econ-115 lecture 03 - kids in prison program · 2016-02-06 · project, which . . . – generates z...

ECON 115

Industrial Organization


1.Decision-making over Time

2. Market Structure and Market

Power

3. Technology and Cost


• Converting the value of

tomorrows $ into today’s.

• Discounting & present Value.

• Basic discounting rules.

• Measuring market structure.

– Concentration ratio

– Herfindahl-Hirschman Index

• NAICS

– Production vs. substitutability

– Geography and globalization

• Lerner Index

• Two quick problems

• Neoclassical view of the firm

• AC, MC and sunk cost

• Cost and output decisions

• Economies of scale

– Minimum Efficient Scale

– Natural Monopoly

• Multiproduct firms

• Economies of scope

• Flexible manufacturing

• Size, networks, government

• One quick problem


• Last week we discussed profit maximization

(MR = MC) there was no mention of time.

• Time, however, is important since all firms

make decisions over time.

– is it better to make profit now or invest for future

profit?

• Sacrificing profit today imposes a cost. How

do you determine if the cost is justified?

`


• The problem is that money today is not the same

as money tomorrow.

• We need techniques to convert tomorrow’s

money into today’s.

• Financial market techniques can be applied.

• Specifically, the concept of discounting and

present value


Start with an example . . .

• You have $1,000.

• This can be deposited in the

bank at 5% per year interest.

• Or it can be loaned to a

startup for one year.

• how much will the startup

have to contract to repay?

• $1,000 x (1 + 5/100) =

$1,000 x 1.05 = $1,050

More generally . . .

• You have a sum of money Y.

• Y can generate an interest

rate r per year (i.e., r = 0.05)

• Y will grow to Y(1 + r) in

one year.

• Therefore Y today will trade

for Y(1 + r) in one year’s

time.


• Discounting builds on this notion of the

value of money over time, except instead of

approaching value from the present to the

future, values are discounted from the

future to the present.

• The amount that was discounted from the

future to today is called the present value.


• Assume an interest rate of 5% per annum.

• The start-up contracts to pay $1,050 in one year.

• How much is that contract worth today?

• Answer: $1,000 since it grows to $1,050 in one year.

• Therefore, $1,050 in one year is worth $1,000 today.

• The current price of the contract is $1,050/1.05 =

$1,000.

• In other words, the present value of $1,050 in one year’s time at 5% is $1,000.


• More generally:

– the present value of Z in one year at interest rate

r is Z/(1 + r).

• The discount factor is defined as R = 1/(1 + r).

• The present value of Z in one year is then RZ.


• What if the loan is for two years?

– How much must startup promise to repay in two

years’ time?

– $1,000 grows to $1,050 in one year.

– The $1,050 grows to $1,102.50 the next year.

– Therefore, the contract is for $1,102.50.

• Mathematically: $1,102.50 = $1,000 x 1.05 x 1.05

= $1,000 x 1.052


• More generally:

– a loan of Y for t years at interest rate r grows to

Y(1 + r)t = Y/Rt

• Y today grows to Y/Rt in t years

• Put in terms of present value (Z):

– the present value of Z received in 2 years’ time

is R2Z– the present value of Z received in t years’ time is

RtZ


• Now consider how to

evaluate an investment

project, which . . .

– generates Z1 net

revenue at the end of

year 1

– Z2 net revenue at the

end of year 2

– Z3 net revenue at the

end of year 3 and so on

for T years

• What are the net revenues

worth today?

– Present value of Z1 is RZ1

– Present value of Z2 is R2Z2

– Present value of Z3 is R3Z3 ...

– Present value of ZT is RTZT

– Therefore, the present value

of these revenue streams is:

PV = RZ1 + R2Z2 + R3Z3 +

… + RTZT


• Here are two special cases of discounting:

• Case 1: the net revenues in each period are identical.

– Z1 = Z2 = Z3 = … = ZT = Z, therefore the present value =

PV =

• Case 2: The net revenues are constant and perpetual.

Therefore the present value =

Z

(1 - R)(R - RT+1)

PV = Z*R

(1 - R)= Z/r


• Present value is directly relevant to profit maximization.

• For a project to go ahead, the rule is

– the present value of future income must at least cover

the PV of the expenses in establishing the project.

• The appropriate concept of profit is profit over the

lifetime of the project.

• The application of present value techniques selects the

appropriate investment projects that a firm should

undertake to maximize its value.


• How to characterize market structure and

market power? Here are the main issues:

– How to measure market structure (index?)

– How to define a market

– How to measure market power

• This is critical because industries are diverse in

terms of number for firms, size of firms and size

distribution of firms.

– EXAMPLE: Breakfast cereals vs. newspapers


• In measuring market structure, the goal is to

find a number to summarize industry structure.

• One index is the concentration ratio: CRn, which

is defined as the market share of the industry’s

top n firms; n is frequently defined as 4.

• Herfindahl-Hirschman index (HHI) is the sum

of squares of market share of all the firms in

a market. HHI often uses percentages; HHI of a

pure monopoly = 10,000.

