Management Engineering - Business & Industrial Economics

Complete Course Notes

Complete course

1 052909 - BUSINESS & INDUSTRIAL ECONOMICS (GRILLI LUCA) 24/02 Efficiency, coordination and economic organization “Economic organizations are created -entities within and through which people interact to reach their goals ” -Milgrom and Roberts. This definition is sufficiently general to embrace what is commonly intended with an economic organization, but we like it because it contains some elements which are hidden and conceal which is nevertheless make it more visible and apparent. The first el ement is that economic organization are instruments , they are created entities, they are humanly device tool to reach some goals . With goals we intend economic goals, the satisfaction of economic needs in term of consumption of goods and services. It is im plicitly said that all economic agents that set up these organization should know what is best for them, and what they like the most (they should have a precise order of preferences). The other element which is important to stress is the fact that all ec onomic organization make sense in the real world because we live in a world of scarcity of resources , scarcity of both input and goods to be produced. If everything was clearly available we would not need any economic organization to satisfy our economic n eed. With scarcity, we mean a within individual scarcity and also scarcity between individual . Ex if I want to consume something more, given my income, I have to give up something else. Or we can say that the increase of our utility, level of satisfaction, may come at the expense of another individual. This is the between component of scarcity. We may identify the most important economic organization which we will encounter. The whole economic system is an economic organization which can be divided in different layers (national, regional, local etc). The whole economic system is made of a collec tion of different markets. We have to think of it as a matriosca , for whatever good and services. Within market there are 2 different actors, firms and individuals. Firms are not the only economic organization involved in the function of market, but there are also other organizations such as association of firms, association of consumers, regulatory agencies, labor unions etc. To keep things simple, in the first place we will focus on firm as the main economic organization acting in markets. Here it is a graphical representation of what we just said. All markets are interconnected one with the other in one economic system. The choices that firms and individual s are making in one market affect the other market and then the whole economic system. If we choo se to consume more of A we have to give up the consumption of good B. If we want to consume more we have to give up the consuption of spare time and work more. If firms want to increase their production they have to increase more the labor input . Everythin g is very interconnected and interelated. 2 How as a sociey can we choose what is the best preferred allocation of resources and goods given the infinite spectrum of possibilities available? We will never have a proper answer to this question, but we can give some guidelines that may remove the fog surrounding this possible answer. This is the very famous Pareto efficiency criterion, “an allocation of resources A is inefficient if there is some other available allocation B that everyone concerned likes at least as A and that one person strictly prefers. In such a case A is Pareto dominated by B (B is Pareto superior to A) and it is clearly wasteful from a society poin t of view. Otherwise A is said to be Pareto efficient (or Pareto optimal). ” Suppose the situation where we have A and B. there are just 5 individuals, we say that A is pareto dominated by B if the utility level, level of satisfaction, in scenario A is equa l for the first 4 individuals, but at least one individual, the 5 th one, has a greater level of satisfaction with respect to the situation A. The we can say that B pareto dominates A. In a case in which the first individual in B gains less than A we can s ay that both these 2 allocation are pareto efficient, because we can’t move from A to B without decreasing the level of utility of an individual. If we say that the first individual is indifferent between A and B and there is at least one individual in B that gains more in term of utility than situation A, we can say that B pareto dominates B. Two remarks: • This criterion does not contemplate fairness, in other words, in situation where, like in scenario A, 4 people ga in more than in B and only one person gains less, according to pareto these are both efficient . Giving all the resources to one individual, from a pareto stand point does not allow us to discriminate whether one scenario is better than the other. • In any economic system there could be mu ltiple pareto efficient allocation of resources, there is not only 1 pareto efficient allocation, but there could be multiple. Pareto efficiency has not a very good predictive power in fact it cannot say whether a pareto efficiency will emerge from a give n situation. However it is not totally absent, because of the Efficiency Principle , which says: If people are able to bargain together effectively and can effectively implement and enforce their decisions, then the outcomes of economic activity will tend t o be efficient (at least for the parties to the bargain). What does it mean? In the first situation we saw, referring to the pareto efficiency, the first 4 individuals are indifferent in the level of satisfaction between scenario A and B, if at least one person gains more in scenario B than A the efficiency principle tells us that endogenously, if the market is stuck in this situation, everyone will migrate toward the efficient configuration. This is what we mean with the efficiency principle. It is in tuitive to understand why, we will not have any force in blocking us from the migrating from A to B. 3 The efficiency principle tells us that in the long run inefficient allocation will be left. we should not observe pareto dominated situation. Most of t he external intervention that we see occur in market are in situation in where this efficiency principle cannot work because there are not pareto dominated situation, but there are situation that we have already depicted. In example we already thing, where 4 ind ividuals are better off in scenario A, while only the 5 th player is better off in scenario B. In any case A is important to be implemented because more people stay better than scenario B, but the migration from B to A will not occur endogenously in t he system there should be an external force that intervene and forces the migration from B to A. If this is an example of monopoly, where the 5 individuals are economic organization and the 5th organization is gaining a lot of money at the expense of consumer, consumer, the first four individuals, may migrate to a more competitive market where they can acquire