Economics. Session #1: Getting started. Getting started. About this lecture

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1 Prof. r. Hanno Beck Economics Session #1: Getting started 1 Getting started About this lecture How to study and why What is Economics? Catwalk: Germanys next To-Model 2 About this lecture 14 chaters every chater has one toic: basic ideas, examles, case studies, olitical imlications, discussion reading assingments: see syllabus for details you are suosed to do the reading assigments before the lecture reeat what you have learned in the lecture; answer uestions and discuss them with your fellow students Questions, comments: Office-Hours; ; after (or during) the lecture 3 1

2 How to study How many days do you need to finish your term aer / thesis? (Bühler, Griffin Ross 1994) Exectations: on average 34 days; otimistic students: 27 days real time needed to finish aer: 55 days Huh, you are not suosed to do such mistakes? A simle uestion: how do you ronounce the caital of Kentucky: Loo-ee-ville or Loo-iss-ville? how many Euros are you willing to bet that you know the right answer? Emirical findings: We suffer from overcon-fidence, illusion of control, and self serving bias 4 How to study Neuroeconomics: your brain has two different areas limbic system: affective system; basic survival; immediate satisfaction cognitive system (räfrontal Cortex): self-control; willower As long as the limbic systems rules our behavior (as it in fact does), we smoke, drink, eat to much on t learn enough, start learning to late Solution: self-committment tight schedule; learning routinely, regulary learning with fellow students learning with good students imrovesyour own grades (Sacerdote 2002) comare your learning goals with your real learning efforts by means of a diary romise yourself a reward (after you finished) 5 Why should you study? more money, restige The economics of education: going to university is like an investment a economics student costs Euro this is how an investment works: sacrifying consumtion today for more consumtion tomorrow Tuitition fees: an investor has to ay for his investment (class rooms, teaching staff, etc.). investments are usually financed by credit (bonds) or euity. This does not work for an investment in human caital because there is no collateral Tuitition fees: if your investment (your visit of the university) ays off, you are able to ay back your fees. As long as the return of teh investment is > than the costs of your investment it makes you better off A matter of fairness: who really ays if your studies are for free? 6 2

3 Homework: reading assignments Reading assignments: A letter from London At LSE, we don t have one single book for one course. The amount of literature is huge: 900 ages for three courses, that is 120 ages er day. For examle, the caital markets session reuires the reading of nine research Paers, seven articles from newsaers, selected readings from seven books lus the slides from the lecture. Source: F.A.Z. Please get all the slides and the literature you are suosed to read for this lecture. From now on, you ought to read all the reading assigments before the lecture. You have to read them anyway, so why not before the lecture? 7 What is economics? Economics is making best out of life The roblem with life: so many wishes, but so little means to fulfill these wishes. Economics means to organize an economy in order to reduce scarcity in the most efficient way Peole resond to incentives Economists think of eole as selfish beings rewards make them work; unishment makes them behave roerly Economists as olicy advisers Economics is not an selfish art: reducing scarcity is one common olitical goal. 8 What is economics? Why do we need models? They are like a ma to solve economic roblems Methods: ceteris aribus-analysis (holding other things constant ) make your assumtions transarent (eole maximize utility) make exlanations (how do eole maximize utility) make redictions (if you increase rices, consumtion will decrease) Three ways to craft a model: verbal descrition grahical reresentation mathematical reresentation (exact) Statistics: testing theories and models with emirical observation Positive vs. normative theory 9 3

4 Catwalk: Germanys next To-Model Brazilian to-model Gisele Bündchen is according to the Forbeslist the best-aid model of the world. She earns 33 million ollar (23,9 million euro) er year. Born in 1980, she is aid u to Euro er show. To-model Kate Moss is ranked as the second-best aid model. Aged 33, she earns 9 million ollar (6,5 millionen euro) er year. After leaving her friend, babyshambles-singer Pete oherty, and loosing her contracts with Burberry and Agent Provocateur she made a comeback: she is the new Chanel-girl. Heidi Klum earns 8 million ollar (5,8 million euro) er year. Born in Bergisch-Gladbach, she still is on the catwalk, doing romotion for several comamies and is hosting TV-shows ( Germany s Next Tomodel, Runway ). source: Gala 10 Ökonomisches enken: Germanys next To-Model A few uestions Ein aar Fragen: - warum wollen so viele Frauen Model werden? - warum werden Models so hoch bezahlt? - sollte man die Gehälter für Models nach oben begrenzen? 11 Prof. r. Hanno Beck Economics Session #2: Economic thinking 12 4

5 Economic thinking Scarcity, Incentives, roerty rights Oortunity costs Secialisation Economics, freedom and Markets 13 Economic thinking: Scarcity Scarcity: the cookie-exeriment - test erson is asked to try a cookie and to tell her willingness to ay for that cookie - Two grous: cookie-jar #1 ist full; cookie-jar #2 is almost emty - variation I: show a full jar, relace it with an almost emty jar - another exeriment: the toys-artitionwall-exeriment - Emirical findings: humans are focussed on scarce ressources - exlanations: - if other eole value something as valuable, then it must be valuable - scarcity means a loss of otions; eole don t like the idea of loosing otions (i.e. freedom) 14 Under discussion: scarcity Scarcity: Conseuences and olitical imlications why is coffee at Frankfurt Main station so exensive? And who earns the money from the exensive coffee? in 15. Century, the black death killed almost one-third of the oulation. Afterwards, wages increased; the system of serfdom and lords of the manor disaeared. Why? What justifies huge salaries and rofits? The ower of scarcity: If there is a deal to be done and one of the contractors is in ossesion of a scarce, uniue ressource, then the rofits will go to the owner of the scarce resource. Always ask yourself: who owns the scarce resource? 15 5

6 Economic thinking: Incentives Incentives: the cobra-effect In the 19th Century, the English government in India tried to fight a cobra-lague in India by aying money for every cobra caught. What haened? 1965: Unsafe at Any Seed by Ralh Nader forced a wide array of automobile safety legislation cars became much safer. Conseuence: the number of accidents increased. Two effects: More accidents, fewer drivers killed (side effect: more edestrians killed) Basic idea of economics: eole resond to incentives selfishness: eole tend to maximise their own utility olitics: if you want eole to behave in a certain way, watch out for the incentives they are exosed banning certain behavior: costs of controlling and rosecution; eole will always try to evade a ban Wrong incetives lead to a desaster: theory of oilsots 16 Case study: aying farmers for nothing Incentives: oilsot-theory E.g. agricultural olicy in the E.U.: goal: a minimum income for farmers olicy: guaranteed rices conseuence: excess suly next ste: destroying excess sully; aying farmers for not growing agricultural roducts Next ste: fraud conseuence: more and closer monitoring of farmers result: you are aying eole for not to work and sending a whole lot of money for controlling if they really do not work Oilsot-theory (W. Eucken): once you start with a wrong olicy, your mistakes start to sread over your economy like oil over water Homework: taking a cab 17 Taking a cab in Prague Homework: Taking a cab Journalists from the daily newsaer Mlada fronta nes claimed to be foreign tourists while taking a cab in Prague. In six out of ten cases, they were charged extremely high rices. In one case, they had to ay a rice eight times as high as the rice allowed. The city council of Prague said that it controlled 755 cab-drivers; 1.5 ercent of them charged a rice too high. How would you like to ay a cab-driver assuring that he will not cheat you? How do you think a hysician should be aid? 18 6

7 Economic thinking: roerty rights Proerty rights: ay the ier, call the tune why are there so many exensive restaurants in Frankfurt City and who is willing to ay for the exensive food? Who ays the bill? you: maybe you ll choose Mconalds instead your comany: you may order chamagne instead of table water If you have to ay your bill by yourself, you will take care of your exenses and your roerty Proerty rights ensure an efficient allocation of ressources; if your boss ays the restaurant, you make a decision about hisrooerty, not yours Private roerty is neccesary for a market-economy For a world without roerty rights see former easterneuroean socialist economies 19 Case study: Tokio Hotel serving for the army? Tokio Hotel: You re in the army now? Instead of staging concerts, Tom and Bill Kaulitz from Germany s most sucessfull o grou Tokio Hotel may soon be serving for the german army. They got their call-u-order recently, as Bild, a tabloid newsaer, wrote. We do not make any exetions for rominent eole, actors or musicians says Uwe Ullrich from the draft comission Stendal. If they don t show u at the recruiting station they may be forced by the olice to do so. (Source: Bild-Zeitung) 20 Oortunity costs Oortunity costs: should the german army draft Tokio Hotel? (from an economic oint of view) should Tiger Woods mow his own lawn? should you bake your own bread? the costs of some action might not be as obvious as it seems what about your time? oortunity costs of an item is what you give u to get that item. There is no free lunch whatever you choose to do, you do it at exense of the next best alternative So what is more exensive: comulsory military services or volunteers? 21 7

