Econ Exam #4 Notes - Exam #4 for ECON102 with Jadrian Wooten PDF

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Exam #4 for ECON102 with Jadrian Wooten...

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Exam 4 Notes Lesson 15 – Pricing Strategy (Chapter 16) Law of One Price (200) An economic theory that the price of a commodity should be the same regardless of location. 



Holds only if: o Transaction costs, like shipping, are zero o Products can be resold Doesn’t hold if: o Company of one product has a better reputation than its competitors o Product services can be differentiated

Arbitrage (200) Buying a product in one market at a low price and reselling it in another market. Profits received from engaging in arbitrage – arbitrage profits Big Mac Index (200) Created by The Economist magazine in 1986 to measure purchasing power parity (PPP) between nations, using the price of a McDonald's Big Mac as the benchmark. Price Discrimination (201-203) When companies charge different prices to different people of the same good. Charging different prices for the same product where the price differences are not due to cost!   

Firms charge demand-inelastic consumers more, and demand-elastic consumers less. Firms charge a higher price for a product when it is first introduced and a lower price later Firms charge each consumer a different price equal to that consumer’s willingness to pay

Examples of Price Discrimination    

Orange juice vs. jugo de naranja Charging OSU fans more than OU fans for parking Flights at different times Wedding vs. Party flutes

Requirements for Price Discrimination 

Firms must possess market power – be a price maker

 

  

Cannot resell the product Firms must be able to divide up / segment market for the product so that consumers who buy the product at a low price are not able to resell it (no arbitrage!) Some consumers must have greater WTP for a product than others Firm must know consumer WTP for the product Not be in a perfectly competitive market (that way, it would only be able to charge the market price and that’s not what we want)

Methods of Price Discrimination   

Volume discounts Advance purchase discounts (buying products early) Two-part tariffs

Profits from Price Discrimination  

Firms separate out the markets and charge prices that would optimize their profit Ex. Movie Theaters o Segment into afternoon vs. evening movie-watchers o Should maximize profit by charging higher price for evening movie

Airlines 



Airlines practice discrimination because: o Airline seats are a perishable product o Marginal cost of flying one additional passenger is low o Strong incentive to manage prices to fill as many seats as possible on each flight Divided between leisure travelers (more elastic) and business travelers (more inelastic)

Efficiency of Price Discrimination 

A firm will maximize profits by producing the quantity of output where MR =



MC By reducing the deadweight loss, price discrimination is more allocatively efficient

Perfect Price Discrimination (203-204) When a firm charges each customer a different price according to WTP.  

Unlikely to occur; firms don’t know everyone’s WTP Efficient; converts all DWL and CS into PS

Under perfect price discrimination, the firm captures all consumer surplus as profit.

Pricing Strategies (203-204) Odd-Pricing  

Charging $4.99 instead of $5 Why odd pricing? o Originated when imported goods transferred pounds to USD, which resulted in an odd price; imported goods were associated with higher quality

o Guard against employee theft (employees need to give change) o Penny or nickel cheaper seems significant to the consumer (left-digit effect) Cost-Plus Pricing     

Charging consumers a price by adding a percentage markup to the average total cost CPP is not consistent with a firm maximizing profits because it ignores demand; it doesn’t necessarily result in a quantity where MR = MC CPP focuses only on ATC and ignores MC, is difficult to calculate Percentage markup is higher on products that have inelastic demand and lower on products that have elastic demand Ex. charging a price 30% higher than average cost

Two-Part Tariffs (204-205) Firms requiring consumers to pay an initial fee for the right to buy the product and then an additional fee for each unit purchased. Examples:    

Disney and rides Printer and toner/paper Razor and razorblades Barbie and clothes

Lesson 16 – Game Theory (Chapter 14.2 & 14.3) Cooperative vs. Noncooperative Behavior (207) Cooperative: collusion; reaching and holding to an agreement that maximizes their combined profits. Equilibrium is when players cooperate to increase their mutual

payoff (sum). Noncooperative: firms ignoring the effects of their actions on each other’s profits; acting in own self-interest, even if it drives down everyone’s profits Game Theory (207) Study of behavior in situations of interdependence; a way of predicting outcomes in strategic situations like oligopolies. Rules (determine what actions are allowable), Strategies (employed by players to attain objectives), Payoffs (results of interaction among players’ strategies). In economics, Rules include matters beyond a firm’s control, Strategy is a firm maximizing profits, and Payoffs are profits. Prisoner’s Dilemma (208-210) Occurs when each firm has an incentive to cheat, but both are worse off if they both cheat. The best strategy for each player is to not cooperate (dominant strategy) no matter what the other player does. However, this leaves everyone worse off. Premises of Prisoner’s Dilemma  

Each player has an incentive to choose an action that benefits itself at the other player’s expense When both players act in this way, both are worse off than if they had cooperated

Overcoming the Prisoner’s Dilemma  

Repeated interaction and tacit collusion Tit-for-tat strategies

Dominant Strategies (209) A strategy that is a player’s best action regardless of the action taken by the other player. A player may or may not have a dominant strategy. Nash Equilibrium (209) Occurs when each player in a game chooses the action that maximizes their payoff given the actions of other players, ignoring the effects of their action on the payoffs received by those other players. Interdependence (210) Players who don’t take interdependence into account arrive at a Nash equilibrium. Repeated Interaction & Tacit Collusion (210) If a game is played repeatedly, players may engage in strategic behavior and sacrifice

short-run profit to influence future behavior.   