the good to a lower price, but the firm has not interest in the migration. If we want that this the situation to be applied in the real world , there is the need of an external force intervening Edgeworth Box and the gains from Trade To highlight in a more structured way the benefit of trading and, why this migration toward pareto superior a llocation is to some extent possible we will use a very classical tool which is the Edgeworth Box . This tool has a positive side effect that it will useful to us when we will deal with the second market imperfection, externalities. Suppose that there are 2 consumers and the 2 goods, 1 and 2. The 2 consumers with the Greek letter omega we identify the endowment allocation on these 2 goods among the 2 consumer. ΩA=( 6,4) Ω B=( 2,2) In this system we have 8 units of good 1 and 6 units of goods 2. We c an build the Box ew put the total of good one in the x -axis. And on the y -axis we put the total unit of good 2. The box includes all the feasible allocation between the 2 consumers. And of course it includes the before trading allocation. The endowment all ocation. Consumer A has 6 units o f good 1 and 4 of good 2 and consumer B has 2 units of both. We measure the orgin for consumer A on the lower left angle and the origin for consumer 2 on the upper right angle and the endowment 4 location is represented by the gr een dot. We can denote with x all the feasible allocation, that are not the endowment allocation which are signed with omega . The allocation to be feasible the following inequalities needs to be respected . This is another possibility inside the box, where consumer A reduces the consumption of both goods and consumer B increases the consumption of both goods. Which among the feasible allocation can make both consumer better off, or which other allocation will be blocked by one of the 2 consumers? In this graph B will be very happy to move from the green to the black dot. To answer to this question we need to introduce the preference of the 2 consumers and in particular the concept of the indifference curve. The indifference curve is a graph that shows the combination of 2 goods that bring to the consumer the same level of utility. If prefer ence are said to be well behaved. The one in the picture is the typical shape . This shape is based on 3 assumptions: • Preferences should be monotonic . Also called non satiety assumption the more the better. The consumer never reach a satiety point . Moving to a higher indifference curve is always better to the consumer . Monotonic preferences explain why indifferent curves are negatively sloped, because in order to be on the same indifference curve you have to give up 5 the consumption of the other good. • Convex preferences . (which is the condition seen in the graph above ). It means that instead of a situation where we have a vertical line on the x axis, and we consume up to an infinite value of good two and a small quant ity of good 1 and also the reversal, the customer will prefer a balanced mix among the 2. • Transitivity of preferences, indifference curve never cross one with the other. These are different bundle of the 2 goods. The bundle x is indifferent to bundle y and it is also indifferent to z. Since the transitivity of preferences is in place should be indifferent to z. The all should lie on the same indifferent curve. We have the the indifference curve also for consumer B, which is upside down . Now in the box we have the 2 indifferent curves. In addition we can say that the 2 customers are better off in between the 2 indifferent curves . Let’s make a focus on that tiny space and how to arrive at that tiny space, we arrive it by transacting. Consumer 1 sell to 2 one product for another one , hence we move from the green dot to the orange one. The transaction movement may be further exploited and the process of tranding will end up when the 2 indifferent curve will be tangent to each other. 6 W e arrived to the pareto efficient equilibrium, but that specificity was really depended on our starting point , in term of endowment allocation, different endowment may lead to very different pareto efficient equilibrium and the set of all pareto efficient allocation is toward the contract curve . In the contract curve there will be all ocation which will never occur because they will be blocked by one consumer or the other. In gergon term, the limited set of pareto optimal allocation that lies on the contract curve which are achievable by the 2 consumers is called the core , it is the set of all pareto optimal allocation that are welafa re- improving for both consumers relative to their own endowment. Trade is very useful for welfare. 2 considerations The fir st consideration is related to the fact that in an intuite way we derived the 2 fundamentals theorem in welfare economics . The first theorem said any competitive equilibrium , which means an equilibrium that emerged from perfect competition, where trading competition are at their best, any competitive equilibrium will be a pareto efficient equilibrium, so allowing trade will allow the system to reach a pareto efficient equilib rium . (1st theorem of welfare economic). We just saw that. From any endowment allocation we will reach apoint in the contract curve, so a pareto efficient allocation. The 2 nd is very much the reverse if we want a specific pareto efficient solution emergin g, we have to choose the right endowment allocation and allowing trade. If we want a specific allocation in the contract curve, we need to be able to find the right endowment allocation and once we found them we just have to make people trade. Naturally th e bargaining among the 2 will lead to the pareto efficient equilibrium. We made our example of the Edward Box taking 2 consumers and 2 goods. Let’s be provocative and bring to our attention the foll owing possibility. Now A and B are not 2 consumers in str ictu senso, but they are 2 families, family A and family B. Good 2 is money, good 1 are babies. Suppose the following endowment allocation , family A they are very reach 7 but they cannot have children, while family B they are very poor, but they have many ch ildren . There are 2 indifferent curves one for family A and one for B. The same mechanism can work also here, but there is something wrong here, babies cannot be put in sale. Putting something in sale can reduce the moral and ethical value that we are attatched to the thing. It is not neutral. Trade is not only important because it enables economic agents to reach pareto efficient allocation given the amout of resources and good available, but also because it enables the system to have more goods and resources to be traded. It occurs because tra de calls into action specialization. As specialziation per se the th rou gh the theory of compa rative may increase the amount of good and and resources available in an economic system. The second reason has to deal with the fact that specialization increase productivity. The joint action of both reasons, lead to the fact that trade and specialziation may lead