8 Homework: Too busy for university? Too busy for university? What do Bill Gates, avid Beckham an Kylie Minougue have in common? None of them has a university degree. In fact many extremely sucessfull eole esecially those in careers like acting or athletics, where starting early in life is esecially crucial do not attend university. On the other hand, Queen-guitarist Brain May just recently finished his Ph.. in astrohysics more than 30 years after he left university to rock the world. o you think Mr Beckham or Mrs. Minougue should have finisehd their studies before making a fortune? Should you leave university for a career as singer/manager? And do you think that it was clever from Mr. May to finish his Ph..? 22 Secialisation Secialisation: should Tiger Woods mow his own lawn? the rincile of secialisation: everybody should secialise in the activities he is best at the division of labor (i.e. secialisation) constitutes modern market economies: journalists, lawyers, car makers, baker etc. idea: everybody does what he is best at and trades the fruits of his work on the market division of labor is ALWAYS welfare-increasing division of labor on an international level: globalisation Ricardo: the rincile of comarative advantage 23 Economics, freedom and markets freedom as a value; eole want to enjoy the benefits of liberty efficiency needs freedom: voluntary contracts between rational, eually entiteled arties are welfare-maximising Problems eually entiteled artners? One needs to rotect wekaer arties and minorities rational arties: unintended, unforeseen conseuences of our actions contracts bothering third arties: enviromental olicy; seed limit to rotect other drivers here, olicy has to ste in and restrict ersonal freedom in order to rotect consumers, weak arties, third arties. Markets need additional olicy. 24 8

9 Economics, freedom and markets Policy to rotect weaker arties (labor market, information asymmetries, subsistence level) to rotect consumers from their selves (obligation to save for retirement, comulsory health insurance, drug olicy, education) to rotect third arties (enviromental olicy, seed limit) What should this olicy be designed? marginal utility should eual marginal costs efficient and effective use the ower of incentives instead of coercion 25 Economics, freedom and markets markets are secialisation: you can only secialise in what you are good at if you can exchange your roduction on an market therefore you need the right to exchange with whom you want and the right to choose the job you want to do the distribution of the gains from secialisation is done by the market according to the scarcity of the goods exchanged incentives: I will only exchange goods if it makes me better off and if I am sure that I can rea the benefits form this exchange. Therefore you need roerty rights (Art. 14 GG) A exchange of goods via markets makes both arties better of is is always welfare-increasing 26 Economics, freedom and markets what makes markets work cometition; no ower resulting from scarcity or monoolies rotection from sweating rational consumers and voters no externalities Policy to make markets work cometition olicy (GWB) Social rotection against hardshis of life (Art. 20 GG) consumer rotection; (alcohol, drugs etc.) rotection of third arties from externalities (enviromental olicies) 27 9

10 Prof. r. Hanno Beck Economics Session #3: How markets work 28 Homework: Taking a cab assenger: wants to get to his destination fast and chea cab driver: wants to maximise his income ay er hour: driving lot of roundabout ways or traveling at seed of light ay er kilometer: no good idea fixed rice: fear for your life bonus for reaching destination as fast as oassible: see fixed rice Fixed rice lus bonus if the assenger reaches destination without suffering from the roman disease Other examles: rofit sharing schemes in comanies; ayment of hysicains; managers salaries 29 Homework: Too busy for university? Oortunity costs: oortunity costs of an item is what you give u to get that item What about Bill,Kylie and avid? the costs of their studies are the foregone rofits from their career avid and Kylie: they are making their fortune in young years maybe they should go to university after they finished their active career Brian: leaving university for Queen was a good decision now, the Brians oortunity costs are decreasing due to the decreasing marignal utility of money (why?) Should you leave university? it deends on your oortunity costs it deends on the changes of making it to the charts / Bayern München; the higher the risk of failing, the closer you should stick to your studies 30 10

11 How markets work The hog-cycle The ath to euilibrium Suly and demand Markets in action 31 The hog cycle The year of the golden ig Economists are remebered of the so-called hog-cycle taught in economics-courses in the first year at university. It exlains why rices are volatile because roductions resonds not immideately to changes in demand. In 2004, the rice for igs was not higher than today. Then, high rices made farmers to raise more igs. In conseuence, rices droed dramatically, what in turn made farmers sto raising igs. As an inevitable result, the rice for ork increased to todays high level this may lead to lower rices in the next years. (Economist, June 9th 2007;. 59) 32 The hog cycle More examles: teachers, doctors How does this work, anyway? scarcity as a sign of demand for a roduct / service scarcity leads to higher rices higher rices as an incentive for roducers to increase roduction as long as he can reas the rofits from his increased roduction (roerty rights!) as rices rise, suly rises, which hels to reduce scarcity this haens only as long as rices are allowed to change and roducers are allowed to rofit from their increased efforts Result of free markets: euilibrium 33 11

12 The ath to euilibrium You are in a suermarket: which cash desk to choose? That s how markets work: Incentives (save time) trigger behavior (search for the shortest ueue); that will bring markets into euilibrium (all ueues do have the same exected time to wait) Incetives, roerty rights and freedom make diseuilibria dissaear sulier: seeks for rofit consumer: seeks for cheaest contract markets channel egoims of sulier and consumer to a social efficient result Adam Smith: invisible Hand In fact, there are two invisible hands: Suly and demand 34 Suly and demand A markets consists of consumers (demand) and roducers (suly) the rice is the crucial variable that coordinates suly with demand reuirements for well-functioning markets: free rices; no obstacles to changes in rices roerty rights, incentives freedom to choose job, sulier, contract artner cometitive marktes: no single sulier; no exloitation Grahical reresentation: Suly-demanddiagramm 35 Suly and demand rice uantity Law of demand: as decreases, increases substitiution Income-effect but: ceteris-aribusassumtion rice uantity demanded 36 12

13 Suly and demand rice uantity Law of suly: as increases, S increases, too Selling more romises more rofits but: ceteris-aribusassumtion rice S uantity sulied 37 Suly and demand rice S euilibrium: suly = demand Excess sully: S > Excess demand: > S rice S uantity 38 Markets in action old new Change of a exogenous variable: demand-curve shifts; loosening the ceteris-aribusassumtion This is not a movement along the curve (endogenous variable)

14 Markets in action The government decides to increase the tax on income The demand for Playstations: a new version enters the market The interest rate is rising The government introduces a new minimum wage legislation The rice of your laystation is increasing iscuss the demand-curve for hard drugs silicon 40 Case study: the BSE-crisis with the 1996 BSEcrisis, consumers switched from beef to ork farmers switched from rearing cows to igs what haened to the rice of beef? what haened to the rice of ork? S S 41 Case study: natural ressources For the last years, demand for natural ressources was steadily increasing Prices for natural ressources were steadily decreasing S S 42 14

15 Case study: drug olicy What can olitics do against drugconsumtion? More unishment, more rosecution more educational work What if government decides to give heroin to addicted eole for free? S S 43 Case study: chea food no more findings: Food-rices are rising Inventories are decreasing record cros worldwide Why are rices rising? China and India are getting richer; demand for meat is increasing; meat needs more grain as inut emand for (state-sonsored) biofuels increases bad harvest in Australia measurements olitics: rice controls; exort restruictions farmers: roducing gen-food; re-activate fallow lands 44 Case study: chea food no more emand curve shifts due to - increasing incomes - increasing demand for biofuels Suly curve shifts due to - bad harvest in australia - but: suly-curve may shift back due to reactivated fallow land S S 45 15

