Appunti a. a. 25/26 - Industrial Organization and industrial policy

INDUSTRIAL ORGANIZATION AND INDUSTRIAL POLICY

Students must study the whole book, except for the following parts:



- chapter III par. 3.4;



- chapter VI par. 6.2;

- chapter X parr. 10.5 and 10.6;

- chapter XI parr. 11.3.2; 11.3.3, 11.3.4, 11.3.5, 11.5, 11.6.3, 11.7.2, 11.7.3 and 11.7.4;

- chapter XII every parr.;

- chapter XIII parr. 13.1.1.2, 13.1.2.2. and 13.1.3.1;

- chapter XIV parr. 14.2.3 and 14.2.4;

- chapter XVI par. 16.6.2

Industrial organization:

• Competition dynamics, structure-conduct-performance paradigm, cost structure, theories of the firm, market

structures, firm strategies and innovation dynamics (...)

Industrial policy:

• Market failures

• Government failures

LECTURE 1 THE MARKET: DEMAND AND SUPPLY

In economics, the market is the institution, i.e. the set of rules, that define the perimeter (not necessarily

physical) within which exchanges of goods and services take place.

In other words, it is the place where demand and supply meet, that is, where sellers and buyers reach an

agreement on the exchange of a specific product. It is made by two elements:

1. Demand;

2. Supply.

THE DEMAND FUNCTION

It represents the relation between the quantity that consumers WISH to buy of a certain good n and a series of

variables on which this quantity depends:

- the price of the good itself (p )

n

- the price of other goods (p ...p )

1 n-1

- the income of the consumer (Y)

- other elements (E), such as environmental features and consumers’ preferences.

Each of the variables on which demand depends acts on it with different strength and direction. Therefore, to

understand how demand varies it is useful to consider one variable at a time, keeping all the others fixed, i.e.

ceteris paribus.

FACTORS AFFECTING DEMAND

1. price of the good itself (p )

n

The demand curve graphically represents the relation between the quantity demanded of a good/service and

its price, ceteris paribus. 1

The relationship between price and quantity of a given good is not necessarily linear, but whatever the shape

the curve takes, the lower the price of a good, the greater the quantity demanded (law of demand).

Each individual has their own demand curve and the sum of the curves of all consumers in a specific market

allows us to obtain the aggregate demand curve for that particular type of good.

2. Price of other goods (p ...p )

1 n-1

- independent goods a variation in the price of the former will have no effect on the quantity demanded

of the latter (e.g. the price of pasta and the demanded quantity of shoes).

- complementary goods they are often consumed together, then a rise in the price of the former will not

only generate a decrease in demand for the good itself, but also a drop in the demand for the latter good. For

example, tennis rackets and tennis balls.

- substitute goods they are demanded one as an alternative to the other, a rise in the price of the first good

will result in a fall in its quantity demanded and a rise in the quantity demanded of the second good.

3. Income of individuals (Y)

The relation between income and quantity demanded is represented by the Engel curve:

- For very low levels of income, the quantity demanded is zero.

- Once the income grows and exceeds the threshold y , increasing levels of income correspond to increasing

1

quantities demanded. In this case we speak of normal goods.

- If income continues to increase, we reach a stage (in the graph between y and y ) where the quantity

2 3

demanded of the good remains stable.

- Further increases in income will then lead the consumer to decrease the quantity demanded of the good,

which will thus take on the characteristics of an inferior good, as consumer preferences shift towards

alternatives considered to be of higher quality or more “luxurious”.

This trend can be considered realistic for all types of goods; what changes are the levels of income needed to

reach the y , y and y thresholds.

1 2 3

4. Total income distribution (Y)

5. Environmental variables (E)

Environmental variables (E) include, for example:

- changes in the social structure (if in a given market there are fewer children and more elderly people, there

will be a gradual decline in the demand for goods for children, and a corresponding rise in demand for goods

for the elderly)

- weather (the demand for many products, such as sunscreen lotions, electricity or heating gas, depends on

climatic conditions)

- consumer preferences (for example, an increased focus of recent generations on fitness and wellness has

translated into an increasing demand for sports services, low-calorie food, dietary supplements) 2

THE SUPPLY FUNCTION

The supply is related to the decisions taken by companies.

Our only initial hypothesis is that firms’ unique objective is profit maximisation.

The supply function indicates the relation between the quantity of goods (and services) that a firm IS

WILLING to offer and:

- the price of the good itself (p )

n

- the price of inputs (F ...F )

1 m

- and other elements affecting such quantity (E).

Also in this case we will analyse the impact of the variables on the supplied quantity under the “ceteris

paribus” condition.

FACTORS AFFECTING SUPPLY

1. the price of the good itself (p )

n

The supply curve graphically represents the relation between price and supplied quantity of a good or service,

other conditions being equal.

- The trend of the curve is not always linear, but the relationship between price and quantity is positive .

- In some cases, the supply curve starts from the origin of the axes (figure a).

- In others, however, this is not the case due to the presence of fixed costs (represented by C in figure B),

which must be incurred regardless of the quantity produced and which make the firm unwilling to start

production if the price does not cover at least this amount.

