Business Economics Notes

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BUSINESS FOR PROFESSIONAL ENGINEERS AND SCIENTISTS

UNDERGRADUATE STUDIES

The purpose of our Business for Professional Engineers and Scientists (BPES) Programme is to provide engineering and science students with the opportunity to learn about business and management. Many of the modules we offer are provided for the engineering departments and have been jointly developed to enhance specific programmes of study. Additionally we offer a number of options or electives which are open to students from all the engineering and science disciplines. As Programme Director for Undergraduate Studies, I welcome you to our modules. I believe what we offer will stimulate your interest and enhance your capacity to succeed in our ever more competitive world.

Jeremy Fernando Director of Undergraduate Studies [email protected]

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Rose Brown Undergraduate Programme Coordinator [email protected]

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IMPORTANT NOTICES REGARDING ALL BPES MODULES

KEY DATES

Autumn term: Monday 6th October 2014 Friday 19th December 2014 NB: All BPES modules begin in Week 2, Monday 13th October 2014 **Autumn Exams: 12th January 2015 16th January 2015 NB: Your exam timetable will be made available as soon as it is finalised. **Subject to change. Exams may also be later in January depending on home departments exam timetable. Spring term: Monday 12th January 2015 27th March 2015 NB: All BPES modules will begin in Week 16, Monday 19th January 2015. **Spring Exams: Monday 27 th April 2015 Friday 1 st May 2015 **Subject to change. Exams may also be later in May depending on home departments exam timetable. COMMUNICATION Please ensure you check your college e-mail regularly as this is how any important notices or last minute details will be communicated to you. All important notices will also be put up on the module area on Blackboard. BLACKBOARD Blackboard is Imperials Virtual Learning Environment (VLE) and is used to deliver online modules as well as being an important space for students to access any module materials. Website: http://learn.imperial.ac.uk Login: with your regular college user ID and password If you cant see the BPES module for which you are registered, please contact [email protected] with your user ID, full name and the module you are registered for. We can then give you access to the module immediately. All module materials will be available on Blackboard. This will include lecture slides, readings and anything else your lecturer believes is important for your module.

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Submitting assignments via Blackboard

Please note:

1. All assignments at Imperial College Business School must be submitted via Blackboard. Submissions by hand or by e-mail will not be accepted.

2. Electronic submission for an assignment will close at the cut-off deadline.

3. If you are late in submitting an assignment, you need to contact your administrator. Note the College procedure that in cases where an assignment is submitted late, a reduction of 5% per day (per week for part-time programmes), will apply.

4. Note that it is your responsibility to ensure that an assignment has been submitted.

5. Assignment submissions must be accompanied by a completed plagiarism form.

6. If you experience technical problems when submitting an assignment, click on the Help link in the Blackboard menu bar for detailed help and instructions. You can also contact the Imperial help desk at: [email protected]. For all other problems contact your BPES coordinator.

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PLAGIARISM FORMS EVERY STUDENT must submit their own plagiarism form via Blackboard. If you do not personally submit a plagiarism form by the coursework due date, you will score zero for the coursework. The form is in Blackboard, under Assessment and then Plagiarism Form. This will take you to a new web link where you can complete the form. By submitting this form you are agreeing that you have not plagiarised any part of the submitted coursework. Details of how to correctly reference can be found on the Library website using the following link: http://www3.imperial.ac.uk/library/subjectsandsupport/referencemanagement You should keep an audit trail of who contributed to each part of any group coursework. If you do not do this and the work is judged to contain plagiarism, the whole group could be penalised. The plagiarism form allows you to give each member of your group a mark out of 5 for effort. If you believe that someone has not done as much work as the rest of the group you can mark them accordingly. All forms with a mark lower than 5 for any student will be reviewed and a decision made by the Programme Director as to whether their coursework mark should be adjusted. If you are having trouble with the group dynamics during the term, please do not hesitate to contact either your lecturer or the programme co-ordinator Rose Brown and they will try to sort out any issues before the coursework is completed. FORMING GROUPS ON BLACKBOARD You will need to form your own groups for the coursework by the end of Week 3 (Friday 1st November 2014) and there should be 4 students per group. If you make a mistake with the group you have chosen, please contact Rose on the above e-mail address to make changes. If you have not joined a group by the stated date, Rose will allocate you into a group and No changes will be permitted after this date. You will need to go to the module in Blackboard and click on Assessment. Then select Entrepreneurship group sign-up sheet. There will be a selection of numbered groups which you can allocate yourself to. It is best if one person in your group, (perhaps the nominated group leader) chooses a group number and then lets the rest of you know which group number they have chosen so you can all allocate yourselves to that group.

Module Notes Business Economics - Page 1 of 81. ' Ralf Martin

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G$! ,4%! )$9)$3$%+! 9)$5$)$%,$3! *%! 4! 8*4A)4! 43! 6$..:!H*A&)$! IJ ! )$9)$3$%+3! +#$! 9)$5$)$%,$3!5)-! "4(.$ !J!*%!4!K*+74+LA&1!($4)!8*4A)4: !

!

Figure&14:&Preferences&for&KitKat&and&gummy&bears&

!

!

3.2 Indifference(Curves(C%8*55$)$%,$!,&)E$3!8$3,)*($!,-(*%4+*-%3!-5!,-%3&$)!-9+*-%3!8$.*E$)*%A!+#$!34$!4-&%+!-5!&+*.*+1:!H*A&)$!IM!3#-63!4%!$N49.$:!O-+$!+#4+!-9+*-%!!(&+!-9+*-%!;!*3!-%!#*A#$)!,&)E$:!

C%8*55$)$%,$! ,&)E$3! ,4%! ,-$! *%! E4)*-&3! 3#49$3! -)! 5-)3:! P-6$E$)>! +#$! -%$3! 9.-++$8! *%!H*A&)$! IM! 4)$! ,#4)4,+$)*3+*,! -5! 4! 94)+*,&.4)!+19$! -5! 9)$5$)$%,$3>! 6#*,#! *9.1! +#4+! +#$)$! *3!declining&marginal&utility:!"#*3!$4%3!+#4+!,-%3&*%A!-)$!-5!4!A--8!6*..!4.6413!*%,)$43$!

U =U Good1,Good2,! Bad1,....( )

Gummy Bears (G)

10

20

30

40

10 20 30 40

Kitkat (K)

50

C

A

B

50
HillelHillelHillelthe first unit of consumption of a good or service yields more utility than the second and subsequent units, with a continuing reduction for greater amounts


!"#$% #&(&!)% *"+,-,$.% &/,%!""#$#%&!%#&(&!% !"#% 0,&% "#&% "1% 2% 0-,3% #3&% 4,5(3,6% 26% !"#%5"36#7,%7"$,8% ,)0)%&/39% "1%&/,%1$6&% :,,$% !"#%4$39% "3%2% ;$42!%30/&% 3%&/,%

Module Notes Business Economics - Page 21 of 81. Ralf Martin

&

Figure&16:&A&utility&function&with&declining&marginal&utility&

!

!

!

Figure&17:&Declining&marginal&utility&in&kitkatXgummyXbearXspace&&

!

!

!

3.3 Marginal(rate(of(substitution(Notice! that! our! thought! experiment! ! i.e.! the! ratio! between! kitkats! and! gummy! bears! to!leave!utility!unaffected!!is!the!gradient!of!the!indifference!curve.!We!also!refer!to!it!as!the!Marginal!Rate!of!Substitution!(MRS)!

Gummy Bears (G)

10

20

30

40

10 20 30 40

Kitkat (K)

50

50

! K1! G1

! G1

! K1

K2G2

! G2 ! K2

K1G1

&+,"5&21;,+& ,49"&+*& )45&+,4+&+*&4&01/2& /"#+1#;& *(+& ."")1#;& "&E,"5&4/"&:"01#":&4&+,"&$*+&:191:":&@5&">&10&+*+4A&$*+&4/"&4&4@*9"&+,"#&."&$4#&./1+"&

!"# ! !!"

