IOA2017Q13

Question 1

What is interdependent decision making?

Answer 1

When your payoff does not only depend on your own decision, but also another player’s decision.

Question 2

What is a game?

Answer 2

A stylized model that depicts situations of strategic behaviour, where the payoff for one agent depend on its own actions as well as on the actions of other agents.

Question 3

What does a game consists of?

Answer 3

A set of: players, rules, and payoff

Question 4

What are the two types of decision-making?

Answer 4

Simultaneous decision making

Sequential decision making

Question 5

What is a dominant strategy?

Answer 5

A strategy that is strictly better than any other strategy regardless of the other players’ strategy choices.

If a player has a dominant strategy and if the player is rational, we should expect the player to choose the dominant strategy (we do not even need to assume the other players to be rational)

Question 6

What is the prisoner’s dilemma?

Answer 6

It depicts the conflict between individual incentives and joint incentives.

Question 7

What is a dominated strategy?

Answer 7

One whose payoff is inferior to that of another strategy regardless of what the other player does.

Intuition: if a given player has a dominated strategy and that player is rational, then we would expect the player not to choose such strategy

Question 8

What is the difference between dominant and dominated strategies?

Answer 8

A player will always choose a dominant strategy, however, NEVER a dominated strategy. However, when we have a dominated strategy, it doesn’t tell us which strategy the player will then choose.

Question 9

What is the importance of rationality in a game?

Answer 9

It is not only important whether players are rational. It is also important whether players believe the other players are important.

Question 10

What is a Nash equilibrium?

Answer 10

A pair of strategies constitutes a Nash equilibrium if no other player can unilaterally change its strategy in a way that improves payoff.

Most games have a NE, but not all.

Equilibria sometimes requires players to randomly choose one of the actions

Question 11

What are the assumptions for a monopoly?

Answer 11

• Well-defined market
• One single supplier
• Seller chooses a price to maximize profits

Question 12

What is the profit condition for a monopoly?

Answer 12

MR=MC

Question 13

How does the price elasticity of demand relate to the price-cost margin?

Answer 13

The more inelastic (steep demand curve) the demand is, the greater is the price-cost margin for the monopoly → inelasticity leads to higher price, i.e. higher markup

Question 14

What is monopoly power and how is it related to demand elasticity?

Answer 14

• The ability of the firm to sell at a price substantially above costs
• It is inversely related to the demand elasticity
  
  • Inelastic markets (0<ϵ<1) imply high degree of monopoly power (easier for monopoly to set price substantially above costs)
  • Elastic markets (1<ϵ) imply low degree of monopoly power (harder for monopoly to set price substantially above costs)
• I.e. monopoly is not as much about market shares, but more about the ability to sell at a price substantially above costs (monopoly power)

Question 15

What is the allocative efficiency under monopoly?

Answer 15

• Monopoly implies allocative inefficiency
  
  • I.e. price is greater than marginal costs (P>MC)

Question 16

What is a natural monopoly?

Answer 16

• A situation where only one firm is viable, and thus the optimal solution to only have one firms (e.g. due to large fixed costs / economies of scale)
• Solution: direct regulation of the firm
  
  • For example, set price equal to average costs
    
    • But, can lead to no incentives to reduce costs or improve quality

Question 17

What is a monopoly bottleneck?

Answer 17

• When the monopolist’s assets or output is an essential facility
• E.g. an airport, railroads, etc.

Question 18

What is the Efficient Component Pricing Rule (ECPR)?

Answer 18

• Implies that the maximum price an integrated firm can charge another downstream firm is w₂=p₁-c₁
• Meaning that, the other firm can set the same price, but will only receive a positive margin if its marginal costs are lower: c₂ < c₁
• Implies productive efficiency (however, can end in monopoly prices)

Question 19

What are the assumptions for perfect competition?

Answer 19

• Many small independent sellers and many small independent buyers
• Homogenous product
• Perfect information regarding price (Sellers and buyers are price takers)
• Free entry in long run (zero profits (for marginal firm))

Or as quoted by the book:

• Atomicity (many suppliers)
• Product homogeneity
• Perfect information
• Equal access (symmetric cost functions)
• Free entry

Question 20

What are the characteristics of perfect competition?

Answer 20

• An individual firm cannot affect price or quantity
• Long run equilibrium: No firms want to enter/exit: P=MR=MC and P=AC
• Short run definition: firms cannot change the usage of fixed inputs
• Long run definition: firms can change all factors of production
• Long run equilibrium has both productive and allocative efficiency (it is actually the condition for perfect condition)
• Demand faced by each firm is horizontal
• Perfect competition only leads to maximum efficiency given the existing technology → does not say anything about technological progress
• Positive profits: firms are attracted to industry
• Negative profits: firms make losses and exit
• Because technology is the same (equal access assumption): firms receive zero supranormal profits in long run
• All plants must be of same size in long run

Question 21

What is the allocative efficiency under perfect competition?

Answer 21

• Equilibrium is efficient:
  
  • Firms set efficient output (P = MC) (max allocative efficiency)
  • Active firms are efficient in LR (P = min AC) (productive efficiency)

Question 22

What is productive efficiency?

Answer 22

Productive efficiency: goods are sold and produced at the lowest possible average cost (P = min AC )

Question 23

What is allocative efficiency?

Answer 23

Allocative efficiency: that price is equal to marginal cost of production (measured by total surplus) (P = MC)

Question 24

What is dynamic efficiency?

Answer 24

Dynamic efficiency: rate of introduction of new products and improvements in production techniques

Question 25

What are the assumptions of competitive selection?