2. the price of inputs (F ...F )

1 m

for example, the price of energy to run the plants, labour to be used in the production processes, rents for land

or buildings, etc. If the price of these inputs decreases, other things being equal, the firm will be willing to offer

greater quantities for each price level of the produced good (i.e. the supply curve shifts to the right).

The variable E includes all the remaining factors that may affect the quantity supplied. Among these we can

find:

3. Objectives of the firm.

The quantities supplied may be decided on the basis of precise choices by top management. For example,

management may wish to minimise risks, and thus adopt a safer strategy that may result in lower quantities

supplied. In other cases, the quantity produced is not increased so as not to have to invest in new plants and new

hires, thus increasing its size. Or, again, because of the image one wants to give to customers, a company might

find it convenient to forgo producing certain goods that are highly disapproved of by the public (e.g. products

containing specific ingredients, such as palm oil). 3

4. Technology.

The availability of more efficient organisational or production methods leads to a rightward and downward

shift in the supply curve, because it allows producers to offer a greater quantity for each price level.

5. Price of related goods.

Two goods are said to be related on the supply-side if the firm has the ability to switch relatively easily

between producing one and the other (e.g., cars and trucks). If, therefore, the price of either one increases (e.g.,

trucks), the firm will tend to want to offer larger quantities. However, in the short run it will not be able to

change its structure immediately to correspond with a price increase (e.g., by opening or expanding its truck

production department). Therefore, in order to increase its truck production in the immediate term, it will have

no choice but to shift some of the resources that were previously employed in car production to the expanding

truck production, resulting in a decrease in the quantity of cars supplied in the short run.

6. Expectations.

The trends that a company assigns to market dynamics in the future can affect its present choices in terms of

quantity supplied. If, for example, management expects the price to increase in the future, it may decide to

decrease the quantity supplied today so as to increase the stock to be placed on the market when more

favourable future conditions arise.

7. Public regolation

8. Other special factors.

For example, the quantity supplied can be affected by the fallout from particularly adverse or favourable

weather conditions (as in the case of agricultural production or the tourism industry) or by the occurrence of

exogenous shocks affecting supply (think of the production lockdown imposed by the COVID-19 pandemic

health measures enforced in March 2020 and periodically reintroduced in the following months).

MARKET EQUILIBRIUM

From individual demand to market demand From individual supply to market supply 4

- The equilibrium price is that at which the quantity

demanded is equal to the quantity supplied (equilibrium

quantity ).

- The demand curve identifies the consumers’ maximum

willingness to pay for each quantity of a product, while the

supply curve indicates the minimum price at which firms are

willing to offer each level of output. It follows that, at the

equilibrium price, all consumers buying the good will spend an

amount less than, or at most equal to, their maximum

willingness to pay. For a price higher than the equilibrium

price, there will be an excess supply, with many sellers willing to supply, but few buyers willing to buy, and

this will cause both parties to change their behaviour: sellers will try to convince more customers by

lowering their prices, and buyers will tend to defer purchases by waiting for a reduction in prices. The

opposite happens in the case of excess demand. The adjustment mechanisms just described thus tend

to gradually push the price towards the equilibrium price.

MOVEMENT ALONG THE CURVES AND SHIFTS OF THE CURVE

- Variations in the price of goods will cause movements along the demand/supply curve.

- Variations in other factors will cause shifts of the demand/supply curve.

LAW OF DEMAND AND SUPPLY

1. An increase in the demand function (shift) causes an increase both in the equilibrium price and quantity.

2. A decrease in the demand function (shift) causes a decrease both in the equilibrium price and quantity.

3. A increase in the supply function (shift) causes a decrease in equilibrium price and an increase in equilibrium

quantity.

4. A decrease in the supply function (shift) causes an increase in equilibrium price and a decrease in

equilibrium quantity. 5

SIMULTANEOUS SHIFT OF SUPPLY AND DEMAND: 1995 EARTHQUAKE IN JAPAN AND THE

SAKE’ MARKET

LECTURE 2 CONSUMER’S AND PRODUCER’S SURPLUS

CONSUMER’S SURPLUS

Given that the demand curve is descending, all consumers pay an amount that is lower than (or equal to) their

willingness to pay for the good.

The consumer surplus is the difference between the maximum price that a consumer is willing to pay for a

good (their "willingness to pay") and the actual market price they pay.

- The total consumers’ surplus originated by the purchase of a specific good is equal to the area under the

demand curve and above the price.

- The greater the consumer surplus, the greater the economic welfare (not necessarily the general welfare,

since there are not only consumers in the market).

- The surplus is subjective, since it depends on the maximum willingness to pay of each consumer.

PRODUCER’S SUPPLY

Similar to the consumer surplus, the producer surplus is equal to the area above the supply curve and below

the price.

The producer surplus is the difference between the market price that a producer receives for a good and the

minimum price they would have been willing to accept to supply that same good.

