Riassunti BIE Business And Industrial Economics

Review: Basic of microeconomics

Market

A market is a physical or virtual place where the demand meets the supplier. There is an exchange or transaction that can happen in two different ways: price and agreement.

Supplier

A supplier offers a good (storable) or a service (not storable) where the production is simultaneous with the consumption.

Demand

Demand refers to subjects that need a good or service and are willing to buy it.

Demand function

Demand function: Q=Q(p) vs inverse demand function: p=Q(p). For any price (p), it returns the quantity (Q) demanded by price as a function of quantity (Demand) of the whole market, so by all the customers in the market. Example: p = a-b·Q or p = a·Q.

Willingness to pay

Willingness to pay is the maximum price the number of Q individuals from the entire market will pay. There are Q customers that want to pay P and the price reduces it.

Price elasticity

Price elasticity: Can be rigid when if I change the price a lot, the Q (Demand) of the market doesn’t change. It happens for non-substitutive products like water or gasoline. It can be elastic when if the price changes, the quantity changes a lot. This happens for products with a lot of substitutes like food or luxury products (e.g., during sales). The demand can be moved (+/-) by:

• Income increase (+);
• Changes in culture, taxes (+/-);
• Increase of price of complementary (-);
• Increase of price of substitute (+).

Cost

Total cost (TC): TC=TC(q). To produce a quantity q (one firm) should pay TC(q) that includes labor, material, plant, debts, interest, and so on but also a minimum fair profit for stakeholders. TC = F + VC(q) is the fixed plus variable cost(q). The variable changes in the short/long run:

• Short-> Labor, Material, Salary
• Long-> Everything except patents

Marginal cost

Marginal cost: Additional cost that the firm has to sustain when producing an additional unit of output. It goes up when we reach saturation.

Average cost

Average cost: High at the beginning because we are not spreading the cost, then it goes down (thanks to economies of scale) then up (close to saturation). Remember TC includes even a minimum fair profit for stakeholders.

Economies of scale

Economies of scale (scale economies): Happen when a company reaches a certain level of spread, making total cost and production efficient. After the minimum point of the AC called Minimum Efficient Size or Scale (MES), we will start experiencing diseconomies of scale because we are becoming closer to saturation.

Perfect competition

Perfect competition: Firms are price takers and cannot influence the market with their decisions.

In the short run:

• Homogeneous product
• Full information (both parties)
• Large number of small firms, no one big firm

In the long run:

• No entry barriers
• No exit barriers
• Access to knowledge is possible

Perfect competition: short run

Price taker firms find profitability only if MC are ≤ than the market price and not one unit more, so p=MC(q). Since p is given by the market, they understand the q from the reciprocal of MC, so q=MC(p). It’s not certain that the company will break even. The whole industry supply is Q = Σq and the equilibrium is achieved by merging with the demand curve, finding p* and Q*. So each firm will decide its quantity q = MC1(p*) and this could be profitable or not: π* = (p* - AC(q)) · q*. There are L-type firms that are low-cost firms, so with π>0 and H-type firms that are high-cost firms and don’t find it profitable.

Perfect competition: long run

In the long run, there will be players that will exit the market, new entrants, and players that will imitate the profitable ones. So, we will have only efficient firms inside the market with: LR MINp = AC LR D LR i LR i-1 LR LR LR i LR i LR Q = Q(p) q = MC(p) N = Q/q and π = 0.

Monopoly

A monopoly is a market dominated by one firm, which is a perfect price maker, setting the price that is most profitable to it and exploiting market power. This could be caused by control of natural resources (e.g., a hotel close to the sea, concessions), innovation (industrial secrets, patents), natural monopoly (e.g., wireline, water distribution), or abuse of dominant position (e.g., predatory pricing). Since q=Q (because it is the only producer), the monopolist's objective is profit maximization: π = R – TC = p(Q)·Q – TC(Q). We can maximize in three ways:

• If we have the function Rev – Tot Cost = R – TC, we can see where its minimum is.
• We can put Marginal Profit to 0 (the maximum of the derivative of profit).
• MR(Q) = MC(Q) with MR = ∂TR(Q)/∂Q.

Mark-up: Represents how much the price deviates from the marginal cost. Consumer Surplus: area under the demand function and over the price. Producer Surplus: π(Q) = R(Q) – VC(Q) (VC = variable cost).

Social welfare (W = CS + π) measures the industry efficiency, summing net benefits of Consumer Surplus and Producer Surplus. Any price different from the perfect competition price, p*, causes a social welfare loss called allocative inefficiency, measured by DWL, Dead Weight Loss (also EL, Efficiency Loss; see the green triangle). Monopoly creates allocative inefficiency even because producer’s surplus increases less than consumer’s surplus decreases, whereas Perfect Competition is the benchmark for maximum social welfare.

