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Managerial Economics
Mid Term Summer 2015
341
Economics
Undergraduate 3
06/24/2015
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Term
Incentives
 Definition
matter (significantly)!!
Term
A well-designed organization
 Definition
is one in which employee incentives are aligned with organizational goals. Employee access to accurate information is critical
Term
Voluntary transactions
 Definition
create wealth by moving assets from lower-valued to higher-valued uses.
Term
Anything that impedes the movement of assets to higher-valued uses, like taxes, subsidies, price ceilings, and/or price floors,
 Definition
destroys wealth.
Term
A company is simply
 Definition
a series of transactions
Term
Stopping unprofitable transactions is
 Definition
is nearly as important as completing profitable transactions.
Term
This principle may be even more important in government:
 Definition
stopping bad bills/laws may be more important than passing good ones!
Term
Opportunity cost
 Definition
example: What are you giving up to study (next best thing...and NOT everything)?
Term
Consider ALL costs and benefits that vary with a decision...and ONLY the costs and benefits that vary with the consequences of a decision.
 Definition
These are know as the relevant costs and relevant benefits of a decision.
Term
Fixed vs. variable costs
 Definition
fixed cost example: rent on the business space; variable cost example: raw materials
Term
Explicit vs. implicit costs
 Definition
explicit costs are accounting costs; implicit costs are opportunity costs
Term
Accounting profit
 Definition
Total revenue - minus total explicit costs; also known as net income
Term
accounting profit
 Definition
does not necessarily correspond to economic profit
Term
Sunk costs
 Definition
should be ignored in decision-making (to the extent that they are irreversible).
Term
Sunk costs are:
 Definition
irrelevant costs. Example: allowing overhead or depreciation costs to influence short-run decisions
Term
Hidden-cost fallacy occurs
 Definition
when you ignore relevant costs
Term
Example of Hidden-cost fallacy
 Definition
ignoring the opportunity cost of capital when making investment or shutdown decisions.
Term
Hidden-cost fallacy Question that should be asked......
 Definition
could the money used to acquire this capital be used more effectively elsewhere?
Term
Hidden-cost fallacy - Solid decision-making advice:
 Definition
begin your analysis with the decision that you are considering (and not by looking at costs, which are only a means to that end).
Term
Marginal Cost (MC)
 Definition
the additional cost of producing and selling an additional unit of output; decisions are made at the margin
Term
Average Cost (AC)
 Definition
Total Cost/Quantity produced...where Total Cost = Fixed Cost (FC) + Variable Cost (VC)
Term
It is important not to confuse Marginal Cost and Average Cost. Average Cost is
 Definition
irrelevant to extent decisions.
Term
Marginal Revenue (MR)
 Definition
is the additional revenue gained from selling one more unit.
Term
Selling decisions - Sell more if
 Definition
MR > MC
Term
Selling decisions - Sell less if
 Definition
MC > MR
Term
you are selling the right amount if
 Definition
MR = MC (you are also maximizing profit!)
Term
An incentive compensation program that increases marginal revenue or reduces marginal cost
 Definition
will increase effort.
Term
Do incentives matter?
 Definition
Yes!
Term
Good incentive compensation programs
 Definition
link pay-for-performance measures with effort (aka behavior).
Term
You are faced with an investment decision. Are the future benefits greater than the current costs?
 Definition
Discounting helps one see the future benefits in current dollars
Term
Invest only in projects where
 Definition
the return is greater than the cost of capital
Term
The NPV rule states
 Definition
that if the present value of the net cash flows of a project is larger than zero, the project earns economic profit
Term
Invest only in projects where the return is greater than the cost of capital. The NPV rule states that if the present value of the net cash flows of a project is larger than zero, the project earns economic profit. These concepts are also covered in
 Definition
a Principles of Finance course
Term
Break-even analysis is
 Definition
sometimes (incorrectly) used to analyze investments
Term
, if you expect to sell more than the break-even quantity,
 Definition
then your investment will be profitable
Term
. Break-even quantity is
 Definition
equal to fixed cost divided by contribution margin
Term
Avoidable costs
 Definition
can be recovered by shutting down
Term
If the benefits of shutting down (getting back your avoidable costs) are greater than the costs (giving up your revenue),
 Definition
then shut down
Term
Sunk costs make one vulnerable to
 Definition
post-investment hold-up
Term
To prevent post-investment hold-up
 Definition
one must be careful in contract negotiations and organizational management.
Term
buyer and seller should negotiate
 Definition
appropriate incentives to do business and incur necessary sunk (often capital) costs.
Term
Law of Demand
 Definition
As price increases, all else equal, quantity demanded decreases (common sense)
Term
Reduce price (increase quantity) if
 Definition
MR > MC
Term
Increase price (reduce quantity) if
 Definition
MR < MC
Term
Optimal price is where
 Definition
MR = MC
Term
Price elasticity of demand (e)
 Definition
(% change in quantity demanded) / (% change in price)
Term
Elastic demand
 Definition
- is due to more substitute goods, more time to shop, and/or the good/service being a big purchase relative to one's budget
Term
Inelastic demand
 Definition
- is due to less substitute goods, less time to shop, and/or the good/service being a small purchase relative to one's budget
Term
When demand is more elastic,
 Definition
optimal price tends to be lower
Term
Demand for brands is
 Definition
more elastic than industry demand
Term
. Elasticity may be used to
 Definition
forecast changes in demand. However, recognize that forecasting is an inexact science.
Term
Types of goods
 Definition
– substitute goods (subjective): burgers and chicken sandwiches;
complementary goods example (subjective): hot dog and mustard
Term
Total-revenue test
 Definition
Does TR increase or decrease due to a price increase?
What happens when the price is reduced?
Term
Income elasticity, cross-price elasticity, and advertising elasticity are measures of
 Definition
how changes in these factors affect demand.
Term
Stay-even analysis can be used to
 Definition
determine the quantity change required to offset a price change
Term
A proposed price increase is
 Definition
is profitable if the predicted quantity loss is less than the stay-even quantity
Term
Law of diminishing marginal returns
 Definition
As output increases, marginal productivity (the extra output associated with extra inputs) eventually declines
Term
Example of Law of diminishing marginal returns
 Definition
hiring more workers when lack of capital is the problem
Term
Economies of scale (increasing returns to scale)
 Definition
As output increases, average cost decreases.
Term
Total cost =
 Definition
fixed cost + variable cost
Term
Average cost =
 Definition
total cost/quantity
Term
Economies of scale usually happen when
 Definition
most of total cost is fixed cost
Term
Example of Economies of scale
 Definition
banking – this is why so much consolidation has happened
Term
What does MPV Rule stand for?
 Definition
Net Present Value Rule
Term
Diseconomies of scale (decreasing returns to scale)
 Definition
- As output increases, average cost increases
Term
Examples of Diseconomies of scale
 Definition
a “bureaucracy” effect ---> for instance, governments and large corporations sometimes experience this
Term
Learning curves
 Definition
when current production lowers future costs. Make sure to consider the product’s life cycle here!
Term
Economies of scope
 Definition
when the cost of producing outputs jointly is less than the cost of producing them separately;
can be an important source of competitive advantage and can influence acquisitions
Term
A market
 Definition
has product, geographic, and time dimensions. It is important to properly define one’s market.
Term
Market demand
 Definition
describes buyer behavior
Term
market supply
 Definition
describes seller behavior in a competitive market.
Term
Law of Demand
 Definition
As price increases, all else equal, quantity demanded decreases (common sense)