Answer 25

• Atomicity (many suppliers)
• Product homogeneity
• Perfect information
• Firms must incur a sunk cost in order to enter
• Not all firms have access to same technology (not symmetric cost functions)

Three first assumptions are the same as perfect competition, number 4 is new, and 5 is changed. Moreover, the assumption that there is free entry is gone

Question 26

What is the characterisation of competitive selection?

Answer 26

• Firms have different degrees of efficiency (different cost functions – more efficient firms have lower marginal cost)
• Each firm is uncertain about its own efficiency (firm has a vague idea upon entry, and gradually adjust to optimal efficiency)

Implies that (remember that firms do not know their exact costs upon entry):

• Firms that incur high production costs gradually decrease their output and might exit
• Firms that incur low production costs gradually increase their output and stay

Question 27

How does competitive selection consist with the empirical facts?

Answer 27

• Different firms earn different profit rates (also in long run)
• Simultaneous entry and exit in the same industry (new entrants do not know if they will be unprofitable beforehand so they will enter, and existing unprofitable firms have found out that they are unprofitable so they exit)
• Efficient firms have higher output, and inefficient firms have low output (implying that entrant and firms exiting have lower output than average)

Question 28

Is the equilibrium under competitive selection efficient?

Answer 28

The equilibrium under competitive selection is efficient

Question 29

What are the assumption of monopolistic competition?

Answer 29

• Atomicity (many suppliers)
• No product homogeneity
• Perfect information
• Equal access (symmetric cost functions)
• Free entry

Question 30

What are the characteristics of monopolistic competiton?

Answer 30

• Demand faced by each firm is not horizontal
• Changing the assumptions (homogeneity, access, entry) about perfect competition does not change the results much
• Strategic behaviour changes things more radically
• Divide industries into:
  
  • Highly concentrated (monopoly)
  • Oligopolies
  • Competitive industries (perfect competition, monopolistic competition, competitive selection)

Question 31

What happens in the short-run in monopolistic competition?

Answer 31

• P > AC (price could also be lower – it depends on number of firms)
• As long as P ≠ AC it is the short-run equilibrium
• If P > AC → more firms enter
• If P < AC → firms exit

Question 32

What happens in the long-run in monopolistic competition?

Answer 32

• Firms maximize profits: MR=MC
• Firms make zero profit: P=AC
  
  • Remember that under perfect competition, we had that price should be equal to the minimum of average cost. This is not the case here.

Question 33

How is monopolistic competition similar to perfect competition?

Answer 33

• Because of free entry, profits are zero in the long run (P = AC)
  
  • However, remember that the there still is a difference here. Under perfect competition price is equal to minimum of average costs, while under monopolistic competition, the price is just equal to average costs.

Question 34

How is monopolistic competition different from perfect competition?

Answer 34

• Price is equal to minimum of average costs under perfect competition (P = min AC )
• Price is greater than the minimum of average costs under monopolistic competition (P > min AC )

Question 35

What is the allocative efficiency under monopolistic competition?

Answer 35

P > MC implies that total surplus would increase by increasing output

See the condition for maximum allocative efficiency (P = MC)

Question 36

What is the productive efficiency under monopolistic competition?

Answer 36

• P > min AC implies that total costs for the industry would be lower if fewer firms produced a higher output
• See the condition for maximum production efficiency (P = min AC )
• Because firms are price makers
• → They do not produce at the minimum of their average costs

Question 37

What are the characteristics of an oligopoly?

Answer 37

• Few competitors
  
  • If only 2 competitors: Duopoly
• Strategic interdependencies
  
  • Perfect competition and monopoly does not have to react to competitors
  • In oligopoly, however: an action by one firm is likely to influence another firm

Question 38

What are the assumption of the Bertrand model?

Answer 38

• 2 firms
• Homogenous product
• Simultaneously set prices
• One period (price is chosen once and for all)
• No capacity constraints
• In book: Same constant marginal cost
• In book: Linear demand

Question 39

What is the Nash Equilibrium in the Bertrand model?

Answer 39

• A pair of prices such that no firm can increase profits by unilaterally changing price
• Each firm will undercut the other, until price is equal to marginal costs, as an undercut in price by little will steal all demand
• Result: P = MC (Allocative efficiency)
• Result: price ends at perfect competition, even with only 2 competitors

Question 40

Why is the Bertrand model not very realistic?

Answer 40

• There are no profits
• Change from 1 firms to 2 firms is changing profits from monopoly to 0

Question 41

What kind of competition is there in the Bertrand model?

Answer 41

Price competition

Question 42

What is the Bertrand paradox?

Answer 42

• Product differentiation (Chapter 12)
  
  • Undercutting the rival if products are not homogenous will not necessarily lead to all demand, and thus, it does not lead price down to marginal costs
• Dynamic competition → Repeated interaction (Chapter 8 - Collusion)
  
  • When prices are set more than once, and competition is over more than one period, it may not drive prices down to MC even though product is homogenous
• Capacity constraints (Chapter 7)
  
  • What happens if firms are constrained by capacity?

Question 43

What are the assumption in the Bertrand model with capacity constraints?

Answer 43

• 2 firms
• Homogenous product
• Simultaneously set prices
• In book: Same constant marginal cost
• Each firm is constrained by its capacity ki
• Capacity: long-run variable
• Price: short-run variable

Question 44

What is the equilibrium in the Bertrand model with capacity constraints?

Answer 44

• p_i = P (k_i + k_j)
• Price is set such that the industry total capacity is equal to the demand curve. I.e. firms are producing as much as the can to the highest possible price.
• It can not pay of for an individual firm to set price above or below. As if they set it below, they will not receive more demand, because they are capacity constrained (thus, they just lower their own profit).
• If the total industry capacity is low in relation to market demand, then equilibrium prices are greater than marginal costs
  
  • Meaning that, if capacity is sufficiently large, prices will must end up being equal to marginal costs (back to old Bertrand model).
• The same result applies if firm must decide capacity beforehand

Question 45

What are the assumptions of the Cournot model?

