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Thinking like an economist
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Rationality, Incentives, and Constraints
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Rationality
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Individuals have goals and will try to achieve these goals in the least costly way possible
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Incentives
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The costs and benefits of an action
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Constraints
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The limits within which we make our choices, which are fixed in the short run
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Preferences
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They matter too but we try not to lean on them. Instead, we look for incentives and constraints
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Questions to ask - Ch.1
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1. Who made the bad decision?
2. Did they do so because they didn't have enough info?
3. Do they have an incentive to make a better decision?
2. Did they do so because they didn't have enough info?
3. Do they have an incentive to make a better decision?
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Ways to solve questions - Ch.1
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1. Let someone with better incentives or info make the decision
2. Provide the decision-maker with more information
3. Change the incentives to bring about better decisions
2. Provide the decision-maker with more information
3. Change the incentives to bring about better decisions
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The Fundamental Law of Exchange
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When two parties engage in a voluntary transaction, wealth is created (wealth can be subjective)
Exchange is a positive-sum game
Assets are moving from lower-valued to higher-valued uses
Exchange is a positive-sum game
Assets are moving from lower-valued to higher-valued uses
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What role do governments play in wealth creation? (Double-Edge Sword)
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1. Protect private property rights, allowing exchange to occur
2. Provide legal services to adjudicate contracts and settle disputes
2. Provide legal services to adjudicate contracts and settle disputes
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Wealth Destroying Policies
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Taxes, Subsidies, Price Controls
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Taxes
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Increase the cost of a transaction or an action
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Subsidies
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Increase the benefit of taking an action
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Price Controls
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Restrictions that allow trade only at certain prices
Price Floor - restrict trade BELOW a certain price
Price Ceiling - restrict trade ABOVE a certain price
Price Floor - restrict trade BELOW a certain price
Price Ceiling - restrict trade ABOVE a certain price
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Core Concepts in Economics - Efficiency
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Economies are efficient when all assets are employed in their most highly-valued uses
Moving towards efficiency increases total wealth - identify inefficiencies, identify opportunities for wealth creation
Moving towards efficiency increases total wealth - identify inefficiencies, identify opportunities for wealth creation
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Why might performance compensation caps be bad?
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Compensation caps can discourage employees from being productive after the cap
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Which of the following is NOT one of the three problem-solving principles laid out in Chapter 1?
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Under whose jurisdiction is the problem
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The rational-actor paradigm assumes that people do NOT
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Use rules of thumb
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Wealth creating transactions are more likely to occur
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All of the above (with private property rights, strong contract enforcement, & black markets)
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A price ceiling
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is a government-set maximum price
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Voluntary transactions
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Always produce gains for both parties
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Fixed costs
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Costs that do not vary with output
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Variable costs
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Costs that depend on-and increase-with output
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Total costs
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Fixed plus variable costs
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Opportunity cost
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The highest valued alternative we give up when we take an action
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Sunk cost fallacy
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When you take into account irrelevant costs when making a choice; can't get your money back
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Hidden cost fallacy
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When you ignore relevant costs when making a choice
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How do marginal costs and marginal revenue change?
