BE Midterm - Assignment Essays

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What are the normative rules of choice?

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1) net-benefit principle
2) the opportunity cost principle
3) the sunk cost principle

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Net benefit principle

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The best choice or action from a set of actions is the one that yields the highest expected net benefits

Equation = Value - Direct costs

Policy or action A is worthwhile if -- Expected Benefits of A > Expected Costs of A

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Opportunity cost principle

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- The cost of taking a particular course of action is the loss of the (net) benefits of the next best course of action
- Opportunity cost = the cost in terms of forgone benefits of taking a particular course of action

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The sunk cost principle

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Only current and future benefits and costs should be considered in current decision making

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Consumer surplus (consumer net benefits)

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The difference between what a consumer would be WTP for a given quantity (rather than go without) and the amount actually paid

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Consumer surplus equation

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Total Value (TV) - Total Expenditure (TE)

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Consumer surplus example

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If you pay $17,000 for a Honda Accord but would have been willing to pay $18,500, your consumer surplus is $1500

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The demand curve...

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- Shows the quanity a consumer (or consumers) would be willing to purchase at each price
- The demand curve shows a consumer's maximum WTP (value) for each unit

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The surplus available to extract rises as ______

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The per unit price falls

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How do we shift from individual to collective rationality?

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- The normative rules of choice describe best choices for an individual
- Economic efficiency characterizes "best" choices for two or more individuals

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Gains from trade

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Vb-Cs

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Economic efficiency

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- An outcome is efficient if there is no alternative outcome that would yield higher gains from trade
- An outcome is efficient if there are no reallocations that would leave no one worse off
- An allocation is more efficient if it generates larger gains from trade than the alternative

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Efficiency =

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Pareto optimality-- an allocation at which it is not possible to make one person better off without making someone worse off

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A change results in a Pareto improvement if....

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if no one is made worse off and at least one person is made better off

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If further Pareto improvements exist...

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Then an allocation is inefficient

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At outcome is Pareto efficient (or Pareto optimal) ...

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when there are no more Pareto improvements

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Raising price will be more desirable if...

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quantity falls only a little bit when we raise price

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Lowering price will be more attractive

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to the extent that quantity increase a lot when we lower price

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Elasticity varies along a demand curve

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demonstrating that elasticity is not the same as slope

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Cross-price elasticity

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Percentage change in the quantity demanded of one product resulting from a 1% change in the price of another product

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Income elasticity

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Percentage change in the quantity demanded resulting from a 1% change in income

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An ____ is a measure of the ___ of one variable to another

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An elasticity is a measure of the sensitivity of one variable to another

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perfectly inelastic

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- Firms want to choose price that yields largest profit given demand and costs
- Rule: continue to produce as long as marginal benefit is greater than marginal cost

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infinitely elastic

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Continue to increase quantity (lower price) as long as doing so increases revenue more than it increases cost; compare incremental revenue and incremental cost

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Applying the Normative Rules of Choice to pricing:

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MR = MC

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The normative rules of choice tell us that for deciding how much to produce and for evaluating net benefits, we need to look costs that vary with that decision. Thus,

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- Which costs are relevant
- How do costs vary with each decision

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Profit is maximized at the quantity for which

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- the sum of all the costs of producing a certain output level in a given time period
-Including the opportunity cost of any resource used in the production process that might not be paid for directly, such as.. An owner's time, a "normal" return on capital

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In deciding whether to produce, how much to produce or what production capacity to invest in, we want to ask

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are the ones that don't vary with the level of output (incurred even if quanitty = 0)

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Total costs

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The change in total cost from proudcing one more unit of output, or the incremental cost of an additional unit

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fixed costs

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- The long run (planning or investment horizon) is the period of time over which all inputs (including capital inputs such as plant capacity) can be changed
- The short run (operating horizon) is a period of time over which at least some inputs (often capital inputs) cannot be changed

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Marginal cost

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- Rule 1: Sell all units whose incremental contribution to revenues (MR) is greater than or equal to their incremental contribution to costs (MC) -- Set q* so that MR=MC
- Rule 2: Produce q* as long as operating profits are positive (P greater than or equal to AVC); shut down if operating profits are negative (P<AVC)

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Long run versus short run costs

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reductions in costs that result as a producer gains experience

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To maximize short-run (operating) profits, a firm should

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they tend to be related to cumulative output--how much output produced in the past, as opposed to level of output per period at a point of time

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Learning economies refers to

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it can produce any level of output in a given period (q) at a lower cost

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Because learning economies arise from the experience

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LR(MR)=LRMC

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When a firm has more experience in producing the good (cumulative output Q2>Q1)

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we move from the long-run (investment/planning) horizon to short run (operation) horizon

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The firm will want to choose a planned output qp, so that

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where the incremental value is equal to the incremental cost

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Once investment decisions have been made and capacity has been put into place..