changes in quantity demanded are represented by a movement along the demand curve
Term
Determinants of Demand (consumer perspective)
 Definition
price, income, prices of other goods, tastes and preferences (wants, needs, quality), expectations of future conditions (particularly prices and income)

any changes in these factors are represented by a shift in the demand curve, and are referred to as changes in demand
Term
Law of Supply
 Definition
As price increases, all else equal, quantity supplied increases (common sense)
Term
Determinants of Supply (producer perspective)
 Definition
price, costs (such as wages, raw materials), technology (ways and methods), number of producers, expectations, taxes/subsidies
Term
Surplus and shortage
 Definition
surplus is excess supply (incentive for price reduction)

shortage is excess demand (incentive for price increase)
Term
Equilibrium
 Definition
free market works toward this, exactly the amount offered for sale is sold

the resulting market price conveys valuable information
Term
Making a market
 Definition
is costly, and competition between market makers forces the bid-ask spread down to the costs of making a market
Term
Competitive industries
 Definition
The example, lawnmowing businesses.
Doing the analysis:
1. There are many firms
2. Product is pretty standardized (I guess it's possible to do a bad job with a lawn - then again, it's possible to do shoddy/variable work in any field)…therefore, demand is very elastic
3. Firms can freely enter and leave the market (the only capital requirement is a ~ $200 lawnmower)
4. Market price is a given (I know, I know - there's some variation here. But not too much.)...a different way of saying this is that market participants are price takers
Term
Profit exhibits
 Definition
mean reversion, where the mean is zero economic profit.
Term
indifference principle
 Definition
asset is mobile, it will make the same profit no matter where it goes
Term
Unattractive jobs will pay
 Definition
compensating wage differentials
Term
risky investments will pay
 Definition
compensating risk differentials (or a risk premium).
Term
The difference between stock returns and bond yields
 Definition
a compensating risk premium
Term
when risk premiums become too small, some investors view this as a time to get out of risky assets because
 Definition
the market may be ignoring risk in pursuit of higher returns
Term
Monopoly
 Definition
a one-firm situation
there are no close product substitutes
the firm is a price maker
Term
many monopolies are subject to
 Definition
pricing regulation, which gives little incentive to minimize costs

