Firms , consumers and the market

1. Firms, consumersandthe market

2. Thefirm • We start ourdescription of thefirmbydefiningthevarioustypes of coststhatenter a firm’sprofitfunction. • Thenwediscussthehypothesisthatfirmsmaximizeprofits.

3. Opportunitycosts • A basiclessonfrommicroeconomics is thatwhat a firmreports as costsareoften not economiccosts. • Opportunitycost is one of themostimportantaspects of economics.

4. Costfunctions, economiesanddiseconomies of scale • In market analysiscostfunctionsare of quiteimportance. However, it is usefultorecallthatcostfunctionsarederivedfrom a costminimization problem. • C(q), representsthe minimal cost of thefirmgiventheinputpricesandtheproductiontechnology.

5. So far wehaveassumedthat a firms’ costfunctionis independent of thedecisions of otherfirms in the market. • However apart fromtheperfectcompetitionsetting, otherfirms’ actionsarequiteimportant. • Theoutputdecision of otherfirms in thesameindustry/market affectprices. • Theoutputdecision of firms in otherindustriesmighteven be relative. How?

6. Economiesanddiseconomies of scale • How do we define them? • Scaleeconomiesareimportant in theformation of an industry. • Intheshorttermfixedcostsareirrelevantandonlymarginalcostsarerelevantforfirmdecisionmaking. • Marginalcosts can be increasing, constant, decrasingor u-shaped. • Weusuallyassumeconstantmarginalcosts. Why?

7. Assumingconstantmarginalcostswiththe presence of fixedcostsimpliesthatfirmsaresubjettoeconomies of scale. • Ifwearetalking of a multiproductfirm, thenwe can talk abouteconomies of scope.

8. Fixedcosts • Fixedcosts: operation-independentcosts. • Fixedcostsdepend on earlierdecisions of a firm, such as capacity, geographiccoverageandoutputrange. • Fixedcostsaffectprofit but not pricingdecisions. (Why?)

9. Sunkcosts • Thesearealsoinitialcostsanddepend on earlierdecisionsso not theoutput. • Thedifference is thatsunkcosts can NEVER be fullyrecovered. • Can youthink of anyexamples?

10. Theprofitmaximizationhypothesis • A singleproductfirm is assumedtomakeprofitsΠ(q) whichdepend on theoutputq (forthe time beingweareassumingthatthefirm is sellingall of theoutput). • As youallknowtheprofitfunction: • π(q) = qP(q) − C(q) • Accordingtothisformulaprofitonlydepends on outputandcosts. • So far weignoreothervariablesthat can affectprofits (such as?).

11. Theprinciple-agenttheorem • Weassumethatfirmsareprofitmaximizers. • Since wearemostlyconcernedwithfirmswith market power, weareconfidentthatprofitmaximization is often a goodbehavioualassumption. • Howeverfirms can have an objectivefunctionthat not onlycontainsprofits but alsootherobjectives. • Howeverthequestionremains: Is profitmaximization a reasonableobjective?

12. We mostly consider firms as single decision making units that maximize profits; • This also holds for the industrial organization literature at large. While this is a helpful abstraction, it may be inappropriate. • One reason is that in firms which are not owner-run, top management may have different objectives than the owners of a firm. • Top management may have non-monetary incentives such as empire building. (can youthink of anything else?)

13. PerfectCompetition • Pricetakingfirms. • Largenumber of buyersandsellers in the market. • Freeentryandexit. • Perfectinformation.

14. As a firm takes the market price as given, it perceives that it can sell any quantity at thatprice. • Therefore, a perfectly competitive firm faces a horizontal demand curve and themarginal revenue generated by each additional unit of output produced and sold is just equalto the current market price. • Like any firm, the perfectly competitive firm chooses output soas to maximize its profit.

15. A perfectly competitive firm produces at marginal cost equal to the market price. • MC=MR=P

16. Monopoly • Suppose, as a first approximation, that a firm can treat the market environment as given whentakingitsdecision. • This market environment is then described by a downward sloping inversedemand function P(q) that depends negatively on the quantity the firm offers on the market. • Suppose that the firm faces an increasing cost function C(q). Marginal costs C(q) may beconstantorupwardsloping.

