Onderstal, S. (2014).
Economics of Organisations and Markets
Summary Post-Midterm / for final exam Tahrim Ramdjan
d.d. 20 december 2017 Alterations on pages: 52-53, 70-82
Table of Contents
Introduction 3
1 Organisations and efficiency 3
1.1 Efficiency 3
1.2 Neoclassical general equilibrium model 3
1.3 Perfect competition 3
3 Industrial Organisation 5
3.1 Market power 5
3.2 Market concentration 5
3.3 Monopoly: The inverse inelasticity rule 6
3.4 Government intervention 6
Strategic Interaction 8
4 Game Theory 8
4.1 The prisoner’s dilemma 8
4.2 The Nash Equilibrium 8
4.3 The Hotelling game 9
5 Team Incentives 9
5.1 The model 9
5.2 Paying for team performance 10
5.3 Comparative performance evaluation 11
6 Oligopoly 14
6.1 Bertrand Competition 14
6.2 Competition under capacity constraints 14
6.3 Cournot competition 15
6.4 Other ways to resolve the Bertrand paradox 18
Dynamic Interaction 20
2 Organisational Economics 20
2.1 Hiring decisions 20
2.2 The Principal-Agent Problem 20
2.3 Critical assumptions in the Principal-Agent-model 22
7 Dynamic games 23
7.1 Subgame Perfect Nash Equilibrium 23
7.2 Pricing in the Vertical Chain 24
8 Optimal incentive contracts 27
8.1 The optimal incentive contract 27
8.2 Risk sharing 29
9 Market entry and product positioning 31
9.1 Market entry also see par. 6.2 31
9.2 Product positioning also see par. 4.3 34
Repeated Interaction 36
10 Repeated interaction and value of revenge 36
10.1 A simple example 36
10.2 Infinitely repeated games and trigger strategy 37
10.3 Analysing the stability condition 38
11 Relational contracts 39
11.1 What are relational contracts? 39
11.2 Bull’s model 40
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12 Collusion in markets 43
12.1 Collusion in markets: Why, how, and when 43
12.2 Factors facilitating collusion 44
12.3 Collusion and competition policy 46
Information Asymmetry 48
13 Games with asymmetric information N.B. NOTE THAT 13.4 IS NOT PART OF THE EMO 2
FINAL EXAM 48
13.1 The adverse selection problem 48
13.2 Screening 49
13.3 Signalling 50
14 Hiring and firing 51
14.1 Credentials 51
14.2 Assessments 51
14.3 Probation 52
14.4 Incentive contracts 53
15 Price discrimination 54
15.1 First-degree price discrimination 54
15.2 Third-degree price discrimination 55
15.3 Second-degree price discrimination 56
15.4 Price discrimination and competition policy 59
Commitment 60
16 The value of commitment 60
16.1 The value of commitment 60
16.2 First-mover (dis)advantages 61
16.3 The Stackelberg model 61
16.4 The hold-up problem 63
17 Make or Buy 65
17.1 Advantages and disadvantages of vertical integration 65
17.2 Vertical restraints 66
17.3 Vertical restraints and competition policy 66
18 Predation 67
18.1 Examples of predation 67
18.2 Building overcapacity to deter entry 67
18.3 Predation and competition policy 69
Relevant case studies from the book 70
Ch. 2, Moral hazard & mortgage market 70
Ch. 4, Game theory in football (Palacios-Huerta) 70
Ch. 5, Fruit pickers (Bandiera et al.) 71
Ch. 8, Daycare centers (Gneezy & Rustichini) 72
Ch. 10, Auctions strategies (Cramton, Schwartz) 72
Ch. 11, Big bonuses trouble (Ariely et al.) 73
Ch. 12, Lysine cartel (Harrington & Skrzypacz) 74
Ch. 14, Performance pay as screening (Lazear) 75
Ch. 15, Damaged goods (Deneckere & McAfee) 76
Ch. 17, Vertical EU car market (Brenkers & Verboven) 76
Ch. 18, Predatory bundling in web browser market 77
Relevant research articles 79
Note: In this summary, Q and q are used interchangeably. But do note:
Q = total output
q = individual output
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Topic: Introduction (Chapters 1, 3) |3
Introduction
1 Organisations and efficiency
1.1 Efficiency
• In the economy as a whole, workers offer their time and skills to firms; firms
distribute goods and services to consumers.
• An allocation of goods and services is efficient, or Pareto-optimal, if there is no
reallocation of goods and services in which one is better of without making another
worse off.
• Value maximisation principle: An allocation of goods and services is efficient
only if it maximises the total value among the affected agents.
