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MAE214 > Week 1 - Introduction: Strategy and Economics > Flashcards

Week 1 - Introduction: Strategy and Economics Flashcards

1
Q

What 4 crucial elements do economic models feature?

A
  • Decision makers
  • Goals
  • Choices
  • Relationship between choices and outcomes
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2
Q

What are the main topics studied in this unit?

A
  • Economic foundations of strategy
  • Boundaries of the firm
  • Market and competitive analysis
  • Strategy dynamics
  • Internal organisation
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3
Q

What does the following topic consist of: economic foundations of strategy?

A
  • Cost and revenue functions
  • Profit maximisation
  • Pricing and output decisions
  • Game theory
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4
Q

What does the following topic consist of: boundaries of the firm?

A
  • Historical perspective
  • Horizontal boundaries of the firm
    o Australia’s chicken meat industry
  • Integration and its alternatives
    o Pepsi, Disney and Pixar, KFC
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5
Q

What does the following topic consist of: market and competitive analysis?

A 
-	Market structure and competition
o	Retail petrol market in Australia
o	Airbus and Boeing
-	Entry and exit
o	Victoria taxi industry
-	Dynamic competition
o	Target, Bunnings, Tesla
-	Industry analysis
o	Australia’s banking industry
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6
Q

What does the following topic consist of: strategy dynamics?

A 
-	Strategic positioning
o	U.S. airline industry
o	Qantas, Virgin and the Dark Knight
-	Sustaining competitive advantage
o	Coke and Pepsi; FedEx and UPS
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7
Q

What does the following topic consist of: internal organisation?

A
  • Performance measurement and incentives

o Australia’s sugar industry

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8
Q

What is a firm’s ultimate objective?

A

To maximise profits.

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9
Q

Calculation of a firm’s profit:

A 
Profit = Revenue – Costs.
Pi(Q) = TR(Q) – TC(Q)

Pi(Q): firm’s profit function
TR(Q): total revenue function
TC(Q): total cost function

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10
Q

Why is profit maximisation an important concept in understanding the formation of business strategies?

A

Because it helps a firm make a better decision in several dimensions, such as:

  • Whether to take a specific marketing strategy or not
  • When to expand the production capacity
  • When to trigger a price war with competitors
  • How to make a trade-off between long-term benefits and short-term losses.
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11
Q

What does the total cost function represent?

A

TC(Q) represents the relationship between a firm’s total costs and the total amount of output it produces in a given time period, denoted by Q.

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12
Q

What are the 2 components of the total cost function?

A
  • Fixed costs = remain constant as output increases
    o E.g. General and administrative expenses, property taxes
  • Variable costs = increase as output increases
    o E.g. direct labour and commission to salespeople
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13
Q

What is the average cost function?

A

It describes how the firm’s average or per-unit-of-output costs vary with the amount of output it produces.

AC(Q) = TC(Q)/Q

If total costs were directly proportional to output, then average costs would be constant.
- However, often average cost will vary with output.

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14
Q

Average cost and economies of scale:

A
  • When AC decreases as output increases = economics of scale
  • When AC increases as output increases = diseconomies of scale
  • When AC remains unchanged with respect to output = constant returns to scale.
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15
Q

What is the marginal cost function?

A

This describes the rate of change of TC with respect to output (AKA the cost of producing one additional unit of output).

MC(Q) = Change in TC(Q)/Change in Q
MC(Q) = TC(Q + ΔQ) – TC(Q)/ΔQ
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16
Q

Relationship between AC and MC:

A
  • When average cost is decreasing in output, marginal cost is less than average cost
  • When average cost is increasing in output, marginal cost is greater than average cost
  • When average cost is constant or at a minimum point, marginal cost is equal to average cost
17
Q

What does the demand function describe?

A

It describes the relationship between the quantity of product that the firm is able to sell and all the variables that influence that quantity.

18
Q

What factors affect demand?

A
  • Price
    o This is the main factor that determines demand of a product
  • Income
  • Substitutes and complements (the prices of related produces)
    o E.g. Australia’s declining taste for beef and growing appetite for chicken (beef is more expensive)
  • Consumer tastes/preferences
    o E.g. soft drinks
  • Quality of the product
  • Market structure and competition
  • Government policy
    o E.g. Netflix tax
19
Q

The relationship between quantity and price:

A

The demand curve demand curve is downward sloping:
- the lower the price, the greater the quantity demanded
- the higher the price, the smaller the quantity demanded
This inverse relationship is called the law of demand.

20
Q

What does the total revenue function describe?

A

It describes the relationship between total revenue and output. In other words, it indicates how the firm’s sales revenues vary as a function of how much product it sells.

TR(Q) = P(Q) x Q

21
Q

What does the marginal revenue function describe?

A

It describes the rate of change of total revenue with respect to output.

MR(Q) = ΔTR(Q)/ΔQ

22
Q

What is price elasticity of demand?

A

It is commonly denoted by η (n with long tail) and is the percentage change in quantity brought about by a 1% change in price.

