Lets consider an example say we have two firms call

This preview shows page 54 - 56 out of 64 pages.

Let’s consider an example.Say we have two firms, call them A and B.The firms compete for clients. Let xAand xBdenote the number of clients that firm A and B have. Each firm has a total cost of F + Vxi, where F & V are just some positive numbers, and xiis the number of clients that firm i has. In this case, i can be either A or B. For example, let’s assume that F = $1,000 and V = $5.So, if say, a firm has 100 clients, its total cost is 1000 + 5(100) = $1,500.Sometimes we say the F is a fixed costand the 5xiis the variable cost. Practice Problem 1:If firm B has 230 clients, what is its total cost? Use the same F & V. Firm A & B compete for a large population of clients.Just to get the discussion started, let’s assign A & B an arbitrary amount of clients. Say firm A has xA= 200 and B has xB= 160.To model competition (for new clients) between the firms, we focus on price.What is the lowest price these firms can afford to charge?First, Firm A has cost 1000 + 5(200) = $2000.Firm A must charge a price per client, call it PA, such that its total revenue is not less thanits total cost.Total revenue is PAxA, so we need PA(200) ≥ $2000, or PA≥ $10.Hence, $10 is the lowest price firm A can charge.54
Practice Problem 2: What would be the lowest price firm A could charge if it had 90 clients?Second, Firm B has cost 1000 + 5(160) = $1,800.Firm B must choose PBso that PB(160) ≥ 1800, or PB≥ $11.25.Hence, $11.25 is the lowest price firm B can charge.Main Observation:The firm with the largest customer base can charge the lowest price. The important implication of this is that Firm A should be able to win more new customers than its competitor because Firm A can charge a lower price.What happens is that firm A wins due to economies of scale.The way that this works is that the firm must recover its fixed costs, namely F = $1000. Itdoes this by charging each customer a small fraction of this cost. Thus, the more clients the firm has, the less each client has to pay in order to cover the firm’s fixed cost. The lesson here is that banks and other financial intermediaries come into existence because they are able to take advantage of these economies of scale.As a result, the intermediaries can provide services to individual customers at low, competitive prices, which would be much more expensive if each individual (or firm) had to conduct the same service on their own. This is one important explanation for why bank funding is so important for U.S. firms.Now we discuss asymmetric information.When looking at financial markets, information is often an important aspect of trade.Information about a financial product is critical to accurate pricing, but often one or more of thepeople trading in the market lack full information.For example, if a company issues a discount bond with a maturity date of 7 years, it is important for an investor to assess the default risk when calculating a price.

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture