MIDTERM

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The Hidden Costs Fallacy

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where you ignore relevant costs

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fixed (sunk) cost fallacy

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you consider costs that do not vary as a consequence of your decision in the short-run

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Discount Rate

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the "price" you charge to trade current dollars for future dollars; the HIGHER the discount rate, the more value individuals place on current dollars.

a company's discount rate is determined by its cost of capital.

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Interest Rate

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price paid for borrowing money today

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Discount Rate vs. Interest Rate

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If you require a HIGH rate of return (high interest rate) in order to invest or lend money, your discount rate must be large --> you value future dollars significantly less than current dollars.

If you require a LOW rate of return (low interest rate), your discount rate must be smaller --> value future dollars is closer to your value for current dollars.

Wealth-creating transactions occur when individuals with low discount rates (rate at which they value future vs. current dollars) lend to those with high discount rates

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Net Present Value (NPV)

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sum of the present value (discounted value) of all future cash flows from the investment minus the current cost of the investment

If NPV > 0, invest!

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NPV and Economic Profit

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Positive NPV: create economic profit because positive NPV projects return higher than the company's cost of capital

Negative NPV: may create accounting profits, but not economic profits,

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Break-Even Quantity

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equal to fixed cost divided by contribution margin; used BEFORE incurring any fixed costs to determine if project should be taken on or not.

DO NOT USE FOR EXTENT DECISIONS

If you expect to sell more than the breakeven quantity, then your investment is profitable.

A decrease in price level will INCREASE breakeven quantity

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Break-Even Price

answer

average avoidable cost per unit; allows managers to determine the minimum price that must be charged for the product so that the avoidable costs are covered

** in the short-run, ONLY variable costs are avoidable
** in the long-run, fixed costs AND variable costs avoidable

^^ thus, in the long-run, the break-even price includes the average fixed cost per unit.

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Hold Up

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once relationship-specific investments are made, parties are locked into a trading relationship with each other, and can face hold-up by trading partner.

anticipate hold-up and choose organizational or contractual forms to give the parties the incentive to make relationship-specific investments and to trade after these investments are made

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Monopolistic (Simple) Pricing

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where a single firm sells a single product at the price they chose

The clear connection between price and quantity allows us to think of pricing as a quantity decision (marginal analysis for an additional unit)

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The First Law of Demand

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As price increases, quantity of demand decreases.

** demand curves always slope downwards

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Aggregate Demand

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Sum of individual demands at each price. This gives the total quantity demanded at any given price.

**Allows us to turn pricing decisions into corresponding quantity decision

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Pricing and Marginal Analysis

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compares the marginal revenue of selling an additional unit with the marginal cost of the additional unit

If MR > MC --> decrease price to sell an additional unit
If MR < MC --> increase price to sell one fewer unit
If MR = MC --> leave at price at this optimal level

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Five factors affecting demand elasticity

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1. products with close subs = more elastic demand
2. demand for a single product is more elastic than industry aggregate demand
3. products with many complements have less elastic demand
4. Second Law of Demand
5. As price increases, demand becomes more elastic (this is the ONLY factor that is a movement ALONG THE CURVE, vs. a shift out)

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The Second Law of Demand

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states that in the long run, demand curves become more elastic

** in the long run, more subs will become available to consumers

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Demand Shift vs. Price Change

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a price change will cause a movement along the demand curve (a change in quantity demanded).

When something other than price affects the curve as a whole, this causes a shift in demand (the curve moves)

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The Income Elasticity of Demand

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measures the change in demand arising from a change in income

= (% change in quantity demanded) / (% change in income)

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Inferior good

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a good that consumers demand less of when their incomes increase

= negative income elasticity

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Normal Good

answer

a good that consumers demand more of when their incomes increase

= positive income elasticity

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The Cross-Price Elasticity of Demand

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measures the change in demand in for your good arising from the change in price of another good

= (% change in quantity of good X) / (% change in price of good Y)

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Cross-Price Elasticity and Substitutes

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Two products are substitutes if the cross-price elasticity is positive

As the price of a substitute increases, demand for your good increases

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Cross-Price Elasticity and Complements

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Two products are complements if the cross-price elasticity is negative

As the price of a complement increases, demand for your good decreases

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Suppose the price of an inferior good, product A, is currently $14 and is produced at a marginal cost of $10.50 per unit. The estimated price elasticity of demand for product A to be -2.5. The producer of product A should ____________. The suggested new price calculated using the current elasticity is ____________.

answer

Current price = $14
MC = 10.50

Equilibrium point is MC = MR = 10.50
Elasticity of demand (absolute value) = 2.5

Soo....