16 Case study: chea food no more Before rice controls and exort restrictions: - omestic suliers roduce S 1 ; exorts: S 1-1 sold at rice P 1 - Price controls; exort restrictions - rice decreases to 2 - demand increases - suly decreases - conseuences: more fallow land; smuggling; black markets 1 2 S 1 S 1 46 Homework: Beating the traffic Beating the traffic All big cities have traffic roblems, and many ities try to discourage eole from driving into the crowded city centre. If we think of a car journey into the city as a good that eole consume, one can use the economics of demand and suly as a tool to analyze antitraffic olicies. Here are a few strategies: One could reduce the rices of substitutes (making bus or rail-tickets cheaer) or raise the rice of comlements (high taxes on commercial car arks; shorter times on the arking meters). The city of London imosed a congestion charge on cars entering the city during the business hours. Some cities restrict the number of cars allowed to enter the city during the rush-hours. Show grahically what haens to the market for car journeys to the city if you imlement the olicies described above. 47 Prof. r. Hanno Beck Economics Session #4: Elasticities and welfare analysis 48 16

17 Homework: Beating the traffic Reducing demand by taxes on cararks; higher costs of arking in the city shifts demand curve to the left Lower rices for substitutes shift demand curve to the left What haens if the government decides to restrict the number of cars allowed to enter the city? S S 49 Elasticities and welfare-analysis Elasticity of demand Elastic and inelastic demand Other elasticities Consumer- and Producer-Surlus 50 Elasticitiy of demand Who needs rotection in social and economic life and why? tenants / lodgers emloyees What is the roblem with drugs? Should we sell life-saving medicine via markets and if not, why? What is exloitation and what is the root of it? 51 17

18 Elasticitiy of demand Basic idea of marktes: suly and demand react to changes in rices How can we measure the reaction of suly / demand to changes in rices? ( sensity of demand to rice changes ) We may use the absolute decline of demand (suly) er Euro decline of demand (suly) in ercent er Euro elasticities 52 Elasticitiy of demand Elasticity: ercent change in demand divided by the corresonding ercent change in its rice decreases by -20 % = -(5 4) / 5 demand increases by 11,11 % = (100 90) / 90 elasticity: 11,11 / (-20) = -0,55 If the rice decreases by one %, demand increases by 0,55 % unit-free number enables comarisons between different goods; PE is indeendent from the rice level Elasticitiy of demand What if the rice increases? increases by 25 % = (5 4) / 4 decreases by -10 % = -((100 90) / 100) elasticity: (-10) / 25 = -0,4 The value of PE deends on whether the rice increases or decreases solution: averaging

19 Elasticitiy of demand Price on average: (5 4) / 4,5 changes by 22 % average uantity: (100 90) / 95 changes by 10,5 % elasticity: 10,5 / 22 = 0,47 Lets omit the - -sign bow elasticity change in uantity mean uantity change in rice mean rice 5 4,5 4 elasizität Elasticity is NOT the sloe of a curve (ΔQ/Δ); but it is an imortant art of it: PE = (ΔQ/Δ) (/) Homework: some elasticities Oscar Angela demand demand Elastic and inelastic demand elasticity: if the rice decreases by one %, demand increases by Є % inelastic demand: Є < 1. (0,19) elastic demand: Є > 1 (1,6) Isoelastic demand: Є = 1. (113 90) / 101,5 (5 4) / 4,

20 Elastic and inelastic demand Comlete inelastic demand: demand does not react to a change in rice; Є = 0. E.g. drugs. Totally elastic demand: if increases only slightly, demand goes to zero;if decreases only slightly, eole every uantity offered. Є =. Perfect substitutes; demand in the case of olyol 58 Case study: hard and soft drugs Hard drugs (heroin): comletely inelastic demand Soft drugs: elastic demand (ott; alcohol, cigarettes) conseuence: drug olicy has to distingiush between hard and soft drugs rosecution: shift of the suly-curve. Hels with soft drugs; not with hard drugs education: shift of demandcurve; does not work that well with soft drugs because as decreases; demand increases again. Hels with hard drugs. S 59 Elastic and inelastic demand What determines elasticity of demand? Essentials or luxury goods travelling, restaurants gasoline, basic foods Availability of substitutes are there good substitutes? (I-Pod and telecom) Suly; i.e. cometition revents consumers from being exloited (GWB) Time gasoline: in the long rund demand is more elastic Cars (durables): in the long rund demand is more inelastic 60 20

21 Elastic and inelastic demand revenue: rice times uantity revenue at = 5: 90 * 5 = 450 revenue at P = 4: 100 * 4 = 400 revenue has decreased altthough demand has increased: reason: the decrease of the rice. Inelastic demand Elastic and inelastic demand revenue: rice times uantity revenue at = 5: 90 * 5 = 450 revenue at P = 4: 120 * 4 = 480 if demand is elastic; a decrease of rice increases revenues Elasticity of demand deends also on the actual rice as declines, PE declines, too Other elasticities Elasticity of suly %-change of uantity sulied divided by %-change of rice shows how suly reacts on changes of market data (how long does it take to close a ga between demand and suly?) ES is determined by availability of inuts, time, rofits income elasticity %-change of demand divided by %-change of income inferior goods: food (IE<1); suerior goods: travelling (IE>1) cross-rice-elasticity %-change of demand for good 1 sulied divided by %-change of rice for good 2 imortant for cometition olicy close substitutes: CPE is small and < 0; comlements: CPE >

22 Emirical estimates PE tomatoes 4,6 legal gambling 1,9 marijuana 1,5 cigarettes 0,51 cinema 0,87 IE cars 2,5 restaurant 1,4 clothes 1,0 margarine -0,2 source: Samuelson Home work: the boll weevil Boll Weevil Monument, Enterrise, Alabama From , the boll weevil, a bug from mexico, destroyed almost the entire harvest of the local cotton farmers, exsecially in Enterrise, Alabama. In december 1919, a monument was built in the heart of the city to remind of the bug. It was manufactured in Italy, the city ayed 1800 dollars for it. It is the only monument worldwide built in honor of a arasite. Why should the city build a monument in honor of the boll weevil? 65 Consumer- and roducer surlus emand curve reresents the willingness to ay of every single consumer; i.e the utility they derive from consuming the roduct What if the rice is below the willingness to ay?

23 Consumer- and roducer surlus If = 4 Euro, consumer #1 and 2 buys one unit; consumer #1 ays 4 Euro for something he is willing to ay 5 Euro this increases his total welfare by 1 Euro Is = 2 Euro, so the increase in welfare for #1 = 3 Euro #2 = 2 Euro #3 = 1 Euro Consumer- and roducer surlus Consumer surlus: welfare increases if is below the willingness of the consumer to ay If decreases, total welfare increases grahically: area between market rice and demand curve Consumer- and roducer surlus Suly curve reresents the willingness to offer a good for a given rice; i.e. his total costs what if is above costs? S

24 Consumer- and roducer surlus with = 2 euro, sulier #1 gains 1 on to; #2 just breaks even with = 4 Euro, the additional gains are: #1 three Euro #2 two Euro #3 one Euro #4 breaks even S Consumer- and roducer surlus Producer surlus: increase in roducers welfare, if market rice is above total costs of roduction if is increasing, total welfare increases, too grahically: area between suly curve and rice S Consumer- and roducer surlus CS and PS reresent consumers and roducers welfare from market transactions Overall welfare (OW): CS lus PS CS = total utility consumers receive from the good ayments to roducer PS = consumers ayments costs OW = total utility of consumers costs S

25 Markets revisited markets are efficient: if is above euilibrium rice, total utility consumers derive from consuming the good is larger than costs of roduction if is below euilibrium rice, total utility consumers derive from consuming the good is smaller than costs of roduction on markets, goods are allocated to the customers with the highest willingness to ay on markets, customers by at the comanies with the lowest costs (rice) remember: markets need freedom of coalition; freedom to buy where ever and what ever you want; freedom to sell what ever you want a which rice you want on markets, goods are only distributed by ability to ay, not by needs markets do not rovide euity 73 Case study: chea no more (revisited) Before rice controls and exort restrictions: - domestic suliers roduce S 1 ; exorts: S 1-1 sold at rice P 1 - PS: 0 1 B - CS: 1 CE - Price controls; exort restrictions - PS: 0 2 A; roducers lose 2 1 CBA - CS: 2 AE; consumers gain 2 1 CA - Net loss of welfare: CBA E 1 2 C A B S 0 1 S 1 74 Case study: chea food no more (revisited) E S 1 2 B C CS PS CS with PS Loss with exort of free welfare: restrictions: trade: C : E ABC : EB A A

