Lecture 1: Introduction to IO Tom Holden

What is IO? An introductory game… Some revision:
◦ Monopoly ◦ Static oligopoly

Structure of the rest of the module

IO is not the economics of manufacturing industries (as opposed to agriculture etc.). IO is the economics of:
◦ the firm and its behaviour, ◦ the structure of markets, ◦ the regulation of markets.

IO is the field of most economic consultants.

Firm’s decisions:
◦ ◦ ◦ ◦ ◦

Entry, exit, mergers R&D Advertising Capital investment Pricing

Market structure:

◦ How do firms interact? ◦ Why are some firms large? ◦ Why are some industries highly concentrated? ◦ Cartels and collusion ◦ When should we regulate firms?

Competition policy:

Imagine you are each the manager of an auto-mobile firm, researching fuel cell technology. The first firm to successfully commercialize it will be granted a patent. How much would you spend?

Monopoly

◦ Firm price decision ◦ Welfare implications

Static oligopoly

◦ Cournot (1838) model of quantity competition ◦ Bertrand (1883) model of price competition

Price

Marginal cost

Demand Marginal revenue Quantity

P

MC

MR

D Q

P

Consumer surplus

Deadweight loss Producer surplus (profits) MR

MC

D Q

  

Market demand: 𝑃 𝑄 Costs: 𝐶 𝑄 Profits: 𝑃 𝑄 𝑄 − 𝐶 𝑄

First order condition: 𝑃 𝑄∗ + 𝑃′ 𝑄∗ 𝑄∗ − 𝐶 ′ 𝑄∗ = 0 So:

MR = 𝑃 𝑄∗ + 𝑃′ 𝑄∗ 𝑄∗ = 𝐶 ′ 𝑄∗ = MC

 
 𝑃

𝑄 = 𝑝0 − 𝑝1 𝑄 𝐶 𝑄 = 𝑐0 + 𝑐1 𝑄
Monopoly:
◦ 𝑄 ∗ = 𝑝
0 −𝑐1 2𝑝1

◦ 𝑃 𝑄 ∗ + 𝑃′ 𝑄∗ 𝑄∗ = 𝐶 ′ 𝑄 ∗ ◦ 𝑝0 − 𝑝1 𝑄 ∗ − 𝑝1 𝑄 ∗ = 𝑐1

Perfect competition:
◦ 𝑝0 − 𝑝1 𝑄 ∗ = 𝑐1 ◦ 𝑄 ∗ = 𝑝
0 −𝑐1 𝑝1

◦ 𝑃 𝑄 ∗ = 𝐶 ′ 𝑄 ∗

So production is halved.

 𝑃

𝑄 = 𝑝0 𝑄−𝛼 Monopoly: 𝑄
∗ −𝛼

◦ 𝑃 𝑄 ∗ + 𝑃′ 𝑄∗ 𝑄∗ = 𝐶 ′ 𝑄 ∗ ◦ 𝑝0 𝑄 ∗ −𝛼 − 𝛼𝑝0 𝑄 ∗ −𝛼−1 𝑄∗ = 𝐶 ′ 𝑄 ∗ ◦ 1 − 𝛼 𝑝0 𝑄 ∗ −𝛼 = 𝐶 ′ 𝑄 ∗ ◦ 𝑃 ◦ 𝐶
′ 𝑄∗ = 1−𝛼 𝑝0 1 𝑄 ∗ = 𝐶 ′ 1−𝛼

Price is a constant mark-up over marginal cost. 𝑄

∗ =

1 𝐶 ′ 1−𝛼 𝑄

  

Market demand: 𝑃 𝑄 Firms: 𝑖 = 1, … , 𝑛 Firm 𝑖:
◦ Produces 𝑞𝑖 ◦ Costs: 𝑐𝑖 𝑞𝑖 ◦ Profits: 𝑃 𝑄 𝑞𝑖 − 𝑐𝑖 𝑞𝑖

◦ 𝑄 is now total quantity

 

