Managerial Economics

Managerial Economics
Tew 2e Bachelor
Mieke Simons
C1: Introduction to Managerial Economics
Managerial economics is the science of directing scarce resources to manage cost more effectively
 Managers must make the best of scarce resources
Introduction: Airbus vs Boeing
 Did Airbus respond correctly to Boeing’s new launche?
 Should Boeing proceed with the development?
 …
New economy vs old economy
 Most things similar
 Main differences
o Network effects in demand
o Importance of scale and scope
Scalability of Google vs scalability of traditional library
 Microeconomics
: The study of individual economic behavior where resources are costly
 Macroeconomics
: The study of aggregate economic variables
 Managerial economics : The application of microeconomics to managerial issues
 Economic behavior is systematically
 An economic model
= A concise description of behavior and outcomes
 Focus on a few key variables
 Similar with a map
Marginal vs average
 Marginal value :The change in the variable associated with a unit increase in a driver
 Average value :The total value of the variable divided by the total quantity of a driver
Stocks and flows
 A stock : The quantity of a given item at a specific point of time
 A flow : The change in a given item over a period of time
Other things equal
The assumption that all other relevant factors do not change, made so that changes due to the factor
being studied may be examined independently of those other factors
A procedure used to transform future dollars into an equivalent number of present dollars.
Net present value
The sum of the discounted values of a series of inflows and outflows over time
The current valuation of a flow of dollars over time
𝑁𝑃𝑉 = (𝐵0 − 𝐶0 ) +
(𝐵1 −𝐶1 )
(𝐵2 −𝐶2 )
+ (1+𝑑)
2 +
(𝐵𝑛 −𝐶𝑛 )
𝐵𝑡 = 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑡 𝑒𝑛 𝐶𝑡 = 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑡
Read “internal rate of return” p 18
Organizational boundaries
 Vertical boundaries
: Delineate activities closer to or further from the end user
o Example: automobile industry: from production of steel to vehicle distribution
o Example: America Online wider vertically than Google
 Horizontal boundaries : Are defined by the scale and scope of an organization’s operations
o Scale : the rate of production/ delivery
o Scope : the range of different items
Individual behavior
 Bounded rationality: they have limited cognitive abilities and cannot fully exercise self-control
o Causing people to adopt simplified rules for decision-making
o Lack of self-control: people having difficulties postponing
 2 implications for managerial economics
o People relatively sluggish (traag) in responding to changes
o Now also has an important role in correcting systematic biases
A market: consists of the buyers and sellers that communicate with one another for voluntary exchange
Markets for consumer products
Markets for industrial products
Markets for human resources
Household buyers, businesses sellers
Businesses buyers and sellers
Businesses buyers, households sellers
An industry: consists of the businesses engaged in the production/ delivery of the same/ similar items
Competitive markets (demand-supply model)
 Many buyers and many sellers
 No room for managerial strategizing
 Achieves economic efficiency
Market power
 Market power : The ability of a buyer or seller to influence market conditions
 Seller with market power must manage his demand
Costs | pricing | advertising | strategy towards competitors | …
Imperfect markets
 Imperfect market
o One party directly conveys a benefit/ cost to others
o One party has better information than others
 Managers in imperfect markets need to think strategically
Communications and trade barriers
 Costs of international transport and communication have fallen
 Barriers to trade have been reduced
 Regional free trade areas
EU | ASEAN | …
 Markets became more integrated across geographical boundaries
The purchase of services or supplies from external sources
Summary + Key Concepts
p. 15
Review Questions
p. 16
C2: Demand
Introduction: Rising gasoline prices
 Lutz: “it sounds cavalier, but in any household budget, gasoline isn’t a factor.”
 Wrong! Gasoline prices rose very sharp:
o Sales of full-size SUVs dropped!
o Sales of hybrid gasoline-electric vehicle soared!
 Other things equal, how many… would you buy at a price of…?
 Individual demand curve shows
o The quantity the buyer will purchase at every possible price
o The maximum price the buyer is willing to pay
 Marginal Benefit: The benefit provided by an additional unit of the item
 Diminishing MB: Each additional unit provides less benefit then the preceding unit
 The consumer’s preferences may change
 Different customers: different preferences
=> demand curve will change
=> demand curves different
Income changes
 Change in price : movement along the curve
 Change in income : movement of the entire curve
Normal vs inferior products
 Normal products : Demand increases with income
o Broad categories
o Movies in general, transportation services,…
 Inferior products : Demand falls with income
o Particular products within the categories
o Afternoon matinees, public transport,…
 Important distinction for
o Business strategy
Growing economy vs recession
o International business Rich country vs poor country
Part I : Competitive Markets
Complements and substitutes
 Complements : increase in 𝑝1 causes a fall in 𝑞2
 Substitutes
: increase in 𝑝1 causes an increase in 𝑞2
 Informative or persuasive
 Demand increases with advertising
 Effect depends on medium
Durable goods
3 factors particularly significant in demand for durable goods
Expectations about future prices and incomes
Interest rates
Price of used models
The market demand: graph showing the quantity that all buyers will purchase at every possible price
 Horizontal summation of the individual demand curves
Other factors
 Change in price
: movement along the curve
 Change in other factors : movement of the entire curve
 Measure incomes in different countries
o With GDP and GNP
o GNP = GDP + net income from foreign sources
Income distribution
 Average income when estimating market demand
 Ignores the distribution of income!
 Total benefit: benefit yielded by all the units that the buyer purchases
 Graphically: area under the demand curve up to the last unit purchased
Benefit vs price
 Buyer surplus: total benefit – actual expenditure
Part I : Competitive Markets
Price changes
 Price reduction: buyer gains in 2 ways
o Lower price for original quantity
o Will by more
 Price increase: buyer loses in 2 ways
o Higher price for original quantity
o Will by less
Package deals and two-part pricing
 To take the buyer surplus
o Package deals (ex p.41)
o Two-part price: fixed payment + charge based on usage
Market buyer surplus
 The same principles as those for the individual buyer surplus
In many ways the principles are the same as for the consumer demand. The most important differences
between consumers (C) and businesses (B):
 C: buy goods and services for final consumption or usage
 B: buy goods and services to use them as inputs
 C: MB: The benefit provided by an additional unit of the item
 B: MB: The increase in revenue arising from an additional unit of the input
 Business demand: the input that the B will purchase at every possible price
o Diminishing MB
o Curve slopes downward
Factors in demand
 Change in price
: movement along the curve
 Change in other factors : movement of the entire curve
Summary + Key Concepts
p. 44
Review Questions
p. 45
Part I : Competitive Markets
C3: Elasticity
Introduction: MTA
 Fares and tolls raised => Increase in prices
 The effect of the increase in prices?
Elasticity of demand
 The responsiveness of demand to changes in an underlying factor
When 𝑝 rises by 1%, what is the percentage of change for 𝑞?
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝
𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑡𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞
𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑡𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝
 Arc approach
o From the average values of observed 𝑝 and 𝑞
𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑡𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞/𝑝 =
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞/𝑝
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑞/𝑝
o Between 2 points
Point approach
o From a mathematical equation, in which q is a function of p and other variables
o At a specific point
 It’s a negative number
 It’s a pure number that does not depend on units or measure
 −∞ ≤ 𝜀𝑝𝐷 ≤ 0
o Elastic if a 1% increase in p leads to more than a 1% drop in q : |𝜀𝑝𝐷 | > 1
Inelastic if a 1% increase in p leads to less than a 1% drop in q : |𝜀𝑝𝐷 | < 1
Intuitive factors
 Availability of (in)direct substitutes
o More substitutes, more elastic
o Specific product more elastic than product category
 Buyer’s prior commitments
 Benefits/ costs of economizing
Elasticity and slope
 Demand curve steeper => demand is less elastic
 Elasticity and slope are related, but not equivalent!!
 Elasticity can also vary with changes in price, demand,…
Part I : Competitive Markets
Quantity demanded
 How will a … % in p affect q?
