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Managerial EconomicsTew 2e Bachelor

Mieke Simons

C1: Introduction to Managerial Economics

WHAT IS 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 demando Importance of scale and scope

Scalability of Google vs scalability of traditional library

PRELIMINARIES

Scope 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

Methodology 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 equalThe assumption that all other relevant factors do not change, made so that changes due to the factorbeing studied may be examined independently of those other factors

2Introduction

TIMING

DiscountingA procedure used to transform future dollars into an equivalent number of present dollars.

Net present valueThe sum of the discounted values of a series of inflows and outflows over timeThe current valuation of a flow of dollars over time

NPV=(B0−C0 )+(B1−C1 )

(1+d )+

(B2−C2 )(1+d )2

+…+(Bn−Cn )

(1+d )n

Bt=inflowsat period t enC t=outflows at period t

Read “internal rate of return” p 18

ORGANIZATION

Organizational boundaries Vertical boundaries : Delineate activities closer to or further from the end user

o Example: automobile industry: from production of steel to vehicle distributiono Example: America Online wider vertically than Google

Horizontal boundaries : Are defined by the scale and scope of an organization’s operationso 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-makingo Lack of self-control: people having difficulties postponing

2 implications for managerial economicso People relatively sluggish (traag) in responding to changeso Now also has an important role in correcting systematic biases

MARKETS

A market: consists of the buyers and sellers that communicate with one another for voluntary exchange

Markets for consumer products Household buyers, businesses sellers Markets for industrial products Businesses buyers and sellers Markets for human resources 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

3Introduction

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

GLOBAL INTEGRATION

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

OutsourcingThe purchase of services or supplies from external sources

Summary + Key Concepts p. 15

4Introduction

Review Questions p. 16

5Introduction

C2: Demand

INTRODUCTION

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!

INDIVIDUAL DEMAND

Construction Other things equal, how many… would you buy at a price of…?

Slope Individual demand curve shows

o The quantity the buyer will purchase at every possible priceo 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

Preferences The consumer’s preferences may change => demand curve will change Different customers: different preferences => demand curves different

DEMAND AND INCOME

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 categorieso Movies in general, transportation services,…

Inferior products : Demand falls with incomeo Particular products within the categorieso Afternoon matinees, public transport,…

Important distinction foro Business strategy Growing economy vs recessiono International business Rich country vs poor country

6Part I : Competitive Markets

OTHERS FACTORS IN DEMAND

Complements and substitutes Complements : increase in p1causes a fall in q2 Substitutes : increase in p1causes an increase in q2

Advertising 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

MARKET DEMAND

The market demand: graph showing the quantity that all buyers will purchase at every possible price

Construction 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 GNPo GNP = GDP + net income from foreign sources

Income distribution Average income when estimating market demand Ignores the distribution of income!

BUYER SURPLUS

Benefit 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


Price changes Price reduction: buyer gains in 2 ways

o Lower price for original quantityo Will by more

Price increase: buyer loses in 2 wayso Higher price for original quantityo 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

BUSINESS DEMAND

In many ways the principles are the same as for the consumer demand. The most important differences between consumers (C) and businesses (B):

Inputs C: buy goods and services for final consumption or usage B: buy goods and services to use them as inputs

Demand 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 MBo Curve slopes downward

Factors in demand Change in price : movement along the curve Change in other factors : movement of the entire curve




C3: Elasticity

INTRODUCTION

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

OWN-PRICE ELASTICITY

When p rises by 1%, what is the percentage of change forq?

% change∈q% change∈ p

∨ proportionate change∈qproportionate change∈ p

Construction Arc approach

o From the average values of observed p and q

o proportionatechange∈q/ p= change∈q/ paverage q/ p

o Between 2 points Point approach

o From a mathematical equation, in which q is a function of p and other variableso At a specific point

Properties It’s a negative number It’s a pure number that does not depend on units or measure −∞≤ε p

D≤0o Elastic if a 1% increase in p leads to more than a 1% drop in q : ¿ε p

D∨¿1o Inelastic if a 1% increase in p leads to less than a 1% drop in q : ¿ ε p

D∨¿1

Intuitive factors Availability of (in)direct substitutes

o More substitutes, more elastico 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,…

FORECASTING QUANTITY DEMANDED AND EXPENDITURE

Quantity demanded How will a … % in p affect q?

