ec208 lecture notes
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EC 208 Industrial Economics
Robert Akerlof
Lectures 2 and 3
I. Introduction II. Basic Concepts
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I. Introduction 1. Module Outline
Online material Lecture notes; Handouts; Problem sets/solutions; Essay topics
Textbooks Cabral, L. (2000) Introduction to Industrial Organization Carlton, D. and J. Perloff (2005) Modern Industrial Organization, 4ed Readings Additional readings for each lecture in the course syllabus
20 Lectures
4 Tutorials (fortnightly) § Tutorials will begin in weeks 2-3.
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Assessment
§ 2 Problem sets 10% (2 × 5%)
§ 1 Essay 10% § 1.5 hour final exam 80%
Problem sets (Term 1)
§ Two assessed problem sets: handed out Oct 10 and Oct 31.
§ Due on October 19 and November 9 respectively. § Also: Several practice problem sets will be handed out. Essay § Due December 10 (first week of break).
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Class participation: highly encouraged!
Advice § Keep on top of material! Understanding of earlier material
necessary for later material. § Make sure you understand how to do all of the problem sets.
è will be key for doing well on the exam. § Use the resources available to you:
My office hours: Wednesday 2-4pm or by appt., Room S2.103 Amir’s office hours: Monday 8-10am, Room S2.94 Come see us sooner rather than later.
Your feedback on the course is valued.
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Industrial Economics:
• how firms compete in a given industry
• firms strategic interaction and how it affects the industry
Industry: business activity producing substitutable goods or services
Strategies: setting prices; choosing products; investing in R&D; ...
• individual firms’ strategies affect other firms in the industry
Main focus on: IMPERFECT COMPETITION MARKET POWER
Market power à ability to influence prices
2. What is Industrial Economics? What will we learn in this course?
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Basic conditions Demand Production technology R&D technology Advertising technology
Structure Number of firms Market shares Product differentiation Entry conditions
Conduct Pricing strategies Production strategies Product choice R&D investment Collusion Entry & exit Advertising
Performance Market power Profit rates Static efficiency Dynamic efficiency
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A few examples of things we will see in this course:
1) What are the determinants of prices?
Example: effect of the introduction of generic drugs?
2) Importance of strategic interaction (game theory)
Example: effect of Whole Earth Access pricing policy
3) Sources of market power? Why do industries differ in the extent to which firms exhibit market power?
Example: cable companies, Facebook, Google
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Policy • Regulation
Public intervention to regulate/correct the behaviour of firms with high potential market power (often monopolists) in industries where technology exhibits strong economies of scale and concentration (e.g. utilities)
• Antitrust (competition policy)
Promote competition and contrast anticompetitive behaviour
Focus on the degree of industry concentration and market power
• Patent policy Protect intellectual property rights and promote innovation (and the diffusion of welfare gains generated by innovation).
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Outline of Topics Lectures 2 and 3: Introduction and Basic Concepts
Lectures 4 through 8: Market Structure
Lectures 9 and 10: Game Theory I
Lectures 11 and 12: Game Theory II
Lectures 13, 14, and 15: Cartels and Collusion
Lecture 16: Product Differentiation
Lecture 17: Contestable Markets
Lectures 18 and 19: Durable Goods
Lecture 20: Transfer Pricing
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II. Basic Concepts 1. Economic Notion of Cost
Economic notion of cost=opportunity cost Opportunity cost:
Cabral (Ch. 2): “the foregone benefit from not applying the resource in the best alternative use.”
Sunk cost: Cost that cannot be recovered. Examples? Zero opportunity cost.
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Why focus on opportunity cost? This is the notion of cost that firms should base decisions on. Therefore: firms should ignore sunk costs!
Two cases: Apple (see handout) Carnegie
Opportunity Costs in Practice
Example: valuing the costs of owning a 1998 Boeing 737
The 1998 Boeing 737-700
Global airline profit forecast revised upwards By Sharon Chen, Bloomberg Tuesday, October 02, 2012 The International Air Transport Association raised its 2012 global airline profit forecast 37% as carriers slow capacity growth to cope with higher fuel prices and waning travel demand. Carriers may post $4.1bn (€3.2bn) of profits this year with a margin of 0.6%, the group — whose members account for 84% of global airline traffic — said in a statement. That compares with a June forecast for gains of $3bn and a profit of $8.4bn in 2011. The group raised its forecast as airlines reported improved earnings in the second quarter, it said. Delta Airlines and US Airways Group beat analysts’ profit estimates, while Singapore Airlines posted its first increase in net income in seven quarters. "The industry has re-shaped itself to cope by investing in new fleets, adopting more efficient processes, carefully managing capacity and consolidating," Tony Tyler, IATA chief executive said. !
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User Cost of Capital (UCC)
UCC(t) = rV(t)+(V(t)-V(t+1)) = foregone interest + economic depreciation
UCC(t) is the opportunity cost: Actual use of V(t) pounds is: purchase capital YieldsèV(t+1) Best alternative use of V(t) pounds is: invest with a return of r Yieldsè(1+r)*V(t) Opp. Cost=Difference=(1+r)*V(t)-V(t+1)=UCC(t)
Check the Airliner Price Guide
25,803,980
27,448,430 98 737-700
97 737-700
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Cost of owning Boeing 737-700 for 1 year: UCC = interest +depreciation
= 5%*($27.4m)+ ($27.4m-$25.8m) = $2.97m
Question for the airline: Will the added revenue from an additional plane exceed $2.97m?
