Econ Midterm 2

Behavioral Economics
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loss aversionWe focus more on loss than gain. Example: $1 loss pains us 2.25x more than benefit of $1 gain.mental accountingMoney from a windfall is likely to be spent on "treating oneself." People hold their budgets in different categories. Example: I have a wine-night budget, a bread budget, and an ice cream budget for the grocery store.base rate neglectWhen calculating probabilities, we ignore frequencies and focus on appearance cues. People suck at probability calculations. Example: How can you tell a math student is extraverted? He looks at the other person's shoes instead of his own. There are probably more introverts in the business school just based on percentage population of business to math students. Therefore, don't assume person looking at shoes is math (example from data class)System 1 vs. System 2System 1: automatic evaluation based on pre-set assumptions System 2: Slower, more effortful, deliberate processingHow is behavioral econ different than traditional econ?Traditional econ assumes rationality - people make consistent and informed decisions in their best interest. Traditional omits people's state of mind while behavioral does not.HeuristicsIrrational mental shortcuts we use to make decisionsOverweighting small probabilitiesWe often don't realize the difference between unlikely and practically impossible. Example: LotteryCompetition biasBeating others is more important than absolute performance. Example: Beating this person/company is more important than actually winning.increasing and decreasing returns to scale- Increasing RTS: double the inputs creates more than double the outputs. Reduces the cost as you expand - Decreasing RTS: double the inputs creates less than double the outputs. Increases cost as you expand.increasing/decreasing/constant economies of scale- Increasing/economies: cost/unit decreases as volume increases. LRATC curve decreases as output increases - Decreasing/diseconomies: cost/unit increases as volume increases. LRATC curve increases as output increases. - Constant: LRATC curve is constant as output increaseseconomies of scopeCost/unit of different goods decreases by producing multiple products using the same resourcesdiseconomies of scopethe simultaneous production of multiple products at a higher cost than if a firm made each product separatelyefficiency wageA higher-than-market wage that a firm pays to increase worker productivity.tight labor marketEveryone is employed so employers have to entice employees to work for them with more money.learning curveYou can and will get more productive as you figure out production process and organization of production. Example: At the beginning of jam season, it takes the same team with the same equipment 5 hours to make the same amount of jam. At the end of jam season, it takes the same team with the same equipment 4 hours to make the same amount of jam.Why would you want to pay an efficiency wage (more than the wage rate)?Decrease turnover and increase productivityAre employees more or less sensitive to wage changes than employers? How about their power dynamic?More because we often don't have many choices when it comes to employment. Employers have more choices as to whom they hire. Therefore, employers have more power. The more applicants applying to a position, the less power each individual applicant has.What's the issue with paying new employees a higher wage in a tight labor market?Incumbent employees will also want pay raises because why should the newbies get more money? Cost to the company is higher than just paying the new employees more.Economic rentIf skills are rare, then it's hard to find more rare people. Elasticity of supply of inputs is low (MRPl > wage rate). Example: LeBron JamesWhat are the sources of economies of scale?1) Specialization of labor and capital 2) volume discountsCan you have increasing RTS, but not economies of scale?Yes! Volume discounts do not count as an increase in RTS, but are a source of economies of scale.Can you have decreasing RTS, but not diseconomies of scale?Yes! Example: you buy lower quality farm land so you produce less with the same costs, but the farm land itself was cheaper.In the short run...Some costs are fixedIn the long run...all costs are variableLong-Run avg cost curve (LRATC curve)shows the relationship between outputs and ATC.Joint costscosts that are shared in the manufacturing and marketing of several products in a product line. They do not change with scope of production. Example: AT&T and DSL using same wire networkCost approach vs resource approach- cost approach: the cost depends on the size & production levels (Quantity 1st, then planning) - resource approach: determine core competencies and then plan.When would you use cost approach or resource approach?Since the cost is hard to determine when you haven't started producing anything, the cost approach is only good for established firms. The resource approach is good for new firms or R&D.Why does the MRPl decrease as the rate of inputs increases?You can only shove a certain amount of workers into the factory until they stop becoming productive. Some may wonder off and do nothing which is a really high cost to you.When should you STOP hiring workers?When MRPl = Pl or wage rateWhy don't we use the piece rate wage anymore (2 reasons here)?1) It's hard to determine the value or P of people's work now. Example: administrative work in an office is more difficult to relate to P than making t-shirts. 