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ECP 3403 MT 1 Review

question
What is the economic definition of the demand curve?
answer
the quantity demanded of a good as a function of the price of the good, holding everything else constant
question
What is the economic definition of the inverse demand curve?
answer
answers the question, "what price will induce each quantity
demanded?"
question
What is the difference between a movement along the demand curve and a shift in demand?
answer
Demand curve movement refers to changes in price that affect the quantity demanded. A demand curve shift refers to fundamental changes in the balance of supply and demand that alter the quantity demanded at the same price.
question
Price Elasticity of Demand
answer
represents the percent change in quantity demanded in response to a given change in price
question
Calculating Price Elasticity of Demand (2 Options)
answer
Option 1: (Q2 - Q1) / Q1 / (P2 - P1) / P1

Option 2: (Change in Q / Change in P) / (P1 / Q1)
question
What does |E| > 1 mean in terms of demand?
answer
demand is elastic
question
What does |E| < 1 mean in terms of demand?
answer
demand is inelastic
question
What does |E| = 1 mean in terms of demand?
answer
demand is unit elastic
question
What is the connection between elasticity of demand and revenue?
answer
If |E| > 1, then an increase in price leads to a decrease in total revenue.
If |E| < 1, then an increase in price leads to an increase in total revenue.
question
What does Consumer Surplus represent?
answer
the difference between what a consumer pays for a good or service and what they are willing to pay for that good or service
question
How to calculate Consumer Surplus
answer
the area below the demand curve and above the market price
question
Fixed costs
answer
the portion of the cost that does not depend on the output level; for
example, the cost of renting a factory
question
Variable costs
answer
the portion of cost which would be zero if output were zero; for
example, hourly wages in the factory
question
Marginal costs
answer
the derivative cost with respect to output quantity; MC(q) = Cʼ(q) = VC'(q)
question
Average costs
answer
total costs divided by output quantity
question
Average variable costs
answer
variable cost divided by output quantity
question
What rule characterizes the optimal quantity choice of a price taking firm?
answer
A price-taking firm will produce where p = MC
question
What rule characterizes the optimal quantity choice of a price setting firm?
answer
A price-setting firm will produce q^m where MR(q^m) = MC(q^m)
question
Producer Surplus
answer
the total revenue that a producer receives from selling their goods minus the marginal cost of production
question
What is the margin-elasticity rule for a price setting firm?
answer
The margin-elasticity rule says that if we can measure the price elasticity of demand, we can measure margins, and therefore the extent of market power.
question
How do the price and quantity choices of a price setting firm differ from those of a price taking firm?
answer
A price-taking firm will supply the quantity such that price equals marginal cost.
A price-setting firm will supply the quantity such that marginal revenue equals marginal cost (This leads the firm to produce less and set a higher price than it would as a price taker.)
question
What is a perfectly competitive industry?
answer
An industry with many small firms, all of them are price takers, homogenous products that have the same characteristics, perfect information and no externalities, free entry into the industry, no artificial barriers to entry
question
Allocative Efficiency
answer
resources should be allocated to their most valuable uses (output should be at the right level)
question
Productive Efficiency
answer
output should be produced in the most efficient way possible (firms should minimize costs)
question
Dynamic Efficiency
answer
resources should be allocative at the right rates to lead the development and improvement of technology over time
question
In what sense is a perfectly competitive industry efficient in the short run, and why?
answer
In the short run, competitive firms set p = MC and produce the quantity which maximizes total surplus (using allocative efficiency)
question
What does deadweight loss measure, and how is it calculated?
answer
DWL measures the reduction in total surplus as a result of firms choosing to not produce units for which WTP > MC. It's the area under the demand curve, above the line of MC, and to the right of the line of quantity demanded.
question
Why does market power lead to DWL?
answer
Market power leads firms to set higher prices and produce lower quantities
question
What is the Lerner Index and how does it measure market power?
answer
The Lerner index measures a firm's market power in terms of its price-cost margin. L measures the fraction of price that is markup.
question
What does a low Lerner index (L ≈ 0) tell you?