to a greater amount of goods and resources to be traded. The formulation of comparative advantage is due to Ricardo, an economist. Let’s see how it works. Let’s take into consideration our simplyfing framework , 2 individuals and 2 goods. Bob and Anna and fish and bananas. In 24 hours Bob can produce 10 fishes or 10 bananas. Ann has a special talent in the production of fishes 30 fishes or 10 bananas. L et’s suppose that the 2 individuals have monotonic and convex preference. Let’s suppose the first scanarion of no trade , the outcome is the following, Bob will produce 5 bananas and 5 fishes, and Ann will produce 15 fishes and 5 bananas, the total prodcuti on is made of 20 fishes and 10 bananas. It is apparent the fact that this is not the best outcome in production possibilities. If for some reason bob specializes in production of bananas and Ann in production of fishes the total amount of goods available will be made of 10 bananass and 30 fishes . Of course this second scenario is not possible in a no trade context because of the presence of convex preferences. Let’s see if trade make this scenario possible. To investigate this issue we have to introduce the concept of opportunity cost. The opportunity cost can be described as, the value that one can obtain from using that resource in the best alternative way with respect to what it is actually doing . The opportunity cost of bob which is producing 1 banana is 1 fish. The time that he devotes to produce this banana it will give up the opportunity to produce one fish. The time spent for the production of 1 banana si the same for the production of 1 fish . In an analogous way the opportunity cost of Ann to produce one Banana is 3 fish, because in this case she gives up 3 fishes to produce 1 banana. Ann will be keen of trading if for acquaring 1 bana she gives a way a little bit less than 3 fishes otherwis e she would trade with herself the same for Bob. By making this consideration we are aware of the fact that both have an interest in trading. The bargaining power is equal they will probably end up in trading 1 banana for 2 fishes. If these are the actual agreement term this is the final situation: Bob will end up with 5 bananas and 10 fishes, Ann will end up with 5 bananas and 20 fishes. All trading possibilities have been exploited , now everyone is better off with respect to the 8 first scenario, because th ey have the same quantity of bananas and the amount of fished consumed is increased. This is the spectacular part of market . The total welfare is maximized. Adam Smith says that it is better if all of us specilizes in one activity or more broadly one nati on. Specialization increases productivity , it is a statement made by Adam Smith. If we look it in an economic system, it is true that specialization enhances gains in productivity, but to make it possible it requires coordination. Time and efforts of spec ialists are wasted unless a) they can be sure about the fact that the others specialists are doing their part; and b) they will be able to buy on the market what is necessary for their needs. How do we know that coordination activity is effectively taking place? The coordination activity in fact it requires a lot of information, info about production possibility, but also preference of people. Here they comes 2 possible solution to gather as ma ny information as possible. The 2 possible solution are centralizing planning and markets enable autonomous decentralized decisions. Centralized planning is the solution used by socialist economies, when there was a social planner that collected all th e needed information of resources availability and inputs and preference of people, it set a yearly of 5 year production plan where everyone has a specified activity. There was the production and then the there was the distribution of production to the cit izens . M arkets enable autonomous decentralized decisions it is represented by the capitalistic view and it is based of free initiative of individuals. Markets are the economic organization where the needed information are. In particular, if there is only one dimension that condenses all the relevant information that is important to take action . If there is an increase in demand for a particular good the demand shifts toward North east , for this reason the price increases. The increase in price it means tha t there is scarcity in that market . Everything happens without the intervention of any external force. The market through the price is capable of highlight scarcity. Market are costless mechanism to achieve efficient allocation, because the price is the information vehicle to take decision on what to do. One important remark price s are truly informative mechanism only to the extent that these markets are perfectly competitive. An increase in price it may signal that there is marker power, monopoly oligopoly . This nature of being purely informative mechanisms is 100% true only to the extent that the market that we are talking about are perfectly competitive. An economic system is made by a collection of different market where all the choices are interconnect ed from a concept of static efficiency the white spectrum of market are all perfectly competitive it is the best outcome from a social welfare point of view. We have 4 cases of market imperfections: 9 • Market power • Externalities • Transaction costs • Asymmetric information 25/02/2022 Comparative advantage, we need to compute the opportunity cost of each good. Insights on competitive structures: The market power increases moving from perfect competition to monopoly. The market power is the ability of a firm to set a price higher than the cost faced. We have intermediate market forces such as pential competition oligopoly and dominant firm. Perfect competition A perfectly competitive market is a market where firms are price -taker, i.e. they do not determine the price to which sell their products, price is settled by the market, i.e. by the interaction of demand and supply. Here firms do not have any market power, they are price takers. They take the price that is prevalent in the market as given. No power in setting the price they wish. The price emerges from the interaction from D and S. 5 key assumptions Atomicity , each firm is like a drop in the ocean, it is really tiny compared to the size of the demand Product homogeneity , the consum er does not care whether it purchases the product from one or another firm. There has to be a perceived homogeneity by consumer. There has to be physical homogeneity. Ex, electricity. Perfect information (every agent, firms and consumers) know the price charged by every firm, each firm should observe the price charged by the other companies and the same has to do customers. Firms have access to all production technologies (for simplicity one can assume the extreme form of technology symmetry, but it’s not necessary). It is a strong assumption not always required, but it is in the analysis of this market. It is sufficiently needed that the firm has access to all the production