Second part of the Summary Principles of Microeconomics written in 2013-2014.

Chapter H: Imperfect competition and market power and its consequences

Price setter: a firm with at least some latitude to set its own price

Imperfect competitive firms: that are firms that differentiate their products from those of their rivals, with whom they compete.
They are price-setters rather than price-takers (firms that have some control over price)

Forms of imperfect competition:

• Pure monopoly: the only supplier of a unique product with  no close substitute, they are the most inefficient form.
• Oligopoly: a market in which a few rival firms produce reasonably close substitutes. More efficient than a monopoly.
• Monopolistic competition: a large number of firms that produce slightly differentiated products that are reasonably close substitutes for one another. Closest to perfect competition.

The difference:

• Perfectly competitive firm: if a firm raises its price, all its customers will buy from its many identical competitors. (Straight horizontal demand curve), and also perfect elastic demand.
• Imperfectly competitive firm: if a firm raises its price, its customer do not have a perfect substitute and so some of them still buy (downward-sloping demand curve)

Perfect competition:

1. supply and determine equilibrium price
2. the firm has no market power
3. the firm sells all it wishes at the equilibrium price
4. sales will be zero if the firm raises its price, sales will not increase if the firm lowers its price
5. the firm’s demand curve is the horizontal line at the  market price

Imperfect competition:

1. the firm has some control over price or some market power
2. the firm faces a downward-sloping demand curve

Market power: the firm’s ability to raise the price without losing all sales because of the 5 sources.

The 5 sources of market power:

• exclusive control over inputs
• patents and copyrights
• government licenses or franchises
• economies of scale
• network economies

If a firm doubles all its factors of production, what happens to its output?

OR

• Constant returns to scale: when all inputs are changed by a given proportion , output changes by the same proportion

OR

• Increasing returns to scale: when all inputs are changed by a given proportion, output changes by more than that proportion. Also called economies of scale

Natural monopoly: a monopoly that results from economies of scale

The importance of fixed costs: firms with large fixed and low variable cost have:
- low marginal cost (mc)
- sharply declining average total cost as output increases
- economies of scale

With economies of scale, increased production leads to lower average total cost.
à Average costs declines and is always higher than marginal cost.

Total and average total costs with economies of scale:
à Total cost rises at a constant rate as output rises.
TC = F + MQ
F= fixed costs
à Average costs decline and are always higher than marginal costs. (Increased production leads to lower average total costs)
ATC = F/Q +M

Marginal revenue: the change in a firm’s total revenue that results from a one-unit change in output. In the perfectly competitive firm, it is exactly equal to the market price of the product.

Perfect competition and monopoly should:

• increase output when MR>MC
• calculate mc the same way
• do not have the same MR at a given price: MR=P in perfect competition, MR

   

Marginal revenue for the monopolist:
The monopolist’s benefit to selling an additional unit is lower than the price because he has to reduce his price to existing customers in order to sell more.
à MR declines as quantity increases
à prices must be lowered to sell an additional unit: MR

Demand curve: P = a-bQ
Total revenue: TR = total sales- PQ= aQ-bQ²
Marginal revenue: TR’ = dTR/dQ = MR = a-2bQ

Total cost = TC = fixed costs + variable cost = c + dQ
Marginal cost per unit = dTC/dQ = MC = d

Maximise profit: continue increasing production Q until MC=MR
D= a-2bQ       or         Q= (a-d)/2b

P=a-bQ = a-b(a-d)/2b = a – (a-d)/2 = (a+d)/2

Profit maximisation for monopoly and perfect competition:

• Profit is maximised at the level of output for which marginal revenue precisely equals marginal cost (monopoly). Being an monopolist does not guarantee an economic profit.
• Profit is maximised at the level of output for which marginal cost equals the market price (perfect competition)

The invisible hand versus perfect competition:

Monopoly:

• Profits are maximised where MR=MC
• P>MR
• P>MC
• Deadweight loss (i.e. no social optimum)

Perfect competition:

• Profit are maximised where MR=MC
• P=MR
• P=MC
• No deadweight loss (i.e. social optimum)

Social efficiency is achieved at the output level at which the market demand curve intersects the monopolist’s marginal cost curve.

Since the monopolist’s marginal revenue is always less than the price, the monopolist’s profit maximising output level is always below the socially efficient level.