example: electric utilities and “fair-return” pricing
Term
Monopoly is achieved by
 Definition
‘winning’ the competition and/or gaining control of a scarce resource;

most examples are actually “near-monopolies”;
Term
while monopolies can earn positive profits longer than competitive firms, entry and imitation eventually
 Definition
erode their profit as well
Term
Read what Warren Buffett means by moats…
 Definition
Term
In theory, strategy is
 Definition
simple
Term
To increase performance
 Definition
, figure out a way to increase price or reduce cost (and make sure you know the difference between price and cost!).
Term
Strategy is the art of
 Definition
matching the resources and capabilities of a firm (or of yourself?) to the opportunities and risks in the external environment.
Term
Porter’s Five Forces model
 Definition
model is a framework for analyzing the attractiveness of an industry
Term
Attractive industries have
 Definition
have low supplier power,
low buyer power,
low threat of entry,
low threat of substitutes,
low rivalry.
Term
To be the source of sustainable competitive advantage,
 Definition
resources should be valuable, rare, and difficult to imitate/substitute.
Term
Be wary (!) of
 Definition
any advice you read that claims to identify critical resources or capabilities that successful companies must develop in order to gain competitive advantage
Term
To stay ahead of the competition, a firm
 Definition
can adopt one of three basic strategies: cost reduction, product differentiation, or reduction in competitive intensity (i.e. the Warren Buffett moats concept).
Term
In the market for foreign exchange between England and Iceland, the supply of British Pounds includes
 Definition
everyone in Britain who wants to sell British Pounds to buy Icelandic Krona…in order to buy Icelandic goods or invest in Iceland.
Term
In the market for foreign exchange between England and Iceland, the demand for British Pounds includes
 Definition
everyone in Iceland who wants to sell Icelandic Krona to buy British Pounds…in order to buy British goods or invest in Britain
Term
A decline in U.S. interest rates will induce
 Definition
foreign investors to borrow in dollars
Term
carry trade
 Definition
These foreign investors may sell the dollars to buy foreign currency, and then invest in the foreign country
Term
The result of carry trade is
 Definition
dollar depreciation
Term
Currency devaluations
 Definition
devaluations increase domestic demand by making exports cheaper and imports more expensive.
Term
Expectations about the future play a role in
 Definition
price bubbles
Term
If buyers expect a future price increase
 Definition
they will accelerate their purchases to avoid it.
Term
If a sellers expects a future price increase
 Definition
they will delay selling to take advantage of this
Term
One may be able to identify bubbles by
 Definition
applying the indifference principle (see Chapter 9).
Term
Are market prices moving away from their long-run equilibriums?
 Definition
Yes
Term
The rational-actor paradigm assumes what?
 Definition
People act rationally, optimally, and self-interestedly
Term
A well-designed organization is one in which employee Incentives are aligned with what?
 Definition
organizational goals
Term
What power does the government have to control economic stability?
 Definition
the ability to control the economy by bills/laws that prevent inhibiting economic growth
Term
increase marginal revenue and decreased marginal costs provide room for what?
 Definition
incentive pay/ rewards
Term
NPV stands for what Rule?
 Definition
Net Present Value rule
Term
Q=F/(P-MC)
 Definition
Break Even Quantity=annual fixed cost/(Profit-Marginal Cost)
Term
the law of demand states:
 Definition
as price increases, quantity of demand decreases, and vice versa
Term
Incentives
 Definition
matter (significantly)!!
Term
A well-designed organization
 Definition
is one in which employee incentives are aligned with organizational goals. Employee access to accurate information is critical
Term
Voluntary transactions
 Definition
create wealth by moving assets from lower-valued to higher-valued uses.
Term
Anything that impedes the movement of assets to higher-valued uses, like taxes, subsidies, price ceilings, and/or price floors,
 Definition
destroys wealth.
Term
A company is simply
 Definition
a series of transactions
Term
Stopping unprofitable transactions is
 Definition
is nearly as important as completing profitable transactions.
Term
This principle may be even more important in government:
 Definition
stopping bad bills/laws may be more important than passing good ones!
Term
Opportunity cost
 Definition
example: What are you giving up to study (next best thing...and NOT everything)?
Term
Consider ALL costs and benefits that vary with a decision...and ONLY the costs and benefits that vary with the consequences of a decision.
 Definition
These are know as the relevant costs and relevant benefits of a decision.
Term
Fixed vs. variable costs
 Definition
fixed cost example: rent on the business space; variable cost example: raw materials
Term
Explicit vs. implicit costs
 Definition
explicit costs are accounting costs; implicit costs are opportunity costs
Term
Accounting profit
 Definition
Total revenue - minus total explicit costs; also known as net income
Term
accounting profit
 Definition
does not necessarily correspond to economic profit
Term
Sunk costs
 Definition
should be ignored in decision-making (to the extent that they are irreversible).
Term
Sunk costs are:
 Definition
irrelevant costs. Example: allowing overhead or depreciation costs to influence short-run decisions
Term
Hidden-cost fallacy occurs
 Definition
when you ignore relevant costs
Term
Example of Hidden-cost fallacy
 Definition
ignoring the opportunity cost of capital when making investment or shutdown decisions.
Term
Hidden-cost fallacy Question that should be asked......
 Definition
could the money used to acquire this capital be used more effectively elsewhere?
Term
Hidden-cost fallacy - Solid decision-making advice:
 Definition
