BSP1703 Managerial Economics
Exam Notes
Lecture 3: Consumer Theory
Outline
1. Optimal consumption choice
o Tastes and Preferences
o Utility function, indifference curve, budget line
o Conditions for optimal choice
o Applications
2. Individual demand and Market demand
•
Concepts in Consumer Preference
1) Consumer preference: how the consumer would rank any two combinations of goods
- Combinations of goods = baskets/ bundles
2) Budget constraint: goods and services consumers can afford
•
Consumer Optimization
1) Consumer’s tastes/ preferences
2) Budget constraint
•
Tastes and Preferences
1) 3 academic approaches to consumer tastes:
o Minimum conditions (axioms) for a ‘rational’ consumer
o Represent through utility function
o Represent through indifference curves
2) Market basket (bundle)
: list with specific quantities of one or more goods à to explain the theory of consumer
behavior, ask whether consumers prefer one market basket to another
3) Three basic assumptions about preferences
o Completeness
- Given any 2 bundles of goods a consumer either:
a) Prefers bundle A to bundle B: A > B
b) Or prefers bundle B to bundle A: B > A
c) Or is indifferent between the two: A ~ B
- Completeness implies that consumers can compare and rank all possible market baskets (note
that these preferences ignore costs)
o Transitivity
: if a consumer prefers bundle A to bundle B and prefers bundle B to bundle C, then she must
prefer bundle A to bundle C (e.g. A > B and B > C, then A > C)
- Transitivity is normally necessary for preference consistency
- No transitivity à no choice among three or more options
o
•
Non-satisfaction (more is better than less)
: Consumers prefer more units of a good than less (e.g. X, Y two goods in a bundle; Bundle A: (5,
6), Bundle B: (5, 5), then A is preferred to B)
- Consumers are never satisfied or satiated; more is always better, even if just a little better
- If there is a bundle C: (4, 6), how about B vs. C?
a) Non-satiation doesn’t apply
b) It depends on how much satisfaction a consumer derives from a bundle of X and Y.
c) We need more information on consumer preference
Utility Function
1) Utility: a numerical score representing the level of satisfaction that a consumer receives from a
given basket of goods
2) Utility function: assigns a number to each basket to measure the level of satisfaction that a
consumer receives from the basket of goods
o U = U(x)
- U is consumer-specific
- Generally assume utility functions are ordinal in scale
o Marginal utility: the additional utility one receives from (one) additional unit of consumption of
goods
- MUX = Change in utility/ change in quantity = dU/dX
- Marginal utility is represented by the slope of the curve
- Graph:
3) Diminishing marginal utility: marginal utility falls as the consumer consumes more of a good
o Marginal utility and happiness: happiness increases with income, but at a diminishing rate
4) Utility function with two goods (Example)
o Two goods X, Y in a bundle
o Compare bundles: A(5,6), B(5,5), C(4,6), D(3,10)
•
o
Utility function: U(x,y) = √𝑥𝑦
o
U(5,6) = U(3,10) = √30 > U(5,5) = 5 > U(4,6) = √24
Hence, A~D > B > C
Indifference Curve (IC)
: represents the locus of bundles that give a consumer an identical satisfaction (or utility) level: a
consumer is indifferent along all combinations of the goods found on the same indifference curve
1) Indifference map: shows a set of indifference curves representing different satisfaction levels (or
utilities) of a consumer
o
o
o
o
IC’s are downward slopping
Those further from the origin provide greater levels of satisfaction (non-satisfaction)
They cannot have positive slopes, cannot intersect and cannot be thick
Generically, they are bowed (or convex) to the origin, but not always
2) Shape of indifference curve
o Marginal rate of substitution (MRS) quantifies the number of units of clothing a consumer is
willing to sacrifice to consume one additional unit of good while maintaining her utility at the
same level
∆𝑦 𝑀𝑈!
𝑀𝑅𝑆 = −
=
∆𝑥 𝑀𝑈"
o Is MRS of good F for clothing C is the same as MRS of clothing C for food F?