Measuring market power:

1. Concentration index
2. Simple approach (e.g. percentage of sales of 3 or 4 largest companies)
3. Hirshman-Herfindahl index(HHI): sum squares shares of firms in the market
4. Lerner index

HHI: Measure of concentration

• 1 firm with 100% market share (a monopoly: HHI = 1²
• 2 firms with each 50% market share: HHI = 0.5² + 0.5² etc....

Lerner index: an indicator of a firm’s market power, and the market power of a group of firms in a market. It describes the relationship between marginal cost and price.

L= (p-MC)/P

In perfect competition:
P=MR=MC and L=0
As a firm’s market power increases, L increases, with a theoretical maximum value of 1 as(P-MC) > P

High contestability: implies prices being driven down towards average cost

Price discrimination: the practice of charging different buyers different prices for essentially the same good or service.

Examples of price discrimination:

• Senior citizen and student discounts on cinema tickets and art galleries
• Rebate coupons offered by supermarkets and other retailers
• Airline bookings in advance

Perfectly discriminating monopolist: a firm that charges each buyer exactly his or her reservation price:

3 degrees of discriminating:

1. First-degree: a firm that can sell each unit it produces at its reservation price.
à economic surplus is maximized
à consumer surplus is zero
à economic surplus= producer surplus

2. Second degree: a firm with market power that can discriminate between groups of purchases in a market.

3. Third-degree: a firm that can segment whole markets.

Limitations to perfect price discrimination:

• Information on each buyer’s reservation price
• Possible reselling

Problems to implementing this pricing strategy:

• Seller does not know the reservation prices
• Seller must separate high and low price buyers
• Notions of fairness and equity

Hurdle method of price discrimination: the practice by which a seller offers a discount to all buyers who overcome some obstacle.

Perfect hurdle: a threshold that completely segregates buyers whose reservation prices lie above it from others whose reservation prices lie below it, imposing no cost on those who jump the hurdle.

X-efficiency: where market power results in inefficient production rather than higher profits.

Cost-plus regulation: A method of regulation under which the regulated firm is permitted to charge a price equal to its explicit costs of production plus a mark-up to cover the opportunity cost of resources provided by the firm’s owners.

RPI-X approach: the price may rise only at X percent less that the inflation rate

Rate of return: lays down the maximum profits a supplier may earn by reference to the capital employed.

Chapter I: thinking strategically (1): Interdependence, decision making and the theory of games

The payoff to many actions will depend on:

• The action themselves
• When the actions are taken
• How the actions relate to actions taken by others

Basic elements of the game:

• The players
• The strategies available to each player
• The payoffs each player receives for each possible combination of strategies

Payoff matrix: a table that describes the payoffs in a game for each possible combination of strategies.

Types of strategies:

• Dominant strategy: one that yields a higher payoff no matter what the other players in a game choose.
• Dominated strategy: a strategy available to a player that yields a lower playoff than some other strategy

Prisoner’s dilemma: a game in which each player has a dominant strategy and, when each plays it, the resulting payoffs are smaller for each than if each had played a dominated strategy.

Nash equilibrium: any combination of strategies in which each player’s strategy is his or her best choice, given the other player’s strategies.

• If each player in a game has a dominant strategy, equilibrium occurs when each player follows that strategy
• However, there can be an equilibrium when players do not have a dominant strategy

Repeated prisoner’s dilemma:

• a standard prisoner’s dilemma that confronts the same players repeatedly.
• Cooperation between players will increase the payoffs in a prisoner’s dilemma
• There is a motive to enforce cooperation

Tit-for-tat: a strategy for the repeated prisoner’s dilemma in which players cooperate on the first move. Then mimic their partner’s last move on each successive move.

Decision tree/game tree: a diagram that describes the possible moves in a game in sequence and lists the payoffs that correspond to each possible combination of moves.

Ultimatum bargaining game: one in which the first player has the power to confront the second player with a take-it-or-leave it offer.

Credible threat:  a threat to take an action that is in the threaterner’s  interest to carry out.

Credible promise: a promise that is in the interests of the promisor to keep when the time comes to act.

Commitment problem: a situation in which people cannot achieve their goals because of an inability to make credible threats or promises.

• Prisoner’s dilemma
• Ultimatum bargaining game
• Remote office

Commitment device: a way of changing incentives so as to make otherwise empty threats or promises credible.

• Underworld code of omertà
• Military arms control agreements
• Tips for waiters

The strategic role of preferences:

What would be your first offer in the ultimatum bargaining game?
à If narrow self-interest is not the only motive for making choices, then other motives must be understood to predict and explain human behaviour.

