EKONOMI MANAJERIAL - Arditobhinadi.comarditobhinadi.com/...file=Materi+Kuliah+Ekonomi+Manajerial.pdf · ekonomi manajerial dosen: dr. ardito bhinadi, se., m.si jurusan ilmu ekonomi,

EKONOMI MANAJERIAL

DOSEN:

DR. ARDITO BHINADI, SE., M.SI

JURUSAN ILMU EKONOMI, FAKULTAS EKONOMI, UPN “VETERAN” YOGYAKARTA

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006

Managerial Economics & Business Strategy

Chapter 1The Fundamentals of Managerial

Economics

OverviewI. IntroductionII. The Economics of Effective Management

Identify Goals and ConstraintsRecognize the Role of ProfitsUnderstand IncentivesFive Forces ModelUnderstand MarketsRecognize the Time Value of MoneyUse Marginal Analysis

Managerial Economics

• ManagerA person who directs resources to achieve a stated goal.

• EconomicsThe science of making decisions in the presence of scare resources.

• Managerial EconomicsThe study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.

Economic vs. Accounting Profits

• Accounting ProfitsTotal revenue (sales) minus dollar cost of producing goods or services.Reported on the firm’s income statement.

• Economic ProfitsTotal revenue minus total opportunity cost.

Opportunity Cost• Accounting Costs

The explicit costs of the resources needed to produce produce goods or services.Reported on the firm’s income statement.

• Opportunity CostThe cost of the explicit and implicit resources that are foregone when a decision is made.

• Economic ProfitsTotal revenue minus total opportunity cost.

Sustainable IndustryProfits

Power ofInput Suppliers

•Supplier Concentration•Price/Productivity of Alternative Inputs•Relationship-Specific Investments•Supplier Switching Costs•Government Restraints

Power ofBuyers

•Buyer Concentration•Price/Value of Substitute Products or Services•Relationship-Specific Investments•Customer Switching Costs•Government Restraints

Entry•Entry Costs•Speed of Adjustment•Sunk Costs•Economies of Scale

•Network Effects•Reputation•Switching Costs•Government Restraints

Substitutes & Complements•Price/Value of Surrogate Products or Services•Price/Value of Complementary Products or Services

•Network Effects•Government Restraints

Industry Rivalry•Switching Costs•Timing of Decisions•Information•Government Restraints

•Concentration•Price, Quantity, Quality, or Service Competition•Degree of Differentiation

The Five Forces Framework

Market Interactions• Consumer-Producer Rivalry

Consumers attempt to locate low prices, while producers attempt to charge high prices.

• Consumer-Consumer RivalryScarcity of goods reduces the negotiating power of consumers as they compete for the right to those goods.

• Producer-Producer RivalryScarcity of consumers causes producers to compete with one another for the right to service customers.

• The Role of GovernmentDisciplines the market process.

The Time Value of Money

• Present value (PV) of a lump-sum amount (FV) to be received at the end of “n” periods when the per-period interest rate is “i”:

FVi n=

+1• Examples:

Lotto winner choosing between a single lump-sum payout of $104 million or $198 million over 25 years.Determining damages in a patent infringement case.

Present Value of a Series

• Present value of a stream of future amounts (FVt) received at the end of each period for “n” periods:

( ) ( ) ( )PV

221 1 1

Net Present Value• Suppose a manager can purchase a stream of

future receipts (FVt ) by spending “C0” dollars today. The NPV of such a decision is

( ) ( ) ( )NPV

2 01 1 1...

Decision Rule:If NPV < 0: Reject project

NPV > 0: Accept project

Present Value of a Perpetuity• An asset that perpetually generates a stream of cash flows

(CF) at the end of each period is called a perpetuity.• The present value (PV) of a perpetuity of cash flows paying

the same amount at the end of each period is

( ) ( ) ( )

iCFPV Perpetuity

= ...111 32

Firm Valuation• The value of a firm equals the present value of current and

future profits.PV = Σπt / (1 + i)t

• If profits grow at a constant rate (g < i) and current period profits are πο:

• If the growth rate in profits < interest rate and both remain constant, maximizing the present value of all future profits is the same as maximizing current profits.

1 before current profits have been paid out as dividends;

1 immediately after current profits are paid out as dividends.

Ex DividendFirm

iPVi g

gPVi g

• Control VariablesOutputPriceProduct QualityAdvertisingR&D

• Basic Managerial Question: How much of the control variable should be used to maximize net benefits?

Marginal (Incremental) Analysis

Net Benefits

• Net Benefits = Total Benefits - Total Costs• Profits = Revenue - Costs

Marginal Benefit (MB)

• Change in total benefits arising from a change in the control variable, Q:

• Slope (calculus derivative) of the total benefit curve.

∆∆

Marginal Cost (MC)

• Change in total costs arising from a change in the control variable, Q:

• Slope (calculus derivative) of the total cost curve

∆∆

Marginal Principle

• To maximize net benefits, the managerial control variable should be increased up to the point where MB = MC.

• MB > MC means the last unit of the control variable increased benefits more than it increased costs.

• MB < MC means the last unit of the control variable increased costs more than it increased benefits.

The Geometry of Optimization

Total Benefits& Total Costs

Benefits

CSlope = MC

Slope =MB

Conclusion• Make sure you include all costs and benefits

when making decisions (opportunity cost).• When decisions span time, make sure you

are comparing apples to apples (PV analysis).

• Optimal economic decisions are made at the margin (marginal analysis).

Chapter 2 Market Forces: Demand and Supply

Overview

III. Market EquilibriumIV. Price RestrictionsV. Comparative Statics

II. Market Supply CurveThe Supply FunctionSupply ShiftersProducer Surplus

I. Market Demand CurveThe Demand FunctionDeterminants of Demand Consumer Surplus

Market Demand Curve

• Shows the amount of a good that will be purchased at alternative prices, holding other factors constant.

• Law of DemandThe demand curve is downward sloping.

QuantityD

Determinants of Demand

• IncomeNormal goodInferior good

• Prices of Related GoodsPrices of substitutes Prices of complements

• Advertising and consumer tastes

• Population• Consumer expectations

The Demand Function• A general equation representing the demand curve

Qxd = f(Px , PY , M, H,)

Qxd = quantity demand of good X.

Px = price of good X.PY = price of a related good Y.

• Substitute good.• Complement good.

M = income.• Normal good.• Inferior good.

H = any other variable affecting demand.

Inverse Demand Function

• Price as a function of quantity demanded.

• Example:Demand Function

• Qxd = 10 – 2Px

Inverse Demand Function:• 2Px = 10 – Qx

• Px = 5 – 0.5Qxd

Change in Quantity DemandedPrice

Quantity

A to B: Increase in quantity demanded

Quantity

D0 to D1: Increase in Demand

Change in Demand

Consumer Surplus:

• The value consumers get from a good but do not have to pay for.

I got a great deal!

• That company offers a lot of bang for the buck!

• Dell provides good value.• Total value greatly exceeds

total amount paid.• Consumer surplus is large.

I got a lousy deal!• That car dealer drives a

hard bargain! • I almost decided not to

buy it!• They tried to squeeze the

very last cent from me!• Total amount paid is

close to total value.• Consumer surplus is low.

Quantity

1 2 3 4 5

Consumer Surplus:The value received but notpaid for. Consumer surplus =(8-2) + (6-2) + (4-2) = $12.

Consumer Surplus: The Discrete Case

Consumer Surplus:The Continuous Case

Price $

Quantity

1 2 3 4 5

Valueof 4 units = $24Consumer

Surplus = $24 - $8 = $16

Expenditure on 4 units = $2 x 4 = $8

Market Supply Curve

• The supply curve shows the amount of a good that will be produced at alternative prices.

• Law of SupplyThe supply curve is upward sloping.

Quantity

Supply Shifters• Input prices• Technology or

government regulations• Number of firms

Entry Exit

• Substitutes in production• Taxes

Excise taxAd valorem tax

• Producer expectations

The Supply Function

• An equation representing the supply curve:Qx

S = f(Px , PR ,W, H,)

QxS = quantity supplied of good X.

Px = price of good X.PR = price of a production substitute.W = price of inputs (e.g., wages).H = other variable affecting supply.

Inverse Supply Function

• Price as a function of quantity supplied.

• Example:Supply Function

• Qxs = 10 + 2Px

Inverse Supply Function:• 2Px = 10 + Qx

• Px = 5 + 0.5Qxs

Change in Quantity SuppliedPrice

Quantity

A to B: Increase in quantity supplied

Quantity

S0 to S1: Increase in supply

Change in Supply

Producer Surplus• The amount producers receive in excess of the amount

necessary to induce them to produce the good.Price

Quantity

Market Equilibrium

• Balancing supply and demand

QxS = Qx

• Steady-state

Quantity

Shortage12 - 6 = 6

If price is too low…

Quantity

Surplus14 - 6 = 8

If price is too high…

Price Restrictions• Price Ceilings

The maximum legal price that can be charged.Examples:• Gasoline prices in the 1970s.• Housing in New York City.• Proposed restrictions on ATM fees.

• Price FloorsThe minimum legal price that can be charged.Examples:• Minimum wage.• Agricultural price supports.

Quantity

P Ceiling

Impact of a Price Ceiling

Shortage

Full Economic Price

• The dollar amount paid to a firm under a price ceiling, plus the nonpecuniary price.

PF = Pc + (PF - PC) • PF = full economic price• PC = price ceiling• PF - PC = nonpecuniary price

An Example from the 1970s

• Ceiling price of gasoline: $1.• 3 hours in line to buy 15 gallons of gasoline

Opportunity cost: $5/hr.Total value of time spent in line: 3 × $5 = $15.Non-pecuniary price per gallon: $15/15=$1.

• Full economic price of a gallon of gasoline: $1+$1=2.

Impact of a Price FloorPrice

Quantity

Surplus

Comparative Static Analysis• How do the equilibrium price and quantity

change when a determinant of supply and/or demand change?

Applications of Demand and Supply Analysis

• Event: The WSJ reports that the prices of PC components are expected to fall by 5-8 percent over the next six months.

• Scenario 1: You manage a small firm that manufactures PCs.

• Scenario 2: You manage a small software company.

Use Comparative Static Analysis to see the Big Picture!

• Comparative static analysis shows how the equilibrium price and quantity will change when a determinant of supply or demand changes.

Scenario 1: Implications for a Small PC Maker

• Step 1: Look for the “Big Picture.”• Step 2: Organize an action plan (worry

about details).

Priceof

Quantity of PC’s

Big Picture: Impact of decline in component prices on PC market

• Equilibrium price of PCs will fall, and equilibrium quantity of computers sold will increase.

• Use this to organize an action plancontracts/suppliers?inventories?human resources?marketing?do I need quantitative estimates?

Big Picture Analysis: PC Market

Scenario 2: Software Maker• More complicated chain of reasoning to

arrive at the “Big Picture.”• Step 1: Use analysis like that in Scenario 1

to deduce that lower component prices will lead to

a lower equilibrium price for computers.a greater number of computers sold.

• Step 2: How will these changes affect the “Big Picture” in the software market?

Priceof Software

Quantity ofSoftware

Big Picture: Impact of lower PC prices on the software market

• Software prices are likely to rise, and more software will be sold.

• Use this to organize an action plan.

Big Picture Analysis: Software Market

Conclusion• Use supply and demand analysis to

clarify the “big picture” (the general impact of a current event on equilibrium prices and quantities).organize an action plan (needed changes in production, inventories, raw materials, human resources, marketing plans, etc.).

Chapter 3Quantitative Demand Analysis

Overview

I. The Elasticity ConceptOwn Price ElasticityElasticity and Total RevenueCross-Price ElasticityIncome Elasticity

II. Demand FunctionsLinear Log-Linear

III. Regression Analysis

The Elasticity Concept

• How responsive is variable “G” to a change in variable “S”

If EG,S > 0, then S and G are directly related.If EG,S < 0, then S and G are inversely related.

SGE SG ∆

If EG,S = 0, then S and G are unrelated.

The Elasticity Concept Using Calculus

• An alternative way to measure the elasticity of a function G = f(S) is

dSdGE SG =,

If EG,S > 0, then S and G are directly related.If EG,S < 0, then S and G are inversely related.If EG,S = 0, then S and G are unrelated.

Own Price Elasticity of Demand

• Negative according to the “law of demand.”

Elastic:

Inelastic:

Unitary:

PQ PQE

XX ∆∆

1, >XX PQE

1, <XX PQE

1, =XX PQE

Perfectly Elastic & Inelastic Demand

)( ElasticPerfectly , −∞=XX PQE

Quantity

)0, =XX PQE( Inelastic Perfectly

Own-Price Elasticity and Total Revenue

• Elastic Increase (a decrease) in price leads to a decrease (an increase) in total revenue.

