ECON 101 Final Material (UMICH - Wolfers)

expected utility

average utility if you make a choice: EU = (probability of success * utility gained if success) + (probability of failure * utility lost if fail) (choose the highest expected utility)

if you are very risk ___, your marginal utility curve is (flat/steep) and diminishes (slowly/quickly)

averse, steep, quickly

profit margin

avg revenue - avg cost of production (larger in imperfect competition than it would be under perfect competition)

you will have more market power when you have (more/fewer) competitors

fewer

marginal supplier

firms keep entering the market until P=AC for the marginal supplier, but if you are not the marginal supplier, your costs are less than their costs so you will still profit

pay for performance

linking income to performance quality/quantity (can backfire to lead to less of other good things or cutting corners)

strategic plan

list of instructions to respond in any situation

payoff table

lists your choices vs other player's outcomes, showing all possible outcomes and payoffs (break down choices individually and think about separately)

thinking slow

logical decisions that take cognitive effort

high deductibles will attract ___ cost customers, while low deductibles will attract ___ cost customers

low, high

switching costs

makes it costly for customers to switch to buying from another business (demand side barrier) (ex: hassle to switch, rewards to stay, network effect)

monopolistic competition

many small businesses competing selling differentiated products (each seller has a "monopoly" on each specific kind but they are also all in competition with each other)

adverse selection results in ___ failure

market

perfect competition

markets in which a) all businesses in the industry sell an identical good and b) there are many buyers and sellers who are all small relative to the market

reservation price

max price a customer will pay (equal to their marginal benefit)

solutions to principal-agent problem

monitoring, complements to good behavior, give people stakes in the outcome (internalize the externality), government and social norms, picking the right agents

solutions to adverse selection of sellers

third party verification, quality signalling, government intervention

accounting profit

total revenue a business receives (all income from all sources) minus explicit financial costs (all money that leaves the business)

diminishing marginal utility

as you get more money, the value of a single dollar diminishes

under monopoly, the firm demand curve (</>/=) market demand curve

=

marginal revenue equation

MR = P - (change in P * Q)

find P+Q when given marginal revenue curve, firm demand curve, and marginal cost (remember that MC =/= Supply in imperfect competition)

Q = where MRC meets MC, P = point on DCf immediately above Q

firm demand curve

Quantity demanded of buyers from an individual firm as Price changes

bargaining power

ability to negotiate a better deal (determined by next best alternative - buyers can buy from someone else or do without, sellers can sell to someone else or reduce production)

economic profit

accounting profit minus opportunity cost (ex: foregone wages, foregone interest, current benefits/job) (focus on the best decision, not money flow)

hedging

acquire an offsetting risk (take a risk that bets on the bad outcome so you always come out on top)

moral hazard

actions taken which are not fully observable and you are partially insulated from the consequences

marginal revenue

addition to total revenue from selling one more unit (reflects the output effect - discount effect)

collusion

agreement between different companies to limit competition such as by agreeing to not lower prices or improve products (ILLEGAL)

coordination game

all players have a common interest in coordinating their choices (ex: phone calls, protesting)

with no price competition, you should differentiate your product so it is ___ relative to your competitors

as close as possible

the amount of potential entrants varies based on ___

barriers to entry

anti-coordination game

best response is to take a different but complementary action to the other player (ex: entering a business, avoiding traffic)

nash equilibrium

both players pick their best response (box in which there are as many check marks as players) (this means that each player chose their best option AND correctly predicted the other player's best option)

risk spreading

breaking a big risk into smaller ones that can be shared (lowers stakes for participants, more willing to take risk)

examples of entry deterrence barriers

build excess capacity to show strength/resources, stockpile financial resources, brand proliferation (fill all niches so nothing for competitors), build reputation for fighting

conditions for price discrimination

business has market power, can prevent resale, able to target right prices to right customers

vertical integration

businesses along a production chain combine (good: suppliers can't exploit you, reduce transaction costs, eliminate supplier market power, less within-brand competition) (bad: weaker incentives to innovate, less specialization)

