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Industrial Economics An-najah National Univ. Lecturer: Baker Shtayeh First Semester - 2013. Definitions of Industrial Economics “It is concerned with the workings of markets and industries, in particular the way firms compete with each other.” Luis Cabral (2000)

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Industrial Economics An-najah National Univ. Lecturer: Baker Shtayeh First Semester - 2013

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Industrial economics an najah national univ lecturer baker shtayeh first semester 2013

Industrial EconomicsAn-najah National Univ.Lecturer: Baker ShtayehFirst Semester - 2013

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial economics an najah national univ lecturer baker shtayeh first semester 2013

Definitions of Industrial Economics

“It is concerned with the workings of markets and industries, in particular the way firms compete with each other.”

Luis Cabral (2000)

“It is the study of the operation and performance of imperfectly competitive markets and the behavior of firms in these markets.”

Church & Ware (2000)

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial economics an najah national univ lecturer baker shtayeh first semester 2013

Definitions of Industrial Economics

“…Moreover, whereas microeconomics typically focuses on the extreme cases of monopoly and perfect competition, industrial organization is concerned primarily with the intermediate case of oligopoly, that is, competition between a few firms.”

(Cabral)

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial economics an najah national univ lecturer baker shtayeh first semester 2013

Definitions of Industrial Economics

“The main reason for considering industrial organization as a separate subject is its emphasis on the study of the firm strategies that are characteristic of market interaction: price competition, product differentiation , advertising, research and development, and so forth …”

Industrial Economics - Baker Shtayeh - 2012-2013


The importance of the industrial sector in the national economy

The importance of the industrial sector in the national economy:

Industrial sector is increasingly important in the national economy and development, especially in developing countries, for several reasons:

1. The growth in the industrial sector can provide opportunities for employment. Most developing countries suffer from the problem of unemployment.

Industrial Economics - Baker Shtayeh - 2012-2013


The importance of the industrial sector in the national economy1

The importance of the industrial sector in the national economy:

2. The industrial sector helps to increase the sources of production, income and exports in the developing countries. So, the importance of the industrial sector will rise as a percent of (GDP). This helps reducing the dependence on exporting row materials.

Industrial Economics - Baker Shtayeh - 2012-2013


The importance of the industrial sector in the national economy2

The importance of the industrial sector in the national economy:

3. The industrial sector is a high productivity sector, because it is most able to apply the use of modern technology, and it can make use of specialization. The industrial sector is not affected by the law of diminishing returns as speed as the agricultural sector does.

Industrial Economics - Baker Shtayeh - 2012-2013


The importance of the industrial sector in the national economy3

The importance of the industrial sector in the national economy:

4. The growth of the industrial sector contributes in raising the rate of economic growth in the national economy, because the growth of industrial activities helps to drive growth in other sectors, such as agriculture and services sector, because there is interdependent relationships between industry and other sectors.

Industrial Economics - Baker Shtayeh - 2012-2013


The importance of the industrial sector in the national economy4

The importance of the industrial sector in the national economy:

5. Industrial sector provides the foreign exchange currency, and solves the payment balance deficit, through the manufacturing of goods to replace imports or manufacturing of goods for export to the outside.

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial strategies

Industrial Strategies:

Industrial strategies can be divided to several groups, according to:

1. Project ownership (Private or Public)

The size of each of the private sector and public sector and the role of each sector in the growth of the industrial sector differs from one country to another for several reasons, including:

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial strategies 1 project ownership private or public

Industrial Strategies:1. Project ownership (Private or Public)

a. The economic system: Is it a capitalist, socialist or mixed economy.

b. The stage of economic growth: With economic growth, the importance of the private sector increases, and raises its relative importance.

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial strategies 1 project ownership private or public1

Industrial Strategies:1. Project ownership (Private or Public)

c. The type of industry (heavy or light): The private sector usually seeking for light industry, a consumer industries that do not require large amounts of capital, where the rate of profit is high, and the degree of risk is low.

The heavy industries are usually government industries through public sector projects, as they require a huge volume of capital with high degree of risk, and they don not make quick profits.

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial strategies 1 project ownership private or public2

Industrial Strategies:1. Project ownership (Private or Public)

d. The external economies and diseconomies of scale: The projects with high external economies of scale are highly social benefit projects than private benefit. The government usually gets involved to establish such projects or to regulate them, especially at the beginning of the development process.

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial strategies 2 the type of industry heavy or light

Industrial Strategies:2. The type of industry (heavy or light)

a. Light manufacturing strategy:

It is based on the consumer and light industries, such as: clothes, food. Then after that moving to intermediate-goods industries that produce inputs for other industries. Such as: spinning and weaving industry - Manufacture of building materials, fertilizers, and other. And finally transition to establish heavy industries such as machinery manufactures and equipment industries.

This pattern of industrialization was followed by the Western industrial countries.

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial strategies 2 the type of industry heavy or light1

Industrial Strategies:2. The type of industry (heavy or light)

b. Heavy manufacturing strategy:

It is based on starting and establishment of heavy capital industries, like machinery and equipment. This strategy believe that supply of such capital goods will generate demand in the future, because it will encourage the setting up of consumer and intermediate industries that use these machines and equipments. such a strategy relies mainly on the expected market in the future not on the current market .

States that have followed this strategy are the socialist countries (Soviet Union).

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial strategies 3 the production technique labor or capital intensive

Industrial Strategies:3. The production technique (Labor or Capital Intensive)

Production technique reflects the ratio of production factors use in the production process.

Labor Intensive technique depends on using labor (relatively) more than using capital, and vice versa. That depends on many factors such as:

  • The relative prices of production factors.

  • Whether the industry is heavy or light.

  • The availability and ease of substitute the production factors (Labor and Capital)

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial strategies 4 the target market

Industrial Strategies:4. The target market:

a. The local market target (Import Substitution Industrialization)

Local production of goods to replace the goods imported from abroad or that could be imported if we didn't produce.

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial strategies 4 the target market1

Industrial Strategies:4. The target market:

The tools applied by developing countries to implement the strategy of import substitution:

- Tariff barriers against imported consumer goods.

- Reduce the cost of production of consumer goods through the reduction or elimination of tariffs on the import of machinery and equipments and production requirements for the manufacture of consumer goods.

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial strategies 4 the target market2

Industrial Strategies:4. The target market:

Advantages of import substitution strategy: (arguments based on this strategy):

- This strategy could help in treating the deficit in payment balance.

- This strategy could help in reducing the unemployment rates.

- This strategy is the easiest way to develop the industrial sector and increase its percentage contribution in economic activity, and to diversify the production structure in developing countries.

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial strategies 4 the target market3

Industrial Strategies:4. The target market:

Disadvantages of import substitution strategy:

- It could raise the market power, where some producers will make use of tariffs imposed on imports, which prices will be higher than before.

- When this strategy was applied in most of developing countries, it found that it did not effectively reduce unemployment rates, because of wildly usage of capital intensive production techniques.

- Most of developing countries that applied this strategy where failed in reducing the deficit in its payment balances, because of the increased demand on imports of machinery and equipment and production requirements for the manufacture of consumer goods.

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial strategies 4 the target market4

Industrial Strategies:4. The target market:

b.The foreign market target (Export Oriented Industrialization Strategy)

Some developing countries, especially where the local market constraints, have tended to follow this strategy, such as: South Korea, Taiwan, Singapore, Hong Kong and Malaysia.

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial strategies 4 the target market5

Industrial Strategies:4. The target market:

The export oriented strategy is based on the following basis:

  • Encouraging foreign target industries, besides producing for the local market.

  • Encourage the participation of foreign investors, to take advantage of advanced technology, and to help in abroad marketing of products, and to participate in financing heavy export industries.

  • Laws and regulations encouraging foreign investment and providing the appropriate circumstances, such as providing low rate services and labor,free transfer of profits abroad and tax and tariff exemptions.

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial strategies 4 the target market6

Industrial Strategies:4. The target market:

Advantages of Export Industrialization Strategy:

  • Expansion of production, which make benefit from economies of scale, reaching the optimal size of the project and thus lower the average cost per unit of product, which means high production efficiency. As we know, small size of the market is the most important constraint facing manufacturing in the developing countries.

  • It could raise the level of production efficiency and improve product quality, because of the competitiveness power.

  • It helps to encourage make benefit from comparative advantages for that developing countries, especially the availability of raw materials.

  • This strategy could help in treating the deficit in payment balance.

  • This strategy helps in diversifying the export structure, and not to rely on the raw materials export only.

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial strategies 4 the target market7

Industrial Strategies:4. The target market:

Disadvantages of Export Industrialization Strategy:

  • Its dependence on foreign markets.

  • The high competition from the industrialized countries.

    - The establishment of strategic industries in developing countries is not easy. It requires conditions, such as tax and customs exemptions, Provision of basic services at low prices and economic and political stability, which are difficult to be captured in such countries.

Industrial Economics - Baker Shtayeh - 2012-2013


Introduction

Introduction

  • The field of industrial economics developed as an offshoot of microeconomic theory.

  • Industrial economics emphasizes the behavior of firms as compared with the behavior of industries more than does traditional microeconomic theory.

  • The two traditional approaches to the study of industrial economics are: 1) The Structure – Conduct – Performance approach (SCP) 2) The Chicago School approach, which emphasize the use of price theory.

  • Modern industrial economics emphasizes the use of game theory to explore Oligopoly behavior.

Industrial Economics - Baker Shtayeh - 2012-2013


Introduction1

Introduction

Usefulness of the (SCP) Model:

  • Provides a systematic way of analyzing markets & industries

  • Consistent with microeconomic theory’s approach

  • Policy implications for regulation & competition policy – targeting structure or/and conduct

Industrial Economics - Baker Shtayeh - 2012-2013


Introduction2

Introduction

  • Structure

  • Concentration – market power of firms measured by market shares (sales, assets, employees)

  • Product differentiation – uniqueness of products (brands, actual or imagined)

  • Size of firms – in relation to market size and minimum efficiency scale (& exploitation of scale economies)

  • Entry conditions – entry barriers that places potential entrants at a disadvantage

  • Vertical integration – extent of upstream-downstream integration of production

Industrial Economics - Baker Shtayeh - 2012-2013


Introduction3

Introduction

2. Conduct

  • Policy objectives – profit, growth, sales or non-financial objectives

  • Pricing objectives – price in relation to MC, or other types e.g. price discrimination, predatory pricing, penetration pricing, limit pricing etc.

  • Marketing strategies – product differentiation, advertising

  • Research and development – innovation activities (product, process)

Industrial Economics - Baker Shtayeh - 2012-2013


Introduction4

Introduction

3. Performance

  • Profitability (producer surplus)

  • Efficiency (scale of production)

  • Product Quality

  • Technical Progress (Innovation)

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial economics an najah national univ lecturer baker shtayeh first semester 2013

Industrial Economics - Baker Shtayeh - 2012-2013


Cost theory and estimation revew

Cost Theory and Estimation (Revew)

  • Empirical Estimation

Functional Form for Short-Run Cost Functions

Theoretical Form

Linear Approximation

Industrial Economics - Baker Shtayeh - 2012-2013


Cost theory and estimation revew1

Cost Theory and Estimation (Revew)

Empirical Estimation

Theoretical Form

Linear Approximation

Industrial Economics - Baker Shtayeh - 2012-2013


Common math functions used in economics

Common Math Functions Used in Economics

Industrial Economics - Baker Shtayeh - 2012-2013


Graphical concepts variable relationships

Graphical Concepts (Variable Relationships)

  • Y axis:

    a vertical line in a graph along which the units of measurement represent different

    values of, normally, the Y or dependent

    variable.

