HKU — MBA Managerial Economics Summary

Price Theory + Game Theory

In a perfectly competitive market, the price will guide demand and supply.

• Demand is determined by marginal value instead of total value! MV = Price.
• Consumer surplus is the maximum amount of added value that a seller can extract by selling a product.
• Demand is driven by = Value, Preference, Culture, competition, bundle offers, climate, Social Influence.
• A product is a complementary product if consumers value the second product more when they have the first product than when they do not (e.g., iPhone and accessories; PC and monitor; cars and tires…)
• A product is a substitutional product if consumers value the second product less when they have the first product than when they do not (e.g., coffee and tea; iPad and Galaxy Tab; Mercedes-Benz and BMW…)
• Economics is about the efficient allocation of scarce resources. Scarcity = Time, Budget, Information, Attention.
• It’s a normal good if the demand increases with the increase in income. A good is inferior if the need for it decreases with income.
• Understanding the cost structure is key to understanding firm behavior.
• Accounting cost and Economic costs are different because in economical cost, we consider = utilizing economic resources, including actual expenses and opportunity cost.
• Marginal cost (mc): extra cost for producing an additional unit. eg: A restaurant should stay open until it can cover the variable costs can be covered
• A seller produces up to the point where mc=p

• A competitive market is incompatible with decreasing mc
• Marginal cost is U-shaped for most products
• Demand = Marginal Revenue and Supply == Marginal cost
• Homogeneous Product = Identical products. Same products like an agricultural product
• Heterogeneous Product = Like smartphones, tablets, cars.
• Demand, Price, and Supply Equilibrium. When demand increases, it shifts to the right, reduced it shifts to left. Supply reduces moves to left and supply increases moves to right.
• Change in demand means in the short run you will make so much profit and in the long run economic profit will be zero
• For-profit maximization in monopoly is when MC == MR
• If the total revenue is greater than total variable cost the company should keep operating.
• There is a strategic benefit of being soft under strategic complement: aggression is met with aggression. There is a strategic benefit of being aggressive under strategic substitutes: aggression is met with softness.
• Cartel Definition: a group of players restrains competition through explicit agreements.
• In strategic deterrence, an incumbent firm strategically creates a harsh environment for potential competitors and thus deters entry.
• Predatory pricing is a pricing strategy where a product or service is sold at a low price, possibly lower than average variable cost, intending to drive competitors out of the market or create barriers to entry for potential new competitors. Engagement in predatory pricing is a money-losing in the short run
• Rational choice theory is where consumers buy more when the price is low.
• Exception for the law of demand: Limited edition products and Gas price
• Buyers surplus (p1 — p2) * Q/2
• Economies of scale: bigger is better; double output for less than twice the cost Diseconomies of scale: doubling of output requires more than twice the cost
• Elasticity % = % change in Quantity / % change in Price
• If the price elasticity of demand is greater than 1, it is deemed elastic. Demand for the product is sensitive to an increase in price. … Price elasticity of demand that is less than 1 is called inelastic.
• Suppose consumers’ types are relatively easy to verify and resale is unlikely to happen. In that case, sellers can directly set different prices for different types of customers who have different levels of elasticities of demand. When a firm can sell a product to every customer at their maximum willingness to pay, the firm extracts all consumer surplus. This is called perfect price discrimination.
• New firms will enter the market until the producer surplus is exhausted, in which case all firms break even.
• In the long run, profit-maximizing firms will earn zero economic profit — Adam Smith, Invisible hand
• Consumers’ preferences are relatively homogeneous, cost function consists of a large fixed cost and a small variable cost.

Types of Markets:

