Solutions Problem Set 1: Review of Economic Concepts

Hold-Up Problem and Transaction Costs

(1.) More difficult contract negotiations and more frequent re-negotiations - Time-consuming and costly - Delays and disruptions, raising production costs and impeding delivery of products to consumers (2.) Investments to improve ex post bargaining positions. (3.) Distrust - Increases direct costs of the contract - Impedes sharing information or ideas to achieve production efficiency or quality improvements (4.) Reduced ex ante investment in relationship-specific investments and/or reduced ex post cooperation - Firms may reduce investments in RSI's or substitute general-purpose assets for more specific ones -RSI's allow allow firms to achieve inefficiencies that they cannot achieve with general-purpose instruments

The potential for holdup raises the cost of market transaction by making contract negotiation...

- Making contact negotiations more contentious - Inducing parties to invest in "safeguards" to improve postcontracutal bargaining positions - Endangering trust - Leading to underinvestment in RSI

Make/Buy Decision

1.) Asses whether the market provides any any alternative to vertical integration 2.) If no, the firm must either take on the task itself or prop up a quasi-independent supplier through a joint venture or strategic alliance If yes, than the manager must determine whether market information will be impacted by information, coordination, or holdup problems. Then, can these problems be fixed through contract (favoring the use of the market) or through internal governance (favoring integration)

Total Revenue Function

A function indicating how the firm's sales revenues vary as a function of how much product it sells

Is the prisoners' dilemma always a Nash equilibrium? Is a Nash equilibrium always a prisoners' dilemma? Explain.

A prisoners' dilemma game illustrates the conflict between self-interest and collective interest. In the Nash equilibrium of a prisoners' dilemma game, each player chooses a non-cooperative action even though it is in the players' collective interest to pursue a cooperative action. If players chose strategies that did not constitute a Nash equilibrium, then the players could choose another strategy that increased their payoff given the strategies chosen by the other players. Since players could increase their payoffs by choosing other strategies, strategies that do not constitute a Nash equilibrium are an unlikely out come in a game. No, not every game in the chapter is a prisoners' dilemma. A Nash equilibrium in a game occurs when each player chooses a strategy that gives it the highest payoff, given the strategies chosen by the other players in the game.

Zero-Sum Game

A situation in game theory in which one person's gain is equivalent to another's loss, so the net change in wealth or benefit is zero

Law of Demand

Concept relating to lower price with greater quantity demanded, and higher price with smaller quantity demand

Economic Costs

Concept that cost of deploying resources in a particular activity is the value of the best foregone alternative use of those resources

Agency Problem

Conflict of interest inherent in any relationship where one party is expected to act in another's best interests

Accounting Costs

Costs located on accounting statements and generally historic

Explain what we mean by "semi-fixed costs" and provide unique examples.

Costs that are fixed over a RANGE of output. Ex. A delivery van can hold 30 boxes. If the factory needs to deliver 60 boxes they need 2 vans. If the volume increases to 65 they need 3 vans.

Sunk Costs

Costs that are incurred and therefore cannot be avoided - For this reason they should not be factored when making a business decision.

Avoidable Costs

Costs that can be avoided if certain choices are made

Contracts are incomplete because of

Hidden Actions Hidden Information Bounded Rationality

How would you characterize the nash equilibrium of a prisoners dilemma game?

I'm looking for "uncoorperative".

Why should managers focus mainly on economic profits?

If a firm chose to produce and sell a product it could earn a positive accounting profit but negative economic profit. This would occur if the economic cost of the re sources used was greater than the accounting cost of the re sources used. For example, the firm might purchase resources for $1 million and use these to produce a product when instead the firm could have resold the re sources for $2 million. In this case, the economic cost exceeds the accounting cost and economic profit would be less than accounting profit.

Explain why long-run prices in a perfectly competitive market tend toward the minimum average cost of production.

If firms are making a profit, competitors will enter. As more quantity is made available, prices are driven down until minimum average cost is the same as marginal cost. Once price hits this point, competitors will cease to enter as it will no longer be profitable. This can be seen in Figure 1.14.

If the average cost curve is increasing, must the marginal cost curve lie above the average cost curve? Why or why not?

If the average cost curve is increasing, the marginal cost curve will lie above it because as things are added to a group, if the average increases because of the most recently added thing, that "'marginal" thing must be greater than the average.

Economies of Scale

If the average cost per unit of output falls as the volume of input increases

Economies of Scope

If the total cost of producing two different product/services is lower when they are produced by a single firm instead of two separate firms

Variable Costs

Increase as output increases

Influence Cost

Internal lobbying for resources ex.) Lower-level managers may seek to command more of their company's resources as to advance their own careers and boost their own incomes, possibly at the expense of corporate profits. May exaggerate the likely success of their project of badmouth proposals from other departments

Calculate price elasticity of demand, and be able to interpret a given elasticity value sentence (e.g. "if the PED of beer is 2.0, a 1% increase in the price of beer will result in a ____________.")

