economics of the firm: same basic information - esteban jaimovich

Economics of the Firm: Same basic information

Economics of the Firm: just another name for what we usually callIndustrial Organisation

Therefore, this is a basic course in Industrial Organisation

Main textbook: Luis Cabral "Introduction to Industrial Organization"

Mathematical requirements:

Being able to compute derivativesBeing familiar with maximisation (and minimisation) problemsIf you are not: start refreshing your knowledge today!

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Roadmap: �rst half of the course

1 Today: some basics

2 Week two: Firms Behaviour under Perfect Competition

3 Week three: Theory of Monopoly (pure monopoly andprice-discriminator monopoly)

4 Week four: Basic concepts of game theory (Nash equilibrium solutionin pure strategies)

5 Week �ve: Main theories of Oligopoly (Cournot and Bertrandcompetition)

6 Week six: mid-term test (50% of �nal grade)

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Industrial Organisation: Some De�nitions

Luis Cabral (textbook):

�Industrial organization is concerned with the workings of markets andindustries, in particular the way �rms compete with each other.�

What happens in the traditional perfect competition environment?

�rms don�t actually compete with one another.they take prices as given!they take other �rms�behaviour as given!they consider all goods o¤ered by others identical/homogenous!

But the real world is (most) often somewhat di¤erent

Industrial organisation: the economics of IMPERFECT competition.

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�rms don�t actually compete with one another.

they take prices as given!they take other �rms�behaviour as given!they consider all goods o¤ered by others identical/homogenous!



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�rms don�t actually compete with one another.they take prices as given!

they take other �rms�behaviour as given!they consider all goods o¤ered by others identical/homogenous!



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�rms don�t actually compete with one another.they take prices as given!they take other �rms�behaviour as given!

they consider all goods o¤ered by others identical/homogenous!



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�rms don�t actually compete with one another.they take prices as given!they take other �rms�behaviour as given!they consider all goods o¤ered by others identical/homogenous!



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Introduction �Environment

In the setups we will study in the course:

Firms will be in charge of deciding (among other things)

1 what to produce2 how much to produce3 what price to charge

Consumers will respond to this by shopping for the best alternative

Other �rms will also respond to this...

there may be strategic interactions among �rms and markets.

Other important (related) questions1 What is a �rm? What de�nes the boundaries of a �rm?2 Given established boundaries, how do �rms compete with each other?

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Introduction �A motivational example

Product di¤erentiation and market power

Pharmaceutical Industry in late 90s

Glaxo Wellcome produced Zantac �an ulcer and heartburn medicine.

The marginal cost was negligible.Still... the market prices were well above zero �about $3 per tablet.At odds with predictions under perfect competition.

What was then di¤erent in this market from perfect competition?

There were few close substitutes for Zantac.

This grants Glaxo market power in this speci�c market.

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The marginal cost was negligible.

Still... the market prices were well above zero �about $3 per tablet.At odds with predictions under perfect competition.




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The marginal cost was negligible.Still... the market prices were well above zero �about $3 per tablet.

At odds with predictions under perfect competition.




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The marginal cost was negligible.Still... the market prices were well above zero �about $3 per tablet.At odds with predictions under perfect competition.




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Barriers of entry

Glaxo was enjoying an extraordinary rate of return.

This should attract new �rms into the market, until pro�ts are drivento zero (or �normal�levels)

Especially, as copying pharmaceutical drugs is relatively easy and cheap!

So, why didn�t �rms try to enter and contest this market?

Glaxo held patent protecting its exclusivityRelated question �why should we grant patents to producers?

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Barriers of entry





Glaxo held patent protecting its exclusivity

Related question �why should we grant patents to producers?

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Barriers of entry





Glaxo held patent protecting its exclusivityRelated question �why should we grant patents to producers?

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Market power without entry barriers

Patents tend to grant exclusivity (i.e., monopoly power) only for acertain number of years.

Novopharm (another pharmaceutical company) has wonpermission from the U.S. Federal Court of Appeals to market ageneric version of Glaxo Wellcome�s ulcer drug Zantac. Thecourt ruled against Glaxo Wellcome�s claim that Novopharm�sdrug infringes its patent rights.

Patents: temporary market power.

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Market power without entry barriers

A generic is a chemically equivalent drug that is sold under thegeneric chemical name (ranitidine, in the case of Zantac) rather thanunder the brand name.

Zantac and generic medicines were essentially perfect substitutes

Yet, competition in this product did not drive prices down to marginalcost...

Zantac tablets were still 7 times more expensive than generic tablets.That means, consumers or doctors actually perceived these products asbeing di¤erentiated on some dimension.

Reason: hundreds of millions poured by Glaxo Wellcome intoadverstising to establish brand loyalty to Zantac.

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Introduction �4 central questions in IO

This is what this course will be about from Week 3 omwards:

1 Do �rms have (some) market power?

2 How do they manage to obtain (and retain) market power?

3 What are the e¤ects (in terms of economic e¢ ciency) of �rms�market power?

4 Is there any room for economic policy to mitigate the (negative)e¤ects market power?

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Introduction �Types of Markets

No market power on either sides:

Perfect competition: many buyers and sellers with homogeneousproducts (perfect substitution).

Market power on supply side

Monopoly : only one producer/seller for a product (with no closesubstitutes)Oligopoly: a few �rms producing/selling the same (or similar) product.Monopolistic Competition: many producers selling slightlydi¤erentiated products.

