ECON 202 EXAM 3

profit

total revenue - total cost

production technology

used by firms to turn inputs into outputs

fixed costs

don’t change based on outputs

variable costs

changes based on outputs

short run

firms can’t change fixed costs or technology

production capacity and # & type of competitors you face cannot change

long run

everything is variable

may expand or contract production capacity, new rivals may enter the market or existing firms may exit

explicit costs

costs in which the firm spends on buyinh stuff

implicit costs 

nonmonetary opportunity costs

economic costs

implicit + explicit

accounting profit

total revenue - explicit financial costs

economic profit

• total revenue a firm receives

  • total revenue - explicit financial costs - entrepreneur’s implicit opportunity costs

average revenue

total revenue/quantity = price

average cost

(total costs/quantity) = (fixed costs/quantity) + (variable costs/quantity)

profit margin

price - average cost

average total costs

Δtotal costs/Δquantity

average variable cost

Δvariable cost/Δquantity

marginal cost

Δvariable costs/Δquantity

economies of scale

long run average costs fall as quantity increases

perfect competition

1. many buyers and sellers, all small

2. identical products

3. no barriers to entry

price takers

firms in a perfectly competitive market — no bargaining power because they’re not big enough to influence the market

marginal revenue 

Δtotal revenue/Δquantity

price in perfect competition

marginal revenue

total cost

the costs of producing a given quantity of output
fixed costs + variable costs

in perfect competition, when will the owner keep producing to maximize profits

as long as MR>MC

last production in perfect competition

where MR=MC

to maximize profit, a firm in a competitive industry increases output until

price = marginal cost

average cost

cost per unit

total cost/quantity

profit equation

total revenue - total cost

economic profits lead to

firm entry

economic losses lead to

firm exit

rational rule for entry

enter a market to earn a positive economic profit, which occurs when the price exceeds your average cost

rational rule for exit

exit the markets if you expect to earn a negative economic profit, which occurs if the price is less than your average costs

free entry

when there are no factors making it particularly difficult or costly for a business to enter or exit an industry

free entry pushes price

down toward average cost

free exit pushes price

up toward average cost

zero profits

when P=AC
firm is covering all of its costs inculding enough to pay labor and capital

monopolistic competition

many competitors, differential products, low barriers to entry

oligopoly

few competitors, same or differentiated products, some barriers to entry

perfect competition

markets in which:

1. all firms in an industry sell an identical good

2. there are many buyers and sellers, each of whom is small relative to the size of the market

monopoly

when there is only one seller in the market

monopolistic competition

a market with many small business competing, each selling differentiated products

barriers to entry

government regulation, supply side factors, demand side advantages, natural monopoly (when fixed costs are very high)

firms demand curve

illustrates how the quantity that buyers demand from an individual business or firm varies as it changes the price it charges

marginal revenue

the addition to total revenue you get from selling one more unit

market power leads to

higher prices, inefficiently smaller quantity, larger economic profits

competitive forces

exisiting competitors, potential competitors, competition from substitutes, bargaining power of buyers, bargaining power of suppliers

five forces framework

the structure of competition in your market can be described with

1. competition from existing competitors

2. threat of potential entrants

3. threat of substitute prodicts

4. bargaining power of suppliers

5. bargaining power of customers

price competition

competing to win customers by offering lower prices

non-price competition

competing to win customers by differentiating your product

bargaining power

your ability to negotiate a better deal

relationship-specific investments

an investment that is more valuable if the current business relationship continues

hold-up problem

once you have made a relation-specific investment, the other side may try to renegotiate so that they get a better deal and you get a worse one

hold up problem leads to:

• fewer relationship-specific investments, even if they’re productuve

• more investment in boosting your next best alternative, even if it’s unproductive

solutions to the hold-up problem

• long term contracts

• reputation and repeated interactions

• vertical integration

vertical integration

when 2 or more companies along a production chain combine to form a single company

price discrimination

selling the same good at different prices

reservation price

max willingness to pay

perfect price discrimination

firm charges reservation price and total surplus is higher
allows a firm to make every possible sale and charge the highest price

when can a business price discriminate

• has market power

• no resale

• segment the market and target prices

group pricing

charging different groups different prices

hurdles

making it harder to purchase for particular people

tying

company sells a product which must be used with something sold by the company

bundling

items bought together

criteria for successful segmentation

• groups whose demand differs

• groups based on verifiable characteristics

• groups based on difficult to change characteristics

hurdle method

offer lower prices only to those buyers who are willing to overcome some hurdle or obstacle

asymmetric information

discrepancies in knowledge between buyers and sellers

adverse selection

one party knows something about the goods or services that the other doesnt

moral hazard

one party does something relevant to the transaction but unseen to the other party

private information

when one party to a transaction knows something the other doesnt

adverse selection of sellers

the tendency for the mix of goods to be skewed toward more low-quality goods when buyers can’t observe quality

solutions to adverse selection of sellers

1. buyers can learn from 3rd party verifiers

2. sellers can signal their products quality

3. government can increase information or weed out low quality goods

adverse selection of buyers

tendency for the mix of buyers to be skewed toward more high cost buyers when sellers don’t know buyers’ type

actuarially fair price for insurance

a policy that is expected to pay out as much in comparison as it recieves in premiums

solutions for adverse selection of buyers

1. sellers can use information that is related to buyers’ likely costs

2. sellers can offer different contracts so buyers sort themselves

3. government can increase information, offer subsidies, enforce mandates or provide insurance

principal

doing the hiring

agent

who is being hired

shirk

slack off

principal-agent problem

incentives of the principal don’t align with the incentives of the agent

principal-agent problem solutions

1. make hidden actions observable by monitoring

2. reward things that go along with the actions you want

3. give the actor “skin in the game” or a stake in the outcome

4. government rules and social norms can help align incentives

5. pick the right kind of agents

pay for performance

linking the income your workers earn to measures of their performances

third party payer

causes a principal agent problem

underwriting

evaluating the risk of a prosective client

mandate

everyone must purchase

adverse selection death spiral

where rising insurance premiums drive healthy (low-risk) individuals out of the market, leading to an even sicker risk pool, higher premiums, and ultimately the collapse of the market.

credible

a strategy or promise is credible is it is an agent’s interest to follow through on that strategy or keep that promise

signaling

when one party takes an action/signal to credibly convey private information about themselves to another party

human capital model

more education, more productive, higher wage

signaling model of education

education is more costly for low types

game theory

study of decision-making where your decisions are driven by the actions of others

game

interaction between two people whose payoffs depend on each others actions

strategies

plan of action for what each player will do

dominant strategy

best response is the same regardless of what decision the other person takes

dominant strategy equilibrium

both have an obvious best response

simultaneous-move game

choices are made at the same time

best response

put yourself in their shoes, then make the decision

strategic interactions

when your best choice may depend on what others choose and their best choice may depend on what you choose

how to make good strategic decisions

1. consider all the possible outcomes

2. think about the “what ifs” separately

3. evaluate your best response

4. put yourself in someone else’s shoes

nash equilibrium

no player has incentive to change

check-mark method

put a check mark next to each player’s best response and an outcome with a check mark from each player is nash equilibrum

multiple equilibria

more than one equilibrium