Doulton - Econ Flashcards
Elasticity
= the percent change in the quantity demanded for a 1% change in the price
Ed < 1 = inelastic (an increase in price leads to a small decrease in quantity, such that the overall revenue will still increase
Ed = 1 = Unit elastic (am increase in price is perfectly off-set by a change in quantity such that revenue will not change)
Ed > 1 = Elastic demand (An increase in price leads to a large decrease in quantity such that the overall revenue will fall
Formula given on sheet
Cross - Price elasticity
measures the responsiveness of the quantity demanded for a good to a change in the price of another good
Forumla given on sheet
Complements
An increase in price of Y leads to a decrease in the quantity sold of X
ex: if the price of X-box games go up, the sale of X-box consoles will decrease
Substitues
An increase in price of Y leads to an increase in the quantity sold of X
Ex: if the price of X-boc consoles go up, the quantity of PS4s sold go up
Demand Forecasting: Linear Trend
the growth in sales can sometimes be modelled using a linear trend, where Q is the quantity demanded and T is the time period
Equation:
Q = bo + b1T + error
Demand Forecasting: Exponential Trend
the exponential trend/exponential growth model is
Q= Ae^(b1T)
Demand Estimation:
Linear Regression
A linear regression model, used to predict demand can use any number of independent variables to predict the quantity of a product sold. The most relevant is the price of the product, but prices of other products and advertising expenditure for the product
Interpreting co-efficients:
once coefficients are found, they can be interpreted as the change in Q for a $1 change in the value of the variable.
Constant Elasticity of Demand
Must Transform in ln(Qx).
Interpreting co-efficients:
An increase inPx 1% will decrease Qx by b%
Coefficients in Demand Functions
Can only be included in the model if they are statistically significant (meaning they are statistically different than 0, recall from stats class) - therefore the Pvalue must be less than 5%
Rsquared (goodness to fit)
R-squared measures the proportion of the variation in your dependent variable (Y) explained by your independent variables (X) or all linear regression model.
We select the model with the adjusted R-squared value closest to 1. (because it implies that the independent variables of our model perfectly predict our dependent variable.
Average production of labour
gives us the total output, per unit of labour
Formula given
Marginal product
the additional output produced from 1 additional unit of labour
Formula given
Short Run (Capital is fixed, Labour is variable)
Capital is fixed, Labour is variable.
In the short run, only labour can be adjusted, and the amount of capital must be accepted as fixed (therefor rearrange)
Long run
Both Labour and Capital are variable.
In the Long run, both labour and capital can be adjusted, we must solve for both
Isocost - show all the combinations of L and K which you can get for the same cost
Isoquant - shows all the combinations of L and K which gives the same level of Output (Q)
Long Run profit maximation
MPk = MPL
____ ____
r w
Marginal Rate of Technical Substitution
- the slope of the isoquant line
- shows how much of one input you can replace with the other (the tradeoff between the inputs) to maintain the same level of output
- if the MRTS is constant (no variables in the equation) the inputs are perfect substitutes, which means the isoqaunt is a straight line and the tradeoff between K and L is the same no matter what the production level or level of inputs
When the inputs are perfect complements the isoquant is L shaped and only one combination of L and K will work for each output level since there is no direct rate off
Equation:
MRTS = - MP l
______
MP k
Cost of Production:
Sunk costs
= the costs has already occurred and therefor should not be considered when making decisions
Cost of Production:
Opportunity cost
= The income/profit that you are giving up by not pursuing an alternative option
Different cost models:
Cubic model:
C(q) = a + Bq + yq2 + Sq3
Quadratic:
C(q) = a + Bq + yq2
Linear:
C(q) = a + Bq
Economies of Scale
MC < ATC
Diseconomies of Scale
MC > ATC
Industry Structures:
- Perfect competition
- Monopoly
- Monopolistic competition
- Oligopoly
- for all industry structures, profit maximization occurs when MR = MC
Perfect competition
Many firms, each firm sells a small amount of the total market output.
each firm produces the same product.
Perfect information and zero transaction costs.
