Students

Chapter 2

Demand

Learning Objectives

• Appreciate why buyers purchase more at lower prices. 
• Distinguish consumer demand for normal products and inferior products.
• Appreciate the impact on demand of changes in the prices of substitutes and complements.
• Appreciate the effect of the output of the item being produced on business demand for inputs. 
• Appreciate the concept of buyer surplus.
• Apply package deals and two-part pricing to extract buyer surplus.

Key Takeaways

• Owing to diminishing marginal benefit, consumers and businesses are only willing to buy more if the price is lower.
• Consumer demand for normal products increases with income, while consumer demand for inferior products decreases with income.
• The demand for a product increases with the price of a substitute, and decreases with the price of a complement.
• Business demand increases with the output of the item being produced.
• Buyer surplus is the difference between the buyers' total benefit from consumption and the buyers' actual expenditure.
• A seller can extract the buyers' surplus and raise profit by selling through package deals and two-part pricing.

Detailed Notes

1. The Demand Curve.A demand curve describes the quantity demanded of an item as a function of its price.
2. Individual Demand.
1. Construction.
1. Definition: a graph showing the quantity (horizontal axis, e.g., no. of movies watched per month) that the buyer will purchase at every possible price (vertical axis, e.g., ticket price per movie).
2. Slope.
1. Marginal benefit – the benefit provided by an additional unit of the item.
2. The principle of diminishing marginal benefit – each additional unit of consumption provides less benefit than the proceeding unit. Accordingly, the price that an individual is willing to pay will decrease with the quantity purchased.
3. Diminishing marginal benefit gives rise to a downward sloping demand curve: the lower the price, the larger the quantity demanded.
3. Preferences.
1. The procedure for constructing a demand curve relies completely on the consumer's individual preferences and this has two implications:
1. Different consumers may have different preferences and hence different demand curves;
2. Demand curves will change with changes in the consumer's preferences.
3. Demand and Income.
1. Income changes.
1. A change in income will affect individual demand at all price levels.
2. A change in price vis-à-vis changes in income or other factors on individual demand.
1. A change in the price of an item (holding income and all other factors unchanged) generally causes movement along the demand curve (a change in the quantity demanded)
2. A change in income or factors other than the price of an item (e.g., the prices of related products, advertising, season, weather, and location) causes a shift in the entire demand curve (a change in demand at all price levels).
2. Normal vis-à-vis inferior products.
1. Goods and services are categorized according to the effect of changes in income on demand.
2. Normal product: demand is positively related to the buyer’s income. Demand increases as buyer’s income increases, and demand falls as buyer’s income falls.
1. When the economy is growing and incomes are rising, demand for normal products will rise.
2. In a recession where incomes are falling, demand for normal products will fall.
3. The demand for normal products is relatively higher in richer countries.
3. Inferior product: demand is negatively related to the buyer’s income. Demand increases as buyer’s income decreases, and demand falls as buyer’s income increases.
1. When the economy is growing and incomes are rising, demand for inferior products will fall.
2. In a recession where incomes are falling, demand for inferior products will rise.
3. The demand for inferior products is relatively higher in poorer countries.
4. Broad categories (e.g., movies, transportation, consumer electronics) tend to be normal, while particular products within the categories (e.g., matinees, bus services, all-in-one stereos) may be inferior.
5. Distinction between normal and inferior products is important for business strategy and international business.
4. Other Factors in Demand.
1. Prices of related products.
1. Complements: two products are complements if an increase in the price of one causes a fall in the demand for the other, e.g., popcorn and movies.
2. Substitutes: an increase in the price of one causes an increase in the demand for the other, e.g., video rentals and movies.
3. In general, the demand curve shifts to the left when there is an increase in the price of a complement or a fall in the price of a substitute.
4. In general, the demand curve shifts to the right when there is a fall in the price of a complement or an increase in the price of a substitute.
2.  Advertising.
1. Advertising may be informative or persuasive.
2. In general, an increase in the seller’s advertising increases individual demand, and the buyer’s demand curve shifts to the right.
3. The effect of advertising expenditure on demand may be subject to diminishing marginal product – each additional dollar spent on advertising has a relatively smaller effect on demand.
5. Business Demand.
1. Inputs.
1. Consumers buy goods and services for final consumption or usage.
2. Businesses buy goods and services as inputs for the production of other goods and services for sale to consumers or other businesses.
3. The inputs purchased by a business can be classified into materials, energy, labor, and capital.
4. The inputs may be substitutes (workers/machines) or complements (trucks and drivers).
2. Demand.
1. By increasing inputs, the business can produce a larger output and raise revenue.
2. Demand curve of a business.
1. A business can measure its marginal benefit from an input as the increase in revenue arising from an additional unit of the input.
2. Construct the demand curve of a business for an input using the marginal benefit of an input.
3. A business should buy an input up to the quantity that its marginal benefit from the input exactly balances the price.
4. If the input provides a diminishing marginal benefit to the business, the demand curve for the input slopes downward.
3. Demand factors.
1. A change in the price of an input is represented by a movement along the demand curve.
2. Changes in other factors will lead to a shift of the entire demand curve.
1. A major factor in consumer demand is income. Business demand does not depend on income but rather on the output – if the output is larger, the demand for inputs will increase.
2. The demand for an input also depends on the prices of complements and substitutes in the production of the output, e.g., trucks and drivers are complements – an increase in drivers’ wages will reduce the demand for trucks.
6. Buyer Surplus.
1. Implication for pricing policy: the perspective of “willingness to pay” shows the maximum that the buyer can be charged.
2. The individual demand curve shows:
1. The quantity that the buyer will purchase at every possible price; and
2. The maximum amount that a buyer is wiling to pay for each unit of the item, i.e., the buyer’s marginal benefit from each unit.
3. Total benefit.
1. Total benefit: the benefit provided by all the units that the buyer consumes, i.e., the marginal benefits from the first up to and including the last unit purchased.
2. Graphically, this is the area under the buyer's demand curve up to an including the last unit consumed.
3. This is the maximum that the buyer is willing to pay for that quantity of purchases, this is also the maximumthat a seller can charge.
4. Benefit and expenditure.
1. Buyer surplus: The difference between the buyer's total benefit from some consumption and her or his actual expenditure.
2. Graphically represented by the area between the buyer’s demand curve and the price line.
3. Effect of price changes. Price reduction leads to increase in buyer’s surplus in two ways.
1. First, the buyer gets a lower price on the quantity that the buyer would have purchased at the original higher price; and
2. Second, as the buyer buys more (depending on the buyer’s sensitivity to the price reduction), she gains buyer surplus on each of the additional purchases.
4. The buyer loses from a price increase.
1.  Pay higher price; and
2.  Reduction in the quantity purchased.
5. Package deals and two-part pricing. A seller who has complete flexibility over pricing maximizes profit by charging buyer just a little less than total benefit – extracting buyer’s surplus as follows:
1. Package deal: a pricing scheme comprising a fixed payment for a fixed quantity of consumption.
2. Two-part price: a pricing scheme comprising a fixed payment and a charge based on usage, e.g., telephone monthly charge coupled with an airtime charge.
3. A combination of the above two pricing techniques.
7. Market Demand.
1. Construction of market demand curve.
1. Definition: a graph showing the quantity that all buyers will purchase at every possible price. It is the horizontal summation of the individual demand curves.
2. It enables businesses to understand the demand of the entire market rather than individual customers.
2. The properties of the market demand curve are similar to those of the individual demand curve.
3. Slope. As each buyer’s marginal benefit diminishes with the quantity of consumption, the market demand curve slopes downward. At a lower price, the market as a whole will buy a larger quantity.
4. Price changes, income changes and other factors in demand.
1. A change in the price of an item (holding income and all other factors unchanged) generally causes movement along the market demand curve from one point to another on the same curve.
2. A change in income or factors other than the price of an item (e.g., the prices of related products, advertising) causes a shift of the entire market demand curve.
5. Market demand for a business input depends on output of all businesses and the prices of related products.
6. Market buyer surplus.
1. This is the difference between the buyers’ total benefit from the input and the buyers’ actual expenditure.
2. Graphically, it is the area between the market demand curve and the price line.

Progress Checks and Review Questions

Please refer to the textbook for answers to selected Progress Check and Review questions.

Discussion Questions #1 and Answer

An important issue in economic development is the relationship between fertility and female literacy. With data from 110 countries, the following linear relationship between the female literacy rate and the number of births per woman (fertility rate) was estimated. When the literacy rate is 0%, the fertility rate is 7.63 per woman; and when the literacy rate is 100%, the fertility rate is 2.42 per woman.

1. On a figure with female literacy on the vertical axis and fertility on the horizontal axis, draw a graph of the linear relationship. Referring to the linear relationship, if the literacy rate is 60%, what would be the fertility rate (approximately)?
2. A large cost of having a baby is the time that the mother must invest to bear and rear the child. For a more educated woman, is the value of this time higher or lower?
3. In the chart, mark “cost of child” on the vertical axis. Does the trend line have any relation to a demand curve? Please explain.
4. Please give an alternative explanation of the figure: use the fertility rate to explain female literacy.

Answer

1. Fertility rate = 4.5.
2. Higher (the opportunity cost is higher).
3. The trend line is like a demand curve: the lower is the cost of a child, the higher is the fertility rate.
4. Women who bear more children would have less time and resources to attend school. Hence, the higher the fertility rate, the lower would be the female literacy rate.

Chapter 3

Elasticity

Learning Objectives

• Understand the concept of own-price elasticity of demand.
• Distinguish price elastic and price inelastic demand.
• Appreciate that, if demand is inelastic, the seller can increase profit by raising the price.
• Appreciate the behavioral factors underlying the elasticity of demand.

Understand the concepts of income elasticity, cross-price elasticity, and advertising elasticity of demand.

Key Takeaways

• The own-price elasticity of demand is the percentage by which the quantity demanded will change if the price of the item rises by 1%.
• The demand for an item is price elastic if a 1% increase in price leads to more than a 1% drop in quantity demanded, and price inelastic if a 1% increase in price leads to less than a 1% drop in quantity demanded.
• If demand is inelastic, the seller can increase profit by raising the price.
• The demand for an item will be more elastic to the extent that: (i) it has more direct or indirect substitutes, (ii) buyer has fewer prior commitments to the item, and (iii) the benefits of economizing are larger than the costs.
• The income elasticity of demand is the percentage by which the demand will change if the buyers' incomes rise by 1%.
• The cross-price elasticity of demand is the percentage by which the demand will change if the price of a related item rises by 1%.
• The advertising elasticity of demand is the percentage by which the demand will change if sellers increase advertising expenditure by 1%.

Detailed Notes

1. Elasticity of Demand.
1. Theconcept. It measures the responsiveness of demand to changes (increase or decrease) in an underlying factor (e.g., price of the item itself, buyers’ income, prices of complementary or substitute products, advertising expenditure … etc).
2. There is an elasticity corresponding to every factor (i.e., measuring the responsiveness of demand to changes in each factor) that affects demand.
2. Own-Price Elasticity of Demand (Price Elasticity or Demand Elasticity).
1. This measures the responsiveness of the quantity demanded to changes in the price of the item. The own-price elasticity can be measured along any demand curve (including the individual demand curve and market demand curve).
1. Definition. Own-Price Elasticity = Percentage by which the quantity demanded will change if the price of the item rises by 1%.
1. Own-Price Elasticity =Percentage change in quantity demanded divided by Percentage change in price.
2. Own-Price Elasticity =Proportionate change in quantity demanded divided by Proportionate change in price.
1. Proportionate change in quantity demanded = the change in quantity demanded divided by the initial quantity demanded.
2. Proportionate change in price = the change in price divided by the initial price.
2. Properties.
1. It is a negative number (sometimes reported as an absolute number, without negative sign), as demand curves generally slope downward;
2. It is a ratio of two proportionate changes, and hence a pure number independent of units of measurement and can be used to compare the price sensitivity of the demand for different goods and services;
3. It ranges from 0 (where a large % change in price causes no change in quantity demanded) to negative infinity (where an infinitesimal % change in price causes a large change in quantity demanded).
3. Elastic/Inelastic demand.
1. Demand is price inelastic if a price increase causes a proportionately smaller reduction in quantity demanded.
1. Elasticity > −1;
2. Absolute value of elasticity < 1.
2. Demand is price elastic if a price increase causes a proportionately larger reduction in quantity demanded.
1. Elasticity < −1;
2. Absolute value of elasticity > 1.
4. Estimation and accuracy.
1. Denominator.
1. Use of initial prices and quantities; or
2. Average or final prices/quantities.
2. “Point estimate” of elasticity: as we consider smaller and smaller price changes, the estimate will converge to a single number.
3. Changes in any of the factors that affect demand (e.g., price of the item itself, buyers’ income, prices of complementary or substitute products, advertising expenditure … etc.) may lead to a change in the own-price elasticity.
4. The own-price elasticity may vary along the demand curve, and changes in the price itself. Strictly, it is accurate only for small changes in the price.
5. Intuitive factors affecting own-price elasticity.
1. Availability of direct or indirect substitutes.
1. The fewer substitutes are available, the less elastic the demand.
2. The demand for the product category (cigarettes as a whole) will be relatively less elastic than demand for particular product in category (particular brand of cigarettes).
2. Buyer's prior commitments, e.g., buyer of a particular car/software becomes a captive customer/locked in for spare parts/future upgrades.
3. Benefits/costs of economizing.
1. Cost relative to the benefit from searching for better prices. Buyers have limited time so they focus on items that account for relatively larger expenditure (as opposed to “low involvement” products).
2. The balance between the cost and the benefit of economizing also depends on a possible split between the person who incurs the cost of economizing and the person who benefits.
6. Forecasting quantity demanded and expenditure.
1. Forecasts. Given the own-price elasticity of demand, a seller (both an individual seller or all sellers) can estimate the impact of an increase of reduction in price on:
1. quantity demanded, i.e., sales in the case of an individual seller;
2. buyers’ expenditure (quantity demanded × price) = revenue in the case of an individual seller.
2. Quantity demanded.
1. Proportionate change in quantity demanded = Proportionate change in price × own-price elasticity of demand.
3. Expenditure.
1. Proportionate change in expenditure = Proportionate change in price + Proportionate change in quantity demanded.
2. Proportionate change in expenditure = Proportionate change in price × (1 + own-price elasticity of demand).
7. Pricing strategy.
1. If demand is price inelastic at the current price, a price increase will raise buyers’ expenditure and the seller’s revenue. A seller can increase profit by raising price:
1. Net effect. The drop in quantity demanded (i.e., the drop in sales which reduces expenditure) will be proportionally smaller than the increase in price (which will tend to raise expenditure);
2. Buyers’ expenditure (seller’s revenue) will increase; and
3. Also, as production is reduced, costs are cut.
2. If demand is price elastic, a price increase would reduce buyers’ expenditure and seller’s revenue. When a seller raises price:
1. The drop in quantity demanded will be proportionally larger than the increase in price; and
2. Buyers’ expenditure (seller’s revenue) will decrease.
3. Generally, it is in the best interest of a seller to raise the price until the demand becomes price elastic.
3. Other Elasticities.
1. Income elasticityof demand.
1. Definition. Income Elasticity = Percentage by which demand will change if the buyers’ incomes rise by 1%.
1. Income Elasticity =Percentage change in demand divided by Percentage change in buyers’ incomes.
2. Properties.
1. Can range from negative infinity to positive infinity.
1. Normal products: if buyers’ income rise, demand will rise; positive income elasticity.
2. Inferior products: if buyers’ incomes rise, demand will fall; negative income elasticity.
3. Elastic/Inelastic Demand.
1. Demand is income inelastic if a 1% increase in income causes a less than a 1% change in the quantity demanded;
2. Demand is income elastic if a 1% increase in income causes a more than 1% change in the quantity demanded.
4. Factors affecting income elasticity.
1. Demand for necessities (e.g., raw food) tends to be relatively less income elastic than the demand for discretionary items (restaurant meals).
2. Cross-price elasticity of demand with respect to another item.
1. Definition. Cross-price elasticity =Percentage by which demand will change if the price of the related item rises by 1%.
1. Cross-price elasticity = Percentage change in demand divided by Percentage change in price of related item.
2. Properties.
1. Can range from negative infinity to positive infinity.
1. Substitutes: an increase in the price of one will increase the demand for the other; positive cross-price elasticity. The more substitutable two items are, the higher their cross price elasticity will be.
2. Complements: an increase in the price of one will reduce the demand for the other; negative cross-price elasticity.
3. Advertising elasticity.
1. Definition. Advertising elasticity = Percentage by which the demand will change if the sellers’ advertising expenditure rises by 1%.
1. Advertising elasticity = Percentage change in demand divided by percentage change in sellers’ advertising expenditure.
2. Most advertising is undertaken by individual sellers to promote their own business.
1. By drawing buyers away from competitors, advertising has a much stronger effect on the sales of an individual seller than on the market demand.
2. Advertising elasticity of the demand faced by an individual seller tends to be larger than the advertising elasticity of the market demand.
4. Forecasting Multiple Factors. Generally, the net effect on the percentage change in demand due to changes in multiple factors (sometimes pushing in different directions) = sum of the percentage changes due to each separate factor, using the corresponding elasticities.
5. Adjustment Time.
1. Buyers need time to adjust. Adjustment time is a factor that affects all elasticities. Distinguish between short run and long run.
1. Short run for the buyer – the time horizon within which buyers cannot adjust at least one item of consumption.
2. Long run for the buyer – the time horizon long enough for buyers to adjust all items of consumption.

