Industrial organization perspective 2 Flashcards
Explain the Cournot-Nash Model
- A static (one period simultaneous move) model where actors compete for quantity
- Each firm believe that output of rivals will remain constant if they change own output
(- Barriers to entry are present
- Few firms and many customers
- Firms can produce either homogeneous or heterogenous products)
Explain the Stackelberg Model
Firms competing for quantity just like in the Cournot model. However, here there is a leader who selects a quantity that maximizes profits and a follower that follows a reaction curve.
(This is a dynamic game where firms only interact once)
1. Calculate follower’s reaction function
2. Put reaction function in leaders price function
Explain the Bertrand Model
Firms compete over price where price equilibrium becomes equal to marginal cost.
1. Firm 1 and firm 2 has equal output
2. Firm 1 lowers price by 1 which gives them the total demand
3. Firm 2 conquers this by lowering price to 1 – firm one price
4. This goes back and forth until P=MC (perfectly competitive)
(It thus assumes that if P does not equal MC then there are incentives to lower price and get the whole market)
What’s Perfect Collusion?
When the firms are producing the joint profit-maximizing output. However, both parties have incentives to cheat
Describe a Tit-for-tat strategy
- Start by cooperating the first round
- In every following round, play the strategy played by the opponent in the previous round
(this could be a solution to the prisoners dilemma)
Explain Limit Pricing
Assumes that rational firms will maximize profits in the long run rather than the short run
This means that they would rather charge a low price today to deter entry than charge a high price that attract entry
(However, this has been heavily critizised by Game Theory)
Explain Predatory Pricing
Assumes a monopolist maximizes profit until an entry occurs, and after an entry, the monopolist expands output aggressively and cuts price, so the entrant suffers economic loss
(of course the monopolist does that as well)
Explain Product Proliferation
A strategic decision to prevent entrants by creating brands to fill every available product niche
What six strategic methods are proposed for maintaining long-run market dominance?
- Limit Pricing
- Predatory Pricing
- Creating excess capacity
- Advertising
- Learning by doing
- Product proliferation
(Lobbying)
Explain how creating excess capacity is a method for maintaining long-run market dominance
When the monopolist moves first and selects a level of capacity, then the potential entrant decides whether to enter
How can increased advertising be used as a method for maintaining long-run market dominance?
It can either have a positive or negative effects on profits. However, advertising creates brand loyalty which forces entrants to do the same
What’s Game theory?
The study of how independent decision makers make choices
What’s the different information structures in game theory
Perfect / Imperfect
Complete / Incomplete
Symmetric / Asymmetric
Certain / Uncertain
What is nature referred to in game theory?
Nature, a player of random actions are sometimes required for a game. For example, nature can decide whether one of the players will always take the same action or vary its actions.
What’s a Dominant strategy?
A strategy that outperforms any other strategy no matter what strategy opponent selects
What’s a Nash equilibrium?
A place in the game where both players are doing the best they can when given the choice of the opponent (games without a dominant strategy can have several)
What’s a Zero-sum game?
Games where one player’s gain always is matched by the others loss. The dominant solution to zero-sum games is a minimax strategy
What’s the difference between static and dynamic games?
Static – players move simultaneously
Dynamic – players take turns
What’s a Dominated strategy?
A strategy that is always worse than some other strategy. It can thus be eliminated as a possible solution
What’s a Mixed strategy?
Each player randomly selects its actions with given probabilities that maximize its expected payoff
Explain Price discrimination
When a firm charges either different customers different prices for the same product supplied with identical costs or different consumers the same price even though cost of supplying varies. This can be divided into first degree (perfect discrimination), second degree, and third degree
Explain Adverse selection
Refers to any situation where products of different qualities are sold at the same price because buyers or sellers do not have sufficient information to determine the true quality of the products
What’s Double marginalization?
Is referred to when there are monopolies in both vertical stages. Which hurts both the retailer and the consumer since there is going to be a double monopoly markup.
(With a deadweight loss that increases for each stage there is a monopoly)
What are the three common vertical restraints?
Franchise fees
Resale price maintenance agreements
Exclusive dealing
What’s foreclosure?
When downstream firms have difficulty finding suppliers or upstream firms have difficulty finding buyers
What are the advantages of vertical integration?
- Reduces transaction costs
- Solves potential economic problems (double marginalization, insufficient presale service, inefficient input substitution)
How can vertical integration and relationships increase barriers to entry?
Exclusive dealing arrangements
Price squeezes
Increased capital barrier
Explain the Bertrand-Edgeworth model
The Bertrand model but with capacity restraints
No firm has capacity to supply all demand at a competitive price
Thus it may not exist a sustainable Nash equilibrium
What’s a Cartel?
A formal agreement between competing firms
When can effective cartels form?
- When group action can raise price and profits
- Enforcing an agreement is relatively safe
- Punishment is low relative to gains
- Fluctuation of demand is low (elasticity)
What’s Bertrand’s Paradox?