  • Y axis intercept:

    the value of Y when the value of X = 0, or the value of Y where a line or curve intersects the Y axis; = ‘a’ in Y = a + bX

Industrial Economics - Baker Shtayeh - 2012-2013


Graphical concepts variable relationships1

Graphical Concepts (Variable Relationships)

  • X axis:

    a horizontal line in a graph along which the units of measurement represent different values of, normally, the X or independent variable

  • X axis intercept:

    the value of X when the value of Y = 0, or the value of X where a line or curve intersects the X axis

Industrial Economics - Baker Shtayeh - 2012-2013


Graphical concepts variable relationships2

Graphical Concepts (Variable Relationships)

  • Slope:

    • = the steepness of a line or curve; a +(-) slope => the line or curve slopes upward (downward) to the right

    • = the change in the value of Y divided by the change in the value of X (between 2 pts on a line or a curve)

    • = Y/X = 1st derivative (in calculus)

    • = Y/ X using algebraic notation

    • = the ‘marginal’ effect, or the change in Y brought about by a 1 unit change in X

    • = b if Y = a + bX

Industrial Economics - Baker Shtayeh - 2012-2013


Market structure

Market Structure

  • Market structure – identifies how a market is made up in terms of:

    • The number of firms in the industry

    • The nature of the product produced

    • The degree of monopoly power each firm has

    • The degree to which the firm can influence price

    • Profit levels

    • Firms’ behaviour – pricing strategies, non-price competition, output levels

    • The extent of barriers to entry

    • The impact on efficiency

Industrial Economics - Baker Shtayeh - 2012-2013


Market structure1

Market Structure

  • Market structure as Models

  • Market structure deals with a number of economic ‘models’

  • These models are a representation of reality to help us to understand what may be happening in real life

  • There are extremes to the model that are unlikely to occur in reality

  • They still have value as they enable us to draw comparisons and contrasts with what is observed in reality

  • Models help therefore in analysing and evaluating – they offer a benchmark

Industrial Economics - Baker Shtayeh - 2012-2013


Market structure2

Market Structure

  • Characteristics of each model:

    • Number and size of firms that make up the industry

    • Control over price or output

    • Freedom of entry and exit from the industry

    • Nature of the product – degree of homogeneity (similarity) of the products in the industry (extent to which products can be regarded as substitutes for each other)

    • Diagrammatic representation – the shape of the demand curve, etc.

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial economics an najah national univ lecturer baker shtayeh first semester 2013

Market Structure

Features of the four market structures

Industrial Economics - Baker Shtayeh - 2012-2013


Market structure3

Market Structure

Perfect Competition

  • Characteristics:

    • Large number of firms

    • Products are homogenous (identical) – consumer has no reason to express a preference for any firm

    • Freedom of entry and exit into and out of the industry

    • Firms are price takers – have no control over the price they charge for their product

    • Each producer supplies a very small proportion of total industry output

    • Consumers and producers have perfect knowledge about the market

Industrial Economics - Baker Shtayeh - 2012-2013


Perfect competition

3.The typical firm can sell all it wants at the market price…

1.The intersection of the market supply and the market demand curve…

Price per Ounce

Price per Ounce

Ounces of Gold per Day

Ounces of Gold per Day

4.so it faces a horizontal demand curve

2.determine the equilibrium market price

Perfect Competition

  • The Competitive Industry and Firm

Market

Firm

S

$400

$400

Demand Curve Facing the Firm

D

Industrial Economics - Baker Shtayeh - 2012-2013


Perfect competition1

Perfect Competition

  • Computing the Total Revenue of a Price-taker

  • Since the perfectly competitive firm faces a constant price, the shape of its total revenue is an upward-sloping line. Total revenue changes only with changes in the quantity sold.

Industrial Economics - Baker Shtayeh - 2012-2013


Perfect competition2

Perfect Competition

  • The Totals Approach to Profit Maximization

  • To maximize profit, a producer finds the largest gap between total revenue and total cost.

Industrial Economics - Baker Shtayeh - 2012-2013


Perfect competition3

Perfect Competition

  • Profit Maximization Using the Marginal Approach

Industrial Economics - Baker Shtayeh - 2012-2013


Perfect competition4

Perfect Competition

  • Profit Maximization Using the Marginal Approach

  • Profit per unit equals revenue per unit (or price) minus cost per unit (or average total cost).($25 - $14) = 11

  • Total economic profit equals:(price – average cost) x quantity produced($25 - $14) x 9 = $99

Industrial Economics - Baker Shtayeh - 2012-2013


Perfect competition5

Dollars

Price per Bushel

Bushels per Year

Bushels per Year

Perfect Competition

  • Short-run Supply Curve

(b)

(a)

ATC

Firm's Supply Curve

MC

$3.50

$3.50

d1=MR1

2.50

2.50

d2=MR2

2.00

2.00

d3=MR3

AVC

1.00

1.00

d4=MR4

0.50

0.50

d5=MR5

1,000

4,000

7,000

2,000

4,000

7,000

2,000

5,000

5,000

Industrial Economics - Baker Shtayeh - 2012-2013


Perfect competition6

Perfect Competition

A Market in Long-run Equilibrium

  • The quantity of the product supplied equals the quantity demanded

  • Each firm in the market maximizes its profit, given the market price

  • Each firm in the market earns zero economic profit, so there is no incentive for other firms to enter the market

  • A market reaches a long-run equilibrium when three conditions hold:

Industrial Economics - Baker Shtayeh - 2012-2013


Perfect competition a market in long run equilibrium

Perfect CompetitionA Market in Long-run Equilibrium

  • In long-run equilibrium, price equals marginal cost (the profit-maximizing rule), and price equals short-run average total cost (zero economic profit).

Industrial Economics - Baker Shtayeh - 2012-2013


Monopoly

Monopoly

  • Monopoly is a situation in which there is a single seller of a product for which there are no good substitutes.

  • When a monopoly exists, there are generally high barriers to entry into the industry.

  • What are the reasons for these barriers?

Industrial Economics - Baker Shtayeh - 2012-2013


Monopoly1

Monopoly

Reasons for these barriers

(1) Legal Barriers

patent - grant of an exclusive right to use a specific process or produce a specific product for a period of time (17 years in the U.S.)

licenses and franchises - permission, granted by a government, to enter an industry or occupation

Industrial Economics - Baker Shtayeh - 2012-2013


Monopoly2

Monopoly

Reasons for these barriers

(2) A single firm has some control of a resource essential to an industry.

  • Economies of Scale

    Costs per unit in an industry may be low only when a firm produces a lot of output.

    Consequently, small firms will be unable to enter the industry because costs are too high.

Industrial Economics - Baker Shtayeh - 2012-2013


Monopoly3

Monopoly

  • The Key Difference Between a Monopolist and a Perfect Competitor

  • For a competitive firm, marginal revenue equals price.

  • For a monopolist it does not.

  • The monopolist takes into account the fact that its production decision can affect price.

  • A competitive firm is too small to affect the price.

  • A competitive firm's marginal revenue is the market price. While a monopolistic firm’s marginal revenue is not its price

Industrial Economics - Baker Shtayeh - 2012-2013


Monopoly demand and marginal and total revenue

Monopoly Demand and Marginal and Total Revenue

(a) Demand and Marginal Revenue

Demand and marginal revenue are shown in the upper panel and total revenue is in the lower panel.

Elastic

d

n

o

m

a

Unit elastic

i

d

r

$3,750

e

Note that the marginal revenue curve is below the demand curve and total revenue is at a maximum when marginal revenue equals zero.

p

s

r

a

Inelastic

l

l

o

D

0

D =Average revenue

Marginal revenue

16 32

diamonds per day

Notice also that when demand is elastic, a decrease in price increases total revenue  marginal revenue is positive. Conversely, when demand is inelastic, a decrease in price reduces total revenue  marginal revenue is negative

(b) Total Revenue

$60,000

s

r

a

l

l

o

d

l

Total revenue

a

t

o

T

0 16 32

diamonds per day

Industrial Economics - Baker Shtayeh - 2012-2013


Monopoly costs and revenue

Monopoly Costs and Revenue

The intersection of the two marginal curves at point e in panel (a) indicates that profit is maximized when 10 diamonds are sold. At this rate of output, we move up to the demand curve to find the profit-maximizing price of $5,250. The average total cost of $4,000 is identified by point b the average profit per diamond equals the price of $5,250 minus the average total cost of $4,000  $1,250  economic profit is the equal to $1,250 * 10 units sold  $12,500 as shown by the blue shaded area.

(a) Per-Unit Cost and Revenue

Marginal cost

Average total cost

a

$5,250

Profit

b

4,000

Dollars per unit

e

D =Average revenue

MR

Diamonds per day

0

32

10

16

(b) Total Cost and Revenue

Total cost

Maximum

profit

$52,500

In panel (b), the firm’s profit or loss is measured by the vertical distance between the total revenue and total cost curves  again profit is maximized where De Beers produces 10 diamonds per day

40,000

Total dollars

Total revenue

15,000

Diamonds per day

0 10 16 32

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial economics an najah national univ lecturer baker shtayeh first semester 2013

The Monopolist’s Profit- Maximizing Output and Price

Industrial Economics - Baker Shtayeh - 2012-2013


The monopolist minimizes losses in the short run

The Monopolist Minimizes Losses in the Short Run

Recall that average variable cost and average fixed cost sum to average total cost .

Marginal cost

Loss minimization occurs at point e, where the marginal revenue curve intersects the marginal cost curve  Q and p are the loss minimization quantity and price, respectively.

a

Average total cost

Loss

b

p

Average variable cost

c

Notice that at point b, the firm is covering its average variable cost  it is making some contribution to its fixed costs. However, it is not covering all of its costs. The average loss per unit, measured by ab, is identified by the yellow shaded area.

e

Dollars per unit

Demand = Average revenue

Marginal revenue

Quantity per period

0

Q

Industrial Economics - Baker Shtayeh - 2012-2013


Monopolist s supply curve

Monopolist’s Supply Curve

  • The intersection of a monopolist’s marginal revenue and marginal cost curve identifies the profit maximizing quantity, but the price is found on the demand curve

  • Thus, there is no curve that shows both price and quantity supplied  there is no monopolist supply curve

Industrial Economics - Baker Shtayeh - 2012-2013


Long run profit maximization

Long-Run Profit Maximization

  • For a monopoly, the distinction between the long and short run is not as important

  • If a monopoly is insulated from competition by high barriers that block new entry, economic profit can persist in the long run

  • However, short-run profit is no guarantee of long-run profit

Industrial Economics - Baker Shtayeh - 2012-2013


Long run profit maximization1

Long-Run Profit Maximization

  • A monopolist that earns economic profit in the short-run may find that profit can be increased in the long run by adjusting the scale of the firm

  • Conversely, a monopoly that suffers a loss in the short run may be able to eliminate that loss in the long run by adjusting to a more efficient size

Industrial Economics - Baker Shtayeh - 2012-2013


Natural monopoly

Natural Monopoly

  • a situation in which ATC declines continually with increased output.

  • So a single firm would be the lowest cost producer of the output demanded.

  • ATC doesn’t turn upward until a very high output level, beyond the amounts that consumers will buy.

A.C

ATC

Q

Industrial Economics - Baker Shtayeh - 2012-2013


Natural monopoly1

Natural Monopoly

  • What can the government do about a natural monopoly?

