Lecture 1

1st year:
First Welfare Theorem: Perfectly competitive markets distribute resources in a Pareto-efficient way.
Second Welfare Theorem: Any Pareto-efficient outcome is a general equilibrium outcome for some
initial allocation of resources. Also true taking production into account
Then: The market mechanism will make sure that (one of) the best outcome(s) is achieved. No need
for a government to intervene.
However: we need strong assumptions:

 Everyone is price-taker, so no one has market power.

 There are no externalities, or public goods.

 Everyone knows everything, there is no asymmetric information.

 Everyone acts fully rationally.

Then: In a perfect world, the market is perfectly competitive, and prices equal marginal costs. ›  But
in the real world, firms often have market power, driving a wedge between price and marginal costs.
›  We already know that a monopolist leads to a deadweight welfare loss. ›  But what would happen
if a few firms interact, who are not price takers but do take each other’s actions into account?

What is IO

Industrial Organization is concerned with te workings of markets and industries, in particular the way
firms compete with each other. It studies the economics of imperfect competition.

Market Power: The ability to set prices above (marginal) cost.

Central questions. Do firms have market power? How do firms acquire and maintain market power?
What are the implications of market power? What role is there for public policy with regard to
market power? Examples

Why do mobile phone companies design so many different bundles with so many different prices?
How does a textbook publisher decide on price? When will it decide also to offer an electronic
version? What price to charge for that? Why does Apple charge a royalty of 30% of all money made
by providers of apps?  How does Google make money? Why do firms merge? How did beer brewers
in the Netherlands manage to keep prices in bars high for an extended period?

Question that we cover?

›  Firms often charge different prices to different consumers. Is that a good thing? Or should we not
allow it? (weeks 1 and 2). ›  How can we avoid that firms conspire and make agreements to raise
prices? (week 4). ›  When should we allow mergers? (week 5). ›  What can firms do to keep potential
competitors out of their market? (week 6). ›  What are platforms? How to deal with them? (week 7).

We use models: simplified representations of reality that focus on the aspects of reality that are
important for the problem at hand. ›Like a road map. If the map is too detailed, it is no longer useful.
›  We focus on strategy – use game theory.
Refresher: perfect competition›  Many small buyers and many small sellers. ›  Complete and perfect
information. ›  Homogeneous product. ›  Free and easy entry and exit. ›  In the long run, each firm
charges price equal to marginal costs, and prices equal the minimum of average costs. ›  LI = 0.

How a firm w market power maximizes

profit

Markup percentage of a firm’s

price that is greater than its
marginal cost
The Lerner Index is a measure of a
firm’s markup, which indicates the
degree of market power the firm
enjoys
Competition policy:

US the players: › Department of Justice› Federal Trade Commission› Sectoral regulators (e.g. FCC,
FAA) › District Courts› Supreme Court

US the sources:›  Sherman Act ▪  Section 1: Horizontal and vertical agreements ▪  Section 2: Abuse of
dominant position ›  Clayton Act. Illegal if substantially lessens competition: ▪  Section 2: Price
discrimination ▪  Section 2: Exclusivity agreements ›  Section 7: Mergers and acquisitions ›  Federal
Trade Commission Act ▪ Section 5: Unfair methods of competition are unlawful › Regulations and
guidelines: ▪ Merger guidelines ▪ Leniency program

EUrope: players : › DG Comp, part of the European Commission (EC) › National competition
authorities › Court of First Instance (CFI) › European Court of Justice (ECJ)

EU: sources› EC Treaty: Articles 101 and 102 (formerly 81,82; or 85,86) ▪ 101: Horizontal and vertical
agreements ▪ 102: Abuse of dominant position › EC Regulations, e.g.: ▪ Regulation 4064/1989
(mergers) ▪ Regulation 2790/1999 (block exemptions to Art 101)

Differences between US and EU competition law criminal law /importance of common market in EU
/treble damages /EU competition law uses concept of market dominance

Main areas of competition policy › Price fixing› Merger policy› Abuse of dominant position

Price fixing › Explicit collusion is illegal› Implicit collusion is not illegal› Implicit collusion is frequently
more effective › Per se vs rule of reason› Leniency programs

Merger policy › US guidelines, EU regulation › Efficiency vs market power › Market definition › HHI
thresholds

Regulation › Please read sections 3 and 6 at home. › There will be much more on that in the MSc
course “Economics of Regulating Markets”.

Measure Market structure

Can we come up with an index that allows us to say how close or how far a market structure is from
the competitive ideal? The lerner index in practice is hard to figgure out what exacly marginal cost is.

Concentration Ratio, e.g. CR4: gives the combined market share of the 4 largest firms

Perhaps better (since it contains more information): the Herfindahl-Hirschman Index: sum of
squares of market shares of all firms:

Monopolist decides to increase output from Q1 to Q2

This is no longer true since we charge different P to different consumers ->Introducing the concept
of price discrimination. A seller sells the same product to different buyers at different prices.
Or: similar goods charged at different prices where the price difference is not only from
cost difference. Ex:Airlines, telecoms, trains, Quantity discounts, also electricity bill

Types of Price discrimination:

1. First degree (or perfect or personalized pricing). The firm charges each consumer highest amount
she would be willing to pay.