technologies to be in the business. (not strictly necessary ) No entry and exit barriers (free entry and exit). Firms should not bear any cost to enter or exit from the market. The interplay of all these 5 assumption lead to 2 important results: firms are price takers. WHY? Product are homogeneous, if a firm raises the price the customer thanks to perfect information the customer goes to another customer. No rational firm would find convenient to raise the price. Thanks to atomicity, firms cannot collude. Since it is not sustainable. If firms lower the 10 price customer switch to him, but due to production constraint the firm cannot serve the whole market. (atomicity). Firms do not realize any extra profit. It does not mean that firm do not gain anything, because our concept of cost in economics include the annotation of opportunity cost in the employment of resources. If a firm makes extra profit, it will function as a source of signal that in that market there is the possibility to rip a positive extra profit. Since there is the assumption of no entry or exit barrier new companies will enter to the market without any cost. A new entrant will have access to the technology eroding the extra profit and leading to 0 extra profit. Having the price equal to marginal cost. P=MC=AC min In this respect a perfect competition maximizes productive efficiency, the production of the good is at the minimum possible cost. For allocative efficiency, the good is sold at the minimum possible price given the cost of the firm. Perfect competition is the best possible scenario for social welfare from a static point of view. Productive efficiency , allocative efficiency (static efficiency) and dynamic efficiency ( intrudcition of new goods and services innovation). 11 Productive efficiency : Scenario A, A is more efficient from a productive point of view, if the quantity of good produced by A if it is the same of B, but we employ less input. Allocative efficiency : same level of input in A and B, but the quantity produced and sold in A is higher than the quantity produced and sold in B. In this case we say that configuration of A is more efficient in allocative term than configuration B. Perfect competition relies on the maximum possible of the two eff iciencies. Companies produce at the minimum of the average cost curve. The MC intersect the AC at the minimum. The intersection is called minimum efficient scale . The equilibrium in perfect competition, where price is taken as given, is the intersection between Aggregate demand and aggregate supply. AD and AS. Marginal revenue, marginal cost. P*Q total revenues. There are not extra profit, the total cost include the opportunity cost. Firms would not gain nothing more in employing inputs in an alternative way. It is the different between the accounting perspective and economic perspective . If the demand in increases the AD shifts outward, leading to a higher price and higher quantity. In the AC MC P graph. The company will increase the produc tion only if there are people willing to pay an higher price. Companies are not willing to produce more if the costs are higher than prices. The MC represents the supply curve for each company. In this new scenario the companies realises extraprofit. The profit is P’ -AC. 15.17. since the extraprofit is greater than zero, firms will enter into the market and start to compete TC=AC*q. The aggregate supply will move outward, up to the former positioning. Opportunity cost Our time is a valuable resource. It can be employed in becoming a manager of a medium company, entry salary 50k, but we also have a good entrepreneur idea to find our start -up and the profit that our start up can obtain is 30k, but it is less than what we could have obt ained by being a manager. In both scenario we are obtaining something. Our extra profit by choosing to be entrepreneur is -20k. We still gain something that in economic term is like we lost 20k euros. In our framework profit=0 when we have the same revenues. The concept of social welfare can be defined with the concept of consumer’s surplus and producer’s surplus . 12 Consumer surplus , Difference between the price an individual is willing to pay to have a certain good or service and the market price for the same good or service. Producer Surplus , Difference between the price of a certain good or service paid to the producer and the price the producer is willing to accept for selling the same good or service Social welfare : consumer’s surplus + producer’s surplus. Producer surplus is represented by the sum of what are called variable profits, total revenues – variable costs (integral of the marginal cost curve). Suppose that we have to go to the cinema, we enter to the pizzeria and we ask ourselves what is the maximum price that I would pay from a slice of pizza? We are willing to pay for the first slice of pizza 4 euros since we are starving. After the first slice we are still hungry but less hungry than before, now I w ould pay less than before, 2 euro. The third slice is .50 euro. Everything is based on the fact that we have an increasing utily, but it increases at a marginal decreasing rate. How do we obtain from these aggregate demand curve from this individual aggreg ate curve? We sum the individual one the first slice of pizza, is 4 then 3 then 2 then 1.5. for this reason since there are many individual we can obtain a straight line for the demand curve. If the price set for pizza is 1 euro. The consumer surplus for consumer 1 is (4 -1)=€3. The second slice of pizza is willing to pay €2 and the partial consumer surplus is 2 -1=€1. The total consumer surplus is 4 euros. If we have different firms and their respective marginal cost curve, the aggregate MC=AS, is the horizontal sum of the quantities. In correspondence of the equilibrium price in perfect competition we have the maximum social welfare, which is the sum of consumer surplus and producer surplus. Which is the concept of variable profit. Potential competition (contestable market) In this case we do not need any atomicity assumption and we do not require to have many firms 13 in the market. We can have for example 1 firm to the market and we can have a result close to the one of PC. There are no entry or exit barriers, we need perfect information for costumers and for firms. We need an additional assumption: Time requested for the incumbent to retaliate to the entry of the new firms (by lowering price) is superior to the time needed for the entrant to make all the investment necessary to operate in the focal market.incumbent are forced to set a price close to the AC in order not to trigger profit signal. If the market is contestable we can say that every 14 extra profit will be capture by new entrants with a hit and run mechanism. If the market is contestable the number of firms is a poor predictor of the market power, and even a market with only 1 firm may behave more similarly to perfect competition rather than monopoly. Monop oly Under a monopoly there is only one firm that is in charge of serving the entire market and