Lecture 1
● Producer theory: competition
○ The competition structure of a market is important; this structure predicts firm behaviour
such as setting price, quantity, and innovation.
○ Competition structure also has implications for consumers and producers.
○ Types of competition:
■ Perfect competition → many firms
■ Monopoly → one firm
■ Oligopoly → a couple of firms
● How firms make decisions
○ Firms make decisions based on a cost-benefit analysis.
○ To decide whether to enter a market, they compare expected profits from entering the
market with the best alternative.
○ Once the firm entered the market:
■ How much to sell, at what price? → marginal benefit = marginal costs
■ Marginal costs: costs of 1 additional unit of the good
■ Marginal benefit: benefit from 1 additional unit of the good
■ Note: MC and MB typically differ per number of products.
● What is a market?
○ A market is where two or more parties buy and sell a
good.
○ Determination of price and quantity
■ Demand: consumers
■ Supply: firms
■ Equilibrium: price and quantity
○ When is a market efficient
■ Units are sold to those with the highest value
for good.
■ Optimal outcome: each product for which the
costs are lower than or equal to the value that
the buyer attaches to the good is traded,
mc_producer=mb_consumer
■ Consumer surplus: surplus that the
consumers receive from the market.
■ Producer surplus is the surplus that the
producer(s) receive from the market.
○ When is a market not efficient
■ mc_producer<mb_consumer
● Producer theory: competition
,○ Perfect competition
■ Many firms are essentially the same.
■ These firms sell the same good (in the eye of the consumer)
■ Firms have no effective possibility of choosing a price
■ Price equals marginal costs
■ Cost structure: often decreasing returns to scale (i.e. when producing
■ more goods each good costs more than the previous good)
■ Individual firms produce little (as compared to the total output in the market).
■ In the short run, firms can make a profit
■ Free market entry and exit of firms
■ In the long run, firms make no economic profit (accounting profit is possible)
■ If higher price → no one buys
■ If lower price → firm makes a loss
■ Long run, no profit is due to free firm entry and exit
■ The market is efficient (the optimal amount is produced and sold)
■ Each product is sold for which marginal benefit consumer > marginal costs firm.
■ Producer surplus (PS): how much producers benefit from participating in the
market.
■ Consumer surplus (CS): how much consumers benefit from participating in the
market.
○ Monopoly
■ Only 1 firm in the market: The product has
no close substitute.
■ Cost structure: increasing returns to scale
due to high fixed costs.
■ Two reasons for a monopoly: natural or
legal.
■ Free entry may or may not be possible (legal
versus natural monopoly).
■ A firm chooses its price (a lot of market
power) → mc_producer=mb_producer for the last unit of the good
(mc_producer<mb_producer for all the other goods).
■ However: the marginal benefit for the monopolist decreases when selling more
(when reducing the price, the monopolist also reduces the benefits from selling all
the other goods).
■ Therefore too little is sold for a price that is too high.
, ■ Producer surplus (PS) higher than when setting the socially optimal price: p* (for which
D=S). Consumer surplus is lower than is socially optimal p,q combination.
■ Deadweight loss (DWL) is the loss in the total surplus from the monopolist’s behaviour.
■ A monopoly does not have a supply function since the firm sets its price.
○ Oligopoly
■ A couple of firms
■ Firms sell similar products (but not the
same product)
■ Each firm has some market power
■ Entry barriers: economies of scale, access
to expensive/complex technology, and
strategic actions by incumbent firms
designed to discourage or destroy new
entrants
■ Temptation of collusion
● Agree on a ‘market’ price or quantity
● Competition authority as a watchdog
■ Prices and quantity in between perfect competition and monopoly
■ Incentives to be competitive, but also profits to take investment/R&D risks
● Comparing market structures
○ Cost structure
■ High fixed costs are typically associated with fewer firms
■ Increasing marginal costs (the faster/stronger the increase, the more firms)
○ Pricing
■ Prices: monopolist>oligopolist>perfect competition
■ Quantities: monopolist<oligopolist<perfect competition
○ Efficiency
■ The higher the deadweight loss, the lower the efficiency.