Progress Checks and Review Questions

Please refer to the textbook for answers to selected Progress Check and Review questions.

Discussion Questions #1 and Answer

Economists Fabian Berges, Daniel Hassan, and Sylvette Monier-Dilhan analyzed demand at a major French food retailer. The own-price elasticities of the demand for pasta were: −1.36 for national brands, −2.16 for private labels, and −1.85 for low-price brands. The own-price elasticities of the demand for biscuits were: −1.00 for national brands, −1.14 for private labels, and −0.50 for low-price brands.

1. Compare the elasticities of the demand for national brands and private labels of pasta. Does the difference make sense?
2. Do national brands or private labels or low-price brands command more brand loyalty? (Hint: Interpret brand loyalty by the own-price elasticity.)
3. Which is more price elastic? The demand for pasta or biscuits?
4. Based on the own-price elasticities, can you make any recommendations on pricing?

Answer

1. The demand for national brands is more inelastic (less elastic) than private label pasta.
2. National brands command more loyalty.
3. The demand for pasta is more price elastic.
4. Supermarkets should set relatively higher incremental margins on biscuits than pasta. Within each product category, they should set higher margins on national brands than private labels.

Chapter 4

Supply

Learning Objectives

• Appreciate why producers supply more at higher prices.
• In the short run, appreciate how to decide whether to continue in production, and if so, how much to produce.
• Distinguish fixed and variable costs.
• Understand the concepts of marginal cost and marginal revenue.
• In the long run, appreciate how to decide whether to continue in production, and if so, how much to produce.
• Appreciate that, in the long run, producers can adjust by entering or exiting the industry.
• Apply the concept of price elasticity of supply.
• Appreciate the concept of seller surplus.

Key Takeaways

• To the extent that marginal costs increase with production, sellers will only increase production for higher prices.
• In the short run, a business (which can sell as much as it would like at the market price) maximizes profit by: if the total revenue covers the variable cost, producing at the rate where the marginal cost equals the price; if the total revenue does not cover the variable cost, shutting down.
• Fixed cost is the cost of inputs that do not change with the production rate, while variable cost is the cost of inputs that do change with the production rate.
• Marginal cost is the change in total cost due to the production of an additional unit, while marginal revenue is the change in total revenue arising from selling an additional unit.
• In the long run, a business (which can sell as much as it would like at the market price) maximizes profit by: if the total revenue covers the total cost, producing at the rate where the marginal cost equals the price; if the total revenue does not cover the total cost, shutting down.
• In the long run, businesses can adjust by entering or exiting the industry.  
• The price elasticity of supply is the percentage by which quantity supplied will change if price of the item rises by 1%.
• Seller surplus is the difference between the seller's revenue from some quantity of production and the seller's avoidable cost to produce that quantity.

Detailed Notes

1. Introduction: short run and long run.
1. Two key business decisions. 
1. Participation: whether to continue in production.
1. Whether the business would break even, depending on total revenue and total (relevant) cost.
2. Extent: the scale at which to operate (= rate of production = sales).
1. Depends on marginal revenue and marginal cost.
2. Both two key business decisions depend on the time horizon.
1. Short run: time horizon in which the seller cannot adjust at least one input. In the short run, the business must work within the constraints of past commitments such as employment contracts and investment in facilities and equipment.
2. Long run: time horizon long enough for the seller to adjust all inputs, including possibly entering or exiting the industry. The business will have complete flexibility in deciding on inputs and production.
2. Short-Run Costs.
1. Fixed vis-à-vis variable costs.
1. Assign estimates of the expenses on inputs (e.g., rent, equipment lease, wages, and payments on supplies needed at various scales of operation (production rates)) into the 2 categories of fixed costs and variable costs.
2. Fixed cost: the cost of inputs that do not change with the production rate. Assume that the entire fixed cost is a sunk cost, i.e., a cost that has been committed and cannot be avoided. Downsizing will have no effect on fixed costs.
1. Represented by the height of the total cost curve at the production rate = zero.
3. Variable cost: thecost of inputs that do change with the production rate.
4. Total cost: the sum of fixed cost and variable cost (C = F + V).
1. Total cost curve: the variable cost curve shifted up everywhere by the amount of the fixed cost.
2. Marginal cost = the change in total cost due to the production of an additional unit.
1. Derived from the analysis of fixed costs and variable costs.
3. Average cost.
1. Average cost = average total cost = unit cost: the total cost divided by the production rate.
1. The cost of producing a typical unit.
2. The sum of average fixed cost and average variable cost.
1. Average fixed cost = fixed cost divided by the production rate.
2. Average variable cost = variable cost divided by the production rate.
4. Marginal product.
1. Definition. The increase in output arising from an additional unit of an input.
2. Diminishing marginal product from the variable inputs: the marginal product becomes smaller with each increase in the quantity of the variable inputs.
5. Average cost generally first declines with increase in the production rate and then increases because:
1. When the production rate is higher, the fixed cost will be spread over more units, and the average fixed cost will decline.
2. With respect to the average variable cost:
1. At low production rate, owing to the mismatch between the variable inputs and the fixed input, the average variable cost is high;
2. At higher production rate, as the variable inputs match the fixed input relatively better, the average variable cost falls; and
3. Then, as more of the variable inputs are added in combination with the fixed input, there will be a mismatch again, leading to a diminishing marginal product from the variable inputs, the average variable cost rises.
3. If the fixed cost is not too large and the average variable cost increases sufficiently, the average cost will first decline with the production rate and then increase.
6. Production technology.
1. Adjustments in a seller’s technology.
1. A technology with a lower fixed cost will lower the seller’s average cost curve;
2. A technology with a lower variable cost will lower the seller’s average cost, average variable cost, and marginal cost curves.
2. Sellers with different technologies have different cost curves.
1. Better technologies yield lower overall costs.
3. Revenues and Short-Run Individual Supply.
1. Individual and market supply: counterparts to individual and market demand.
2. Assumptions.
1. Business aims to maximize profit.
2. Assumption of smallness: The business is so small relative to the market that it can sell as much as it would like at the going market price.
3. To decide whether to continue production at all.
1. Compare profit from continuing in production with the profit from shutting down. Profit = total revenue – total cost. Note: Total revenue = price × sales (production rate); R = p × q.
1. If continue in production, profit = R – F – V.
2. If the business shuts down, it must pay the fixed cost, though not the variable cost.
1.  Since R = 0 and V is avoidable; profit = −F.
2. Short-run break-even condition. A business should continue in production if the maximum profit from continuing in production is at least as large as the profit from shutting down, i.e., if the business breaks even.
1.  R – F – V ≥ −F; or R ≥ V.
1. So long as total revenue covers variable cost (the fixed cost is a sunk cost and is not relevant); or equivalently,
2. So long as price (R divided by q) covers average variable cost (V divided by q).
4. Profit-maximizingscale of production.
1. Profit = total revenue – total cost.
1. If continuing in production, profit = R – F – V.
2. Total revenue = price × sales (production rate); R = p × q.
3. Marginal revenue = the change in total revenue arising from selling an additional unit.
4. Profit-maximizing scale.
1. The point where marginal revenue equals marginal cost (where the total revenue line and the total cost curve climb at exactly the same rate).
1. Whenever the marginal revenue exceeds the marginal cost, profit will be raised by increasing production.
2. Whenever the marginal revenue is less than the marginal cost, profit will be raised by reducing production.
2. When a business can sell as much as it would like at the market price, marginal revenue equals price (it does not have to reduce price to sell more units); and therefore, the profit-maximizing rule for such a business becomes that production rate at which price equals marginal cost.
5. Summary. In the short run, a business maximizes profit by:
1. If the total revenue does not cover the variable cost, shutting down.
2. If the total revenue covers the variable cost, producing at the rate where the marginal cost equals the price.
6. Individual supply curve.
1. A graph showing the quantity that one seller will supply at every possible price. It shows the minimum price that the seller will accept for each unit of production.
2. It is identical to that part of the marginal cost curve above the average variable cost curve.
3. For every possible price of its output, a business should produce at the rate that balances its marginal cost with the price, provided that the price covers average variable cost.
4. As marginal cost rises when production is expanded, a seller should expand production only if it receives a higher price. Accordingly, the individual supply curve slopes upward.
5. A change in the price of the output generally causes movement along a supply curve.
4. Long-Run Individual Supply.
1. Long-run costs.
1. Based on estimates of expenses on inputs (e.g., rent, equipment lease, wages, and payments on supplies needed at various scales of operation (production rates)) when all inputs are avoidable.
2. Even in the long run, there may be fixed costs (but these are not sunk). The business may incur some costs even at production level of zero, e.g., maintenance of minimum size facility.
2. To decide whether to continue production at all in the long run.
1. Compare profit from continuing in production with the profit from shutting down. Profit = total revenue – total cost. Note: Total revenue = price × sales (production rate); R = p × q.
1. If continue in production, profit = R – C.
2. If the business shuts down, it will incur no costs (as all costs are avoidable in the long run); profit = 0.
2. Long-run break-even condition. A business should continue in production if the maximum profit from continuing in production is at least as large as the profit from shutting down, i.e., if the business breaks even.
1. R – C ≥ 0; or R ≥ C.
1. So long as total revenue covers total cost; or equivalently,
2. So long as price (R divided by q;average revenue) covers average cost (C divided by q).
3. Profit-maximizing production rate in the long-run. The profit-maximizing rule is to produce:
1. where marginal revenue equals marginal cost; or equivalently,
2. where price equals marginal cost. Note: for a business that can sell as much as it would like at the market price, the marginal revenue equals the price of its output.
4. Summary. In the long run, for a business that can sell as much as it would like at the market price, a business maximizes profit by:
1. If the total revenue does not cover the total cost, shutting down.
2. If the total revenue covers the total cost, producing at the rate where the marginal cost equals the price.
5. Long-run individual supply curve.
1. By varying the price, we can determine the quantity that the seller will supply at every possible price of the output.
2. It is identical to that part of the long-run marginal cost curve above the long-run average total cost.
6. Short and long run.
1. Long-run average cost curve is lower and has a gentler slope than that of the short run. In the short run, the seller may not be able to change one or more inputs. In the long run, the seller has more flexibility in optimizing inputs to changes in the production rate, and can thus produce at a lower cost.
2. The short-run average cost includes the average fixed cost, which, being sunk, is not relevant. To compare the short-run and long-run break-even conditions, the relevant comparison is between the short-run average variable cost and the long-run average cost.
5. Seller Surplus.
1. Seller’s surplus: the difference between a seller’s total revenue from some quantity of production and the seller’s avoidable cost of producing that quantity.
1. In the short run, the seller surplus = total revenue less variable cost (assuming that the fixed cost is sunk).
2. In the long run, the seller surplus = total revenue less total cost (assuming that the fixed cost is avoidable).
6. Elasticity of Supply.
1. Price elasticity of supply.
1. This measures the responsiveness of the quantity supplied to changes in the price of an item.
2. Definition. It is the percentage by which the quantity supplied will change if the price of the item rises by 1%.
1. Price elasticity of supply =Percentage change in quantity supplied divided by percentage change in price
2. Intuitive factors.
1. Available production capacity.
1. A seller with considerable excess capacity will step up production in response to even a small price increase.
2. If capacity is tight, the seller may not increase production much even if the price rises substantially, and supply will be relatively inelastic.
2. Adjustment time.
1. In the short run, some inputs may be costly or impossible to change, the marginal cost of expanding production will be relatively high and supply inelastic.
2. In the long run, the marginal cost will increase more gently, and an individual and market supply curve will be more elastic.
3. Generally, the long-run supply will be more elastic than the short-run supply.
7. Market Supply.
1. Market supply curve.
1. It is a graph showing the quantity that all sellers will supply at every possible price.
2. Properties.
1. The market supply curve slopes upward. The higher the price of the output, each individual seller will wish to produce more, the market as a whole will also produce more.
2. A change in the price of an input will affect an individual seller’s marginal cost at all production levels and shift the entire marginal cost curve. Such changes will also shift the market supply curve.
3. The market supply curve depends on the sellers in existence.
4. The market seller surplus is the difference between the sellers’ total revenue and the sellers’ avoidable cost.
5. The effect of a change in the price of an output is represented by a movement along the supply curve.
6. A change in the price of an input will cause a shift in the entire market supply curve.
3. Short and long run.
1.  Freedom of entry and exit is the essential difference between the short run and the long run. In the long run, every business has complete flexibility in deciding on inputs and production.
1. Sellers whose total revenue cannot cover total costs will leave the industry until all remaining sellers break even.
2. An industry where businesses are profitable (i.e., total revenue exceeds total costs) will attract new entrants. This will increase market supply, reduce market price (push down the profit of all sellers):
1. If the existing sellers continue making profits, new entrants will enter the industry;
2. Some sellers may leave or enter the market until all sellers just break even.
2. In the long run, a change in the market price will have two effects.
1. Existing sellers will adjust along their individual supply curves;
2. Sellers may enter or exit.
3. The long-run market supply curve slopes upward more gently (i.e., is more elastic) than the short-run market supply curve.

Progress Checks and Review Questions

Please refer to the textbook for answers to selected Progress Check and Review questions.

Discussion Questions #1 and Answer

In 2020, Bank of the West held US$46.1 billion, US$4.4 billion, and US$6.0 billion of funds in demand, savings, and time deposits. On these deposits, the bank paid interest of 0.41%, 0.04%, and 1.81% respectively.

• In a table, list the three sources of funds and amounts in order of interest rate from lowest to highest.
• On a diagram with funds in billions of dollars on the horizontal axis and interest rate on the vertical axis, illustrate the (i) marginal cost of funds and (ii) average variable cost of funds.
• If the bank had to downsize, which type of deposits should it reduce?

Answer

• Savings deposits, US$4.4 billion; Demand deposits, US$46.1 billion; Time deposits, US$6.0 billion.
• See diagram.
• If the bank had to downsize, it should reduce time deposits, as they incur the highest marginal cost of funds.

Chapter 5

Market equilibrium

Learning Objectives

• Understand the market equilibrium of demand and supply.
• Appreciate the impact of excess supply on the market price and quantity.
• Appreciate the impact of excess demand on the market price and quantity.
• Apply the price elasticities of demand and supply to predict the impact of shifts in demand on market price and quantity.
• Apply the price elasticities of demand and supply to predict the impact of shifts in supply on market price and quantity.
• Appreciate the effect of intermediation on buyers and sellers.
• Understand economic efficiency.
• Appreciate that perfect competition achieves economic efficiency.

Key Takeaways

• At the equilibrium price, the quantity demanded equals the quantity supplied, and the price will not change.
• If the market price exceeds equilibrium, there will be excess supply and the price will tend to fall.
• If the market price falls below equilibrium, there will be excess demand and the price will tend to rise.    
• A shift in demand will affect the market price and quantity to an extent that depends on the elasticities of both demand and supply.
• A shift in supply will affect the market price and quantity to an extent that depends on the elasticities of both demand and supply.
• The incidence of a change in market conditions on buyers vis-à-vis sellers depends on elasticities of both demand and supply.
• The price system ensures that the allocation of resources is economically efficient.

