Midterms Econ Reviewer (Less The Written On Board)

Prelim week 4: An incentive compensation scheme
that increases MC or reduces MC

Decision on Extent of will increase effort. Fixed fees
Costs have no effects on effort.
Average Cost
- the total cost of
production divided by the number
of units produced. AC=TC/Q
- not relevant to extent
decision
- this often decreases as
quantity increases due to presence
of fixed costs AC=(VC+FC)/Q, FC
does not change as Q increases.
Marginal Cost
- the cost to make and sell
one additional unit of output. MC=
TC↓Q+1 - TC↓Q-
- additional cost required
to produce and sell one more unit.
Marginal Revenue (MR)
- additional revenue gained
from producing and selling one
more unit.
- if benefits of selling
another unit (MR) are bigger than
the costs (MC), then sell another
unit. Produce more when MR>MC,
less when MR<MC. Profits are
maximized when MR=MC.
Midterm week 7: - is the amount you need to
sell to just cover your costs. Profit
Investment Decisions is 0.
Investment Profitability - Q=FC/(P-MC), p= price
All investments represent a trade- -if you expect to sell more
off between possible future gain than the break-even quantity, then
and current sacrifice. your investment id profitable.
Determining Investment Shutdown decision
profitability
- made using break-even
The current/future trade-off can be prices rather than quantities. The
calculated by, break-even price is the average
avoidable cost per unit.
Compounding
- Profit= Rev-st=(P-AC)
Future value, one period in the
(Q)
future = Present value x (1 + r)
where r is the rate of return - if you shutdown you will
lose revenue but you get back your
Future value, n period in the future
avoidable cost. If average AC <
= Present value x (1 + r)^n
Price, shutdown.
Discounting (the opposite of
To identify Avoidable Cost use
compounding)
Cost Taxonomy.
Present value, one period in the
future = Future value/ (1+r) where Costs
r is the rate of return

Avoidable Unavoidable
Present value, n period in the Costs or "Sunk" cost
future = Future value / (1+r)^n

FC (Avoidable VC (AVoidable
Present value and investment in long term) in short term)
decisions
Example problem:
The NPV rule: if the present value
of the net cash flows > 0, the Fixed Cost(FC)= $100/year
project is profitable. Marginal Costs(MC)=$5/unit
Break-even quantity Quantity(Q)=100/year
In short run Mc is the only AC, so
the shutdown price is $5.
In the long run, FC become
avoidable, and it become relevant
to the shutdown decision. The
shutdown price includes average
FC and so rises to $6.
*Avoidable costs can be recovered
by shutting down.
*If you are incur to sunk costs, you
are vulnerable to post-investment
hold-up. Anticipate hold-up and
choose contracts or organizational
forms that give each party both
incentives to make sunk-cost
investments and to trade after these
investments are made.
Midterm week 8: - the total number of units
that will be purchased by a group
Pricing Decisions of Consumers at a given price.
Pricing is a powerful but often Consumer values and demand
neglected tool. Profit = (P-AC) x curve
Q.
Ceteris paribus
Simple pricing
- a latin term meaning, all
- involves charging what other things being equal,
competitions charge for similar unchanged or constant
products and services. This is often
used by retailers and wholesalers. Mutatis Mutandis
Complex pricing - states changing some

factors, the opposite of Ceteris
- based on the originality paribus.
of a product or service and what
customers are willing to pay for it.
Demand curves Example: If the price of milk
increases, ceteris paribus, people
- functions that release the will purchase less milk.
price of a product to the quantity
demanded by consumers. Pricing Tradeoff
- gives the idea on how Lower price – sell more, but earn
much goods and services a less on each unit sold.
consumer purchases at a given Higher price- sell less, but earn
price more on each unit sold.
Individual demand Proposition: Profits are maximized
- refers to how many units when MR-MC
an individual would purchase at a Example:
given price.
Aggregate demand or market
demand
Formula: Elasticity and MR
Proposition: MR=P(1-1/|e|)
*If |e|>1, MR>0.
*If |e|<1, MR<0.
Elasticity and Pricing
MR>MC is equivalent to
*P(1-1/|e|)>MC
Price Elasticity is related to *P>MC/(1-1/|e|)
Marginal Revenue (MR)
*(P-MC)/P>1/|e|
Price Elasticity = (%Change in
quantity demanded) +
(%Change in price) What Makes Demand More
*If |e| is < 1, demand is said to be Elastic?
inelastic Products with close substitutes
*If |e| is > 1, demand is said to be have elastic demand.
elastic Demand for an individual brand is
MR and Price Elasticity more elastic than industry
aggregate demand.
%DRev ≈ %DP + %DQ
Products with many complements
Elasticity tells you the size of | have less elastic demand.
%DP| relative to |%DQ|
Describing Demand with Price
If demand is elastic Elasticity
*If P↑ then Rev↓ First law of demand: e<0 (price
goes up, quantity goes down).
* If P↓ then Rev↑
Second law of demand: in the long
If demand is inelastic
run, |e| increases.
*If P↑ then Rev↑
Third law of demand: as price
*If P↓ then Rev↓ increases, demand curves become
more price elastic, |e| increases.
Other elasticities
Income Elasticity =
(%change in quantity demanded) +
(%change in income)
- Inferior if Negative,
normal if positive
Cross-price elasticity of good one
with respect to the price of good
two = (%change in quantity of
good one) ¸ (%change in price of
good two)
- Substitute (positive)
complement (negative).
Advertising elasticity=(%change
in quantity) ¸ (%change in
advertising) .
Stay-even analysis can be used to
determine the volume required to
offset a change in costs or prices.

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Prelim week 4: An incentive compensation scheme

that increases MC or reduces MC

r is the rate of return

future = Future value / (1+r)^n

Complex pricing - states changing some

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