FTMBA Fall 2024 Session 5 Slides PDF

F T M B A FA L L 2 0 2 4 SESSION 5 THE MOST HATED CEO IN AMERICA Shkreli Inter view 2 PRICE DISCRIMINATION 3 FIRST DEGREE PRICE DISCRIMINATION (A.K.A. PERFECT PRICE DISCRIMINATION) Question: How is prod...

F T M B A FA L L 2 0 2 4 SESSION 5 THE MOST HATED CEO IN AMERICA Shkreli Inter view 2 PRICE DISCRIMINATION 3 FIRST DEGREE PRICE DISCRIMINATION (A.K.A. PERFECT PRICE DISCRIMINATION) Question: How is production different when the monopolist can perfectly price discriminate versus when she cannot? Question: How does consumer surplus differ when the monopolist can price discriminate versus when she cannot? Definition: Where the same goods are sold at different prices 4  FIRST DEGREE PRICE DISCRIMINATION IS A UNICORN (IT IS NEVER ATTAINABLE). WHY? 5 SECOND-DEGREE PRICE DISCRIMINATION Price MC EXAMPLE: $ 10 Shetty Soda Contribution to profits under Company $7.60 second-degree price charges $5.20 discrimination $7.60 per case for the first three cases of soda, and $5.20 for Demand each 3 5 Quantity additional Hur case dle SECOND-DEGREE PRICE DISCRIMINATION: THE HURDLE MODEL THE GOAL: To set up a "hurdle" or obstacle that consumers must overcome to obtain a lower price. Consumers reveal their willingness to pay based on whether they choose to jump the hurdle. EXAMPLES: 1. Coupons and rebates 2. Non-refundable airline tickets 3. Newly released hardcover books vs. later edition soft cover books 7 THIRD-DEGREE PRICE DISCRIMINATION RULE IN ACTION: EXAMPLE: You are the manager of a pizzeria that produces at a marginal cost of $6 per pizza. The pizzeria is a local monopoly near campus. During the day, only students eat at your restaurant. In the evening, while students are studying, faculty members eat there. If students have an elasticity of demand for pizza of and faculty has an elasticity of demand of , what should your pricing policy be to maximize profits? 11- 8 Calculating Price as a Function of Elasticity 9  THIRD-DEGREE PRICE DISCRIMINATION RULE IN ACTION- CALCULATION Using the pricing rule, these prices are determined as follows: Plunch (-3/-4) = $6 MC = $6 Plunch =$8 E students = - Pricing Rule: 4 MR = P [(1+ E faculty = -2 E)/E] Solve for Plunch (-1/-2) = $6 Price where Plunch =$12 MR = MC Solving these equations shows, and. What does this mean for pricing? 11- 10 THE EFFICIENCY LOSSES FROM SINGLE-PRICE AND TWO-PRICE MONOPOLY Which monopoly has the lowest efficiency loss? WHY? 11 Question: How do you think Adam Smith feels about Monopoly markets? 12  TYPE OF RISK PREFERENCES Risk averse: Does not like uncertainty. Risk seeking: Welcomes uncertainty. Risk neutral: Does not consider uncertainty. One example is Prospect Theory: People tend to be risk averse with gain and risk seeking with loss. In other words, LESS likely to take risks after gains and MORE likely to take risks after losses. Question: What is something that could shift a person’s risk preferences? Question: Do you think most people are risk seeking, risk averse, 13  PROSPECT THEORY (ESTABLISHED BY DANIEL KAHNEMAN AND AMOS TVERSKY) 14  PROSPECT THEORY EXAMPLE Consider the following scenarios: A) You can either choose a 100% chance to gain $400, or a 50% chance to gain $950. As per prospect theory, which is the preferred choice? Which do you prefer? B) You can either choose a 100% chance of losing $500 or a 50% chance of losing $1100. Which would you prefer? As per prospect theory, which is the preferred choice? Expected Utility (EU) of A: Expected Utility (EU) of B: EU of 100% chance of EU of 100% chance of losing getting $400 = $400 %500 = - $500 EU of 50% chance of getting EU of 50% chance of losing 15 $950 = $475 $1100 = - $550 Example of Prospect Theory in Business Decision Making Scenario: A retail company, ShopSmart, is considering two strategies to boost sales during the holiday season. The company's management team is evaluating these options based on potential gains and losses, illustrating the principles of prospect theory. Options: 1.Option A: Implement a guaranteed 10% discount on all products, which is expected to increase sales by a moderate but certain amount. 2.Option B: Introduce a promotional lottery where 16 customers have a 50% chance of winning a 20% discount Prospect Theory Application to ShopSmart Example: Loss Aversion: According to prospect theory, people tend to prefer avoiding losses over acquiring equivalent gains. In this scenario, ShopSmart's management might perceive the potential loss of not attracting enough customers with Option B as more significant than the potential gain of attracting more customers with a higher discount. Certainty Effect: The certainty effect suggests that people are more likely to favor outcomes that are certain over those that are merely probable. Therefore, ShopSmart's management might lean towards Option A, as the guaranteed 10% discount provides a certain outcome, even if the potential gain is smaller than the possible gain from 17 INFORMATION ASYMMETRY: WHEN ONE PERSON HAS MORE INFORMATION THAN ANOTHER. FULL INFORMATION: WHERE EVERYONE HAS THE SAME INFORMATION. 