EC314 Exam 2 Study Guide
Reasons for
firms and
incentives
Production
costs and the
theory of the
firm
Firms’
debt/equity
structures
Firm production
under idealized
competitive
conditions
Team
production,
value of teams
Monopoly
power and firm
pricing
decisions
Creative pricing,
price
discrimination,
cartels
Firm strategy
under
imperfectly
competitive
markets
Hostile
takeovers
Organizing through firms vs. transacting through markets.
Economies of scale; economies of scope.
The effects of increase/decrease in market transaction costs vs. firm size and profitability.
The economic value of a firm's reputation.
Agency costs and firm expansion.
Firm’s hold-up problems and ways to mitigate it.
Sunk cost defined.
Economic profit vs. accounting profit.
The law of diminishing marginal returns example.
Profit maximizing production level and marginal analysis.
Cost structure and three time horizons.
Cost structure: FC, VC, TC, AFC, AVC, ATC, MC (quantitative and graph).
Points that intersect MC.
Why is financial structure so important for a firm?
How lenders can protect themselves against borrowers’ opportunistic behaviors.
Free cash flow problem.
Why do banks make risky loans?
Mortgage-backed securities, inflow of capital in the housing market, and the implications.
Bailouts and stimulus: pros and cons.
Individual firm’s demand curve vs. market demand curve under idealized competitive conditions.
Characteristics of market structures:
Perfect competition.
Monopolistic competition.
Oligopoly.
Monopoly.
The production rule for optimizing profits for the short and long run.
Can perfectly competitive firms make economic profits in the short run? Long run?
Graph: identify perfect competitor’s profit maximizing production quantity, total cost per unit, per unit profit.
When should team production be used?
Ways to pay teams that could be motivating.
What makes an effective team?
Individual firm’s demand curve vs. market demand curve in the case of a monopoly.
A monopolist’s marginal revenue curve in relations to its demand curve.
What is “monopoly power,” sources of monopoly power and Limits of monopoly power.
Monopoly firm as a price maker: is the price-setting power restricted or unrestricted? How?
Monopoly and network effects: the case of QWERTY keyboard.
Monopoly and inefficiency (deadweight loss): what that means and why?
Graph: identify the monopolist’s profit maximizing Q, price charged, total cost per unit, and total profit
Monopoly profit in the short run and long run: is it possible? How can it be kept high?
Price discrimination: what is it? Examples.
Reasons for price discrimination: demand, willingness to pay, elasticity, etc.
Price discrimination as pricing strategy (e.g., after Christmas sale, Black Friday sales).
Subtle forms of price discrimination (e.g., frequent fliers, rebates, coupons).
The monopolistically competitive firm’s demand curve: its elasticity compared to a perfectly competitive firm
and a monopolist.
Monopolistically competitive firms: profit in the short run and long run, is it possible?
Monopolistically competitive firms: is it efficient in the long run?
Oligopoly, market concentration, and interdependence.
Behaviors of a cartel: incentives to form a cartel and incentives to chisel/defect from the agreement.
Goods with network effects and lagged demand.
Natural monopolies: what are the causes, is it sustainable, can it be regulated?
Reasons for corporate takeover; potential efficiencies to be realized, etc.
Leverage and potential for takeover.
Bondholders and takeover: know about winner’s curse.
Essay Questions (50 points total).
Answer Only FIVE of the possible questions; each is worth 10 points
1. Answer both (a) and (b).
a) Why do firms exist? List one advantage and one downside of organizing production in a firm, as opposed to
market transactions.
b) How big should firms be? What two cost factors should be considered when deciding the optimal size of a
firm? List one specific example for each cost.
2. Answer both (a) and (b).
a) Briefly explain the concept of leverage in terms of a firm’s financial structure. When can leverage be a good
thing? When is too much leverage be a bad thing for the firm?
b) How did financial leverage directly or indirectly contribute to the recent housing and financial crisis?
3. List two reasons why a franchisor would rather franchise its extended operations rather than owning the
additional outlets directly. Also, list two reasons why a franchisee would rather buy a franchise license rather than
start her own business from scratch. Which would you rather start, a franchise or a standalone, and why?
4. List two advantages of being a first-mover in a consumer market and give an example of a firm/product that
succeeded as a first-mover. List two advantages of waiting for others to make the first move and give an example
of a firm/product that succeeded despite not being the first-mover (i.e., subsequent mover advantage).
5. What does the term “monopoly power” refer to? Does a firm have to be a pure monopolist to have it? What are
some of the potential sources of monopoly power? Can it sustainable in the long run and how?
[*Hint: You can use the article we discussed in class as a starting point  Google this: “In the Grip of the New
Monopolist” or direct link:
http://online.wsj.com/article/SB10001424052748704635704575604993311538482.html]
6. Economist Ronald Coase suggested that a monopolistic producer of a durable good would charge a competitive
price for its product. That was the case with Ford’s model T that had a strong monopoly in the low cost car market
during its first few years. Then enters GM’s new business strategy of planned obsolescence, essentially making a
product obsolete (functionally, technologically, or even stylistically) before it reaches the end of its useful life. This
strategy is still widely used today. Question: How can planned obsolescence as a business strategy extend or
increase a firm’s monopoly power over its products? What are some of the ways that a firm can convince
consumers that products that are still durable are no longer desirable? Give an example.
[Read this article to help you with this question  Google: “How the iPhone Got Tail Fins” or use this link:
http://www.huffingtonpost.com/steve-blank/auto-industry-history_b_1021611.html]
7. Can organizing a large firm by departments, and each department by teams, be cost effective? How the cost
savings be attained if the firm has to hire supervisors and managers to lead and monitor these teams and
departments? Further, what do you think is the best way to incentivize work teams to improve their
performance?
8. According to your textbook, a hostile takeover could increase economic efficiency of the target firm. It could also
decrease the principle-agent problem. Why? What are some of the arguments supporting this assertion? Do you
agree? What about the line workers and middle managers who are often laid off during takeovers?