Managerial Economics Summary - TEW & Trading Engineer - 16/20 First Seat

MANAGERIAL‌‌ECONOMICS‌ ‌
Simon‌‌Kuhn‌‌ ‌
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LECTURE‌‌1:‌‌FOUNDATIONS‌ ‌
PART‌‌ONE‌ ‌
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WHAT‌‌IS‌‌INDUSTRIAL‌‌ORGANISATION?‌‌ ‌
Industrial‌‌Organisation‌‌i‌s‌‌a‌‌branch‌‌of‌‌economics‌‌that‌‌is‌‌concerned‌‌with‌‌the‌‌study‌‌of‌i‌mperfect‌‌
competition‌.‌‌We‌‌will‌‌look‌‌at‌‌ways‌‌for‌‌a‌‌company‌‌to‌‌escape‌‌perfect‌‌competition.‌ ‌
⇒ ‌‌through‌m ‌ arket‌‌power‌:‌ ‌
- innovation‌ ‌
- advertisement‌ ‌
- product‌‌differentiation‌ ‌
- price‌‌discrimination‌ ‌
In‌‌this‌‌course,‌‌we‌‌will‌‌use‌‌managerial‌‌economics‌‌to‌‌answer‌‌practical‌‌questions‌‌on‌‌these‌‌topics.‌ ‌
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HOW‌‌WE‌‌STUDY‌‌INDUSTRIAL‌‌ORGANISATION‌ ‌
We‌‌will‌‌make‌‌use‌‌of:‌ ‌
- fundamental‌‌economic‌‌principles‌‌(e.g.‌‌rational‌‌agents,‌‌optimality,...)‌ ‌
- game‌‌theory‌‌because‌‌of‌‌high‌i‌nterdependence‌b ‌ etween‌‌firms‌‌ ‌
- abstract‌‌modeling‌ ‌
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THE‌‌PROBLEM‌‌OF‌‌THE‌‌MANAGER‌ ‌
The‌‌Small‌‌Business‌‌Administration‌‌gives‌‌some‌‌basic‌‌guidelines‌‌on‌‌how‌‌to‌‌structure‌‌a‌‌business‌‌plan:‌ ‌
- executive‌‌summary‌‌‌→‌‌the‌‌unique‌‌selling‌‌point,‌‌what‌‌differentiates‌‌the‌‌business‌‌from‌‌others‌ ‌
- company‌‌description‌‌‌→‌‌which‌‌products‌‌and‌‌services,‌‌product‌‌differentiation,...‌ ‌
- market‌‌analysis‌‌‌→‌‌economies‌‌of‌‌scale,‌‌market‌‌concentration,‌‌sunk‌‌costs,...‌ ‌
- service‌‌or‌‌product‌‌line‌→ ‌ ‌‌explain‌‌production‌‌processes,‌‌R&D,‌‌innovation,...‌ ‌
- marketing‌‌and‌‌sales‌→ ‌ ‌‌describe‌‌the‌‌marketing‌‌strategy,‌‌price‌‌discrimination,...‌ ‌
- financial‌‌plan‌‌and‌‌funding‌‌ ‌
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All‌‌of‌‌these‌‌elements‌‌have‌‌to‌‌do‌‌with‌‌concepts‌‌studied‌‌in‌‌Managerial‌‌Economics‌.‌ ‌
→‌‌we‌‌will‌‌look‌‌at‌‌the‌‌economics‌‌behind‌‌these‌‌concepts‌‌within‌‌(im)perfect‌‌competition‌‌ ‌
‌in‌‌order‌‌to‌‌use‌‌them‌‌for‌‌more‌‌practical‌‌applications‌‌(e.g.‌‌a‌‌business‌‌plan)‌ ‌
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MARKET‌‌DEMAND‌ ‌
In‌‌Managerial‌‌Economics,‌‌we‌‌will‌‌mainly‌‌focus‌‌on‌‌firm‌‌profit-maximizing‌‌behavior‌‌and‌‌a‌‌resultant‌‌market‌‌
outcome‌‌that‌‌such‌‌behavior‌‌implies.‌ ‌
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Market‌‌Demand‌‌Curve‌‌d ‌ escribes‌‌the‌‌relationship‌‌between‌‌how‌‌much‌‌money‌‌(aggregated)‌‌consumers‌‌