it faces the aggregate demand curve. We can’t assume anymore that the firm is price taker. For this reason the firm will be the price setter. How does the monopo ly chose the price for the market? Fixing a price is equal to fix the quantity that will be sell in the market since there is the connection between the quantity and the price. Quantity is the decision variable. The objective function of the firm is to max imize profit. In this case marginal revenues=marginal cost. the formula can be rearranged in term of the mark up, which is the inverse of the elasticity of demand. The monopolist will charge an higher price the more the demand curve is inelastic. The price will be close to marginal cost the higher is the elasticity of demand, hence the higher is the epsilon and the lower the margin. We will see only linear demand curve. On the left size we have a quite inelastic demand curve. On the right we have an elastic demand curve, since it is flat. The optimal price of the monopolist will be much higher in the left scenario than in the right one. Why is it the case? In the first case the demand curve is really inelastic. In the right case we have a very elastic demand curve. If we take the same price in both scenarios, and we take an increase in price. In this second scenario the quantity demanded will be reduced but not that much, while in the second case the quantity demanded will be much lower. With an elastic demand curve the monopolist is damaged a lot. The elasticity of demand is how the quantity of demand changes in percentage for any percentage change in price. with a linear demand curve elasticity is not constant along the curve. In the highest part tend to infinite, in the middle to one and in the lower part is lower than 1. If p=50 -0.8q, the inverse of elasticity is given by the derivative of the -dp/dq* q/p. ex 1/elasticity= -4/5*q/p. elasticity= -5/4*p/q. Dominant firm In market wher e there is only 1 very large firm and several large tiny firms I nterm of production capacity, we still may think that this market will not differ from a poor monopoly. The best image to give us the intuition behind this we have to see the large firm like a whale surrounded by very small fishes. These small fishes will take the prices of this dominant firm. What the big firm will do is to take into consideration the specific behaviour of the small fishes. There will be a discount of the aggregate demand, and the small companies will work on the residual demand Dr. Having 1 monopoly is better than having 2 monopolies in the market. It is better not only I nterm of social welfare. It is the so called double marginalization problem. It is an important fact explaining vertical integration across the supply chain. The double marginalizaation problem can be solved thanks to the merging of monopolies. An example which is also an exercise is: suppose that we have a monopoly in the retailer market, he faces a demand curve p=5 -1/50q. the marginal cost is constant and the supply is constant… ex slide 19. Problem of monopoly in term of social welfare 03/03 NATURAL MONOPOLY 15 We have different typology of competition structures. We have the Natural Monopoly sometimes having a monopoly is better than anything else. It is the fundamental concept of natural monopoly. It is due to the cost function that a company faces in a given company and it is called the subadditivity of cost function. When we have a technology that imply this subadditivity of the cost function, we basically have a natural monopoly. The subadditivity of cost function means assigning all the production for a given good to a single firm has less cost than partitioning this quantity that must be delivered in more than one firm. In orange is the quantity that has to be delivered in the market and it is the same in scenario a and b. having this quantity produced by one firm rather than more than one generates less cost than partitioning the production among different companies. It is important to say that scale economies are a sufficient but not a necessary condition to prove subadditivity characteristic of the cost function . Scale economies= the derivative of the average cost curve, with respect to quantity, is always negative, less than zero. Typical total cost function that lead price to a natural monopoly because this property of the subadditivity of cost function is verified. It is the so called affine total cost function , which depends on q. Whatever quantity it has to be delivered into the market making producing this quantity to a single firm, it will have a lower cost than partitioning this quantity in more than one firm. 16 If the cost function is as the one represented we are 100% we are in a natural monopoly situation, it is a sufficient, but not strictly necessary condition for the verification of the subadditivity of the cost function and then the verification of the natural monopoly. In fact we can still be in a natural monopoly even with a classical total cost curve. 17 The more we move far from the MES the less we are likely to be in a natural monopoly condition.. Which is the partition of the total quantity that it minimizes the total cost of the industry? Total Cost industry= Total Cost (X) + Total Cost (X -C). We have X is the amount of goods produced by one firm. If we had 2 companies with a total cost function of this shape, a+bq^2, the quantity where the subadditivity property of the cost function stops to hold is q= (2a/b)^1/2 which is larger than the MES. In this case we have to see which is the partition the total quantity that minimizes the 18 total cost of the industry? 19 Non è possibile visualizzare l'immagine. This inequality is verified when q< (2a/b)^1/2 and it is > (a/b)^1/2 which is the MES. The trick is to find the right partition that minimizes the TC of the industry and once we have found X we pose the inequality. As long as the inequality is verified we are in a natural monop oly 20 Who will decide which will be the relevant quantity delivered in the market? Who will decide which is the right q? (in the graph before Q1, Q2 and Q3). It will be decided by consumer. So, the relevant quantity will be represented by the point of which the aggregate demand curve intercepts the average cost curve . If the AD intercepts the AC in point A then it will be produce an amount of output equal to q1. The demand curve settles the quantity to be delivered in the market, the demand curve expresses the willingness to pay of costumers. If the willingness to pay of consumers is greater than the cost that the firm suffers from delivering this quantity to the market is convenient to carry on the product. For lower level the willingness to pay of customers is lower than the average cost, then the units do not have to be produced. For sake of simplicity let’s assume that the total cost curve is affine and therefore we are sure to be in a natural monopoly. Here the idea is to assign all the production to a single firm. What is the problem of assigning all the production to a firm? The problem is that if condition for