• InelasticIncrease (a decrease) in price leads to an increase (a decrease) in total revenue.

• UnitaryTotal revenue is maximized at the point where demand is unitary elastic.

Elasticity, Total Revenue and Linear Demand

0 010 20 30 40 50

0 10 20 30 40 50

60 1200

0 10 20 30 40 500 10 20 30 40 50

60 1200

0 10 20 30 40 500 10 20 30 40 50

60 1200

0 10 20 30 40 500 10 20 30 40 50

60 1200

Elastic

0 10 20 30 40 500 10 20 30 40 50

60 1200

Inelastic

Elastic

Elastic Inelastic

0 10 20 30 40 500 10 20 30 40 50

P TR100

60 1200

Inelastic

Elastic

Elastic Inelastic

0 10 20 30 40 500 10 20 30 40 50

Unit elasticUnit elastic

Factors Affecting Own Price Elasticity

Available Substitutes• The more substitutes available for the good, the more elastic

the demand.Time

• Demand tends to be more inelastic in the short term than in the long term.

• Time allows consumers to seek out available substitutes.Expenditure Share

• Goods that comprise a small share of consumer’s budgets tend to be more inelastic than goods for which consumers spend a large portion of their incomes.

Cross Price Elasticity of Demand

If EQX,PY> 0, then X and Y are substitutes.

If EQX,PY< 0, then X and Y are complements.

PQ PQE

YX ∆∆

Predicting Revenue Changes from Two Products

Suppose that a firm sells to related goods. If the price of X changes, then total revenue will change by:

( )( ) XPQYPQX PERERRXYXX

∆×++=∆ %1 ,,

Income Elasticity

If EQX,M > 0, then X is a normal good.

If EQX,M < 0, then X is a inferior good.

MQX ∆∆

Uses of Elasticities

• Pricing.• Managing cash flows.• Impact of changes in competitors’ prices.• Impact of economic booms and recessions.• Impact of advertising campaigns.• And lots more!

Example 1: Pricing and Cash Flows

• According to an FTC Report by Michael Ward, AT&T’s own price elasticity of demand for long distance services is -8.64.

• AT&T needs to boost revenues in order to meet it’s marketing goals.

• To accomplish this goal, should AT&T raise or lower it’s price?

Answer: Lower price!

• Since demand is elastic, a reduction in price will increase quantity demanded by a greater percentage than the price decline, resulting in more revenues for AT&T.

Example 2: Quantifying the Change

• If AT&T lowered price by 3 percent, what would happen to the volume of long distance telephone calls routed through AT&T?

Answer• Calls would increase by 25.92 percent!

( )%92.25%

%64.8%3%3

%%64.8,

∆=−×−−∆

∆∆

Example 3: Impact of a change in a competitor’s price

• According to an FTC Report by Michael Ward, AT&T’s cross price elasticity of demand for long distance services is 9.06.

• If competitors reduced their prices by 4 percent, what would happen to the demand for AT&T services?

Answer• AT&T’s demand would fall by 36.24 percent!

%24.36%

%06.9%4%4

%%06.9,

−=∆

∆=×−−∆

∆∆

Interpreting Demand Functions• Mathematical representations of demand curves.• Example:

• X and Y are substitutes (coefficient of PY is positive).

• X is an inferior good (coefficient of M is negative).

MPPQ YXd

X 23210 −+−=

Linear Demand Functions

• General Linear Demand Function:

HMPPQ HMYYXXd

X ααααα ++++= 0

Own PriceElasticity

Cross PriceElasticity

IncomeElasticity

XXPQ Q

MMQ QME

YYPQ Q

Example of Linear Demand

• Qd = 10 - 2P.• Own-Price Elasticity: (-2)P/Q.• If P=1, Q=8 (since 10 - 2 = 8).• Own price elasticity at P=1, Q=8:

(-2)(1)/8= - 0.25.

0ln ln ln ln lndX X X Y Y M HQ P P M Hβ β β β β= + + + +

:Elasticity Income:Elasticity Price Cross :Elasticity PriceOwn

βββ

Log-Linear Demand

• General Log-Linear Demand Function:

Example of Log-Linear Demand

• ln(Qd) = 10 - 2 ln(P).• Own Price Elasticity: -2.

Linear Log Linear

Graphical Representation of Linear and Log-Linear Demand

Regression Analysis

• One use is for estimating demand functions.• Important terminology and concepts:

Least Squares Regression: Y = a + bX + e.Confidence Intervals.t-statistic.R-square or Coefficient of Determination.F-statistic.

An Example

• Use a spreadsheet to estimate the following log-linear demand function.

0ln lnx x xQ P eβ β= + +

Summary OutputRegression Statistics

Multiple R 0.41R Square 0.17Adjusted R Square 0.15Standard Error 0.68Observations 41.00

ANOVAdf SS M S F Significance F

Regression 1.00 3.65 3.65 7.85 0.01Residual 39.00 18.13 0.46Total 40.00 21.78

Coefficients Standard Error t Stat P-value Lower 95% Upper 95%Intercept 7.58 1.43 5.29 0.000005 4.68 10.48ln(P) -0.84 0.30 -2.80 0.007868 -1.44 -0.23

Interpreting the Regression Output

• The estimated log-linear demand function is:ln(Qx) = 7.58 - 0.84 ln(Px).Own price elasticity: -0.84 (inelastic).

• How good is our estimate?t-statistics of 5.29 and -2.80 indicate that the estimated coefficients are statistically different from zero.R-square of .17 indicates we explained only 17 percent of the variation in ln(Qx).F-statistic significant at the 1 percent level.

Conclusion

• Elasticities are tools you can use to quantifythe impact of changes in prices, income, and advertising on sales and revenues.

• Given market or survey data, regression analysis can be used to estimate:

Demand functions.Elasticities.A host of other things, including cost functions.

• Managers can quantify the impact of changes in prices, income, advertising, etc.

Chapter 4The Theory of Individual

Behavior

OverviewI. Consumer Behavior

Indifference Curve AnalysisConsumer Preference Ordering

II. ConstraintsThe Budget ConstraintChanges in IncomeChanges in Prices

III. Consumer EquilibriumIV. Indifference Curve Analysis & Demand Curves

Individual DemandMarket Demand

Consumer Behavior• Consumer Opportunities

The possible goods and services consumer can afford to consume.

• Consumer PreferencesThe goods and services consumers actually consume.

• Given the choice between 2 bundles of goods a consumer either

Prefers bundle A to bundle B: A f B.Prefers bundle B to bundle A: A p B.Is indifferent between the two: A ∼ B.

Indifference Curve Analysis

Indifference CurveA curve that defines the combinations of 2 or more goods that give a consumer the same level of satisfaction.

Marginal Rate of Substitution

The rate at which a consumer is willing to substitute one good for another and maintain the same satisfaction level.

Good Y

Good X

Consumer Preference Ordering Properties

• Completeness• More is Better• Diminishing Marginal Rate of Substitution• Transitivity

Complete Preferences• Completeness Property

Consumer is capable of expressing preferences (or indifference) between all possible bundles. (“I don’t know” is NOT an option!)

• If the only bundles available to a consumer are A, B, and C, then the consumer

– is indifferent between A and C (they are on the same indifference curve).

– will prefer B to A.– will prefer B to C.

Good Y

Good X

More Is Better!• More Is Better Property

Bundles that have at least as much of every good and more of some good are preferred to other bundles.

• Bundle B is preferred to A since B contains at least as much of good Y and strictly more of good X.

• Bundle B is also preferred to C since B contains at least as much of good X and strictly more of good Y.

• More generally, all bundles on ICIII are preferred to bundles on ICII or ICI. And all bundles on ICII are preferred to ICI.

Good Y

Good X

Diminishing Marginal Rate of Substitution

• Marginal Rate of SubstitutionThe amount of good Y the consumer is willing to give up to maintain the same satisfaction level decreases as more of good X is acquired.The rate at which a consumer is willing to substitute one good for another and maintain the same satisfaction level.

• To go from consumption bundle A to B the consumer must give up 50 units of Y to get one additional unit of X.

• To go from consumption bundle B to C the consumer must give up 16.67 units of Y to get one additional unit of X.

• To go from consumption bundle C to D the consumer must give up only 8.33 units of Y to get one additional unit of X.

Good Y

Good X1 3 42

33.3325

Consistent Bundle Orderings• Transitivity Property

For the three bundles A, B, and C, the transitivity property implies that if C f B and B f A, then C fA.Transitive preferences along with the more-is-better property imply that

• indifference curves will not intersect.

• the consumer will not get caught in a perpetual cycle of indecision.

Good Y

Good X21

The Budget Constraint• Opportunity Set

The set of consumption bundles that are affordable.

• PxX + PyY ≤ M.

• Budget LineThe bundles of goods that exhaust a consumers income.

• PxX + PyY = M.

• Market Rate of SubstitutionThe slope of the budget line

• -Px / Py

The Opportunity Set

Budget Line

Y = M/PY – (PX/PY)XM/PY

Changes in the Budget Line

• Changes in IncomeIncreases lead to a parallel, outward shift in the budget line (M1 > M0).Decreases lead to a parallel, downward shift (M2 < M0).

• Changes in PriceA decreases in the price of good X rotates the budget line counter-clockwise (PX0

).An increases rotates the budget line clockwise (not shown).

YNew Budget Line for a price decrease.

M0/PX0M0/PX1

Consumer Equilibrium

• The equilibrium consumption bundle is the affordable bundle that yields the highest level of satisfaction.

Consumer equilibrium occurs at a point where

MRS = PX / PY.

Equivalently, the slope of the indifference curve equals the budget line. I.

Consumer Equilibrium

Price Changes and Consumer Equilibrium

• Substitute GoodsAn increase (decrease) in the price of good X leads to an increase (decrease) in the consumption of good Y.

• Examples: – Coke and Pepsi.– Verizon Wireless or T-Mobile.

• Complementary GoodsAn increase (decrease) in the price of good X leads to a decrease (increase) in the consumption of good Y.

• Examples:– DVD and DVD players.– Computer CPUs and monitors.

Complementary Goods

When the price of good X falls and the consumption of Y rises, then X and Y are complementary goods. (PX1

> PX2)

Pretzels (Y)

Beer (X)

M/PX1M/PX2

Income Changes and Consumer Equilibrium

• Normal GoodsGood X is a normal good if an increase (decrease) in income leads to an increase (decrease) in its consumption.

• Inferior GoodsGood X is an inferior good if an increase (decrease) in income leads to a decrease (increase) in its consumption.

Normal Goods

An increase in income increases the consumption of normal goods.

(M0 < M1).

M1/XX0

Decomposing the Income and Substitution Effects

Initially, bundle A is consumed. A decrease in the price of good X expands the consumer’s opportunity set.

The substitution effect (SE) causes the consumer to move from bundle A to B.

A higher “real income” allows the consumer to achieve a higher indifference curve.

The movement from bundle B to C represents the income effect (IE). The new equilibrium is achieved at point C.

Individual Demand Curve

• An individual’s demand curve is derived from each new equilibrium point found on the indifference curve as the price of good X is varied.

Market Demand• The market demand curve is the horizontal

summation of individual demand curves.• It indicates the total quantity all consumers would

purchase at each price point.

Individual Demand Curves

Market Demand Curve

1 2 1 2 3 DM

Other goods (Y)

Pizza (X)

0.5 1 2

A buy-one, get-one free pizza deal.

A Classic Marketing Application

Conclusion

• Indifference curve properties reveal information about consumers’ preferences between bundles of goods.

Completeness.More is better.Diminishing marginal rate of substitution.Transitivity.

• Indifference curves along with price changes determine individuals’ demand curves.

• Market demand is the horizontal summation of individuals’ demands.

Chapter 5The Production Process and Costs

OverviewI. Production Analysis

Total Product, Marginal Product, Average ProductIsoquantsIsocostsCost Minimization

II. Cost AnalysisTotal Cost, Variable Cost, Fixed CostsCubic Cost FunctionCost Relations

III. Multi-Product Cost Functions

Production Analysis

• Production FunctionQ = F(K,L)The maximum amount of output that can be produced with K units of capital and L units of labor.

• Short-Run vs. Long-Run Decisions• Fixed vs. Variable Inputs

Total Product

• Cobb-Douglas Production Function• Example: Q = F(K,L) = K.5 L.5

K is fixed at 16 units. Short run production function:

Q = (16).5 L.5 = 4 L.5

Production when 100 units of labor are used?

Q = 4 (100).5 = 4(10) = 40 units

Marginal Productivity Measures

• Marginal Product of Labor: MPL = ∆Q/∆LMeasures the output produced by the last worker.Slope of the short-run production function (with respect to labor).

• Marginal Product of Capital: MPK = ∆Q/∆KMeasures the output produced by the last unit of capital.When capital is allowed to vary in the short run, MPK is the slope of the production function (with respect to capital).