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Marginal cost tends to rise as we produce more of a good
Marginal revenue tends to fall as we sell more of a good
Marginal revenue tends to fall as we sell more of a good
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Rules of Thumb for MR & MC
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If MR > MC, then produce the next unit
If MC > MR, produce one less unit
If MR = MC, don't produce any more, or any less - you're profit maximizing
If MC > MR, produce one less unit
If MR = MC, don't produce any more, or any less - you're profit maximizing
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Compounding
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Future value = (present value) x (1+r)^k
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Discounting
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Present value = (future value) / (1+r)^k
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Net Present Value
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The difference between the value of the future benefit today and the cost of the investment
If the NPV is POSITIVE, take the deal. If the NPV is NEGATIVE, pass
If the NPV is POSITIVE, take the deal. If the NPV is NEGATIVE, pass
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Breaking even
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Selling enough to cover your costs
Q = F / (P-MC)
F = Fixed cost
P = Price you sell at
MC = Marginal cost
Q = Quantity
Q = F / (P-MC)
F = Fixed cost
P = Price you sell at
MC = Marginal cost
Q = Quantity
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Shut Down Decisions
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When to shut down: when the revenue you earn is less than the costs you can avoid
Short run: your price has to cover marginal cost
Long run: your price has to cover total costs
Fixed costs are "avoidable" in the long run
Short run: your price has to cover marginal cost
Long run: your price has to cover total costs
Fixed costs are "avoidable" in the long run
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The Hold-up Problem
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Usually comes up when you're to make an investment that has sunk up-front costs and is highly specific
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Vertical Integration
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Have the company buy the machine and rent it to the producer
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After graduating from college, Jim had three choices, listed in order of preference: (1) Move to Florida from Philadelphia, (2) work in a car dealership in Philadelphia, or (3) play soccer for a minor league in Philadelphia. His opportunity cost of moving to Florida includes
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The income he could have earned at the car dealership
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The fixed-cost fallacy occurs when
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A firm considers irrelevant costs
A firm considers overhead or depreciation costs to make short-run decisions
A firm considers overhead or depreciation costs to make short-run decisions
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When economists speak of "marginal," they mean
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Incremental
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Managers undertake an investment only if
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marginal benefits are greater than marginal costs
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A firm is thinking of hiring an additional worker to their organization who can increase total productivity by 100 units a week. The cost of hiring him is $1,500 per week. If the price of each unit is $12,
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The firm should not hire the worker since MR < MC
(100 units * $12 price) = $1,200 revenue < $1,500 cost
(100 units * $12 price) = $1,200 revenue < $1,500 cost
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Assume a firm has the following cost and revenue characteristics at its current level of output: price = $10, average variable cost = $8, and average fixed cost = $4. This firm is
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Incurring a loss per unit of $2 but should continue to operate in the short run
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What is the net present value of a project that requires a $100 investment today and returns $50 at the end of the first year and $80 at the end of the second year? Assume a discount rate of 10%
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$11.57
(50/1.1) + (80/1.12) = 111.57 - 100
(50/1.1) + (80/1.12) = 111.57 - 100
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In early 2008, you purchased and remodeled a 120-room hotel to handle the increased number of conventions coming to town. By mid-2008, it became apparent that the recession would kill the demand for conventions. Now, you forecast that you will only be able to sell 20,000 room- nights that cost on average $50 per room per night to service. You spent $20 million on the hotel in 2008, and your cost of capital is 10%. The current going price to sell the hotel is $15 million. What is your break-even price?
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Break-even price is $125
Selling price = $15,000,000 * Cost of Capital = 10%
= $1,500,000 / 20,000 rooms-night = 75 + $50 per room
Selling price = $15,000,000 * Cost of Capital = 10%
= $1,500,000 / 20,000 rooms-night = 75 + $50 per room
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Consumer Surplus
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The difference between the maximum price that a consumer is willing to pay for a given quantity, and the market price that consumer has to pay
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Price Elasticity
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How responsive quantity demanded is to a change in pruce
A big change means your demand curve is elastic
A small change means your demand curve is inelastic
A big change means your demand curve is elastic
A small change means your demand curve is inelastic
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Price Elasticity pt. 2
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IeI = %ΔQuantity demanded / %ΔPrice (Always negative)
IeI > 1 = demand is elastic
IeI < 1 = demand is inelastic
IeI = [(Q1 - Q2)/(Q1 + Q2)] / [(P1 - P2)/(P1 + P2)]
IeI > 1 = demand is elastic
IeI < 1 = demand is inelastic
IeI = [(Q1 - Q2)/(Q1 + Q2)] / [(P1 - P2)/(P1 + P2)]
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Price Elasticity pt. 3
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When demand is elastic:
Raising price decreases revenue
Lowering price increases revenue
When demand is inelastic:
Raising price increases revenue
Lowering price decreases revenue
Raising price decreases revenue
Lowering price increases revenue
When demand is inelastic:
Raising price increases revenue
Lowering price decreases revenue
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Price Elasticity pt. 4
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Perfectly inelastic is a straight vertical line
Perfectly elastic is a straight horizontal line
The steeper the slope, the more inelastic
Perfectly elastic is a straight horizontal line
The steeper the slope, the more inelastic
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Price Elasticity pt. 5
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Goods with more substitutes are more elastic
Demand for brands is more elastic than industry aggregates
Products with many complements are less inelastic
In the long run, demand curves become more elastic
As price increases, demand becomes more elastic
Demand for brands is more elastic than industry aggregates
Products with many complements are less inelastic
In the long run, demand curves become more elastic
As price increases, demand becomes more elastic
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Price Elasticity and Decisions
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Factor elasticity = (%ΔQuantity demanded) / %Δfactor
For income:
Positive = normal goods
Negative = inferior goods
For income:
Positive = normal goods
Negative = inferior goods
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Cross Elasticity
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Change in quantity demanded of Good A in response to a change in price of Good B
Positive = Substitutes
Negative = Complements
Positive = Substitutes
Negative = Complements
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Returns to Scale
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Constant returns to scale - when long-run average costs are constant with respect to output
Diseconomies of scale - when long-run costs rise without output
Economies of scale - when long-run costs fall with output
Diseconomies of scale - when long-run costs rise without output
Economies of scale - when long-run costs fall with output
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Economies of Scale
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Depends of how much you produce
For economies of scale, average total cost decreases as you produce more of a good.