are‌‌willing‌‌to‌‌pay‌‌per‌‌unit‌‌of‌‌the‌‌good‌‌and‌‌the‌‌quantity‌‌(aggregated)‌‌of‌‌the‌‌goods‌‌consumed.‌ ‌
→‌‌depends‌‌on:‌ ‌
- price‌ ‌
- income‌ ‌
- expectations‌‌of‌‌price‌‌movement...‌ ‌
-⇒ ‌‌Quantity = f (price, income, marketing, ...) ‌
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However,‌‌we‌‌will‌‌express‌‌a‌‌simplified‌‌demand‌‌curve‌‌in‌‌terms‌‌of‌‌the‌‌price:‌
1. Q = a bP ‌ −
- a‌‌=‌‌quantity‌‌demanded‌‌when‌‌price‌‌is‌‌very‌‌small‌ ‌
- a/b‌‌=‌‌the‌‌maximum‌‌willingness‌‌to‌‌pay‌ ‌
⇒‌‌this‌‌equation‌‌is‌‌used‌‌when‌‌firms‌‌have‌‌a‌f‌ ixed‌‌quantity‌‌‌but‌‌can‌‌easily‌‌
change‌‌the‌‌price‌‌(e.g.‌‌bakkery)‌‌=‌p ‌ rice-focused‌ ‌
‌
−
2. P = A B Q (‌ i‌nverse‌)‌ ‌
- A‌‌=‌‌the‌‌maximum‌‌willingness‌‌to‌‌pay‌ ‌
- A/B‌‌=‌‌quantity‌‌demanded‌‌when‌‌price‌‌is‌‌very‌‌small‌ ‌
⇒‌‌this‌‌equation‌‌is‌‌used‌‌when‌‌firms‌‌have‌‌a‌v‌ ariable‌‌quantity‌‌‌(in‌‌extremely‌‌
concentrated‌‌markets‌‌e.g.‌‌oil,‌‌gold,...)‌‌=‌q ‌ uantity-focused‌ ‌
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,We‌‌need‌‌to‌‌ask‌‌ourselves‌‌whether‌‌a‌‌linear‌‌market‌‌demand‌‌curve‌‌is‌‌even‌‌realistic?‌ ‌
- it‌‌has‌‌a‌f‌ unctional‌‌form‌‌ ‌
→‌‌closer‌‌to‌‌an‌‌estimation,‌‌yet‌‌fairly‌‌accurate‌‌a‌‌local‌‌level‌ ‌
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- it‌‌does‌‌no‌‌take‌‌into‌‌account‌‌the‌t‌ ime‌f‌actor‌ ‌
a. short‌‌run:‌‌no‌‌possibility‌‌to‌‌change‌‌production‌‌facilities‌ ‌
b. long‌‌run:‌‌firm‌‌can‌‌change‌‌its‌‌production‌‌facilities‌‌to‌‌meet‌‌demand‌ ‌
→‌‌but‌‌market‌‌demand‌‌curve‌‌does‌‌not‌‌make‌‌the‌‌distinction,‌‌though‌‌markets‌‌change‌‌constantly‌ ‌
‌
- demand‌‌is‌‌a‌‌function‌‌of‌m ‌ any‌‌aspects‌ ‌
→‌‌income‌‌(cfr.‌‌Engel‌‌Law),‌‌Giffen‌‌goods,‌‌preferences,...‌ ‌
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Yet,‌‌despite‌‌its‌‌limitations,‌‌we‌‌will‌‌continue‌‌to‌‌use‌‌the‌‌simple‌‌(inverse)‌‌linear‌‌demand.‌ ‌
→‌‌we‌‌need‌‌to‌‌emphasise‌‌competition,‌‌not‌‌the‌‌demand‌‌curve‌ ‌
→‌‌easy‌‌way‌‌to‌‌find‌‌the‌‌equilibrium‌‌in‌‌any‌‌market‌‌situation‌ ‌
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FIRM'S‌‌DEMAND‌ ‌
The‌F ‌ irm's‌‌Demand‌‌g ‌ ives‌‌a‌‌company‌‌an‌‌idea‌‌how‌‌much‌‌they‌‌can‌‌sell,‌‌given‌‌the‌‌price‌‌they‌‌ask:‌ ‌
a. if‌‌there‌‌is‌‌only‌o ⇒
‌ ne‌f‌irm‌‌ ‌‌the‌‌firm's‌‌demand‌‌is‌‌equal‌‌to‌‌the‌‌market‌‌demand‌ ‌
b. if‌‌there‌‌are‌m ⇒
‌ ultiple‌f‌irms‌‌ ‌‌the‌‌firm's‌‌demand‌‌depends‌‌on‌‌other‌‌firms:‌ ‌
⇒
‌‌QJ = f (P J , P K , income, marketing J , marketing K , ....) ‌
