Question: High Flyer Airlines wants to build new airplanes with greatly increased cabin space. This will allow High Flyer Airlines to give passengers more comfort and sell more tickets at a higher price. However, redesigning the cabin means rethinking many other elements of the airplane as well, like the placement of engines and luggage, and the most efficient shape of the plane for moving through the air. High Flyer Airlines has developed a list of possible methods to increase cabin space, along with estimates of how these approaches would affect costs of operating the plane and sales of airline tickets. Based on these estimates, Table shows the value of R&D projects that provide at least a certain private rate of return. Column 1 = Private Rate of Return. Column 2 = Value of R&D Projects that Return at Least the Private Rate of Return to High Flyer airlines use the data to answer the following questions.
Private Rate of Return Value of R&D
12% $100
10% $200
8% $300
6% $400
4% $500
a. If the opportunity cost of financial capital for High Flyer Airlines is 6%, how much should the firm invest in R&D?
b. Assume that the social rate of return for R&D is an additional 2% on top of the private return; that is, an R&D investment that had a 7% private return to High Flyer Airlines would have a 9% social return. How much investment is socially optimal at the 6% interest rate?