EC 170 Industrial Organization

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					        Econ 310A
  Industrial Organization
         Chapter 1
 Based on George Norman’s Lecture
We will have a very short discussion of
Chapter 1.3 (PRN p32-43). I won’t test
   you contents on Chapter 1.3 &
         Appendix (p48-52).
• How firms behave in markets
• Whole range of business issues
  –   price of flowers
  –   which new products to introduce
  –   merger decisions
  –   methods for attacking or defending markets
• Strategic view of how firms interact
• How should a firm price its product given
  the existence of rivals?
• How does a firm decide which markets to
• Trial of the century:Microsoft Case (Ch4)
   Issue: Bundling of its Windows operating
  system with its Web browser, Internet
  Explorer, and to sell the two as one product.
• Rely on the tools of game theory
   – focuses on strategy and interaction
• John Maynard Keynes : “ the theory of economics does
  not furnish a body of settled conclusions immediately applicable
  to policy. It is a method rather than a doctrine, an apparatus of
  the mind, a technique of thinking which helps its possessor to
  draw correct conclusion.”
• Modern industrial economics, or the new
  industrial organization (IO), is just that, a
  technique of thinking or a means of thinking
  strategically and applying the insights of such
  analysis to the field of IO.
      Efficiency and Market
• Contrast two polar cases
  – perfect competition (leads to an efficient market
  – Monopoly (leads to an inefficient market
  – Major justifications for the key role that antitrust
    policy plays in most market economies
• What is efficiency? (Pareto Optimality)
  – no reallocation of the available resources makes
    one economic agent better off without making
    some other economic agent worse off
  • Focus on profit maximizing behavior of firms
  • Take as given the market demand curve
                               $/unit   Maximum willingness
                                              to pay
          Equation:            A
         P = A - B.Q
                           P1                               slope
        Linear Inverse
       Demand Function
• short-run vs. long-run
• Equilibrium: no one has                Q1                   A/B
  an incentive to change his
  or her decision ( P 5)                      At price P1 a consumer
                                              will buy quantity Q1
           1.1.1 Perfect Competition
• Firms and consumers are price-takers
• Each firm’s potential supply of the product is small relative
  to market demand for the product.
• Firm can sell as much as or as little as it likes at the ruling
  market price (p 6)
   – do need the idea that firms believe that their actions will not affect
     the market price
• A perfectly competitive firm faces a horizontal demand
  curve even though the demand curve confronting the
  industry is downward sloping.
• Therefore, marginal revenue equals price (P=MR)
• To maximize profit a firm of any type must equate
  marginal revenue with marginal cost (MR=MC)
• So in perfect competition price equals marginal cost
•   Profit is p(q) = R(q) - C(q)
•   Profit maximization: dp/dq = 0 (FOC)
•   This implies dR(q)/dq - dC(q)/dq = 0
•   But dR(q)/dq = marginal revenue
•       dC(q)/dq = marginal cost
•   So profit maximization implies MR = MC
•   We know P=MR, therefore P=MC
• MR = MC  P = MC
     Perfect competition: an illustration
                        (a) The Firm                           (b) The Industry
With market price PC
        $/unit                   •                  $/unit
 the firm maximizes
   profit by setting             •Existing firms maximize               Now assume that
MR (= PC) = MC and                                                          demand
                                     profits by increasingD                     S1
                                                                          increases to
producing quantity qc                                      1
                                         output to q1
                                          AC                                   D2

      P1                                            P1                                  S2
                                     Excess profits induce
                                      new firms to enter
                                         the market                               D2

                         qc q1          Quantity               QC     Q1 Q´C       Quantity
With market demand D1 and market supply S1
Then, the equilibrium price is PC and quantity is QC

With market demand D2 and market supply S1
Then, the equilibrium price is P1 and quantity is Q1