!! !" ! ! !!" &

J*+1$"&+,4+&24/;1#4A&$*+&1#&+,1&$4"&@"$*2"&

!" ! ! !" !! ! ! !!" &

K1;(/"&LM&)A*+&+,""&$(/9">&C(2@"/&*0&+,1#;&4/"&.*/+,&)*1#+1#;&*(+>&

E,"& CEH& $(/9"& 1#1+14AA5& :"$/"4"%& ,4& 4& 21#12(2&4#:& +,"#& 1#$/"4"& 4;41#>& E,"&/"4*#& +,4+& 1+& :"$/"4"& 1& @"$4("& +,"& 01N":& $*+& @"1#;& )/"4:& *9"/&2*/"& (#1+>&!*."9"/%& .1+,&1#$/"41#;&24/;1#4A&$*+&+,1&$4##*+&;*&*#&0*/"9"/&4#: &4+&*2"&)*1#+&49"/4;"&$*+&1#$/"4">&

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

!"#$%&() *+,%#"-,./01/&%,#&23040

&

0"

5"

10"

15"

20"

25"

30"

0" 5" 10" 15" 20" 25"

MC(Q)" ATC(Q)"
fixed costAverage Total Costs = TC(Q)/QMarginal Costs = dTC/dQIn other words, rate of change of total costswrt change in demand


Key(concepts(in(this(chapter( !"#$%& !"#()*&%#+$)+*&%#+ ,-".%+-/!"#()*& 0#1&$)+*&%#+ ,-".%+-/0#1&12345"-.50#1&26%75(0#1&128-"%-9/50#1&1

Further(Reading(!%+(:*;-?&5"1@-+(A


5 Competition and Monopoly !"#$%&()*$&)*%"+,$-"$".-%.-$(/0+1)*$23 $0$*%)(4($4&5$,)%)+,*$"+$-/)$!"#$%&()*&)#%6$73$50&8)-$*-&.(-.&)$#)$5)0+$/"#$50+3$4&5*$0&)$0(-9)$+$0$50&8)-$0+,$/"#$-/)3$+-)&0(-$#-/$)0(/$"-/)&6$ $

!"# $%&%()*(+,-%).).+/ *:)$*-0&-$#-/$0+$);-&)5)$(0*)"&)"9)&?$-/)&)$0&)$+,%+-."##/%#(?$*"$-/0-$4&5*$(0+$4&))=3$)+-)&$0+,$);-$-/)$50&8)-6$

@"$ /)=%$ #-/$ -/)$ ,*(.**"+$ "4$ +,9,.0=$ 4&5*$ 0(-"+*$ 0+,$ #/"=)$ 50&8)-$ ".-("5)*$ =) -A*$/09)$-/)$4"=="#+1$("+9)+-"+


Figure!28!contains!a!number!of!additional!ways!of! representing! this.! !For! instance!we!can!plot!revenue!R,!which!is! linear!along!with!costs!C.!Profits!can!be!read!off!as!the!difference!between!these!two!lines.!!

So!what!do!we!expect!a!firm!with!such!profit,!revenue!and!cost!functions!to!do?!As!we!said!before!they!will!maximise!profits.!Clearly!profits!are!maximised!at!the!top!of!the!inverted!u!shape.!The!graph!also!makes!clear!that!this!is!happening!when!the!slope!of!the!revenue!line!and!the!slope!of!the!cost!curve!are!equal.!Another!way!of!expressing!this!is!that!the!marginal!revenue!MR!has!to!be!equal!to!the!marginal!cost!MC.!Or!expressed!more!intuitively:!in!order!to! maximise! profits,! we! should! expand! production! until! the! point! where! the! last! unit!produced!costs!no!more!(and!also!no!less)!than!the!amount!we!make!when!selling!this!last!unit.!Figure!28!illustrates!this!as!well!by!plotting!the!marginal!revenue!!notice!that!marginal!revenue! in! this! case! is! a! constant! equal! to! P! =! and! marginal! cost! curves.! Note! that! they!intersect!where!profits!are!highest.!Finally,!if!we!want!spell!out!this!condition!formally!it!is!that!the!optimal!production!point!!!!satisfies:!

! = !" !! !

i.e.! the!price! is! equal! to!marginal! costs.!With! the! cost! function!we!have!been!using! in! this!section!this!simply!becomes:!

! = 2!!! (3)!!

Notice,!that!while!this!condition!gives!us!a!profit!maximising!production!point,!there!is!no!guarantee! that! the! firm!will!actually!make!a!positive0profit.!Why! is! this?!Note! in! the!above!reasoning!we!have!at!no!point!taken!fixed!costs!into!account.!Hence,!while!!!!might!be!the!highest!profit! the! firm! is! able! to!make! it! could! still! not!be! enough! to! recover! all! the! fixed!costs.!Of!course!this!also!depends!on!the!price.!The!higher!the!price! in!the!market!that!the!firm!can!charge!the!more!likely!it!is!that!overall!profits!are!positive.!

Hence!we!have!to!examine!the!relation!between!market!price,!optimal!production!point!and!fixed!costs.!A!good!way!to!do!this!is!using!average!costs!and!by!drawing!graphs!such!as!in!Figure!27.!Notice!that!unlike!marginal!costs,!average!(total)!costs!take!into!account!the!level!of! fixed!costs.!Also!note! that! the!average!cost! is!obviously! the!cost!per!unit!of!output.!The!price!on!the!other!hand!is!the!revenue!per!unit!of!output.!Hence!as!long!as!

! > !"# !! !

the!firm!is!making!a!profit.!With!a!diagram!such!as!in!Figure!27!we!can!immediately!see!if!this! is! the! case! for! a! given!price.! Figure! 29! contains! several! examples! for! the! specific! cost!function!used!in!this!sections!(i.e.!the!cost!function!in!equation!(2)).!In!the!left!panel!the!price!is! higher! than! the!minimum! of! the! average! cost! function.!Hence,! it! is! possible! to!make! a!profit.!How!much!profit!exactly!we!can!work!out!by!locating!the!optimal!production!point!using! the!marginal! cost! curve! (the! red! curve);! i.e.! in! the! left! panel! this!would! be!!! = 6.!Hence,!revenue!will!be!equal!to!!!!times!the!price,!which!is!equal!to!the!surface!area!of!the!green!and!grey!shaded!rectangle.!Costs!will!be!equal!to!the!level!of!the!average!cost!curve!at!
HillelHillelHillel


!!!times!!!;!i.e.!the!grey!shaded!rectangle.!Profits!are!the!difference!between!the!two,!which!is!the!greenish!rectangle.!!

We!can!look!at!the!same!areas!in!the!right!panel!where!the!price!is!much!lower.!Now!it!turns!out!that!the!revenue!is!smaller!than!costs!and!the!firm!would!make!a!loss!equivalent!to!the!red!rectangle.!

When! discussing! demand! and! supply! we! were! stressing! that! prices! adjust! to! achieve! a!market!equilibrium.!In!this!section!we!have!taken!the!price!as!given!until!now.!How!can!we!figure!out!what!the!equilibrium!price!is!going!to!be!here?!

What!we!have! been!discussing! so! far! is! all! related! to! the! supply! side.!However,!we!have!only! ever! been! discussing! an! individual! firm.! However,! the! supply! curve! represents! the!combined!decisions!of!all!firms.!It!is!easy!to!get!from!individual!firms!to!the!supply!curve.!From!Equation!(3)!we!can!work!out!how!much!an!individual!firm!will!supply!given!a!price!P;!i.e.!!

!! =!2!

Suppose!now!that!we!have!! !identical!firms.!Then!the!market!supply!curve!is!simply!

! = !"2 !

Or!in!the!usual!inverse!notation:!

! = 2!! !

!

Hence,!together!with!a!demand!curve!we!can!find!the!market!equilibrium.!Suppose!we!have!again!the!simple!linear!(inverse)!demand!curve:!

! = ! !"!

We!can!compute!the!market!equilibrium!price!from!!! !

!!!2 =

!!

1! !

! !

hence!

!2 +

1! !

! = !!!

!! = !!!2 +

1!

!!= 2!!" + 2!

and!!


!! = !! + 2!

!

!

Notice!how!the!market!equilibrium!is!related!to!the!number!of!firms!in!the!market:!the!more!firms! there! are! (the!higher!!),! the! lower! the! equilibrium!price! and! the!higher! equilibrium!output.!This!makes!intuitive!sense:!more!firms!mean!more!competition!for!the!same!number!of! consumers.! As! a! consequence! prices! go! down! and! total! amount! sold! in! the! market!increases.! But! of! course! if! prices! go! down! each! individual! firm! is! selling! less! while! the!market!as!a!whole!is!selling!more;!i.e.!!

