Behavioural economics

Increasing Returns to Scale, Economies of Scale, Marginal Cost Function

Short run costs are associated with production only, with the capacity already fixed.

Total and marginal revenues assume that a firm can choose a single price. The total revenue function maps price and quantity, while marginal revenue maps the quantity of selling an additional unit and how it affects total revenue.

In a monopoly, there is a single firm in the market with the choice of price in the short run. The capacity is already installed, and the firm chooses the quantity to sell and the price. Given the demand and cost function, the firm maximizes its profit.

To maximize profit, the condition is that marginal revenue equals marginal cost. If marginal revenue is greater than marginal cost, there is an increase in revenue for each additional unit. If marginal revenue is smaller than marginal cost, the firm decreases the quantity and decreases profit.

If the price is greater than the marginal cost, it indicates the market power of the firm, making it a monopolist.

The equilibrium price is the point where quantity and price

DEMAND ELASTICITY: percentage variation of quantity/percentage variation of price must be greater than 0.

MONOPOLY: in a monopolist firm, there exists an inverse relation between market power and elasticity of demand. The lower the elasticity, the higher the market power. The Lerner index (between 0 and 1, 1=maximum market power, 0=no market power) indicates market power. Market power for a monopoly derives from low elasticity.

IMPORTANT - Monopoly Short Run: in the short run, the choice of price is made and the capacity is already defined. The firm cannot sell a quantity greater than its capacity.

Monopoly Long Run: in the long run, the monopolist chooses a capacity equal to the quantity the firm will produce.

SOCIAL EVALUATION OF MONOPOLY: Monopoly is a kind of benchmark for the simplest model of pricing. Social evaluation of monopoly means the social evaluation of market outcomes (price and quantity sold or produced).

CONSUMER SURPLUS: the difference between the willingness to pay of consumers and what they actually pay. Consumer surplus is the area between the inverse

1. DEMAND FUNCTION: the relationship between the quantity of a good or service that consumers are willing to buy at different prices. It is represented by a downward-sloping curve on a graph.
2. HORIZONTAL LINE: a line that is parallel to the x-axis on a graph. It represents a specific price level.
3. PRODUCER SURPLUS: the difference between the price received by producers and the marginal cost of production. It represents the additional profit that producers make above and beyond their production costs.
4. TOTAL/SOCIAL SURPLUS: the sum of consumer surplus and producer surplus. It represents the overall welfare or benefit to society from the production and consumption of a good or service.
5. MAXIMIZE TOTAL SURPLUS: the goal of maximizing the total welfare or benefit to society by ensuring that the quantity produced and consumed is at the point where the demand function and marginal cost intersect.
6. MONOPOLY: a market structure in which there is only one seller or producer of a good or service. It is considered inefficient from a social perspective because the monopolist does not have an incentive to produce at the level where marginal cost equals marginal revenue.
7. PRICE DISCRIMINATION: the practice of charging different prices to different consumers for the same good or service, even though the costs of production are the same. It allows firms to increase their profits by capturing more of the consumer surplus.
8. FIRST DEGREE PRICE DISCRIMINATION: a form of price discrimination where each consumer is charged a different price based on their willingness to pay. This allows the firm to capture all of the consumer surplus.

discrimination or full price discrimination: each consumer pays a price equal to his willingness to pay for each unit of the good. Personalized pricing.

1. First degree price discrimination: full price discrimination - not observable because each consumer pays a different price. Firms ask consumers to fix price according to their willingness. (Airlines company, different price at)
2. Second degree price discrimination: each consumer faces the same price, price varies according to different quantity bought. (QUANTITY DISCOUNT)
3. Third degree price discrimination or direct price discrimination: consumers are classified according to observable characteristics, different groups of consumers. Group pricing.
4. Indirect price discrimination: menu pricing - firms offer different variants of product (discriminated by quantity, quality, time of delivery) and each consumer chooses its preferred variants as a function of non-observable characteristics. It includes second degree price discrimination.

different moments). Valuation of good for consumer from 0 to vmax (highest willingness to pay the good). SOCIAL VALUATION: total surplus higher with full price discrimination, consumer surplus goes down because he pays high price. Consumers with highest willingness to pay à they transfer their surplus to firms. Consumer with low willingness to pay à surplus for firm: 0. ISSUE OF EQUITY: MORE IMPORTANCE TO CONSUMER OR PRODUCER SURPLUS? Example: mass of consumer which are identical. For each consumer the firm can fix a 2 part tariff à unit price p and fix component. (telephone companies) à non-linear price, your price depends on your quantity in non-linear way. Consumer surplus is obtained through the fix component. Firms get the total surplus because total surplus is maximized by consumer surplus generated by the price, transferred to firm thank the fix component. It is based on the willingness of consumer to buy for a price. Price of one unit of consumption equal to

MC.DIRECT PRICE DISCRIMINATION: THIRD DEGREE PRICE DISCRIMINATION (group pricing)

Firm uses observable characteristics of consumer of discriminating (age, gender, motive, professional status, tourists or not). Firm maximizes profit fixing 2 prices one for each group of consumers. Prices for the 2 groups are connected by inequality. If elasticity is different optimal prices should be different but price different in order to maximize profit. If consumers are sensitive to priceà higher price implies low demand.

