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Managerial Economics AUT13 final exam Student: 1290428 Stream E, MBA 2015

Thursday 5 December 2013

Part I 1. According to a newspaper article in the Wall Street Journal, some stores in shopping malls are losing money and as a result considering not sticking around once their leases expire. Do you think these stores should instead shut down immediately? Why or why not? In the short run these stores should shut down immediately if its revenues are less than its total variable costs. This conclusion is based on the short-run supply curve, which is illustrated in Figure 1.

Figure 1 - Short-run supply curve (Chapter 14, Mankiw & Taylor)

This conclusion is intuitive because the revenue received for all products sold should at least cover the variable costs associated with those products. Otherwise it doesnt make sense to stay open because we are making a loss on every sale. However in the long run, when the leases have expired, stores should shut down if revenues are less than total costs. This condition is illustrated in Figure 2 below.

Figure 2 - Long-run supply curve (Chapter 14, Mankiw & Taylor)

In this long-run situation we know also consider the fixed costs of leases, which means we compare our revenues against total costs, not just variable costs. These fixed costs were not considered in the short run case because they were sunk and could not be reversed. Therefore they were not a factor in the short-run decision making process.

2. In poker, players pay a buy-in to participate in the game. Some of the buy-in goes to the house as entry fee and the rest determines the total winning prize pool. A professional poker player describes the following situation: I played a poker tournament at Caesars Palace last night with the following setup: The buy-in is $65, which gets you 2500 chips. The house keeps $5 and the rest goes to the prize pool. There is also the option to buy an additional 500 chips for $5 more, giving you a total of 3000 chips for $70. At 1 cent/chip, this add-on sounds like a great bargain compared to the 2.6 cents/chip of the regular buy-in. The kicker is that the house keeps the entire $5 add-on fee; none of it goes into the prize pool. Assume a player buys the additional chips, only if, in the beginning of the game, the difference in the total value of his chips with and without the additional chips exceeds the price that he needs to pay to get them. (Assume also that that all the players are equally-skilled professionals who have the same probability of winning.) Would any of the players buy the additional chips? And if so how many would buy them? Explain your reasoning clearly. Yes, all players have an incentive to buy the additional chips and will do so unless they collaborate. This is a classic prisoners dilemma scenario in which the Nash equilibrium is the non-optimal solution. We can determine this equilibrium point by considering from the perspective of Player X in the context of all other players decisions. From Player Xs perspective, there are two scenarios that could happen: 1) All players take the standard buy-in, or 2) One or more players take extra buy-in In either situation it is in Player Xs best interest to take the extra buy-in. In scenario 1 he/she gains advantage by taking the extra buy-in. In scenario 2 he/she prevents a disadvantage and is equal to the other players. The Nash equilibrium is therefore the point where all players decide to get the extra buy-in. This of course assumes that all players act rationally (the same way as Player X) This is best illustrated in a two-by-two matrix as shown in Table 1.
Table 1 - prisoner's dilemma matrix

Other players All players take standard buy-in Player X Standard buy-in Extra buy-in Best option Everyone is better off Player X has an advantage over other players One or more players take extra buy-in Player X is at a disadvantage relative to other players Nash equilibrium All parties are equal but worse off

3. Consider the following quote from New York Times. A lot of small-business owners set prices just by looking at what their competitors charge. Naomi Poe, founder of Better Batter Gluten Free Flour near Altoona, Pa., learned that it is important to try to understand how your customers value your product. Her first year in business, 2008, she raised prices 20 percent, increasing her gross profit margin the profit on each item she sells about 11 percent and increasing sales revenue 25 percent, she said. What does the above quote tell us about consumer response to prices? We can immediately conclude that the consumer demand is inelastic because revenue increased when price increased. We can quantify this inelasticity by first solving for the volume change after the price change. R = P*Q 1.25R = 1.2P * x*Q (where x is the change x = 1.042 Percentage change in quantify = Q = x 1 = 4.2% Elasticity = Q / P = .042/.2 = 0.21 (which is <1 and therefore inelastic)

