linked to studies of pricing, tend to imply that
corporations do not maximize profits.

- Shipley (1981) and Hornby (1986) are two such studies of the United Kingdom (1995). Shipley
(1981) used a questionnaire to study a sample of 728 UK businesses. He discovered that 47.7% of
respondents stated they aimed to maximize earnings, while the rest said they tried to generate adequate
profits. Only 26.1 percent of respondents answered profit maximization was of overwhelming
importance compared to others responding to a second question. Shipley found that just 15.9% of
responding companies were "true" profit maximizers after further investigation. This research also
revealed that rather than having a single aim, businesses prefer to have a variety of goals. Profit is thus
a vital goal, but it should not be pursued at the expense of other goals.

- We cannot conclude that the association between corporate social performance (CSP) and
profitability is generally positive based on empirical evidence. Griffin and Mahon (1997) conducted a
study and found 51 studies that looked into this relationship. Though the majority of this research
indicated that CSP has a favorable impact on financial performance, a significant number of them
found no effect or even a negative impact. According to Hillman and Keim (2001), some types of CSR
(corporate social responsibility) have a beneficial impact on profitability, while others have a negative
impact. This suggests that depending on how the CSP aspects are weighted, combining them into one
would yield varying responses regarding the link between CSP and profits.

→ The primary empirical research' criticisms of the profit maximization assumption are:

+ Profit maximization is an inadequate description of what many businesses strive for.

+ Other goals, such as raising revenue in the short term, maybe more essential.
+ There is no such thing as maximizing a single goal.

+ Marginalism is a bad explanation of how firms pick what to produce and at what price.

+ Profit is a byproduct, and the outcome is uncertain.

Q2: Sales revenue maximization

Explain your understandings of the objective of sales revenue maximization in the following
aspects:

- The rationale for the existence of this objective (rather than profit maximization)

- How do firms maximize their sales revenue in the 2 cases of without and with profit
constraints?

- How do you explain the determinants affecting the profit constraint?

- How will the quantity at the point of profit and sales revenue maximization change as fixed
costs increase in the case of non-linear total revenue and total cost?

* The rationale for the existence of sales revenue maximization (rather than profit maximization):

A model developed by Baumol (1959) recognizes the importance of profit but assumes that managers
set the goals of the firm which is sales maximization. Baumol argued that in oligopolistic markets,
managers have more discretion in setting goals, and sales revenue maximization is a more likely short-
run goal than profit maximization. The reasons are as follow:

- Sales revenue is a more useful short-term goal for the firm than profit. Sales are measurable and may
be used to motivate employees, whereas profits, which are a residual, are more difficult to use in this
way. Everyone in the company is assumed to be aware of certain sales targets.

- Senior managers' rewards are frequently based on sales revenue rather than profit, as they are for
lower-level employees.

- Increasing the size of the firm as measured by sales revenue or turnover is considered by shareholders
as a good predictor for short-run profit gains since it is expected that an increase in revenue will more
than offset any associated increases in costs, resulting in additional sales increasing profit.
- Increasing revenues and, as a result, the firm's size, makes it easier to manage since it generates an
environment in which everyone believes the company is successful. When a company's sales drop, it's
viewed as failing, forcing managers to review their policies.

* How do firms maximize their sales revenue in the 2 cases of without and with profit constraints?

The figure is presented in terms of average and marginal revenue and cost. At the output level OQpi,
the firm would maximize profits, whereas at OSs, it would maximize sales revenue. The output level
for limited sales revenue maximization will be OQc, which is halfway between profit and sales-
maximizing outputs. Because the model predicts a downward-sloping demand curve, the price set by
the constrained sales revenue maximizer OPC will be lower than that set by the profit maximizer OPpi.
As a result, when the constrained sales revenue-maximizing output exceeds the profit-maximizing
output, the firm will always offer a lower price, and OPc will be lower than OPpi.

* Determinants affecting the profit constraint?

The absolute amount of profit that the firm must produce on a given quantity of capital employed is
shown as the profit constraint that represents the preferences of shareholders. This profit constraint is
set lower than the maximum profit level. The profit constraint for each firm is derived after considering
the following factors:

- The sector's normal profit levels/rate of returns, taking into account cyclical/long-term tendencies.

- The rate of return that will satisfy shareholders with the company's performance, causing them to
keep or buy shares rather than sell them.

- If profits fall short of expectations, the stock price will drop, encouraging further share sales and
takeover bids.

- A profit level that discourages hostile takeover bids would also fulfill management's desire to keep
control of the company.
* How will the quantity at the point of profit and sales revenue maximization change as fixed costs
increase in the case of non-linear total revenue and total cost?

A drop in output will result from an increase in fixed costs (or the implementation of a lump sum tax).
A profit maximizer, on the other hand, would keep output constant. The profit function is uniformly
moved downward from pi2 to pi1 as a result of an increase in fixed costs, as seen in the figure. The
profit-maximizing output stays the same in Q1, whereas the profit constraint of the sales maximizer
CpiC causes a decrease in output and a rise in price from Q2 to Q3. This helps to explain price rises
that occur in the real world as a result of increases in fixed costs or lump-sum tax.
 Business Economics
Short exam on November 19, 2021

Q1: Demand function

We have a function of quantity demanded good x as follows:

The denotations of variables are mentioned in class (X n is a matrix of other control variables, which are
not clarified here).