26 Case study: organ donations Should one ay organ donors? Some eole would sent even without ay (S ) Those who receive an organ gain A, those who do not get one, loose B voluntary donators loose A; those who would sent their organs for ay loose C but: - who shall receive organs? - does a rofessional market for organs undermine the willingness to sent without ay? A S B C S Prof. r. Hanno Beck Economics Session #5: How markets work: Price controls and taxes 77 Homework elasticities: Oscar d dp M old +M new P old +P new 2 (3) / (5) (4) / (6) PE: (7) / (8) ,75-0,22-3, ,5 7 0,08-0,28-0, ,5 5 0,22-0,4-0, ,5 3 0,28-0,66-0,4 = uantity; =rice; dm=change of uantity; dp = change of rice; M old = uantity before change of rice; M new = uantity after change of rice; P old = old rice; P new = new rice 78 26

27 Homework elasticities: Angela d dp M old +M new P old +P new 2 (3) / (5) (4) / (6) PE: (7) / (8) ,22-4, ,4-0,28-1, , ,5 3 0,05-0,66-0,08 = uantity; =rice; dm=change of uantity; dp = change of rice; M old = uantity before change of rice; M new = uantity after change of rice; P old = old rice; P new = new rice 79 Homework: the boll weevil why should one built a monument for a arasite? the destruction of the harvest shifts the suly curve to the left. conseuence: revenues are increasing With inelastic demand, revenues are increasing Second reason: weevil made farmers switch to other roducts (eanuts) S S 80 Analysis of cometitive markets Price strategy and consumer surlus Price ceilings Minimum wages Taxes 81 27

28 Price strategy and consumer surlus Basic idea: caturing consumer surlus by charging customers according to their willingness to ay Two rices: exensive t and chea P b Old CS: A+B+C New CS: A+C Old PS: +E New PS: +E+ B t b N A B C E A M 82 Case study: hardcover or aerback? o you refer exensive brands? Müller Milchreis or Elite -Milchreis (40 %) Nestlé-Eis or Classic Choco Vanilla from Lidl? Hochland-Feta or Mitakos-Feta? Searate customers by their income (lawyers, consultants, families (ensioners) ay half the rice ) ifferent discounts to different customers (car sales) Slighty imerfect roducts with discount out-of-fashion roducts rofessional vs. homeworker edition hardcover vs. aerback edition Premium vs. non-remium brands Perfect rice discrimination: E-Bay 83 Price ceilings: rent control P Rent ceiling A E B C S Are rent controls a good idea to rotect tenants from exloitation?

29 Price ceilings: rent control Are rent controls a good idea to rotect tenants from exloitation? Rent ceiling: demand increases from m0 to m2 Suly decreases to m1 Excess demand m2 m1 PS: decreases by A+C; CS: increases by A deadweight loss: B+C A S B C rent ceiling m1 m0 m2 85 Price ceilings: rent control Rent controls make the economy as a whole worse off suly decreases; shortage of chea aartments increases (C) some tenants don t get an aartment anymore (B) If you get an aartment, you win (A), but on the exense of the landlord conseuences: Under-the-table-ayments; subcontracting in the long run: suly decreases even more who gets the chea aartment? The needy? 86 emand for labour (for hours worked) = L1, suly of labour (hours worked) = L2 unemloyment L2 L1 L1 hours are actually emloyed CS (rent of those who demand labour; i.e. emloyers) decreases by A (higher wages for those who still have a job) and B (those who loose their job due to higher wages) PS increases by A (higher wages for those who still have a job); decreases by C (those who loose their job ) eadweigh loss: B+C Minimum wages w w A E B C w min S L 1 L 0 L 2 29

30 Minimum wages Minimum wages hurt some workers; but do they hel all workers as a grou? Loss of PS for workers: A C If the demand curve is flat (elastic demand for labour) B > A, i.e. workers as a grou loose Emirical findings: demand for low-skilled labour is more or less elastic, because one can relace it with machines w min w w A B C S L1 L0 L2 L 88 Minimum wages You don t need minimum wages for high-skilled workers but for low-skilled workers. conseuences: total loss of welfare to workers as a gruo (B > A) wage sum: L min * workers ayed decreases if demand is elastic; wage increases, but the number of ersons receiving this higher wage dereases (see session #4) A few uestions concerning minimum wages: in Germay, we are talking about different minimum wages for different industries why, if the MW shall rovide workers with a minimum income to make their living? minimum wages for self-emloyed ersons? minimum wages lead to more unemloyment; but: what, if emloyers are able to ass the increased wages to their customers. If the demand for their roduct is inelastic, minimum wages don t lead to unemloyment; but the higher wages are aid by the customers 89 Minimum wages and social market economy Social market economy: use efficient markets and rovide social rotection by additional social olicy say: free wages, no minimum wages lus additional govermental ayments on the wage. Conseuences: no unemloyment social rotection is now ayed by the tax-ayer, not by comanies who emloy emloyees for minimum wages or their customers minimum wages in germany: Hartz IV Concets: so-called Kombilohnmodelle (Mainzer Model), negative income tax (USA) 90 30

31 Taxes Taxes / SSC make suly curve shift to S Consumers ay gross rice G, roducers receive net rice n. difference b n = t Consumers loose B+C roducers loose A+ tax revenues: B+A; shared by consumers (B) and roducers (A) C+ = excess burden; deadweigh loss of a tax G N E B A F C S t S Taxes Now: demand inelastic; suly elastic Tax burden (A+B) is now being shouldered mainly by the consumer (B) because of their dire need of the roduct the more inelastic art of the market bears the main burden of a tax Inelastic demand yields a larger tax revenue Inelastic demand: cigarettes, alcohol, gasoline so why are taxes on these goods so oular? G n B A S C 1 0 S 92 A sea of milk Homework: EU-agricultural olicy Since 1957, the Euroeam Union has a common agricultural olicy. The goal of this olicy was to rovide an income for farmers. Brussels romised to buy the entire roduction of dertain cros. Chea imorts from abroad were heavily taxed via tariffs. With the Uruguay-round, the EU was forced to change its system of agricultural subsidies and rice controls. Since 1993, farmers were ayed direct transfers. What haens if the EU romises to buy any roduction? Show the conseuences for consumer- and roducer-surlus

32 Prof. r. Hanno Beck Economics Session #6: Production 94 Homework: EU-agricultural olicy Government romises to buy the whole roduction for minimum rice min CS: loss of A, which is redistributed to roducers; loss of B for those who sto consuming PS: gain A+B+C Government: buys surlus roduction 2-1; i.e. totals costs are min (2-1) (seckled rectangle) Guess who ays this olicy? Net welfare loss: deends on what haens to the roduction the government buys min S A B C Production Production function Costs Cost function Shareholder and Stakeholder 96 32

33 Production function Why learning about roduction? Goal: efficent roduction; avoiding waste of time and inuts comanies need rofits to survive emloyees need comanies comanies lay a crucial role for emloyment and welfare of a country What do you need to know? roduction function costs owner, shareholder 97 Production function The jelly baby-exeriment your roduct: delivery of jelly-babys from chair A to B time: 15 seconds amount of workers variies we may use more caital Please write down the results of the exeriment total outut average outut (outut er worker) marginal roduct (additional outut roduced as inut is increased by one unit ) 98 Production function W = worker; MP = marginal roduct; AP = average roduct; TO = total outut #W TO AP MP

34 Production function w = worker; TO = total outut; AP = average roduct; MP = marginal roduct Law of diminishing returns: the more workers we use, the lower is the additional outut most times: starting with increasing MP, later on decreasing MP Sources: Synergies; division of labour; learning w TO AP MP , , , , , , , ,5 2,95 0,5 100 Production function TO w 101 Costs Costs: oortunity costs exlicit and imlicit costs (do not reuire a cash outlay) cost of caital: loans (interest) and euity (oortunity costs) measures of costs total costs fixed costs (do not vary with outut) variable costs (deend on outut) average costs (total costs divided by uantity of outut) marginal costs (increase of total costs that arises from an extra unit of roduction)

