2.

- CONSUMER CHOICE AND DEMAND

Price changes move along demand curve Other factor changes shift demand curve Elasticity of demand: sensitivity of quantity
reactions to price changes elasticity <1 =1 >1 demand inelastic unit elastic elastic price expenditure consumers insensitive don't care sensitive

No free entry: different supply curves S(p)=Si(p) If constant MCi=ACi S(p)=min(ACi) Free entry: S(p)=min(ACi)=P -

5.- SHORT-RUN / LONG-RUN & AND PRICES Law of dim. returns: SR mc(Q) always increasing

Aggregate supply curve very elastic when: individual curves very elastic (mc flat) competition intense (prices ~ ac) many potential firms with similar cost curves RESULT: incumbent firms will produce at capacity if P > MC (=AVC)

Capacity constraint mod.: Increase in demand

Linear demand: d(P) = Q(P) = a+bP

Supply decisions: 1) Decr. AC (EoS) => natural monopoly 2) Const. AC = MC => Agg. supply at lowest MC (zero profit)

Impact of LR FC: FC do not influence Q, because same for all levels Only influence in decision to operate at all How to solve: 1. Calculate solution ignoring FC

LR compared to original situation: > ACu = P stays the same > Qu firms stays the same > Q total increases, N increases > Zero profit before and after increase D Capacity constraint mod.: tax per unit Increasing (decreasing) returns of scale: increase x% inputs increase of more (less) than x% in output Short Term vs Long Term Change in Market. price output decision less responsive in the Short run Q responds to changes in P less in SR than in LR Supply less elastic in SR than LR P is more volatile in SR than LR SR increasing marginal cost and FC can not be avoided by shutting down in SR Shut-down rules:

2.

Calculate var. profit (P-MC)*Q or var. surplus (triangle calculation) 3. Compare FC to var. amounts

LR

ac above mc ac decreasing economies

ac below mc ac increasing diseconomies

3) Incr. AC (Dis.EoS) [no FC & incr. MC]: Supply is mc(Q)

Exponential demand: d(P) = AP E = B Vertical curve: perfectly inelastic Horizontal curve: perfectly elastic Cross-price elasticity: E with respect to other
-B

sources of economies of scale:

return to specialization of labor indivisible inputs elimination of duplicate (long-run) fixed costs (R&D, dist networks etc.) sources drive towards mergers and monopolies better purchasing power not source of economies

SR

goods Eab = %Qa/%Pb Complements Eab<0 Substitutes Eab>0 goods are P2 D1 cross-elasticity complements Negative substitutes Positive

sources of diseconomies of scale:

scale of coordination poorer decision making 4) U-Shaped TC

TAX impact:
Per-unit tax: AC and MC shift by Tax => Q does not change and AC/MC keep intersection at MC+Tax

SR: when P < min MVC (=where AVC = MC) LR: when P < min AC (=where AC = MC) If P < MC produce less but do not shutdown
Respond to swift in demand curve 6.- MARKET POWER

Income E of demand: Ei = %Q/%I

Ei>0 good is Inferior normal (luxury) Inferior goods Ei<0 income demand cross-elasticity negative positive Normal goods

Monopolies have market power: a firms ability to change

market price Price determined by elasticity and MC,(not S&D) linear demand curve, constant MC

Demand becomes more point-elastic moving upwards on the demand curve 3.- PRODUCTION AND COSTS

enter market when Price (=MC) > min AC

Monopoly SHOULD operate where E>1! (= MR>1)

Overshooting With constant MC & lin. D: P = (MC+Choke P) / 2 With constant MC & exp. D: P = B / (B-1) * MC Monopoly vs. socially efficient solution: Shortcut: MC = P when MC constant

Patents: Monopoly leads to R&D underinvestment, because firm bears all R&D, but cannot get all gains from trade. Without patents no firm would invest in R&D, because comp. drives P to ACu (zero profit). Still imperfect as: Once developed, firm produces less than socially efficient & firm does still not get all gains from trade (so inv. below soc. eff. amount) Alternative: Subsidization Other stuff:

In equil. of free entry: Fixed tax: MC does not change, AC shifts up by

(tax/Q), Q increases All firms same tech. & cost curve > P = ACu > Qoutput = Qu > Qtotal market = d(P) > N = Qtotal / Qoutput

Sunk costs: already unchangeable/occurred

costs for all alternatives ignore in decision

If MC = 0: max profit with revenue, price at E = 1 If MC > 0: price at E > 1, lower Q than previous -> in
elastic part of curve if Q maximizes revenue, higher Q cannot max profit Elasticity demand mr increase output <1 inelastic <0 revenue =1 unit elastic =0 revenue = >1 elastic >0 revenue

Opportunity costs: consider in decision!! Long-run fixed: Costs that cannot be reduced
without changing the quality of the product and hence are not linked to the size of circulation

Tax effect for U-shaped ac in free entry:

1) unit tax: > Q stays, ACu goes up by tax > P increases, D/Qtotal decreases > N decreases 2) Fixed tax > Qu increases, ACu increases L/Qu > P increases, D/Qtotal decreases > N decreases

short-run: FC cannot be changed, VC changed

by shutdown

maximum profit does not maximize total surplus

quantity is lower MR always below demand curve - MR < P; only in perfect competition: MR = P If the whole industry mistakes price can go lower than initial level-> no LR equilibrium Capacity Constraint Model

AC: (dis)economics of scale; entry/exit decision MC: output/pricing decision MR=MC Area under mc curve = variable cost FC: source of economies of scale; entry/exit
decision (does variable profit exceed FC?)