2) People commonly work in teams now so it's difficult to measure the exact output of each individual.In the short-run, should a firm stay open or close down if they are earning a negative ECONOMIC profit?Stay open because they might still be earning an accounting profit. Remember: Economic profit = accounting profit - implicit costs.In the long-run, should a firm stay open or close down if the price is below the AVC curve?Shut down because they are operating below the shut-down price. This means that the firm can't cover any variable costs and basically produces nothing. Note: when you shut down, your costs are limited to the fixed costs.Where is the break even point on the graph?At the intersection of the MC curve and the ATC curve.Where do you start earning profit on the graph?When the price is above the ATC. P>ATCWhat are the benefits of perfect competition (2 benefits)?1) Maximizes consumer surplus (yay!) 2) Prices are lower (double yay!)What are the drawbacks of perfect competition (2 drawbacks)?1) competition among sellers decreases the Q each seller can sell 2) Less diversity of products for consumersT or F: Since there are 100 kinds of Mayo on the shelf, Mayo must have a monopolistically competitive market.False, you can't tell kind of market based on the products on the shelf. There might only be 3 mayo companies in the US who make 100 different mayos between them.How does a firm choose its optimal size?Choose the plant size that has the lowest cost at every output level. Follows along the LRATC curve. Example: In small plant, you start making more and more salsa that causes your cost/case to rise. You must move to larger plant to continue making more salsa, but at a lower cost/case again.Examples of industries with higher fixed costs and lower variable costs:design and R&D, water, electric, cable TVHorizontal IntegrationAbsorption into a single firm of several firms involved in the same level of production and sharing resources at that levelVertical Integrationthe combination in one company of two or more stages of production normally operated by separate companies.Conglomerate combinationsA business enterprise that participates in multiple value chains that are different in nature. Example: Amazon, Unilever...double marginalization problemUnder a decentralized supply chain, The downstream firm(retailer) orders too LITTLE inventory because they are afraid of higher OVERAGE costs and have lower UNDERAGE costs compared to the supply chain's true costs.adverse selection problema problem that occurs when buyers and sellers have different amounts of information about the good for sale and use that information to the detriment of the othertransaction costThe costs associated with the time and effort needed to search out, negotiate, and consummate an exchangeCost center vs profit center- Cost center: central managers give info to division managers who produce an output. Lower innovation risks and lower quality. - Profit center: Each division is treated individually with its own revenue and profit. Lower waste and higher value to company.principal-agent problemOne party (the principal) would like another party (the agent) to act in some way, or have an attribute, in the interest of the principal, but can't enforce this by contract.hidden action problemThis occurs when some action taken by one party to an exchange is not known or cannot be verified by the other. The employer cannot know (or cannot verify) how hard the worker she has employed is actually working. Example: Banker (P) and Borrower (A). The banker can't verify or guarantee the repayment of a loan, or prudent conduct.signalingan action taken by an informed party to reveal private information to an uninformed partyinstitutionwritten and unwritten rules that govern what people do when they interact in a joint project & distribution of the products of their joint effort.bargaining powerthe ability to do and get what we want in opposition to the intentions of others.asymmetric informationowners and managers don't know what employees know. Not all commands from management are carried out by employees.relationship-specific assetsresources that are specific to a relationship and cannot easily be transferred to another onefree-rider problemFor a group, the problem of people not joining because they can benefit from the group's activities without joining.piece rateemployees are paid according to how much output they produce. Example: I get $2 for every t-shirt I makecooperative firmA firm that is mostly or entirely owned by its workers, who hire and fire the managers.Two advantages of conglomerates are that...they can withstand hard times because of its diversity of products and they can easily move capital between businesses without difficultyWhat are 2 ways to incentivize managers?1) Tie managerial compensation with the share price of the company. Value will depend on performance 2) The board can monitor the manager's performanceWhy are contracts incomplete (3 main reasons)?1) Employees have the right to leave at anytime 2) Companies don't exactly know all the tasks required of an employee so can't specify on a contract 3) Individual's work can't be perfectly monitoredT or F: co-ops need more management and supervision than other types of companies to ensure work is being done.False. Since workers are also owners, they are more invested in the success of the company so work harder, which requires less supervision.What are the 5 assumptions in the perfect competition model?1) The market consists of many buyers who are price takers 2) The market has many sellers who are also price takers 3) Firms that sell in the market are free to enter/exit the market. In other words, there are no barriers to entry 4) All goods are the same and sold at the same price 5) Buyers and sellers