35 Costs Fixed costs = 100; wage: 10 er worker TO = total outut TC = total costs VC = variable costs AC = average costs MC = marginal costs (change of total costs / additional outut), i.e.: 5 = ( ) / (5-3) w TO TC VC AC MC , ,25 3, ,6 2, , ,95 1, ,54 3, , , , , Costs Most times: total cost curve is S-shaed i.e.: MC are decreasing at the beginning; they tend to increase with increased outut Reason: first increasing MP; decreasing MP as outut increases TC TO Cost function AC: decreasing at the beginning; increasing with increased outut Reason for decreasing AC: fixed costs alication: natural monoolies AC TO

36 Case study: The Bundesnetzagentur The federal agency for ostal services and telecommunication is resonsible for for ostal services, energy services and the telecommunications industry. Since January 2006 it is resonsible for the railway-infrastructure, too. It is obliged to assure that every cometitor has access to the infrastructure of its industry. Natural monoolies arise when there are huge fixed costs. They lead to a market where one comany is able to satisfy the whole market demand. The most visible natural monoolies are utilities (water, gas), electricity, and hone services. 106 Cost function MC: decreasing with small outut; increasing with increasing outut Reason for decreasing and (later) increasing MC: law of diminishing returns MC TO 107 Cost function - FC: fixed costs - AC: average costs - MC: marginal costs - AFC: average fixed costs - Minimum of average costs: where AC = MC (why?) AC MC 60 FC AFC outut

37 The Gummi Bear Homework: Jelly-Babies, Baby The Gummi Bear originates from Germany where it is hugely oular under the name Gummibär (rubber bear) or Gummibärchen (little rubber bear). Hans Riegel of Bonn invented bear-shaed sweets and started the Haribo comany in 1922, which first roduced and introduced its Gold-Bear roduct in the 1960s. In the United States, Haribo gummi bears usually come in rasberry (red), orange, strawberry (green), ineale (clear), and lemon (yellow), however, many offshoot comanies (tyically the health-related gummi bears) may use more exotic flavors and colors. Please comlete the table for the jelly-baby-exeriment. Calculate different costs (one worker is 5 ; fixed costs are 100 ) 109 Shareholder Value and Stakeholder Value Shareholder value the more rofit a comany earns, the more valuable it is a sucessfull comany is valuable idea: high market caitalisation means a valuable comany; i.e. a sucessfull comany goal: increase market value of the comany (market caitalisation = sharerice * number of shares roblems: short-term-thinking of shareholders (?); what about stakeholder s interets Stakeholder Value: interest of comanies business artners (workers, customers, government, creditors) 110 Case study: 12 million euros Why is Josef Ackermann earning 12 million Euro er year? scarcity? international cometition for excellent managementtalents? negligent shareholders? ( devil may care ) Why do shareholders not care about the income of the CEO one share, one vote small amount of shares, small influence on decicions concerning the comany why should you care about voting if your influence is that small similiar roblem with democracies

38 Shareholder Value and Stakeholder Value Should there be a legal limit on CEO s salaries? unearned income? Remember the suer-models lack of control by owner (shareholder) and suervisory board high salaries of CEO s lead to mistrust in market economies conseuences: lack of suly of good CEO s; under-thetable-ayments Other olicy measures shareholders: comulsory voting legal framework for salary schemes shareholder activism; esecially asset management firms education 112 Prof. r. Hanno Beck Economics Session #7: suly 113 Suly Revenue and rofit Profit maximisation Suly-curve and cometition Taxes, Social security contributions and suly

39 Revenue and rofit = uantity sulied; R= revenue; AR = average revenue; MR = marginal revenue rice is always the same and is 12 average revenue = revenue dividedby uantity sold ( er unit sold) marginal revenue = revenue added by the last unit sold R AR MR Profit maximisation the additional revenue from one more unit sold must at least eual the additional costs caused by the roduction of this unit i.e: if marginal revenue exceeds the marginal costs one should roduce one more unit if marginal revenue is below the marginal costs one should decrease roduction i.e.: rofit-maximum when marginal revenue euals marginal costs marginal revenue if the rice remains unchanged: (one unit roduced times its rice) P = MC alies as long as an increase (decrease) in suly does not lead to an decrease (increase) of the rice 116 Profit maximisation P TC R MC MR Pr MR-MC

40 Profit maximisation Profit-maximisation where = MC (B) Revenue = uantities sold G * ; i.e. OEB G Total costs: costs er unit (=average costs) * ; i.e. OC G rofit: revenue minus costs, i.e. EBC in the long run cost must at least eual revenues; i.e. = minimum rice roducer must charge in the long run if < AC (), the comany should exit the market P; MC; AC P E O MC B C G AC 118 Profit maximisation Profit-maximisation where = MC (B) Revenue = uantities sold G * ; i.e. OAB G Total costs: costs er unit (=average costs) * ; i.e. OC G rofit: revenue minus cost, here: zero = minimum of AC is the least rice the comany must charge If < minimum of AC, comany must exit the market in the long run P; GRK; K MC A P B O G AC 119 Profit maximisation If < minimum of AC, comany must exit the market in the long run In the short run? As long as > AVC the comany should continue to roduce (contribution margin) Total costs: OC G Revenue: OEB G Loss: ECB Variable Costs: OFAM G Contribution margin: FEBA; art of fixed costs that are covered by revenues E F O P, MC; ATC; AVC P MC C B A G ATC AVC

41 Cheaer flights Homework: Is it uming? In November 2001, the german airline Germania Charged 99 for flights between Berlin und Frankfurt. eutsche Lufthansa, which held the largest market share For flights between Berlin and Frankfurt, reacted uick: it reduced the rice for its tickets by 60 ercent to 100 resectively 105. Additional services (Catering, Miles & More, more connections) made Lufthansa s offer more attractive than Germanias. Assume that Lufthansa is selling its tickets below total costs. o you think that Germania should accuse Lufthansa for duming? Is Lufthansa right to sell tickets below total costs? 121 Suly-curve and rofit maximisation In = 1 suly is 1 In = 2 suly is 2 In = 3 suly is 3 In = 4 suly is 4 ABC: as increases, suly increases, too ABC = suly curve Suly in the long run: starts from minimum of TAC Suly in the short run: starts with minimum of VAC A MC C AC B Suly-curve and rofit maximisation Suly curve: marginal-cost-curve; starting from minimum of TAC Total market suly: sum of all MC-curves of all firms Total market suly in the long run: if firms in the market are already rofitable, new firms will have the incentive to enter the market new entrants will increase the number of firms in the market; suly increases; rice decreases at the end of this rocess, economic rofit in the market will be zero; if there would be a rofit higher than in any other sector, more suly would shift to this sector economic rofit is zero - i.e. will eual minimum of average costs but: economic rofit = accounting rofit; economic costs include oortunity costs of the owner (time, work etc.) result: cometition drives rices down to minimum average costs

42 Suly-curve and cometition cometition makes firms roduce as cost-efficient as ossible (in minimum of TAC); this makes roducts as chea as ossible makes firms adat to changes in market data (otherwise you loose rofit and revenue) gives incentives for innovation; innovation leads to lower costs / higher demand; gives you a leading edge on your cometitors firms are roducing according to the wishes of the customers Cometition needs: free entry to the market roerty rights (Art. 14 GG) many suliers market transarency 124 Taxes and suly curve What haens to suly if we introduce taxes or social security contributions? tax on fixed costs: total costs increase; marginal costs remain unchanged; average costs increase. AVC-curve shifts uwards taxes on inuts: MC and AC increase; AC-curve and MCcurve shift uwards taxes on rofits: cost-curves remain unchanged; marginal sulier leaves the market As we introduce taxes (or social security contributions), suly decreases and thereby emloyment 125 Taxes and suly curve FC= 100; wage: 10 er worker TR= total revenue TC = total costs VC = variable costs AC = average costs MC = marginal costs Now: 20 % tax on TC (social security contributions) W TR TC VC AC MC ,9 1, ,2 1, ,18 1, , ,5 1, , ,3 2, ,3 3, ,