Preferences are solutions to commitment problems:

• Concerns about fairness, guilt, honour, sympathy, etc., do influence the choices people make in strategic interactions.
• Commitment to these preferences must be communicated for them to influence choices

Chapter J: Thinking strategically (2): competition among the few

Interdependence and firm behaviour:

• When markets contain a small number of large firms, decisions and actions of these firms will reflect their beliefs as to the reactions of their competitors.
• Decision making reflects the understanding by firms of their interdependence
• Interdependence will affect market structure: merger and acquisition decisions & market entry and exit decisions

Examples:

• Pharmaceutical sector: investment decisions in R&D
• Supermarkets: pricing policy decisions
• Mobile telephone services: pricing and service level decisions

Cartel: a coalition of firms that agrees to restrict output for the purpose of earning an economic profit.

Backward induction: establishing second stage (or later stage) outcomes in order to see how the first stage will work out.

Basic models that can affect prices and outputs in those market:

• Market structure: the degree of similarity or difference between firms (players, in theory terms) and the number of firms
• Beliefs: the outcome reflected the knowledge and beliefs of each players about the other
• Competition: firms also differ as to how they compete, usually reflecting the products they are engaged in producting.

1. Cournot competition: if firms compete by setting quantities
2. Bertrand competition: if firms compete by setting prices

Reaction function: shows the preferred/best response of a firm in terms of a decision variable as a response to a value of that variable chosen by the other firms.

Residual demand: demand that could be met by the firm if it decides to produce output and sells it. It is the difference between the existing level of production and the level of production at which P=MC, AC for all firms

Collision: forming a cartel, or equivalent, which increases profit, but also prices to the consumer

Competition: independent decision making by firms, which means lower prices and higher consumer welfare.

Leaders and followers: firm’s beliefs and timing affect the outcome in an oligopolistic market

Nash equilibrium: where the 2 curves intersect:
Q1 = Q x 1 (Q2)
And Q2= Q x 2 (Q1)

Duopoly output: Nash equilibrium is lower than the perfectly competitive output and higher than the monopoly output.

Nash equilibrium for equal sized firms:

Q= (N/N+1)Qpc
N= number of equal sized firms
Qpc= the output level associated with perfect competition.

More concentrated markets mean higher prices and lower output

Betrand competition: firms choose a price and accept that quantity sold depends on demand at that price.

Betrand paradox: for 2 similar firms producing a highly substitutable output, the Nash Equilibrium in prices is P=MC. As long as there are at least 2 players, the perfectly competitive price emerges.

Edgeworth critique: The economist demonstrated that if the firms face rising marginal cost, or, a capacity constraint such that neither can supply the entire market at competitive prices, then price will not be driven down to average cost, and firm prices can differ.

Tacit collusion: firms behaving in a manner that resembles what might emerge from a collusive agreement because they recognise their interdependence.

Chapter K: Externalities and property rights

External cost/negative externality: a cost of an activity that falls on people other than those who pursue the activity.

External benefit/positive externality: A benefit of an activity received by people other than those who pursue the activity.

Observations:

• Externalities reduce economic efficiency
• Solutions of externalities may be efficient
• Government intervention or other collective action may be effective when efficient solutions to externalities are not possible

Externality: an external cost or benefit of an activity

Inoculation:

• Positive externality: it confers benefits on others at no cost to the decision maker, benefits that do not increase the welfare of the decision maker
• Negative externality: imposing costs on others at no cost the for the person undertaking the action.

No externality: the optimal level of an activity for the individual is the socially optimal level of the activity.

Positive externality: the level of the activity will be less than the social optimal level.

Negative externality: the level of the activity will be higher than the social optimal level.

Inefficient: a situation is inefficient if it can be rearranged in a way that would make at least some people better off without harming other. In this situation there is cash on the table.

Coase theorem: if at no cost people can negotiate the purchase and sale of the right to perform activities that cause externalities, they can always arrive at efficient solutions to the problems caused by externalities.

The optimal amount of negative externalities is not zero: the socially optimal level of pollution reduction.

MB and MC almost always intersect below the maximum amount of pollution reduction.

Tragedy of the commons: the tendency for a resource that has no price to be used until its marginal benefit fails to zero.

• When no one has the property right the opportunity cost of using the property is not considered. The use of the property will increase until MB=0
• The problem of unpriced resources: tropical rainforests, fisheries
• One person’s use of the commons imposes an external cost on the others by making the property less valuable: national and/or EU Fisheries policy

Positional externality: occurs when an increase in one person’s performance reduces the expected reward of another in situations in which reward depend on relative performance.