Expenditure 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↑↑

Accuracy ε p

D may vary along a demand curve

Forecast using ε pD is less precise as a forecast directly from the demand curve

OTHER ELASTICITIES

Income elasticity When the income rises by 1%, what is the percentage of change for q?

% change∈q% change∈ y

+ for normal products – for inferior products

Pure number −∞≤ε y

D≤+∞o Elastic if a 1% increase in y leads to more than a 1% change in q : ε y

D>1o Inelastic if a 1% increase in y leads to less than a 1% change in q : ε y

D<1 Demand for necessities is less income elastic than the demand for discretionary items

Cross-price elasticity When p1rises by 1% , what is the percentage of change for q2? + for substitutes

– for complements −∞≤ε xy

D ≤+∞

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


ADJUSTMENT TIME

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

Nondurables Cigarettes, liquor, bus, subway,… More elastic in the long run than in the short run

Durables Cars, refrigerators, furniture,… Balance between 2 effects

o Adjustment time: more elastic in LRo Replacement frequency effect: more elastic in SR

Forecasting demand By using LR-elasticities instead of SR-elasticities

ESTIMATING ELASTICITIES

Data 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

Specification 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 valueo u=−¿ when actual quantity is less than the predicted value

Method of least squares Minimize the sum of the squares of the residuals

Interpretation Using estimates to calculate elasticities


ε xD=∂q

∂ x. x

¿

q¿

Results => ∂q∂x

Statistical significance

F statistic

Assumption: coefficients all 0 0≤F ≤∞ 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

T-statistico Evaluate the significance of a particular indep.var.o −∞≤t ≤+∞

P-valueo Probability that estimated coefficient could be the result of chance (when coeff = 0)o Statistical significant when below specific benchmark


C4: Supply

INTRODUCTION

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?

SHORT-RUN COSTS

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=Cq

=Fq

+Vq

o Average F: falls with the production rateo Average V: falls and then increases with the production rate

Marginal product: the increase in output arising from an additional unit of the inputo Diminishingo Causes AC and MC curves to rise

Technology Better technology can reduce costs

o To reduce F : will lower its AC curveo To reduce V : will lower its AC, AV an MC

Different sellers may have different technologies


SHORT-RUN INDIVIDUAL SUPPLY

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=po 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 expensiveo pinput increases: the MC will shift upward => input more expensive

Price of an input will affect the demand for that inputo Similar to the individual demand

LONG-RUN INDIVIDUAL SUPPLY

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=po 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


MARKET SUPPLY

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 curveso Begins with the seller who has the lowest average variable cost

Change in the input priceo Market supply curve also shifts

Long run Market supply curve

o Horizontal sum of the individual supply curveso Slopes more gently (is more elastic) than the short run

Freedom of entry and exito If R≥- C then they leaveo Market supply↘ and market price ↗and profits↗o New entrants because profitso Market supply ↗ and market price ↘ and profits ↘

Change in market priceo Existing sellers will adjust along their curveo Sellers may enter or leave the market

Properties SR market supply : slopes upward LR market supply

o Slopes upward : vary in qualityo Is flat : replication of existing businesses

SELLER SURPLUS

Price vs marginal cost Seller surplus SR

o Revenue from some q – the minimum amount necessary to produce that qo Revenue from some q – the sum of the MC up to qo R−V

Seller surplus LRo Revenue from some q – the minimum amount necessary to produce that qo R−C

Purchasing 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

ELASTICITY OF SUPPLY

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∈q% change∈ p

∨ proportionate change∈qproportionate change∈ p

Properties It’s a positive number It’s a pure number that does not depend on units or measure 0≤ ε p

S ≤+∞o Elastic if a 1% increase in p leads to more than a 1% increase in q : ε p

S>1o Inelastic if a 1% increase in p leads to less than a 1% increase in q : ε p

S<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


C5: Competitive Markets

INTRODUCTION

Introduction: oil tanker market What would be the impact of… Increasing oil prices Increasing oil consumption …

PERFECT COMPETITION

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

MARKET EQUILIBRIUM

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 : qsupplied>qdemanded : p↘ Excess demand : qsupplied<qdemanded : p↗


Significance of equilibrium If not => buyers/sellers will push the market toward equilibrium To compare equilibria

SUPPLY SHIFT

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

DEMAND SHIFT

Same reasoning as for a supply shift Again: look at the price elasticities!