 Buyer expenditure = 𝑞 ∗ 𝑝
 Demand is price elastic
o 𝑝 ↑ will reduce expenditure : 𝑞 ↓↓ ∗ 𝑝 ↑
 Demand is price inelastic
o 𝑝 ↑ will increase expenditure : 𝑞 ↓ ∗ 𝑝 ↑↑
 𝜀𝑝𝐷 may vary along a demand curve
Forecast using 𝜀𝑝𝐷 is less precise as a forecast directly from the demand curve
Income elasticity
 When the income rises by 1%, what is the percentage of change for 𝑞?
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑦
+ for normal products
– for inferior products
Pure number
−∞ ≤ 𝜀𝑦𝐷 ≤ +∞
o Elastic if a 1% increase in y leads to more than a 1% change in q
o Inelastic if a 1% increase in y leads to less than a 1% change in q
: 𝜀𝑦𝐷 > 1
: 𝜀𝑦𝐷 < 1
Demand for necessities is less income elastic than the demand for discretionary items
Cross-price elasticity
 When 𝑝1 rises by 1% , what is the percentage of change for 𝑞2 ?
 + for substitutes
– for complements
 −∞ ≤ 𝜀𝑥𝑦
≤ +∞
Advertising elasticity
 When advertising expenditure rises by 1% , what is the percentage of change for q?
 Bigger for individual demand than for market demand (competitors)
Forecasting the effects of multiple factors
 % change in q due to changes in multiple factors
= sum of % changes due to each separate factor
Part I : Competitive Markets
The short run : buyer cannot adjust at least one item of consumption or usage
The long run : buyer can adjust all items of consumption or usage
 Cigarettes, liquor, bus, subway,…
 More elastic in the long run than in the short run
 Cars, refrigerators, furniture,…
 Balance between 2 effects
o Adjustment time: more elastic in LR
o Replacement frequency effect: more elastic in SR
Forecasting demand
 By using LR-elasticities instead of SR-elasticities
Records of past experience
Surveys and experiments
Time series
: a record of changes over time in 1 market
Cross section : a record of data at one time over several markets
 Dependent variable
: whose changes are to be explained
 Independent variable : a factor affecting the dependent variable
 𝐷 = 𝑏0 + (𝑏1 ∗ 𝑝) + (𝑏2 ∗ 𝑁) + (𝑏3 ∗ 𝐴) + (𝑏4 ∗ 𝑐) + 𝑢
Multiple regression
 Statistical technique to estimate the separate effect of each independent variable on the dependent
 So makes the “other things equal” condition count
 Residual = difference between predicted value and actual 𝐷
 𝑢 = 𝐷 − [𝑏̂0 + (𝑏̂1 ∗ 𝑝) + (𝑏̂2 ∗ 𝑁) + (𝑏̂3 ∗ 𝐴) + (𝑏̂4 ∗ 𝑐)]
o 𝑢 = + when actual quantity exceeds the predicted value
o 𝑢 = − when actual quantity is less than the predicted value
 Method of least squares
 Minimize the sum of the squares of the residuals
 Using estimates to calculate elasticities
=> 𝜕𝑥
𝜀𝑥𝐷 = 𝜕𝑥 .
Part I : Competitive Markets
Statistical significance
F statistic
Assumption: coefficients all 0
Estimates statistical significant when
o Probability of value below specific benchmark
R² statistic
Variations of the dep.var. caused by the indep.var.?
0 ≤ 𝑅2 ≤ 1
o 0: indep.var. account for none of the variation in the dep.var.
o 1: all residuals are exactly 0
t-statistic and p-value
o Evaluate the significance of a particular indep.var.
o −∞ ≤ 𝑡 ≤ +∞
o Probability that estimated coefficient could be the result of chance (when coeff = 0)
o Statistical significant when below specific benchmark
Summary + Key Concepts
p. 77
Review Questions
p. 78
Part I : Competitive Markets
C4: Supply
Introduction: furniture manufacturer Bestar
 How do changes in the prices of lumber and wood affect the furniture industry?
 How do competitors affect the supply?
 Shut down or continue?
The short run : seller cannot adjust at least one input
The long run : seller can adjust all inputs
Fixed vs variable costs
 Fixed cost
: cost of inputs that do not change with the production rate
 Variable cost : cost of inputs that change with the production rate
 Total cost
: 𝐶 =𝐹+𝑉
Marginal cost
 Marginal cost : the change in C due to the production of an additional unit
: the slope of the C-curve
 Increasing MC : with each increase in the production, the MC increases
Average cost
 Average cost = unit cost
𝐴𝐶 = 𝑞 = 𝑞 + 𝑞
o Average F: falls with the production rate
o Average V: falls and then increases with the production rate
Marginal product: the increase in output arising from an additional unit of the input
o Diminishing
o Causes AC and MC curves to rise
 Better technology can reduce costs
o To reduce F
: will lower its AC curve
o To reduce V : will lower its AC, AV an MC
 Different sellers may have different technologies
Part I : Competitive Markets
Production rate
 Total revenue : 𝑅 = 𝑝 ∗ 𝑞
 Profit
:𝜋 =𝑅−𝐶
 Marginal R
: the change in R arising from selling an additional unit
: the slope of the R-curve
 Competitive market
o 𝑀𝑅 = 𝑝
o Maximize profit
: 𝑀𝐶 = 𝑀𝑅 = 𝑝
Break even
 Avoidable cost : a cost that can be avoided when shutting down (V)
 A sunk cost
: a cost that has been committed and cannot be avoided
 Break even condition so that price cover average V
o 𝑅 − 𝑉 − 𝐹 ≥ −𝐹 ⟺ 𝑅 ≥ 𝑉 ⟺ 𝑝 ≥ 𝑉/𝑞
Individual supply curve
 A graph showing the q one seller will supply at every possible p
 Slopes upward
Input demand
 Price of an input will affect the costs for supply
o 𝑝𝑖𝑛𝑝𝑢𝑡 decreases: the MC will shift downward => input less expensive
o 𝑝𝑖𝑛𝑝𝑢𝑡 increases: the MC will shift upward
=> input more expensive
Price of an input will affect the demand for that input
o Similar to the individual demand
Long-run costs
 Production close to 0 => long-run so no F => minimum size of production
 AC lower + more flexible
Production rate
 Competitive market
o 𝑀𝑅 = 𝑝
o Maximize profit
: 𝑀𝐶 (𝐿𝑅) = 𝑀𝑅 = 𝑝
Break even
 Break even condition so that price cover average C
o 𝑅−𝐶 ≥0 ⇔ 𝑅 ≥𝐶
⇔ 𝑝 ≥ 𝐶/𝑞
Individual supply curve
 A graph showing the q one seller will supply at every possible p
 Slopes upward
Part I : Competitive Markets
A graph showing the quantity that the market will supply at every possible price
Short run
 Market supply curve
o Horizontal sum of the individual supply curves
o Begins with the seller who has the lowest average variable cost
 Change in the input price
o Market supply curve also shifts
Long run
 Market supply curve
o Horizontal sum of the individual supply curves
o Slopes more gently (is more elastic) than the short run
 Freedom of entry and exit
o If 𝑅 ≱ 𝐶 then they leave
o Market supply ↘ and market price ↗ and profits ↗
o New entrants because profits
o Market supply ↗ and market price ↘ and profits ↘
 Change in market price
o Existing sellers will adjust along their curve
o Sellers may enter or leave the market
 SR market supply
: slopes upward
 LR market supply
o Slopes upward : vary in quality
o Is flat
: replication of existing businesses
Price vs marginal cost
 Seller surplus SR
o Revenue from some q – the minimum amount necessary to produce that q
o Revenue from some q – the sum of the MC up to q
o 𝑅−𝑉
 Seller surplus LR
o Revenue from some q – the minimum amount necessary to produce that q
o 𝑅−𝐶
 Use the analysis of seller surplus
 Purchase in bulk and steal the surplus
Market seller surplus
 Sum of the individual seller surpluses
 Price line – market supply curve
Part I : Competitive Markets
The responsiveness of supply to changes in an underlying factor
Price elasticity
 When p rises by 1%, what is the percentage of change for supplied q?