Know the formula for elasticity: % change in Q / % change in P Answer to the above question is 2% decrease in sales of beer (aka quantity demanded of beer). So elastic demand in that price range.

Draw (freehand) a MC and AC curve on the same graph. Make sure the shapes are appropriate and that they intersect at the correct point. Label everything.

Look at figure 1.5 in the text. Note that MC will ALWAYS intersect AC at the minimum point on the AC curve. ALWAYS!

Why is marginal revenue less than total revenue?

Marginal revenue is the amount at which each additional unit is sold. This will always be less than the cumulative amount which is represented as total revenue.

3 methods for minimizing agency problems

Monitoring Pay-for-performance (P4P) incentives Control/Bureaucracy

Learning

Processes with substantial learning benefits, firms that can accumulate and protect the knowledge gained by experience can achieve superior cost and quality positions in the market

Vertical Chain

Processing and handling activities associated directly with the processing and distribution of inputs and outputs, and professional support activities (accounting, planning, etc.)

Hold-up Problem

RSA and RSI leads to this - A firm "holds up" its trading partner by attempting to renegotiate the terms of a deal. - one trading partner exploits contractual incompleteness to renegotiate the terms of a contract - An attempt to renegotiate in the ex-post period

RSI

RSI is the amount of the investment that cannot be recovered if "___" does not go ahead.

Marginal Revenue Function

Rate of change in total revenue that results from the sale of the change in Q additional units of output

Upsteam to Downstream

Raw inputs -> manufacturers -> distributors -> retailers

Marginal Cost

Refers to the rate of change of total cost with respect to output and often depends on the total volume of output.

Agent Relationship

Relationship between the principle and the agent; an agent is someone who carries out tasks on behalf of the principle

Fixed Costs

Remain constant as out put increases

Total Costs

Represents the relationship between a firm's total costs, TC, and the total amount of output it produces in a given time period, Q

What are the formulas for TC, AC, MC, AVC, AFC, SR-ATC (SAC), TR, MR (both formulas), MP. If I gave you data (on an exam) you should be able to calculate any of these.

See text for definitions. Note the textbook formula for MC is overly complicated ... it is just (the change in TC / the change in Q). Also notice how these formulas are related. That is, to get ATC, AVC or AFC just that the corresponding cost (like TC) and divide by Q.

An important source of EoS and EoSc is...

Spreading of individible fixed costs

Game Theory

The analysis of optimal decision making when all decision makers are presumed to be rational and each is attempting to anticipate actions and reactions of competitors

Prisoner's Dilemma

The conflict between the collective interest and self-interest

4. What is the difference between economic profit and accounting profit?

The difference between accounting profit and economic profit is in how total cost is measured. With accounting profit, total cost is measured as total accounting cost, whereas with economic profit, total cost is measured as total economic cost. Accounting cost measures the historical expenses the firm incurred to produce and sell its product, whereas economic cost measured the opportunity cost of the resources that the firm uses to produce and sell its product.

Quasi Rent

The extra profit that you get if the deal goes ahead as planned versus the profit you would get if you had to turn to your next-best alternative The risk/vulnerability Difference between two rents

Elasticity

The measurement of the sensitivity quantity demanded to price

Nash Equilibrium

The outcome in game theory where each player in the game is doing the best that it can, given the strategies of the other players

Rent

The specific profit you expect to get when you "Build the plant" --> Expected Return Revenue-RSI-Exp = Rent

Why does the elasticity of demand affect a firm's optimal price?

The supply elasticity can be used to determine the extent to which the equilibrium price will change when demand shifts exogenously. If supply is elastic, then a shift in demand will have a smaller impact on the equilibrium price than when supply is inelastic.

Explain the relationship between the shape of the average cost curve and economies of scale, diseconomies of scale, and constant returns to scale

We have a slide on this. Also see figure 1.3 in the text. Economies of scale, diseconomies of scale, and constant returns to scale are all related terms that describe what happens as the scale of production increases. It is important to understand the concepts of these returns to scale because they can be an important factor in determining the optimal and equilibrium size of firms. From that decision, the structure of industries and their prices and output levels can also be determined appropriately Economies of scale: This term characterizes a production process in which an increase in the number of units produced causes a decrease in the average cost of each unit. Constant returns to scale: It refers to a technical property of production that examines changes in output subsequent a proportional change in all inputs (where all inputs increase by a constant). Diseconomies of scale: A term used to describe processes that do not conform to the definition of economies of scale due to the costs for production does not decrease with the increased production.

Revenue Destruction

When revenue is destroyed as a result of a firm lowering its price in order to sell a greater quantity that does not result in greater total revenue

Mutually Beneficial Exchange

When your action/exchange is equally beneficial to both parties participating

Make/Buy Decision

Which activities in the vertical chain should a firm perform itself and which should it leave to independent firms int he market

Large size can create inefficiencies through

higher labor costs agency problems dilution of specialized resources