Detailed Notes

1. Introduction. It is important to consider both demand and supply when predicting the impact of any change on price and quantity.
1. Even though only one side of the market may be changing initially, it is necessary to consider the interaction with the other side to obtain a complete picture.
2. The central concepts are the role of price in communicating information to buyers and sellers, and market equilibrium of demand and supply.
3. Demand–supply framework: core of managerial economics. It can be applied to address managerial decision-making in goods and services, consumer and industrial products, and domestic and international markets.
2. Perfect Competition.
1. Market demand and supply.
1. When deriving a market demand curve, it is assumed that every buyer can purchase as much as she would like at the going price and all buyers pay the same price.
2. When deriving a market supply curve, it is assumed that every seller can deliver as much as she would like at the going price and all sellers receive the same price.
2. Five conditions for perfect competition. If a market meets the five conditions for perfect competition, we can validly apply demand–supply analysis. A market is said to be in perfect competition if:
1. Homogeneous product.
1. The products are homogeneous (i.e., they are perfect substitutes).
2. Competition in a market where products are differentiated (e.g., mineral water from different sources, owing to different chemical compositions) is not as keen as that in a market where products are homogeneous (e.g., gold). Generally, prices for differentiated products may differ.
2. Many small buyers.
1. There are many buyers, each purchasing a quantity that is small relative to the market (e.g., cotton). No buyer can get a lower price than others. All buyers pay the same price and all buyers compete on the same level playing field.
2. In a market where some buyers have market power (e.g., Roche buying a Chinese herb), buyers pay different prices,
1. The same buyer may even pay different prices for different units of the same product,
2. It is not possible to construct the market demand curve – construction of the demand curve requires an assumption that each buyer can buy as much as he or she would like at the market price.
3. Many small sellers.
1. There are many sellers, each supplying a quantity that is small relative to the market. No seller can get a higher price than others (e.g., dry cleaners). All sellers face the same price and all sellers compete on the same level playing field.
2. Where some sellers have market power (e.g., cable TV), they receive different prices,
1. It is not possible to construct a market supply curve – construction of the supply curve requires an assumption that each seller can supply as much as he or she would like at the market price.
4. Free entry and exit.
1. New buyers and sellers can enter freely, and existing buyers and sellers can exit freely.
1. There are no technological, regulatory, or legal barriers.
2. With free entry and exit, the market price cannot stay above a seller's average cost for very long.
1. If the market price is above a seller’s average cost, new sellers will enter, add to the market supply, and bring down the price.
3. The market is very competitive.
5. Symmetric information.
1. All buyers and all sellers have symmetric information about market conditions (e.g., photocopying services), e.g., prices, available substitutes, and technology.
2. Markets where there are differences in information among buyers, among sellers (e.g., medical services), or between buyers and sellers (e.g., medical services), are not as competitive as those where all buyers and sellers have equal information.
3. Very few markets exactly satisfy all five conditions for perfect competition. We can still apply the demand – supply analysis but must check the implications against the conditions that are not met.
3. Market Equilibrium.
1. Definition. Market equilibrium is the price at which the quantity demanded equals the quantity supplied (a price in which there is neither a surplus nor a shortage).
1. Demand and supply.
1. The price will not tend to change: the quantity demanded just balances the quantity supplied.
2. Purchases will not tend to change: buyers maximize benefits less expenditure at the equilibrium quantity.
3. Sales will not tend to change: sellers maximize profits at the equilibrium quantity.
4. Neither buyers nor sellers may face rationing or other restrictions. Both the demanded and quantity supplied must be the voluntary choices by buyers and sellers.
2. When the market is not in equilibrium, the market price will change in a way to restore equilibrium. The price signals information and provides incentive for buyers and sellers to converge to equilibrium.
2. Excess supply: the amount by which the quantity supplied exceeds the quantity demanded.
1. If the market price is above equilibrium, there will be an excess supply.
2. Sellers will compete to clear their extra capacity, buyers will cut back purchases, and the market price would fall back toward the equilibrium level.
3. The higher the price above equilibrium, the larger will be the excess supply.
3. Excess demand (a shortage): the amount by which the quantity demanded exceeds the quantity supplied.
1. If the market price is below equilibrium, there will be an excess demand.
2. Buyers will compete for the limited quantity, sellers will expand production, and the market price would tend to rise to the equilibrium level.
3. The lower is the price below equilibrium, the larger will be the excess demand.
4. Demand Shift.
1. When there is a demand shift, for a complete understanding of the outcome, it is necessary to consider the supply side as well.
2. Equilibrium Change, e.g., an increase in oil shipments:
1. The entire demand curve shifts to the right.
2. The supply curve does not change.
3. A new market equilibrium (price and quantity).
3. Price elasticity. The change in the equilibrium price depends on the price elasticities of both demand and supply.
1. Extremely inelastic demand. When demand is extremely inelastic, buyers               are completely insensitive to price (they purchase the same quantity              regardless of the price). When the demand curve shifts, buyers continue to              purchase exactly the same quantity, and the equilibrium price changes by the             same amount as the demand shift.
2. Extremely elastic demand. When demand is extremely elastic, buyers are   extremely sensitive to price. When the demand curve shifts, the equilibrium      price changes by the same amount as the demand shift.
1. Generally, if demand is more elastic, the change in the equilibrium price resulting from a demand shift will be larger.
3. Extremely inelastic supply. When supply is extremely inelastic, sellers are completely insensitive to price (they provide the same quantity regardless of      price). When the demand curve shifts, sellers continue to produce exactly the          same quantity, and the equilibrium price changes by the same amount as the              demand shift.
4. iv)      Extremely elastic supply. When supply is extremely elastic, the marginal              cost of production is essentially constant. If the cost of an input changes, the   marginal cost changes by the same amount at all production levels. When          the demand curve shifts, sellers soak up all the additional quantity                demanded, and the the equilibrium price remains unchanged.
1. Generally, if supply is more elastic, the change in the equilibrium price resulting from a demand shift will be smaller.
4. Impact of demand shift. Realistically,
1. Demand is somewhat elastic and sensitive to price.
2. Supply is somewhat elastic and sensitive to price.
3. Both market quantity and price will change to some degree.
5. Supply Shift.
1. Changes in the cost of inputs (e.g., wages, interest rates) or government policies will shift the demand, supply or both. To understand the impact of a supply shift, it is crucial to consider the interaction between supply and demand.
2. Equilibrium change, e.g., a reduction in wages:
1. Affects sellers’ marginal costs whatever the quantity that they supply.
2. The entire supply curve of (e.g., tanker service) shifts down. Alternatively, the entire supply curve shifts to the right: at every possible price, sellers want to supply more.
3. The demand curve is unchanged.
4. A new market equilibrium (price and quantity). Generally, a supply shift will change the equilibrium price by no more than the amount of the supply shift.
3. Price elasticity. The change in the equilibrium price depends on the price elasticities of both demand and supply.
1. Extremely inelastic demand. When demand is extremely inelastic, buyers are completely insensitive to price (they purchase the same quantity regardless of the price). When the supply curve shifts, buyers continue to purchase exactly the same quantity, and the equilibrium price changes by the same amount as the supply shift.
2. Extremely elastic demand. When demand is extremely elastic, buyers are extremely sensitive to price. When the supply curve shifts, buyers soak up all the additional quantity supplied, and the equilibrium price remains unchanged.
1. Generally, if demand is more elastic, the change in the equilibrium price resulting from a supply shift will be smaller.
3. Extremely inelastic supply. When supply is extremely inelastic, sellers are completely insensitive to price (they provide the same quantity regardless of price). When their costs change, the sellers provide the same quantity, and the equilibrium price remains unchanged.
4. Extremely elastic supply. When supply is extremely elastic, the marginal cost of production is essentially constant. If the cost of an input changes, the marginal cost changes by the same amount at all production levels. When the supply curve shifts, the equilibrium price changes by the same amount as the supply shift.
1. Generally, if supply is more elastic, the change in the equilibrium price resulting from a supply shift will be larger.
4. Impact of supply shift. There is a common misconception is that if sellers’ costs fall by some amount, then the market price will fall by the same amount. Realistically,
1. Demand is somewhat elastic and sensitive to price.
2. Supply is somewhat elastic and sensitive to price.
3. Both market quantity and price will change to some degree.
6. Intermediation.
1. Buyer’s price and seller’s price. In the presence of agents that act as intermediaries between buyers and sellers, the buyer’s price and seller’s price must be distinguished. The seller’s price is the buyer’s price minus the cost of intermediation.
2. Incidence. The change in the price for a buyer or seller resulting from a shift in demand or supply. Generally, the incidence depends only on the price elasticities of demand and supply.
3. Impact of changes in intermediation, e.g., a tenant searches for apartments online and avoids the real estate agent commission, so the demand curve shifts up: The incidence will depend only on the price elasticities of demand and supply, and not on who originally paid the cost of intermediation.
   1. With moderate demand and supply elasticities, the buyer’s price will fall by less than the amount of the commission and the seller’s price rise by less than the amount of the commission, and quantity will rise by some amount.
   2. When demand is extremely inelastic, the incidence of the change in intermediation falls completely on the buyer. The buyer’s price falls by the full amount of the commission.
   3. When supply is extremely inelastic, the incidence of the change in intermediation falls completely on the seller. The seller’s price falls by the full amount of the commission.
7. Invisible Hand.
1. Economic efficiency.
1. An allocation of resources is economically efficient if:
1. All users achieve same marginal benefit;
2. All suppliers operate at same marginal cost; and
3. Marginal benefit equals marginal cost.
2. An economically efficient allocation of resources will maximize the sum of buyer and seller surpluses.
3. Perfect competition achieves economic efficiency.
2. Two roles of prices.
1. In a competitive market, buyers and sellers acting independently and selfishly channel scarce resources into economically efficient uses (satisfying all three conditions). The invisible hand that guides buyers and sellers is the market price.
2. Market prices allocate scarce resources in an economically efficient way. Prices lead to an efficient allocation of resources by providing information and incentives:
1. Users buy until marginal benefit equals price (to maximize benefit);
2. Producers supply until marginal cost equals price (to maximize profit);
3. Users and producers face same price.
3. Market or price system: the economic system in which resources are allocated through the independent decisions of buyers and sellers, guided by freely moving prices.
3. Distortion. Under conditions of perfect competition, any distortion of the market price (e.g. price ceiling, price floor, tax or subsidy) is economically inefficient.

Progress Checks and Review Questions

Please refer to the textbook for answers to selected Progress Check and Review questions.

Discussion Questions #1 and Answer

In New York City, 1 million apartments are subject to rent stabilization. The Rent Guidelines Board regulates changes in rents, usually limiting increases to 2.5% or less per year. Columbia Business School professor Stijn Van Nieuwerburgh estimated that, on average, a person lucky enough to secure a rent-stabilized apartment would pay 7% less than market, and after 20 years, 45% less.

1. Discuss whether the rent stabilization would cause excess demand or excess supply.
2. Using suitable demand and supply curves, illustrate the equilibrium in the market for apartment rentals.
3. How does the rent stabilization policy affect incentives to pay bribes to secure rent-stabilized apartments?
4. How would the shift to work from home affect the equilibrium in (b)?

Answer

1. Rent stabilization would cause excess demand, as the market price is lower than the equilibrium price. There would be too many tenants chasing too few rent-stabilized apartments.
2. See diagram.
3. The rent stabilization policy strengthens the incentives for prospective renters to pay bribes to secure rent-stabilized apartments. In particular, prospective renters will be willing to offer bribes equal to the difference between the stabilized rent and their willingness-to-pay. In this manner, the price ceiling resulting from the rent stabilization policy may promote corruption.
4. The answer depends on how the shift to work from home affects the demand for apartments. (i) It could shift people further away, so, reducing the demand for city apartments. (ii) Or it could increase the demand as people need more space at home. The supply curve is unchanged. In case (i), either demand falls by a relatively small amount, so the stabilized rent remains binding but excess demand is reduced, or demand falls by a relatively large amount, so the stabilized rent is no longer binding. Excess demand is eliminated and a lower equilibrium rent is attained. See diagrams. The analysis of case (ii) is similar but in the opposite direction.

Chapter 6

Costs

Learning Objectives

• Appreciate opportunity costs.
• Appreciate sunk costs.
• Understand economies of scale.
• Understand economies of scope.
• Recognize behavioral biases in cost analysis.

Key Takeaways

• For effective decision-making, consider alternative courses of action and take account of opportunity costs and ignore sunk costs.
• The opportunity cost is what must be foregone from the best alternative course of action.
• Commit to sunk costs with caution as they cannot be reversed.
• Economies of scale arise from fixed costs, which support the production of multiple units of output.
• With economies of scale, businesses should produce on a large scale and the industry will tend to be concentrated.
• Economies of scope arise from joint costs, which support production of multiple products.
• With economies of scope, businesses should produce multiple products.
• Managers should take care to avoid behavioral biases in decisions with respect to costs.

