Conclusions

Evolution & Free will

  1. Begin in Ethiopia rainforest
  2. Climate warms and dries out, pushes us out into grasslands
  3. Predators are much stronger than us, requires us to adapt
  4. We use tools to survive (rocks, speaking, dogs)
  5. We form civilizations for protection, requires us to form morals & norms
  6. Agriculture requires long-term thinking, planning, written words

Intuition and Reasoning

Intuition (Short): Our core driver from evolution. Primary focus is on emotions and pain/pleasure.

Reasoning (Long): What sets us apart from other animals. Deliberate and effortful thought, focus is long-term

How much does someone value right now compared to the future? Would you rather have $20 today or $25 next month?

Behavioral Economics

Bounded rationality

  • Decision making is stressful & complicated. We try to gather just enough without overwhelming ourselves.
  • Alternatives: Procrastinate, follow the social network instead

Framing Effects

Framing effects: how information is presented. Sets the “default” view.

Anchoring

Anchoring: The order of info matters - Group 1 - How many dates have you been on this month? How happy are you? .66 correlation - Group 2 - How happy are you? How many dates have you been on this month? .12 correlation - For Group 1 - The happiness question was anchored by the dating question

Default options

We tend to go with the default option.

    1. Helps cope with anxiety
    1. Some view the default as the recommendation
    1. Might feel like the “normal” thing to do

Short-term

  1. Overconfidence: We tend to be overconfident when assessing their abilities
  2. Confirmation bias: We accept info that supports their view, reject info that doesn’t
  3. Cognitive Dissonance: When actions diverge from beliefs. Must change belief, change behavior, or accept false belief

Time

Discounting: We tend to value today more than tomorrow

\(PV(U,t) = D^{t}U\)

Higher D = Higher weight on the future

  • Immediate gratification: Reduce cost of first purchase, boost temptation of reward
  • Impulsivity: Time pressure, cognitive overload, stress
  • Environmental cues

Identity

  1. Groups: A man wearing a dress will likely feel loss of identity in the male group. Other males will also feel loss of identity
  2. Prestige or snob: jumping to a “higher” social group
  3. Mass market: people who like to associate with a large social group will jump on the bandwagon
  4. Niche market: people who like to set themselves apart will associate with a smaller niche market

Advertising

Informative

Informative: People collecting info is costly, ads let the company should price, features, etc

Signal of quality: Only successful companies can afford to advertise. If the company is able to continue to keep advertising, their product must be pretty good

Persuasive

Attempts to overcome cognitive dissonance.

Emphasize the benefits, downplay the negatives.

Subj Differentiation

Name brands able to charge a price premium for perceived quality

Ch 2

What drives firm behavior?

  • Customers (Demand)
    • Exogenous besides marketing
  • Nature (Technology)
  • Competitors

Short vs Long Run

  • Short: Capital is fixed, labor is variable
  • Long: Both are variable

2.2 Consumer Theory and Demand

Model

\(Individual\:utility = U\underbrace{(q1,\:\:q2,\:\:}_{\text{Goods}} \overbrace{t,\:\:\:m)}^{\text{Tastes\:and\:income}}\)

Demand

  • \(q1, q2\): Available goods (\(Q = q_1 + q_2\))
  • \(t\): Tastes, preferences
  • \(m\): Income, budget constraints

Law of demand: Negative relationship between P & Q, slope determined by substitution and income effects

Demand:\(q_1(p_1) = \frac{a-p_1}{b}\)

  • \(a\): Price intercept
  • \(b\): Slope

Demand shifters:

  1. p2: Price of other goods
  2. m: Income
  3. t: Tastes

Price elasticity:

  • % change in quantity demand divided by % change in price
  • \(\epsilon = \frac{\part Q}{\part p} * \frac{p}{Q}\)
  • If\(\epsilon * -1 > 1\), then 1% change in price = 1% change in Q. This good is Elastic

Revenue

  • \(TR = p(Q) * Q\)
  • \(MR = \frac{\part TR}{\part Q} = \frac{\part AR}{\part Q} * Q + AR\)

2.3 Technology and Costs (Multiple Products)

  • \(W_{L} = Price\:of\:labor\)
  • \(W_{K} = Price\:of\:capital\)
  • \(q1 = Quantity\:of\:good\:1\)
  • \(q2 = Quantity\:of\:good\:2\)
  • \(T = Technology\)

\(Total\:Cost = TC\:(\underbrace{W_{L},\:W_{K}},\underbrace{\:q1,\:q2},\:T)\)

We will see economies of scale when the long run average cost falls as output increases. As long as the average cost is less than the marginal cost, we should keep producing. Minimum efficient scale - Mimimum quantity produced to take advantage of economies of scale.