Answer 45

• Constant marginal costs
• Simultaneously choose quantity (output)
• Homogenous product

Question 46

What kind of competition is the Cournot model?

Answer 46

Quantity competition:

• You cannot set a lower price and get higher market-share, because you are committed to the quantity produced (and the others know you are committed). Therefore, you only compete on quantity.

Question 47

What are the characteristics of the Cournot model?

Answer 47

• What output levels should firms choose in the first place?
• Price is set such that the demand equals the total quantity produced by both firms
• Static model

Question 48

What are the steps in the Cournot model?

Answer 48

• First step:
  
  • Derive each firm’s optimal choice given what it thinks the rival does
  • I.e. derive the firm’s reaction curve
• Second step:
  
  • Put reaction curves together
  • Find a mutually consistent combination of actions and guesses

Question 49

What is the residual demand curve in the Cournot model?

Answer 49

• All possible combinations of firm i’s quantity and price for a given quantity of firm j

Question 50

What is the best response function in the Cournot model?

Answer 50

Question 51

What is the Nash-Cournot equilibrium?

Answer 51

• A pair of values (q_i, q_j) such that q_i is firm i’s optimal response given q_j, and likewise, q_j is firm 2’s optimal response given q_i
• The intersection of the firms’ reaction curves
• Note: when demand is linear and marginal cost is constant, there is only 1 equilibrium (otherwise, more than 1 can exist).

Question 52

What is the profit in the Cournot model?

Answer 52

Profit firm i: π_i = Pq_i - C (q_i) = [a - b (q_i + q_j)] q_i - cq_i

Question 53

What is the first order condition in the Cournot model?

Answer 53

Question 54

What is the best response function with more than 2 firms in the Cournot model?

Answer 54

[image]

• If n goes up, individual quantity goes down, total quantity goes up, market price goes down, and markup goes down
• If n goes towards infinity, we have zero markup and a perfectly competitive market

Question 55

What is the comparative static of an increase in MC in the Cournot model?

Answer 55

Question 56

Is the Bertrand or Cournot model better?

Answer 56

• Industries differ – so model depends on industry and circumstances
• In general:
  
  • If capacity can easily be adjusted but prices cannot
    
    • Bertrand is the better approximation
  • If prices can easily be adjusted but capacity cannot
    
    • Cournot is the better approximation

Question 57

What are the characteristics of collusion?

Answer 57

• Increases market power
• Secret agreements
• Intuition: that each firm’s decision involves a trade-off between short-run gains and medium- to long-term losses

Question 58

How is model of Collusion?

Answer 58

A dynamic Bertrand game:

• Prices change over time with t = 1, 2, …
• In each period, prices are set simultaneously
• A Bertrand game is played in each period of an infinite series of periods
  
  • Also called a dynamic game
• Follows a grim strategy
  
  • A strategy that can continue until it is first violated, and will not work anymore thereafter
  • As long as the game is ‘respected’ prices are set at monopoly level

Question 59

What is the equilibrium under collusion?

Answer 59

The dynamic Bertrand games for collusion basically check if the payoff for deviating one period (and thus gain monopoly profit once) is higher or lower than the discounted payoff forever

• V = discounted equilibrium payoff
• V’ = payoff from optimal deviation (monopoly profit once)

Question 60

What is the discount factor in collusion?

Answer 60

Question 61

Why don’t we observe collusion more often?

Answer 61

• Antitrust policies
• Probability of continuation, when there are a lot of firms (the probability each firm exists in the next period is low, if the rate of entry and exits is high, therefore, firms have no incentive to collude)
• The proposed trigger strategies might not be an equilibrium because the involved punishments are not credible.
• Not all prices are observed with precision

Question 62

What are some conclusions on collusion?

Answer 62

• If price cuts are difficult to observe, then occasional price wars may be necessary to collusion
• Collusion is more likely in concentrated industries
• Collusion is more likely between symmetric firms (e.g. symmetric MC)
• Collusion is more likely if firms compete in more than 1 industry

Question 63

What are the notations under collusion?

Answer 63

• δ = Discount factor
• V = discounted equilibrium payoff
• V’ = payoff from optimal deviation (monopoly profit once)
• r = interest rate
• f = frequency
• h = probability industry exists 1 period later
• g = industry growth rate

Question 64

How many firm does it take for the Cournot to converge towards perfect competition?

Answer 64

• It does not take a large number of firms, for competition to be close to perfect competition
  
  • When there are 15 firms, the allocative inefficiency as a percentage of allocative inefficiency under monopoly is 1.5%.
• If we have more than 2 symmetric firms, the equitation for the Cournot equilibrium becomes (output is identical for all firms):

Question 65

What is market power?

Answer 65

The Lerner index

Question 66

What is the Lerner index?

Answer 66

• Measures market power
  
  • The ability to set price above marginal costs
  • Implies a higher degree of allocative inefficiency
• Weighted average of each firm’s margin with weight given to market shares

Question 67

What is the relationship between market power and concentration?

Answer 67

The degree of market power is increasing in the degree of concentration (in a cournot market)

L=H / ϵ [see attached image]

• The lower the ϵ (the more inelastic (0 < ϵ <1) is the market) and the higher is the ability for the monopoly to set a price above marginal costs
  
  • On the contrary, the higher the ϵ (the more elastic (ϵ > 1) is the market) and the worse is the ability for the monopoly to set a price above marginal costs
• So, the Lerner index (market power) is increasing the lower the elasticity.
  
