DD309 21J Tutorial 5th Dec 2021

Game theory, econometrics, and

innovation & competition policy

Colin Cannon & Haluk Sezer

The tutorial will start at 7pm. In the meantime,

please check your audio using the Audio Setup
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top toolbar.
 Game Theory: Topics Covered:

The Prisoners’ Dilemma

The classification of games

Nash equilibrium; dominant equilibrium

Sequential games

Repeated games
 Why Is Game Theory Used in
Economics?

Mainly to explain oligopolistc behaviour.

Typology of Markets

Perfect competition

Monopoly

Imperfect competition

monopolistic competition

oligopoly
 Different Market Types
Perfect competition (although a mythical concept because
of the unrealistic assumptions it is based on, such as very large
number of buyers & sellers, homogeneous products, perfect
mobility of factors, perfect knowledge, etc.) has a general
theory explaining it
Monopoly is characterised as a market of single
seller, also has a general theory (Example: Network
Rail)

Monopolistic competition is a market containing

large number of sellers but differentiated product, also
has a general theoretical model (examples: law firms,
accountants, dentists, etc.)

Oligopoly contains a small number of sellers. The

product might be homogenous or differentiated.
 OLIGOPOLY (1)

Oligopoly is characterised by a small number

of sellers. This characteristic gives rise to
interdependence among the firms, which in
turn, necessitates ‘strategic thinking.’

Interdependence means actions of a firm will

create reactions by the rivals, which in turn
will determine the reaction of the firm to
those reactions, and so on. It is like a chess
game where strategic thinking is the
essence.
 OLIGOPOLY (2)

Various theories of oligopoly, such as the

kinked-demand curve, Cournot model,
Bertrand model, etc. have not manged to
produce a general theory of oligopoly.

Because oligopoly necessitates strategic

thinking, game theory is a very useful tool to
explain oligopolistic behaviour.
Figure 1: The prisoners’ dilemma

BONY

CONFESS DENY

Clive 3 yrs Clive 1 yr

CONFESS
Bony 3 yrs Bony 10 yrs
CLIVE
Clive 10 yrs Clive 2 yrs
DENY
Bony 1 yr Bony 2 yrs
 Introduction to Game Theory
The theory of games is the study of mathematical models of conflict and
cooperation between rational and intelligent decision-makers. Here rational means
a maximising behavior, and intelligent means the ability to understand the structure
of the situation.

A game is a situation in which rational decisions are necessarily interdependent.

A player is a participant in a game.

A strategy is a plan which describes how the player will move in every conceivable
situation.

Nash strategy is the best strategy for a player given the strategy of its rival(s).

Dominant strategy is the best strategy for a player whatever the strategy of its
rival(s).

A payoff matrix is a table showing the pay-off for every possible move by each
player.
 Classification of games

1) Simultaneous-moves games

One-shot games Vs. Repeated games

Cooperative games Vs. Non-cooperative games

2) Sequential-move (dynamic) games

 An application: climate change game

Let us consider, for example, motives behind what

happened to the Paris Agreement on climate change
(although overtaken by COP26) from which the US
unilaterally withdrew.

The numbers in are for illustration but indicative of the

benefits to be gained. If both countries cut emissions they
each gain 6, while both adopts the strategy of ‘not cutting’
means they each lose by 2. If one country cuts emissions
while the other does not, the one complying with the
agreement (the cutter) loses out (-4) while the other gains
by 8.
Figure 2: Nash & Dominant Equilibria

US

Cut Do not cut

EU: 6 EU: - 4
Cut
US: 6 US: 8
EU
EU: 8 EU: - 2
Do not cut
US: - 4 US: - 2
 An application: climate change game
This is the same situation as that of the prisoners’ dilemma
The equilibrium position is reached in the SE quadrant, where
both countries adopt the strategy of ‘Do not cut emissions’. This
is a Nash equilibrium which is a non-cooperative equilibrium in
which each player is achieving optimum results (doing best it
can) given the strategies of other players. Moreover, the
equilibrium reached in the SE quadrant is also a dominant-Nash
equilibrium since the Nash strategies for both players are also
the dominant strategies.