\(AC=\frac{100\quad-\quad\overbrace{20Q + Q^2}^{\text{Minimize this}} \qquad + \overbrace{40\alpha}^{\text{Parameter (Larger = flatter parabola)}}}{4\alpha}\)

\(MC =\frac{100-40Q + 3Q^2+40\alpha}{4\alpha}\)

\(At\:the\:quantity\:where\:AC\:is\:minimized,\:AC = MC.\)

There is economies of scope if joint production by a single firm is cheaper than production by two seperate firms. Why? (1) Complements in production (using by-products of each other) (2) Share common inputs (railroads transporting passengers and freight)

2.4 Theory of the Firm

“The goal of the firm is to maximize profits.”

  • \(Economic\:profits \:= \:total\:revenue\:-\:economic\:costs\)
  • \(Value\:of\:an\:asset\:=\:PV\:of\:the\:stream\:of\:its\:expected\:future\:returns\)

Issue: Firms look to maximize in the long run, not just right now

Solution: Discounting

\(\beta = Discount\:factor\:(PV\:of\:1\:dollar\:recieved\:next\:period,\:scale\:from\:0\:to\:1)\) \(\quad \beta = .9\:represents\: 90\:cents\:today\:equaling\:1 \:dollar\:tomorrow\)

\(Value(\pi,\infty) = \beta^0 \pi + \beta^1 \pi + ... + \beta^n \pi\)

\(Value(\pi,\infty) = \frac{\pi}{1-\beta}\)

Discounting Example

So, the PV of receiving 1 dollar every day when we value 90c today as 1 USD tomorrow is 10 dollars D = .9 \(\pi\)= 1 dollar \(Value = \frac{\pi}{1-\beta} = \frac{1}{1-.9} = 10\)

This helps us see how much profit we will be willing to give up today in exchange for additional profit in the future. A higher\(\beta\)implies that a greater value is placed on the future.

Another issue:

Principle-agent problem - managers and employees look to maximize their own utility (income, prestige, other psychological factors)

2.4 Boundaries of the firm

Why set up a firm? (1) Horizontal growth - provides greater economies of scale (merger in same industry) (2) Conglomerate growth - provides greater economies of scope (merger in different industries) (3) Reduces transaction costs (costs associated with trading) (4) Vertical growth - buying up the supply chain

Forces that limit size of firm: (1) Merger with a supplier reduces the suppliers flexibility and control -> market inefficiencies (2) The supplier may be too large to be profitably owned by a single wholesaler (3) Managerial capacity - costs grow as firm grows

Costs can be broken down into 2 groups: (1) Those that decline as the org grows (eg transaction costs) (2) Those that grow as the org grows (eg managerial costs)

\(TC = C_{MGT} + C_{MKT}\)

Extra

How do firms compete in imperfect competition?

  1. Interactions between firms
  2. Info
  3. Externalities
  4. Public policy

Game theory: study of strategic decisions between agents

  1. Interactions between players
  2. Order of movers
  3. Information

Behavioral econ: integrate psychology & economics

  1. Framing effects (how we present a choice)
  2. Bounded rationality (take into account info we want)
  3. Heuristics: Mental shortcuts

Extras:

Nonfunctional demand: motivated by qualities other than inherent characteristics

  1. Interdependent - based on other people
    1. Bandwagon effect - purchase because others purchased
    1. Snob effect - purchase to be different than others
    1. Veblen / conspicuous consumption effect - purchase to impress, expensive
  1. Speculative - purchase as an investment
  2. Irrational - purchase on a whim