begin your analysis with the decision that you are considering (and not by looking at costs, which are only a means to that end).
Term
Marginal Cost (MC)
 Definition
the additional cost of producing and selling an additional unit of output; decisions are made at the margin
Term
Average Cost (AC)
 Definition
Total Cost/Quantity produced...where Total Cost = Fixed Cost (FC) + Variable Cost (VC)
Term
It is important not to confuse Marginal Cost and Average Cost. Average Cost is
 Definition
irrelevant to extent decisions.
Term
Marginal Revenue (MR)
 Definition
is the additional revenue gained from selling one more unit.
Term
Selling decisions - Sell more if
 Definition
MR > MC
Term
Selling decisions - Sell less if
 Definition
MC > MR
Term
you are selling the right amount if
 Definition
MR = MC (you are also maximizing profit!)
Term
An incentive compensation program that increases marginal revenue or reduces marginal cost
 Definition
will increase effort.
Term
Do incentives matter?
 Definition
Yes!
Term
Good incentive compensation programs
 Definition
link pay-for-performance measures with effort (aka behavior).
Term
You are faced with an investment decision. Are the future benefits greater than the current costs?
 Definition
Discounting helps one see the future benefits in current dollars
Term
Invest only in projects where
 Definition
the return is greater than the cost of capital
Term
The NPV rule states
 Definition
that if the present value of the net cash flows of a project is larger than zero, the project earns economic profit
Term
Invest only in projects where the return is greater than the cost of capital. The NPV rule states that if the present value of the net cash flows of a project is larger than zero, the project earns economic profit. These concepts are also covered in
 Definition
a Principles of Finance course
Term
Break-even analysis is
 Definition
sometimes (incorrectly) used to analyze investments
Term
, if you expect to sell more than the break-even quantity,
 Definition
then your investment will be profitable
Term
. Break-even quantity is
 Definition
equal to fixed cost divided by contribution margin
Term
Avoidable costs
 Definition
can be recovered by shutting down
Term
If the benefits of shutting down (getting back your avoidable costs) are greater than the costs (giving up your revenue),
 Definition
then shut down
Term
Sunk costs make one vulnerable to
 Definition
post-investment hold-up
Term
To prevent post-investment hold-up
 Definition
one must be careful in contract negotiations and organizational management.
Term
buyer and seller should negotiate
 Definition
appropriate incentives to do business and incur necessary sunk (often capital) costs.
Term
Law of Demand
 Definition
As price increases, all else equal, quantity demanded decreases (common sense)
Term
Reduce price (increase quantity) if
 Definition
MR > MC
Term
Increase price (reduce quantity) if
 Definition
MR < MC
Term
Optimal price is where
 Definition
MR = MC
Term
Price elasticity of demand (e)
 Definition
(% change in quantity demanded) / (% change in price)
Term
Elastic demand
 Definition
- is due to more substitute goods, more time to shop, and/or the good/service being a big purchase relative to one's budget
Term
Inelastic demand
 Definition
- is due to less substitute goods, less time to shop, and/or the good/service being a small purchase relative to one's budget
Term
When demand is more elastic,
 Definition
optimal price tends to be lower
Term
Demand for brands is
 Definition
more elastic than industry demand
Term
. Elasticity may be used to
 Definition
forecast changes in demand. However, recognize that forecasting is an inexact science.
Term
Types of goods
 Definition
– substitute goods (subjective): burgers and chicken sandwiches;
complementary goods example (subjective): hot dog and mustard
Term
Total-revenue test
 Definition
Does TR increase or decrease due to a price increase?
What happens when the price is reduced?
Term
Income elasticity, cross-price elasticity, and advertising elasticity are measures of
 Definition
how changes in these factors affect demand.
Term
Stay-even analysis can be used to
 Definition
determine the quantity change required to offset a price change
Term
A proposed price increase is
 Definition
is profitable if the predicted quantity loss is less than the stay-even quantity
Term
Law of diminishing marginal returns
 Definition
As output increases, marginal productivity (the extra output associated with extra inputs) eventually declines
Term
Example of Law of diminishing marginal returns
 Definition
hiring more workers when lack of capital is the problem
Term
Economies of scale (increasing returns to scale)
 Definition
As output increases, average cost decreases.
Term
Total cost =
 Definition
fixed cost + variable cost
Term
Average cost =
 Definition
total cost/quantity
Term
Economies of scale usually happen when
 Definition
most of total cost is fixed cost
Term
Example of Economies of scale
 Definition
banking – this is why so much consolidation has happened
Term
What does MPV Rule stand for?
 Definition
Net Present Value Rule
Term
Diseconomies of scale (decreasing returns to scale)
 Definition
- As output increases, average cost increases
Term
Examples of Diseconomies of scale
 Definition
a “bureaucracy” effect ---> for instance, governments and large corporations sometimes experience this
Term
Learning curves
 Definition
when current production lowers future costs. Make sure to consider the product’s life cycle here!
Term
Economies of scope
 Definition
when the cost of producing outputs jointly is less than the cost of producing them separately;
can be an important source of competitive advantage and can influence acquisitions
Term
A market
 Definition
has product, geographic, and time dimensions. It is important to properly define one’s market.
Term
Market demand
 Definition
describes buyer behavior
Term
market supply
 Definition
describes seller behavior in a competitive market.
Term
Law of Demand
 Definition
As price increases, all else equal, quantity demanded decreases (common sense)

