Industrial Organization PGDMM501

1
Industrial Organization PGDMM501

• Lecture 11 Market Clearing

2
Introduction

• So far we assumed that prices adjust in order
  that markets clear. i.e. at the prevailing price
  QsQd
• Conventional micro models that assumed the above
• Alternative theories that questions the above and
  suggest ways other than prices which helps market
  clearing (discussed mainly within macro tradition)

3
A concise family tree
Classical Economics Supply creates its own
demand. (Smith, Ricardo etc.) A general glut was
impossible. "substance" theories of value
Neo-classical 1870s Marginalist Revolution of
Jevons, Menger and Walras. Value comprise of
costs of production and subjective elements,
called "supply" and "demand."
Keynes (1936) The great depression
Micro
Macro
4
(No Transcript)
5
Theories of how markets clear

• Competition
• Prices adjust so as to clear the markets
• Price changes are perfectly correlated across
  various buyers
• No transactions cost (see p.3)
• Oligopoly
• Price may be sticky in response to small cost
  changes
• http//www.tutor2u.net/economics/content/topics/mo
  nopoly/kinked_demand.htm
• Monopoly
• Draw examples in p.545

6
Oligopoly price increase vs. price decline
7
Oligopoly Kinked demand
8
Oligopoly Price stickiness
9
Theories of how markets clear

• Competition
• Oligopoly
• Monopoly
• In all of the above three models generally
• Transactions cost is zero
• Price changes among buyers are correlated
• No unsatisfied demanders or suppliers at existing
  price
• Price adjustment depend on shape of S and D curves

10
Role of price Empirical Evidence

• Price Rigidity
• Queues at petrol station (Excess demand)
• Empty shelves at Cargills
• How do we explain the unsatisfied demanders?

11
Mills (1972)
There could be twoexplanations of the U
shaped frequency dist. 1. That there are
markets in which prices to not adjust much (price
rigidity) 2. There are markets that under go a
fewer number of shocks to demand and/or supply
12
Other studies

• Means (1935) attempt to explain great depression
  using the concept of administered prices
• Stigler an Kindahl (1970) Uses a different data
  set revealing more flexible prices. Also
• long term buyer seller relations
• During booms spot prices go above long term
  contract prices
• Contracts specify neither a price nor a quantity

13
Other studies

• Carlton (1986) reexamine Stigler-Kindahl data.
• Price rigidity differs across industries
• Price movements across buyers in some markets not
  highly correlated
• High correlation between industry concentration
  and price rigidity (no such relation in simple
  models!!)

14
Explaining the evidence

• How to explain
• Rigidity-concentration relations
• Poor correlation between price changes of
  different buyers. i.e. Buyer X gets a lower price
  when Buyer Y gets a higher price
• Two approaches
• Extend the simple theories
• Find alternative theories

15
Extension 1 Include Time

• This enables inter-temporal substitution in both
  demand and supply
• The effect of this on the competitive model
• Shocks to D and S can be absorbed by something
  other than prices today

16
Today Tomorrow
Increase in demand today can should increase the
price. But alternatively it could force the
consumers to consume tomorrow. Confirmed by large
fluctuations in delivery dates and small
fluctuations in prices.
17
Dynamic theory

• For oligopoly theory the time factor has a
  similar impact
• MonopolyMay want to absorb temporary cost
  increases leading to price rigidity

18
Extension 2 Menu Cost

• fixed costs of changing prices
• Apart from the menu costs a price change can
  trigger a consumer search session which might
  lead to loss of business
• Change prices only if cost thereof is less than
  the benefits

19
Extension 3 Inventories

• Monopolies set prices and output before observing
  the demand
• Do this by equating expected price to marginal
  cost
• Expected price Price ? Probability of
  purchase
• Inventory policy f (price cost margin)
• This is because of the trade off between cost of
  holding inventory and profit from sales
• P(stock out) increase with falling mark up
• Fluctuating demand requires high inventories
  therefore S f (D)

20
Inventories
q
q
T
T

• S f (D)
• Explains poor correlation between price changes
  of different buyers.

21
Extension 3 Adverse Selection and moral Hazard

• The lemons problem can lead to higher prices and
  excess demand. This is useful because the buyer
  has no idea of the quality of the car.
• Similarly excess supply could also result from
  asy.

22
Explaining the evidence

• How to explain
• Rigidity-concentration relations
• Poor correlation between price changes of
  different buyers. i.e. Buyer X gets a lower price
  when Buyer Y gets a higher price
• Two approaches
• Extend the simple theories
• Find alternative theories

23
General theory of allocation

• Even financial markets are costly to set up (this
  is why you pay fees for the use of such markets)
• That is when you want to have prices clear the
  market
• What helps the establishment of price clearing
  markets?

24
Price rigidity not inefficient if

• When other methods of clearing markets are in use
  (salespeople) prices do not move to even if
  markets are cleared
• Sellers knowledge (due to long term associations)
  of buyers