ADJUSTMENT TIME

Short-run equilibrium Competitive market

o MR=po Maximize profit: MC=MR=p>AVC

Long-run equilibrium Competitive market

o MR=po 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 LRo q more volatile in the LR than in the SR

More sunk costs => sharper inequality between SR and LR

Summary + Key Concepts p. 137Review Questions p. 138


C6: Economic Efficiency

INTRODUCTION

Introduction: price increases for welfare Economic efficiency in management

o To manage resourceso Opportunities for profit

Whenever the allocation of resources is not economically efficient, there is a way to make money by resolving the inefficiency

CONDITIONS FOR ECONOMIC EFFICIENCY

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 MB2. All suppliers the same MC3. MB=MC

Philosophical basis Technical efficiency: provision of an article at the minimum possible cost Economic efficiency extends beyond

o MB=MCo MB reflect each individual user’s evaluation

Internal organization To make the best use of scarce resources

ADAM SMITH’S INVISIBLE HAND

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 : pequal→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


DECENTRALIZED MANAGEMENT

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

Implementation Rules for decentralizing control

o If competitive market for item => transfer p=market po Outsourcing + external selling must be allowed

Outsourcing: the purchase of services or supplies from external sources

INCIDENCE

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

Incidence 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

Taxes

Buyer’s vs seller’s price

ps=pb−tax Buyer’s point of view : supply curve shifts up : pb=p+ tax Seller’s point of view : demand curve shifts down : ps=p−tax

Tax incidence

Effect of tax will be the same, whether collected from sellers or buyerso The more elastic a party, the more advantageo The less elastic a party, the larger the portion of the tax for that party




C7: Costs

INTRODUCTION

Introduction: Boeing vs Airbus What’s the reason for the cheaper cost for Airbus? Why was Northwest buying new planes amidst continuing losses?

ECONOMIES OF SCALE

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 inputso 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 costso Average VC increases with production rate

Strategic implications Economies of scale => mass marketing, low pricing => concentrated (market power) Diseconomies of scale => niche marketing, high pricing => fragmented

ECONOMIES OF SCOPE

Economies of scope : when the TC1+2<TC1+TC2

Diseconomies of scope : when the TC1+2>TC1+TC2

23Part 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 papero 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 costo Immediately advertising for all the underlying products

Core competenceo Generalized expertise on common or closely related technologieso Can be applied to several products => wore competence = joint cost

Diseconomies of scope When no significant joint cost

EXPERIENCE CURVE

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

OPPORTUNITY 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


TRANSFER PRICING

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 definedo transfer price=opportunity cost input

SUNK COSTS

Cost that cannot be avoided => not relevant to business decisionsWhen 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




C8: Monopoly

INTRODUCTION

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

SOURCES OF MARKET POWER

Monopoly Prevent entry by other competing sellers

Unique resource (only 1 needed) Intellectual property (patents, copyrights,…) Economies of scope and scale Product differentiation Regulation

MonopsonyPrevent entry by other competing buyers

Unique resource Intellectual property Economies of scope and scale Product differentiation Regulation The existence of a monopoly

Monopoly electricity distributor => monopsony in the market for power engineers services

MONOPOLY PRICING

A monopoly can set the price or quantity, but not both

Revenue Inframarginal units are those other than the marginal units By lowering the price

o Gain revenue on marginal unito Lose revenue on inframarginal units

Difference between p and MR depends on the demand elasticityo Very elastic => difference smallero Very inelastic => difference bigger


Costs 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 AND COST CHANGES

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∧MR do not depend on the fixed cost

p¿∧q¿ do not depend on the fixed cost When fixed costs so big that TC>TR => better shut down!