  • And, the Lerner index (market power) is increasing as market concentration increases
    
    • Hence, the ability to set prices above marginal costs increases as the number of firms in the industry decreases
    • Market concentration measures the number of firms, however, it does not only depend on the number of firms, it also depends on the market share of each firm. (E.g. an industry with 3 firms, with market shares 70%, 15%, 15% has a higher concentration than an industry with 2 firms and market share 50%, 50% - but not by much).

Question 68

What is the Herfindahl index?

Answer 68

• Measures market concentration
• The sum of the squared market share of all firms

Question 69

How is market concentration measured?

Answer 69

By the Herfindahl index (Market Concentration):

• The sum of the squared market share of all firms

Question 70

What is the C4?

Answer 70

• Measures market concentration
• The sum of the market share of m firms:

Question 71

What is the Structure-Conduct-Performance paradigm (SCP)?

Answer 71

Structure (concentration)

Conduct (behaviour of firms, e.g. collusion)

Performance (market power, allocative efficiency etc.)

• Influence (→) on each other
  
  • Structure → conduct
    
    • Collusion is easier with few firms
    • Collusion is easier when firms are similar
  • Structure (H) → performance (L)
    
    • The higher the concentration (H), the higher the market power (L)
      
      • Derived above from the equation: L=H / ϵ [see attached image]
      • L is increasing in H
        ​
  • Conduct → performance (L)
    
    • The more competitive firms behave, the lower the market power, and the greater the allocative efficiency
      
      • Bertrand equilibrium (P = MC) vs. collusive price setting (P > MC)
• Structure-Performance hypothesis:
  
  • Implies that we have positive relationship between structure (concentration, H) and performance (market power, L)

Question 72

What is the Structure-Performance hypothesis?

Answer 72

Implies that we have positive relationship between structure (concentration, H) and performance (market power, L)

Question 73

What is the Simultaneity problem (feedback effect)?

Answer 73

• The Structure-Performance hypothesis ignores the possibility of a reserve link between Market structure and performance
• As price is increased and the number of firms adjusts, concentration decreases as market power increases
• Now:
  
  • Market structure = endogenous
  • Market performance = exogenous

Question 74

What is collusion hypothesis?

Answer 74

Concentration implies market power through increased collusion between firms

Hence, policymakers should be concerned with anything that increases market concentration

Question 75

What does the New Emperical Industrial Organization say?

Answer 75

Question 76

What does the degree market power (Lerner index) depend on?

Answer 76

• Demand elasticity, ϵ
• Market concentration, H
• Collusive behaviour, θ

Question 77

What is the SSNIP-test?

Answer 77

SSNIP = Small significant non-transitory increase in price

Suppose one firm controlled all products in the market:

1. Would it be profitable to increase all prices by 5-10%?
2. NO: If new prices don’t give higher profits then need to add suppliers of substitute products to make it a market → to back to 1.
3. YES: If new prices give higher profits, then we have identified the market. Stop here.

Question 78

What is the notation under collusion?

Answer 78

Question 79

What are the types of price discrimination?

Answer 79

• Requires the absence of resale (arbitrage)
• 3rd degree price discrimination:
  
  • On observable characteristics
• 2nd degree price discrimination:
  
  • Non-observable characteristics
  • Self-selection
• 1st degree price discrimination:
  
  • Unique price for each buyer

Question 80

What is the equilibrium for a monopoly doing 3rd degree price discrimination?

Answer 80

Monopoly doing 3rd degree price discrimination:

• Has MC equal to each market’s marginal revenue
• Firm charges a lower price for market segments with a higher price elasticity (price elasticity greater than 1)
  
  • Remember: ability to set price above MC decreases as the price elasticity increases

Question 81

What is the two-part tariff for a monopoly under price discrimination?

Answer 81

• Fixed part, f → positive for monopoly
• Variable part, p → lower than monopoly price
• Total surplus is greater than under uniform pricing

Question 82

What is the Incentive-compatibility constraint?

Answer 82

type i prefers plan i to plan j

Question 83

What is the participation constraint?

Answer 83

each consumes prefers to consume relative to not consuming at all

Question 84

How to set the two-part tariff for low and high consumption consumers?

Answer 84

For low consumption consumers:

• Fixed part: f₁ = CS₁ (p₁)
• Variable part: p₁ > c

For high consumption consumers

• Fixed part: f₁ < f₂ < CS₂ (p₂)
• Variable part: p₂=c

High consumption consumers pay a higher fixed fee, and lower variable fee, and low consumption consumers pay a lower fee but higher variable part

Consumers choose the plans they do, because they prefer the one plan compared to the other

Consumers are sorted out by self-selection

Under 2nd degree price competition, the seller must ‘pay a price’ to sort buyers out in means of self-selection

Question 85

What is the definition of vertical relations?

Answer 85

Definition: relations between two firms in a sequence along the value chain

• Upstream firm (M/U) - Manufacturer
• Downstream firm (R/D) - Retailer

Question 86

Why is the relation between a manufacturer and retailer different from the relation between a retailer and consumer?

Answer 86

1. A manufacturer selling to a retailer does not control most of the variables that determine demand, e.g. price, quality, advertising, sales service etc.
2. Retailers compete with each other, consumers do not.

Question 87

What is the double marganalization?

Answer 87

Integrated firm:

• π=(p^M - c) · D (p^M)

Separate firms:

• π^D = (p^R - w) · D (p^R) → where p^R > p^M, and w is the same as MC
• π^U = (w - c) · D(p) → where w is wholesale price paid by retailer

Conclusion:

• π > π^D +π^U
• Because of a double margin being made
• When firms are separated, two monopoly pricing decisions are being made

Question 88

How is the two-part tariff under vertical relations?