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝
𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑡𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞
𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑡𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝
 It’s a positive number
 It’s a pure number that does not depend on units or measure
 0 ≤ 𝜀𝑝𝑆 ≤ +∞
o Elastic if a 1% increase in p leads to more than a 1% increase in q
Inelastic if a 1% increase in p leads to less than a 1% increase in q
: 𝜀𝑝𝑆 > 1
: 𝜀𝑝𝑆 < 1
Intuitive factors
 Capacity utilization affects the elasticity off supply
 LR-supply is more elastic than the SR-supply
Forecasting quantity supplied
 Use the elasticities to forecast certain changes
Summary + Key Concepts
p. 111
Review Questions
p. 111
Part I : Competitive Markets
C5: Competitive Markets
Introduction: oil tanker market
 What would be the impact of…
 Increasing oil prices
 Increasing oil consumption
 …
Perfect competition/ demand-supply framework
 Products homogeneous
 Many buyers + many sellers
 Free enter and exit
 Symmetric information
Homogeneous product
 Perfect substitutes
 Price from any source is exactly the same
Many small buyers/sellers
 Purchase/supply a 𝑞 that is small relative to the market
 No market power
 All buyers/sellers face the same price
Free entry and exit
 Barriers may reduce number of sellers/buyers
Symmetric information
 Sellers vs buyers
 Sellers vs sellers and buyers vs buyers
The price at which the demanded 𝑞 equals the 𝑞 supplied
Demand and supply
 Market equilibrium where supply en demand curves cross
 Price, purchases or sales will not tend to change
Excess supply/demand
 Excess supply
Excess demand
: 𝑞𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑 > 𝑞𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
:𝑝 ↘
: 𝑞𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑 < 𝑞𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
:𝑝 ↗
Part I : Competitive Markets
Significance of equilibrium
 If not => buyers/sellers will push the market toward equilibrium
 To compare equilibria
Equilibrium change
 Cost for supply drops
 Entire supply curve drops
 New equilibrium
Price elasticities
 Change in 𝑝 bigger when 𝐷 less elastic
 Change in 𝑝 bigger when 𝑆 more elastic
 Draw the curves!
Common misconception
 The effect of a change on 𝑝 depends on the price elasticities of both demand and supply
Same reasoning as for a supply shift
Again: look at the price elasticities!
Short-run equilibrium
 Competitive market
o 𝑀𝑅 = 𝑝
o Maximize profit: 𝑀𝐶 = 𝑀𝑅 = 𝑝
Long-run equilibrium
 Competitive market
o 𝑀𝑅 = 𝑝
o Maximize profit: 𝑀𝐶(𝐿𝑅) = 𝑀𝑅(𝐿𝑅) = 𝑝 > 𝐴𝐶
Demand increase/reduction
 Think logically + always draw the curves!
Price and quantity over time
 Shift in demand
o 𝑝 more volatile in the SR than in the LR
o 𝑞 more volatile in the LR than in the SR
 More sunk costs => sharper inequality between SR and LR
Summary + Key Concepts
Review Questions
p. 137
p. 138
Part I : Competitive Markets
C6: Economic Efficiency
Introduction: price increases for welfare
 Economic efficiency in management
o To manage resources
o Opportunities for profit
 Whenever the allocation of resources is not economically efficient, there is a way to make money by
resolving the inefficiency
An allocation of resources is economically efficient is no reallocation can make one person improve without
making another person worse off.
Sufficient conditions
 Allocation sufficient, if for every item
1. All users the same 𝑀𝐵
2. All suppliers the same 𝑀𝐶
3. 𝑀𝐵 = 𝑀𝐶
Philosophical basis
 Technical efficiency: provision of an article at the minimum possible cost
 Economic efficiency extends beyond
o 𝑀𝐵 = 𝑀𝐶
o 𝑀𝐵 reflect each individual user’s evaluation
Internal organization
 To make the best use of scarce resources
The invisible hand that guides multiple buyers and sellers, acting independently and selfishly, to channel
scarce resources into economically efficient uses, is the market price.
Competitive market
 Demand
: 𝑀𝐵 = 𝑝
(1st condition)
 Supply
: 𝑀𝐶 = 𝑝
(2nd condition)
 Equilibrium
: 𝑝 𝑒𝑞𝑢𝑎𝑙 → 𝑀𝐵 = 𝑀𝐶
(3rd condition)
 Competitive markets are economically efficient
Market systems
 A price: communicates necessary information + provides a concrete incentive
 Market system = price system: economic system in which resources are allocated through the
independent decisions of buyers and sellers, guided by freely moving prices
Part I : Competitive Markets
Internal market
 With decentralizing policies => integration with the external market
 Strive for economic efficiency
 Transfer price: price charged for the sale of an item within an organization
 Rules for decentralizing control
o If competitive market for item => 𝑡𝑟𝑎𝑛𝑠𝑓𝑒𝑟 𝑝 = 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝
o Outsourcing + external selling must be allowed
 Outsourcing: the purchase of services or supplies from external sources
Freight inclusive pricing
 The cost and freight (CF) price includes the cost of delivery to the buyer
 Supply CF < supply
=> 𝑝 higher
Ex-works pricing
 The ex-works price does not yet include the cost of delivery to the buyer
 Demand ex-works < demand => 𝑝 lower
 Both give the same results
 New and old equilibrium are identical
 The change in 𝑝 for a buyer or seller resulting from a shift in demand or supply
 The same for freight inclusive and ex-working pricing
 Depends only on the price elasticities
 Regardless of whether buyers or sellers pay brokerage fees => 𝑝 en 𝑞 stay the same
Buyer’s vs seller’s price
𝑝𝑠 = 𝑝𝑏 − 𝑡𝑎𝑥
Buyer’s point of view
Seller’s point of view
: supply curve shifts up
: demand curve shifts down
: 𝑝𝑏 = 𝑝 + 𝑡𝑎𝑥
: 𝑝𝑠 = 𝑝 − 𝑡𝑎𝑥
Tax incidence
Effect of tax will be the same, whether collected from sellers or buyers
o The more elastic a party, the more advantage
o The less elastic a party, the larger the portion of the tax for that party
Summary + Key Concepts
p. 159
Review Questions
p. 160
Part I : Competitive Markets
C7: Costs
Introduction: Boeing vs Airbus
 What’s the reason for the cheaper cost for Airbus?
 Why was Northwest buying new planes amidst continuing losses?