Note, however, that this equilibrium position is not Pareto

optimal, since both would improve their position if they both
adopted the alternative strategy of ‘cut emissions’.
The non-dominant Nash equilibrium
Let us, for example, consider a duopoly (a market with
two sellers) in which the duopolists are faced with two
choices: advertise or not to advertise.

Further assume that if both firms advertise, Firm A makes

€300 profit and Firm B makes only €200, while if neither
advertises, Firm A makes €500 and Firm B €400.
However, if Firm A advertises and Firm B does not, then
Firm A makes €750 and Firm B €100 while reversing roles
results in Firm A making €200 and Firm B €250 profit.
Figure 3: The non-dominant Nash equilibrium

Firm B

Not to
Advertise
advertise

Advertise 300, 200 750, 100

Firm A
Not to
200, 250 500, 400
advertise
The non-dominant Nash equilibrium (contd)
It is clear that while Firm A’s Nash strategy is also its
dominant strategy, Firm B does not have a dominant
strategy.

If Firm A advertises, Firm B does best by advertising, but

if Firm A does not advertise, then Firm B’s best choice
(Nash strategy) is not to advertise. Note that Firm B
knows that Firm A will advertise whatever happens and
therefore it also knows that its best strategy is also to
advertise.

Thus, the equilibrium (Nash) is achieved in the NW

quadrant where both advertise, and Firm A earns €300
while Firm B earns €200, which is the non-optimal
outcome.
 Repeated games
In repeated games a player has the opportunity to punish others
for bad behaviour. For example, if Firm A refuses to cooperate
this week, Firm B may refuse to cooperate next week.

The lightest penalty to be imposed on the cheater is called tit-

for-tat. A tit-for-tat strategy is one in which a player cheats in the
next period if the other player cheats in the current period, but
continues to cooperate thereafter. That is, Firm B cheats in
period (t), and Firm A retaliates and cheats in period (t+1) but
reverts to complying in subsequent periods. The strategy of Firm
A is called a tit-for-tat strategy.

The heaviest punishment is called a grim trigger strategy which

is to cooperate if the other cooperates but to play the Nash
strategy forever thereafter (i.e. retaliate) if the other player
cheats.
 Figure 4: Repeated games
COLLUDE TIT-FOR-TAT

Period of play Profits (€mil. per period) Profits (€mil. per period)
A B A B
1 20 20 20 20

2 20 20 45 -10

3 20 20 -10 45

4 20 20 20 20

. 20 20 20 20

. 20 20 20 20

. 20 20 20 20

n 20 20 20 20
 The outsourcing game (1)
Let us assume that there are two firms, a supplier (S) and a
buyer (B). The buyer wishes to outsource the production of
some components of his main product to the supplier firm but
worries about the quality of the supplier’s product. S needs to
decide on the product quality she wants to deliver while B needs
to decide on the price he pays. Thus the strategies open to S are
to supply ‘high quality’ or ‘low quality’ product, and the
strategies for B are to pay ‘high price’ or ‘low price’.

If they decide their moves without knowing what the other has
decided, the game is a simultaneous-move game. B cannot
distinguish the true quality of the components bought until after
purchase. Similarly, S cannot know whether the buyer, B, will
honour his commitment to pay a high price until after she has
incurred the production costs.
Figure 5: Outsourcing game: Simultaneous moves

High quality Low quality

High price 5, 5 - 4, 10
B
Low price 10, - 4 1, 1
 The outsourcing game (2)
The order of preferences for B is high-quality components at low price
to earn the highest pay-off, 10, followed by a high-quality component
at a high price (giving a pay-off of 5). Next down his preference list is
a low-quality/low-price component (pay-off of 1), and the worst
outcome is to pay a high price for low-quality components, and make
a loss (pay-off of −4).

