Managerial Economics Flashcards
1
Q
What is the fundamental concept behind economics?
A
- social science
- allocate scarce resources in the most efficient way possible to satisfy as many of societies wants as possible
Scarcity:
- all resources (natural, human, capital goods) are limited in comparison to society’s infinite wants
- decision making is therefore important
2
Q
What are opportunity costs?
A
- Related to a decision
- benefits to the society of what is sacrificed or given up when a choice is made
3
Q
What is the difference between Micro and Macroeconomics?
Why are they important?
A
Microeconomics:
- branch of economics that studies the behaviour of individual economic units
- focus on firm, consumers, specific markets
Important for managers: pricing, output, strategies and the potential of impacting cost, demand, revenue and profit
Macroeconomics:
- study of the economy as a whole
- focus on aggregate (total) expenditure and aggregate (total) consumption
- international trade, government spending, taxation and money supply
Important for managers: estimate current market situation, understand politic environment, predict economic cycles
4
Q
What are normative economics?
A
Normative = opinion about what the government “ought to” or “should do” or how the economy “should be”
5
Q
What are positive economics?
A
Positive = facts and statements that can be tested in practice
6
Q
What the difference between deductive and inductive methods?
What are the purposes of them?
A
Deductive
- hypotheses are made, tested and then rejected or approved based on quantitive analysis of data
Inductive:
- economics create theories based on facts which have been determined after the analysis of data
–> Economists use both methods to find support for their economic theories, build theories or create new theories
7
Q
What is ceteris paribus?
What does it mean?
A
Economists build models on the relationship between a few variables and assume other variables that influence the study are unchanged
Ceteris paribus = other things being equal assumption
8
Q
Describe the idea of economic optimisation.
A
Idea of optimisation:
- economic agent (household, government, firm) aims to maximize their utility, profits and social welfare respectively
- subject to certain constraints
- act rationally based on the marginal cost and marginal benefit of a good
9
Q
What is the assumption of the rational expectation school of thought?
A
Economic agents are able to understand the future effects of government policy decisions to the point that such policies may become ineffective
10
Q
What is the criticism regarding the scientific methodological approach used by many economists?
A
- Often difficult to realistically build models of the economy and the behaviour of its economic agents using structural equations and optimisation theory
- many models are based on assumptions that are unrealistic
- many models do not represent the real world
- critic: if policy prescriptions are based on these models it could lead to inaccurate and potentially hazardous courses of action regarding the economic well being
11
Q
List different economic schools of thought.
A
- Classical
- New Classical
- Neo Classical
- Austrian
- Keynesian
- New Keynesian
- Post Keynesian
- institutional
- evolutionary
- radical
- Marxist
- feminist
- behavioural
12
Q
What are categories of economic schools of thought?
How are the different from each other?
What is the criticised?
A
Mainstream:
- classical, new classical, Neo classical, austrian
- limited government intervention in the economy
- promote the idea that markets by themselves can correct any imbalances
- government intervention create inefficiencies
Heterodox:
- Keynesian, etc.
- markets are inefficient and they do bot correct themselves
- governments need to intervene to correct market failures arising from imperfect competition and imperfect information
13
Q
What are implications for managers regarding the different economic schools of thought? Which analytical tools should they rely on?
A
- Understand underlying economic framework which an analytical tool is based
- Are the assumptions realistic?
- Are the assumptions relevant?
- Are they relevant to the Marco environment of the firm?
2
- understand the limitations of the data at the disposal
3
- be aware to only rely on quantitative data when making decisions
- focus on instincts as well
- Challenge: mix gut feeling with quantitive data
14
Q
What is the critic of the main schools of thought in economics?
A
Critic with Mainstream:
- creating economic models are too simplistic and unrealistic
- models cannot describe how the economy works
- models are very useless at best and potentially dangerous if governments follow the prescriptions at worst
Critic with Heterodox:
- thinking lacks credibility because of its non-scientific methodology approach
- does not use mathematical equilibrium optimisation models
- qualitative research alone cannot explain the behaviour of firms, governments and individuals on a basis for valid recommendations
15
Q
What is a business cycle?
Which phases are there?
A
- regular fluctuations in the economic activity
- represent macroeconomic instability
- economic prosperity tends to be followed by economic downturns
- Recession
- aggregate expenditure falls and unemployment rises
- GDP in two consecutive quarters are decreasing - Trough
- economic activity at the lowest point - Growth
- economic activity rises / recovers - Peak
- highest point right before it begins to fall
16
Q
How can mangers deal with the business cycle?
A
1: Understand the terminology used to describe the macro conditions
2: Look for signs suggesting economic changes
3: economic indications that governments, central banks, and firms follow to gauge upcoming changes
4: Challenge of interpreting them correctly
17
Q
What are economic indicators?
List them.
A
Economic indicators reflect the health of an economy
1 Labor market conditions
- initial claims for unemployment benefits
- employment rate and unemployment rate
- labor force participation rate
- long-term unemployment rate
2 Government finances
- budget deficit / surplus
- government debt
3 Surveys
- Surveys of Consumer Expectations (SCE)
- ECB Surverys
- Business Leader surveys
4 Inflation
- HICP (Harmonized index of consumer prices)
- CPI (Consumer Price Index)
- PPI (Producer Price Index)
5 National Income and trade
- GDP
- personal income
- BOP (Balance of Payments - Import/Export)
- exchange rates
6 Key expenditures
- construction spending
- motor vehicle sales
7 Manufacturing and inventories
- industrial production and capacity utilisation
- manufacturers shipments, inventories and orders
- wholesale and retail inventories
18
Q
What policies should governments use to create conditions of macroeconomic stability?
A
1 Sustainable economic growth 2 Price stability (low inflation) 3 Full employment (low unemployment) 4 Balance of Payment equilibrium 6 Sustainable national debt (including low budget deficit) 7 More equitable distribution of income
19
Q
What is monetary policy?
A
Focus on:
- supply of money
- interest rates
- availability of credit
Done by the central banks (FED, ECB, etc.)
Tool = OMO (Open Market Operations):
- buying and selling of securities –> changes in money supply
- changing the discount rate –> change interest rates of credit
- changing the reserve ration –> affect availability of credit
20
Q
Describe OMO.
Who uses it?
What’s the underlying policy?
A
Tool = OMO (Open Market Operations):
- buying and selling of securities –> changes in money supply
- changing the discount rate –> change interest rates of credit
- changing the reserve ration –> affect availability of credit
Used by central banks such as ECB, FED, etc.
Part of monetary policy to affect money supply, interest rates and availability of credit.
21
Q
What is tight/contractionary monetary policy?
A
Executed as part of the OMO of the central banks:
Aims to decrease inflationary pressures by:
- decreasing money supply growth
- increasing interest rates
- Decreasing money supply by selling securities to commercial banks or the general public
- Increasing interest rates = more expensive to borrow money
22
Q
What is loose/expansionary monetary policy?