!!! =! !

!= !!" + ! !

Hence,! as! more! firms! enter! the! profits! of! an! individual! business! are! shrinking! for! two!reasons:!Firstly,!because!they!sell!less!and!secondly!at!a!lower!price.!This!implies,!that!as!the!number!of!firms!goes!up!more!and!more!firms!will!find!themselves!in!a!situation!such!as!the!right!panel!in!Figure!29;!i.e.!the!profit!they!make!is!not!enough!to!cover!their!fixed!costs.!Of!course!no!business!in!their!right!mind!will!carry!on!like!that!for!very!long.!Rather,!they!will!be!exiting!the!market.!This!of!course!means!that!the!number!of!firms!in!the!market!! ! comes!down.!Hence,! for! the! remaining!businesses!profits!will! go!up.! In!other!words! this! exit! mechanism! balances! the! market! so! that! when! starting! from! a!situation!where!businesses!make! losses!we! slowly! end!up!with!businesses!making!profits!again.!!

Equally,!if!a!market!is!characterised!by!high!profits!we!expect!that!more!firms!enter!to!get!a!share!of!the!pie.!This!will!bring!prices!down!along!with!lower!quantities!so!that!the!high!profits!erode.!!

Hence,! this! exit! and! entry!process! leads! to! a! long! run! equilibrium!where! firms!make!neither!profits!nor!losses.!Note!that!we!can!use!this!property!to!work!out!!within!the!context!of!our!simple!model!=!how!many!firms!will!be!in!the!market!in!this!long!run! equilibrium.! For! that! notice! that! a! firm!will! make! zero! profits! if! the! market! price! is!exactly! equal! to! its! average! costs.!Now,! if! firms! are!profit!maximisers!we!know! that! their!production!point!is!determined!by!the!marginal!cost!curve.!Hence,!the!only!point!where!we!are!both!on!the!MC!and!AC!curve!is!the!intersection!between!the!two.!!Hence,!using!the!cost!function!from!earlier!we!would!get!

!"# !!! =10!!!

+ !!! = 2!!! = !" !!! !

Implying!that!!

!!! = 10!
HillelHillel


!"#$%&(#)%*+,#-.+.+/%#01(*+$*1$+&%23#! !! ! #4(#&.%#"1&,13+6&4&7#"8#+6#4624/421+$#84)9#!#46#

&.%#$"6:#)16#%514$4;)419#-.%)%#,)"84&(#+)%#


Figure&28:&Profit&maximisation&of&price&takers&

!

!

Figure&29:&Entry&and&Exit&

! !

!"# $%&%%()*Under!perfect!competition!firms!consider!the!market!price!as!given.!At!the!other!end!of!the!spectrum!we!have!monopoly:!there!is!only!one!firm!in!the!market.!How!will!prices!respond!to!output!decisions!by!this!firm?!As!they!are!the!only!firm!the!price!response!is!driven!by!the!demand!function.!

To!find!the!profit!maximising!production!point!we!still!need!to!equalise!marginal!revenue!with!marginal!costs.!However!now!marginal!revenue!is!no!longer!simply!the!market!price,!rather,!since!

! !!we!have!that!

! !!!

Notice! that! this! marginal! revenue! curve! is! similar! to! the! demand! curve:! it! has! the! same!intercept! but! twice! the! steepness! of! the! demand! curve.! Its! therefore! easy! to! draw! in! the!

R = PQ = a bQ( )Q = aQ bQ2

MR = a 2bQ

!!! !! !! !
Hillel


!"#$%&()*+#+,&-#).")/&01%%&2#.("%&3456&7%&$)*&8%%&+9)+&:(+!(+&;:%&/)".#*);&$:8+85&+9)**&+9%&!%"?%$+&$:/!%+#+#:*&$)8%6&

&

!"#$%&() *+%,-"./01"/"20.",3,-0/,3,4,56

&

&

&

&

!"# $%&()*+,-(&*%./*(0%1)232)4*@&


where!! = !!! !!!,!!is!the!mark=up!over!marginal!costs.!Notice!that!the!closer!the!elasticity!is!to!

0!(i.e.!the!less!elastic)!the!larger!the!mark=up!will!be!(recall!that!the!elasticity!is!negative)!

!

!"#$%&%"()*$+$),+*$%,-()". $ Price!taking! Profit!maximisation! P=MC! Market!Entry!and!Exit! Perfect!Competition! Monopoly! MR=MC!

/0.),".$1"-2+3 $Pindyck!&!Rubinfeld!Chapters!8!and!9!

!

!


6 Welfare & Market Failure 6.1 Producer(and(consumer(surplus(How! can! we! assess! the! value! of! a! market! or! compare! different! markets! and! as! well! as!different!market!outcomes?!For!that!we!need!so!called!welfare&measures.!

Journalists! and! commentators! often! assess!markets! on! the! basis! of! the! turnover;! i.e.! how!much! money! changes! hand! in! a! market.! However,! this! might! be! entirely! misleading! in!assessing! the! true!value!of! a!market.!To! immediately! see!why! consider! a! market!where!prices!are!zero!such!as!the!market!for!air!to!breathe.!There!is!clearly!a!demand!for!such!air!judging! from!the!amount!of!air!people!breathe!all! the! time!and!hence! there!must!be!some!value!attached!to!breathing!air.!However,!as!the!price!is!zero!judging!by!the!turnover!does!not!get!us!very!far.!

Economists!deal!with!the!matter!using!the!concept!of!surplus.!There!are!at!least!two!types!of!surplus!that!are!of!interest:!

Consumer!surplus! Producer!surplus!

Lets!first!examine!consumer!surplus,!which!is!easily!grasped!by!looking!at!a!demand!curve!such! as! in! Figure! 31.! Suppose! this! is! the!demand! for! concert! tickets! to! see! the! band! The!Economists.!We! see! that! there!are!100! consumers!willing! to!pay!90! to! see! the!band.! 100!consumers! are!willing! to! pay! 80! and! so! on.! Suppose! the! price! for! a! concert! ticket! in! the!market!is!actually!40.!!Hence!the!people!who!were!willing!to!pay!90!have!their!happiness!improved! by! a! value! equivalent! to! 90=40=40.! The! people!who!were!willing! to! pay! 80!have!their!happiness!improved!by!30!and!so!on!until!the!people!who!are!willing!to!pay!40!who! are! indifferent! about! this!market.! The! consumer! surplus! is! the! sum! of! all! happiness!improvements!!in!money!terms!!for!all!consumers!in!the!market;!i.e.!it!is!equivalent!to!the!area!under!the!demand!curve!and!above!the!price!line.!

Another!way!to!think!about!the!consumer!surplus!is!the!following!thought!experiment:!how!much!would!we!have! to!pay!all! consumers! to!make! them! just! indifferent!between!buying!the!good!in!the!market!and!not!buying!it?!

!


Figure&31:&Consumer&Surplus&

!

!

!

Consumer!surplus!can!easily!be!computed!with!any!kind!of!demand!function;!e.g.!in!Figure!32!with!a!linear!demand!function!it!is!also!the!area!between!the!demand!curve!and!the!price!line.!Note!that!this!area!is!a!rectangular!triangle!so!we!can!compute!it!as!

!!"#$%&'($')*$# = 12 !"#$%&$'# !"#$% !"#$%&%' = 0.550600 = 15,600!

! !!!Figure&32:&Consumer&surplus&with&linear&demand&

!

!

We!can!analogously!derive! the!producer! surplus!as! the! total!amount! required! to!make!all!producers! indifferent!between!selling!and!not! selling! in! the!market.!Or! in!graphical! terms!

100 200 300 400 500 600 700 800 900

10

20

30

40

50

60

70

80

90

Concert Tickets

Pric

e

Market Price

100 200 300 400 500 600 700 800 900

10

20

30

40

50

60

70

80

90

Concert Tickets

Pric

e

Market Price


we! can! compute! the!producer! surplus! as! the! areas! between! the!price! line! and! the! supply!curve.!

Figure&33:&Producer&surplus&with&linear&supply&

!

!

Hence!for!the!supply!curve!shown!in!Figure!33!

!"#$%&'"(%")*%+ = 12 !"#$% !"#$%&$'# !"#$%&%' = 0.520600 = 6,000!

