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Microeconomics (4) Market Power and Information Microeconomics (4) Market Power and Information

Market Power in Most Markets • The products sold by your firm are different Market Power in Most Markets • The products sold by your firm are different from those of the competitors • Differentiation in many dimensions: location, colour, size, brand name, quality, customer service… • As a result, a firm can raise the price of its good and still sell to some consumers! • Effectively, the residual demand curve faced by the firm is downward sloping Product differentiation gives market power! • How to use (or abuse) market power?

Demand Faced by Individual Firm in a Perfectly Competitive Market Price Firm’s price is Demand Faced by Individual Firm in a Perfectly Competitive Market Price Firm’s price is given P 0 =P 1 Rev. GAIN Price at which firm can sell as much or little as desired Q 0 Q 1 Quantity

Demand Faced by Individual Firm in a Imperfectly Competitive Market Firm’s price is affected Demand Faced by Individual Firm in a Imperfectly Competitive Market Firm’s price is affected by sales Price Demand P 0 P 1 Rev. LOSS Demand for individual firm is referred to as “residual demand curve”, essentially equal to market demand minus demand by other firms at given prices Rev. GAIN Q 0 Q 1 Quantity

Monopoly Beryllium Price • Brush Wellman (Utah) is Industry demand (essentially) the only seller Monopoly Beryllium Price • Brush Wellman (Utah) is Industry demand (essentially) the only seller of beryllium in the world • Brush Wellman’s reserves 0 500 Beryllium are enough to supply the Brush Wellman’s Quantity world’s beryllium needs Beryllium Price for next 60 years BW’s demand • A monopolist faces the market demand curve Brush Wellman’s 0 500 Beryllium Quantity

Beryllium Demand Price ($/oz. ) Quantity Revenue Cost (million oz. ) ($ million) 12 Beryllium Demand Price ($/oz. ) Quantity Revenue Cost (million oz. ) ($ million) 12 0 0 11 1 . 5 10 2 2 9 3 4. 5 8 4 8 7 5 12. 5 6 6 18 5 7 24. 5 4 8 32 MR MC Profits ($ million)

Profit Maximising Price? Price ($/oz. ) Quantity Revenue Cost (million oz. ) ($ million) Profit Maximising Price? Price ($/oz. ) Quantity Revenue Cost (million oz. ) ($ million) MR MC Profits ($ million) 12 0 0 0 -- -- 0 11 1 11 . 5 10 2 20 2 9 1. 5 18 9 3 27 4. 5 7 2. 5 22. 5 8 4 32 8 5 3. 5 24 7 5 35 12. 5 3 4. 5 22. 5 6 6 36 18 1 6. 5 18 5 7 35 24. 5 -1 5. 5 10. 5 4 8 32 32 -3 7. 5 0

Profit Maximisation Price Demand Marginal Revenue POptimal Marginal Cost QOptimal Quantity Marginal Revenue = Profit Maximisation Price Demand Marginal Revenue POptimal Marginal Cost QOptimal Quantity Marginal Revenue = Marginal Cost P * ( 1 – 1/e) = MC => Inverse elasticity rule:

Welfare in Perfect Competition P Difference between consumers’ willingness to pay and amount paid Welfare in Perfect Competition P Difference between consumers’ willingness to pay and amount paid S Consumer Surplus P Difference between what producers receive and their marginal costs Producer Surplus 0 Q D Q

P Welfare in Monopoly Consumer surplus Deadweight loss due to the lower output and P Welfare in Monopoly Consumer surplus Deadweight loss due to the lower output and higher prices under monopoly PMon MC Profits MR 0 QMon QComp D Q

Efficiency of Competitive Markets An efficient allocation maximizes the sum of consumer and producer Efficiency of Competitive Markets An efficient allocation maximizes the sum of consumer and producer surplus Free (competitive) markets are efficient! • Buyers with highest valuations (willingness to pay) get the goods • Sellers with lowest costs produce the goods “It is not from the benevolence of the butcher, the brewer or the baker, that we expect our dinner, but from their regard to their own interest. ” Adam Smith The Wealth of Nations (1776)

Is Monopoly Evil? YES… Ex-post costs: • Low output – Deadweight loss • High Is Monopoly Evil? YES… Ex-post costs: • Low output – Deadweight loss • High costs – X-inefficiency • Low R&D Ex-ante costs: • Rent dissipation NO! Ex-post benefits: • Low costs due to economies of scale Ex-ante benefits: • High R&D