Implications:

4.- COMPETITIVE MARKETS Individual firm MC=supply=P how much Q Entry/shut down P>minAC = entry Aggregate supply

Diseconomies of scale are not bad at

competition!!! firms produce at mc = P diseconomies mean: ac < mc firms earn profit

1. 2.
3.

Q in monopoly lower than socially efficient solution (mr curve below mv curve) MR = P + dP/dQ * Q and as dP/dQ<0 follows MR<P Monopoly leads to DTW = Total gains from trade go down & consumer surplus goes down

output level below efficient output deadweight loss

(total possible surplus - total surplus under monopoly)

MR = MC pricing is fine
MR > MC increase Q, reduce P MR < MC decrease Q, increase P

The more elastic supply, the more tax burden to

buyer

fixed cost does not affect optimum quantity

only affects startup decision:

 calculate optimal P/Q without fixed cost calculate profit without fixed cost compare with fixed cost: startup decision

demand curve A more elastic than B

for all P: EA > EB linear demand: P'A < P'B (the higher the choke price: the less elastic)

same constant MC: more elastic curve lower

price E MR Q P monopoly price is always at MR > 0, E >= 1 effect of advertising Effects in CHAPTER 7 advertising just expands the market, maintaining its composition no change in P' no change in E no change in P advertising does not change the group of consumers, but it in-creases their valuation P' up E down P up Exponential demand E constant choke price not valid mass market situation P low, demand high P high, demand low deadweight loss is due to uniform pricing can be solved by perfect price disc. (cant be done) GENERAL ISSUES ALWAYS TRUE: o E = %Q/%P = QxP/PxQ = QxP/Q o MR = P(1-1/E) = R(Q) R(Q-1) = R = P(1+PxQ/P) ONLY WHEN MAXIMIZED:

sellers valuation: cost c total surplus: v-c = gains from trade demand curve d(P) gives all the buyers valuations supply curve s(P) gives all the sellers cost
trade at intersection d(P*)=s(P*) at price P*

Output will be lower than that which maximizes revenue if MC >0 Price-sensitivity effect: MC is constant (in order to isolate effect) Charge higher price where demand is less elastic When comparing 2 linear demand curves the one with higher choke price is more inelastic Volume effect: MC are increasing Demand shifts out so that both E are equal Increase price and quantity when demand shifts out Examples of combined effect: Ad campaign / Increase P of substitute o Positive volume effect o Demand less elastic o So increase prices Decrease in price of complementary o Negative volume effect o More elastic demand (not always) o So reduce price Nash equilibrium: Self-enforcing agreement, Social norm or convention, Steady state of repeated interactions 12.- IMPERFECT COMPETITION Price competition with imperfect substitutes: 2 demand functions interrelated by P1 and P2 Find 2 reaction curves equilib. @ intersection Prices are strategic complements Perfect subs. perfect competition model (Bertrand) price cutting P=MC; Profit=0 Quantity competition (Cournot) with perfect substitutes 1 demand function Quantities are strategic substitutes Cournot Qeq < Qeq perfect competition Cournot Peq > Peq perfect competition Cournot model becomes competitive as # of firms increases Bertrand model (perfect substitutes) is more competitive (even with two firms) When goods are not very substitutes Bertrand and Cournot models converge Imperfect competition with free entry Higher entry smaller market share greater pressure on prices smaller profit per firm Higher FC less entry higher Prices Increase in market volume higher profits more entry smaller price 13.- INDIVIDUAL VERSUS COLLECTIVE ACTION Repeated games or enforced cooperation Positive externalities higher action of one player benefits the other Nash actions < best collective actions Eg. Price competition with substitute goods Merge increases P Negative externalities higher action of one player hurts the other Nash actions > best collective actions Eg. Price competition with complementary goods (merge decreases P) Grim-trigger strategies: cooperate until the other defeats, then defeat forever unless the discount is too high cooperation is preferred for infinite games Nevertheless after defeating cooperation can be equilibrium again if r is not too high 14.- STRATEGIC COMMITMENT Sequential games In a Stackelberg game the leader can cause any NE of the static game to be played The Stackelberg leaders payoff is at least as high as her best NE payoff 1st mover advantage: payoffs are better as a leader 1st mover disadv: payoffs are lower as a leader Solving the games: calculate reaction curve of follower. Maximize profits of Leader taking in consideration the reaction curve of follower Price competition with subst. goods & Partnership game positive externalities + strategic complements

Cournot game & Price competition with complementary goods negative externalities + strategic substitutes

marginal valuation with quantity Q

inverse of demand curve

mv(Q) =

dv(Q) dQ

marginal cost
inverse of supply curve consumer always chooses that maximizes his surplus

mc(Q) =

dc(Q) dQ
quantity

Aggregate reaction curve: fix Price. A change in the P will shift the aggregate reaction curve and the equilib.