• Consumer surplus: The difference between a consumer’s value for an item, and
the price of this item. In formula:
1
𝑪𝑺 = ∗ 𝑄 ∗ (𝑣 − 𝑝)
2
• Producer surplus: The difference between the price of an item, and the costs a
producer has to incur to make this item. Equals the profit. In formula:
𝑷𝑺 = 𝜋 = 𝑄(𝑝 − 𝑐)
• Welfare: The sum of consumer and producer surplus. In formula:
𝑾 = 𝐶𝑆 + 𝑊𝑆
• Welfare can only be maximised in case that 𝑝 = 𝑀𝐶. In this case…
o …for a buyer, a marginal utility as gained from a transaction is not higher
than the price he has to pay.
o …for a producer, he cannot sell the product for more than he has to pay
himself for producing it.
o At 𝑝 = 𝑀𝐶, it is notable that 𝑊 = 𝐶𝑆.
1.2 Neoclassical general equilibrium model
• There are two possibilities for an economy with asymmetric information as our real-
life economy is:
o Individuals communicate their information to a central planner who makes
all the relevant decisions.
o Individuals make independent choices based on the prices of goods and
services.
• The latter possibility is served by the neoclassic general equilibrium model, leading
to the fundamental theorem of welfare economics: an efficient allocation of
goods, emerges at a competitive equilibrium.
o Consequences:
§ No central coordination of decision is required.
§ Producers and consumers behave in line with the interests of the
entire economy, even though they follow only their self-interest.
1.3 Perfect competition
• Four assumptions of the perfectly competitive market:
o There are many buyers and sellers which makes the price exogenous.
o A homogeneous product is traded on the market.
o There are no entry barriers for firms.
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Topic: Introduction (Chapters 1, 3) |4
o There is perfect information for buyers and sellers, regarding both price
and production process.
• The long-run equilibrium of the market is so, that 𝑀𝑅 = 𝒑 = 𝑨𝑪 = 𝑴𝑪. Why?
o A firm’s marginal revenue is equal to the price, because a firm itself cannot
influence the market clearing price.
o The marginal revenue is equal to marginal costs.
o A firm may, when just entering the market, make profits if the price is higher
than average costs. Because of the free entry and exit, however, more and
more firms will join the market, inducing price competition and an increasing
QS until MC = AC.
1.4 Market failure
• Markets can be efficient in three ways:
o Allocatively efficient. Producers sell goods and services for which the
consumer’s value exceeds production costs.
o Productively efficient. Goods and services are produced at the lowest
possible costs.
o Dynamically efficient. Markets establish an efficient balance over time
between production and consumption.
• There are four sources that lead to market failure:
o Market power.
§ If there is a low number of producers or consumers in a market, they
may influence the market price.
o Information asymmetry.
§ When one party engaged in a transaction has more or better
information than the other.
o Externalities.
§ For negative externalities, too much of the good is traded, because
the externality is not taken into account.
à i.e. air pollution
§ Too little of a good is traded when a positive externality is not taken
into account.
à i.e. team production: free-riding (good: effort/labour)
o Transaction costs, among which:
§ Coordination costs, referring to costs parties incur to complete a
transaction. Think of search costs on the part of a consumer, or
advertising costs on the part of a producer.
§ Information asymmetry. A firm may have to invest in ways to
prevent adverse selection, as caused by information asymmetry.
§ Imperfect commitment. Trading partners suffer from costs caused
by imperfect commitment in the case that they cannot bind
themselves to fulfil promises they would like to make before the
transaction takes place.
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Topic: Introduction (Chapters 1, 3) |5
3 Industrial Organisation
3.1 Market power
• The more a price within a market deviates from marginal costs, the lower this
market’s welfare is.
• Market power: ability of a firm to sell its products at a price deviating from (above)
marginal costs.
• Lerner’s index: equalising the difference between price and marginal costs,
divided by the price. Serves as a mechanism to measure a firm’s market power,
across very different products. In formula, for a firm i:
𝑝 − 𝑀𝐶
𝑳𝒇𝒊𝒓𝒎 =
𝑝
In perfectly competitive markets 𝑝 = 𝑀𝐶 so 𝐿 = 0.
• To measure market power in a market, a weighted average of the Lerner indices
must be made. Market power (designated m) for an individual firm may be
calculated through revenue (designated R) as:
𝑅CDEF
𝒎𝒇𝒊𝒓𝒎 =
𝑅GHGIJ
• The market’s Lerner index is then given by:
𝑳𝒎𝒂𝒓𝒌𝒆𝒕 = 𝐿CDEF O ∗ 𝑚CDEF O + 𝐿CDEF Q ∗ 𝑚CDEF Q + ⋯
• Market power can be retained for instance by patents and copyrights, through
which the law protects firms against competing firms entering the market.
