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EC 208 Industrial Economics

Robert Akerlof

Lectures 2 and 3

I. Introduction II. Basic Concepts

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I. Introduction 1. Module Outline

Online material Lecture notes; Handouts; Problem sets/solutions; Essay topics

Textbooks Cabral, L. (2000) Introduction to Industrial Organization Carlton, D. and J. Perloff (2005) Modern Industrial Organization, 4ed Readings Additional readings for each lecture in the course syllabus

20 Lectures

4 Tutorials (fortnightly) §  Tutorials will begin in weeks 2-3.

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Assessment

§  2 Problem sets 10% (2 × 5%)

§  1 Essay 10% §  1.5 hour final exam 80%

Problem sets (Term 1)

§  Two assessed problem sets: handed out Oct 10 and Oct 31.

§  Due on October 19 and November 9 respectively. §  Also: Several practice problem sets will be handed out. Essay §  Due December 10 (first week of break).

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Class participation: highly encouraged!

Advice §  Keep on top of material! Understanding of earlier material

necessary for later material. §  Make sure you understand how to do all of the problem sets.

è will be key for doing well on the exam. §  Use the resources available to you:

My office hours: Wednesday 2-4pm or by appt., Room S2.103 Amir’s office hours: Monday 8-10am, Room S2.94 Come see us sooner rather than later.

Your feedback on the course is valued.

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Industrial Economics:

•  how firms compete in a given industry

•  firms strategic interaction and how it affects the industry

Industry: business activity producing substitutable goods or services

Strategies: setting prices; choosing products; investing in R&D; ...

•  individual firms’ strategies affect other firms in the industry

Main focus on: IMPERFECT COMPETITION MARKET POWER

Market power à ability to influence prices

2. What is Industrial Economics? What will we learn in this course?

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Basic conditions Demand Production technology R&D technology Advertising technology

Structure Number of firms Market shares Product differentiation Entry conditions

Conduct Pricing strategies Production strategies Product choice R&D investment Collusion Entry & exit Advertising

Performance Market power Profit rates Static efficiency Dynamic efficiency

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A few examples of things we will see in this course:

1)  What are the determinants of prices?

Example: effect of the introduction of generic drugs?

2)  Importance of strategic interaction (game theory)

Example: effect of Whole Earth Access pricing policy

3)  Sources of market power? Why do industries differ in the extent to which firms exhibit market power?

Example: cable companies, Facebook, Google

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Policy •  Regulation

Public intervention to regulate/correct the behaviour of firms with high potential market power (often monopolists) in industries where technology exhibits strong economies of scale and concentration (e.g. utilities)

•  Antitrust (competition policy)

Promote competition and contrast anticompetitive behaviour

Focus on the degree of industry concentration and market power

•  Patent policy Protect intellectual property rights and promote innovation (and the diffusion of welfare gains generated by innovation).

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Outline of Topics Lectures 2 and 3: Introduction and Basic Concepts

Lectures 4 through 8: Market Structure

Lectures 9 and 10: Game Theory I

Lectures 11 and 12: Game Theory II

Lectures 13, 14, and 15: Cartels and Collusion

Lecture 16: Product Differentiation

Lecture 17: Contestable Markets

Lectures 18 and 19: Durable Goods

Lecture 20: Transfer Pricing

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II. Basic Concepts 1. Economic Notion of Cost

Economic notion of cost=opportunity cost Opportunity cost:

Cabral (Ch. 2): “the foregone benefit from not applying the resource in the best alternative use.”

Sunk cost: Cost that cannot be recovered. Examples? Zero opportunity cost.

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Why focus on opportunity cost? This is the notion of cost that firms should base decisions on. Therefore: firms should ignore sunk costs!

Two cases: Apple (see handout) Carnegie

Opportunity Costs in Practice

Example: valuing the costs of owning a 1998 Boeing 737

The 1998 Boeing 737-700

Global airline profit forecast revised upwards By Sharon Chen, Bloomberg Tuesday, October 02, 2012 The International Air Transport Association raised its 2012 global airline profit forecast 37% as carriers slow capacity growth to cope with higher fuel prices and waning travel demand. Carriers may post $4.1bn (€3.2bn) of profits this year with a margin of 0.6%, the group — whose members account for 84% of global airline traffic — said in a statement. That compares with a June forecast for gains of $3bn and a profit of $8.4bn in 2011. The group raised its forecast as airlines reported improved earnings in the second quarter, it said. Delta Airlines and US Airways Group beat analysts’ profit estimates, while Singapore Airlines posted its first increase in net income in seven quarters. "The industry has re-shaped itself to cope by investing in new fleets, adopting more efficient processes, carefully managing capacity and consolidating," Tony Tyler, IATA chief executive said. !

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User Cost of Capital (UCC)

UCC(t) = rV(t)+(V(t)-V(t+1)) = foregone interest + economic depreciation

UCC(t) is the opportunity cost: Actual use of V(t) pounds is: purchase capital YieldsèV(t+1) Best alternative use of V(t) pounds is: invest with a return of r Yieldsè(1+r)*V(t) Opp. Cost=Difference=(1+r)*V(t)-V(t+1)=UCC(t)

Check the Airliner Price Guide

25,803,980

27,448,430 98 737-700

97 737-700

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Cost of owning Boeing 737-700 for 1 year: UCC = interest +depreciation

= 5%*($27.4m)+ ($27.4m-$25.8m) = $2.97m

Question for the airline: Will the added revenue from an additional plane exceed $2.97m?