Average Productivity Measures

• Average Product of LaborAPL = Q/L.Measures the output of an “average” worker.Example: Q = F(K,L) = K.5 L.5

• If the inputs are K = 16 and L = 16, then the average product oflabor is APL = [(16) 0.5(16)0.5]/16 = 1.

• Average Product of CapitalAPK = Q/K.Measures the output of an “average” unit of capital.Example: Q = F(K,L) = K.5 L.5

• If the inputs are K = 16 and L = 16, then the average product oflabor is APL = [(16)0.5(16)0.5]/16 = 1.

Q=F(K,L)

IncreasingMarginalReturns

DiminishingMarginalReturns

NegativeMarginalReturns

Increasing, Diminishing and Negative Marginal Returns

Guiding the Production Process

• Producing on the production functionAligning incentives to induce maximum worker effort.

• Employing the right level of inputsWhen labor or capital vary in the short run, to maximize profit a manager will hire

• labor until the value of marginal product of labor equals the wage: VMPL = w, where VMPL = P x MPL.

• capital until the value of marginal product of capital equals the rental rate: VMPK = r, where VMPK = P xMPK .

Isoquant

• The combinations of inputs (K, L) that yield the producer the same level of output.

• The shape of an isoquant reflects the ease with which a producer can substitute among inputs while maintaining the same level of output.

Marginal Rate of Technical Substitution (MRTS)

• The rate at which two inputs are substituted while maintaining the same output level.

LKL MP

MPMRTS =

Linear Isoquants

• Capital and labor are perfect substitutes

Q = aK + bLMRTSKL = b/aLinear isoquants imply that inputs are substituted at a constant rate, independent of the input levels employed.

Q3Q2Q1

Increasing Output

Leontief Isoquants

• Capital and labor are perfect complements.

• Capital and labor are used in fixed-proportions.

• Q = min {bK, cL}• Since capital and labor are

consumed in fixed proportions there is no input substitution along isoquants (hence, no MRTSKL).

Increasing Output

Cobb-Douglas Isoquants

• Inputs are not perfectly substitutable.

• Diminishing marginal rate of technical substitution.

As less of one input is used in the production process, increasingly more of the other input must be employed to produce the same output level.

• Q = KaLb

• MRTSKL = MPL/MPK

Increasing Output

Isocost• The combinations of inputs that

produce a given level of output at the same cost:

wL + rK = C• Rearranging,

K= (1/r)C - (w/r)L• For given input prices, isocosts

farther from the origin are associated with higher costs.

• Changes in input prices change the slope of the isocost line.

KNew Isocost Line for a decrease in the wage (price of labor: w0 > w1).

C1/wC0

C/w0 C/w1

New Isocost Line associated with higher costs (C0 < C1).

Cost Minimization

• Marginal product per dollar spent should be equal for all inputs:

• But, this is justrw

LKL =⇔=

rwMRTSKL =

Cost Minimization

Point of Cost Minimization

Slope of Isocost=

Slope of Isoquant

Optimal Input Substitution • A firm initially produces Q0

by employing the combination of inputs represented by point A at a cost of C0.

• Suppose w0 falls to w1.The isocost curve rotates counterclockwise; which represents the same cost level prior to the wage change.To produce the same level of output, Q0, the firm will produce on a lower isocost line (C1) at a point B.The slope of the new isocost line represents the lower wage relative to the rental rate of capital.

C0/w1C0/w0 C1/w1L0 L1

Cost Analysis

• Types of CostsFixed costs (FC)Variable costs (VC)Total costs (TC)Sunk costs

Total and Variable Costs

C(Q): Minimum total cost of producing alternative levels of output:

C(Q) = VC(Q) + FC

VC(Q): Costs that vary with output.

FC: Costs that do not vary with output.

C(Q) = VC + FC

Fixed and Sunk Costs

FC: Costs that do not change as output changes.

Sunk Cost: A cost that is forever lost after it has been paid.

C(Q) = VC + FC

Some Definitions

Average Total CostATC = AVC + AFCATC = C(Q)/Q

Average Variable CostAVC = VC(Q)/Q

Average Fixed CostAFC = FC/Q

Marginal CostMC = ∆C/∆Q

ATCAVC

Fixed Cost

AFC Fixed Cost

Q0×(ATC-AVC)

= Q0× AFC

= Q0×(FC/ Q0)

Variable Cost

AVCVariable Cost

Q0×AVC

= Q0×[VC(Q0)/ Q0]

= VC(Q0)

Total Cost

Q0×ATC

= Q0×[C(Q0)/ Q0]

= C(Q0)

Total Cost

Cubic Cost Function

• C(Q) = f + a Q + b Q2 + cQ3

• Marginal Cost?Memorize:

MC(Q) = a + 2bQ + 3cQ2

Calculus:

dC/dQ = a + 2bQ + 3cQ2

An ExampleTotal Cost: C(Q) = 10 + Q + Q2

Variable cost function:VC(Q) = Q + Q2

Variable cost of producing 2 units:VC(2) = 2 + (2)2 = 6

Fixed costs:FC = 10

Marginal cost function:MC(Q) = 1 + 2Q

Marginal cost of producing 2 units:MC(2) = 1 + 2(2) = 5

Economies of Scale

Economiesof Scale

Diseconomiesof Scale

Multi-Product Cost Function

• C(Q1, Q2): Cost of jointly producing two outputs.

• General function form:

( ) 22

212121, cQbQQaQfQQC +++=

Economies of Scope

• C(Q1, 0) + C(0, Q2) > C(Q1, Q2).It is cheaper to produce the two outputs jointly instead of separately.

• Example:It is cheaper for Time-Warner to produce Internet connections and Instant Messaging services jointly than separately.

Cost Complementarity

• The marginal cost of producing good 1 declines as more of good two is produced:

∆MC1(Q1,Q2) /∆Q2 < 0.

• Example:Cow hides and steaks.

Quadratic Multi-Product Cost Function

• C(Q1, Q2) = f + aQ1Q2 + (Q1 )2 + (Q2 )2

• MC1(Q1, Q2) = aQ2 + 2Q1

• MC2(Q1, Q2) = aQ1 + 2Q2

• Cost complementarity: a < 0• Economies of scope: f > aQ1Q2

C(Q1 ,0) + C(0, Q2 ) = f + (Q1 )2 + f + (Q2)2

C(Q1, Q2) = f + aQ1Q2 + (Q1 )2 + (Q2 )2

f > aQ1Q2: Joint production is cheaper

A Numerical Example:

• C(Q1, Q2) = 90 - 2Q1Q2 + (Q1 )2 + (Q2 )2

• Cost Complementarity?Yes, since a = -2 < 0MC1(Q1, Q2) = -2Q2 + 2Q1

• Economies of Scope?Yes, since 90 > -2Q1Q2

Conclusion• To maximize profits (minimize costs) managers

must use inputs such that the value of marginal of each input reflects price the firm must pay to employ the input.

• The optimal mix of inputs is achieved when the MRTSKL = (w/r).

• Cost functions are the foundation for helping to determine profit-maximizing behavior in future chapters.

Chapter 6The Organization of the Firm

OverviewI. Methods of Procuring Inputs

Spot Exchange Contracts Vertical Integration

II. Transaction CostsSpecialized Investments

III. Optimal Procurement InputIV. Principal-Agent Problem

Owners-ManagersManagers-Workers

Manager’s Role• Procure inputs in the least

cost manner, like point B.• Provide incentives for

workers to put forth effort.• Failure to accomplish this

results in a point like A.• Achieving points like B

managers mustUse all inputs efficiently.Acquire inputs by the least costly method.

$10080

Methods of Procuring Inputs

• Spot ExchangeWhen the buyer and seller of an input meet, exchange, and then go their separate ways.

• ContractsA legal document that creates an extended relationship between a buyer and a seller.

• Vertical IntegrationWhen a firm shuns other suppliers and chooses to produce an input internally.

Key Features• Spot Exchange

Specialization, avoids contracting costs, avoids costs of vertical integration.Possible “hold-up problem.”

• ContractingSpecialization, reduces opportunism, avoids skimping on specialized investments.Costly in complex environments.

• Vertical IntegrationReduces opportunism, avoids contracting costs.Lost specialization and may increase organizational costs.

Transaction Costs• Costs of acquiring an input over and above

the amount paid to the input supplier.• Includes:

Search costs.Negotiation costs.Other required investments or expenditures.

• Some transactions are general in nature while others are specific to a trading relationship.

Specialized Investments• Investments made to allow two parties to exchange

but has little or no value outside of the exchange relationship.

• Types of specialized investments:Site specificity.Physical-asset specificity.Dedicated assets.Human capital.

• Lead to higher transaction costsCostly bargaining.Underinvestment. Opportunism and the hold-up problem.

Specialized Investments and Contract Length

Contract Length0 L1

Longer Contract

Due to greater need for specialized investments

Optimal Input Procurement

Substantial specialized investments relative to contracting costs?

Spot ExchangeNo

Complex contracting environment relative to costs of integration?

Vertical Integration

Contract

The Principal-Agent Problem• Occurs when the principal cannot observe the effort of

the agent.Example: Shareholders (principal) cannot observe the effort of the manager (agent).Example: Manager (principal) cannot observe the effort of workers (agents).

• The Problem: Principal cannot determine whether a bad outcome was the result of the agent’s low effort or due to bad luck.

• Manager’s must recognize the existence of the principal-agent problem and devise plans to align the interests of workers with that of the firm.

• Shareholders must create plans to align the interest of the manager with those of the shareholders.

Solving the Problem Between Owners and Managers

• Internal incentivesIncentive contracts.Stock options, year-end bonuses.

• External incentivesPersonal reputation.Potential for takeover.

Solving the Problem Between Managers and Workers

• Profit sharing• Revenue sharing• Piece rates• Time clocks and spot checks

Conclusion

• The optimal method for acquiring inputs depends on the nature of the transactions costs and specialized nature of the inputs being procured.

• To overcome the principal-agent problem, principals must devise plans to align the agents’ interests with the principals.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc. , 2006

Chapter 7The Nature of Industry

OverviewI. Market Structure

Measures of Industry Concentration

II. ConductPricing BehaviorIntegration and Merger Activity

III. PerformanceDansby-Willig IndexStructure-Conduct-Performance Paradigm

IV. Preview of Coming Attractions

Industry Analysis• Market Structure

Number of firms.Industry concentration.Technological and cost conditions.Demand conditions.Ease of entry and exit.

• ConductPricing.Advertising.R&D.Merger activity.

• PerformanceProfitability.Social welfare.

Approaches to Studying Industry

• The Structure-Conduct-Performance (SCP) Paradigm: Causal View

Market Structure

Conduct Performance

• The Feedback CritiqueNo one-way causal link.Conduct can affect market structure.Market performance can affect conduct as well as market structure.

Power ofInput Suppliers

•Supplier Concentration•Price/Productivity of Alternative Inputs•Relationship-Specific Investments•Supplier Switching Costs•Government Restraints

Power ofBuyers

•Buyer Concentration•Price/Value of Substitute Products or Services•Relationship-Specific Investments•Customer Switching Costs•Government Restraints

Entry•Entry Costs•Speed of Adjustment•Sunk Costs•Economies of Scale

•Network Effects•Reputation•Switching Costs•Government Restraints

Substitutes & Complements•Price/Value of Surrogate Products or Services•Price/Value of Complementary Products or Services

•Network Effects•Government Restraints

Industry Rivalry•Switching Costs•Timing of Decisions•Information•Government Restraints

•Concentration•Price, Quantity, Quality, or Service Competition•Degree of Differentiation

Level, Growth, and SustainabilityOf Industry Profits

Relating the Five Forces to the SCP Paradigm and the Feedback Critique

Industry Concentration

• Four-Firm Concentration RatioThe sum of the market shares of the top four firms in the defined industry. Letting Si denote sales for firm i and ST denote total industry sales

• Herfindahl-Hirschman Index (HHI)The sum of the squared market shares of firms in a given industry, multiplied by 10,000: HHI = 10,000 × Σ wi

2, where wi = Si/ST.

SSwwherewwwwC =+++= 143214 ,

Example

• There are five banks competing in a local market. Each of the five banks have a 20 percent market share.

• What is the four-firm concentration ratio?

• What is the HHI?

8.02.02.02.02.04 =+++=C

( ) ( ) ( ) ( ) ( )( ) 000,22.2.2.2.2.000,10 22222 =++++=HHI

Limitation of Concentration Measures

• Market Definition: National, regional, or local?• Global Market: Foreign producers excluded.• Industry definition and product classes.

Measuring Demand and Market Conditions

• The Rothschild Index (R) measures the elasticity of industry demand for a product relative to that of an individual firm:

R = ET / EF .ET = elasticity of demand for the total market.EF = elasticity of demand for the product of an individual firm.The Rothschild Index is a value between 0 (perfect competition) and 1 (monopoly).

