Midterm Exam 1 Flashcards
Identify the significant differences between traditional microeconomics courses and those on the economics of industrial organization.
-Traditional economics is about profit maximization whereas I.O. studies firms who want to maximize utility.
- Traditional economics focuses on theoretics whereas I.O. focuses on real-life applications.
- In traditional economics, P=MC whereas in I.O., P>MC.
-In traditional economics, firms are price takers whereas in I.O., firms aren’t necessarily price takers.
Identify and summarize the significant differences between the structure-conduct performance approach to industrial organization and the Chicago School approach.
Chicago School Approach:
- Increased efficiencies are correlated with increased market power and profits
- Advertising provides information that bring down pricing
- Efficient capital markets bring potential entrants
Structure Conduct Performance:
-Direct positive relationship between monopoly power and profits s.t. P>MC s.t. more market power means more profit
-Advertising increases barriers to entry and increased profits for existing firms
High capital costs are associated with high entry barriers
Explain what caused legislators to pass the Sherman Act in 1890. Analyze the act’s strengths and weaknesses.
- Political pressures; Industrial Revolution sparked rapid growth and development; changes of national markets.
- Strength: Made price fixing (collusion) illegal
- Weakness: Making collusion illegal incentivized merging; doesn’t protect against the occurrence of monopoly
Analyze how the Clayton Act and Federal Trade Commission Act each attempted to address the Sherman Act’s weaknesses.
Weakness of Sherman Act: Anything other than the attempt and act of price-fixing was illegal.
- Clayton Act’s contributions: Prohibited price discrimination that decreases competition or creates a monopoly.
- FTC Act’s contributions: Established FTC; prohibited “unfair methods of competition.”
Briefly summarize how antitrust violations are enforced in the U.S. and analyze how significant punishments can be.
- How they are enforced:
- Through Antitrust Division of the FTC
- Through Antitrust Division of the Justice system
- Punishment Significance:
- A.D. of Justice system can bring or file criminal suits, which result in fines or jail time; fines aren’t relatively hefty to large corporations
- Civil judgements that involve payments to plaintiffs
Distinguish the difference between economies of scale and economies of scope, using a real-world example from the reading to illustrate each.
Economies of scale and economies of scope are production cost advantages.
Economies of scale: Increased levels of productions result in savings since producing in bulk drives down ATC. For example, Microprocessing companies like Intel are advantaged by economies of scale once chips are produced due to rising demands for mobile phones.
Economies of scope: Producing multiple goods result in savings, only when costs of production is lower than producing goods separately. For example, rather than Apple receiving chips from Intel of AMD, they began producing their own series of chips on top of mobile devices.
Explain what is meant by “bounded rationality” and how it “implies that contracts are of necessity incomplete.”
Bounded rationality: Assumption that a firm or individual doesn’t know enough to solve complex problems on their own.
Implies that contracts are of necessity incomplete because firms lack skill/ability to predict future outcome.
In your own words, explain what opportunism is. Explain how opportunism and high transaction costs can cause firms to produce goods themselves rather than rely on outside suppliers.
Opportunism: self interest seeking behavior of firms.
Opportunism and high transaction costs causes firms to produce goods on their own because transaction costs can get too expensive (suppliers have control over those prices). If firms save on transaction costs, utility and profits can be maximized.
In our first class, we briefly discussed how executive compensation in large corporations in the U.S. has reached a staggeringly high level. For example, the Chief Financial Officer of Comcast, Michael Cavanagh, received $17,622,186 in 2017. If he works 50 weeks a year, for 80 hours per week (13.3 hours per day), that corresponds to approximately $352, 443.72 per week (working for one week plus one day would put him in the top 1 percent of income earners in the U.S.), $4,405.55 per hour, or $73.43 per minute.
Explain how the practice discussed in section “2.3.1 Separation of Ownership and Control” can help explain this result.
For large corporations, there are many co-owners (stockholders). Stockholders usually don’t elect board of directors, so executive managers elect them instead. Managers are incentivized by electing board members through generous managerial compensation.
Using the term “rate of return” or “markup,” explain what rule of thumb pricing is and analyze if firms appear to use rule of thumb pricing, profit maximization, some combination of the two, or if it depends on the situation.
Rule of thumb pricing: Firms set up an acceptable rate of return on invested capital.
Rule of thumb pricing depends on the circumstances of the time such as changes in demand, company elasticity, and market/economy expansion.
Explain how the threat of takeover can encourage publicly traded companies to maximize profits.
Management failing to maximize profits lead to stock prices dropping. Different management can buy the cheap stocks, revolt and take over existing management, then pursue profit-maximizing strategies to capitalize on stock gains since the value of the firm is expected to increase (potential gains > cost of takeover)
Explain why it is worthwhile for a firm to continue producing if economic profits are zero, but not if accounting profits are zero.
Accounting Costs: Financial reports of costs by firms
Economic Costs: Payment input would receive in its best alternative
Economic costs rely on opportunity costs for capital and labor input, whereas accounting costs don’t rely on capital and labor. When economic profits=0, there’s enough income for both the worker and the firm. When accounting costs=0, firms are not making any profits for income (just breaking even).
Identify the main sources of economies of scale and diseconomies of scale.
Economies of scale:
- Machinery and unit specialization
- Advertising
- Mass reserves
Diseconomies of scale:
- Transportation costs
- Managerial ability/entrepreneurship
Explain how there can be “economies of scope in institutions of higher education.”
Higher education firms are multi-product firms. Both the output and input are measured. The input involves the faculty and staff, and the output involves research and educated undergraduate/graduate students. Institutions save money on having teachers who simultaneously teach and research compared to hiring people who strictly teach and strictly research.
Many economists have a bias or predisposition towards perfectly competitive markets. Some, arguably fewer, have a bias or predisposition towards free markets. This begs the question of how the two can be different.
Using one of the assumptions of perfect competition from this chapter, explain how a market that is free may not necessarily be perfectly competitive.
Use a real world example (from the text or any other source (your own personal experience is totally fine)) to illustrate how sometimes your chosen assumption of perfect competition can be violated in otherwise free markets.
Assumption: No barriers to entry
A free market may not necessarily be perfectly competitive under this assumption because free markets with high barriers exist, such as cable companies. A high barrier to entry in the cable market is high startup costs to establish towers and networks. This violates the assumption of no barriers to entry.
Explain what the price elasticity of demand is. Interpret a given elasticity of demand.
For example, if the price elasticity of demand for a good is -0.3, by what percent will quantity demanded increase or decrease in response to a decrease in price of 1%?
Price elasticity of demand: Measures sensitivity of demands with respect to changes in price.
(Put EOD equation and work on cheat sheet)
Explain why a firm should shut down in the short run if the highest price it can charge to sell its profit maximizing quantity is still less than the firm’s minimum average variable cost.
i.e. compare the two situations of staying in business vs. leaving business.
Firms have a shut down price P = AVC. Firms can produce in the short run if P = MC given Price >= AVC. If firms produce at a price less than AVC, profits will be negative and debt will increase. It is better for a firm to at least be able to stay in business to recover some fixed costs rather than shutting down when no recover costs are available.
Explain why in the long run all costs are variable, i.e. why the average total cost curve and average variable cost curve are one in the same.
In the long run, all costs are variable because nothing is fixed. They end up being the same because they are both investments for some output and everything ends up varying in the long run.