43 Taxes and suly curve FC= 100; wage: 10 er worker TR= total revenue TC = total costs VC = variable costs AC = average costs MC = marginal costs Now: 20 % tax on TC (social security contributions) W TR TC VC AC MC , , ,8 1, ,2 1, , , Taxes and suly curve AC AC-curve before and after taxes total 60 revenue Taxes and suly curve MC-curve before and after taxes 6 5 MC total 50 revenue

44 Taxes and suly curve Previous analysis: minimizing cost; maximising rofits by choosing the adaeuate level of outut Now: minimizing costs by choosing the right combination of roduction factors Basic idea: - use chea inuts whenever you can; avoid using exensive inuts - use inuts which are more roductive than others - balancing costs and roductivity of an inut: if it is exensive, avoid using; if it is roductive, use it - So: balancing marginal roductivity of an inut (outut er unit inut) and its marginal costs 130 Taxes and suly curve Labour wage in 10 outut er unit labour 10 caital Interest in 5 Outut er unit caital 4 Sending one for work yields one more unit outut Sending one for Caital, yields 0,8 more units of outut i.e.: emloy more workers Labour wage in 10 outut er unit labour 8 caital Interest in 5 Outut er unit caital 4 With increasing amount of labour emloyed; marginal roductivity of work decreases (from 10 to 8) as rices remain unchanged, caital as an inut is becoming more attractive 131 Taxes and suly curve MP labour rice for labour = MP caital Price for caital the marginal roductivity er Euro - how do I sent the next Euro if I want a maximum of additional roductivity? - it is not only the rice of an inut or its marginal rodutivity, but the marginal roductivity er Euro sent for this inut - as the rice increases, MP er Euro decreases. The same roductivity is now more exensive - as MP increases, MP er Euro increases; one should increase the use of this inut Imlications for the labour market?

45 Case study: roductivity-oriented wage olicy In the concetion of the council of economic advisors, room for higher wages deends on the marginal roductivity of labour. If wages remain below the increase of the marginal roductivity of labour, one can say that wage olicy may hel to boost emloyment. (SVR, 2007) 133 Prof. r. Hanno Beck Economics Session #8: Monooly and imerfect cometition 134 Homework: is it uming? Why should Lufthansa sell below cost rice? contribution margin: temorarily selling beloe cost rice because of fixed costs seasonal/closing-out sales; ersihable goods marketing strategy to lure in new customers But: what about cut throat ricing? German cometition authority (Kartellamt): Lufthansa is selling tickets below cost rice this strategy makes only sense if it is suosed to hel to sueeze Germania out of the market and to raise rices afterwards the Kartellamt restrained Lufthansa form charging low rices, because Lufthansa dominates the market; has enough money to bridge temorarily losses and the barriers to (re-)enter the market are very high

46 Monooly and imerfect cometition Monoly Other market forms Cometition olicy German antitrust law 136 Monooly Monooly: only one sulier Sources of monooly ower? - control of inuts (atents; know-how, coy-rights) - Branding, elasticity of demand - roduction function (natural monoolies) conseuences - consumer: loss of freedom - Monoolist may gain olitical ower - loss of efficiency and welfare - Pricing in monooly: marginal revenue euals marginal costs 137 Monooly = uantity sulied; TR= total revenue; AR = average revenue; MR = marginal revenue As uantity sulied increases, rice decreases, because the monoolist is the sole sulier in the market average revenues reresent demand curve revenue = * As increases, there are two effects on revenues: increases decreases P TR AR MR

47 Monooly Average revenues and marginal revenues AR 8 6 MR total revenue 139 Monooly In monooly, demand curve euals average revenue (see table) because the monoolist is the sole sulier MR is always below demandcurve (AR) (see table) Profit maximisation in monooly: marginal costs = marginal revenues (Cournots Point) demand = AR MR 140 Monooly Profit-maximisation in monoly: first, find oint where MC = MR (where MC-curve intersects MR-curve) Find the uantity M, where MC = MR Find rice corresonding to M M demand = AR MC C C M MR C

48 Monooly Monoolist s rofit: revenue total costs revenue: uantities sold * rice (P M M ) Total costs: average costs * uantity sulied (AC M M ) Profit: AC M M C M demand = AR MC AC AC M C MR M 142 Monooly Comared to erfect cometition (P P ): Consumer surlus in monooly: consumers loose A lus C Producer surlus in monooly: monoolist gains A (from the consumers) and looses B eadweight loss: BC Monoolies always lead to a loss in total welfare M P demand = AR A C B MC MR M P 143 Monooly Sources of monoly ower Elasticity of demand the higher elasticity of demand, the lower the monoolist s ower determinants of the elasticity of the firms demand: roduct differentation, marketing, substitutes, branding Number of cometitors the monooly ower of a firms increases as the number of cometitors is decreasing the monooly ower of a firms increases as the barriers of entry increase Interaction among firms (collusion vs. cometition) there are (almost) no erfect monoolies and no erfect cometition. More realistic: Oligoolies and monoolistic cometition

49 Monooly Rule of thumb for ricing in a monooly: ( MC) / = - 1 / E Left side of euation: marku on MC in ercent erfect cometition: E aroaches infinity, so 1/E aroaches zero. So = MC; no mark-u on MC ossible due to comletely elastic demand the smaller E, the higher is the right-hand side of the euation,i.e. the higher is the mark-u on MC. Inelastic demand means high market ower Re-arrange as a simle rice-formula: = MC / (1+(1/E )) 145 Other market forms Monooly: demand curve is demand of the whole market Oligooly: few suliers; strategic interaction between suliers Oligooly I: very few suliers; acting in concert, maybe even without exlicit communication Oligool II: more suliers; fierce cometition as a result Monoolistic cometition: demand curve is the demand curve for the roduct of each sulier heterogeneous roducts limited market ower of every sulier in a narrow range branding rice differentitation sulier has a limited degree of market ower erfect cometition: demand curve for the single sulier ist the rice, because he has no market ower 146 Cometition olicy Cometition needs additonal olicy to ensure that there is a sufficient degree of cometition uestions: what is a sufficient degree of cometition? how shall we estimate the market ower of a comany? how shall we define a market (time / roduct / lace) how shall we idetify anti-cometitive, unfair behaviour? Problems of cometition olicy Collusion: rohibiting agreements or ractices that restrict free trading and cometition between business entities. (e.g. cartells) abusive behaviour and anti-cometitive ractices: banning abusive behaviour by a firm dominating a market, or anti-cometitive ractices that tend to lead to such a dominant osition. Practices controlled in this way may include redatory ricing, tying, refusal to deal and others. concentration of market ower (takeovers; merger)

50 Cometition olicy collusion: negogiations between suliers aimed to reduce the ressure of cometition horizontal: between cometitors vertical agreements: between firms at different levels of the suly chain acting in concert roblems: finding evidence of collusion (smoking gun) distinguish between collusion and behaviour resulting from the ressure of cometition Germany s cometition law (GWB): horizontal cartells and collusion aimed to restrict cometition are forbidden 148 Cometition olicy The great vitamin consriracy In 1999 some of the worlds largest drug comanies agreed to ay billions of dollars in damages to customers after being convicted of a huge consiracy to rig the world vitamin market. The consriacy began in 1989 when Roche and BASF began secret talks about raising rices for vitamins; soon Rhone-Poulenc and other jaanese comanies joined. The members of the grou met regularly in hotels or rivate homes to set rices and divide u markets for bulk vitamins mainly sold to other comanies (e.g. animal feed makers). The animal feed comanies grew susicious about the rices they were charged, which led to a series of investigations. The case broke down when Rhone-Poulenc made a deal with cometition officials in the US to rovide evidence about the consiracy. 149 Cometition olicy abusive behaviour and anti-cometitive ractices Germany: the abusive exloitation of a dominant osition by one or several undertakings is rohibited abusive behavior against cometitors and other firms in the suly chain examles: rice discrimination: dominant firm demands ayment or other business terms which differ from those which would very likely arise if effective cometition existed; redatory ricing: a comany offers goods or commercial services not merely occasionally below its cost rice, unless there is an objective justification for this boycott: small firms deend on one single sulier / buyer (Uhren- Krämer / Seiko; adidas) exclusive commitments and contracts: (Meto-Handreisauszeichner) Problems: definition of dominant osition and abusive behaviour versus regularly business olicy