A
Executed as part of the OMO of the central banks:
Aims to increase or accommodate aggregate spending:
- increasing money supply
- decreasing interest rates
- Increasing money supply by buying securities from commercial banks or the general public
- Decrease interest rates = cheaper to borrow money
- Adopt non-traditional methods such as QE (quantitative easing) to stimulate bank lending and spending
23
Q
Describe the term fiscal policy.
A
- Fiscal policy is the government’s policy with respect to the government spending and taxation
Government can
- increase spending and/or
- decrease taxes
Expansionary fiscal policy:
- Decreasing income and/or corporate taxes:
- leaves households with more money
- more profits for companies to reinvest
- focus on aggregate expenditure
- used to pull economy out of a recession
- mainstream economists: increase aggregate expenditure = short-term effect only since long-term results in higher inflation
- results in higher budget deficits = government borrowing + cloud out (reduce) private sector and business spending (reducing the effectiveness)
- Heterodox economists:
- strong disagree with the view of mainstream regarding expansionary fiscal policy
- will result in higher tax revenue + lower government spending on unemployment benefits
- help to minimise budget deficit
- interest rates do not have an effect on crowding out
24
Q
Describe the supply-side policies.
Name six examples.
A
- Fiscal and monetary policies focus on the demand-side to influence aggregate spending
- Alternative approach to increase the supply-side
- Aims to increase aggregate supply by increasing efficiency in the product and resource market
Examples:
1 lowering the size and duration of unemployment benefits to motivate the unemployed to search for work
2 reducing minimum wages to create greater incentive for employers to hire workers
3 reducing marginal income tax to create incentive for works to work more hours
4 reduce trade union power
5 making information about jobs more accessible to unemployed
6 increase competition in the product markets
25
What is the macro goal that policy makers perceive as the most important?
- Does not exist and depends on the country
- If unemployment is high --> Employment rates
- If inflation is high --> inflation
Mainstream view:
* focused more on long-term growth that requires price stability and fiscal discipline
* full employment or low unemployment is not explicitly stated
* price stability ensures competitiveness which contributes to economic growth and smaller levels of unemployment
* appropriate monetary and fiscal policies to avoid excessively expansive fiscal policy
Heterodox view:
+ keeping inflation and fiscal deficits low will not lead to high growth and falling unemployment
+ inflation and sound fiscal finance counties can have high unemployment rates
+ effectiveness of monetary policy without expensionary fiscal policy will not work
26
What is demand?
Demand is the amount (quantity) of a good or service that buyers are willing and able to buy at different prices over a given period of time in a given market.
27
Describe the law of demand.
- As the price rises the demanded quantity falls and vice versa
- relationship between price and demand is inverse
- negative sloping curve
Income effect:
- effect on demand due to changes in the purchasing power of income that arises from a change in price
- if price of a good falls, an individual can afford to buy more
Substitution effect:
- if a price of a good changes, it becomes more expensive or cheaper compared to other products and services
- consumers will substitute the more expensive for a cheaper product
28
What are Non-Price determinants of demand?
| Describe them.
1 Changes in tastes and preferences
- seasonal changes
- trends in fashion and technology
- advertising or publicity
2 Income levels
- people become unemployed = lower demand
- higher payments = higher demand = more buying power
3 Expectation of the future
- bleak future outlook; worried people = lower demand
- demand based on good: normal goods, inferior goods, superior goods
4 Prices of related goods
- substitutes = satisfy the same want
- demand for a product is positively related to the price of a substitute product
- price of substitute rises = demand for the other substitute good rises
- goods consumed together = complementary good
- demand for complementary goods are inversely related
5 Number of buyers in a market
- more buyers = more demand
29
What is the demand function?
```
Qd = f (
price of good,
tastes and preferences,
income levels,
expectations,
prices of related goods,
number of buyers)
```
30
What is the difference between changes in demand vs. changes in quantity demanded?
Changes in Quantity demanded:
- changes when price changes
- changes in price (ceteris paribus) = change along the demand curve
Demand changes:
- tastes/preferences, income, expectations, number of buyers, related product changes
- shift of the whole demand curve (right or left)
- shift to right = increase in demand at any given price
- shift to right = decrease in demand at any given price
31
What is price elasticity of demand?
| What is the result?
PED = measures how much the quantity demanded for a good changes when its price changes
PED = % change in Qd / % change in P
Result is always absolute
Result:
* PED > 1: percentage change in Qd is greater than the percentage change in price --> demand is price elastic
* PED < 1: percentage change in price is greater than the percentage change in Qd --> demand is price inelastic
32
What are factors influencing the PED?
| Give an example for each.
1 Availability of close substitutes
- if price rises, some buyers will switch to substitutes
- if there are no substitutes it is difficult to switch = price inelastic
Example: demand for petrol = the same for each price = price inelastic due to the lack of substitutes
2 Proportion of income spent on the good
- if proportion of income spent is small = customers are less likely to significantly decrease the amount they buy
Example: Salt, butter, milk = very small amount of income = price inelastic goods
3 Luxury vs. necessities
- demand for necessities are price inelastic (people do not need to buy more or less of it)
- demand for luxury goods are price elastic (people could not go on holiday for a season and still survive)
- Habit or addition demand: very price inelastic since people buy the product anyways
4 Time
- demand for products tend to be inelastic in the short-term
- long term = elastic
Example: People need to buy petrol in the short-term; however long-term they could purchase alternative fuel tech
33
What types of goods can be differentiated regarding their relation to demand?
Inferior goods:
- negatively related to demand
- e.g. bus tickets: as income increases demand decreases and vice versa
Normal goods:
- positive relationship
- e.g. vacation/luxury items: as income decreases the demand decreases
34
Why is it important for managers to be aware of price elasticity of demand?
- Knowledge about product being inelastic means prices can be raised without worrying that demand will fall very much
- quantity demanded will be lower but total revenue will increase
- Knowledge about product being ELASTIC means prices can NOT be raised because quantity demanded will be lower than the price gain and total revenue will decrease
35
What is income elasticity of demand?
How is it calculated?
What does the results mean?
YED (income elasticity of demand) measures how much the demand changes when income levels change
YED = % change in demand / % change in income
YED < 1: Percentage change in demand is smaller than percentage change in income therefore demand is income inelastic
Results:
* Normal goods: YED = 0 bis 1 (demand increases when income increases)
* Inferior goods: YED < 1 (demand decreasing when income increases - e.g. bus ticket)
* Superior goods: YED > 1 (luxury good: demand increases a lot when income increases)
36
What is the implication for managers regarding the YED?
- important to understand the income elasticities of the products
- YED that are highly elastic (luxury goods) ca be affected significantly by a recession and decreases in buying power
- companies with YED elastic goods can diversify as part of preparation for a recession
37
What is XED?
How is it calculated?
What are the results?