• Because of market power, prices can rise, and some consumers will not buy. A
high price, therefore, reduces QS and prevents some of the value-enhancing
transactions.
o Market power leads to allocative inefficiency.
o The deadweight loss may be measured of above marginal cost pricing:
1
𝑫𝑾𝑳 = ∗ 𝑝 − 𝑐 ∗ (𝑄T 𝑐 − 𝑄T 𝑝 )
2
• Market power may, however, also be beneficial for welfare:
o The prospective of getting market power (and high profits) may
induce firms to innovate, and thus, develop new products or
production technologies.
3.2 Market concentration
• A market is concentrated if only a handful of firms have a serious combined market
share.
• Only in concentrated markets, firm can establish market power.
o If many firms are active in a market, however, market concentration is low
and therefore it will be hard to establish market power.
• The Herfindahl-Hirschmann-Index allows for comparison of market concentration
between markets, in which m is market share:
Q Q
𝑯 = 𝑚CDEF O + 𝑚CDEF Q + ⋯
The number of the index is always between 0 and 1. If it equals 1, you have found
a monopoly: if it equals 0, you have found a perfect competition.
• In the case of several equally sized firms, let the number of firms be n, you may
use:
,Economics of Organisations and Markets (S. Onderstal) Summary (Tahrim Ramdjan)
Topic: Introduction (Chapters 1, 3) |6
1
𝑯=
𝑛
• Using this expression, you may get a meaningful analogous idea about the
concentration of a market, rewriting the expression, let the ‘numbers equivalent’ be
N, as:
1
𝑵=
𝐻
• Market concentration and market power are linked as:
𝑯
𝑳=
𝜺
in which 𝜀 is the price elasticity of the demand to be calculated as:
𝑝(𝑄)
𝜺= [
𝑝 𝑄 ∗𝑄
You may derive from this formula that:
o Considerable market power (L) is found in concentrated markets (high H)
with relatively price-inelastic demand (𝜀) à cf. monopoly
• Authorities use the Herfindahl-Hirschman-index to predict the effect of mergers.
o Why? Because information about market shares is much easier to obtain
than information about marginal costs, such as needed for the Lerner
index.
o If not all market shares are known in the market, one may calculate a
lower bound and upper bound for H.
§ The lower bound can be calculated by calculating the squares of
the known market shares.
§ The upper bound can be calculated by assuming as few firms as
possible are responsible (preferably only 1) for the remaining
market share.
3.3 Monopoly: The inverse inelasticity rule
• In a monopoly market, only one supplier is active.
• A monopolist may find his profit maximised where MR = MC. This can be derived
into a new formula:
1
𝐿=
𝜀
This rule implies that in general, a monopoly firm has market power because 𝜀 > 0,
and therefore, L > 0.
\
• This is a special instance of the rule 𝐿 = because H in a monopoly is 1.
]
3.4 Government intervention
• Governments can deal with market power in two ways:
o Competition policy. Applies to markets in general.
§ Anti-cartel law. Prohibiting cartel agreements between firms about
price, production and market division.
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Topic: Introduction (Chapters 1, 3) |7
Prevention of abuse of dominant positions. Prohibition of
§
dominant firms to use price discrimination, product bundling,
predatory pricing.
§ Merger control. Concentrations (mergers, acquisitions, joint
ventures) may be blocked if it effects competition adversely.
§ State aid control. Governments may directly and indirectly support
companies selectively, so that competition in a market may be
distorted.
o Economic regulation. Applies to specific markets only.
§ Oftentimes in natural monopolies, where production by only one firm,
minimises costs. Government authority regulates.
§ Two types:
• Rate-of-return regulation. Regulator sets prices so that the
firm is compensated for the costs it incurs, inducing a ‘fair
rate-of-return’.
o PRO: Allocative inefficiency reduced as much as
possible.
o CON: Firms have no incentives to reduce costs.
• Price regulation. A firm may keep the profits, but is bound to
a price maximum.
o PRO: Allocative inefficiency reduced as much as
possible.
o PRO: Firm is incentivised to cut costs, because firm
may keep profits.
o CON: It may be hard to find the optimal price cap.
Regulator mostly lacks information about the firm’s
marginal costs.
o CON: Strong commitment required from the regulator.
He should avoid the ratchet effect, when the
regulator tightens up the price cap because a firm cuts
its costs.
o CON: Regulated firm may be tempted to cut costs,
leading to reduced quality, harming customers.
