Chapter 5 & 6

Question 1

What is a demand curve

Answer 1

A demand curve tells you how much consumers will purchase at a given price

Question 2

What is Marginal Analysis of Pricing

Question 3

What is Elasticity

Answer 3

Elasticity measures the sensitivity of the change in one variable to another

A demand curve for which quantity changes more than price is said to be elastic, or sensitve to price.

A demand curve for which quantity changes less than price is said to be inelastic, or insensitive to price

Question 4

What are Other Elasticities

Answer 4

1. Income elasticity of demand (e can be > 0)
2. Cross-price elasticity of demand (i.e. a change in the price of A causes a change in demand for B)

Income elasticity: if ie > 0 (positive income elasticity), this is normal, good. if ie < 0 (negative income elasticity), inferior good (what you buy in hard times)

Cross-price elasticity: if cpe > 0, then Good A is a good substitute for Good B. cpe < 0 means that Good A is a good compliment to Good B

Question 5

What 4 things make the demand curve elastic

Answer 5

1.

Question 6

All investment decisions involve a trade-off between what?

Answer 6

Between current sacrifice and future gain.

Question 7

Define Compounding

Answer 7

(Future value, one period int he future) = (Present value) x (1 + r)

where r is the rate of return

Question 8

The general formula for Compounding

Answer 8

(Future value, k periods in the future) = (Present value) x (1+ r)^k

Question 9

Rule of 72

Answer 9

If you invest at a rate of return r, divide 72 by r to get the number of years it takes to double your money

Question 10

The general formula for Discounting

Answer 10

(Present value) = (future value, k periods into the future) / (1 + r)^<em>k</em>

Question 11

By how much are most public pensions underfunded

Answer 11

25%

Question 12

What is the NPV rule

Answer 12

If the net present value of the sum of all discounted cash flows is larger than zero, then the project earns more than the cost of capital

Question 13

What is the IRR

Answer 13

The internal rate of return is the discount rate that sets NPV equal to zero

To find the IRR, increase the discount rate until the NPV falls to zero

(When in doubt, use NPV)

Question 14

What does break-even analysis tell you

Answer 14

The break-even quantity is the quantity that will lead to zero profit

If you can sell more than the break-even quantity, then entry is profitable

Question 15

What is the break-even quantity equation

Answer 15

Q = F/(P-MC)

where F is annual fixed costs, P is price, and MC is marginal cost

Question 16

When should you not use break-even analysis

Answer 16

Do not use break-even analysis to justify higher prices or greater output

Pricing and production are extent decisions that require marginal analysis

Question 17

What is the break-even price

Answer 17

The break-even price is the average avoidable cost per unit

Question 18

When should a company shut down

Answer 18

When revenue is less than avoidable cost

When you shut down, you lose your revenue but you get back your avoidable costs

Question 19

What are Avoidable Costs

Answer 19

Fixed Costs are avoidable in the long run

Variable Costs are avoidable in the short run

Sunk costs are never avoidable

Question 20

What is post-investment hold-up

Answer 20

When, after you incur sunk-costs, a business partner changes their negotiations

Before they are incurred, sunk costs are relevant to the negotiation

Sunk costs are unavoidable, even in the long run, so after you incur them, you are vulnerable to post-investment hold up

Question 21

Equation for Profit as a function of the difference between price and average cost

Answer 21

Profit = Rev - Cost = Q * P - Q * (Cost / Q) = Q * (P - AC)

Where P is price, Q is quantity, and AC is Average Cost

Question 22

The one lesson of business

Answer 22

to figure out how to profitably consummate a transaction

Question 23

What is the first law of demand

Answer 23

the consumer purchases more as price falls

Question 24

What is consumer surplus

Answer 24

Consumer surplus is the difference between the total value and amount paid.

As price declines, consumer value increases

Question 25

What is an aggregate demand curve

Answer 25

An aggregate or market demand curve is the relationship between the price and the number of purchases made by this group of consumers

Question 26

What is the equation for Price Elasticity

Answer 26

e = %ΔQD ÷ %ΔP

Where QD is the quantity demanded, and P is the price

Price elasticity is always negative

If |e| > 1, demand is elastic; if |e| < 1, demand is inelastic

Question 27

What is the equation for the best estimate of e (elasticity)

Answer 27

The best estimate comes from dividing by the midpoint of price (P₁ + P₂) / 2 and the midpoint of quantity (Q₁ + Q₂) / 2

e = [(Q₁-Q₂) ÷ (Q₁+Q₂)] ÷ [(P₁-P₂) ÷ (P₁+P₂)]

Question 28

For an elastic demand:

a in price leads to a in revenue

Answer 28

A decrease in price leads to an increase in revenue

Question 29

What is the equation for revenue change

Answer 29

%ΔRevenue ≈ %∆Q + %∆P

Question 30

What is the table for Elastic Demand

Answer 30

Price increase > Revenue decrease

Price decrease > Revenue increase

Question 31

What is the table for Inelastic Demand

Answer 31

Price increase > Revenue increase

Price decrease > Revenue decrease

Question 32

What is the exact numberical relationship between MR (change in revenue) and elasticity

Answer 32

MR = P(1-1/|e|)

Question 33

What is the Markup Formula

Answer 33

MR > MC implies that (P-MC)/P > 1/|e|

the left side of the expression is the current margin (P-MC)/P, whereas the right side is the desired margin, which is the inverse of elasticity, 1/|e|

i.e.

MR = (P - MC) ÷ P > 1 ÷ |e|

The more elastic demand becomes (1/|e| becomes smaller), the less you can profitably raise price because you will lose too many customers

Question 34

How do we use elasticity as a forcasting tool

Answer 34

%∆QD ≈ e(%∆P)

Question 35

What is the factor of elasticity demand

Answer 35

Factor of elasticity of demand = %∆QD ÷ %∆F

Where a factor, F, can be anything that affects demand, such as temperature, other prices, or incomes.

Question 36

What is stay-even analysis

Answer 36

A simple two-step procedure that tells you whether a given price increase (e.g. 5%) will be profitable

Step 1: compute how much quantity you can afford to lose before the price increase beomces unprofitable

This “stay-even” quantity is a simple function of the size of the price increase and the contribution margin, %∆Q = %∆P/(%∆P + margin), where margin = (P - MC)/P

Step 2: You predict how much quantity will go down if you raise price by the given amount

Question 37

What is cost-plus pricing and Markup pricing

Answer 37

Cost-plus pricing arrives at a price by adding a fixed dollar margin to the cost of each product

Markup pricing multiplies the cost by a fixed number greater than 1

Both lead to sub-optimal pricing