Strategic substitutes + positive externalities

consumer surplus = v-P*, producer surplus = P*-c

total surplus = consumer + producer

impact of tax: shift supply up or demand down by t

buyers price now differs from sellers price, less quantity sold, result is deadweight loss (dwl)

Negative externalities + strategic complements

Constant expectations demand curve: fixed Qe

SUMMARY

o o o o o o
o

MC = MR (if MR > MC produce more; if MR<MC produce less); if MR MC pricing is wrong! UNLESS two sub goods in same company!!! MC = p(1-1/E) P = MCxE/(E-1)

o R = TC ONLY WHEN LINEAR DEMAND + MC CONSTANT (assuming MAXIMIZED) P* = (Pchoke+MC)/2 midpoint pricing rule

tax affects those most with steepest curve: biggest

loss, e.g.: supply more price sensitive demand and supply must fall by same amount buyers by tax more affected than sellers in post tax equilibrium total welfare is reduced 7.- PRICING DEPENDING ON DEMAND CURVE Only relevant for firms with market power E>1 if profit maximized for MC>0 E=1 if profit maximized for MC=0 Max MR If MC shifts up, produce less & charge more: D with higher choke price is more inelastic Price should be set in elastic region of demand curve

ONLY IN PERFECTLY COMPETITIVE MARKET o MC = P (=MR) MC = AC (only if all firms have same MC) P = MR

o MC = C ONLY IN MONOPOLISTIC MARKET o P > MC o MR = P(Q) + PxQ MR < P (MR can be < 0 !) -> Subsidise -> It could be use to maximize social surplus MR curve = below D curve MC = MR (only when max!) MR = P(1-1/E) (only when max!)=MC -> formula used to check if price profit max-> P=MC(E/(E-1)) MC = AVC (since MC is constant) Supply, Demand, and Markets (Chapter 1)

9.- EXPLICIT SEGMENTATION Charge higher price to segment with less E demand MR1=MR2 (same E, higher volume same price) 1. Cte. MC: MR1(Q1)=MC ; MR2(Q2)=MC 2. Increas. MC: MR1(Q1)=MC(Q1+Q2) MR2(Q2)=MC(Q1+Q2) 3. Fixed Cap: MR1(Q1)=MR(Q2) ; Q=Q1+Q2 MR = P*(1-1/E) No arbitrage; observability; different demands Limit: Perfect Price Discrimination: Pi=Vi 10.- SCREENING - IMPLICIT SEGMENTATION Versioning; Bundling; Bundling + Screening Participation constraint (each customer prefers trading to not to) and selfselection constraint (each customer prefers his deal) 11.- STATIC GAMES AND NASH EQUILIBRIUM Best response Dominant strategy? equilibr. Reaction curve Maximize your profit taking in consideration the other action as fix Strategic Complements: More of one variable yields to more of the other -> Price competition

o o
o o

15 NETWORK EXTERNALITIES Notation: Customers expectations: Qe or Qcurrent Customers decisions: Q or Qtarget NE or steady state: Qe=Q=Q* Externalities effect: Each potential consumer helps or hurts other consumers by using the product, but he only thinks about his own valuation when deciding to buy Equilibrium consumption is lower than socially optimal with positive network externalities (typically higher when they are negative) Strategic effect: Consumer decisions are interrelated. When network externalities are positive purchase decisions are strategic complements (and viceversa) Positive extern: Firms might underestimate the elasticity of demand bandwagon effect CONCENTRATION OF THE MARKET Negative extern: Firms might overestimate the elasticity of demand congestion DESCONCENTRATION Dynamic pricing strategies: for a constant Price, customers stop adjusting their decisions when they reach a NE low price at the beginning to generate demand and rise price when demand rises and externality effect takes place Price cut = 2 effects: Price and bandwagon effect Equilibrium demand curve: equilibrium where expected demand = current demand Qe=Q=Q*

Dynamic adjustment

Consumer surplus: Consumers marginal valuation (demand curve) is measured by the inverse of the constant expectation demand curve. Consumer surplus is larger than if we use the area below the equilibrium demand curve

buyers valuation: willingness to pay v

Formulas only used to check current pricing and to give direction how to adjust Formula for actual pricing only useable when E and MC are constant P=B*MC/(B-1) Elasticity used to measure market power: Einfinitely elastic-demand no market power The effect of an increase on MC If MC goes up produce less and charge more Q prof.max < Q rev.max, Pprof.max > P rev.max

Strategic substitutes: More of one variable yields less of the other. Quantity competition.