Total quantity is given by: 𝑄 = ∑𝑛 𝑞𝑖 = 𝑞1 + 𝑞2 + ⋯ + 𝑞𝑛 𝑖=1 First order condition: (for each 𝑖) ∗ ∗ 𝑃 𝑄∗ + 𝑃′ 𝑄 ∗ 𝑞𝑖 − 𝑐𝑖′ 𝑞𝑖 = 0 Add up all of the first order conditions: 𝑖
=1 ∗ 𝑛𝑃 𝑄∗ + 𝑃′ 𝑄 ∗ 𝑄 ∗ = � 𝑐𝑖′ 𝑞𝑖 𝑛

   𝑃

𝑄 = 𝑝0 − 𝑝1 𝑄 𝑐𝑖 𝑞𝑖 = 𝑐𝑖,0 + 𝑐𝑖,1 𝑄 (for all 𝑖) Sum of the FOCs (divided by 𝑛):
◦ ◦

So:

◦ The RHS is average marginal cost. Call this 𝑐̅1 .

1 ′ 1 𝑛 ∗ ∗ ∗ 𝑃 𝑄 + 𝑃 𝑄 𝑄 = ∑𝑖=1 𝑐𝑖′ 𝑞𝑖 𝑛 𝑛 1 1 𝑝0 − 𝑝1 𝑄∗ − 𝑝1 𝑄∗ = ∑𝑛 𝑐𝑖,1 𝑛 𝑛 𝑖=1 ∗ 𝑝

0 − 𝑐̅1 𝑄 = 1 1 + 𝑝1 𝑛

  𝑃

𝑄 = 𝑝0 𝑄−𝛼 Sum of the FOCs (divided by 𝑛):
◦ ◦

1 ∗ 𝑃 𝑄 = � 𝑐𝑖′ 𝑞𝑖 𝛼 𝑛 1− 𝑛 𝑖=1 I.e. price is a mark-up over average marginal costs. More firms means lower mark-ups. So:
∗ 𝑛

1 ′ ∗ 𝑄 ∗ = 1 ∑𝑛 𝑐 ′ 𝑃 + 𝑃 𝑄 𝑛 𝑛 𝑖=1 𝑖 𝛼 1 𝑝0 𝑄∗ −𝛼 − 𝑝0 𝑄∗ −𝛼 = ∑𝑛 𝑐𝑖′ 𝑛 𝑛 𝑖=1 𝑄

1

∗ 𝑞𝑖

∗ 𝑞𝑖

  

Inverse market demand: 𝑄 𝑃 Firms: 𝑖 = 1, … , 𝑛 Firm 𝑖:
◦ ◦ ◦ ◦

◦ Sets price 𝑝𝑖 ◦ Consumers buy from the firm(s) that set the lowest price. So, demand for firm 𝑖, 𝑞𝑖 = 𝑄 𝑝𝑖 if 𝑝𝑖 < 𝑝𝑗 for all 𝑗. And 𝑞𝑖 = 0 if for some 𝑗, 𝑝𝑗 < 𝑝𝑖 . Constant marginal costs: 𝑐𝑖 Profits: 𝑝𝑖 𝑞𝑖 − 𝑐𝑖 𝑞𝑖
 Assume equal shares when there is a tie. 𝑖
=1,…,𝑛

 𝑃

= min 𝑝𝑖

Suppose for a firm 𝑖 we have 𝑝𝑖 > 𝑃 > 𝑐𝑖 .

Thus, in any (pure-Nash) equilibrium, and for any firm 𝑖, at least one of the following two statements must be true:
1. 𝑝𝑖∗ = 𝑃∗ so the firm is one of the cheapest, and so
∗ is selling (recall 𝑃∗ ≤ 𝑝𝑖 by definition). 2. 𝑃∗ ≤ 𝑐𝑖 so at the market price the firm cannot make a profit from selling.

