Economics Exam Review Notes

The Firm's Problem

  • Firms maximize profits by setting marginal revenue equal to marginal cost: MR=MCMR = MC.
  • Underproduction means firms are leaving money on the table.
  • Overproduction means firms are losing money.
  • Fixed Costs: Costs that do not vary with output.
  • Variable Costs: Costs that do vary with output.
  • Short Run: Period where many costs are fixed.
  • Long Run: Period where all costs are variable. The difference between short run and long run depends on the industry, defined by when all costs become variable.
  • Explicit Costs (Accounting Costs): Actual expenditures.
  • Implicit Costs: Opportunity cost of the firm owner’s time and investment.
  • Economic Costs: The sum of explicit and implicit costs.
  • Average and Marginal Costs: analysis of how costs behave as output changes
  • Shutdown Condition:
    • Short Run: Firm should shut down if price is less than average variable cost.
    • Long Run: Firm should shut down if price is less than average total cost.

Market Structures

  • Perfect Competition:
    • A baseline case, somewhat unrealistic but useful.
    • Competitive equilibrium yields productive and allocative efficiency.
    • Productive efficiency: goods are produced at the lowest possible average cost.
    • Allocative efficiency: resources are allocated such that consumers get the goods/services they value most.
    • Assumptions are important because deviations from them yield other market structures.
  • Market Power:
    • Firms have some control over price-setting.
    • Tradeoff between the output effect (selling more) and the discount effect (lowering price).
  • Monopoly:
    • Barriers to entry allow a single seller to control the market.
    • Monopoly price is greater than competitive price.
    • Monopoly quantity is less than competitive quantity.
    • Leads to deadweight loss from underproduction.
  • Oligopoly: Few firms with some barriers to entry.
  • Monopolistic Competition: Differentiated products.
  • Competitive Forces: Understanding market power and competition helps explain real-world phenomena.

Price Discrimination

  • Charging different prices for the same good or versions of the same good.
  • Companies segment the market to implement price discrimination strategies.
  • Price discrimination can solve part of the underproduction problem caused by market power.

Asymmetric Information

  • One side of the market has more information than the other.
  • Adverse Selection:
    • Hidden characteristics about a product.
    • Occurs before a transaction.
    • Example: Used car market where buyers can’t be sure of quality.
    • Can lead to a death spiral where only lemons remain in the market.
    • Health insurance market: those expecting high medical bills are more likely to purchase insurance, driving up prices and pushing healthy people out.
  • Moral Hazard:
    • Hidden actions after a transaction.
    • Agents don’t bear the full cost of their actions.
    • Example: Health insurance leading to increased risk-taking.
  • Principal-Agent Problem:
    • Principal hires an agent to do a task, but the principal is not fully informed and can’t fully monitor the agent.
    • Incentives are not aligned. (e.g., hiring a mechanic).
  • Solutions to Asymmetric Information:
    • Online ratings.
    • Warranties: A costly signal to demonstrate product quality.
    • Brand Names: Provide assurance of consistent quality.
    • Signaling Quality: Attending a reputable university signals human capital and dependability.

Strategic Behavior and Game Theory

  • Strategies and Payoffs: Basics of game theory.
  • Nash Equilibrium:
    • No player has an incentive to change their strategy, given the strategies of others.
    • Analyzed for simultaneous and sequential games.
  • Applications:
    • Prisoner’s Dilemma.
    • Entry Deterrence.
    • Business, politics, and day-to-day life.
  • More Realistic Approaches:
    • Repeated Games.
    • Social Norms.
    • Reputation.
    • Trust.
    • Communication.
  • Finding Nash Equilibrium: Understand the concept rather than merely memorizing the game format.

Behavioral Economics

  • Relaxing standard assumptions of rationality.
  • Loss Aversion: Losses hurt more than gains feel good, relative to a reference point.
  • Anchoring: Retailers use reference numbers to influence perceptions of value.
  • Present Bias (Myopia): Overemphasis on the present.
  • Sunk Costs: Decisions should be made on the margin, considering only future costs and benefits. Do not consider sunk costs.