‌
Firms‌‌have‌‌an‌‌explicit‌‌(e.g.‌‌through‌‌quantitative‌‌market‌‌analysis)‌‌or‌‌implicit‌‌(e.g.‌‌gut-feeling)‌‌of‌‌the‌‌
⇒
market‌‌demand,‌‌and‌‌they‌‌try‌‌to‌‌increase‌‌their‌‌firm's‌‌demand‌‌ ‌‌they‌‌need‌‌Managerial‌‌Economics.‌ ‌
→‌‌a‌‌good‌‌understanding‌‌of‌‌the‌‌firm's‌‌demand‌‌is‌‌necessary:‌‌indeed,‌‌we‌‌cannot‌‌start‌‌producing‌‌before‌ ‌
‌we‌‌know‌‌what‌‌we‌‌can‌‌sell.‌ ‌
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PRICE‌‌ELASTICITY‌‌OF‌‌DEMAND‌‌ ‌
Elasticity:‌‌ ‌

⇒‌‌ε = ×
Δq
q Δq p Δq Δp
Δp = Δp q
‌‌with‌‌ q = percentage change in q ‌and‌‌ p = percentage change in p ‌
p

‌
- if‌‌|ε| = 1 ⇒‌‌if‌‌price‌‌reduces/increases,‌‌the‌‌quantity‌‌will‌‌reduce/increase‌‌by‌‌the‌‌same‌‌amount‌ ‌
- if‌‌|ε| < 1 ⇒‌‌increasing‌‌price‌‌increases‌‌revenues:‌d‌ emand‌‌is‌‌inelastic‌ ‌
- if‌‌|ε| > 1 ⇒‌‌increasing‌‌price‌‌reduces‌‌revenues:‌d‌ emand‌‌is‌‌elastic‌ ‌
‌
Given‌‌a‌‌demand‌‌curve,‌‌you‌‌would‌‌need‌‌to‌‌find:‌ ‌
Δq dq
- Δp = dp =‌‌the‌‌first‌‌derivative‌‌of‌‌the‌‌Q(p)‌‌function‌ ‌

- p/q =‌‌just‌‌fill‌‌in‌ ‌
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‌
Cross-elasticity:‌ ‌

⇒‌‌ε ×
Δq 1
q1 Δq 1 p2
1,2 = Δp2 = Δp2 q1
‌
p2

‌
- if‌‌|| ε1,2 || > 0 ⇒‌s‌ ubstitute‌‌‌goods‌ ‌
- if‌‌|| ε1,2 || < 0 ⇒‌c‌ omplement‌‌‌goods‌ ‌
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,PERFECT‌‌COMPETITION‌ ‌
In‌‌perfect‌‌competition,‌‌firms‌‌and‌‌consumers‌‌are‌p ‌ rice-takers‌ ‌
→‌‌there‌‌is‌‌no‌‌market‌‌power,‌‌no‌‌possibility‌‌to‌‌alter‌‌the‌‌price‌ ‌
→‌‌a‌‌firm‌‌can‌‌sell‌‌as‌‌much‌‌or‌‌as‌‌little‌‌as‌‌it‌‌wants‌‌at‌‌the‌‌ruling‌‌market‌‌price‌ ‌
→‌‌the‌‌demand‌‌curve‌‌for‌‌an‌‌individual‌‌firm‌‌is‌‌therefore‌‌a‌‌horizontal‌‌line‌ ‌
‌
Every‌‌player‌‌in‌‌perfect‌‌competition‌‌will,‌‌as‌‌is‌‌normal,‌‌choose‌‌an‌‌output‌‌level‌‌
that‌‌maximises‌‌their‌‌individual‌‌profit.‌ ‌
→‌‌MC‌‌=‌‌MR‌‌and‌‌because‌‌each‌‌product‌‌is‌‌sold‌‌at‌‌the‌‌market‌‌price,‌‌ ‌
M
‌ R‌‌=‌‌P‌‌=‌‌MC‌:‌‌price‌‌therefore‌‌equals‌‌marginal‌‌costs‌‌in‌‌perfect‌‌competition‌ ‌
→‌‌for‌‌every‌‌individual‌‌company,‌‌the‌‌optimal‌‌output‌‌level‌‌q‌‌will‌‌be‌‌summed‌ ‌
‌and‌‌this‌‌gives‌‌us‌‌the‌‌aggregate‌‌output‌‌level‌‌Q‌ ‌
‌
The‌‌market‌‌demand‌‌curve‌‌still‌‌has‌‌a‌‌negative‌‌slope:‌ ‌
→‌‌if‌‌the‌‌entire‌‌market‌‌output‌‌or‌‌price‌‌changes,‌‌the‌‌effect‌‌is‌‌still‌‌noticeable‌‌in‌ ‌
‌the‌‌demand‌‌curve‌ ‌
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(graphs‌‌are‌‌for‌o ‌ ne‌‌‌individual‌‌company‌‌left‌‌and‌‌for‌‌the‌e
