Prof. Wolfram Elsner Faculty of Business Studies and Economics iino Institute of Institutional and Innovation Economics. Real-World Markets

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1 Prof. Wolfram Elsner Faculty of Business Studies and Economics iino Institute of Institutional and Innovation Economics Real-World Markets

2 Readings for this lecture Required reading this time: Real-World Markets:, in: Elsner/Heinrich/Schwardt (2014): The Microeconomics of Complex Economies, Academic Press, pp The lecture and the slides are complements, not substitutes An additional reading list can be found at the companion website Geben Sie hier eine Formel ein. 2

3 Introduction Real-world markets are not simple, clear-cut, unique, or transparent. They are networks of directly interdependent agents, facing information problems, different problem structures, and uncertainty. Such situations are complex. 3

4 Introduction To protect themselves in such an environment, firms have various options to take strategic actions, e.g.: Size growth (technological factors can support this) Influencing customers and/or suppliers in production networks Avoidance of competition (through signals among competitors, or market segmentation, for instance) 4

5 Introduction Decentralized market systems thus tend to develop into power-based systems. Oligopolistic structures are the rule rather than the exception in real-world markets. Due to direct interdependence, turbulence can nevertheless remain a factor in the environment, though. 5

6 Factors leading to size and power Real-world markets exist in limited space, they are networks of (relatively few) directly interdependent agents. Technological factors in production tend to favor size growth. Informal collusion or formal cartelization help to avoid competition. It pays to try and deter new entrants. Network effects in consumption may favor structures with few suppliers. 6

7 Factors leading to size and power First-mover advantages favor few suppliers. Learning curves in production leading to cost reductions reinforce these advantages. Technological knowledge may be difficult to transfer, tacit knowledge can play an important part in production and distribution. Factors effects are cumulative, they can combine their influences. 7

8 A model of a monopoly market One firm produces the total supply in a market for one good. Its goal is to maximize its profit. Numerous buyers purchase the product. A demand function has a negative slope the higher the price, the lower the quantity that can be sold. The monopolist has market power: It can select its preferred point on the demand schedule (Cournot point) through its choice of output produced. 8

9 A model of a monopoly market Maximize profit π the difference between revenue R and cost C, all as function of quantity q: max π q = R q C(q) q From the first order condition we can derive the general rule for profit maximization (marginal revenue = marginal cost): MR = dr dq = dc dq = MC In contrast to the perfect market, the market-price changes when the monopolist changes output. 9

10 A model of a monopoly market The demand function is q = q(p), the inverse demand function hence p = p(q). Revenue is R(q) = p(q)q, and marginal revenue (using the product rule of differentiation): MR q = dr dq = d p q q dq = p + dp q = MC dq 10

11 A model of a monopoly market We can rearrange this expression as (ε is the price elasticity of demand): p + dp dp q q = p 1 + dq dq p = p dp dq p q p dp dq p q = p ε = MC The monopolist will offer a quantity for which marginal cost ist below the price in the market (as ε < 0). 11

12 A model of a monopoly market The expression can be rearranged to give the Amoroso- Robinson relation: p ε = p 1 1 ε = MC p = 1 MC 1 ε In the perfect market-benchmark case, price is equal to marginal cost. The higher price in the monopoly case, is inversely related to the elasticity of demand a company faces. 12

13 A model of a monopoly market We can analyze the welfare effects of monopoly markets as well, the benchmark case is the perfectly competitive market. Consumer surplus (CS): the difference between the price consumers are willing to pay and the price they have to pay Producer surplus (PS): the difference between unit cost and the price units are sold for (zero in a competitive market) 13

14 A model of a monopoly market Perfect market CS: ACF; Monopoly market CS: EDF; Monopoly market PS: ABDE; Welfare loss monopoly: BCD 14

15 Oligopoly models There are three standard oligopoly models, Cournot, Bertrand, and Stackelberg. In all models, few companies provide the supply of a homogenous good to a market with many buyers. Their individual decisions have an impact on the overall quantity supplied. Companies take their decisions at the beginning of a period. These cannot be changed during the period. 15

16 Oligopoly models In the Cournot model, companies decide simultaneously, how much to produce. Their combined output determines the market price. In the Bertrand model, companies set their prices. The one with the lowest price serves the entire demand. If more than one company (say, n) set an equally low price, each serves 1/n of total demand. In the Stackelberg model, companies decide sequentially, how much to produce. Earlier decisions are known to those who choose later. Combined output determines the market price. 16

17 Oligopoly models Cournot 2 companies, A and B. Let the inverse demand function be p(q)=a-bq, with positive parameters a and b, and q = q A + q B. Constant unit costs for both are c. The problem for A is (taking the decision of B as given): max a b q A + q B q A cq A q A 0 The resulting first order condition is (for B equivalently): a 2bq A bq B = c 17

