Introduction to Microeconomics: How markets work. Pedro Ferreira Professor ECE Instituto Superior Técnico

Transcription

1 Introduction to Microeconomics: How markets work Natural Monopolies Pedro Ferreira Professor ECE Instituto Superior Técnico

2 Supply, Demand, Equilibrium, Surplus

3 Supply, Demand, Equilibrium, Surplus

4 Supply, Demand, Equilibrium, Surplus

5 Monopoly

6 Monopoly

7 Price Discrimination In first degree price discrimination, price varies by customer. This arises from the fact that the value of goods is subjective. A customer with low price elasticityis less deterred by a higher price than a customer with high price elasticity of demand. As long as the price elasticity (in absolute value) for a customer is less than one, it is very advantageous to increase the price: the seller gets more money for fewer goods. With an increase of the price elasticity tends to rise above one. One can show that in the optimum the price, as it varies by customer, is inversely proportional to one minus the reciprocal of the price elasticity of that customer at that price. This assumes that the consumer passively reacts to the price set by the seller, and that the seller knows the demand curve of the customer. In practice however there is a bargainingsituation, which is more complex: the customer may try to influence the price, such as by pretending to like the product less than he or she really does, and by threatening not to buy it. An alternative way to understand First Degree Price Discriminationis as follows: This type of price discrimination is primarily theoretical because it requires the seller of a good or service to know the absolute maximum price that every consumer is willing to pay. As above, it is true that consumers have different price elasticities, but the seller is not concerned with such. The seller is concerned with the maximum willingness to pay (or reservation price) of each customer. By knowing the reservation price, the seller is able to absorb the entire market surplus, thus taking all consumer surplus from the consumer and transforming it into revenues. From a social welfare perspective, first degree price discrimination is not undesirable. That is, the market is still entirely efficient and there is no deadweight lossto society. However, it is the complete opposite of a perfectly competitive market. In a perfectly competitive market, the consumers receive the bulk of surplus. In a market with first degree price discrimination, the seller(s) capture all surplus. Efficiency is unchanged but the wealth is transferred. This type of market does not much exist in reality, hence it is primarily theoretical.

8 Price Discrimination In second degree price discrimination, price varies according to quantity sold. Larger quantities are available at a lower unit price. This is particularly widespread in sales to industrial customers, where bulk buyers enjoy higher discounts. Additionally to second degree price discrimination, sellers are not able to differentiate between different types of consumers. Thus, the suppliers will provide incentives for the consumers to differentiate themselves according to preference. As above, quantity "discounts", or nonlinear pricing, is a means by which suppliers use consumer preference to distinguish classes of consumers. This allows the supplier to set different prices to the different groups and capture a larger portion of the total market surplus. In third degree price discrimination, price varies by location or by customer segment, or in the most extreme case, by individual customer. Additionally to third degree price discrimination, the supplier(s) of a market where this type of discrimination is exhibited are capable of differentiating between consumer classes. Examples of this differentiation are student or senior "discounts". For example, a student or a senior consumer will have a different willingness to pay than an average consumer, where the reservation price is presumably lower because of budget constraints. Thus, the supplier sets a lower price for that consumer because the student or senior has a more elastic price elasticity of demand (see the discussion of price elasticity of demand as it applies to revenues from the first degree price discrimination, above). The supplier is once again capable of capturing more market surplus than would be possible without price discrimination.

9 Cournot Competition Cournotcompetitionis an economicmodel used to describe an industry structure in which companies compete on the amount of output they will produce, which they decide on independently of each other and at the same time. It is named after Antoine Augustin Cournot( ). It has the following features: There is more than one firm and all firms produce a homogeneous product; Firms do not cooperate, i.e. there is no collusion; Firms have market power, i.e. each firm's output decision affects the good's price; The number of firms is fixed; Firms compete in quantities, and choose quantities simultaneously; The firms are economically rational and act strategically, usually seeking to maximize profit given their competitors' decisions.

10 Cournot Competition

11 Cournot Competition

12 Bertrand Competition Bertrand competitionis a model of competitionused in economics, named after Joseph Louis François Bertrand( ). Specifically, it is a model of price competition between duopolyfirms which results in each charging the price that would be charged under perfect competition, known as marginal cost pricing. The model has the following assumptions: There are at least two firms producing homogeneous products; Firms do not cooperate; Firms have the same marginal cost(mc); Marginal cost is constant; Demandis linear; Firms compete in price, and choose their respective prices simultaneously; There is strategic behavior by both firms; Both firms compete solely on price and then supply the quantity demanded; Consumers buy everything from the cheaper firm or half at each, if the price is equal.

13 Bertrand Competition

14 Bertrand Competition

15 Stackelberg Competition The Stackelbergleadership modelis a strategic game in economicsin which the leader firm moves first and then the follower firms move sequentially. It is named after the German economist Heinrich Freiherrvon Stackelbergwho published Market Structure and Equilibrium (Marktformund Gleichgewicht)in 1934 which described the model.