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The practice of charging different prices to different customers for the same good (or for different units of the good) where the different prices are not based on cost differences

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When it is costly to supply additional quantities the efficient quantity is

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involves charging a different price to each customer for each unit in such a way that all the consumer surplus is extracted; also known as "perfect price discrimination"

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Price Discrimination

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charging different prices for different quantities of a good; an approximation to "perfect" price discrimination; "declining block pricing": "quantity/volume discounts"

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First degree price discrimination

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Charging different groups of customers (different "markets") different prices based on differences in their sensitivity to price (elasticity); market segmentation

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Second degree price discrimination

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Price discrimination may allow enough surplus to be captured so that Average Revenue exceeds ATC, making it profitable to serve the market

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Third degree price discrimination

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charging higher prices in high-demand periods than in low-demand periods because of differences in marginal cost (due to capacity constraints) at different output levels

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Serving niche markets: Even at the profit-maximizing price and quantity, revenue may not be sufficient to cover costs, leaving production unprofitable...

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not price discrimination because price differences are cost based

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Peak-load pricing

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are not

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Peak load pricing is..

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1) To the extent that price discrimination increases quantity, it tends to be efficient
2) Differences in prices among markets implies a misallocation of goods under 3rd degree price discrimination (some potential buyers in high priced segment value good more than actual buyers in lower-priced market, which is inefficient
3) By allowing companies to capture more surplus, price discrimination allows more markets to be served than would occur otherwise

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demand-based (price discrimination) and cost-based reasons for differential pricing ______ mutually exclusive e.g. airline pricing, day/night phone rates; weekend/weekday ski-lift tickets

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1) "Market power": firms must face downward sloping demand
2) Market separation: firms must be able to distinguish customers or markets by their willingness to pay or elasticities
3) No arbitrage: Firms must be able to prevent resale between customers

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Efficiency of Price discrimination

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the cost of joint production of two (or more) distinct products is less than the cost of producing the same amount of each product separately

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Neccessary conditions for price discrimination (it is not always possible for firms to price discrimination)

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With economies of scope, the entire LRAC function for q1 will shift down as production of q2 increases (and vice versa)

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Economies of scope exist when:

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Examples: lamb and wool; beef and leather; B-schools having multiple degree programs such as BBA, MBA; Microsoft operating systems, word processors, browsers

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With economies of scope, the entire LRAC function for q1 will shift _____ as production of q2 _____ (and vice versa)

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From the NYT article: - New academic research suggests that a tiered system has a twofold benefit: it uses something akin to market pricing to encourage conservation but makes sure much of that burden is borne by those most able to afford it
- Tiered pricing offers a balance between fairness and efficiency

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Economies of scope examples

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Set price = MC and charge flat fee to extract surplus

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Why tiered pricing?

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Set price > MC and charge smaller flat fee

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TWO PART PRICING (two-part tariffs) If customer demands are similar

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Set price equal to uniform profit-maximizing price

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TWO PART PRICING (two-part tariffs) If customer demands differ a little

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- Supply curve represents the total quantity producers are willing to supply at different prices (holding other things constant)
- The supply curve also represents the minimum price at which producers would be willing to supply a particular quantity (the producer's opportunity cost)

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TWO PART PRICING (two-part tariffs) If customer demands differ a lot

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Producer surplus or economic rent is a measure of net benefits accruing = the difference between the amount actually received for given quantity of output and the minimum amount necessary to induce the quantity to be supplier

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The supply curve represents

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The difference between the amount actually received for a given quantity of output and the minimum amount necessary to induce that quantity to be supplied

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Producer surplus or economic rent is a measure of net benefits accruing

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substitutes for a producer's product

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Producer surplus (or economic rent)

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the quantity of the firm product demanded will be more sensitive to price

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Competition creates

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With larger numbers of firms, each firms output is only a small part of the total, and its behavior has a negligible effect on the market

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More substitutes makes demand for the firm's product more elastic that is,

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Price

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With larger numbers of firms, each firms output is _______ part of the total, and its behavior has a ______ effect on the market

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In the short run is MC above min AVC

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What is MR for a firm in a perfectly competitive market?

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Supply = demand

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The individual firm's supply curve

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then a shortage (excess demand) exists, which tends to push the price up toward P*

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market equilibrium occurs where

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then a surplus (excess supply) exists, which pushes the price down toward P*

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If P < P*

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a quota imposed by country A is restriction on the quantity of a certain good that can be imported into country A

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If P > P*

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- a tariff is a tax imposed by country A per unit of a good imported into country A
- Like quotas, tariffs cause domestic prices to increase and result in similar transfers and inefficiencies
- One difference: domestic government gets tax revenue directly from tariffs

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Quota

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Use Q= a+bp

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Tariff

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Covering its average total cost, including a "normal" rate of return

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For summing individual demand curves

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Average total cost declines as planned output increases

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A firm making zero economic profit is _______