The supply curve moves to the right
Price falls
Entry continues while profits exist
Long-run equilibrium is restored at price PC and
  supply curve S2
    Perfect competition: additional
• Derivation of the short-run supply curve
   – this is the horizontal summation of the individual firms’
     marginal cost curves
                                    $/unit   Firm 3
                                                      Firm 1
    Example 1: Three firms
                                                         Firm 2
             q = = 4q - 2
     Firm 1: MCMC/4+ 8
             q = = 2q - 4
     Firm 2: MCMC/2+ 8
             q = = 6q - 4/3
     Firm 3: MCMC/6+ 8
     Invert these
     Aggregate: Q= q1+q2+q3
                 = 11MC/12 - 22/3
             MC = 12Q/11 + 8                                   Quantity
    Example 2: Eighty firms   $/unit     Firm i

               q = = 4q - 2
    Each firm: MCMC/4+ 8

    Invert these
  Aggregate: Q= 80q
              = 20MC - 160
          MC = Q/20 + 8

• Definition of normal profit
  – not the same as zero (economic) profit
  – implies that a firm is making the market return on
    the assets employed in the business
See Practice Problem 1.1
  • The only firm in the market
      – market demand is the firm’s demand
      – output decisions affect market clearing price
At price P1
consumers                                                      Marginal revenue from a
buy quantity                                                    change in price is the
                             Loss of revenue from the
                                                               net addition to revenue
   Q1                        reduction in price of units
                              currently being sold (L)          generated by the price
               P1                                                  change = G - L
               P2                         Gain in revenue from the sale
At price P2                                  of additional units (G)
consumers                        G
buy quantity                                        Demand
   Q2                       Q1       Q2
                       Monopoly (cont.)
   • Derivation of the monopolist’s marginal revenue

       Demand: P = A - B.Q              $/unit
Total Revenue: TR = P.Q = A.Q - B.Q2    A
Marginal Revenue: MR = dTR/dQ
               So MR = A - 2B.Q

   With linear demand the marginal
    revenue curve is also linear with
        the same price intercept
   but twice the slope of the demand                  Quantity
                  curve                          MR
  Monopoly and profit maximization
• The monopolist maximizes profit by equating
  marginal revenue with marginal cost
• This is a two-stage process
                                          Stage 1: Choose output where MR = MC
                                               This gives output QM
                          Output by the
                                        Stage 2: Identify the market clearing price
                        monopolist is less
                        than the perfectly     This gives price PM
      PM                        AC
                            output QC           MR is less than price
                                                Price is greater than MC: loss of
    ACM                                         Price is greater than average cost
                                                      Positive economic profit
                     QM QC             Quantity       Long-run equilibrium: no entry
            Derivation Checkpoint (P13)