have perfect information. Example: Janet knows how Peter makes his pies and vice versa.So if everything is the same price in the short run in perfect competition, how do firms make a profit?Since all firms have the same info, some firms might have lower production costs or higher production capacities and earn more profit.Why do institutions exist in a capitalist, democratic society like ours?Institutions protect consumers from violence and coercion (yay!)Firms represent a _____ of economic power; Markets are characterized by a _____ of power.centralization, decentralizationmarket structureThe nature and degree of competition among firms operating in the same industry.price takerA buyer or seller who cannot affect the market price. They must accept the price as it is, and each individual has very little effect on the market overall ("a drop in the bucket")marginal revenuethe additional income from selling one more unit of a good; sometimes equal to price when in perfect competition. MR=Pmonopolistic competitiona market structure in which many companies sell products that are similar but not identical. Example: Thai restaurants in San Luis Obispofree entryThere are no barriers to entry into the marketconsumer surplusthe amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it.producer surplusthe amount a seller is paid for a good minus the seller's cost of providing itWhy can't perfectly competitive firms earn profit in the long run?More firms will enter the market --> supply shifts right --> price goes down --> some firms have to close down because they can't afford to keep up production at the lower price --> supply shifts left again --> stops at break-even point every time.What are some barriers to entry in a market?Resources and capital available, patent protections, regulatory clearance, etc...What are the 2 steps to profit MAXIMIZATION?1) Choose the quantity where MC=MR 2) Choose the highest price consumers are willing to pay for that QWhy do you need the AVC curve?Because we can use it to figure out the shut down price. Recall: we shut down when P<AVCJessica is a tutor who charges $8/hour. The market price paid for tutoring is $10/hour. What is her producer surplus?$10-$8=$2 surplusMatthew is willing to spend $5,000 for a superbowl ticket becuse he wants to see the Rams win. The market price is $8,000. What is Matthew's consumer surplus?$0 because he can't afford the ticket :(Break-even priceprice where you earn zero ECONOMIC profits (ATC=MC)Where is the optimal quantity on the graph of PERFECT COMPETITION?Where the MC curve crosses the MR curveWhen the optimal price is above the ATC curve, are you generating a profit or a loss?Profit $$Profit EquationProfit = (P-ATC)*Q or (TR/Q-TC/Q)*QWhat happens when your ATC is above the point where MR crosses MC?Loss ---$$$What does total surplus (consumer surplus + producer surplus) represent?Demonstrates the benefit of market transactionsAn elastic market will have a ____slope while an inelastic market will have a ____ slope.flatter, steeperIn monopolistic competition, is the MR curve above or below the demand curve?Below! MR curve has 2x the slope of the demand curveT or F: There is only one highest price consumers will accept for ideal quantity.TrueOn the monopolistic competition graph, where is the optimal price? How about quantity?Price= point on the demand curve that aligns with the intersection of the MC curve and MR curve. Quantity= point on the graph where MR crosses MCIs the output (Q) at the optimal price point in perfect competition more or less than monopolistic competition?more because the price is dictated by the market.What are the drawbacks of monopolistic competition (3 drawbacks)?1) Disruption ethically 2) Higher prices for a lower quantity 3) Not producing at minimum cost (less efficient)What is the benefit of monopolistic competition?More variety!What happens in the long run to a monopolistically competitive firm?Short run profit in this industry will attract competitors and shift the demand curve left until it reaches the ATC because more entrants will decrease the amount of customers for original firms. When the demand curve aligns with the ATC, all firms will generate zero economic profits which will bring the market back to equilibrium since firms will start dropping out.What does the LRATC curve look like?See the picture!Who was Karl Marx and what did he believe?Karl Marx was a German philosopher who believed in a communist society that would have no social classes.Who was John Stuart Mill and what did he believe?John Stuart Mill was an English philosopher, political economist, Member of Parliament and civil servant who advocated for limits on gov power, individual freedom, and privacy.In what ways did Karl Marx and John Stuart Mill criticize the worker-firm relationships that exist in capitalism (CORE reading)?Marx: "Perpetual change arose, Marx observed, because capitalists could survive only by introducing new technologies and products, finding ways of lowering costs, and by reinvesting their profits into businesses that would perpetually grow...In the labour market, in which owners of capital are buyers and workers are the sellers, the appearance of freedom and equality was, to Marx, an illusion." Basically, owners had too much power over workers which led to serious inequality. Mill: "Mill thought that the structure of the typical firm was an affront to freedom and individual autonomy...'To work at the bidding and for the profit of another, without any interest in the work ... is not, even when wages are high, a satisfactory state to human beings of educated intelligence.' " He would have been a proponent of the co-op model.