17. Themonopoly problem • Maxπ(q) = qP(q) − C(q). • The first-order condition of profit maximization is qP’(q) + P(q) − C’(q) = 0. • We can rewritethefirstordercondition as: • P(q) − C’(q) = −qP’(q). • Note that −qP(q)/P(q) is the inverse priceelasticity of demand 1/η (expressed as an absolute value).

18. TheLernerIndex

19. A profit-maximizing monopolist increases its markup as demand becomes less priceelastic. • In particular, as demand becomes infinitely inelastic the markup turns to infinity. • Consider the polar opposite case that demand becomes infinitely elastic, i.e. η→∞. Thenthe price tends to marginal costs, which implies that the markup (and profit) tends to zero. • A monopolisticfirmproduces at: MR=MC

20. Dominant firm model • An important feature of the monopoly model is that the monopoly pricing formula states thatthe markup only depends on demand side characteristics. • We extend this monopoly modelby introducing a perfectly competitive segment. This perfectly competitive fringe limits themarket power of the single firm with price-setting power.

21. Dominant firm • Monopolies are easy to work with in theory, but harder to find in practice. Much more common are“near monopolies”—firms that have a market share of less than 100%, but are still large enough thatthey dominate the industry in terms of price setting. • In other words a dominant firm still possessesconsiderable market power. • Anyexamples?

22. Two factors contribute to the rise of a dominant firm: • 1. The dominant firm is more efficient than its rivals and as a result enjoys a significant costadvantage. • 2. The dominant firm has a superior product.

23. CompetitiveFringe • The small producers are usually assumed to have no market power—they act as price takers,supplying output competitively in response to whatever market price the dominant firm chooses toset. • These small producers are collectively called a competitive fringe and their total supply at anygiven price will correspond to their horizontally summed marginal cost curves—to the amount thatthey would supply at any price in a perfectly competitive market.

24. The effect of the competitive fringeis to dampen, but not eliminate, the dominant firm’s control over price. • Inessence, thereadinessof the fringe to supply makes the dominant firm’s perceived demand more elastic, and hence like amonopolist who faces a more elastic demand curve, her profit-maximizing price is lower.

25. Let the supply function of the competitive fringe be given by Q f = Q f (p) where p is the pricecharged by the dominant firm. • Suppose that the market demand function is QM = QM(p). Then theresidual demand of the dominant supplier is the difference between market demand and the supply of thefringe: • QD(p) = QM(p) − Q f (p)

26. The residual demand for the dominant firm shows its sales for any price it charges. It is an exampleof a firm’s demand function: the difference between market demand and the dominant firm’s demandis the supply response of the competitive fringe.

27. The profits of the dominant firm are • π D = pQD(p) − C(QD(p)). • Tomaximizeitsprofit:

28. Reorginizingyields:

29. The market power of the dominant firm is determined by three factors: • 1. The elasticity of market demand. • 2. The elasticity of supply of the fringe. • 3. The more efficient the dominant firm vis-a-vis the fringe—the lower its marginal costs—thegreaterits market power.

30. Market Power • As mentionedbefore, market power can be assesedusingtheLernerindex. • The Lerner index is a snapshot of the intensity of competition. However, costs (and,in particular, marginal costs) are often not directly observable.

31. Another way to try and capture the market power of firms is to look at concentrationindices,which are statistics of the degree of concentration of the market. One such measure addsup the market shares of one or a certain number of firms; this is the m-firm concentration ratio:

32. While the m-firm concentration ratio adds market shares of a small number of firmsin the market, the so-called Herfindahl index (also known as Herfindahl–Hirschman index)considers the full distribution of market shares. It is defined as the sum of squared marketshares for all n firms active on the market:

33. Arguably, the Herfindahl index provides a better measure of concentration as it captures boththe number of firms and the dispersion of the market shares. One expects higher concentrationif the number of firms decreases or if market shares become less dispersed.

34. At one extreme, H = 1 if one firm serves the whole market. At the other extreme, H = 1/nif there are n firms with identical market shares. • Then, in a perfectly competitive market withmany small firms (i.e., n→∞), the index has a value close to 0.

35. Assignment • Do not forgettheassignmentsthatweregiventhroughoutthelecture. • Assignmentsshould be submittedbeforethenextlecture. • Latesubmissionswill not be tolerated.

36. NextWeek • An introductiontogametheory