■ Efficiency: monopolistic<oligopoly<perfect competition
■ Efficiency here is: given that the product/market exists (lack of protection may prevent a
market from developing).
● The market structure of ‘big pharma.’
, ○ Often medicine is only useful for a small group of diseases (that are not common);
therefore, there is typically little competition in a market.
○ Individual medicine -> often a legal monopolist due to patenting
○ COVID vaccine: huge market, high in demand -> oligopoly
■ Recall: price and quantity comparison oligopoly and monopoly.
● Patents and competition:
○ Firms that develop an innovation / new product can ask for a patent.
○ Patents allow a firm to be the only producer of a good (or user of a specific technology),
which gives this producer a monopoly position.
○ Monopoly leads to higher profits as compared to other market structures.
○ Pharma claims the main reason they need patents is to recoup the R&D
○ costs for unsuccessful projects.
○ When the patent time has ended, and drugs are in high demand, then firms
○ may enter an oligopoly or perfect competition
○ Perfect competition: counter painkillers.
○ Oligopoly: products with smaller markets with larger fixed costs.
● Patenting is common in the pharmaceutical industry; why?
○ High R&D costs with uncertain outcomes
■ Many products fail ->, leading to negatives profits on those products
○ Manufacturing a product is often cheap
■ Once the research and tests are completed, production costs are low
○ Without patenting, firms may not even attempt to produce medicines/vaccines, because:
■ Many products fail, leading to negative profits
■ For those products that succeed, other firms will copy the production process and sell
the products for a low price (because of low MC), hence there will still be low profits.
○ When patents are about to end, the firm fears entry of competitors. What do these firms (try
to) do to continue making profits?
■ Make minor changes and file for a new patent
■ pay-for-delay agreements
● Price discrimination
○ Increase profit through price discrimination: charging different prices for the same product
to different consumers.
■ First degree price discrimination: individual pricing
■ Second degree price discrimination: different prices for different
■ Quantities
■ Third degree price discrimination: different prices for different groups or
■ Countries
● Other reason for high prices
● Producer theory: competition
○ The competition structure of a market is important; this structure predicts firm behaviour
such as setting price, quantity, and innovation.
○ Competition structure also has implications for consumers and producers.
○ Types of competition:
■ Perfect competition → many firms
■ Monopoly → one firm
■ Oligopoly → a couple of firms
● How firms make decisions
○ Firms make decisions based on a cost-benefit analysis.
○ To decide whether to enter a market, they compare expected profits from entering the
market with the best alternative.
○ Once the firm entered the market:
■ How much to sell, at what price? → marginal benefit = marginal costs
■ Marginal costs: costs of 1 additional unit of the good
■ Marginal benefit: benefit from 1 additional unit of the good
■ Note: MC and MB typically differ per number of products.
● What is a market?
○ A market is where two or more parties buy and sell a
good.
○ Determination of price and quantity
■ Demand: consumers
■ Supply: firms
■ Equilibrium: price and quantity
○ When is a market efficient
■ Units are sold to those with the highest value
for good.
■ Optimal outcome: each product for which the
costs are lower than or equal to the value that
the buyer attaches to the good is traded,
mc_producer=mb_consumer
■ Consumer surplus: surplus that the
consumers receive from the market.
■ Producer surplus is the surplus that the
producer(s) receive from the market.
○ When is a market not efficient
■ mc_producer<mb_consumer
● Producer theory: competition
,○ Perfect competition
■ Many firms are essentially the same.
■ These firms sell the same good (in the eye of the consumer)
■ Firms have no effective possibility of choosing a price
■ Price equals marginal costs
■ Cost structure: often decreasing returns to scale (i.e. when producing
■ more goods each good costs more than the previous good)
■ Individual firms produce little (as compared to the total output in the market).
■ In the short run, firms can make a profit
■ Free market entry and exit of firms
■ In the long run, firms make no economic profit (accounting profit is possible)
■ If higher price → no one buys
■ If lower price → firm makes a loss
■ Long run, no profit is due to free firm entry and exit
■ The market is efficient (the optimal amount is produced and sold)
■ Each product is sold for which marginal benefit consumer > marginal costs firm.