Review: Game theory

Game theory

Game theory is a method of building models for interdependent decisions. The payoff (performance) of the players depends on others’ decisions, and the choices are made with strategy making. There are i=1,2,3..n players, and the actions they take could be discrete or continuous. The payoff function depends on other players: π = π(α1;α2); π = π(α1;α2)… We focus on non-cooperative games, so players do not cooperate. Normal Games: players choose actions simultaneously.

Equilibrium in dominant action

Equilibrium in dominant action: A given action of player 1 is a dominant action if it maximizes 1’s payoff regardless of the action taken by 2 and vice versa. An equilibrium in dominant actions (EDA) is an outcome of the game where all players play their dominant action. EDA is more stringent than Nash Equilibrium.

Nash equilibrium

Nash equilibrium: If each player has chosen a strategy and no player can increase its own expected payoff by changing its strategy while the other players keep theirs unchanged, then the current set of strategy choices constitutes a Nash Equilibrium. We are in a NE if there aren’t players that find it beneficial to deviate unilaterally from the NE outcome. For example, in the prisoner's dilemma, one prefers to confess because it is more profitable for each decision of the other. The other will think the same, so both will confess, and this is a Nash Equilibrium.

Efficiency à la Pareto

An outcome is efficient à la Pareto or Pareto Optimal if there isn’t the possibility to make one of the players improve without deteriorating the others' situation. That means that there isn’t the possibility to improve everyone’s condition without making at least one worse. Given an initial situation, a Pareto improvement is a new situation which is weakly preferred by all agents and strictly preferred by at least one agent. In a sense, it is a unanimously-agreed improvement: if we move to the new situation, some agents will gain, and no agents will lose. A situation is called Pareto dominated if it has a Pareto improvement. A situation is called Pareto optimal or Pareto efficient if it is not Pareto dominated.

Sequential game

Sequential game: Agents choose actions in different periods. Game tree: players’ decisions at different times (actions) and final payoffs. Decision nodes: Name of the player who is entitled to make decisions in that period & actions available to the player in the node; Payoffs defined for each player in the final node; Subgame: Any (non-final) decision node along with all the nodes following it.

Subgame perfect equilibrium (SPE)

Subgame perfect equilibrium (SPE): We should use backward induction, starting from the last decision and asking which one is the best in that node, then moving up and doing the same until finding the best sequence, which is the SPE. It is possible that a firm, to avoid new entrants, will commit itself to do something that is not profitable: they sign a commitment (irreversible action) that must be credible, costly, irreversible, visible (act as a signal). In this way, new entrants know that since there is this commitment, the firm will fight hard not to share the market. Example: 2 firms, I (Incumbent) and E (new Entrant). I have to decide if to start a price war or not or sign a commitment.

Sustainability and SDGs

Sustainability

Sustainability: Ability to meet the needs of the present without compromising the ability of future generations to meet their needs. The process to achieve sustainability is called sustainable development and includes economic growth, environment protection, and people.

SDGs

SDGs: In the world, there are Grand Challenges, a family of initiatives fostering innovation to solve key global health and development problems. Governments are dealing with grand challenges trying to reach the 17 Sustainable Development Goals (SDGs) like No Poverty, Zero Hunger, Climate Action, and so on. Consumers play an important role, but business enterprises have a fundamental role. There is a Triple Bottom Line (TBL) approach, where the firm cares about:

• Profit and People
• Profit and Planet
• All together and should follow this last option

SDGs are important for business enterprises because they act as a checklist of the expectations that governments and society have, so SDGs have value even for the firm.

Synergies

Synergies: There are synergies between one SDG and other SDGs, but also trade-offs (negative synergies) that must be considered because, for example, we cannot have an incredible increase in production for everyone without having waste.

Sustainable innovation

Sustainable innovation: To remedy trade-offs, it’s possible to have government action (next lecture) or Sustainable Innovation developed by business enterprises. Sustainable innovation includes technological, organizational, design, and/or institutional innovation introduced by business enterprises and other players into markets or organizations to foster sustainable development and fix its trade-offs. An example is reusing waste.

Oligopolistic markets

Oligopolistic markets

Between Monopoly and Perfect Competition, there are Oligopolistic markets, a situation where more firms compete, and their actions are influenced by the behavior of other companies.

Duopoly

To model Oligopolistic Markets, we use the duopoly, a market where there are 2 firms. Models can be Collusive (illegal, like cartels) or Competitive. There are 2 Competitive models:

• Simultaneous Model (Cournot, Bertrand) with quantities as a key variable.
• Sequential Model (Stackelberg) with prices as a key variable.

Assumptions

Duopoly relies on assumptions:

• Homogeneous products (same product, customers care just about price and quantity);
• Firms have perfect information and act rationally (maximize profit);
• Barriers to entry/exit;
• Linear cost and inverse demand functions.

