Economic Analysis for Business Decisions Mid Term Review

ECONOMIC ANALYSIS FOR BUSINESS DECISIONS MIDTERM EXAM REVIEW SESSION PAGE MARKET DEFINITION, SUPPLY/DEMAND, ELASTICITIES 2 GOVERNMENT POLICIES 7 PRODUCTION/COST 13 NETWORK EXTERNALITIES 17 LEARNING CURVE 20 DYNAMIC DEMAND 25 TIME AND UNCERTAINTY 31 MONOPOLIES, MARKET POWER 36 MIDTERM SECRET KEY 42 Midterm Review 1 Market Definition A market is a collection of buyers and sellers, resulting in the possibility for exchange. Market boundaries are defined in both geographic terms and in terms of a range of products. • Demand Substitutability: − Would consumers adjust purchases of good A when the price of good B changes? • Supply Substitutability: − Would producers modify production of good A as a result of a change in the price of good B? Midterm Review 2 Market Definition Example: True / False: Fast food chains like McDonald’s, Burger King, and Wendy’s operate all over the United States. Therefore, from the consumer’s perspective, the market for fast food is a national market. Answer: False. San Francisco consumers won’t travel to New York to buy a BigMac there even if the price is lower (or has decreased) in New York. Midterm Review 3 Supply and Demand Where do the curves come from and what do they represent? • Demand − Aggregate reservation prices of the market. What consumers are willing to pay. − How much consumers will buy at a particular price − Linear Demand: Qd = a - b P − Isoelastic Demand: ln(Qd) = a - b ln(P) • Supply − Aggregate marginal cost curves of an industry − How much will producers provide at a particular price − Linear Supply: Qs = c + d P − Isoelastic Supply: ln(Qs) = c + d ln(P) Midterm Review 4 Elasticities An elasticity is a measure of the sensitivity of one variable to another. For our purposes, it is the percentage change in quantity (demanded / supplied) in response to a 1 percent increase in price, income, etc. • Price elasticity of demand − Linear Demand: P Ed = - b Q − Isoelastic Demand: Ed = - b • Price elasticity of supply – Linear Supply: P Ed = d Q – Isoelastic Supply: Ed = d • Cross-price elasticity of demand − Substitutes: positive cross price elasticity (butter and margarine) − Complements: negative cross price elasticity (cars and gasoline) Midterm Review 5 • Short run and long run elasticities may be different. – Consumable Goods: ESR < ELR (example: orange juice) – Durable Goods: ESR > ELR (example: cars) Example: True / False: The potential gain to the OPEC cartel from agreeing to production cutbacks and adhering to the agreement is greater if the elasticity of supply is low rather than if it is high. Answer: True. If supply is inelastic (e.g., low), a small production cutback will result in a large price increase. Example: What happens to elasticity along a linear demand curve as Q increases? Ed = -b*P/Q Thus, as Q increases, demand becomes less elastic. Midterm Review 6 Government Policies: Unregulated, Competitive Market • Consumers and producers buy and sell at market clearing price CS P0 PS • Consumer surplus: for some consumers, the value of the good exceeds the market price Q0 • Producer surplus: some producers produce units at a cost lower than the market price Measuring Impact of Government Policies: • Start with unregulated competitive market • Determine new price, quantity given government policy • DWL is resultant loss of welfare after all transfer of surplus between producers, consumers, government and foreign entities. Midterm Review 7 Government Policies: Price Control Unregulated Market: Price Control: Maximum Price P1 S S CS P0 PS D P0 B A C P1 D C – some producers can no longer sell the good Q0 Q1 Midterm Review A – Transfer from producers to consumers. Consumers who can purchase good do so at a lower P B – some consumers can no longer buy the good. 8 Q0 ∆CS = A – B ∆PS = -(A + C) DWL = -(B + C) Example: If supply is very inelastic, do consumers gain or lose on net from imposition of Pmax? Why? – If Pmax > PFree, then the price ceiling is