Cross-price elasticity of demand (XED) measures how much the demand for one product changes when the price of another product changes
XED ab = % change in demand for good A / % change in price of good B
Result:
XED < 0: Two goods are substitute products (the higher the more substitutable)
XED > 0: Two goods are complementary products
38
Why is XED important for managers?
- understand how XED affects substitutes and complementary products
- if XED for a product is elastic with respect to competitors product = more attention needs to be paid to competitors pricing strategies
- if XED is elastic and competitor lowers prices, it will significantly influence the demand for the product
- price cuts, ads, promos, etc. can be an option
39
What is cross-sectional data?
Information obtained about variables for a specific time period
40
What is time-series data?
Information about a variable over a period of time
41
How can a Demand estimation be performed?
```
- Regression analysis
appropriate data:
- accurate
- reliable
- valid
- data must be collected in a way to avoid potential issues (e.g. surveys, biases)
```
42
What data is required to properly estimate demand?
- dependant variable: e.g. demand for hotel rooms
independent variables:
* price per room
* income levels of potential customers
* preferences and tastes
* perceived safety and advertisement
* prices charged by other hotels
43
What is the coefficient of determination in a regression analysis?
R2 indicates the proportion of variations in the dependant variable that is explained by the explanatory (independent) variables in the regression equation.
e.g. R2 = 0.75
means 75 percent of the variations in the demand for hotels rooms can be account for by the variations in the independent variables
44
What is the F-value in a regression analysis?
F-Value is compared to a critical value to determine whether the entire regression equation is statistically significant based on the degrees of freedom and the designed significant level
F-value measures the significance of R2 (coefficient of determination)
44
What is the F-value in a regression analysis?
F-Value is compared to a critical value to determine whether the entire regression equation is statistically significant based on the degrees of freedom and the designed significant level
F-value measures the significance of R2 (coefficient of determination)
45
What are t-statistics in a regression analysis?
t-statistics (value) are determined by a t-test to determine the statistical significance of each regression coefficient
t-value = estimated coefficient / standard error of the coefficient
significance level of .05 is considered acceptable
= 95% confidence that the results obtained from the sample are representative
46
What could be potential issues in a regression analysis?
1 Misspecification of equation
- regression analysis is incorrectly specifying the form of the regression equation
- e.g. linear equation used when dependant and independent variables are not linearly related
- regression may also be inadequate in t hat It does not include important predictors (e.g. missing variables that are important for the outcome)
2 Multicollinearity
- two or ore independent variables are related to each other in a systematic way
- difficult to know if the independent variable affects the dependent variable
- biases the standard error reducing the t-values and making it more difficult to identify statistically significant independent variables and reject the null hypothesis
3 Identification problem
- equilibrium price and quantity in the market are simultaneously determined by demand and supply
- difficult to know if supply or demand had a bigger effect
- not identifying and resolving will lead to biased estimates
4 Problems with random errors
- every regression has random terms
- random term is assumed to have a normal distribution, a zero mean, and a constant variance
- variance of the random error is not constant and changes over time
- leads to prediction errors due to repeated overestimations or underestimations
47
What's the definition of supply?
Supply is the amount (quantity) of a good or service that firms/producers/sellers are willing and able to offer for sale at different prices over a given period of time in a given market.
48
Describe the law of supply.
| What is the implication for firms?
- Supply represents a positive relationship between to price and quantity supplied.
- Upward slowing curve of supply.
- As prices increase, a firm has a greater incentive and ability to produce and offer more for sale.
- Higher prices may allow to cover additional costs that it may have to incur in order to produce and sell more.
- higher prices = opportunity to earn higher profits, thus creating an incentive for firms to take on the risk associated with expansion and increasing output
49
What is meant by "extension of supply" and "contraction of supply"?
Expansion of supply:
- move up along the supply curve as prices rise (e.g. form 200$ to 250$)
- quantity of supply increases
Contraction of supply:
- move down along the supply curve as prices decrease (e.g. form 250$ to 200$)
- quantity of supply decreases
50
What are non-price determents of supply?
1 Weather
- agricultures output is highly affected by weather conditions
- good weather = higher output = shift of supply curve to the right
- bad weather = lower output = shift of supply curve to the left
2 Cost of production
- higher raw material prices (e.g. wages, electricity, etc.) will increase the total cost of production = firm needs to sell at higher prices = shift of supply curve to the left
- Advances in technology = more output = shift to right
- lower taxes or subsidies = lower cost for production = more output = shift to right
3 Expectations of the future
- optimistic outlook = more willing to invest to expand and produce more = shift to right
- negative outlook/expectations = produce less / reduce inventory = shift to left
4 Prices of other products or services by the seller
- if firm produces more than one product using the same inputs, it will have an incentive to produce more of the products that are in higher demand
- e.g. farmers = carrots are more profitable than potatoes = lower supply for potatoes = shift to the left of potatoes = shift to the right of carrots
5 Number of sellers in the market
- firms enter the market to produce and compete = more output = shift to the right
- existing firms go bankrupt = shift to the left
51
What is Price elasticity of supply?
How is it calculated?
How can the results be interpreted?
Price elasticity of supply measures how much the quantity supplied of a good changes when its prices change.
PES = % change in quantity supplied / % change in Price
Results:
- PES < 1 = percentage change in Qs smaller than percentage change in P = supply is inelastic
- PES > 1 = percentage change in Qs greater than percentage change in P = supply is elastic
52
Why is it important for managers to understand the price elasticity of supply?
PES of their products and inputs very important
- if demand rises but supply is relatively inelastic = firm will not be able to increase the output fast enough to satisfy the demand = loss of customers, sales and profits
53
What are determinants of price elasticity of supply?
1 Storage and costs of storage
- prices rise = use stocked quantity = more profit = elastic supply
- if products cannot be stored (e.g. vegetables = supply is relatively price inelastic (short term)
2 Production capacity
- if company is not producing at full production capacity = fast increase in supply possible = elastic supply
- firm at fully production capacity already = inelastic supply = no increases possible in the short term
3 Time
- short term: if prices rise firms may not be able to increase supplied amount
- long term: increases in supply are much more likely (new machines, facilities, production capacities)
54
How are prices determined?
* Price mechanisms based on supply and demand
* Equilibrium between Qs and Qd is the price
Supply surplus:
- supplied quantity is higher than demanded quality
- firms will lower the price
- lower price will lead to increase in Qd
- lower price will reduce incentive to produce as much = lower Qs
Supply shortage:
- quantity demanded in greater than quantity supplied
- excess demand = higher prices for sellers possible
- increase of sellers in the market = higher Qs
55
How can changes in non-price determinants affect demand and the market equilibrium?
1 Successful advertising
2 changes in tastes and preferences in favor of a good
3 increase in income (effect on normal goods)
4 increase in the price of a substitute good
5 increase in the number of potential buyers
6 consumer expectations are optimistic / expected price increase
- -> Demand increases
- -> Demand curve shifts right
- -> Price Equilibrium and Quantity Equilibrium RISE
56
What happens to the market equilibrium (Qe and Pe) if the following happens?