Large-scale production => mass marketing, relatively low pricing
Small-scale production => niche marketing, relatively high pricing
Fixed and variable costs in the long run
 Fixed cost
: does not change with the production rate/scale
 Variable cost : does change with the production rate/scale
 Only variable costs will be affected by changes is the production scale
Marginal and average cost
 Economies of scale = increasing returns to scale
 The average cost decreases with the scale of production
o Average variable cost => constant (and equal to MC)
o Average fixed cost
=> decreases
 Because MC < AC more production will reduce the average
Intuitive factors
 2 possible sources for economies of scale
o Substantial fixed inputs
o Average VC falls with the production rate
Diseconomies of scale
 Decreasing returns to scale
 The average cost increases with the scale of production
o No substantial fixed costs
o Average VC increases with production rate
Strategic implications
 Economies of scale
=> mass marketing, low pricing
 Diseconomies of scale => niche marketing, high pricing
=> concentrated (market power)
=> fragmented
Economies of scope
: when the 𝑇𝐶1+2 < 𝑇𝐶1 + 𝑇𝐶2
Diseconomies of scope : when the 𝑇𝐶1+2 > 𝑇𝐶1 + 𝑇𝐶2
Part II : Market Power
Joint cost
 The cost of inputs that do not change with the scope of production
 Example: the scope of a newspaper
o Daily globe
=> each day expense of the printing press for 1 paper
o Daily + afternoon globe => each day the same expense => for both papers
Strategic implications
 Multiproduct suppliers dominate industries with economies of scope
 Brand extension
o Expenditure on advertising the brand is a joint cost
o Immediately advertising for all the underlying products
 Core competence
o Generalized expertise on common or closely related technologies
o Can be applied to several products => wore competence = joint cost
Diseconomies of scope
 When no significant joint cost
Learning curve
Shows how the unit (average) cost of production falls with cumulative production over time
Experience curve
=> cumulative production over preceding periods
Economies of scale
=> scale of production within one period
Strategic implications
 Crucial to forecast cumulative production accurately
 Big difference in cost
Principle of relevance: managers should consider only relevant costs
Uncovering relevant costs
 Conventional accounting overlooks the alternatives
 Explicitly consider the alternative courses of action
o Investigate them and look what gives the best results
 Use the concept of opportunity cost
o Opportunity cost = the net revenue from the best alternative course of action
Opportunity cost of capital
 Shareholders would like the management to earn a rate of return on equity that at least matches the
return from other investments with the same risk profile
 Economic value added
o Net operating profit after tax (adjusted for accounting conventions)
– a charge for the cost of capital
Part II : Market Power
A transfer price = a price that is charged for a sale of an item within an organization
To maximize the profit of the entire organization
=> Transfer price = MC input
Perfectly competitive market
 Transfer price should be equal to the market price
 𝑀𝐶 = 𝑝 → 𝑡𝑟𝑎𝑛𝑠𝑓𝑒𝑟 𝑝𝑟𝑖𝑐𝑒 = 𝑝 → 𝑡𝑟𝑎𝑛𝑠𝑓𝑒𝑟 𝑝𝑟𝑖𝑐𝑒 = 𝑀𝐶
Full capacity
 When the upstream division (that supplies the input) operates at full capacity
o MC is not well defined
o 𝑡𝑟𝑎𝑛𝑠𝑓𝑒𝑟 𝑝𝑟𝑖𝑐𝑒 = 𝑜𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦 𝑐𝑜𝑠𝑡 𝑖𝑛𝑝𝑢𝑡
Cost that cannot be avoided => not relevant to business decisions
When total of sunk cost > loss by continuing => better to continue!
Uncovering relevant costs
 Explicitly consider the alternative courses of action
o Investigate them and look what gives the best results
 Use the concept of avoidable cost
o Avoidable cost = the total cost – the sunk cost
Strategic implications
 Managers should ignore sunk cost and only consider avoidable cost
 Businesses can exploit investment in sunk cost to influence the behavior of competitors
Commitments and the planning horizon
 Longer planning horizon => more time + freedom of action
 Lon-run horizon => no sunk cots
Sunk costs vs fixed costs
 Not all fixed cost become sunk once incurred
 Not all sunk costs are fixed
Summary + Key Concepts
p. 192
Review Questions
p. 193
Part II : Market Power
C8: Monopoly
Introduction: Prozac, Zoloft and Paxil
 Prozac: monopoly
 Then Zoloft and Paxil came up
 Monopoly
=> the only seller in a market
 Monopsony
=> the only buyer in a market
Prevent entry by other competing sellers
Unique resource
(only 1 needed)
Intellectual property (patents, copyrights,…)
Economies of scope and scale
Product differentiation
Prevent entry by other competing buyers
Unique resource
Intellectual property
Economies of scope and scale
Product differentiation
The existence of a monopoly
 Monopoly electricity distributor => monopsony in the market for power engineers services
A monopoly can set the price or quantity, but not both
 Inframarginal units are those other than the marginal units
 By lowering the price
o Gain revenue on marginal unit
o Lose revenue on inframarginal units
 Difference between 𝑝 and 𝑀𝑅 depends on the demand elasticity
o Very elastic
=> difference smaller
o Very inelastic => difference bigger
Part II : Market Power
Change in 𝑇𝐶 => from change in 𝑉𝐶
Profit-maximizing price
 𝑑𝑒𝑚𝑎𝑛𝑑 = 𝑀𝐵 = 𝑝
 𝑀𝑅 < 𝑝
 Maximize profit: 𝑀𝐶 = 𝑀𝑅 < 𝑝 (< 𝑀𝐵)
 Contribution margin: 𝑇𝑅 − 𝑉𝐶
 At a scale where the sale of an additional unit results in no change to the contribution margin
Economic inefficiency
 Maximizing profit => 𝑀𝐵 > 𝑀𝐶
 People are willing to pay more but cannot get it
 Economically inefficient
 Various pricing policies (chapter 9)
Demand change
 Shift in demand => new 𝑀𝑅-curve
 The 𝑀𝐶-curve remains the same
Marginal cost change
 Price again where 𝑀𝑅 = 𝑀𝐶
 Price will drop proportionately less than the fall in 𝑀𝐶
Fixed cost change
 𝑀𝐶 𝑎𝑛𝑑 𝑀𝑅 do not depend on the fixed cost
 𝑝∗ 𝑎𝑛𝑑 𝑞 ∗ do not depend on the fixed cost
 When fixed costs so big that 𝑇𝐶 > 𝑇𝑅 => better shut down!
Promotion is the set of marketing activities that a business undertakes to communicate with its customers
and sell its products
=> following principles apply to all sellers with market power (not only monopolists)
Benefit of advertising
 Advertising
=> demand shifts out + becomes less elastic
 𝑛𝑒𝑡 𝑏𝑒𝑛𝑒𝑓𝑖𝑡 𝑜𝑓 𝑎𝑑𝑣𝑒𝑟𝑡𝑖𝑠𝑖𝑛𝑔 = 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛 − 𝑎𝑑𝑣𝑒𝑟𝑡𝑖𝑠𝑖𝑛𝑔 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
Advertising-sales ratio
 The incremental margin: marginal contribution margin = 𝑝 − 𝑀𝐶
 The incremental marginal percentage
= (𝑝 − 𝑀𝐶)/𝑝
 𝑎𝑑𝑣𝑒𝑟𝑡𝑖𝑠𝑖𝑛𝑔 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒/ 𝑠𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 = (𝑝 − 𝑀𝐶)/𝑝 ∗ 𝜀𝐴𝐷
 𝑝 ↑ 𝑜𝑟 𝑀𝐶 ↓
: advertising expenditure should increase
 𝜀𝐴 ↑ 𝑜𝑟 𝑠𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢 ↑
: advertising expenditure should increase
Part II : Market Power
R&D => demand shifts out + becomes less elastic
The same logic as with advertising => R&D-sales ratio
Project evaluation
 Often smaller commitment of resources initially
o With significantly larger expenditures
o If technical feasibility + demand conditions are favorable
 Most R&D projects are multi-stage
o Opportunity to modify or abandon
o When more info becomes available
 The real options approach (like a call option)
 Purchaser has the right, but not obligation, to exercise the option at a future date
How do price and production depend on the market structure?
Effects of competition
 When the market is perfectly competitive (LT)
o 𝑀𝐶 = 𝑀𝑅 = 𝑝
o Push p down toward the LR average cost
o Each seller earns zero profit
 When the market is a monopoly
o 𝑀𝐶 = 𝑀𝑅 < 𝑝
o 𝑝 will be higher, 𝑞 will be lower
o Profits will be made
Potential competition
 A perfectly contestable market is a market in which sellers can enter and exit at no cost
 Potential competition will be sufficient to keep the 𝑝 low
 A monopoly in a perfectly contestable market => 𝑝 will not be set very high!