Note!that!the!producer!surplus!is!equivalent!to!the!profit!of!all!producers.!

6.2 Government(intervention(in(the(market(An!important!application!of!the!concept!of!consumer!and!producer!surplus!is!the!analysis!of!government! interventions! in! a!market.! For! instance! in! Figure! 34!we! look! at! a! tax! on! the!producer! equal! to! the! amount! t! for! sales! of! a! good.! There! are! many! goods! where! the!government!imposes!taxes!such!as!petrol!or!cigarettes.!Note!that!this!is!a!tax!on!the!quantity!sold!not!the!value!!like!a!value!added!tax.!

Without! the! tax! the!market! equilibrium! is! at! !with!price! ! .! The! consumer! surplus! is!

equal!to!areas!A+B+E.!The!producer!surplus!is!equal!to!D+C+F.!

!

With!a!tax!the!market!equilibrium!is!at! !with!price! !for!consumers!whereas!producers!

receive!only!a!price!of! .! !Notice!that!the!consumer!surplus!is!reduced!to!area!E!whereas!

the!producer! surplus! is! reduced! to! area!F.!The! surplus! lost! consists! consequently!of! areas!A+B+D+C.! Note! that! A+B! corresponds! to! the! amount! the! government! is! raising! in! taxes.!Hence,! this! is! not! really! lost! surplus! but! rather! surplus! that! has! been! transferred! to!government.!The!areas!B+C,!however,!constitute!surplus!that!is!lost.!It!is!often!referred!to!as!deadweight0loss.0It!happens!because!the!tax!distorts!the!price!signal.!

!

100 200 300 400 500 600 700 800 900

10

20

30

40

50

60

70

80

90

Concert Tickets

Pric

e

Market Price

Supply Producer Surplus

Q0 P0

Q1 PbPs


Figure&34:&A&tax&on&sales&of&a&good&

6.3 (Market(Failure(Any!government! intervention! in! the!market! affecting!marginal! costs!or!benefits!of!market!participants!will! lead! to!deadweight! loss! !unless! the!market! is! subject! to! a!market0 failure.0What!this!means!is!that!even!in!the!absence!of!government!regulation!the!market!is!not!fully!efficient;! i.e.! the!market!has!an!equilibrium!that! leaves!opportunities! to!generate!value!un=exploited.!

There!are!three!types!of!reasons!why!this!could!be!happening:!

1. Externalities:!As!a!result!of!a!market!transaction!costs!or!benefits!arise!to!people!not!part!of!the!market!transaction.!An!example!of!a!cost!is!pollution.!An!example!of!a!benefit!is!innovation.!

2. Imperfect! Information:! if! market! participants! have! imperfect! information! about! the!things!that!are!being!traded!in!the!market.!

3. Market!Power;!e.g.!as!in!the!case!of!a!monopoly!

We!will!explore!these!issues!in!more!detail!in!the!following!sections.!

Key(concepts(in(this(chapter( Producer!surplus! Consumer!surplus! Market!failure!

Further(Reading(Pindyck!&!Rubinfeld!Chapter!!9!

! !

D

S

B

D

A Buyers lose A + B, and sellers lose D + C, and

the government earns A + D in revenue. The deadweight

loss is B + C. C

Quantity

Price

P0

Q0 Q1

PS

Pb

t

Pb is the price (including the tax) paid by buyers.

PS is the price sellers receive, net of the tax. The burden

of the tax is split evenly.

E

F


7 Government regulation 7.1 Pollution(Externality(Consider! once! more! the! Southpark! chocolate! market! discussed! earlier.! Suppose! that! the!wrapping! from! the! chocolate! leads! to! litter! that! has! to! be! cleaned! up! by! Southpark! city!council.! Table! 7! suggests! a! cost! schedule.! Note! that! we! assume! that! marginal! costs! are!increasing.!Of!course!this!doesnt!have!to!be!the!case!but!it!is!a!more!interesting!case.!!

!

Table&7:&Litter&cleanXup&costs&

!

!

To!analyse!the!implications!of!this!we!add!these!costs!to!the!supply!curve!in!Figure!35!(recall!that! the! supply! curve! represented! the! increasing!marginal! costs! suppliers! are! facing).! The!clean=up!costs!are!an!additional!cost!that!is!associated!with!the!consumption!of!chocolate!so!it!makes!sense!to!add!them!to!the!supply!curve.!!

We!have!seen!before!that!an!efficient!allocation!is!achieved!when!marginal!costs!are!equal!to!marginal!willingness!to!pay.!Hence,!because!the!full!social!costs!are!now!higher!we!see!that!the!efficient!allocation!is!now!lower!than!before!with!only!two!chocolate!bars!sold.!However,!because!the!market!participants!of!the!chocolate!market!dont!have!to!pay!for!the!clean=up!costs! themselves! the!market! equilibrium!will! be! as! before! at! a! chocolate! consumption! of!three.!Thus,!the!external!clean=up!costs!drive!a!wedge!between!the!efficient!market!outcome!and!the!actual!market!equilibrium.!!

Number of wrappings to be disposed

Total Cost Marginal Cost

1 $ 1 $ 1

2 $ 3 $ 2

3 $ 6

$ 3

4 $ 9 $ 3


Figure&35:&External&costs&in&a&supply&and&demand&diagram&

!

!

So!what!can!or!should!be!done!about! this?!Before!we!discuss!possible!policy!options,! lets!first!introduce!an!alternative!way!of!representing!the!externality!shown!in!Figure!36.!

On!the!left!hand!side!we!reproduce!the!normal!market!diagram.!On!the!right!hand!side!we!look!at!the!externality!in!terms!of!a!diagram!where!units!of!pollution!(i.e.! in!this!chocolate!wrappers)! are! on! the! x=axis.!Moreover! rather! drawing! the! complete! supply! and! demand!picture!we! focus!on!only! the!marginal!benefit!as!well!as! the!marginal!cost! from!pollution.!Note! that! the! marginal! benefit! combines! both! the! producer! and! consumer! surplus! with!every!unit!of!pollution.!!

Note! that! sometimes! we! look! at! these! curves! starting! from! the! status! quo;! i.e.! the!equilibrium!that!arises!when!the!market!is!left!to!its!own!devices,!which!in!the!current!case!is! at! an! output! level! of! 3.! We! then! consider! the! effect! of! reducing! pollution.! From! this!perspective!the!marginal!cost!of!abating!emissions!is!what!we!have!to!give!up!as!pollution!falls! from! 3! wrappers! to! 2! to! 1.! ! In! some! settings,! this! is! the! cost! of! fitting! clean=up!equipment!to!a!polluting!plant;!in!this!example,!it!is!the!net!benefit!of!consumption.!!X!was!willing!to!pay!more!for!chocolate!bar!number!2!than!it!cost!to!produce,!and!if!he!doesnt!get!to! eat! it,! his!welfare! goes! down.! ! Since!we! normally! have! to! give! up!more,! the!more!we!reduce!pollution,!this!curve!slopes!up!as!we!abate!the!emissions!and!move!from!right!to!left.!The! marginal! benefit! of! abating! emissions,! on! the! other! hand,! is! the! curve! showing! the!marginal!external!cost,!and!this!one!slopes!down!as!we!move!from!right!to!left.!


&

Figure&36:&An&alternative&way&of&representing&externalities&

!

!

Debates!around!pollution!can!often!be!very!polarised.!On!the!one!hand!there!are!those!who!suffer! from! pollution! and! they! would! often! suggest! that! any! amount! of! pollution! is! un=acceptable.! On! the! other! hand! there! are! polluters! ! perhaps! big! businesses! !who! all! too!often! want! us! to! believe! that! efforts! to! curtail! pollution! will! have! dire! economic!consequences.!Figure!36!=!reproduced!in!Figure!37!=!offers!a!more!nuanced!view.!We!have!to!balance!costs!and!benefits!of!pollution!by!equating!marginal!costs!and!marginal!benefits!of!pollution.!This!provides!a!theoretically!clear!notion!of!a!pollution!level!that!is!desirable;!i.e.!good!pollution!in!Figure!37.!!

Figure&37:&Good&and&bad&pollution&

!


!

!

As! in! the! case!of! the! supply!and!demand!diagram!we! typically!work!with! simple! smooth!functions!to!describe!the!abatements!costs!and!benefits!as!illustrated!in!Figure!38.!

