Chapter 5 & 6 Flashcards
What is a demand curve
A demand curve tells you how much consumers will purchase at a given price
What is Marginal Analysis of Pricing
What is Elasticity
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
What are Other Elasticities
- Income elasticity of demand (e can be > 0)
- 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
What 4 things make the demand curve elastic
1.
All investment decisions involve a trade-off between what?
Between current sacrifice and future gain.
Define Compounding
(Future value, one period int he future) = (Present value) x (1 + r)
where r is the rate of return
The general formula for Compounding
(Future value, k periods in the future) = (Present value) x (1+ r)k
Rule of 72
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
The general formula for Discounting
(Present value) = (future value, k periods into the future) / (1 + r)<em>k</em>
By how much are most public pensions underfunded
25%
What is the NPV rule
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
What is the IRR
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)
What does break-even analysis tell you
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
What is the break-even quantity equation
Q = F/(P-MC)
where F is annual fixed costs, P is price, and MC is marginal cost
When should you not use break-even analysis
Do not use break-even analysis to justify higher prices or greater output
Pricing and production are extent decisions that require marginal analysis
What is the break-even price
The break-even price is the average avoidable cost per unit
When should a company shut down
When revenue is less than avoidable cost
When you shut down, you lose your revenue but you get back your avoidable costs
What are Avoidable Costs
Fixed Costs are avoidable in the long run
Variable Costs are avoidable in the short run
Sunk costs are never avoidable
What is post-investment hold-up
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
Equation for Profit as a function of the difference between price and average cost
Profit = Rev - Cost = Q * P - Q * (Cost / Q) = Q * (P - AC)
Where P is price, Q is quantity, and AC is Average Cost
The one lesson of business
to figure out how to profitably consummate a transaction
What is the first law of demand
the consumer purchases more as price falls
What is consumer surplus
Consumer surplus is the difference between the total value and amount paid.
As price declines, consumer value increases
What is an aggregate demand curve
An aggregate or market demand curve is the relationship between the price and the number of purchases made by this group of consumers
What is the equation for Price Elasticity
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
What is the equation for the best estimate of e (elasticity)
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)]
For an elastic demand:
a in price leads to a in revenue
A decrease in price leads to an increase in revenue
What is the equation for revenue change
%ΔRevenue ≈ %∆Q + %∆P
What is the table for Elastic Demand
Price increase > Revenue decrease
Price decrease > Revenue increase
What is the table for Inelastic Demand
Price increase > Revenue increase
Price decrease > Revenue decrease
What is the exact numberical relationship between MR (change in revenue) and elasticity
MR = P(1-1/|e|)
What is the Markup Formula
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
How do we use elasticity as a forcasting tool
%∆QD ≈ e(%∆P)
What is the factor of elasticity demand
Factor of elasticity of demand = %∆QD ÷ %∆F
Where a factor, F, can be anything that affects demand, such as temperature, other prices, or incomes.
What is stay-even analysis
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
What is cost-plus pricing and Markup pricing
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