4. Analyst Martin Borghetto at Morgan Stanley Dean Witter notes that discount airlines in Europe still have only 3.7% of the intracontinental traffic, compared with 16.7% in the U.S., but he prefers the bigger and older European discounter, Ryanair. EasyJet, with revenue of $450 million, has to fill 71% of its seats to break even, compared with Ryanairs 53%. EasyJet needs to fill 71% of its seats to break even; Ryanair needs to fill 53% of its seats. Does that mean that we can expect Ryanair to be more profitable than EasyJet? To be more specific (and to simplify), suppose that Airline A and Airline B have the same total number of seats per day, and charge the same single price for a seat. Flying involves a fixed cost and a constant marginal cost per seat (though these are not necessarily the same for the two airlines). Suppose that A needs to be 70% full to break even while B needs to be 50% full to break even. Finally, suppose that both airlines are 80% full. Can we conclude that B is more profitable than A? We cannot conclude that B is more profitable than A. The profitability of both airlines is dependent on the both the fixed and variable costs. Consider scenario 1, where B is more profitable than A at 80% load factor:

50%

70% B A Load factor 100%

Profit

0 FCB FCA 80%

In this case A has a slightly higher fixed cost and comparable variable cost relative to B. In contrast consider scenario 2, where A is more profitable than B at 80% load factor:

50%

70%

A B

Profit

0 FCB

Load factor 100%

80%

FCA In this case As fixed costs are much larger than Bs. However the variable cost of As ticket is much lower than Bs, and therefore the profit per ticket (slope of the second line segment is steeper). Since we dont know the fixed and variable costs for each airline we cannot determine their relative profitability. Either scenario 1 or 2 could be valid until further information is provided.

Part II I have chosen to answer Question 1. Word Count: Part A) Prisoners dilemma two players are faced with a decision to either stay silent or betray the other prisoner. The result of each combination of these decisions is shown in Table 2 below.
Table 2 - prisoner's dilemma

Prisoner 2 stays silent

Prisoner 2 betrays

Prisoner 1 stays silent

Both sentenced to 1 year in prison

Prisoner 1: 3 years Prisoner 2: goes free

Prisoner 1 betrays

Prisoner 1: goes free Prisoner 2: 3 years

Both sentenced to 2 years in prison

The game has a Nash equilibrium in the bottom right corner because the rational decision is for both prisoners to betray. However this is not the optimal outcome, which is the top left scenario (when both stay silent). Cooperation game two players are faced with the same or corresponding decisions, much like in the prisoners dilemma. However in a cooperation game there are multiple Nash equilibriums. For example consider two cars that are driving towards each other on a single lane road. If they both choose to swerve to their left (or both swerve to their right) then they will avoid collision. If one chooses left and the other right (or vice versa) then they will collide. In this example there are two Nash equilibriums at which both parties can realise mutual gain, but only by making mutually consistent decisions. Part B) This is a somewhat simplified version of reality but I believe it still contains the essence of a coordination game. At London Business School there are many students who are interested in career in social impact or social enterprise. Students who find work in this field typically report higher level of job satisfaction relative to peers in traditional corporate or professional services roles. However it is a relatively nascent field that does not have a large number of employment opportunities. As a result it is necessary for students to collaborate in order to secure summer internships and create networking events for the school.

On the other hand we have the more traditional roles (such as investment banking or management consulting) which do not require the same collaboration because employers come to campus and actively recruit MBAs. The drawback to these jobs is a lower job satisfaction. To determine the Nash equilibrium of the coordination game, we first represent job satisfaction by three numbers: 0 no summer internship 3 medium job satisfaction from traditional finance/consulting job 5 high job satisfaction from social impact job

Other students collaborate

Other students pursue traditional roles

Student X collaborates with others

(5,5) Both students have highest job satisfaction

(0,3) Student X gets no summer internship. Other students get medium job satisfaction.

Student X pursues traditional role

(3, 0) Only student X gets medium job satisfaction. Others get no summer internship.

(3,3) Both student have medium job satisfaction

In this case we can see that there are two (albeit unequal) Nash equilibriums where both parties mutually benefit from cooperation. The traditional, traditional (3,3) equilibrium is safer than the social impact, social impact (5,5). However if all parties agree and trust each other, the superior equilibrium can be reached. I do not believe that we at LBS have achieved the superior equilibrium. This is due to a number of factors including: Lack of mutual trust in committing to the collaboration decision (e.g. students believes others are hedging with traditional recruitment) Job satisfaction is actually quite subjective so for some people the actual weights of each outcome may be different (e.g. top left = (2,2) and bottom right = (5,5))

Possible ways of improving the outcome include: Irreversible commitment to one career path at the start of the MBA (e.g. specialisation which limits career options) More trust between students enabled by open discussions about career choices, career services support networking events and admitting more risk-taking students