2. Second degree (or by self-selection). The firm cannot distinguish between different types of
consumers, but designs products in such a way that consumers choose to reveal themselves by their
choices.

3. Third degree (or by indicators). The firm can distinguish between different groups, can charge
them different prices and can also avoid arbitrage.

Ex. Senior discounts: you have to prove your age to get the senior price. Third-degree./ Student
discounts: you have to prove you are a student to get the student price. Third-degree. / Business
class: you don’t have to prove that you are (not) a business man to get this rate. Rather, classes (and
their prices) are designed such that rich guys choose to reveal their type.
Second-degree./ Mobile phone: different bundles for heavy users and light
users. Second-degree.

First-degree price discrimination Largely a theoretic possibility... ->

› The firm can capture entire social welfare. Profits is the green area

Third degree price discrimination  The firm is able to distinguish between two
groups and is able and allowed to separate them. Example: student discount.
Students pay a lower price and can prove they are a student by showing their
card. Or: senior citizen discounts. Senior citizens
pay a lower price on the bus. they can prove they are senior by showing their
card.

›  Let’s analyze the last case.

Suppose the bus company faces two types of consumers: Senior citizens (S) and
Other citizens (O).

› Inverse demand from Senior citizens: p = 50 – 1⁄2q . › Inverse demand from

S S
Other citizens: p = 100 – 2q . Marginal costs: constant and equal to 10. What
O O
would be the profit maximizing price? ›  We first have to derive total demand. ›
Total demand = demand from S + demand from O. ›  Demand from S:q =100–2p
S S
›  Demand from O:q =50–1⁄2p ›  Total demand: Q = 150 – 21⁄2 p ›  But this only
O S S
holds for low p! ›  For higher p, we only have demand from O.

Maximizing profits ›  Strategy: maximize profits on the joint demand curve. ›

Check that quantity demanded at that price is indeed non-negative for all
groups. >If so, then it is the true profit-maximizing quantity. ›  If not, restrict
to high demand consumers. ›  But first, derive inverse total demand. ›  Here: Q = 150 – 21⁄2 P, so P =
60 – 2/5 Q ›  π=(60–2/5Q–10)Q. ›  Maximized by Q = 125/2, so P = 35 and π = 3125/2. ›  At that price,
q = 30 and q = 65/2. Feasible.
S O

A side› What if we would have MC = 45!?

› π=(60–2/5Q–45)Q.
› Maximized by Q = 75/4, so P = 105/2.
› But at that price, q = – 5 and q = 95/4. Not feasible.
S O
Profit maximizing is to only serve O consumers: ›  π =
(100 – 2Q – 45)Q, hence Q = 55/4 and P = 145/2.

Back to the original situation

›  MC=10.π=(60–2/5Q–10)Q. ›  Maximized by Q
= 125/2, so P = 35 and π = 3125/2. ›  At that
price, q = 30 and q = 65/2. ›  What if the
S O
monopolist can price discriminate?

›  Suppose it can separate both markets (for

example by checking for senior citizen card)
and charge a different price for both types of
consumers. ›  Senior citizens: π = (50 – 1⁄2 q –
S S
10)q ›  Maximized by q = 40, so p = 30 and
S S S
π = 800. ›  Other citizens: π = (100 – 2q –
S 0 O
10)q ›  Maximized by q = 45/2, so p = 55
O O O
and π = 2025/2. ›  Total profits: 3625/2. More than above!
O

Some notes ›  Price discrimination makes seniors better off, Others worse... ›  The monopolist is
better off. ›  By construction, he cannot be worse off. ›  He always has the option to charge the same
price to both as in the situation without price discrimination... ›  Note:

› With price discrimination, that holds in each market separately. ›  Hence,

consumers with high elasticity (Seniors) are charged lower price than those with
low elasticity (Others). ›  They are more sensitive to price.

› This can work for bus tickets, but is less likely to work for e.g. bread. › If the bakery would price in
this way, I would just send my grandmother there to buy my bread. › That is not feasible for bus
tickets.› In other words: arbitrage should not be possible.

Welfare effects ›  A necessary condition for third-degree price discrimination to increase welfare, is
that it increases total output. (look book)›  That is never the case with linear demand. ›  Hence, with
linear demand, it decreases welfare. ›  But all this is only true if the same markets are served with
and without price discrimination. ›  Important caveat: it may still increase welfare if it opens up new
markets.

Second degree price discrimination  A firm knows it faces two groups, but it cannot tell who
belongs to which group...  Or at least, it cannot base its prices on that. There is no card it can ask for.
 For example, consumers with a high willingness-to- pay for high quality, and
consumers with a low willingness-to-pay for high quality. ›  Still, also here, there may be a possibility
to price discriminate. ›  The firm may induce consumers to self-select. ›  As an example, take 1and
2class on your train. Hence: self-selection ›  In most cases, seller cannot directly identify consumer
type, but can still induce consumers to distinguish themselves ›  Versioning: design product lines
that appeal to different consumers.

