Managerial Economics Exam questions

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Therefore, these invisible shields protect incumbent firms and reduce competition within the market, which an often lead to market power and the existence of a monopoly. Barriers to entry are one Of the key aspects in porter’s five forces analysis, which is a framework for industry analysis and business strategy development based on the competitive intensity and therefore attractiveness of a market. Different barriers will effect companies in different ways, to understand their impacts they are grouped into 3 categories known as consumer preference barriers, absolute cost advantages and scale economies.

Preference and cost advantage barriers are present if established firms have lower average unit sots than potential entrants at any given output level. This makes entry expensive for entrants as they have to spend more on advertising and research and development in order to try and create a competitive advantage. To overcome absolute cost advantages entrants have to pay higher prices for inputs, this may be due to economies of scale or due to existing firms owning or controlling the supply of scarce resources. Scale economy barriers exist when declining CRA for the product in question makes it difficult for smaller firm to enter the market.

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Perfectly competitive markets are said to have O, or low, barriers to entry compared to monopoly industries which have very high barriers. It is possible for monopolies to own patents and intellectual property that give a firm the legal right to stop other firms producing a product for a given period of time, and so restrict entry into a market. Monopolies also have an established relationship with customers within the industry, making it hard for new entries to tease consumers away from this brand loyalty. This is true in the telecommunications industry which is run by a few giant companies like Avoidance and Orange.

It would be very hard for a new company to attract customers away as long term contracts are signed which, provide switching barriers, and economies of scale help them maintain low prices. If these economies of scale are substantial, the industry may not be able to support more than one producer. Line Del represents the industry demand curve and supernormal profits can be gained be;en points A and B. However if there were 2 firms each producing half the output and charging the same price, they would each face the demand curve DO which means they would not be able to cover costs. This is known as a natural monopoly.

An example is two bus companies running the same routes, but half full buses makes business UN- profitable compared to if there was one company running the routes with full buses. One tool companies companies can use to inhibit other firms entering the market is limit pricing. This is where a monopolist charges a price below the short run profit maximizing level to deliberately restrict it’s the size of its profits so as to not attract new entrants. Lowering of price will also restrict new entrants from competing in terms of rice and increasing the number of customers the monopoly retains due to lower prices.

In other industries, markets with monopolistic competition tend to have low barriers to entry, whereas oligopolies,are normally surrounded by slightly higher barriers. In some cases, governments have reduced barriers to entry into these industries, but high sunk costs have discouraged entry. These costs cannot be recovered if a firm decides to leave the market, as they cannot be used elsewhere and an example is investment in oil refining machinery. To counter this, strategic behavior by firms in these industries can restrict impasses expanding into the market and it helps them achieve some of the benefits of protection that a monopoly has.

This is known as collusion and through successfully colluding oligopolies’ can charge a price considerably in excess of their average costs, therefore at a level which would hold if the industry was a monopoly. This is contrast to perfect competition where price cannot for long exceed average costs since the appearance of new entrants will exert downward pressure on prices. Collusion goes against the theory of entry barriers which is based on one principal assumption known as the Solos Postulate, which alleges that potential entrants expect firms to maintain their output levels and reduce their price to accommodate the entrant.

According to the Salsas postulate the entrant must increase the industry total output and therefore the industry price must fall by a sufficient amount. The entrants demand curve is that segment of the total industry demand curve to the right of the ruling price. To ascertain whether or not to enter an industry, a potential entrant will compare this demand curve with his particular cost function. Overall barriers to entry inhibit increased competition in a market and help peep prices high.

Governments and the public encourage barriers to e knocked down in order to support smaller firms and drive down the average prices of goods and services within the economy. Theory of Principal Agent: The principal- agent problem has been used by Gaffe in 1 994 to discuss energy consumption, but in political sciences and economics it is the problem of motivating a party to act on behalf of another. It underlies the concepts of moral hazard, adverse selection and information asymmetry, which have caused the need to overcome contractual problems.

The theory is also known s agency dilemma and it differs from dealing with normal contractual problems where parties have no similar risk preferences by treating the difficulties that arise under conditions of incomplete and asymmetric information. The principal hires the agent to into a job where the agent’s effort is unobservable, so managers need to understand how contracts can be written to overcome such circumstances of opportunistic behavior in order to ensure goal congruence when interests diverge.

Principal-agent theory tackles a sub case of the strategic behavior called bounded rationality behavior. An agent is someone who carries out a task on behalf of another, for example a builder working for a property developer. In this case, the property developer is the principal and is the risk neutral party whereas the builder is the risk averse party to the contract. This is an employer- employee contract but the theory covers a wide range of relationships including shareholder- manager and insurer- insured.

The power and risk is with the principal, as he can keep his wealth in well diversified portfolios, which in this case means the property developer has many employees to use whereas the elder one has one job to lose. The problem with the agreement of the builder to work for the property developer is that the 2 parties may have different attitudes towards risk, so managers need to encourage workers to produce the same amounts of effort in the long run. The property developer needs to inject incentives to the contract to assist the business objectives, this can be done by transferring some of the risk to the agent/ builder.