• When an industry is composed of many firms, each producing similar products, the Rothschild index will be close to zero.

Own-Price Elasticities of Demand and Rothschild Indices

IndustryElasticityof MarketDemand

Elasticityof Firm’sDemand

RothschildIndex

Food -1.0 -3.8 0.26Tobacco -1.3 -1.3 1.00Textiles -1.5 -4.7 0.32Apparel -1.1 -4.1 0.27Paper -1.5 -1.7 0.88Chemicals -1.5 -1.5 1.00Rubber -1.8 -2.3 0.78

Market Entry and Exit Conditions

• Barriers to entryCapital requirements.Patents and copyrights.Economies of scale.Economies of scope.

Conduct: Pricing Behavior• The Lerner Index

L = (P - MC) / PA measure of the difference between price and marginal cost as a fraction of the product’s price.The index ranges from 0 to 1.

• When P = MC, the Lerner Index is zero; the firm has no market power.

• A Lerner Index closer to 1 indicates relatively weak price competition; the firm has market power.

Markup Factor

• From the Lerner Index, the firm can determine the factor by which it should over MC. Rearranging the Lerner Index

• The markup factor is 1/(1-L).When the Lerner Index is zero (L = 0), the markup factor is 1 and P = MC.When the Lerner Index is 0.20 (L = 0.20), the markup factor is 1.25 and the firm charges a price that is 1.25 times marginal cost.

P ⎟⎠⎞

⎜⎝⎛−

Lerner Indices & Markup Factors

Industry Lerner Index Markup FactorFood 0.26 1.35Tobacco 0.76 4.17Textiles 0.21 1.27Apparel 0.24 1.32Paper 0.58 2.38Chemicals 0.67 3.03Petroleum 0.59 2.44

Integration and Merger Activity

• Vertical IntegrationWhere various stages in the production of a single product are carried out by one firm.

• Horizontal IntegrationThe merging of the production of similar products into a single firm.

• Conglomerate MergersThe integration of different product lines into a single firm.

DOJ/FTC Horizontal Merger Guidelines

• Based on HHI = 10,000 Σ wi2, where

wi = Si /ST.• Merger may be challenged if

• HHI exceeds 1800, or would be after merger, and• Merger increases the HHI by more than 100.

• But...Recognizes efficiencies: “The primary benefit of mergers to the economy is their efficiency potential...which can result in lower prices to consumers...In the majority of cases the Guidelines will allow firms to achieve efficiencies through mergers without interference...”

Performance

• Performance refers to the profits and social welfare that result in a given industry.

• Social Welfare = CS + PSDansby-Willig Performance Index measure by how much social welfare would improve if firms in an industry expanded output in a socially efficient manner.

Dansby-WilligPerformance IndexIndustry Dansby-Willig Index

Food 0.51Textiles 0.38Apparel 0.47Paper 0.63Chemicals 0.67Petroleum 0.63Rubber 0.49

Preview of Coming Attractions

• Discussion of optimal managerial decisions under various market structures, including:

Perfect competitionMonopolyMonopolistic competitionOligopoly

Conclusion• Modern approach to studying industries involves

examining the interrelationship between structure, conduct, and performance.

• Industries dramatically vary with respect to concentration levels.

The four-firm concentration ratio and Herfindahl-Hirschman index measure industry concentration.

• The Lerner index measures the degree to which firms can markup price above marginal cost; it is a measure of a firm’s market power.

• Industry performance is measured by industry profitability and social welfare.

Chapter 8Managing in Competitive, Monopolistic,

and Monopolistically Competitive Markets

OverviewI. Perfect Competition

Characteristics and profit outlook.Effect of new entrants.

II. MonopoliesSources of monopoly power.Maximizing monopoly profits.Pros and cons.

III. Monopolistic CompetitionProfit maximization.Long run equilibrium.

Perfect Competition Environment

• Many buyers and sellers.• Homogeneous (identical) product.• Perfect information on both sides of market.• No transaction costs.• Free entry and exit.

Key Implications

• Firms are “price takers” (P = MR).• In the short-run, firms may earn profits or

losses.• Long-run profits are zero.

Unrealistic? Why Learn?• Many small businesses are “price-takers,” and decision

rules for such firms are similar to those of perfectly competitive firms.

• It is a useful benchmark.• Explains why governments oppose monopolies.• Illuminates the “danger” to managers of competitive

environments.Importance of product differentiation.Sustainable advantage.

Managing a Perfectly Competitive Firm

(or Price-Taking Business)

Setting Price

FirmQf

MarketQM

Profit-Maximizing Output Decision

• MR = MC.• Since, MR = P, • Set P = MC to maximize profits.

Graphically: Representative Firm’s Output Decision

Pe = Df = MR

Profit = (Pe - ATC) × Qf*

A Numerical Example• Given

P=$10C(Q) = 5 + Q2

• Optimal Price?P=$10

• Optimal Output?MR = P = $10 and MC = 2Q10 = 2QQ = 5 units

• Maximum Profits?PQ - C(Q) = (10)(5) - (5 + 25) = $20

Pe = Df = MR

Profit = (Pe - ATC) × Qf* < 0

Should this Firm Sustain Short Run Losses or Shut Down?

Shutdown Decision Rule

• A profit-maximizing firm should continue to operate (sustain short-run losses) if its operating loss is less than its fixed costs.

Operating results in a smaller loss than ceasing operations.

• Decision rule:A firm should shutdown when P < min AVC.Continue operating as long as P ≥ min AVC.

P min AVC

Firm’s Short-Run Supply Curve: MC Above Min AVC

Short-Run Market Supply Curve

• The market supply curve is the summation of each individual firm’s supply at each price.

Firm 1 Firm 2

10 20 30

Market

18 25 43

Long Run Adjustments?

• If firms are price takers but there are barriers to entry, profits will persist.

• If the industry is perfectly competitive, firms are not only price takers but there is free entry.

Other “greedy capitalists” enter the market.

Effect of Entry on Price?

FirmQf

MarketQM

Pe* Df*

Effect of Entry on the Firm’s Output and Profits?

Pe* Df*

Summary of Logic• Short run profits leads to entry.• Entry increases market supply, drives down

the market price, increases the market quantity.

• Demand for individual firm’s product shifts down.

• Firm reduces output to maximize profit.• Long run profits are zero.

Features of Long Run Competitive Equilibrium

• P = MCSocially efficient output.

• P = minimum ACEfficient plant size.Zero profits • Firms are earning just enough to offset their opportunity

Monopoly Environment

• Single firm serves the “relevant market.”• Most monopolies are “local” monopolies.• The demand for the firm’s product is the

market demand curve.• Firm has control over price.

But the price charged affects the quantity demanded of the monopolist’s product.

“Natural” Sources ofMonopoly Power

• Economies of scale• Economies of scope• Cost complementarities

“Created” Sources of Monopoly Power

• Patents and other legal barriers (like licenses)

• Tying contracts• Exclusive contracts• Collusion

Contract...I.

Managing a Monopoly

• Market power permits you to price above MC

• Is the sky the limit?• No. How much you sell

depends on the price you set!

A Monopolist’s Marginal Revenue

0 010 20 30 40 50 10 20 30 40 50

60 1200

Inelastic

Elastic

Elastic Inelastic

Unit elastic

Monopoly Profit Maximization

Profit

Produce where MR = MC.Charge the price on the demand curve that corresponds to that quantity.

Useful Formulae

• What’s the MR if a firm faces a linear demand curve for its product?

• Alternatively,

bQaP +=

.0,2 <+= bwherebQaMR

⎥⎦⎤

⎢⎣⎡ +

EPMR 1

A Numerical Example• Given estimates of

• P = 10 - Q• C(Q) = 6 + 2Q

• Optimal output?• MR = 10 - 2Q• MC = 2• 10 - 2Q = 2• Q = 4 units

• Optimal price?• P = 10 - (4) = $6

• Maximum profits?• PQ - C(Q) = (6)(4) - (6 + 8) = $10

• None, unless the source of monopoly power is eliminated.

Why Government Dislikes Monopoly?

• P > MCToo little output, at too high a price.

• Deadweight loss of monopoly.

Deadweight Loss of Monopoly

Arguments for Monopoly

• The beneficial effects of economies of scale, economies of scope, and cost complementarities on price and output may outweigh the negative effects of market power.

• Encourages innovation.

Monopoly Multi-Plant Decisions

• Consider a monopoly that produces identical output at two production facilities (think of a firm that generates and distributes electricity from two facilities).

Let C1(Q2) be the production cost at facility 1.Let C2(Q2) be the production cost at facility 2.

• Decision Rule: Produce output whereMR(Q) = MC1(Q1) and MR(Q) = MC2(Q2)

Set price equal to P(Q), where Q = Q1 + Q2.

Monopolistic Competition: Environment and Implications

• Numerous buyers and sellers• Differentiated products

Implication: Since products are differentiated, each firm faces a downward sloping demand curve.

• Consumers view differentiated products as close substitutes: there exists some willingness to substitute.

• Free entry and exitImplication: Firms will earn zero profits in the long run.

Managing a Monopolistically Competitive Firm

• Like a monopoly, monopolistically competitive firms

have market power that permits pricing above marginal cost.level of sales depends on the price it sets.

• But …The presence of other brands in the market makes the demand for your brand more elastic than if you were a monopolist. Free entry and exit impacts profitability.

• Therefore, monopolistically competitive firms have limited market power.

Marginal Revenue Like a Monopolist

0 010 20 30 40 50 10 20 30 40 50

60 1200

Inelastic

Elastic

Elastic Inelastic

Unit elastic

Monopolistic Competition: Profit Maximization

• Maximize profits like a monopolistProduce output where MR = MC.Charge the price on the demand curve that corresponds to that quantity.

Short-Run Monopolistic Competition

Profit

Quantity of Brand X

• If the industry is truly monopolistically competitive, there is free entry.

In this case other “greedy capitalists” enter, and their new brands steal market share. This reduces the demand for your product until profits are ultimately zero.

Quantity of Brand XMR1

Long Run Equilibrium(P = AC, so zero profits)

Long-Run Monopolistic Competition

Monopolistic Competition

The Good (To Consumers)Product Variety

The Bad (To Society)P > MCExcess capacity

• Unexploited economies of scale

The Ugly (To Managers)P = ATC > minimum of average costs.

• Zero Profits (in the long run)!

Optimal Advertising Decisions

• Advertising is one way for firms with market power to differentiate their products.

• But, how much should a firm spend on advertising?Advertise to the point where the additional revenue generated from advertising equals the additional cost of advertising.Equivalently, the profit-maximizing level of advertising occurs where the advertising-to-sales ratio equals the ratio of the advertising elasticity of demand to the own-price elasticity of demand.

Maximizing Profits: A Synthesizing Example

• C(Q) = 125 + 4Q2

• Determine the profit-maximizing output and price, and discuss its implications, if

You are a price taker and other firms charge $40 per unit;You are a monopolist and the inverse demand for your product is P = 100 - Q;You are a monopolistically competitive firm and the inverse demand for your brand is P = 100 – Q.

Marginal Cost

• C(Q) = 125 + 4Q2,• So MC = 8Q.• This is independent of market structure.

Price Taker• MR = P = $40.• Set MR = MC.

• 40 = 8Q.• Q = 5 units.

• Cost of producing 5 units.• C(Q) = 125 + 4Q2 = 125 + 100 = $225.

• Revenues:• PQ = (40)(5) = $200.

• Maximum profits of -$25.• Implications: Expect exit in the long-run.

Monopoly/Monopolistic Competition• MR = 100 - 2Q (since P = 100 - Q).• Set MR = MC, or 100 - 2Q = 8Q.

Optimal output: Q = 10.Optimal price: P = 100 - (10) = $90.Maximal profits:

• PQ - C(Q) = (90)(10) -(125 + 4(100)) = $375.

• ImplicationsMonopolist will not face entry (unless patent or other entry barriers are eliminated).Monopolistically competitive firm should expect other firms to clone, so profits will decline over time.

Conclusion

• Firms operating in a perfectly competitive market take the market price as given.

Produce output where P = MC.Firms may earn profits or losses in the short run.… but, in the long run, entry or exit forces profits to zero.

• A monopoly firm, in contrast, can earn persistent profits provided that source of monopoly power is not eliminated.

• A monopolistically competitive firm can earn profits in the short run, but entry by competing brands will erode these profits over time.

Chapter 9Basic Oligopoly Models

OverviewI. Conditions for Oligopoly?II. Role of Strategic InterdependenceIII. Profit Maximization in Four Oligopoly

SettingsSweezy (Kinked-Demand) ModelCournot ModelStackelberg Model Bertrand Model

IV. Contestable Markets

Oligopoly Environment

• Relatively few firms, usually less than 10.Duopoly - two firmsTriopoly - three firms

• The products firms offer can be either differentiated or homogeneous.