For example: if MRS of F for C is 3, it means the consumer will give up 3 units of clothing to
obtain 1 additional unit of food. We can deduce MRS of C for F is 1/3, it means the consumer
will give up 1/3 units of food to obtain 1 additional unit of clothing
o Diminishing marginal rate of substitution
- Generically, MRS decreases in diminishing rate, i.e. ICs are convex to the origin
= It means, the relative (or subjective) value of food (measured in terms of clothing units)
decreases as the consumer consumes more food and less clothing.
o Interpretation:
- As more and more of one good is consumed, we can expect that a consumer will prefer to
give up fewer and fewer units of a second good to get additional units of the first one.
- Another way of describing this principle is to say that consumers generally prefer balanced
market baskets to market baskets that contain all of one good and none of another.
•
Application of Indifference Curve: Designing New Automobiles (I) – Producer
: Each curve shows the combination of acceleration and interior space that give the same
satisfaction
•
Special Preferences
zero MRS
•
Budget Constraint (Budget Line)
: all possible bundles of goods a consumer can buy given her disposable income and market prices of
the goods
Focus on: 1. Prices of the goods 2. Consumer’s disposable income
1) Budget constraints: constrains that consumers face as a result of limited incomes
2) Budget line: all combinations of goods for which the total amount of money spent is equal to
income
-
-
-
A budget line describes the combinations of goods
that can be purchased given the consumer’s income
and the prices of the goods
Line AG (which passes through points B, D, and E)
shows the budget associated with an income of
$80, a price of good of PF = $1 per unit, and a price
of clothing of PC = $2 per unit
The slope of the budget line (measured between
points B and D) is -10/20 = -1/2 = - PC/PF
THEREFORE, it measures the objective value – or
cost – of one additional unit of food in terms of
units of clothing
o
Changes in the budget line
- Income changes
-
•
Price changes
Consumer’s Optimal Choice under Two Good Case
: Combination of indifference curve + budget line
1) Description
o Consider a consumer in her quest to choose the optimal consumption bundle (X, Y) given her
budget constraint. Her choice is described by:
Max U (X, Y)
Subject to PXX + PYY = I
2) How much of each good to buy?
o The optimal consumption bundle is the affordable bundle is
the affordable bundle that yields the highest level of
satisfaction
o Consumer chooses the bundle
- On the budget line
- On the highest indifference curve
3) Condition for optimal choice
o The budget line is tangent to the indifference curve
o The slope of the indifference curve is the same as the slop of the budget line
𝑀𝑈! 𝑃!
𝑀𝑅𝑆 =
=
𝑀𝑈" 𝑃"
o How to judge if a consumption bundle is the optimal?
𝑀𝑈! 𝑃! 𝑀𝑈! 𝑀𝑈"
= →
=
𝑀𝑈" 𝑃"
𝑃!
𝑃"
o The money spent on good x must bring the same amount of additional utility as the money
spent on good y does, vice versa.
•
Application of Indifference Curve and Budget Line: Designing New Automobiles (II) – Consumer
•
Corner Solutions
: situation in which the marginal rate of substitution for one good in a chosen market basket is not
equal to the slope of the budget line
•
Graphical Derivation of An Individual Demand
•
Individual Demand and Market Demand
1) Consumers are heterogenous (income, taste etc.). So, individual demands are not necessarily
identical for all consumers
2) Market Demand from individual demands: horizontal summation
Lecture 4: Uncertainty and Behavioral Economics
Outline
1. Describing uncertainty and risk
o Probability and expected value
o Decision making
o Preferences toward risk
o Reducing risk
2. Behavioral economics
o Subjective probability weighting
o Reference points and consumer preferences
o Status quo bias and endowment effect
o Loss aversion
o Framing effects
o Anchoring effects
o Nudging
o Importance of understanding cognitive distortion and biases
Part I: Uncertainty and Risk
• Uncertainty
1) Ways to compare and choose among risky alternatives
o Quantifying risk
o Examining people’s preferences toward risk
o Seeing how people can sometimes reduce or eliminate risk
o In some situations, people must choose the amount of risk they wish to bear
2) Describing risk
o Probability: likelihood that a given outcome will occur
o Expected value: probability-weighted average of the payoffs associated with all possible
outcomes
- With two possible outcomes, the expected value is:
E(X) = Pr1X1 + Pr2X2
- When there are n possible outcomes, the expected value becomes
E(X) = Pr1X1 + Pr2X2 + … + PrnXn
- Example: Throw a dice. You win $4 if even number and lose $4 if odd. Then EV = $4*(1/2) +
$4*(1/2) = $0.