Competition & Efficiency: Summary Ex post, i. e. after product innovation & development: • Competition & Efficiency: Summary Ex post, i. e. after product innovation & development: • Compared to competition monopoly results in high profits, but low output (Y inefficiency) [and possibly inefficiently high cost (X inefficiency)] • Ex-post monopoly is bad for consumers and society! Ex ante, i. e. before product innovation & development: • Expectation of monopoly profits drives innovation • Ex-ante monopoly can be socially better than competition This is why intellectual property is protected with the patent system, so that innovators can reap benefits from research

Quiz: Interpret Each Area P Pm Consider industry with no fixed cost and constant Quiz: Interpret Each Area P Pm Consider industry with no fixed cost and constant marginal cost Compare outcome and welfare in: • Perfect competition • Standard monopoly • Perfect price discriminating monopoly 3 4 5 Ppc MC = AC 1 0 2 MR Qm D Qpc Q

P Pm Monopoly and “welfare” Deadweight loss due to the lower output and higher P Pm Monopoly and “welfare” Deadweight loss due to the lower output and higher prices under monopoly 3 4 5 Ppc MC = AC 1 0 2 MR Qm D Qpc Q

P Resource cost under monopoly, Ppc*Qm Pm Ppc MC = AC 1 0 D P Resource cost under monopoly, Ppc*Qm Pm Ppc MC = AC 1 0 D MR Qm Qpc Q

P Resources redeployed elsewhere under monopoly due to fall in output Pm Ppc MC P Resources redeployed elsewhere under monopoly due to fall in output Pm Ppc MC = AC 2 MR 0 Qm D Qpc Q

P Consumer surplus under monopoly 3 Pm Ppc MC = AC D MR 0 P Consumer surplus under monopoly 3 Pm Ppc MC = AC D MR 0 Qm Qpc Q

P Monopolist’s profits added to producer surplus (obtained from consumers!) Pm 4 Ppc MC P Monopolist’s profits added to producer surplus (obtained from consumers!) Pm 4 Ppc MC = AC D MR 0 Qm Qpc Q

An auction for £X • • • I will sell £X to the highest An auction for £X • • • I will sell £X to the highest bidder Write your bid down on a piece of paper Don't show anyone Bid must be in GBP sterling I'll collect bids Whoever bids highest gets the money, and pays what they've bid • In the event of a tie, I'll flip a coin • Any questions? • Write your bid down now: and don't show anyone else

Let me sell you some more money • I will sell £X to the Let me sell you some more money • I will sell £X to the highest bidder • Write your bid down on a piece of paper; don’t show anyone • Bid must be in GBP sterling • Whoever bids highest gets the money • Everybody who has bid pays what they’ve bid • Any questions?

A harder game • Each team produces an identical good • Each unit produced A harder game • Each team produces an identical good • Each unit produced costs £ 10 to make; no fixed costs • Together face the demand schedule P = 40 – Q • You can set output at 6, 10, 15 or 20 • So if you produce e. g. , 10 units, your profit is (P - 10)*10 = (30 - Q)*10

DWL and Competition I 1 DWL 2 3 4 ∞ 112. 5 50 28. DWL and Competition I 1 DWL 2 3 4 ∞ 112. 5 50 28. 1 18 0 11% 6. 25% 4% DWL/ 25% SW 0

DWL and Competition II DWL and Competition II

Broad lessons • Lack of competition is bad • Mode of competition matters • Broad lessons • Lack of competition is bad • Mode of competition matters • Price competition tougher than capacity/quantity competition • But don’t need many competitors to get a fair degree of competition • Watch out for collusion

Competition Policy Most OECD countries have competition laws that: 1) Prevent firms from fixing Competition Policy Most OECD countries have competition laws that: 1) Prevent firms from fixing prices 2) Prevent dominant firms from abusing their position 3) Limit mergers that raise market concentration beyond some level

Summary • If markets are not perfectly competitive, prices are too high and quantity Summary • If markets are not perfectly competitive, prices are too high and quantity too low • Imperfect competition results in a welfare loss • But market power need not be evil (incentives for R&D, fixed cost savings, survival of the fittest) • A “market” consists of all products that consumers find “reasonably” substitutable • Competition policy aims at: – avoiding formation of monopolies [merger policy] – preventing firms from colluding and monopolising markets [antitrust policy]

Information failures • Doctor knows treatment more than patient • Applicants are better informed Information failures • Doctor knows treatment more than patient • Applicants are better informed about their riskiness than insurance company/bank • Used car’s owner knows faults better than potential buyers