• Competitive Firm’s Problem

• Monopoly Firm’s Problem
    1.1.3 Profit today versus profit tomorrow

• Money today is not the same as money tomorrow
  – need way to convert tomorrow’s money into today’s
  – important since firms make decisions over time
     • is it better to make profit now or invest for future profit?
     • how should investment in durable assets be judged?
  – sacrificing profit today imposes a cost
     • is this cost justified?
• Techniques from financial markets can be applied
  – the concept of discounting and present value
        The concept of discounting
• Take a simple example:
  –   you have $1,000
  –   this can be deposited in the bank at 5% per annum interest
  –   or it can be loaned to a start-up company for one year
  –   how much will the start-up have to contract to repay?
  –   $1,000 x (1 + 5/100) = $1,000 x 1.05 = $1,050
• More generally:
  – you have a sum of money Y
  – can generate an interest rate r per annum (in the
    example r = 0.05)
  – so it will grow to Y(1 + r) in one year
  – but then Y today trades for Y(1 + r) in one year’s time
• Put this another way:
   – assume an interest rate of 5% per annum
   – the start-up contracts to pay me $1,050 in one year’s time
   – how much do I have to pay for that contract today?
   – Answer: $1,000 since this would grow to $1,050 in one year
   – so in these circumstances $1,050 in one year is worth $1,000
   – the current price of the contract is $1,050/1.05 = $1,000
   – the present value of $1,050 in one year’s time at 5% is $1,000
• More generally
   – the present value of Z in one year at interest rate r is Z/(1 + r)
• The discount factor is defined as R = 1/(1 + r)
• The present value of Z in one year is then R.Z
• What if the loan is for two years?
   –   How much must start-up promise to repay in two years’ time?
   –   $1,000 grows to $1,050 in one year
   –   the $1,050 grows to $1,102.50 in a further year
   –   so the contract is for $1,102.50
   –   note: $1,102.50 = $1,000 x 1.05 x 1.05 = $1,000 x 1.052
• More generally
   – a loan of Y for 2 years at interest rate r grows to Y(1 + r)2 =
        • Y today grows to Y/R2 in 2 years
   – a loan of Y for t years at interest rate r grows to Y(1 + r)t = Y/Rt
        • Y today grows to Y/Rt in t years
• Put another way
   – the present value of Z received in 2 years’ time is R2Z
   – the present value of Z received in t years’ time is RtZ
• Now consider how to evaluate an investment
   – generates Z1 net revenue at the end of year 1
   – Z2 net revenue at the end of year 2
   – Z3 net revenue at the end of year 3 and so on for T
• What are the net revenues worth today?
   –   Present value of Z1 is RZ1
   –   Present value of Z2 is R2Z2
   –   Present value of Z3 is R3Z3 ...
   –   Present value of ZT is RTZT
   –   so the present value of these revenue streams is:
   –   PV = RZ1 + R2Z2 + R3Z3 + … + RTZT
• Two special cases can be considered
   Case 1: The net revenues in each period are identical
   Z1 = Z2 = Z3 = … = ZT = Z
   Then the present value is:

   PV =             (R - RT+1)
            (1 - R)
   Case 2: These net revenues are constant and perpetual
   Then the present value is:

   PV = Z            = Z/r
             (1 - R)
           Present value and profit
• Present value is directly relevant to profit
• For a project to go ahead the rule is
   – the present value of future income must at least cover
     the present value of the expenses in establishing the
• The appropriate concept of profit is profit over the
  lifetime of the project
• The application of present value techniques selects
  the appropriate investment projects that a firm
  should undertake to maximize its value
        Efficiency and Surplus
• Can we reallocate resources to make some individuals
  better off without making others worse off?
• Need a measure of well-being
   – consumer surplus: difference between the maximum
     amount a consumer is willing to pay for a unit of a good and
     the amount actually paid for that unit
   – aggregate consumer surplus is the sum over all units
     consumed and all consumers
   – producer surplus: difference between the amount a
     producer receives from the sale of a unit and the amount
     that unit costs to produce
   – aggregate producer surplus is the sum over all units
     produced and all producers
   – total surplus = consumer surplus + producer surplus
       Efficiency and surplus: illustration
 The demand curve measures the      $/unit
 willingness to pay for each unit
 Consumer surplus is the area
 between the demand curve and the
 equilibrium price

                                                         Equilibrium occurs
 The supply curve measures the           surplus
                                    PC                   where supply equals
 marginal cost of each unit                               demand: price PC
 Producer surplus is the area                               quantity QC
 between the supply curve and the
 equilibrium price
Aggregate surplus is the sum of
consumer surplus and producer surplus
                                                    QC          Quantity
 The competitive equilibrium is
 Illustration (cont.) (Explanation on p 24)
Assume that a greater quantity QG    $/unit
is traded                                     The net effect is a   Competitive
Price falls to PG                             reduction in total      Supply
Producer surplus is now a positive
and a negative part

Consumer surplus increases           PG
Part of this is a transfer from
producers                                                              Demand
Part offsets the negative producer
                                                     QC      QG       Quantity
           Deadweight loss of Monopoly
Assume that the industry is          $/unit
The monopolist sets MR = MC to                                         Competitive
give output QM                                                           Supply
                                              This is the deadweight
The market clearing price is PM                 loss of monopoly

Consumer surplus is given by this
And producer surplus is given by     PC
this area

