ECONOMICS 3200M Lecture 5 January 18, 2005

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ECONOMICS 3200MLecture 5January 18, 2005
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Existence of Firms

• Internalization
• Vertical integration, horizontal diversification
• Reduce transactions costs
• Economies of scale, scope
• Transferability of source of competitive
  advantage (design, marketing, costs, superior
  management, reputation)
• Proprietary information
• Tax advantages transfer pricing
• Quality control minimize liability risks
• Entry deterrence

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Existence of Firms

• Optimal size of firm
• MC of internalizing vs. MC of external
  transactions
• Diseconomies of scale vs. economies of
  scale/scope
• Technological change (communications,
  transportation, organization)
• Optimal size differs across industries, time,
  location (country-specific characteristics)

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Organization of Firms

• Holding company model GE, BCE, Power
  Corporation, Citigroup, Onex, GM, ACE
• Consider case of Air Canada
• Consists of number of related subsidiaries
  Aeroplan, Air Canada, Jazz, AC Technical
  Services, AC Groundhandling Services, AC
  Vacation, Destina, AC Cargo
• Advantages
• Market-based transfer prices efficient
  production/allocation decisions
• Performance/rewards
• Encourages entrepreneurship
• Strengthens accountability
• Revenue potential 3rd party revenues
• Leverages superior management talent at centre

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Competition

• Schumpeterian competition and dynamic efficiency
• Competition that counts is not price competition,
  but competition from new products, new
  technology, new sources of supply, new types of
  organization
• Dynamic change and efficiency gains result of
  strategic behaviour and risk-taking
  (decision-making under uncertainty absence of
  full information) technological change,
  productivity growth
• Pursuit of economic profits (above-average
  returns on investment) motivates risk-taking
• Investments anticipate payoffs commensurate with
  the risks (probability of failure) VC model
• Small number of winners in each time period/round
• Monopoly power short-lived because of dynamic
  nature of competition
• Strategic behaviour to solidify monopoly position

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Competition

• Carlton Perloff (p. 57) Even though perfect
  competition is rarely, if ever, encountered in
  the real world, we study the perfect competition
  model because it provides an ideal against which
  to compare other models and markets.
• Assumptions
• Homogeneous, perfectly divisible product
• Perfect information
• Price takers
• Zero transactions and search costs
• No externalities
• Free entry and exit

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Competition

• Price determination
• Some degree of market power for each firm because
  of search costs
• High degree of substitutability firm elastic
  demand curve
• How is initial price point established?
• Long-run equilibrium
• Economic profits or losses as signal for
  entry/exit definition of economic profits
• Rate/speed of adjustment how long does it take
  to get from short-run to long-run?
• Perfect information, zero transactions costs and
  free entry and exit
• Incentives to innovate technological change
• Perfect information, zero transactions costs and
  free entry and exit

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Competition

• Contestability
• If there is free entry into and exit from a
  market instantaneously (no sunk costs), firms
  have an incentive to enter whenever price exceeds
  average cost. Markets with free instantaneous
  entry and exit are called perfectly contestable.
• Assumes no sunk costs, zero entry/exit costs,
  reactions of incumbents, possible competitive
  advantages of incumbents, speed/number of
  entrants
• Solid waste collection competitive bids every
  year
• Relocation costs, experience, lobbying
• Airline industry city-pairs assumed to be
  contestable
• Start-up costs, competitive advantages of
  incumbents networks

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Competition

• Barriers to entry
• Absolute cost advantages of incumbents
• Access to customers access to distribution
  channels, switching costs
• Access to inputs, technology role of patents
• Product differentiation importance of
  reputation, brand names
• Scale of entry and capital requirements
• Exit costs
• Strategic behaviour of incumbents reputation of
  incumbents
• Future market conditions
• Number of potential entrants

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Competition

• Scale, speed of entry
• Information re. economic profits
• Information re. production, distribution,
  consumer tastes, etc.
• Access to inputs at same prices as incumbents,
  including access to capital and management talent
• Start-up costs sunk costs
• Time required to enter develop strategies,
  acquire facilities and resources
• Actions of other potential entrants
• Actions of incumbents
• Willingness of external investors to finance
  entry
• Expected growth
• Excess capacity

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Monopoly

• Assumptions
• No price discrimination
• Quality known by consumers
• Entry barriers
• Profit maximization pricing
• MRMC ? PM/MC (? 1)/? (? is the absolute
  value of the price elasticity of demand)
• Price-cost mark-up Lerner index of market power
• Relative mark-up inversely related to price
  elasticity of demand
• Constant elasticity of demand ? ? therefore
  constant mark-up
• PM/MC ?1/ ?
• Rule of thumb pricing constant mark-up over
  costs where MC approximated by AC

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Monopoly

• Profit maximization pricing over time
• Price elasticity in long run may differ from
  price elasticity in short run
• Case of oil
• Inelastic short-run demand
• Elastic long-run demand as substitution
  possibilities expand

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Monopoly

• X-inefficiency
• Absence of competitive pressures to minimize
  costs
• In competitive markets inefficient firms cannot
  survive
• Agency problem, not a problem of monopoly
• Incentives to innovate, invest in new technology
• Carlton Perloff, p. 94 A firm in a market
  with many firms can observe what other firms are
  doing assumes information freely available. It
  can observe, for example, whether its own costs
  of production are above or below the market
  price. Because the market price reflects the
  efficiency of the other firms in the market, a
  competitive firm knows that it can improve its
  production efficiency if its costs of production
  are high relative to the market price how does
  it survive?. In contrast, a monopoly has no
  other firms to look at other firms in other
  industries who supplies the technology and
  production equipment? and may have no other
  standard by which to judge how efficiently it is
  operating.

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Monopoly

• Multi-product monopoly
• N products Qi (i 1,.,N)
• N prices Pi
• General case interdependent demands,
  interdependent costs
• Pi Pi (Q1, Q2,.., QN)
• Ci Ci (Q1, Q2,.., QN)
• Case 1 independent demands and costs
• Pi Pi (Qi)
• Ci Ci (Qi)
• N separate monopolies with first-order
  profit-maximization condition
• (Pi M MCi)/ Pi M 1/?ii
• Mark-ups can vary across products