Answer 88

• Manufacturer (upstream firm) sets the price paid by the retailer (downstream firm) equal to the manufacturers marginal costs, i.e. w = c
  
  • The retailer gets variable profit equal to the integrated profit, however, must pay a fixed fee
• Moreover, it sets a fixed fee, which is equal to the profit the integrated firm would gain i.e. f=π^M, where π^M = (p^M - c) · D (p^M)
  
  • The manufacturer gets no variable profit, but gets a fixed fee equal to profit for an integrated firm
  • The fixed fee is corresponding to the maximum that the retailer is willing to pay
• Conclusion:
  
  • When using a two-part tariff, i.e. allowing for fixed fees, the manufacturer (upstream firm) profit maximization is to maximize joint profits (i.e. maximize profits for an integrated for, and avoiding double marginalization) and then charge a fixed fee equivalent to the join profit, which is the maximum the retailer is willing to pay

Question 89

What are the assumptions for vertical relations?

Answer 89

• No competition at each stage (only 1 downstream firm)
• Complete information about costs and prices

Question 90

What are the assumptions for retailer competition?

Answer 90

• No capacity constraints for downstream firms
• More than 1 retailer/downstream firm
• No other variable costs than the wholesale price paid to the manufacturer

Question 91

What is the conclusion on retailer competition?

Answer 91

• Without retailer competition:
  
  • If manufacturer sets wholesale price (price paid by retailer) equal to its own marginal costs, it will lead the retailer to set the price equal to monopoly price (where it would otherwise had set it above monopoly price).
• With retailer competition:
  
  • If manufacturer sets wholesale price (price paid by retailer) equal to its own marginal costs, it will lead the retailer to set the price below the monopoly price, because it will have an incentive to steal market share from its competitors.

Question 92

What is the conclusion when we have retailer competition?

Answer 92

• With Bertrand competition:
  
  • The price will be equal to the wholesale price (the price paid by the retailer, i.e. the retailers’ marginal costs, P = MC)
  • w=p^M, so the retailers will set p=p^M
  • Retailers will get zero profit, and manufacturer gets monopoly profit
• With Cournot competition:
  
  • The optimal solution for the manufacturer will be to set a price for the retailer between w and p^M
• Conclusion
• The greater the degree of competition between retailers, the higher the optimal wholesale price

Question 93

What is Resale-Price Maintenance (RPM)?

Answer 93

• Problem:
  
  • When retailers do sales efforts to increase sales, it is often the case that other retailers also benefit from it (positive externality)
  • When retailer 1 gives a good service, but charges a higher price than retailer 2, the customer will go to retailer 1 for service, and buy at retailer 2 for a lower price
• Solution: Resale-Price Maintenance (RPM):
• Also called a vertical restraint
  
  • Manufacturer imposes a minimum price on retailers
  • If the minimum price is high enough, retailers will stick to it
    
    • Every retailer prices at the uniform minimum level
  • Hence, if each retailer prices at the minimum level, and thus have the same prices, all extra effort by the retailers will benefit themselves in form of extra sales.
• Exclusive territory:
  
  • Same as RPM, just with territories.
  • Retailer is given the exclusive rights to sell e.g. a specific car-brand within a country, but cannot sell that car in other countries.
  • Advertising effort will only benefit the retailer due to the retailer’s exclusive territory

Question 94

What is slotting allowance?

Answer 94

The fact that, when there are many competing manufacturers and few retailers, the manufacturer has to pay a fixed fee (instead of receiving a fixed fee) to the retailer in order to get shelf space

Question 95

What is exclusive dealing?

Answer 95

The manufacturer pays the retailer to supply only the manufacturers’ product.

Question 96

How is the notation under vertical relations?

Answer 96

• w= wholesale price
• f= fixed fee
• D or R= downstream firm (retailer)
• U or M= upstream firm (manufacturer)
• c= marignal costs
• s_i = sales effort by firm i

Question 97

What is horizontal differentiation?

Answer 97

• When different consumers value products differently
• E.g., one consumer might value memory capacity higher than speed, whereas another value higher speed over memory capacity
• Even though both consumers can agree that both more memory and a higher speed is better, they value them differently

Question 98

What is vertical differentiation?

Answer 98

• Where all consumers prefer a product over another
• E.g. fuel efficiency (everybody agrees that the more fuel efficiency the better)
• Universal agreement that more is better

Question 99

What is the characteristics approach?

Answer 99

• The demand for each good is derived from the demand of each characteristics
• The reason why the recent graduate prefers a Geo, and the CEO prefers a Porsche

Question 100

What are the assumptions of the Bertrand-Hotelling model?

Answer 100

• Large number of buyers - distributed along a line
• Sellers simultaneously set prices
• Products differentiation
• Firm located at each end
• Location/positioning is given
• Costumers incurs a transportation costs (t)

Question 101

What are the characteristics of the transportation costs in the Bertrand-Hotelling model?

Answer 101

• Costumers incurs a transportation costs (t)
  
  • The transportation costs determines the slope of the demand curve, the higher the t, the steeper the demand
  • The lower the transportation costs, the flatter the demand curve
    
    • And the closer price will be to MC (the closer to Bertrand competition)
  • A greater value corresponds to a greater degree of product differentiation

Question 102

What is the conclusion of the Bertrand-Hotelling model?

Answer 102

• The greater the degree of product differentiation, the greater the degree of market power:
  
  • Remember definition of market power (Lerner index): the ability to set a higher markup, i.e. set a higher price than marginal costs

Question 103

What are the assumption of product positioning?

Answer 103

• Product positioning/location is no longer given
  
  • Firms choose their position
  • Implies a strategic behaviour​
• Firms choose position firms (LR variable) and then choose price (SR variable)

Question 104

What is the direct effect?