Firms can enter and exit the market without barrier
No firm has market power
Each firm must set their price at the price of the other firms (otherwise they will loose all their market share)
The long run economic profits are zero
Perfectly competitive firms:
MR = P
therefore
P = MC
Short-term profits under perfect competition
A firm should exit the market (shit-down condition) if the average variable cost (MC) is > than the price of the market (P)
The firm should produce at the level where P=MC if the avg. variable cost of production is less than the market price (P)
break-down:
P>ATC = positive economic profits (new firms enter market)
P=ATC = zero economic profits (revenues cover total costs, including opp. costs, but new firms have no incentive to enter
PAve variable cost the form will produce in the short run, but in long run may exit)
Long Run profits under perfect competition
Firms will earn zero economic profit since first will enter or exit the market until P=ATC
Monopoly
= one firm produces for the entire market, has market power to set prices
Monopolist can control the quantity supplied to the market to influence price
Profit maximization occurs when MR=MC
Monopolist Rule of Thumb for Pricing
Price is a markup over marginal cost, where the markup amount depends on the elasticity of demand. (same rule of thumb, but change denominator to (1+(1/Ed))
Effect of Advertising
If a firm is able to stimulate demand through advertising than they will have an elasticity of advertising
Rule of thumb for optimal level of advertising is given by equation on formula sheet
Oligopoly
A few firms account for the total production of the market.
products may or may not be differentiated.
no free entry to the market.
Pricing and output (quantity) decisions are made taking into account the impact on competitors and the expected reaction from competitors.
Oligopoly (Quantity Based Competition) - Cournot Competition
= Firms decide on quantity at the same time.
- maximizing decision based on what it thinks the other firm will produce
- market price depends on the TOTAL output of both firms
- Each firm finds their reaction curve which is the relationship between their profit maximizing output and the output of their compeititors
Steps:
- market Quantity (Q) is split between the two firms
- find firm 1’s reaction curve by setting MC = MR and solving for Q1 as a function of Q2
- Find firm 2’s reaction curve setting MC = MR and solving for Q2 as a function of Q1
- Set firm 1’s reaction curve equal to firm 2’s reaction curve to solve for Q1 and Q2
Oligopoly (Quantity Based Competition) - Stackelberg Competition
= one firm decides Q before other, first mover advantage
Steps:
- Firm 1 sets output before firm 2
- Firm 1 will set output taking into account how firm 2 will respond, firm 2 will see the output level of firm 1 and set their own output accordingly
- FIrm 1 has a first mover advantage and will have higher profits than firm 2
Oligopoly (Quantity Based Competition) - Collusion
= Firms work together like a monopoly to set price and quantity
Steps:
- Set profit function as if 1 firm (use Q, not Q1 + Q2)
- Find optimal Q by setting MR=MC
- Find corresponding price by substituting into demand function
- Split Q* between two firms
Oligopoly (Price Based Competition) - Bertrand Competition
= compete on the basis of price
Different market price for each firm
Homogeneous products (identical products) - each firm sets P=MC, undercutting when possible
Heterogeneous Products (differentiated products)
same process as cournot or stackelber EXCEPT we sub out Q for P .
Take derivative of profit, with respect to P1 or P2
Pricing with Market Power
1st degree 2nd degree 3rd degree * 4th degree * Tariffs Bundlign
1st degree price discrimination
= the monopolist charges each customer their reservation price (exactly what they are willing to pay)
All consumer surplus is transferred to the producer (there is no DWL, however efficient does not equate with fair
2nd degree price discrimination
= the monopolist sets a different price for a set of different quantities
some of the consumer surplus is transferred to producer (depending on the quantity sold, DWL can occur. If the producer produces until P=MC no DWL will occur)
3rd degree price discrimination
= only occurs when we can break the market into different segments
a demand function for each segment is required (or elasticity of demand and then use the monopolists pricing rule
Steps for each segment
- MR1 = MC1 —> Q1
- Plug q for segment into demand to solve for P1
- Total profit = revenue of market 1 + Revenue of Market 2 - costs
- Total profit = P1Q1 + P2Q2 - costs
If we are unable to differentiate markets or cannot enforce segments:
- only set one price and one quantity
total demand is required! Which is found by adding the demand function of the two segments
Set MR+MC and solve for Q (total market quantity)
Tariffs
= a tariff system, set an entry fee (t) per user and a usage free (P) per unit used. For example a cell phone bill is $30 per month plus $5 per GB of data used would have a t=30 and P=5
Tariffs - one segment
The tariff (t) is set to equal consumer surplus and the usage fee (P) is set at MC
Tariffs - two segments
= to maximize profit, we set (P) above MC, since we cannot absorb all of the consumer surplus. The entry fee (t) is set on the segment with lower demand, but applied to both segments
steps:
1. find t as a function of P
2. Set up the profit function as a function of only P
Bundling
= different customers have different reservation prices for different products (different willingness to pay)
at a single price point for each product, we either are unable to sell to both customers or we miss out on potential surplus.