Figure&38:&Abatement&and&benefit&curves&

!

7.2 (Emission(taxing(Earlier!we!discussed,!how!a! tax!would! imply! that! the!economy! is!subject! to!a!deadweight!loss,!where!economic!value!is!below!its!optimal!value.!However,!when!the!equilibrium!the!economy!reaches!is!not!(socially)!optimal!because!of!the!presence!of!an!externality,!a!tax!on!polluters!can!improve!things.!Figure!39!illustrates!how.!Suppose!polluters!face!a!tax!that!is!exactly! equal! to! the! marginal! cost! of! emissions! at! the! intersection! between! emission!marginal! cost! and! benefit! curves.! Faced! with! such! a! tax,! polluters! would! not! want! to!increase!pollution!beyond!E*,!the!optimal!emission!point.!

!

Pollution/Emissions: E

(Mar

gina

l) C

osts

/Ben

efits


Figure&39:&A&pollution&tax&

!

!

7.3 (Tax(versus(direct(regulation(Instead!of! imposing! an! emission! tax! the! government!might! consider! simply! imposing! the!

regulation!that!emissions!should!not!be!higher!than!E*.!This!can!be!problematic!if!there!are!

many! different! polluters! with! different! abatement! cost! schedules.! Figure! 40! suggests! the!

example!of!two!firms.!Firm!1!has!a!steeper!marginal!abatement!cost!curve!meaning!that!she!

finds!it!harder!to!reduce!emissions!than!firm!2.!Suppose!now!the!regulator!wants!to!ensure!

that! emissions! are! no! higher! than! E*! and! to! be! fair! and! imposes! that! either! firm! is! only!

allowed!to!emit!E*/2!units!of!pollution.!We!can!see!that!at!this!point!marginal!costs!are!much!

higher! than! for! firm! 1! than! for! firm! 2.! This! means! that! we! can! reduce! the! total! costs! of!

achieving! emission! level! E*! by! reducing! emissions! of! firm! 2! further! than! E*/2! whereas!

increasing!them!for!firm!1.!To!minimise!costs!we!should!increase!firm!1!and!reduce!firm!2!

emissions!until!marginal!abatement!costs!are!exactly!equal,!which!happens!in!the!figure!at!

E1!and!E2.! !Note! that! firms!would!respond!with!exactly! the!same! level!of!emissions! if!we!

simply!imposed!a!tax!of!T!!rather!than!micro!regulating!the!amount!of!emissions!required!

for!every!firm.!

This! has! an! important! implication:! even! if! the! government! does! not! know! the! marginal!

abatement!cost! schedule!of!every! firm!by! imposing!a! tax! the!government!can!be!sure! that!

that!the!resulting!level!of!emissions!is!achieved!in!an!optimal!manner.!

!


Figure&40:&Tax&vs&regulation&

!

7.4 (Emission(trading(Instead!of!imposing!a!tax!to!reduce!emission!efficiently!the!government!could!alternatively!allow!for!emission!trading.!

Consider! again! the! case!where! the! government! imposes! that! each! firm! is! only! allowed! to!pollute!E*/2.!However,!suppose!the!government!implements!this!by!giving!each!firm!a!set!of!pollution!permits! equivalent! to!E*/2!and!allows! firms! to! trade! these!permits! freely!among!themselves.!At!point!E*/2!firm!1!would!happily!by!permits!for!any!price!that!is!lower!than!her! marginal! abatement! cost! at! E*/2.! ! At! this! price! firm! 2! is! happy! to! sell! some! of! her!permits.! This!will! continue! until! firm! 1! pollutes! at! E1!whereas! firm! 2! pollutes! at! E2.! The!price!of!the!last!permit!traded!will!be!equal!to!the!tax!in!Figure!40.!

7.5 (Monopoly(and(welfare(We!can!use!welfare!analysis!to!examine!the!impact!of!a!monopoly.!Figure!41!shows!a!similar!diagram!as!we!have! seen! in! Figure! 30! but! compares!welfare! changes! between! the!perfect!competition! and! monopoly! case.! Recall! that! in! the! perfect! competition! case! the! market!equilibrium!is!at!the!intersection!between!marginal!cost!curve!and!demand!curve!(which!is!also! the! average! revenue! curve).! The! market! equilibrium! under! monopoly! occurs! at! the!point!where!marginal! revenue!and!marginal!cost!curve! intersect.!How!is!welfare!affected?!The! consumer! surplus! reduces! by! A+B.! Producers! lose! C! but! they! gain! A.! Hence! this! is!clearly! good! for! the! monopolist! as! A>C.! However,! the! economy! as! whole! is! losing! the!deadweight!loss!of!B+C.!

!

E*/2% E*/2%E2%

Firm%2'Firm%1'

E1%

T%
Hillel


Figure&41:&Welfare&loss&and&Monopoly&

!

7.6 (Regulating(market(power(What!is!a!sensible!way!to!deal!with!market!power?!One!thing!the!government!could!do!is!impose!a!price! ceiling!as! illustrated! in!Figure!42.!Unlike! in!a! competitive!market,!where!a!binding!price!ceiling!would!reduce!total!welfare,!in!this!case!the!price!ceiling!moves!us!to!a!point!with!higher!welfare.!!

Notice!that!the!net!welfare!increase!emerges!!once!the!price!ceiling!is!in!place!!because!the!monopoly! has! now! an! incentive! to! increase! its! output! from!!!! to!!! .!Without! the! price!ceiling! the!monopoly! looses!A! and! gains!C!when!doing! that.!However,! now! it!would! no!longer!loose!A!but!gain!C!so!its!a!no!brainer!to!increase!output!which!leads!to!a!social!gain!of!C+B.!

There! is! one!big!problem!with! this,! however.! In! order! to! set! such! a! ceiling! effectively! the!government!needs!to!have!good!idea!about!the!cost!structure!of!the!regulated!company.!!

This! can! be! challenging! in! particular! because! the! people! who! have! the! best! information!about! this! ! i.e.! the! regulated! firms! ! have! also! strong! incentives! to! exaggerate! the! real!numbers.!!

An! alternative! to! out=right! price! regulation! are! efforts! to! prevent! the! emergence! of!monopolies!or!the!break=up!of!any!monopolies!that!might!have!arisen.!

Most!governments!have!a!number!of!different!policy!options!for!that!purpose.!In!the!UK!this!falls!under!the!remit!of!the!Office!of!Fair!Trading!and!the!Competition!Commission.3!The!EU!competition!authorities!can!also!pursue!firms!operating!in!the!UK.!

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!

3!In!the!future!these!will!merge!themselves!into!a!new!authority!called!the!Competition!and!Markets!Authority!(http://en.wikipedia.org/wiki/Competition_and_Markets_Authority!).!

B A

Lost Consumer Surplus

Deadweight Loss

Because of the higher price, consumers lose

A+B and producer gains A-C.

C

Quantity

AR

MR

MC

QC

PC

Pm

Qm

$/Q


These! institutions! have! the! power! to! fine! companies! that! are! found! to! engage! in! anti=competitive! practices.! A! recent! famous! example! for! this! are! the! cases! brought! against!Microsoft!by!both!the!EU!and!the!American!competition!authorities.4!Microsoft!was!found!guilty!of!using!their!dominant!position!for!operating!systems!as!an!entry!barrier!for!smaller!competitors!in!other!markets!such!as!media!players!or!Internet!browsers.5!

They! can! also! prevent! companies! from! merging! if! the! merger! threatens! to! reduce!competition.! Finally,! they! can! order! the! break=up! of! companies! in! an! effort! to! increase!competition.! For! instance,! a! couple! of! years! ago! BAA! who! still! owns! airport! such! as!Heathrow!and!Stansted,!was!ordered!to!sell!Gatwick!in!an!effort!to!improve!competition!in!airports!near!London.6!

There! are! also! still!many! instances!where!monopolies! are! the! consequence!of! government!policies;7!e.g.!in!many!cities!the!number!of!taxi!firms!is!regulated!by!law.!Hence!government!policy! creates! an! out=right! entry! barrier! for! new! companies.! To! encourage! competition!governments!can!then!simply!remove!such!barriers.!

Figure&42:&A&price&ceiling&and&monopoly&

!