 The more barriers, the easier a monopolist can set a higher price
Lerner index
 Lerner Index = (𝑝 − 𝑀𝐶)/𝑝
 Good to measure monopoly power
 1 problem
o When monopoly does not exercise power
o LI will indicate a competitive market
Part II : Market Power
Benefit and expenditure
 Supply = average expenditure = marginal cost
 Marginal expenditure > average expenditure
Maximizing net benefit
 Marginal expenditure = MB
 𝑝 lower than when 𝑀𝐶 = 𝑀𝐵
Summary + Key Concepts
p. 220
Review Questions
p. 220
Part II : Market Power
C9: Pricing
Introduction: Emirates Airline
 Differences in fares
 Load factor of 71%
 …
A policy where a seller charges the same price for every unit of the product
Price elasticity
 When demand is inelastic => 𝑝 ↑↑ → 𝑞 ↓ => higher profit
 Seller should raise the price
Profit-maximizing price
 𝑀𝐶 = 𝑀𝑅 < 𝑝 (< 𝑀𝐵)
 Not always information about the 𝑀𝑅 => need for a rule based on elasticity
 Set 𝑝 where
𝑝 − 𝑀𝐶
=− 𝐷
Demand and cost changes
 Demand more (less) elastic: the price will be lower (higher)
 𝑀𝐶 is higher (lower): the price should be higher (lower)
Common misconceptions
 Cost accounting
o contribution margin percentage
o (𝑅 − 𝑉𝐶)/𝑅 = (𝑝 − 𝐴𝑉𝐶)/𝑝
o ≠ incremental margin percentage (𝑀𝐶 ≠ 𝐴𝑉𝐶)
 Profit-maximizing price: look at elasticity + costs
 Sometimes it looks easy to set the price by marking up average cost => wrong!
Shortcomings of uniform pricing
 Still people with 𝑀𝐵 > 𝑝
o People are willing to pay more
o By taking a little some buyer surplus => profit can be increased
 Economic inefficiency
o Because 𝑀𝐶 = 𝑀𝑅 < 𝑀𝐵
o By providing the product to people where 𝑀𝐶 < 𝑀𝐵 => profit can be increased
Part II : Market Power
Price discrimination
 A policy where a seller sets different incremental margins on various units of the same product
 Complete price discrimination
o Prices each unit at the buyer’s benefit and sells a 𝑞 such that 𝑀𝐵 = 𝑀𝐶
o Selling down the market demand
o The policy leaves each buyer with no surplus
 Pro’s : resolves the 2 shortcomings of uniform pricing
: gets higher prices for the previous units + sells additional units
 Con’s : customer that wants more units => different 𝑝 for each unit
: not possible to get all the information needed (everybody’s personal MB!)
The policy where a seller charges a different incremental margin to each identifiable segment
A segment: a significant cohesive group of buyers within a large market
Homogeneous segments
 Buyers within each segment are homogenous
 Within 1 segment the same willingness to pay
Heterogeneous segments
 Buyers within each segment no longer homogeneous
 Solutions
o Identify sub-segments
o Apply uniform pricing within each segment
o Indirect segment discrimination
 Identify characteristics that segments the market
o Characteristic must be fixed => a buyer cannot switch from segment
o Prevent buyers from reselling among themselves
 Good example: use age to differentiate
 Easier to do for services (harder to resell)
Discriminate on the basis of the buyer’s location
Free on board (FOB)
 Set a common price to all buyers that does not conclude delivery
 Buyer pays FOB price + cost of delivery
 Differences among prices => cost of delivery
Delivered priding
 Set prices that include delivery
 Buyer pays cost including freight = CF
 Differences among prices => not necessarily the cost of delivery
Part II : Market Power
 FOB ignores the differences between the price elasticities
 CF
implements direct segment discrimination
Difference among prices
o Difference in incremental margin percentage
o Difference in marginal costs of supplying
Restricting resale
 A gray market: buy product where cheaper and ship it over
 Avoid a gray market
o Customize the product for the market
o Limit the sales (according demand in low-price markets)
o Durable goods: warranty service in country of purchase
The policy where a seller structures a choice for buyers so as to earn different incremental margins
When it’s not easy to find a fixed characteristic
o Buyers can change from segment
o Direct segment discrimination becomes impossible
Structured choice
 Set up some restrictions
 Segment with higher benefit will be able to buy unrestricted goods
 Segment with lower benefit will have to buy the restricted one or none
 Seller must have a variable to set up choices (example: restrictions)
 Buyers must not be able to circumvent (evade) the discriminating variable
 Set the prices of all products at the same time (substitution)
The combination of 2 or more products into 1 package with a single price
A method of indirect segment discrimination that restricts buyer choices
More profitable than uniform pricing
Less profitable than direct segment discrimination
Pure bundling
Offer only a bundle
Mixed bundling
Offer a choice between bundle or individual products
 Bundling is relatively more useful when
o A substantial difference among the segments in their benefits from the separate products
o Benefits of the segments are negatively correlated
(product that is more beneficial to 1 segment will be less beneficial to the other)
o Marginal cost of providing the product is low
Part II : Market Power
Ranking of the policies
 Complete price discrimination
 Direct segment discrimination
 Indirect segment discrimination
 Uniform pricing
(buyer attributes)
(product attributes)
 The sales of 1 product reduce the demand for another with a higher incremental margin
 Consumers of one segment buy the item aimed at the other segment
 Will occur with indirect segment discrimination
 Several ways to mitigate cannibalization
o With product design
 Upgrade and degrade
 Use multiple discrimination variables
o Control availability
Summary + Key Concepts
p. 253
Review Questions
p. 254
Part II : Market Power
C10: Strategic Thinking
Introduction: Coca-Cola vs Pepsi
 A strategy
: a plan for action in a situation where the parties actively consider the interactions
with one another in making decisions
 Game theory : a set of ideas and principles that guides strategic thinking
A game in strategic form is a tabular representation of a strategic situation
 Decisions must be taken simultaneously
A dominated strategy is one that generates worse consequences than some other strategy,
regardless of the choices of the other parties => will not be chosen
A cartel is an agreement to restrain competition
o A cartel’s dilemma
o Follow the agreement or not?
 A Nash equilibrium is a set of strategies such that, given that the other players choose their Nash
equilibrium strategies, each party prefers its own Nash equilibrium strategy
Solving the equilibrium
 Rule out the dominated strategies
 Check the remaining strategies, one at a time
 Nash equilibrium is not always the best solution! (prisoners’ dilemma)
 The “arrow” technique
o Strategy is dominated when all arrows pointing out
o Nash equilibrium: cell with all arrows leading in
Nonequilibrium strategies
 If some party does not follow its Nash equilibrium strategy
 Better for other parties to deviate as well
 Unless there are dominated strategies (keep the N-equilibrium)
A strategy for choosing among the alternative pure strategies in accordance with specified
o A pure strategy is one that does not involve randomization
o A pure strategy has not always a N-equilibrium
Nash equilibrium in randomized strategies
 Advantage comes from being unpredictable
 The other party cannot benefit from learning the strategy
Part II : Market Power
Solving the equilibrium
 By making a graph
 By using algebra
=> N-equilibrium where lines cross
=> expected profit (1) = expected profit (2)
A zero-sum game
: one party can become better off only if another is made worse off
(sum can be 0,+,- the same in every cell)
A positive sum game : one party can become better off without another being made worse off
 If they can coordinate, benefit will be higher
 Strategic situations involving coordination => positive-sum games
Focal point
 A N-equilibrium provides a focal point for discussion & action between parties
 Competition + coordination
 After being repeated cooperation may arise (see repetition)
 A game in extensive form is a graphical representation of a strategic situation
 Decisions must be taken in sequence
Backward induction
 A procedure for solving games in extensive form
 Look forward to the final nodes and reasoning backward toward the initial node
Equilibrium strategy
 The sequence of the best actions for a party
 Each action is decided at the corresponding node
Uncertain consequences
 Still backward induction
 Using the probabilities
An action to influence the beliefs or actions of other parties in a favorable way
 To be credible, it must involve sufficient commitment
 Sunk investments are very persuasive (if totally sunk!)