Answer 104

• Direct effect (induces firms to locate close to each other):
  
  • When prices are given, then we see the direct effect takes place, which implies that for a given price, one of the firms will locate closer to the other firms where the demand is, and thus get higher profits

Question 105

What is the strategic effect?

Answer 105

• Strategic effect (leads firm to differentiate):
  
  • Implies that, if prices are NOT given (and they are normally not → they are determined in second period), then firms locating close to each other will end up in a Bertrand competition with zero profits (as the product is the same in the eyes of the consumers). Therefore, they will differentiate their products (move to another location to avoid Bertrand).

Question 106

What is the conclusion of product positioning?

Answer 106

If price competition is intense, then firms tend to locate far apart (high degree of differentiation). If price competition is not intense, then firms tend to locate close to the center (low degree of differentiation).

Question 107

How does search/switching cost affect the Hotelling model?

Answer 107

• Homogenous products, but consumers treat sellers differently, which is the same as product differentiation
• Consumers are imperfectly informed about prices
• Incurs a search costs, s
  
  • If s = 0 → Bertrand equilibrium, and P = MC
  • If s > 0 → may lead to monopoly price, P = u
    
    • No firms have an incentive to reduce price
    • Lowering price will only lower revenue

Question 108

What is the conclusion of search/switching costs in the Hotelling model?

Answer 108

The greater the search or switching costs, the greater the sellers’ market power tends to be

Question 109

What is the tourists-local model?

Answer 109

Tourists-locals model:

• Some consumers might incur positive search costs (tourists), while others incur no search costs (locals)
  
  • Store with high price: only sells to those with a positive search costs, that happens to enter the store (i.e. tourists that happen to go into the expensive store). Will not sell to the locals, as they have no search costs, and will thus go to the cheap store
  • Store with low price: sells to both locals and tourists (i.e. tourists that happen to go into the cheap store)

Question 110

What is the notation under product differentiation?

Answer 110

• b_<em>ij</em> = consumer i’s valuation for characteristic j
• c_<em>kj</em> = how much k has of characteristic j
• k = the product
• j = the characteristic
• m = number of characteristics
• t = travel costs
• x = indifferent consumer
• u = max price a consumer is willing to pay

Question 111

What are the types of advertising and goods?

Answer 111

• Informative advertising: describes the products characteristics (provides information)
  
  • Has value for consumers
• Persuasive advertising: aims to change consumers’ preferences
  
  • Little direct value
• Search good: features and quality is known beforehand
• Experience good: features and quality is not known beforehand (i.e. taste of wine)
• Advertising expenditures may serve to signal product quality

Question 112

What is the effect of advertising?

Answer 112

• Leaving aside whether advertising is informative or persuasive:
  
  • Simply assume that: advertising expenditures imply a shift in the consumer demand curve

Question 113

What is add-elasticity?

Answer 113

• Marginal gain from advertising is greater the more sensitive the demand curve (the more add-elastic the demand curve) is to advertising
  
  • Add-inelastic: advertising has little impact, and only shifts demand out to the right by a little
  • Add-elastic: advertising has larger impact, and shits demand out to the right by more

Question 114

What is the relationship between demand- and add-elasticity?

Answer 114

Tmore price elastic the demand curve, ϵ (NOT ADD-elastic, η, here we talk about the price elasticity of the demand itself), the less is the effect of advertising.

• Remember from chapter 5:
  
  • The more elastic the demand curve, the less market power, and the lower ability to set a high markup
  • The more inelastic the demand curve, the more market power, and the better ability to set a high markup (i.e. price above MC)

Question 115

What is the Dorfman-Steiner formula?

Answer 115

[formula: attached image]

η= how much does quantity demanded increase (in percent) when advertising expenditures are increased by 1%?

ϵ= how much does quantity demanded decrease (in percent) when price is increased by 1%?

Question 116

What is the advertising-to-sales ratio?

Answer 116

The advertising-to-sales ratio, a/R, is greater the greater the advertising elasticity of demand, η, and the lower the price elasticity of demand, ϵ.

Question 117

What is the relationship between market structure and the Dorman-Steiner formula?

Answer 117

[see attached image for formulas]

Effect of market structure:

• On price elasticity:
  
  • The more fragmented the industry, the greater the price elasticity of demand
  • I.e., as n↑→ϵ↑
  • The more firms, the more the demand decreases for a 1% increase in price → i.e. the flatter line
  • As η/ϵ↑↓=a/R↓, so as the number of firms goes up, the expected advertising intensity is expected to go down
• On advertising elasticity:
  
  • On the one extreme: advertising increases every firms demand equally
    
    • The more fragmented the industry, the more firms advertising benefit, and the less the advertising benefit the firm itself
    • Advertising, η, decreases, as the number of firms increases
    • i.e. n↑→η↓
    • As η↓/ϵ↓= a/R↓, so as the number of firms goes up, the expected advertising intensity is expected to go down
  • On the other extreme: advertising does not increase demand, but switches demand between sellers
    
    • Opposite effect than above. The more fragmented the industry, the higher the advertising elasticity (as there are more firms to steal customers from)
    • In fact, if n = 1, i.e. monopoly, advertising elasticity = 0, as the monopoly cannot steal market-share from itself
    • i.e. n↑→η↑
    • As η↑/ϵ↑=a/R↑, so as the number of firms goes up, the expected advertising intensity is expected to go up
• The net-effect of the market structure:
  
  • Two effect implies that more concentration implies less advertising intensity, whereas the last effect implies a higher advertising intensity.
  • Net-effect is ambiguous

Question 118

What are the assumptions of the advertising and price competition model?

