0 Basics ˆb b ˆb Pareto efficiency: if you can’t improve one thing without

u(t)v (t) dt = u(t)v(t) − u0 (t)v(t) dt

0
worsening something else.

√ a
2 −b ± b2 − 4ac a a
ax + bx + c = 0 =⇒ x1,2 =
2a
1 Supply and Demand 1.1 Elasticity
0.1 Exponential Function and Logarithm Assumption: Buyers will buy if V ≥ C and sellers will sell
Basic price elasticityWatch that minus sign!:
if P ≤ C. Think at the margins (P = M C)! Marginal
∞
zk et valuation example % change in Q
exp(z) =
X
lim E=−
k! t→∞ tq
= ∞, ∀q > 0 % change in P
k=0
mv(5) = 550 ⇒ 5th-highest valuation is 550
• Price-elastic, top part of linear demand: E > 1
⇒ 5 buyers with valuation at least 550
• Unit-elastic, maximal revenue on linear demand: E = 1
bc = x ⇐⇒ logb (x) = c ⇒ d(550) = 5 • Price-inelastic, bottom part of lin. demand: 0 < E < 1
logb (1) = 0 logb (b) = 1 • Griffen good, more consumption at higher price: E < 0
blogb (x) = x logb (bx ) = x The equilibrium price P ∗ is also called efficient:
dQ P

Q2 − Q1 P2 − P1
logd (a) E=− E=−
logb (a) = xlogb (y) = y logb (x) 1
(Q2 + Q1 )
1
(P2 + P1 ) dP Q
logd (b) d (P ∗ ) = Q∗ = s (P ∗ ) 2 2

For linear demand d(P ) = Q = A − BP we define the Choke

logb (xy) = logb (x) + logb (y) logb xd = d logb (x)


Price P at which d P = 0, thus

√
1
 
x
logb = logb (x) − logb (y) logb d x = logb (x) A dQ P P
y d P = =⇒ E=− =
B dP Q P −P

Note that elasticity changes along a linear demand curve.

0.2 Analysis
 0 Constant elasticity with elasticity E = B:
0 0 0 f f 0 · g − f · g0
(f · g) = f · g + f · g =
g g2
Q = d(P ) = AP −B =⇒ log Q = log A − B log P
d 1
g(f (t)) = g 0 (f (t)) · f 0 (t) g 0 (y) g:=f −1 =


dt f 0 (g(y))
d k d f (t) d 1 Income elasticity, notice the sign of EY :
t = k · tk−1 e = f 0 (t)ef (t) ln t =
dt dt dt t
ˆ % change in Q dQ I
f 0 (t) EY = =
dt = ln |f (t)| + c % change in I dI Q
f (t)

ˆb ˆ
φ(b) • Inferior goods, counter-cyclical: EY < 0
f φ(t) φ0 (t) dt = f (x) dx • Income-inelastic goods, recession-proof: 0 < EY < 1

a φ(a) • Luxury goods, pro-cyclical, 1 < EY

Cheat Sheet: Prices and Markets 1 Floyd Basler

Cross price elasticity: dTR dP 3.2 Implicit Market Segmentation
TR = P · Q(P ) =⇒ M R = = P (Q) + Q
dQ dQ
% change in Qx dQx Py 1 The set of of options is called Menu. Objective: Customize
Ecross = = = P (1 − ) = M C
% change in Py dPy Qx E trades in the menu such that high valuation consumers freely
choose the more expensive option on the menu.
• Substitute: 0 < Ecross
• Complement: Ecross < 0 Mid-Point Pricing: Shortcut for linear demand curve with
• Participation constraint: Customer prefers the deal
choke price P and constant marginal cost MC :
over not trading at all
MC + P • Self-selection constraint: Customer prefers the deal
P∗ = you have designed for him/her over other deals in menu.
2
Thus, customer is assumed to optimise consumer
2 Costs and Pricing surplus.

Consumer Surplus = Consumer Valuation − Price

Long-run vs. Short-run and fixed vs. variable
mc dictates how the next produced piece will influence ac.
Assume NA + NB = 100 and calculate outcomes! Examples:
Coupons, Versioning/Bundling, Damaged Goods, Happy
c(Q) = fc + vc(Q) Total cost
Hours
c(Q) vc(Q) fc(Q)
ac(Q) = = + Average / unit cost
Q Q Q To maximise for revenue, simply assume MC = 0.
4 Competitive Markets
| {z } | {z }
avc(Q) afc(Q)
(
c(Q) − c(Q − 1)
mc(Q) = Marginal cost
dc(Q) No market power, thus price takers! Local view:
dQ
3 Market Segmentation
1
MR = P (1 − ) = P = MC
!
EP → ∞ =⇒
Perfect Price Discrimination requires the following: E
Knowing each customer’s valuation (WTP); Ability to make
take-it-or-leave-it offers; Stopping arbitrage Short-run (MC := AVC ) idle when: P < min(AVC )
Long-run (MC := AC ) shutdown when: P < min(AC )
Need to consider (forecasted) long-run prices!
3.1 Explicit Market Segmentation