First mover advantage
 Not always! Sometimes followers have an advantage
Part II : Market Power
An action under specified conditions to influence the beliefs or actions of other parties in a favorable way
Conditional strategic move
: has no cost
Unconditional strategic move : usually a cost under all circumstances
 Imposes costs under specified conditions to change the beliefs or actions of other parties
 Example: to deter a hostile takeover
Costs will be imposed as hostile takeover begins
o A scorched earth defense
: destroy the company
(very costly)
o The poison pill
: shareholder rights plan
(costly for taker)
 In negotiations with employers, unions may threaten a strike
 Compare the current wage with possible future wages
 Conveys benefits under specified conditions to change the beliefs or actions of other parties
 Example: deposit insurance: government pays when bank cannot
Conditioning on external events
 Example: condition on an independent variable => odd years vs even years
Conditioning on other parties’ actions
 Example: tit for tat
o Follow another party
o Combines a promise with a threat
Summary + Key Concepts
p. 287
Review Questions
p. 288
Part II : Market Power
C11: Oligopoly
Introduction: Sprint and Nextel merger
 Oligopoly: a small number of sellers, whose actions are interdependent
 Short run
strategic variable
=> pricing
 Long run
strategic variable
=> capacity
Homogeneous product
 The Bertrand model of oligopoly
o Sellers which produce at constant 𝑀𝐶 with unlimited capacity compete on 𝑝
o To market a homogenous product
 Under these conditions
o Demand of newcomer is perfectly elastic
o Competition by lowering 𝑝 will go on until 𝑝 = 𝑀𝐶
o Situation of a perfectly competitive market
 Nash-E where 𝑝 = 𝑀𝐶
 One way to avoid a price war = repeated competition (tit-for-tat)
Differentiated products
 The Hotelling model of duopoly
o Sellers which produce at constant 𝑀𝐶 with unlimited capacity compete on 𝑝
o To market products differentiated by their distance from the consumer
 Under these condition
o Demand of competition no longer perfectly elastic
o 𝑝 now interdependent => best response functions
 Nash-E at the intersection
 This is another way to avoid a price war
 A seller’s best response function shows its best action as a function of competing sellers’ actions
 Higher transport costs => products more differentiated => demand less price elastic => prices higher
 Differentiation is good for prices, not necessarily for sales
Product design
 No position that all customers prefer
 Balance between market share (close to customer) & avoiding a price war (differentiation)
Strategic complements
 Actions by various parties are strategic complements if an adjustment by one party leads other
parties to adjust in the same direction
 Hotelling model & Bertrand model
o Prices are strategic complements
o So if one party raises its price, the other one should follow
Part II : Market Power
The Cournot model of oligopoly
o Sellers which produce at constant 𝑀𝐶 compete on 𝑞
o To market a homogeneous product
Under these circumstances
o 𝑞 now interdependent
o Best response functions
 Nash-E at the intersection
A seller’s residual demand curve = the market demand curve – the 𝑞 supplied by other sellers
Total capacity duopoly < total capacity perfect competition
Market price duopoly > market price perfect competition
Cost differences
 Change in fixed cost will not affect the sellers’ choice of capacity
 Change in variable cost will
o Shift the response curve outward (inward) when cost reduces (increases)
o Lower (increase) the price when cost reduces (increases)
Multiple sellers
 When in a Cournot model the # of sellers increases
o The price will decrease
o The total capacity will increase
 Nash-E of the best response functions
𝑝 − 𝑐̅ 𝐻𝐻𝐼
𝑝 = Nash-E price 𝑐̅ = weighted average MC 𝜂 = elasticity of demand
Herfindahl-Hirschman Index = HHI
o Measures industry concentration
o As the sum of the squares of the various sellers’ market shares
The more concentrated the industry + the less elastic demand, the higher the incremental margin
Strategic substitutes
 Actions by various parties are strategic substitutes if an adjustment by one party leads other parties
to adjust in the opposite direction
 Cournot model
o Capacities are strategic complements
Limit pricing is a strategic move by which an industry leader commits to a level of production so high
that any entrant cannot make a profit, and so, will not enter the industry
o The commitment will not be reversed, regardless of the entrant’s actions
o Production involves a fixed cost
Part II : Market Power
 The Stackelberg model of oligopoly
o Sellers which produce at constant 𝑀𝐶 compete in sequence on 𝑞
o To market a homogeneous product
 Under these circumstances
o The best response function of the follower remains the same (Cournot)
o The one for the leader will absorbe this in its own response function
 Total capacity Stackelberg > total capacity Cournot
 Market price Stackelberg < market price Cournot
Competing sellers can restrain competition through agreement or by integration
 A cartel is an agreement to restrain competition
 Restrains sales to raise 𝑝
o Need enforcement against existing sellers exceeding their quotas
o Need enforcement against new entrants
 Factors that influence the effectiveness of a cartel
o Number of sellers in the market
o Industry capacity
o Sunk cost
o Barriers to entry and exit
o Nature of the product
 Normally cartels are not allowed
the fewer, the better
better to operate near capacity
the fewer, the better
better stronger
better to be homogeneous
Labor unions
 Explicit seller cartels that are allowed
 Collective bargaining: negotiations in which workers are represented by a union
 Restrain the amount of employment so as to raise wages
 Competition by nonunion workers
o Prefer closed shop: employer commits not to hire nonunion workers
o Union becomes a monopoly
 Substitutions for labor: automation, overseas location (foreign labor),…
 Vertical integration
: the combination of the assets for 2 successive stages of production under a
common ownership
 Horizontal integration : the combination of 2 entities, in the same or similar businesses, under a
common ownership
o Cartel illegal => agreement on prices within the same company legal
o Leads to reduction in 𝑞 => raises market price and profits
Part II : Market Power
Aims to ensure a degree of competition that maximizes social welfare
Competition laws
 They prohibit:
o Competitors from colluding on price
o Monopolies & monopsonies from abusing market power
o Mergers/acquisitions that would create monopolies/monopsonies
 Competition agency must enforce the competition laws
o Prosecute against those who violate the laws
o Review proposals for mergers/acquisitions (must meet the criteria)
 Competition laws may provide to sue in civil court
(for persons affected by anticompetitive behavior)
Merger guidelines
 On horizontal mergers
 Investigate mergers
o Whose HHI > 1800
o That raises the HHI by 50 points or more
Summary + Key Concepts
p. 316
Review Questions
p. 317
Part II : Market Power
C12: Externalities
Introduction: General Growth
 An externality arises when 1 party directly (not through a market) conveys a benefit or cost to others
 An item is a public good if 1 person’s increase in consumption does not reduce the quantity available
to others
Positive externalities : when one party directly conveys a benefit to others
o Group’s MB = vertical sum of the individual MBs
Negative externalities : when one party directly conveys a cost to others
o Group’s MC = vertical sum of the individual MCs
Externalities in general
 Externality is resolved at the economically efficient level when
∑ 𝑀𝐵𝑖 = ∑ 𝑀𝐶𝑖
 Also applies when source and recipients are separated
 Also applies for nonmonetary externalities
o Maximize the net benefit
o When monetary => net benefit = profit
 The source + the recipient become 1 entity
 It does not matter who buys whom
 Single entity: invest at the economically efficient level
Joint action
 Negotiate and agree on how to resolve the externality
o Agree how to resolve
o Enforce compliance with the plan
 Deals, contributions,…
Free rider problem
 A free rider contributes less than its marginal benefit to the resolution of an externality
 Will arise when it’s costly to exclude individuals from receiving the externalities
 The more recipients, the stronger the incentive to take a free ride
o Contribution relatively small
o Enough others to compromise
Part III : Imperfect Markets
A network effect
: when a benefit/ cost depends on the total number of other users
A network externality : when a benefit/cost directly conveyed to others depends on the total
number of users
Critical mass
 The critical mass
: the number of users at which the quantity demanded becomes positive
 The installed base
: the quantity of the complementary hardware in service
o A user may need 0,1 or more units of the complementary hardware
o When the user needs 1 => critical mass = installed base
 Optimistic equilibrium : expect lots of users to subscribe
 Pessimistic equilibrium : expect < critical mass to subscribe
 Find a way to influence the expectations
o Commitments, a hype,…
=> subscribe
=> don’t subscribe
 The tendency for the market demand to shift toward a product that has gained a small initial lead
 Demand for product X just exceeds the critical mass
 Slight movement in demand (away from that product) will tip all users away
 This way one product may dominate the market
Price elasticity
 Market demand < critical mass
o Demand = 0
o Extremely inelastic
 Market demand > critical mass
o Demand = elastic
o Network effect causes demand to be more elastic
 Nonviral if one person’s increase in consumption does not reduce the quantity available to others
o Public good
=> consumption is nonviral
o Private goods
=> consumption is viral
o Congestible goods
=> consumption first nonviral => viral when more consumers
Content vs delivery
 Content and delivery can be a different kind of good
Economic efficiency
 All the individual MBs will be below the MC
o No one is willing to pay for any quantity
 The vertical sum of all the MBs are higher than the MC
o Collectively they are willing to pay for the public good
Part III : Imperfect Markets
Consumption is excludable if the provider can exclude particular consumers
Excludability is a fundamental requirement for commercial provision of any item
o Otherwise free rider problem!
