Economics for Management Flashcards
Rational Actor Paradigm (RAP)
Assumes that people act rationally, optimally, and in their self-interest, thus responding to incentives.
How to diagnose the source of any business dilemma (3 Q’s)
- Who is making the bad decision?
- Do they have enough information to make a good decision?
- Do they have the incentive to make a good decision?
General approaches to solving these issues…
- Change the decision maker to somebody with better information or incentives
- Give more info to the current decision maker (eg. Matrix structure)
- Change the current decision makers incentives.
Sunk / Fixed cost fallacy
Taking account of irrelevant costs (eg. keeping an incompetent employee because you’ve already invested thousands in their training)
Hidden cost fallacy
Costs that are not accounted for in the decision making process (eg. maintenance costs)
Economic Value Added (Economic Profit)
Takes into consideration Cost of Capital (equity) to avoid hidden cost fallacy.
Marginal Cost
The cost to make one additional unit of output (Change in Cost / Change in Output) or TC (Unit 2) - TC (Unit 1)
Average Cost
Per Unit cost of production (Total Cost / Quantity)
Variable Cost Formula
Marginal Cost x Quantity
Marginal Revenue
The revenue gained from selling one more unit. You only sell when MR > MC.
Break even Point
FC / SP - MC
Net Present Value
- initial investment
+ (Cash flow / 1 + Discount Factor^1)
+ (Cash flow / 1 + Discount Factor^2)
+ (Cash flow / 1 + Discount Factor^3)
etc.
Post-investment Hold Up
When 2 parties have a contract, and one seeks to take advantage of the party that has undertaken a large investment by changing the terms of the agreement (sunk costs cannot be recovered). Can be prevented through contracts.
Law of diminishing returns
When more workers are added, productivity and output falls in the SR.
Different returns to scale
Increasing returns to scale - A % increase in inputs leads to a more than proportional increase in output. LR
Constant returns to scale - A % increase in inputs leads to the same % increase in output. LR
Decreasing returns to scale - A % increase in input leads to a less than proportional increase in output. LR
PED
responsiveness of demand to a change in price.
% Change in QD / % Change in $ = PED
Economies of scope
The cost of producing two products together is cheaper than the cost of producing them separately.
Economies of scale
The cost advantages a company enjoys from increasing the scale of it’s operations.
How does a firm sell substitutes and complements?
A firm sells substitutes by moving them further apart geographically or in product attributes to ↑ profit
A firm sell complements by reducing selling price to increase MR and profit of both products.
What does price advertising do to demand?
Price advertising makes demand more elastic (lower price = more demand).
What does product advertising do to demand?
Product advertising makes demand more inelastic (quality and celebrity endorsements).
Bundle of substitutes and complements elasticity
Bundles of substitute are inelastic as you can’t switch.
Bundles of complements are elastic as consumers can substitute towards alternative goods.
Price Discrimination
when a firm charges a high price in an inelastic market and sells the additional stock a lower price in an elastic market e.g. Adults and Students.
Conditions for price discrimination to occur
- No market arbitrage or seepage
- Price setting power
- two consumer groups with different PED’s
Optimal Price formula
MC * (PED / PED + 1)
Game Theory
Devised to consider strategic situations
Consists of 3 elements:
- Players
- Strategies
- Payoffs
Sequential Move Game (Tree Diagram)
Players take turns after evaluating their rivals moves.
Simultaneous Move Game (Table Diagram)
Each player chooses their actions without any knowledge of the actions chosen by other players eg. prisoners dilemma.
Nash Equilibrium
A situation where no player could gain by changing their own strategy.
In sequential, both parties can achieve best outcome.
In simultaneous, both parties act self interestedly.
Expected Value Formulae
(Risk 1 % x Payoff 1) + (Risk 2 % x Payoff 2) cont.
Difference between Moral Hazard and Adverse Selection
Moral Hazard is when an individual feels more inclined to take risks if someone else bears the costs.
Adverse Selection is when one party has more information than the other, and use this to their advantage.
How to resolve adverse selection
Screening - identifies high & low risk individuals, to enable insurance companies to set prices depending on their target market.
Signalling - Consumers reveal info about themselves to the insurance company eg. low risk to lower costs.
Principal-Agent problem
How it can be resolved?
When an employees refuses to carry out a task as their incentives don’t align with the employers.
solution - incentive pay e.g. commission, however, exposes agent to risk.