Detailed Notes

1. Introduction.
1. Framework for understanding costs. Within a single period of production, costs are:
1. Sunk (committed and cannot be avoided); or
2. Avoidable.
1. Includes opportunity costs.
1. Not reported in accounting statements but are relevant to management decisions.
2. Must be forgone to continue with the current course of action.
2. Classifications.
1. Fixed vis-à-vis variable costs, depending on the technology of production.
1. Fixed costs.
1. Do not vary with the scale of production.
2. An essential reason for economies of scale.
2. Variable costs.
1. Vary with the scale of production.
2. Joint vis-à-vis not joint costs.
1. Joint costs.
1. Do not vary with the number of products.
2. An essential reason for economies of scope.
2. Managers (profit, non-profit, government) need to understand costs from more than a pure accounting perspective to make more effective decisions in investment, performance evaluation, outsourcing, and pricing.
2. Economic Cost.
1. Definition.Economic cost = Accounting cost + Opportunity cost – Sunk cost.
2. Adjustments to Accounting Cost.
1. Economic cost includes opportunity cost.
2. Economic cost excludes sunk costs.
3. Opportunity Cost.
1. Alternative courses of action. A proper evaluation of performance should consider the alternative uses of investment funds.
1. Accounting statements do not always provide the appropriate information for effective business decisions. Conventional cost accounting:
1. Focuses on the cash outlays of the course of action (more easily verifiable) that management has adopted; and ignores costs that are relevant but do not involve cash outlays.
2. Does not present the revenues and costs from alternative courses of action.
2. Identifying opportunity cost.
1. Definition. The opportunity cost of the current course of action is what must be forgone from the best alternative course of action.
2. Two ways of dealing with opportunity costs to arrive at the correct decision:
1. Explicit approach. Explicitly present the revenues and costs of alternative courses of action; or
2. The opportunity cost approach. Includes the opportunity costs among the costs of the business and compute the economic profit.
3. When there is more than one alternative, the explicit approach still works well, but the opportunity cost approach becomes more complicated:
1. First identify the best of the alternatives; and
2. Then charge the profit contribution from that alternative as the opportunity cost of the current course of action.
4. Sunk Cost.
1. Alternative courses of action.
1. Conventional accounting statements present some costs which are not relevant to effective business decisions and hence should be ignored. Conventional cost accounting:
1. Focuses on the cash outlays of the course of action (more easily verifiable) that management has adopted.
1. These methods report all costs that involve cash outlays, even sunk costs which are not relevant and should be ignored.
2. Identifying sunk cost.
1. Definition. A sunk cost is a cost that has been committed and cannot be avoided once incurred. Since sunk costs cannot be avoided, they are not relevant to business decisions and managers should ignore them.
2. To arrive at the correct decision:
1. Explicit approach. Explicitly consider the alternative courses of action; or
2. The sunk cost approach. Use a single income statement that omits all sunk costs and includes only avoidable costs (rather than cash outlays).
3. When there is more than one alternative, the explicit approach still works well, but the sunk cost approach becomes more complicated:
1. What is sunk depends on the alternative at hand.
3. Strategic implications.
1. Managers should ignore sunk costs, and consider only avoidable costs.
1. Sunk costs, once incurred, are not relevant for investment, pricing, or any other business decision.
2. Substantial sunk costs (relatively low avoidable costs):
1. Participation: the break-even revenue would be relatively low. The business should continue in operation even with relatively low revenues, provided that the revenues cover the avoidable costs.
2. Extent (how much to produce, at what scale to operate): marginal costs would be relatively low. The business should price relatively low and aim to serve larger demand.
3. Managers should be careful about committing costs that will become sunk, since such commitments cannot be reversed.
5. Economies of Scale.
1. For effective business decisions, managers must identify all relevant costs and appreciate how costs vary with scale (scale of production/production scale/production rate) and scope (scope of production/variety of different products).
2. Costs depend on scale.
1. Fixed and variable costs.
1. By distinguishing between fixed and variable costs, management can understand which cost elements will be affected by changes in scale.
2. Fixed cost: cost of inputs that do not change with scale. This supports the production of multiple units of output, e.g., first copy cost of the newspaper industry.
3. Variable cost: cost of inputs that change with scale.
4. The distinction between fixed and variable costs applies in the short and long run.
5. Note: some costs may be partly fixed and partly variable.
2. Marginal and average costs.
1. Average cost (unit cost): total cost divided by scale; equals to the sum of average fixed cost and average variable cost.
1. Average fixed cost = fixed cost divided by scale.
2. Marginal cost: change in total cost due to the production of an additional unit; equals the rate of change of the variable cost.
3. Economies of scale/increasing returns to scale.
1. Definition: the situation where the average cost decreases with the scale of production.With economies of scale, marginal cost will be lower than the average cost. Since the marginal unit of production costs less than the average, any increase in production will reduce the average. So the average cost curve slopes downward.
2. Intuitive factors. Scale economies arise from two possible sources.
1. Substantial fixed inputs – those that can support any scale of production.
1. At a larger scale, the cost of fixed inputs will be spread over more units, so that the average fixed cost will be lower. If the average variable cost is constant or does not increase much with scale, the average cost will fall with scale.
2. Any business with a strong element of composition, design, or invention has substantial fixed inputs, e.g., newspaper production, cost of developing a new pharmaceutical, cost of preparing a software code.
2. Average variable costs that fall with scale (e.g., pipeline).
1. Generally, an increase in scale may increase or reduce the average variable cost. Whether the average variable cost increases or falls with scale depends on the particular technology of the business. The average variable cost decreases with scale in the physical storage and transport industries.
1. For example, if a 10% increase in the capacity of a gas pipeline requires less than 10% additional materials, the average variable cost falls with the scale of service.
3. Diseconomies of scale/decreasing returns to scale.
1. Definition: the situation where the average cost increases with the scale of production.
2. Intuitive factors, eg., a hairdressing salon:
1. Non-substantial fixed cost; and
2. Variable cost rises more than proportionately with scale.
1. Initially, the average cost decreases with scale because of the decreasing average fixed cost.
2. The variable cost rises more than proportionately with scale. The main variable cost is labor. To the extent additional workers are less productive, the cost of labor rises more than proportionately with scale. The average variable cost is increasing.
3. There is a scale where the decreasing average fixed cost is outweighed by the increasing average variable cost.
4. Then average cost reaches a minimum and rises with further increases in scale. The average cost curve is U-shaped.
4. Strategic implications.
1. If production is subject to economies of scale, large scale operators achieve a lower average cost than smaller-scale competitors. The industry will tend to be concentrated, with a few producers serving the entire market, e.g., broadband service (via a network, wired or wireless). Extreme case: a monopoly (one producer).
2. If production is subject to diseconomies of scale, the industry will tend to be concentrated. Extreme case: perfect competition (many producers, none of whom can influence market demand).
5. Sunk and fixed costs.
1. Fixed cost: cost of inputs that do not change with the production rate, tends to give rise to economies of scale, and so management should aim to operate on a large scale.
2. Sunk cost: a cost that cannot be avoided once incurred. Managers should ignore sunk cost as they cannot be avoided.
3. Some fixed costs become sunk once incurred, e.g., design cost for the shoes.
1. The design can support any number of shoes.
2. Once committed, the cost cannot be avoided.
4. Not all fixed costs become sunk, e.g., license fee to provide telecommunications service. If the license is transferrable, the fee need not be sunk. Only the part of the fee that cannot be recovered from resale is sunk.
1. Sunk costs are not fixed (in the sense of supporting any scale of operations), e.g., cost for making the shoe molds. More molds may be required as production increases.
6. Economies of Scope.
1. The determination of the scope of a business depends in part on the relation between cost and the scope of production.
2. Costs depend on the scope of production.
1. Joint cost: the cost of inputs that does not change with the scope of production. The joint cost supports the production of multiple products (e.g., the expense of the printing press is a joint cost of the morning and afternoon newspapers).
3. Economies of scope.
1. Definition: there are economies of scope across two products if the total cost of production is lower when two products are produced together than when they are produced separately.
2. Intuitive factors.
1. Economies of scope arise wherever there are significant joint costs.
3. Strategic implications.
1. A supplier of two products linked by economies of scope achieves a relatively lower cost than competitors that specialize in one or the other product. Subject to market demand and competition, management should offer both products, e.g., broadband service and cable TV.
2. Multiproduct suppliers dominate industries with economies of scope.
4. Diseconomies of scope.
1. Definition: there are diseconomies of scope across two products if the total cost of production is higher when two products are produced together than when they are produced separately.
2. Intuitive factors: diseconomies of scope arise where joint costs are not significant and making one product increases the cost of making the other in the same facility.
3. Strategic implications: it will be relatively cheaper to produce the various items separately. Specialized producers can achieve relatively lower costs than competitors that combine production. Management should aim for a narrow scope and focus on one product.
7. Bounded Rationality in Costing Decisions.Mangers, like consumers, are subject to bounded rationality in decision-making.
1. Sunk cost fallacy.
1. The human tendency to rationalize costs that are already sunk by increasing usage/consumption or additional expenditures results in overinvestment, e.g., case of the Concorde.
2. Status quo bias.
1. Opportunity costs: the status quo bias reinforces any systematic failure to account for opportunity costs, resulting in an even stronger bias toward continuing with the status quo, rather than taking an alternative course of action which might be more profitable.
2. Fixed cost fallacy. Related to sunk cost fallacy, but resulting in the opposite outcome.
1. The tendency to treat fixed costs as variable: the mistake is to set a target production rate and allocate the fixed cost to each unit of production. The allocation increases the perceived variable cost and results in underproduction relative to the profit-maximizing level.

PROGRESS CHECKS AND REVIEW QUESTIONS

Please refer to the textbook for answers to selected Progress Check and Review questions.

Discussion Questions #1 and Answer

Harvard Business School estimated the cost of studies for MBA students graduating in the year 2022 to be US$213,636. The largest expense was the tuition fee of US$68,440 per year, which for two years totaled US$136,880. On the plus side, the median graduate received a starting salary of US$148,750 and signing bonus of US$30,000.

• What major opportunity cost of studying for MBA degree did the School not mention?
• Compare the opportunity cost for two individuals with different earnings. Which one would be more likely to apply for the Harvard MBA program?
• By reporting the costs of the MBA as the School did, explain which one of the following behavioral biases in decision-making the School exploited: (i) Sunk-cost fallacy; (ii) Status quo bias; (iii) Anchoring.

Answer

• The School did not mention that individuals forgo two years of earnings, work experience, and career advancement.
• The opportunity cost of attending the MBA program – foregone earnings – is higher for the individual with higher earnings. Therefore, the individual with lower earnings is more likely to apply for the Harvard MBA program.
• The School exploited individuals’ tendency to commit anchoring bias. By reporting the annual tuition fee first, followed by the (higher) median starting salary, individuals will be prone to viewing a Harvard MBA as a good investment and therefore be inclined to apply to the program.

Chapter 7

Monopoly

Learning Objectives

• Appreciate how to gain market power.
• For a seller with market power, identify the scale of production/sales that maximizes profit.
• Appreciate how to adjust sales to changes in demand and costs.
• For a seller with market power, identify the levels of advertising and R&D expenditure that maximize profit.
• Appreciate that sellers with market power restrict sales to raise margins and profit.
• For a buyer with market power, identify the scale of purchases that maximize net benefit.

Key Takeaways

• Gain market power by limiting competition and making demand less price-elastic.
• To maximize profit, produce if total revenue covers total cost, and, then, produce at the scale where marginal revenue equals marginal cost.
• When demand or costs change, adjust production to the scale where marginal revenue equals marginal cost.
• To maximize profit, spend on advertising to the level where the advertising–sales ratio equals the incremental margin percentage multiplied by the advertising elasticity of demand.
• To maximize profit, spend on R&D to the level where the R&D–sales ratio equals the incremental margin percentage multiplied by the R&D elasticity of demand.
• Sellers with market power restrict sales to raise margins and profit.
• To maximize profit, purchase at the scale where marginal benefit equals marginal expenditure.

Detailed Notes

1. Introduction.
1. Market power: the ability of a buyer or seller to influence market conditions.
1. A seller with market power can influence market demand, in particular, the price and quantity demanded.
2. A buyer with market power can influence market supply, in particular, the price and quantity supplied.
2. Business can use their market power to increase revenue, reduce cost and so increase economic profit.
3. Monopoly: only one seller in the market.
4. Monopsony: only one buyer in the market.
2. Sources of Market Power.
1. Ingredients of market power.
1. Barriers to competition. Competitors must be deterred or prevented from entering the market to compete for the business.
2. Elasticity of demand or supply. Seller with market power can reduce the price elasticity of demand, raise prices, and increase profit.
2. Sellers can create barriers to competition and reduce the price elasticity of demand in four ways:
1. Product differentiation.To the extent that differentiation appeals to buyers it would increase demand and reduce price elasticity of demand.
1. Design (appearance, form, and feel): an appealing design can transform utilitarian products into distinctive offerings.
2. Function.
3. Distribution channels.
1. Luxury products: exclusive distribution to build brand image and demand.
2. Mass consumer goods: intensive distribution to provide wide and timely availability.
4. Advertising and promotion introduce the buyers to products and communicate the brand image; and can be used to influence and sustain buyers’ preferences.
2. Intellectual property (IP).Product differentiation builds, in part, on innovation. Innovators may able to exclude competitors by establishing IP over their innovators.
1. Patent: gives the owner exclusive right to an invention for a specified period of time, e.g., Pfizer’s patent over Lipitor.
2. Copyright: exclusivity over published expressions for a specified period of time, e.g., Microsoft’s copyright over Windows.
3. Trademarks: exclusivity over words or symbols associated with a good or service; the basis for branding, advertising, and promotion, e.g., Pfizer’s Lipitor trademark.
4. Trade secrecy: exclusivity over information that is not generally known and provides commercial advantage; broader in scope than patents – extends to customer lists and technical information, e.g., Google’s algorithms.
3. Economies of scale, scope. By establishing a sufficient cost advantage and through strategic management of costs, an incumbent producer may be able to deter entry by potential competitors.
1. Economies of scale. A producer that produces on a larger scale has a cost advantage over smaller-scale competitors, e.g., cable network (large fixed costs and relatively low variable costs).
2. Economies of scope. A combined provider of multiple products can achieve lower costs/gain a cost advantage over specialized competitors, e.g., the broadband and cable TV industries (both depend on a network of cables) tend to be dominated by a few providers, each providing both services.
4. Regulation.The government may limit competition by law and in the extreme, allow only a single producer.
1. Economic reason: the presence of large fixed costs in production, e.g., the government may award exclusive franchises (intended to avoid duplication of the fixed costs of the distribution network) in the distribution of electricity, natural gas, and water.
2. Social policy or profit maximization: major sports, mass media, alcohol, tobacco, gambling.
3. Profit Maximum.
1. Extent: Scale of production and price. A monopoly (unlike a perfectly competitive seller) has to consider how its sales will affect the market price.
1. Given a downward sloping market demand curve, a monopoly can either:
1. Decide how much to sell and let the market determine the price at which it is willing to buy that quantity; or
2. Set the price and let the market determine how much it will buy.
3. A monopoly can set either sales or price, but not both. Otherwise, there may be inconsistency (a combination of sales and price off the demand curve).
4. Profit-maximizing sales.
1. Revenue. Consider the relationship among price, sales, and revenue.
1. For simplicity: scale of production and sales are equivalent (by ignoring inventories, hence production = sales).
2. Total revenue = price × sales.
3. To sell additional units, the price must be reduced. When increasing sales by one unit, the monopoly:
1. Gains revenue from selling the additional or marginal unit; but
2. Loses revenue on the inframarginal units.
3. Inframarginal units are those units sold other than the marginal unit. The monopoly would have sold the Inframarginal units without reducing the price.
4. Marginal revenue = change in total revenue arising from selling an additional unit.
1. In general, the marginal revenue from selling an additional unit will be less than the price of that unit. It is the price of the marginal unit minus the loss of revenue on the inframarginal units.
1. The difference between price and marginal revenue depends on the elasticity of demand.
2. If demand is very elastic, the seller need not reduce the price very much to increase sales, the marginal revenue will be close to price.
3. If demand is very inelastic, the seller must reduce the price substantially to increase sales, the marginal revenue will be much lower than price.
2. Marginal revenue could be negative: if the loss of revenue on the inframarginal units exceeds the gain on the marginal unit.
5. Costs. The other side to profit is cost.
1. Total cost increases with the scale of production.
2. Marginal cost = change in total cost due to the production of an additional unit.
1. The change in total cost arises from change in the variable cost.
6. Profit-maximizing rate.
1. Profit = total revenue – total (fixed and variable) cost.
2. Profit-maximizing rate of production (and profit-maximizing price) is where: Marginal revenue balances marginal cost.
2. Break-even analysis: participate if the total revenue covers total cost – with both revenue and cost calculated at the profit-maximizing scale.
3. Profit measures.
1. Profit contribution is the total revenue less variable cost.
2. The incremental margin =
1. Price less marginal cost; or
2. The increase in the profit contribution (and profit) from selling an additional unit, holding the price constant.
3. The incremental marginal percentage = the ratio of the incremental margin (price less marginal cost) to the price.
4. A seller should simultaneously maximize on price, advertising, and other influences on demand.
5. Changes in demand and cost. The monopoly should adjust sales until marginal revenue equals marginal cost.
1. Demand change. Suppose that demand increases:
1. From the new demand curve, calculate the new marginal revenue curve. The new marginal revenue curve lies further to the right.
2. The original marginal cost curve does not change.
3. The new marginal revenue curve and the original marginal cost curve cross at a larger scale.
4. The new profit-maximizing price is higher.
2. Marginal cost change. Suppose that marginal cost decreases:
1. The original marginal revenue curve and the new marginal cost curves cross at a larger scale.
2. The new profit-maximizing price is lower. The cut in price is less than the fall in marginal cost.
3. Fixed cost change.
1. So long as fixed cost is not too large, changes in fixed cost do not affect marginal cost, and will not affect the profit maximizing price and scale.
2. However, if the fixed cost is so large that total cost exceeds total revenue, then the monopoly should shut down.
3. Fixed costs only matter for the break-even decision (whether to be in business at all).
4. Note: knowledge-intensive industries like media and publishing, pharmaceuticals, software characterized by relatively high fixed costs and low variable costs.
6. Advertising.
1. A seller with market power and can influence market demand (changes in demand and/or elasticity of demand) through advertising.
1. Advertising can influence market demand by:
1. Shifting out the demand curve; and
2. Causing demand to be less price elastic.
2. Benefit of advertising.
1. Increase in sales will affect total revenue and variable cost and the profit contribution.
3. Profit-maximizing level of advertising expenditure.Advertise up to:
1. The level that the marginal benefit = the marginal cost, i.e., where the increase in contribution margin = the additional advertising expenditure; or
2. The level that the Advertising–sales ratio = the incremental marginpercentage multiplied bythe advertising elasticity of demand.
1. Advertising–sales ratio = theratio of the advertising expenditure to sales revenue.
2. The advertising elasticity of demand = the percentage by which demand will change if the seller’s advertising expenditure rises by 1%, other things equal.
4. A seller should spend more on advertising if:
1. The incremental margin percentage is higher, as each dollar of advertising produces relatively more benefit as measured by the incremental margin percentage. This means that, whenever a seller raises its price or its marginal cost falls, it should also increase advertising expenditure; or
2. Either the advertising elasticity of demand or the sales revenue is higher, as the influence of advertising on buyer demand is relatively greater.
7. Research and Development.
1. A seller with market power and can influence market demand (changes in demand and/or elasticity of demand) through R&D.
1. R&D can:
1. Shift out the demand curve; and
2. Cause demand to be less price elastic
2. Generally, R&D in knowledge-intensive industries drives new products and refreshes existing products.
2. Benefit of R&D.
1. Increase in sales will affect total revenue and variable cost and the profit contribution.
2. Net benefit from R&D = change in profit contribution less the R&D expenditure.
3. Profit-maximizing level of R&Dexpenditure.
1. R&D–sales ratio = the incremental margin percentage multiplied by the R&D elasticity of demand.
1. R&D–sales ratio = the ratio of the R&D expenditure to sales revenue.
2. The R&D elasticity of demand = the percentage by which demand will change if the seller’s R&D expenditure rises by 1%, other things equal. This elasticity depends on two factors:
1. The effectiveness of R&D in generating new products and enhancing existing product,
2. The effect of new and enhanced products on demand.
4. A seller should increase R&D expenditure relative to sales revenue if:
1. The incremental margin percentage is higher (higher price or lower marginal cost); or
2. Either the R&D elasticity of demand or the sales revenue is higher.
8. Market Structure. Production and price depend on the competitive structure of the market.
1. Effects of competition. Perfect competition (a market with numerous sellers, each too small to affect market conditions) vis-à-vis monopoly.
1. Market price.
1. A monopoly restricts production below the competitive level to raise price above competitive level, and so, extract a relatively higher margin and larger profit.
2. Competition drives the market price down toward the long run average cost and results in more production.
2. The profit of a monopoly exceeds what would be the combined profit of all the sellers if the same market were perfectly competitive.
9. Monopsony: A Single Buyer.
1. Benefit and expenditure.
1. Assumption: Maximization of net benefit of an input.
2. Net benefit = benefit less expenditure.
3. Suppose the marginal benefit of a small quantity is very high and falls with the scale of purchases.
4. The supply curve represents the monopsony’s average expenditure for every possible quantity of purchases.
1. Since the price must be higher to induce a greater quantity of supply, the average expenditure curve slopes upward.
5. Marginal expenditure is the change in expenditure resulting from an increase in purchases by one unit.
1. For the average expenditure curve to slope upward, the marginal expenditure curve must lie above the average expenditure curve and slope upward more steeply.
2. Maximizing net benefit.
1. A buyer with market power will maximize its net benefit by purchasing at the scale such that its marginal benefit equals marginal expenditure.
2. A monopsony restricts purchases (demand) to get a lower price and increases its net benefit above the competitive level.