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deadweight loss is the difference in production and consumption of any given product or service including government tax. The presence of deadweight loss is most commonly identified when the quantity produced relative to the amount consumed differs in regards to the optimal concentration of surplus

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The existence of economies of scale implies

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- political reasons, restrictions benefit certain industries, impacts job market (ex study finds that elimination of the US sugar program would decrease jobs in the sugar growing industry but increase jobs in sugar using industries)

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Deadweight loss

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- The conditions necessary to make strategic trade barriers desirable rarely exist
- Politicians are unlikely to be able to recognize them or to know how set barriers at appropriate levels
- Political pressurers are likely to induce politicians to adopt strategic barriers even where they don't increase national welfare
- use of strategic barriers by one country is likely to provoke retaliation by other countries

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Why do we have quotas if they are both inefficient and hurt consumers more than they benefit producers?

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Concentrated benefits vs dispersed costs

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What are arguments against strategic trade barriers?

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- designed to redistribute existing surpluses rather than generate additional surpluses
- Ex. Company lobbies the government for grants, subsidies or tariff protection
- Rent seeking activities do not yield an increase in total surplus because they use up resources

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Why do we have quotas if they are both inefficient and hurt consumers more than they benefit producers?

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shows that the burden of a tax tends to fall more heavily on the relatively less price sensitive (less elastic) (inelastic) party. Removal of the tax will therefore benefit that party the most

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rent-seeking activities

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Describes how the quantity demanded changes in response to a price change

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Tax incidence analysis

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Describes how sensitive quantity supplied of a good is to changes in price

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Price Elasticity of Demand

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economic term for understanding the division of a tax burden between stakeholders, such as buyers and sellers or producers or producers and consumers

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Price elasticity of supply

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They will only be willing to supply a given quanitty if price covers MC plus the tax

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Tax incidence

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They will only be willing to buy a given quantity if their WTP is at least the price plus the tax

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If suppliers pay the tax

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The relative elasticity of supply and demand

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If consumers pay the tax

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cause price (compensation) to fall (from W' to W'') but leaves sellers and buyers no better or worse off than before and has no effect on employment

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What determines who bears the burden of the tax?

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- Risk transfer: doesn't reduce risk, just shifts who bears it (ex. Insurance)
- Risk mitigation: perform activities that reduce risk (ex. Hard hats on a construction site)

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Shifting a cost from sellers (drivers) to buyers (companies)

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- Individuals have different risk tolerance (differential risk aversion)
- The allocation of risk affects incentives

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How to deal with risk?

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- a person who is risk neutral is indifferent between a sure outcome and an uncertain outcome with the same expected value
- A risk neutral person focuses on potential gains when making investment decisions

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The allocatio of risk matters only where

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Probability (cost )*(cost)

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Risk neutral

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- A person who is risk averse prefers a sure outcome over an uncertain outcome with the same expected value
- to avoid risk, risk averse personal would be willing to pay a risk premium
- such person will require extra compensation to accept a risk

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E(cost)

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they would always choose the option with the highest expected value regardless of the risks involved

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Risk averse

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only if its expected value is higher than that of a less risky alternative

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If people made their choices to maximize expected value

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which is the probability weighted average of the utility from each possible outcome

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Risk averse people will choose an action or a situation with higher risk

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diminishing marginal utility of wealth

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Risk averse people maximize expected utility (not expected value)

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it doesn't matter who bears the risk: wages adjust so that expected surpluses are the same

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Risk aversion implies

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then insurance premia are just another cost and the same analysis applies

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If workers and companies are risk neutral (or equally risk averse)

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There are gains to having employers bear risk

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If risks are insurable

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- Allocate risk to the low-cost risk bearer (i.e., the less risk averse party)
- If workers (drivers) are more risk averse than companies, companies should bear the risk

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If workers are more risk averse than companies

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- refers to the reduction in incentives to reduce or avoid risk when individuals do not bear the risk
- Health insurance --> bad behavior (sky diving, street luging) - Warranties-- owners may spend less on maintenance

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risk aversion principle

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There are gains to having workers bear risk

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Moral hazard

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- Allocate risk to the low-cost risk avoider (i.e., the party better able to reduce the probability or cost of losses)
- If workers (drivers) are better able to avoid or reduce risks, workers should bear the risk

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If workers affect the expected loss

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- Problem that can occur when one party is better informed about risks or quality than the other
- If the party without the information cannot distinguish high quality/ low risk goods from inferior (low quality. High risk) goods, it will have to offer a price based on the average quality
- Only parties with low quality goods (high risks) will find a price based on average quality attractive; informed parties with high quality goods (or low risk) will withhold their business
- As a result the average quality of goods in the market falls, causing the uninformed party to adjust its price, causing still more high-quality transactors to leave the market

