Managerial Economics

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- Describe the key factors that determine price elasticity of demand.

Price Elasticity of a Demand, refers to the % change in quantity demanded (Q) divided by the % change in price (p). The number and degree of substitutes is the single most important factor in price elasticity. However, there are 2 more important factors: amount of income available to spend on the good, and time.

Demand Curve (Price | Quantity) slope (steepness): it express price elasticity. Vertical line: elasticity low (perfectly inelastic). Flat line: elasticity high (perfectly elastic).

- Aggregate demand: sum of individual demand (that’s why assumption of independent decision making is important).

- Product Innovation: it increases the choice available in the market

- Process innovation: it reduces the cost of production

The higher the price the more elastic the demand curve. The demand curve is perfectly inelastic, where it hits the horizontal axis, and it is perfectly elastic where it hits the vertical axis.[pic 10]

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Definitions adapted from class discussions and material. Right hand text taken from class material and charts retrieved from http://www.investopedia.com/university/economics/economics4.asp

- Describe Nash Equilibrium and what it implies for the best strategies companies can use against each other.

“Nash Equilibrium is a key concept of game theory, which explains how people and groups approach complex decisions, where the optimal outcome of a game is one where no player has an incentive to deviate from his chosen strategy after considering an opponent’s choice. It implies, a business can receive no incremental benefit from changing actions, assuming other players remain constant in their strategies. It also refers to a condition in which every player has optimized its outcome based on the other players expected decision”. Retrieved from http://www.investopedia.com/terms/n/nash-equilibrium.asp

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A quick case example, if 2 producers, A and B, of tables who dominate the market. Each one with a production output of 1million tables a year for USD 10.00 each piece, with earning a profits of USD 4Million a year. One of the players, producer A, know that the market is bigger and could decide to produce 1.5million tables a year with a reduced price of USD7.00. In this scenario, producer’s A earning profits could jump to 6Million dollars a year. However, producer A knows that if he decided to do that producer B will follow the same strategy and with a 1Million extra tables in the market, the price will drop lower than USD7.00 (approx. USD 5.00) reducing both producers profit significantly, lower than it is now at current production levels were their profit are USD 4Million a year. So by definition, both producers are now in a current state of Nash equilibrium, as neither producer can make more money by unilaterally deciding to increase production. This example illustrates why game theorists look at decisions not in isolation but as part of a system in interaction. Retrieved and adjusted from http://www.investopedia.com/terms/n/nash-equilibrium.asp

- Ceteris Paribus, using demand and supply curves, explain how trade liberalization leads to lower prices and more quantity available for consumers.

“Ceteris paribus, a Latin phrase, roughly means “holding other things constant.” The more common English translation reads “all other things being equal.” This term is most widely used in economics and finance as a shorthand indication of the effect of one economic variable on another, keeping all other variables constant that could render an effect on the second variable”. Retrieved from http://www.investopedia.com/terms/c/ceterisparibus.asp

Considering the laws of supply and demand, if there is a reduction or removal of restrictions or barriers “trade liberalization” of a certain good, there will be an oversupply in the market, and in the short run shifting out the supply curve, and the demand will increase which will lead to lower prices shifting the demand curve out. [pic 14]

However, in the mid - long term, “it could be said that if demand for a product is balanced by the product’s supply, ceteris paribus, prices will likely rise again as substitutes will also tend to produce. The use of the Latin phrase in this example simply indicates if all additional factors that could affect the outcome, such as the presence of a substitution, remain the same, prices will generally increase”. Retrieved from http://www.investopedia.com/terms/c/ceterisparibus.asp

Part B – Extended Essay

Examine the core cognitive theories of behavioral economics (e.g. social norms) and how they impact economic decision making.

Rational Behavior

A. P. Herbert, Fardell v. Potts (Misleading Cases) suggested “….the Economic Man, whose every action is prompted by the single spur of selfish advantage and directed to the single end of monetary gain.” Retrieved from http://rationalwiki.org/wiki/Homo_economicus

Homo-Economicus will tend not to behave in a way that can create bad things in the short-run if it creates long-term consequences that it does not desires. They prefer to have all the possible available information in place, avoid any uncertainties, before making rational choices. They prefer to act in a predictable environment, optimizing his expected utilities in line with the decision maker. In most cases self-centered caring about his benefit and end game rather than taking in consideration the utility of others.

“In contrast to the empirically rich forms of economic inquiry, much work in neoclassical economics is instead concerned with the largely theoretical analysis of how markets would work if they were populated with individuals endowed with perfect rationality. In other words, this work concerns creatures of fantasy. We might be tempted to classify these areas of economics as science fiction. Alternatively, we might think that this brand of economics does not tell us how the world is; instead, it tells us how the world ought to be, if only people would think straight. Both reactions suggest a gulf between neoclassical economics and the typical practice of science.” — Timothy Mark Lewens (2015). The Meaning of Science: A Pelican Introduction.

Behavioral