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2. Production cost functions Total Cost: Suppose firm plans to produce q:

C(q)=Minimum cost to obtain level of production q

REMARK: C(q) will depend upon the time horizon (short run, longer run?) Reason: In longer run, more aspects of the production process can be changed than in the short-run. For example: difficult to hire more workers, build new plants in short-run, or change technology but can do in longer-run. èHigher C(q) in short-run than long-run

Example: Changes in Technology

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Average Cost (pounds per kilowatt)

Size (kilowatts)

Average Cost of Turbine Generators

Tandem-compound design

cross-compound design

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Fixed Costs and Variable Costs:

C(q) = FC + VC(q) Total cost = Fixed cost + Variable cost

Examples of Fixed Costs? Variable Costs? To check your understanding: How do fixed costs differ from sunk costs?

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Marginal Cost and Average Cost:

Marginal cost: how much would it cost to produce an additional unit? MC(q) = C’(q) = VC’(q) Marginal cost = Derivative of Total cost

= Derivative of Variable cost Average cost: AC(q) = AVC(q) + AFC(q) Average cost = Average Variable cost + Average Fixed cost

qFC

qqVC

qqC

+=)()(

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Economies and diseconomies of scale •  Economies of Scale

– AC decreases with q, so MC < AC – Most anything digital

•  Constant Costs – AC constant with q, so MC = AC –  “Scalable Business”

•  Diseconomies of Scale – AC increases with q, so MC > AC

Some Sources of Economies of Scale

•  Spreading out fixed costs – Example: Software development costs

•  Change in technology – Example: Automation, increased specialization

•  Technical scaling relationships – Example – volume vs. surface area – container

ships, pipelines

Example: Software or CD’s

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10

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30

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60

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0 5 10 15 20 25 Output

AC

MC

Some Sources of Diseconomies of Scale

•  Specific assets in limited supply

•  Capacity constraints

•  Bureaucracy, management difficulties, limited management resources

Example: Producing Near Full Capacity

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0 5 10 15 20 25 Output

MC

AC

Full Range: U-Shaped Average Cost

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0 1 2 3 4 5 6 7 8 9 10

Range of Economies of Scale

Range of Diseconomiesof Scale

Point ofConstantCosts

Output

MC

AC

Efficient Scale:

Level of output where AC is minimized. Note: at efficient scale, AC=MC. Efficient scale influences firm size in an industry: Suppose there is a firm that is much larger than the efficient scale (high AC). èother firms may want to enter the market.

Market Impact of Economies of Scale

•  Economies of scale can create: – Barriers to entry – Market concentration or natural monopoly –  Incentives to outsource or merge

•  This depends on: – Level of scale economies – Size of market relative to efficient scale – Contracting possibilities

Economies of Scope

•  Cost savings associated with the joint or simultaneous production of several products – Unit costs are lower than if products are

produced separately in stand alone firms

•  Sources? – Shared use of indivisible inputs

•  Examples: 3M, Ski/Tennis Shops

EC 208 Industrial Economics 34

Production cost function for multiproduct firms:

C(q1,q2)=minimum cost of producing quantity q1 of product 1 and q2 of product 2.

Economies of scope

Cost of producing two products together is cheaper than making separately:

C(q1,q2)<C(q1)+C(q2)

Mergers: people often talk about “synergies.” Really talking about economies of scope.

Learning Effects

•  Costs savings that arise from repetition, practice or experience of ongoing production

•  Todays output affects tomorrow’s costs.

Some sources: •  Workers become more adept at jobs •  Managers learn to schedule production tasks more efficiently •  Engineers, initially cautious in product design, gain experience and are

better able to allow for tolerances in design that decrease costs without compromising quality.

•  Suppliers of materials learn how to produce better and pass on fraction of cost savings.

Learning versus Scale

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WWII Liberty shipbuilding program

Date of keel laying

Day

s fro

m k

eel l

ayin

g to

del

iver

y

On 16 January 1943, Schenectady, a Liberty tanker, split in two while moored in calm water at the outfitting dock at Swan Island, Oregon. A US Coast Guard report described the incident: Without warning and with a report which was heard for at least a mile, the deck and sides of the vessel fractured just aft of the bridge superstructure. The fracture extended almost instantaneously to the turn of the bilge port and starboard. The deck side shell, longitudinal bulkhead and bottom girders fractured. Only the bottom plating held. The vessel jack-knifed and the center portion rose so that no water entered. The bow and stern settled into the silt of the river bottom. The ship was twenty-four hours old. The official Coast Guard report on the Schenectady incident attributed the fracture to welds in critical seams that "were found to be defective.“ Peter Thompson, "How Much Did the Liberty Shipbuilders Learn? New Evidence for an Old Case Study.“ Journal of Political Economy 2001. Photos from http://www.fiu.edu/~thompsop/liberty/photos/liberty_summary.html

Esso Manhattan, 29 March 1943, at the entrance to New York Harbor.

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John P. Gaines, November 1943. Vessel broke in two off Shumagin Aleutians with the loss of ten lives.

Estimation of Learning Curves

•  How is the effect of learning on costs quantified? – With cost data, estimate learning curves

•  Firms often attempt to estimate learning curves: – way to know precise benefit of today’s

production on tomorrow’s costs

Typically Estimate a Log-Log Specification:

ln(AC per lot) = α - β ln(Cumulative Production) β = estimate of percentage decrease in cost of a batch

associated with a 1% increase in cumulative production.

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50

100

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Lot Number (or Cumulative Production)

AC

pe

r L

ot

3.84

4.24.44.64.8

0 1 2 3 4

Ln(Lot Number (or Cum. Prod.))

Ln

(AC

pe

r L

ot)

Learning Curve ‘Strategy’

•  Overproduce now for lower costs in future

•  Needs to be undertaken with care è risks associated with following strategy.

Note: also logic for countries to protect underdeveloped industries.