product differentiation introduces a tradeoff between being attractive to as many ___ as possible while also being as different from as many ___ as possible

buyers, competitors

perfect price discrimination

charging each customer their reservation price (highest price possible, make every possible sale)

natural monopoly

cheapest/most efficient for a single business to service the market (marginal costs decrease as output increases, no competition bc new businesses always at disadvantage)

simultaneous game

choose without knowing the other player's choice (make the table, find equilibrium)

systematic risk

common across the whole economy (diversification cannot fix this)

solutions to multiple equilibria

communication (only works w mutual trust), focal points and norms, laws and regulations

non-price competition

competing to win customers by differentiating your product

price competition

competing to win customers by offering lower prices (most likely when products are similar, prices easily observed, switching costs low)

competitive forces of the market (5)

competition from existing competitors, threat of potential entrants, threat of substitute products, bargaining power of suppliers, bargaining power of customers

steps to making strategic decisions (4)

consider all possible outcomes, think about what-ifs separately, play your best response, put yourself in other people's shoes (think what their best response is)

average cost

cost per unit (total costs/quantity)

focal point

cue from outside the game that helps coordinate to a specific equilibrium (diff cultures = diff norms to predict actions)

effects of market entry on existing firms

demand decreases, profits decrease, market power decreases: firm demand curve shifts left, becomes flatter

effects of market exit on existing firms

demand increases, profits increase, market power increases: firm demand curve shifts right, more steep

types of barriers to entry (4)

demand side: keep existing customers, supply side: keep costs lower than marginal supplier, regulatory: laws that make entry/exit harder, entry deterrence: convince newcomers it's not worth it

group pricing should treat each group as a ___ market

different

behavioral economics

economic analysis that includes psychological factors in assessing how people make decisions

product differentiation

efforts by sellers to make their products differ from those of competitors (elasticity - makes products less of a substitute for each other)

government can use a price ceiling to solve problems created by market power because it...

eliminates incentive to restrict production (can shift to what Q would be under perfect competition)

rational rule for entry

enter a market if economic profit is positive, or price >= avg cost

rational rule for exit

exit the market if economic profit is negative, or price >= avg costs

free entry in an unprofitable market: rivals ___, everyone else's profits ___, keep going until ___ is zero

exit, increase, economic profit

how to find the firm demand curve

experiment with price and different groups of customers over time - survey customers, change price over time and location, different groups

market power and what it arises from

extent to which a seller can charge a higher price without losing many sales to competing businesses. comes from the # of competing firms and the level of product differentiation

solutions to adverse selection of buyers

get information on buyers' likely costs, different contract options (high/low deductible), government intervention

oligopoly

handful of large sellers (strategic battle w main rivals, choices depend on each other, lots of market power)

only ___ cost customers are willing to pay for insurance, which rises the costs for ___, which means that they will charge more and ___ will rise, so only high cost customers will be ___ to ___ (adverse selection of buyers death spiral)

high, insurers, premiums, willing, pay

parts of price discrimination (2)

higher prices for those who will pay them (increases profits/producer surplus, decreases consumer surplus), discounts to induce new customers to buy (need to charge just under reservation price but still above marginal cost) (increases total economic surplus but redistributes most to sellers)

short run

horizon over which production capacity, number, and type of competitors cannot change (pricing decisions)

long run

horizon over which you or rivals can change production capacity and firms may enter or leave the market (planning decisions)

game tree

how a game plays out over time, branching out to all possible outcomes (look forward to anticipate consequences of actions, reason backward to think about the outcome and figure out decisions that would lead there) (prune the tree to find the best response)

output effect

how much revenue rises for each item sold (price of each extra item sold)

grim trigger strategy

if everyone has cooperated previously, continue to cooperate - defect otherwise (can lead to good equilibrium in prisoner's dilemma, indefinite repeated game)

advertising is most advantageous in ___ and not a ___ because there are no other substitutes and not in ___ because advertising will benefit everyone and not just you

imperfect competition, monopoly, perfect competition

market power leads price to (increase/decrease) and quantity sold to (increase/decrease) which leads to a socially inefficient outcome but more profits for the business, sometimes even so that it can stay afloat with inefficient practices (*market failure!*)

increase, decrease (underproduction problem)

advantages of price discrimination

increases quantity sold (via discounts), solves underproduction problem

more market competition leads to ___ pricing strategies

independent: this means that firms are no longer price takers (P increase = marginal revenue product increase but Quantity sold decrease) and can charge different people different prices

actuarially fair

insurance policy expected to pay in compensation as much as it receives in premiums (good if you're risk averse, but not common in reality bc no profit)

asymmetric information is caused by...

