Week 1: An Overview of Welfare & Industrial Economics

Francis O'Toole (fotoole@tcd.ie)

Department of Economics

Trinity College Dublin

30th September 2011

Economics: Fundamentals

Economics: Scarcity and Choice Scarcity: Wants > Resources (Needs < Resources?) Choice: Optimising Behaviour, Cost-Benefit Analysis Incentives and Institutions

Neo-Classical Perspective (self-interested individuals, rational or at least rationally irrational)

Broad (political economy) Narrow (consumers and producers + some government)

Economic Agents & Models

Consumers (Individuals or Households?) Firms (Suppliers/Producers) Government(s) (Ireland, EU?, USA, … ) Agencies (e.g. Competition Authority, ComReg, CER,

Department, … ) Consumers maximise happiness (utility, satisfaction)

subject to income constraint Firms maximise profit (subject to cost environment) Government(s) maximise ? Agencies maximise ? Economics, Political Economy, Public Choice ≠ Public

Finance

Economics: Demand & Consumer Surplus Individual Consumer Demand Quantity Demanded = F(P, Psub, Pcom, Y,

Taste, …) Market Demand = Individual Demands

Consumer Surplus = Willingness to Pay – Price

Consumer Surplus = “Value” – Price

Economics: Supply

Individual Firm Supply Quantity Supplied = F(P, Pother, w, r, …) Market Supply = Individual Supplies

Economic Profits = Revenue – (Economic) Costs Economic Profits ≠ Accounting Profits

Producer Surplus = Revenue – Total Variable Costs Long Run: Economic Profits = Producer Surplus

Economics: Societal Welfare

Consumer Surplus

+ Producer Surplus

= Societal Welfare

Income Distribution (in “background” at least)

Price Determination & Elasticity

Quantity Demanded = Quantity Supplied

Own-Price Elasticity of Demand (e.g. market power?)

Cross-Price Elasticity of Demand (e.g. substitutes and market definition)

Income Elasticity of Demand (Own-Price) Elasticity of Supply

Firm’s Costs: Short Run

Short Run: At least one input is fixed Diminishing Marginal Product/Returns Total Costs (TC), Average Costs (AC) Fixed Costs (FC), Average Fixed Costs (AFC) Variable Costs (VC), Average Variable Costs

(AVC) (e.g. predatory pricing) Marginal Costs (MC): Link to Supply Curve (e.g.

predatory pricing)

Firm’s Costs: Long run

Long Run: All inputs are variable (TC = VC)

Shape of Average Cost Curve?

Increasing Returns to Scale

Decreasing Returns to Scale

Constant Returns to Scale

Market Structure

Perfect Competition Monopoly Oligopoly, Monopolistic Competition, Imperfect

Competition

Contestable Markets Effective/Workable Competition

Structure Conduct Performance (SCP)? Game Theory Empirical Industrial Organisation

Perfect Competition: Assumptions Large number of sellers and buyers Homogeneous product Free entry and exit Full information about demand and supply

Profit Maximisation (MR = MC)

Perfect Competition: Characteristics Short Run: Profits/Losses possible Long Run: Entry or Exit until Zero

Economic (Excess, Supernormal, Abnormal) Profits

Allocative Efficiency: P (SMB) = MC (SMC)

Productive Efficiency: P = Min AC

Monopoly: Assumptions

One seller, large number of buyers Homogeneous product (by definition) Barriers to resource transfers Full information about demand and supply

Profit Maximisation (MR = MC)

Monopoly: Characteristics

Short Run: Profits/Losses possible Long Run: Economic Profits (subsidised losses) possible

Allocative Inefficiency: P (SMB) > MC (SMC) Productive Inefficiency: P > Min AC (generally) X-Inefficiency? (minimise costs?)

Natural Monopoly (can’t compare with competition) → regulation (narrow sense)

Deadweight Loss: Harberger Triangle

R & D, Profit Motivation

Oligopoly: Assumptions

Few sellers, large number of buyers Homogeneous or heterogeneous product Free entry or barriers to entry Full information about demand and supply

(usually)

Aside: Monopolistic Competition = Oligopoly with Heterogeneous + Free Entry

Oligopoly: Characteristics?

Cournot (1838): Quantity Competition Bertrand (1883): Price Competition Game Theory Cournot: Assumptions? Results Bertrand: Assumptions Results?

Repeated Games ???

Contestable Markets: Assumptions & Outcome Free entry and exit: No sunk costs Some price rigidity (e.g. menu costs) or lags

relative to entry lag

Perfectly competitive outcome: potential use of hit-and-run strategy (even when n = 1)

Policy Relevance?

Effective/Workable Competition: Assumptions/Characteristics No “harmful” inhibitions on entry and exit No “harmful” product differentiation No “harmful” coordination (e.g. price

collusion) No “harmful” price discrimination Intrabrand competition, Interbrand

competition, potential competition No Excess (Economic) Profits

Effective/Workable Competition: Assumptions/Characteristics “To determine whether any industry is

workably competitive, therefore, simply have a good graduate student write his dissertation on the industry and render a verdict. It is crucial, of course, that no second graduate be allowed to study the industry.” (Stigler 1956)

Round & Siegfried (1994) Update?