GSF 1025 Lecture : Chapter 5 - Consumers and Incentives

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25 Feb 2023

School

Université Laval

Department

Gestion financière

Course

GSF 1025

Professor

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Chapter 5 - Consumers and Incentives

Key Ideas

1. The buyer’s problem has three parts:

what you like, prices, and your budget

2. An optimizing buyer makes decisions at the margin.

3. An individual’s demand curve reflects an ability and willingness to pay for a good or service.

4. Consumer surplus is the difference between what a buyer is willing to pay for a good and what

the buyer pays.

5. Elasticity measures a variable’s responsiveness to changes in another variable.

Evidenced-Based Economics example:

Would a smoker quit the habit for $100 a month?

Incentives ; What would motivate you?

1. What do you like?

Everyone has different likes and dislikes, but we assume everyone has two things in common:

1. We all want the “biggest bang for our buck”

2. What we actually buy reflects our tastes and preferences

2. How much does it cost?

We also assume two characteristics of prices:

1. Prices are fixed—no negotiation

2. We can buy as much as we want of something without driving the price up (because of an

increase in demand)

3. How much money do you have?

There are lots of things to do with your money, but we assume:

1. There is no saving or borrowing, only buying

2. That even though we use a straight line to represent purchase choices, we only purchase whole

units

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Document Summary

There are lots of things to do with your money, but we assume: there is no saving or borrowing, only buying, that even though we use a straight line to represent purchase choices, we only purchase whole units. The difference between what you are willing to pay and what you have to pay (the market price) A measure of how sensitive one variable is to changes in another. Three measures of elasticity: price elasticity of demand, cross-price elasticity of demand, income elasticity of demand, price elasticity of demand answers the question: Mathematically: the percentage change in quantity demanded due to a percentage change in price: If demand is inelastic, when price increases, quantity decreases a little: The price increase pushes total revenue up, the quantity decrease pushes total revenue down, but the price increase is more than the quantity decrease, so the final result is that total revenue increases.

Related Questions

Exercise

1. What information would you like to have when planning advertising spending?

2. Offer examples of attribute-based product differentiation and information-based product differentiation.

3. Two physical therapy firms want to merge. The price elasticity of demand for physical therapy is â0.40. Firm A has a volume of 10,400, fixed costs of $50,000, marginal costs of $20, and a market share of 8 percent. Firm B has a volume of 15,600, fixed costs of $60,000, marginal costs of $20, and a market share of 12 percent. The merged firm has a volume of 26,000, fixed costs of $100,000, marginal costs of $20, and a market share of 20 percent.

a. What are the total costs, prices, revenues, and profits for each firm and for the merged firm?

b. How does the merger affect markups and profits?

4. A local hospital offered to buy Firm A in Exercise 5 for $5,000, and the offer was refused. However, many observers now perceive that Firm A is âin playâ and may be sold if the right offer comes along.

a. In successful transactions, purchasers have typically paid 10 times current profits. How much would Firm A be worth to a buyer from outside the industry?

b. Would you expect that Firm B would be willing to pay more or less than an outside buyer?c. What is the most Firm B would be willing to pay for Firm A?

5. Two clinics want to merge. The price elasticity of demand is â0.20, and each clinic has fixed costs of $60,000. One clinic has a volume of 7,200, marginal costs of $60, and a market share of 2 percent. The other clinic has a volume of 10,800, marginal costs of $60, and a market share of 4 percent. The merged firm would have a volume of 18,000, fixed costs of $80,000, marginal costs of $60, and a market share of 6 percent.

a. What are the total costs, revenues, and profits for each clinic and for the merged firm?

b. How does the merger affect markups and profits?

6. What would each of the clinics in Exercise 5 be worth to an outside buyer (using the guideline of 10 times annual profits)? What would each of the clinics be worth to each other?

3. Consider a retailer selling blenders currently priced at $54.Suppose it pays $29 per blender from the manufacturer.

A. Initial contribution margin is $54-$29= $25

B. Suppose it is considering a 33% cut in price to boost sales.What is the break-even change in sales required to maintain itsprofitability?

C. Alternatively, suppose an expert tells the retailer that itshould consider raising its price of the blenders to $59 to improveprofit. What is the break-even change in sales permissible to againmaintain its profitability?

D. Using the break-even change in sales you obtained in (b) and(c), plot the break-even curve for the retailer.

E. Suppose the retailerâs market research team determines thatthe elasticity of demand for consumers of blenders is â 1.5. Whatdoes this imply about the actual demand for blenders in case of thetwo situations: a 33% price cut or a price increase to $59? Plotthe demand curve alongside the break-even curve to show thedifference between the two curves.

F. Can you make recommendations to the retailer regarding whichstrategy makes more sense: a 33% price cut or a price rise to $59from its current price level of $54?

