Economics for Management

Question 1

Rational Actor Paradigm (RAP)

Answer 1

Assumes that people act rationally, optimally, and in their self-interest, thus responding to incentives.

Question 2

How to diagnose the source of any business dilemma (3 Q’s)

Answer 2

1. Who is making the bad decision?
2. Do they have enough information to make a good decision?
3. Do they have the incentive to make a good decision?

Question 3

General approaches to solving these issues…

Answer 3

1. Change the decision maker to somebody with better information or incentives
2. Give more info to the current decision maker (eg. Matrix structure)
3. Change the current decision makers incentives.

Question 4

Sunk / Fixed cost fallacy

Answer 4

Taking account of irrelevant costs (eg. keeping an incompetent employee because you’ve already invested thousands in their training)

Question 5

Hidden cost fallacy

Answer 5

Costs that are not accounted for in the decision making process (eg. maintenance costs)

Question 6

Economic Value Added (Economic Profit)

Answer 6

Takes into consideration Cost of Capital (equity) to avoid hidden cost fallacy.

Question 7

Marginal Cost

Answer 7

The cost to make one additional unit of output (Change in Cost / Change in Output) or TC (Unit 2) - TC (Unit 1)

Question 8

Average Cost

Answer 8

Per Unit cost of production (Total Cost / Quantity)

Question 9

Variable Cost Formula

Answer 9

Marginal Cost x Quantity

Question 10

Marginal Revenue

Answer 10

The revenue gained from selling one more unit. You only sell when MR > MC.

Question 11

Break even Point

Answer 11

FC / SP - MC

Question 12

Net Present Value

Answer 12

• initial investment
  + (Cash flow / 1 + Discount Factor^1)
  + (Cash flow / 1 + Discount Factor^2)
  + (Cash flow / 1 + Discount Factor^3)
  etc.

Question 13

Post-investment Hold Up

Answer 13

When 2 parties have a contract, and one seeks to take advantage of the party that has undertaken a large investment by changing the terms of the agreement (sunk costs cannot be recovered). Can be prevented through contracts.

Question 14

Law of diminishing returns

Answer 14

When more workers are added, productivity and output falls in the SR.

Question 15

Different returns to scale

Answer 15

Increasing returns to scale - A % increase in inputs leads to a more than proportional increase in output. LR

Constant returns to scale - A % increase in inputs leads to the same % increase in output. LR

Decreasing returns to scale - A % increase in input leads to a less than proportional increase in output. LR

Question 16

PED

Answer 16

responsiveness of demand to a change in price.

% Change in QD / % Change in $ = PED

Question 17

Economies of scope

Answer 17

The cost of producing two products together is cheaper than the cost of producing them separately.

Question 18

Economies of scale

Answer 18

The cost advantages a company enjoys from increasing the scale of it’s operations.

Question 19

How does a firm sell substitutes and complements?

Answer 19

A firm sells substitutes by moving them further apart geographically or in product attributes to ↑ profit

A firm sell complements by reducing selling price to increase MR and profit of both products.

Question 20

What does price advertising do to demand?

Answer 20

Price advertising makes demand more elastic (lower price = more demand).

Question 21

What does product advertising do to demand?

Answer 21

Product advertising makes demand more inelastic (quality and celebrity endorsements).

Question 22

Bundle of substitutes and complements elasticity

Answer 22

Bundles of substitute are inelastic as you can’t switch.

Bundles of complements are elastic as consumers can substitute towards alternative goods.

Question 23

Price Discrimination

Answer 23

when a firm charges a high price in an inelastic market and sells the additional stock a lower price in an elastic market e.g. Adults and Students.

Question 24

Conditions for price discrimination to occur

Answer 24

• No market arbitrage or seepage
• Price setting power
• two consumer groups with different PED’s

Question 25

Optimal Price formula

Answer 25

MC * (PED / PED + 1)

Question 26

Game Theory

Answer 26

Devised to consider strategic situations Consists of 3 elements: - Players - Strategies - Payoffs

Question 27

Sequential Move Game (Tree Diagram)

Answer 27

Players take turns after evaluating their rivals moves.

Question 28

Simultaneous Move Game (Table Diagram)

Answer 28

Each player chooses their actions without any knowledge of the actions chosen by other players eg. prisoners dilemma.

Question 29

Nash Equilibrium

Answer 29

A situation where no player could gain by changing their own strategy. In sequential, both parties can achieve best outcome. In simultaneous, both parties act self interestedly.

Question 30

Expected Value Formulae

Answer 30

(Risk 1 % x Payoff 1) + (Risk 2 % x Payoff 2) cont.

Question 31

Difference between Moral Hazard and Adverse Selection

Answer 31

Moral Hazard is when an individual feels more inclined to take risks if someone else bears the costs. Adverse Selection is when one party has more information than the other, and use this to their advantage.

Question 32

How to resolve adverse selection

Answer 32

Screening - identifies high & low risk individuals, to enable insurance companies to set prices depending on their target market. Signalling - Consumers reveal info about themselves to the insurance company eg. low risk to lower costs.

Question 33

Principal-Agent problem How it can be resolved?

Answer 33

When an employees refuses to carry out a task as their incentives don't align with the employers. solution - incentive pay e.g. commission, however, exposes agent to risk.