Market power on demand side

Monopsony: There is only one customer for a certain product.Oligopsony: A few (possibly collusive) buyers for a certain good.

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The Firm under Perfect Competition

Before moving on to studying Imperfect competition, we shouldrefresh how �rms behave under perfect competition.

The basic mathematical concept for a �rm under perfect competitionis the production function.

Suppose a �rm produces output Q (for example, wheat) using unitsof labour L

Q = F (L)

We usually assume that: F 0(L) > 0 and F 00(L) < 0.

The marginal productivity of labour is positive but decreasing.Each additional unit of labour increases production by less than theprevious one.

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A competitive �rm is, by de�nition, very small (it is atomistic)

As a consequence of this:

It sells its product at the market price: pIt hires labour at the market wage: wIn other words, since it�s so small it can neither a¤ect prices, nor wages.

The income of the �rm equals the total sales: pQ = pF (L)

The cost incurred by the �rm equals the total labour cost: wL

So, the �rm�s pro�t: Π(L) = pF (L)� wLNotice the pro�t is function of L

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The standard assumption is that a �rm aims at maximising pro�ts

Maximisation problem: choose the level of L that maximises Π(L)

maxL

: Π(L) = pF (L)� wL

First Order Condition for a maximum:

pF 0(L)� w = 0

which leads to the well-known equality between marginal product oflabour and real wage

F 0(L) =wp.

How do we know this is actually a maximum?

Second order condition: F 00(L) < 0

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Graphic Solution of Maximisation Problem

L� is the solution to: pF 0(L�)� w = 0Equality of slopes of pF (L) and wL.

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Graphic Solution of Maximisation Problem

The gap between both functions measures the total pro�t

When slopes are equal this gap is largest

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From the production function to the total revenue function

Before we represented the total revenue by pF (L)...

So, it was ultimately a (concave) function of the amount of labourused L

But, we now want to put everything in terms of unit of output Q

Therefore, using again Q = F (L), we can just write...

Revenue = pQ

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From the labour cost function to the total cost function

Before we represented total labour cost by wL....

So, it was ultimately a (linear) function of the amount of labour used L

But, again, we now want to put everything in terms of unit of output Q

In this case this is (mathematically) more involved than for totalrevenue

we need to invert a function.

Given that Q = F (L), then we can invert it to

L = F�1(Q)

We can denote F�1(Q) � Φ(Q), which is also a fuction.

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Graphic Representation

Notice the change of variables (L,Q) on the axis

When Q = F (L) is concave in L, then L = Φ(Q) is convex in Q.

It�s like if we�re rotating the axis of the functions.

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Back to... From the labour cost function to the total cost function

So, now we transformed L = Φ(Q).

The total labour cost function was wL...

So, now we can simply write: wL = wΦ(Q)

This wΦ(Q) is now a function of QSo, we can denote: C (Q) � wΦ(Q).

So, we can now write: wL = C (Q)

Where: C 0(Q) > 0 and C 00(Q) > 0

Notice that C 0(Q) = wΦ0(Q) and C 00(Q) = wΦ00(Q)

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Back to the optimisation problemBefore we wrote:

maxL

: Π(L) = pF (L)� wL

Now, since pF (L) = pQ and wL = C (Q), we can write the sameproblem in terms of Q (total output).

Optimisation problem in terms of Q

maxQ

: Π(Q) = pQ � C (Q)

First order condition:p � C 0(Q) = 0

which is the famous: p = C 0(Q), that is Price = Marginal Cost.

How do we know it is a maximum?second order condition

�C 00(Q) < 0.() September 30, 2013 20 / 28

Total Cost, Average Cost and Marginal Cost

Total Cost: what we saw before

C (Q)

Average Cost: unit cost

AC (Q) =C (Q)Q

Marginal Cost: increase in total cost when raising production Q inone unit:

MC (Q) = C 0(Q)

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Example 1

Concave Production FunctionAssume w = 2 and p = 1Assume Q = 2

pL

Then, the Total Cost Function is

C (Q) =Q2

2

This is because when Q = 2pL, then L =

�Q2

�2And, C (Q) = wL = 2L = 2

�Q2

�2.

Average Cost:C (Q)Q

=Q2

Marginal Cost:MC (Q) = Q

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Example 1


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Example 2

Linear Production Function

Keep assuming w = 2 and p = 1

Assume Q = 2 L


C (Q) = Q

This is because when Q = 2L, then L = Q2

And, C (Q) = wL = 2L = 2Q2 .

Average Cost:C (Q)Q

= 1

Marginal Cost:MC (Q) = 1

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Example 2


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Example 3

Convex Production Function

Keep assuming w = 2 and p = 1Assume Q = 4 L2


C (Q) =pQ

This is because when Q = 4L2, then L =qQ4

And, C (Q) = wL = 2L = 2qQ4 .

Average Cost:C (Q)Q

=1pQ

Marginal Cost:

MC (Q) =1

2pQ

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Example 3


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Reading List

Today�s lecture:

Chapter 1, Luis Cabral �Introduction to Industrial Organization��Required reading.

Chapter 21 (Cost Curves), Hal Varian �Intermediate Microeconomics�,5th Edition �Suggested reading.

Next week�s lecture

Chapter 2, Luis Cabral �Introduction to Industrial Organization��Required reading.

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economics of the firm: same basic information - esteban jaimovich

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