answer
A low Lerner index means that the firm is a price-taker and has low market power
question
What does a high Lerner index (L ≈ 1) tell you?
answer
A high Lerner index means that the firm is a price-setter and has high market power
question
What is the connection between the Lerner index and the price elasticity of demand?
answer
A low Lerner index indicates high price elasticity of demand. A high Lerner index indicates low price elasticity of demand.
question
What is the goal of antitrust policy?
answer
The goal of antitrust policy is to promote effectiveness of competition and mitigate market failures due to market power
question
What are the three main areas of antitrust enforcement?
answer
Price fixing, merger policy, and abuse of dominant position
question
What is price fixing? (as an area of antitrust enforcement)
answer
an conspiracy by firms to increase prices
question
What is merger policy? (as an area of antitrust enforcement)
answer
mergers which substantially increase the firm's concentration of their share of the market
question
What is abuse of dominant position? (as an area of antitrust enforcement)
answer
includes exclusive dealing, predatory pricing, tying arrangements, etc. in which firms attempt to create and exploit market power
question
What is the goal of price discrimination?
answer
to transfer surplus to firms / producers
question
Factors that limit price discrimination
answer
- iminited information on consumer preferences
- possibility of resale
- consumer outrage over "unfair prices"
question
What is price discrimination through selection on indicators (market segmentation)?
answer
Occurs when a seller divides buyers into groups and charges a different prices to each group
question
Why would a firm wish to employ market segmentation?
answer
This way, they can effectively target the segments that are most valuable to their business
question
What is price discrimination through self selection?
answer
Occurs when a seller indirectly sorts consumers into groups by offering different deals or packages
question
Why would a firm want to discriminate through self selection?
answer
Because they can use it to sort out the high-value consumers from the low-value ones
question
What is the economic meaning of the incentive constraint?
answer
High-end customers need to prefer (or be incentivized) to buy high-end products
question
What is the economic meaning of the participation constraint?
answer
People need to believe that they're better off participating in the market / buying something rather than not participating in the market at all
question
In lecture, we saw that in the long run, a perfectly competitive industry will lead to production at minimum average cost. Explain how long-run firm entry and exit gives rise to this result. What type of efficiency does this represent?
answer
In the long run, as firms enter the market, they will not be able to produce much profit due to the fact that their incumbent competitors are all selling their products for less money than the new firm. That new firm will then be forced to conform to the status quo / low price that the incumbent firms have been selling at, or they will be forced to leave the market due to lack of profit. This would lead to productive efficiency
question
Teva and Turing are both accused of taking actions which increase the prices of prescription pharmaceuticals. How do these actions affect producer surplus, consumer surplus, and total surplus?
answer
Increase producer surplus, decrease consumer surplus, decrease total surplus due to Dead Weight Loss
question
How do economic outcomes (producer surplus, consumer surplus, quantity) under perfect price discrimination differ relative to the same outcomes under simple monopoly?
answer
If you can perfectly price discriminate, there is zero consumer surplus because each individual pays their exact willingness to pay. It's seemingly efficient because TS is maximized, but it's distributed differently, with the producers taking most if not all of the surplus
question
What is the pricing rule for a firm using selection on indicators?
answer
Sellers divides buyers into groups, charges a different price to each group
question
How does the pricing rule compare to that used by a standard monopoly? (Note: the takeaway here is that the two rules are very similar. A firm using selection on indicators essentially acts as a monopolist in each market separately. Once we know how to solve monopoly problems, we know how to price using selection on indicators.)
answer
If the firm can set prices using selection by indicators, it should charge lower prices in the market segments with more elastic demand
question
What is information rent in a self-selection problem?
answer
To induce high-value consumers to select the high-value product, the firm must leave them some consumer surplus, also known as information rent
question
We identified several examples of firms which deliberately damaged their products (Intel 486SX versus 486DX, IBM LaserPrinter E). How does price discrimination explain this behavior?
answer
Producers want to see if they can sell you a cheaper product, so they can get information from you on what you're willing to buy, leading you to a sort of self-selection
1 of 52
question
What is the economic definition of the demand curve?