S would prefer to sell low-quality components at a high price to earn

10. The high-quality/high-price outcome would give a higher payoff
(5) than that of the third choice of low-quality/low-price outcome
(giving a payoff of 1). The worst-case scenario is to produce high-
quality components at a high cost and receive a low price, ending up
with a loss (payoff of −4).

The solution to the game is provided by applying the usual reasoning

and finding the Nash equilibrium, which is in the SE quadrant where
they each earn 1, i.e. they are in a prisoners’ dilemma situation.
 Sequential games (1)
However, the situation changes if the supplier knows the price she will
receive with certainty before incurring the costs of production, because
she can respond to the buyer’s offer accordingly. This situation can no
longer be modelled as a simultaneous game; instead it should be modelled as
a sequential game, in which the supplier knows each buyer’s move before
she has to decide what to do (Figure 6).

The game begins at the first decision node where the buyer, B, has to decide
between offering a high or low price, noting that B discovers the quality of the
component only after purchase. At the second stage of the game, already
knowing the price offered by B, the supplier, S, decides on the quality to
produce. The fact that S knows the move made by B is the defining feature of
a sequential game.

In sequential games, at a decision node the player that has to move knows all
the moves that have been made in previous stages of the game, but not those
that will happen in later stages. If B offers a high price, the game continues in
the top branch, otherwise it continues in the bottom branch. In the second
stage of the game, S decides whether to produce high or low quality.
Figure 6: Outsourcing game: Sequential moves

High quality 5, 5
Subgame I

S
High
- 4, 10
price
Low quality

B Subgame III
High quality
10, - 4
Low
price S
Subgame II
1, 1
Low quality
 Sequential games (2)
In order to find the equilibrium solution, we use the process of
backward induction. We first analyse the best responses of the
player in the last stage and work backwards to anticipate what the
player in the first round will do.
We start from the top decision node of the last stage, which is called
Sub-game I. Here, S needs to decide between low or high quality,
with payoffs 10 and 5 respectively – the best response is thus to
produce low quality to receive 10. At the bottom decision node, which
called Sub-game II, S needs to choose between low or high quality,
with payoffs of 1 and −4 respectively. Again, S will choose low quality.
So the supplier’s best response at both decision nodes is to produce
low quality.

B anticipates that S will produce low quality if she goes for the high
price strategy, giving B a payoff of −4. If B chooses the low-price
strategy, then S will choose low quality, giving B a pay-off of 1. Since
1 is preferable to −4, B will offer a low price. So, the outcome of this
game is that B offers, in sub-game III, a low price and S supplies low
quality.
 Sequential games (3)
Note that this outcome corresponds to a Nash equilibrium
because both players are choosing their best response
strategies and no player could benefit from unilaterally
changing their strategy. Given that the supplier will supply
low quality at both decision nodes, the buyer would be
worse off by offering a high price, and given that the buyer
is offering a low price, the supplier is better off supplying
low quality.

Just as in the simultaneous version, in this sequential

game only low-quality goods can result. Thus, the
outcome of a single transaction does not depend on
whether the game is simultaneous or sequential: in either
case the equilibrium is suboptimal.
 Question 1
Generate summary statistics for output (measured by turnover), capital (measured by assets) and labour (measured by employees). Report and briefly describe
the results.

