LECTURE 1: FOUNDATIONS
PART ONE
WHAT IS INDUSTRIAL ORGANIZATION?
Industrial Organization is a branch of economics that is concerned with the study of imperfect
competition. We will look at ways for a company to escape perfect competition.
→ Trough market power:
- innovation
- advertisement
- product differentiation
- price discrimination
In this course we are going to use managerial economics to answer practical questions on these
topics.
HOW WE STUDY INDUSTRIAL ORGANIZATION
We will make use of:
- fundamental economic principles
▪ e.g. rational agents, optimality, …
- game theory to analyze strategic interactions
▪ high interdependence between firms
- abstract modeling
▪ trade off detail vs. generalization
THE PROBLEM OF THE MANAGER
The Small Business Administration gives some basic guidelines on how to structure a business plan:
- executive summary
▪ the unique selling point, what differentiates the business from others, …
- company description
▪ which products and services, product differentiation, …
- market analysis
▪ economies of scale, market concentration, sunk costs, …
- service or product line
▪ explain production processes, R&D, innovation, …
- marketing and sales
▪ describe the marketing strategy, price discrimination, …
- financial plan and funding
All of these elements have to do with concepts studied in Managerial Economics!
→ We will look at the economics behind these concepts within (im)perfect competition in order to use
them for more practical applications, e.g. a business plan.
MARKET DEMAND
Market demand of a good is the quantity that consumers purchase for that good at various prices.
→ Demand is the relationship between price and quantity.
In Managerial Economics we will mainly focus on firm profit-maximizing behavior and a resultant
market outcome that such behavior implies.
The market demand curve describes the relationship between how much money (aggregated)
consumers are willing to pay per unit of the good and the quantity (aggregated) of the goods
consumed
→ depends on:
- price
- income
1
, - preferences and factors that affect them
- expectations
- price of substitute products and complements
Firms and their managers, explicitly or implicitly, have an idea of the market demand of their product
and they take actions to:
- Increase the demand for their product, short to long run.
- Price correctly given the product and market condition, short to long run.
→ These are key elements of a business plan!
However, we will express a simplified demand curve in terms of the price:
1. Q = a – bP
- a = The quantity demanded when the price is very small.
- a/b = The maximum willingness to pay.
→ This equation is used when firms have a fixed quantity but can easily
change the price, e.g. a bakery. → price-focused
2. P = A – BQ (inverse)
- A = The maximum willingness to pay.
- A/B = The quantity demanded when the price is very small.
→ This equation is used when firms have a variable quantity, e.g. in
extremely concentrated markets like oil and gold. → quantity-focused
We need to ask ourselves whether a linear market demand curve is realistic?
- it had a functional form
▪ It is closer to an estimation, yet fairly accurate a local level.
- it does not take into account the time factor
▪ short run: There is no possibility to change production facilities.
▪ long run: The firm can change its production facilities to meet demand.
- demand is a function of many aspects
▪ income (Engel law), normal goods, inferior goods, price, Giffen goods, …
Despite these potential complications, we will mainly use simple linear demand functions and focus on
the supply side.
→ This is an easy way to find the equilibrium in any market situation.
FIRM’S DEMAND
The firm’s demand gives a company an idea of how much they can sell, given the price they ask.
- If I am the only firm, demand for my product is equal to the market demand.
- If I am not the only firm, demand also depends on other things:
▪ how many competitors
▪ their products
▪ their prices
▪ their marketing
▪ …
2
,PRICE ELASTICITY OF DEMAND
→ A measure of how responsive the demand is with changes in prices.
Cross-elasticity:
- > 0: substitutes
- < 0: complements
PROFIT MAXIMIZATION
∏(q) = R(q) – C(q)
→ The goal is to maximize profits.
PERFECT COMPETITION
In perfect competition firms and consumers are price-takers.
→ There is no market power, no possibility to alter the price.
→ A firm can sell as much as it produces at the market price.
→ The demand curve for an individual firm is therefore a horizontal line.
Every player will choose an output level that maximizes their
individual profit.
→ MC = MR and because each product is sold at the market price
MR = P = MC.
→ For every individual company, the optimal output level q will be
summed and this gives us the aggregate output level Q.
The market demand curve still has a negative slope.
→ If the entire market output or price changes, the effect is still
noticeable in the demand curve.
