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Summary Microeconomics Industrial Organisation - Book, lectures and tutorials

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  • Microeconomics Industrial Organisation
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  • Rijksuniversiteit Groningen (RuG)
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  • Introduction to Industrial Organization

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  • January 20, 2019
  • 17
  • 2019/2020
  • Summary

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1 - Industrial organisation
IO is concerned with the workings of markets and industries, competition, and market power: The
ability to set prices above costs. Market power leads to allocative inefficiency by loss resulting
from the absence of sales. It would be efficient to serve customers with lower willingness to pay
than the monopoly price: As long as WTP is above MC, there is value creation.
A second inefficiency is productive inefficiency which is cost increase due to market power:
Intense competition drives down costs.
Rent seeking is a third inefficiency of market power, and exists when government intervention
artificially maintains market power. Rent seeking are unproductive resources spend to influence
policymakers.

The Lerner Index measures a firm markup, which indicates market power: (P - MC) / P
The Lerner index also equals the inverse of elasticity of demand: The higher
market power, the lower the elasticity of demand.
More elastic demand means lower optimal markup.

5.3 - Monopoly
Monopolies could be granted by the government and patents or
copyrights. Another source of monopoly is the nature of cost or demand functions: Network
effects are one example.
The monopoly quantity Qm is lower
than efficient. All trades below QC but
above Qm fail to take place in
monopolies, despite these trades
being efficient: Buyer WTP is greater
than MC.
The loss due to missing efficient
trades is the p - MC for Qc - Qm, and
adds up to area C: A Harberger
triangle.
This Harberger triangle is the
allocative inefficiency, or the excess
burden.
Comparing areas A and B, we also see market power
means a transfer from consumers to firms.
Then there’s the missing productive efficiency due to
inefficient firms not failing to survive as they would in
perfect competition, potentially driving up costs
under monopoly. Lastly, as mentioned before, there’s
rent seeking.

Pure monopolies are rare, yet a price leader acts
similar. If the competitors of a price leader set prices
just below them but are constrained to capacity K,
the leader is essentially a monopolist for the residual
demand. Moving demand D K units to the left gives
us DR where the leader acts as a monopolist and sets
MR = MC.

The degree of monopoly power is
inversely related to the demand
elasticity faced by the seller.
Look at the two graphs and
suppose the firm on the left
commands 90% market share
and the other 100%. Despite this,
the one on the left has more
monopoly power as measured by
his markup over price ratio.
(P - MC) / P = - 1 / Elasticity D

,5.4 - Regulation
Regulation is government intervention in economic activity using commands, controls and
incentives.
Normative theories of regulation state that consumers demand regulation from politicians to
protect them against negative effects of market failure.
Capture theories are more skeptical and state that not consumers but firms demand regulation:
Think of regulations protecting certain industries.

5.5 - Competition policy and antitrust
Competition policy (EU term) and antitrust (US) mean the same. They focus on:
-Price fixing, horizontal agreements where prices are colluded on.
-Merger policy to prevent excessive concentration since it could create monopolies.
-Abusive practices by dominant firms when their power is inevitable.
In the US the DoJ and FTC mostly matter, while in the EU the Commission’s Competition
Directorate largely controls competition policy.

5.6 - Firm regulation
With large fixed costs or economies of scale competition may not be viable: Natural monopolies
where costs are minimised
with one supplier only.
If the firm in the first panel is
forced to set price equal to
c to make output socially
optimal (no allocative
inefficiency since the area E
then becomes 0) the firm
have negative total profits:
Fixed costs are not reflected
in marginal costs, so π = -F.
The regulator could give a
subsidy F, but efficiency
costs of taxing this may be
greater than the inefficiency it eliminates. Another risk is regulatory capture: Firms investing
resources into influencing regulators to the point that regulation reflects the objective of profit
maximisation rather than welfare maximisation. Using these resources is socially wasteful.