competition is not in place, hence the single firm is not facing a real threat to be in a monopolistic position, this firm will maximize profit. The problem is that what we gain from a productive efficiency point of view in terms of the cost needed to produce that quantity we lose it in term of allocative efficiency and the price will be quite high. The monopolist would maximize the profit. The quantity produced is given by the intercept of the MR with the MC. But it will be charge the price for that quantity on the demand curve. In addition, we will observe a deadweight loss . To ensure productive efficiency without deteriorating allocative efficiency, we need ex -ante regulations the government should step in and force the price to be much lower and closer to the costs. So that the deadweight loss can be reduced. As a consequence, the producer surplus would decrease, while the consumer one will increase. There is also a reduction in profit. It is not a transfer of wealth from producer to consumer, but we also recoup the deadweight loss. The entire pie gets bigger. We say it is a deadweight loss because it is a missing opportunity in terms of trading opportunity. 21 The dimension that says us if we should deliver into a market is represented by the marginal cost curve. A price equal to MC it would maximize the social welfare and it would wipe out the deadweight loss. In regulation language it is called first best solution . The quantity of the first best solution is not implementable because by forcing a firm to fix a price equal to marginal cost give rise to negative extra profit . The total revenues in this case only cover the variable cost and there are not repaid fixed costs. If the first best solution cannot be implemented, we have a second best solution which is a price always quite close to MC, in this case the company is capable to cover both the Variable and the Fixed. It corresponds to the point where the AC intercept the Demand curve. The price will be a little bit higher. Why is the concept of natural monopoly being so important? Because it has shade and it continue to model how many industries are structured. All the pu blic utility and the network industry represent some stages of production which exhibits the subadditivity characteristic of the cost function. It is applied to gas, electricity, communication services. We will focus all over the course on gas, electricity and telecommunications. These 3 industries have 4 stages of production, which are: • Production/Generation/TLC Network service. Import of natural gas from abroad. Generation of electricity and the provision of telecommunication services • Transportation/Transmission/TLC backbone. These are the intermediate stages. Here we need a grid, a network to make the service to be delivered. Transportation, pipelines for natural gas, then we have the transmission, for electricity and the TLC backbone • Distribution/TLC local loop. Then we have the distribution stage for electricity and natural gas. In tele is called local loop. • Sale. The last stage is represented by the sale of the service All these 3 sectors were characterised in the past by the presence of natural monopoly. Before the starting of the liberalization processes, which invested all the three sectors and it started from 2000, the production of these services was demanded by a singl e firm. It was carried on by a single firm because all the stages of production were characterized by natural monopoly. A single Non è possibile visualizzare l'immagine. Non è possibile visualizzare l'immagine. 22 firm was in charge of production, transportation, distribution and sale. The 3 companies in 23 Italy are ENI, ENEL and Telecom. The production in the respective sector was assigned to a single firm. From a productive efficiency point of view was more convenient to assign all the steps of the production to a single firm. How to prevent the problem with allocative e fficiency, meaning that they could have charged a monopolistic price? First by the fact that these firms are government owned. These sectors were organized as only government owned. Why the government ownership prevent possible problem with the allocative efficiency? Because the objective function of a state -controlled firm is not the one of maximizing profit, but it is the maximization of social welfare. Starting from 2000 it was evident that the condition of natural monopoly did not hold anymor e for all the stages of production, more specifically the production and the sale stages were not natural monopolies anymore. The cost structure changed, it could not be possible to be assimilated to a natural monopoly. The natural monopoly condition was still applying to the infrastructural stages. The transportation was considered a natural monopoly as well, not in the tlc however. The distribution stages were considered a local natural monopoly. The loss of the natural monopoly for the production and the sale stages opened a de liberalization process. It was allowed to any firm to enter into this production and sale. In parallel with a De liberalization model it also stsarted a privatization model, for this government owned firms. The sh ares were offered to private. The aftermath of a de liberalization and a privatization was the set up of a regulatory agency. Government condition had to set up right from the beginning the rule of the game and to exert a control to the price set to the consumers. Agicom is the regulatory body for telecommunication. The regulatory agency need to check the price that is set to consumers. Why the upward stage and the downward stage, compered to the intermediate one were opened to competition? First of all because the NM condition no longer were not holding anymore. For two reasons: • Demand -side explanation, the reason is that we know for sure that in case of D1 we were in a natural monopoly condition, while since the demand curve moved outward we are no longer in that condition. • Supply -side explanation. Technological process made more effective and the production and the management of these services, where firms of a much more limited size than the past, then the MES shifted toward the origin. In the united states the new utility generating units by years decreased in the maximum production capacity generation. It is the example of how the MES shifted leftward. Currently the scenario is as follows, there is room for competition and make the price of the service going 24 down, thanks to market competition. Regulations The regulation of natural monopoly is an ex -ante one. We have also an ex -post regulation which is performed by the antitrust. The antitrust intervenes for the correction of anti -competitive behaviours. There are 2 important reasons which are complementary to the presence to the need of ex ante regulatory regulation in NM. The reasons for ex -ante regulation are 2: • Inelastic demand , the services which are provided by NM, they are necessity goods. They do not have substitutes and the substitute is quite imperfect. The demand will be quite rigid and