51 Cometition olicy Uhren-Krämer versus Seiko Seiko, a manufacturer of watches, refused to deliver his watches to Uhren-Krämer (Berlin). Krämer went to courts and accused Seiko of unfair hindrance: Seiko refused deliverey because Krämer did not commit to the rice recommended by Seiko if he would stick to this rice, Seiko would deliver the watches. Seiko had a market share of 75 ercent in Berlin Adidas versus SB-Kauf Adidas refused to deliver his roducts to SB-Kauf (who intended to sell the shoes with a large discount) and claimed that it intended to have its shoes only sold by secialty stores. The cartell authorities recognised adidas as market-dominant comany. 151 Homework: T-Mobile and the I-Phone No I-Phone in Australia? Queensland University of Technology (QUT) law researcher ale Claerton has uestioned whether Ale could release the I-Phone in Australia under the same conditions that has seen it locked to a single carrier in the US, UK, Germany and France. That said, an aeal was laced in Germany by Vodafone to force eutsche Telekom to offer an unlocked version, but this was successfully challenged in court. Customers will now only be able to buy the hone for a 399-euro offer with a binding two-year contract. After two years, users can have the iphone unlocked so they can switch to other roviders, T-Mobile said. The French I-Phone can be urchased in an unlocked configuration, but can reortedly only be used with SIM cards from other French comanies not any SIM from any carrier worldwide. Is it abusive behaviour if Ale refuses to deliver the I-Phone to other telecoms? What do you think about the french solution? 152 Cometition olicy Better than reventing dominant comanies from abusing their ower: reventing the rise of a dominant market osition Internal and external growth may lead to a dominant market osition concentration Horizontal, vertical or conglomeral olicy: control of concentrations (suervising mergers and acuisitions) breaking u market-dominant firms suervising market-dominant firms

52 German cometition law Hertie und Karstadt In 1993, the largest deartment store Hertie took over the third-largest deartment store, Karstadt. The cartell authority aroved the merger; although the number of deartment store-chains in Germany was being reduced to two. The authority found evidence for market-dominance only in some local areas; but it said that deartment stores comete also with local secialised stores. Cometition would be only reduced in some secial areas. So Hertie had to sell only some lines of business (for examles the sale of records in Kiel) 154 German cometition law Act against restraints of cometition (GWB) is made of three arts #1: Prohibition of agreements restricting cometition (cartels) #2:market dominance, restrictive ractices #3: control of concentrations Enforcement: cartell authority (Bundeskartellamt) Euroean cometition law (Art. 81, 82 EG-treaty) restrictions of cometition are forbidden if they affect the trade between member states of the Euroean community national law alies as long as the trade between community members is not affected rimary cometence for alying EU cometition law rests with Euroean Commission and its irectorate General for Cometition ublic rocurement: state aid, control of direct and indirect aid given by EU Member States to comanies (Article 87 EC) 155 German cometition law GWB #1: Prohibition of agreements restricting cometition (cartels) horizontal cartells and collusion aimed to restrict cometition are forbidden vertical contracts are forbidden if they restrict one of the arties of the contract in closing other contracts with third arties this alies to an acting in concert even if there is no contract exemtion ermits for some cartells and cooeration of small comanies

53 German cometition law GWB #2: control for market dominance and abusive behaviour: abusive behaviour is forbidden market-dominant comanies: if 1 (3 / 5) comanies share 33 (>50 / 66) ercent of revenues in the relevant geograhic market relevant geograhic market: elasticities of demand and suly abusive behaviour redatory ricing: rices differ from what you exect them to be with cometition (rebates, rice discrimination) restrictive ractices: market-dominant comanies restrict ossibilities / oortunities of customers or stakeholders 157 German cometition law GWB #3: Control of concentrations to kee markets cometitive; acting before a market-dominant comany rises Princiles the rovisions on the control of concentrations shall aly if in the last business year receding the concentration: 1. the combined aggregate worldwide turnover of all the undertakings concerned was more than EUR 500 million, and 2. the domestic turnover of at least one undertaking concerned was more than EUR 25 million. a concentration which is exected to create or strengthen a dominant osition shall be rohibited unless the comanies concerned rove that the concentration will also lead to imrovements of the conditions of cometition and that these imrovements will outweigh the disadvantages of dominance 158 Prof. r. Hanno Beck Economics Session #9: Game theory

54 Hausaufgabe: No I-Phone in Australia? To find out wheter Ale is involved in abusive behaviour one must ask for a dominant market osition and restrictive ractices ominant market share: not, if the relevant market ist the market for mobile communication. There are enough substitutes Ale has market ower: its brand. o we need to rotect brandaddicted customers by law? but: may Ales brand lead to a reduction in cometition on the market for mobile communication? restrictive ractices if Ale has market-dominance, the fact that Ale is selling its I- Phone only locked to a singel carrier oints towards the direction of abusive behaviour is the tariff for the I-Phone above other rices? the user is locked to the carrier for two years does this reduce cometition in the long run? 160 Game theory Oligooly Prisoners ilemma Seuential games Reeated games 161 Oligooly Oligooly: a market where only a few firms comete with each other and entry by new firms is imeded due to barriers of entry scale economies atents, technology, branding Entry deterence Airlines, cigarettes, aluminium, automobile industries Because only a few firms are cometing, all decisions involve imortant strategic considerations each firm must take in account how cometitors may react to a move (comete, collude) An examle: the OPEC-Cartel

55 Oligooly The market for gasoline homogenous Produkt; one can only differentiate through the rice only a few suliers; every move of every suliers is visible to his cometitors First idea: Cartel. Producers decide to collude and to maximize joint rofits by charging to monooly-rice (total MR of all firms = Total MC); e.g. OPEC. Problem: every member of the cartel has an incentive to charge a lower rice ( cheating ) Second idea: rice war; this may lead to arallel moves of the rice each cometitor charges evidence: rices for gasoline tend to be cointegrated; i.e. they move together does this mean that there is tacit collusion or fierce cometition? 163 Oligooly - Iran and Ira agree on a cartel - If both of them co-oerate, each of them receives 50 - In case of a rice war, each of them receives 40 - if one co-oerates while the other one cheats, the ay-off is 60 for the cheater and 30 for the other contract arty - result: both countries will cheat - (collude, collude) would make both countries better off cooerate Cheat Ira Iran cooerate 50, 50 30, 60 cheat 60, 30 40, 40 ay-off Ira ay-off Iran 164 Oligooly A game is a situation in which the articiants (layers) make strategic decisions strategic decisions: decisions that take into account the actions and resonses of the other layers strategic decisions result in ayoffs to the layers; i.e. the outcomes of the decisions strategy: a rule or lan of action for laying the game otimal strategy: maximise the exected ayoff If I assume that my cometitors (the other layers) try to maximise their ayoffs, how shall I take their behavior in account when making my decisions OPEC-examle: both layers have a dominant strategy most famous examle: risoners dilemma

56 Prisoners ilemma - after a robbery, A and B are caught by the olice - Police may arrest them for one year for a minor offence (illegal osession of weaons); not for the robbery - Police offers a searate deal to A and B: if one confesses while the other one denies; his charge will be droed. The other one who remained silent gets 20 years - if A and B confess, each of then gets 8 years - result: both of them will confess A. deny confess B. deny 1, 1 20, 0 confess 0, 20 8, Prisoners ilemma In this game, confess is a dominant strategy: no matter what the other layers does, it is the best strategy. I m doing the best I can no matter what layer #2 does Examles of risoners dilemma: - collusion; rice wars; advertising wars - Military sending - Sorts owners and layers Not every game has dominant strategies ominant strategies: I m (you) doing the best I can no matter what you (I) do Nash euilibrium: I m (you) doing the best I can given what you (I) are doing omimant strategies are secial cases of Nash euilibria 167 Prisoners ilemma - Two new variations of a breakfast cereal can be introduced - but market volume is only enough for one comany - each comany can only introduce only one new roduct - each firm is indifferent which rocuct to introduce as long as it is not the same roduct as its cometitor - what if the comanies must behave noncooeratively? - two Nash-euilibria A. crunchy sweet B. crunchy -5, -5 10, 10 sweet 10, 10-5,