The graph on the left is for one individual company and the graph on the right is for the entire market.
MONOPOLY
If there is only one firm in the market, its firm’s demand is identically to the market demand.
→ It could singlehandedly influence the price as it can choose the supply.
3
, Since a monopolist can choose the quantity/price, he is faced with a
production dilemma:
→ L is the loss in revenue from the reduction in price from P₁ to P₂.
→ G is the gain in revenues from the sale of additional units.
Like any other firm, we need to keep the optimality condition in mind:
MR = MC
→ TR = quantity . price = Q . (A-BQ) = AQ-BQ²
→ MR is the derivative of TR.
The MR-curve of a monopolist has the same intercept as its demand-
curve, but twice the slope.
→ The MR-curve will always lie beneath the demand-curve.
The main difference between a monopolist and a firm in perfect
competition is that the MR is not equal and always less than the actual
market price.
The monopolist will produce Qm units, but will sell them at a clearing price
of Pm.
→ The total revenue is greater than the total costs and thus the monopolist
attains an economic profit.
If the total costs are greater than the total revenue, there is a loss of
efficiency.
It is therefore interesting, for any firm, to try and achieve a certain level of
market power.
In a perfect competition, economic profit is by no means possible, unless in
the short run.
PART TWO
THE CONCEPT OF DISCOUNTING
Both the competition and monopoly models are somewhat vague with respect to time.
As we know, money has a time value, the meaning of profit or break-even is less clear.
→ We need a way to convert tomorrow’s money into today’s money.
We will make use of discounting and Net Present Value.
(Net) Present Value is directly relevant to profit maximization:
- For one-period problems, we just continue to use the MR = MC optimality constraint.
- For multiperiod problems, we need to make sure that the present value of future income
streams must at least cover the present value of the expenses in establishing the project:
PV – I > 0.
EFFICIENCY AND SURPLUS
Monopolies are often blocked because they are inefficient!
efficiency: A market outcome is efficient when it is impossible to find a small change in the allocation of
capital, labor, goods or services that would improve the well-being of individuals, without
hurting others.
→ An analysis of surpluses will give us an idea of why a monopoly is inefficient and thus unwanted.
4
PART ONE
WHAT IS INDUSTRIAL ORGANIZATION?
Industrial Organization is a branch of economics that is concerned with the study of imperfect
competition. We will look at ways for a company to escape perfect competition.
→ Trough market power:
- innovation
- advertisement
- product differentiation
- price discrimination
In this course we are going to use managerial economics to answer practical questions on these
topics.
HOW WE STUDY INDUSTRIAL ORGANIZATION
We will make use of:
- fundamental economic principles
▪ e.g. rational agents, optimality, …
- game theory to analyze strategic interactions
▪ high interdependence between firms
- abstract modeling
▪ trade off detail vs. generalization
THE PROBLEM OF THE MANAGER
The Small Business Administration gives some basic guidelines on how to structure a business plan:
- executive summary
▪ the unique selling point, what differentiates the business from others, …
- company description
▪ which products and services, product differentiation, …
- market analysis
▪ economies of scale, market concentration, sunk costs, …
- service or product line
▪ explain production processes, R&D, innovation, …
- marketing and sales
▪ describe the marketing strategy, price discrimination, …
- financial plan and funding
All of these elements have to do with concepts studied in Managerial Economics!
→ We will look at the economics behind these concepts within (im)perfect competition in order to use
them for more practical applications, e.g. a business plan.
MARKET DEMAND
Market demand of a good is the quantity that consumers purchase for that good at various prices.
→ Demand is the relationship between price and quantity.
In Managerial Economics we will mainly focus on firm profit-maximizing behavior and a resultant
market outcome that such behavior implies.
The market demand curve describes the relationship between how much money (aggregated)
consumers are willing to pay per unit of the good and the quantity (aggregated) of the goods
consumed
→ depends on:
- price
- income
1
, - preferences and factors that affect them
- expectations
- price of substitute products and complements
Firms and their managers, explicitly or implicitly, have an idea of the market demand of their product
and they take actions to:
- Increase the demand for their product, short to long run.
- Price correctly given the product and market condition, short to long run.
→ These are key elements of a business plan!
However, we will express a simplified demand curve in terms of the price:
1. Q = a – bP
- a = The quantity demanded when the price is very small.