‌ ntire‌‌‌market‌‌right)‌ ‌
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MONOPOLY‌ ‌
If‌‌there‌‌is‌‌only‌‌one‌‌firm‌‌in‌‌the‌‌market,‌‌its‌‌firm's‌‌demand‌‌curve‌‌would‌‌be‌‌identical‌‌to‌‌the‌‌market‌‌demand.‌ ‌
→‌‌it‌‌could‌‌singlehandedly‌‌influence‌‌the‌‌price‌‌as‌‌it‌‌can‌‌singlehandedly‌‌choose‌‌the‌‌supply‌ ‌
‌
As‌‌a‌‌monopolist‌‌has‌‌the‌‌opportunity‌‌to‌‌choose‌‌the‌‌quantity‌‌/‌‌price‌‌as‌‌he‌‌pleases,‌‌he‌‌is‌‌also‌‌
faced‌‌with‌‌a‌‌production‌‌dilemma:‌ ‌
−
→‌‌producing‌‌ΔQ = Q2 Q1 more‌‌units‌‌increases‌‌revenue‌‌with‌‌G‌ ‌
→‌b −
‌ ut‌‌‌decreased‌‌price‌‌with‌‌ΔP = P 1 P 2 and‌‌thus‌‌revenue‌‌with‌‌L‌ ‌
What‌‌choice‌‌should‌‌the‌‌monopolist‌‌make‌‌if‌‌he‌‌wants‌‌to‌‌maximize‌‌profits?‌ ‌
‌
Like‌‌any‌‌other‌‌firm,‌‌we‌‌need‌‌to‌‌keep‌‌the‌‌optimality‌‌condition‌‌in‌‌mind:‌‌MR‌‌=‌‌MC.‌ ‌
So,‌‌what‌‌is‌‌MR?‌ ‌
× × −
→‌‌T R = q uantity price = Q (A B Q) = AQ B 2 Q ‌ −
⇒ dT R(Q)
‌‌M R = dQ = A 2BQ ‌ −
The‌‌MR-curve‌‌of‌‌a‌‌monopolist‌‌has‌‌the‌‌same‌‌intercept‌‌as‌‌its‌‌demand‌‌curve,‌‌but‌‌twice‌‌the‌‌
slope.‌‌This‌‌means‌‌that‌‌the‌‌MR-curve‌‌will‌‌always‌‌lie‌‌beneath‌‌the‌‌demand‌‌curve.‌ ‌
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The‌‌main‌‌difference‌‌between‌‌a‌‌monopolist‌‌and‌‌a‌‌firm‌‌in‌‌perfect‌‌competition‌‌is‌‌that‌ ‌
the‌‌MR‌‌is‌n ‌ ot‌‌equal‌a ‌ nd‌a‌ lways‌‌less‌t‌han‌‌the‌‌actual‌‌market‌‌price.‌‌ ‌
‌
Following‌‌the‌‌optimality‌‌rule,‌‌MC=MR,‌‌the‌‌monopolist‌‌will‌‌product‌‌QM units‌‌ ‌
but‌‌will‌‌sell‌‌them‌‌at‌‌a‌‌clearing‌‌price‌‌of‌‌P M ‌
×
→‌‌the‌‌total‌‌revenue‌‌QM P M ‌is‌‌greater‌‌than‌‌the‌‌total‌‌costs‌‌AC(Q) QM ‌ ×
and‌‌thus‌‌the‌‌monopolist‌‌attains‌‌an‌e ‌ conomic‌‌profit‌.‌ ‌
‌
It‌‌is‌‌therefore‌‌interesting,‌‌for‌‌any‌‌firm,‌‌to‌‌try‌‌and‌‌achieve‌‌a‌‌certain‌‌level‌‌of‌‌market‌‌power.‌ ‌
In‌‌a‌‌perfect‌‌competition,‌‌economic‌‌profit‌‌is‌‌by‌‌no‌‌means‌‌possible‌u ‌ nless‌‌‌in‌‌the‌‌short‌‌run.‌ ‌




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,PART‌‌TWO‌ ‌
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In‌‌this‌‌course,‌‌we‌‌adapt‌‌a‌n ‌ eoclassical‌‌approach‌‌‌in‌‌which‌‌a‌‌firm‌‌is‌‌solely‌‌envisioned‌‌as‌‌a‌‌production‌‌
unit:‌‌the‌‌firm‌‌transforms‌‌inputs‌‌into‌‌outputs:‌ ‌
→‌g ‌ oal‌:‌‌maximize‌‌profits‌‌and‌‌hence‌‌minimize‌‌the‌‌production‌‌costs‌‌ ‌
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COST‌‌RELATIONSHIPS‌ ‌
A‌‌firm‌‌is‌‌characterised‌‌by‌‌a‌p ‌ roduction‌‌function‌‌‌for‌‌a‌‌single‌‌product‌‌q.‌‌This‌‌function‌‌specifies‌‌the‌‌quantity‌‌