changes in quantity demanded are represented by a movement along the demand curve
Term
Determinants of Demand (consumer perspective)
 Definition
price, income, prices of other goods, tastes and preferences (wants, needs, quality), expectations of future conditions (particularly prices and income)

any changes in these factors are represented by a shift in the demand curve, and are referred to as changes in demand
Term
Law of Supply
 Definition
As price increases, all else equal, quantity supplied increases (common sense)
Term
Determinants of Supply (producer perspective)
 Definition
price, costs (such as wages, raw materials), technology (ways and methods), number of producers, expectations, taxes/subsidies
Term
Surplus and shortage
 Definition
surplus is excess supply (incentive for price reduction)

shortage is excess demand (incentive for price increase)
Term
Equilibrium
 Definition
free market works toward this, exactly the amount offered for sale is sold

the resulting market price conveys valuable information
Term
Making a market
 Definition
is costly, and competition between market makers forces the bid-ask spread down to the costs of making a market
Term
Competitive industries
 Definition
The example, lawnmowing businesses.
Doing the analysis:
1. There are many firms
2. Product is pretty standardized (I guess it's possible to do a bad job with a lawn - then again, it's possible to do shoddy/variable work in any field)…therefore, demand is very elastic
3. Firms can freely enter and leave the market (the only capital requirement is a ~ $200 lawnmower)
4. Market price is a given (I know, I know - there's some variation here. But not too much.)...a different way of saying this is that market participants are price takers
Term
Profit exhibits
 Definition
mean reversion, where the mean is zero economic profit.
Term
indifference principle
 Definition
asset is mobile, it will make the same profit no matter where it goes
Term
Unattractive jobs will pay
 Definition
compensating wage differentials
Term
risky investments will pay
 Definition
compensating risk differentials (or a risk premium).
Term
The difference between stock returns and bond yields
 Definition
a compensating risk premium
Term
when risk premiums become too small, some investors view this as a time to get out of risky assets because
 Definition
the market may be ignoring risk in pursuit of higher returns
Term
Monopoly
 Definition
a one-firm situation
there are no close product substitutes
the firm is a price maker
Term
many monopolies are subject to
 Definition
pricing regulation, which gives little incentive to minimize costs

example: electric utilities and “fair-return” pricing
Term
Monopoly is achieved by
 Definition
‘winning’ the competition and/or gaining control of a scarce resource;