When we have multiple products with different reservation prices, we can combine them into a bundle
Pure bundling
= would occur when products are only available in bundles (Microsoft office products)
Mixed bundling
= occurs when we sell bundles AND we sell the individual products (windows operating system comes with laptop but can also be purchased separately).
When we use mixed bundling, we have to ensure we cannot buy the individual components for less than the bundle price.
Competition Policy: Vertical Merger
= combing businesses which are different stages along the supply chain which helps eliminate the issue of double marginalization, but can also lead to monopolistic situations
Competition Policy: Horizontal Merger
combining businesses which fulfill the same business process or sell a similar product. Increased industry concentration can lead to greater DWL, but cost savings due to changes in costs (fixed and MC) can lead to increased efficiency
- in canada, mergers are monitored by the competition bureau. The commissioner must be made aware of any mergers above 92 M before they take place
Inelastic demand
Ed < 1
(increase in price leads to small decrease in quantity
Unit elastic
Ed = 1
increase in price is perfectly off-set by a change in quanittiy
Elastic demand
Ed > 1
Increase in price leads to a large decrease in quantity, such that revenue will fall
Complements
When the price of x goes up, the demand for y goes down
Substitutes
When the price of x goes up, demand for y goes up
Linear Demand
= the coefficients change in quantity, for every $1 change in price
Constant elasticity demand
= the change in quantity for every 1% increase in price
P value greater than 5%?
replace coefficient with 0
Average product of Labour
gives the total output per 1 unit of labour
Marginal product of Labour
the additional output produced from 1 more unit of labour
Average product of Capital
gives the total output per 1 unit of capital
Marginal product of Capital
the amount of quantity produced from 1 more unit of capital
Short run
= capital is fixed, labour is variable
solving - use Q and K and rearrange to find L
Long run
Both L and K are variable
Long run maximization = Optimal input combination formula
MRTS
marginal rate of technical substitution is the slope of the isoqaunt line (the ratio of how much one input you can replace with the other, tradeoff)
Accounting vs. Economic costs
economic costs includes opportunity cost, therefor is always > than accounting
Sunk costs
= costs that you can’t get back, not considered when making a decision
Opportunity cost
= the income/profit you would receive from doing something else, that you are giving up
Economies of scale
ATC > MC
Diseconomies of scale
ATC < MC
Industry structure
Perfect competition (P=MC) monopoly (MR=MC) Monopolistic competition (MR=MC) Oligopoly (cornet - MR=MC, stackelberg - MR=MC, Cartel - MR=MC, Bertrand - P=MC)
Perfect competition
P=MC
if P>ATC - firms enter market until LONG RUN P=ATC and no economic profit
if P
Monopoly
only supplier
FULL market power to set the price
MR= MC
Monopolistic Rule of Thumb Pricing and Advertising (use from formula sheet)
Monopolistic Competition
a monopoly without the barriers to entry
Imperfect competition - products are slightly different and firms can enter
Short run - MR=MC, has economic profit
Long Run - P = ATC , no economic profit (like perfect competition)
Oligopoly
cornet competition (decides q at the same time)
stackelberg (one firm decides Q before, first mover advantage)
collusion (Set price and quantity together)
bertrand (compete on basis of Price, undercut)
Cornet competition
Decide quantity at the same time
- Q = q1 + q2
- P = 1000 - Q ——> 1000 - q1 - q2
- find revenue for firm 1 (P*q1)
- MR = MC
- solve for q1 (reaction curve)
- *SAME, solve for q2 (reaction curve)
- set reaction curves equal to 0 - solve for q1 and q2
- sub Q into Price function - by symmetry, same price
Stackelberg
One firm decides Q before the other (first mover advantage)
- Find revenue
- MR=MC
- find each reaction curve
- q1 subs q2 into the profit function before derivative
- find quantity’s
- sub in quantity’s for price
Collusion
- Firms work together like monopoly to set P and Q
- Q = split Q at the end in 2
Bertrand Competition (homogeneous)
Compete on the basis of price
- find MC’s - whoever has the lowest MC of the 2, wins.