1. Operating freely

$

D

P*

MR

MC

ATC

Q

Q*

Industrial Economics - Baker Shtayeh - 2012-2013


Natural monopoly2

Natural Monopoly

  • What can the government do about a natural monopoly?

    2. Price Regulation

    a. marginal cost pricing regulation

P < ATCFirm has a loss! So this won’t work unless the government provided subsidies to the producer by his loss.

$

D

MR

MC

ATC

Pr

Q

Qr

Industrial Economics - Baker Shtayeh - 2012-2013


Natural monopoly3

Natural Monopoly

  • What can the government do about a natural monopoly?

    2. Price Regulation

    a. marginal cost pricing regulation

$

D

MR

MC

ATC

Pr

Q

Qr

Industrial Economics - Baker Shtayeh - 2012-2013


Natural monopoly4

Natural Monopoly

  • What can the government do about a natural monopoly?

    2. Price Regulation

    b. Average Cost Pricing Regulation

Zero economic profits: this can work.

$

D

MR

MC

ATC

Pr

Q

Qr

Industrial Economics - Baker Shtayeh - 2012-2013


Natural monopoly5

Natural Monopoly

Solved Problem:

A monopolist faces the following situation.

Demand: P = 300 – 3 Q

TC = Q3 – 21 Q2 + 333 Q + 180

1) Determine the profit-maximizing output, price, TR, TC & profit if the monopolist operates without regulation.

2) Determine the output, price, TR, TC & profit if the monopolist is regulated using average cost pricing.

Industrial Economics - Baker Shtayeh - 2012-2013


Answer 1 monopolist operating without regulation demand p 300 3 q tc q 3 21 q 2 333 q 180

Answer:1) monopolist operating without regulation Demand: P = 300 – 3 QTC = Q3 – 21 Q2 + 333 Q + 180

Natural Monopoly

To maximize profits, the firm will set MR = MC.

TR = PQ = 300 Q – 3 Q2

MR = dTR/dQ = 300 – 6Q

MC = dTC/dQ = 3Q2 – 42 Q + 333

Industrial Economics - Baker Shtayeh - 2012-2013


Equate mr 300 6q to mc 3q 2 42 q 333

Equate MR = 300 – 6Q to MC = 3Q2 – 42 Q + 333

Answer: (CON)

300 – 6Q = 3Q2 – 42 Q + 333

0 = 3Q2 – 36 Q + 33

Dividing through by 3, we find

0 = Q2 – 12 Q + 11

0 = (Q – 1) (Q – 11)

So Q = 1 or Q = 11

It can be shown using the second derivative of the total profit function that profit is maximized at Q = 11 and minimized at Q = 1

Industrial Economics - Baker Shtayeh - 2012-2013


So at the maximum where q 11

So at the maximum, where Q = 11

Answer: (CON)

P = 300 – 3 Q = 300 – 3(11) = 300 – 33 = 267

TR = PQ = (267)(11) = 2937

TC = Q3 – 21 Q2 + 333 Q + 180 = (11)3 – 21 (11)2 + 333(11) + 180 = 2633

Profit = TR – TC = 2937 – 2633 = 304

Industrial Economics - Baker Shtayeh - 2012-2013


2 monopolist regulated by average cost pricing

2) Monopolist regulated by average cost pricing

Answer: (CON)

Demand: P = 300 – 3 QTC = Q3 – 21 Q2 + 333 Q + 180

ATC = TC/Q = Q2 – 21 Q + 333 + (180/Q)

Plotting points & graphing ATC & D, you see that they intersect when Q = 15.

At that output, P = 300 – 3 Q = 300 – 3(15) = 255, and

ATC = Q2 – 21 Q + 333 + (180/Q) = (15)2 – 21 (15) + 333 + (180/15) = 255

So the regulator sets the price at 255 & the firm produces 15 units of output.

Industrial Economics - Baker Shtayeh - 2012-2013


With p 255 q 15

With P = 255 & Q = 15:

Answer: (CON)

TR = PQ = (255)(15) = 3825

TC = Q3 – 21 Q2 + 333 Q + 180 = (15)3 – 21(15)2 + 333 (15) + 180 = 3825

[or TC = ATC(Q) = 255(15) = 3825]

Economic profit = TR – TC = 0& firm makes just a normal accounting profit.

Industrial Economics - Baker Shtayeh - 2012-2013


Natural monopoly6

Natural Monopoly

Assignment:

A monopolist faces the following situation.

Demand: P = 100 – Q

ATC = (400/Q) + 15

1) Determine the profit-maximizing output, price, TR, TC & profit if the monopolist operates without regulation.

2) Determine the output, price, TR, TC & profit if the monopolist is regulated using average cost pricing.

3) Determine the output, price, TR, TC & profit if the monopolist is regulated using marginal cost pricing.

Industrial Economics - Baker Shtayeh - 2012-2013


Dead weight loss due to monopoly

Perfectly competitive

output

Perfectly competitive

output

Monopoly

output

Dead Weight Loss Due to Monopoly

Industrial Economics - Baker Shtayeh - 2012-2013


Market power lerner index

Market Power (Lerner Index)

MR = dTR/dQ  MR = d(P.Q)/dQ  MR = (PdQ + QdP)/dQ

MR = P + ]Q(dP/dQ)[(Multiplied by P/P):

MR = P ](P/P) + (QdP/dQ/P)[

MR = P ]1 + (Q/P) (dP/dQ)[BUT: (P/Q) (dQ/dP) = Ed

SO: (Q/P) (dP/dQ) = 1/Ed

MR= P]1 - (1/Ed)[

BUT when equilibrium: MR = MC

MC = P]1 – (1/Ed)[

MC = P – (P/Ed)

1/Ed = (P-MC) / P

(Which is Lerner Index)

Industrial Economics - Baker Shtayeh - 2012-2013


Lerner index other method to derive

Lerner Index (Other Method to Derive)

From the graph beside:

TRa = P1.Q1 & TRb = P2 . Q2

TR = TRb – TRa

TR = (P2.Q2) – (P1.Q1)

= A – B

= (P2. Q) – (Q1. P)

MR = TR / Q

MR = ](P2 . Q)/ Q[ + ](Q1. P)/ Q[

MR = P2 + ]Q1( P/ Q)[

(Multiplied by P/P):

(………….. Etc)

P

a

P1

B

b

P2

A

Q1

Q2

Q

Industrial Economics - Baker Shtayeh - 2012-2013


Market power lerner index1

Market Power (Lerner Index)

LI and Pricing Behavior

• The Lerner Index

LI = (P - MC) / P

  • The Lerner index measures the degree to which firms can markup price above marginal cost; it is a measure of a firm’s market power. The index ranges from 0 to 1.

    • When P = MC, the Lerner Index is zero; the firm has no market power.

    • A Lerner Index closer to 1 indicates relatively weak price competition; the firm has market power.

Industrial Economics - Baker Shtayeh - 2012-2013


Market power lerner index2

Market Power (Lerner Index)

LI and Pricing Behavior (Markup Factor):

From the Lerner Index, the firm can determine the

factor by which it should over MC. Rearranging the

Lerner Index:

P= ]1/(1-LI)[*MC

• The markup factor is (P/MC) = 1/(1-LI).

  • When the Lerner Index is zero (LI = 0), the markup factor is 1 and P = MC.

  • When the Lerner Index is 0.20 (LI = 0.20), the markup factor is 1.25 and the firm charges a price that is 1.25 times marginal cost.

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial economics an najah national univ lecturer baker shtayeh first semester 2013

Industrial Economics - Baker Shtayeh - 2012-2013


Dead weight loss cowling and mueller approach

Dead-Weight Loss(Cowling and Mueller Approach)

D.W.L = ½( P. Q)

Multiplied by (Pm/Pm)( P/ P)(PmQm/PmQm)

DWL= 1/2 ](dQ/dP . Pm/Qm) * ((Pm-MC)/Pm)^2 * (Qm . Pm)[

(TR)

(Ed)

(1/Ed)^2 = r^2

  • DWL= ½ ](Ed) . (1/Ed) . (1/Ed) . (TR)[

  • = ½ . (1/Ed) . (TR)

  • = ½ ](Pm – AC)/Pm[ * (Pm . Qm)

  • = ½ ](Pm . Qm) – (AC . Qm)[

  • DWL = ½

  • Hence dead weight losses are equal to approximately one-half of economic profits realized by firms.

P

0.5 *( P/ Q)

Pm

MC=AC

Pc

Qm

Qc

Q

Industrial Economics - Baker Shtayeh - 2012-2013


Important applications

Important Applications

Exercise (1):

If you got the following functions:

D: P = 60 – 10Q

TC = 10Q

Find out:

  • The monopolist profit maximization quantity and price

  • If we transformed this industry to a perfect competition market. Find out the competitor profit maximization quantity and price

  • The Lerner Index for both monopolist and competitor (Market Power)

  • The markup factor for monopolist.

  • D.W.L due to monopoly using Cowling and Mueller approach

  • Illustrate this case graphically using both total and averages graphs

Industrial Economics - Baker Shtayeh - 2012-2013


Important applications1

Important Applications

Answer:

1. MR = MC  TR =60Q – (10Q^2)

MR = dTR/dQ = 60 – 20Q

MC = dTC/dQ = 10

60 – 20Q = 10  Q = 2.5 & P = 35

2. MC = P  10 = 60 – 10Q

Q = 5 & P = 10

3. The monopolist Lerner Index = 1/Ed = (P-MC) / P

Ed (When profit Max.) = ](1/slope) . (P/Q)[

= (1/-10) . (35/2.5) = 1.4  1/Ed = 0.71

&: (P-MC) / P = (35 – 10) / 35 = 0.714

But the competitor Lerner Index = 0  MC = P

Industrial Economics - Baker Shtayeh - 2012-2013


Exercise 1 con

Exercise (1): Con

4. The monopolist markup factor = 1/(1-LI)

= 1/(1-0.714) = 3.5 (Which is P/MC)

That is: the firm charges a price that is 3.5 times marginal cost.

But the competitor markup factor = 1  MC = P = 10

5. D.W.L = ½ . Profits  Profit = TR – TC

Profit = 60Q – (10Q^2) – 10Q = 50Q – 10Q^2

Profit = (50 * 2.5) – (10 * 2.5^2) = 62.5

OR:

Profit = TR – TC  TR = (P . Q) = (35 * 2.5) = 87.5

TC = (10 * 2.5) = 25

Profit = 87.5 – 25 = 62.5

Then: DWL = ½ * 62.5 = 31.25

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial economics an najah national univ lecturer baker shtayeh first semester 2013

Exercise (1): Con

P

70

60

50

d

40

30

20

DWL

MC

10

Q

1

2

3

4

5

6

TR

MR

100

80

TC

60

40

TR

20

Q

5

2

3

4

6

1

-20

profit

-40

Industrial Economics - Baker Shtayeh - 2012-2013


Problems

Problems:

If you got the following functions:

d: P = 940 – 0.02Qd

TC = 250,000 + 40Q + 0.01Q^2

Answer the following questions:

  • Is this case represents short or long run? Why?

  • Estimate each (VC) and (AVC) functions

  • Calculate TR when TR.MAX

  • The monopolist profit maximization quantity and price

  • If we transformed this industry to a perfect competition market. Find out the competitor profit maximization quantity and price

  • The Lerner Index for both monopolist and competitor

  • The markup factor for monopolist.