Note: Turnover and Assets are in Euros 000s. Employees are in numbers.
Comment that average (mean) output (measured by Turnover) is €185.68 million, capital (measured by Assets) is €285.23 million and employees are 475. In
addition, there is significant variation between firms in the sample on which they may comment. For instance, turnover ranges from €41.785 billion for the largest
firm by turnover to €2212.6. Assets vary from €126.730 billion to €8819.3 and employee numbers from 106 090 to 1.
We may also comment on the skewness of the data, particularly the difference between mean and median values of turnover and assets, highlighting the positive
skew of the distribution. Scientific notation: 1.33e+006. 1.33 is coefficient. e is 10 to the power of. 6 is exponent. 1.33e+006 = 1.33 x 10 to power of 6 = 1,330,000
 2. How to generate Summary Statistics with gretl. Statistics reported.
On the Toolbar, click on ‘View’.
On the Menu, click on ‘Summary Statistics’.
Enter one of the three variables by highlighting it, then clicking on the rightwards arrow.
Repeat, until all three variables appear in the righthandside column.
Enter.
Definitions. ‘Std. Dev.’ is standard deviation. ‘C.V.’ is coefficient of variation: a statistical measure of the
dispersion of data points in a data series around the mean.
C.V. = Standard Deviation / Mean
In finance, if the C.V. results in a lower ratio of standard deviation to mean return, then the lower
(better) is the risk-return trade-off.
‘Skewness’ is a measure of a dataset’ symmetry. A perfectly symmetrical data set has skewness = 0.
Positive skewness means the right-hand tail will be longer than the left-hand tail. Kurtosis is a measure
of the combined weight of the tails relative to the rest of the distribution. Statistics for skewness and
kurtosis do not give useful information not already given by dispersion?
95th percentile is the highest value left when the top 5% of a numerically sorted data set is discarded.
IQ range is the difference between the 75 th and 25th percentiles of data.
How to generate Scatterplot. Click on ‘View’. Choose ‘Graph specified variables’. Choose ‘X-Y
Scatterplot’. Enter your chosen variables.
3. Question 2
Using scatter plots and correlation coefficients, assess the strength of the linear association between log output
and each of the two inputs, log labour and log capital. (

.
4. From the correlation coefficient and scatterplot above, we can answer Question 3.

The correlation coefficient for l_output and l_capital is 0.88 which is strong evidence of a positive linear
correlation. A perfect positive linear correlation is 1.
The scatterplot shows that most of the data points approximate a linear fit, so a positive linear correlation seems
to be determined by the majority of data points across the whole distribution. There is some evidence of outlier
firms with low turnover against asset values, but these make up a relatively small number of data points
compared to the overall sample, and are distributed across the range of values of l_assets.

Lets define a number as N. The natural logarithm of N is (ln N). The natural log of N is the power or exponent by
which the Napier constant, e, has to be raised in order that the result equals N. The Napier constant is approx.
2.718282.

Regarding TMA02 Part B, the 29 th observation of Employees is 1 = N, when observations are placed in numerical
order.
(ln 1) = 0; 2.718282 to the power 0 = 1 = N.
The 30th observation of Employees is 2 = N, when observations are placed in numerical order.
(ln 2) = 0.6932; 2.718282 to the power 0.6932 = 2 = N.

One of the basic properties of logs is the Product rule: (ln (a x b)) = ln(a) + ln(b).
This will be useful as we come to construct econometric models.
The Power rule is, ln (a to the power of b) = b ln(a). Any log transformation can be used to transform a model that
is non-linear in parameters into one with desired linearity (linearity in parameters is one OLS assumption.
5. Question 3
Write the linear econometric model that represents a production function in which log of output is a
linear function of log of capital. Estimate the coefficients using a simple (univariate) regression OLS
model. Explain your results.
The model can be written as: l_turnover = a + b x l_assets + u.
(Where a and b are coefficients to be estimated and u is the error term.)
Note: We can use other names for the variables, such as log(output) and log(capital).
So long as the meaning is clear it is fine.

The results indicate that l_turnover is positively related to the log of capital
because the coefficient of l_assets is positive: b = 0.87. The slope coefficient of
l_assets, b, is an estimate of the output elasticity of capital and indicates that
a 1% change in assets leads to a 0.87% change in turnover. Alternatively,
capital elasticity of output, matches the logic of price elasticity of demand.
6. Question 4
Extend the model of the production function that you wrote in your answer to
. Question 3, by
adding log of labour into your equation and write down the extended (multivariate)
model equation.
Estimate its coefficients and explain the results using elasticities.
l_turnover = a + b x l_assets + c x l_employees + u .
(Where a, b and c are coefficients to be estimated and u is the error term.)
The results are indicated below
7