17

Industrial Organization• Compare two different measures of concentration:

Firm Rank Market Share Squared

Market (%) Share

1 25

2 25

3 25

4 5

5 5

6 5

7 5

8 5

625

625

625

25

25

25

25

25

CR4 = 80Concentration Index H = 2,000

25

25


• HHI better reflects the effects of unequal firm

size and high market share.

– Consider two markets, A and B, each with four

firms. In A, each firm has a 25% market share. In

B, one firm has 85% of the market while the others

have 5%.

– CR(A) = 100;CR (B) = 100

– HHI (A) = 2500; HHI = 7300

This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers

visit http://www.djreprints.com. http://www.wsj.com/articles/wave-of-megadeals-tests-antitrust-limits-in-u-s-1445213306

BUSINESS

Wave of Megadeals Tests Antitrust Limits in U.S.

Analysis shows that in many industries, most firms are competing in highly concentrated markets

If regulators approve the merger of Anheuser-Busch InBev and SABMiller, it will create an international beer behemoth.

PHOTO: LUKE SHARETT/BLOOMBERG NEWS

By THEO FRANCIS And RYAN KNUTSON Updated Oct. 18,

2015 10:55 p.m. ET

A growing number of industries in the U.S. are dominated by a shrinking number of companies.

The past year has brought major mergers in many industries, from health insurers and food

manufacturers to cable-TV providers. At the same time, many companies are focusing on narrower

markets that they can more easily dominate.

The result: In nearly a third of industries, most U.S. companies compete in markets that would be

considered highly concentrated under current federal antitrust standards, up from about a quarter in

1996, a Wall Street Journal analysis of competition data from the University of Southern California shows.

Last week’s $104.2 billion deal between big brewers illustrates the trend: If regulators approve the merger

of Anheuser-Busch InBev NV and SABMiller PLC, it will create an international behemoth commanding

nearly 30% of the global beer market. It is the culmination of years of mergers among a half-dozen major

brewing companies.

The trend toward increased concentration extends well beyond beverages, into household appliances,

mobile-phone service, air travel, grocery stores and more. In some cases, technological advances or the

rise of national markets for advertising and branding are driving consolidation.

HHI Index & Concentration

21


• What is a market?

• There is no clear consensus.

– the market for automobiles

• do we include light trucks; pick-ups; SUVs?

– the market for soft drinks

• Coca-Cola vs. Pepsi vs. fruit juices?

22

Industrial Organization• Currently the most common system is the

Census Bureau’s North American Industry

Classification System (NAICS).

• It uses categories and subcategories

primarily defined by production

processes.

23

• Presumably we define a market by closenessin substitutability of the commodities involved.

• One measure of the closeness of products is the cross-price elasticity of demand:

• Because the Census Bureau looks at production, this is not often included.


i

j

j

iij

q

p

p

q

24

• Other Issues with the NAICS and market definitions

– Geography

– Foreign competitors (globalization of a market)

• Finally vertical relations between firms are important.

– upstream and downstream production

– Firms at different stages may also be assigned to

different industries:

• bottlers of soft drinks: low concentration

• suppliers of soft drinks: high concentration

• the bottling sector is probably not competitive.


25

Industrial Organization• Market structure is often a guide to market

performance. But this is not a perfect measure

– Can a market have near competitive prices even

with “few” firms?

• Also, strong price competition may allow fewer

firms to survive, leading to higher concentration

• We measure market performance from an

efficiency perspective by using the Lerner Index:

LI =P-MC

P

26


• The Lerner Index captures the different

between Price and Marginal Cost. Under

perfect competition: LI = 0 since P = MC

• Monopoly: LI = 1/h – inverse of elasticity

of demand; That means the less elastic

the demand, the higher the price-cost

distortion.

27


• LI has limitations

– Difficult to measure elasticity of demand and

marginal cost

– Interpreting its meaning can be ambiguous:

• if there are sunk entry costs that need to be

covered by positive price-cost margin;

• low price by a high-cost incumbent to

protect its market

28


WL =1

2

• Welfare Loss in relation to sales:

WL

PQ

1

2D(LI)2

• Harberger (1954) exercise: Welfare Loss (WL) is:

(P – MC)(QC – Q)

WL

PQ=

1

2

(P – MC)

P

(QC – Q)Q

• This can be expressed as:

=


• For 73 manufacturing industries assuming D=1

• Multiplying the result by each industry’s output

and summing it up over all industries Harberger

estimated a total welfare loss from monopoly

power of about two-tenths of one percent

(.2%) of GDP.


• We are now beginning the technology and cost

section of the course.

• In general, we will view the firm in what is

known as “neoclassical” terms, where a firm is

envisioned solely as a production unit.

31


Inputs Outputs

The Firm

• There is an alternative approach (Coase)

– What happens inside firms?

– How are firms structured? What determines size?

– How are individuals organized/motivated?