Positional arms race: a series of mutually offsetting investments in performance enhancement that is stimulated by a positional externality.

Positional arms control agreements: an agreement in which contestants attempt to limit mutually offsetting investments in performance enhancement.

Chapter L: The economics of information

The invisible hand theory:

• Assumes buyers are fully informed about how to spend their money (transparency)
• Consumers must employ strategies for gathering information but are never really fully informed

The free-rider problem: an incentive problem in which too little of a good or service is produced because non-players cannot be excluded from using the good.

2 guidelines for rational search for information:

1. Additional search time is more likely to be worthwhile for expensive items than cheap ones
2. Prices paid will be higher when the cost of a search is higher

The gamble inherent in search:

• There are additional costs and uncertain benefits when engaging in further search
• Therefore, there is a degree of risk or gamble from the search

Determining whether or not to gamble: compute the expected value.

Expected value of a gamble: the sum of the possible outcomes of the gamble weighted by their probability of occurrence.

Fair  gamble: a gamble whose expected value is zero

Better-than-fair gamble: one whose expected value is positive.

Risk-neutral person: someone who would be willing to accept any fair gamble (or better than fair gamble)

Risk-averse person: someone who would refuse any fair gamble.

Asymmetric information: where buyers and sellers are not equally informed about the characteristics of products or services.

Lemons model:  George Akerlof’s explanation of how asymmetric information tends to reduce the average quality of goods offered for sale.

Example:

• People who have below average cars are more likely to sell hem
• Buyers know that below-average-cars are more likely to be on the market that good ones and lower their reservation prices
• Because used car prices are low, people with good cars keep them longer
• The average quality of used cars falls even further.

The credibility problem in trading: people tend to interpret ambiguous information in ways that promote their own interests.

Costly-to-fake principle: to communicate information credible to a potential rival, a signal must be costly or difficult to fake.

Statistical discrimination: the practice of making judgements about the quality of people, goods or services based on the characteristics of the groups to which they belong.

Adverse selection: the pattern in which insurance tends to be purchases disproportionately by those who are most costly for companies to insure.

• It raises premiums
• It reduces the number of low-risk policy holders
• It increases the risk level of insured

Moral hazard:  the tendency of people to take greater risks when they are protected from the full consequences when the risk turns out badly.

Chapter M: Labour markets, income distribution, wealth and poverty

Marginal physical product, or marginal product of labour (MP): the additional output a firm gets by employing one additional unit of labour.

Value of marginal product of labour (VMP): the money value of the additional output a firm gets by employing one additional unit of labour.

VMP: number of products a worker produces (marginal) multiplie by the selling price.

The number of workers should be expanded till the VMP is lower than the labour market wage.

Human capital theory: a theory of pay determination that says a worker’s wage will be proportional to his or her stock of human capital.

Human capital: an amalgam of factors such as education, training, experience, intelligence, energy, work, habits, trustworthiness and initiative that affect the value of a worker’s marginal product.

Labour union: a group of workers who bargain collectively with employers better wages and working conditions.

Monopsony: firm is the only buyer of labour

Monopoly: firm is the only seller of the product

Compensating wage differential: a difference in the wage rate (negative or positive) that reflects the attractiveness of a job’s working condition.

Employee discrimination: an arbitrary preference by an employer for one group of works over another.

à discrimination is costly because competitive markets penalise firms with higher than necessary costs.

Customer discrimination: the willingness of consumers to pay more for a product produced by members of a favoured group, even if the quality of the products is unaffected.

Winner-take-all labour market: one in which small differences in human capital translate into large differences in pay.

Gini coefficient: a measure of equality of distribution that compares the actual distribution with a benchmark of absolute equality.

• 0 = perfect equality
• 1 =  perfect inequality

Lorenz curve: the graph of the cumulative distribution of income or wealth by percentages from poorest to richest.

Redistribution takes place through 1 or 2 channels:

1. Tax structure: those with greater resources pay more for the services provided to all, or to some (progressive)
2. Composition of public spending:  providing income or services to those with fewer resources.

In-kind transfer:  a payment made not in the form of cash, but in the form of a good or service

Monetary transfers: consists of cash payments to recipients who are designated by some standard as entitles to the payment. E.g. non-contributory old age persons/children’s allowances.

Means-tested: a benefit programme whose benefit level declines as the recipient earns additional income.