inelastic. if the price of the natural gas goes up we still need to warm up the house. When a monopolist faces the inelastic demand curve, the monopoly price will be higher. • Non -redeployable investment (sunk costs), these are investments that generate value in that context, but outside this context their value is decreased if not null. We have 2 cases the redeployable investment and the non -redeployable investment . The life expectancy is 40 years. We have a depreciation rate. At the beginning the value of the asset is 100M. At the end of the life expectancy the asset it has still a value. At the middle, in 2020, with a linear depreciation rate it has a value of 50M. it is the case of a redeployable investment. If for whatever reason we want to exit the market, and we find in the condition to sell this asset we can realise the entire residual value, we recoup 50M. In case b, in case of a non -redeployable investment, and we want to exit the market in 2020, we do not realise the entire residual value of this asset, but only a portion of that. The red area get loss, loss value , why does it occur? In case of non -redeployable investment, second -hand market are highly imperfect. For 2 reasons, the specificity of the investment, it can be geographical, product related or also institutional. The number of credible b uyers, for the asset that the firm what to sell, shrinks a lot. There are not many buyers. In any transaction and the number of acquirers is low, the bargaining power shifts from the seller to the buyer. In addition, we are dealing with assets that are characterized by asymmetric information and only the seller knows the true value of the true value of the asset. When the buyer is unsure about the quality of what it is buying, he offers a low price. the presence of asymmetric information is one reason why the red area originates. The implications are the following. These market are characterized by a non -fully redeployable investments and it generates barriers to exit . There is the fear to lose all investments made in case of exit and it is best to remain in the market even if the possibility to make profit is lower. However it generates barriers to enter . The monopolist will be relatively sure that nobody 25 will enter in this market even if prices are above MC, it is another reason why there is only one firm governmentally owned. 04/03 Firm heterogeneity, market power and price discrimination Competitive Selection Model There are three stylized facts that to do combine well with the ultimate outcome of perfect competitive market. In perfect competition all firm realize the same level of profit. The extra profit in the long run equilibrium they are zero. Even in market which are competitive, there is a lot of rivalry, we observe profit differential. The level of profit is often not necessary equal for all the firms. The second result that we have in perfect competition that does not copy well in perfect competition is that in PC we observe simultaneous entry or exit of firms, but not a contemporaneous entry and exit of a firm in a market. In very competitive market we observe a lot of turbulence, with the contemporaneous exit and entry of firm. In PC either firms’ entry or exit. Third result in PC is the fact that all firms, in the long run, have the same or similar, assuming technology symmetry, firms have the same size and productivity. Conversely, in reality the observed size and productivity is differential. At the same time in the market there larger and relatively smaller firms one which are more and less productive. The idea of this model is to make PC in such a way that these effects are taken into account . It starts from the assumption that each firm, which is a potential entrant is characterized by a parameter teta which show the innate characteristics in terms of capabilities, or capacity to organize properly the production, it means that a company has a higher teta, more capable to organize the production and viceversa. It assumes that firms do not know their own teta before entering into the market. They discover if they are good by only entering into the market. All the assumptions of PC still hold. Each firm is a price taker and the objective function of each firm is to maximize profit, profit are given by TR -TC=q^2/teta. It assumes that there are not fixed costs then VC=TC. The higher teta the lower the costs and the higher profits. Time is made by several different periods, at the beginning of each a firm chooses to operate or not, once entered it has discovered its own teta. The active firm chooses how much to produce. The company chooses a quantity that maximises profits. The first order condition is q* that maximises profit. Since now the quantity produc ed is a positive function of the teta 26 parameter. The more productive firms are the ones who produce more and are larger. Profit do not need to be the same for all firms, the one with high teta, have a high level of profit. We therefore see profit differentials. The second stylized effect is therefore conciliated, because with this model, firm characterized, by a low teta, and therefore negative profits exit the market. At the same time it may still be possible, that new firms which do not know thei r own teta, will enter into the market. We have concurrent enters and exits. Monopolistic Competition “It is evident that virtually all products are differentiated, at least slightly, and that over a wide range of economic activity differentiation is of considerable importance”. There is revisitation of the 5 assumption of PC. • Atomicity • Product differentiation , product may different for some basic characteristics. Cornflakes may differ for the flavour or the packaging, degree of swee tness. This apparent small twist makes a huge difference. In perfect competition with product homogeneity, the perceived demand for each firm was a flat line, each firm knows that it can produce as long as the price that it charges is equal to MC. Hence the demand curve was flat, now it is downward sloping. An increase in price will result in a demand curve=0. Product differentiation means that the perceived demand curve for each firm will be downward sloping and when a firm faces a downward sloping curve , it has some degree of market power , some capability to decide the price to charge. o • Perfect information (every agent, firms and consumers) know the price charged by every firm. • Firms have access to all technologies. • No entry and exit barriers (free entry and exit) Demonstration of why the firm is capable of charging an higher price. suppose we are in the cornflakes industry. We have a line that indicates the preferences of consumer of a certain characteristic of cornflakes. Let’s assume that we are focusing on sweetness of cornflakes. This value goes from 0 to 1. Let’s assume that the benefit from consuming cornflakes is equal for all consumers and it is equal to u, it determines the utility that a 27 consumer has by consuming a certain type of cornflakes. Any given consumer chooses whether to consume