q‌‌that‌‌the‌‌firm‌‌produced‌‌from‌‌using‌‌k‌‌different‌‌inputs:‌‌q = f (x1 , x2 , ..., xk ) ‌
‌
The‌‌relationship‌‌between‌‌the‌‌output‌‌choice‌‌(production‌‌function)‌‌and‌‌the‌‌production‌‌costs‌‌is‌‌expressed‌‌
using‌‌the‌c‌ ost‌‌function‌:‌‌C (q) + F ‌.‌‌As‌‌we‌‌are‌‌looking‌‌to‌‌maximize‌‌profits,‌‌we‌‌will‌‌solve:‌ ‌
k
M inimize ∑ wi xi ‌s.t. f (x1 , x2 , ..., xk ) = Q ‌‌with‌‌Q‌‌=‌‌the‌‌chosen‌‌production‌‌level‌ ‌
i=1
solving‌‌this‌‌linear‌‌problem‌‌for‌a
‌ ll‌‌‌quantity‌‌levels,‌‌results‌‌in‌‌the‌‌optimal‌‌cost‌‌function‌ ‌
where‌‌costs‌‌are‌‌minimized.‌ ‌
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There‌‌are‌‌4‌‌categories‌‌of‌‌costs:‌ ‌
1. Fixed‌‌costs‌:‌‌a‌‌given‌‌amount‌‌of‌‌expenditure‌‌that‌‌the‌‌firm‌‌must‌‌incur‌e ‌ ach‌‌p
‌ eriod‌‌‌and‌‌that‌‌is‌‌
unrelated‌‌‌to‌‌how‌‌much‌‌output‌‌the‌‌firm‌‌produces.‌ ‌
‌
2. Average‌‌costs‌:‌‌the‌‌total‌‌costs‌‌divided‌‌by‌‌output:‌ ‌
- Average F ixed Costs : F /Q ‌
- Average V ariable Costs : C(Q)/Q ‌
‌
3. Marginal‌‌costs‌:‌‌the‌‌addition‌‌to‌‌total‌‌costs‌‌that‌‌is‌‌incurred‌‌in‌‌increasing‌‌output‌‌by‌‌one‌‌unit‌ ‌
→‌‌M arginal Costs : dC(Q)/dQ ‌
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4. Sunk‌‌costs‌:‌‌costs‌‌that‌‌are‌‌also‌u ‌ nrelated‌‌‌to‌‌the‌‌output,‌‌but‌‌that‌‌are‌‌spent‌‌before‌‌measuring‌‌the‌‌
total‌‌costs‌‌(e.g.‌‌licences,‌‌research‌‌expenditures,...)‌‌and‌‌are‌‌also‌u ‌ nrecoverable‌‌‌if‌‌the‌‌firm‌‌
decides‌‌to‌‌exit‌‌the‌‌market.‌ ‌
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COST‌‌VARIABLES‌‌AND‌‌OUTPUT‌‌DECISIONS‌‌ ‌
Profit‌‌maximization‌‌over‌‌any‌‌period‌‌of‌‌time‌‌requires‌‌that‌‌the‌‌produced‌‌where‌M ‌ C‌‌=‌‌MR‌.‌ ‌
But‌‌‌it‌‌is‌‌important‌‌to‌‌note‌‌that‌‌this‌‌is‌‌only‌‌applicable‌i‌f‌‌the‌‌company‌‌produces‌.‌ ‌
‌
A‌‌company‌‌can‌‌produce‌‌in‌‌its‌‌equilibrium‌‌but‌‌the‌‌total‌‌revenue‌‌could‌‌be‌‌smaller‌‌than‌‌the‌‌
total‌‌costs.‌‌This‌‌happens‌‌when‌‌the‌‌equilibrium‌‌is‌‌under‌‌the‌‌AVC-curve.‌ ‌
→‌‌in‌‌this‌‌case,‌‌the‌‌firm‌‌would‌‌not‌‌produce‌‌and‌‌leave‌‌the‌‌market‌‌=‌s‌ hut-down‌‌decision‌ ‌
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In‌‌short,‌‌output‌‌decisions‌‌are‌‌based‌‌on:‌ ‌
1. Marginal‌‌Costs‌ ‌
→‌‌to‌‌decide‌h ‌ ow‌‌much‌‌‌to‌‌produce:‌‌MC‌‌=‌‌MR‌ ‌
2. Average‌‌Costs‌ ‌
→‌‌to‌‌decide‌‌if‌‌the‌‌firm‌‌will‌‌even‌‌produce‌‌in‌‌the‌l‌ong‌‌run‌ ‌
(losses‌‌in‌‌the‌‌SR‌‌are‌‌tolerated,‌n ‌ ot‌‌‌in‌‌the‌‌long‌‌run)‌ ‌
3. Average‌‌Variable‌‌Costs‌‌ ‌
→‌‌to‌‌decide‌‌if‌‌the‌‌firm‌‌will‌‌even‌‌produce‌‌in‌‌the‌s ‌ hort‌‌run‌ ‌
