Industrial Organization - I

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Industrial Organization - IUgo BollettaRITM, Université Paris-SaclaySeptember 17, 20211 / 67

Information and ContactsII am in office D.101 (Building D). I will schedule office hours,but you can always write me an e-mail and schedule anappointment.IMy e-mail address isugo.bolletta@universite-paris-saclay.frII will update regularly my personal web page. You can findthe link to my page from the RITM researchers/There you can find all the material we covered during lectures.2 / 67

Course informationWe will meet in class 7 times.Lectures are on Fridays from 14 to 17.No classes on the 22nd of October and the 5th of November.The textbook of reference is “Introduction to IndustrialOrganization”, by Luis Cabral.3 / 67

ExamBy attending the course, you will have all the required knowledgeto be successful in the exam. The exam takes place November, 14th (I need to verify).It will (most likely) be a mixture of small exercises, open questionsand multiple-choice questions.4 / 67

Outline1. Introduction and review of Microeconomics2. Monopoly and perfect competition3. From perfect competition to monopolistic competition4. Oligopoly and collusion5. Price discrimination6. Product differentiation7. Entry and exit5 / 67

Today’s class1. Introduction and review of Microeconomics2. Monopoly and perfect competition3. From perfect competition to monopolistic competition4. Oligopoly and collusion5. Price discrimination6. Product differentiation7. Entry and exit6 / 67

What is Industrial Organization (IO)?Question:Is it Macroeconomics? Is it Microeconomics?Hint: Who are we studying?7 / 67

What is Industrial Organization (IO)?Question:Is it Macroeconomics? Is it Microeconomics?Hint: Who are we studying?Industrial organization is a branch of microeconomics thatstudies how markets and industries work, with a specific focus onthe way firms compete with each other.8 / 67

The main ingredientsThe elements of interest in a market for IO (not exhaustive):9 / 67

The main ingredientsThe elements of interest in a market for IO (not exhaustive):IThe number of firms,Imarket power,Iregulations,Ientry and exit,Istrategic interaction.10 / 67

A real-world example: the smartphones market11 / 67

A real-world example: the smartphones market IIIThere is a finite number of firms.IFew firms detain a large share of the market (Samsung andApple).INo substantial regulations (Huawei?).IEntry is relatively hard (Vivo): maturity is important in thissector.IThe actions of firms depend on the other firms’ choices (thinkat announcement events).12 / 67

Review of some conceptsBefore jumping into the core of the course we will review togethersome core concepts.1. Supply and demand: firms’ production choices.2. Efficiency and profit maximization.3. Games and strategy.13 / 67

The demand and the willingness to pay14 / 67

The demand and the willingness to payThe demand curveMeasuring the willingness to pay (vertical axis) for a specific goodas a function of the quantity (horizontal axis), we obtain theconsumer demand.15 / 67

The demand and the willingness to pay IIMore generally, we can define the demand curve in two ways:1. Q(p) is the total quantity demanded by consumers for a givenprice p.2. P(q) is the willingness to pay for the q th unit of output.Consumer surplusThe consumer surplus is the difference between the willingness topay and the price.It is measured by the area between the demand curve and the priceline.16 / 67

Demand elasticityDemand elasticityThe percent variation of quantity demanded divided by the percentvariation in price.17 / 67

Demand elasticityDemand elasticityThe percent variation of quantity demanded divided by the percentvariation in price.Demand elasticity - formal dd qp ·pq q/q p/p18 / 67

CostsUsually described by a cost function, relevant factor of firms’production decisions.Some definitions:IFixed costs: the cost that does not depend on the outputlevel.IVariable costs: the cost that would be zero if the output iszero.ITotal cost: sum of the two above.IAverage cost: Total cost/quantity (per unit cost)IMarginal cost: the cost of one additional unit.19 / 67

Costs: an exampleProduction of T-shirts. (1 manager - 1 worker)IA manager leases one machine at 20 per week.IThe worker earns 1 per-hour during weekdays. Then 2 onthe weekend. The working week is 40 hours.IThe machine can produce one t-shirt per hour, and thestandard production is 40 t-shirts per week.Questions:What is the average cost?What is the marginal cost?20 / 67

Economies of scale and economies of scopeEconomies of scaleWe have economies of scale when average cost declines withoutput.21 / 67

Economies of scale and economies of scopeEconomies of scaleWe have economies of scale when average cost declines withoutput.If average cost is constant with output, we have constant returnsto scale.22 / 67