A patent is a legal, exclusive right to a product or process
o Makes it excludable => commercial production now feasible
A copyright is a legal, exclusive right to an artistic, literary, or musical expression
o Makes it excludable => commercial production now feasible
Infringement: when not respecting a legal, exclusive right
Effectiveness of exclusion depends on enforcement
 Technology can make a nonexcludable consumption excludable
Commercial provision
 Depends on the extent to which the seller can exclude non-payers
 Technology and laws can change over time and place
Summary + Key Concepts
p. 347
Review Questions
p. 348
Part III : Imperfect Markets
C13: Asymmetric Information
Introduction: group vs individual insurance
 Asymmetric information arises when one party has better information than another
The absence of certain knowledge
Imperfect vs asymmetric information
 Asymmetric information
: involves 2 or more parties
 Imperfect information
: for a single person
o Market can still be perfectly competitive
o IF symmetric imperfect information
Risk defined
 Risk is uncertainty about benefits or costs
o When information is imperfect
o When it affects your own benefits or costs
Risk aversion
 Risk neutral
: indifferent between a certain and risky amounts with the same expected value
 Risk averse
: preference for a certain amount to risky amounts with the same expected value
o Will pay to avoid risk
Demand and supply
 If one market with genuine and fake
o Supply
: no cost for fake ones => supply (genuine + fake) shifts outward
o Demand
: probability of fake
=> demand (genuine + fake) shifts downward
Market equilibrium
 When 𝑝 ↓ , less genuine product will be offered, the quantity of fake ones remains the same
 There will be relatively more fake ones by reducing the price
 Adverse selection: less-informed party draws a selection with relatively less attractive characteristics
Economic inefficiency
 Buyer surplus : falls when receiving a fake, rises when receiving a genuine
 Seller surplus : falls for sellers of genuine ones, rises for sellers of fake ones
Market failure
 Small number of fake ones
 Big number of fake ones
=> equilibrium: fake + genuine
=> demand becomes zero => market will fail
Part III : Imperfect Markets
Lending and insurance
 Not only the buyer is necessarily the less-informed party
 Insurance, loans,… => buyer has more information
 Higher rate or higher premium will lead again to adverse selection
2 conditions for an information asymmetry to be directly resolved
 The characteristic must be objectively verifiable
 Potential gain (resolving it) > cost of appraisal
o Proportion of fakes
o MB – MC
Procuring the appraisal
 When many buyers: relatively greater cost saving if the seller will procure the appraisal
 When needed information between buyers is too different
o Too difficult for seller to procure
o Better individual appraisal procured by buyer
 Lenders can also appraise applicants for loans
An initiative of a less-informed party to indirectly elicit the other party’s characteristics
o Through a variable to which the better-informed parties are differentially sensitive
o To induce self-selection
In self-selection, parties with different characteristics choose different alternatives
Differentiating variable
 Choose the one that drives the biggest possible wedge between the better-informed parties
 A combination of several differentiating variables may work good as well
Multiple unobservable characteristics
 As many differentiating variables are needed as there are characteristics
A pricing technique that screens by exploiting strategic interaction along potential buyers
 Differentiating variable = probability of winning
Auction methods
 Open auction vs sealed-bid auction
 Discriminatory aution
: pay the price that he/she bid
Nondiscriminatory auction
: pay the price bid by the marginal winning bidder
 Set a reverse price
o To defeat collusion among the bidders
o Risk of a failing sale
Part III : Imperfect Markets
Winner’s curse
 The winning bidder overestimates the true value of the item for sale
 More severe when
o Number of bidder is larger
o True value is more uncertain
o Sealed-bid auction
 Bid more conservatively
An action by the better-informed party to communicate its characteristics in a credible way
 The signal must induce self-selection among the better-informed parties
 Cost of the signal must be sufficiently lower for the superior parties
Advertising and reputation
 The investment must be sunk
 Buyers must be able to detect poor quality fair quickly
(otherwise sunk cost may already be covered)
 Word of poor quality must spread and cut into the seller’s future business
(for a one time offer there will be no effect)
A payment made if a specific event occurs
Bets, contingency fees, sell for cash/for a share in production, …
Induces self-selection
Can be used to screen or as signal
Summary + Key Concepts
p. 376
Review Questions
p. 377
Part III : Imperfect Markets
C14: Incentives and Organization
Introduction: Airbus vs Boeing
 Different organizational architectures
o Airbus needed to change
o Brought along some disagreement
 Organizational architecture: distribution of ownership, incentive schemes and monitoring schemes
 If efficient, 4 internal issues can be solved
o Holdup
o Moral hazard
o Monopoly power
o Economies of scale
When 1 party’s actions affect but are not observed by another party with whom it has a conflict of interest
Asymmetric information about actions
 Moral hazard if
o Asymmetry of information
o Concerning some future actions of the better-informed party
Economic inefficiency
 Economically efficient
o Maximizing group’s benefit
o 𝑀𝐶𝑤𝑜𝑟𝑘𝑒𝑟 = 𝑀𝐵𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑟
Moral hazard
o Maximizing individual benefit
o 𝑀𝐶𝑤𝑜𝑟𝑘𝑒𝑟 = 𝑀𝐵𝑤𝑜𝑟𝑘𝑒𝑟
Degree of moral hazard
 The economically efficient action – the action chosen by the party subject to moral hazard
 How bigger the difference
o How greater the degree of MH
o How greater the gain by resolving
2 complementary approaches to resolve MH
 Collecting information
 Align the incentives
Part III : Imperfect Markets
 Time clock | supervision (random checks) | monitor worker performance
Performance pay
 Performance pay: an incentive scheme that bases pay on some measure of performance
 Example: commission
 Incentive scheme stronger when higher personal MB for effort
Performance quota
 Performance quota: a minimum standard of performance, below which penalties apply
 Cost-effective: does not reward effort below or above the economically efficient level
 Graphically: worker’s MB vertical
Multiple responsibilities
 Try to balance the multiple responsibilities
 Harder when difficult to measure performance
 Use weak incentives
When incentives are based on an indicator
That depends on extraneous factors
Party subject to MH has imperfect information about these extraneous factors
Cost of risk
 Depends on
o The structure of the incentive
: stronger  more risk
o The degree of risk aversion
: more aversion  higher cost
o The effect of the extraneous factor
: indicator sensitive  higher risk
 Incentive scheme should be
o Stronger if less risk averse + weaker extraneous factors
o Weaker when higher risk aversion + strong extraneous factors
Relative performance incentives
 Will eliminate the risk due to extraneous factors that affect all parties equally
 Relative  example: take the average sales revenue of the various salespersons
An action to exploit another party’s dependence
Does not require asymmetric information
Arises only when there is a conflict of interest
Other parties will take precautions to avoid dependence
o Reduces benefit from the relationship
o Or increases own costs
Part III : Imperfect Markets
Specific investments
 Specificity: the % of the investment that will be lost is the asset is switched to another use
 𝑠𝑝𝑒𝑐𝑖𝑓𝑖𝑐𝑖𝑡𝑦 = 𝑎𝑚𝑜𝑢𝑛𝑡 𝑠𝑝𝑒𝑐𝑖𝑓𝑖𝑐 𝑎𝑠𝑠𝑒𝑡/𝑎𝑚𝑜𝑢𝑛𝑡 𝑡𝑜𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Incomplete contracts
 Complete contract: specifies the party’s obligations + payments under every possible contingency
 In practice  incomplete
o Extremely costly
o A huge number of contingencies
 How incomplete?