(price‌‌<‌‌AC‌‌can‌‌be‌‌tolerated,‌‌price‌‌<‌‌AVC‌n ‌ ot‌‌‌because‌‌then‌‌every‌‌unit‌‌is‌‌a‌‌loss)‌ ‌

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ECONOMIES‌‌OF‌‌SCALE‌‌ ‌
The‌‌state‌‌of‌‌affairs‌‌in‌‌which‌‌average‌‌costs‌‌fall‌‌as‌‌output‌‌increases,‌‌meaning‌‌that‌‌the‌‌cost‌‌per‌‌unit‌‌of‌‌
output‌‌declines‌‌as‌‌the‌‌scale‌‌of‌‌operations‌‌rises.‌ ‌
⇒
→‌f‌alling‌‌AC-curve‌‌ ‌ ‌MC‌‌<‌‌AC‌ ‌
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AC(Q)
We‌‌define‌‌S = M C(Q) ‌
- ⇒
if‌‌S‌‌>‌‌1‌‌ ‌‌economies‌‌of‌‌scale‌ ‌
- ⇒
if‌‌S‌‌=‌‌1‌‌ ‌m‌ inimum‌‌efficient‌‌scale‌‌
- ⇒
if‌‌S‌‌<‌‌1‌‌ ‌‌diseconomies‌‌of‌‌scale‌ ‌

,We‌‌conclude‌‌that‌‌the‌‌greater‌‌the‌‌extent‌‌of‌‌economies‌‌of‌‌scale,‌‌the‌‌larger‌‌the‌‌output‌‌at‌‌which‌‌the‌‌average‌‌
cost‌‌is‌‌minimized,‌‌the‌‌fewer‌‌firms‌‌that‌‌can‌‌operate‌‌efficiently‌‌in‌‌the‌‌market‌ ‌
⇒ ‌l‌arger‌‌economies‌‌of‌‌scale‌‌for‌‌a‌‌few‌‌firms‌‌will‌‌result‌‌in‌‌concentrated‌‌markets‌ ‌
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Now,‌‌what‌‌causes‌‌economies‌‌of‌‌scale?‌ ‌
- underlying‌‌technology‌ ‌
⇒
- greater‌‌scale‌‌of‌‌operations‌‌ ‌‌specialization‌‌and‌‌division‌‌of‌‌labor‌ ‌
- economies‌‌on‌‌inventory,‌‌repair,...‌ ‌
- capacity‌‌related‌‌solutions‌‌(e.g.‌‌volume‌‌of‌‌container‌‌that‌‌increases‌‌exponentially)‌ ‌
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ECONOMIES‌‌OF‌‌SCOPE‌ ‌
The‌‌state‌‌of‌‌affairs‌‌in‌‌which‌‌it‌‌is‌‌less‌‌costly‌‌to‌‌produce‌‌a‌‌set‌‌of‌‌goods‌‌in‌‌one‌‌firm‌‌than‌‌it‌‌is‌‌to‌‌produce‌‌that‌‌
set‌‌in‌‌two‌‌or‌‌more‌‌firms.‌ ‌
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We‌‌define‌‌S C =
−
C(q 1 , 0) + F 1 + C(0, q 2 ) + F [C(q 1 , q 2 ) + F ]
‌
C(q 1 , q 2 ) + F

- ⇒
if‌‌S‌‌>‌‌0‌‌ ‌‌economies‌‌of‌‌scope‌ ‌
- ⇒
if‌‌S‌‌=‌‌0‌‌ ‌‌critical‌‌point,‌‌indifference‌ ‌
- ⇒
if‌‌S‌‌<‌‌0‌‌ ‌‌no‌‌economies‌‌of‌‌scope‌ ‌
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The‌‌concept‌‌of‌‌economies‌‌of‌‌scope‌‌is‌‌an‌‌important‌‌one,‌‌as‌‌it‌‌provides‌‌the‌‌central‌‌technological‌‌reason‌‌
for‌‌the‌‌existence‌‌of‌‌multiproduct‌‌firms.‌‌There‌‌are‌‌two‌‌causes‌‌for‌‌economies‌‌of‌‌scope:‌ ‌
1. Shared‌‌inputs‌ ‌
→‌‌e.g.‌‌shared‌‌R&D,‌‌equipment‌‌that‌‌can‌‌be‌‌used‌‌for‌‌multiple‌‌products,...‌ ‌
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2. Cost‌‌complementarities‌‌ ‌
→‌‌producing‌‌one‌‌good‌‌reduces‌‌the‌‌cost‌‌of‌‌another‌ ‌
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MARKET‌‌STRUCTURE‌‌ ‌