irrelevant. Consumers will gain when Pmax < PFree when ∆CS is positive. Obviously, ∆CS will be positive when A > B as shown above. Given the demand curve depicted above, for very inelastic supply curves, A > B, therefore consumers will be better off. Midterm Review 9 Government Policies: Taxes Unregulated Market: S CS P0 Taxes: t Pd P0 PS D S A B t C D Ps D Q0 Pd = Ps + t QD = QD(Pd) QS = QS(Ps) QD = QS = Q1 Q1 Q0 ∆CS = -(A + B) ∆PS = -(C + D) Govt = A + D DWL = -(B + C) To solve taxes exercises, follow these steps: 1) Express QD = QD(Pd) and QS = QS(Ps) [Demand and Supply in terms of Pd and Pd] 2) Use [Pd = Ps + t] to replace Pd in the demand curve (or alternatively replace Ps in supply curve) 3) Equate QD = QS and solve for price Pd (or alternative Ps). Find Q1 using one of the equations and the price. 4) If you are asked for CS, PS and DWL, use the graph to calculate areas (remember to find the intercepts of the curves on the y-axis by making Q=0 in each curve). Midterm Review 10 Impact of a tax depends on εs and εd. εs Fraction of tax borne by consumers = ε − ε = PASS THROUGH FORMULA s d Note: the higher the elasticity of demand (supply), the less the burden for consumers (producers) Inelastic Demand Elastic Demand P S P S D D Q Q Elastic Supply P P Inelastic Supply S S D D Midterm Review Q 11 Q Government Policies: Tariffs/Quotas Without a tariff or quota, a company will import a good when Pworld < Pmarket if there were no imports Unregulated Market: Tariff OR Quota Sdomestic CS Sunregulated Pworld PS Imports S* P1 Pworld A B D Tariff C Quota Qdomestic Qdomestic Q1 Q0 Q0 ∆CS = -(A + B + C + D) ∆PS = A Quota: Gain to Foreign Producers = D Tariff: Gain to Government =D DWL = -(B + C) Midterm Review 12 Production Costs: Terms • Economies of Scale ¾ Means you can double output without a doubling of costs ¾ Marginal costs are less than average costs • Diseconomies of Scale ¾ Means that if you double output, you more than double costs ¾ Marginal costs are greater than average costs • Constant Costs ¾ If you double output, your costs exactly double ¾ Point where marginal costs equal average costs Midterm Review 13 Total Cost Fixed cost TC = 5000 + 20Q + 0.5Q 2 Variable cost (anything with ‘Q’ in it) Average Total Cost ATC = TC/Q = 5000/Q + 20 + 0.5Q 600 Fixed costs distributed over larger production volume 500 400 300 200 100 Midterm Review 40 0 37 0 34 0 31 0 28 0 25 0 22 0 19 0 16 0 13 0 10 0 70 40 10 0 14 Rising marginal cost (cost of producing one more unit rises as more units are produced) How do we find the minimum ATC? Note, before we reach minimum ATC, each additional unit costs LESS than the ATC (and results in a lower ATC); after we’ve passed minimum ATC, each additional unit costs MORE than the ATC (resulting in a higher ATC). At the minimum ATC, an additional unit produced costs the SAME as the ATC. Marginal Cost MC = ∂TC/∂Q 2 = ∂[5000 + 20Q + 0.5Q ]/ ∂Q = 20 + Q Minimum ATC at intersection of ATC and MC: 20 + Q Q 0.5Q 0.5Q2 Q2 Q Midterm Review 15 = = = = = = = 5,000/Q + 20 + 0.5Q 5,000/Q + 0.5Q 5,000/Q 5,000 5,000/0.5 10,000 100 units Economic vs. Accounting Cost Opportunity costs Î Economists include opportunity costs as part of cost - accountants do not. Opportunity costs are the cost of opportunities forgone by not putting a resource to the highest value alternative use. Depreciation Î Economists and accountants measure depreciation differently. Economists focus on actual wear-and-tear of equipment when determining the decline in economic value of machines - accountants will classify assets according to tax rules to allocate the cost of an investment over time. How do you measure wear-and-tear on a machine? determine the current market value of the asset and then deduct the value of the same asset manufactured one year earlier. What if you bought a highly specialized machine, and its value in the marketplace is now zero (e.g. machine which is obsolete)? It is a sunk cost. Sunk costs Î these are costs already spent and unrecoverable - Economists exclude these