most examples are actually “near-monopolies”;
Term
while monopolies can earn positive profits longer than competitive firms, entry and imitation eventually
 Definition
erode their profit as well
Term
Read what Warren Buffett means by moats…
 Definition
Term
In theory, strategy is
 Definition
simple
Term
To increase performance
 Definition
, figure out a way to increase price or reduce cost (and make sure you know the difference between price and cost!).
Term
Strategy is the art of
 Definition
matching the resources and capabilities of a firm (or of yourself?) to the opportunities and risks in the external environment.
Term
Porter’s Five Forces model
 Definition
model is a framework for analyzing the attractiveness of an industry
Term
Attractive industries have
 Definition
have low supplier power,
low buyer power,
low threat of entry,
low threat of substitutes,
low rivalry.
Term
To be the source of sustainable competitive advantage,
 Definition
resources should be valuable, rare, and difficult to imitate/substitute.
Term
Be wary (!) of
 Definition
any advice you read that claims to identify critical resources or capabilities that successful companies must develop in order to gain competitive advantage
Term
To stay ahead of the competition, a firm
 Definition
can adopt one of three basic strategies: cost reduction, product differentiation, or reduction in competitive intensity (i.e. the Warren Buffett moats concept).
Term
In the market for foreign exchange between England and Iceland, the supply of British Pounds includes
 Definition
everyone in Britain who wants to sell British Pounds to buy Icelandic Krona…in order to buy Icelandic goods or invest in Iceland.
Term
In the market for foreign exchange between England and Iceland, the demand for British Pounds includes
 Definition
everyone in Iceland who wants to sell Icelandic Krona to buy British Pounds…in order to buy British goods or invest in Britain
Term
A decline in U.S. interest rates will induce
 Definition
foreign investors to borrow in dollars
Term
carry trade
 Definition
These foreign investors may sell the dollars to buy foreign currency, and then invest in the foreign country
Term
The result of carry trade is
 Definition
dollar depreciation
Term
Currency devaluations
 Definition
devaluations increase domestic demand by making exports cheaper and imports more expensive.
Term
Expectations about the future play a role in
 Definition
price bubbles
Term
If buyers expect a future price increase
 Definition
they will accelerate their purchases to avoid it.
Term
If a sellers expects a future price increase
 Definition
they will delay selling to take advantage of this
Term
One may be able to identify bubbles by
 Definition
applying the indifference principle (see Chapter 9).
Term
Are market prices moving away from their long-run equilibriums?
 Definition
Yes
Term
The rational-actor paradigm assumes what?
 Definition
People act rationally, optimally, and self-interestedly
Term
A well-designed organization is one in which employee Incentives are aligned with what?
 Definition
organizational goals
Term
What power does the government have to control economic stability?
 Definition
the ability to control the economy by bills/laws that prevent inhibiting economic growth
Term
increase marginal revenue and decreased marginal costs provide room for what?
 Definition
incentive pay/ rewards
Term
NPV stands for what Rule?
 Definition
Net Present Value rule
Term
Q=F/(P-MC)
 Definition
Break Even Quantity=annual fixed cost/(Profit-Marginal Cost)
Term
the law of demand states:
 Definition
as price increases, quantity of demand decreases, and vice versa
Term
Incentives
 Definition
matter (significantly)!!
Term
A well-designed organization
 Definition
is one in which employee incentives are aligned with organizational goals. Employee access to accurate information is critical
Term
Voluntary transactions
 Definition
create wealth by moving assets from lower-valued to higher-valued uses.
Term
Anything that impedes the movement of assets to higher-valued uses, like taxes, subsidies, price ceilings, and/or price floors,
 Definition
destroys wealth.
Term
A company is simply
 Definition
a series of transactions
Term
Stopping unprofitable transactions is
 Definition
is nearly as important as completing profitable transactions.
Term
This principle may be even more important in government:
 Definition
stopping bad bills/laws may be more important than passing good ones!
Term
Opportunity cost
 Definition
example: What are you giving up to study (next best thing...and NOT everything)?
Term
Consider ALL costs and benefits that vary with a decision...and ONLY the costs and benefits that vary with the consequences of a decision.
 Definition
These are know as the relevant costs and relevant benefits of a decision.
Term
Fixed vs. variable costs
 Definition
fixed cost example: rent on the business space; variable cost example: raw materials
Term
Explicit vs. implicit costs
 Definition
explicit costs are accounting costs; implicit costs are opportunity costs
Term
Accounting profit
 Definition
Total revenue - minus total explicit costs; also known as net income
Term
accounting profit
 Definition
does not necessarily correspond to economic profit
Term
Sunk costs
 Definition
should be ignored in decision-making (to the extent that they are irreversible).
Term
Sunk costs are
 Definition
irrelevant costs. Example: allowing overhead or depreciation costs to influence short-run decisions
Term
Hidden-cost fallacy occurs
 Definition
when you ignore relevant costs
Term
Example of Hidden-cost fallacy
 Definition
ignoring the opportunity cost of capital when making investment or shutdown decisions.
Term
Hidden-cost fallacy Question that should be asked......
 Definition
could the money used to acquire this capital be used more effectively elsewhere?
Term
Hidden-cost fallacy - Solid decision-making advice:
 Definition
begin your analysis with the decision that you are considering (and not by looking at costs, which are only a means to that end).