The monopolist produces less                                              Demand
surplus than the competitive
industry. There are mutually
beneficial trades that do not take            QM     QC MR               Quantity
place: between QM and QC
     Deadweight loss of Monopoly (cont.)
• Why can the monopolist not appropriate the deadweight
   – Increasing output requires a reduction in price
   – this assumes that the same price is charged to everyone.
• The monopolist creates surplus
   – some goes to consumers
   – some appears as profit
• The monopolist bases her decisions purely on the surplus
  she gets, not on consumer surplus
• The monopolist undersupplies relative to the competitive
• The primary problem: the monopolist is large relative to
  the market
               A Non-Surplus Approach
•   Take a simple example (p 29)
•   Monopolist owns two units of a valuable good
•   There are 50,000 potential buyers
•   Reservation prices:
     Number of Buyers               Reservation Price
           First 200                      $50,000
           Next 40,000                    $30,000
           Last 9,800                     $10,000
    Both units will be sold at $50,000; no deadweight loss
    Why not?      Monopolist is small relative to the market.
                   Example (cont.)
• Monopolist still has 2 units
• Reservation prices:
  Number of Buyers              Reservation Price
       First 1                        $50,000
       Next 49,999                    $10,000

Now there is a loss of efficiency and so deadweight loss
no matter what the monopolist does.
• The Competition Act ( C-34, 1985)
An Act to provide for the general regulation of trade and
 commerce in respect of conspiracies, trade practices and
 mergers affecting competition.
The Competition Tribunal
The Tribunal consists of judicial members appointed from
  the Federal Court, Trial Division and lay members. The
  Tribunal has exclusive jurisdiction to hear application in
  respect of reviewable practices and specialization
  agreements under Part VIII of the Competition Act.
                         Part I Purpose
1.1 The purpose of this Act is to maintain and encourage
   competition in Canada
 in order to promote the efficiency and adaptability of the
   Canadian economy,
in order to expand opportunities for Canadian participation
   in world markets while at the same time recognizing the
   role of foreign competition in Canada,
in order to ensure that small and medium-sized enterprises
   have an equitable opportunity to participate in the
   Canadian economy and
in order to provide consumers with competitive prices and
   product choices.
                        PART VI
45. (1) Every one who conspires, combines, agrees or
  arranges with another person
• (a) to limit unduly the facilities for transporting,
  producing, manufacturing, supplying, storing or
  dealing in any product,
• (b) to prevent, limit or lessen, unduly, the
  manufacture or production of a product or to
  enhance unreasonably the price thereof,
• (c) to prevent or lessen, unduly, competition in
  the production, manufacture, purchase, barter,
  sale, storage, rental, transportation or supply of
  a product, or in the price of insurance on
  persons or property, or
• (d) to otherwise restrain or injure competition
• is guilty of an indictable offence and liable to
  imprisonment for a term not exceeding five
  years or to a fine not exceeding ten million
  dollars or to both.
   1.3 US.Anti-trust Policy: an overview
• Need for anti-trust policy recognized by Adam
  Smith (1776)
• Smith had written on both monopoly and collusion
  among ostensibly rival firms:
   – “The monopolists, by keeping the market constantly
     understocked, by never fully supplying the effectual
     demand, sell their commodities much above the
     natural price.”
   – “People of the same trade seldom meet together, even
     for merriment or diversion, but the conversation ends
     in a conspiracy against the public, or in some
     contrivance to raise prices.”
• Sherman Act 1890
  – Section 1: prohibits contracts, combinations and
    conspiracies “in restraint of trade”
  – Section 2: makes illegal any attempt to monopolize a
  – contrast per se rule
     • collusive agreements/price fixing
  – rule of reason
     • “unreasonable” conduct
• Clayton Act (1914)
  – intended to prevent monopoly “in its incipiency”
  – makes illegal practices that “may substantially
    lessen competition or tend to create a monopoly”
• Federal Trade Commission (1914)
  - Endowed with powers of investigation and
    adjudication to handle to handle Clayton Act
    violations and also outlaws “ unfair methods of
    competition” and “unfair and deceptive acts or

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