1 The customers changed the preferences and now prefer another good of the good of the company
2 Economy is in a recession and the income decreases (normal good)
3 The company produces swimwear and winter is approaching
1 Lower demand for the product of the company = shift of demand to the left = Pe decreases; Qe decreases
2 Lower overall demand of the customers due to lower income (cannot afford as much as before) = shift of demand to the left = Pe decreases; Qe decreases
3 seasonal business = demand temporarily shifts to the left = Pe decreases; Qe decreases
57
How can changes in non-price determinants affect supply and the market equilibrium?
1 Favourable weather (mainly agricultural)
2 Decreases in the input costs (price of raw materials; rent, etc)
3 Advances in technology
4 Decreases in indirect taxes
5 Increase in government subsidies
6 Increase in the number of sellers
7 Business managers expect prices to fall and want to sell more now
8 Decrease in the price of another good the company produces
- -> Supply increases
- -> Supply curve shifts to the right
- -> Pe FALLS ; Qe RISES
58
What is production?
Process during which inputs such as raw materials are transformed into outputs using other inputs such as labor, land, and capital goods such as machines, tools, factories, and offices.
59
What is the production function?
- Shows the relationship between input and output
- maximum level of output that can be produced within a given period using given combinations of inputs and level of technology
Q = f (X1, X2, X3, ..., Xn)
60
What is the difference between short run and long run production?
Give an example for each.
Short run:
- period of time during which at least one factor of the production cannot be changed
- in this period, if a firm wants to increase its output, one of its input factors is fixed in quantity or size and cannot be varied
Example: Pizzeria produces certain amount of Pizze that cannot be increase with adding more Pizzaioli because only one oven is available
Long run:
- period of time during which the quantity or size of all input factors including capital and land can be increased
Example: Pizzeria produces certain amount of Pizze. Over the long run it can purchase more ovens, open more than one shop and increase output.
61
What is MP(L)?
| What is AP(L)?
```
MP (L) = Marginal product of labor:
The additional (extra) output that is created from using one more unit of labor.
```
AP (L) = Average product of labor:
- Represents labor productivity and is calculated by dividing total product by quantity of labor
- Result does not mean that each unit of labor produces AP(L) but together in average they product AP(L)
62
In the short run MP(L) initially rises and begins to fall.
| Explain the cause.
- When there is only one worker, adding another worker increases the productivity
- Workers can specialise and divide labor effectively
- Cooperation increases output MP(L)
- both MP(L) and AP(L) rise
- due to limitations in input factors (e.g. kitchen space) the addition of more labor units will not increase efficiency anymore
- addition of more workers will increase the output but at an decreasing rate since the workers could get in each others way
- diminishing marginal returns
63
Describe the law of diminishing marginal returns.
| Give an example.
As more and more units of variable input are added to a fixed amount of another input, eventually the marginal product will start to decrease and thus output will begin to rise at a diminishing rate.
Example:
- two cooks are working in a kitchen
- adding a third will increase the output
- adding a forth will still increase the output but at a slower rate due to limited ovens
- adding a fifth will increase the output very little
- adding a sixth will decrease the output (they get in each others way)
64
Describe the product curves in the short run.
| What stages can be defined?
Stage 1:
- average product of labor rises
- specialisation and cooperation of workers allows for greater use of underutilised fixed capital resulting in MP(L) being greater than AP(L)
- MP(L) cuts AP(L) when APL(L) is at the max level
Stage 2:
- diminishing marginal returns; TP continues to rise since MP(L) is positive
Stage 3:
- TP begins to fall as MP(L) becomes negative
65
Why is the production function of importance for managers?
- Managers engage in careful capacity planning to avoid operating in stages I and III in the short run
- During stage 1 they would underutlize the fixed inputs
- During stage 3 they would be operating ineffectively
- Level of output is determined by customer demand - managers must try to estimate future demand in order to have the right amount of fixed and variable inputs to operate in stage 2
66
Describe the long run output analysis in production.
- firm can vary the size and quantity of all factors in an effort to increase output
- all factors of input are changed by the same proportion, there is a change in the scale of production
1 Increasing returns to scale
- output increases proportionally more than its input
- Increase input by 30% increases output by 40%
2 Decreasing returns to scale
- output increases proportionally less than its input
- Increase input by 30% increases output by 20%
3 Constant returns to scale
- output increases proportionally with input
- Increase input by 30% increases output by 30%
67
What are relevant costs to consider for a manager when making decisions?
Relevant cost are the incremental costs explicit and implicit for a decision.
Explicit cost:
- actual costs incurred in producing goods or services such as wages, rental payments for office space, advertising expenses, interest on loans, and payments for raw materials
Implicit costs:
- are not actually paid but represent the opportunity costs of resources used
Opportunity costs:
- costs in terms of the benefits foregone of the next best alternative due to a particular choice
Incremental costs:
- managers must compare the potential incremental benefits of courses of actions with the incremental costs
- incremental costs = total current and future costs associated with a decision (thus all implicit costs including opportunity costs)
68
What are sunk costs?
| What is special about them?
- Expanses that cannot be recovered
- They are irrelevant for a decision of a manager and not considered
- Managers focus only on relevant costs and not sunk costs
- Sunk costs do not change because of a decision
69
Describe the cost function.
| How is it calculated?
- Expresses costs as a function of output
- total cost of producing any level of output
Determined by the production function
- one factor is fixed and cannot be varied in size or quantity
- short run: at least one fixed cost
Short run cost function:
TC = TVC + TFC
70
What is the difference between fixed and variable cost?
Fixed costs are costs that do not vary with output - they remain the same whether the output increases or decreases
Variable costs are costs that vary with output - as output increases the variable costs rise accordingly
71
What are marginal costs?
How are the calculated?
What is the relation to the marginal returns?
MC = additional cost of producing one more unit of output
```
MC = change in total cost / change in total quantity
MC = change in total variable cost / change in quanity
```
- -> increasing marginal returns (MP(L) is rising), MC falls
- -> when diminishing marginal returns set in (MP(L) begins to fall), MC begins to rise
72
What are the implications of short run costs?
- Short run firms try to increase the output by using more labor = initially increasing marginal returns to labor
- This causes MC of production to decrease which in turn causes AVC to fall
- As firms add more and more workers to a fixed amount of capital or land, diminishing returns begin to set in = MC of production begins to rise
- once MC rises above AVC, AVC begins to rise causing ATC to rise
73
What are the implications of long run costs?
- Long run, all factors of production can be varied and there are no fixed cost
- no fixed cost = law of diminishing returns does not apply in the long run
- average cost curve is not determined by diminishing marginal returns but by internal economies and diseconomies of scale that lead to increasing and decreasing returns to scale respectively
Internal economies of scale = when firms long run average costs (LRAC) falls as output increases
Internal diseconomies of scale = when firms LRAC rises as output increases
74
What are possible economy of scale effects?
| When do they occur?