Results show that l_turnover is positively related to both the log of capital (l_assets) and the
log of labour (l_employees). In the multivariate model that includes a labour variable, the
coefficient of l_assets, b, (the estimate of the output elasticity of capital) is 0.67, which means
that a 1% change in assets leads to a 0.67% change in turnover.
We can also see that the coefficient of log labour, c, which is an estimate of the
output elasticity of labour, is 0.35, which means that a 1% change in the number of employees
leads to a 0.35% change in turnover.
8. Question 5
 Comment on the estimates of the output elasticity of capital
obtained, comparing the univariate and multivariate regression
models in Question 3 and Question 4.
Note that the slope coefficient estimated for the univariate
model of Question 3 estimated a total elasticity encompassing
all effects on turnover, those explicitly included such as log
assets, and those not included, such as log employees.
 By including the log of labour in the model, the estimate of the
output elasticity of capital (the coefficient of l_assets, b)
becomes 0.67, which is lower than in the case of the univariate
model, where it was 0.87. The difference between the two
estimates is due to the inclusion of the labour variable in the
multivariate model. In the multivariate model, the coefficient of
l­_­assets is an estimate of the partial effect of l_assets on
l_turnover, whereas in the univariate model it represented the
total effect since the labour variable was not included in the
model.
 
 Market power and market structure. Chapter 7,
Section 2.2
Competition is the drive to get ahead of rivals. It offers good results for
society, (1) cuts price, (2) offers more choice, (3) produces innovation.
In practice, competition policy cares about two main interrelated factors:
the exercise of market power, and market structure: e.g. barriers to entry.
Competition policy addresses itself to maintaining sufficient levels of
competition in markets. Textbook, p.306 cites EC interventions of (1)
merger leading to market dominance (Ryanair’s bid to acquire Aer Lingus,
main competitor on flights in and out of Dublin airport), (2) conspiring to
set high prices in vitamins A and E markets (Hoffman-La Roche and BASF),
(3) market entry restriction (Microsoft including Media Player within the
Windows operating system, thereby undermining demand for another
music/video management application.
A firm’s market power can be defined as its ability to raise the price of its
output above its marginal cost.
The problem is that prices that are set above marginal cost entail a loss of
welfare for society as a whole.
The focus is on the market for products of a specific industry, not on firm.
 Competition and welfare.
An industry is a set of producers of similar goods or services that compete
directly with each other in a market.
p.311. The market power of each firm is itself hard to measure. In practice
most companies sell a variety of products, and some production is carried
out jointly, by sharing equipment and manpower. The products of a firm
can belong to different industries.
p.308. Consumer surplus is the benefit to consumers, in money terms, of
a specific quantity of a good. It is the difference between the maximum
price consumers would have been willing to pay for each additional unit
of the good (shown by the demand curve) and the purchase price.
p.308. Producer surplus is the difference between the selling price of a
specific quantity of a good and the minimum price at which producers
would have been willing to sell each additional unit. In perfect
competition, the supply curve shows the amount that firms are willing to
supply at each market price. In long-run competitive equilibrium the
supply curve is the horizontal sum of marginal cost curves of all firms
above their point of minimum average cost. Chapter 5, Section 3.4.
 Competition and welfare
Consumers’ and producers’ surplus in a perfectly competitive market
(Textbook, Fig.7.1). For producers, price P e is equal to the marginal cost
of producing the last unit of output at Q e. Area C = Total cost of
prodn.
Price, cost Producer surplus = area B. S

A
Pe

B D

Qe Quantity
The whole area under the demand curve up to Q e (A+B+C) measures full benefit
to consumers, in money, for consumption of Q e. Consumers pay P e,
equilibrium price.
 Total surplus and competition policy, Textbook
p.309.

Producer surplus = area B = industry profit in long-run equilibrium.

Consumer surplus = area A
Total economic benefit = consumer surplus + producer surplus = A + B.
Often weights are given to the importance of benefits given to different
groups.
Heavier weight may be given to consumer benefit (as for the European
Commission, the Ryanair case : Textbook p.310.
Welfare, W = CS + ƛ PS, where, 0 < ƛ < 1. Textbook p.310.