•
Decision Making
1) Decision is not only based on the expected value only. We consider satisfaction and risk as well.
o Satisfaction is not always expressed by the amount of money.
o When making decision, people care about risk.
2) We have to trade-off between expected value vs. variability
o
o
•
Prefer a higher expected value
Prefer a lower variability
Variability
: extent to which possible outcomes of an uncertain event differ
1) Deviation: a measure of difference between the observed value of a variable and some other
value, often that variable’s mean
2) Standard deviation: square root of the weighted average of the squares of the deviations of the
payoffs associated with each outcome from their expected values
•
Expected Utility
: sum of the utilities U(Xi) associated with all possible outcomes Xi, weighted by the probability Pi,
that each outcome will occur
$
𝐸𝑈(𝑋# ) = 6 𝑃# 𝑈(𝑋# )
#%&
Example: The satisfaction we would get from $2 million isn’t necessarily two times of – in fact not
that much greater than – the satisfaction we would get from $1 million.
•
Different Preferences Toward Risk
1) Risk Averse: condition of preferring a certain income to a risky income with the same expected
value
2) Risk Loving: condition of preferring a risky income to a certain income with the same expected
value
3) Risk neutral: preference that are neither risk averse nor risk loving
•
Reducing Risk
1) Diversification: allocating your resources to a variety of activities whose outcomes are not
closely related
o ‘Don’t put all your eggs in one basket.’
o The stock market: even with a diversified portfolio of stocks, you still face some risk
- Example: ETF’s that track various market index funds
2) Insurance: risk-averse people are willing to pay to avoid risk. They will buy enough insurance to
recover fully from any financial losses they might suffer.
o The law of large numbers: Although single events may be random and largely unpredictable,
the average outcome of many similar events can be predicted.
- Examples: health insurance, life insurance, home insurance, car insurance
Part II: Behavioral Economics
• Subject Probability Weighting
A reduction in winning chance is always a displeasure. But, we feel, a reduction results in larger
psychological effect when it is a reduction from certainty than from uncertainty. (More generally
speaking, distinguish this effect from the old ‘risk aversion’)
•
Reference Point
: a basis or standard for evaluation, location, assessment, or comparison
1) Example
o Just recall your spending during Christmas: ‘originally $90 but now 30%-off’ vs. ‘$58’
o You earn $0.5m/year – feel rich or poor
•
Anchoring Effect
: Our first perception of something lingers in our minds and this continues to influence later
decisions. People ‘anchor’ on trait or piece of information when making decisions
1) Example:
o Apple launched the first iPhone at $599, then sliding the scale down to $399 just in a few
months to experience a huge increase in sale.
o Making the exam scripts (You had better do well in Q1 or have beautiful handwriting. No such
issues with MCQs.)
o How employers hire an employee? (You had better give a good impression in your first
interview.)
•
Endowment Effect (status quo bias)
: an emotional bias; a preference for the current state of affairs
1) Example: You are a house owner. You purchased your house at 2 million. Would you sell it at 1.5
million?
Result: The randomly assigned owners of a mug required significantly more money to part with
their possession ($7.12) than randomly assigned buyers were willing to pay to acquire it ($2.87)
2) Targets people’s perceptions of what is the normal and usual thing to do – the status quo.