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moral hazard principle

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- Represent another method by which transactors can transfer risk
- A futures contract is a promise to buy or sell a particular commodity (usually) at a specified time or place at a pre-specified price.
- Future transactions take place on an organized exchange
- In future contracts, the identity of the party you are transacting with is not important future contracts are standardized and tradable

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Adverse selection

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many standardized (homogeneous) commodities and financial instruments

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Future markets

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- Future contracts are liquid that is can be readily bought and sold on organized exchanges
- You can risk reduction without having to search for a trading partner

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Future markets exist for

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the correlation of the price of good you have to sell with the price of the futures commodity (if prices move in opposite directions, a short hedge would increase risk

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Advantages of trading on future markets

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someone (a buyer) anticipates the need for a commodity in say Dec and wants to lock in current futures price. That person would then buy "long" promise to purchase at a specified price in Dec

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The ability to hedge depends crucially on

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a smaller expected loss when the expected value is the same

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A long hedge would be used where

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hedging or trade speculation

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Risk neutral people prefer

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hedge or guarantee the price at which the commodity is sold or purchased

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Futures can be used for

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it is possible to make a profit by trading futures, even if one does not have a direct interest in the underlying commodity

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Producers or purchasers of an underlying asset

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is an invest strategy used to protect (hedge) against the risk of a declining asset price in the future

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Since many commodity prices tend to move in predictable patterns

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a long hedge, which protects against rising prices

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Short hedge

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the entity is seeking to sell a commodity in the future at a specified price

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A short hedge is the opposite of

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The company seeking to buy the commodity takes the opposite position on the contract

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In a short-hedged position

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drive up futures price. Speculation sends a signal to the marker that wheat is likely to be more scarce than previously expected

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long-hedged position

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1) Dispersed information and knowledge; It is a problem of how to secure the best use of resources known to any of the members of society for ends whose relative importance only these individuals know
2) Continual change; The economic problem of society is mainly one of rapid adaptation to changes in the particular circumstances of time and place

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Speculation tends to

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- The price system is a mechanism for communicating information
- Prices convey the information necessary to coordinate decentralized decisions without the need to know the details of why a particular good or service has become relatively more or less scarce

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What did Hayek say is the true economic problem of society?

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- contracts, negotiation, integration, auctions, posted / list prices, government

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How can we coordinate economic activity given that the so much of the knowledge and information needed to act rationally is dispersed and constantly changing?

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- Contracts that commit specific parties to future performances

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Other ways we organize economic activity

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value to the buyer of seller's performance

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Forward contracts

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seller's opportunity cost (the value of the seller's next best alternative)

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contract price

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price offered by alternative customer

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production costs

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contract damages

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buyer would perform only when v>Pk

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weird symbol

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If performance would result in an inefficiency, the parties have an incentive to renegotiate and split the gains from adaption between them

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With no enforcement,

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if there are no costs or impediments to bargaining, transactors will negotiate to an efficient outcome regardless of the organizational form

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Breaching and paying damages is not the only way to deal with contingencies.

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1) Bounded rationality-- recognizes limited memory and decision making ability; failures of foresight and cognition
2) Opportunism: refers to the willingness of at least some people to take advantage of others

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Organizational coase theorem

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an investment specially designed or located for a specific user that, as a consequence, has a significantly lower value in its next best alternative use (or with the next best user)

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Williamson argued that transaction costs can be traced to two human factors

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When a buyer and seller must locate their plants close to each other (and away from potentially partners) to be able to engage in exchange (e.g. co-location of coal mines and power generators)

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Relationship-specific investment

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when capital equipment is specially designed to meet a particular need and cannot be readily adapted for use by other parties (ex movie set, digital products)

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Site specificity

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firm-specific skills or knowledge

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Physical asset specificity

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large investments for a particular customer that would depress market price if released to the market

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human asset specificity

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situations in which the importance of timing makes delays costly (ex. Newspapers or perishables, construction, assembly line workers)

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Dedicated assets

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Rivian specified in the lawsuit that there is no alternative supplier for the custom designed seat packages for the electric van and it could take well over a year for it to find another vendor

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Temporal specificity

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Advantages: Purchasing from a single supplier include the ability to exploit scale economies, the need to attend to fewer accounts, better protection of proprietary information, the development of better working relationships with a single partner

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Rivian

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Disadvantage: Increased exposure to supply disruptions from natural or market factors, greater vulnerability to strategic (opportunistic) behavior (hold ups

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What are some potential advantages of sole sourcing (using a single supplier for inputs)?

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- Vertically integrate complex products that involve large, relationship-specific investments
- If large relationship specific investments are necessary but the hazards of contracting are too great vertical integration may become the best alternative

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What are some potential disadvantages of sole sourcing (using a single supplier for inputs)?

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the hazards of contracting are too great, vertical integration may become the best alternative

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When should a firm vertically integrate?