Although competition policy tries to follow principles that should be

applicable in a variety of market situations, in practice competition policy
cares about two interrelated factors: (1) the exercise of market power to
raise prices, (2) manipulation of market structure to undermine incentive
to get better.
 Competition policy, market power and market structure
A firm’s market power is its ability to raise its price above marginal cost. If price is
set above marginal cost, a welfare loss results.
Market structure covers the character of the market including the number and
concentration of sellers, and the distribution of their market shares, and ease of
entry.
Competition authorities find it easier to measure market shares than to measure
marginal costs.
Loss of consumers’ surplus resulting from market power (Textbook, Figure 7.2)

Price Marginal
Cost cost
Pm A
B C
P c = MC
D E
MCc m = MR
m F
Demand

Output
Q Qc
 Fig. 7.2 Loss of total surplus from market power
Textbook, p.311-312.
This exercise compares the case of supply by a monopolist Q m (single seller) with the case of
supply by a competitive industry Q c.
In a perfectly competitive industry, long-run equilibrium market price P c is the price at which
demand = supply, and where P c = MC c.
At P c, consumers buy Q c of the good.
Consumer surplus under perfect competition is A + B + C.
Producer surplus is D + E + F.
Total surplus = A + B + C + D + E + F.
Under monopoly, the firm has power to set higher price P m, while consumers purchase Q m.
Marginal cost is Q m = Marginal revenue m.
At P m, consumer surplus has shrunk to area A, while
producer surplus = B + D + F.
Total surplus = A + B + D + F.
Setting price at P m, above MC m, reduces total surplus by C + E.
This reduction is deadweight welfare loss: the loss to one group that does not accrue to
another. Textbook p.312.

.
 Market power and market structure
Market power is the ratio of price-cost margin ( the difference between
market price and firms’ marginal cost ) to market price. This is the Lerner
Index (Textbook, pp.312-314).
Textbook p.313. Market structure refers to characteristics of a market that
influence the nature of competition within the market, such as the
number and concentration of sellers. The distribution of market shares
tells us whether we are looking at an industry with a number of firms of
similar size , or a market where a few produce most of the total output.
Market structure affects firms’ incentives to use technology efficiently,
and affects their incentives to invest in better technologies (dynamic
efficiency. Textbook, p.314). Competition authorities may defend
innovation, as in the proposed Dow – Dupont merger, where the
producers planned to cut back research after the merger.
A firm in perfect competition is a price taker. Its demand curve is
horizontal. It has no market power.
A monopolist can either set market price or decide quantity sold. Its
downwards sloping demand curve means P m > MC m, because the
marginal revenue gained from an additional unit sold is less than the
price at which it is sold. To sell an extra unit, then price must be lowered,
say to P1 < P0.
Textbook p.317. Monopolist’s marginal revenue MR = P1 – Q0(P0 – P1)
 Cournot model connects number of firms and market
power Textbook pp.317-319)
The Cournot model assumes the market is served by N independent firms, all
of the same size. All produce a homogeneous product.. For industry output
Q0, each firm i produces qi = Q0/N, and each has a market share si = 1/N
Suppose the firms compete by output-setting rather than by price.
Suppose each firm is large enough relative to the market for their individual
output decision to influence market price. Textbook p.317.
(1)The Cournot firm gets additional revenue P1 from selling the extra unit,
but (2) must in consequence sell all of its output at the lower price P1.
MRi = P1 - (Q0/N) (P0 – P1), (Textbook p.318)
The second term on the right-hand side is smaller for Firm i than for the
monopolist. Firm i has less to lose from the price drop required to sell an
extra unit. A firm that is not alone in the market bears only part of industry
loss. Each competitor is too aggressive for the interests of the industry.
So we predict, in aggregate, firms in this industry will find it profitable to
expand output above the profit maximising output of a monopolist.
The larger the number of firms, N, the smaller the loss that each firm suffers.
Cournot provides a negative relation between N and market power (PCM).
 Competition policy, concentration & market power
(Textbook pp.319-323)

The loss to a large firm (relative to the market) from a price decrease is large. So
competition authorities pay attention to the number of firms and to the
distribution of market share. The n firms concentration ratio is the simplest index
of concentration and market power: it is the percentage of total industry output
accounted for by the largest n firms in the industry. Textbook, p.319.