How could you interpret the impacts of each determinant on quantity demanded if we achieve the value
of each coefficient:

b1 b2 b3 b4

-0.5 1.2 1.1 -0.6

Answer

We have:

● Qx = quantity demanded of good X

● Px = price of X
● Py = he price of good Y
● Y = income
● Ax = advertising expenditure on good X
● Xn = all the other variables that might be included in the model.

From the table, we can infer that:

 ● b1 = -0,5 means that when the price of X increases by 1 unit, Qx will decrease by 0,5 unit
● b2 = 1,2 means that when the price of Y increases by 1 unit, Qx will increase by 1,2 unit
● b3 =1,1 means that when advertising expenditure increase by 1 unit, Qx will increase by 1,1 unit
● b4 = -0,6 means that when the income increase by 1 unit, Qx will decrease by 0,6 unit

Q2: Log-linear demand function

From the textbook, we have the result table as follows:

Explain your understanding of the results of this table.

Answer

The log-linear demand functions for each product are provided in Table 6.2 with the following data:
- Constant term.
- The real price of the good.
- The real price of all other goods.
- Real income.
- The coefficient of determination, or adjusted R^2
- Coefficients for each independent variable.
- t-ratios for each variable.
 - The Durbin–Watson statistic.
We may deduce from the information provided that:
- For all three items, changes in real income are considerable, and measured income elasticities
are positive:
+ For beer, income elasticity is 0.8 which is less than 1
+ For spirits, it is 1.6
+ For wine, it is 2.8 which is greater than 1
- Own price elasticity of demand is
+ Negative for wines and spirits (the expected sign). However, it is less than 1 for wine (-
0.6) and greater than 1 for spirits (-1.18)
+ For beer, price elasticity is positive rather than negative, however, the observed elasticity
of (0.2) is not significantly different from 0.
- Advertising elasticity
+ is positive and significant for beer (0.07) but minor for wine (0.01) and spirits (0.01).
+ It is negative and insignificant for wine (0.01) and spirits (0.08).
→ The findings suggest that advertising has little influence on overall beer, wine, and

spirits sales.
- The corrected R^2 taking into account degrees of freedom of more than 0.9 indicates that the
models have strong explanatory power, whereas the Durbin-Watson Statistic indicates that there
were no autocorrelation issues, as discussed above.

Q3: Indifference curve criticisms

Despite the popularity of the indifference curve, there exist criticisms about using this
curve. What are those criticisms? Clarify the argument for those.

Despite its popularity, critics of the indifference curve exist. Some of the concerns are as follow
- First, the theory does not explain how preferences are formed or changed. Consumers may have
established purchasing behaviors based on experience and learning through practice.
- Second, the theory is static, and while it compares one position to another, it does not predict the
path of change or examine how consumers adapt their purchases in response to new prices or
income. Purely objective indifference curves are only conceivable if quantitative data can be
 obtained. Because of the logical nature of indifference curve theory, quantifying indifference
curves is challenging. Though attempts to quantify the indifference curve have been attempted,
success has been limited.
- Third, the rational behavior rules do not describe the process by which people decide whether to
consume more or less of a given commodity. Others argue that they are a fair estimate. In
practice, consumers do not make explicit marginal calculations, but they do make such estimates
when making such judgments.
- Fourth, customers do not have enough information to make appropriate assessments of the
values they expect to gain from a purchase or to make reasonable product choices.
- Fifth, individuals' preference ordering is merely utility-driven, with no consideration for moral
preferences or the idea of a hierarchy of requirements with some being more significant than
others. The weak ordering hypothesis states that a consumer can be indifferent to a wide variety
of combinations. Indifference curve analysis is based on this concept. However, in the real
world, there are few examples of indifference. It's subjective due to the unsteady ordering.
- Sixth, consumers are expected to act independently of one another. In reality, utility functions
are not always independent, and the utility of one consumer may be affected by the activities of
another.
- Seventh, the model only deals with private commodities that are used immediately. It does not
identify commodities that give advantages over time or have external impacts, nor does it
acknowledge disappointing goods that fail to meet the consumer's expectations for the benefit of
consumers.
- Eighth, the indifference curve approach cannot explain the risky choice. Indifference curve
analysis has been criticized for failing to explain customer behavior when faced with options
including risk or uncertainty of expectation. To assess if a risk is worth taking among uncertain
alternatives, a quantitative calculation of utility is required.
- Ninth, other consumer behavior factors are not taken into account. The indifference curve
approach ignores speculative demand, the interdependence of consumer preferences in the form
of advertising, stock market influences, and so on.
- Tenth, the hypothesis of the indifference curve is based on the unrealistic assumption of perfect
competition. In reality, consumers face differentiated products and monopolistic competition,
therefore the indifference curve technique is based on false assumptions of perfect competition
 and homogeneity of commodities. The indifference hypothesis is unrealistic since it is based on
baseless assumptions.