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would contract for low RSI procurements and vertically integrate high RSI ones

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If large relation-specific investments are necessary

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- Bargaining and hold up costs (opportunism) rise with the need for relationship specific investments
- Contracting costs rise with the difficulty of contracting (complex products, uncertainty about the future)

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Firms wanting to choose the organizational form with the lowest transaction costs

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that are dissimilar from other activities in which the firm is engaged and for which there is greater uncertainty

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Market transaction costs rise with RSI and with complexity and uncertainty

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both the cost of transacting on the market and the costs of organizing internally

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Internal organization costs are likely to be higher for transactions

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selling two or more distinct products as a package (at a single price) (ex. Word and powerpoint, cable tv channels)

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Communicaton technologies tend to affect

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- requiring that a buyer of one product also buy one or more other products from the same firm; Xerox requiring copier customers to buy paper from Xerox

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Bundling

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1) price discrimination; price exploits differences in WTP
- Bundling takes advantage of negatively correlated relative values
- Tying takes advantage of the correlate between value of monpolized good and intensity of use to charge different implict prices to high and low volume consumers
2) reducing wasteful search and sorting costs
3) tying as a means of quality assurance

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Tying

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- It works because the value consumers place on the bundle are less dispersed than the values for the individual goods
-The reduced dispersion in reservation prices allows the firm to charge more and still sell to more consumers

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Why bundle products

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allows firms to capture more surplus more niche products will be profitable, increasing gains from trade (efficiency)

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The motive for bundling is considered a subtle form of price discrimination because it results in consumers seeing different implicit prices for the components of the bundle

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Having purchased the bundle the cost to the consumer of using or view goods in the bundle is zero

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Because bundling like other forms of price discrimination

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Selling heterogeneous items in a bundle reduces the amount of sorting and searching, saving transaction costs

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Bundling also addresses the problem of how to price nonrivalrous goods.

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Bundling and tying allow forms to extend a firm's monopoly power in one good to competitively produced good

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Where products differ greatly in quality and characteristics but all customers value products similarly sorting redistributes surpluses but adds no value to the transaction.

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- Bundling allows firms to price discriminate by exploiting different relative values customers place on the bundled products
- Tying allows firms to price discriminate by charging high-intensity users more than low-intensity users for the monopolized product
- Bundling allows firms to reduce excessive search and sorting costs for heterogeneous products

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All of the following are plausible reasons for why companies find it profitable to bundle or tie products, except:

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Moral hazard refers to the reduction in incentives to reduce the size or the probability of loss if you are insured against bad events

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All of the following are plausible reasons for why companies find it profitable to bundle or tie product

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if the value to the buyer is greater than the seller's opportunity costs

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Moral hazard refers to

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shifting taxes from buyers to sellers (consumers to producers or employers to employees) will cause price (here, driver compensation) to decrease by an amount that leaves the burden of the tax (consumer and producer surplus) and the quantity traded (here, drivers hired) unchanged.

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A transaction is efficient

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organizational form matters only to the extent that the costs of transacting under different organizational forms differ.

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As tax incidence analysis demonstrates,

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sorting and pricing of each tuna by species would not be worthwhile

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According to the coase theorem

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is if supply decreases relative to demand.

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As discussed in class, the large quantities and heterogeneity of tuna, and the relatively similar values tuna processors place on tuna makes it likely that

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that firms should integrate production when the costs of transacting with an external supplier is greater than the cost of organizing internally. According to Coase, the costs of organizing internally will be higher where transactions are dissimilar, which is the case for airline operations and refining.

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The only shifts in supply and demand that will result in an increase in price and decrease in the quantity demanded

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according to transaction cost theory, the absence of a motive for integration

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Transaction cost theory says that

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undefined

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The existing of spot and futures markets implies the absence of significant relationship-specific investments and therefore

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undefined

1 of 162

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What are the normative rules of choice?

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1) net-benefit principle
2) the opportunity cost principle
3) the sunk cost principle

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Net benefit principle

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Opportunity cost principle

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The sunk cost principle

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Only current and future benefits and costs should be considered in current decision making

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Consumer surplus (consumer net benefits)

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The difference between what a consumer would be WTP for a given quantity (rather than go without) and the amount actually paid

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Consumer surplus equation

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Total Value (TV) - Total Expenditure (TE)

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Consumer surplus example

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If you pay $17,000 for a Honda Accord but would have been willing to pay $18,500, your consumer surplus is $1500

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The demand curve...

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- Shows the quanity a consumer (or consumers) would be willing to purchase at each price
- The demand curve shows a consumer's maximum WTP (value) for each unit

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The surplus available to extract rises as ______

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The per unit price falls

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How do we shift from individual to collective rationality?

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- The normative rules of choice describe best choices for an individual
- Economic efficiency characterizes "best" choices for two or more individuals

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Gains from trade

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Vb-Cs

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Economic efficiency

answer

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Efficiency =

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Pareto optimality-- an allocation at which it is not possible to make one person better off without making someone worse off

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A change results in a Pareto improvement if....