Answer 118

• Homogenous products
• Advertising only shifts market shares (does not increase demand, i.e. demand is constant)
• The one that advertises more receives all demand

Question 119

What game is played in the advertising and price competition model?

Answer 119

Bertrand game:

• We will have a game similar to a Bertrand, where firms advertise until net profit is equal to 0, because on firm will have an incentive to advertise just a bit more than the other, until profits are 0

Question 120

What is the conclusion of the advertising and price competition model?

Answer 120

Repeated interaction:

• As we have seen with collusion, repeated interaction might lead to P > MC
• However, there are differences:
  
  • Frequency:
    
    • Prices are often set more often than advertising budget, so the frequency of the game is lower for advertising than for prices.
    • Remember from chapter with collusion, that the discount factor is decreasing in the frequency
  • Short and long run effects.
    
    • Prices only have a short-run effect
    • Advertising has a long-run effect (brand equity)
• Therefore: it will be harder for firms to keep advertising at a low level (i.e. collude with respect to advertising-ish) because the discount factor if higher → greater incentive to break the cartel

Question 121

What are the difference between advertising prices and characteristics?

Answer 121

• Advertising product characteristics:
  
  • Likely to increase product differentiation and soften price competition
• Advertising prices:
  
  • Likely to increase price competition

Question 122

What is the notation under advertising?

Answer 122

• a/R = advertising-to-revenues ratio
• η/ϵ = Dorfman-Steiner formula
• η = demand elasticity with respect to advertising expenditure
• ϵ = price elasticity of demand

Question 123

What are the assumptions of the free entry equilibrium?

Answer 123

• All firms have access to same unique available technology
  
  • Costs-function: C=F + cq is the same for all
• Firms have perfect information regarding the market (they all know the demand function
• The entry process is well coordinated
  
  • Each firm make their entry decision sequentially, knowing the decision earlier entrants have made
• All firms in equilibrium are of same size

Question 124

What is the free entry equilibrium?

Answer 124

[image]

Question 125

What is the intuition of the free entry equilibrium?

Answer 125

[image]

• Note also that, this relationship implies that, the higher the fixed costs are, the more concentrated the industry will be.
  
  • I.e. the higher minimum efficient scale, the more concentrated the industry
• The same will be true for scale economies
  
  • The higher the economies of scale, the more concentrated the industry
• Conclusion:
  
  • MES and scale economies are instances of barriers to entry
  • The higher the barriers to entry, the more concentrated the industry will be

Question 126

What is the conclusion of the free entry equilibrium?

Answer 126

• MES and scale economies are instances of barriers to entry
• The higher the barriers to entry, the more concentrated the industry will be

Question 127

Why does history matter in the free entry equilibrium?

Answer 127

One can find examples where industries do not match this model. There can be several reason:

• E.g., there might be more than one equilibrium
  
  • Imagine we have an industry with 2 ways of production:
    
    • High fixed costs, low variable costs
    • Low fixed costs, high variable costs
  • The total costs will approximately be the same, and more than 1 equilibrium will exist

Question 128

What is the effect of entry costs on market concentration in the free entry equilibrium?

Answer 128

How can Portugal have 2 beer producers, when the U.S. have 3 beer producers?

• US is around 30-50 times bigger than Portugal
• Suggested by the free-entry equilibrium, the US should have about 30 to 50 [see attached image] more firms than Portugal (because S will be 30-50 times higher in US). This means there should be 10-15 firms in the US.
• An important aspect that is not considered is advertising.
• Advertising is an endogenous entry cost, with respect to market size

Question 129

How is the lottery game played (exogenous costs)?

Answer 129

Lottery (exogenous):

• Imagine rights to technology is given to only 1 firm by lottery, then the probability to get the license is 1/n
• The expected revenue will be S/n
• And we will have equilibrium number of firms n=[S/F]
• As market size, S, increases, the number of entrants increases by the same factor → because we have no price competition!

Question 130

How is the auction game played (endogenous costs)?

Answer 130

• Firms pay a fixed cost F, to bid on the right to exploit a license
  
  • Highest bid gets the license
• If more than 1 firm is bidding, it will result in Bertrand competition
  
  • Firms set their bid equal to the value of the license, S
  • Equilibrium expected profit is 0
• It there is only 1 bidder:
  
  • Will bid zero (or what the minimum bid is)
  • Bidder receives license with certainty
  • Expected payoff is value of license minus the bid (i.e. minimum bid or 0)
• Equilibrium:
  
  • Only 1 firm will enter bidding contest, regardless of the size of the market (i.e. value of the license, S)
  • It will not payoff for another firm to enter bidding contest, if it knows there is another firm entering

Question 131

What is the conclusion on costs in the free entry equilibrium?

Answer 131

• Going from exogenous costs to endogenous costs:
  
  • Takes us from a proportional change in the number of firms with respect to market size (exogenous), to not change at all (endogenous).
• If entry costs are endogenous, then the number of firms is less sensitive to changes in market size.
• It is likely that, in any situation where firms engage in an “escalation war” for grabbing a share of the market, or the whole market, it is likely to involve some degree of entry costs endogeneity
  
  • With endogenous entry costs, the relation between the market size and industry concentration is also likely to be flatter

Question 132

Is the equilibrium number of firms in an industry excessive or insufficient from a social perspective?

Answer 132

• It depends on what conditions are satisfied
• If all conditions, among other free entry, for the perfect competition are satisfied, the perfect competition equilibrium is socially efficient
• However, let’s imagine that there is not free entry
• The business stealing effect:
  
  • The result can be that, it is profitable to enter the industry, but not economic profitable in a social sense in form of welfare
• [image]*
• ​The above figure shows an example where this is the case
  
  • Imagine that [BCI] + [CDEI] < k < [CDFH]
  • It is profitable for the firm to enter, but society does not gain as a whole, because of entry costs
  • The loss in profits for the other firms is larger than the gain for the entrant
  • Result: is excessive entry
• The business steal effect is approximately equal to [IEFH]

Question 133

What is the conclusion on social welfare in the free entry equilibrium?