Economies of scale and economies of scopeEconomies of scaleWe have economies of scale when average cost declines withoutput.If average cost is constant with output, we have constant returnsto scale.Economies of scopeWhen we have multiple goods, there are economies of scope whenproducing q1 and q2 together, the cost is lower than producingthem separately.C (q1 , q2 ) C (q1 , 0) C (0, q2 )23 / 67

Profit maximizationProfits are simply given by revenues minus costs:Π(q) R(q) C (q)Firms want to maximize profits. This is an optimizationproblem, solved via first order conditions.The basic principle of profit maximizationProfit maximization implies that marginal revenue is equal tomarginal cost.MR MC24 / 67

Profit maximization IIMarginal revenueTotal revenue is given by the price times the output. Themarginal revenue is the additional revenue by selling an extra-unitof outputR pqIPerfect competition: MR p.IImperfect competition: MR p(1 1 )MR and elasticityIf markets are imperfectly competitive, when selling more, firmshave to adjust the price. So, the marginal revenue is lower thanthe price. The more the demand is inelastic, the lower themarginal revenue.25 / 67

Derivation of marginal revenuesWe have to take the derivative of the total revenues:R pq(1)26 / 67

Derivation of marginal revenuesWe have to take the derivative of the total revenues:R pq(1)But price is function of quantity p(q).dRdp p qdqdq(2)dR1 p dq p pdq(3)dR1 p(1 )dq (4)dp q27 / 67

EfficiencyTransactions take place because everybody obtains gains fromtrade.Fundamental theorem of welfareExchange generates surplus:ISeller sell for more than the marginal cost.IConsumers pay less than their willingness to pay28 / 67

EfficiencyTransactions take place because everybody obtains gains fromtrade.Fundamental theorem of welfareExchange generates surplus:ISeller sell for more than the marginal cost.IConsumers pay less than their willingness to payHence, we talk about both consumer and producer surplus.If markets are competitive markets are efficient.29 / 67

Consumer surplus30 / 67

Producer surplus31 / 67

Consumer and producer surplus32 / 67

Underproduction33 / 67

Overproduction34 / 67

The fundamental theoremIConsumer with higher valuation (willingness to buy) than theprice will buy.IProducers with marginal cost lower than price will sell.IPrices determine whether the trade is advantageous for bothparties.35 / 67

The fundamental theoremIConsumer with higher valuation (willingness to buy) than theprice will buy.IProducers with marginal cost lower than price will sell.IPrices determine whether the trade is advantageous for bothparties.The survival of the fittestCompetition introduces a natural selection of firms: only the bestfirms (more efficient, lower costs, better quality.) will survive.36 / 67

Games and strategy(a) John Nash Father of game theory(b) You might know him like this.37 / 67

The prisoner dilemmaTwo members of a criminal organization are arrested and imprisoned.Each prisoner is in solitary confinement with no means of communicatingwith the other.38 / 67

The prisoner dilemmaTwo members of a criminal organization are arrested and imprisoned.Each prisoner is in solitary confinement with no means of communicatingwith the other.The prosecutors lack sufficient evidence to convict the pair on theprincipal charge, but they have enough to convict both on a lessercharge. Simultaneously, the prosecutors offer each prisoner a bargain.39 / 67

The prisoner dilemmaTwo members of a criminal organization are arrested and imprisoned.Each prisoner is in solitary confinement with no means of communicatingwith the other.The prosecutors lack sufficient evidence to convict the pair on theprincipal charge, but they have enough to convict both on a lessercharge. Simultaneously, the prosecutors offer each prisoner a bargain.Each prisoner is given the opportunity either to betray the other bytestifying that the other committed the crime, or to cooperate with theother by remaining silent.40 / 67

The prisoner dilemma - IIThe possible outcomes are:IIf A and B each betray the other, each of them serves two years inprison,IIf A betrays B but B remains silent, A will be set free and B willserve three years in prison,IIf A remains silent but B betrays A, A will serve three years inprison and B will be set free,IIf A and B both remain silent, both of them will serve only one yearin prison (on the lesser charge).41 / 67

The “payoff” of the game42 / 67

Main lesson from prisoner dilemmaWhat is a game?43 / 67

Main lesson from prisoner dilemmaWhat is a game?IThe players (how many? how do they interact?)IThe strategies (what can the players do?)IThe available information (can they communicate?)IThe payoff (what are the consequences of their actions?)44 / 67