16 Herfindahl-Hirschman Index Formula: where s i is the market share of firm iin the market, and Nis the number of firms. Thus, in a market with two firms that each have 50 percent market share, the Herfindahlindex equals = 1/2. HHI ranges from 1/Nto one, where Nis the number of firms in the market. A small index indicates a competitive industry with no dominant players. If all firms have an equal share the reciprocal of the index shows the number of firms in the industry. HHI below 0.1 (or 1,000) indicates an un-concentrated index. HHI index between 0.1 to 0.18 (or 1,000 to 1,800) indicates moderate concentration. HHI index above 0.18 (above 1,800) indicates high concentration.

17 Herfindahl-Hirschman Index Problems The usefulness of this statistic to detect and stop harmful monopolies however is directly dependent on a proper definition of a particular market (which hinges primarily on the notion of substitutability). For example, if the statistic were to look at a hypothetical financial services industry as a whole, and found that it contained 6 main firms with 15% market share apiece, then the industry would look nonmonopolistic. However, one of those firms handles 90% of the checking and savings accounts and physical branches (and overcharges for them because of its monopoly), and the others primarily do commercial banking and investments. In this scenario, people would be suffering due to a market dominance by one firm; the market is not properly defined because checking accounts are not substitutable with commercial and investment banking. The problems of defining a market work the other way as well. To take another example, one cinema may have 90% of the movie market, but if movie theatres compete against video stores, pubs and nightclubs then people are less likely to be suffering due to market dominance. Another typical problem in defining the market is choosing a geographic scope. For example, firms may have 20% market share each, but may occupy five areas of the country in which they are monopoly providers and thus do not compete against each other. A service provider or manufacturer in one city is not necessarily substitutable with a service provider or manufacturer in another city, depending on the importance of being local for the business for example, telemarketing services are rather global in scope, while shoe repair services are local. The United Statesuses the Herfindahlindex to determine whether mergersare equitable to society; increases of over points generally provoke scrutiny.

18 Herfindahl-Hirschman Index Intuition When all the firms in an industry have equal market shares, H = 1/N. HHI is correlated with the number of firms in an industry because its lower bound when there are N firms is 1/N. An industry with 3 firms cannot have a lower HHI than an industry with 10 firms when firms have equal market shares. But as market shares of the 10-firm industry diverge from equality the HHI can exceed that of the equal-market-share 3-firm industry. A higher Herfindahlsignifies a less competitive industry. Decomposition The index can be expressed as where nis the number of firms and Vis the statistical variance of the firm shares, defined as. If all firms have equal (identical) shares (that is, if the market structure is completely symmetric, in which case s i = 1/nfor all i) then Vis zero and Hequals 1/n. If the number of firms in the market is held constant, then a higher variance due to a higher level of asymmetry between firms' shares (that is, a higher share dispersion) will result in a higher index value.

19 Herfindahl-Hirschman Index Intuition When all the firms in an industry have equal market shares, H = 1/N. HHI is correlated with the number of firms in an industry because its lower bound when there are N firms is 1/N. An industry with 3 firms cannot have a lower HHI than an industry with 10 firms when firms have equal market shares. But as market shares of the 10-firm industry diverge from equality the HHI can exceed that of the equal-market-share 3-firm industry. A higher Herfindahlsignifies a less competitive industry. Decomposition The index can be expressed as where nis the number of firms and Vis the statistical variance of the firm shares, defined as. If all firms have equal (identical) shares (that is, if the market structure is completely symmetric, in which case s i = 1/nfor all i) then Vis zero and Hequals 1/n. If the number of firms in the market is held constant, then a higher variance due to a higher level of asymmetry between firms' shares (that is, a higher share dispersion) will result in a higher index value.

20 Economies of Scale Economies of scale, in microeconomics, are the cost advantages that a business obtains due to expansion. They are factors that cause a producer s average cost per unit to fall as output rises. Diseconomies of scaleare the opposite. Economies of scale may be utilized by any size firm expanding its scale of operation. The common ones are purchasing(bulk buying of materials through long-term contracts), managerial (increasing the specialization of managers), financial (obtaining lower-interestcharges when borrowing from banks and having access to a greater range of financial instruments), and marketing(spreading the cost of advertising over a greater range of output in media markets). Each of these factors reduces the long run average costs.

21 Natural Monopoly A natural monopolyis often defined as a firm which enjoys economies of scale for all reasonable firm sizes; because it is always more efficient for one firm to expand than for new firms to be established, the natural monopoly has no competition. Because it has no competition, it is likely the monopoly has significant market power. Hence, some industries that have been claimed to be characterized by natural monopoly have been regulated or publicly-owned.

22 Network Externalities In economicsand business, a network effect(also called network externality) is the effect that one user of a goodor servicehas on the valueof that product to other people. The classic example is the telephone. The more people own telephones, the more valuable the telephone is to each owner. This creates a positive externalitybecause a user may purchase their phone without intending to create value for other users, but does so in any case. The expression "network effect" is applied most commonly to positive network externalities as in the case of the telephone. Negative network externalities can also occur, where more users make a product less valuable, but are more commonly referred to as "congestion" (as in traffic congestion or network congestion). Over time, positive network effects can create a bandwagon effectas the network becomes more valuable and more people join, in a positive feedback loop.

23 Network Externalities

24 Network Externalities

25 Part 1: Fundamentals of Microeconomics INTRODUCTION: supply, demand, surplus, efficient market PART II: Monopoly pricing, price discrimination, competition models PART III: Economies of scale, natural monopoly, network externalities Additional: Game theory, Nash equilibrium