Progress Checks and Review Questions

Please refer to the textbook for answers to selected Progress Check and Review questions.

Discussion Questions #1 and Answer

Vertex Pharmaceuticals manufactures Ivacaftor, the only treatment for cystic fibrosis in children below the age of two with a specific genetic mutation. Bayer manufactures aspirin, which is not covered by patent, and is one of several drugs that relieve the symptoms of the common cold.

1. Which company has relatively more market power: Vertex over drugs to treat cystic fibrosis among infants, or Bayer over drugs for relieving the common cold? Explain your answer.
2. How is the difference between price and marginal revenue related to the price elasticity of demand?
3. Ivacaftor is manufactured through a biological process that is more costly than the chemical synthesis used to manufacture aspirin. How does this difference affect the pricing of Ivacaftor compared with aspirin?

Answer

1. Infants suffering from cystic fibrosis do not have an alternative to Ivacaftor. People suffering from the common cold can choose from many drugs including Bayer’s aspirin. Accordingly, Vertex Pharmaceuticals has relatively more market power.
2. If the demand is very elastic, then the marginal revenue will be close to the price, and hence the difference between price and marginal revenue will be small. If, however, the demand is very inelastic, then the marginal revenue will be much lower than the price, and hence the difference between price and marginal revenue will be large.
3. The demand for Ivacaftor is relatively inelastic by comparison with the demand for aspirin. Hence, the difference between price and marginal revenue will be greater for Ivacaftor.

Chapter 8

Pricing

Learning Objectives

• Apply uniform pricing.
• Appreciate how price discrimination can increase profit beyond uniform pricing.
• Understand complete price discrimination.
• Apply direct segment discrimination.
• Apply indirect segment discrimination.
• Choose between alternative pricing policies.

Key Takeaways

• To maximize profit with uniform pricing, set the price so that the incremental margin percentage equals the reciprocal of the absolute value of price elasticity of demand.
• Price discrimination can increase profit by taking buyer surplus and providing a quantity closer to economically efficient.
• Complete price discrimination charges a different price for each unit of the product.
• Direct segment discrimination sets prices to earn different incremental margins from each segment.
• Indirect segment discrimination structures a choice for buyers to earn different incremental margins from each segment.
• The ranking of pricing policies from most to least profitable is complete price discrimination, direct segment discrimination, indirect segment discrimination, and uniform pricing.

Detailed Notes

1. Introduction. This chapter systematically ties threads from previous chapters on demand, elasticity, costs, and monopoly to analyze how a seller with market power should set prices to maximize profit.
2. Uniform Pricing.
1. Definition. Uniform pricing is a policy where the seller charges the same price for every unit of the product.
2. Price elasticity. Generally, if demand is inelastic, an increase in price will lead to a higher profit. A seller that faces an inelastic demand should raise the price until the demand is elastic.
3. Profit-maximizing price.
4. In the price elastic range, what price maximizes the seller’s profit?
1. The rule of marginal revenue equals the marginal cost; or
2. Equivalently, the incremental margin percentage rule: a price such that the incremental margin percentage (i.e., price less marginal cost divided by the price) equals the reciprocal of the absolute value of the price elasticity of demand.
1. Determining the profit-maximizing price typically involves a series of trials with different prices as:
1. price elasticity may vary along a demand curve; and
2. marginal cost may change with scale of production.
5. Price adjustments following demand and cost changes.
1. The price adjustment following a change in price elasticity or marginal cost depends on both the price elasticity and marginal cost.
2. Changes in price elasticity.
1. If demand is more elastic (price elasticity will be a larger negative number), the seller should aim for a lower incremental margin percentage.
2. If demand is less elastic, the seller should aim for a higher incremental margin percentage.
3. Changes in seller’s marginal cost.
1. The seller must consider the effect of the price change on the quantity demanded.
2. A seller should not necessarily adjust the price by the same amount as the change in the marginal cost.
6. Common misconceptions.
1. Cost-plus pricing (i.e., setting price by marking up average cost) is problematic.
1. In businesses with economies of scale, average cost depends on scale. To apply cost-plus pricing, the seller must make an assumption about the scale. But sales and production scale depend on price. Cost-plus pricing leads to circular reasoning.
2. Cost plus pricing gives no guidance as to the appropriate mark-up on average cost.
2. A common mistake is the belief that the profit-maximizing price depends only on the price elasticity. This approach considers only the demand and ignores costs. To maximize profits, however, management should take into account both price elasticity and marginal costs.
3. Complete Price Discrimination.
1. Shortcomings of uniform pricing. Uniform pricing does not yield the maximum possible profit.
1. It does not extract the entire buyer surplus: the inframarginal buyers do not pay as much as they would be willing to pay. By taking some of the buyer surplus, a seller could increase profit.
2. It does not provide the economically efficient quantity. By providing the service to everyone whose marginal benefit exceeds the marginal cost, a seller could also earn more profit.
2. Price discrimination/price differentiation. This is a pricing policy under which a seller sets prices to earn different incremental margins on various units of the same or a similar product.
3. Complete price discrimination is the policy whereby the seller prices each unit at the buyer’s benefit and sells a quantity such that the marginal benefit equals the marginal cost. “Complete” as it charges every buyer the maximum they are willing for pay for each unit. Hence, the policy leaves each buyer with no surplus. A seller earns a higher profit with complete price discrimination than with uniform pricing. It resolves the two shortcomings of uniform pricing:
1. By pricing each unit at the buyer’s benefit, the policy extracts all the buyer surplus.
2. The policy provides the economically efficient quantity; hence, it exploits all opportunity for additional profit through increasing sales.
4. Economic efficiency.Maximizing profit is aligned with the social goal of economic efficiency: allocating resources so that no person can be better off without making another person worse off. By charging more to customers who are willing to pay more, a non-profit or government organization can use the additional revenue to provide service to more (poorer) customers.
5. Information and resale. To implement complete price discrimination:
1. The seller must know each potential buyer’s entire individual demand curve. It is not enough to know the price elasticities of the individual demand curve.
2. The seller must be able to prevent customers from buying at a low price and reselling to others at a higher price.
1. Hence, complete price discrimination is more widespread in services (especially personal services) than goods.
4. Direct Segment Discrimination.
1. Introduction. If a seller does not know the entire individual demand curve of each potential buyer and cannot price on an individual basis, the seller may still be able to discriminate among segments of buyers.
2. Direct segment discrimination is the policy of pricing to earn different incremental margins from each identifiable segment (e.g., adults vis-à-vis seniors). A segment is a significant, cohesive group of buyers within a larger market.
3. Homogeneous segments.
1. If the buyers within each segment are homogeneous, direct segment discrimination will achieve complete price discrimination.
2. For each segment, the profit-maximizing price is the buyers’ willingness to pay (which is also their benefit from the item).
4. Heterogeneous segments.
1. If the buyers within each segment are heterogeneous and:
1. The seller lacks sufficient information to identify sub-segments; or
2. The seller cannot prevent resale within the sub-segments, direct segment discrimination will not achieve complete price discrimination. There are two alternatives for pricing within each segment:
1. Apply uniform pricing within each segment.
1. Profit maximizing prices: Set prices so that the incremental margin percentage of each segment equals the reciprocal of the absolute value of that segment’s price elasticity of demand.
2. Apply indirect segment discrimination within each segment.
2. Generally, prices should be set to derive a relatively lower incremental margin percentage from the segment with the more elastic demand and a relatively higher incremental margin percentage from the segment with the less elastic demand.
5. Implementation.
1. The seller must identify and be able to use some identifiable and fixed (otherwise the buyer might switch segments to take advantage of a lower price) buyer characteristic that divides the market into segments with different demand curves (e.g., age, gender, location … etc).
2. The seller must be able to prevent resale. Generally, resale of services is more difficult than resale of goods, hence it is easier to implement price discrimination in services than goods.
5. Indirect Segment Discrimination. A seller may know that specific segments (e.g., business vis-à-vis  leisure travelers) have different demand curves but cannot find a fixed characteristic with which to discriminate directly. The seller may still be able to discriminate on price, but indirectly.
1. Indirect segment discrimination is the policy of structuring (where a seller cannot directly identify the customer segments) a choice for buyers so as to earn different incremental margins from each segment.
2. Structured choice.
1. Indirect segment discrimination usually involves a structured choice that persuades the various buyer segments to identify themselves through their choices (e.g., an airline structures a choice between unrestricted and restricted fares to exploit the differential sensitivity of business and leisure travelers to fees for changes).
2. The seller must consider how buyers with different attributes substitute among the various choices. Accordingly, the seller must not price any product in isolation. It must set the prices of all the products together.
3. Implementation.
1. The seller must control some variable to which buyers in the various segments are differentially sensitive. The seller then uses this variable to structure a set of choices that will discriminate among the segments.
2. Buyers must not be able to circumvent the differentiating variable. The seller must strictly enforce all conditions of sale to prevent switching. Note: since indirect segment discrimination allows each buyer a choice of products, the seller obviously cannot prevent buyers from reselling the product.
6. Selecting the Pricing Policy.
1. Ranking. Generally, the ranking of the pricing policies by profitability and information requirement is as follows.

Policy	Conditions	Profitability	Information requirement
Complete price discrimination	Seller discriminates directly on the buyer attributes. Seller can identify each buyer.	Highest	The most
Direct segment discrimination	Seller discriminates directly on the fixed segment attributes. Seller can identify each segment and prevent one segment from buying the product targeted at another segment.	(Exception: when all buyers within each segment are identical, profit equals that with complete price discrimination.)
Indirect segment discrimination	Uses product attributes to discriminate indirectly (rather than directly through buyer attributes) among various buyer segments.	Less profitable than direct segment discrimination for 2 reasons: Buyer benefit: the product provides less benefit to buyers. To induce buyers with different attributes to choose different products, the seller may resort to designing low-end products in a less appealing way. For example, airlines deliberately impose conditions on restricted fares to make them unappealing to business travelers. Cost: indirect discrimination may involve relatively high costs. Coupons (to indirectly discriminate among consumers with different price elasticity) impose costs on manufacturers, retailers, and consumers
Uniform pricing	No discrimination	Lowest	The least

2. Technology.
1. Information technology both facilitates and impedes price discrimination.
2. With the explosion in consumer usage of the Internet and the falling costs of computing power and storage:
1. Marketers can collect, store, analyze, and apply large volumes of detailed information about consumer preferences.
2. Sellers can better design and target offers to particular segments.
3. With the explosion in consumer usage of the Internet and the falling costs of computing power and storage:
1. Consumer-oriented search services grow and help consumers to compare product and prices, thus identifying the best offer and circumventing price discrimination.
3. Cannibalization. This occurs when buyers switch from high incremental margin products to lower incremental margin products, i.e., high-benefit segments buying the item aimed at low-benefit segments, e.g., business travelers flying on restricted fares, high-income consumers redeeming coupons.
1. Cannibalization reduces the profitability of indirect segment discrimination.
2. Reason for cannibalization: the seller cannot discriminate directly, and must rely on a structured choice of products to discriminate indirectly. To the extent that the discriminating variable does not perfectly separate the buyer segments, cannibalization will occur.
3. Ways to mitigate cannibalization.
1. Product design:
1. Upgrade the high-margin item to make it relatively more attractive. Degrade low-margin item.
2. Use multiple discriminating variables to differentiate products, e.g., airlines specify multiple conditions for restricted fares: minimum and maximum stay, limits on stopovers, penalties for changes. Each condition helps to reduce the degree to which the restricted fare would cannibalize the demand for the unrestricted fare.
2. Limit the availability of low-margin item, e.g., limited number of seats allocated to lower fares.

Progress Checks and Review Questions

Please refer to the textbook for answers to selected Progress Check and Review questions.

Discussion Questions #1 and Answer

In November 2014, Morgan Stanley, Citigroup, Deutsche Bank, and JP Morgan led the syndication of a three-year $300 million loan to Alibaba. The interest rate on the loan was set at the London Interbank Offer Rate (Libor) plus a spread of 52 basis points (0.52%). Banks source funds from demand, savings, and time deposits, as well as the interbank market. However, Libor is relatively higher than interest rates on deposits.

1. Does Libor reflect a typical bank's average or marginal cost of funds?
2. For purposes of pricing, explain which is relevant – average or marginal cost?
3. Explain the banks' pricing policy in terms of the incremental margin percentage and the price elasticity of demand.

Answer

1. Since banks prefer to source funds from sources other than the London Interbank market, Libor reflects a bank’s marginal cost of funds.
2. Marginal cost. This is the effect on cost of producing an additional unit. It should be compared with the additional revenue from the additional unit.
3. The spread, 0.52%, reflects the difference between price and the marginal cost for the loan (Libor plus an appropriate adjustment for risk). Then, 0.52%, when divided by the total interest rate on the loan, should be equal to the reciprocal of the absolute value of the price elasticity of demand.

Chapter 9

Strategic thinking

Learning Objectives

• Appreciate strategic situations.
• Apply games in strategic form to situations with simultaneous moves.
• Appreciate the use of randomization in competitive situations.
• Distinguish zero-sum from positive-sum games.
• Apply games in extensive form to situations with sequential moves.
• Plan strategic moves and conditional strategic moves, both threats and promises.

Key Takeaways

• A situation is strategic if the parties consider interactions with one another in making decisions.
• Never use a dominated strategy.
• In a situation of simultaneous moves, a Nash equilibrium strategy is stable in the sense that, if other parties choose their Nash equilibrium strategies, each party prefers its own Nash equilibrium strategy.
• In competitive situations, it may help to randomize.
• Zero-sum games characterize extreme competition: one party can be better off only if another is worse off.
• In a situation of sequential moves, plan by looking forward to the final nodes and reasoning backward toward the initial node.
• Use strategic moves to influence beliefs or actions of other parties in a favorable way. To be effective, they must be credible.
• If possible, use conditional strategic moves, both threats and promises, as they are more cost-effective than unconditional strategic moves.