•
Loss aversion
1) The pain from a loss and the pleasure from the same size of gain is not symmetric.
2) A person can be risk-averse over gains and risk-loving over losses, but she still can be lossaverse.
3) Loss aversion theory teaches that people would rather avoid a loss than reap a reward.
4) When you understand loss aversion theory, it’s easy to spot the tactics everywhere from the
grocery store to television commercials. The trick is to harness the same strategy and utilize for
your particular consumer demographics.
5) Example: Taxi Drivers
o Have you thought about why it is hard to get a cab on a rainy evening? Is it just because
demand is greater than supply?
- Income targeting: drivers view a rainy day through a gain framework but a sunny day through
a loss framework à loss aversion
•
Framing Effects
: presenting the same option in different formats alters people’s decisions
•
Nudging
: behavioral findings of human nature and psychology can manipulate people’s decisions. It can also
help people make choices more beneficial to the society
Lecture Notes 5: Costs and Firm Behavior in Competitive Markets – Deriving the Supply Curve
Outline
1. Part A: Costs
o Which costs matter?
o Costs in the short run and long run
o Economies of scale
2. Part B: Firm behavior in competitive markets
o Perfect competition
o Profit maximization – Intuitive approach
o A firm’s short run supply
- Short run profit maximization
- Shut down decision
- Deriving a firm’s supply curve
o Long run equilibrium
3. Managerial implications
Part A: Costs
• Measuring cost
1) Economic (Opportunity) cost: forward-looking concept
o Accounting cost: actual expenses appeared in accounting books
o Opportunity cost: the values of a resource in its best alternative use
2) Opportunity cost
o Example: Where to build the new law school? Downtown in Chicago or on the main campus in
Evanston?
- Downtown location has prominent supporters, arguing as follows:
“It is cost-effective because the university already owns the land. A large parcel of land should
be purchased in Evanston if the building were to be built there.”
- Does this argument make economic sense?
- No. It makes the common mistake of failing to appreciate opportunity cost. From an economic
point of view, it is very expensive to locate downtown because the opportunity cost of the
valuable lakeshore location is high: That property could have been sold for enough money to
buy the Evanston land with substantial funds left over. In the end, Northwestern decided to
keep the law school in Chicago. This was a costly decision. It may have been appropriate if the
Chicago location was particularly valuable to the law school, but it was inappropriate if it was
made on the presumption that the downtown land had no cost.
3) Accounting and Economic profit
o Accounting profit = TR – Total accounting cost
o Economic cost = TR – Total economic cost (or opportunity cost)
4) Opportunity costs vs. Sunk costs:
o Opportunity costs of resources are their values when they are put to the best possible
alternative use – the value of the best opportunities that are to be foregone.
o
o
o
Sunk costs are expenditure that are spent and cannot be recovered (i.e. fixed assets with zero
salvage value or zero opportunity cost)
All future decisions should ignore this non-recoverable initial outlay à Sunk cost fallacy
Sunk investments can often lower future costs though
•
Fixed Costs vs. Variable Costs
1) Fixed cost (FC): the cost that does not vary with operation scale
o Example: expenditures for plant maintenance, insurance, heat and electricity
o Generally, fixed costs occur even if Q=0 as long as you stay in business and can be eliminated
only by going out of business.
2) Variable cost (VC): the cost that varies with it
o Example: wages, salaries, raw materials used for production
o Variable costs = 0 if Q=0
o Many costs become variable as time horizon becomes longer
•
Fixed Costs vs. Sunk Costs
1) Fixed costs can be eliminated when you go out of the business, while sunk costs cannot be
recovered. Thus fixed cost is still a part of economic cost in the LR (while sunk costs are not
included in economic costs)
o Expenditure on NUS building/ IT facilities is non-sunk fixed costs
o Expenditure on equipment/ service which is of no use in another business is sunk fixed costs
o Example:
•
Average Costs vs. Marginal Costs
1) Total costs: TC(q) = TFC(q) + TVC(q)
2) Average costs: ATC(q) or AC(q) = TC(q)/q = AFC(q) + AVC(q)
3) Marginal cost: increasing in cost of producing one additional unit of output
MC(q) = change in total cost/ change in quantity = change in variable cost/ change in quantity (=
d(VC)/cq)
4) Why do we care?