TOTAL SOCIAL WELFARE: CS + PS

From an ECONOMIC point of view, in the neoclassical model there is no reason to prefer the consumer to the

producer or viceversa. What matters is the TOTAL SOCIAL WELFARE. 6

ELASTICITY OF DEMAND

PRICE ELASTICITY OF DEMAND

Price elasticity of demand (η - eta) represents the «sensitivity» of the demanded quantity to the price: it

measures the variation of the demanded quantity of a certain good in correspondence to a variation in its price.

Intuitively, the concept of elasticity is related to the slope of the demand curve: the quantity demanded is

more sensitive to price variations for goods considered frivolous or luxury, which have “flatter” demand curves

(FIGURA B).

A prima facie adequate measure of elasticity might be represented by the ratio of the change in the quantity

demanded to the price change that generated it. If, for example, as price increased by one euro, the quantity of

books demanded decreased by 50, we would have an elasticity of –50.

Problem: the number obtained is tied to the unit of measurement considered (in this case, the number of

books), making it impossible to make comparisons across sectors.

To get around this problem, elasticity of demand with respect to price is calculated by means of a coefficient

given by the ratio of the percentage change in the quantity demanded to the corresponding percentage change

in price:

Price elasticity of demand:

1) As the relation between price and quantity is inversely proportional, elasticity of demand with respect to

price always has a negative sign (many are those who therefore use its absolute value).

The elasticity thus calculated is given by the product between the slope of the curve (given by Δq/Δp, which

is constant in a linear function) and the ratio p/q (which decreases as q increases).

The demand curve does not have the same elasticity in all its points elasticity

2) varies

along the curve from 0 to ∞ (a part in the case of isoelastic curves):

- In the elastic section of the curve, the quantity

demanded varies more than proportionally to the

change in price;

- in the inelastic section the quantity demanded

varies less than proportionally to the change in

price.

- At the midpoint of the curve, where demand has

unit elasticity, the percentage change in the

quantity demanded is equal to the percentage

change in price. 7

2 methods to calculate elasticity:

1) INITIAL VALUE:

Price: Quantity:

|5-6| : 6 = 0,17 (4-2) : 2 = 1

2) MEDIUM VALUE:

Price: Quantity:

|5-6| : [(5+6):2] = 0,18 (4-2) : [(4+2):2] = 0,67

No matter which method you use, the important thing is that you always use the same one for price and

quantity.

ELASTICITY OF DEMAND: ISOELASTIC CURVES

1) Perfectly elastic demand 8

2) Perfectly rigid demand

3) Unitary elasticity

THE DETERMINANTS OF THE ELASTICITY OF DEMAND

Elasticity of demand varies according to: :

1) Consumer tastes and preferences. When a good is considered "frivolous" in a given social context,

demands tend to be price elastic. The social and cultural context in which that demand is expressed means that

the same good may be considered frivolous in one market and necessary in another.

2) Existence of substitute products possibility to replace the good with others that perform the same

functions.

3) Width of the market. Ex. The demand for a specific cigarette brand is more elastic than the demand for

cigarettes in general.

4) Reference period elasticity of demand for a given good also depends on the time period being

considered. In particular, demand that is relatively rigid in the short run may be elastic when analysed over a

longer period of time (gasoline). In fact, the longer the period considered, the greater the possibility for the

consumer to find substitute goods or to change their consumption habits.

Consider the situation illustrated in figure below suppose we want to analyse the gasoline market and we are

in the starting equilibrium condition E . If the price rises to p , in the short run consumers will only be able to

0 1 ’1

move along their demand curve D , with a modest reduction in the quantity demanded from q to q’ (E ).

0 0 1 9

However, if the price increase persists, consumers will find

ways to reduce their demand for gasoline, for example by

buying a car that consumes less fuel or uses alternative fuels.

This will result in the consumer shifting onto a new demand

curve D , in which, for each price level, smaller quantities of

1

gasoline will be demanded, and the new equilibrium will

become E . A similar behaviour will occur if there is a further

1

price increase from p to p , which in the long run will see the

1 2

market settle to the E equilibrium position. Combining all

2

the short-run equilibrium points, we obtain the long-run

demand curve, which is much steeper than the short-run

curves, and thus tends to be more elastic. This situation is

most evident in the case of a good used in conjunction with

durable goods, which require investments that cannot be

made in the short term, or where purchases are infrequent (for

instance, for French consumers going on holiday to Barcelona, an increase in hotel prices in Spain will only

take hold from the following summer) the long-run demand curve for a good used together with durable

goods tends to be significantly more elastic than the short-run curve.

ELASTICITY OF DEMAND AND REVENUES

From the producers’ point of view, knowing the price elasticity of demand is important, since the total revenue

that companies can earn as a result of a price change depends on it.

Other conditions being equal, the demand function and the demand curve make it possible to calculate the

expenditure that consumers are willing to incur to purchase a good or service, which corresponds to the sellers’

revenue and is given by the quantity sold multiplied by the selling price.

The effect of a price change on the total revenue depends on the elasticity of the section of the curve in which

the change occurs:

- Suppose we are in the case where demand is in its inelastic section An increase in price determines a less

than proportional reduction in quantity, and total revenues of firms (or consumers’ expenditure) rises.

If the price increases, e.g. from 1 euro to 2 eu