• Perfect Competition: Price takers, no entry or exit barriers, many sellers sell the homogenous product. A large number of small firms in the market — Each firm takes price as given and produces until marginal cost equals price. In the long run, price=minimum of average cost; firms earn zero profit; consumer surplus is maximized
• Monopoly: Price setters, high entry or exit barriers, one sellers, heterogeneous product. A single firm in the market, setting price above marginal cost, earns positive profit at the cost of consumer surplus. Imperfect market
• Oligopoly: Price setter, limited entry and exit barriers, few sellers. Several firms dominate the market, each having some market power — The extent of market power depends on strategic interaction between firms (the next big topic).
• Monopolistic Competition: Price setter, few players, less power to set price, limited barriers, heterogeneous product
• In a duopoly, elasticity is high eg. New York pizza places. There is perfect competition. In this case there is no first-mover advantage. Set the price close to Marginal Cost. Best way would be to use the economy of scale and get the MC low so that you can kill the competition
• Nash Equilibrium is the best strategy for a firm in any given situation, even if the other company chooses any strategy — no player has an incentive to deviate from their chosen strategy after considering an opponent’s choice.
• Dominant Equilibrium: the dominant strategy is the optimal move for an individual regardless of how other players act.
• Bertrand Model — Price moves in the same direction. The cost has an advantage sometimes government gets involved in coordinating the price.
• Airlines cutting price- consumers win, its a homogeneous market, MC is low to get the market share to reduce your price
• Match Price Strategy: Is to kill competition and punish themselves eg. Best buy. That way, competitors are encouraged to match their prices and not go lower. Market leaders can do price matching. It can happen in China and US and not HK. : Price matching facilitates collusion even if firms do not repeatedly interact
• Bertrand Reaction curve & Collusion outcome: How competitors respond to pricing and when they agree to a common price is collusion. Eg HK Jewellery market — the association sets the price of the gold every morning.
• First Mover advantage: Market share, keep cost low, innovation, strong brand, big market, product categories, control specific segments. Companies compete to gain the first-mover advantage by launching its product earlier and building its capacity faster. first-mover advantage may be less important for a stronger brand
• Cournot Model : Be so aggressive kill the competition, so aggressive it can hurt their business. Airlines are cutting price. Produce more, price will be low. But less profit. Collusion in Cournot Model: eg airlines both agree to halt flights in desserts. OPEC is the org that sets quota as to how much each country must produce oil. US, Russia, and middle east.
• Collusion: When competitors sign an agreement to coordinate and fix the price. Pepsi and coke had a collision price agreement. Difficult to maintain when demand is high.
• Prisoner Dilemma: Individuals make selfish choices. If you expand — I shrink and if you shrink, I expand.
• Cartel: a group of players restrains competition through explicit agreements. Difficult to maintain when there are more players. Oil price was ero in 2020 and now we are facing a shortage. Oil price eg: Cartel fails and collision helped.
• Hotelling Linear city model Means competitors are places in different locations when there is a travel cost involved.
• Hotelling Paradox Where competitors are next to each other in the same location, Vivo opp Huawei or Starbucks vs CCD. This way, they stop possible competitor entry.
• Predatory Pricing: Like Mi burning money to get market share. This will work for state-owned companies having deep pockets. In many countries, predatory pricing is considered anti-competitive and is illegal under competition laws. Works in monopoly
• Product proliferation: Is where big brands create many different products in the same categories where its difficult to differentiate them Eg: Fast Fashion brands like H&M and Zara or Cereal companies.
• Deterrence Strategy Predatory pricing — Requirements: Low-cost advantage, deep pocket Capacity competition — Excessive capacity, Requirements: economies of scale, deep pocket, strategic commitment product competition(strategic positioning) — Full coverage of all segments, entry targeting (strengthen vulnerable position in a specific segment) Requirements: strategic choice of product scope
• In the US and China trade war, consumers pay more for the same products and the US makes money from tax. Taking away suppliers surplus and market will lose. Hence trade war hurts consumers.
• To avoid the great depression during covid-19, government is throwing stimulus policies to push demand.
• US and China GDP growth will slow down due to shortage crises of Chips, labour & natural gas.
• In 10 years are so — we won’t be able to avoid polarization across the world.
• Suck Cost: Cost that can never be recovered. Eg Entry cost like R&D, Patents, Licensing.
• The Law of diminishing utility expectation is products consumers are addicted too like drugs.
• Nero economics = Where they measure consumer’s happiness, but we can’t measure it.
• Types of Elasticity:
• Price elasticity of demand
• Income elasticity of demand (income & inferior products)
• Cross Elasticity of demand
• Price Elasticity of supply (given a price, how can you scale your supply)
• Advertise Elasticity

Advertising elasticity: The percentage by which demand will change if sellers’ advertising expenditure rises by 1%. Elasticity will be positive.

Elasticity also depends on time. In the long or short term.

•If demand is inelastic, the seller can increase profit by raising the price.

•The income elasticity of demand is the percentage by which the demand will change if buyers’ incomes rise by 1%.

•The cross-price elasticity of demand is the percentage by which the demand will change if the price of a related item rises by 1%.

•The advertising elasticity of demand is the percentage by which the demand will change if sellers increase advertising expenditure by 1%.

•For non-durables, the demand is more elastic in the long run than in the short run. For durables, the demand may be more or less elastic in the long run than in the short run, depending on the balance between time for adjustment and replacement frequency.

•Incurring a sunk cost causes demand to be less price elastic.

•Demand is price elastic above the anchor price, and price inelastic below the anchor price.

Indifferent curve — consumers prefer a higher indifference curve. More is better

- Indifference curve never crosses

- Indifference curves (IC) are downward sloping

- Only one IC through every bundle

- They feature Diminishing Marginal Utility eg: Second cookie you have it will decrease the cray for it the happiness you will derive consuming the next cookie. But it will make you less and less happy as you keep consuming the same thing

- Utility function can never be negative but it’s constantly reducing. Marginal Utility is always positive