The Herfindahl – Hirschman concentration index, HHI, Textbook p.320, has

advantages.

HHI = ∑ (Si)squared

i=1
HHI measures the sum of the squares of market share of each firm in the
industry.
Its advantages are: (1) it covers the market shares of all firms in the industry,
rather than just a few, (2) The HHI is mathematically related with the Lerner
Index by means of the absolute value of the price elasticity of demand.
(Textbook, p.321).
 Entry, market power, SCP model, and efficiency.
Textbook pp.324-326.
Contestable markets are where firms can freely enter and exit the market
without incurring losses when they dispose of their capital. There are no sunk
costs. Sunk costs are a firm’s fixed and irrecoverable costs. They are specific
and have no resale value. Otherwise the incumbents’ market power would be
limited by hit and run raiders.
Competition authorities consider barriers to entry or barriers to expansion of
existing firms in the market. Textbook p.325. Cases are limited availability of
inputs, institutional barriers e.g. planning permission problems, established
brands, strategic barriers. Google used the power of its search engine in its
comparison shopping services to demote rivals’ so on average Google’s rivals
lost up to 90% of their traffic.
The Structure, Conduct, Performance Model, SCP, states that Market
Structure (concentration, entry/mobility problems, econs of scale, product
differentiation) influences the behaviour (Conduct) of firms (price setting,
investment and innovation, advertising, collusion), which determines the
Performance of the industry ( welfare impact, firms technical or dynamic
efficiency). On the contrary, the ‘efficiency hypothesis’ (Demsetz), p.326,
counters with the argument, efficient firms have above average profits.
Market structure affects efficiency of the industry through incentives to avoid
X-inefficiency (Textbook pp.217-8, 326) . Competition gives an incentive to
limit X-inefficiency.
 Competition and strategic behaviour
Module textbook, Chapter 7, Section 4.

Oligopoly is a market containing a small number of firms whose

behaviour is influenced by recognised mutual interdependence.
A profitable dominant firm risks attracting new profit-seeking entrants.
Such a firm may therefore decide to over-produce, driving down market
price to below a limit price (maximum price an incumbent firm can set
that limits new entry to zero).
Game theory allows us to explore the strategic reasoning of both the
incumbent and the firm considering market entry. E.g. Fig.7.5, p.329 (A
three-stage entry game in extensive form). Also you may wish to refer to
Fig.6.15, p.279, which structures such a multi-stage game into three
subgames. Backward induction is a method of solving games that looks
ahead to the final payoffs and works backwards to the beginning of the
game. Module textbook, p.275.
Fig.7.6, Textbook p.332, models a game where the incumbent achieves
entry deterrence by investing in sunk costs.
 A taxonomy of anti-competitive behaviour
Module textbook, Chapter 7, Section 5.

Business strategies to give firms power over competitors and leading to

high profits are likely to be at odds with competition law.
However some may not be welfare-reducing. E.g. Product differentiation
may better meet consumers diverse preferences.

Strategies that are likely to fall foul of competition law are :

(1) collusion, p.335 (agreements to restrict competition, punishment,
uncertainties), (2) horizontal mergers, p.336 (perhaps supported by
arguments for efficiences), (3) abuse of dominant position, p.338
(hampering ability to compete or removing some competitors), (4)
predatory pricing, p.339 involving setting prices below cost for long
enough to induce exit of some competitors, followed by price rises, an
action enabled by greater financial resources. A profitable track record
attracts finance.
 Chapt. 5.2, 5.3, 5.4, 5.5 Technical change: from static to dynamic
efficiency