lack of expertise in that field, lack of situation-specific knowledge

competition policy

laws to ensure competition in the market thrives (prevent exclusionary/predatory practices or using monopoly power in one industry to gain it in another)

examples of supply side barriers

learning by doing, mass production, research and development, build relationships w input suppliers, tie up key inputs thru long term contracts

mergers are not allowed if...

lessens competition or creates monopoly (monopolies are legal, but creating one by taking action to exclude competitors is illegal)

relationship specific investments

more valuable if current business relationship continues

(more/less) product differentiation leads to (more/less) market power

more, more (your product is less of a substitute for that of your competitors)

if the stakes are low, you should be risk ___

neutral (diminishing marginal utility)

free entry in a profitable market: ___ competitors enter --> everyone else's profits ___, keep going until everyone's net profit is ___

new, decrease, zero

free entry

no factors making it particularly difficult for a business to enter/exit the industry

barriers to entry

obstacles that make it difficult for new firms to enter a market (not natural, created by existing firms to prevent market from going to zero profit in long run)

hurdle method

offering lower prices to only those buyers who are willing to overcome some obstacle to get it (method of getting customers to reveal their reservation price)

fair bet

on average will leave you with the same amount of money (ex: 50/50 chance of winning $10k, but if you lose, you lose $10k) (risk averse people will NOT take this bet because of diminishing marginal utility)

private information

one party to a transaction knows something the other doesn't (aka "asymmetric information")

monopoly

only one seller in the market (most market power)

deductible

out of pocket payment before insurance kicks in

examples of regulatory barriers

patents, paperwork to start business, compulsory licenses for certain industries, lobbying

since buyers can't tell quality, they won't be willing to ___ as much so prices ___, leading to sellers selling fewer ___ quality goods, so now ___ quality goods dominate the market and buyers are willing to pay even ___. (adverse selection of sellers death spiral)

pay, decrease, high, low, less

quantity discount

per-unit price is lower for larger quantity (targets those with lower willingness to pay since they already have one)

discount effect

price cut necessary to get more customers to buy your product (price cut * quantity that gets the price cut)

group pricing

price discrimination by charging different prices to different groups of people, approximating reservation price based on certain group characteristics (described in terms of discounts, not raised prices)

premium

price of insurance

principal-agent problem

principal hires agent to do something on their behalf, but cannot observe their actions (incentives change after signing a contract)

essential elements of risk (2)

probability (likelihood of each event occuring), payoff (what you'll get from each outcome if it occurs)

insurance

promise of compensation if a specified bad thing happens (insurance company pays)

government can intervene in a natural monopoly by...

providing the service directly and pay for the loss out of taxes

examples of product differentiation

quality, customer service, reputation, location, style, advertising, reliability, design, features

the closer your product is to that of your competitors, the more ___ ___, but the further you get from them, the more ___ ___ you have. So, you should place your product in the ___ part of the market.

quantity sold, market power or profit margin per item, underserved

diversification

reducing risks by combining a large number of small risks whose outcomes are not closely related (needs to be unrelated bc disaster for one could mean disaster for all) (reduces reliance on any one risk) (stock portfolio: optimize 30-40 stocks)

hold up problem

renegotiating relationship specific investments for a more unequal deal once the investment has already been made (people want to avoid this, so they underinvest or make unproductive investments)

solutions to holdup problem

reputation and repeated interactions (building trust), vertical integration, contracts

average revenue

revenue per unit (total revenue/quantity) (=price if everyone is charged same price) (same as firm demand curve)

