Week 1: An Overview of Welfare & Industrial Economics

1. Week 1: An Overview of Welfare & Industrial Economics Francis O'Toole (fotoole@tcd.ie) Department of Economics Trinity College Dublin 30th September 2011

2. Economics: Fundamentals • Economics: Scarcity and Choice • Scarcity: Wants > Resources (Needs < Resources?) • Choice: Optimising Behaviour, Cost-Benefit Analysis • Incentives and Institutions • Neo-Classical Perspective (self-interested individuals, rational or at least rationally irrational) • Broad (political economy) • Narrow (consumers and producers + some government)

3. Economic Agents & Models • Consumers (Individuals or Households?) • Firms (Suppliers/Producers) • Government(s) (Ireland, EU?, USA, … ) • Agencies (e.g. Competition Authority, ComReg, CER, Department, … ) • Consumers maximise happiness (utility, satisfaction) subject to income constraint • Firms maximise profit (subject to cost environment) • Government(s) maximise ? • Agencies maximise ? • Economics, Political Economy, Public Choice ≠ Public Finance

4. Economics: Demand & Consumer Surplus • Individual Consumer Demand • Quantity Demanded = F(P, Psub, Pcom, Y, Taste, …) • Market Demand = Individual Demands • Consumer Surplus = Willingness to Pay – Price • Consumer Surplus = “Value” – Price

5. Economics: Supply • Individual Firm Supply • Quantity Supplied = F(P, Pother, w, r, …) • Market Supply = Individual Supplies • Economic Profits = Revenue – (Economic) Costs • Economic Profits ≠ Accounting Profits • Producer Surplus = Revenue – Total Variable Costs • Long Run: Economic Profits = Producer Surplus

6. Economics: Societal Welfare • Consumer Surplus + • Producer Surplus = • Societal Welfare • Income Distribution (in “background” at least)

7. Price Determination & Elasticity • Quantity Demanded = Quantity Supplied • Own-Price Elasticity of Demand (e.g. market power?) • Cross-Price Elasticity of Demand (e.g. substitutes and market definition) • Income Elasticity of Demand • (Own-Price) Elasticity of Supply

8. Firm’s Costs: Short Run • Short Run: At least one input is fixed • Diminishing Marginal Product/Returns • Total Costs (TC), Average Costs (AC) • Fixed Costs (FC), Average Fixed Costs (AFC) • Variable Costs (VC), Average Variable Costs (AVC) (e.g. predatory pricing) • Marginal Costs (MC): Link to Supply Curve (e.g. predatory pricing)

9. Firm’s Costs: Long run • Long Run: All inputs are variable (TC = VC) • Shape of Average Cost Curve? Increasing Returns to Scale Decreasing Returns to Scale Constant Returns to Scale

10. Market Structure • Perfect Competition • Monopoly • Oligopoly, Monopolistic Competition, Imperfect Competition • Contestable Markets • Effective/Workable Competition • Structure  Conduct  Performance (SCP)? • Game Theory • Empirical Industrial Organisation

11. Perfect Competition: Assumptions • Large number of sellers and buyers • Homogeneous product • Free entry and exit • Full information about demand and supply • Profit Maximisation (MR = MC)

12. Perfect Competition: Characteristics • Short Run: Profits/Losses possible • Long Run: Entry or Exit until Zero Economic (Excess, Supernormal, Abnormal) Profits • Allocative Efficiency: P (SMB) = MC (SMC) • Productive Efficiency: P = Min AC

13. Monopoly: Assumptions • One seller, large number of buyers • Homogeneous product (by definition) • Barriers to resource transfers • Full information about demand and supply • Profit Maximisation (MR = MC)

14. Monopoly: Characteristics • Short Run: Profits/Losses possible • Long Run: Economic Profits (subsidised losses) possible • Allocative Inefficiency: P (SMB) > MC (SMC) • Productive Inefficiency: P > Min AC (generally) • X-Inefficiency? (minimise costs?) • Natural Monopoly (can’t compare with competition) → regulation (narrow sense) • Deadweight Loss: Harberger Triangle • R & D, Profit Motivation

15. Oligopoly: Assumptions • Few sellers, large number of buyers • Homogeneous or heterogeneous product • Free entry or barriers to entry • Full information about demand and supply (usually) • Aside: Monopolistic Competition = Oligopoly with Heterogeneous + Free Entry

16. Oligopoly: Characteristics? • Cournot (1838): Quantity Competition • Bertrand (1883): Price Competition • Game Theory • Cournot: Assumptions? Results • Bertrand: Assumptions Results? • Repeated Games  ???

17. Contestable Markets: Assumptions & Outcome • Free entry and exit: No sunk costs • Some price rigidity (e.g. menu costs) or lags relative to entry lag • Perfectly competitive outcome: potential use of hit-and-run strategy (even when n = 1) • Policy Relevance?

18. Effective/Workable Competition: Assumptions/Characteristics • No “harmful” inhibitions on entry and exit • No “harmful” product differentiation • No “harmful” coordination (e.g. price collusion) • No “harmful” price discrimination • Intrabrand competition, Interbrand competition, potential competition • No Excess (Economic) Profits

19. Effective/Workable Competition: Assumptions/Characteristics • “To determine whether any industry is workably competitive, therefore, simply have a good graduate student write his dissertation on the industry and render a verdict. It is crucial, of course, that no second graduate be allowed to study the industry.” (Stigler 1956) • Round & Siegfried (1994) Update?