For economies of scale, average total cost decreases as you produce more of a good.
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Economies of Scope
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Depend on the variety of what you produce
For economies of scope, average total cost will fall as you produce more varieties of goods
For economies of scope, average total cost will fall as you produce more varieties of goods
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It's lunch time, you are hungry and would like to have some pizza. By the law of diminishing marginal value,
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You would pay more for your first slice of pizza than your second
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An economist estimated the cross-price elasticity for peanut butter and jelly to be 1.5. Based on this information, we know the goods are
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Substitutes
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Which of the following is the reason for the existence of consumer surplus?
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Some consumers are willing to pay more than the price
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What is the slope of a demand curve?
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Downward
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What are the axis labels on a graph
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Vertical axis (y-axis) = Price
Horizontal axis (x-axis) = Qty Demanded
Horizontal axis (x-axis) = Qty Demanded
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George has been selling 5,000 T-shirts per month for $8.50. When he increased the price to $9.50, he sold only 4,000 T-shirts. What is the demand elasticity?
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(5,000-4,000)/(5,000+4,000) / (8.50-9.50)/(8.50+9.50) = -2
-2 = I2I
-2 = I2I
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Microsoft found that instead of producing a DVD player and a gaming system separately, it is cheaper to incorporate DVD playing capabilities in its new version of the gaming system. Microsoft is taking advantage of
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Economies of scope
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What might you reasonably expect of an industry in which firms tend to have economies of scale
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A small number of firms
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Once marginal cost rises above average cost,
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Average costs will increase
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Demand Curves
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Shifts in the demand curve are changes in demand
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What shifts demand?
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Change in price of substitutes
Change in price of complements
Change in tastes (preference)
Change in expectations
Change in income
Change in population
(Decreases usually means shift to the left)
Change in price of complements
Change in tastes (preference)
Change in expectations
Change in income
Change in population
(Decreases usually means shift to the left)
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What is the slope of the supply curve?
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Upward
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Supply Curves
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Shifts in the supply curve are changes in supply
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What shifts supply?
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Changes in technology (shifts outwards)
Taxes and subsidies (increase in taxes shifts inwards)(Subsidies shifts outwards)
Entry/exit of producers
Decrease in input costs
Changes in expectations
Changes in opportunity costs
Taxes and subsidies (increase in taxes shifts inwards)(Subsidies shifts outwards)
Entry/exit of producers
Decrease in input costs
Changes in expectations
Changes in opportunity costs
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Equilibrium price
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Price at which quantity supplied equals quantity demanded
The equilibrium point is the efficient point
The equilibrium point is the efficient point
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Perfect Competition
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A theoretical model of competition in which:
-Firms produce goods or services that are virtually the same (very close substitutes, very elastic demand)
-There are many firms in the industry (lots of competition)
-Every firms faces the same costs
-Firms can freely enter and exit the industry at will
-Firms produce goods or services that are virtually the same (very close substitutes, very elastic demand)
-There are many firms in the industry (lots of competition)
-Every firms faces the same costs
-Firms can freely enter and exit the industry at will
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Perfect Competition pt. 2
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Perfectly competitive firms cannot impact price themselves; they take the market price as given
They are "price takers"
Marginal revenue in this case is just the market price
They are "price takers"
Marginal revenue in this case is just the market price
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Profits and the Long Run
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In the long-run, no firm earns a profit. Profits are ZERO
Profits exist but for short periods of time, but are eventually competed away
Accounting profit may exist but economic profit goes to zero
In competitive industries, every asset earns the same return
This holds for labor markets too
Compensating differentials equalize the returns to labor
Profits exist but for short periods of time, but are eventually competed away
Accounting profit may exist but economic profit goes to zero
In competitive industries, every asset earns the same return
This holds for labor markets too
Compensating differentials equalize the returns to labor
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Monopoly
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Monopoly firms:
Produce products/services with no substitutes
Face no rivals
Benefit from entry barriers
Raise price by restricting output
Produce products/services with no substitutes
Face no rivals
Benefit from entry barriers
Raise price by restricting output
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When demand for a product falls, which of the following events would you not necessarily expect to occur?