1 Commercial Economies
- discounted prices on bulk purchases of supplies
2 Financial Economies
- arise if large firm is able to obtain a loan at a lower interest rate (less risky)
3 Managerial Economies
- larger firms using more specialized managers for different functions of the company (marketing, finance, etc.)
4 Marketing Economies
- lower average ad cost
5 Technical economies
- increased specialisation and division of labor e.g. container principle (larger containers on same surface area)
6 R&D economies
- large firms spread costs of R&D over a greater level of output
--> Occur in the long run where no fixed costs are present because LRAC falls as output increases
75
When do diseconomies of scale occur?
- When firm becomes too big
- Managerial diseconomies: effective and timely communication and coordination between departments, divisions, and orga level becomes slow and more difficult
- decreased productivity
- alienation of work
- workers feel not heard and cared for
76
What are possible aims firms want to achieve?
1 Profit maximization
2 Revenue maximization
3 Sales (output) maximisation
4 Profit satisficing
77
What is meant by profit maximization?
To what extend does it apply in the real world?
- Neoclassical economics assume that the goal of a firm is to maximize profits.
- Important: Higher prices or more output does not result in high profits
- Profit maximisation is the level of output where MR = MC
- As long as MR is greater than MC associated with producing that unit a firm can increase the profit by producing more
Real world:
- Neoclassical economics: Rational managers use all relevant info when making decisions
- Critics argue:
* most business managers do not aim to maximise profits due to incomplete knowledge of a firms production function and potential search cost
* Focus on making decisions based on heuristics and gut feeling
78
What is meant by revenue and sales maximisation?
Revenue maximisation:
- TR = Q*P
- As long as MR is greater than 0, a firm can increase its TR by selling more
- most cases a firm must lower prices to sell more
Sales Maximisation:
- sell as much output as possible without making a loss
- output level where price is equal to average total cost (P=ATC)
79
What is "normal profit"?
Normal profit
- minimum amount of profit that a person is willing to earn to remain in business
- represents opportunity cost of resources employed incl. minimum amount that the person could earn using his human capital elsewhere
- Minimum profit constraint: firm could increase its output as much as possible and up to the point where it would still be able to earn a certain level of profit that had been previously determined as minimum acceptable level
80
What is the minimum profit constraint?
Minimum profit constraint:
firm could increase its output as much as possible and up to the point where it would still be able to earn a certain level of profit that had been previously determined as minimum acceptable level
81
Why would a firm wish to pursue revenue or sales (output) maximisation and not profit maximisation?
- Principle-agent problem: Who makes the decisions for a firm?
- CEO is hired to serve the interest of the shareholders
- CEO is incentivised by year bonus (e.g. focus on stock price)
- CEO has incentive to make decisions regarding the stock price (e.g. expansion or M&A) that focuses on increasing revenue, output but not profit
- Todays bonus plans are more oriented towards long term performance and profitability
82
What is meant with the term profit satisficing?
- insufficient info, uncertainty and complexity regarding many decisions = difficult for managers to make right decisions regarding profit maximisation
- aim to achieve a certain profit level that will be satisfactory for the board of directors and shareholders
- satisficing reflects the need to satisfy shareholder (principle) demands
83
What are possible market structures?
| Order them regarding the competitiveness (highest number = highest competitiveness)
4 Pure Competition
3 Monopolistic competition
2 Oligopoly
1 Monopoly
84
What are possible market structures?
What are their characteristics?
Give an example for each.
```
1 Perfect (pure) competition
Number of firms: very large >100
Size of firms: very small
Control over price: none; price takers
Differentiated or homogenous product: homogenous, perfect substitutes
Price competition or non-price competition: compete on price, no-non price competition
Barriers to entry and exit: none
Example: farming and currency market
```
```
2 Monopolistic competition
Number of firms: many (e.g. 50)
Size of firms: small
Control over price: some control
Differentiated or homogenous product: differentiated, close substitutes
Price competition or non-price competition: many compete on price but also non-price competition
Barriers to entry and exit: weak if any
Example: café and restaurant market
```
3 Oligopol
Number of firms: few (e.g. 3-5)
Size of firms: large
Control over price: control but interdependent on other firms
Differentiated or homogenous product: differentiated but homogenous in some markets
Price competition or non-price competition: mainly non-price competition but also price competition in some markets
Barriers to entry and exit: strong barriers and large exit costs
Example: airplane manufacturing industry
4 Monopoly
Number of firms: one
Size of firms: large
Control over price: large, price maker
Differentiated or homogenous product: no close substitutes
Price competition or non-price competition: many engage in PR activities or restrictive trade practices
Barriers to entry and exit: entry is blocked
Example: electricity provider
85
Explain production efficiency and allocation efficiency.
Give an example for each.
When do they exist?
Production efficiency:
- P = minimum ATC
- Example: firm produces ice cream at the cost of 5$ and sells the ice cream on the market for 5$
Allocation efficiency:
- P = MC
- firm produces cars. Each car they produce more costs 10.000$. The price on the market for the car is 10.000$
- Productive and allocative efficiency only under conditions of pure (perfect) competition
- no barriers to entry
- many small firms that sell homogenous products which have no control over the market or price
86
What are natural monopolies?
| What are the characteristics?
- monoploy where internal economies of scale are very large and extend over a large range of output
- one firm cannot satisfy the whole market demand and maximise all internal economy of scale effects
- firm can satisfy the whole market but does not sell t the lowest possible costs
Characteristics are strong barriers to entry
- existence of high capital costs
- strong brand names
- patents and copyrights
- ownership of scarce resources
- restrictive trade practices (charge limit prices to discourage competitor)
87
When do firms have monopoly power?
| What are the characteristics of firms with market power?
- monopoly power is not a monopoly
- monopoly power > 40% market share and dominant in the industry
- market power firms are price makers
- greater the power the more inelastic the demand curve
- profit maximsing firms will charge a price and product a level of output that will result in MC = MR
- price it charges is above ATC (=supernormal profits)
88
Why can a firm be in a monopoly market and still make losses?
- at the loss minimizing output where Q = MR, ATC is greater that the price charged
- ATC is above the firms/market demand resulting in a loss at any demanded quantity
- usually happens for state own monopolies
- inefficiencies of state firms can be covered with tax revenue
Reasons:
- state firms did not have incentive to produce effectively due to lack of competition (organisational slack)
- Orga slack = costs are higher than what they should be
- more employees that a firm needs
- salaries being higher that what employees are willing to work for
- inadequate control over quality or production oversight
- extravagant spending of managers
89
Explain the kinked-demand curve.
| What does this say about the PED?
Kinked-demand curve model in a Oligopol market
- Oligopol firms are reluctant to change prices due to anticipated responses from competitors
- prices will tend to be sticky (do not change often)
- Kinked-demand curve = MR curve
- lowering the price in an oligopol market when competitors do the same results in inelastic quantity demanded (unchanged)
- decrease of revenue in Qd from lower prices = lower revenue (kinked)
- demand is price elastic above P, demand is price inelastic below P
90
Explain the kinked-demand curve.
| What does this say about the PED?