cornflakes or not and in that case the utility that it gets from consuming cornflakes is greater than the price that it has to pay, but also t*|x -a|, distance, where x is the preference concerning the degree of sweetness, t is the transportation cost and a is the location c hoice of a firm on the axis of the sweetness. The larger is the gap from x, the less likely that the consumer will purchase that brand of cornflakes. Suppose that we have 2 firms and for the sake of simplicity. The first firm locates on the zero, where the sweetness is null, a1=0, while the other firm locates at the end of the line, a2=1. One possible situation is the following, the first firm chooses a price equal to p1, consumer which is indexed by x=0 will only consider this price. all the other who choose to buy the product from firm 1 as long as the level of the utility is greater than p+t*|x -a|. the same applies for the second firm. It can choose a price, p2, and consumer in x=1 is happy and only takes in consideration that firm. The slope of the line of the left is tx, while the slope of the line of the right is t(1 -x). Consumer which are indexed in this spectrum, x, up to the point in red will buy from the firm one, consumers up to the point in blue will buy from firm 2. The consumers in the middle will not buy the cornflakes neither from firm one nor firm 2. What is the point? From this framework we can understand how consumer have different characteristic for one feature of the product may originate the fact that the firm perceived demand cu rve is downward sloping and have some market power. First consideration is that the price can be different in the 2 firms, but still their demand curve is not null. Even if we have price differential the firm with the higher price has some demand. The firm has some market power because if they raise the price, their demand will decrease, but it won’t be zero. Here we have the demonstration on how product differentiation leads to a downward sloping perceived demand curve by the firm. The demand curve is no longer flat.The greater is the differentiation of each firm the greater is the market power and the more inelastic the firm is. Each firm perceives a downward sloping demand curve and has a demand curve, it will maximize profit. The condition is MR=MC, which is the profit maximizing quantity. In that case we have positive extraprofit. But since the condition of no entry and no entry barriers still apply, this level of extraprofit will function as a signal for entry. New firms will entry in the mar ket and will compete, with existing firms. The perceive demand curve will decrease. Clearly it will decrease, until the extra profit level is 0. In this case there is no clase of signal for entry. Basically the long run equilibrium in monopolistic competit ion will be P=AC. It is not very far from what we obtain in perfect 28 competition, but still we have some inefficiencies, from the productive and allocative. There is a productive inefficiency because now firms do not produce at the MES. They are producing less that that. It is a proliferation of firms. We have also a negative point also in the allocative efficiency POV, because price is not at the minimum anymore as we had in perfect competition, and it is above MC . It means that there are people who are willing to pay more than the cost of providing them the service. There are trading possibilities to increase social welfare, but they are not exploited. Even in the competitive selection model the results were sim ilar to PC, but as in this case some inefficiencies are produced. They stem from the fact that in any period of time some inefficient firm, which is realizing negative extra profit, is in the market. Having a negative extra profit means that those input used for the production would have higher value if used in alternative ways. Price Discrimination We will see 3 different types of price discrimination. Firms charge different prices for different consumers. Firms which have some degree of market po wer can discriminate. We are in monopoly, it has not fixed cost to bear and the marginal costs are constant. This solution, which maximizes monopoly profit, is highly inefficient from a social welfare POV. It is also inefficient for the monopoly itself. The uniform pricing produces 2 areas, which are problematic for the monopolist. The consumer surplus A and the deadweight loss B. the deadweight loss is a problem because there are people who are willing to spend more than the marginal cost that th e monopoly will suffer to provide them the good. It explains why the monopolist with a sort of market power may wish to price discriminate. The attempt is to increase the profit more than in the scenario of a uniform single price. The first price discrimination: Perfect price discrimination It is perfect because it allows the monopoly to recoup the consumer surplus and the deadweight loss. The monopoly charges a different price to each different consumer. The aim here is that the extra profit of t he monopoly increases. The profit of the monopoly also includes the deadweight loss and the customer surplus. This solution maximizes social welfare, because now all trading possibilities are exploited in the market. The area of the triangle is the maximum possible. All this pie goes to the producer and the consumer surplus is 0. The limit is that the seller has to know the precise willingness to pay for each single unit of the good and each customer . the other problem is that is difficult to prevent arbitrage , resale. The guy who is positioned belowe the price of the interception of the MR with the MC can purchase the good and resell it to the ones which are in the highest part of the demand curve. 29 With the increasing relevance of e-commerce and all the possibilities that the firms have to estimate more accurately the willingness to pay, the possibilities of 1 st price discriminination is not a curiosity anymore. On internet we do not have menu cost, it does not cost to customer to change the price. firms have the possibilities to track the purchase history record, they know what we bought. They have the possibility to implement algorithm to establish which will be our WTP. It is more a third price discrimination more than 1 type. Third degree price discrimination It deals with group pricing. Within the same group individuals pay the same. It is called selection by exogenous indication: • Age • Occupation • Geography • (Internet) Device For example people which are 40 -30. This one is a pricing strategy that respects the incentive compatibility constraint , which requires that the version that is designed for a typology of customer is bought by them. When the profit was 5800 incentive compatibilit y constraint was not respected. 33 10/03 The second degree price discrimination is applied when the third degree can’t be applied because we did not find any exogenous indication that allowed us to segment the market in submarket exhibiting different demand e lasticity. Even the end of season sale is a sort of versioning, if yo