ADVERTISING

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∈contributionmargin−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∗ε A

D

p↑∨MC↓ : advertising expenditure should increase ε A

D↑∨sales revenu↑ : advertising expenditure should increase


RESEARCH AND DEVELOPMENT

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 expenditureso If technical feasibility + demand conditions are favorable

Most R&D projects are multi-stageo Opportunity to modify or abandono 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

MARKET STRUCTURE

How do price and production depend on the market structure?

Effects of competition When the market is perfectly competitive (LT)

o MC=MR=po Push p down toward the LR average costo Each seller earns zero profit

When the market is a monopolyo MC=MR< po p will be higher, q will be lowero 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 plow 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


MONOPSONY

Benefit and expenditure Supply = average expenditure = marginal cost Marginal expenditure > average expenditure

Maximizing net benefit Marginal expenditure = MB p lower than when MC=MB




C9: Pricing

INTRODUCTION

Introduction: Emirates Airline Differences in fares Load factor of 71% …

UNIFORM PRICING

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−MCp

=−1ε pD

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 percentageo (R−VC )/R=( p−AVC)/ po ≠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!

COMPLETE PRICE DISCRIMINATION

Shortcomings of uniform pricing Still people with MB> p

o People are willing to pay moreo By taking a little some buyer surplus => profit can be increased

Economic inefficiency


o Because MC=MR<MBo By providing the product to people where MC<MB => profit can be increased

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=MCo Selling down the market demando 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!)

DIRECT SEGMENT DISCRIMINATION

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-segmentso Apply uniform pricing within each segmento Indirect segment discrimination

Implementation Identify characteristics that segments the market

o Characteristic must be fixed => a buyer cannot switch from segmento Prevent buyers from reselling among themselves

Good example: use age to differentiate Easier to do for services (harder to resell)

LOCATION

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

FOB or CF FOB ignores the differences between the price elasticities CF implements direct segment discrimination

Difference among priceso Difference in incremental margin percentageo 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 marketo Limit the sales (according demand in low-price markets)o Durable goods: warranty service in country of purchase

INDIRECT SEGMENT DISCRIMINATION

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 segmento 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

Implementation 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)

BUNDLING

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

Implementation Bundling is relatively more useful when

o A substantial difference among the segments in their benefits from the separate productso 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

SELECTING THE PRICE POLICY

Ranking of the policies Complete price discrimination Direct segment discrimination (buyer attributes) Indirect segment discrimination (product attributes) Uniform pricing

Cannibalization 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




C10: Strategic Thinking

INTRODUCTION

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

NASH EQUILIBRIUM

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 competitiono A cartel’s dilemmao Follow the agreement or not?

Definition 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 outo 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)

RANDOMIZED STRATEGIES

A strategy for choosing among the alternative pure strategies in accordance with specified probabilities

o A pure strategy is one that does not involve randomizationo 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

Solving the equilibrium By making a graph => N-equilibrium where lines cross By using algebra => expected profit (1) = expected profit (2)

COMPETITION OR COORDINATION

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

Coordination 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

Co-opetition Competition + coordination After being repeated cooperation may arise (see repetition)

SEQUENCING

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

STRATEGIC MOVES

An action to influence the beliefs or actions of other parties in a favorable way

Credibility 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

CONDITIONAL STRATEGIC MOVES

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

Threats 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 beginso A scorched earth defense : destroy the company (very costly)o The poison pill : shareholder rights plan (costly for taker)

Strikes In negotiations with employers, unions may threaten a strike Compare the current wage with possible future wages

Promises Conveys benefits under specified conditions to change the beliefs or actions of other parties Example: deposit insurance: government pays when bank cannot

REPETITION

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 partyo Combines a promise with a threat




C11: Oligopoly

INTRODUCTION

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

PRICING

Homogeneous product The Bertrand model of oligopoly

o Sellers which produce at constant MC with unlimited capacity compete on po To market a homogenous product

Under these conditions o Demand of newcomer is perfectly elastico Competition by lowering p will go on until p=MCo 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 po To market products differentiated by their distance from the consumer

Under these conditiono Demand of competition no longer perfectly elastico 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 complementso So if one party raises its price, the other one should follow

