ECO5000 Economics for Managers

1. Outline and explain the rational actor paradigm. Give any two examples of when it has not held.
2. Outline the advantages and disadvantages of using net present value and break even analysis as criteria for assessing a firm’s investment decision.
3. An ice cream factory has set up shop in town. It paid $200k for the land and $100K for custom machinery that cannot be relocated elsewhere. The factory can produce litres of ice cream with the following operating schedule:
Volume (000’s litres) Operating cost schedule
100 $50k
200 $150k
300 $350k
400 $550k
500 $750K
600 $1.05M

a) Briefly explain the sunk cost fallacy.
b) What are the sunk costs for the firm
c) If the ice cream is sold for $2.50 per litre (hint: allow for 000’s units), what is the optimum quantity the factory should produce
d) What is the profit or loss it will make at the optimum quantity.

Rational actor paradigm refers to individuals tending to opt for options that favour them. The proposal is that people usually act rationally in an ideal way and for the purpose of their own self-interest. This theory infers that to influence the way people behave, then one has to alter the satisfaction levels when individuals choose certain alternatives. Typically, people aim at getting the highest rewards from the actions they want to take. Thus, rational actor paradigm refers to the act of persons choosing the alternative that will result in the maximum level of satisfaction. (behravesh, 2014).

This talks about situations when persons did not use rationality. A good situation is when a person goes to buy an item in an alternate store to save on five dollars on a fifteen dollars purchase but do not change stores to save the same 5$ on a 10000$ purchase.

Moreover, a person who makes decisions in anxious situations will result in making irrational decisions. The individual does not have time to come up with the best alternative due to the pressures that he or she faces in the making of decision. The availability of few alternatives is the cause of anxiety. This result in an individual being forced to pick the alternatives due to their availability, but not because they are the best alternatives. Thus, rational actor paradigm does not happen because the alternative chosen is not the best considering the individual could have wanted better alternatives, which were not available.

2. Net present value is the difference between net present cash inflows and net present outflows of a project or investment.

   The main benefit of net present value is in computing the value of a firm’s project. A negative NPV indicates that the plan will not increase the firm’s value, while a positive NPV indicates that the plan will raise the firm’s value.

Shortcomings of net present value

          The main shortcoming with net present value is often for doing cash estimations for the cash inflows and outflows. This is because it is hard to account for unforeseen expenses.

Break even analysis is the determination of when a business will be able to cover all its costs and start making profits from the sales revenue. When the expenses are more than the revenues, the company ends up making losses.

Benefits of breakeven analysis

The computation of the level of sales required by a business to start earning profits. This assists the business plan its sales activities.

Shortcomings of breakeven analysis

The shortcoming of breakeven analysis is to come up with realistic expectations. The reason for this is unpredicted expenses that may come up in the cause of operations, causing a rise in the breakeven point.

3. Sunk cost fallacy- this is the idea that a business is most likely to carry on with an investment if they have expended too much resources, time and effort on the investment.

The sunk costs are $200k used to buy land and $100k for buying the machinery. A sunk cost is a cost experienced by a business in the past. The costs for buying land and machinery are sunken costs. This is because a company experiences this cost before it has started its operations activities. Hence, the firm has a challenge of recuperating sunk costs. The sunk cost regaining is through sales revenue. The goal is to have higher sales incomes than the sunk costs to attain turnover.

Optimum quantity is the quantity at which the marginal expenses and the marginal incomes are equal. This is typically the point where the expenses experienced are same as the incomes received by the company. The optimal quantity is 120 litres as it yields a revenue of 300k, which is same as the costs experienced by the company. Additional sales beyond this stage results to the production of profit by the company.

There is no profit or loss at this point because it is the breakeven point. It talks about the point in which a company recovers its expenses incurred in activities from the revenues. Thus, at breakeven point the returns and losses are nil. Additional sales beyond this stage thus results to profits for the company.

References

William stallings, t. c., 2012. business data communication. s.l.:pearson.

Je, c. d. a. d., 1999. the appreciative inquiry handbook:for leaders of change. s.l.:s.n.