Midterm Flashcards
(26 cards)
risk averse
prefers receiving the expected value of a risky prospect to facing that prospect
risk neutral
indifferent between risky prospects and their expected value
risk seeking/loving
prefers to face a risky prospect rather than receive its expected value
Certainty Equivalent
What is the smallest offer from the bank you would accept to quit the game?
Risk Premium
What is the difference between the EV and your certainty equivalent?
Economies of Scale
average costs are decreasing in quantities of same product
Economies of Scope
average costs across two distinct product lines will decrease if produced together (synergies).
• Examples:
• If you produce laptops, it is cheaper to also produce servers.
• If you have large machined production, it’s cheaper to produce more machined types
John Deere: Summary
• Allocation of indirect costs
• First determine which can be tied to products and which are true “overhead” (e.g., CEO pay)
• Don’t create an “overhead rate” because this distorts
“economies of scale” (or conversely, distorts
diseconomies of scale)
• Use economic depreciation and not accounting depreciation: you care only about true replacement costs of assets!
• General Overhead only matters for total bottom line, not for individual product pricing! (i.e., you need to make a profit…)
Optimal Behavior
• What to produce: every unit for which the income
on that unit (in this case the price) is greater than
the cost
• What not to produce: any unit for which the
income on that unit (in this case the price) is less
than the cost
• This simple rule includes the intuition for monopoly
pricing going beyond a fixed price and a linear cost
function.
• NOTE: AC(q) is not playing a role for how much to
produce, only for if to produce at all!
The Sunk Cost Fallacy
Definition: Sunk costs are costs that are spent or committed in an irreversible way.
Key Principle: Ignore costs that are not affected by your decision.
Key Hurdle: Whether we treat a cost as sunk depends on the decision we are considering.
Takeaways- COST
- There are many ways to think about costs; which you use depends on what you are using it for.
- For this reason, accounting costs can be deeply misleading when mistaken for economic costs.
- ”Intuitive” and ad hoc decision-making systematically falls into traps, including but not limited to:
1. The average cost fallacy, and
2. The sunk cost fallacy.
Willingness to Pay (WTP)
Definition: the highest price at which a consumer would buy a product or service
• If price > WTP, consumer will not buy
• If price = WTP, consumer is indifferent
• They are just as happy buying as not buying
• If price < WTP, consumer will buy
WTP minus price equals consumer value
• Value = WTP –Price
• Also known as “consumer surplus”
Consumer Demand Curve
•Definition: the quantitative relationship between prices and sales volume- All else held constant
Demand curve plots consumers’ WTP
•Starts with highest WTP in the population
•Sales equal zero for any price > WTPMAX
•As price decreases, quantity increases
•Ends with the number of sales that would occur if the price was zero (i.e., free)
Revenue
Revenue is price times quantity (R = P*Q)
Calculating Marginal Revenue
Derivative of Revenue
- MR = ΔR/ΔQ for a small change (Δ) in Q
- The per-unit change in revenue for
marginal effect
𝑀R(𝑄)=𝑃(𝑄)+[𝜕P(𝑄)/𝜕Q]×𝑄
•The first term, P(Q) is the marginal effect: if I sell one more unit, my revenue goes up by the sale price.
inframarginal effect:
𝑀R(𝑄)=𝑃(𝑄)+[𝜕P(𝑄)/𝜕Q]×𝑄
The second term, the derivative of price times quantity, is the inframarginal effect: the discount I give on all other units to capture the extra sale.
Marginal Revenue and Elasticity
• Consumer demand is often characterized by “elasticity”, which directly links to MR
- Elastic means MR > 0 (Q is “sensitive” to P)
- Inelastic means MR < 0, (Q is “insensitive”)
Definition: Elasticity = % change in sales when price is decreased by a small %
=(Δ𝑄/𝑄)/(Δ𝑃/𝑃)
Takeaways- Demand
- Demand is driven by willingness to pay, which varies across consumers.
- Understanding the demand curve is crucial for pricing.
• Optimal markups depend on the shape of the demand curve
• Forgiving in a neighborhood of optimal
• Justifies experimentation and market research
Profit
Profit = total revenue (P*Q) –total cost
Marginal Cost (MC)
Definition: the incremental cost of selling an additional unit of a product/service
• MC = ΔC/ΔQ for a small change (Δ) in Q
• The “per-unit” change in total costs associated with a small increase in volume
• In our case, marginal cost = $1.50 per bar
- For each additional snack bar we sell, our total costs will rise by $1.50
The Inverse Elasticity Pricing Rule
Lerner Markup.
𝑀R(𝑄) = P(Q)(1 +1/𝜖)
And
𝑀R(𝑄) = 𝑀C(𝑄)
Then
[P(Q) - 𝑀C(𝑄) ]/ P(Q) = - 1/𝜖
Markets with HIGH demand elasticity
Markets with HIGH demand elasticity
(at the optimal price)
• −1/𝜖~0, so markups are very small.
Firms with close substitutes, or price-sensitive consumers.
Markets with LOW demand elasticity
Markets with LOW demand elasticity
(at the optimal price)
−1/𝜖 s larger, so 𝑃>𝑀C
Monopolists or firms with market power