Kinked-demand curve model in a Oligopol market
- Oligopol firms are reluctant to change prices due to anticipated responses from competitors
- prices will tend to be sticky (do not change often)
- Kinked-demand curve = MR curve
- lowering the price in an oligopol market when competitors do the same results in inelastic quantity demanded (unchanged)
- decrease of revenue in Qd from lower prices = lower revenue (kinked)
- demand is price elastic above P, demand is price inelastic below P
91
Explain the price leadership model.
| Why does this occur?
- Oligopol market has often one firm bigger than the rest
- leader raises prices; others follow
- managers are not worried about losing customers due to pricing strategies
- key: buyers must still be willing to buy at different prices (demand must be inelastic)
- if PED is inelastic and prices can rise = higher profit for the companies
How to ensure that firms will actually follow the leader's price?
- price leader usually sends messages to rival companies in form of press speeches
- other firms (smaller) need to follow to avoid revenge by big leader
- price leader could drop prices below the AC levels of competitors (price them out) but above the own AC to avoid losses
92
Explain collusion.
| Why does this occur?
- firms agree to behave in a certain way that will benefit them
- often in oligopol markets
- companies raise prices on purpose to increase profit
- companies divide markets geographically or do not compete in each other's market
- Illegal in the US, EU and many other countries
- more likely in oligopol market due to interdependency
93
Explain barometric price leadership.
- no dominant market leader (e.g. in oligopol market)
- price changes are initiated by any firm in the industry
- price change acts as barometer and other firms follow (price leadership)
- other firms pricing strategy may follow and adapt
94
Explain cartels and price fixing.
Collusion can be overt (formal and known) or cartels/covert (tacit)
- most often cartels are covert since collusion is illegal
- most-well known example of overt collusion is the OPEC cartel (biggest oil producers worldwide)
- OPEC influences the world price of oil setting production quotas for its members
- demand tends to be inelastic so the supply controls the price
95
Explain limit pricing.
- Firms in contestable markets always face the threat of potential entrants to the industry
- arrival of new competitors will decrease the demand, revenue and profit of the existing firm
- to prevent this existing firms use limit pricing: charge a price lower that the one that will maximise profits in order to discourage new arrivals entering the market
- set prices lower than new firms AC but higher than own firms AC
- firms accept lower profits in short run but keep market share in long run
96
Explain predator pricing.
Predator pricing
- practise of charging a price that is low enough to drive competitor out of business
- adopted by existing firms to eliminate a competitor
- charge a lower price than the competitors AC
- firms engaging in these strategies might make losses in the short run
- difficult: if successful new competitors might enter
97
If barriers to enter a market are weak and the market is contestable, what type of pricing strategy might the existing firms adopt?
Limit pricing:
- Firms in contestable markets always face the threat of potential entrants to the industry
- arrival of new competitors will decrease the demand, revenue and profit of the existing firm
- to prevent this existing firms use limit pricing: charge a price lower that the one that will maximise profits in order to discourage new arrivals entering the market
- set prices lower than new firms AC but higher than own firms AC
- firms accept lower profits in short run but keep market share in long run
98
What could be an effective strategy if a new competitor sets up in the market?
How can the existing firms react regarding the price strategies?
Predator pricing
- practise of charging a price that is low enough to drive competitor out of business
- adopted by existing firms to eliminate a competitor
- charge a lower price than the competitors AC
- firms engaging in these strategies might make losses in the short run
- difficult: if successful new competitors might enter
- very difficult if new competitor has financial strength to engage in penetration pricing
99
Explain penetration pricing.
Occurs when a firm charges a low price in order to gain market share and establish itself in an industry.
Enter with low prices and increase price once market share goal is reached
100
Explain prestige pricing.
Buyers willing to pay a higher price for a product bestows upon them some level of prestige
Firm will be able to earn high profits if it is able to make people believe that the product conveys the prestige
101
How can a seller charge a low price to those who are sensitive to price and a higher price to those buyers who are less price sensitive?
Price discrimination (price strategy)
- goal is to increase profits
- charge different prices for the same good when differences in price are not due to differences in costs
1st degree Price discrimination: charge maximum price that each buyer is willing to pay for each unit of a good/service
2nd degree price discrimination: occurs when a firm charges buyers different according to how much they purchase.
3rd degree Price discrimination: occurs when the sellers divide or segment buyers into distinct markets (age, income, geography) and charges a different price in each market
102
Explain price discrimination.
Explain the different degrees.
What other forms of price discrimination are there?
Charge different prices to those who are more/less sensitive to higher prices
- goal is to increase profits
- charge different prices for the same good when differences in price are not due to differences in costs
1st degree Price discrimination: charge maximum price that each buyer is willing to pay for each unit of a good/service
2nd degree price discrimination: occurs when a firm charges buyers different according to how much they purchase.
3rd degree Price discrimination: occurs when the sellers divide or segment buyers into distinct markets (age, income, geography) and charges a different price in each market
Other forms:
- peak-load pricing
- price skimming
- intertemporal pricing
- two-tariff pricing
103
What are requirements for price discrimination?
1 buyers must have different price elasticities of demand
2 firm must be able to determine PED differences amongst buyers
3 price discriminating firm must be able to keep the segmented markets segmented at low cost (avoid reselling customers that undercut prices)
4 firm must have control over prices (market power)
104
Which degrees of price discrimination exist?
1st degree: difficult to know maximum price that buyers want to pay for
2nd degree: more common; buy one get a third at 50%; as long as price is above the ATC company can increase quantity and generate additional revenue and profit
3rd degree: very common, fares for busses differ based on retirement or student as those groups tend to be more price elastic
105
Explain peak-load pricing.
- if costs differ, price discrimination (e.g. 3rd degree for bus fares) are not sufficient
- customers are charged a higher price during peak demand (e.g. rush hour) and lower at off-peak times (evening/night)
- strategy acknowledges importance of PED but at different peak demand levels to cover higher marginal costs
106
Explain price skimming.
| What other forms exist?
- Firm introduces a new product/service without any close substitutes
- demand is relatively price inelastic
- firm can charge more until new competitors arise
- decrease prices over long run to avoid too much competition
Intertemporal pricing:
- different prices in two different time periods that span over weeks, months or years.
- e.g. Apple with new iPhone as customers have waited for the new model (inelastic)
Two-part tariff:
- determine price based on fixed and variable cost
- charge customers a base rate to cover FC and variable fee to cover VC
- e.g. electricity, water or other utility firms
107
Explain cost-plus pricing.
- also called mark-up cost
- average costs of production is defined + certain percentage (mark-up) for profit to define final price
- mark-up cost differs depending on product line, etc.
- can respect different PEDs in markets
- lower mark-up when prices are elastic
108
Explain multiproduct pricing.
| Provide an example.