o Making a profit or a loss à look at AC (and compare it to P)
o Maximizing your profit à look at MC (and compare it to MR)
•
Short Run vs. Long Run Costs
1) Short run: a time horizon within which firms cannot adjust at least one input
2) Long run: a time horizon long enough for firms to adjust all inputs
•
Short run costs
•
Long Run Costs vs. Short Run Costs
•
Economies of Scale vs. Diseconomies of Scale (check you IB notes)
Part B: Firm Behavior in Competitive Markets
Lecture Notes 6: Competitive Equilibrium and Economic Efficiency
Outline
1. Measuring Economic Efficiency
o Consumer surplus (CS)
o Producer surplus (PS)
2. Motivation Example: Price controls
3. Government Intervention
o Price ceiling and Price floor
o Price supports and production quotas
o Excise tax and subsidy
•
Consumer surplus (CS)
: an economic measure of consumer satisfaction. It is measured by the difference between the
maximum price levels consumers are willing to pay for a good or service – i.e., consumer reservation
prices and its actual price
•
Producer surplus (PS)
: an economic measure of producer (or seller) benefits. It is measured by the difference between the
minimum price levels a producer of a good or service is willing to sell it for and the actual market
price
•
Total surplus
= consumer surplus + producer surplus
•
Underproduction & Overproduction
•
Perfectly Competitive Equilibrium Attains Economic Efficiency
1) Total surplus is maximized at (perfectly) competitive market equilibrium
2) How does the competitive market achieve economic efficiency? Invisible Hand
o No central planner: Each consumer maximized his/her own utility. Each firm maximizes its own
profit.
o One price rule and “the right price”(P = MB = MC à allocative efficiency): Every consumer who
is willing to pay more than the cost of producing extra output is able to buy; every consumer
who is not willing to pay the cost of the extra output does not buy
3) Perfect competition as the “ideal” benchmark
o Real-world markets frequently deviate from this benchmark
o Identifying the sources of market failure is a key task
- Negative production/ consumption externality
- Positive production/ consumption externality
- Lack of public goods
- Common access resources
- Asymmetric information
•
Economic Efficiency and Deadweight Loss
1) Benchmark: a market outcome (quantity and price) is efficient if the total surplus is maximized
2) If a market outcome is not efficient, then the market suffers from deadweight loss
3) Deadweight loss: the net loss in total surplus resulting from an inefficiency allocation of
resources (Allocative inefficiency MB not equal to MC)
4) Where does deadweight loss come from?
•
o
o
o
o
•
Normative Economics and Welfarism
1) Normative Economics: a school of thought which believes that economics as a subject should
pass value statements, judgments, and opinions on economic policies, statements, and projects.
It evaluates situations and outcomes of economic behavior as morally good or bad.