Price = MR * (E/E-1)
= 10.50 * (2.5/(2.5-1))
= 10.50 * (2.5/1.5)
= 17.50

ANSWER: INCREASE THE PRICE; $17.50

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Law of Diminishing Marginal Returns

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states that as output expands the marginal productivity (the extra output associated with extra inputs), returns eventually decline.

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constant returns to scale

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long-run average costs are constant with respect to output

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Diseconomies of Scale

answer

the situation in which a firm's long-run average costs rise as the firm increases output

results from scarcity of factors

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Economies of Scale

answer

the property whereby long-run average total cost falls as the quantity of output increases

results from technology synergies, learning, etc.

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Economies of Scope

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savings that come from producing two (or more) outputs at less cost than producing each output individually, despite using the same resources and technology

important source of competitive advantages and major cause of mergers

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Characteristics of a perfectly competitive firm

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PRICE TAKER, which means the demand for the firm is perfectly elastic (horizontal line)

Firm can only choose how much to produce and whether or not to exit in long run

1 of 30

question

The Hidden Costs Fallacy

answer

where you ignore relevant costs

question

fixed (sunk) cost fallacy

answer

you consider costs that do not vary as a consequence of your decision in the short-run

question

Discount Rate

answer

question

Interest Rate

answer

price paid for borrowing money today

question

Discount Rate vs. Interest Rate

answer

question

Net Present Value (NPV)

answer

sum of the present value (discounted value) of all future cash flows from the investment minus the current cost of the investment

If NPV > 0, invest!

question

NPV and Economic Profit

answer

Positive NPV: create economic profit because positive NPV projects return higher than the company's cost of capital

Negative NPV: may create accounting profits, but not economic profits,

question

Break-Even Quantity

answer

question

Break-Even Price

answer

question

Hold Up

answer

question

Monopolistic (Simple) Pricing

answer

question

The First Law of Demand

answer

As price increases, quantity of demand decreases.

** demand curves always slope downwards

question

Aggregate Demand

answer

Sum of individual demands at each price. This gives the total quantity demanded at any given price.

**Allows us to turn pricing decisions into corresponding quantity decision

question

Pricing and Marginal Analysis

answer

question

Five factors affecting demand elasticity

answer

question

The Second Law of Demand

answer

states that in the long run, demand curves become more elastic

** in the long run, more subs will become available to consumers

question

Demand Shift vs. Price Change

answer

question

The Income Elasticity of Demand

answer

measures the change in demand arising from a change in income

= (% change in quantity demanded) / (% change in income)

question

Inferior good

answer

a good that consumers demand less of when their incomes increase

= negative income elasticity

question

Normal Good

answer

a good that consumers demand more of when their incomes increase

= positive income elasticity

question

The Cross-Price Elasticity of Demand

answer

measures the change in demand in for your good arising from the change in price of another good

= (% change in quantity of good X) / (% change in price of good Y)

question

Cross-Price Elasticity and Substitutes

answer

Two products are substitutes if the cross-price elasticity is positive

As the price of a substitute increases, demand for your good increases

question

Cross-Price Elasticity and Complements

answer

Two products are complements if the cross-price elasticity is negative

As the price of a complement increases, demand for your good decreases

question

answer

question

Law of Diminishing Marginal Returns

answer

states that as output expands the marginal productivity (the extra output associated with extra inputs), returns eventually decline.

question

constant returns to scale

answer

long-run average costs are constant with respect to output

question

Diseconomies of Scale

answer

the situation in which a firm's long-run average costs rise as the firm increases output

results from scarcity of factors

question

Economies of Scale

answer

the property whereby long-run average total cost falls as the quantity of output increases

results from technology synergies, learning, etc.

question

Economies of Scope

answer

question

Characteristics of a perfectly competitive firm

answer

PRICE TAKER, which means the demand for the firm is perfectly elastic (horizontal line)

Firm can only choose how much to produce and whether or not to exit in long run

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