- firms sell more than one product
- prices should be defined how the products are related on demand side and supply (cost) side
- demand side = products might be supplements or complementary
Full range pricing:
- determine the prices of all their complementary and substitute products jointly so they can set prices to maximise profits form all its sales
Example:
- Lidl charges very low prices for certain products to attract people into the market
- product generates losses because prices are higher than ATC
- however: customers tend to buy more than one products
- high mark-up for other product cover the costs and generate additional profit
- full range pricing can justify loss leader products
109
Describe transfer pricing.
- many large orgas divide and operate within profit centers
- each profit center aims to maximise profits and reach targets
- incentive to set prices that will increase profit in their profit center
- however: profit of one PC will affect input prices of other PC so final price is also affected by this
- conflict of interest should be solved by setting divisional targets regarding the MC of intermediate products
- focus on efficiency to keep MC low
110
Explain net value gain and net value loss for society.
- MSC = MSB is the socially optimal level of output
- if MSB > MSC net value gain for society of producing additional units
- if MSC > MSB, MSB is lower than MSC; additional value to society of consuming the last unit of the good is lower than the additional cost to the economy of producing that unit (society is allocating too many resources to the production)
111
What are positive externalities?
| Name an example.
- social benefits from the production and consumption of a good
- positive spillover effects to third parties who did not pay for the inoculation also benefit
- Usually MSB = MPB
- for Positive Externalities: MSB is greater than MPB
- MSB = MPB + positive externalities
- society is undervaluing the good that is creating the external benefit
- society is producing less than would be socially optimal (market failure/inefficiency)
- external benefit is larger for lower levels of output
- prices for these goods are (perceived) too high because people do not understand the full benefit to the society (difference between MPB and MSB)
Example:
Education/training
health care
112
Explain the term merit good.
Education and healthcare are merit goods
- merit good would be under consumed if provided by a private sector
- people do not understand true value of merit goods
- people perceive good too expensive
- MPB is lower than MSB (gap is a positive externality)
113
What are negative externalities?
| Give an example.
- production and/or consumption of a good creates external costs
- costs for third parties not directly involved
- price did not factor negative effect of third party in
- MPC to MSC gap increases with increased output
- too many resources are allocated to producing the good (price too low)
- net welfare (deadweight) loss
Example:
Firm produces tires and has toxic fumes that affect farmers nearby. Their crops cannot grow like they would and these effects are not priced into the "production cost" of the tire producer.
114
What are missing markets?
| Give an example.
- Firms aim for profit maximisation, profit satisfying or some other goals to make profit
- some markets suffer from "free rider" issues: people who will not want to pay for a good but cannot be excluded from consuming it
- firms cannot make a profit will depend on legal rights to charge tolls for free riders
- inefficient allocation of resources = market failure
- necessity to provide public goods: street lights or national defence otherwise these would not be provided by private firms = missing market
115
What is a public good?
- Good is provided by the government because it would otherwise not be provided by the private sector due to free rider issues
- Non-excludability: once a good/service has been provided, it is difficult or too costly to exclude non-payers from benefiting
- non-rivalry: consumption of a good does not result in less of the good for other people
116
How can monopoly power lead to market failures?
| Provide an example.
- pure monopoly: market demand is firms demand
- monopoly produces less and charges a higher price than optimal (allocative inefficiency)
- MC of the company = supply curve of the market in a pure monopoly (at MC = P there would be an allocative efficiency)
- monopoly maximises profits by charging MC = MR at ATC min which is lower than P resulting in allocative inefficiency and productive inefficiency
- producer surplus: difference between minimum price the firm is willing to sell for one more unit and price it actually receives
- producer surplus is part of consumer surplus but some of the producer surplus is also lost (deadweight welfare loss to society)
Example:
Electricity provider charges a very high price per kW/h and costumers do not have an alternative = deadweight welfare loss
117
What are market failures due to imperfect information?
| Provide an example.
- lack of perfect information
- asymmetric information between parties engaging in transaction
- advantage for one party at the expense of the other
- two main issues: additional cost + efficiency reduction in the economy
Example:
Company requires a bank credit; company is hiding potential sales losses but requires the credit to survive. Bank does not know about this and thinks the company is successful.
118
What are potential market failures?
- externalities (positive or negative)
- monopoly power
- missing information (asymmetric information)
119
What are options to reduce market failures arising from positive externalities?
Positive externalities = under-allocation of resources and under consumption resulting in a price being too high for the true benefit
Governments can:
1 provide subsidies to firms:
- reduce production costs and incentives to produce more
- subsidies must be large enough to lower the price to the level MPC = MSB
2 provide subsidies to the buyers
- e.g. by tax deductions to increase consumption of the good
- subsidies must be large enough to increase MPB (demand) to the level MSB = MSC
3 providing the good itself
- e.g. public education, public hospitals
- costs are covered by tax revenue
- resolves positive externalities and reduces missing markets due to the free rider problems
120
What are options to reduce market failures arising from negative externalities?
Negative externalities = over-allocation of resources and over-consumption
Problem is not the amount of the good but the negative spillover effects
Prices of the good should increase
Governments can:
1 Internalise the negative externality
- third parties negatively affected can sue for damages
- Farmers affected can sue the production factory for the pollution (cover their costs and internalise the true costs to society for the producer)
2 Regulations
- regulate the maximum level of pollution and charge fines if exceeded
- incentive to pollute less to avoid fines
- difficult to set the right max. level where MSB = MSC
3 Taxes
- general tax (e.g. green tax for pollution) on damages that create external costs
- higher costs = higher prices
- MPC must be raised to equal MSC (MSC = MSB) socially efficient output
4 Tradable permits
- permits are handed to companies by determined maximum amount (e.g. of pollution)
- each firm can use these permits to exchange for negative spillover effects
- similar to regulation but tradable (if firm does not have any more permits, it needs to buy more from competitors)
- permits cost money and incentivise lower negative effects
121
What are options to reduce market failures arising from monopoly markets?
Monopoly markets = prices are too high and quantity is too low
- governments can pass anti-trust laws that prohibit firms from exploiting customers
- reducing barriers to entry in the market to allow competitors in the market (price reduction due to output increase)
- regulate natural monopolies to reduce the exploitation by focusing on price and quality e.g. customer service
122
What are options to reduce market failures arising from imperfect information?
- regulations to provide clear and accurate information to make informed decisions
- laws to require a risk and cost analysis
- laws to force firms to promote negative effects from their products (fatty foods, cigarettes, etc.)
- provide informations (e.g. to unemployed people) about opportunities to reduce regional failures (e.g. labor market)
123
Describe game theory.
| Why is it useful in economics?
- helps to analyse how individuals make decisions when they know that their decision affect others while at the same time the decisions of others affect them
- mutual interdependence
- better understanding of strategy and pricing (e.g. how competitors would respond to price changes)
- predict potential behaviour of firms based on assumptions the managers make to adopt the appropriate strategy
- predefine strategies based on potential strategy by competitors, payoffs and outcomes
zero-sum game: one player's loss is the other player's gain and vice versa.
non-zero-sum game: both players (e.g. firms) may lose or gain depending on each player's actions.