7.7 Barriers(to(entry(To!determine!if!government!action!in!a!market!is!required!it!is!important!to!examine!if!there!are!barriers!to!entry!which!prevent!competing!firms!from!entering!the!market.!An!obvious!example!for!barriers!to!entry!are!legal!barriers;!e.g.!in!many!cities!the!number!of!taxi!firms!is!

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!

4!See!http://en.wikipedia.org/wiki/European_Union_Microsoft_competition_case!and!http://en.wikipedia.org/wiki/United_States_v._Microsoft_Corporation!5!Similar!charges!are!now!being!drawn!up!against!Goolge:!http://www.ft.com/cms/s/0/e4e9f1f8=42ff=11e4=9a58=00144feabdc0.html#axzz3E8neTAJv!!6!http://news.bbc.co.uk/1/hi/8317662.stm!7!E.g.!in!many!cities!the!number!of!taxi!firms!is!regulated!by!law.!

B A

Regained Consumer Surplus

Regained Deadweight Loss

C

Quantity

AR

MR

MC

QC

PC

Pm

Qm

$/Q

Price ceiling


regulated! by! law.! Hence! government! policy! creates! an! out=right! entry! barrier! for! new!

companies.!To!encourage!competition!governments!can!then!simply!remove!such!barriers.!!

In!the!case!of!Microsoft!the!barriers!was!implied!by!Microsofts!dominance!in!the!operating!

system! market.! They! could! then! leverage! this! dominance! into! other! markets;! e.g.! by!

automatically!installing!the!Microsoft!media!player!along!with!the!operating!system.!

Price!dumping!can!be!another!barrier:!an!incumbent!might!lower!prices!to!an!extent!where!a!

potential!entrant!will!make!losses!if!she!were!to!enter.!Of!course!this!might!also!imply!that!

the!incumbent!is!making!losses.!However,!if!this!is!only!temporary!and!the!incumbent!can!

rise! prices! in! the! future! such! a! move! can! make! sense.! Moreover,! it! might! sometimes! be!

enough! to! threaten! price! dumping! and! a! price! war! to! keep! competitors! away.! We! shall!

examine!this!in!greater!detail!when!looking!at!Game!Theory.!

7.8 Natural(monopoly(We!have!seen!earlier,!that!a!major!determinant!of!the!number!of!firms!in!a!market!are!fixed!

costs.!The!higher! the! fixed! costs,! the! lower! the!number!of! firms.! In! the! extreme!case!! i.e.!

when!fixed!costs!are!very!high!=!this!means!that!only!one!firm!can!profitably!operate!in!the!

market.!!

Examples!of! such!markets! include! the! railways,! electricity!provision,!water! supply,! etc.! In!

these!industries!large!amounts!of!investment!are!needed!to!provide!a!useful!service.!!

Because!the!presence!of!such!fixed!costs!prevents!more!than!one!firm!from!entering!we!can!

think!of!them!as!an!entry!barrier!as!well.!However,!unlike!with!other!entry!barriers,!it!would!

not!be!wise!nor! feasible! for! the!government! to! increase! the!number! firms.! It!would!not!be!

wise,! because! incurring! the! fixed! costs! several! times!would! create!more!waste! =! and! thus!

destroy! economic! value! ! than! could! be! gained! by! removing! monopoly! power;! e.g.! in!

principle!we! could!have! two!or!more! train! tracks! going! everywhere! for!different! firms! to!

compete.!However,! the!costs!would!be!absurd! for! this!!not! to!mention! the! impact!on! the!

landscape!!and!given!that!existing!customers!would!be!split!between!these!companies,!they!

would!not!be!able!to!recover!these!fixed!costs.!!

Some!authors! therefore!advocate!not! to!consider! fixed!costs! that!apply! to!both! incumbents!and! entrants! as! an! entry! barrier.! Rather:! an! entry! barrier! is! a! factor! that! prevents! a!more!

competitive!market!structure!with!a!larger!number!of!firms!in!a!situation!where!this!market!

structure!would!be!welfare!improving.8!

In! industries! where! we! are! dealing! with! natural! monopolies,! governments! often! have!

specialised! agencies! regulating! the! market.! These! typically! have! the! power! to! set! price!

targets.!For!instance!in!the!UK!this!includes!government!agencies!such!as!the!Office!of!Gas!

and! Electricity! Markets! (OFGEM),! the! Office! of! Rail! Regulation! (ORR)! or! the! Office! of!

Communications!(OFCOM).!

!

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!

8!See!McAfee!(2004),!http://www.jstor.org/stable/3592928!for!a!discussion!of!this!point.!


!

Also!note! that! even! in! those! industries! it! is! often!only!a! subset!of! the!value! chains! that! is!characterised!by!a!natural!monopoly.!Hence,!what!government!are!trying!to!do!is!allow!for!competitive! markets! in! the! sub! activities! of! these! industries! where! this! is! possible.! For!instance!for!electricity!market!this!implies!that!we!have!a!highly!regulated!national!grid!but!competitive!markets! for!power!generation!and!power! retailing.!For! the! railways,! the! large!fixed! cost! arises! because! of! the! network! of! tracks.! Hence,! the! government! has! created!Network!Rail,! a! company! that! owns! the! track.! It! sells! track!usage! services!with! regulated!prices!and!contracts!to!a!wide!range!of!train!operating!companies!that!compete.!

Notice! that! if! a! regulator! wants! to! set! the! price! of! a! monopoly! that! is! dealing! with! a!substantial! fixed!costs! the! target!price!cannot!be! the!marginal!cost!as! in!Figure!42.!Rather,!the!regulator!has!to!aim!to!set!the!price!close!to!average!costs!as!illustrated!in!Figure!43.!

!"#$%&() *+$,-."/#-/-.$%-,01/121,3

!

Key(concepts(in(this(chapter( Market!failure! Deadweight!loss! Natural!monopoly! Barriers!to!entry! Externality! Pollution!tax! Pollution!trading!

Further(Reading(Pindyck!and!Rubinfeld!Chapters!17,!18!

Begg!and!Ward!Chapter!8!

Pm

Qm

Unregulated, the monopolist would produce Qm and

charge Pm.

MC

AC

AR MR

$/Q

Quantity

Setting the price at Pr yields the largest possible

output;excess profit is zero.

Qr

Pr

PC

QC

If the price were regulate to be PC, the firm would lose money

and go out of business.


!

8 Uncertainty and Information 8.1 The(market(for(lemons(Another!issue!that!can!lead!to!market!failure!is!uncertainty!and!lack!or!limited!information!about!the!product!being!traded.!Clearly,!to!participate!in!market!as!either!buyers!or!sellers!people!need! to! know! something! about! the!product! that! is! being! traded.!The! perfect! competition! model! formally! assumes! perfect! information!which!is!another!way!of!saying!that!everybody!knows!everything.!This!is!a!rather!strong!assumption!and!it!can!be!relaxed!to!some!extent.!In!fact!it!turns!out!what! is!particularly!problematic! is!not! so!much!uncertainty!as!such!but!if!some!market!participants!are!more!uncertain!than!others.!This!is! called!asymmetric! information.!The!most! famous!example! to! illustrate!this! has! to! do! with! lemons.! Lemons! refers! in! this! case! to! used! cars! that! regularly! fail!leading!to!high!repair!costs!without!this!being!immediately!apparent!by!visual!inspection!or!a!short!test!drive.!We!examine!the!implications!of!lemons!for!a!used!car!market.!

Suppose!we!have!a!used!car!market!where!we!have!two!types!of!sellers:!

1. Good!car!sellers!want!at!least!3000!for!their!car.!2. Lemon!sellers!who!just!want!to!get!rid!of!their!car!for!whatever!they!can!get.!

Potential!buyers!are!willing!to!pay!5000!for!a!good!car!and!nothing!for!a!lemon.!!

Suppose! there! is! information!asymmetry! so! that!only! sellers!know! the!quality!of! the! cars.!However,!they!know!approximately!how!many!sellers!of!either!type!operate!in!the!market.!!

Suppose!initially!10%!of!sellers!sell!lemons.!Buyers!will!make!the!following!calculation:!the!expected!value!they!will!derive!from!buying!on!this!market!is!

90%!x!5000!+!10%x!0!=!4500!