18 Oligopoly models Cournot A firm s best response function (BR) shows its optimal amount of output given the output of the rest. Rearranging the FOC gives: q A BR q B = 1 2 q B BR q A = 1 2 a c b a c b q B q A Substituting one into the other gives the mutual best response: q A = q B = 1 a c 3 b 18

19 Oligopoly models Cournot We can compare this outcome to monopoly (M) and perfectly competitive (PC) market. As price is equal to MC (p = c) in a PC, the inverse demand schedule gives q PC = (a c)/b Solving for the monopoly solution above, gives q M = a c 2b Overall, thus: 1 2 a c b q M < 2 3 a c b q C < a c b q PC 19

20 Oligopoly models Cournot 20

21 Oligopoly models Bertrand In the Bertrand model, companies compete through price setting. For two companies, demand takes the form: q A p A, p B = q p A if p A < p B 0.5q p A if p A = p B 0 if p A > p B In the sole Nash equilibrium in this situation, price is equal to marginal cost and the companies split the market. 21

22 Oligopoly models Bertrand If there was a chance for one company to undercut the other, it would do so and attract the entire demand in the market to itself. If p A > c, it is advantageous to charge an amount just below that price for B. The limit to this dynamic is provided by marginal cost c, as negative profits result below. If cost structures differ, the cheaper producer can undercut the other slightly and service the entire market at the resulting price. 22

23 Oligopoly models Stackelberg The sequential decisions in the Stackelberg model allow the leader to ask how the follower will react to its decision. The reaction functions are the same as in the Cournot case (the basic maximization problem stays the same): q BR B q A = 1 a c q 2 b A Instead of substituting in the BR, we substitute this in A s profit function. 23

24 Oligopoly models Stackelberg This gives: max q A 0 a b q A a c b q A q A cq A 1 max q A 0 2 a + c bq A q A cq A 24

25 Oligopoly models Stackelberg Solving for the optimal quantities (from FOC for A, and BR for B) gives: a c q A = 2b a c q B = 4b The first mover advantage for the leader allows it higher profits. 25

26 Natural monopolies We find monopolies in a number of areas in the economic sphere. Why? A particularly stable set are the natural monopolies. Characterized by subadditive costs in production: m i=1 C q i < m n j=1 Cq j m < n with q i = q j = q n i=1 j=1 26

27 Natural monopolies Given such subadditivity, average costs fall with increased production. To avoid multiple investments, let one supplier provide the product in question and put regulations in place. Examples include all the classic public utilities products (gas, water, electricity, landline telephone, ) that rely on extensive networks for their delivery. 27

28 Natural monopolies 28

29 Natural monopolies 29

30 Natural monopolies 30

31 Sticky prices in oligopoly markets Prices tend to be sticky over time. Instead of asking how an equilibrium in one period may look, we can ask how companies behave in a stable market. Assume that competitors react differently to changes in prices, depending on whether another company raises or lowers its prices. The objective is to at least maintain market shares. 31

32 Sticky prices in oligopoly markets Then, price increases may not be met. Companies raising prices lose market share. Price decreases may be met. Market shares remain the same, revenue is reduced. Price competition does not make sense. 32

33 Sticky prices in oligopoly markets The demand function is kinked as a consequence. Standard demand schedules may not be useful under strategic interdependence. 33

34 Heterogenization and monopolistic competition Avoid price competition and bind customers more tightly competition through non-price variables. Creation of a niche -> market power therein. Niches occupied by imperfect substitutes. 34

35 Heterogenization and monopolistic competition The above refers to the monopolistic aspect. For the competitive character, free entry as long as profits are realized. Eventually, enough niches are occupied to drive prices down to average costs and profits down to zero. If entry barriers exist, companies may be able to protect their profits, an oligopoly with heterogeneous products results. 35

36 Opportunities for strategic behavior Companies have various non price-based options for (further) increasing control over their environment and strengthening their position. Some rooted in the character of production technology (e.g., increasing returns to scale). Others include: Brand strategies, niche creation Horizontal integration Deter entry Vertical integration. 36

37 Opportunities for strategic behavior These measures tend to increase the turbulence for all other companies in a market. This remains a noticeable factor, attempts to the contrary notwithstanding. Over time, though, some ways have been found for reducing direct interdependence among companies, e.g.: avoidance of product homogeneity. circumvention of price competition through various ways of instituting informal arrangements 37

38 Opportunities for strategic behavior Increasing action capabilities of companies has facilitated market segmentation. For consumers, this typically goes hand in hand with increased search and information costs. Competition shifts to competition for markets, as opposed to competition in markets. 38

39 Readings for the next lecture Required reading: Chapter 8: Game theory II, in: Elsner/Heinrich/Schwardt: Microeconomics of Complex Economies, pp For further readings visit the companion website 39