Role of Strategic Interaction

• Your actions affect the profits of your rivals.

• Your rivals’ actions affect your profits.

An Example

• You and another firm sell differentiated products.

• How does the quantity demanded for your product change when you change your price?

D1 (Rival holds itsprice constant)

D2 (Rival matches your price change)

Q0 QL2 QL1QH1 QH2

(Rival holds itsprice constant)

Demand if Rivals Match Price Reductions but not Price Increases

Key Insight• The effect of a price reduction on the quantity

demanded of your product depends upon whether your rivals respond by cutting their prices too!

• The effect of a price increase on the quantity demanded of your product depends upon whether your rivals respond by raising their prices too!

• Strategic interdependence: You aren’t in complete control of your own destiny!

Sweezy (Kinked-Demand) Model

• Few firms in the market serving many consumers.• Firms produce differentiated products.• Barriers to entry.• Each firm believes rivals will match (or follow)

price reductions, but won’t match (or follow) price increases.

• Key feature of Sweezy ModelPrice-Rigidity.

Sweezy Demand and Marginal Revenue

D1(Rival holds itsprice constant)

DS: Sweezy Demand

MRS: Sweezy MR

Sweezy Profit-Maximizing Decision

DS: Sweezy DemandMRS

MC1MC2

D1 (Rival holds price constant)

Sweezy Oligopoly Summary

• Firms believe rivals match price cuts, but not price increases.

• Firms operating in a Sweezy oligopoly maximize profit by producing where

MRS = MC.The kinked-shaped marginal revenue curve implies that there exists a range over which changes in MC will not impact the profit-maximizing level of output.Therefore, the firm may have no incentive to change price provided that marginal cost remains in a given range.

Cournot Model• A few firms produce goods that are either

perfect substitutes (homogeneous) or imperfect substitutes (differentiated).

• Firms set output, as opposed to price.• Each firm believes their rivals will hold output

constant if it changes its own output (The output of rivals is viewed as given or “fixed”).

• Barriers to entry exist.

Inverse Demand in a Cournot Duopoly

• Market demand in a homogeneous-product Cournot duopoly is

• Thus, each firm’s marginal revenue depends on the output produced by the other firm. More formally,

212 2bQbQaMR −−=

121 2bQbQaMR −−=

( )21 QQbaP +−=

Best-Response Function

• Since a firm’s marginal revenue in a homogeneous Cournot oligopoly depends on both its output and its rivals, each firm needs a way to “respond” to rival’s output decisions.

• Firm 1’s best-response (or reaction) function is a schedule summarizing the amount of Q1 firm 1 should produce in order to maximize its profits for each quantity of Q2 produced by firm 2.

• Since the products are substitutes, an increase in firm 2’s output leads to a decrease in the profit-maximizing amount of firm 1’s product.

Best-Response Function for a Cournot Duopoly

• To find a firm’s best-response function, equate its marginal revenue to marginal cost and solve for its output as a function of its rival’s output.

• Firm 1’s best-response function is (c1 is firm 1’s MC)

• Firm 2’s best-response function is (c2 is firm 2’s MC)

( ) 21

211 21

bcaQrQ −

( ) 12

122 21

bcaQrQ −

Graph of Firm 1’s Best-Response Function

(Firm 1’s Reaction Function)

(a-c1)/b Q1 = r1(Q2) = (a-c1)/2b - 0.5Q2

Cournot Equilibrium

• Situation where each firm produces the output that maximizes its profits, given the the output of rival firms.

• No firm can gain by unilaterally changing its own output to improve its profit.

A point where the two firm’s best-response functions intersect.

Graph of Cournot Equilibrium

Cournot Equilibrium

(a-c1)/b

(a-c2)/b

Summary of Cournot Equilibrium

• The output Q1* maximizes firm 1’s profits,

given that firm 2 produces Q2*.

• The output Q2* maximizes firm 2’s profits,

given that firm 1 produces Q1*.

• Neither firm has an incentive to change its output, given the output of the rival.

• Beliefs are consistent: In equilibrium, each firm “thinks” rivals will stick to their current output – and they do!

Firm 1’s Isoprofit Curve

• The combinations of outputs of the two firms that yield firm 1 the same level of profit

π1 = $100

π1 = $200

Increasing Profits for

Firm 1D

Another Look at Cournot Decisions

Firm 1’s best response to Q2*

π 1 = $100

π 1 = $200

Another Look at Cournot Equilibrium

Firm 1’s Profits

Firm 2’s Profits

Q2M Cournot Equilibrium

Impact of Rising Costs on the Cournot Equilibrium

Cournot equilibrium prior to firm 1’s marginal cost increase

Cournot equilibrium afterfirm 1’s marginal cost increase

Collusion Incentives in Cournot Oligopoly

Cournot2π

Cournot1π

Stackelberg Model• Firms produce differentiated or homogeneous

products.• Barriers to entry.• Firm one is the leader.

The leader commits to an output before all other firms.

• Remaining firms are followers.They choose their outputs so as to maximize profits, given the leader’s output.

Stackelberg Equilibrium

Follower’s Profits Decline

Stackelberg Equilibrium

Stackelberg Summary• Stackelberg model illustrates how

commitment can enhance profits in strategic environments.

• Leader produces more than the Cournot equilibrium output.

Larger market share, higher profits.First-mover advantage.

• Follower produces less than the Cournot equilibrium output.

Smaller market share, lower profits.

Bertrand Model• Few firms that sell to many consumers.• Firms produce identical products at constant marginal

cost.• Each firm independently sets its price in order to

maximize profits.• Barriers to entry.• Consumers enjoy

Perfect information. Zero transaction costs.

Bertrand Equilibrium• Firms set P1 = P2 = MC! Why?• Suppose MC < P1 < P2.• Firm 1 earns (P1 - MC) on each unit sold, while

firm 2 earns nothing.• Firm 2 has an incentive to slightly undercut firm

1’s price to capture the entire market.• Firm 1 then has an incentive to undercut firm 2’s

price. This undercutting continues...• Equilibrium: Each firm charges P1 = P2 = MC.

Contestable Markets• Key Assumptions

Producers have access to same technology.Consumers respond quickly to price changes.Existing firms cannot respond quickly to entry by lowering price.Absence of sunk costs.

• Key ImplicationsThreat of entry disciplines firms already in the market.Incumbents have no market power, even if there is only a single incumbent (a monopolist).

Conclusion• Different oligopoly scenarios give rise to

different optimal strategies and different outcomes.

• Your optimal price and output depends on …Beliefs about the reactions of rivals.Your choice variable (P or Q) and the nature of the product market (differentiated or homogeneous products).Your ability to credibly commit prior to your rivals.

Chapter 10Game Theory: Inside Oligopoly

Overview

I. Introduction to Game TheoryII. Simultaneous-Move, One-Shot GamesIII. Infinitely Repeated GamesIV. Finitely Repeated GamesV. Multistage Games

Normal Form Game

• A Normal Form Game consists of:Players.Strategies or feasible actions.Payoffs.

A Normal Form Game

Strategy A B Cabc

Player 2

er 1 12,11 11,12 14,13

11,10 10,11 12,1210,15 10,13 13,14

Normal Form Game:Scenario Analysis

• Suppose 1 thinks 2 will choose “A”.

Strategy A B Cabc

Player 2

er 1 12,11 11,12 14,13

11,10 10,11 12,1210,15 10,13 13,14

• Then 1 should choose “a”. Player 1’s best response to “A” is “a”.

Strategy A B Cabc

Player 2

er 1 12,11 11,12 14,13

11,10 10,11 12,1210,15 10,13 13,14

• Suppose 1 thinks 2 will choose “B”.

Strategy A B Cabc

Player 2

er 1 12,11 11,12 14,13

11,10 10,11 12,1210,15 10,13 13,14

• Then 1 should choose “a”.Player 1’s best response to “B” is “a”.

Strategy A B Cabc

Player 2

er 1 12,11 11,12 14,13

11,10 10,11 12,1210,15 10,13 13,14

Normal Form GameScenario Analysis

• Similarly, if 1 thinks 2 will choose C…Player 1’s best response to “C” is “a”.

Strategy A B Cabc

Player 2

er 1 12,11 11,12 14,13

11,10 10,11 12,1210,15 10,13 13,14

Dominant Strategy• Regardless of whether Player 2 chooses A, B, or

C, Player 1 is better off choosing “a”!• “a” is Player 1’s Dominant Strategy!

Strategy A B Cabc

Player 2

er 1 12,11 11,12 14,13

11,10 10,11 12,1210,15 10,13 13,14

Putting Yourself in your Rival’s Shoes

• What should player 2 do?2 has no dominant strategy!But 2 should reason that 1 will play “a”.Therefore 2 should choose “C”.

Strategy A B Cabc

Player 2

er 1 12,11 11,12 14,13

11,10 10,11 12,1210,15 10,13 13,14

The Outcome

• This outcome is called a Nash equilibrium:“a” is player 1’s best response to “C”.“C” is player 2’s best response to “a”.

Strategy A B Cabc

Player 2

er 1 12,11 11,12 14,13

11,10 10,11 12,1210,15 10,13 13,14

Key Insights

• Look for dominant strategies.• Put yourself in your rival’s shoes.

A Market-Share Game

• Two managers want to maximize market share.

• Strategies are pricing decisions.• Simultaneous moves.• One-shot game.

The Market-Share Game in Normal Form

Strategy P=$10 P=$5 P = $1P=$10 .5, .5 .2, .8 .1, .9P=$5 .8, .2 .5, .5 .2, .8P=$1 .9, .1 .8, .2 .5, .5

Manager 2

Market-Share Game Equilibrium

Strategy P=$10 P=$5 P = $1P=$10 .5, .5 .2, .8 .1, .9P=$5 .8, .2 .5, .5 .2, .8P=$1 .9, .1 .8, .2 .5, .5

Manager 2

Nash Equilibrium

Key Insight:

• Game theory can be used to analyze situations where “payoffs” are non monetary!

• We will, without loss of generality, focus on environments where businesses want to maximize profits.

Hence, payoffs are measured in monetary units.

Examples of Coordination Games

• Industry standardssize of floppy disks.size of CDs.

• National standardselectric current.traffic laws.

A Coordination Game in Normal Form

Strategy A B C1 0,0 0,0 $10,$102 $10,$10 0,0 0,03 0,0 $10,$10 0,0

Player 2

A Coordination Problem: Three Nash Equilibria!

Strategy A B C1 0,0 0,0 $10,$102 $10,$10 0,0 0,03 0,0 $10, $10 0,0

Player 2

Key Insights:

• Not all games are games of conflict. • Communication can help solve coordination

problems.• Sequential moves can help solve coordination

problems.

An Advertising Game

• Two firms (Kellogg’s & General Mills) managers want to maximize profits.

• Strategies consist of advertising campaigns.• Simultaneous moves.

One-shot interaction.Repeated interaction.

A One-Shot Advertising Game

Strategy None Moderate HighNone 12,12 1, 20 -1, 15

Moderate 20, 1 6, 6 0, 9High 15, -1 9, 0 2, 2

General Mills

Equilibrium to the One-Shot Advertising Game

Moderate 20, 1 6, 6 0, 9High 15, -1 9, 0 2, 2

General Mills

Nash Equilibrium

Can collusion work if the game is repeated 2 times?

Moderate 20, 1 6, 6 0, 9High 15, -1 9, 0 2, 2

General Mills

No (by backwards induction).• In period 2, the game is a one-shot game, so

equilibrium entails High Advertising in the last period.

• This means period 1 is “really” the last period, since everyone knows what will happen in period 2.

• Equilibrium entails High Advertising by each firm in both periods.

• The same holds true if we repeat the game any known, finite number of times.

Can collusion work if firms play the game each year, forever?

• Consider the following “trigger strategy”by each firm:

“Don’t advertise, provided the rival has not advertised in the past. If the rival ever advertises, “punish” it by engaging in a high level of advertising forever after.”

• In effect, each firm agrees to “cooperate”so long as the rival hasn’t “cheated” in the past. “Cheating” triggers punishment in all future periods.

Suppose General Mills adopts this trigger strategy. Kellogg’s profits?

ΠCooperate = 12 +12/(1+i) + 12/(1+i)2 + 12/(1+i)3 + …= 12 + 12/i

Moderate 20, 1 6, 6 0, 9High 15, -1 9, 0 2, 2

General Mills

Value of a perpetuity of $12 paidat the end of every year

ΠCheat = 20 +2/(1+i) + 2/(1+i)2 + 2/(1+i)3 + …= 20 + 2/i

Kellogg’s Gain to Cheating:• ΠCheat - ΠCooperate = 20 + 2/i - (12 + 12/i) = 8 - 10/i

Suppose i = .05

• ΠCheat - ΠCooperate = 8 - 10/.05 = 8 - 200 = -192• It doesn’t pay to deviate.