Builders are unwilling to provide effort without a suitable reward and their objective function is to maximize his own utility: IS= f(w,e). So the builders satisfaction upends on wages (w) and effort (e). One characteristic of a risk avert is diminishing marginal utility, so as W is raised beyond a certain point, it will provide diminishing values of utility. Lets assume the builder can choose between 2 levels of effort, higher effort is assumed to result in greater build progress but it is also influenced by environmental factors such as the weather, quality of materials and other builders level of effort.

BOOM NORMAL SLUMP Expected build progress related pay 500 100 233 366 When E=l the property developer receives IEEE from the owner of the house ND when E is twice as much the property developer receives IEEE. The builder does however require a minimum guaranteed opportunity wage to provide a minimum level of utility of 2, otherwise he would work elsewhere, this is EH. The wage needed to get A to work is determined by deriving Ass minimum reservation wage given the knowledge his overall utility must be at least equal to 2.

Up’s expected receivable is therefore IEEE so profit is IEEE and Ass incentive bonus is EYE. This is a joint value maximizing contract since the alternative to pay A just EH results only in a net profit of IEEE. But P is unable to set level of effort at E=2 and only the outcomes can be observed. A self-interested A would select and blame the external environment when El 00 is received instead of IEEE. Therefore, a good outcome would result in exposing A to some risk so that it is in Ass interest to implement Up’s desired effort and no shirking takes place.

The principals problems is findings values of pay for different build receivables which meet both Ass incentive compatibility constraint ( ) and participation constraint( ). So now the agents income is dependent on the agents own efforts and not only on the environment, so an efficient sharing of risk has taken place. Y=is pay when El 00 are received and z=pay when IEEE is received. Solving simultaneously we have y=E and z=EH 00, so on the occasion when IEEE receivables are obtained the basic pay offered is El and the bonus pay is EYE.

In a full information setting, the risk averse agent bore no risk and the risk neutral principal bore all the risk. Now, in a situation of bounded rationality some risk has been shifted to provide an appropriate incentive alignment situation. Without contracting the principal would have settled for sales of IEEE but tit contracting at E=2 the expected sales rise to IEEE. The agents wage rises from 9 to EYE. 33. Joint value minimization has occurred given the construction of the appropriate incentive contract.

Optimal transacting would not have occurred if fencing costs had exceeded IEEE so joint value minimization would not have occurred. If We had relaxed Our assumption Of risk neutrality of the principal then the optimal risk sharing proportions would have been altered. If average revenue = a-BC then marginal revenue = a-BBC: In order to understand this theory we must firstly understand the three venue concepts of total revenue, average revenue, marginal revenue and then progress onto the differences seen when price varies with output and when not.

Total revenue is a firms total earnings from a specified level of sales within a specified period. It is calculated by multiplying price by quantity (TRY= Pix), an example is if a company sells 1000 apples per month at a price of EH each, then total revenue is EH. The amount earned per unit sold is known as average revenue (TRY/Q) and in this case is EH, which is simply price! Finally, marginal revenue is the extra revenue gained by selling one more one more nit per period of time.

It is calculated using the change in total revenue divided by the change in total output, so if an extra 20 apples are sold this month bringing in an extra OHIO, then marginal revenue is EH. Now, let us look at how each varies with output, this will depend on the market conditions under which the firm operates. If a firm is small relative to the market, it is likely to be a price taker. Being so small it can sell as much as it can produce as it experiences a horizontal demand curve, its output is insignificant in influencing market price as average revenue is constant

However, if a firm has a relatively large market share, price does vary with the firms output, meaning the price must be lowered in order to sell more. Firms in this situation include monopoly firms such as Coca Cola. This type of firm face a downward sloping demand curve, which shows them how much is sold at each price level. Saying this, a monopolist cannot charge any price it wants if its objective is to maximize profits. To maximize, the monopolist must determine its cost and characteristics of market demand, which are crucial for economic decision-making.

The monopolist must then decide how much to reduce and sell, the price per unit then follows directly from the market demand curve. The monopolists average revenue curve is precisely the market demand curve and in order to know its profit maximizing level of output the marginal revenue must be determined. Consider a firm following the demand curve the table below shows the behavior of the total, average and marginal revenue curves for this demand curve. PRICE QUANTITY AR 6 5 4 2 8 3 9 We can see that when marginal revenue is positive revenue is increasing with quantity, but when marginal revenue is negative revenue is decreasing.

If the demand curve is written so that price is a function of quantity (P=A-BC), then total revenue is given by PC=as-BBC. Using calculus marginal revenue is a-BBC In the example above, demand is P=6-Q and therefore marginal revenue is MR.=6-SQ. Setting marginal revenue equal to zero we obtain the revenue maximizing quantity for the monopoly which is 3. From this several things are evident. First, the marginal revenue curve has the same y intercept as the inverse demand curve. Second, the slope of the marginal revenue curve is twice that of the inverse demand curve.