Term
Marginal Cost (MC)
 Definition
the additional cost of producing and selling an additional unit of output; decisions are made at the margin
Term
Average Cost (AC)
 Definition
Total Cost/Quantity produced...where Total Cost = Fixed Cost (FC) + Variable Cost (VC)
Term
It is important not to confuse Marginal Cost and Average Cost. Average Cost is
 Definition
irrelevant to extent decisions.
Term
Marginal Revenue (MR)
 Definition
is the additional revenue gained from selling one more unit.
Term
Selling decisions - Sell more if
 Definition
MR > MC
Term
Selling decisions - Sell less if
 Definition
MC > MR
Term
you are selling the right amount if
 Definition
MR = MC (you are also maximizing profit!)
Term
An incentive compensation program that increases marginal revenue or reduces marginal cost
 Definition
will increase effort.
Term
Do incentives matter?
 Definition
Yes!
Term
Good incentive compensation programs
 Definition
link pay-for-performance measures with effort (aka behavior).
Term
You are faced with an investment decision. Are the future benefits greater than the current costs?
 Definition
Discounting helps one see the future benefits in current dollars
Term
Invest only in projects where
 Definition
the return is greater than the cost of capital
Term
The NPV rule states
 Definition
that if the present value of the net cash flows of a project is larger than zero, the project earns economic profit
Term
Invest only in projects where the return is greater than the cost of capital. The NPV rule states that if the present value of the net cash flows of a project is larger than zero, the project earns economic profit. These concepts are also covered in
 Definition
a Principles of Finance course
Term
Break-even analysis is
 Definition
sometimes (incorrectly) used to analyze investments
Term
, if you expect to sell more than the break-even quantity,
 Definition
then your investment will be profitable
Term
. Break-even quantity is
 Definition
equal to fixed cost divided by contribution margin
Term
Avoidable costs
 Definition
can be recovered by shutting down
Term
If the benefits of shutting down (getting back your avoidable costs) are greater than the costs (giving up your revenue),
 Definition
then shut down
Term
Sunk costs make one vulnerable to
 Definition
post-investment hold-up
Term
To prevent post-investment hold-up
 Definition
one must be careful in contract negotiations and organizational management.
Term
buyer and seller should negotiate
 Definition
appropriate incentives to do business and incur necessary sunk (often capital) costs.
Term
Law of Demand
 Definition
As price increases, all else equal, quantity demanded decreases (common sense)
Term
Reduce price (increase quantity) if
 Definition
MR > MC
Term
Increase price (reduce quantity) if
 Definition
MR < MC
Term
Optimal price is where
 Definition
MR = MC
Term
Price elasticity of demand (e)
 Definition
(% change in quantity demanded) / (% change in price)
Term
Elastic demand
 Definition
- is due to more substitute goods, more time to shop, and/or the good/service being a big purchase relative to one's budget
Term
Inelastic demand
 Definition
- is due to less substitute goods, less time to shop, and/or the good/service being a small purchase relative to one's budget
Term
When demand is more elastic,
 Definition
optimal price tends to be lower
Term
Demand for brands is
 Definition
more elastic than industry demand
Term
. Elasticity may be used to
 Definition
forecast changes in demand. However, recognize that forecasting is an inexact science.
Term
Types of goods
 Definition
– substitute goods (subjective): burgers and chicken sandwiches;
complementary goods example (subjective): hot dog and mustard
Term
Total-revenue test
 Definition
Does TR increase or decrease due to a price increase?
What happens when the price is reduced?
Term
Income elasticity, cross-price elasticity, and advertising elasticity are measures of
 Definition
how changes in these factors affect demand.
Term
Stay-even analysis can be used to
 Definition
determine the quantity change required to offset a price change
Term
A proposed price increase is
 Definition
is profitable if the predicted quantity loss is less than the stay-even quantity
Term
Law of diminishing marginal returns
 Definition
As output increases, marginal productivity (the extra output associated with extra inputs) eventually declines
Term
Example of Law of diminishing marginal returns
 Definition
hiring more workers when lack of capital is the problem
Term
Economies of scale (increasing returns to scale)
 Definition
As output increases, average cost decreases.
Term
Total cost =
 Definition
fixed cost + variable cost
Term
Average cost =
 Definition
total cost/quantity
Term
Economies of scale usually happen when
 Definition
most of total cost is fixed cost
Term
Example of Economies of scale
 Definition
banking – this is why so much consolidation has happened
Term
What does MPV Rule stand for?
 Definition
Net Present Value Rule
Term
Diseconomies of scale (decreasing returns to scale)
 Definition
- As output increases, average cost increases
Term
Examples of Diseconomies of scale
 Definition
a “bureaucracy” effect ---> for instance, governments and large corporations sometimes experience this
Term
Learning curves
 Definition
when current production lowers future costs. Make sure to consider the product’s life cycle here!
Term
Economies of scope
 Definition
when the cost of producing outputs jointly is less than the cost of producing them separately;
can be an important source of competitive advantage and can influence acquisitions
Term
A market
 Definition
has product, geographic, and time dimensions. It is important to properly define one’s market.
Term
Market demand
 Definition
describes buyer behavior
Term
market supply
 Definition
describes seller behavior in a competitive market.
Term
Law of Demand
 Definition
As price increases, all else equal, quantity demanded decreases (common sense)