from consideration once expended; accountants may include them under certain conditions (e.g. if an obsolete machine which cannot be resold is not fully depreciated for accounting purposes, it is still a “cost” for the accountant). User cost of capital Î Cost of holding onto capital. UCC = (r + depr %) Vt Midterm Review 16 Network Externalities • Quantity Demanded depends on belief / knowledge about demand of others • Direct network externalities (e.g., email, IM, telephone) • Indirect network externalities (e.g., platforms like Windows, XBox) • Snob effect (e.g., works of art, sports cars) Midterm Review 17 Network Externalities see Figure 4.15: Positive Network Externality: Bandwagon Effect Robert Pindyck and Daniel Rubinfeld, Microeconomics, 5th edition, (Upper Saddle River, NJ: Prentice-Hall, 2000) Midterm Review 18 TRUE/FALSE The snob effect makes market demand more elastic. FALSE: If Rolex lowers its prices, many consumers will purchase Rolex watches because of the price effect (i.e., from the definition of the demand curve, when P goes down, Q demanded goes up). Because there is a snob effect, however, the value of a Rolex will decline, and the extent to which Q demanded increases will be reduced. Thus, the snob effect makes market demand less elastic. Midterm Review 19 Learning Curves When do they occur? When costs decrease with cumulative production (workers and managers learn how to “optimize” as they keep producing). Examples: aircraft assembly, chip production, etc. NO LEARNING ACt Qt Period 1 2 3 4 LEARNING 10 30 30 30 $ $ $ $ Period 1 2 3 4 975 375 375 375 NO LEARNING $1,400 $1,200 $1,200 $1,000 $1,000 $800 $800 $600 $600 $400 $400 $200 $200 $- $20 30 40 50 0 10 40 70 $ $ $ $ 975 262 215 198 CP=0 CP=10 CP=40 CP=70 0 60 10 20 30 40 50 60 Q Q The AC curve stays there! Any changes in AC are due to Economies or Diseconomies of Scale only. Midterm Review 10 30 30 30 ACt AC $1,400 10 CPt-1 LEARNING AC 0 Qt The AC curve SHIFTS DOWN because there is learning: As CP go up, the AC shifts down Important: The AC curve does not shift down indefinitely. There are limits for learning! 20 What is NOT a learning curve? • When the reduction in costs is due to reduction in input prices (not to increased CP) How does it look like in the equations? Basically, wherever you see “CP” on it, and the more CP the less costs (holding everything else equal), chances are there is learning going on. Examples: • lnACt = 1.75 - 0.20 lnQt - 0.25 lnCPt-1 • TC = 5,000 + (100×0.8CP)×Q + 0.05×Q2 • Etc. Midterm Review 21 Pricing with Learning Objective: Maximize TOTAL profits (Πtotal=πtoday+πtomorrow+π3+π4+…) • Myopic output/pricing decision (wrong): Set MR in every period = MC in every period. This way we ignore the learning benefit of producing extra units. • Correct approach: Set MC = MR + correction for reduced future costs from producing one more unit today This way we recognize the future learning benefits of producing more today. Pricing with Network Externalities The concept is similar to pricing with learning curves. In the presence of Network Externalities: Set MC = MR + correction for additional MR realized in the future due to bandwagon effect of one more unit now Midterm Review 22 Wait a minute! If I start selling at this low P*, I won’t be maximizing my current profits because MR Short term Elasticities (Absolute Value) • If price of good goes down, or if income of consumers goes up, result is a positive shock. Quantity Sold New Equilibrium Sales (long term effect after positive shock) Original Equilibrium Sales Positive Shock Time Midterm Review 25 Dynamic Demand Response – Non - Durables (cont.) • If price goes up or incomes go down, think of a negative shock Quantity Sold Original Equilibrium Sales Negative Shock New Equilibrium Sales (long term effect after negative shock) Time Midterm Review 26 Dynamic Demand Response – Non - Durables (cont.) • We can also observe the effect of a price increase on quantity sold using supply and demand charts. S P Initial Equilibrium