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if no one is made worse off and at least one person is made better off

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If further Pareto improvements exist...

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Then an allocation is inefficient

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At outcome is Pareto efficient (or Pareto optimal) ...

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when there are no more Pareto improvements

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Raising price will be more desirable if...

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quantity falls only a little bit when we raise price

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Lowering price will be more attractive

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to the extent that quantity increase a lot when we lower price

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Elasticity varies along a demand curve

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demonstrating that elasticity is not the same as slope

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Cross-price elasticity

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Percentage change in the quantity demanded of one product resulting from a 1% change in the price of another product

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Income elasticity

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Percentage change in the quantity demanded resulting from a 1% change in income

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An ____ is a measure of the ___ of one variable to another

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An elasticity is a measure of the sensitivity of one variable to another

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perfectly inelastic

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- Firms want to choose price that yields largest profit given demand and costs
- Rule: continue to produce as long as marginal benefit is greater than marginal cost

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infinitely elastic

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Continue to increase quantity (lower price) as long as doing so increases revenue more than it increases cost; compare incremental revenue and incremental cost

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Applying the Normative Rules of Choice to pricing:

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MR = MC

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The normative rules of choice tell us that for deciding how much to produce and for evaluating net benefits, we need to look costs that vary with that decision. Thus,

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- Which costs are relevant
- How do costs vary with each decision

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Profit is maximized at the quantity for which

answer

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In deciding whether to produce, how much to produce or what production capacity to invest in, we want to ask

answer

are the ones that don't vary with the level of output (incurred even if quanitty = 0)

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Total costs

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The change in total cost from proudcing one more unit of output, or the incremental cost of an additional unit

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fixed costs

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Marginal cost

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Long run versus short run costs

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reductions in costs that result as a producer gains experience

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To maximize short-run (operating) profits, a firm should

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they tend to be related to cumulative output--how much output produced in the past, as opposed to level of output per period at a point of time

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Learning economies refers to

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it can produce any level of output in a given period (q) at a lower cost

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Because learning economies arise from the experience

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LR(MR)=LRMC

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When a firm has more experience in producing the good (cumulative output Q2>Q1)

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we move from the long-run (investment/planning) horizon to short run (operation) horizon

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The firm will want to choose a planned output qp, so that

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where the incremental value is equal to the incremental cost

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Once investment decisions have been made and capacity has been put into place..

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The practice of charging different prices to different customers for the same good (or for different units of the good) where the different prices are not based on cost differences

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When it is costly to supply additional quantities the efficient quantity is

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involves charging a different price to each customer for each unit in such a way that all the consumer surplus is extracted; also known as "perfect price discrimination"

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Price Discrimination

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charging different prices for different quantities of a good; an approximation to "perfect" price discrimination; "declining block pricing": "quantity/volume discounts"

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First degree price discrimination

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Charging different groups of customers (different "markets") different prices based on differences in their sensitivity to price (elasticity); market segmentation

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Second degree price discrimination

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Price discrimination may allow enough surplus to be captured so that Average Revenue exceeds ATC, making it profitable to serve the market

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Third degree price discrimination

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charging higher prices in high-demand periods than in low-demand periods because of differences in marginal cost (due to capacity constraints) at different output levels

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Serving niche markets: Even at the profit-maximizing price and quantity, revenue may not be sufficient to cover costs, leaving production unprofitable...

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not price discrimination because price differences are cost based

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Peak-load pricing

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are not

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Peak load pricing is..

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demand-based (price discrimination) and cost-based reasons for differential pricing ______ mutually exclusive e.g. airline pricing, day/night phone rates; weekend/weekday ski-lift tickets

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Efficiency of Price discrimination

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the cost of joint production of two (or more) distinct products is less than the cost of producing the same amount of each product separately

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Neccessary conditions for price discrimination (it is not always possible for firms to price discrimination)

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With economies of scope, the entire LRAC function for q1 will shift down as production of q2 increases (and vice versa)

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Economies of scope exist when:

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Examples: lamb and wool; beef and leather; B-schools having multiple degree programs such as BBA, MBA; Microsoft operating systems, word processors, browsers

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With economies of scope, the entire LRAC function for q1 will shift _____ as production of q2 _____ (and vice versa)

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Economies of scope examples

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Set price = MC and charge flat fee to extract surplus

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Why tiered pricing?

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Set price > MC and charge smaller flat fee

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TWO PART PRICING (two-part tariffs) If customer demands are similar

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Set price equal to uniform profit-maximizing price

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TWO PART PRICING (two-part tariffs) If customer demands differ a little

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TWO PART PRICING (two-part tariffs) If customer demands differ a lot

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The supply curve represents

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The difference between the amount actually received for a given quantity of output and the minimum amount necessary to induce that quantity to be supplied

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Producer surplus or economic rent is a measure of net benefits accruing

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substitutes for a producer's product

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Producer surplus (or economic rent)

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the quantity of the firm product demanded will be more sensitive to price

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Competition creates

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With larger numbers of firms, each firms output is only a small part of the total, and its behavior has a negligible effect on the market

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More substitutes makes demand for the firm's product more elastic that is,

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Price

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With larger numbers of firms, each firms output is _______ part of the total, and its behavior has a ______ effect on the market

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In the short run is MC above min AVC

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What is MR for a firm in a perfectly competitive market?