• Not an issue for us


• Assume there are n inputs at levels x1 for the first,

x2 for the second,…, xn for the nth. The

production function, assuming a single output, is

written: q = f(x1, x2, x3,…,xn)

• The cost function is the relationship between

output choice and production costs. Derived by

finding input combination that minimizes cost,

wx, for

• .Minimize xi

subject to f(x1, x2,…,xn) = q1 wixi


• Analysis gives formal definition of the cost

function

– denoted C(Q): total cost of producing output Q

– average cost = AC(Q) = C(Q)/Q

– marginal cost: cost of one more unit

• formally: MC(Q) = dC(Q)/d(Q)

• Also consider sunk cost:

– incurred on entry independent of output

– cannot be recovered on exit


• Cost Variables and Output Decisions

• Firms produce where MR = MC provided

– output is greater than zero

– price is greater than average variable cost

– If P<AVC, firm will shut-down

• Firms enter if price is greater than average cost

– must expect to cover sunk costs of entry

• (Discounted present value of the expected future

profits must be as great at the sunk cost of entry.)


• The relationship between average and

marginal cost is:.

• = [MC(q) – AC(q)]q

• So average cost is increasing whenever it is

less than marginal cost.

22

'/

q

qACqMCq

q

qCqqC

dq

qqCd

dq

qdAC

36


$/unit

Quantity

AC

MC

Typical average and marginal cost curves

Relationship between AC and MC

If MC < AC then AC is falling

If MC > AC then AC is rising

MC = AC at the minimum of the

AC curve

37

Industrial Organization• Economies of Scale Definition: average

costs fall with an increase in output

• Represented by the scale economy indexS = AC(Q)

MC(Q)• S > 1: economies of scale

• S < 1: diseconomies of scale


• Sources of economies of scale:

– “the 60% rule”: capacity related to volume

while cost is related to surface area

– product specialization and the division of

labor

– “economies of mass reserves”: economize on

inventory, maintenance, repair

– indivisibilities


• Definition of Minimum Efficient Scale: the lowest

level of output at which economies of scale are

exhausted

• In other words, where S = 1

• Definition of Natural Monopoly: If scale

economies are global (present throughout the

relevant range of production), the market is a

natural monopoly, because it’s cheaper for one firm

to supply the entire market than multiple firms.


• The greater the sunk costs, the more

concentrated is market structure.

• A high sunk cost requires that each firm that

enters earns significant profit from its operations

to repay initial entry expense.

• This can only happen if the number of firms is

small so that price exceeds marginal (and

average) cost.

41


• Formal definition of Economies of Scope:

• The critical value in this case is SC = 0

• SC < 0 : no economies of scope; SC > 0 : economies

of scope.

SC =C(Q1, 0) + C(0 ,Q2) - C(Q1, Q2)

C(Q1, Q2)

42

• Sources of economies of scope:– shared inputs:

• same equipment for various products

• shared advertising creating a brand name

• marketing and R&D expenditures that are generic

– cost complementarities:

• producing one good reduces the cost of producing another


43


• Flexible manufacturing offers an extreme version of economies of scope

“Production units capable of producing a range of discrete products with a minimum of manual intervention”

• Production units can be switched easily with little if any cost penalty

44

Industrial Organization• A simple model based on Flexible Manufacturing

– Assume a characteristic that distinguishes different

varieties of a product, which can be measured and

represented as a line:

• sweetness or sugar content

• color

• texture

– One product is chosen by the firm as its base product.

– All other products are variants on the base product.

45


• Three types of soft drinks that vary in sugar content:

0 10.5

This is the

characteristics

line

Each product is located

on the line in terms

of the amount of the

characteristic it has

Low High

(Diet) (LX) (Super)

46


• Assume the process is centered on LX as base product.

• A switching cost s is incurred in changing the process to

either of the other products.

• There are additional marginal costs making Diet or

Super, e.g., adding or removing sugar. These are r per

unit of “distance” between LX and the other product.

• There are shared costs F: design, packaging, equipment.

01

0.5

LowHigh

(Diet) (LX) (Super)

47


• Economies of scale and scope affect market

structure but cannot be looked at in isolation.

• They must be considered relative to market size.

• Should see concentration decline as market size

increases.

– Entry to the medical profession is going to be

more extensive in Chicago than in Merced.

– Find more extensive range of financial service

companies in New York than in Turlock.

48


• Market structure is also affected by the presence of network externalities

– a consumer’s willingness to pay increases as the number of current consumers increases.

• telephones, fax, Internet, Windows software

• utility from consumption increases when there are more current consumers

• These markets are likely to contain a small number of firms even if there are limited

economies of scale and scope.


• Government can directly affect market structure

– by limiting entry

• taxi medallions in Boston and New York

• airline regulation

– through the patent system

– by protecting competitors e.g. through the

Robinson-Patman Act


• Next week is a short quiz.

• Look at the problems.

• Review the slides.

• 8 – 10 multi-choice problems; 2 -3 simple calculations.

econ-115 lecture 03 - kids in prison program · 2016-02-06 · project, which . . . – generates z...

Documents