Employ retaliation strategies Signal or collude your “short term profit” Ex. if Walter and Jesse get arrested over and over again, they know whether they can trust each other or not

Tit-for-Tat Strategy (210) Cooperating at first, then doing whatever the other player did in the previous period  

Can help lead to cooperation if both participate, or make it worse Players could also use a credible threat to signal cooperation

Sequential vs. Simultaneous Games (210) In sequential games, one player gets to act first and the other firm will respond; diagrammed using a game tree. Backward Induction (210) Method of solving a sequential game. First Move vs. Second Move Advantage (210) First-Mover  

Gains competitive advantage by being first, get additional time to perfect product, set market price for new item. Often face high research and development costs, and the marketing costs necessary to educate the public about a new type of product.

Second-Mover  

Firm following the lead of the first-mover is actually able to capture greater market share, despite having entered late. Can use its resources to focus on making a superior product or out-marketing the first-mover.

Decision Trees (211) Contains decision nodes where firms must make decisions, arrows illustrating the decisions, and terminal nodes showing the resulting rates of return. Subgame Perfect Equilibrium: Nash Equilibrium in which no player can make himself better off by changing his decision at any decision node. Use backwards induction to see if second-mover will enter the market.

Lesson 17 – Consumer Choice & Behavioral Economics

(Chapter 10) Economic Model of Consumer Behavior Predicts that consumers will choose to buy the combination of goods and services that makes them as well off as possible from among all the combinations that their budgets allow them to buy. Marginal Analysis (212) Change in total value / utility a person receives from consuming one additional unit of a product. Examples of Marginal Decisions (anything you do one at a time):  

House Car

Utility & Assumptions (212) Utility: the enjoyment or satisfaction people receive from consuming goods and services; measured in utils Assumptions: 

 

All goods have value. o Benefit: value that comes from dollars o Utility: value or satisfaction from consumption There is no saving. o Consumers spend all income and ignore future consumption Marginal utility/benefit diminishes over time. o Each additional unit of a good adds less to utility than the previous unit

Consumption Bundles (213, 216) A collection of goods and services. Optimal Consumption Bundle: bundle that maximizes total utility given a budget constraint. Principle of Diminishing Marginal Utility (213) Each successive unit of a good adds less than the last one. In general, utility diminishes, but it doesn’t have to. Examples of Non-Diminishing Marginal Utility  

Painting a wall: the first stroke isn’t the “best” Reading a book: the first page isn’t the “best”

Budget Constraints / Lines (214-216)

The limited amount of income or time available to consumers to spend on goods and services. An increase in income shifts the budget constraint outward. If the price changes, the slope of the budget constraint changes. Calculating Marginal Utility Marginal Utility = MU per dollar =

∆∈Utility ∆∈Quantity Marginal Utility per item Price of item

Rule: Compare the marginal utility and price for all goods, then adjust your spending toward the goods that give you more marginal utility per dollar.

Equimarginal Principle “Bang for Your Buck” Consumers will choose a combination of goods to maximize their total utility. Income Effect (220) The change in the quantity consumed of a good that results from a change in the consumer’s purchasing power due to the change in the price of the good. Normal Goods: a consumer increases the quantity demanded as the consumer’s income rises 

Ex. if pizza were a normal good, the income effect of a fall in the price would have caused you to consume more pizza.

Inferior Goods: a consumer decreases the quantity demanded as the consumer’s income rises 

Ex. if pizza were an inferior good, the income effect of a fall in the price would have caused you to consume less pizza.

Substitution Effect (220) The change in the quantity demanded of a good that results from a change in price making the good more or less expensive relative to other goods, holding constant the effect of the price change on consumer purchasing power.

Rationality (221) A rational decision maker chooses the option that leads them to the outcome they most prefer. Ultimatum Game (221) An experiment that tests whether fairness is important in consumer decision-making. When the game is actually carried out, both players act as if fairness is important. 1. Allocator gets $20. They have to make the decision of how much to split. 2. The Recipient must then decide whether to accept or reject the allocation. If they reject, neither get the money. Optimal Play: Allocator gives Recipient $0.01. Recipient accepts it. Preferring a Worse Economic Outcome (222) Concerns About Fairness: we want to make sure people are treated fairly, ex. tips Bounded Rationality: choosing a “close enough” option because the math is hard

Risk Aversion: giving up some profit to avoid risk, ex. insurance Economic Irrationality (222-225) An irrational decision-maker chooses an option that leaves them worse off than choosing another available option. 1. Misperceptions of Opportunity Costs  

A sunk cost is already incurred and not recoverable; should be ignored in decisions about future actions. “Don’t cling to a mistake just because you spent a lot of time making it.”

2. Overconfidence 

Nonprofessional investors who engage in speculative investing have significantly worse results than professional brokers because of their misguided faith.

3. Unrealistic Expectations About Future Behavior  

A form of overconfidence (in future self). Essentially, people procrastinate; businesses and people create strategies to overcome this. Ex. alarm clock that rolls around, or apps

4. Counting Dollars Unequally / Mental Accounting  

The act of assigning dollars to different accounts so that some dollars are worth more than others. Ex. overspending on payday or sales, being uptight when poor

5. Loss Aversion  

Oversensitivity to losing money such that people can’t move on. Similar to girlfriend issue and sunk costs.

6. Status Quo Bias  

Tendency to avoid making decisions; people just keep doing what they’ve always been doing. Ex. walk into class and see someone in your seat (you get annoyed), or organ donation opt-out system instead of opt-in....