As Q increases, the gap between marginal ___ curve and the ___ demand curve (increases/decreases)

revenue, firm, increases (MRC decreases twice as fast as the firm DC, but they start at the same point, Q=1)

variable costs per unit (rise/fall) as quantity increases because ___, and fixed costs per unit (rise/fall) as quantity increases because ___. This leads to an average cost curve that (rises/falls) at first then (rises/falls).

rise, production inefficiences increase and diminishing marginal benefit, fall, spread over more units, falls, rises

strategies for reducing risk (5)

risk spreading, diversification, insurance, hedging, gathering information

repeated game

same strategic interaction with same rivals and payoffs in successive periods (either finite (still prisoner's dilemma) or indefinite (can go to good equilibrium))

informative advertising is best for ___ goods, while persuasive advertising is better for ___ goods

search (helps customers determine quality and specifics), experience (have to consume to evaluate it)

rational rule for sellers

sell one more item if marginal revenue >= marginal cost

bundling

selling different goods together as a package (bundle what you like with what you don't really need)

price discrimination

selling the same good at different prices

effects of advertising

shift firm demand right, make steeper (convince more people to buy at any price, build brand loyalty making demand more inelastic) (raise prices)

consider when taking a risk... (3)

size of the risk relative to reward, how high the stakes are, your personal degree of risk aversion

thinking fast

snap, irrational decisions

imperfect competition

some competitors, products differ at least a little (ex: monopolistic competition, oligopoly, this is much more common than either extreme of market power)

segmenting the market

sort by groups based on verifiable characteristics that are difficult to change and whose demand differs

more market power leads to a (steeper/flatter) curve while less market power leads to a (steeper/flatter) curve (in the Firm Demand Curve)

steeper, flatter

2nd mover advantage

strategic advantage from taking an action that adapts to your rival's choice (advantage of flexibility)

1st mover advantage

strategic gain from anticipatory action that could force rival to respond less aggressively (move needs to be credible and commit to it) (advantage of aggression)

one shot game

strategic interaction that only occurs once (if multiple equilibria, will be prisoner's dilemma)

adverse selection of buyers

tendency for mix of buyers to skew towards high cost buyers when sellers don't know the type of buyers (mainly for insurance, ex: unhealthy customers more willing to pay than healthy ones which raises premiums)

adverse selection of sellers

tendency for mix of goods to skew towards low quality goods when buyers can't observe quality (fewer high quality goods sold, more low quality goods sold because buyers can't tell quality)

representativeness bias

tendency to assess likelihood that something belongs in a category only by how similar they are to that category (accounts for qualities, but not statistics and proportion)

anchoring bias

tendency to begin with anchor or starting point then insufficiently adjust (opinions swayed by 1st impression or one related fact)

availability bias

tendency to overestimate frequency of events that are easily recalled and underestimate frequency of less memorable events (if something made a big impact on your memory you'll think it's more common)

overconfidence

tendency to overrate accuracy of your own forecasts (leads to underestimating risk and making bad decisions)

prisoner's dilemma

the nash equilibrium is at the "bad outcome" because neither party can trust the other to cooperate to make both of them better off (self interest leads to the worse equilibrium) (best choice is always to defect)

contract theory

the solution to the holdup problem is to write long term contracts to hold both sides to specific terms (its hard to account for everything though)

examples of hurdle method

wait time after release, shopping around, fluctuating prices (need to price watch), haggling, distance from city, coupon collecting, worse service/imperfect good

moral hazards lead to...

wasteful/risky choices

example of natural monopoly

water, gas, electricity (utilities)

best response

whatever has the highest payoff given the other player's choice (depends on what the other player does)

business stealing effect

when rivals advertise only to steal business from each other (societal waste - offset each other's gains/losses)

strategic interaction

when your best choice depends on what others choose and vice versa

the discount effect is ___ under perfect competition

zero

economic profits under free entry tend towards ___ in the long run, so the best option of any firm is to produce until P = ___. free entry ___ desirable opportunities

zero, avg cost, eliminates

under perfect competition, all sellers have ___ market power, so they are all ___-takers

zero, price