The‌M ‌ arket‌‌Structure‌‌i‌s‌‌defined‌‌as‌‌the‌‌amount‌‌and‌‌size‌‌of‌‌firms‌‌within‌‌that‌‌market‌‌+‌‌other‌‌factors.‌ ‌
How‌‌to‌‌measure‌‌the‌‌market‌‌structure?‌‌ ‌
- summary‌‌measures‌‌(e.g.‌‌number‌‌of‌‌firms,‌‌market‌‌share‌‌of‌‌each‌‌firm,...)‌ ‌
- concentration‌‌curve‌ ‌
- concentration‌‌ratios‌‌(e.g.‌‌C Rn )‌ ‌
- Herfindahl-Hirschman‌‌Index‌‌(HII)‌ ‌
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Summary‌‌measures‌ ‌
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Most‌‌of‌‌the‌‌times‌‌fairly‌i‌n‌accurate‌‌as‌‌is‌‌hard‌‌to‌‌list‌‌all‌‌competitors‌‌within‌‌one‌‌
market.‌ ‌
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Concentration‌‌Curve‌‌ ‌
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How‌‌large‌‌are‌‌the‌‌largest‌‌firms?‌‌→‌‌cfr.‌‌steepness‌‌of‌‌curve‌ ‌
How‌‌quickly‌‌do‌‌we‌‌reach‌‌100%?‌ ‌
…‌ ‌
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Concentration‌‌Ratios‌ ‌
e.g.‌‌C R4 =‌‌ratio‌‌that‌‌tells‌‌you‌‌how‌‌much‌‌market‌‌share‌‌the‌‌4‌‌largest‌‌firms‌‌in‌‌a‌‌market‌‌have‌‌combined.‌ ‌
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Herfindahl-Hirschman‌‌Index‌‌(HHI)‌ ‌
N
H HI = ∑ si2 ‌‌=‌‌sum‌‌of‌s
‌ quared‌m
‌ arket‌‌shares‌‌of‌‌each‌‌company.‌ ‌
i=1
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, MARKET‌‌DEFINITION‌ ‌
We‌‌understand‌‌that‌‌it‌‌is‌‌impossible‌‌to‌‌calculate‌‌metrics‌‌on‌‌the‌‌market‌‌structure,‌‌if‌‌we‌‌have‌‌no‌‌clear‌‌
definition‌‌of‌‌the‌‌market‌‌we‌‌are‌‌studying.‌‌But‌‌defining‌‌a‌‌market‌‌is‌‌no‌‌easy‌‌thing‌‌to‌‌do:‌ ‌
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1. define‌‌by‌‌substitutability‌‌in‌p ‌ roduction‌ ‌
→‌‌standard‌‌approach,‌‌based‌‌on‌‌industry‌‌codes‌‌ ‌
→‌‌but‌‌limitations‌ ‌
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2. define‌‌by‌‌substitutability‌‌in‌c ‌ onsumption‌‌ ‌
→‌‌=‌d ‌ emand‌‌substitutability‌‌ ‌
→‌‌based‌‌on‌‌cross-price‌‌elasticity‌‌ ‌
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We‌‌should‌‌also‌‌ask‌‌ourselves:‌w ‌ hat‌‌drives‌‌potential‌‌market‌‌concentration?‌‌ ‌
a. economies‌‌of‌‌scale‌‌/‌‌economies‌‌of‌‌scope‌ ‌
→‌‌larger‌‌firms‌‌become‌‌more‌‌efficient,‌‌concentration‌‌rises‌ ‌
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b. network‌‌externalities‌ ‌
→‌‌concentrated,‌‌even‌‌though‌‌there‌‌could‌‌be‌‌no‌‌economies‌‌of‌‌scale‌‌/‌‌scope‌ ‌
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c. government‌‌and‌‌antitrust‌‌policy‌ ‌
→‌‌by‌‌limiting‌‌entry,‌‌patent‌‌system,‌‌blocking‌‌of‌‌mergers,...‌ ‌