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Multiple Choice Quiz
PLS EXPLAIN ALL YOUR ANSWERS AND SHOW THE CALCULATIONS
1
A share of common stock represents:
A) A claim from a lender against a borrower.
B) A share in the company's debts.
C) A share of ownership of the company.
D) An unlimited liability to the owner of the stock.

2
The fact that common stockholders are residual claimant'smeans:
A) The stockholders have a claim against the revenue that remainsafter everyone else is paid.
B) The stockholders receive their dividends before any otherresiduals are paid.
C) The stockholders are paid any past due dividends before otherclaims are paid.
D) The stockholders are paid before the bondholders but after anytaxes are paid.

3
The concept of limited liability says a stockholder of acorporation:
A) Is liable for the corporation's liabilities, but nothingmore.
B) Cannot receive dividends that exceed his/her investment.
C) Cannot lose more than his/her investment.
D) Is only responsible for any taxes that the corporation may owebut not its other debts.

4
You have a portfolio valued at $1000. Over the next twelve monthsit loses 80% of its valuWhat return does the portfolio need to earnover the following twelve months to restore the portfolio to itsoriginal value?
A) 75%.
B) 200%.
C) 400%.
D) 25%.

5
The theory of efficient markets assumes that:
A) Prices of bonds, but not stocks, reflect all availableinformation.
B) The prices of all financial instruments reflect all availableinformation.
C) Stock prices are relatively rigid because it takes a while forinformation to efficiently move through the market.
D) The best approach to determining stock prices is to follow thechartists.

6
The notion that stock prices reflect all current availableinformation:
A) Makes the risk of holding stocks greater.
B) Indicates that mutual fund managers will not, on average,outperform market averages.
C) Says stock prices should be more rigid than they are.
D) Makes it easier to predict the movements in the price of astock.

7
Why are stock market bubbles costly for the economy?
A) They imply that the actual stock price is equal to thefundamental value of the stock.
B) They hurt consumers more than corporations.
C) They lead to a reduction in real investment in both theshort-term and long-term.
D) They lead to a misallocation of resources in both the short-termand long-term.

8
Stock market bubbles impact consumers by:
A) Encouraging greater consumption of luxury goods and greatersaving.
B) Encouraging greater consumption of luxury goods and lesssaving.
C) Encouraging more work and delaying retirement.
D) Resulting in less investment in home ownership and more intostocks.

9
If a public corporation goes bankrupt and does not have enoughassets to pay off all creditors:
A) The stockholders are personally liable for the balance.
B) The fact that stockholders are residual claimants means they mayhave to pay in additional capital to cover the obligations.
C) The stockholders receive any dividends due before the othercreditors are paid.
D) The stockholders cannot lose more than their investment.

10
The Dow Jones Industrial Average:
A) Gives equal weight to a change in the price of the stock of anycompany in the index.
B) Reflects that a 10% increase in a share of stock selling for $30will have the same affect on the index as a 10% increase in theprice of a stock selling for $60.
C) Is a value-weighted index.
D) Gives greater weight to shares with higher prices.

11
The Standard & Poor's 500 Index differs from the Dow JonesIndustrial Index because:
A) It takes into account the stock prices of 500 of the largestfirms, which is less than the DJIA.
B) It is a price-weighted index, where the DJIA is a value-weightedindex.
C) Larger firms are less important in the S&P 500 than in theDJIA.
D) It takes into account the prices of more stocks and it uses adifferent weighting scheme.

12
The theory of efficient markets implies:
A) Stock prices should be highly unpredictable.
B) The price at which stocks currently trade only reflects pastinformation.
C) Expectations do not play a role in stock prices because thisisn't real information.
D) The chartists are in fact correct that there are patterns instock prices.

13
The theory of efficient markets me
A) Professional fund managers should be able to consistently beatthe market average.
B) A professional fund manager should really not expect to beat themarket average consistently.
C) A professional fund manager who beats the market average oneyear should expected to beat the market average the nextyear.
D) A professional fund manager who beats the market average oneyear should be expected to not beat the market average the nextyear.

14
Stocks appear to present risk, yet many people have substantialparts of their wealth invested in them. This behavior could beexplained by the fact that:
A) People are irrational in their investment behavior, onlyfocusing on positive outcomes.
B) People are not very risk-averse and do not require a riskpremium for stocks.
C) Investing in stocks over the long run is not as risky asshort-term holdings.
D) People are not efficient users of information.

15
The price of a stock is currently $750 and the stock will pay a $43dividend. The interest rate is 7.5%. Based on the dividend-discountmodel, what is the expected price of this stock for nextyear?
A) $651.17.
B) $657.67.
C) $691.17.
D) $763.25.

GSF 1025 Lecture : Chapter 5 - Consumers and Incentives

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