Collusion is a Nash equilibrium in the infinitely repeated game!

Moderate 20, 1 6, 6 0, 9High 15, -1 9, 0 2, 2

General Mills

Benefits & Costs of Cheating• ΠCheat - ΠCooperate = 8 - 10/i

8 = Immediate Benefit (20 - 12 today)10/i = PV of Future Cost (12 - 2 forever after)

• If Immediate Benefit - PV of Future Cost > 0Pays to “cheat”.

• If Immediate Benefit - PV of Future Cost ≤ 0Doesn’t pay to “cheat”.

Moderate 20, 1 6, 6 0, 9High 15, -1 9, 0 2, 2

General Mills

Key Insight

• Collusion can be sustained as a Nash equilibrium when there is no certain “end”to a game.

• Doing so requires:Ability to monitor actions of rivals.Ability (and reputation for) punishing defectors.Low interest rate.High probability of future interaction.

Real World Examples of Collusion

• Garbage Collection Industry• OPEC• NASDAQ• Airlines

Normal Form Bertrand Game

Strategy Low Price High PriceLow Price 0,0 20,-1High Price -1, 20 15, 15

Firm 1

Firm 2

One-Shot Bertrand (Nash) Equilibrium

Firm 1

Firm 2

Potential Repeated Game Equilibrium Outcome

Firm 1

Firm 2

Simultaneous-Move Bargaining• Management and a union are negotiating a wage

increase.• Strategies are wage offers & wage demands.• Successful negotiations lead to $600 million in surplus,

which must be split among the parties.• Failure to reach an agreement results in a loss to the

firm of $100 million and a union loss of $3 million.• Simultaneous moves, and time permits only one-shot at

making a deal.

The Bargaining Gamein Normal Form

Strategy W = $10 W = $5 W = $1W = $10 100, 500 -100, -3 -100, -3W=$5 -100, -3 300, 300 -100, -3W=$1 -100, -3 -100, -3 500, 100

Three Nash Equilibria!

Strategy W = $10 W = $5 W = $1W = $10 100, 500 -100, -3 -100, -3W=$5 -100, -3 300, 300 -100, -3W=$1 -100, -3 -100, -3 500, 100

Fairness: The “Natural” Focal Point

Strategy W = $10 W = $5 W = $1W = $10 100, 500 -100, -3 -100, -3W=$5 -100, -3 300, 300 -100, -3W=$1 -100, -3 -100, -3 500, 100

Lessons in Simultaneous Bargaining

• Simultaneous-move bargaining results in a coordination problem.

• Experiments suggests that, in the absence of any “history,” real players typically coordinate on the “fair outcome.”

• When there is a “bargaining history,” other outcomes may prevail.

Single Offer Bargaining

• Now suppose the game is sequential in nature, and management gets to make the union a “take-it-or-leave-it” offer.

• Analysis Tool: Write the game in extensive form

Summarize the players. Their potential actions. Their information at each decision point. Sequence of moves.Each player’s payoff.

Step 1: Management’s Move

Accept

Reject

Accept

Reject

Step 2: Add the Union’s Move

Accept

Reject

Accept

Reject

Step 3: Add the Payoffs

100, 500

-100, -3

300, 300

-100, -3

500, 100

-100, -3

Accept

Reject

Accept

Reject

The Game in Extensive Form

100, 500

-100, -3

300, 300

-100, -3

500, 100

-100, -3

Step 4: Identify the Firm’s Feasible Strategies

• Management has one information set and thus three feasible strategies:

Offer $10.Offer $5.Offer $1.

Step 5: Identify the Union’s Feasible Strategies

• The Union has three information set and thus eight feasible strategies:

Accept $10, Accept $5, Accept $1Accept $10, Accept $5, Reject $1Accept $10, Reject $5, Accept $1Accept $10, Reject $5, Reject $1 Reject $10, Accept $5, Accept $1Reject $10, Accept $5, Reject $1Reject $10, Reject $5, Accept $1Reject $10, Reject $5, Reject $1

Step 6: Identify Nash Equilibrium Outcomes

• Outcomes such that neither the firm nor the union has an incentive to change its strategy, given the strategy of the other.

Finding Nash Equilibrium Outcomes

Accept $10, Accept $5, Accept $1Accept $10, Accept $5, Reject $1Accept $10, Reject $5, Accept $1Reject $10, Accept $5, Accept $1Accept $10, Reject $5, Reject $1Reject $10, Accept $5, Reject $1Reject $10, Reject $5, Accept $1Reject $10, Reject $5, Reject $1

Union's Strategy Firm's Best Response

Mutual Best Response?

$1 Yes$5$1$1$10

YesYesYesYes

$5 Yes$1

$10, $5, $1

Step 7: Find the Subgame Perfect Nash Equilibrium

Outcomes• Outcomes where no player has an incentive

to change its strategy, given the strategy of the rival, and

• The outcomes are based on “credible actions;” that is, they are not the result of “empty threats” by the rival.

Checking for Credible Actions

Union's StrategyAre all Actions

Credible?YesNoNoNoNoNoNoNo

The “Credible” Union Strategy

Union's StrategyAre all Actions

Credible?YesNoNoNoNoNoNoNo

Finding Subgame Perfect Nash Equilibrium Strategies

Union's Strategy Firm's Best Response

Mutual Best Response?

$1 Yes$5$1$1$10

YesYesYesYes

$5 Yes$1

$10, $5, $1

Nash and Credible Nash Only Neither Nash Nor Credible

To Summarize:

• We have identified many combinations of Nash equilibrium strategies.

• In all but one the union does something that isn’t in its self interest (and thus entail threats that are not credible).

• Graphically:

Accept

Reject

Accept

Reject

There are 3 Nash Equilibrium Outcomes!

100, 500

-100, -3

300, 300

-100, -3

500, 100

-100, -3

Accept

Reject

Accept

Reject

Only 1 Subgame-Perfect Nash Equilibrium Outcome!

100, 500

-100, -3

300, 300

-100, -3

500, 100

-100, -3

Bargaining Re-Cap

• In take-it-or-leave-it bargaining, there is a first-mover advantage.

• Management can gain by making a take-it-or-leave-it offer to the union. But...

• Management should be careful; real world evidence suggests that people sometimes reject offers on the the basis of “principle”instead of cash considerations.

Pricing to Prevent Entry: An Application of Game Theory

• Two firms: an incumbent and potential entrant.• Potential entrant’s strategies:

Enter.Stay Out.

• Incumbent’s strategies: {if enter, play hard}.{if enter, play soft}.{if stay out, play hard}.{if stay out, play soft}.

• Move Sequence: Entrant moves first. Incumbent observes entrant’s action and selects an action.

The Pricing to Prevent EntryGame in Extensive Form

EntrantOut

Incumbent

Identify Nash and SubgamePerfect Equilibria

EntrantOut

Incumbent

Two Nash Equilibria

EntrantOut

Incumbent

Nash Equilibria Strategies {player 1; player 2}:{enter; If enter, play soft}{stay out; If enter, play hard}

One Subgame Perfect Equilibrium

EntrantOut

Incumbent

Subgame Perfect Equilibrium Strategy:{enter; If enter, play soft}

Insights

• Establishing a reputation for being unkind to entrants can enhance long-term profits.

• It is costly to do so in the short-term, so much so that it isn’t optimal to do so in a one-shot game.

Chapter 11Pricing Strategies for Firms with

Market Power

OverviewI. Basic Pricing Strategies

Monopoly & Monopolistic Competition Cournot Oligopoly

II. Extracting Consumer SurplusPrice Discrimination Two-Part PricingBlock Pricing Commodity Bundling

III. Pricing for Special Cost and Demand StructuresPeak-Load Pricing Price MatchingCross Subsidies Brand LoyaltyTransfer Pricing Randomized Pricing

IV. Pricing in Markets with Intense Price Competition

Standard Pricing and Profits for Firms with Market Power

Quantity

P = 10 - 2Q

1 2 3 4 5

MR = 10 - 4Q

Profits from standard pricing= $8

An Algebraic Example• P = 10 - 2Q• C(Q) = 2Q• If the firm must charge a single price to all

consumers, the profit-maximizing price is obtained by setting MR = MC.

• 10 - 4Q = 2, so Q* = 2.• P* = 10 - 2(2) = 6.• Profits = (6)(2) - 2(2) = $8.

A Simple Markup Rule• Suppose the elasticity of demand for the

firm’s product is EF.• Since MR = P[1 + EF]/ EF.• Setting MR = MC and simplifying yields

this simple pricing formula:P = [EF/(1+ EF)] × MC.

• The optimal price is a simple markup over relevant costs!

More elastic the demand, lower markup.Less elastic the demand, higher markup.

An Example• Elasticity of demand for Kodak film is -2.• P = [EF/(1+ EF)] × MC• P = [-2/(1 - 2)] × MC• P = 2 × MC• Price is twice marginal cost.• Fifty percent of Kodak’s price is margin

above manufacturing costs.

Markup Rule for Cournot Oligopoly

• Homogeneous product Cournot oligopoly.• N = total number of firms in the industry.• Market elasticity of demand EM .• Elasticity of individual firm’s demand is given

by EF = N x EM.• Since P = [EF/(1+ EF)] × MC,• Then, P = [NEM/(1+ NEM)] × MC.• The greater the number of firms, the lower the

profit-maximizing markup factor.

An Example• Homogeneous product Cournot industry, 3 firms.• MC = $10.• Elasticity of market demand = - ½.• Determine the profit-maximizing price?• EF = N EM = 3 × (-1/2) = -1.5.• P = [EF/(1+ EF)] × MC.• P = [-1.5/(1- 1.5] × $10.• P = 3 × $10 = $30.

First-Degree or Perfect Price Discrimination

• Practice of charging each consumer the maximum amount he or she will pay for each incremental unit.

• Permits a firm to extract all surplus from consumers.

Perfect Price Discrimination

Quantity

1 2 3 4 5

Profits*:.5(4-0)(10 - 2)

Total Cost* = $8

* Assuming no fixed costs

Caveats:

• In practice, transactions costs and information constraints make this difficult to implement perfectly (but car dealers and some professionals come close).

• Price discrimination won’t work if consumers can resell the good.

Second-Degree Price Discrimination

• The practice of posting a discrete schedule of declining prices for different quantities.

• Eliminates the information constraint present in first-degree price discrimination.

• Example: Electric utilities

4 Quantity

Third-Degree Price Discrimination• The practice of charging different groups

of consumers different prices for the same product.

• Group must have observable characteristics for third-degree price discrimination to work.

• Examples include student discounts, senior citizen’s discounts, regional & international pricing.

Implementing Third-Degree Price Discrimination

• Suppose the total demand for a product is comprised of two groups with different elasticities, E1 < E2.

• Notice that group 1 is more price sensitive than group 2.

• Profit-maximizing prices?• P1 = [E1/(1+ E1)] × MC• P2 = [E2/(1+ E2)] × MC

An Example• Suppose the elasticity of demand for Kodak film in

the US is EU = -1.5, and the elasticity of demand in Japan is EJ = -2.5.

• Marginal cost of manufacturing film is $3.• PU = [EU/(1+ EU)] × MC = [-1.5/(1 - 1.5)] × $3 = $9• PJ = [EJ/(1+ EJ)] × MC = [-2.5/(1 - 2.5)] × $3 = $5• Kodak’s optimal third-degree pricing strategy is to

charge a higher price in the US, where demand is less elastic.

Two-Part Pricing

• When it isn’t feasible to charge different prices for different units sold, but demand information is known, two-part pricing may permit you to extract all surplus from consumers.

• Two-part pricing consists of a fixed fee and a per unit charge.

Example: Athletic club memberships.

How Two-Part Pricing Works

1. Set price at marginal cost.2. Compute consumer surplus.3. Charge a fixed-fee equal to

consumer surplus.

Quantity

1 2 3 4 5

Fixed Fee = Profits = $16

Per UnitCharge

Block Pricing• The practice of packaging multiple units of

an identical product together and selling them as one package.

• ExamplesPaper.Six-packs of soda.Different sized of cans of green beans.

An Algebraic Example

• Typical consumer’s demand is P = 10 - 2Q• C(Q) = 2Q• Optimal number of units in a package?• Optimal package price?

Optimal Quantity To Package: 4 UnitsPrice

Quantity

1 2 3 4 5

MC = AC

Optimal Price for the Package: $24 Price

Quantity

1 2 3 4 5

MC = AC

Consumer’s valuation of 4units = .5(8)(4) + (2)(4) = $24Therefore, set P = $24!