Average cost pricing forces the firm to set the lowest price without negative profits: P = AC, as
depicted in the second panel. For natural monopolies the US usually uses rate-of-return
regulation which allows firms a fair rate of return on capital, roughly equal to average cost pricing.
A problem with this is that firms have little incentive for cost reduction, which is alleviated by
regulatory lag: A gap between lower costs and lower price allowed by the regulator.
Rate-of-return regulation is a low-power incentive mechanism: Price varies as cost does,
minimising incentives or cost reduction.
High-power incentive mechanisms set price before hand and doesn’t change if prices do, such as
a price cap regulation: This incentivises firms to lower costs as it implies profits. In reality though,
it usually just has a very long regulator lag as eventually the price-cap is likely to decrease.
Another problem with price cap regulation is firms being incentivised to decrease services to
decrease costs and increase markup.

Electricity generation is not a natural monopoly, but the grid is: The monopolist controlling the grid
is an upstream bottleneck since his assets is an essential facility. Downstream competitors may
face foreclosure as the upstream monopolist attempts to recapture monopoly profits. Vertical
integration may lead to efficiency gains, meaning we face a trade-off between efficiency and
market power. Regulators could also allow the upstream firm to compete downstream but prevent
it from discriminating agains downstream competitors, e.g. by regulating the acces price paid by
competitors downstream. The Efficient Component Pricing Rule ECPR states that the wholesale
price offered to an independent downstream firm can’t be higher than p - MC of the integrated
downstream firm.

, 6.1 - Price discrimination
Optimal output depicted here would be Qm where
MR = MC. Higher price means higher margin but
less quantity. The seller leaves money: A is area of
consumers willing to pay more than the price, and
B are consumers willing to pay more than the costs
but less than the monopoly price. Price
discrimination aims to get this untapped revenue
source, given that the seller knows each
consumer’s valuation and is able to charge different
prices. One example are customer markets where
sales terms are tailored to each individual customer.

First degree price discrimination or perfect price discrimination is knowing each buyer’s valuation
and being able to set a different price for each as well. Charging each their maximum WTP.

Second degree price discrimination or by self-selection is used when the firm can’t distinguish
between consumers and designs products to let them sort themselves. Business and economy
class.

Third degree price discrimination or by indicators is when the firm can distinguish and prevent
arbitrage. E.g. student discount through student cards.

This arbitrage which is prevented with third degree happens when there’s a possibility of resale.
The law of one price states that with different prices, arbitrage would take place in a perfectly
competitive market. Physical impossibility of resale, transaction costs, imperfect information, and
legal restrictions help allow for price discrimination.

Selection by indicators
When the seller can set prices for different groups by dividing them is market-segmentation e.g.
on geographical location. With two markets with two prices MR1 = MR2 = MC is the optimal profit.
MR in each market equals this market’s P(1 + 1/elasticity of demand). So the higher the elasticity
of demand, the lower the inverse elasticity, thus the lower the market charged. Greater price
elasticity of demand means lower price.
Market segmentation allows for greater profits.

6.2 - Self selection
Second degree price discrimination or self selection happens when sellers can’t identify
consumers or aren’t allowed to discriminate. Then the seller indirectly sorts them with different
deals in terms of quality and price, e.g. airfares. An extreme is producing damaged goods simply
to reduce quality to select, e.g. not allowing passengers to choose their seat, which doesn’t
decrease costs for the airline but only makes economy less attractive.
Dupuit: It hits the poor, not because it wants to hurt them but to frighten the rich, referring to why
third-class train tickets are so unattractive.

When we face two consumer groups and offer them two different products we face two
constraints. The participation constraint means we must ensure each consumer still buys, so his
his WTP ≥ Price. The incentive constraint means we must ensure that the high-WTP consumer
has no incentive to choose the deal intended for the low-WTP consumer. This means:
WTPh - Ph ≥ WTPL - PL for the high-WTP consumer.
The participation constraint means that the product meant for the low-WTP consumer has a price
equalling their WTP. Prices cause the low-WTP to get a net surplus of pro, while the high-WTP
consumer marks a strictly positive surplus equalling the minimum consistent with the incentive
constraint: The minimum that’ll make him prefer the expensive product. The high-WTP’s surplus is
also known as the information constraint: If the seller has the info to identify each seller’s type it
could set price to extract the entire consumer surplus (perfect or first degree price discrimination).

Tie-in sales or bundling are alternative strategies for sorting and discriminating. Pure bundling
means purchasing the bundle with no alternative, mixed bundling gives buyers the choice of
buying goods separately as well.

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