changes in quantity demanded are represented by a movement along the demand curve
Term
Determinants of Demand (consumer perspective)
 Definition
price, income, prices of other goods, tastes and preferences (wants, needs, quality), expectations of future conditions (particularly prices and income)

any changes in these factors are represented by a shift in the demand curve, and are referred to as changes in demand
Term
Law of Supply
 Definition
As price increases, all else equal, quantity supplied increases (common sense)
Term
Determinants of Supply (producer perspective)
 Definition
price, costs (such as wages, raw materials), technology (ways and methods), number of producers, expectations, taxes/subsidies
Term
Surplus and shortage
 Definition
surplus is excess supply (incentive for price reduction)

shortage is excess demand (incentive for price increase)
Term
Equilibrium
 Definition
free market works toward this, exactly the amount offered for sale is sold

the resulting market price conveys valuable information
Term
Making a market
 Definition
is costly, and competition between market makers forces the bid-ask spread down to the costs of making a market
Term
Competitive industries
 Definition
The example, lawnmowing businesses.
Doing the analysis:
1. There are many firms
2. Product is pretty standardized (I guess it's possible to do a bad job with a lawn - then again, it's possible to do shoddy/variable work in any field)…therefore, demand is very elastic
3. Firms can freely enter and leave the market (the only capital requirement is a ~ $200 lawnmower)
4. Market price is a given (I know, I know - there's some variation here. But not too much.)...a different way of saying this is that market participants are price takers
Term
Profit exhibits
 Definition
mean reversion, where the mean is zero economic profit.
Term
indifference principle
 Definition
asset is mobile, it will make the same profit no matter where it goes
Term
Unattractive jobs will pay
 Definition
compensating wage differentials
Term
risky investments will pay
 Definition
compensating risk differentials (or a risk premium).
Term
The difference between stock returns and bond yields
 Definition
a compensating risk premium
Term
when risk premiums become too small, some investors view this as a time to get out of risky assets because
 Definition
the market may be ignoring risk in pursuit of higher returns
Term
Monopoly
 Definition
a one-firm situation
there are no close product substitutes
the firm is a price maker
Term
many monopolies are subject to
 Definition
pricing regulation, which gives little incentive to minimize costs

example: electric utilities and “fair-return” pricing
Term
Monopoly is achieved by
 Definition
‘winning’ the competition and/or gaining control of a scarce resource;

most examples are actually “near-monopolies”;
Term
while monopolies can earn positive profits longer than competitive firms, entry and imitation eventually
 Definition
erode their profit as well
Term
Read what Warren Buffett means by moats…
 Definition
Term
In theory, strategy is
 Definition
simple
Term
To increase performance
 Definition
, figure out a way to increase price or reduce cost (and make sure you know the difference between price and cost!).
Term
Strategy is the art of
 Definition
matching the resources and capabilities of a firm (or of yourself?) to the opportunities and risks in the external environment.
Term
Porter’s Five Forces model
 Definition
model is a framework for analyzing the attractiveness of an industry
Term
Attractive industries have
 Definition
have low supplier power,
low buyer power,
low threat of entry,
low threat of substitutes,
low rivalry.
Term
To be the source of sustainable competitive advantage,
 Definition
resources should be valuable, rare, and difficult to imitate/substitute.
Term
Be wary (!) of
 Definition
any advice you read that claims to identify critical resources or capabilities that successful companies must develop in order to gain competitive advantage
Term
To stay ahead of the competition, a firm
 Definition
can adopt one of three basic strategies: cost reduction, product differentiation, or reduction in competitive intensity (i.e. the Warren Buffett moats concept).
Term
In the market for foreign exchange between England and Iceland, the supply of British Pounds includes
 Definition
everyone in Britain who wants to sell British Pounds to buy Icelandic Krona…in order to buy Icelandic goods or invest in Iceland.
Term
In the market for foreign exchange between England and Iceland, the demand for British Pounds includes
 Definition
everyone in Iceland who wants to sell Icelandic Krona to buy British Pounds…in order to buy British goods or invest in Britain
Term
A decline in U.S. interest rates will induce
 Definition
foreign investors to borrow in dollars
Term
carry trade
 Definition
These foreign investors may sell the dollars to buy foreign currency, and then invest in the foreign country
Term
The result of carry trade is
 Definition
dollar depreciation
Term
Currency devaluations
 Definition
devaluations increase domestic demand by making exports cheaper and imports more expensive.
Term
Expectations about the future play a role in
 Definition
price bubbles
Term
If buyers expect a future price increase
 Definition
they will accelerate their purchases to avoid it.
Term
If a sellers expects a future price increase
 Definition
they will delay selling to take advantage of this
Term
One may be able to identify bubbles by
 Definition
applying the indifference principle (see Chapter 9).
Term
Are market prices moving away from their long-run equilibriums?
 Definition
Yes
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