  • Illustrate this case graphically using averages graph. (use the next slide diagram)

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial economics an najah national univ lecturer baker shtayeh first semester 2013

P

1100

1000

900

800

MC

700

600

500

400

300

d

200

100

Q

10000

15000

20000

25000

30000

5000

MR

Industrial Economics - Baker Shtayeh - 2012-2013


Problems1

Problems:

If you got the followig functions:

d: P = 100 – 2Q

TC = 125Q – 7.6Q^2 + 0.18Q^3

Find out:

  • Total profits when profit maximization for both monopoly and competition cases

  • TFC and TVC functions

  • The Lerner Index for both monopolist and competitor cases (Market Power)

  • Prove that MC function crosses the AC function from the minimum point

Industrial Economics - Baker Shtayeh - 2012-2013


Problems2

Problems:

If you got the following function:

TC = 200 + 5Q – 0.1Q^2

Find out:

  • FC function

  • VC function

  • MC function

  • AVC function

  • ATC function

  • AFC function

  • Is it a short or long-run case? Why?

Industrial Economics - Baker Shtayeh - 2012-2013


Problems3

Problems:

If you got the following function:

Profit = 50Q – Q^2

  • Find out (Q) that maximize profits

  • Calculate total profits

    ----------------------------------------------------

    If MR = 20 , P* = 40 , Q* = 10

    And the (MC) function is horizontal

  • Find out (Market Power)

  • Illustrate graphically

    ------------------------------------------------------

    If Ed = 3 , Q* = 30 , P* = 60

  • Find out (Market Power)

  • Illustrate graphically

Industrial Economics - Baker Shtayeh - 2012-2013


Price discrimination

Price Discrimination

  • Price discrimination is a common type of pricing strategy. It is a classic part of price competition between firms seeking a market advantage.

  • price discrimination exists when two “similar” products which have the same marginal cost to produce are sold by a firm at different prices.

  • Conditions Necessary for Price Discrimination

  • Imperfect competition markets. Firm must be a price maker with a downwardly sloping demand curve.

  • The firm must be able to separate markets and prevent resale. E.g. stopping an adults using a child ticket.

  • Different consumer groups must have elasticities of demand. E.g. students with low income will be more price elastic.

Industrial Economics - Baker Shtayeh - 2012-2013


Price discrimination1

Price Discrimination

  • Different types, classified by Pigou (1920):

  • 1. First-degree price discrimination:

  • Each consumer is charged the maximum he is willing to pay

  • Consumer surplus is nil

  • Producer surplus is maximized

  • Output is the same as in a competitive market

    - This type of price discrimination is primarily theoretical because it requires the seller of a good or service to know the absolute maximum price that every consumer is willing to pay.

Industrial Economics - Baker Shtayeh - 2012-2013


Price discrimination2

Price Discrimination

  • 1. First- degree price discrimination:

P

Producer surplus = Total surplus

MC = S

D = AR = MR

Q*F = QCM

Q

Industrial Economics - Baker Shtayeh - 2012-2013


Price discrimination3

Price Discrimination

Suppose the demand curve for a monopolist’s product is: P = 9 – 0.005 Q.

The average total cost curve is a horizontal line: ATC = MC = 1.5

Determine the price, quantity, consumer surplus, producer surplus (profit), & the sum of consumer & producer surplus, if the firm does NOT price discriminate.

Determine the quantity, consumer surplus, producer surplus (profit), & the sum of consumer & producer surplus, if the firm does price discriminate.

  • First- degree price discrimination: Example:

Industrial Economics - Baker Shtayeh - 2012-2013


Price discrimination4

Price Discrimination

1. if the firm does NOT price discriminate:

We have the demand curve for a monopolist’s product is: P = 9 – 0.005 Q.

& the average total cost curve is: ATC = MC = 1.5

TR = PQ =(9 – 0.005 Q) Q = 9 Q – 0.005 Q2 .

Then MR = dTR/dQ = 9 – 0.01 Q .

Setting MR = MC, we have 9 – 0.01Q = 1.5

or 7.5 = 0.01 Q .

So Q = 750,

& P = 9 – 0.005 Q = 9 – 0.005 (750) = 5.25.

Profit or producer surplus = TR – TC = PQ – (ATC)Q = (5.25)(750) – (1.5)(750) = 2812.5

Industrial Economics - Baker Shtayeh - 2012-2013


Price discrimination5

Price Discrimination

Consumer Surplus = (1/2)(750)(3.75) = 1406.25

$

9

P*= 5.25

profit

ATC =MC =1.5

D

MR

Q

Q*= 750

Combined consumer & producer surplus is CS + PS = 1406.25 + 2812.5 = 4218.75

Industrial Economics - Baker Shtayeh - 2012-2013


Price discrimination6

Price Discrimination

2. If the firm does 1st degree price discrimination:

We had the demand curve: P = 9 – 0.005 Q,

& the average total cost curve: ATC = MC = 1.5

MR is now the same as the demand function,

so MR = 9 – 0.005 Q.

Setting MR = MC,

we have 9 – 0.005Q = 1.5

or 7.5 = 0.005 Q .

So Q = 1500.

Industrial Economics - Baker Shtayeh - 2012-2013


Price discrimination7

Price Discrimination

$

Profit = (1/2) (1500) (7.5) = 5625

9

ATC =MC =1.5

D=MR

Q

Q*= 1500

Combined consumer & producer surplus is CS + PS = 0 + 5625 = 5625

Industrial Economics - Baker Shtayeh - 2012-2013


Price discrimination8

Price Discrimination

2. Second-degree price discrimination = selling larger quantities of a same product at a lower unit price. This is particularly widespread in sales to industrial customers, where bulk buyers enjoy higher discounts.

  • sellers are not able to differentiate between different types of consumers. Thus, the suppliers will provide incentives for the consumers to differentiate themselves according to preference.

Industrial Economics - Baker Shtayeh - 2012-2013


Price discrimination9

Price Discrimination

3. Third-degree price discrimination:

  • Different prices are charged for the same product to different consumers

  • Requires each market to be impenetrable

  • Requires different price elasticity of demand in each market

  • Example:

    Prices for rail travel differ for the same journey at different times of the day

Industrial Economics - Baker Shtayeh - 2012-2013


Price discrimination10

Price Discrimination

P

P

P

MC

3. Third-degree price discrimination:

P2

P1

d

MR

d1

d2

MR1

MR2

Q

q1+2

q2

Q

q1

Q

Market (a)

Market (b)

Total Market

  • When equilibrium: MR1 = MC = MR2  MR1 = MR2

  • P1(1-1/Ed1) = P2(1-1/Ed2)

    But: Slope 1 < Slope 2

    So: Ed1 > Ed2

  • 1/Ed1 < 1/Ed2

  • (1-1/Ed1) > (1-1/Ed2)

  • P1 < P2

Industrial Economics - Baker Shtayeh - 2012-2013


Price discrimination11

Price Discrimination

3. Third-degree price discrimination:

Q1 = 120 - 10 P1 or P1 = 12 - 0.1 Q1 and MR1 = 12 - 0.2 Q1

Q2 = 120 - 20 P2 or P2 = 6 - 0.05 Q2 and MR2 = 6 - 0.1 Q2

MR2 = MC = 2

MR1 = MC = 2

MR1 = 12 - 0.2 Q1 = 2

MR2 = 6 - 0.1 Q2 = 2

Q1 = 50

Q2 = 40

P1 = 12 - 0.1 (50) = $7

P2 = 6 - 0.05 (40) = $4

Industrial Economics - Baker Shtayeh - 2012-2013


Price discrimination12

Price Discrimination

Exercise:

Monopolistic firm has the following functions:

P = 100 – 4Q & TC = 20Q

The producer is able to divide demand to two groups:

d1: P = 80 – 5Q & d2: P = 180 – 20Q

Compare the profit in the two cases. Will you advice this producer to discriminate pricing? Explain.

P

P

P

Profit

Profit

Profit

MC=AC

Q

Q

Q

Market (1)

Total Market

Market (2)

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial economics an najah national univ lecturer baker shtayeh first semester 2013

Problem:Suppose the demand functions for two groups of consumers areD1: P = 101 – 13Q and D2: P = 53 – 7 Q.The total cost function is: TC = 90 + 128Q – 22Q2 + Q3 .1. If the firm is able to price discriminate between the two groups, determine the prices that should be charged, the quantities that will be purchased, total revenue, total cost, and profit.2. With no price discrimination, determine the profit.

Price Discrimination

Industrial Economics - Baker Shtayeh - 2012-2013


Price discrimination13

Price Discrimination

Problem:

Monopolistic firm has the following functions:

P = 100 – 4Q

TC = 50 + 20Q

The producer is able to divide demand to two groups:

d1: P = 80 – 5Q

d2: P = 180 – 20Q

Compare the profit in the two cases. Will you advice this producer to discriminate pricing? Explain.

Industrial Economics - Baker Shtayeh - 2012-2013


Price discrimination14

Price Discrimination

  • Advantages of Price Discrimination

  • Firms will be able to increase revenue. This will enable some firms to stay in business who otherwise would have made a loss. For example price discrimination is important for train companies who offer different prices for peak and off peak.

  • Increased revenues can be used for research and development which benefit consumers

  • Some consumers will benefit from lower fares. E.G. old people benefit from lower train companies, old people are more likely to be poor.

Industrial Economics - Baker Shtayeh - 2012-2013


Price discrimination15

Price Discrimination

Disadvantages of Price Discrimination

  • Some consumers will end up paying higher prices. These higher prices are likely to be allocatively inefficient because P>MC.

  • Decline in consumer surplus.

  • Those who pay lower prices may not be the poorest. E.g. adults could be unemployed.

  • There may be administration costs in separating the markets.

  • Profits from price discrimination could be used to finance predatory pricing.

Industrial Economics - Baker Shtayeh - 2012-2013


Economic of scale

Economic of Scale

Internal Economies of Scale:

  • When the cost per unit falls as output –the size of firm- increases. (Cost per unit depends on the size of firm)

  • Firms usually achieve E.S because of:

    - Technical E.S

    - Marketing E.S

    a. Purchasing input factors at a less discount rate.

    b. Obtaining larger output at the same advertising budget

    - Financial E.S. (Less rental cost)

    - Managerial E.S. (Specialization, which is more efficient)

    - Research and Development. (R & D)

Industrial Economics - Baker Shtayeh - 2012-2013


Economic of scale1

Economic of Scale

External Economies of Scale:

  • Cost per unit depends on the size of industry

  • The main tips of External Economies of Scale are:

    - Transport and communication links improve

    - Training and education becomes more focused on the industry

    - Other industries grow to support this industry

Industrial Economics - Baker Shtayeh - 2012-2013


Economic of scale2

Economic of Scale

Internal Diseconomies of Scale:

  • Decisions are not taken quickly.

  • Lack of communication.

  • Poor labor relations.

  • The disadvantage of the division of labor.

    External Diseconomies of Scale:

  • Local labor becomes scarce and firm will have to offer higher wages to attract new workers.

  • Land and factories become scarce, and rents begin to rise.

  • Local roads become congested and so transportation costs begin to rise.

Industrial Economics - Baker Shtayeh - 2012-2013


Economies of scope

Economies of Scope

  • Where it is cheaper to produce two products together (Joint Production) rather than separately.

  • A measure of Economies of Scope:

    TC (Qa) + TC (Qb) – TC (Qa & Qb)

    S=

    TC (Qa & Qb)

    EX. TC to produce (X) good alone = 50,000$

    TC to produce (Y) good alone = 30,000 $

    TC to produce (X & Y) goods together = 70,000$

    S = (50,000 + 30,000 – 70,000) / 70,000

    S = 0.14

    That is producing (X) and (Y) together will save (14%) in total cost.