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2. Production cost functions Total Cost: Suppose firm plans to produce q:
C(q)=Minimum cost to obtain level of production q
REMARK: C(q) will depend upon the time horizon (short run, longer run?) Reason: In longer run, more aspects of the production process can be changed than in the short-run. For example: difficult to hire more workers, build new plants in short-run, or change technology but can do in longer-run. èHigher C(q) in short-run than long-run
Example: Changes in Technology
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Average Cost (pounds per kilowatt)
Size (kilowatts)
Average Cost of Turbine Generators
Tandem-compound design
cross-compound design
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Fixed Costs and Variable Costs:
C(q) = FC + VC(q) Total cost = Fixed cost + Variable cost
Examples of Fixed Costs? Variable Costs? To check your understanding: How do fixed costs differ from sunk costs?
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Marginal Cost and Average Cost:
Marginal cost: how much would it cost to produce an additional unit? MC(q) = C’(q) = VC’(q) Marginal cost = Derivative of Total cost
= Derivative of Variable cost Average cost: AC(q) = AVC(q) + AFC(q) Average cost = Average Variable cost + Average Fixed cost
qFC
qqVC
qqC
+=)()(
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Economies and diseconomies of scale • Economies of Scale
– AC decreases with q, so MC < AC – Most anything digital
• Constant Costs – AC constant with q, so MC = AC – “Scalable Business”
• Diseconomies of Scale – AC increases with q, so MC > AC
Some Sources of Economies of Scale
• Spreading out fixed costs – Example: Software development costs
• Change in technology – Example: Automation, increased specialization
• Technical scaling relationships – Example – volume vs. surface area – container
ships, pipelines
Example: Software or CD’s
0
10
20
30
40
50
60
70
0 5 10 15 20 25 Output
AC
MC
Some Sources of Diseconomies of Scale
• Specific assets in limited supply
• Capacity constraints
• Bureaucracy, management difficulties, limited management resources
Example: Producing Near Full Capacity
0
10
20
30
40
50
60
70
0 5 10 15 20 25 Output
MC
AC
Full Range: U-Shaped Average Cost
-1
1
3
5
7
9
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13
15
0 1 2 3 4 5 6 7 8 9 10
Range of Economies of Scale
Range of Diseconomiesof Scale
Point ofConstantCosts
Output
MC
AC
Efficient Scale:
Level of output where AC is minimized. Note: at efficient scale, AC=MC. Efficient scale influences firm size in an industry: Suppose there is a firm that is much larger than the efficient scale (high AC). èother firms may want to enter the market.
Market Impact of Economies of Scale
• Economies of scale can create: – Barriers to entry – Market concentration or natural monopoly – Incentives to outsource or merge
• This depends on: – Level of scale economies – Size of market relative to efficient scale – Contracting possibilities
Economies of Scope
• Cost savings associated with the joint or simultaneous production of several products – Unit costs are lower than if products are
produced separately in stand alone firms
• Sources? – Shared use of indivisible inputs
• Examples: 3M, Ski/Tennis Shops
EC 208 Industrial Economics 34
Production cost function for multiproduct firms:
C(q1,q2)=minimum cost of producing quantity q1 of product 1 and q2 of product 2.
Economies of scope
Cost of producing two products together is cheaper than making separately:
C(q1,q2)<C(q1)+C(q2)
Mergers: people often talk about “synergies.” Really talking about economies of scope.
Learning Effects
• Costs savings that arise from repetition, practice or experience of ongoing production
• Todays output affects tomorrow’s costs.
Some sources: • Workers become more adept at jobs • Managers learn to schedule production tasks more efficiently • Engineers, initially cautious in product design, gain experience and are
better able to allow for tolerances in design that decrease costs without compromising quality.
• Suppliers of materials learn how to produce better and pass on fraction of cost savings.
Learning versus Scale
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WWII Liberty shipbuilding program
Date of keel laying
Day
s fro
m k
eel l
ayin
g to
del
iver
y
On 16 January 1943, Schenectady, a Liberty tanker, split in two while moored in calm water at the outfitting dock at Swan Island, Oregon. A US Coast Guard report described the incident: Without warning and with a report which was heard for at least a mile, the deck and sides of the vessel fractured just aft of the bridge superstructure. The fracture extended almost instantaneously to the turn of the bilge port and starboard. The deck side shell, longitudinal bulkhead and bottom girders fractured. Only the bottom plating held. The vessel jack-knifed and the center portion rose so that no water entered. The bow and stern settled into the silt of the river bottom. The ship was twenty-four hours old. The official Coast Guard report on the Schenectady incident attributed the fracture to welds in critical seams that "were found to be defective.“ Peter Thompson, "How Much Did the Liberty Shipbuilders Learn? New Evidence for an Old Case Study.“ Journal of Political Economy 2001. Photos from http://www.fiu.edu/~thompsop/liberty/photos/liberty_summary.html
Esso Manhattan, 29 March 1943, at the entrance to New York Harbor.
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John P. Gaines, November 1943. Vessel broke in two off Shumagin Aleutians with the loss of ten lives.
Estimation of Learning Curves
• How is the effect of learning on costs quantified? – With cost data, estimate learning curves
• Firms often attempt to estimate learning curves: – way to know precise benefit of today’s
production on tomorrow’s costs
Typically Estimate a Log-Log Specification:
ln(AC per lot) = α - β ln(Cumulative Production) β = estimate of percentage decrease in cost of a batch
associated with a 1% increase in cumulative production.
0
50
100
150
0 10 20 30 40
Lot Number (or Cumulative Production)
AC
pe
r L
ot
3.84
4.24.44.64.8
0 1 2 3 4
Ln(Lot Number (or Cum. Prod.))
Ln
(AC
pe
r L
ot)
Learning Curve ‘Strategy’
• Overproduce now for lower costs in future
• Needs to be undertaken with care è risks associated with following strategy.
Note: also logic for countries to protect underdeveloped industries.
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