CAPACITY

The Cournot model of oligopolyo Sellers which produce at constant MC compete on qo To market a homogeneous product

Under these circumstanceso q now interdependento 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 decreaseo The total capacity will increase

Nash-E of the best response functions

p−cp

= HHIη

p = Nash-E price c = weighted average MC η = elasticity of demand

Herfindahl-Hirschman Index = HHI o Measures industry concentrationo 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


PRICE/CAPACITY LEADERSHIP

Price 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 industryo The commitment will not be reversed, regardless of the entrant’s actionso Production involves a fixed cost

Capacity The Stackelberg model of oligopoly

o Sellers which produce at constant MC compete in sequence on qo To market a homogeneous product

Under these circumstanceso 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

RESTRAINING COMPETITION

Competing sellers can restrain competition through agreement or by integration

Cartels A cartel is an agreement to restrain competition Restrains sales to raise p

o Need enforcement against existing sellers exceeding their quotaso Need enforcement against new entrants

Enforcements Factors that influence the effectiveness of a cartel

o Number of sellers in the market the fewer, the bettero Industry capacity better to operate near capacityo Sunk cost the fewer, the bettero Barriers to entry and exit better strongero Nature of the product better to be homogeneous

Normally cartels are not allowed

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 workerso Union becomes a monopoly

Substitutions for labor: automation, overseas location (foreign labor),…


Integration 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 ownershipo Cartel illegal => agreement on prices within the same company legalo Leads to reduction in q => raises market price and profits

ANTITRUST (COMPETITION) POLICY

Aims to ensure a degree of competition that maximizes social welfare

Competition laws They prohibit:

o Competitors from colluding on priceo Monopolies & monopsonies from abusing market powero Mergers/acquisitions that would create monopolies/monopsonies

Competition agency must enforce the competition lawso Prosecute against those who violate the lawso 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 > 1800o That raises the HHI by 50 points or more


C12: Externalities

INTRODUCTION

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

BENCHMARK

Positive externalities : when one party directly conveys a benefit to otherso Group’s MB = vertical sum of the individual MBs

Negative externalities : when one party directly conveys a cost to otherso Group’s MC = vertical sum of the individual MCs

Externalities in general Externality is resolved at the economically efficient level when

∑MB i=∑MC i

Also applies when source and recipients are separated Also applies for nonmonetary externalities

o Maximize the net benefit o When monetary => net benefit = profit

RESOLVING EXTERNALITIES

Merger 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 resolveo 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 smallo Enough others to compromise

42Part III : Imperfect Markets

NETWORK EFFECTS AND EXTERNALITIES

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 hardwareo When the user needs 1 => critical mass = installed base

Expectations Optimistic equilibrium : expect lots of users to subscribe => subscribe Pessimistic equilibrium : expect < critical mass to subscribe => don’t subscribe Find a way to influence the expectations

o Commitments, a hype,…

Tipping 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 = 0o Extremely inelastic

Market demand > critical masso Demand = elastico Network effect causes demand to be more elastic

PUBLIC GOODS

Rivalness Nonviral if one person’s increase in consumption does not reduce the quantity available to others

o Public good => consumption is nonviralo Private goods => consumption is viralo 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


EXCLUDABILITY

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!

Law 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 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




C13: Asymmetric Information

INTRODUCTION

Introduction: group vs individual insurance Asymmetric information arises when one party has better information than another

IMPERFECT INFORMATION

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 competitiveo IF symmetric imperfect information

Risk defined Risk is uncertainty about benefits or costs

o When information is imperfecto 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

ADVERSE SELECTION

Demand and supply If one market with genuine and fake

o Supply : no cost for fake ones => supply (genuine + fake) shifts outwardo 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 => equilibrium: fake + genuine Big number of fake ones => demand becomes zero => market will fail


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

APPRAISAL

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 fakeso 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 procureo Better individual appraisal procured by buyer

Lenders can also appraise applicants for loans

SCREENING

An initiative of a less-informed party to indirectly elicit the other party’s characteristicso Through a variable to which the better-informed parties are differentially sensitiveo 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

