# The federal government estimation paper

1. Approximately 14 million Americans are addicted to drugs and alcohol. The federal government estimates that these addicts cost the U.S. economy \$300 billion in medical expenses and lost productivity. Despite the enormous potential market, many biotech companies have shied away from funding research and development (R&D) initiatives to find a cure for drug and alcohol addiction. Your firm – Drug Abuse Sciences (DAS) – is a notable exception. It has spent \$170 million to date working on a cure, but is now at a crossroads. It can either abandon its program or invest another \$30 million today. Unfortunately, the firm’s opportunity cost of funds is 7 percent and it will take another five years before final approval from the Federal Drug Administration is achieved and the product is actually sold. Expected (year-end) profits from selling the drug are presented in the accompanying table.

 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 \$0 \$0 \$0 \$0 \$15,000,000 \$16,500,000 \$18,150,000 \$19,965,000 \$21,961,500

What is the net present value of the project?

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Instruction: Round your answer to the nearest penny (2 decimal places). Use a negative sign (-) where appropriate.

\$

If the firm prices below \$140, revenue will:

b. What is the own price elasticity of demand when Px = \$240? Is demand elastic or inelastic at this price? What would happen to the firm’s revenue if it decided to charge a price above \$240?

Instruction: Round your response to 1 decimal place.

Own price elasticity:

If the firm prices above \$240, revenue will:

c. What is the cross-price elasticity of demand between good X and good Z when Px = \$140? Are goods X and Z substitutes or complements?
Instruction: Round your response to 2 decimal places.

Cross-price elasticity:

6. You are an assistant to a senator who chairs an ad hoc committee on reforming taxes on telecommunication services. Based on your research, AT&T has spent over \$15 million on related paperwork and compliance costs. Moreover, depending on the locale, telecom taxes can amount to as much as 25 percent of a consumer’s phone bill. These high tax rates on telecom services have become quite controversial, due to the fact that the deregulation of the telecom industry has led to a highly competitive market. Your best estimates indicate that, based on current tax rates, the monthly market demand for telecommunication services is given by Qd = 250 – 5P and the market supply (including taxes) is QS = 3P – 110 (both in millions), where P is the monthly price of the telecommunication services.

The senator is considering tax reform that would dramatically cut tax rates, leading to a supply function under the new tax policy of QS = 3.5P – 110. How much money per unit would a typical consumer save each month as a result of the proposed legislation?

\$

What price should BAA charge for runway slots between July and September?

£

 18. A risk-neutral consumer is deciding whether to purchase a homogeneous product from one of two firms. One firm produces an unreliable product and the other a reliable product. At the time of the sale, the consumer is unable to distinguish between the two firms’ products. From the consumer’s perspective, there is an equal chance that a given firm’s product is reliable or unreliable. The maximum amount this consumer will pay for an unreliable product is \$0, while she will pay \$100 for a reliable product.

 a. Given this uncertainty, what is the most this consumer will pay to purchase one unit of this product?

\$[removed]

 b. How much will this consumer be willing to pay for the product if the firm offering the reliable product includes a warranty that will protect the consumer?

\$[removed]

 19 As the manager of Smith Construction, you need to make a decision on the number of homes to build in a new residential area where you are the only builder. Unfortunately, you must build the homes before you learn how strong demand is for homes in this large neighborhood. There is a 60 percent chance of low demand and a 40 percent chance of high demand. The corresponding (inverse) demand functions for these two scenarios are P = 300,000 – 400Q and P = 500,000 – 275Q, respectively. Your cost function is C(Q) = 140,000 + 240,000Q.

How many new homes should you build, and what profits can you expect?

 Number of homes you should build: [removed] homes

Profits you can expect:

 20. You are the manager of a firm that sells a “commodity” in a market that resembles perfect competition, and your cost function is C(Q) = 2Q + 3Q2. Unfortunately, due to production lags, you must make your output decision prior to knowing for certain the price that will prevail in the market. You believe that there is a 70 percent chance the market price will be \$200 and a 30 percent chance it will be \$600.

 a. Calculate the expected market price.

\$[removed]

 b. What output should you produce in order to maximize expected profits?

[removed] units

 c. What are your expected profits?

\$[removed]

 21. Pelican Point Financial Group’s clientele consists of two types of investors. The first type of investor makes many transactions in a given year and has a net worth of over \$1.5 million. These investors seek unlimited access to investment consultants and are willing to pay up to \$30,000 annually for no-fee-based transactions, or alternatively, \$50 per trade. The other type of investor also has a net worth of over \$1.5 million but makes few transactions each year and therefore is willing to pay \$105 per trade.

 As the manager of Pelican Point Financial Group, you are unable to determine whether any given individual is a high- or low-volume transaction investor. To deal with this issue, you design a self-selection mechanism that permits you to identify each type of investor.  You offer two types of plans for customers with more than \$1.5 million in assets: one plan has an annual maintenance fee but offers a large number of “free” transactions (call this the “Free Trade” Account); the other plan has no annual maintenance fee but charges for each transaction (call this the “Free Service” Account).  Determine the specifics for each plan as listed below:

 Annual maintenance fee \$[removed]

 Number of “free” transactions [removed]

 Price for each transaction in excess of the number of “free” transactions \$[removed]

“Free Service” Account:

 Price per transaction

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