Microeconomics and Corporate Analysis

Microeconomic Foundations for the Analisys of Market Structure

Lecture Slides

Rui Baptista

Consumer TheoryBudget Constraint Showing Increase in Income

Q2

Q1

M / P2

M / P1

Slope = - P1 / P2

M’ / P1

M’ / P2

M’ > M

Consumer TheoryBudget Constraint Showing Increase in Price

Q2

Q1

M / P2

M / P1M / P’1

P’1 > P1

Consumer Theory:Indifference Curves

Q2

Q1

U1

U2

U1 < U2

Q’1

Q’2

Slope=MRS

Consumer TheoryOptimal Choice

Q1

Q2

Q*1

Q*2

U*dQ2 / dQ1 = - P1 / P2

Consumer TheoryThe Consumer Problem

Max U(Q1, Q2) subject to P1.Q1 + P2.Q2 = M

leads to the First Order Conditions:

MU1 / MU2 = MRS = P1 / P2

P1.Q1 + P2.Q2 = M

thus deriving:

Q1 = Q1 (M, P1, P2) - P1 = Q1(P1)

Q2 = Q2 (M, P1, P2) - P2 = Q2(P2)

Inverse Demand Funcions

Technology and CostsInternal Efficiency

Min C = w.L + r.K subject to Q = Q(L, K)

Leads to: C = C(Q, w, r) = C(Q)

Average Cost: AC = C(Q) / Q

Marginal Cost MC = dC(Q) / dQ

Short Run: CSR = r.K + w.L(Q) = FC + VC(Q)

ACSR = FC / Q + VC(Q) / Q

MCSR = dVC(Q) / dQ

Technology and CostsFixed and Variable costs

Q

C

CSR

VC

FC

Technology and CostsShort Run Average Costs

QQ

QQ

AC AC

AVC

AFC

AC

Technology and CostsLong Run Average Costs

Q

AC

ACLR

ACSR (K1)ACSR (K2)

Q1 Q2

Technology and CostsMarginal Costs and Firm Supply

Q

P P = P(QS) = MC

P*

Q*

AC (Q)AC(Q*)

Perfect CompetitionShort Run Market Equilibrium

DS

S’

MCi

ACi

Q (Market)Q Q’ Q (Firm i)QiQi’

P

P’

MonopolyMarket Equilibrium

AC

MC

DMR

PM

ACM

PPC

Q

P

QM

M

QPC

Welfare Loss from Monopoly

AC

MC

DMR

PM

PPC

P

M

M

C

M’

Oligopoly:Reaction Curves and Isoprofit Lines

Q1

Q2

Reaction Curve - f2 (Q2)

Isoprofit Lines - firm 2

Q1

Oligopoly:Stackelberg Equilibrium

Q1

Q2

Isoprofit Lines - Firm 1

Reaction curve - Firm 2 - f2 (Q2)

Q1*

Q2*

Oligopoly:Cournot Equilibrium

Q1

Q2

Q1=f1(Q2)

Q2=f2(Q1)

T

T+1

T+2

T+3

T+4

T+5

T*

Oligopoly:Quantity Games

Stackelberg Equilibrium

Follower’s Problem: Max 2 = P(Q1+Q2).Q2 -C2(Q2)

yielding the Reaction Function: Q2 = f2(Q1)

Leader’s Problem: Max 1 = P(Q1 + f2(Q2)).Q1 - C1(Q1)

Equilibrium: dQ2 / dQ1 = df2 / dQ1

Cournot Equilibrium

Max 1 = P (Q1 + Q2).Q1 - C1(Q1) yields Q1 = f1(Q2)

Max 2 = P (Q2 + Q1).Q2 - C2(Q2) yields Q2 = f2(Q1)

Equilibrium: f1(Q2) = f2(Q1)

Oligopoly:Collusion

Cartel’s Problem:

Max P(Q1+Q2).(Q1+Q2) - C1(Q1) - C2(Q2)

yielding:

MR = P + (dP / dQ).Q = MC1 = MC2 with Q = Q1 + Q2

and:

d1 / dQ1 = P + (dP / dQ).Q1 - MC1 = - (dP / dQ).Q2 > 0

d2 / dQ2 = P + (dP / dQ).Q2 - MC2 = - (dP / dQ).Q1 > 0

(incentive to break the agreement)

Corporate Analysis

Firm Behaviour and the Determinants of Market Structure

Lecture Slides

Rui Baptista

Performance

• Efficiency in Production

• Efficiency in Resource Allocation

• Productivity and Quality

• Technological Progress

• Macroeconomic Stability and Employment

• Equity

Basic Conditions

• Technology

• Accessibility of Raw Materials

• Product Characteristics

• Price elasticity and Substitutes

• Life-Cycle

• Seasonality of Demand

Market Structure

• Concentration

• Cost Structures

• Barriers to Entry

• Vertical Integration

• Diversification

• Product Differentiation

Firm Conduct

• Pricing Competition (Rivalry vs. Collusion)

• Product Strategy and Advertising

• Research and Innovation

• Investment in Production Capacity

Public Policy

• Taxes and Subsidies

• Trade Policy

• Regulation and Price controls

• Anti-Trust Laws

• Public Ownership

Basic Conditions Determining Market Concentration

• Economies of Scale

• Indivisibilities

• Learning Economies

• Product Life-Cycle

Firm Strategies Leading to Concentration

• Rivalry and Co-operation

• R&D Strategies

• Product Differentiation Strategies

• Barriers to Entry Strategies

Government Strategies Leading to Concentration

• Trade Policy - Promoting Competitiveness

• Development Policy - Protecting Infant Industries

• Patents and Technology Policy

• Regulation of Natural Monopolies

Market structure and the Intensity of Price Competition

Nature of Market Structure Range of H Intensity of Competition

Close to PerfectCompetition

below 0.2 Fierce, depending onproduct differentiation

Oligopoly 0.2 to 0.7 Fierce or light, dependingon the degree of collusion

Close toMonopoly

above 0.7 Usually light, unlessthreatened by entry

Vertical Integration: The Value Chain

Primary Activities• Inbound Logistics

• Manufacturing Activity

• Outbound Logistics

• Marketing and Sales

• Customer Service

Support Activities

• Procurement

• Technology Development

• Human Resources Management

• Infrastructure Activities

Determinants of Vertical Integration

• Localised Economies of Scale

• Efficiency and Innovation

• Agency and Influence Costs

• Transaction Costs:– Co-ordination– Information– Market Imperfections

Determinants of Product Diversification

• Economies of Scope

• Scale Economies and Market Size

• Capital-Raising Economies

• Pricing Strategies

• Departmental Inefficiencies

• Agency and Influence Costs

• Managerial Diseconomies

Sources of Scale Economies

• Technological Indivisibilities

• Increases in the Productivity of Variable Inputs

• The Need for Inventories

• Physical Properties of the Processing Units

• Marketing, Purchasing and R&D Costs

• Experience and Learning Economies

Structural Conditions Facilitating Oligopolistic Co-ordination

• Environment and Business Attitudes

• Market Concentration

• Conditions Affecting the Speed of Detection and Reaction

• Asymmetries between Firms

• Multimarket Contact

Behavioural Conditions Facilitating Oligopolistic Co-ordination

• The Nature of The Adopted Strategies

• Price Leadership Practices

• Advance Public Announcements

• Most Favoured Customer Clauses

• Uniform Delivered Prices