- a/b = The maximum willingness to pay.
→ This equation is used when firms have a fixed quantity but can easily
change the price, e.g. a bakery. → price-focused
2. P = A – BQ (inverse)
- A = The maximum willingness to pay.
- A/B = The quantity demanded when the price is very small.
→ This equation is used when firms have a variable quantity, e.g. in
extremely concentrated markets like oil and gold. → quantity-focused
We need to ask ourselves whether a linear market demand curve is realistic?
- it had a functional form
▪ It is closer to an estimation, yet fairly accurate a local level.
- it does not take into account the time factor
▪ short run: There is no possibility to change production facilities.
▪ long run: The firm can change its production facilities to meet demand.
- demand is a function of many aspects
▪ income (Engel law), normal goods, inferior goods, price, Giffen goods, …
Despite these potential complications, we will mainly use simple linear demand functions and focus on
the supply side.
→ This is an easy way to find the equilibrium in any market situation.
FIRM’S DEMAND
The firm’s demand gives a company an idea of how much they can sell, given the price they ask.
- If I am the only firm, demand for my product is equal to the market demand.
- If I am not the only firm, demand also depends on other things:
▪ how many competitors
▪ their products
▪ their prices
▪ their marketing
▪ …
2
,PRICE ELASTICITY OF DEMAND
→ A measure of how responsive the demand is with changes in prices.
Cross-elasticity:
- > 0: substitutes
- < 0: complements
PROFIT MAXIMIZATION
∏(q) = R(q) – C(q)
→ The goal is to maximize profits.
PERFECT COMPETITION
In perfect competition firms and consumers are price-takers.
→ There is no market power, no possibility to alter the price.
→ A firm can sell as much as it produces at the market price.
→ The demand curve for an individual firm is therefore a horizontal line.
Every player will choose an output level that maximizes their
individual profit.
→ MC = MR and because each product is sold at the market price
MR = P = MC.
→ For every individual company, the optimal output level q will be
summed and this gives us the aggregate output level Q.
The market demand curve still has a negative slope.
→ If the entire market output or price changes, the effect is still
noticeable in the demand curve.
The graph on the left is for one individual company and the graph on the right is for the entire market.
MONOPOLY
If there is only one firm in the market, its firm’s demand is identically to the market demand.
→ It could singlehandedly influence the price as it can choose the supply.
3
, Since a monopolist can choose the quantity/price, he is faced with a
production dilemma:
→ L is the loss in revenue from the reduction in price from P₁ to P₂.
→ G is the gain in revenues from the sale of additional units.
Like any other firm, we need to keep the optimality condition in mind:
MR = MC
→ TR = quantity . price = Q . (A-BQ) = AQ-BQ²
→ MR is the derivative of TR.
The MR-curve of a monopolist has the same intercept as its demand-
curve, but twice the slope.
→ The MR-curve will always lie beneath the demand-curve.
The main difference between a monopolist and a firm in perfect
competition is that the MR is not equal and always less than the actual
market price.
The monopolist will produce Qm units, but will sell them at a clearing price
of Pm.
→ The total revenue is greater than the total costs and thus the monopolist
attains an economic profit.
If the total costs are greater than the total revenue, there is a loss of
efficiency.
It is therefore interesting, for any firm, to try and achieve a certain level of
market power.
In a perfect competition, economic profit is by no means possible, unless in
the short run.
PART TWO
THE CONCEPT OF DISCOUNTING
Both the competition and monopoly models are somewhat vague with respect to time.
As we know, money has a time value, the meaning of profit or break-even is less clear.
→ We need a way to convert tomorrow’s money into today’s money.
We will make use of discounting and Net Present Value.
(Net) Present Value is directly relevant to profit maximization:
- For one-period problems, we just continue to use the MR = MC optimality constraint.
- For multiperiod problems, we need to make sure that the present value of future income
streams must at least cover the present value of the expenses in establishing the project:
PV – I > 0.
EFFICIENCY AND SURPLUS
Monopolies are often blocked because they are inefficient!
efficiency: A market outcome is efficient when it is impossible to find a small change in the allocation of
capital, labor, goods or services that would improve the well-being of individuals, without
hurting others.
→ An analysis of surpluses will give us an idea of why a monopoly is inefficient and thus unwanted.
4