AUCTIONS

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 bidderso Risk of a failing sale


Winner’s curse The winning bidder overestimates the true value of the item for sale More severe when

o Number of bidder is largero True value is more uncertaino Sealed-bid auction

Bid more conservatively

SIGNALING

An action by the better-informed party to communicate its characteristics in a credible way

Credibility 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)

CONTINGENT PAYMENTS

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




C14: Incentives and Organization

INTRODUCTION

Introduction: Airbus vs Boeing Different organizational architectures

o Airbus needed to changeo Brought along some disagreement

Organizational architecture: distribution of ownership, incentive schemes and monitoring schemes If efficient, 4 internal issues can be solved

o Holdupo Moral hazardo Monopoly powero Economies of scale

MORAL HAZARD

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 informationo Concerning some future actions of the better-informed party

Economic inefficiency Economically efficient

o Maximizing group’s benefito MCworker=MBemployer

Moral hazardo Maximizing individual benefito 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 MHo How greater the gain by resolving

INCENTIVES

2 complementary approaches to resolve MH Collecting information Align the incentives


Monitoring 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

RISK

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 risko The degree of risk aversion : more aversion higher costo The effect of the extraneous factor : indicator sensitive higher risk

Incentive scheme should beo Stronger if less risk averse + weaker extraneous factorso 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

HOLDUP

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 relationshipo Or increases own costs


Specific investments Specificity: the % of the investment that will be lost is the asset is switched to another use specificity=amount speci fic asset /amount total investment

Incomplete contracts Complete contract: specifies the party’s obligations + payments under every possible contingency In practice incomplete

o Extremely costlyo A huge number of contingencies

How incomplete?o Potential benefits and costs at stake : higher stake more detailo 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 incompletenesso By changing the ownership of the relevant assets

OWNERSHIP

Ownership : 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 consumero Upstream : further from the final consumer (often “make or buy”)

Changes the ownership of assets

ORGANIZATIONAL ARCHITECTURE

Holdup 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 cost internal>cost external


Economies of scale and scope Economies of scale

o Lower AC with a larger scaleo Internal provider lower scale higher AC

Economies of scopeo Lower C when products are produced togethero If the company doesn’t produce either better to outsource both

Balance Holdup : investment in more detailed contracts + change the ownership Moral hazard : incentive + monitoring Internal mon. : outsourcing Find a good balance between these factors




C15: Regulation

INTRODUCTION

Introduction: the electricity industry Why does the government allow a monopoly? How will the government resolve market power? …

NATURAL MONOPOLY

A natural monopoly is a market where the AC of production is minimized with a single suppliero Economies of scale/scope relatively large

Examples: distribution of electricity, water, gas,… Government must establish controls

o Government can own and operate itselfo A monopoly franchise (private) subjected to government regulation

Government ownership Relatively inefficient

o Serves his employees rather than its customerso Must compete for the allocation from the budgeto 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 demandedo Subsidy = ( AC−MC )qo Economically efficient

When government is not willing to pay a subsidyo Average cist pricing: p=AC and provider must supply the q demandedo Supplier breaks even because TC=TRo 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 returno Disputes over what assets are needed to provide the serviceo Incentive for supplier to enlarge the rate base


POTENTIALLY COMPETITIVE MARKET

A market where economies of scale and scope are small relative to market demand

If perfect competition => economic efficiencyIf government protection => needs to open up for economic efficiency

Unregulated industries => general competition lawRegulated industries => 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 distributiono Government may separate the 2 markets

ASYMMETRIC INFORMATION

Disclosure 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

Self-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!

EXTERNALITIES

User fees Regulator must set a fee: fee=MC ¿ society Every individual will produce until MB=fee=MC This is economic efficient because MBall individuals=MC society

Standards Regulator may issue licenses: price license=MC ¿ society Every individual will buy them until MB=price=MC This is economic efficient because MBall individuals=MCsociety

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)

Accidents 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

PUBLIC GOODS

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 excludeo Do not charge a p so quantity where MB=0 => economically efficient

Congestible facilities Should levy a price: p=MCof 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 noto Many patented products are substitutes for products that are provided at a p>MC




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