The Railway’s Problem ›  A railway company offers first class and

second class seats. ›  There are two types of consumers; those with
a high willingness to pay and those with a low willingness to pay. ›
Both come in equal numbers. ›  For simplicity, we refer to them as
the Rich and the Poor. ›  Willingness to pay of poor for 2class: 6. ›
WTP of rich for 2 class: 8.  WTP of poor for 1 class: 10. ›  WTP of rich
for 1class: 19. ›  Marginal cost 2class: 1. ›  Marginal cost 1class: 2. Scenario 1: complete information
Suppose the railway can perfectly observe who is Rich and who is
Poor (and is allowed to base prices on that). ›  To the Poor it can either offer 1 class or 2class. ›  In
either case, it sets price equal to willingness to pay. ›  When offering 2 class: p = 6, so π = (6 – 1) = 5.
2
›  When offering 1class: p1 = 10, so π = (10 – 2) = 8. ›  A similar analysis holds for the Rich. ›  When
offering 2class:p =8, so π=(8–1)=7. ›  When offering 1class: p = 19, so π = (19 – 2) = 17. ›  Hence, it
2 1
offers 1class to both, at prices: p = 10 and p = 19. It makes profits of 25. ›  Note: this is effectively
1 1
perfect price discrimination. Scenario 2: incomplete information

› Suppose now the railway cannot observe who is Rich and who is Poor (or is not allowed to base
prices on that). › It has a number of options: Option 1: Offer only 2class. Option 2: Offer only 1class.
Option 3: Offer both 1 and 2 class and try to make sure the Rich travel 1 and the Poor travel 2class.
› Let’s go through all three options. The first two options › Offer only 2 class:

›  If you only sell to the Rich: p = 8, so π = 8 – 1 = 7. ›  If you sell to both: p = 6, so π = (6 – 1)∙2 =
2 2 2 2
10. ›  Offer only 1class: ›  If you only sell to the Rich: p = 19, so π = 19 – 2 = 17. ›  If you sell to both:
1 2
p = 10, so π = (10 – 2)∙2 = 16. ›  Hence, if these were your only options, you would offer 1class at a
2 2
price that the Poor cannot afford. ›  This gives profits π = 17.
But now: 2nd degree price discrimination

›  Offer both 1 and 2 class and try to make sure the Rich travel 1 and the Poor travel 2class. ›  How?
You cannot force Rich in 1 and Poor in 2 class... ›  Suppose you charge p for 1 p for 2 class. ›  Make
1 2
sure the Poor want to travel: p ≤ 6. (participation constraint) ›  Make sure the Rich want to travel:
2
p ≤ 19. ›  Make sure Rich prefer 1over 2 class: 19 – p ≥ 8 – p . (incentive compatibility constraint) ›
1 1 2
Technically: also make sure Poor prefer 2 over 1, but that will always be satisfied.
But now: 2nd degree price discrimination ›  p ≤ 6. ›  p ≤ 19. ›  19 – p ≥ 8 – p so p ≤ 11 + p ›
2 1 1 2 1 2
This gives three constraints. ›  First set p as high as possible (doing so never violates the other
2
constraints!): p = 6 ›  The other constraints then imply p ≤ 19 and p ≤ 17. ›  Hence set p = 17. ›
2 1 1 1
Here, profits are maximized by setting p = 6 and p = 17 ›  That yields π = (6 – 1) + (17 – 2) = 20. ›
2 1
Higher than the π = 17 we had before! ›  Hence this maximizes profits overall. Some things to note ›
The Poor get zero consumer surplus – as in the case of first degree price discrimination. (no surplus
at the bottom) ›  The Rich do get positive consumer surplus! 19 – 17 = 2. ›  In their case, the
condition that they should prefer 1 over 2 class is binding. ›  This surplus is known as informational
rent. ›  The Rich get it because they can take advantage of the fact that the railway cannot observe
their true type. ›  It also implies that profits are now lower than if first degree price discrimination
were possible.

nd
Extension ›  Suppose the railway would be able to lower the quality of 2 class such that WTP for
Poor and Rich is 5.5 and 6.5 respectively (rather than 6 and 8). Would it do so?

›  We now need: ›  p ≤ 5.5. ›  p ≤ 19. ›  19 – p ≥ 6.5 – p so p ≤ 12.5 + p ›  This implies p = 5.5
2 1 1 2 1 2 2
and p = 18 ›  That yields π = (5.5 – 1) + (18 – 2) = 20.5 ›  Higher than the 20 we had before!
1

Why does this work? › It relaxes the incentive compatibility constraint of the Rich. › Hence, we can
charge the Rich a higher price for 1 class, as they are less tempted to travel 2class. › More generally,
it can be shown that the quality for the poor will always be lower than the socially optimal outcome.