Industrial economics summary
Week 1: perfect competition and monopolies
Introduction
Industrial economics is about how firms compete with each other. We especially focus on
imperfects competition, strategic behavior of firms and the effect of policy interventions in
this setting.
Modern industrial economics studies the effects of imperfect competitive markets.
We study the supply side: we only take from the demand side what is needed to study to
supply side.
Different kind of markets
Which kind of markets we have depends on how many producers (do producers have an
influence on prices?) there are and if products are differentiated or not (slide 6). A
standardized product means that if the price of one product increases people switches to
another seller (= perfect substitutes).
The focus of the course
The main focus is on the idea of sellers having market power. there's a small number of
sellers and they all have a strategy. There's a large number of buyers and they don't have a
strategy; they just want to consume. We will use game theory concepts.
Basic market models
We know from microeconomics that the demand side of the economy has a market demand
curve. Since there are a lot of consumers, consumers do not have market power. The
market demand shows how much demander is for a given price (Q = a + bP). The inverse
demand shows how much consumers are willing to pay for a given quantity (P = a + bQ).
The price elasticity of demands is the minus percentage change in quantity demanded in
response to a percentage change in price (slide 22).
The supply side of the economy tries to maximize profits: π= pq−C ( q ) .
Firms will always set marginal costs equal to marginal
revenue in this case and from this we can know the
profit maximizing quantity. The cost function
determines part of the profits as well. There are
variable and fixed costs. In the cost function, economic
costs are included.
Average costs are obtained by dividing the cost by Q.
Variable costs are obtained by taking a derivative of the
costs function which respect to Q.
The distinction between fixed and variable costs comes
down to a distinction between the long and the short
run (fixed costs do not matter in the long run) and the
entry/expansion possibility (fixed costs make entry
possibility more difficult).
Opportunity costs
This is the foregone benefits from not applying the
resource in the best alternative use. This can be
different from monetary slash accounting costs. Economic costs take these into account.
,Sunk costs
A cost is sunk if the value of an investment cannot be recovered by resale upon exit from
markets. This asset doesn’t have an opportunity cost because we can’t use it in an
alternative way. The sunk costs increase when the investments are narrower.
Perfect competition
Assumptions:
- many buyers and sellers
- perfectly informed about the market
- standardized products (=homogeneous)
- same technology available for all sellers
- easy to enter or exit (imitation is possible because all firms face the same costs)
- firms are price takers (atomistic firms)
- each face a perfectly elastic demand curve
If a firm has a competitive advantage disadvantage has arised from violation of one of these
conditions.
Imperfect competition can give rise to branding, which means firms sell higher quality at a
higher price.
The maximization problem in this market is sought by setting marginal revenue equal to
marginal cost. Since prices are exactly equal to the marginal revenue, firms set the price
equal to the marginal costs.
How to solve for the perfectly competitive market:
- determine Q
- look at whether P is greater than ATC or P smaller than ATC (loss/profit?)
- When P is smaller than AVC the firm doesn’t produce anything.
The short-run supply curve of the firm is given by the marginal cost function because this
gives the quality of the firm if it’s equal to the price. When we sum up all quantities of the
industry, we get to the industry short-run supply curve (horizontal summation) quantities
are multiplied by the number of firms, because every firm produces the same quantity.
Short run equilibrium is where demand equals supply. None of the participants in a market
have an incentive to change their behavior. Lars supply and demand is the tendency of the
market price to move to the equilibrium price.
The number of firms increases, the price goes down and therefore the demand goes up.
The long run
Supply and demand curves can shift all the time because of exogenous factors. The short
run equilibrium can change every time. The extent to which quantities and prices change
due to these changes in supply and demand is determined by the slopes of the lines
(elasticities). In the long run all costs are variable, there is free entry and exit and this means
that if there are economic profit firms will always enter or exit when there is a loss, and this
leads to no economic profits in equilibrium.
Not a realistic model
In the long run we see positive economic profits and other productivities (= different
technology) between firms. Entry and exit take place simultaneously. New firms entering or
smaller than firms already existing and the growth rates are declining for the existing firm.
Not all firms have the same size.
However, the Fundamental Theorum states that the maximum surplus is in the case of a
perfect competitive markets.
Monopoly
,Assumptions:
- There are many small buyers and one seller
- Entry in the market is impossible because of various factors (slide 38)
Maximization problem of a monopolist equals: MR = MC.