Detailed Notes

1. Introduction.
1. A strategy is a plan for action in a strategic situation.
2. A strategic situation is one where parties consider the interactions with one another in making decisions.
3. Game theory is a set of principles to guide strategic thinking.
1. Model of games in strategic form applies to situations where parties choose strategies at the same time.
1. Example: price competition in markets with few sellers.
2. Model of games in extensive form applies to situations where parties act in sequence.
1. Use game in extensive form to plan strategic moves and conditional strategic moves, both threats and promises.
3. Game theory is useful to any business with market power in deciding competitive strategy. The ideas and principles of game theory provide an effective guide to strategic decision-making in many businesses, e.g., leveraged buyouts; takeovers; bargaining between labor unions and employers.
2. Nash Equilibrium.
1. A game in strategic form depicts one party’s strategies in rows, the other party’s strategies in columns, and the consequences for the parties in the corresponding cells. This is a useful way to organize thinking about strategic decisions that parties must take simultaneously.
1. A dominated strategy is one that generates worse consequences than some other strategy, under all circumstances (regardless of the choices of the other parties). It makes no sense to adopt a dominated strategy.
2. A Nash equilibrium in a game in strategic form is a set of strategies such that, given that the other parties choose their Nash equilibrium strategies, each party prefers its own Nash equilibrium strategy.
1. A stable situation.
2. In many typical strategic situations such as the cartel’s dilemma, the Nash equilibrium strategies seem like the most reasonable and obvious way to behave. (In the cartel’s dilemma, the pair of strategies in which both gas stations cut price is a Nash equilibrium.)
3. In less intuitive settings, the relevant parties should also act according to Nash equilibrium strategies.
3. Solving equilibrium – formal method.
1. First, rule out dominated strategies; and
2. Next, check all the remaining strategies, one at a time.
4. Solving equilibrium – informal method. The “arrow” technique.
1. A strategy is dominated if the row or column corresponding to the strategy has all arrows pointing out.
2. If there is a cell with all arrows leading in, then the strategies marking that cell are a Nash equilibrium, e.g., going north for Kimura and going north for Kenney in the Battle of the Bismarck Sea.
5. Non-equilibrium strategies.
1. If some party does not follow its Nash equilibrium strategy, then the best strategy for the other parties may or may be the Nash equilibrium strategy:
1. If the alternative to the Nash equilibrium strategy is a dominated strategy, then the Nash equilibrium strategy is better, even if the other party does not follow its Nash equilibrium strategy.
3. Randomized Strategies.
1. A pure strategy is one that does not involve randomization.
2. With a randomized strategy,the party specifies a probability for each of the alternative pure strategies. It then adopts each pure strategy randomly according to the probabilities. The probabilities must add up to 1.
3. A Nash equilibrium in randomized strategies. A Nash equilibrium in randomized strategies is like a Nash equilibrium in pure strategies: given that the other parties choose their Nash equilibrium strategies, each party’s best choice is its own Nash equilibrium strategy.
4. In a competitive setting, the advantage of randomization comes from its being unpredictable (e.g., a coin toss). If a party chooses in a conscious way, the other party may be able to guess or learn the first party’s decision and act accordingly.
5. Solving for Nash equilibrium in randomized strategies.
1. Crossing point of lines representing the outcomes of alternative pure strategies as a function of the other party’s probability; or
2. Using algebra.
4. Competition or Coordination.
1. Classification of strategic situations by outcomes.
1. A zero-sum game.
1. This is a strategic situation where one party can be better off only if another is made worse off.
2. A strategic situation is a zero-sum game if the outcomes for the parties add up to the same number (whether negative, zero, or positive) in every cell of the game in strategic form.
3. A zero-sum game characterizes the extreme of competition. There is no way for all parties to become better off.
2. A positive-sum game.
1. This is a strategic situation where one party can become better off without another being made worse off.
2. For example, in the price war between the gas stations, if we add the outcomes for the gas stations in each cell, the sum varies from 1,600 to 2,000.
3. A positive-sum game involves at least some element of coordination, e.g., the challenge is for the gas stations to enforce the agreement to maintain price.
2. Some situations involve elements of both competition and coordination.
1. For example, the two TV stations would certainly cooperate to avoid the outcome where both schedule their news at the same time. The situation is a positive-sum game. The total profit of the two TV stations is the largest when the stations broadcast in different time slots. But there are elements of competition for the 8:00pm time slot as the station that gets the 8:00pm slot will benefit more.
5. Sequencing.
1. In many strategic situations, various parties move sequentially, rather than simultaneously. A game in extensiveform explicitly depicts the sequence of moves and the corresponding outcomes. It consists of nodes and branches: a node represents a point at which a party must choose a move, while the branches leading from a node represent the possible choices at the node.
2. Backward induction. We can use this procedure to identify the best strategies for the parties. We solve the game in extensive form by backward induction:
1. Looking forward to the final nodes; and
2. Reasoning backward toward the initial node.
3. Equilibrium strategy.
1. In a game in extensive form, a party’s equilibrium strategy consists of a sequence of its best actions, where each action is decided at the corresponding node.
2. Difference between the Nash equilibrium strategy in a game in strategic form and the equilibrium strategy in a game in extensive form: Jet manufacturers example.
1. When the 2 jet manufacturers move simultaneously: there are 2 Nash equilibria in pure strategies.
2. When the 2 jet manufacturers move in sequence: there is only 1 equilibrium.
3. In the jet manufacturers example, the equilibrium in the extensive form is also the equilibrium in the strategic form.
6. In other situations, the equilibrium in the extensive form need not be a Nash equilibrium in the corresponding strategic form.
1. First mover advantage.
1. There is first mover advantage in any strategic situation where a party gains an advantage by moving first (before others). For example, in the evening news, the station that is first to commit its schedule will make the larger profit.
2. To identify whether a strategic situation involves first mover advantage, it is necessary to analyze the game in extensive form.
1. The first mover has an advantage in situations of coordination and competition. For example, in the evening news, both stations can agree to broadcast at different times, but they cannot agree on who gets the 8:00pm time slot. The power of the first mover is to determine the equilibrium.
3. First mover advantage is not a universal rule in business or other strategic situations.
1. If the equilibrium is the same whether a party moves first or second, then there is no first mover advantage.
2. In some circumstances, the follower has an advantage, e.g., the launch of smart phones, other manufacturers can piggyback on the advertising of the pioneer and introduce their products at lower cost.
7. Strategic Move.
1. Astrategic move is an action to influence the beliefs or actions of other parties in a favorable way.
2. To be effective, a strategic move must be credible – and typically involves self-imposed restrictions and real costs.
3. The outsourcing of the development of the new plane is a strategic move. This commitment is credible and the competing jet manufacturer would respond accordingly.
8. Conditional Strategic Move.
1. A conditional strategic move is an action under specified conditions to influence the actions or beliefs of other parties in a favorable way.
2. Two forms of conditional strategic moves.
1. A promise conveys benefits under specified conditions, e.g., deposit insurance offered by the government.
2. A threat imposes costs under specified conditions, e.g., strikes.
1. Threats are frequently used in negotiations.
2. To be effective, it must be credible, e.g., the union’s threat of a strike is credible only if the workers are better off with a strike – this in turn depends on the probability that the employer will eventually raise wages.
3. Conditional strategic moves are more cost-effective than unconditional strategic moves.
1. An unconditional strategic move usually involves a cost under all circumstance (not conditioned on any eventuality), e.g., the lithographer destroying her plates.
2. A conditional strategic move has no cost if it need not actually be carried out.

Progress Checks and Review Questions

Please refer to the textbook for answers to selected Progress Check and Review questions.

Discussion Questions #1 and Answer

Angela and Maggie stole a car and have been caught by the police. Detective Lenny Briscoe does not have sufficient evidence to convict them of auto theft. He ushers Angela and Maggie into separate interview rooms and offers each a deal: “If the other suspect doesn't confess and you do, we'll give you a reward of $1,000." Each suspect knows that if neither confesses, they will be let off. If one confesses while the other does not, then the confessing suspect will receive the $1,000 reward, while the other will be jailed for one year. If both confess, each will be jailed for one year.

1. Construct a game in strategic form to analyze the choices of Angela and Maggie between confessing and not confessing.
2. Identify the equilibrium/equilibria.
3. Compare this situation to the gasoline station price war in Table 9.1.

Answer

		Maggie
		Confess	Not confess
Angela	Confess	A: Jail 1 year M: Jail 1 year	A: $1000 M: Jail 1 year
	Not confess	A: Jail 1 year M: $1000	A: Let off M: Let off

1. Maggie prefers the $1,000 reward to being “let off,” and so, “not confess” is dominated by “confess.” The same is true for Angela. Hence, there is one Nash equilibrium: both Angela and Maggie confess.
2. This strategic situation is essentially the same as the gasoline station price war. For each player, one strategy dominates the other. There is only one Nash equilibrium.

Chapter 10

Externalities

Learning Objectives

• Understand positive and negative externalities.
• Appreciate economic efficiency as a benchmark and the opportunity to profit by resolving an externality.
• Appreciate how to resolve an externality and the corresponding barriers.
• Understand network effects and appreciate how to manage demand with network effects.
• Understand public goods.
• Appreciate how to provide public goods commercially.

Key Takeaways

• Externalities are benefits or costs directly conveyed to others.
• The economically efficient level of an externality is where the combined marginal benefits equal the combined marginal costs.
• There is an opportunity to add value and profit by resolving an externality up to the economically efficient level.
• Resolve an externality through merger or agreement.
• The two hurdles to resolution of an externality are unclear assignment of rights and possible free-riding.
• Network effects are benefits or costs that increase with the size of network.
• A public good provides non-rival consumption: one person's increase in consumption does not reduce quantity available to others.
• The economically efficient level of a public good is where the combined marginal benefits equal the marginal cost.
• Provide public goods on a commercial basis by excluding non-payers through law or technology.

Detailed Notes

1. Introduction.
1. Externality.
1. Definition. An externality arises when one party directly conveys a benefit or cost to others (not through a market).
1. A positiveexternality arises when one party directly conveys a benefit to others, e.g., the additional customers that an anchor department store generates for nearby specialty retailers in a mall.
2. A negativeexternality arises when one party directly imposes a cost to others, e.g., the customers that a betting shop drives away from a family restaurant.
2. Public good.
1. Definition. An item is a public good if one person’s increase in consumption does not reduce the quantity available to others, e.g., fireworks. Public goods can be privately provided.
3. In any market with externalities and public goods, managers can increase value added (and profit) by bringing provision closer to the economically efficient level.Positive externalities. For example, the additional customers that a supermarket’s advertising generates for nearby shops.
4. In deciding on the levels of activities that give rise to externalities, e.g., a supermarket must decide on how much to spend on advertising to attract shoppers:
1. If the source of the externality (the supermarket) considers only the benefits and costs to itself, and ignores the benefits and costs to others (e.g., a nearby restaurant), i.e., ignoring the externalities; the level of customer traffic that maximizes the supermarket’s profit is that where the marginal profit contribution to the supermarket equals the marginal customer cost.
2. For economic efficiency in customer traffic, the number of customers should be such that the combined marginal benefit (supermarket’s plus restaurant’s marginal profit contribution) equals the marginal cost of attracting customers:
1. The combined marginal benefit is the vertical sum of the supermarket’s marginal profit contribution and the restaurant’s marginal profit contribution.
2. Another perspective is to suppose that the supermarket owns the restaurant.
2. Negative Externalities. For example, a betting shop’s customers (attracted by advertising by the betting store) discourage families with children from patronizing the next-door toy store. The betting shop imposes a cost (negative externality) on the next-door toy store.
1. In deciding on the levels of activities that give rise to externalities, e.g., a betting store must decide on how much to spend on advertising to attract gamblers:
1. The level of customer traffic that maximizes the betting store’s profit is that where the marginal profit contribution to the betting store equals the marginal customer cost.
2. For economic efficiency in customer traffic, the number of customers should be such that the betting shop’smarginal benefit (marginal profit contribution) equals the combined (betting shop’s plus toy store’s) marginal cost of customers:
1. The combined marginal cost is the vertical sum of the betting shop’s marginal cost of advertising and the toy store’s marginal cost (loss of profit contribution).
2. Another perspective is to suppose that the betting shop owns the toy store.
3. General Benchmark.
1. Benchmark. In the presence of both positive and negative externalities, the affected parties maximize combined profit: where the combined marginal benefits equal the combined marginal costs. This is the point where an externality is resolved.
2. Resolving Externalities. This involves deliberate action as externalities do not pass through markets. Two ways to resolve externalities.
1. Common ownership. Combine the source and the recipient of an externality under common ownership. The common owner will choose the economically efficient level of the externality, whether positive or negative.
1. For example, if the department store owned the restaurant, it would consider all the benefits and costs of additional customers, and would increase advertising to attract the economically efficient number of customers.
2. Agreement.
1. The source and recipient of the externality could negotiate and agree on the level of the externality.
1. For example, the restaurant could offer to pay part of the department store’s advertising cost. This would encourage the store to increase advertising.
2. Similarly, the restaurant could pay the betting shop to reduce advertising.
2. Two steps.
1. The affected parties must agree on how to resolve the externality. They must collect information on the benefits and costs to the various parties and then agree on the level of the externality.
2. Then, they must enforce compliance: monitoring the source and applying incentives to ensure that the source complies with the agreed level of the externality.
3. Hurdles.
1. Unclear assignment of rights.
1. If rights are not clearly assigned, the two parties would have difficulty agreeing on common ownership or the level of externality. For example, does the betting shop have the right to impose an externality on the restaurant, or does the restaurant have the right not to suffer an externality?
2. Free-rider problem.
1. Definition. A free rider is a party that contributes less than its marginal benefit to the resolution of the externality, e.g., a florist that takes a free ride on the advertising by the department store and fees paid by the other specialty retailers (to the department store for advertising).
2. In the extreme, the free rider avoids all contribution.
3. Free riding arises whenever it is costly to exclude certain parties from benefiting from the externality, especially when the externality affects many recipients, and the amount that any particular recipient must pay is relatively small.
4. Network Effects and Externalities.
1. Introduction.
1. Definition. A network effect is a benefit or cost that increases with the size of the network.
1. The adjective “network” emphasizes that the benefit or cost is generated by the entire network of users, e.g., connections to telephone service generate network effects.
2. The marginal benefit and demand for an item that exhibits network effects increases with the number of other users, e.g., when one more person subscribes to telephone service, the marginal benefit and demand curves of all other users will shift up.
2. A network externality is a benefit or cost directly (and not through a market) conveyed to others that increases with the size of the network.
1. The benchmark for a network externality is economic efficiency: the combined marginal benefits equal the combined marginal costs.
3. The presence of network effects or network externalities implies that the character of demand and competition will differ from that in conventional supply–demand markets.
2. Critical mass. In markets with network effects, demand may be zero unless the number of users exceeds the critical mass.
1. Definition. Critical mass is the number of users at which demand becomes positive. Installed base: the quantity of complementary hardware in service (e.g., mobile phones in the demand for mobile service). If each user needs one separate unit of the complementary hardware and if each unit supports just one user, an alternative way to measure the size of the critical mass is the size of the installed base.
3. Expectations. Expectations of potential users help to determine the attainment of critical mass.
1. Good equilibrium: every potential user is optimistic and expects the others to adopt the new technology, and accordingly adopts; demand exceeds critical mass and the technology succeeds as expected.
2. Bad equilibrium: every potential user is pessimistic and expects less than critical mass to adopt the new technology, and accordingly does not adopt; demand fails to reach critical mass and the technology flops as expected.
3. In equilibrium, expectations can be self-fulfilling.
4. Expectations can be influenced through commitments (sellers of items with network effects give away large quantities to establish a sufficient installed base) and hype (a grand launch).
4. Tipping.
1. Definition. Tipping is the tendency for demand to shift toward a product with a small initial lead.
2. In markets with network effects, where demand is close to the tipping point (near critical mass), demand is extremely sensitive to small differences among competitors.
1. A small increase in the user base of one product can tip the market demand toward that product.
3. In a market for competing products that generate network effects, the likelihood of tipping means that one product may dominate the market.
1. If demand for some products just exceeds critical mass, any slight movement in demand away from that product will tip all the users away.
2. By contrast, in a conventional market, several competitors of similar size may continue profitably for a long time.
5. Price elasticity. The presence of network effects affects the price elasticity of demand depending on whether the demand has reached critical mass.
1. When demand is below critical mass, demand is zero, and extremely price inelastic: even large price reductions will not increase demand at all.
2. When demand exceeds critical mass, the network effect causes the market demand to be relatively more price elastic.
3. The network effect tends to amplify the effect or a price increase or price deduction on demand. For example, a price increase would reduce demand, and the reduction would feed back through the network effect to further reduce the demand.
5. Public Goods.
1. Introduction.
1. A public good (such as open-air fireworks) provides non-rival consumption. Consumption is non-rival if one person’s increase in consumption does not reduce the quantity available to others.
2. There is an extreme economy of scale in providing a public good with respect to the number of consumers. The cost of provision is fixed and the marginal cost of serving an additional consumer is zero.
1. There might not be economies of scale with respect to the scale of provision, e.g., increasing the length of a fireworks show does involve more costs.
2. Rivalness. There is a continuum between non-rival, congestible, and rival consumption.
1. Consumption is rival if one person’s increase in consumption reduces the total available to others by the same quantity. A private good (such as food, clothing, computers, electricity, restaurant meals) provides rival consumption.
2. Consumption is non-rival if one person’s increase in consumption does not reduce the quantity available to others. A public good (such as open-air fireworks, scientific formula, musical composition, TV broadcast) provides non-rival consumption.
3. Consumption is congestible if one person’s increase in consumption by some quantity reduces the total available to others but by less than that quantity. Congestible items are public goods when consumption is low but are private goods when consumption is high, e.g., air, Internet service, transportation facilities.
3. Economically efficient quantity of public good: at the point where the combined individual marginal benefits (the vertical sum of the individual marginal benefits cures) equals the marginal cost. Opportunities to profit from adjusting the provision of the public good are exhausted at that point.
6. Excludability. The basis for commercial provision of many public goods is to deliver them in the format of private goods.
1. Excludable consumption.
1. Definition. Consumption is excludable if the provider can exclude particular consumers.
2. Excludability is a fundamental condition for the commercial production of any product. Otherwise free riders will cut into the seller’s revenues and profits, and hamper provision.
2. Content and delivery.
1. Since private goods are excludable, if a public good is delivered in the form of a private good, the public good can be commercially provided.
2. Content. TV programming, ignoring the delivery method (broadcast or cable);
3. Delivery. The method of delivery may be a public good or private good.
1. Delivery by free-to-air transmission: public good.
2. Delivery by cable: private good.
3. Excludability depends on law and technology.
1. Law – establishes excludability through intellectual property, hence commercial development and production are feasible.
1. Patent: a legal exclusive right to a product or process. (Note: scientific formulas are otherwise public goods).
2. Copyright: a legal exclusive right to an artistic, literary, or musical expression. (Note: content of the Oxford English Dictionary, computer software are otherwise non-rival.)
2. Technology.
1. The content of TV programming/software algorithms and codes: pubic goods,but delivery can be excludable via scrambling technology, access technology.