Costs and Profits with Block PricingPrice

Quantity

1 2 3 4 5

MC = AC

Profits = [.5(8)(4) + (2)(4)] – (2)(4)= $16

Costs = (2)(4) = $8

Commodity Bundling• The practice of bundling two or more

products together and charging one price for the bundle.

• ExamplesVacation packages.Computers and software.Film and developing.

An Example that Illustrates Kodak’s Moment

• Total market size for film and developing is 4 million consumers.

• Four types of consumers25% will use only Kodak film (F).25% will use only Kodak developing (D).25% will use only Kodak film and use only Kodak developing (FD).25% have no preference (N).

• Zero costs (for simplicity).• Maximum price each type of consumer will pay is

as follows:

Reservation Prices for Kodak Film and Developing by Type of

Consumer

Type Film DevelopingF $8 $3

FD $8 $4D $4 $6N $3 $2

Optimal Film Price?

FD $8 $4D $4 $6N $3 $2

Optimal Price is $8; only types F and FD buy resulting in profits of $8 x 2 million = $16 Million.At a price of $4, only types F, FD, and D will buy (profits of $12 Million).At a price of $3, all will types will buy (profits of $12 Million).

Optimal Price for Developing?

FD $8 $4D $4 $6N $3 $2

Optimal Price is $3, to earn profits of $3 x 3 million = $9 Million.

At a price of $6, only “D” type buys (profits of $6 Million).

At a price of $4, only “D” and “FD” types buy (profits of $8 Million).

At a price of $2, all types buy (profits of $8 Million).

Total Profits by Pricing Each Item Separately?

FD $8 $4D $4 $6N $3 $2

Total Profit = Film Profits + Development Profits = $16 Million + $9 Million = $25 Million

Surprisingly, the firm can earn even greater profits by bundling!

Pricing a “Bundle” of Film and Developing

Consumer Valuations of a Bundle

Type Film Developing Value of BundleF $8 $3 $11

FD $8 $4 $12D $4 $6 $10N $3 $2 $5

What’s the Optimal Price for a Bundle?

Type Film Developing Value of BundleF $8 $3 $11

FD $8 $4 $12D $4 $6 $10N $3 $2 $5

Optimal Bundle Price = $10 (for profits of $30 million)

Peak-Load Pricing

• When demand during peak times is higher than the capacity of the firm, the firm should engage in peak-load pricing.

• Charge a higher price (PH) during peak times (DH).

• Charge a lower price (PL) during off-peak times (DL).

Quantity

PriceMC

Cross-Subsidies

• Prices charged for one product are subsidized by the sale of another product.

• May be profitable when there are significant demand complementarities effects.

• ExamplesBrowser and server software.Drinks and meals at restaurants.

Double Marginalization• Consider a large firm with two divisions:

the upstream division is the sole provider of a key input.the downstream division uses the input produced by the upstream division to produce the final output.

• Incentives to maximize divisional profits leads the upstream manager to produce where MRU = MCU.

Implication: PU > MCU.• Similarly, when the downstream division has market

power and has an incentive to maximize divisional profits, the manager will produce where MRD = MCD.

Implication: PD > MCD.• Thus, both divisions mark price up over marginal cost

resulting in in a phenomenon called double marginalization.

Result: less than optimal overall profits for the firm.

Transfer Pricing

• To overcome double marginalization, the internal price at which an upstream division sells inputs to a downstream division should be set in order to maximize the overall firm profits.

• To achieve this goal, the upstream division produces such that its marginal cost, MCu, equals the net marginal revenue to the downstream division (NMRd):

NMRd = MRd - MCd = MCu

Upstream Division’s Problem

• Demand for the final product P = 10 - 2Q.• C(Q) = 2Q.• Suppose the upstream manager sets MR = MC to

maximize profits.• 10 - 4Q = 2, so Q* = 2.• P* = 10 - 2(2) = $6, so upstream manager charges

the downstream division $6 per unit.

Downstream Division’s Problem

• Demand for the final product P = 10 - 2Q.• Downstream division’s marginal cost is the $6

charged by the upstream division.• Downstream division sets MR = MC to maximize

profits.• 10 - 4Q = 6, so Q* = 1.• P* = 10 - 2(1) = $8, so downstream division

charges $8 per unit.

Analysis• This pricing strategy by the upstream division results

in less than optimal profits!• The upstream division needs the price to be $6 and

the quantity sold to be 2 units in order to maximize profits. Unfortunately,

• The downstream division sets price at $8, which is too high; only 1 unit is sold at that price.

Downstream division profits are $8 × 1 – 6(1) = $2.

• The upstream division’s profits are $6 × 1 - 2(1) = $4 instead of the monopoly profits of $6 × 2 - 2(2) = $8.

• Overall firm profit is $4 + $2 = $6.

Upstream Division’s “Monopoly Profits”

Quantity

P = 10 - 2Q

1 2 3 4 5

MC = AC

MR = 10 - 4Q

Profit = $8

Upstream’s Profits when Downstream Marks Price Up to $8

Quantity

P = 10 - 2Q

1 2 3 4 5

MC = AC

MR = 10 - 4Q

Profit = $4DownstreamPrice

Solutions for the Overall Firm?

• Provide upstream manager with an incentive to set the optimal transfer price of $2 (upstream division’s marginal cost).

• Overall profit with optimal transfer price:

8$22$26$ =×−×=π

Pricing in Markets with Intense Price Competition

• Price MatchingAdvertising a price and a promise to match any lower price offered by a competitor.No firm has an incentive to lower their prices.Each firm charges the monopoly price and shares the market.

• Randomized PricingA strategy of constantly changing prices.Decreases consumers’ incentive to shop around as they cannot learn from experience which firm charges the lowest price.Reduces the ability of rival firms to undercut a firm’s prices.

Conclusion• First degree price discrimination, block pricing, and

two part pricing permit a firm to extract all consumer surplus.

• Commodity bundling, second-degree and third degree price discrimination permit a firm to extract some (but not all) consumer surplus.

• Simple markup rules are the easiest to implement, but leave consumers with the most surplus and may result in double-marginalization.

• Different strategies require different information.

Chapter 12The Economics of Information

OverviewI. The Mean and the VarianceII. Uncertainty and Consumer BehaviorIII. Uncertainty and the FirmIV. Uncertainty and the MarketV. Auctions

The Mean • The expected value or average of a random variable.• Computed as the sum of the probabilities that different

outcomes will occur multiplied by the resulting payoffs:

E[x] = q1 x1 + q2 x2 +…+qn xn,

where xi is payoff i, qi is the probability that payoff ioccurs, and q1 + q2 +…+qn = 1.

• The mean provides information about the average value of a random variable but yields no information about the degree of risk associated with the random variable.

The Variance & Standard Deviation

• VarianceA measure of risk.The sum of the probabilities that different outcomes will occur multiplied by the squared deviations from the mean of the random variable:

s2 = q1 (x1- E[x])2 + q2 (x2- E[x])2 +…+qn(xn- E[x])2

• Standard DeviationThe square root of the variance.

Uncertainty and Consumer Behavior

• Risk AversionRisk Averse: An individual who prefers a sure amount of $M to a risky prospect with an expected value, E[x], of $M.Risk Loving: An individual who prefers a risky prospect with an expected value, E[x], of $M to a sure amount of $M.Risk Neutral: An individual who is indifferent between a risky prospect where E[x] = $M and a sure amount of $M.

Examples of How Risk Aversion Influences Decisions

• Product qualityInformative advertisingFree samplesGuarantees

• Chain stores• Insurance

Price Uncertainty and Consumer Search

• Suppose consumers face numerous stores selling identical products, but charge different prices.

• The consumer wants to purchase the product at the lowest possible price, but also incurs a cost, c, to acquire price information.

• There is free recall and with replacement.Free recall means a consumer can return to any previously visited store.

• The consumer’s reservation price, the at which the consumer is indifferent between purchasing and continue to search, is R.

• When should a consumer cease searching for price information?

Consumer Search Rule• Consumer will search until

• Therefore, a consumer will continue to search for a lower price when the observed price is greater than R and stop searching when the observed price is less than R.

( ) .cREB =

Consumer Search

The Optimal Search Strategy.

Reservation Price

Accept RejectR

Consumer Search: Rising Search Costs

An increase in search costs raises the reservation price.

Uncertainty and the Firm

• Risk AversionAre managers risk averse or risk neutral?

• Diversification“Don’t put all your eggs in one basket.”

• Profit MaximizationWhen demand is uncertain, expected profits are maximized at the point where expected marginal revenue equals marginal cost: E[MR] = MC.

Example: Profit-Maximization in Uncertain Environments

• Suppose that economists predict that there is a 20 percent chance that the price in a competitive wheat market will be $5.62 per bushel and an 80 percent chance that the competitive price of wheat will be $2.98 per bushel. If a farmer can produce wheat at cost C(Q) = 20+0.01Q, how many bushels of wheat should he produce? What are his expected profits?

• Answer:E[P] = 0.2 x $5.62 + 0.8 x $2.98 = $3.508In a competitive market firms produce where E[P] = MC. Or, 3.508 = 0.01Q. Thus, Q = 350.8 bushels.Expect profits = (3.508 x 350.8) – [1000 + 0.01(350.8)] = 1230.61-1000-3.508 = $227.10.

Asymmetric Information

• Situation that exists when some people have better information than others.

• Example: Insider trading

Two Types of Asymmetric Information

• Hidden characteristicsThings one party to a transaction knows about itself, but which are unknown by the other party.

• Hidden actionsActions taken by one party in a relationship that cannot be observed by the other party.

Adverse Selection

• Situation where individuals have hidden characteristics and in which a selection process results in a pool of individuals with undesirable characteristics.

• ExamplesChoice of medical plans.High-interest loans.Auto insurance for drivers with bad records.

Moral Hazard

• Situation where one party to a contract takes a hidden action that benefits him or her at the expense of another party.

• ExamplesThe principal-agent problem.Care taken with rental cars.

Possible Solutions

1. SignalingAttempt by an informed party to send an observable indicator of his or her hidden characteristics to an uninformed party.To work, the signal must not be easily mimicked by other types. Example: Education.

Possible Solutions

2. ScreeningAttempt by an uninformed party to sort individuals according to their characteristics.Often accomplished through a self-selection device

• A mechanism in which informed parties are presented with a set of options, and the options they choose reveals their hidden characteristics to an uninformed party.

Example: Price discrimination

Auctions

• UsesArtTreasury billsSpectrum rightsConsumer goods (eBay and other Internet auction sites)Oil leases

• Major types of AuctionEnglishFirst-price, sealed-bidSecond-price, sealed-bidDutch

English Auction

• An ascending sequential bid auction.

• Bidders observe the bids of others and decide whether or not to increase the bid.

• The item is sold to the highest bidder.

First-Price, Sealed-bid

• An auction whereby bidders simultaneously submit bids on pieces of paper.

• The item goes to the highest bidder.

• Bidders do not know the bids of other players.

Second-Price, Sealed-bid

• The same bidding process as a first price auction.

• However, the high bidder pays the amount bid by the 2nd highest bidder.

Dutch Auction

• A descending price auction.

• The auctioneer begins with a high asking price.

• The bid decreases until one bidder is willing to pay the quoted price.

• Strategically equivalent to a first-price auction.

Information Structures• Perfect information

Each bidder knows exactly the items worth.

• Independent private valuesBidders know their own valuation of the item, but not other bidders’valuations.Bidders’ valuations do not depend on those of other bidders.

• Affiliated (or correlated) value estimatesBidders do not know their own valuation of the item or the valuations of others.Bidders use their own information to form a value estimate.Value estimates are affiliated: the higher a bidder’s estimate, the more likely it is that other bidders also have high value estimates. Common values is the special case in which the true (but unknown) value of the item is the same for all bidders.

Optimal Bidding Strategy in an English Auction

• With independent private valuations, the optimal strategy is to remain active until the price exceeds your own valuation of the object.

Optimal Bidding Strategy in a Second-Price Sealed-Bid Auction

• The optimal strategy is to bid your own valuation of the item.

• This is a dominant strategy.You don’t pay your own bid, so bidding less than your value only increases the chance that you don’t win.If you bid more than your valuation, you risk buying the item for more than it is worth to you.

Optimal Bidding Strategy in a First-Price, Sealed-Bid Auction

• If there are n bidders who all perceive valuations to be evenly (or uniformly) distributed between a lowest possible valuation of L and a highest possible valuation of H, then the optimal bid for a risk-neutral player whose own valuation is v is

b vv L

n= −

Example

• Two bidders with independent private valuations (n = 2).

• Lowest perceived valuation is unity (L = 1).• Optimal bid for a player whose valuation is

two (v = 2) is given by

b vv a

n= −

−= −

Optimal Bidding Strategies with Affiliated Value Estimates• Difficult to describe because

Bidders do not know their own valuations of the item, let alone the valuations others.The auction process itself may reveal information about how much the other bidders value the object.