It measures the sensitivity of quantity demanded to price. As a result, it alters the shape of the demand curve, which strongly affects the success of the firm’s pricing strategy.
η = ΔQ/Q0/ΔP/P0

  • If elasticity of demand (η) is less than 1 === demand is inelastic
  • If elasticity of demand is greater than 1 === demand is elastic
23
Q

Elasticity of demand example:

A

Formula:
η = ΔQ/Q0/ΔP/P0

Example:
Original price = $5, corresponding demand= 1000 units
If the price rises to $5.75, the Q demanded would fall to 800 units. Then:
η = 800 – 1000/1000 / 5.75 – 5/5
η = -0.2/0.15
η = -1.33

24
Q

Relationship between MR and price elasticity of demand:

A

MR(Q) = p(Q) x (1 – (1/η))

  • When demand is elastic (n > 1), then MR > 0
    o The increase in output brought about by a reduction n price will raise total sales revenue.
  • When demand is inelastic (n < 1), then MR < 0
    o The increase in output brought about by a reduction in price will lower total sales revenues.
Example:
If n = 0.75 and p = 15, then MR = 15 x (1 – (1/0.75) 
MR = 15 X (1 – 1.33)
MR = 15 x -0.333
MR = -4.99 = -5
25
Q

How does a firm maximise profit?

A

By choosing an output where marginal revenue equals marginal cost.
MR(Q) = MC(Q)

(MR can be a downward sloping line below the demand line, or can be a horizontal line which is the same as the Price line)

When MR(Q) =/= MC(Q) the profit is not maximised and the firm needs to adjust its pricing strategy.

  • MR(Q) > MC(Q) === produce more === the firm should decrease price
  • MR(Q) < MC(Q) === produce less === the firm should increase price
26
Q

What is alternative way to write the MC(Q) = MR(Q) condition?

A

P(Q) x (1 – (1/n) = MC(Q)

27
Q

What questions does the MC(Q) = MR(Q) equation help us answer?

A
  • When to adjust prices in response to changes of business environment
  • How to adjust to the optimal price level
  • How the price should change in response to the change of cost structure
  • How consumer sensitivity in price affects a firm’s pricing strategy
  • When a new, similar product is introduced, how should a firm change its pricing strategy
28
Q

How does a firm know whether MR(Q) = MC(Q)?

A

MC(Q) can be easily estimated from the firm’s cost data.

To estimate MR(Q) the firm needs to know the elasticity of demand.

29
Q

How does a firm rationally anticipate how its rivals may react?

A
  • A penetrating approach = attempt to “get inside the minds” of its rivals, figure out what is in their self-interest, and the maximise accordingly.
  • However, your rivals’ optimal choices will often depend on their expectations of what you intend to do, which in turn depends of their assessments of your assessments about them.
30
Q

What is game theory?

A

It is a branch of mathematics and economics that provides powerful tools in analysing strategic interactions among firms. Formally speaking, game theory is the study of mathematical models of conflict and cooperation between intelligent rational decision-makers.

31
Q

Why do game theorists use the concept of Nash equilibrium (NE)?

A

The predict the likely outcome of games. The NE does not necessarily correspond to the outcome that maximises the aggregate profit of the players.
- Firms could be collectively better off by, for example, refraining from expanding their capacities. However, the rational pursuit of self-interest leads each party to take an action that is ultimately detrimental to their collective interest.

32
Q

What is a Nash equilibrium?

A

A Nash equilibrium is a profile of strategies such that each player is doing the best it can, given the strategies of the other players. In other words, at an equilibrium, no player would have any incentive to change his/her strategy given the strategies by his/her opponents.

33
Q

What is the prisoner’s dilemma?

A

It is the conflict between collective interest and self-interest.
- The dilemma arises because in pursuing its self-interest, each party imposes a cost on the other that it does not take into account.
- As a result, the prisoner’s dilemma is a key feature of equilibrium pricing and output decisions in oligopolistic industries.
(this assumes each party moves simultaneously)

34
Q

What is a game of chicken?

A

This is where there are 2 Nash equilibria. (this assumes each party moves simultaneously).

Chicken is a famous game where 2 people drive on a collision course straight towards each other.

  • Whoever swerves is considered a ‘chicken’ and loses
  • But if nobody swerves, they will both crash
35
Q

What is the concept of Subgame Perfect Nash Equilibrium (SPNE)?

A

This is used to predict the outcome of a game when players move sequentially (Game-tree is used). In an SPNE each player chooses an optimal action at each stage in the game that it might conceivably reach and believes that all other players will behave in the same way.

To find the SPNE, remember to work backwards.

36
Q

What do the MC, D and MR curves look like for profit-maximising firms?

A 
D = downward sloping 
MC = curves upwards (same as supply)
MR = below D line, makes acute angle with D line
Optimal Q (Q*) dotted line = goes through where MC and MR intersect
Optimal P (P*) dotted line = goes up to D line where Q* touches D line
37
Q

What do the MC, AC and D look like for a perfectly competitive firm when there is not incentive to enter or exit?

A

AC curve = looks like an upside-down umbrella
- Space between MC and MC after intersection = profit per unit
MC curve = intersects with AC at its minimum
P dotted line = goes through where MC and AC intersect
Q dotted line = goes through where MC and AC intersect

MAE214 (12 decks)

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