Industrial Economics - Baker Shtayeh - 2012-2013


Returns to scale

Returns to Scale

  • Increasing returns to scale

    • When the % change in output > % change in inputs

      • E.g. a 30% rise in factor inputs leads to a 50% rise in output

    • Long run average total cost will be falling

  • Decreasing returns to scale

    • When the % change in output < % change in inputs

      • E.g when a 60% rise in factor inputs raises output by only 20%

    • Long run average total cost will be rising

  • Constant returns to scale

    • When the % change in output = % change in inputs

    • E.g when a 10% increase in all factor inputs leads to a 10% rise in total output

    • Long run average total cost will be constant

Industrial Economics - Baker Shtayeh - 2012-2013


Economic of scale vs return to scale

Economic of Scale Vs Return to Scale

AC

TP

IRS

CRS

LRAC

MC

DRS

MC

TP

TC (L,K)

  • When AC > MC  Economies

  • of Scale

  • When AC = MC  Optimal Size

  • When MC > AC  Diseconomies

  • of Scale

  • When % TP > % TC IRS

  • When % TP = % TC CRS

  • When % TC > % TP DRS

Industrial Economics - Baker Shtayeh - 2012-2013


Economic of scale vs return to scale1

  • AC

  • MC

  • LRAC

  • MC

  • TP

Economic of Scale Vs Return to Scale

Return to Scale

Elasticity of Cost= (% ΔQ)/(% ΔTC)

Ecost = (ΔQ/Q) . (TC/ ΔTC)

= (ΔQ/ΔTC) . (TC/Q)

= ](TC/Q) / (ΔTC/ΔQ)[

Ecost = AC / MCSO, When

(% ΔQ)/(% ΔTC) OR (AC / MC) >1 then we got I.R.S

(% ΔQ)/(% ΔTC) OR (AC / MC) = 1 then we got C.R.S

(% ΔQ)/(% ΔTC) OR (AC / MC) < 1 then we got D.R.S

Economic of Scale

Elasticity of Q = (% ΔTC)/(% ΔQ)

E.Q = (ΔTC/TC) / (ΔQ/Q)

= (ΔTC/TC) . (Q/ΔQ)

= (ΔTC/ΔQ) . (Q/TC)

= ](ΔTC/ΔQ) / (TC/Q)[

E.Q = MC / AC SO, When:

(% ΔTC)/(% ΔQ) OR (MC/AC) < 1 then we got E.S

(% ΔTC)/(% ΔQ) OR (MC/AC) = 1 then we got the optimal size

(% ΔTC)/(% ΔQ) OR (MC/AC) > 1 then we got D.E.S

Industrial Economics - Baker Shtayeh - 2012-2013


Return to scale cobb douglas approach

Return to Scale (Cobb-Douglas Approach)

  • one of the most widely estimated production functions is the Cobb-Douglas:

    q = ALK

  • q = total production (the monetary value of all goods produced in a year)

  • L = labor input

  • K = capital input

  • A = total factor productivity

  • α and β are the output elasticities of labor and capital, respectively

  • Output elasticity measures the responsiveness of output to a change in levels of either labor or capital used in production, ceteris paribus. For example if α = 0.15  1% increase in labor would lead to approximately a 0.15% increase in output.

Industrial Economics - Baker Shtayeh - 2012-2013


Return to scale cobb douglas approach1

Return to Scale (Cobb-Douglas Approach)

q = ALK

Further, if:

  • α + β = 1

    Constant returns to scale. That is, 10% increase in (L & K) will cause in 10% increase in Q

  • α + β < 1 (e.g: a + b = 0.7)

    Decreasing returns to scale. That is, 10% increase in (L & K) will cause in 7% increase in Q

  • α + β > 1 (e.g: a + b = 3)

    Increasing returns to scale are. That is, 10% increase in (L & K) will cause in 30% increase in Q

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial economics an najah national univ lecturer baker shtayeh first semester 2013

Why are returns to scale important?

  • If an industry faces DECREASING returns to scale, small factories make sense

    -It is easier to have small firms in this industry

    • If an industry faces INCREASING returns to scale, large factories make sense

      -Large firms have an advantage; natural monopolies

Industrial Economics - Baker Shtayeh - 2012-2013


Solved problem

Solved problem

Given that the production function is Cobb-Douglas, what is the:

  • average product of labor

  • marginal product of labor

  • relationship between the MPL and the APL?

Industrial Economics - Baker Shtayeh - 2012-2013


Solved problem1

Solved problem

  • determine average product of labor by dividing output by labor:

  • differentiate the production function with respect to labor:

Answer:

3. take the ratio of the MPL and the APL:

Industrial Economics - Baker Shtayeh - 2012-2013


Solved problem2

Solved problem

Medical equipment firm faces the production function:

Q=K1/2L1/2

  • Given labour of 10 and capital of 20, is this firm producing efficiently by producing 12 units?

  • What level of production is technically efficient?

Industrial Economics - Baker Shtayeh - 2012-2013


Solved problem3

Solved problem

Answer:

Q=K1/2L1/2=201/2101/2=14.14

This firm is not operating efficiently by producing 12 units. Given labour of 10 and capital of 20, It should be producing 14.14 units in order to be technically efficient.

Industrial Economics - Baker Shtayeh - 2012-2013


Economic and return to scale for palestinian industries

Economic and Return to Scale for Palestinian Industries

Industrial Economics - Baker Shtayeh - 2012-2013


Economic and return to scale for palestinian industries1

Economic and Return to Scale for Palestinian Industries

  • استغلال المحاجر: 10% increase in production will raise (TC) by 4.5% (Saving in Cost), which is a motive to expand in production (eighth internal expansion or by integration) for more competitiveness power.

    Economies of Scale is an indicator for firms small size.

  • المنسوجات: Very close to the Optimum Size.

  • صنع منتجات المخابز: Has reached Diseconomies of Scale, which is an indicator that it doesn’t work efficiently. It tells us that these firms scale is grater than the Optimum Size. We recommend reducing firms size, by granting licenses for new firms.

  • Large firms in Palestine (in general) can make use of Economies of Scale more than smaller firms.

Industrial Economics - Baker Shtayeh - 2012-2013


The multi plant monopolist

The Multi-plant Monopolist

 A monopolist rarely produces all output in one plant

- how should production be allocated across plants?

- this is especially important if different plants have different costs

 To maximize profit set MR = MC on the last unit produced

 But with several plants what is MC?

Industrial Economics - Baker Shtayeh - 2012-2013


The multi plant monopolist con

The Multi-plant Monopolist (CON)

Suppose MC1 = aq1 and MC2 = bq2

$

$

Maximize profit

by setting marginal

revenue equal

to marginal cost

Allocate output

to the two plants

to equate

marginal costs

MC2 = bq2

MC1 = aq1

MC1 + MC2

MR

q2*

q1*

Quantity

Q*

Quantity

Industrial Economics - Baker Shtayeh - 2012-2013


The multi plant monopolist1

The Multi-plant Monopolist

MC1 = 2Q1 & MC2 = Q2 & MR = 6 – 1/3Q

MCt = The total output that can be produced at every level of Marginal Cost.

MCt = The horizontal summation for each individual MC curves

We need to rewrite the MC functions in quantity form:

P

MC1

MC2

MCt

Q1 = 0.5 MC1

Q2 = MC2

Qt = 3/2 MCt

SO:

MCt = 2/3 Qt

Setting MCt = MR:

Q* = 6 (MR=MC=4)

Q1 = 0.5 * 4 = 2

Q2 = 4

6

5

4

MR

3

2

1

Q

1

2

3

4

5

6

7

8

9

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial economics an najah national univ lecturer baker shtayeh first semester 2013

The Multi-plant Monopolist (CON)

Exercise

  • Market demand curve for monopolist given by

  • P = 120 – 3Q

  • The monopolist has 2 plants, the first plant has a marginal cost function given by

  • MC1 = 10 + 20Q1

  • The second plant’s marginal cost curve is given by

  • MC2 = 60 + 5Q2

  • Find the monopolist’s optimal total quantity and price.

  • Find the optimal division of the monopolist’s quantity between its two plants

Industrial Economics - Baker Shtayeh - 2012-2013


The multi plant monopolist con1

The Multi-plant Monopolist (CON)

Answer:

1. Derive MCT as the horizontal sum of MC1 and MC2. Inverting marginal cost (to get Q as a function of MC), we have:

Q1 = -1/2 + (1/20)MC1

Q2 = -12 + (1/5)MC2

Let MCT equal the common marginal cost level in the two plants. Then:

  • QT = Q1 + Q2 = -12.5 + .25MCT

    And, writing this as MCT as a function of QT:

  • MCT = 50 + 4QT

    Using the monopolist's profit maximization condition:

  • MR = MCT => 120 - 6QT = 50 + 4QT

  • QT* = 7

  • P* = 120 - 3(7) = 99

Industrial Economics - Baker Shtayeh - 2012-2013


The multi plant monopolist con2

The Multi-plant Monopolist (CON)

$

MC1

120

110

Answer (CON):

2.MCT* = 50 + 4(7) = 78

Therefore,

Q1* = -1/2 + (1/20)(78) = 3.4

Q2* = -12 + (1/5)(78) = 3.6

MC2

100

d

d

90

MCT

80

70

60

MR

50

40

30

20

10

Q

2

3

4

5

6

7

8

1

Industrial Economics - Baker Shtayeh - 2012-2013


The multi plant monopolist con3

The Multi-plant Monopolist (CON)

Exercise

A multi-plant monopolist faces demand

P = 460 - 6Q

The first plant (call it Plant 1) has total cost:

TC = 2.5Q^2

and the second plant (call it Plant 2) has total cost:

TC = 5Q^2

a)If the monopolist owned only plant 2, what is the optimal price this monopolist should charge, the total number of units the monopolist should supply, and the profit the monopolist would earn.

b) Suppose that monopolist owns both, plants 1 and 2. Determine the optimal price this monopolist should charge, the total number of units the monopolist will supply, and the number of units the monopolist should produce at each plant. Also calculate the profit of the multi-plant monopolist. TR – ((TC1) + (TC2))

Industrial Economics - Baker Shtayeh - 2012-2013


The multi plant monopolist con4

The Multi-plant Monopolist (CON)

Answer:

Industrial Economics - Baker Shtayeh - 2012-2013


Economic of multi plant activity firm size and plant size

Economic of Multi-plant ActivityFirm Size and Plant Size

  • Multi-plant Economies and Diseconomies of Scale

  • Multi-plant economies are cost advantages from operating several plants.

  • Multi-plant diseconomies are cost disadvantages from operating several plants.