S.T. Equilibrium ¾ Q decreases a little initially P’ P DLong-term DShort-term QLT QST Q Qsold 0 Midterm Review 27 L.T. Equilibrium ¾ Q decreases more later Dynamic Demand Response – Durable Goods • Examples are Automobiles, Washing Machines, Televisions. Items that are useful for a number of periods. • Quantity that you buy today depends on last period stock level, this period’s desired stock level, and number of units that go out of service and need replacing. • Right after a shock, the gap between actual stock and desired stock is the largest. • Short Term Elasticities > Long Term Elasticities (Absolute Value) Midterm Review 28 Time and Uncertainty – Present Value • Cash received at different points in time has differing values for a firm or individual • Present Value allows us to take a future stream of cash flow, profits, revenue, costs, etc. and convert them to a single comparable value for the present • Use interest rate or discount rate (R) to ‘convert’ future values to present values • NPV can be used for capital budgeting decisions—only choose projects with NPV > 0 PV = C0 + C1/(1+R) + C2/(1+R)2 + ….+ CT/(1+R)T where Ct is the (positive or negative) cash flow at time t Midterm Review 31 Time and Uncertainty – Uncertainty and Risk Aversion • Events and cash flows in the future are often uncertain, but can be modeled as a random variable • Expected value represents ‘average’ cash flow E(X) = p1X1+p2X2+p3X3+ ….+ pNXN • Firms can use expected value of cash flows to make capital budgeting decisions • Attitudes toward risk often dictate behavior: • Risk averse: These people prefer a certain outcome over an uncertain, or risky, outcome with the same expected value. • Risk neutral: These people have no preference for a certain outcome over an uncertain, or risky, outcome with the same expected value. • Risk loving: These people prefer an uncertain, or risky, outcome over a certain outcome with the same expected value. Midterm Review 32 Time and Uncertainty – Option Value • Uncertainty of future events often means there is value to waiting until the uncertainty is reduced or eliminated • The value of an option can be calculated based on the outcome of the uncertain events Example: A firm can develop a new line of either laptops or PDAs. Each will take have a development cost of $1,000,000. If the economy recovers, they can sell 1000 laptop units at $1500 each, or they can sell 5500 PDAs at $250 each. If the economy does not recover, they can sell 800 laptop units at $1000 each, or 5000 PDAs at $225 each. There is a 50-50 chance that the economy recovers. How much should the firm be willing to pay to keep both development options alive until they find out if the economy recovers? Answer: If the economy is good: Π (laptop) = 1000*$1500 - $1,000,000 = $500,000 Π (PDA) = 5500*$250 - $1,000,000 = $375,000 Ö produce laptops Midterm Review 33 If the economy is bad: Π (laptop) = 800*$1000 - $1,000,000 = -$200,000 Π (PDA) = 5000*$225 - $1,000,000 = $125,000 Ö produce PDA’s If we don’t know the state of the economy: Π (laptop) = 0.5*1000*$1500 + 0.5*800*$1000 – $1,000,000 = $150,000 Π (PDA) = 0.5*5500*$250 + 0.5*5000*$225 – $1,000,000 = $250,000 Ö produce PDAs If we select a product after determining the state of the economy, we can get expected profits of: 0.5*$500,000 + 0.5*$125,000 = $312,500 If we select a product before learning the state of the economy, we can get expected profits of: $250,000 Option value of keeping both options alive until we learn the state of the economy: $312,500 - $250,000 = $62,500 Midterm Review 34 Question (True or False?) When choosing between two capital projects, a firm will always choose the project with higher future cash flows in each year. Answer False. Why? Because of relative riskiness of each project. A riskier project will have a higher R as compared to a safer project. So although a project has higher future cash flows, it may have a lower NPV than a project with smaller future cash flows. Midterm Review 35 Monopoly: Market with