2) Welfarism: we should maximize efficiency and welfare
Example: You see your friend wearing what you think is a very ugly t-shirt. He asks you, “Doesn’t this
t-shirt look great?” and you say “It’s wonderful” and he is very happy
- Agent: You
- Action: You lie
- Consequence: He’s happy
3) Normative Economics and Welfarism
Consequentialism: Focus on consequence
- Examples: utilitarianism maximizing pleasure over pain, welfarism maximizing efficiency and
welfare
Deontology: Focus on action
- Examples: libertarians focus on human freedom, Kantians focus on treating people as ends,
not means
Virtue ethics: Focus on agents
- Aristotle: teleological ethics focus on figuring out the purpose of each social practice, and
hence what virtue we should honor
Price Floor (Minimum Price)
: the price that can be legally charged by sellers of the good must not be lower than the price floor
1) Food price: to produce income support for farmers by offering the prices for their products that
are above market determinant price
2) Wage: to protect low-skilled low wage workers by offering them a wage that is above market
determinant wage
•
Benefits and Costs of Minimum Wage Laws
•
Price Ceiling (Maximum Price)
: price that can be legally charged by sellers of the good must not be higher than the legal maximum
price set by the government
o
o
1) Rent control: to make house more affordable to low-income family
Consequences
- House becomes more affordable to low-income family
- Shortage of housing (Qd > Qs)
- High income family suffer from shortage
- Unprofitable to landlords to maintain or renovate their rents
2) Food price control: to make food more affordable to low-income family
Consequences
- Food become more affordable to low-income family
- Shortage of food arises
- Producers of agricultural goods face less incentive to produce
•
Price Supports (Government purchase of excess supply)
•
Production Quotas
1) Example: Why can’t I find a taxi?
•
Excise Tax (Specific Tax)
: tax of a certain amount of money per unit sold
1) Without tax, the price that consumers pay (Pb) equals the price producers receive (Ps)
Pb = Ps
2) With an excise tax (T), what buyers actually pay exceeds what sellers actually receive
Pb = Ps + T
3) Graph
4) Tax incidence
•
Subsidy
: payment reducing the buyer’s price below the seller’s price; i.e., a negative tax; monetary
assistance provided by the government to individual or groups of individuals, such as firms,
consumers, industries or sectors of an economy
Lecture Notes 7: Market Power and Monopoly
Outline
1. Preliminary Discussion
o Review of perfect competition
o Market power
2. Economics of monopoly with simple (uniform) pricing strategies
o Monopolistic equilibrium
o Rule of thumb pricing
o A multi-plant monopoly
o Social costs of monopoly
o Antitrust and competition laws
o Mini Case studies: China’s Baidu
o Why do monopolies exist?
•
Market Power
: ability of a seller or buyer to affect the price of a good (or other market outcome)
1) Sources of market power
o Access to unique resources
o Control over intellectual property, patent and copyrights
o Economies of scale
o Regulation
o Network effects (social media)
2) Two approaches to measure market power
o Concentration measures: Concentration Ratio (CRn) / Herfindahl-Hirschman Index (HHI)
o Performance measure: Lerner Index (LI)
•
Concentration measures: Concentration Ratio (CRn) / Herfindahl-Hirschman Index (HHI)
o
Concentration does not imply market power
- Advantages
a) Easy to compute: used frequently by antitrust authorities to gauge whether mergers are
anti-competitive
-
Disadvantages
a) No information about costs or profits: under certain market structures, market can be
very unconcentrated and yet firms have a lot of market power
b) Requires market definition, which is often contentious
c) Deepest conceptual problem: concentration is an outcome, not a core determinant of
how competitive an industry or market is:
(i)
Concentration can be associated with either less or more competition and
decreased or increased productivity
(ii)
A large class of models predicts negative correlation between market power and
concentration
•
Lerner Index of Monopoly Power
•
Comparison between PC and Monopoly
Perfectly Competitive Industry
Industry is highly fragmented:
No single firm has market power
No barriers to entry
No product differentiation
Each firm acts as a price-taker:
A single firm’s production and capacity
decisions has little influence on the market
price (determined by market equilibrium)
Monopoly Industry
Industry is highly concentrated:
A single firm accounts for a dominant share
Significant barriers to entry
Brand loyalty or switching costs
Monopolist acts as a price-maker:
Dominant firm’s decisions to determine the
market price
•
Demand and MR
1) A technical tip for deriving MR
•
The Monopolist’s Output Decision
•
Example of Profit Maximization
•
A Rule of Thumb for Pricing
1) Example:
•
A Multiplant Monopoly
•
The Multiplant Firm
•
Application: Cartel’s Profit Maximization
1) Cartel: a group of firms that collusively determine the price and output in a market; agreement
between firms to limit competition and increase monopoly power à increase in profits
o A cartel acts as a single monopoly firm that maximizes total industry profit
o The problem of optimally allocating output across cartel members is identical to the
monopolist’s problem of allocating output across individual plants
2) A cartel does not necessarily divide up market shares equally among members: higher marginal
cost firms produce less
3) This gives us a benchmark against which we can compare actual industry and firm output to see
how far the industry is from the collusive equilibrium
•
The Social Costs of Monopoly: Deadweight Loss
•
Additional Costs
1) Additional costs of monopoly
o The social cost of monopoly can be bigger than (B+C)
o If the monopolist spends resources to create and/or maintain the monopoly position (“RentSeeking Behavior” such as lobbying, advertising and legal efforts to avoid antitrust scrutiny),
there could be an additional loss: a monopoly would have an incentive to spend up to (A-C) for
the monopoly right
2) Example:
•
Antitrust and Competition Laws
1) Government may intervene to move the market toward a more competitive outcome and
reduce deadweight loss
2) Antitrust and competition laws promote competition by restricting firms from certain behavior
that might limit competition
o Bans on collusion among competitors with regard to pricing
o Prevent firms from merging with or acquiring other firms if doing so will increase market power
3) Competition policy in Singapore
o Competition Commission of Singapore (CCS) oversees anti-compeititive activities
o Competition Act (effective since 2004) is the law in Singapore that protects consumers and
business from anti-competitive activities
- Abuse of dominance
- Anti-competitive agreements
- Mergers and acquisitions that substantially lessen competition
4) Abuse of dominance
o Anti-competitive activities that protects or enhances its dominant position are illegal
- Deter other competitors from entering the market
- Intend to drive competitors out of the market
o Examples
- Exclusive dealing (e.g. Tied petrol stations that only deal with one petroleum suppliers; Seller
agreeing to sell only to certain buyer)
- Aggressive pricing
•
Why Do Monopoly Markets Exist?
1) Natural monopoly
o Economies of scale (long-run AC decline as output increases) may lead to a situation where a
single firm services the entire market for a good
- Example: electricity distribution requires an extensive network of cables (large fixed cost) –
one provider can achieve lower costs than multiple providers à This often occurs in
industries that have prohibitively high fixed costs such as power, sewage, water production,
railways
o Network effects: value of product increases according to the number of other users using it
- Example: Facebook and Instagram are no fun if you are the only one own it
o The beneficial effects of economies of scale may outweigh the negative effects of market
power
o Graph
2) “Created” Barriers to Entry
o Government regulation
- When economies of scale are strong, limiting competition may avoid duplication and reduce
the cost of service
- Examples: local telephone service, electricity and gas, postal services
o Patents, licenses and copyrights
- Intellectual property protection helps the producers monopolize and legally enforce their
market power
- Examples: Drug patents; Microsoft’s copyright over Office
Lecture Notes 8: Pricing with Market Power
Outline
1. Introduction
2. Capturing Consumer Surplus
o Price discrimination: sell the same product or services at different prices
- First degree price discrimination
- Second degree price discrimination
- Third degree price discrimination
- Direct vs. Indirect segmentation
- Economics of coupons/rebates
- Two-part tariff
•
Uniform Pricing
•
Price Discrimination
: practice of charging different prices to different consumers for identical/similar goods
1) Pricing of a product over different quantities (beer price) or pricing of a product over various
consumer segments