Industrial Economics - Baker Shtayeh - 2012-2013


Solved problem4

Solved Problem

Consider a single firm facing the following functions:

d: P = 940 – 0.02Qd

TC = 250,000 + 40Q + 0.01Q^2

Find out:

  • The profit maximization with centralized production

  • The optimal production per plant

  • The optimal multi-plant activity

  • See the next provided diagram

Industrial Economics - Baker Shtayeh - 2012-2013


Answer

Answer:

  • Set MR = MC

    940 – 0.04Q = 40 + .02Q

    900 = 0.06Q  Q = 15,000 & P = 640

    Profit = TR – TC

    = (15,000 * 640) – ]250,000+(40*15,000)+(.01*15,000^2)[

    Profit = 6,500,000

    2. The optimal production per plant is when ATC is minimized  (AC = MC)

    (250,000/Q)+40+0.01Q = 40+0.02Q  Q = 5,000

    3. When Q = 5,000 THEN (MC) = 140

    The optimal multi plant is when MR = MC = 140

     940 – 0.04Q = 140  Q = 20,000 & P = 540

    SO: we suggest (20,000 / 5,000) = 4 plants for this firm

    Then profits = TR – (4TC per plant)

    = (20,000*540) – 4 ]250,000+(40*5,000)+(0.01*5,000^2)[

    Profit = 8,000,000 > 6,500,000

Industrial Economics - Baker Shtayeh - 2012-2013


Tc 250 000 40q 0 01q 2 p 940 0 02q

TC= 250,000 + 40Q + 0.01Q^2 P= 940 – 0.02Q

P

1100

1000

940

900

800

700

MC

640

600

ATC

540

500

400

d

300

200

100

5000

10000

15000

20000

25000

30000

Q

MR

Industrial Economics - Baker Shtayeh - 2012-2013


Tc 250 000 40q 0 01q 2 p 940 0 08q

TC = 250,000 + 40Q + 0.01Q^2P = 940 – 0.08Q

Exercise:

Consider a single firm facing the following functions:

  • The profit maximization with centralized production

  • The optimal production per plant

  • The optimal multi-plant activity

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial economics an najah national univ lecturer baker shtayeh first semester 2013

Exercise:

Consider a single firm facing the following functions:

TC=125Q – 7.6Q^2 + 0.18Q^3 P= 100 – 0.1Q

Find out:

  • The profit maximization with centralized production

  • The optimal production per plant

  • The optimal multi-plant activity

  • See the next provided diagram

Industrial Economics - Baker Shtayeh - 2012-2013


Tc 125q 7 6q 2 0 18q 3 p 100 0 1q

TC=125Q – 7.6Q^2 + 0.18Q^3 P= 100 – 0.1Q

P

MC

110

d

97.4

100

90

MR

94.84

80

70

ATC

60

50

44.8

40

30

20

18.1

10

30

5

10

15

20

25

Q

26

21.1

13.8

Industrial Economics - Baker Shtayeh - 2012-2013


Exercise

Exercise:

  • In the two previous exercises. Explain each firm economic position (Economic of Scale & Return to Scale) at centralized profit maximization production.

  • Read the numbers you reached economically

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial economics an najah national univ lecturer baker shtayeh first semester 2013

Exercise:

Consider a single firm facing the following functions:TC=125Q – 7.6Q^2 + 0.18Q^3 P= 100 – 2Q1. Explain this firm’s economic position (Economic of Scale & Return to Scale) at centralized profit maximization production.2. What’s the efficient production size? And what are the profits there?3. Use the Lerner Index to calculate market power4. See the next provided diagram

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial economics an najah national univ lecturer baker shtayeh first semester 2013

TC=125Q – 7.6Q^2 + 0.18Q^3 P= 100 – 2Q

P

MC

110

100

95

90

80

70

ATC

63.62

60

46.3

50

44.8

40

d

30

27.18

20

18.1

10

2.5

30

5

10

15

20

25

Q

MR

21.1

13.8

18.19

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial economics an najah national univ lecturer baker shtayeh first semester 2013

Exercise:

Consider a single firm facing the following functions:TC=125Q – 7.6Q^2 + 0.18Q^3 P= 100 – 3Q1. Explain this firm’s economic position (Economic of Scale & Return to Scale) at centralized profit maximization production.2. What’s the efficient production size? And what are the profits there?3. Use the Lerner Index to calculate market power4. See the next provided diagram

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial economics an najah national univ lecturer baker shtayeh first semester 2013

TC=125Q – 7.6Q^2 + 0.18Q^3 P= 100 – 3Q

P

MC

110

100

90

80

70

ATC

60

50

40

30

20

d

10

2.5

30

5

10

15

20

25

Q

MR

21.1

13.6

Industrial Economics - Baker Shtayeh - 2012-2013


Operating leverage operating profit elasticity

Operating Leverage(Operating Profit Elasticity)

  • A firm is said to be highly leveraged if (FC) are large relative to (VC).

  • IF (DOL) OR (Elasticity of Profit) = 1.25 it means a 1% increase in output results in a 1.25% increase in profit.

  • D.O.L = The Elasticity of Profit with respect to output.

  • Elasticity of profit = the percent change (Responsiveness) in profits results to percent change in production

Industrial Economics - Baker Shtayeh - 2012-2013


Key concepts

Key Concepts

  • The use of leverage implies high risk

  • Leverage is greater for smaller output (Q) and it decline as (Q) increase.

  • If both firms in the previous example are producing the same output, for any change in output, the percentage change in profit will be greater for (B) than for (A).

  • The management of (B) has structured the firm so that it takes more risk. When (Q) is high, Profits will be greater than (A)

  • BUT: When economic conditions become unfavorable and (Q) falls, profits will decline more rapidly for the higher leverage firm (B).

  • If output continues to fall, firm (B) will make loss before (A) will.

  • Thus, Elasticity of profit (DOL) can be used as an indicator of risk.

Industrial Economics - Baker Shtayeh - 2012-2013


Operating leverage elasticity of profit

Operating Leverage & Elasticity of Profit

TC= 20 + 1.5Q & TR= 2QProfit= -20 + 0.5QQBE = FC / (P-AVC) = 40

TC

TR

240

TR

TC

200

160

120

80

FC

40

20

40

60

80

100

120

Q

Industrial Economics - Baker Shtayeh - 2012-2013


Operating leverage elasticity of profit1

Operating Leverage & Elasticity of Profit

TC= 40 + 1.2Q & TR= 2QProfit= -40 + o.8QQBE = FC / (P-AVC) = 50

TC

TR

240

TR

200

TC

160

120

80

FC

40

20

40

60

80

100

120

Q

Industrial Economics - Baker Shtayeh - 2012-2013


Operating leverage elasticity of profit2

Operating Leverage & Elasticity of Profit

TC= 60 + Q & TR= 2QProfit= -60 + QQBE = FC / (P-AVC) = 60

TC

TR

240

TR

TC

200

160

120

80

FC

40

20

40

60

80

100

120

Q

Industrial Economics - Baker Shtayeh - 2012-2013


Operating leverage

Operating Leverage

  • Three firms in the same industry all sell their products at (20$) per unit. Their total fixed cost and average cost per unit are shown bellow:

    a. What is the breakeven output for each one?

    b. What is the profit elasticity for each firm at an output rate of (200) units?

    c.Which firm is the most leveraged? Which is the least? Comment.

Industrial Economics - Baker Shtayeh - 2012-2013


Measuring market structure

MeasuringMarketStructure

Measuring market structure and market power

• Can we measure whether an industry is close or

far away from Monopoly?

– What do we mean by “close” or “far away”?

• Name some industries out there...

• What do you notice?

– There is a huge range of “market structures”

– By market structure we mean how competitive

the industry is

• Is it close to perfect competition or close to monopoly?

Industrial Economics - Baker Shtayeh - 2012-2013


Measuring market structure1

MeasuringMarketStructure

In the real world of business we see the number of firms varies from industry to industry. In an attempt to find a numerical measure to indicate which industries are more like monopoly and which are more like competition, concentration ratios were devised.

Concentration ratios typically use sales as the concept used in the numerical measure.

Industrial Economics - Baker Shtayeh - 2012-2013


Measuring market structure2

MeasuringMarketStructure

Markets and policy makers...

• Policy makers care about market structures,

– why?

• Policy makers (specifically the DOJ and FTC)

must analyze mergers between two companies

– If they feel that the merger will make the

industry be too close to a monopoly, they will fight it

– To do this they need to come up with a

measure of market structure

• What are some choices?

Industrial Economics - Baker Shtayeh - 2012-2013


Measuring market structure3

MeasuringMarketStructure

Two most common

• Ideally, the policy makers would know how price

compares to marginal cost

– Measure market performance using the Lerner Index

LI = (P-MC)/P

• But, MC is rarely known, so we search for something else

– It would be nice if it was just a single number

– Economists typically use two methods:

• Concentration Ratio (CR4) and the Herfindahl-Hirschman index (HHI)

– Neither are perfect

Industrial Economics - Baker Shtayeh - 2012-2013


Measuring market structure4

MeasuringMarketStructure

The two measures

1) Concentration Ratio (CR4)

– It is the sales of the 4 largest firms added together

divided by total sales in the industry.

– So, it measures the percentage of the market

controlled by the 4 top firms.

• Guidelines:

- Perfect Competition Markets: With very low CR4 ratio.

- Monopolistic Competition Markets: CR4<40%

- Oligopoly Markets: CR4>40%

- Monopolistic Markets: CR4 = 100% OR: CR1>90%

~

Industrial Economics - Baker Shtayeh - 2012-2013


Measuring market structure5

MeasuringMarketStructure

Example:

- 10 firms, each with 10% of market => CR4 =40%,

- 4 firms, each with 10%, and 30 firms, each with 2% => CR4 = 40%.

  • Here we have two examples of industries where the CR4 is the same. But we see the remaining firms after the top 4 are very different in each example. So, another measure has been added and the measure considers all the firms in an industry. The measure is the (HHI)

Industrial Economics - Baker Shtayeh - 2012-2013


Measuring market structure6

MeasuringMarketStructure

2) Herfindahl-Hirschman index (HHI)

- To get the HHI we need the market share of each firm in percentage terms. Then we square the market share of each firm. After this, simply add the squared market share of each firm to get the final number.

– That is:

- The closer the HHI is to 10,000 the more the industry is like a monopoly. The closer to 0 the more the industry is like a competitive industry.

Industrial Economics - Baker Shtayeh - 2012-2013


Measuring market structure7

MeasuringMarketStructure

• A Major Use of HHI

- The department of Justice uses the HHI to

helpdecide whether they should fight a merger

• Guidelines:

– HHI (post merger) below 1000: market is

unconcentrated

– HHI between 1000 and 1800: moderately

concentrated

– HHI over 1800: concentrated

Industrial Economics - Baker Shtayeh - 2012-2013


Measuring market structure8

MeasuringMarketStructure

HHI versus CR4:

  • HHI counts all firms in the industry.

  • (CR4) based on the sum of market share and only use information for the top four or eight firms.

    The squaring of the market shares does a couple of things for the (HHI) index.

  • First, it gives relatively more importance to firms with greater market shares.

  • Second, even though the HHI index includes every firm in the market, in practice the smallest firms have a minimal impact on the calculation and can be largely ignored. For example, firms with less than 1 percent market share add less than 1 point to the Herfindahl index.

    3. HHI is used for (DOJ) merger guidelines, which calls for evaluating mergers, which are likely to harm consumers.

Industrial Economics - Baker Shtayeh - 2012-2013


Measuring market structure9

MeasuringMarketStructure

Industrial Economics - Baker Shtayeh - 2012-2013


Measuring market structure10

MeasuringMarketStructure

Industrial Economics - Baker Shtayeh - 2012-2013


Measuring market structure11

MeasuringMarketStructure

Industrial Economics - Baker Shtayeh - 2012-2013


Measuring market structure12

MeasuringMarketStructure

  • Why some markets are more concentrated?

    1. Economies of Scale: If a firm can decline its (AC) by (30%) due to increasing its production by (10%), then it will increase its scale, which will increase the industry concentration.

    2. Some cases of competition: The cases where the producer can satisfy the tastes of consumers more than other competitors. The demand for that firm’s products will increase, and so its size will.