answer
the quantity demanded of a good as a function of the price of the good, holding everything else constant
question
What is the economic definition of the inverse demand curve?
answer
answers the question, "what price will induce each quantity
demanded?"
question
What is the difference between a movement along the demand curve and a shift in demand?
answer
Demand curve movement refers to changes in price that affect the quantity demanded. A demand curve shift refers to fundamental changes in the balance of supply and demand that alter the quantity demanded at the same price.
question
Price Elasticity of Demand
answer
represents the percent change in quantity demanded in response to a given change in price
question
Calculating Price Elasticity of Demand (2 Options)
answer
Option 1: (Q2 - Q1) / Q1 / (P2 - P1) / P1

Option 2: (Change in Q / Change in P) / (P1 / Q1)
question
What does |E| > 1 mean in terms of demand?
answer
demand is elastic
question
What does |E| < 1 mean in terms of demand?
answer
demand is inelastic
question
What does |E| = 1 mean in terms of demand?
answer
demand is unit elastic
question
What is the connection between elasticity of demand and revenue?
answer
If |E| > 1, then an increase in price leads to a decrease in total revenue.
If |E| < 1, then an increase in price leads to an increase in total revenue.
question
What does Consumer Surplus represent?
answer
the difference between what a consumer pays for a good or service and what they are willing to pay for that good or service
question
How to calculate Consumer Surplus
answer
the area below the demand curve and above the market price
question
Fixed costs
answer
the portion of the cost that does not depend on the output level; for
example, the cost of renting a factory
question
Variable costs
answer
the portion of cost which would be zero if output were zero; for
example, hourly wages in the factory
question
Marginal costs
answer
the derivative cost with respect to output quantity; MC(q) = Cʼ(q) = VC'(q)
question
Average costs
answer
total costs divided by output quantity
question
Average variable costs
answer
variable cost divided by output quantity
question
What rule characterizes the optimal quantity choice of a price taking firm?
answer
A price-taking firm will produce where p = MC
question
What rule characterizes the optimal quantity choice of a price setting firm?
answer
A price-setting firm will produce q^m where MR(q^m) = MC(q^m)
question
Producer Surplus
answer
the total revenue that a producer receives from selling their goods minus the marginal cost of production
question
What is the margin-elasticity rule for a price setting firm?
answer
The margin-elasticity rule says that if we can measure the price elasticity of demand, we can measure margins, and therefore the extent of market power.
question
How do the price and quantity choices of a price setting firm differ from those of a price taking firm?
answer
A price-taking firm will supply the quantity such that price equals marginal cost.
A price-setting firm will supply the quantity such that marginal revenue equals marginal cost (This leads the firm to produce less and set a higher price than it would as a price taker.)
question
What is a perfectly competitive industry?
answer
An industry with many small firms, all of them are price takers, homogenous products that have the same characteristics, perfect information and no externalities, free entry into the industry, no artificial barriers to entry
question
Allocative Efficiency
answer
resources should be allocated to their most valuable uses (output should be at the right level)
question
Productive Efficiency
answer
output should be produced in the most efficient way possible (firms should minimize costs)
question
Dynamic Efficiency
answer
resources should be allocative at the right rates to lead the development and improvement of technology over time
question
In what sense is a perfectly competitive industry efficient in the short run, and why?
answer
In the short run, competitive firms set p = MC and produce the quantity which maximizes total surplus (using allocative efficiency)
question
What does deadweight loss measure, and how is it calculated?
answer
DWL measures the reduction in total surplus as a result of firms choosing to not produce units for which WTP > MC. It's the area under the demand curve, above the line of MC, and to the right of the line of quantity demanded.
question
Why does market power lead to DWL?
answer
Market power leads firms to set higher prices and produce lower quantities
question
What is the Lerner Index and how does it measure market power?
answer
The Lerner index measures a firm's market power in terms of its price-cost margin. L measures the fraction of price that is markup.
question
What does a low Lerner index (L ≈ 0) tell you?