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Supply = demand

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The individual firm's supply curve

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then a shortage (excess demand) exists, which tends to push the price up toward P*

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market equilibrium occurs where

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then a surplus (excess supply) exists, which pushes the price down toward P*

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If P < P*

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a quota imposed by country A is restriction on the quantity of a certain good that can be imported into country A

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If P > P*

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Quota

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Use Q= a+bp

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Tariff

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Covering its average total cost, including a "normal" rate of return

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For summing individual demand curves

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Average total cost declines as planned output increases

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A firm making zero economic profit is _______

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The existence of economies of scale implies

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Deadweight loss

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Why do we have quotas if they are both inefficient and hurt consumers more than they benefit producers?

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Concentrated benefits vs dispersed costs

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What are arguments against strategic trade barriers?

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Why do we have quotas if they are both inefficient and hurt consumers more than they benefit producers?

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shows that the burden of a tax tends to fall more heavily on the relatively less price sensitive (less elastic) (inelastic) party. Removal of the tax will therefore benefit that party the most

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rent-seeking activities

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Describes how the quantity demanded changes in response to a price change

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Tax incidence analysis

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Describes how sensitive quantity supplied of a good is to changes in price

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Price Elasticity of Demand

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economic term for understanding the division of a tax burden between stakeholders, such as buyers and sellers or producers or producers and consumers

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Price elasticity of supply

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They will only be willing to supply a given quanitty if price covers MC plus the tax

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Tax incidence

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They will only be willing to buy a given quantity if their WTP is at least the price plus the tax

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If suppliers pay the tax

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The relative elasticity of supply and demand

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If consumers pay the tax

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cause price (compensation) to fall (from W' to W'') but leaves sellers and buyers no better or worse off than before and has no effect on employment

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What determines who bears the burden of the tax?

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- Risk transfer: doesn't reduce risk, just shifts who bears it (ex. Insurance)
- Risk mitigation: perform activities that reduce risk (ex. Hard hats on a construction site)

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Shifting a cost from sellers (drivers) to buyers (companies)

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- Individuals have different risk tolerance (differential risk aversion)
- The allocation of risk affects incentives

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How to deal with risk?

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The allocatio of risk matters only where

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Probability (cost )*(cost)

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Risk neutral

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E(cost)

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they would always choose the option with the highest expected value regardless of the risks involved

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Risk averse

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only if its expected value is higher than that of a less risky alternative

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If people made their choices to maximize expected value

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which is the probability weighted average of the utility from each possible outcome

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Risk averse people will choose an action or a situation with higher risk

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diminishing marginal utility of wealth

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Risk averse people maximize expected utility (not expected value)

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it doesn't matter who bears the risk: wages adjust so that expected surpluses are the same

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Risk aversion implies

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then insurance premia are just another cost and the same analysis applies

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If workers and companies are risk neutral (or equally risk averse)

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There are gains to having employers bear risk

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If risks are insurable

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- Allocate risk to the low-cost risk bearer (i.e., the less risk averse party)
- If workers (drivers) are more risk averse than companies, companies should bear the risk

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If workers are more risk averse than companies

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risk aversion principle

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There are gains to having workers bear risk

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Moral hazard

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If workers affect the expected loss

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moral hazard principle

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Adverse selection

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many standardized (homogeneous) commodities and financial instruments

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Future markets

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- Future contracts are liquid that is can be readily bought and sold on organized exchanges
- You can risk reduction without having to search for a trading partner

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Future markets exist for

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the correlation of the price of good you have to sell with the price of the futures commodity (if prices move in opposite directions, a short hedge would increase risk

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Advantages of trading on future markets

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someone (a buyer) anticipates the need for a commodity in say Dec and wants to lock in current futures price. That person would then buy "long" promise to purchase at a specified price in Dec

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The ability to hedge depends crucially on

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a smaller expected loss when the expected value is the same

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A long hedge would be used where

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hedging or trade speculation

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Risk neutral people prefer

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hedge or guarantee the price at which the commodity is sold or purchased

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Futures can be used for

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it is possible to make a profit by trading futures, even if one does not have a direct interest in the underlying commodity

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Producers or purchasers of an underlying asset

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is an invest strategy used to protect (hedge) against the risk of a declining asset price in the future

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Since many commodity prices tend to move in predictable patterns

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a long hedge, which protects against rising prices

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Short hedge

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the entity is seeking to sell a commodity in the future at a specified price

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A short hedge is the opposite of

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The company seeking to buy the commodity takes the opposite position on the contract

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In a short-hedged position

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drive up futures price. Speculation sends a signal to the marker that wheat is likely to be more scarce than previously expected

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long-hedged position

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Speculation tends to

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What did Hayek say is the true economic problem of society?