The fact that the Bertrand model assumes perfect competition as long as N > 1. Whereas Cournut need many competitors to achieve an efficiently allocated market.
Creative destruction
When capitalism evolves by constantly destroying old industries and methods of production and replacing them with new, more efficient industries and methods of production. This suggests that static efficiency (P = MC) is irrelevant as concerns should be whether or not markets are evolving in an optimal manner.
The Process of Technical Change
- Basic research – aimed at gaining knowledge for own sake
- Applied research – aimed at obtaining knowledge for commercial purposes
- Invention – a result of the research where an idea that should work is discovered
- Innovation – first commercial application of innovation
- Diffusion – innovation comes into common use
Why does patents exist?
To increase the rate of technological advance, however, theory suggests that it decreases technological advantage as it creates monopoly power.
Patents always results in social benefits for patent-dependent innovations. However, it always results in social losses for nonpatent-dependent innovations because these would be developed without the cost of granting monopoly power
Ramsey Price
The price that maximizes total social benefits with the requirement that price cannot be P < 0
What is regulation?
Regulation places constraints on the operating firm(s) to make decisions in the interest of the public:
- Economic regulation to obtain/maintain efficiency
- Socio-economic regulation to achieve social goals
Regulatory lag
Whenever there is a shock (increase or decrease) in cost
The Averch-Johnson effect
The regulated firm will invest too much capital which leads to a non-optimal allocation of resources
Explain how market structure and investments in R&D can relate to each other and
Investments in R&D requires both ability and incentives
Perfect competition – Low ability, moderate incentives
Oligopoly – Moderate ability, high incentives
Monopoly – High ability, low to moderate incentives
(Present value R&D < Present value benefits)
When is the optimal time for technological development?
Marginal benefits (R&D) = Marginal costs
What is the impact of a patent system?
- Increase incentives to invest in R&D by granting monopoly power
- Firms will spend more on R&D than socially optimal
- The rate of technological development will be too rapid from a social perspective
- Potential profits from R&D will be competed away
Perfect/Imperfect information
Perfect information means that every player knows every move done by the others before taking action. Thus, simultaneously played games have imperfect information
Complete/Incomplete information
When there’s incomplete information some players have more information than others at the beginning (natures move). Thus, complete information means that nature move is observed by all players
Certain/Uncertain information
If nature never moves after any other player, the game has certain information
Symmetric/Asymmetric information
If all players have exactly the same information, it’s symmetric
What must a game include?
Players Action Information Strategies Payoff Outcomes Equilibria
What’s capture theory?
When regulated firms “capture” control of the regulatory commissions
Cournot limit theorem
The Cournot equilibrium approaching competitive equilibrium as N increases
Sweezy model
- Unlike Bertrand, the Sweezy model assumes differentiated products
- Rivals will not follow a price increase
- A price cut will be responded
- Criticised as it gives no explanation of initial price
Secure (minimax criterion) strategy
The strategy that guarantees the highest payoff given worst possible scenario
Risk-lover (maxi-max criterion) strategy
The strategy with the highest potential payoff
Risk-averse (mini-max regret criterion) strategy
The strategy which minimises the regret of choosing the wrong strategy
What’s a trigger strategy?
If one player defects, the other player retaliates by defecting ALL following rounds of an finite played game with an unknown end point.
This works as the payoff from defecting once is lower than colluding indefinitely.
-> no incentives to cheat
What factors affect collusion and cartels?
Cost of capital and degree of uncertainty
Number of firms
Firm sizes
History of the game
Punishment mechanisms and legal framework
The incentive for cartel formation
When uncoordinated firm behaviour leads to lower total profits than can be achieved through coordinated behaviour
When are cartel profits high?
Inelastic market demand
Inelastic supply response by non-cartel members
When is the enforcement of a collusive agreement easier?
Few firms in the cartel
High industry concentration
Homogenous product
Preexisting ties among firms
Patent races
Firms compete to be the first to receive a patent
Does not result in optimal investment in R&D
Natural Monopoly
When one firm can supply the market more efficiently than more than one firm
Regulation instruments
Standard setting and licensing Controlling pricing, investment and profit Marginal cost pricing Profit/price regulation Incentive schemes Rate capping
Marginal cost pricing in natural monopolies
Ramsey pricing Two part tariff Average cost pricing (LRAC) Peak-load pricing Tax subsidy
Profit regulation
Revenue constraint
Price constraint
Rate of return constraint
Rate capping (regulation)
Revenue cap based on assets, investments, and costs
Capital cost cap
Regulation to deregulation
Due to technical development that has eliminated natural monopolies
May increase efficiency and lower prices
(Regulation becomes contra-productive)
Dynamic efficiency
Whether markets are evolving in an optimal manner in terms of technical advancement
Static efficiency
P = MC
Intellectual property rights and law
Research show a positive relationship between strong IPRs and investments in R&D