o Potential benefits and costs at stake : higher stake more detail
o Extent of the possible contingencies : hogher risk  more detail
Gains from resolution
 A profit can be made by resolving a holdup
o By deciding the degree of contractual incompleteness
o By changing the ownership of the relevant assets
: the rights to residual control
These rights have not been contracted away
Residual income
 The income remaining after payment of all other claims
 Example: residual income owner = rent – expenses to bank – taxes
Vertical integration
 The combination of the assets for 2 successive stages of production under a common ownership
o Downstream : nearer to the final consumer
o Upstream
: further from the final consumer
(often “make or buy”)
 Changes the ownership of assets
 By an external contractor
 By an employee  less likely + lower cost
 Can be reduced through vertical integration
Moral hazard
 Can be reduced by giving ownership
 Vertical integration increases the degree of moral hazard
Internal monopoly
 When the use of an internal provider is preferred
 Resolve by outsourcing whenever 𝑐𝑜𝑠𝑡𝑖𝑛𝑡𝑒𝑟𝑛𝑎𝑙 > 𝑐𝑜𝑠𝑡𝑒𝑥𝑡𝑒𝑟𝑛𝑎𝑙
Part III : Imperfect Markets
Economies of scale and scope
 Economies of scale
o Lower AC with a larger scale
o Internal provider  lower scale  higher AC
 Economies of scope
o Lower C when products are produced together
o If the company doesn’t produce either  better to outsource both
 Holdup
: investment in more detailed contracts + change the ownership
 Moral hazard : incentive + monitoring
 Internal mon. : outsourcing
 Find a good balance between these factors
Summary + Key Concepts
p. 408
Review Questions
p. 409
Part III : Imperfect Markets
C15: Regulation
Introduction: the electricity industry
 Why does the government allow a monopoly?
 How will the government resolve market power?
 …
A natural monopoly is a market where the 𝐴𝐶 of production is minimized with a single supplier
o Economies of scale/scope relatively large
Examples: distribution of electricity, water, gas,…
Government must establish controls
o Government can own and operate itself
o A monopoly franchise (private) subjected to government regulation
Government ownership
 Relatively inefficient
o Serves his employees rather than its customers
o Must compete for the allocation from the budget
o Cannot borrow or raise capital independently
 Privatization is the transfer of ownership from the government to the private sector
Price regulation
 When government is willing to pay a subsidy
o Marginal cost pricing: 𝑝 = 𝑀𝐶 and provider must supply the 𝑞 demanded
o Subsidy = (𝐴𝐶 − 𝑀𝐶)𝑞
o Economically efficient
 When government is not willing to pay a subsidy
o Average cist pricing: 𝑝 = 𝐴𝐶 and provider must supply the 𝑞 demanded
o Supplier breaks even because 𝑇𝐶 = 𝑇𝑅
o Economically inefficient
 When economies of scope: 𝑞 supplies will be lower with average cost pricing
 Supplier might exaggerate its reported cost to get higher profits
Rate of return regulation
 Set prices freely, provided that it does not exceed the maximum allowed profit
 Maximum rate of return on the value of the rate base
o Rate base: the assets to which the rate of return regulation applies
 3 major difficulties
o Determining the maximum permissible rate of return
o Disputes over what assets are needed to provide the service
o Incentive for supplier to enlarge the rate base
Part III : Imperfect Markets
A market where economies of scale and scope are small relative to market demand
If perfect competition
If government protection
Unregulated industries
Regulated industries
=> economic efficiency
=> needs to open up for economic efficiency
=> general competition law
=> law specific to the industry
Structural regulation
 Sometimes different markets between upstream and downstream
 Example: natural monopoly for distribution, production potentially competitive
 Challenges the government to maintain both
 Example of structural regulation
o Suppose 1 supplier does production as well as distribution
o Government may separate the 2 markets
 Require the better-informed party to disclose (reveal) its information truthfully
 Only meaningful when the information can be objectively verified
Regulation if conduct
 Regulate the conduct of the better-informed party
 Limit the extent to which it can exploit the informational advantage
 Possible through structural regulation
 The regulation of industry members by an industry organization
 The organization may or may not have legal powers
 Set conditions for licensing and rules of conduct
 Can be a cover to limit competition!
User fees
 Regulator must set a fee: 𝑓𝑒𝑒 = 𝑀𝐶 𝑡𝑜 𝑠𝑜𝑐𝑖𝑒𝑡𝑦
 Every individual will produce until 𝑀𝐵 = 𝑓𝑒𝑒 = 𝑀𝐶
 This is economic efficient because 𝑀𝐵𝑎𝑙𝑙 𝑖𝑛𝑑𝑖𝑣𝑖𝑑𝑢𝑎𝑙𝑠 = 𝑀𝐶𝑠𝑜𝑐𝑖𝑒𝑡𝑦
 Regulator may issue licenses: 𝑝𝑟𝑖𝑐𝑒 𝑙𝑖𝑐𝑒𝑛𝑠𝑒 = 𝑀𝐶 𝑡𝑜 𝑠𝑜𝑐𝑖𝑒𝑡𝑦
 Every individual will buy them until 𝑀𝐵 = 𝑝𝑟𝑖𝑐𝑒 = 𝑀𝐶
 This is economic efficient because 𝑀𝐵𝑎𝑙𝑙 𝑖𝑛𝑑𝑖𝑣𝑖𝑑𝑢𝑎𝑙𝑠 = 𝑀𝐶𝑠𝑜𝑐𝑖𝑒𝑡𝑦
Part III : Imperfect Markets
Regional and temporal differences
 𝑀𝐶 & 𝑀𝐵 of externalities may vary from place to place or with time
 Than the regulation will also be adjusted
 International regulation (between countries) vs federal regulation (among states)
 The law of torts: law governing interactions between parties that have no contractual relationship
o Court system provides the mechanism by which the victim of an accident can enforce her or
his legal rights
o The law of torts specifies the liability of the parties to an accident
 Liability is the set of conditions under which one party must pay damage to another party
 Price for an accident is paid after the event
 𝑀𝐵𝑠𝑜𝑐𝑖𝑒𝑡𝑦 = 𝑀𝐵𝑑𝑟𝑖𝑣𝑒𝑟 = 𝑀𝐶𝑑𝑟𝑖𝑣𝑒𝑟
Legal framework
 A public good should be provided up to the quantity that the 𝑀𝐵 = 0 for each user
 With a copyright or patent they will produce less
 On the other hand, without them there would be less creativity and invention
 Trade-off between incentive to create/invent and inefficient use
Public provision
 Provision by charities or government
o When non-excludable or difficult to exclude
o Do not charge a 𝑝 so quantity where 𝑀𝐵 = 0 => economically efficient
Congestible facilities
 Should levy a price: 𝑝 = 𝑀𝐶 𝑜𝑓 𝑢𝑠𝑒
 The cost includes the externalities imposed on other users
 As the 𝑀𝐶 varies wit time, so should the price
Social vs private benefits
 Trade-off between the inefficiency vs invention
 Investment in R&D will be less than socially optimal
o Accelerate invention & innovation, without determining whether it occurs or not
o Many patented products are substitutes for products that are provided at a 𝑝 > 𝑀𝐶
Summary + Key Concepts
p. 436
Review Questions
p. 437
Part III : Imperfect Markets