◦ Then firm 𝑖 is not currently selling anything. ◦ If it instead set 𝑝𝑖 in the interval 𝑐𝑖 , 𝑃 it would then be making a strict profit.

Now suppose there are two firms 𝑖 and 𝑗, with 𝑝𝑖 = 𝑝𝑗 = 𝑃, and that 𝑝𝑖 > 𝑐𝑖 . Thus, (by Lemma 1) in any (pure-Nash) equilibrium, there can be at most one firm 𝑖 for which 𝑃 > 𝑐𝑖 .
◦ I.e. at most one firm can make a profit. ◦ Then firm 𝑖 can slightly undercut firm 𝑗 and steal the whole market.

If 𝑐𝑖 = 𝑐 for all firms 𝑖, then by Lemma 2: there can be at most one firm 𝑖 with 𝑃 > 𝑐𝑖 = 𝑐. Only possible if either: As long as there are at least two firms then, 𝑃 = 𝑐.
◦ Firms price at marginal cost. ◦ there are no such firms (i.e. 𝑃 = 𝑐), OR ◦ there is only one firm (i.e. 𝑛 = 1), in which case we get the monopoly solution.

If there are at least two firms with marginal cost equal to min 𝑐𝑖 (the lowest marginal cost): Otherwise:
◦ By Lemma 2, 𝑃 = min 𝑐𝑖 and no firms make a profit. ◦ There is a unique firm 𝑘 with 𝑐𝑘 = min 𝑐𝑖 . 𝑖
=1…𝑛 𝑖=1…𝑛 𝑖

=1…𝑛

◦ Only firm 𝑘 sells anything. ◦ That firm sets a price in the interval 𝑐𝑘 , min 𝑐𝑗 , 𝑝𝑀 , where:

 𝑗 is the firm with the next smallest marginal cost, and  𝑝𝑀 is the price a monopolist with marginal cost 𝑐𝑘 would set.

The above analysis was for pure Nash equilibria. Suppose that:
◦ There are two firms (i.e. 𝑛 = 2). ◦ Firms have zero marginal cost (i.e. 𝑐1 = 𝑐2 = 0). ◦ Consumers demand one unit of the good at any price.

Monopoly profits are infinite, pure-Nash Bertrand profits are zero, but…

Idea: suppose that rather than choosing a set price, both firms close their eyes and pick prices at random. In particular, suppose for some fixed constant 𝑧: 𝑝

◦ Each firm never chooses a price less than 𝑧. ◦ Each firm chooses a price greater than 𝑝 (> 𝑧) with 𝑧 probability .

Firm 1 knows firm 2 is picking their price at random like this. So given this, their expected profits from choosing a price 𝑝1 is: 𝑧 𝑝1 Pr 𝑝2 > 𝑝1 = 𝑝1 = 𝑧 𝑝1 So firm 1’s profits do not depend on price! Thus, they are happy to pick at random.

We showed that with completely inelastic demand the Bertrand model has equilibria in which profits are arbitrarily high.
◦ Completely inelastic demand is rather implausible.

Baye and Morgan (1999) show there are mixed equilibria like this whenever, either:

◦ a monopolist’s profits would be infinite, or ◦ there is uncertainty about the location of a choke point in demand (and up to that point demand is sufficiently inelastic).

We will see similar things hold when the firms compete in multiple periods.

Read whichever you feel most comfortable with (and that you can find):
◦ ◦ ◦ ◦ ◦ Cabral, Chapter 8 Tirole, Introduction, Chapters 5 and 6 Motta, Chapter 4 Church and Ware, Chapters 8 and 10 Carlton and Perloff, Chapters 3, 4, 5 and 6

We will cover (some subset) of:
◦ ◦ ◦ ◦ ◦ ◦ ◦ ◦ ◦ ◦ ◦

Static oligopoly (what we did not cover today) Market structure Regulation and monopolies Dynamic oligopoly and collusion Entry (and entry deterrence) The theory of the firm (why do we have firms?) Vertical relationships between firms Mergers Product differentiation Advertising Research and development

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