57 Prisoners ilemma Further alications Cometition between suliers: rice wars, advertising, investment decisions sorts: Americas Cu if you are in the lead, you should behave like the boat which is right behind you hostages and hijacker: one erson must start the attack coordination between arties (battle of sexes) threats (r. Seltsam) Tying ones hands Not every game is a zero-sum-game (like in sorts) Cometition is not a zero-sum-game as soon as you think about the consumers 169 Prisoners ilemma Strategic move: an action that influences the behavior of the other layer in a manner favorable to oneself commitment: you commit yourself for the future in order to change the behaviour of your counterarty; threats or commitments; constraining the artners choice by constraining own behavior Tyes of commitments and threats: ublic commitment Give ower to a third arty ( r. Strangelove ) Probabilistic threat (Kuba-crisis) building u reutation (central banks; newsaers) examles: Xenohon and the conuistadoras: burn your bridges behind you most favorite nation-rincile: each customer gets the same rice what makes it imossible to re-negogiate 170 Homework: threads and commitments Ice cream wars You are the owner of the only ice-cream-arlor in town, but now a new cometitor lans to enter the market. If he enters, you could lower rices, thereby lowering your rofits from 200 to 70. Instead of lowering rices, you could still charge a higher rice a loow your cometitor to enter the market this would make your rofits dro from 200 to 100. If your cometitor enters the market, there are two ossible scenarios: you lower your rices this will make him loose 10. If you don t start this rice war and charge high rices, his rofits will be 20. If you lower your rices and he kees out of the market, your rofits dro to 130. Will your cometitor enter the market? If yes, why?

58 Prisoners ilemma - Which strategy should a football layer choose to shoot a enalty? - as soon as the layer alies a certain attern (RRLLRR) he will loose in the long run, as soon as the goalkeeer finds out about this attern - better strategy: fliing a coin, i.e. euilibrium in mixed strategies - mixed strategy: strategies in which layers make a random choice among ossible actions based on a set of chosen robabilities Kahn right corner left corner you right corner -, + +, - left corner +, - -, Seuential games - Two new variations of a breakfast cereal can be introduced; but one cereal yields a higher revenue than the other - without coordination this game has no single solution as long as both layers must act at the same time - both comanies would like to roduce sweet as long as the other arty does not roduce it - solution: seuential game; extensive form of a game A. crunchy sweet B. crunchy -5, -5 10, 20 sweet 20, 10-5, Seuential games - now: solving the game from the end - if firm B reacts first, it has a first-mover-advantage - what can A do to get the firstmover-advantage? - but sometimes there may be first-mover-disadvantages: if you are in the lead in a gameshow, you should always mimic the strategy of your cometitor - Here: buying machinery, launching an exensive advertising camaign self commitment B sweet crunchy A A sweet crunchy sweet crunchy -5, -5 20, 10 10, 20-5,

59 Seuential games - Commercial aircraft market has large economies of scale - It is only economical for one firm (Airbus or Boeing) to roduce a new aircraft - In game #1 there is a clear first-mover-advantage - Now: EU commits itself to a subsidy of 20 to airbus if it roduces the lane regardless what Boeing does (#2) - Now Boeing surrenders - EU has shifted rofit from the US to Euroe - But: what about retaliation measures by the US- Government? Boeing Airb. roduce no roduction roduce -10, , 0 no roduction 0, 100 0, 0 #1 Airb. Boeing roduce no roduction roduce -10, , 0 no roduction #2 0, 120 0, Reeated games Reeated games: laying the same game several times Reeated games hel you to learn about your cometitor and his strategy; they hel you to built u a reutation How can you built u a reutation as a trustworthy rival? Best solution: tit for tat. collude as laong as the other layer colludes; defect as soon as he defects. TfT: eye for an eye as long as the game is infinitely reeated, it does not ay out for your cometitor to cheat; cumulative loss will outweigh short-term gain Finite number of reetitions: euilibrium is defect right from the start (Eddy Murhy) In these games, reutation is everything as a cometitor as government / central bank as boy/girlfriend 176 Prof. r. Hanno Beck Economics Session #10: Why we need governments

60 Homework: Ice cream wars - The threat of a rice war is not realistic, because charging a high rice is a dominant strategy - but you may change your strategy if you believe that there are more cometitors to come reeated game - in this case, it may ay off to built u a reutation as a loggerhead who is willing to sacrify rofits just in order to kee other cometitors away from your market - but: do you have the financial strengh to built u this reutation? com. you enter Stay away high rice 100, , 0 Low rice 70, , Why we need governments Market failure Public goods Quasi-rivate goods Network externalities 179 Market failure Two tyes of market failure Price mechanism does not work (economic market failure) the outcome of the market is not acceted by olitics or society (olitical market failure) Market failure is caused by Public goods externalities networkexternalities social security and redistribution Merit goods (uasi-rivate goods) olitics

61 Public goods - Nonrival goods: for any level of roduction, the MC of roviding it to an additional customer are zero (lighthouse) Nonexclusive goods: eole cannot be excluded from consuming it. As a conseuence, one cannot charge them for using it. This gives a free rider roblem (lighthouse, defense) How many ublic goods shall the government rivide? How do you estimate the willingness to ay for ublic goods? NR NE rival Nonrival exclusive clothes, food rivate goods environment TV highway non-exclusive environment road army; lighthouse ublic goods 181 Quasi-rivate goods Idea: one has to rotect eole from themselves (alcohol, cigaretts) or suort good things (arts, ublic broadcasting) This is not a economic issue; government intervenes because it does not accet the result of the market mechanism; the rice machanism is not disturbed goods like alcohol and cigarettes are taxed to reduce consumtion; goods like arts or braodcasting are subsidized uestions: - who decides what is good or bad - aternalism: what if you want to drink / smoke; what if you don t like ublic broadcasting? - uasi-rivate goods are a good layground for bad olitics 182 Merit wants : Public broadcasting Public broadcasting: wrong arguments Public broadcasting is not a ublic good Public broadcasting is not natural monooly anymore Political education by ublic brodcasting = externality information is an exerience good; but this roblem is solved by reutation What about the uality of rivate broadcasting? - bribemoney; masked advertising: AR - cometition and reutation revent rivate broadcasters from doing a bad job; do ublic broadcasters have to face cometition, too? - Lower-class-TV: sot the difference (GZSZ or Marienhof?)

62 Homework: ublic broadcasting and the Internet o we need a ublic broadcaster in the Internet? The AR (Consortium of ublic-law broadcasting institutions of the Federal Reublic of Germany), is a joint organization of Germany's regional ublic-service broadcasters. Together with ZF, the secod large ublic broadcaster, almost 8 bn. Euro er year are sent for ublic broadcasting in Germany. The fact that AR (and also ZF) uses license fees to subsidize their World Wide Web sites, and also the non-transarency of their license fee exenditure, is the toic of an ongoing controversy with the Euroean Union. Public broadcasters im Germany are sending 52,5 mn. Euro er year on the internet. o you think we need ublic broadcasting in the internet? 184 Network externalities Examle of an network externality: telehone Network externality: the more eole use a good, the higher the utility derived from this good for all users This is a so-called externality: as A buys a telehone, the utility of the telehone increases for B (who has a telehone, too) but B has not to ay and A does not care Network externalities work like an eidemic; you need a critical mass to start with Further examles E-bay; arshi standards: VHS; TCP/IP; werty software (Microsoft) broadcasting network externalities may cause roblems 185 Network externalities First-Mover-advantage ( gorilla ): in case of a standard, the winner takes it all. Winner will be the first mover, not necessarily the best technology (see VHS vs. Video 2000) Problem #1: lock-in of an inferiorer technology (wertyroblem) Problem #2: the winner may exloit the market after Problem #3: the winner may extend his market ower to other markets (Exlorer; Media Player) solutions: more cometition license agreements nationalization