only one seller (P&R fig. 10.3) • The objective is to maximize profits: Π=TR-TC • This requires MR = MC • Demand is the average revenue curve. If demand is linear, MR is linear. Therefore, it has the intercept and twice the slope as the inverse demand curve, P(Q). • Marginal revenue can be calculated from demand equation as: MR = d ( P ⋅ Q) dQ • Output is determined by solving MR = MC for quantity. Price is obtained by plugging the optimal output in the demand equation. • Reminder: A monopolistic market does not have a supply curve, in the sense that there is no one-to-one relationship between price and quantity produced. The reason is that the monopolist’s output decision depends not only on MC but also on the shape of the demand curve. Midterm Review 36 Monopoly power • A firm has monopoly power if it faces a downward sloping demand curve. Remember that in competitive markets firms face flat (completely elastic) demand curves at the market price. • A firm can have monopoly power even if it is not a monopolist. This happens, for instance, in the case of differentiated consumer goods like clothing. • The determinants of monopoly power are the elasticity of market demand, the number of firms in the market, the interaction among firms. • Market power can be measured by the ability of the firm to charge a markup above marginal cost. The degree of markup is related to the elasticity of demand: 1 P − MC =− P ED • Markup is higher when demand is less elastic. The intuition is that inflexible customers are willing to pay higher prices. Midterm Review 37 Question: A firm with monopoly power has a constant marginal cost of $10 per unit, and is charging a price of $20 per unit. (1) If the firm is maximizing profit, what is the elasticity of demand? (2) Suppose its elasticity of demand doubles. What price should it then charge? Answer: (1) Using the markup formula we have: 1 1 20 − 10 P − MC =− ⇒ = − ⇒ ED = −2 ED ED 20 P (2) We use the markup formula again to find the price: 1 P − 10 1 40 P − MC =− ⇒ =− ⇒ 4( P − 10) = P ⇒ P = = 13.33 ED −4 3 P P Midterm Review 38 Monopolistic vs. competitive markets • In a monopolistic market output is lower, price is higher and profit is higher than in a competitive market (where equilibrium is determined by the intersection of demand and supply). • Monopoly creates deadweight loss, since the firm restricts output to maximize profits. • Monopolies have social costs. Therefore, they are usually regulated (e.g. with price ceilings) or prohibited (anti-trust laws). • Natural monopolies exist when firms have economies of scale over the entire output range because multiple competitors could not survive in a competitive market. In this case, the government frequently allows the monopoly and regulates it. Midterm Review 39 Multi-plant production Optimal condition is MR = MC1 = MC2= MCtotal. Otherwise, profits could be improved by changing production levels. 1. Find MCtotal by horizontally adding the individual plants’ marginal cost curves. Horizontal sum is obtained by first solving marginal cost equations for quantities [obtaining Q1 = f(MCtotal), Q2 = g(MCtotal)] and then adding these expressions (Q = Q1 + Q2). 2. Determine optimal output for the firm by setting MR = MCtotal. 3. Calculate price by plugging total output into demand equation. 4. Determine individual output levels using marginal cost equations, using optimal MCtotal calculated above. Midterm Review 40 Question (True or False?) A monopolist has two plants, one in Italy and another one in France. Due to a new tax on labor, the marginal cost at the Italian plant goes up. Production at both plants should be reduced to reflect increased total marginal cost. Answer False. Why? Before the tax, the monopolist is producing at the point where marginal cost is the same at both plants. When the tax causes the marginal cost to rise at the Italian plant, the firm will shift production away from the Italian plant and to the French plant until the marginal costs are equalized. Midterm Review 41