    3. Merger (Integration): Integration reduces the competition power.

Industrial Economics - Baker Shtayeh - 2012-2013


Oligopoly markets

Oligopoly Markets

  • Oligopoly:a small group of firms in a market with substantial barriers to entry.

    Features

  • few firms

  • either homogeneous or differentiated products

  • interdependence of firms - policies of one firm affect the other firms

  • substantial barriers to entry

    Oligopoly firms may collude (act as a monopoly) and earn positive profits. OR: May compete with each other and drive prices down to where profits are zero.

    examples: auto industry and cigarette industry

Industrial Economics - Baker Shtayeh - 2012-2013


Oligopoly markets1

Oligopoly Markets

1.Kinked Down demand curve model of oligopoly

Assumptions:

1. If a firm raises prices, other firms won’t follow and the firm loses a lot of business.

So demand is very responsive or elastic to price increases.

2. If a firm lowers prices, other firms follow and the firm doesn’t gain much business.

So demand is fairly unresponsive or inelastic to price decreases.

  • Implication is that demand curve will be kinked, MR will have a discontinuity, and oligopolists will not change price when marginal cost changes

Industrial Economics - Baker Shtayeh - 2012-2013


Oligopoly markets2

Oligopoly Markets

P

Changes in cost do not impact output and prices as long as MC remains in the vertical portion of MR

Profit Possibilities for the Oligopolistshort run: positive profits, losses, or breaking even.long run: positive profits, or breaking even.

1. Kinked Down demand curve model of oligopoly

MC

P*

d

Q

MR

Industrial Economics - Baker Shtayeh - 2012-2013


Oligopoly markets3

Oligopoly Markets

2. Cartels:

  • A situation in which there is a formal agreement between firms.

  • Leading firms band together to restrict output and thereby increase price and profits.

  • If successful, the firms begin to resemble a monopoly.

  • Cartels are illegal under U.S. anti-trust laws.

  • Internationally, the best known cartel is the “Organization of Petroleum Exporting Countries” or “OPEC”.

Industrial Economics - Baker Shtayeh - 2012-2013


Oligopoly markets4

Oligopoly Markets

2. Cartels:

  • OPEC is naturally a successful cartel. Output quotas of its members produced staggering price increases (from $1.10 to $11.50 per barrel in the early 1970's, and up to $34.00 in the late 1970's: an increase of 3400% in ten years).

  • Recent OPEC difficulties are also characteristic of cartels: new producers, difficulty to enforce quotas and maintaining prices.

Industrial Economics - Baker Shtayeh - 2012-2013


Oligopoly markets5

Oligopoly Markets

2. Cartels:

MC2

TMC

MC1

ATC2

ATC1

P*

MD

MR

Q*

Q1

Q2

Firms (1+2) horizontal summation

Firm (1)

Firm (2)

Q*= Q1 + Q2

TMC= MC1 + MC2

MD = Market Demand

Industrial Economics - Baker Shtayeh - 2012-2013


Oligopoly markets6

Oligopoly Markets

2. Cartels:

Why Cartels Fail?

  • Cartels fail if noncartel members can supply consumers with large quantities of goods.

  • Each member of a cartel has an incentive to cheat on the cartel agreement.

Industrial Economics - Baker Shtayeh - 2012-2013


Oligopoly markets7

Oligopoly Markets

3. Collusion:

  • Overt Collusion – Markets are divided into territories; each territory has a specific firm assigned as the lead competitor in that territory – Illegal under U.S. Anti-Trust Laws

  • Covert Collusion – firms meet secretly and fix prices.

    – Illegal under U.S. Anti-Trust Laws

Industrial Economics - Baker Shtayeh - 2012-2013


Oligopoly markets8

Oligopoly Markets

4. Price Leadership: (Dominant Firm Model)

• One dominant firm that sets the price for the market (similar to a monopoly).

• At that price the market demands more than the dominant firm supplies.

• Remaining (Fringe) firms sell an extra quantity of units that satisfies the residual demand at the market price.

• Thus, the non-dominant firms accept the price determined by the dominant firm, and behave somewhat like firms within a purely competitive market.

Industrial Economics - Baker Shtayeh - 2012-2013


4 price leadership dominant firm model

4. Price Leadership: (Dominant Firm Model)

  • Why some firms are dominant?

    1)It may have lower costs than fringe firms, which could be as a result of:

  • It may be more efficient. (Such as management and technology)

  • An early entrant to an industry, so, having learned by experience how to produce more efficiently. “Learning by doing”

  • An early entrant may have had time to grow so as to benefit from economic of scale.

  • It can produce with lower Sunk Cost. “Such as lower rental cost of capital with higher profit per unit”

Industrial Economics - Baker Shtayeh - 2012-2013


4 price leadership dominant firm model1

4. Price Leadership: (Dominant Firm Model)

  • What is Sunk Cost?

  • A firm’s investment in capital assets is said to be SUNK if its assets would have to be sold at a substantial loss, compared with the purchased price. “If it decided to leave the market”

  • Sunk Cost can be either:

    a. tangible (Capital assets when assets are specific to a single industry)

    b. Intangible (Advertising, R&D, Evaluating information, …etc)

    - The dominant firm can usually produce with lower S.K compared with entrants, that it can get lower rental cost of capital services with higher profit per unit

Industrial Economics - Baker Shtayeh - 2012-2013


4 price leadership dominant firm model2

4. Price Leadership: (Dominant Firm Model)

  • Why some firms are dominant?

    2) A dominant firm may have a superior product in a market where each firm produces a differentiated product, which may be due to a reputation achieved through advertising or goodwill generated by its having to be in the market longer.

    3) Cartel or collusive firms may act collectively as a dominant firm.

Industrial Economics - Baker Shtayeh - 2012-2013


The dominant strategies

The dominant Strategies

  • Accommodate Allowed Entry Strategy:

    - When the dominant allow the entrants to gain profit by charging high price.

    - It usually occur when there is a small market with low sunk cost facing entrants.

P

Pe

ACe

πe

MCe

MD

De

Qdominant

Qe

Q

MRe

Industrial Economics - Baker Shtayeh - 2012-2013


The dominant strategies1

The dominant Strategies

2) Blockaded Entry Strategy (Limit Price):

  • When the dominant decide to appropriate the market by declining price to increase its portion demanded.

  • It usually occur when there is a small market with high sunk cost facing entrants.

Industrial Economics - Baker Shtayeh - 2012-2013


The dominant strategies2

The dominant Strategies

2) Blockaded Entry Strategy (Limit Price):

Then the entrant’s residual demand is

R1 = D(P) - Q1

These are the cost curves

for the potential entrant

$/unit

The entrant’s residual

demand is

Rd = D(P) - Qd

R1

The entrant equates

marginal revenue

with marginal cost

MCe

ACe

Assume instead that the incumbent commits to output Qd

Assume that the

incumbent commits

to output Q1

Pe

D(P) = Market Demand

Rd

MRd

Quantity

qe

Q1

Qd

Industrial Economics - Baker Shtayeh - 2012-2013


The dominant strategies3

The dominant Strategies

2) Blockaded Entry Strategy (Limit Price):

$/unit

With the residual demand R1, the entrant can operate profitably.Entry is not deterred by the

incumbent choosing Q1.

R1

MCe

ACe

Pe

D(P) = Market Demand

Rd

MRd

Quantity

qe

Q1

Qd

Industrial Economics - Baker Shtayeh - 2012-2013


The dominant strategies4

The dominant Strategies

2) Blockaded Entry Strategy (Limit Price):

By committing to output

Qd the incumbent deters

entry. Market price Pd

is the limit price

$/unit

At price Pe entry is

unprofitable

R1

MCe

Pd

ACe

Pe

D(P) = Market Demand

Rd

MRd

Quantity

qe

Qd

Q1

Qd

Industrial Economics - Baker Shtayeh - 2012-2013


The dominant strategies5

The dominant Strategies

3. Dominant firm as a monopolist:

When the dominant can make use of low (A.C) relative to the entrant’s (A.C). The dominant is alone in the market.

  • It usually occur when there is a small market with very high sunk cost that make no use for entrants to enter the market

P

P

monopolist

ACe

MC (dominant)

MD

Qdominant

Q

Q monopolist

MR

Industrial Economics - Baker Shtayeh - 2012-2013


The dominant strategies6

The dominant Strategies

4. Predatory Pricing Strategy:

 Predatory pricing is said to occur when a firm with some significant monopoly power reduces its price below the short-run profit maximizing (or loss minimizing) level in order to drive its competitors from the market so that following their exit, price can be raised above the level that could otherwise be sustained.

 This strategy represents an investment in current losses that is expected to pay dividends in future monopoly profits.

 It is, then, a strategy specifically designed to monopolize a market.

(Illustrate this strategy graphically)

Industrial Economics - Baker Shtayeh - 2012-2013


The dominant strategies7

The dominant Strategies

5) Direct cost Strategy:

- Firms may work to raise cost industry wide cost levels in an effort to make fringe operation uneconomical. For example, a dominant firm may agree to union demands for increased wage levels, or bid up the price of common inputs to the production process. The idea is that increased costs can be recovered through increased pricing power.

- Such a strategy may be more attractive than predatory pricing strategies for several reasons:

a. Competition with high cost firms is preferred to that with low cost rivals.

b. It may be relatively cheap to raise competitors’ costs when compared with the large losses incurred thorough predatory pricing.

Industrial Economics - Baker Shtayeh - 2012-2013


The dominant strategies8

The dominant Strategies

6) Capacity Expansion: As an entry barrier, the decision to build large amounts of capacity so that incumbents can respond aggressively to entry by dramatically increasing output and lowering price.

M.C

LRAC

P*

PL

D

MR

O*

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial economics an najah national univ lecturer baker shtayeh first semester 2013

Pricing in Industrial Firms

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial economics an najah national univ lecturer baker shtayeh first semester 2013

Pricing in Industrial Firms

1) Mark-up Pricing: P= (a * ATC) + ATC

If (a = 35%) then P = (0.35 * 25.78) + 25.78 = 34.8

2) Direct cost Pricing:

Shut-down Price = TVC/Q = 667500/30000 = 22.25

Break-even Price = TC/Q = 773500/30000 = 25.78

If market price = 28, and the interest rate = 10% then:

S.R.R = (Market Price – Break-even Price) / Break-even Price

= (28 – 25.78) / 25.78

S.R.R = 8.6% < 10%

3) Target Rate of Return Pricing:

If T.R.R = 25% then:

T.R.R * I = a * TC

0.25 * 1000000 = a * 773500

a = 32%

P = (0.32 * 25.78) + 25.78

P = 34

Industrial Economics - Baker Shtayeh - 2012-2013


Barriers to entry

Barriers to Entry

  • Bain (1956) defined an entry barrier as “an advantage of established sellers in an industry over potential entrant sellers, which is reflected in the extent to which established sellers can persistently raise their prices above competitive levels without attracting new firms to enter the industry”

  • Stigler (1968) defined entry barriers as costs that must be borne by a firm that seeks to enter an industry but is not borne by firms already in the industry.

Industrial Economics - Baker Shtayeh - 2012-2013


Barriers to entry1

Barriers to Entry

Bain’s factors that could prevent entry

  • Economies of scale: as an entrant must either enter at a suboptimal scale with a cost disadvantage, or at an efficient scale with a depressing effect on prices.

  • Product differentiation: by allowing incumbents to charge higher prices than entrants and thus to sell profitably when potential entrants could not.

  • Absolute cost advantages: by allowing incumbents to sell profitably at prices below the costs of potential entrants.