Cournot model

À la Cournot: Simultaneous decision, competition choosing quantity. This model is based on finding a Nash equilibrium: since each firm will try to maximize profit, both will create a reaction function (or best-response function) representing the optimal (profit-maximizing) quantity choice for the firm for any possible quantity produced by the other firm:

• Calculate the marginal revenue.
• Calculate the marginal cost.
• Set MR = MC and find q = f(q).

This is the Reaction function or Best Response function. Repeat the same for q. After obtaining both, set them in a system to find the intersection point, which is the equilibrium (we are looking for Nash equilibrium, where neither wants to move). Indeed, given quantity q, to maximize profit, firm 1 will produce at quantity q. The same applies to firm 2, so solving the system gives the values of q. Calculate Q = q + q and substitute Q in P(Q) and π = p * q - TC.

Stackelberg model

Stackelberg: Sequential decision, competition choosing quantity. In this model, there is a leader (first decision) and a follower (second decision). We have to use backward induction. The leader knows that the follower will use the Cournot reaction function R(q), so the leader will maximize his profit knowing the quantity the follower will produce. By maximizing his profit, the leader finds his quantity q, and the follower will Cournot react. Compared to Cournot, the leader ends up producing more and making larger profits, while the follower produces less and makes lower profits (first-mover advantage). Note that this is valid even if the firms are identical.

Bertrand model

Bertrand: Simultaneous decision, competition choosing price. Assumption: Firms simultaneously decide their price; homogeneous costs; price is the only variable. Consumers demand the good from the company with the lowest price (no differences in the quality of products), and if two sellers charge the same price, the demand will be split evenly. But if a firm chooses a price higher than the marginal cost, the other will undercut it by choosing a slightly lower price (p – ε, where ε is a sufficiently small quantity) and stealing all market demand. So, in the end, both prices equal the marginal cost, which is a Nash equilibrium. This is unrealistic because no firm wants to produce without gaining profit. In reality, firms set a price higher than the marginal cost because they have limited capacity K that merges the inverse demand curve.

Collusion

Collusion: Is almost a monopoly:

• Profits are summed
• Final profit is derived partially for each q
• System to find each q

Industry concentration and market power

Industry

Industry: Group of firms offering similar products for a group of customers, e.g., European hammer’s customers.

Market structure

Market structure: Structural (long-term) characteristics of the market (industry structure), e.g., concentration, location, installed capacity, etc.

Industry classifications

Industry classifications: Business enterprises are clustered into industries following one of these three approaches (depends on the location): EU NACE; US NAISC; UN ISIC.

Industry concentration

Industry concentration: The size distribution of firms belonging to the same industry. A concentrated industry could be when very few firms dominate the market or many firms, but only a few have a large size. We can measure the size of an industry with: Output (e.g., Revenues); Added Value (e.g., Revenues – Costs); Inputs (e.g., Number of employees).

Market share

Market share: Weight of the firm relative to the industry (ratio between firm size and industry size).

Concentration vector

Concentration vector: Industry’s market shares in decreasing order.

Concentration indices

Concentration indices: Are a summary of the concentration vector and are used to compare the same industries over time or different industries at the same time. There are several types:

• Concentration ratio: An absolute concentration index summing the first K market shares. For example, from the concentration vector, take the first 4 values, divide by 100% to get C. It is not good at capturing asymmetries.
• HHI Index: An absolute concentration index weighing the market share of each firm by the share itself, hence can capture asymmetries.
• Lorenz curve: Curve of Cumulated Market Shares. Perfect equality: the first 10% of firms serve 10% of the market, the first 20% serve 20% of the market, and so on. Absolute inequality: 1 firm serves the entire market. Look at the right triangle; between the straight line and the curve, there is the concentration area.
• Gini Index: Summarizes the Lorenz curve information. Perfect equality: Gini Index is equal to 0; Absolute inequality: Gini Index is equal to 1.

Encaval and Jacquemin’s classification of market structures

Encaval and Jacquemin’s classification of market structures (MS = Market Share, what was previously s):

• Monopoly: 1 firm with MS higher than 80%
• Dominating firm: 1 firm with MS between 50% and 80%, and the others much smaller
• Duopoly: 2 firms account for 80% of the market
• Asymmetric oligopoly: 3 or 4 firms control 80% of the market, the highest share is around 40%
• Symmetric oligopoly: 3 or 4 firms equally control 80% of the market
• Asymmetric competition: the largest firm holds a share between 20% and 50%
• Symmetric competition: the largest firm controls 20% of the market maximum

Concentration and market power

Concentration and market power: Industry concentration implies firm’s profitability but also inefficiency because firms will exploit market power, which is the ability of a firm to raise the market price profitably. A measure of market power is the Lerner Index.

Concentration and Lerner Index

Concentration and Lerner Index: Are connected because the greater the ability to make a larger margin, the smaller will be the competition.