18  INSURANCE ALLOWS FOR RISK POOLING Example: Car insurance customers are willing to incur small losses with certainty (pay their insurance premiums) in order to avoid the possibility of paying for larger losses on their own (damages from car accident). Who knows for certain if you are an excellent driver or not? 19 ADVERSE SELECTION, MORAL HAZARD, AND INFORMATION ASYMMETRY Adverse selection: Where buyers or sellers use their private information of the risk factors involved in the transaction to maximize their outcomes, at the expense of the other parties to the transaction. THE MARKET FOR LEM ONS 20 QUESTION: HOW DO YOU THINK FINANCIAL MARKETS (E.G. STOCK MARKET) FEEL ABOUT INFORMATION ASYMMETRY? QUESTION: WHAT WOULD HAPPEN IF PUBLICLY TRADED COMPANIES DIDN’T HAVE FINANCIAL STATEMENTS? 21  THE THEORY OF SIGNALING: SPENCE MODEL SIGNALING: When one party credibly conveys information about itself to another party (or to the market). Perspective employees can signal their ability level to the employer by acquiring additional education. The value of the additional education is NOT necessarily the skills learned, it is that the employer believes these credentials are positively correlated with greater ability and/or greater motivation. KEY CHARACHTERISTIC OF SIGNALING: The signal must be costly to send, otherwise both high and low types would do it (cheap talk). FOR EXAMPLE: In the job market model….acquiring education is costly so individuals with lower ability or lower motivation are less likely to try and signal they are the “good” type. 22 QUESTION: WHAT ARE SOME WAYS IN WHICH BUSINESSES CAN SIGNAL QUALITY? REMEMBER, FOR SOMETHING TO BE A SIGNAL IT MUST BE COSTLY TO SEND….. 23 INFORMATION ASYMMETRY CAN LEAD TO MORAL HAZARD HOW? When one party lacks information about the actions or intentions of the other, it can result in the latter engaging in riskier behavior. EXAMPLE: If a lender cannot fully monitor a borrower's actions due to information asymmetry, the borrower might take on riskier projects, knowing that the lender bears some of the risk. 24 MORAL HAZARD: WHERE ON PARTY TAKES ON MORE RISK BECAUSE THEY DON’T BEAR THE FULL CONSEQUENCES OF THAT RISK. 25 QUESTION: WHAT ARE SOME WAYS IN WHICH BUSINESSES CAN ADDRESS THE MORAL HAZARD PROBLEM? 26 Red Card or Black Card? ROUND 2 – 5 Payoffs Column Player Black Red Card Card If you play $10 RED CARD you Black $8 Card increase your earnings by $8 $ $2. Row 0 Playe If you play $0 $2 BLACK CARD r your earnings Red Card do not change $10 $2 but your partner’s THE NASH EQUILIBRIUM CONCEPT Nash equilibrium: Given the combination of strategies in a game, the NE is where neither player has any incentive to deviate, given the strategy of his opponent. OR …. A situation in which everyone is doing the best they can, given what everyone else is doing. 28  PRISONER’S DILEMMA The Classic Setting: Two prisoners are held in separate cells for a crime that they did, in fact, commit. The prosecutor, however, has only enough hard evidence to convict them of a minor offense, for which the penalty is 1 year in jail. Each prisoner is told that if one confesses while the other remains silent, the confessor will go free while the other will spend 20 years in prison. If both confess, they will get an intermediate sentence of 5 years. The two prisoners are not allowed to 29  The Prisoner’s Dilemma Prisoner 1 Keep Rat out Quiet partner 1 year FREEDOM Keep Quiet in jail ! 1 year 20 Prison in jail years in jail er 2 20 5 years years in jail Rat out in jail partner FREED 5 years OM! in jail  Pepsi vs. Coca Cola Pricing War Payoffs represent fictional change Low High in profit Price Price Low $5 $0 Price What is the Million Millio $5 Nash $13 n Million Equilibrium? Million What would $13 $10 both companies High Million Million Price prefer? $0 $10 Million Million NASH EQUILIBRIUM EXAMPLE… OR IS IT? A BEAUTIFUL MIND 32  What’s the issue? COORDINATION FAILURE How can Coordination be attained? Impose Regulation… What kind of regulation? Why? Commit to Retaliate… How? Establish Trust… How? Leverage Reputation… How? Form a Cartel…. 33 RISK COMES FROM NOT KNOWING WHAT YOU’RE DOING. ~ WARREN BUFFETT 34