2) Pricing through upfront fixed fees and per-unit prices (country club, personal seat licenses in
sports)
3) Pricing of many products through bundling
4) For an effective price discrimination strategy:
o Recall managers’ goal is straightforward: you want to price to capture as much consumers
surplus as possible away from the buyers
o The key issues are:
- How to identify different customers
- How to capture consumer surplus
•
First-Degree (Or Perfect) Price Discrimination
: prices each unit sold at the consumer’s maximum willingness to pay à directly observable by the
monopolist
•
Second-Degree Price Discrimination
: practice of charging different prices per unit for different quantities of the same good or
service
1) Quantity discounts are an example of second-degree price discrimination
2) Tiered pricing – the practice of charging different prices for different quantities of
“blocks” of a good
3) Example:
o Electric power companies charge different prices for a consumer purchasing a set block
of electricity
o Frequent flyer program
o Zalora: free shipping for sales of $40 +
4) Graph
•
Third-Degree Price Discrimination
: offers a different price for each segment of the market when membership in a segment
can be observed
1) Direct market segmentation
2) Implementation needs fixed identifiable characteristics (e.g. age, location, nationality)
3) Example: MRT fare for senior citizens and students
4) Challenge: Consumers may resell the product
o Buy the product at one market with lower price and sell to the other market with
higher price
o Grey Market (parallel traders)
- Controlling grey markets
a) Product
à Technical differentiation
à Packaging and labelling
à Limit warranty service
b) Distribution
à Limit sales to certain regions
à increase control over distribution – forward integration
•
Indirect Segment Discrimination
: price discrimination when the seller cannot identify different consumer groups (or
segments)
1) When buyers are not directly identifiable, sellers can design and offer a set of menu to
the unidentifiable consumer groups, through which consumers get to self-reveal their
types
2) It is important to link different prices to the attributes that are specific only to some
consumer segments
3) Example
•
Intertemporal Price Discrimination
: separate consumers with different demand functions by charging different prices at
different points in time
1) Two groups of consumers: one willing to pay more to get the product early and one
willing to wait
o Initial release of a product, the demand is inelastic
o Once market with inelastic demand has yielded a maximum profit, firms lower the price
to appeal to a general market with a more elastic demand
o Example: many elctronics such as phones, tables, TV
•
Coupon and Rebates
•
The Two-Part Tariff
Lecture Notes 9: Monopolistic Competition and Oligopoly
Outline
1. Monopolistic competition (MC)
o What makes an MC market
o Horizontal vs. Vertical differentiation
o Sustainable competitive advantage
o MC market equlibrium in SR and LR
o Comparing monopolistic competition and perfect competition
2. Oligopoly
o What makes an oligopoly market?
o Oligopoly models
o Static oligopoly
o Dynamic oligopoly
o First (second) mover advantage
Part I: Monopolitic Competition (MC Market)
Part II: Oligopoly
•
Cournot Oligopoly
•
Betrand Duopoly
•
Dynamic (Sequential) Oligopoly
•
Cournot – Stackelberg Duopoly
•
Bertrand – Stackelberg Duopoly with Homogenous Products
Lecture Notes 10: Game Theory I: Static Games
Outline
1. Strategic Thinking in Static Games
o Some Equilibrium concepts
- Dominant strategy equilibrium
- Iterated dominance equilibrium
- Maximin equilibrium
o Nash Equilibrium
2. Application
•
Dominant Strategy Equilibrium
•
Iterated Dominant Equilibrium
•
Maximum Strategy Equilibrium
•
Nash Equilibrium
•
The Prisonner’s Dilemma
Lecture Notes 11: Game Theory II: Dynamic Games
Outline
1. Repeated Games
o Dynamic Pricing: Competition vs. Tacit Collusion
2. Sequential Games
o Backward Induction and Subgame perfection
o Game: Firm entry
3. Strategic Moves
o Entry deterrence
4. Platform Markets: Social media
•
Repeated Games
•
Sequential Games
•
Strategic Moves
•
Platform Markets
Lecture Notes 12: Asymmetric Information
Outline
1. Hidden information and adverse selection
o Case of Used Cars: Lemons vs. Plums
o Other examples: dating
o Mitigate adverse selection
- Signaling and screening
- Returns to education: labor and marriage markets
2. Hidden action and moral hazard
o Moral hazard
o Principal-agent problem
o Example: CEO salaries
•
Asymmetric Information
Part II: Hidden Action and Moral Hazard