2 counter-arguments supporting universalist approach:

1. It is significantly more costly to devise, administer and modify a social spending programme that is based on establishing recipient qualifications to receive transfers.
2. It is kinder and more effective to support people in need without requiring them to devote time and resources to proving that they meet the legal requirements of an entitlement à poverty trap

Applying income tax to any universal social-support programme receipts has the effect of:

• Ensuring that the benefits flow preponderantly to those on lower incomes
• The level of payment can be increased without increasing taxes generally

Negative income tax (NIT): a system under which the government would grant every citizen a cash payment each year, financed by an additional tax on earned income.

Poverty threshold: the level of income below which a family is poor.

The earned-income tax credit (EITC): a policy under which low-income workers receive credits on their income tax even if they have paid more.

Chapter N: Government in the market economy: public sector production and regulation

Public good: a good or service that, to at least some degree, is both non-rival and non-excludable

Merit goods: goods produced under non-market conditions by the state for political reasons.

Efficiently: the quantity being produced being that for which marginal benefits equal marginal costs.

Non-rival good: a good whose consumption by one person does not diminish its availability for others.

Non-excludable good: a good that is difficult, or costly, to exclude non-payers from consuming.

Pure-public good: a good or service that, to a high degree, is both non-rival and non-excludable.

Collective good: a good or service that, to at least some degree, is non-rival but excludable.

Free-rider problem: many people are willing to pay enough to cover the cost of producing the good, but if it is non-excludable, the company cannot easily charge for it.

Pure private good: one for which non-payers can easily be excluded and for which each unit consumed by one person means one unit fewer available for others.

Pure common good: one for which non-payers cannot easily be excluded and for which each unit consumed by one person means one unit fewer available for others.

• Private goods: rival and excludable
• Public goods: non-rival and non-excludable
• Common goods: rival and non-excludable
• Collective goods: excludable but non-rival

The benefit of an additional unit of a private good is the highest sum that any individual buyer would be willing to pay for it.

The benefit of an additional unit of a public good is the sum of the reservation prices of all people who will watch that episode.

Poll tax: a tax that collects the same amount from every taxpayer

Regressive tax: a tax under which the proportion of income paid in taxed declines as the income rises.

Proportional income tax: one under which all taxpayers pay the same proportion of their incomes in taxes.

Progressive tax: one in which the proportion of income paid in taxes rises as income rises

Regulation: legal intervention in markets to alter the way in which firms or consumers behave.

Market demand: the horizontal sum of individual demands. The total amount consumed for a given price.

Public good demand curve:  the vertical summation of the individual demand curves.

A pure public good should be provided by the government only when the benefit exceeds the cost.

The cost of the public good: the sum of the explicit and the implicit costs incurred to produce it.
The benefit of the public good: the sum of the reservation prices of all people who want the good.

Emission trading: a system whereby firms can trade emission reductions, with the result that any given level of emission reduction is undertaken by those with the lowest costs of achieving reductions.

Chapter O: the credit crunch and the great contraction: an application of some microeconomics to help explain a macroeconomics crisis.

Sub-prime mortgage: a mortgage that involves a loan to a person or household with a high risk of default and/or without evidence of ability to repay.

Recession: loosely, when economic activity, output and incomes fall below full capacity output and income. Defined as 2 or more successive quarters of economic contraction or negative growth in gross domestic product (GDP).

Financial intermediary: a firm that accepts deposits or otherwise obtains funds in order to lend to firms (or households). E.g. banks, credit unions, life insurance and pension providers.

Gearing: the ratio of debt to equity finance on a firm’s balance sheet. High gearing means the firm holds a high proportion of its assets by virtue of having borrowed to buy them rather than using shareholders’ capital to do so.

Light-touch regulation: a regulatory regime that lays down general rules affecting firm’s operations, and excludes tight restrictions and refrains from day-today supervision and control of those operations.

Securisation: the creation of a financial asset that can be sold to investors, where the issuer of the assets uses financial liabilities of other firms or of households as the asset backing the asset being created.

Financial conglomerates: financial sector firms that operate in several financial markets. E.g. day-to-day banking, insurance and stock exchange transactions.

Volatility: the degree of variability in the market price of an asset over time.

Liquidity: the ease of realizing a known capital value of an asset.

Repo/rediscount rate: this is the interest rate that the central bank charges on funds lent to banks who need funds and can offer certain securities as collateral. It is the base rate to which other interest rates are related.

Systemic risk: the possible impact of an adverse event on the entire financial system as opposed to the effect on the bank directly affected.