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- contracts, negotiation, integration, auctions, posted / list prices, government

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How can we coordinate economic activity given that the so much of the knowledge and information needed to act rationally is dispersed and constantly changing?

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- Contracts that commit specific parties to future performances

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Other ways we organize economic activity

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value to the buyer of seller's performance

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Forward contracts

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seller's opportunity cost (the value of the seller's next best alternative)

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contract price

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price offered by alternative customer

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production costs

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contract damages

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buyer would perform only when v>Pk

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weird symbol

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If performance would result in an inefficiency, the parties have an incentive to renegotiate and split the gains from adaption between them

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With no enforcement,

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if there are no costs or impediments to bargaining, transactors will negotiate to an efficient outcome regardless of the organizational form

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Breaching and paying damages is not the only way to deal with contingencies.

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Organizational coase theorem

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an investment specially designed or located for a specific user that, as a consequence, has a significantly lower value in its next best alternative use (or with the next best user)

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Williamson argued that transaction costs can be traced to two human factors

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When a buyer and seller must locate their plants close to each other (and away from potentially partners) to be able to engage in exchange (e.g. co-location of coal mines and power generators)

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Relationship-specific investment

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when capital equipment is specially designed to meet a particular need and cannot be readily adapted for use by other parties (ex movie set, digital products)

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Site specificity

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firm-specific skills or knowledge

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Physical asset specificity

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large investments for a particular customer that would depress market price if released to the market

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human asset specificity

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situations in which the importance of timing makes delays costly (ex. Newspapers or perishables, construction, assembly line workers)

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Dedicated assets

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Rivian specified in the lawsuit that there is no alternative supplier for the custom designed seat packages for the electric van and it could take well over a year for it to find another vendor

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Temporal specificity

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Rivian

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Disadvantage: Increased exposure to supply disruptions from natural or market factors, greater vulnerability to strategic (opportunistic) behavior (hold ups

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What are some potential advantages of sole sourcing (using a single supplier for inputs)?

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What are some potential disadvantages of sole sourcing (using a single supplier for inputs)?

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the hazards of contracting are too great, vertical integration may become the best alternative

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When should a firm vertically integrate?

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would contract for low RSI procurements and vertically integrate high RSI ones

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If large relation-specific investments are necessary

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Firms wanting to choose the organizational form with the lowest transaction costs

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that are dissimilar from other activities in which the firm is engaged and for which there is greater uncertainty

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Market transaction costs rise with RSI and with complexity and uncertainty

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both the cost of transacting on the market and the costs of organizing internally

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Internal organization costs are likely to be higher for transactions

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selling two or more distinct products as a package (at a single price) (ex. Word and powerpoint, cable tv channels)

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Communicaton technologies tend to affect

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- requiring that a buyer of one product also buy one or more other products from the same firm; Xerox requiring copier customers to buy paper from Xerox

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Bundling

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Tying

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Why bundle products

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allows firms to capture more surplus more niche products will be profitable, increasing gains from trade (efficiency)

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The motive for bundling is considered a subtle form of price discrimination because it results in consumers seeing different implicit prices for the components of the bundle

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Having purchased the bundle the cost to the consumer of using or view goods in the bundle is zero

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Because bundling like other forms of price discrimination

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Selling heterogeneous items in a bundle reduces the amount of sorting and searching, saving transaction costs

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Bundling also addresses the problem of how to price nonrivalrous goods.

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Bundling and tying allow forms to extend a firm's monopoly power in one good to competitively produced good

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Where products differ greatly in quality and characteristics but all customers value products similarly sorting redistributes surpluses but adds no value to the transaction.

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All of the following are plausible reasons for why companies find it profitable to bundle or tie products, except:

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Moral hazard refers to the reduction in incentives to reduce the size or the probability of loss if you are insured against bad events

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All of the following are plausible reasons for why companies find it profitable to bundle or tie product

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if the value to the buyer is greater than the seller's opportunity costs

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Moral hazard refers to

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A transaction is efficient

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organizational form matters only to the extent that the costs of transacting under different organizational forms differ.

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As tax incidence analysis demonstrates,

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sorting and pricing of each tuna by species would not be worthwhile

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According to the coase theorem

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is if supply decreases relative to demand.

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As discussed in class, the large quantities and heterogeneity of tuna, and the relatively similar values tuna processors place on tuna makes it likely that

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The only shifts in supply and demand that will result in an increase in price and decrease in the quantity demanded

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according to transaction cost theory, the absence of a motive for integration

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Transaction cost theory says that

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The existing of spot and futures markets implies the absence of significant relationship-specific investments and therefore

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