- Set their price 1$ below the other MC, other P=MC, and they take full Q of the Market
Bertrand Competition (Hetergeneous) **
Compete on the basis of price
- Find reaction curves
- MR=MC
- Rearrange for P1 and P2 - as the creation curves
- sub reaction curves (p1 ) into in other reaction curve (p2)
- rearrange for P1, sub in and find P2 (By symmetry the same)
- find quantities (same by symmetry)
First mover DISadvantage, pricing before another firm (they can make theirs lower)
Competition Bureau
the competition Bureau monitors the the competition act, which tries to promote competition in Canada —> maximizing total surplus
Illegal Cartels
illegal to have fixing price agreements, market allocation agreements and output restrictions (excess profit)
Legal cartels
members make normal level of profits (the Canadian Dairy commission of Canada)
Immunity program
a cartel member can obtain full immunity if they provide the competition Bureau with evidence about price fixing/cartel before an investigation begins (Lawblaws, 12 minutes before getting searched)
Leniency Program
after an investigation begins cartel members can apply for a reduction in penalties, in exchange for cooperating with the competition bureau
Mergers
Vertical
Horiztonal
Vertical Merger
- combining business which are at different stages along the supply chain, helps eliminate the issue of double marginalization
- can also lead to monopolistic situations
Horiztonal merger
- combining businesses which fulfill the same business process (sell a similar product
- increased industry concentration can lead to greater DWL, but cost savings are created (due to changes in costs which can lead to increased efficiency
Mergers are allowed if
fixed cost savings > change in TS
Change in TS formula
additional savings (change in MC) - Additional DWL (also on formula sheet)
-additional DWL + additional savings
therefore, if additional savings is > than addition DWL, merger can happen
Herfindahi-Hirschman Index
HHI measures competition in an industry
on formula sheet
si = the market share as a whole number of company i
a drop of more than 200 units would be concerning
1500 < HHI < 2500 = moderate concentration
2500 < HHI = high concentration
Natural Monopolies regulation
when natural monopolies arise they are normally regulated with the intent of maximizing total surplus while all ensuring that the company will continue to exist
Marginal Cost Pricing
MC = P (perfect competition)
MC>AC (leads to the reduction of fixed costs)
subsidy can be used
Average Cost Pricing
P = ATC, long run
Some DWL but maximizes total surplus
no incentive for firm to reduce costs
Predatory Pricing
= when a firm sets a price lower than MC to make it impossible for other firms to compete, drive out competition. WALMART
Illegal in canada, but also hard to prove
Tenders and Bidding
those who are able to compete the project submit a bid (secret)
First Price Tender
The Lowest price wins and the contract is for the lowest bid
easiest to collude over bid prices
Second Price Tender
firm with lowest price wins but contract is for second lowest price
harder to collude over bid prices
creates more competitive environment
in long run, it creates more competition, therefor this decreases prices overall
Pricing with market power
1st degree price discrimination 2nd degree price discrimination Intertemporal price discrimination 3rd degree price discrimination two part tariff bundling
1st degree price discrimination
P=MC
charge each buying their reservation price (highest amount they are willing to pay)
full PS
profit = PS - FC
2nd degree pricing
different prices based on different groups of consumers
depending on quantity sold, DWL can occur
MR=MC
Intertemporal Price Discrimination
= prices change depending on time of usage (uber)
3rd degree price discrimination
only occurs when we break market into different segments
need to be able to identify the different segments
use MR=MC
Profit = revenue - all segments - total cost
Two Tariff one consumer group
Usage price - P=MC
T (tariff) = CS
(entry fee) - t = T/n (# of consumers)
Bundling
charge the lowest reservation price of an item or set of items to be able to sell to everyone
- consumers have different reservation prices
- multiple products w/ different reservation prices, can combine them into a bundle
Two tariff two consumer groups
set P > MC, because cannot absorb all of the CS
t
pure bundling
would occur when products are only available in bundles
mixed bundling
happens when products are both sold individually and sold in a bundle. need to make sure than individual prices are higher than in the bundle price
Strategic Interactions among firms
dominant strategy
Nash equilibrium
prisoners dilemma
maximin strategy
Dominant strategy
the strategy that is better than any other strategy for one player
regardless of action of other player
is both players have a dominant strategy, only 1 Nash equilibrium exists
Nash equilibrium (NE)
when no player has an incentive to change strategy, both doing best they can taking into account other players actions
repeated games
if played for a fixed # of games, players will not cooperate
- cooperation, when game Is infinite
- will cooperate as long as the other firm does, will STOP forever as soon as the other firm cheats (grim trigger strategy)
grim trigger strategy
as soon as one firm cheats, the other will stop cooperating forever
tit- for - tat
more common than grim trigger strategy
- player does whatever the opponent did in the last round of play
influencing the outcome of the Game
Credible threats and credible commintemnets
- can change the outcome of the game
- if restricts a firms choice, essentially eliminates branches of the decision tree (threat is only valid if its credible)
Decision making under uncertainty
risk neutral utility function certainty equivalent risk premium risk adverse risk loving
risk neutral
= selects the course of action with the greatest expected payoff (E(x))
- all companies are conisdered risk neutral
Utility function
= translates the payoff into a individuals utility
- make decision based of which has highest E(U)
square root, square root under 1 - risk adverse
exponent (over 1) - risk loving
Certainty Equivalent
the amount you are willing to accept, instead of playing the game.