Main lesson from prisoner dilemmaWhat is a game?IThe players (how many? how do they interact?)IThe strategies (what can the players do?)IThe available information (can they communicate?)IThe payoff (what are the consequences of their actions?)Key concept:Game theory studies all the situations where the payoff dependon the actions of other players.45 / 67

Dominant strategies, dominated strategies and NashequilibriumDominant StrategyA strategy that is strictly better than any other strategy,regardless of the other players’ choices.46 / 67

Dominant strategies, dominated strategies and NashequilibriumDominant StrategyA strategy that is strictly better than any other strategy,regardless of the other players’ choices.Dominated StrategyA strategy whose payoff is inferior to that of another strategy,regardless of what the other player does.47 / 67

Dominant strategies, dominated strategies and NashequilibriumDominant StrategyA strategy that is strictly better than any other strategy,regardless of the other players’ choices.Dominated StrategyA strategy whose payoff is inferior to that of another strategy,regardless of what the other player does.Nash EquilibriumA pair of strategies constitutes a Nash equilibrium if no player canunilaterally change its strategy in a way that improve its payoff.48 / 67

End of Part 149 / 67

MonopolyIOne producerIProfit maximization rule still MR MC .ISince zero competition, the monopolist extracts all thesurplus.IThe monopoly power depends on the elasticity of the demand.50 / 67

Demand elasticity and optimal monopoly margin51 / 67

Do monopolies exist?We often refer to dominant positions:IGoogle (70% market share)IMicrosoft (75% market share)ILuxottica (80% market share)Dominant positionWhen the market share is so high that we can observe features ofmonopolies, although technically it is not a monopoly.In such cases, we refer to dominant position, and the monopoly isapplied to the residual demand.52 / 67

The residual demandSmaller firms have a capacity constraint K . The big firm hasmonopolistic power over the residual quantity in the market.53 / 67

Issues with monopolyMain issuesMonopoly power (or dominant positions) create allocativeinefficiency, and reduce consumer surplus with respect tocompetition.The firm makes positive profits.54 / 67

Issues with monopolyMain issuesMonopoly power (or dominant positions) create allocativeinefficiency, and reduce consumer surplus with respect tocompetition.The firm makes positive profits.Possible solutionsIRegulationIRegulationI.55 / 67

Main types of regulations56 / 67

Main types of regulationsIMarket regulation (Broad definition, by the government)IEntry regulation (Incentives to entry)IFirm regulation (Price rules)ISocial regulation (Protection of public interests)57 / 67

Perfect competitionThe main features of perfect competition are:IInfinite number of firmsIHomogeneous productIPerfect informationIFree entry58 / 67

Perfect competitionThe main features of perfect competition are:IInfinite number of firmsIHomogeneous productIPerfect informationIFree entryQuestionIs perfect competition an interesting case?59 / 67

Why perfect competition?We are interested in perfect competition as a benchmark case.Most of cases that we cannot classify as perfect competition canbe seen as violation of the principles of perfect competition:IMonopoly and oligopolyIMonopolistic competition (differentiated products)IImperfect informationIBarriers to entry (patent protection)60 / 67

The demand under perfect competitionFirms are small (no market power) and so they face infinitelyelastic demand curves.IThey sell all the quantity they can at the market price (pricetakers).IZero profits, quantity determined by average cost andmarginal cost.61 / 67

The demand under perfect competitionFirms are small (no market power) and so they face infinitelyelastic demand curves.IThey sell all the quantity they can at the market price (pricetakers).IZero profits, quantity determined by average cost andmarginal cost.Why the demand is flat?62 / 67

Firms and market supplyUnder perfect competition:ISupplier quantity is decided following this ruleMC MR p.I. as long as the price is greater than the average cost.63 / 67

Firms and market supplyUnder perfect competition:ISupplier quantity is decided following this ruleMC MR p.I. as long as the price is greater than the average cost.The law of supply and demandPrice determines the equilibrium, and makes the supply equal tothe demand.64 / 67

Market shocks: the GPU market65 / 67

Main reasonsGPUs are computer components used mainly for research,professional editing, video-games and Bitcoin mining.ICovid-19 and supply chainsIBitcoin pricesMarket shocksMarket shocks can be supply-driven or demand-driven, sometimesboth.66 / 67

Merci pour votre attention67 / 67

The textbook of reference is \Introduction to Industrial Organization", by Luis Cabral. 3/67. Exam By attending the course, you will have all the required knowledge . Introduction and review of Microeconomics 2.Monopoly and perfect competition 3.From perfect competition to monopolistic competition

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