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PART‌‌THREE‌ ‌
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THE‌‌CONCEPT‌‌OF‌‌DISCOUNTING‌ ‌
Both‌‌the‌‌competition‌‌and‌‌monopoly‌‌models‌‌are‌‌somewhat‌‌vague‌‌with‌‌respect‌‌to‌‌time.‌ ‌
As‌‌we‌‌know‌‌money‌‌has‌‌a‌‌time‌‌value,‌‌the‌‌meaning‌‌of‌‌profit‌‌or‌‌break-even‌‌is‌‌less‌‌clear.‌ ‌
→‌‌we‌‌need‌‌a‌‌way‌‌to‌‌convert‌‌tomorrow's‌‌money‌‌into‌‌today's‌‌money‌ ‌
⇒ ‌‌we‌‌will‌‌make‌‌use‌‌of‌‌discounting‌‌and‌‌Net‌‌Present‌‌Value‌ ‌
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(Net)‌‌Present‌‌Value‌‌is‌‌directly‌‌relevant‌‌to‌‌profit‌‌maximization:‌ ‌
- for‌o ‌ ne-period‌p ‌ roblems,‌‌we‌‌just‌‌continue‌‌to‌‌use‌‌the‌M‌ R‌‌=‌‌MC‌‌‌optimality‌‌constraint‌ ‌
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- for‌m ‌ ultiperiod‌p ‌ roblems,‌‌we‌‌need‌‌to‌‌make‌‌sure‌‌that‌‌the‌‌present‌‌value‌‌of‌‌future‌‌income‌‌streams‌‌
must‌‌at‌‌least‌‌cover‌‌the‌‌present‌‌value‌‌of‌‌the‌‌expenses‌‌in‌‌establishing‌‌the‌‌project:‌P ‌ V‌‌-‌‌I‌‌>‌‌0‌‌ ‌
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EFFICIENCY‌‌AND‌‌SURPLUS‌ ‌
Why‌‌are‌‌monopolies‌‌often‌‌blocked?‌‌ ‌
→‌r‌ eason‌:‌‌monopolies‌‌are‌i‌n‌efficient.‌ ‌
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Efficiency‌:‌a ‌ ‌‌market‌‌outcome‌‌is‌‌efficient‌‌when‌‌it‌‌is‌‌impossible‌‌to‌‌find‌‌a‌‌small‌‌change‌‌in‌‌the‌‌allocation‌‌of‌‌
capital,‌‌labor,‌‌goods‌‌or‌‌services‌‌that‌‌would‌‌improve‌‌the‌‌well-being‌‌of‌‌individuals‌‌without‌‌hurting‌‌others.‌‌ ‌
→‌‌an‌‌analysis‌‌of‌‌surpluses‌‌will‌‌give‌‌us‌‌an‌‌idea‌‌of‌‌why‌‌a‌‌monopoly‌‌is‌‌inefficient‌‌and‌‌thus‌‌unwanted‌ ‌
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PERFECT‌‌COMPETITION‌ ‌
Efficiency‌‌is‌‌basically‌‌a‌‌measure‌‌of‌‌well-being.‌ ‌
a. Consumer‌‌surplus‌:‌t‌he‌‌difference‌‌between‌‌the‌‌maximum‌‌amount‌‌a‌‌consumer‌‌is‌‌
⇒
willing‌‌to‌‌pay,‌‌and‌‌the‌‌amount‌‌actually‌‌paid‌‌ ‌C ‌ S‌‌‌(aggregated)‌ ‌
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b. Producer‌‌surplus‌:‌t‌he‌‌difference‌‌between‌‌the‌‌amount‌‌a‌‌producer‌‌receives‌‌from‌‌a‌‌
⇒
sale‌‌and‌‌the‌‌amount‌‌that‌‌the‌‌sale‌‌cost‌‌him‌‌ ‌P ‌ S‌‌‌(aggregated)‌ ‌
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In‌‌this‌‌diagram‌‌(perfect‌‌competition),‌‌we‌‌can‌‌see‌‌that‌‌both‌‌surpluses‌‌are‌‌maximized.‌ ‌
→‌‌the‌‌competitive‌‌equilibrium‌‌is‌e ‌ fficient‌‌‌and‌‌welfare‌‌is‌‌maximized‌



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