• Optimal bidding requires that players use any information gained during the auction to update their own value estimates.

The Winner’s Curse• In a common-values auction, the winner is

the bidder who is the most optimistic about the true value of the item.

• To avoid the winner's curse, a bidder should revise downward his or her private estimate of the value to account for this fact.

• The winner’s curse is most pronounced in sealed-bid auctions.

Expected Revenues in Auctions with Risk Neutral Bidders

• Independent Private ValuesEnglish = Second Price = First Price = Dutch.

• Affiliated Value EstimatesEnglish > Second Price > First Price = Dutch.Bids are more closely linked to other players information, which mitigates players’ concerns about the winner’s curse.

Conclusion

• Information plays an important role in how economic agents make decisions.

When information is costly to acquire, consumers will continue to search for price information as long as the observed price is greater than the consumer’s reservation price.When there is uncertainty surrounding the price a firm can charge, a firm maximizes profit at the point where the expected marginalrevenue equals marginal cost.

• Many items are sold via auctions English auctionFirst-price, sealed bid auctionSecond-price, sealed bid auctionDutch auction

Chapter 13Advanced Topics in Business

Strategy

OverviewI. Limit Pricing to Prevent EntryII. Predatory Pricing to Lessen CompetitionIII. Raising Rivals’ Costs to Lessen CompetitionIV. Price Discrimination as a Strategic ToolV. Changing the Timing of DecisionsVI. Penetration Pricing to Overcome Network

Effects

Limit Pricing

• Strategy where an incumbent (existing firm) prices below the monopoly price in order to keep potential entrants out of the market.

• Goal is to lessen competition by eliminating potential competitors’ incentives to enter the market.

Monopoly Profits• This monopolist is

earning positive economic profits.

• These profits may induce other firms to enter the market.

• Questions:Can the monopolist prevent entry?If so, is it profitable to do so?

D MAC M

Limit Pricing• Incumbent produces QL

instead of monopoly output (QM).

• Resulting price, PL, is lower than monopoly price (PM).

• Residual demand curve is the market demand (DM) minus QL .

• Entry is not profitable because entrant’s residual demand lies below AC.

• Optimal limit pricing results in a residual demand such that, if the entrant entered and produced Q units, its profits would be zero.

Quantity

Entrant's residualdemand curve

D MP = AC

Potential Problems with Limit Pricing

• It isn’t generally profitable for the incumbent to maintain an output of QL once entry occurs.

• Rational entrants will realize this and enter.• Solution: Incumbent must link its pre-entry price to

the post-entry profits of the potential entrant.• Possible links:

Commitments by incumbents.Learning curve effects.Incomplete information.Reputation effects.

Potential Problems with Limit Pricing (Continued)

• Even if a link can be forged, it may not be profitable to limit price! Limit pricing is profitable only if the present value of the benefits of limit pricing exceed the up front costs:

L DM L

iπ π

π π−

Predatory Pricing

• Strategy of pricing below marginal cost to drive competitors out of business, then raising price to enjoy the higher profits resulting from lessened competition.

• Goal is to lessen competition by eliminating existing competitors.

Potential Problems with Predatory Pricing

• Counter strategies:Stop production.Purchase from the predator at the reduced price and stockpile until predatory pricing is over.

• Rivals can sue under the Sherman ActBut it is often difficult for rivals to prove their case.

• Upfront losses incurred to drive out rivals may exceed the present value of future monopoly profits.

• Predator must have deeper pockets than prey.

Raising Rivals’ Costs

• Strategy where a firm increases the marginal or fixed costs of rivals to distort their incentives.

• Not always profitable, but may be profitable as the following example shows.

Raising a Rival’s Marginal Cost

• Cournot duopoly.• Initial equilibrium at

point A.• Firm 1 raises the

marginal cost of Firm 2, moving equilibrium to point B.

• Firm 1 gains market share and profits.

Other Strategies to Raise Rivals’Costs

• Raise fixed costs in the industry.• If vertically integrated, increase input prices in

the upstream market.Vertical Foreclosure: Integrated firm charges rivals prohibitive price for an essential input.The Price-Cost Squeeze: Integrated firm raises input price and holds the final product price constant.

Price Discrimination as a Strategic Tool

• Price discrimination permits a firm to “target”price cuts to those consumers or markets that will inflict the most damage to the rival (in the case of predatory pricing) or potential entrants (in the case of limit pricing).

• Meanwhile, it can continue to charge the monopoly price to its other customers.

• Thus, price discrimination may enhance the value of other pricing strategies.

Changing the Timing of Decisions or the Order of Moves

• Sometimes profits can be enhanced by changing the timing of decisions or the order of moves.

When there is a first-mover advantage, it pays to commit to a decision first.When there is a second-mover advantage, it pays to let the other player move first.

Examples of Games with First and Second-Mover Advantages

• Example 1: Player naming the smaller natural number gets $10, the other players get nothing.– First-mover always earns $10.

• Example 2: Player naming the larger natural number gets $10, the other players get nothing.– Last-mover always earns $10

• Practical Examples?

If Firms A and B Make Production Decisions Simultaneously

• Firm A earns $10 by playing its dominant strategy, which is “Low Output.”

Firm A

Firm B

Strategy Low Output High Output

Low Output

High Output

$30, $10 $10, $15

$20, $5 $1, $2

But if A Moves First:

• Firm A can earn $20 by producing a high output!

• RequiresCommitment to a high output.Player B observes A’s commitment prior to making its own production decision.

Low Output ($30, $10)

Low Output

High Output ($10, $15)

Low Output ($20, $5)

High Output

High Output ($1, $2)

Networks

• A network consists of links that connect different points in geographic or economic space.

• One-way Network – Services flow in only one direction.

Examples: water, electricity.

• Two-way Network – Value to each user depends directly on how many other people use the network.

Examples: telephone, e-mail.

Example: A Two-Way Star Network Linking 7 Users

• Point H is the hub.• Points C1 through C7 are

nodes representing users.

• Total number of connection services is n(n - 1) = 7(7-1) = 42.

Network Externalities• Direct Network Externality – The direct value

enjoyed by the user of a network because other people also use the network.

• Indirect Network Externality – The indirect value enjoyed by the user of a network because of complementarities between the size of the network and the availability of complementary products or services.

• Negative Externalities such as congestion and bottlenecks can also arise as a network grows.

Penetration Pricing to Overcome Network Effects

• Problem: Network externalities typically make it difficult for a new network to replace or compete with an existing network.

• Solution: Penetration Pricing– The new network can charge an initial price that is

very low, give the product away, or even pay consumers to try the new product to gain users.

– Once a critical mass of users switch to the new network, prices can be increased.

The New Network GameWithout Penetration Pricing

• Coordination Problem Neither user has an incentive to unilaterally switch to H2, even though both users would benefit if they simultaneously switched.With many users, it is difficult to coordinate a move to the better equilibrium.Users may stay locked in at the red equilibrium instead of moving to green one.

Network Provider H1 H2

User 2

User 1 $0, $0$10, $10

$20, $20$0, $0

Table 13-2 A Network Game

The New Network GameWith Penetration Pricing

Network Provider H1 H1 & H2

H1 & H2

User 2

User 1 $10, $11$10, $10

$21, $21$11, $10

Table 13-3 The Network Game with Penetration Pricing

• Network provider H2 pays consumers $1 to try its network; consumers have nothing to lose in trying both networks. The green cell is the equilibrium.

• Users will eventually realize that H2 is better than H1 and that other users have access to this new network.

• Users will eventually quit using H1, at which point provider H2 can eliminate $1 payment and start charging for network access.

Conclusion

• A number of strategies may enhance profits:Limit pricing.Predatory pricing.Raising rivals’ costs.Exercising first- or second-mover advantages.Penetration pricing.

• These strategies are not always the best ones, though, and care must be taken when using any of the above strategies.

Chapter 14A Manager’s Guide to

Government in the Marketplace

OverviewI. Market Failure

Market PowerExternalitiesPublic GoodsIncomplete Information

II. Rent SeekingIII. Government Policy and International Markets

QuotasTariffsRegulations

Market Power • Firms with market

power produce socially inefficient output levels.

Too little outputPrice exceeds MCDeadweight loss

• Dollar value of society’s welfare loss

Deadweight Loss

Antitrust Policies• Administered by the DOJ and FTC• Goals:

To eliminate deadweight loss of monopoly and promote social welfare.Make it illegal for managers to pursue strategies that foster monopoly power.

Sherman Act (1890)

• Sections 1 and 2 prohibits price-fixing, market sharing and other collusive practices designed to “monopolize, or attempt to monopolize” a market.

United States v. Standard Oil of New Jersey (1911)

• Charged with attempting to fix prices of petroleum products. Methods used to enhance market power:

Physical threats to shippers and other producers.Setting up artificial companies.Espionage and bribing tactics.Engaging in restraint of trade.Attempting to monopolize the oil industry.

• Result 1: Standard Oil dissolved into 33 subsidiaries.• Result 2: New Supreme Court Ruling the rule of reason.

Stipulates that not all trade restraints are illegal, only those that are unreasonable are prohibited.

• Based on the Sherman Act and the rule of reason, how do firms know a priori whether a particular pricing strategy is illegal?

Clayton Act (1914)

• Makes hidden kickbacks (brokerage fees) and hidden rebates illegal.

• Section 3 Prohibits exclusive dealing and tying arrangements where the effect may be to “substantially lessen competition.”

Cellar-Kefauver Act (1950)

• Amends Section 7 of Clayton Act.• Strengthens merger and acquisition policies.• Horizontal Merger Guidelines

Market Concentration• Herfindahl-Hirschman Index: HHI = 10,000 Σ wi

• Industries in which the HHI exceed 1800 are generally deemed “highly concentrated”.

• The DOJ or FTC may, in this case, attempt to block a merger if it would increase the HHI by more than 100.

Regulating Monopolies: Marginal-Cost Pricing

Effective Demand

Problem 1 with Marginal-Cost Pricing: Possibility of ATC > PC

ATCATCPM

Problem 2 with Marginal-Cost Pricing: Requires Knowledge of MC

QReg QM

Shortage

Deadweight loss prior to regulation

Deadweight loss after regulation

Effective Demand

Externalities• A negative externality is a cost borne by

people who neither produce nor consume the good.

• Example: PollutionCaused by the absence of well-defined property rights.

• Government regulations may induce the socially efficient level of output by forcing firms to internalize pollution costs

The Clean Air Act of 1970

Socially Efficient Equilibrium: Internal and External Costs

MC external

MC internal

MC external + internal

Socially efficient equilibrium

Competitive equilibrium

Public Goods• A good that is nonrival and nonexclusionary in

consumption. Nonrival: A good which when consumed by one person does not preclude other people from also consuming the good.

• Example: Radio signals, national defenseNonexclusionary: No one is excluded from consuming the good once it is provided.

• Example: Clean air

• “Free Rider” ProblemIndividuals have little incentive to buy a public good because of their nonrival & nonexclusionary nature.

Public Goods

Streetlights

Total demand for streetlights

Individual Consumer Surplus

0 12 30

MC of streetlights

Individual demand for streetlights

Incomplete Information• Participants in a market that have

incomplete information about prices, quality, technology, or risks may be inefficient.

• The Government serves as a provider of information to combat the inefficiencies caused by incomplete and/or asymmetric information.

Government Policies Designed to Mitigate Incomplete

Information• OSHA• SEC• Certification• Truth in lending• Truth in advertising• Contract enforcement

Rent Seeking

• Government policies will generally benefit some parties at the expense of others.

• Lobbyists spend large sums of money in an attempt to affect these policies.

• This process is known as rent-seeking.

An Example: Seeking Monopoly Rights

• Firm’s monetary incentive to lobby for monopoly rights: A

• Consumers’ monetary incentive to lobby against monopoly: A+B.

• Firm’s incentive is smaller than consumers’ incentives.

• But, consumers’ incentives are spread among many different individuals.

• As a result, firms often succeed in their lobbying efforts.

Consumer Surplus

A = Monopoly Profits

B = Deadweight Loss

Quotas and TariffsQuota

Limit on the number of units of a product that a foreign competitor can bring into the country.

• Reduces competition, thus resulting in higher prices, lower consumer surplus, and higher profits for domestic firms.

TariffsLump sum tariff: a fixed fee paid by foreign firms to enter the domestic market.Excise tariff: a per unit fee on each imported product.

• Causes a shift in the MC curve by the amount of the tariff which in turn decreases the supply of all foreign firms.

Conclusion

• Market power, externalities, public goods, and incomplete information create a potential role for government in the marketplace.

• Government’s presence creates rent-seeking incentives, which may undermine its ability to improve matters.

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