Risk Premium
the amount you are willing to pay or give up to either play the game, or avoid the risk and not
Risk adverse
prefers certainty over risk
- diminishing Marginal Utility
- Utility function has exponent less than 1
- Ex > CE
- positive RP (how much willing to give up of potential profit)
Risk adverse
prefers potential upside of risk, over certainty
- increasing marginal utility
- utility has exponent over 1
- Ex< CE
- negative RP (paying)
Insurance
transfers the risk from the individual to the insurance company
- only risk adverse individuals will benefit from it (NEVER risk seeking)
- insurance is risk neutral (as are all companies)
will buy insurance when
EU I = EU NI
Actuarially fair Insurance
the cost of insurance equals the expected payoff.
Premium = expected loss
Value of information
the value of PI is the price someone would be willing to pay to get access to the information
EVPI = EV w PI - EVw/o PI
Asymmetric Information
= arises when one side of transaction has different information than other
asymmetric info in short run
buyer/seller will assume some probability of a high quality vs low quality and use weighted average for price/salary.
Asymmetric info in long run
in long run, high quality products will exit the markets, because price is not high enough and only the low quality will remain, price will then change to the reservation price for low quality products
Adverse selection
= when one party knows more about the quality than the other, which leads to inefficient market outcomes
- ex: high quality cars can’t be sold to those who want a high quality car because of uncertainty that the car is actually high
Moral Hazard
when one party changes their behaviour when they cannot be observed
- not preparing for a flood because you have insured your house against flood damage
Overcoming Adverse selection
- Screening
- Signalling
- incentive compensation
(if can’t tell between low and high productivity employees, add together and divide by 2) (low quality earns more, high quality earns less)
screening
= the uniformed party tried to obtain more information (interviewing candidate for a job)
signalling
= the informed party invest in signals to communicate the quality of a product (warranties, education level, etc.)
ex: warranties on a high quality used car can signal quality
ex: education level can signal quality of employee
Credible signal
= signal which cannot be mimicked by a low quality product
credible signal will have separating equilibrium (beneficial for high to invest and not for low to invest) (can tell apart)
A pooling equilibrium, occurs when both high and low either do not invest or invest (can’t tell apart)
for high quality:
payoff w signal > payoff without signal
(Separating equilibrium) > (Pooling equilibrium)
for Low quality:
Payoff with signal < Payoff without signal
(Separating) < (Pooling)
Incentive contract Types
- fixed payment contract
- rate per effort contract
- profit sharing contract
Principle- agent problem
when the agent is working for principle, but pursuing their own goals rather than goals of the principle
- actions are not observed
- asymmetric information
Incentive contracts
= attempt to line up the agents goals with the principles goals
Complete information
efficiency can be achieved and the moral hazard problem does not occur
- principle is able to see the agents effort and pay them accordingly
Incomplete information
moral hazard occurs, outcome is inefficient (can’t see the agents effort, agent will slack)
Fixed payment contract
- agent receives a fixed amount F
- principals profit = profit - F
Rate-per-effort contract
- agents payment depends on effort level e
- e =1
- e = 0
- wage rate for effort is w
- principals profit = profit - wXe
Profit sharing contract
- agent receives a share of the profit s
- agents payoff is s(profit)
- principles residual payoff is (1-s)profit
Agent will work hard when
Expected utility high > expected utility low
conditions for incentive contract
participation constraint
- utility from participating in contract must be greater than person’s reservation utility
incentive compatibility
- must be in agents best interest to choose the profit-maximizing action, otherwise efficiency can only be achieved if the principal monitors the agent
agency costs:
- (expected profit when observable - expected profit when not observable)
Efficiency wage
= is the wage above the market was that will incentivize employees to not shirk their responsibility out of fear of loosing their job
w = efficiency wage
w* = market wage (opportunity constraint)