Progress Checks and Review Questions

Please refer to the textbook for answers to selected Progress Check and Review questions.

Discussion Questions #1 and Answer

In June 2016, Xiaolan Metro Mall, located in Zhongshan City, Guangdong Province, China, charged supermarket RT-Mart a monthly rent of 34.8 yuan per square meter for 17,882 square meters. It charged the other tenants 119.6 yuan per square meter, or 3.43 times as much.

1. With a relevant diagram, illustrate the supermarket’s marginal benefit from and marginal cost of attracting customers. Show the externality on another retailer and identify the economically efficient number of customers.
2. Explain why Xiaolan Metro Mall charges lower rents to RT-Mart than to other retailers.
3. Compare a supermarket on a public street with one in a shopping mall. Discuss how likely are externalities to nearby retailers to be resolved.

Answer

1. RT-Mart helps to attract customers to the mall, and so, generates positive externalities to the other retailers.
2. Externalities to nearby retailers are more likely to be resolved for a supermarket in a shopping mall compared to a public street. Shops along a public street that receive positive externalities from the department store can simply refuse to pay the department store for the benefits. The department store cannot prevent its customers from patronizing shops that refuse to pay. By contrast, in a shopping mall, with the same management, the management can support positive externalities by charging lower rents to anchor stores and higher rents to specialty stores.

Chapter 11

Asymmetric information

Learning Objectives

• Understand imperfect information and risk.
• Appreciate asymmetry of information and its consequences.
• Apply and apply appraisal to resolve information asymmetry.
• Apply and apply screening to resolve information asymmetry.
• Apply and apply signaling to resolve information asymmetry.
• Apply and apply contingent contracts to resolve information asymmetry.

Key Takeaways

• Risk is uncertainty about benefits or costs.
• A risk averse person will pay to avoid risk.
• If information is asymmetric, the allocation of resources is not economically efficient, and there is an opportunity to add value and profit by resolving the asymmetry.
• If adverse selection is severe, the market will fail.
• Use appraisal if the characteristic about which information is asymmetric is objectively verifiable and it is not too costly.
• Use screening to indirectly elicit the characteristics of the better-informed party if the screening induces self-selection.
• A better-informed party can use signaling to indirectly communicate its characteristics if the signaling induces self-selection.
• Use a contingent contract to screen or signal.

Detailed Notes

1. Asymmetric Information. In a situation of asymmetric information, one party has better information than another, e.g., sellers of wine and antiques have better information about wine quality than buyers.
1. Techniques to resolve asymmetries apply broadly, beyond finance to commercial, non-commercial, and personal settings.
2. Managers can use these methods to resolve information asymmetry and realize transactions and relationships to increase value added and profit.
2. Imperfect Information.
3. Imperfect and asymmetric information.
1. Imperfect information.
1. Imperfect information about something is the absence of certain knowledge about that thing by a single person or by more than one party.
2. A market can be perfectly competitive even when buyers and sellers have imperfect information, so long as they all have symmetric information, e.g., demand for heating oil.
1. In a perfectly competitive market, the forces of demand and supply will channel resources into economically efficient uses; no further profitable transactions are possible.
3. Asymmetric information.
1. Asymmetric information involves two or more parties, one of whom has better information than the other or others.
1. Asymmetric information will always be associated with imperfect information, because the party with poorer information definitely will have imperfect information.
2. A market where information is asymmetric cannot be perfectly competitive. If buyers and sellers can resolve the information asymmetries, they can increase their benefits by more than their costs, and so add value and increase profit.
2. Risk defined. Risk is uncertainty about benefits or costs and arises whenever there is imperfect information about something that affects benefits or costs, e.g., a car owner bears a risk that her car might be stolen.
1. A person can have imperfect information about something, but if that thing does not affect her/his benefits or costs, it does not impose any risk on her/him.
2. Classification:
1. A risk-averse person prefers a certain amount to risky amounts with the same expected value.
1. Risk-averse persons will pay to avoid risk.
1. Insurance is the business of taking certain payments in exchange for eliminating risk.
2. How much risk averse persons are willing to pay for insurance depends on their degree of risk aversion.
2. A risk-neutral person is indifferent between a certain amount and risky amounts with the same expected value.
1. A risk-neutral person will not pay anything to avoid risk.
3. Whenever information is asymmetric, the less-informed party has imperfect information. To the extent that this means uncertainty about benefits or costs, the less-informed party faces risk.
4. Adverse Selection.
1. Definition. Adverse selection arises in situations of asymmetric information: in an adverse selection, the less-informed party draws a selection with relatively bad characteristics, e.g., consumer who cannot distinguish good from bad wines would get an adverse selection – a mixture of bad and good wines.
2. Demand and supply, market equilibrium and economic inefficiency.
1. The equilibrium in a market with asymmetric information will not be economically efficient.
1. Consumers buy up to the point that the expected marginal benefit (adjusted for the probability of getting low quality) equals the market price.
1. Low-quality wine provides no marginal benefit so, in equilibrium, the marginal benefit of consumers who get low-quality wine is less than the wine producer’s marginal cost.
2. The marginal benefit of high quality wine exceeds the wine producer’s marginal cost.
2. At equilibrium, marginal benefit does not equal marginal cost.
3. The quantity traded is not economically efficient.
2. Sellers of low-quality wine impose a negative externality on consumers and producers of high-quality wine. By resolving the negative externality (information asymmetry), a profit can be made.
3. Market failure.
1. Severe adverse selection can cause a market to fail, and price changes do not help to restore equilibrium.
1. As market price drops, high-quality wine producers produce less. Quantity of low-quality wine is not affected, increasing the proportion of low-quality wine, leaving buyers with a worse adverse selection. Consumers’ willingness to pay and the expected demand curve would drop. A price reduction cuts demand and production, and does not necessarily restore the equilibrium.
4. In the extreme, if the price is cut very low, so much low-quality wine floods the market that the actual demand curve drops to zero and the market would fail completely (there is no sale at all).
5. Appraisal.
1. Appraisal (including wine appraisal, credit checks, employment records) overcomes asymmetric information by obtaining the information directly.
2. Appraisal works (resolving the information asymmetry) under two conditions:
1. The characteristic about which information is asymmetric is objectively verifiable.
1. If the expert cannot objectively distinguish high-quality from low-quality wine, then appraisals would not help.
2. If different appraisers give different opinions, the information will still be asymmetric.
2. It is not too costly, i.e., the potential gain (for buyer: difference between marginal benefit and market price; for seller: difference between market price and marginal cost) from resolving the asymmetry covers the cost of appraisal. This, in turn, depends on two factors.
1. One is the proportion of low quality relative to high quality.
2. The other is the difference between the marginal benefit and the marginal cost.
6. Screening.
1. Screening is an initiative of a less-informed party to indirectly elicit the better-informed party’s characteristics (e.g., the true quality of the wine).
1. Screening is an indirect way to resolve asymmetric information. (For example, consumers do not directly determine whether wine is of high quality or low quality; they require producers to make a choice that indirectly communicates their characteristics.)
2. Screening is possible only if the less-informed party can control some variable to which the better-informed parties are differentially sensitive.
1. The less-informed party must design choices around that variable to induce self-selection: in self-selection, parties with different characteristics choose different alternatives.
1. The “deal”: consumers insist that they get the first bottle free and pay double for the second bottle.
2. The deal makes sense only for producers of high-quality wine. Producers of low-quality wine will not get any revenue. They will not accept the deal. Low-quality producers were more sensitive to the “deal” than high-quality producers.
3. Differentiating variable(s).
1. When the less-informed party has the choice of several differentiating variables, it should structure the choice that drives the biggest possible wedge between the better-informed parties with the different characteristics.
4. The most effective screening may involve a combination of the differentiating variables (e.g., to screen between leisure vis à vis business travelers, airlines use a combination of advance booking, penalties for changes, frequent flyer benefits … etc.).
7. Signaling.
1. Definition. Signaling is an initiative of the better-informed party to communicate its characteristics in a credible way to the less-informed party.
1. It is an indirect way to resolve asymmetric information.
2. The communication must be credible: the parties with different characteristics must choose different signaling policies.
1. Signaling is credible only if it induces self-selection among the better-informed parties.
2. The cost of the signal must be sufficiently lower for parties with superior characteristics than for parties with inferior characteristics. Only those with superior characteristics will offer the signal (e.g., offering full refunds on a product).
3. Costless signaling is not credible (e.g., labeling the wine as high quality).
8. Contingent Contracts.
1. Definition. A contingent contract specifies actions under particular conditions.
1. An indirect way to resolve asymmetric information.
2. Induces self-selection among the better-informed parties (e.g., sellers offering products of different quality).
3. May serve as signals, e.g., sellers of better (higher-yielding) vines can distinguish themselves by selling for a share of the production, as opposed to cash (preferred by sellers of average or relatively low-yielding vines).
4. May serve as screens, e.g., a potential buyer could take the initiative of offering the seller a choice between payment in a share of the production or straight cash; a seller of relatively high-yielding vines is more likely to choose the payment with a share of production.

Progress Checks and Review Questions

Please refer to the textbook for answers to selected Progress Check and Review questions.

Discussion Question #1 and Answer

In Hong Kong, insurer AIA offers medical insurance to the public. AIA’s Flexi Plan covers the expenses on hospitalization and surgical care subject to limits of HK$10 million per year and HK$50 million lifetime.

1. Explain the asymmetry of information between AIA and applicants for medical insurance.
2. The Flexi Plan excludes pre-existing conditions that the applicant knew about. Explain why.
3. How would a group policy, which covers all members of an organization, mitigate adverse selection for the insurer? Explain why adverse selection would be less in a larger group.
4. Unlike falling sick or meeting with accidents, in many cases, women voluntarily enter into pregnancy. Explain why the Flexi Plan excludes coverage of pregnancy.

Answer

1. Applicants for medical insurance have better information about their health and lifestyles than providers of medical insurance.
2. The Flexi Plan does not cover pre-existing conditions as individuals with such conditions have certain future health states, whereas insurance is only relevant when individuals’ future health states are uncertain. The cost of treating such conditions is predictable, so there is no scope for insurance.
3. A group policy covers all employees including those with better health and lifestyles and those with worse health and lifestyles. So, the risk profile of the insured people would be more typical and there would be less adverse selection. The larger the group, the less the adverse selection.
4. Pregnancy coverage would create an adverse selection problem. Women planning to become pregnant would buy the Flexi Plan, while others would not.

.

Chapter 12

Incentives and organization

Learning Objectives

• Appreciate moral hazard.
• Apply monitoring and incentives to resolve moral hazard.
• Appreciate holdup and detailed contracting.
• Understand ownership and its consequences.
• Appreciate vertical integration.
• Understand and apply organizational architecture.

Key Takeaways

• Moral hazard arises if one party's actions affect but are not observed by another party.
• Resolve moral hazard through monitoring and incentives.
• Holdup is action to exploit another party’s dependence.
• Resolve holdup through detailed contracts, avoiding specific investments, and by vertical integration.
• Ownership is the rights to residual control, which are those rights that have not been contracted away.
• Vertical integration is the combination of the assets for two successive stages of production under a common ownership.
• Apply organizational architecture to balance holdup, moral hazard, internal market power, and economies of scale and scope.

Detailed Notes

1. Organizational Architecture.
1. Definition. Organizational architecture comprises the distribution of ownership, incentive schemes, and monitoring systems. The vertical and horizontal boundaries of the organization are two aspects of the organizational architecture.
2. An efficient organizational architecture revolves around four issues of internal management:
1. holdup;
2. moral hazard;
3. internal market power; and
4. economies of scale and scope.
2. Moral Hazard.
1. Definition. Moral hazard exists when one party’s actions affect but are not observed by another party, e.g., a delivery worker is subject to moral hazard relative to her employer.
2. Asymmetric information about actions. Moral hazard arises when there is asymmetric information concerning some action of the better-informed party.
3. Economic efficiency.
1. The delivery worker acts independently and chooses her effort to maximize her personal net benefit = her compensation – her cost of effort. The delivery worker’s effort generates a positive externality for her employer.
1. Level of effort that maximizes her net benefit = her marginal compensation – her marginal cost of effort.
1. The lower the delivery worker’s marginal compensation relative to the employer’s marginal profit contribution, the lower will be the effort that the delivery worker chooses relative to the economically efficient level.
2. If the delivery worker’s marginal compensation coincides exactly with the employer’s marginal profit contribution, the delivery worker would choose the economically efficient level of effort, and there will be no moral hazard.
4. Degree of moral hazard. The relevant parties would like to resolve the moral hazard/positive externality (in the delivery context), so that the better-informed party/delivery worker will make the economically efficient choice.
1. The degree of moral hazard is measured by the difference between the economically efficient action and the action chosen by the party subject to moral hazard.
1. The greater the difference, the greater the degree of moral hazard, and the greater the added value (the excess of profit contribution over cost) to the employer and the delivery worker that can be realized by resolving the moral hazard.
3. Incentives.
1. Two complementary approaches to resolve moral hazard: monitoring systems and incentive schemes.
1. They are complementary because all incentives must be based on actions that can be observed. The better the available information is, the wider the choice of incentive schemes.
2. Monitoring systems. These collect information about the actions of the party subject to moral hazard.
1. The simplest monitoring system (e.g., time clock, vehicle log, random checks by supervisors, customer reports) focuses on objective measures of performance such as hours on the job (not necessarily effort).
2. Supervision by supervisors.
3. Monitoring by customers.
3. Incentive schemes align the incentives of the party subject to moral hazard with those of the less-informed party by linking compensation to some observable measure of performance.
1. They depend on alink between the unobservable action and some observable measure of performance.
2. The scope of incentive schemes depends on what indicators of the unobservable action are available, e.g., using information provided by monitoring systems.
3. Performance pay is an incentive scheme that bases pay on some measure of performance (e.g., a 10% commission on sales volume).
1. Note: with a fixed wage and no monitoring, a salesperson cannot affect her earnings in any way. So, her marginal compensation from effort will be zero. Her marginal compensation curve is the horizontal axis.
2. With a 10% commission, the marginal compensation from effort will be positive. The height and slope of her marginal compensation curve depend on how her effort affects sales revenue.
3. With a 15% commission, the marginal compensation curve would be higher, and would cross the marginal cost curve at a higher level of effort. The salesperson would increase effort.
4. An incentive scheme is relatively stronger (resulting in higher level of worker’s effort) if it provides a higher personal marginal compensation for effort.
4. Risk and multiple responsibilities. Two side-effects of incentives.
1. Risk.
1. Incentive schemes resolve moral hazard by linking compensation to some observable measure of the unobservable action.
2. Risk arises whenever the measure of the unobservable action is affected by factors other than the unobservable action, as the compensation would then depend on those other factors.
1. A party who is subject to moral hazard and has imperfect information about those factors will face risk.
2. Risk arises as she will be uncertain about her compensation.
3. For example, besides the delivery worker’s effort, actual deliveries may depend also on the general state of the economy, competition, traffic, weather, customers’ orders, and other factors.
3. An economically efficient incentive scheme must balance the incentive for effort with the cost of risk. The cost of risk depends on 3 factors:
1. The impact of extraneous factors: if the measure is sensitive to these extraneousfactors and the factors are subject to wide swings, the risk would be relatively higher.
2. The degree of risk aversion of the party subject to moral hazard: if the party subject to moral hazard is risk neutral, the risk imposes no cost. The cost of risk increases with the degree of risk aversion.
3. The strength of the incentive scheme: stronger incentives impose a heavier burden of risk on the party subject to moral hazard.
4. Stronger schemes should be adopted if the extraneous factors are weaker and the party subject to moral hazard is relatively less risk-averse.
4. Holdup.
1. Definition. Holdup is an action intended to exploit another party’s dependence.
1. Unlike moral hazard, holdup does not require asymmetric information.
2. The prospect of a holdup leads other parties to take precautions (to avoid dependence) which either reduce benefits or increase costs, reducing the overall value and economic efficiency.
3. There is an opportunity to add value and increase profit by resolving the holdup.
2. Specific investments.
1. The specificity of an investment in an asset (e.g., physical asset like a computerized route planning system, or human capital) is the percentage of the investment that will be lost if the asset is switched to another use.
2. The costs of holdup will be higher if the relevant assets are more specific.
3. The prospect of holdup deters all forms of specific investments.
4. If holdup could be prevented, the relevant parties would increase specific investments and so add value and increase profit.
3. Incomplete contracts. A complete/more detailed contract would resolve holdup, but would be very costly to prepare.
1. A complete contract specifies the actions of all parties under every possible contingency.
2. Generally, a contract should be more detailed if:
1. The potential benefits and costs at stake are larger;
2. Possible contingencies are more serious.
5. Ownership. Another way to resolve holdup is through changing the ownership of the relevant assets.
1. Ownership means the rights to residual control, which are those rights that have not been contracted away (e.g., the right to enter into a second mortgage on the building after granting a first mortgage to a bank).
1. Rights to residual control include the right to receive residual income from the asset, which is the income remaining after the payment of all other claims (e.g., the difference between rental income and expenses).
1.  As the recipient of residual income, the owner gets the full benefit of changes in income (e.g., an increase in rent) and costs.
2. A transfer of ownership means shifting the rights of residual control to another party.
3. An owner has the full incentive to maximize the value of the assets.
1. If information about other parties’ actions is asymmetric, they would be subject to moral hazard relative to the owner.
2. Even absent asymmetric information, other parties may hold up the owner and exploit the owner’s dependence.
2. Vertical integration.
1.  Vertical integration is the combination of the assets for two successive stages of production under a common ownership.
1. With common ownership, the owner would have full incentive to maximize the value of the combined assets.
2. With separate ownership, the owner of each asset would only maximize the value of its asset, and possibly at the expense of the owner of the other asset.
2. Downstream vs upstream vertical integration.
1. Downstream vertical integration: involving the acquisition of assets for a stage of production nearer to the final consumer, e.g., a food manufacturer acquiring a supermarket. The “sell or use” decision is a decision to vertically integrate downstream
2. Upstream vertical integration: involving the acquisition of assets for a stage of production further from the final consumer, e.g., a food manufacturer acquiring a dairy farm. The “make or buy” decision is a decision to vertically integrate upstream.
3. Vertical integration/disintegration changes the ownership of assets and alters the rights to residual control and residual income.
1. These in turnaffect the degree of moral hazard and the potential for holdup.
6. Organizational Architecture.
1. Implications.
1.  Vertical and horizontal boundaries are just 2 aspects of the organizational architecture, which comprises:
1. distribution of ownership;
2. incentive schemes; and
3. monitoring systems.
2. The design of organizational architecture depends on a balance among four issues and the mechanisms by which these issues may be resolved:
1. holdup;
2. moral hazard;
3. internal market power; and
4. economies of scale and scope.
2. Holdup can be resolved by changing the ownership of relevant assets.
1. An external contractor has the power to withhold the services of its assets.
2. Vertical integration can mitigate the potential for holdup. For example, holdup by a delivery service can be resolved by vertical integration into the delivery business (an in house delivery service).
3. Moral hazard. Changes in ownership will also affect the degree of moral hazard.
1. Vertical integration changes ownership. Since an employee is subject to relatively greater moral hazard than an owner, vertical integration increases the degree of moral hazard.
2. Giving ownership to the employee/internal supplier will resolve the moral hazard.
1. If the employee owns the business, she receives the residual income. If she exerts an additional unit of effort, she will receive the entire marginal profit contribution.
2. When balancing her marginal benefit with the marginal cost, the employee will choose the economically efficient level of effort.
4. Internal market power. Changes in ownership will affect the monopoly power of internal sources of input and monopsony power of internal users of outputs.
1.  The internal supplier may acquire monopoly power. The organization should outsource (purchase services or supplies from external sources) whenever the internal provider’s cost exceeds that of external sources.
2. A policy to sell externally whenever the external price is higher than the internal transfer price can resolve the internal monopsony power.
5. Economies of scale and scope. Changes of ownership affect the extent of economies of scale and scope.
1.  Economies of scale. The internal supplier may lack scale as compared with external suppliers. The external contractor would have better capacity utilization and hence a lower average cost. Then, it would be less costly to purchase the service from the external contractor.
2. Economies of scope. Economies of scope are the major factor in favor of wide horizontal organizational boundaries. If the company already produces one item, it can reduce total cost by producing the other one as well. However, if the company does not already produce either item, then economies of scope imply that it should outsource both.
6. Balance. The decision on organizational architecture depends on a balance among: the scope for holdup, the degree of moral hazard, internal market power, and the extent of economies of scale and scope. It also depends on other ways to resolve these issues – more detailed contracts, incentives and monitoring, outsourcing and external sales.
1. Vertical boundaries – the “make or buy” decision:
1. In favor of vertical integration: holdup and economies of scope.
2. In favor of outsourcing: moral hazard, internal market power, and economies of scale and scope.
2. Horizontal boundaries:
1. In favor of horizontal integration: economies of scope.
2. Against horizontal integration: moral hazard.