Hence! this! is! the! maximum! price! they! would! be! willing! to! pay! for! such! a! purchase.! As!sellers!of!good!cars!are!willing!to!let!go!of!their!car!for!3000!trading!will!take!place!on!this!market.!!

Now! consider! what! happens! if! the! share! of! lemon! car! sellers! operating! in! this! market!increases;!e.g.!suppose!the!share!increases!to!50%.!Buyers!willingness!to!pay!would!drop!to!!

50%!x!5000!+!50%x!0!=!2500!

At! this!price!good!car!sellers!would!no! longer!be! interested!in!participating! in! the!market.!Buyers!would!realise!this!and!as!a!consequence!we!have!a!complete!collapse!of!the!market.!

To!address!this,!good!car!sellers!could!engage!in!some!form!of!signalling.!There!are!credible!and!non=credible!signals.!An!example!of!a!non=credible!signal!would!be!a!flashy!sign!saying!No! Lemon.! An! example! of! a! credible! signal!would! be! the! provision! of! a!warranty! ! a!


!"#$%&( )#( !*+( *,+( "!*%"( -#&)&.( /0*)( $*1&( *( 2*""*,)+( $#"( -"3%45( %&( )0( 6*-)( )0*)( %)(2#753(4($#"(-#&)5+(6#"()0(5$#,(&55"()#(!"#8%3(&7-0(*(2*""*,)+()0*,(6#"()0(9##3(-*"(&55".(

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/0.),".$1"-2+3 $4)#5*$2!6!178)#/%95!:;(!

!

! Your%expected%utility%is%a%weighted%average%of%the%two%possible%outcomes%(known%as%states%of%the%world)>

! You%care%much%more%about%the%big%loss%if%your%bike%is%stolen%than%the%smaller%loss%of%paying%the%premium>

Wealth

Utility No losses Bike stolen Expected outcome

Fair premium

Maximum acceptable premium

As good as no insurance

Expected wealth without insurance

Expected utility without insurance Utility when expected

outcome is certain


9 Investment !"#$%&$"&( )%( *+,-&( .,/*0)"1( $.,",).( #*2-$%( *.0,%%( &)$3( 4,5( .*"( &6)%( +$( 7,"$( )"( *(%8%&$*&).(5*89((

!"# $%&&()*+,- ./()&+*012/&*3$456 *:-//,%$(%,$+,78( /0,)%$%(&,(1)#$(8,-( ;&(8$*03(?6*&( )%(&6$(#*2-$( ,@(&6)%(@,0( 8,-( &,7*89( A6)%( @-&-0$( /*8$"&( )%( 5,0&6( ",&6)"1( &,7*8( )@( 8,-( .*"",&( @)"7( %,$+,78(56,()%(5)22)"1(&,(2$"7(8,-(%,$&6)"1(&,7*8()"($>.6*"1$(@,0(/*8)" 1(6$0(&,,00,53(4$".$()"(.,"%)7$0)"1(&6$(#*2-$( ,@(&6$(@-&-0$( /*8$"&(5$(6*#$(&,(&*B$( )"&,(*..,-"&(&6$( )"&$0$%&(&6)%(2$"7$0( )%(1,)"1(&,( .6*01$3( :-//,%$(&6$(*""-*2( )"&$0$%&(0*&$( )%(CDEFG3(4$".$( )@(5$(1$&( ;


Table&8:&Payment&streams&&2&examples&

!

If!you!are!rational! then!answer!depends!on!the! interest!rate.!We!can!calculate!the!PDV!for!both!streams!as!

!

!

!

Table!9! shows! the!PDV!values! for!different! interest! rates.!Note! that! stream!A! is!better! for!higher!interest!rates!as!payments!are!made!earlier.!

!!

Time Year 0 Year 1 Year 2

Payment Stream A $100 $100 0

Payment Stream B $20 $100 $100

Which payment stream is more valuable for us right now?

PDV of Stream A=100+100

(1+ R)

PDV of Stream B = 20+100

(1+ R)+

100(1+ R)2


!"#$%& (&)*+&,"$,-$"./012&304&5/33%4%1.&/1.%4%2.&4".%2&

!

!"# $%%&()*"#$$%&!(!)*+!*!$*,-./!0! /)*/!1&!2$*/3!%+2!&+2*4!$21%3&5! 676!8%2!9:! ,*2&6! ;)!$2&./!+*4#!(144!


Notice! that! this! expression! allows! us! to! examine! what! happens! if! t! goes! to! infinity.! An!annuity!of!this!kind!is!known!as!perpetuity.!Because!! < 1!we!have!that!

!"# !, ! = !"1 ! =!! !

!"# $%&()%*%+&,-./%Typically!an!investment!project!involves!a!negative!payment!stream!in!the!present!with!the!promise! of! a! series! of! positive! payment! streams! in! the! future! as! reward.! The! net! present!value!(NPV)!is!simply!the!PDV!of!all!those!payment!streams.!!

We! can! use! the! NPV! to! decide! about! investment! project.! An! investment! project! is!worthwhile! doing! if! the! NPV! is! positive.! If! we! have! several! investment! projects! that! are!mutually!exclusive!e.g.!the!particular!building!project!we!could!undertake!on!a!given!plot!of!land!!it!is!rationale!to!undertake!the!one!project!that!generates!the!highest!NPV.!

!

!"0 1+&%)+-.)-&%23)%&/)+For!any!investment!project!we!can!calculate!the!internal!rate!of!return!(IRR).!It!is!the!interest!rate! that!makes! the!NPV!of! the! project! equal! to! zero.! For! instance,! if!we!have! to! pay! 100!today!to!get!150!tomorrow!we!can!work!out!the!IRR!as!

!

!!""#!"#

!"#$$!" !

!

!

!

!"#$$%!"#

!""!"#$ !

For!investment!streams!that!extent!over!more!than!1!period!it!is!mostly!impossible!to!derive!an! explicit! expression! for! the! IRR.!However,!many! software! packages! such! as! Excel! have!built!in!functions!to!compute!the!IRR.!

!

Note!that!a!common!mistake!is!to!use!the!IRR!as!a!means!to!compare!investment!projects.!As!we!have!seen!from!the!example!in!Table!,!the!ranking!of!PDVs!(and!equally!NPVs)!depends!on!the!interest!rate!that!is!prevailing.!Hence,!depending!on!the!actual!interest!rate!a!project!with!a!higher!IRR!might!become!less!favourable!than!one!with!a!lower!IRR.!!!

4%562+6%(&*7+&87*68-(&%) Discounting! Present!discounted!value!


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Quantity

Triangles of (lost) Opportunity

P*

Q*

? #OR #


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11 Games and Oligopoly !"#$%&(&&"$# )"*+",# -.)",%,%-/#0/$# .-/-) -123#45"2#0*"# ,6-# "7,*"." -+#0#&)",*(.# -+#.0*8",#&,*(,(*"&3#9/# .0/2#%/$(&,*%""#50:"#0#+"6#+%*.#6%,5#&-."#$";*""#-+# .0*8",#)-6"*3# !50,# $","*.%/" ,5"# &,*(,(*"# -+# 0/# %/$(&,*2# "3;3# %/# .0/2# %,%" %/# ,5"# ST# ,5"# /(.="*# -+# ,07% % *";(10,"$# =2# ,5"# ;-:"*/."/,#J5,,)@UU6663-+,3;-:3(8U&50*"$V-+,U%/:"&,%;0,%-/&U,07%3)$+K3#
Hillel BadermanHillel Baderman


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!

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!

Q1

Q2

Firm 2 s Reaction Curve

30

15

Firm 1 s Reaction Curve

15

30

10

10

Cournot Equilibrium

The demand curve is P = 30 - Q and both firms have 0 marginal cost.