Segment market and charge higher prices in less price elastic

segments!
4.1 Free Entry
This can cause natural monopolies as new entrants will
Requirements: market power, observability, no arbitrage Weak Form: No legal barriers, no threats by active firms,
not be able to compete on cost.
different cost structures
Golden Rule of pricing for profit-maximising monopolist or
Quantities QA and QB being sold in segments A and B:
price maker: Strong Form: Anyone can set up business with same cost
E
P = MC MRA (QA ) = MC (QA + QB ) = MRB (QB ) structures
E−1

Cheat Sheet: Prices and Markets 2 Floyd Basler

Suppliers will enter or exit until 5 Game Theory • Must be credible (Talk is cheap)
• Must be irreversible (inflexibility & burning bridge)
dTC d(AC · q) ! Egocentrism vs. Allocentrism
π = 0 ⇐⇒ AC = P ⇐⇒ MC = = = AC • Could signal irrationality (doomsday device, crazy man)
dq dq Games: simultaneous vs. sequential, one-short vs repeated
q u = arg min AC (q) AC u := AC (q u ) Players, Strategies, Payoffs
q Collusion

Due to sunk costs, it can be that AC SR < AC LR . Account Prisoners’ dilemma: Tacit/Implicit collusion is often allowed while explicit collu-
Clyde
for Cap Ex as opportunity costs per time unit, i.e. percentage sion gets you locked in jail!
Confess Not Confess
of Cap Ex. Consequently: Grim trigger strategy
Confess (5, 5) (20, 0)
Bonnie
AC LR =P d(P ) Not Confess (0, 20) (10, 10) • Start by cooperating
MC LR = AC LR −→ qEntry
!
−→ PEntry −→ QEntry
AC SR =P d(P ) (Confess, Confess) is Nash Equilibrium while (Not Confess, • Continue cooperating until another player cheats; then,
MC SR = AC SR −→
!
qExit −→ PExit −→ QExit
Not Confess) is Pareto superior to it. play Nash strategy forever

Dominant Strategy: A player has a dominant strategy Credible threat: Present value of collusion should be larger
if this strategy gives her higher payoffs regardless of what than present value of cheating once and being punished for
others do. It is uniformly better than all other strategies. the rest of time.
Dominated Strategy: A player has a dominated strategy
E[Ct ]
N N T
X X Cn X
if this strategy is never a best response. Eliminate those! P V (Cn ) =
(1 + r)n (1 + Rf + RP )t
n=0 n=0 t=0

If no player can increase their own expected payoff by chang-

(Growing) Perpetuity, r>g:
ing their strategy while the other players keep theirs un-
How to escape it:
changed, then the current set of strategy choices constitutes ∞
X C C
∞
X C(1 + g)t−1 C
= =
• Relative cost advantage a Nash equilibrium. (1 + r)t r (1 + r)t r−g
t=1 t=1
• Differentiation
(Growing) Annuity:
• First mover advantage 5.1 Sequential Games
• Consolidation, collusion, or government intervention
Look forward and reason back!
T  T !
X C C 1
= 1−
(1 + r)t r 1+r
• Start with the last move in the game
t=1
T T !
C(1 + g)t−1

• Determine what that player will do C 1+g
X
= 1−
(1 + r)t r−g 1+r
• Eliminate the dominated strategies or paths the game t=1

will not take

A more lenient strategy: Tit-for-Tat
Change the game! Threats, customer loyalty programs
etc. • Start by cooperating
Credible threats and commitment devices: • Do what rival did in earlier period

• Must be visible What facilitates implicit collusion

Cheat Sheet: Prices and Markets 3 Floyd Basler

 • Repeated Interaction
• Few Firms
• “Leadership” Role
• ”Communication”
• Safe ‘tit-for-tat’

5.2 Oligopoly
Pricing with Similar Products (Bertrand) Competing on Capacity (Cournot)

If we have imperfect substitutes or complements, we can Identical goods viewed on the long run. Thus MC = AC
reach P > M C, but price wars are dangerous! while P (Q) = P (q1 + q2 )
Played mostly during slumps (empty airplanes) Played mostly during booms (full airplanes)
Best response curve: and Reac- Best response curve: Express MR(q1 , q2 ) = MC and solve for
∗ ∗ !
PCoke (PPepsi ) PPepsi (PCoke ).
tions by each party will always pull us to the Nash equilibrium. q1 (q2 )

Cheat Sheet: Prices and Markets 4 Floyd Basler