A market with information • A market with sellers and buyers • Sellers decide A market with information • A market with sellers and buyers • Sellers decide what quality grade to produce; and can produce up to 2 units • Costs of units – grade 1: 1 st unit costs 1. 40; second unit costs 2. 40 – grade 2: 1 st unit costs 4. 60; second unit costs 5. 60 – grade 3: 1 st unit costs 11. 00; second unit costs 12. 00 • Buyers want 1 unit; values are – grade 1: 4. 00 – grade 2: 8. 80 – grade 3: 13. 60

A market with information • Seller’s profit is price minus cost, over all units A market with information • Seller’s profit is price minus cost, over all units sold • Buyer’s surplus is value minus price, over all units bought • If no trade, get 0

Now play • Sellers announce your qualities and prices; buyers choose who to buy Now play • Sellers announce your qualities and prices; buyers choose who to buy from • Sellers choose your qualities and prices • Sellers announce your prices; buyers choose who to buy from

Market for Lemons (Akerlof) • Used cars either bad “lemons” or good “peaches” • Market for Lemons (Akerlof) • Used cars either bad “lemons” or good “peaches” • For a lemon – seller will accept £ 1, 000 – buyer will pay at most £ 1, 200 • For a peach – seller will accept £ 2, 000 – buyer will pay at most £ 2, 400

Symmetric Information • Suppose that buyers can tell peaches from lemons • Lemons will Symmetric Information • Suppose that buyers can tell peaches from lemons • Lemons will sell for between £ 1, 000 and £ 1, 200 • Peaches will sell for between £ 2, 000 and £ 2, 400 • Trade occurs and final allocation efficient

Asymmetric Information Suppose that • Buyers cannot tell peaches from lemons • Half of Asymmetric Information Suppose that • Buyers cannot tell peaches from lemons • Half of cars are lemons and half peaches • Questions: Will peaches be traded? At what price?

Market Break Down • Lemon seller present in market if car price > 1, Market Break Down • Lemon seller present in market if car price > 1, 000 • Peach seller present if car price > 2, 000 • At price above 2, 000, both peaches and lemons are present in market. The average value of car to buyer is EVB=(1, 200)*1/2+(2, 400)*1/2 = 1, 800

Market Break Down • But then the price paid by the buyer (2, 000) Market Break Down • But then the price paid by the buyer (2, 000) is higher than buyer’s expected value, so buyer gets negative surplus 1, 800 – 2, 000= – 200! • The buyer does not want to trade at 2, 000 • No peaches will ever be traded!

Adverse Selection • Lemons drive peaches out of the market – only cars in Adverse Selection • Lemons drive peaches out of the market – only cars in the market must be lemons • Buyers will pay at most £ 1, 200 for a car knowing it to be a lemon • No peaches are traded, even if the buyer values a peach more than the seller • Inefficiency!

UK Annuity Market Finkelstein & Poterba, 2002, Economic Journal Selection Effects in UK Annuity UK Annuity Market Finkelstein & Poterba, 2002, Economic Journal Selection Effects in UK Annuity Market For average 65 -year-old male in the pop. , prob. of surviving up to age 82 is 41% For average 65 -year-old male compulsory annuitant, prob. of surviving is 48% For average 65 -year-old male voluntary annuitant, prob. of surviving is 56%

Moral Hazard • The tendency of people to expend less effort protecting those goods Moral Hazard • The tendency of people to expend less effort protecting those goods that are insured against theft or damage • Because of insurance, people tend to choose riskier behavior for lower potential loss • Unlike adverse selection, a problem after contract has been signed

Dealing with Information Asymmetry • E. g. , deductibles are used to reduce moral Dealing with Information Asymmetry • E. g. , deductibles are used to reduce moral hazard and adverse selection • Benefits from deductibles in the insurance policy – Lower rates – Increase the incentive to drive safely – Reduce the number of claims, which lowers cost and premiums

How successful? • Chiappori & Salanie (2000): French car insurance market • Drivers with How successful? • Chiappori & Salanie (2000): French car insurance market • Drivers with higher accident probabilities should choose insurance with higher coverage – Adverse selection: high-risk drivers like high coverage – Moral hazard: high coverage makes drivers careless

Looks like insurers overcome AI • Test for conditional independence between coverage choice and Looks like insurers overcome AI • Test for conditional independence between coverage choice and accident occurrence • Conditional on all variables observed by insurer • Cannot reject that coverage and accidents are conditionally independent • Insurance companies’ information is very rich • In most cases, companies know more about drivers than drivers do themselves • Deductibles and no-claim bonuses seem to take care of moral hazard

Conclusion • Asymmetric information causes market failure • Often private incentives to reduce information Conclusion • Asymmetric information causes market failure • Often private incentives to reduce information asymmetries are strong • Organisations and legal institutions develop to complement markets • When should regulation take place?