Third the x intercept f the marginal revenue curve IS half that of the inverse demand curve. What is not quite so evident is that the marginal revenue curve is below the inverse demand curve at all points. Since all companies maximize profits by equating MR. and MAC it must be the case that at the profit maximizing quantity MR. and MAC are less than price, which further implies that a monopoly produces less quantity at a higher price than if the market were perfectly competitive. We can also use the data above to find the marginal revenue curve when only an average curve is known.

At IQ, total revenue is equal to the area contained by he rectangle CACAO . In order to draw a marginal revenue curve we must do so in a way that at output IQ, revenue represented by OBIS is equal to CACAO . This will only be so if the triangles ABE and CEDE are equal. We must make sure that BAD cuts AC at its midpoint so that AWE=CE. The curve is found by drawing a straight line between a straight line from where the average curve cuts the vertical axis to any midpoint of any horizontal line from the average curve to the y axis.

This shows that the -2 means the slope is negative and twice as steep as the slope of the demand curve. So for every El increase n output, marginal revenue decreases by EH. If demand is written so that price is a function of Q then P=a-BC since TRY = (a-BC)Q = as-BBC MR. is TORT/SQ or using calculus – a-BBC Indifference Curves: Demand in the market place is the foundation on which all of managers decisions must ultimately rest. The theory of demand highlights that managers need to consider the individual demand as well as examine total market demand.

The theory suggests that market behavior is merely the behavior of aggregates of individuals and acknowledging this enables us to apply the theory to simple decision making in the market place. Consumers make decisions based on the satisfaction they gain from consuming goods and services, which is known as utility. A consumer will allocate his expenditure among a range of purchase options in such a way that his total utility is maximized. The more realistic ordinal theory argues that satisfaction is subjective and incapable of precise measurement, which is what occurs in the cardinal theory.

Consumers therefore can only rank the degree of satisfaction associated with a range of commodities. The use of indifference curves enables us to adapt the ordinal approach to demand hero. Indifference curves assume there are only 2 products but represent all the combinations of these goods or services that provide consumers with the same level of utility. The curves are a locus of points showing what the consumer wishes to have, each line represents a combination of commodities such that the consumer is indifferent between any of these combinations.

Level of utility is measured in utile, from the diagram we can see that at point R, with 5 units of A and 3 units of B, the same satisfaction is derived at point X where he obtains 2 units of A and 8 units Of B. The consumer will always prefer to have more of A and B so indifference curves which lie above and to the right represent some higher level of satisfaction. So point L is preferred over point M. As we can see from the diagram the indifference curves do not intersect. This is because the consumers choice is rational and there is transitivity between the consumers preferences.

For example: if the consumer is indifferent between products j and k, and he is also indifferent between products k and l, then the consumer must be indifferent between I and j. When dealing with indifference curves we just assume a diminishing marginal rate of substitution (MRS.). The MRS. is the concept that obtaining more of B demands giving up units of A. It is the change in the consumption of one good necessary to offset a given change in consumption of another good, if overall utility is to remain the same. The MRS. measures the slope of the indifference curve, which is normally negative.

The marginal revenue gained must equal marginal revenue lost so….. From this we can understand that at point R, the marginal utility of B will be high, relative to that of A which is in plentiful supply. Here the consumer is ailing to give up 2 units of A to obtain one unit of B. But at position X, where product A is scarcer and B is more plentiful than at R, the consumer is only willing to forfeit 1 unit of A to obtain one unit of B. As a consequence of this indifference curves are convex to the origin and will never intersect.

MRS. of B for A is equal to the ratio of their marginal utilities. Using indifference curves we can determine the consumers optimal combination of goods, which is where the ICC is tangential to a budget line. Indifference curves are integrated with budget lines to find the optimal basket of goods which is achieved where original utility is proportional to price. Budget Lines: If indifference curves are what the consumers wish to have, then budget lines show what the consumer can actually have given income.

They represent all the combinations of goods that can be purchased given a fixed amount of income and is calculated by adding total spending on A with total spending on B, BAL- (PA*A) + (BP*B). Any point within the area of CEDE is a possible choice of combinations for the consumer. Point D represents the number of units of A the consumer can buy if he or she spends the entire budget on commodity A, at price Pa. In the verse point E indicates the maximum units of B he could purchase with the entire budget.

A mathematical way to calculate the budget line is by knowing that it is equal to the inverse of the ratio of the prices of A and B. Given an income and the related utility function, we can use the budget line to determine the purchase combination that will be most satisfying for the individual. Within the range of choice available, the highest attainable indifference curve will be the one tangential to the price line. The individual will only reach equilibrium, the position that cannot be improved on, when he r she reaches point F.

At point F the slope of the indifference curve and the budget line are equal and the slope of the indifference curve at point is equal to the MRS. of B for A at that point. There are 2 major dimensions that influence the position of the optimal combination of goods. If price rises the overall consumption of goods falls. This shifts consumers to a lower indifference curve and is known as the income effect. The substitution effect occurs when a certain price change means more consumption of one good and less of the other. It usual occurs

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