Short exam on 14th December 2021

Q1. Risk and Uncertainty

What are the main differences between Risk and Uncertainty?

- Risk refers to the possibility that the actual outcome of an investment will differ from the
predicted conclusion, whereas uncertainty refers to the lack of assurance regarding an
occurrence.
- The key distinction between risk and uncertainty is that risk is quantifiable, whereas
uncertainty is neither.

Q2. EV, Variance, SD, Covar

How can you calculate: Expected value, Variance, Standard deviation, Coefficient of
variation

- Expected value: The expected value (EV) is an anticipated value for an investment at some point
in the future. In statistics and probability analysis, the expected value is calculated by multiplying
each of the possible outcomes by the likelihood each outcome will occur and then summing all of
those values.

EV=∑P(Xi)×Xi

- Variance: variance measures variability from the average or mean. It is calculated by taking the
differences between each number in the data set and the mean, then squaring the differences to
make them positive, and finally dividing the sum of the squares by the number of values in the data
set.
 where:

xi =ith data point

xˉ=Mean of all data points

n=Number of data points

- Standard deviation: Standard deviation is calculated as follows:

1. The mean value is calculated by adding all the data points and dividing by the number of data
points.

2. The variance for each data point is calculated by subtracting the mean from the value of the
data point. Each of those resulting values is then squared and the results summed. The result is
then divided by the number of data points less one.

3. The square root of the variance—result from no. 2—is then used to find the standard
deviation.

- Coefficient of variation: The coefficient of variation (CV) is a statistical measure of the dispersion
of data points in a data series around the mean. The coefficient of variation represents the ratio of
the standard deviation to the mean

where:

σ=standard deviation

μ=mean
Q3. Risk appetite

Based on the following information for each decision, which decision will you make if (clarify
also the reasons):

a. You just care about the return

b. You just care about the risk

c. You care about both the return and risk

a. You just care about the return

I prefer the choice with the highest return (highest expected value)

→ Decision C because it has the highest expected value of all decisions.

b. You just care about the risk

- If I am a risk-averse, I prefer the choice with the lowest risk (lowest coefficient of variation)
→ Decision C

- If I am a risk lover, I prefer the choice with the highest risk (highest coefficient of variation)

→ Decision B

c. You care about both the return and risk

I prefer the decision with the highest return and the lowest risk.

→ Choose C

Q4. Decision criteria

Given the information of payoffs for each project as follows:

What will be your choices for each of the following strategies (clarify the reasons)

a. Maxi-min

- This a risk-averse test, because the individual identifies the worst possible outcome for each
course of action being considered.

- He then selects the project with the highest value from the list of least values. By choosing the best
of the worst, the decision maker avoids pursuing courses of action that will lead to signiwocant
losses. The decision maker chooses the best of the worst outcomes. The worst outcome for each of
the projects is associated with recession.
→ The highest value of the worst outcomes is 13,000 for project B. This project is chosen by a

risk-averse decision maker.

b. Maxi-max

- This is a risk-loving test, because the individual identifies the best possible outcome for each
course of action being considered.

- He then selects the project with the highest value from the list of the best values. By choosing the
best of the highest outcomes, the decision maker seeks to achieve the highest return irrespective of
the chance of making losses The best outcome for each of the projects is associated with boom.

→ The highest value of the best outcomes is 21,000 for project C.This project is chosen by a

risk-loving individual.

c. Mini-max regret

Mini-max regret decision makes use of the opportunity cost, or regret, of an incorrect decision and
allows the decision maker to analyse the gains and losses associated with a correct or incorrect
decision. A regret matrix may be devised for the projects

+ If we consider project A, then assuming recession prevails it would earn 12,000 compared with
the best outcome, which is 13,000. The regret of having chosen the wrong project is therefore
1,000. The regret for each project can be calculated for each state of the world and is shown in the
final column.

→ If project A had been chosen, then the maximum regret is 1,000. If project B had been

chosen, then the maximum regret is 6,000. If project C had been chosen, then the maximum

regret is 2,000.

→ Thus, using the risk-averse mini-max regret rule the chosen project would be A, because it

has the lowest regret; this contrasts with the choice of C using the maximax and B using the

maxi-min test.

→ Thus, depending on attitudes to risk and uncertainty, different individuals will choose

different courses of action.

d. Bayes (Laplace)

The Bayes’ (Laplace) criterion assumes that there is no information about the probabilities of future
events occurring and that the decision-maker should assume the equal probability of the unknown.
This means that each outcome would be assigned the same probability and a weighted average
calculated; this is illustrated in Table 3.7.

The firm would choose the alternative with the highest expected weighted average or in this case
either project A or project C.
e. Hurwicz

The
Hurwicz alpha decision test is used to select the project with the highest weighted average, where
the average is made up of the maximum and minimum outcomes; this is illustrated by reference to
Table 3.8, where the maximum outcome is given a likelihood outcome value of 0.7 and the
minimum outcomes at 0.3.

→ The results show that project C would be chosen. The assignment of likelihood or expected

probability values could re£ect expectations about how the economy might perform or the

attitudes of decision-makers.