Progress Checks and Review Questions

Please refer to the textbook for answers to selected Progress Check and Review questions.

Discussion Questions #1 and Answer

The National University of Singapore provides outpatient medical insurance to faculty and staff. The plan covers the entire bill for treatment and medicine at an approved general practitioner subject to a copayment of S$5.

• Construct a diagram with quantity of healthcare (including treatment and medicines) on the horizontal axis and marginal benefit and marginal cost of healthcare on the vertical axis. Draw the patient's marginal benefit and marginal cost, and the insurer's marginal cost.
• Compare the level of healthcare that the patient would choose with the level that maximizes the patient's benefit less the insurer's and patient's cost.
• How does the S$5 copayment affect the patient's choice between: (i) a generic drug that costs S$25, and (ii) a branded drug that costs S$50?
• Suppose that the University replaces the S$5 copayment with a 10% copayment. Use your diagram to illustrate how that would affect the patient's choice of healthcare.

Answer

• See figure below.

• For the patient, the $5 copayment is a fixed cost. So, her marginal cost is vertical at zero quantity of healthcare from $5 to $0, and then follows the horizontal axis. She would choose the level of healthcare where her marginal benefit equals marginal cost, at level c. The economically efficient level of treatment (that maximizes the patient's benefit less the insurer's cost) is at level b.
• She would choose the branded drug since her cost is the same $5 for either choice.
• The quantity of medical healthcare would decrease to level d.

Chapter 13

Regulation

Learning Objectives

• Appreciate the conditions for a natural monopoly and how to regulate a monopoly.
• Appreciate the conditions for a potentially competitive market and how to foster competition.
• Appreciate how to regulate markets with asymmetric information.
• Appreciate how governments should regulate externalities.
• Recognize that global externalities require multilateral cooperation.
• Appreciate how to regulate externalities that are contingent on demand or supply.

Key Takeaways

• A market is a natural monopoly if the average cost of production is minimized with a single supplier.
• Governments can regulate monopolies by either price or rate of return.
• Governments can foster competition through competition law and by regulating conduct and structure.
• Governments can regulate markets with asymmetric information through disclosure, conduct, and structure.
• Governments can regulate externalities through user fees/taxes, or quotas/standards.
• Global externalities require multilateral cooperation.
• Regulation of externalities should adjust to demand and supply conditions.

Detailed Notes

1. Economic Inefficiency and Government Regulation. Possible sources of economic inefficiency (situations where marginal benefit diverges from marginal cost):
1. market power;
2. externalities; and
3. asymmetric information.
2. Natural Monopoly.
1. Definition. A natural monopoly is a market where the average cost of production is minimized with a single supplier, e.g., distribution of electricity and water, broadband service.
1. A market is a natural monopoly when economies of scale or scope are large relative to market demand. The average cost of production is lowest when there is only one supplier.
2. If a market is a natural monopoly, the government should prohibit competition and award an exclusive franchise to a single supplier.
3. The monopoly might exploit its exclusive right to raise its price at the expense of its customers, forcing the marginal benefit above the marginal cost.
4. The government can control the monopoly via:
1. Government ownership and operation; or
2. Regulation of commercial enterprise.
2. Government ownership.
1. A government-owned enterprise tends to be relatively inefficient.
1. More prone to be coopted by employees, resulting in high wages and over staffing, inflating the cost of production.
2. Must compete with other priorities for an allocation from the government budget and may not secure the economically efficient level of investment.
2. Privatization. Privatization is the transfer of ownership from the government to the private sector. This does not necessarily mean allowing competition. A private enterprise may have an exclusive franchise and hence be a monopoly.
3. Price regulation.
1. Marginal cost pricing: The provider must set the price equal to the marginal cost and to supply the quantity demanded, behaving like a perfectly competitive supplier.
1. Production at economic efficient level: marginal benefit equals marginal cost.
2. Two challenges.
1. Subsidy. To allow the provider to break even, government subsidy may be required. However, with average cost pricing, no subsidy. The provider must set the price equal to the average cost and supply the quantity demanded.
2. Cost information. The franchise holder has a strong incentive to exaggerate its reported costs to attempt to set a higher price and increase its profit. This situation of information asymmetry, if not resolved, would result in economic inefficiency.
4. Rate of return regulation. This avoids the issue of costs by focusing on the franchise holder’s profit. The regulator stipulates the franchise holder’s maximum allowed profit in terms of a maximum rate of return on the value of the rate base. The franchise holder can set prices freely, provided that they do not exceed the maximum allowed profit.
1. Rate base: Assets or equity on which the franchise holder may earn the allowed rate of return.
2. The franchise holder must reduce its prices if its rate of return exceeds the specified maximum.
3. Three challenges.
1. Rate of return. To determine the appropriate rate of return for the monopoly.
1. There would be few comparable businesses.
2. Typically, the rate base is large, and a small difference in the allowed rate of return will translate into a large sum of money.
2. Rate base. To determine what assets are needed to provide the regulated service.
1. The franchise holder will seek the widest possible definition to increase profit.
3. Overinvestment.
1. The franchise holder has an incentive to invest beyond the economically efficient level.
2. By enlarging the rate base, the allowed rate of return will be applied to a larger base, leading to higher profit.
3. Potentially Competitive Market.
1. Definition. A potentially competitive market is one where economies of scale or scope are small relative to market demand. Having two or more competing suppliers would not raise average costs.
1. In a potentially competitive market, with perfect competition, the invisible hand ensures economic efficiency.
2. In a potentially competitive market, the government should promote competition.
3. The government can promote competition via:
1. Competition law; or
2. Structural regulation.
2. Competition law (“antimonopoly” or “antitrust” law). Regulated industries are subject to competition law specific to the industry.
1. Competition laws generally prohibit/restrict:
1. Collusion – competitors colluding on price or other aspects of purchases or sales;
2. Abuse of market power by businesses with market power;
3. Harmful mergers or acquisitions that would create substantial market power; and
2. Competition laws may also prohibit/restrict specific business practices such as control over resale prices and exclusive agreements.
3. Structural regulation. A natural monopoly may have upstream or downstream markets that are potentially competitive. For example, in electricity, generation may be potentially competitive while distribution may be a natural monopoly.
1. The government must preserve the benefits of monopoly in one market while fostering competition in the other.
2. Challenges.
1. A monopoly franchise holder may also participate in the potentially competitive market, e.g., a holder of monopoly franchise over the distribution of electricity also has a monopsony over the purchase of electricity from generators.
1. The government must regulate the franchiser’s monopoly over the distribution of electricity as well as its monopsony over the purchases of electricity.
2. If a holder of monopoly franchise over the distribution of electricity has vertically integrated upstream into the generation of electricity, it may have an incentive to favor its internal generator of electricity and discriminate against competing generators. It might also exploit superior information about technical and other issues to confound the regulator if the latter tries to intervene to ensure fair competition. The competing generators of electricity may be at a disadvantage in supplying the distribution monopoly.
3. Structural regulation is a way to separate the natural monopoly from the potentially competitive market. Under structural regulation the regulator stipulates the conditions under which a business may produce vertically related goods and services, e.g., compulsory divestment of one of the businesses.
4. Asymmetric Information.
1. If information asymmetry is not resolved, marginal benefit will diverge from marginal cost, and the allocation of resources will not be economically efficient (e.g., inflated demand for medical services).
2. Direct government regulation. The regulator could resolve the asymmetry by regulating:
1. Disclosure of information by the better-informed party. The better-informed party is required by the government to disclose its information truthfully. Note: information should be objectively verifiable .
2. Conduct of the better-informed party. The better-informed party is regulated to limit the extent to which it can exploit its informational advantage. The regulator could stipulate requirements for written agreements and minimum cooling-off periods (e.g., in the case of unsuitably risky investments).
1. Business structure of the better-informed party. By enforcing separation of different businesses, a regulator may reduce the opportunities for exploiting superior information (e.g., in the separation of medical advice and treatment from sale of pharmaceuticals).
5. Regulation of Externalities.
1. When some benefit or cost passes directly from source to recipient and not through a market, the invisible hand cannot work. Also, private action may fail to resolve widespread externalities involving large numbers of parties.
1. Government regulation may be the only solution.
2. The economically efficient level of an externality balances the marginal benefit with marginal cost.
1. Benefit of emissions: allowing the sources to avoid the cost of clean disposal.
2. Cost of emissions: harm to the health of the victims.
2. User fees or taxes.
1. These allow all sources to emit pollutants as much as they like provided that they pay the appropriate fee or tax.
2. The regulator sets the user fee for all sources of emissions at the social marginal cost of emissions.
1. All sources would emit up to the level that their marginal benefit equals the fee. The marginal benefits of all sources would be equal.
2. The marginal benefits of emissions equal the user fee, which equals the social marginal cost of emissions.
3. So the user fee implements the economically efficient rate of emissions.
3. Standards or quotas.
1. The regulator sets the standard/quota at the economically efficient rate of emissions.
2. The regulator then sells the licenses through public auction to all sources.
1. Each source would demand licenses according to its marginal benefit from emissions. The market demand is identical to the social marginal benefit curve.
3. The equilibrium price of each license (where quantity demanded equals quantity supplied) equals the social marginal cost of emissions, same as a user fee determined by a competitive market.
6. Global Externalities.
1. Externalities that transcend national boundaries (e.g. emissions of greenhouse gases).
1. The global marginal benefit is the vertical sum of national marginal benefits.
2. The economically efficient rate of emissions is achieved when the global marginal benefit equals the global marginal cost.
2. Multilateral regulation.
1. Regulation by a single government will not resolve the externality.
2. It is difficult to exclude anyone from the benefits of resolving the externality. Hence, individual countries would like to free ride on the actions of other countries.
3. Resolving global externalities requires multilateral regulation.
3. Information and behavioral biases.
1. Individual adaptation of government policies may be hindered by:
1. Information asymmetries regarding the benefits and costs of resolving global externalities.
2. Hyperbolic discounting, as policies that impose costs in the present for benefits in the future appear less attractive.
3. Sunk cost fallacy, as vested interests will resist change if it renders existing equipment and facilities obsolete.
7. Contingent Externalities.
1. Externality that is contingent on demand or supply conditions (e.g., congestion).
1. For economic efficiency, congestible facilities (e.g., bridges, tunnels, roads, and subways) should levy a user fee equal to the marginal cost of use, where the cost includes the externalities imposed on other users.
2. As marginal cost varies with time of the day, so should the price.

Progress Checks and Review Questions

Please refer to the textbook for answers to selected Progress Check and Review questions.

Discussion Questions #1 and Answer

1. The electricity industry in India’s National Capital Territory is vertically separated into generation, transmission, and distribution. Tata Power Delhi Distribution Limited (TPDDL) is the exclusive distributor in north and north-west Delhi. In financial year 2020/21, TPDDL applied for a rate base of 41.47 billion rupees and cost of capital of 15.82%. However, the Delhi Electricity Regulatory Commission approved a 35.34 billion rupees rate base and 11.61% cost of capital. Also, the Commission did not allow any change in prices.

1. Explain natural monopoly in the context of electricity distribution.
2. Using a relevant diagram, explain average cost pricing of electricity distribution.
3. Explain why the electricity industry should be vertically separated with monopoly franchises for transmission and distribution.
4. What challenges would the Commission face in administering rate-of-return regulation?
5. Under rate-of-return regulation, discuss the incentives to generate electricity from renewable sources.

Answer

1. The average cost of electricity distribution is minimized with a single supplier. So, electricity distribution is a natural monopoly.
2. With average cost pricing, the price equals average cost and the provider must supply the demand. Referring to the figure, the regulated price would be P and the quantity would be Q.



3. If the electricity industry were not vertically separated, the electricity distributor would have an incentive to buy electricity from its internal generator even if doing so was more costly than buying from competing generators. Such discrimination between internal and external suppliers of electricity is eliminated through vertical separation, which is a form of structural regulation.
4. It would be difficult to determine the appropriate rate of return and the rate base.
5. Under rate-of-return regulation, the incentive to generate electricity from renewable sources is stronger as the capital investments for renewable energy increase the firm’s capital stock, which in turn increases its total profit.