Economics > QUESTIONS & ANSWERS > Harvard University - ECONOMICS 1051Problem Set 7 Solutions ALL ANSWERS CORRECT (All)

Harvard University - ECONOMICS 1051Problem Set 7 Solutions ALL ANSWERS CORRECT

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Problem Set 7 Attila Ambrus, Economics 1051 Spring 2011 Due date: April 5 1. A hold-up problem. [this question introduces you to an important kind of problem in sequential strategic settings] Sup... pose that Amtrak is choosing whether or not to build a new high-speed railroad on the East coast. Building the railroad will involve an initial up-front sunk cost k. To keep the accounting simple assume that the railway, if built, will run for exactly one year, and that it will generate (new) revenues of 130,000,000. Operating the railroad for that year would cost $10,000,00 in fuel, plus some labor costs. The labor costs depend on the wage. The railroad would need to employ 1000 workers all of whom would be unionized. The current going wage for union rail labor on the East coast is $50,000. That is, without the new railroad, these workers would earn $50,000. a) Very briefly define what is meant by sunk cost, and what is meant by the ‘sunk cost fallacy’. [Go look it up if you do not know] Ans: When undertaking a project, we say costs are sunk when some of the actions towards realizing the project have already been taken. The sunk cost fallacy is that costs which have been sunk should influence a cost benefit analysis of the current stage of the project. It is a fallacy because a cost benefit analysis of actions should only depend on what the actions can affect. b) Assuming that the labor can be hired at this going wage, for what values of k should Amtrak build the new railroad? (Assume that Amtrak aims to maximize profits without discounting) Ans: If Amtrak builds the railroad, it will make profit 130; 000; 000 − 50; 000 ∗ 1; 000 − 10; 000; 000 − k = 70; 000; 000 − k: So, Amtrak will build the railroad if and only if k ≤ 70; 000; 000 c) Suppose that, if the railroad is built, after it is built the rail union can make a ‘take it or leave it’ wage demand w to Amtrak to apply just for labor on the new line. The railroad’s only choice is to accept to pay the wage demand w, or close the new line down. What demand will the union make? Given this, if you were Amtrak, for what values of k would you build the new line? Why is your answer different from that in part b? 1 This study source was downloaded by 100000816398418 from CourseHero.com on 03-28-2021 10:12:26 GMT -05:00 https://www.coursehero.com/file/10435865/Problem-Set-7-Solutions/ This study resource was shared via Co [Show More]

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