Industrial Economics - Baker Shtayeh - 2012-2013


Barriers to entry2

Barriers to Entry

Stigler’s list is much shorter

  • Economies of scale are not barriers to entry. If an entrant incurs a higher cost because it must produce at a lower level of output, the cost disadvantage is a consequence of overall demand being small relative to minimum efficiency scale.

  • Product differentiation is normally not a barrier to entry. Only if the costs of differentiation (design, advertising, etc.) are higher for a new firm than an existing firm.

  • Cost advantages arising from scarce factors of production, such as patents and natural resources are not entry barriers.

  • Scarce factors generate "economic rents," i.e., returns in excess of those necessary to attract them away from other uses. These rents should be properly understood as opportunity costs.

Industrial Economics - Baker Shtayeh - 2012-2013


Barriers to entry3

Barriers to Entry

Industrial Economics - Baker Shtayeh - 2012-2013


Structural barriers to entry

Structural Barriers to Entry

Structural barriers to entry in common:

1) Governmental Barriers:

a. Custom Tax on imports. (Tariff)

b. Quality Control barriers.

c. Anti-Pollution System.

Industrial Economics - Baker Shtayeh - 2012-2013


Structural barriers to entry1

Structural Barriers to Entry

Learn More: Custom Tax on imports. (Tariff)

  • When there is free international trade,

    P(import) less than P(domestic). The

    consumer wants to get (Qm) and the

    domestic producer willing to (Qd) at

    that price. So, the consumer will cover

    supply shortage by importing.

  • If the government decided to protect the local producer, it would impose a custom tax by (P domestic – P import), that could blockade imports.

P

S

P domestic

P imports

d

Q import

Q

Qd

Qm

Industrial Economics - Baker Shtayeh - 2012-2013


Structural barriers to entry2

Structural Barriers to Entry

2) Absolute Costs:

  • Performance firms usually have less absolute production cost compared with entrants because:

  • Performance firms have more skilled administrators and more experience productivity.

  • Performance firms have accumulated technical knowledge.

  • Performance firms charged with less Sunk Cost compared with entrants.

  • See the next slide diagram to understand (absolute cost) as a barrier to entry.

Industrial Economics - Baker Shtayeh - 2012-2013


Structural barriers to entry3

Structural Barriers to Entry

2. Absolute Cost (CON)

P*

AC entrant

PL

Profit

AC performance

M.C

D

MR

O*

Industrial Economics - Baker Shtayeh - 2012-2013


Structural barriers to entry4

Structural Barriers to Entry

3. Economies of scale.

  • Economies of scale occur when the unit cost of a product declines as production volume increases. When existing competitors in an industry have achieved economies of scale, it acts as a barrier by forcing new entrants to either compete on a large scale or accept a cost disadvantage in order to compete on a small scale.

Industrial Economics - Baker Shtayeh - 2012-2013


Structural barriers to entry5

Structural Barriers to Entry

3. Economies of scale. (CON)

Minimum Efficient Scale (MES) — The smallest level of output for which long-run average cost is at its minimum.

A natural monopoly exists because economies of scale are large and the firm can achieve minimum efficient scale.

Industrial Economics - Baker Shtayeh - 2012-2013


R d and innovation theoretical approach

R&D and Innovation: Theoretical Approach

  • Introduces new concept of efficiency:

    • Static efficiency—traditional allocation of resources to produce existing goods and services so as to maximize surplus and minimize deadweight loss

    • Dynamic efficiency—creation of new goods and services to raise potential surplus over time

  • Schumpeterian hypotheses (conflict between static and dynamic efficiency):

    • Concentrated industries do more research and development of new goods and services, i.e., are more dynamically efficient, than competitively structured industries

    • Large firms do more research & development than small firms

Industrial Economics - Baker Shtayeh - 2012-2013


R d and innovation theoretical approach1

R&D and Innovation: Theoretical Approach

  • A Taxonomy of Innovations:

    Product versus Process Innovations

  • Product Innovations refer to the creation of new goods and new services, e.g., DVD’s, and cell phones

  • Process Innovations refer to the development of new technologies for producing goods or new ways of delivering services.

  • We mainly focus on process or cost-savings innovations.

Industrial Economics - Baker Shtayeh - 2012-2013


R d and innovation theoretical approach2

R&D and Innovation: Theoretical Approach

  • A Taxonomy of Innovations:

    Drastic versus Non-Drastic Innovations

  • Process innovations have two further categories

  • Drastic innovations have such great cost savings that they permit the innovator to price as an unconstrained monopolist

  • Non-drastic innovations give the innovator a cost advantage but not unconstrained monopoly power

Industrial Economics - Baker Shtayeh - 2012-2013


R d and innovation theoretical approach3

R&D and Innovation: Theoretical Approach

  • Drastic versus Non-Drastic Innovations

  • Suppose that demand is given by: P = 120 – Q and all firms have constant marginal cost of MC = $80

  • Let one firm have innovation that lowers cost to MC = $20

  • This is a Drastic innovation. Why?

    - Marginal Revenue curve for monopolist is: MR = 120 – 2Q

    - If MC = $20, optimal monopoly output is:

    Qm = 50 and Pm = $70

    - Innovator can charge optimal monopoly price ($70) and still undercut rivals whose unit cost is $80

Industrial Economics - Baker Shtayeh - 2012-2013


R d and innovation theoretical approach4

R&D and Innovation: Theoretical Approach

  • Drastic versus Non-Drastic Innovations

  • Now consider the case if cost fell only to $60, innovation is Non-drastic

    • Marginal Revenue curve again is: MR = 120 - 2Q

    • Optimal Monopoly output and price: QM = 30; PM = $90

    • However, innovator cannot charge $90 because rivals have unit cost of $80 and could under price it

    • Innovator cannot act as an unconstrained monopolist

    • Best innovator can do is to set price of $80 (or just under) and supply all 40 units demanded.

Industrial Economics - Baker Shtayeh - 2012-2013


R d and innovation theoretical approach5

R&D and Innovation: Theoretical Approach

Innovation is drastic if monopoly output Qm at MR = new Mc, exceeds the competitive output Qc at old Mc

  • Drastic versus Non-Drastic Innovations

$/unit = p

$/unit = p

Non-Drastic Innovation: QM < QC

Drastic Innovation: QM > QC

90

80

Original MC

80

70

60

Mc

Demand

Demand

Mc

20

MR

MR

30

40

40

50

Quantity

Quantity

Industrial Economics - Baker Shtayeh - 2012-2013


Integration

Integration

1. Vertical Integration:

  • Vertical integration is the degree to which a firm owns its upstream suppliers and its downstream buyers

  • Vertical integration is the process in which several steps in the production and/or distribution of a product or service are controlled by a single company in order to increase that company’s power in the marketplace.

  • There are two varieties:

    a. backward (upstream) vertical integration

    b. forward (downstream) vertical integration

Industrial Economics - Baker Shtayeh - 2012-2013


Integration1

Integration

1. Vertical Integration:

a. backward (upstream) vertical integration:

  • Company sets up subsidiaries that produce some of the inputs used in the production of its products.

  • For example, an automobile company may own a tire company, a glass company, and a metal company.

  • Control of these three subsidiaries is intended to create a stable supply of inputs and ensure a consistent quality in their final product.

  • It was the main business approach of Ford and other car companies in the 1920s

Industrial Economics - Baker Shtayeh - 2012-2013


Integration2

Integration

1. Vertical Integration:

b. forward (downstream) vertical integration

  • The company sets up subsidiaries that distribute or market products to customers or use the products themselves.

  • An example of this is a movie studio that also owns a chain of theaters.

  • In balanced vertical integration, the company sets up subsidiaries that both supply them with inputs and distribute their outputs.

Industrial Economics - Baker Shtayeh - 2012-2013


Integration3

Integration

  • Vertical Integration:

  • If you view McDonald's, for example, as primarily a food manufacturer:

    - Backwards vertical integration would mean that they would own the farms where they raise the cows, chickens, potatoes and wheat as well as the factories that processes everything and turns it all into food.

    - Forwards vertical integration would imply that they own the distribution centers for every area and the fast food retailers.

    - Balanced vertical integration would mean that they own all of the mentioned components.

Industrial Economics - Baker Shtayeh - 2012-2013


Integration4

Integration

1. Vertical Integration:

There are internal and external gains and losses due to vertical integration

  • Internal gains:

  • More efficient use of production capacity

  • Price discrimination

  • Save in taxes

  • Facilitate the process of obtaining the necessary information to the productive process in all its stages.

  • Reduce negotiation barriers

  • Internal losses:

  • Higher monetary and organizational costs of switching to other suppliers/buyers

  • Benefits to society:

  • Better opportunities for investment growth through reduced uncertainty

  • Losses to society:

  • Monopolization of markets

  • Rigid organizational structure, having much the same shortcomings as the socialist economy

Industrial Economics - Baker Shtayeh - 2012-2013


Integration5

Integration

2. Horizontal Integration

  • When a company expands its business into different products that are similar to current lines.

  • Horizontal integration occurs when a firm is merged with another firm which is in the same industry and in the same stage of production as the merged firm.

  • In this case both companies are in the same stage of production and also in the same industry.

  • A term that is closely related with horizontal integration is horizontal expansion. This is the expansion of a firm within an industry in which it is already active for the purpose of increasing its share of the market for a particular product or service.

Industrial Economics - Baker Shtayeh - 2012-2013


Integration6

Integration

2. Horizontal Integration

  • Advantages of Horizontal integration

  • Economies of scales by selling more of the same product, for example by geographic expansion

  • Economies of scope by sharing resources common to different product. Synergies created

  • Increase market power

  • Reduction in the cost of international trade by operating factories in foreign markets

  • Reduction in competition

  • Fulfilling customer expectations

  • Increase negotiation power with more leverage power over consumer and suppliers

Industrial Economics - Baker Shtayeh - 2012-2013


Integration7

Integration

2. Horizontal Integration

  • Disadvantage of Horizontal integration

  • Synergies maybe more imaginary than real

  • Substitutes market is often very different. Challenge occurs to management during acquisition.

  • Reduction in competition may lead to anti-trust issues

Industrial Economics - Baker Shtayeh - 2012-2013


Mergers

Mergers

  • Three Types of Mergers

  • Horizontal Merger

    The combination under one ownership of the assets of two or more firms engaged in the production of similar products.Example: two steel manufacturing companies merging

  • Vertical Merger

    The creation of a single firm from two firms, one of which was a supplier of the other.

    Example: a lumber company and a builder merging

  • Conglomerate Merger

    the combining under one ownership of two or more firms that produce unrelated products

    example: a tire manufacturer and a coffee company merging

Industrial Economics - Baker Shtayeh - 2012-2013


Dominant firm high level market power

Dominant firm (High Level Market Power)

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial economics an najah national univ lecturer baker shtayeh first semester 2013

Q3. (10 Marks)

a. Complete the table below.

b. Compare the two markets reading each (CR4) and (HHI) economically

c. In general, Which is more accurate, (HHI) or (CR4)? Why?

Industrial Economics - Baker Shtayeh - 2012-2013


Industrial economics an najah national univ lecturer baker shtayeh first semester 2013

Q4. (6 Marks) A company wants to produce 100,000 units annually. With Project 1, the company's variable costs are $(2,000,000), and its fixed costs total $2.4 million. With Project 2, the company's variable costs are $(3,000,000), and its fixed costs total $2 million. The company has the ability to sell each unit at $50

a. Compute the DOL for Project 1 and Project 2

b. What's the quantity breakeven for each one?

c. Which project is better here? Why?

Industrial Economics - Baker Shtayeh - 2012-2013


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