The degree of monopoly power is inversely related to the demand elasticity face by the
seller. Monopolists earn an economic profit.
Compared to a perfectly competitive market, the quantity is lower in monopoly and the price
is higher. Therefore, there is a dead weight loss because consumers lose consumer surplus.
Measuring market performance
Regulation refers to the case when a firm retains monopoly and its actions are directly under
regulators oversights. Antitrust policy is a much broader field. The idea is to prevent firms
from taking actions that increase market power in a detrimental way. They are policies
motivated by the goal of protecting consumers.
Total welfare equals the profits of the firms plus the consumer surplus. This will always be
less in the case of a monopoly. Sometimes people can add more weight to a consumer
surplus or to the profits of firms, but this is a normative question.
Price ceiling
Slide 46.
Economic profit
A firm that can make economic profits in the long run has market power. We can measure
mark power by the Lerner index: (p-MC)/p
Measures the ability to price above marginal costs. For a monopolist marginal revenue
equals marginal costs and therefore the Lerner index equals p (1 – 1/elasticity). A low-price
elasticity of demand can make scope for the monopolist to raise its rise above marginal
costs.
this does not take into account the number of firms. We can also use:
Concentration ratio = the market share of the X largest firms in the industry.
The market share = % total quantity produced.
this does not take into account the inequality in market shares. We can also use:
Herfindahl index = Sum of square of market shares.
This solves the problem is discussed before and the index lies between zero and one (=
monopoly).
Week 2: Price discrimination
Price discrimination can only exist when a firm has market power, because otherwise other
firms can always try to gain more of the market by selling at a lower price.
I am surprised discriminate because it allows them to capture part of the consumer surplus,
but this has large implications on the welfare of other groups and is therefore the market
performance. Therefore, it’s a concern for public policy.
First need to have information about consumers’ willingness to pay. Often indirect
information is available. Arbitrage should not be possible.
3 types of price discrimination
Sellers can price discriminate either based on observable buyer characteristics or by
inducing buyers to self-select among different product offerings:
- 1st degree price discrimination
- 2nd degree price discrimination
, - 3rd degree price discrimination
Perfect price discrimination
The monopolist should have perfect information about the demands, so it should know each
consumer's willingness to pay. Also arbitrate should not be possible.
Consumer surplus in the case of a perfect competitive market is transferred to the
monopolist in case of price discrimination of the 1st degree.
Selection by indicators (one product charged at different prices)
Consumers should be in segmented groups and there should be no arbitrage possible. This
strategy can be profitable when the different groups have different price elasticities of
demand because then the firm can price differently along the different price
elasticities/groups. They can be 50% with a low willingness to pay and 50% with a high
willingness to pay.
The groups are treated like two different markets with the same goods. Marginal revenue
should equal marginal cost in both markets. We therefore optimize profits in both markets.
There is a dead weight loss in this case, because the monopolist acts like there are two
markets while there is only one. Marginal costs or not constant we can still use this trick.
Sometimes selection by indicators is not possible. The firm has to set the same price in both
markets in this case no price discrimination.
- 2 scenarios: the firm can sell at one market only and exclude the low WTP buyers, or
the firm can serve both markets and sell at a price for which low WTP buyers are
willing to pay as well as high WTP buyers.
- At the left of some certain Q, only the high WTP consumers are willing to buy. Price
function is given by their price function. Note that all demand has to be served for this
group first (in our case, this means that the kink starts at a price of 100).
- Then, for all Q above, everyone demands the product, so we have to combine the
difference demands elasticities into one function by horizontally summing up the
demand curves.
- With this last demand curve, we set MR = MC. From this our price and quantity
follow.
- We have to check that this generates more profits than serving one market only
(optimizing the high WTP demand only). In most cases however, this is the price and
quantity that serves both markets (optimize MR = MC for second demand function).
- It does not always mean that the NSW is better without price discrimination, because
firms can decide to exclude the smaller market with low WTP when this market is
really small.
What we see in practice: long-haul vs short-haul rate discrimination
We would expect long-distance trips to be more expensive, but this is not necessarily the
case in imperfectly competitive markets.
- When selection by indicators is possible, we can ask different prices for different trips
and the monopolist will maximize all profits in all three cases.