124
Describe the Nash equilibrium.
| Provide an example.
- Nash equilibrium is the outcome that results from the players making their best decision based on what they believe will be the other players' decision.
- Stable equilibrium because once players adopt the strategy that is best for them, they do not have an incentive to change it (=dominant strategy)
Example:
Hansel and Gretel are both interrogated for committing a crime.
Hansel will opt for the strategy based on what he think's Gretel's strategy will be.
If Hansel thinks Gretel will confess, he will also confess.
If Hansel thinks Gretel will not confess, he will still chose to confess.
(prisoner dilemma = non-zero sum game)
125
Describe the cooperative equilibrium.
| Provide an example.
- competing firms will not find it acceptable to continue to charge low prices and they may agree to cooperate to both charge high prices and make higher profits = cooperative equilibrium
- repeated games = less incentive to cheat = better understanding how they will react to each other
Example:
One company decides to lower prices the other company will react and lower prices even more. The new equilibrium is way lower and companies decide to increase prices again. The next "game" they will be more or less cooperating because they know each others reactions.
126
What are the two main issues of asymmetric information?
| Provide an example for each.
Asymmetric info = parties not having the same info for decision making
often a problem for insurance companies and banks
1 Adverse selection
- occurs before an agreement is made
- selection to give a loan to someone who says to use it for renovation. After receiving the load the person uses it for vacation (= person lied and is not trustworthy) and is less likely to pay it back
2 Moral hazard
- occurs after an agreement is made
- selection to give a loan to someone who says to use it for renovation. After the loan was provided the person engages in a hazardous business opportunity and loses all the money while gambling. (even though the person intended to pay it back, now it is not possible anymore)
127
What are options to reduce issues of asymmetric information?
| Provide an example for each.
Adverse selection:
- bank could carry out a screening test to increase the likelihood of identifying potentially bad borrowers
- background check: credit score, asset ownership, credit history, income statement, etc.
- bank can require a collateral
- sealed-bid-auction
Moral hazard:
- approve loan only after receiving invoices for the intended purpose
- require collateral to reduce likelihood of careless behaviour
- restrictive clause to avoid certain behaviour
- insurance companies often make clauses void if certain behaviour is different than previously stated
128
What is a sealed-bid auction?
- bids are usually secretly submitted in a sealed envelope
- often used for conducting competitive procurements
- helps to reduce some of the uncertainty regarding prices
- increases chances to make better decisions and reduce adverse selection
129
What is an english auction?
- typically used by private individuals to get best price for a good
- auctioneer calls out for the higher and higher bids
- last and highest bid obtains the product
- helps to gain max price
130
What is the principle-agent problem?
- occurs when managers or employees have an incentive not to behave in the best entrust of their employer
- slack off at work / wrong decisions
- incentive programs should be used to avoid this
131
What is capital budgeting?
| Provide examples for CB decisions.
- determining which capital project a firm should invest in
- how much this investment will cost the company
- how the investment will be financed
- profitable and alignment with long term strategic goals
- not an easy choice: cash outflow early; cash inflow much later
Example:
- purchase of new capital to produce new product
- construction of new facilities, factories, warehouses
- deciding whether to buy or lease
- deciding whether to product or outsource a product
- deciding whether to replace obsolete equipment
132
Explain the time value of money.
- money today is worth more than in the future
| - possibility to earn interest
133
How is the PV calculated?
PV = CF / ( 1+i )^n
134
What tools can be used to calculate the relative worth of investment projects?
NPV (net present value)
IRR (internal rate of return)
Both discount future cash flows and respect the time value of money principle.
135
How is the NPV calculated?
| What does the result say about investment projects?
NPV = sum(CF/ (1+i)^n )
NPV > 0 = project generates a surplus
NPV = 0 = project does not generate surplus nor loss --> still good to increase output/sales and potentially affect market share
NPV < 0 = project generates losses and should be avoided
136
Why should managers not only focus on the NPV of a project?
1 other investments might have a higher NPV and firms needs to prioritise the limited funds accordingly
2 value of NPV is based on expected discount rate over the duration of the expected future cash flow (discount rate = opportunity cost; if higher could lower overall NPV)
3 expected future cash flows may not be risk free (no guarantee regarding size or timing)
137
What is the IRR?
- internal rate of return
- NPV = 0 (investment is earning just enough to cover the cost of capital)
- higher IRR = beneficial since IRR > opportunities cost (cost of capital)
- IRR is higher when most of the cash flow happens early
138
What can be done if NPV and IRR lead to conflicting results?
- NPV of the difference can be calculated:
e. g. initial cost is 500$ higher and annual surplus is 135$ higher over 5 years (NPV = 84$ and IRR = 11%)
IRR is greater than the cost of capital of 5%
NPV is positive and 84$
--> Project can generate a positive result and should be preferred to the other
139
What is the PI?
| How is it calculated?
- two mutually exclusive project: choice has to be made
- choose can not be based only on NPV (the highest should be chosen) otherwise only large projects will be chosen at the expense of small projects with small NPV
- smaller projects with small NPV combined can result in large NPV
- helpful to calculate PI (profitability index):
PI = present value of future streams of income / initial investment outlay
- PI can help to rank and prioritise projects regardless of the size
PI > 1 = project should be accepted (the higher the better)
PI < 1 = project should be rejected
140
What's the difference between risk and uncertainty?
- Risk can be assigned with a probability based on historic data or macroeconomic data
- Uncertainty cannot be predicted = is unknown
141
What is an expected value?
| How can risk be calculated?
- Average of all possible outcomes (factoring in risk associated)
- Average is weighted according to probability of each outcome occurring
Probability 30%: NPV (2-3%) = 300.000
Probability 50%: NPV (1-2%) = 200.000
Probability 20%: NPV (<1%) = -40.000
```
EV = (300.000 * 0,3) + (200.000 * 0,5) + (-40.000 * 0,2)
EV = 182.000€
```
EV can be compared to alternative to choose the best option
Risk:
1 Absolute:
- standard deviation reflect variation of possible outcomes from EV
- can only be used if EV are very similar
2 Relative:
- coefficient of variation is used (cov = standard deviation / EV * 100)
- the lower risk the better
142
Describe sensitivity and scenario analysis.
| What is it used for?
Both are used for factors that can influence the future cash flows of an investment.
Help with risk analysis
Sensitivity analysis:
- creates two forecasts (optimistic and pessimistic)
- optimistic: higher future cashflow
- pessimistic: lower future cashflow
- can also be used for discount rate instead of CF
- one factor or variable is changed to show how sensitive the expected NPV would be
Scenario analysis:
- more variables are changed at the same time
- discount rate, CF, prices, demand, etc.
- state of economy of a country