■ Producer surplus (PS): how much producers benefit from participating in the
market.
■ Consumer surplus (CS): how much consumers benefit from participating in the
market.
○ Monopoly
■ Only 1 firm in the market: The product has
no close substitute.
■ Cost structure: increasing returns to scale
due to high fixed costs.
■ Two reasons for a monopoly: natural or
legal.
■ Free entry may or may not be possible (legal
versus natural monopoly).
■ A firm chooses its price (a lot of market
power) → mc_producer=mb_producer for the last unit of the good
(mc_producer<mb_producer for all the other goods).
■ However: the marginal benefit for the monopolist decreases when selling more
(when reducing the price, the monopolist also reduces the benefits from selling all
the other goods).
■ Therefore too little is sold for a price that is too high.
, ■ Producer surplus (PS) higher than when setting the socially optimal price: p* (for which
D=S). Consumer surplus is lower than is socially optimal p,q combination.
■ Deadweight loss (DWL) is the loss in the total surplus from the monopolist’s behaviour.
■ A monopoly does not have a supply function since the firm sets its price.
○ Oligopoly
■ A couple of firms
■ Firms sell similar products (but not the
same product)
■ Each firm has some market power
■ Entry barriers: economies of scale, access
to expensive/complex technology, and
strategic actions by incumbent firms
designed to discourage or destroy new
entrants
■ Temptation of collusion
● Agree on a ‘market’ price or quantity
● Competition authority as a watchdog
■ Prices and quantity in between perfect competition and monopoly
■ Incentives to be competitive, but also profits to take investment/R&D risks
● Comparing market structures
○ Cost structure
■ High fixed costs are typically associated with fewer firms
■ Increasing marginal costs (the faster/stronger the increase, the more firms)
○ Pricing
■ Prices: monopolist>oligopolist>perfect competition
■ Quantities: monopolist<oligopolist<perfect competition
○ Efficiency
■ The higher the deadweight loss, the lower the efficiency.
■ Efficiency: monopolistic<oligopoly<perfect competition
■ Efficiency here is: given that the product/market exists (lack of protection may prevent a
market from developing).
● The market structure of ‘big pharma.’
, ○ Often medicine is only useful for a small group of diseases (that are not common);
therefore, there is typically little competition in a market.
○ Individual medicine -> often a legal monopolist due to patenting
○ COVID vaccine: huge market, high in demand -> oligopoly
■ Recall: price and quantity comparison oligopoly and monopoly.
● Patents and competition:
○ Firms that develop an innovation / new product can ask for a patent.
○ Patents allow a firm to be the only producer of a good (or user of a specific technology),
which gives this producer a monopoly position.
○ Monopoly leads to higher profits as compared to other market structures.
○ Pharma claims the main reason they need patents is to recoup the R&D
○ costs for unsuccessful projects.
○ When the patent time has ended, and drugs are in high demand, then firms
○ may enter an oligopoly or perfect competition
○ Perfect competition: counter painkillers.
○ Oligopoly: products with smaller markets with larger fixed costs.
● Patenting is common in the pharmaceutical industry; why?
○ High R&D costs with uncertain outcomes
■ Many products fail ->, leading to negatives profits on those products
○ Manufacturing a product is often cheap
■ Once the research and tests are completed, production costs are low
○ Without patenting, firms may not even attempt to produce medicines/vaccines, because:
■ Many products fail, leading to negative profits
■ For those products that succeed, other firms will copy the production process and sell
the products for a low price (because of low MC), hence there will still be low profits.
○ When patents are about to end, the firm fears entry of competitors. What do these firms (try
to) do to continue making profits?
■ Make minor changes and file for a new patent
■ pay-for-delay agreements
● Price discrimination
○ Increase profit through price discrimination: charging different prices for the same product
to different consumers.
■ First degree price discrimination: individual pricing
■ Second degree price discrimination: different prices for different
■ Quantities
■ Third degree price discrimination: different prices for different groups or
■ Countries
● Other reason for high prices