answer
A low Lerner index means that the firm is a price-taker and has low market power
question
What does a high Lerner index (L ≈ 1) tell you?
answer
A high Lerner index means that the firm is a price-setter and has high market power
question
What is the connection between the Lerner index and the price elasticity of demand?
answer
A low Lerner index indicates high price elasticity of demand. A high Lerner index indicates low price elasticity of demand.
question
What is the goal of antitrust policy?
answer
The goal of antitrust policy is to promote effectiveness of competition and mitigate market failures due to market power
question
What are the three main areas of antitrust enforcement?
answer
Price fixing, merger policy, and abuse of dominant position
question
What is price fixing? (as an area of antitrust enforcement)
answer
an conspiracy by firms to increase prices
question
What is merger policy? (as an area of antitrust enforcement)
answer
mergers which substantially increase the firm's concentration of their share of the market
question
What is abuse of dominant position? (as an area of antitrust enforcement)
answer
includes exclusive dealing, predatory pricing, tying arrangements, etc. in which firms attempt to create and exploit market power
question
What is the goal of price discrimination?
answer
to transfer surplus to firms / producers
question
Factors that limit price discrimination
answer
- iminited information on consumer preferences
- possibility of resale
- consumer outrage over "unfair prices"
question
What is price discrimination through selection on indicators (market segmentation)?
answer
Occurs when a seller divides buyers into groups and charges a different prices to each group
question
Why would a firm wish to employ market segmentation?
answer
This way, they can effectively target the segments that are most valuable to their business
question
What is price discrimination through self selection?
answer
Occurs when a seller indirectly sorts consumers into groups by offering different deals or packages
question
Why would a firm want to discriminate through self selection?
answer
Because they can use it to sort out the high-value consumers from the low-value ones
question
What is the economic meaning of the incentive constraint?
answer
High-end customers need to prefer (or be incentivized) to buy high-end products
question
What is the economic meaning of the participation constraint?
answer
People need to believe that they're better off participating in the market / buying something rather than not participating in the market at all
question
In lecture, we saw that in the long run, a perfectly competitive industry will lead to production at minimum average cost. Explain how long-run firm entry and exit gives rise to this result. What type of efficiency does this represent?
answer
In the long run, as firms enter the market, they will not be able to produce much profit due to the fact that their incumbent competitors are all selling their products for less money than the new firm. That new firm will then be forced to conform to the status quo / low price that the incumbent firms have been selling at, or they will be forced to leave the market due to lack of profit. This would lead to productive efficiency
question
Teva and Turing are both accused of taking actions which increase the prices of prescription pharmaceuticals. How do these actions affect producer surplus, consumer surplus, and total surplus?
answer
Increase producer surplus, decrease consumer surplus, decrease total surplus due to Dead Weight Loss
question
How do economic outcomes (producer surplus, consumer surplus, quantity) under perfect price discrimination differ relative to the same outcomes under simple monopoly?
answer
If you can perfectly price discriminate, there is zero consumer surplus because each individual pays their exact willingness to pay. It's seemingly efficient because TS is maximized, but it's distributed differently, with the producers taking most if not all of the surplus
question
What is the pricing rule for a firm using selection on indicators?
answer
Sellers divides buyers into groups, charges a different price to each group
question
How does the pricing rule compare to that used by a standard monopoly? (Note: the takeaway here is that the two rules are very similar. A firm using selection on indicators essentially acts as a monopolist in each market separately. Once we know how to solve monopoly problems, we know how to price using selection on indicators.)
answer
If the firm can set prices using selection by indicators, it should charge lower prices in the market segments with more elastic demand
question
What is information rent in a self-selection problem?
answer
To induce high-value consumers to select the high-value product, the firm must leave them some consumer surplus, also known as information rent
question
We identified several examples of firms which deliberately damaged their products (Intel 486SX versus 486DX, IBM LaserPrinter E). How does price discrimination explain this behavior?
answer
Producers want to see if they can sell you a cheaper product, so they can get information from you on what you're willing to buy, leading you to a sort of self-selection
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