Group price: personalization. Crucial for the firm to find out observable characteristics.

PRICE DISCRIMINATION INVOLVING TIMEà SEASONALITY.

Season: time interval during which demand is stable. Direct discrimination is pricing under demand seasonality. Creating seasons: creating interval time in which demand is stable.

Cycle: time interval including all seasons. If cycle is year: seasons are summer, winter; weekend vs. working days; firm has to fix capacity and price.

Example: 2

seasonsà high and low. Without demand uncertainty for the firm is optimal to choose a capacity level equal to quantity demand in high season. The high season marginal revenue is equal to the overall marginal cost (capacity+production). PROFIT MAXIMIZATION IN LOW SEASON: implies that low season marginal revenues is equal to production marginal cost. INDIRECT PRICE DISCRIMINATION (menu pricing discrimination) Self-selection of variance of products by the consumer. Consumers are not equal, otherwise no sense the offering of a menu of products. Firms know consumers are heterogeneous and they have preferences. Example: hotelà 2 rooms (1 standard, 1 suite). Decision of price and quality of each room. 2 types of consumers (1 attaches importance to high quality, the other to low price). The higher is the price, the higher must be the quality. Optimal offer by hotel: the firm has to convince the consumer with the high willingness to pay to choose the suite. Optimal for firm: reduce or increase

quality.Consumers prefer to buy the room the firm has designed for him (according to their observablecharacteristics)à constraint faced by firm.

DAMAGED GOODS: products offered in the market with inferior quality. Logic of menu pricing.

QUANTITY DISCOUNT MODEL: strategy equivalent to second degree of price discrimination. To induce tourists with higher marginal utility to choose the longer holidayà quantity discount, lower price for the second week.

TEMPORAL PRICE DISCRIMINATION: price differs in relation to the moment you effort the transaction. Strategy in service industries. Firms treat different consumers on the basis of the moment they buy the service.

LAST MINUTE STRATEGY: price is lower the closer the transaction date is to the date when the service is consumed. Fix price of p3 that can be sufficient for the demand left (low capacity), p3 lower than p1 and p2. Capacity here is used entirely, extracting an higher surplus. Closer are periods, larger are firm’s

FIRST MINUTE STRATEGY: price is lower the more distant the transaction date is to the date when the service is consumed. All consumers with a willingness to pay higher than p1 (naïve consumers don't think there will be a variation of price in the future). Price maximizes profit for naïve consumers with a willingness to pay higher than marginal cost. The rest of consumers are those with the willingness to pay below p1 and p2.

Second period: consumers with the willingness to pay higher than p2 book in the second period.

NAÏVE CONSUMER: they do not predict first minute or last-minute strategy. If a consumer predicts or learns the last-minute strategy (sophisticated), they will wait until the last minute for a lower price.

Realistic model: uncertainty in capacity could result in sold-out availability. Consumers with higher willingness to pay would anticipate the purchase.

Profitable for the firm to use a mixed strategy (random strategy).

First minute strategy is a form of price discrimination based on the

assumption of positive correlation between willingness to pay and delay in purchase. Consumers buy in different moments: business travellers need for a travel only just before departure. Lower demand elasticity. Pleasure travellers plan their trip more in advance and they have higher elasticity. Optimal for the firm: price low at the beginning and raise it closer to the departure date. First minute: non-reimbursable à less attractive for business travellers. Airlines sector exploit first minute and last minute strategy à correlation to capacity based theory (uncertain demand). FROM PREFERENCE BASED to NAÏVE BASED DISCRIMINATION 1) Behavioural consumers: monopoly (pricing with loss averse); 2) Anticipating future preferences (time based): consumers are time inconsistent (consumers change their mind in the future). 3) Anticipating future preferences (overoptimistic consumers), they are wrong about future preferences. 1) MONOPOLY BEHAVIOUR WITH CONSUMER LOSS AVERSE: firm should fix a

Mark up over marginal cost, which should depend on demand elasticity. Mark up pricing implies that prices should vary with marginal cost, both when cost increases and decreases, and willingness to pay by consumers. Firm chooses price after observing marginal cost. If marginal cost is 0, price chosen by the firm is below the average price. LOSS AVERSION tends to reduce profit (demand becomes more elastic with high price). If firm puts reference price very high, consumers for any price they observe they do not think they have a loss. (FRAMING EFFECT TO MITIGATE LOSS AVERSION).

2) ANTICIPATING FUTURE PREFERENCES, consumers choose at time t a contract which implies a price associated to goods/services that will be object of choice at t+1. (telecommunications market: you decide at t+1 how many effective giga you use); restaurants (you make a choice at time t and then you pay for your actual choice t+1). Choice at time t (based on expected preferences at time t+1).