11.3 The(Stackelberg(model(!"# $%&$($)# *++,%&)$-"# -.# )/0# 1-,2"-)# %-30# $+# )/0# +$%,)*"0$)4# -.# )/0# &*402+5# 30($+$-"#%*6$"78#9/$"7+# *20#+$7/)4#3$..020")#$.#30($+$-":%*6$"7# /*&&0"+#+0;,0")$*48## ?$# )*60# $")-# *((-,")# )/0# 20+&-"+0# -.# )/0#.--?028 #

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! ! ! !" ! ! !!! 15 12!! !!#

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#

B0"(0#!! = 15#*"3#!! = 7.58#9/$+#$%&$0+#)/*)#)/0# 0*302#$+#%*6$"7#*#/$7/02#&2-.$)#)/*"#)/0#.--?028#F-)0#)/*)#"-)#$"#*#+)2*)07$(#+$),*)$-"+#$)#$+#C0))02#)-#C0#)/0#0*3028#G.)0"#$)#%$7/)#C0#7--3#)-#6"-?#.-2#+,20#?/*)#4-,2#2$D*#$+#3-$"7#C0.-20#)*6$"7#4-,2#*()$-"8#H0$"7#)/0#0*302#$+#7--3#$.#4-,2#.$2+)#%-D0#*-?+#4-,#)-#+-%0/-?#20+)2$()#)/0#-&)$-"+#-.#)/0#.--?02#*"3#$.#4-,#(*"#(203$C4#(-%%$)#)-#4-,2#(/-$(08#


firms!to!get! the!perfect!competition!outcome!!which!most!economists!generally!regard!as!the!best!outcome!available.!!

There!are!a!number!of! issues!worth!discussing!with! this!model.!Firstly,! the!model!doesnt!give!us!any!prediction!regarding! the!distribution!of!output!between!the! two!companies! in!equilibrium.! Secondly,! it! makes! an! implicit! assumption:! firms! can! only! then! compete! in!prices! and! threaten! rivals! with! taking! the! whole! market! if! they! dont! face! any! binding!capacity!constraints.!

This!last!point!gives!us!an!indication!as!to!when!the!Bertrand!model!is! likely!to!apply!and!when!not:!if!firms!dont!face!capacity!constraints!they!are!more!likely!to!compete!in!prices.!

!!"# $%&&()%*+Lets!look!again!at!the!Cournot!example!from!Section!11.2.!Each!firm!produces!10!for!a!price!of! P=30=20=10.! Hence! each! firm! makes! a! profit! of! 100.! Note! that! monopoly! in! the! same!situation!would! produce! 15! for! a! price! of! 15! at! a! profit! of! 225.! So!why! dont! the! firms!create!a!virtual!monopoly;!i.e.!collude?!Splitting!the!monopoly!profit!will!give!each!a!profit!higher!than!100!!i.e.!112.50!for!each.!

Firstly,! collusion! is! an! illegal! practice! in!most! countries! and! industries.!However,! even! if!there! are!no! legal!barriers!here! are! reasons!why!collusion!might! fail.!To! see!why! suppose!that! firm!2!sticks! to!an!output! level!consistent!with!collusion! i.e.!7.5!units!of!output.!From!the!reaction!curve!for!firm!1!we!know!that!the!best!firm!1!can!do!in!this!case!is!produce!

!

!" ! ! .52 = 11.25!

with!profits!for!firm!1!of!!more!than!126!and!profits!for!firm!2!of!less!than!85.!

In! other! words! it! makes! sense! for! firm! 1! to! deviate! from! the! collusion! output! level.!Moreover,!if!firm!2!sticks!faithfully!to!the!collusion!price!they!are!worse!off!than!they!would!have!been!in!the!Cournot!case.!Of!course!firm!1!being!aware!of!this!would!probably!not!stick!to!the!collusion!price!either,!so!we!end!up!in!the!only!Nash=Equilibrium!in!this!case!which!is!at!an!output!of!10!for!each!firm.!

The!strategic!dilemma!the!two!firms!find!themselves!in!is!a!classic!problem!in!Game!Theory!referred!to!as!a!Prisoners!Dilemma.!A!common!way!of!representing!things!in!game!theory!is!in!a!2!by!2!table!as!shown!in!Figure!47!!


!"#$%&() *+,--$.",/0"-&112

!

!

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!

11.6 Repeated(games(I+!(/5!;$!(+5()46$!1&+3!,.$!O&"-+5$&8-!6")$33/!-,+&!,./,!(+))4-"+5!"-!-+3$,."5


crucial! element! of! the! market! structures! we! looked! at! so! far! is! that! they! were! one=shot!

games;!i.e.!the!strategic!interaction!took!place!only!once.!In!practice!most!firms!operate!in!an!

environment!where!they!interact!repeatedly!with!their!competitors.!This!means!that!players!

can! potentially! be! coerced! into! collusion! for! fear! of! retaliation! in! later! periods.! What!

determines!if!this!is!going!to!work?!

Lets!consider!again!the!payoff!structure!from!Figure!47.!However,!suppose!both!firms!are!

playing! this! game! infinitely! many! periods! using! a! tit! for! tat! strategy;! i.e.! they! stick! to!

collusion! until! the! other! party! deviates! from! collusion.! After! a! deviation! they! punish! the!

other! party! by! not! colluding! either! forever! after.! Using! the! formulas! for! perpetuities! we!

derived!earlier,!we!can!examine!if!this!is!a!stable!equilibrium!strategy.!For!that!we!have!to!

check!that!in!the!perpetual!collusion!pay=off!for!both!players!is!higher!than!the!one!off!non=

collusion!payoff!when!the!other!party!colludes!followed!by!perpetual!non!collusion!by!both!

players;!i.e.!for!an!equilibrium!we!need!that!!

112 ! !!"! > 126 +100! !

where!R! is! the! interest!rate.!Note! that!an! increase! in! interest!rate!has!a!stronger! impact!on!

the! LHS! (i.e.! the! payoff! for! never! cheating)! than! on! the! RHS.! Hence,! what! the! equation!

shows! makes! a! lot! of! sense:! if! we! value! the! future! less! sustaining! collusion! will! not! be!

feasible.! Equally! if! the!payoff! from! cheating!were! very!high! ! e.g.! if! it!were!much!higher!

than!126!!then!collusion!would!not!work.!

!"#$%&%"()*$+$),+*$*"%)+&$ Oligopoly! Cournot!Model! Nash!Equilibrium! Betrand!Model! Stackelberg!Model!

-./),"/$0"12+3 $Pindyck!&!Rubinfeld!Chapters!12!and!13!

12 Macroeconomics If!we! focus!on!whole!countries! rather! than!particular!markets!and! try! to!get! to!grips!with!

emergent!phenomena!such!as!business!cycles!or!economic!growth.!

4564 7,"$8,&9"$"%&&:#$1*$&"$:1/;") $A!lot!of!modelling!in!macroeconomics!is!done!by!treating!the!economy!of!a!whole!country!in!

much! the! same! way! as! we! were! treating! until! now! specific! markets.! This! is! done! by!

constructing!a!virtual!good!by!dividing!the!value!added!of!products!and!services!by!a!price!

index;!i.e.!

Macro Output (Y) =Value (Added) of all goods produced in a country

Price Index !


!

For!an!individual!firm,!the!value!added!is!the!value!of!its!sales!minus!the!value!of!payments!for!intermediate!products;!i.e.!if!we!denote!the!price!a!firm!!!charges!by!!

!!! = !! !!!

!

where! ! ! ! is! the! firms! revenue! in! a! given! period! and! ! ! ! is! the! firms! expenditure! on! an!intermediate! product!M.!Hence! the!macro/aggregate! value! added! is! simply! the! sum!over!those!firm!level!added!values:!

!" ! ! ! !!

!

At!the!level!of!the!individual!firm!the!value!added!must!equal!to!the!sum!of!wage!payments,!interest!payments,!dividend!payments!and!re=invested!assets.!The!same!must!be!true!at!the!level!of!the!aggregate!economy.!This!gives!rise!to!a!basic!accounting!identity!which!we!shall!use! below.! Note! that! if! we! would! not! subtract! the! value! of/expenditure! on! intermediate!products! this!would!not! be! true! as!we!would! be!double! counting! the! actual! value! that! is!being!created!in!the!economy.!

The!price!index!is!a!weighted!average!of!all!(most)!prices!in!the!economy.!There!are!a!variety!of! methods! of! how! to! do! this! exactly! (i.e.! which! weights! to! use,! arithmetic! or! geometric!averages! etc.).10! For! the! purpose! of! this! module! we! dont! have! to! worry! about! different!methodologies.!!

Once! we! have! this! virtual! good! we! can! work! again! with! supply! and! demand! curves! as!before!using!the!price!index!as!the!price!level!on!the!y=axis.!

!

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!

10!For!details!on!the!price!indices!used!by!UK!institutions!see!the!ONS!Webpage.!


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