Productive Efficiency is a key neoclassical notion. 3 types of static efficiency (assume

technology is fixed) that apply to the supply side of markets are:
(1) Firms should produce with technical efficiency. P.201. (2) Firms should minimise costs for
each level of output. P.205. (3) Firms should produce at an efficient scale: at minimum
LRAC. P.208-210, Figure 5.13.
Technical change can be incorporated into the neoclassical model as shifts in the production
function (Fig.5.16 and Fig.5.17 Cost minimisation before and after technical change. P.216)
Dynamic efficiency is the increase in technical efficiency that occurs over time with the
introduction of technological innovation (p.216). The firm’s expansion path and related
cost functions will change.
Neoclassical theory models technical change as exogenous, and therefore ignores the
sources of innovation. Nelson and Winter (1982) proposed an evolutionary framework of
processes by which variables in a system change over time (replacing models of market
equilibrium), where continuous industrial change is driven by innovation (novelty: new
products, new ways). Innovation is key to modern capitalist economies. Evolutionary
concepts: bounded rationality; satisfycing; routines; tacit knowledge; path-dependence:
Textbook pp.224-226. Like Hayek, Schumpeter saw markets as discovery procedures
(endogenous), ‘creative ..’.
Temporary profits provide funds, reward innovation. Models should include:
•persistent heterogeneity & disequilibrium • the importance of ‘selection’ of firms • key
role of innovation & entrepreneurship • trial, error and failure.
 Dynamic efficiency, competition and policy
A technique of production is defined by a fixed proportional relation between
inputs: e.g. K/L. Textbook, p.194.
A firm is technically efficient if it is using the minimum quantity of inputs
needed to produce a given output for each technique of production. P.201,
Dynamic efficiency is the increase in technical efficiency that occurs over time
with the introduction of technological innovation (in process and products).
P.216.
Market structure affects dynamic efficiency. Competition authorities need to
be careful that in scrutinising market power, they do not remove incentives for
R&D and technical improvement.
Is R&D (improving technologies) higher in highly concentrated markets than in
very competitive ones? The answer depends upon firms’ ability and incentives
to invest.
With regard to ability to innovate in concentrated markets, such markets may
be more conducive to innovation because information is imperfect (uncertainty
and asymmetric information about rewards). Schumpeter.
With regard to incentives to invest in innovation, there is a mixed picture.
Desire to erect protective barriers to entry may drive innovation by powerful
firms. Network effects may be important. But the incentives confronting a new
entrant who has ‘nothing to lose’ may be large compared with firms whose
existing technology is threatened by innovation.
Competition policy is thus a complex balancing act, sustaining incentives for
efficiency while undermining market dominance that resists welfare-enhancing
competition (Regibeau, Module textbook, p.344).
Part C: Subtle shadings in approaches to regulation of pharmaceutical companies, in
recognition that higher profits from these firms can fund innovation and ESG.

Note that there is a case to be made for both competitive markets and innovating
firms. Therefore regulators such as the CMA – UK’s primary competition and consumer
authority – may allow innovating firms to increase market share, which may be against
the ideals of competitive market theory reliant on the concept of deadweight welfare
loss (Module textbook, Chapter 7, Section 2.2).
Competition authorities may focus more on the importance of consumer welfare than
on firms’ profits. (Chapter 7, Section 2.1) We may illustrate the theory of collusion,
mergers and dominance with the CMA articles, together with materials on anti-
competitive behaviour. Note the tension between regulator’s focus on profits, and risk
of lessened incentives for R&D, and technical improvement.
Evolutionary theory (Chapter 5, Section 5.3) may provide a case for incumbents who
increase both concentration of markets at the expense of new innovating entrants and
productivity. We may use the CMA articles to highlight these tensions. Incumbents can
increase economic welfare.
Social welfare is a broader concept than economic welfare . It includes indirect and
long-term effects, such as Oxford/AZN’s concern towards equitable distribution and
affordability of vaccines, as well as direct effects, as emphasised by Pfizer/BioNTech)
and Moderna. Oxford/AZN appear to be led by clear long-term reputational and ESG
related benefits, as they work to coordinate vaccine delivery to low-income nations.