answer
A decrease in the supply of the product
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Say the average price of a new home in Lampard City is $160,000. The local government has just passed new licensing requirements for housing contractors. Based on possible shifts in demand or supply and assuming that the licensing changes do not affect the quality of new houses, which of the following is a reasonable prediction for the average price of a new home in the future?
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$170,000
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The price of peanuts increases. At the same time, we see the price of jelly (which if often consumed with peanut butter) rise. How does this affect the market for peanut butter?
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The demand curve will shift to the left; the supply curve will shift to the left
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Holding other factors constant, a decrease in the tax for producing coffee causes
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The supply curve to shift to the right, causing the prices of coffee to fall
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What is the main difference between a competitive firm and a monopoly firm?
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Monopoly firms can generally earn positive profits over a longer period of time
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A firm in a perfectly competitive market (a price taker) faces what type of demand curve?
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Perfectly elastic
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What would happen to revenues if a firm in a perfectly competitive industry raised price?
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They would fall to zero
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If a firm in a perfectly competitive industry is experiencing average revenues greater than average costs, in the long-run
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Some firms will enter the industry and prices will fall
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Industrial Organization View
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A firm's profitability depends on characteristics of the industry it is in
Relevant factors:
Low supplier power
Low buyer power
Low entry threat
Low threat of substitutes
Low levels of rivalry
Relevant factors:
Low supplier power
Low buyer power
Low entry threat
Low threat of substitutes
Low levels of rivalry
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Supplier power
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Ability of suppliers to charger higher prices and capture more value
-Common when: production involves "critical" inputs, or there are few suppliers in a market
-Common when: production involves "critical" inputs, or there are few suppliers in a market
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Buyer power
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Ability of buyers to demand lower prices, capturing value
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Entry threat
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Ability of firms to enter industry and take profits (high barriers to entry)
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Substitue threat
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Ability of consumers to switch to other products, even in other industries
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Low rivalry
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Low "intensity" of competition. Usually related to the number of firms in an industry
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Resource View
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Firms derive advantages from superior resources
Resources - the tangible and intangible assets firms use to conceive of and implement strategies
Valuable and rare resources can generate advantages
Resources must be immobile and heterogenous
Resources - the tangible and intangible assets firms use to conceive of and implement strategies
Valuable and rare resources can generate advantages
Resources must be immobile and heterogenous
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Resources are hard to imitate if:
answer
1. They flow from a firm's history, and thus hard to recreate
2. The link between the resources and advantage is unclear
3. Resources are complex, and hard to recreate
2. The link between the resources and advantage is unclear
3. Resources are complex, and hard to recreate
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Final Notes on Strategy
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Cutting costs is only viable if reduction is hard to imitate
Reducing competition can be easy if you enlist the state
Finally, you can differentiate your product
-Reducing the elasticity of your demand curve lets you impact price directly
Reducing competition can be easy if you enlist the state
Finally, you can differentiate your product
-Reducing the elasticity of your demand curve lets you impact price directly
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The Market for Currency
answer
If one dollar can buy you 300 Yen in 2020, but 400 Yen in 2021, the dollar has appreciated (strengthened)
Conversely, the Yen has depreciated (weakened) relative to the dollar
The supply of dollars is the demand for Yen
Conversely, the Yen has depreciated (weakened) relative to the dollar
The supply of dollars is the demand for Yen
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