Answer 133

If product differentiation is very important, or if competition is very fierce, then free entry implies insufficient entry from a social point of view. If, conversely, product differentiation is unimportant and competition is soft, then the business-stealing effect dominates, whereby the free-entry equilibrium entails excessive entry.

Question 134

What is the business stealing effect?

Answer 134

• The result can be that, it is profitable to enter the industry, but not economic profitable in a social sense in form of welfare
• [image]*
• The above figure shows an example where this is the case
  
  • Imagine that [BCI] + [CDEI] < k < [CDFH]
  • It is profitable for the firm to enter, but society does not gain as a whole, because of entry costs
  • The loss in profits for the other firms is larger than the gain for the entrant
  • Result: is excessive entry
• The business steal effect is approximately equal to [IEFH]

Question 135

What is the effect of product differentiation on social welfare in the free entry equilibrium?

Answer 135

There might be a positive externality from an entrant to a consumer (e.g. more varieties, etc.)

Question 136

What is the effect of firm homogeneity on social welfare in the free entry equilibrium?

Answer 136

• It is assumed that firms are homogeny, however, this is not always the case.
• Therefore, there might be gains from free entry
  
  • In form of survival of the fittest
  • Inefficient firms will go out
  • Free entry should therefore take into account the benefits from entry in terms of increased average productivity

Question 137

How is the notation in the free entry equilibrium?

Answer 137

Question 138

What is entry deterrence?

Answer 138

Producing a quantity higher than monopoly quantity, to deter entrance from a possible entrant

[image]

• I.e. setting a quantity ≥q₁^D
• This is an optimal solution if, and only if: π₁^M (q₁^D) > π(q₁^S)
• I.e., the profit is higher when the monopoly deters entry, than if it produces at monopoly level, and a possible entrant enter the market

Question 139

What is blockaded entry?

Answer 139

When entry costs are high enough, such that the incumbent firm should just set monopoly quantity, because the fixed costs are so high, that the monopoly quantity is high enough to deter entry

Question 140

What is entry accommodation?

Answer 140

The loss from deterring entry is higher than the loss from accommodating the possible entrant

Monopoly should now adjust output (optimal output would potentially not be the same as under monopoly) in response to the rationale output of the entrant

Question 141

What is capacity pre-emption?

Answer 141

An announcement by firm 1 about capacity-expansion, that is credible, and deters the entry of firm 2

Is only credible if: capacity costs are high and sunk

Question 142

What is product proliferation to deter entry?

Answer 142

From the hotelling model:

• Deterring entry by making a number of products that give no sustainable market share upon entry to a possible entrant
• Remember exercise 15.1 (Q12)
• Example:

Question 143

What is the effect of long-term contracts to deter entry?

Answer 143

They might be able to agree on contract terms with the incumbent which are more favourable to them than the situation after the actual entry of the entrant.

Question 144

What is predatory pricing and how do you distinguish from normal pricing?

Answer 144

Pricing below costs to induce exit of other incumbent firms

• Very hard to distinguish predatory pricing from a change in market structure
• Case with EasyJet and KLM
  
  • EasyJet enters market with low costs and low prices
  • KLM reduces prices to same level
    
    • It this predatory pricing, or a shift to a new market structure? E.g. a Bertrand competition, where this would be the natural effect
    • One could argue that KLM’s strategy is not to price low, and that the probably made losses

Question 145

What is the rationale of not engaging in price competition?

Answer 145

Rational players should never exit when preyed upon:

• Rational players should never engage in price competition
• Assume that we have two periods, and one incumbent firm and another entrant:
  
  • Incumbent (monopoly) decides whether to price aggressive or not.
    
    • First period:
      
      • If it does price aggressive:
        
        • Both firms make loss L
      • If it does not price aggressive:
        
        • Both firms receive profit D, duopoly profit
    • Second period:
      
      • Entrant exits:
        
        • Incumbent receives monopoly profit
      • Entrant stays:
        
        • Both make loss L
        • Or, if imcubent accommodates:
  • Both firms make duopoly profit It can be seen that, it is not rationale for the incumbent to price aggressively at all, it is better to accommodate.
    
    • It is so, because: the incumbent’s threat to keep prices low is not credible!
    • The entrant should thus not exit, even though it makes loss, L, in the first period (because it is better for the incumbent to accommodate, and the loss L is just temporary)
    • So if the firm just stays in the market, the incumbent will find out that it is better to just accommodate

Question 146

What is the long-purse / deep-pocket theory?

Answer 146

Introducing capital / borrow from bank with probability, p

• If the entrant does not have enough capital to sustain losses, it can borrow from the bank:
  
  • The bank will refuse the loan with probability, p
  • Even though it would always be rational for the bank to borrow the money, we assume that it is not the case
• Now, the rational decision is only for the entrant to stay in the market as long as the initial loss, L, is less than what it expects to get in the future (duopoly profit) times the probability of getting the bank loan, (1-p)
  
  • Entrant is willing to stay as long as: (1-p)_*π^D > L
• Now, it will be a rational strategy for the incumbent to price aggressively.
  
  • If pricing aggressively, it will get monopoly profit, with probability p
  • If not pricing aggressive, it receives duopoly profit
• Therefore, pricing aggressive is optimal as long as:
• p*π^M>L+(1+p)*π^D
• With this theory, we have that:
  
  • Predation is observed in practice
  • Rationale for the incumbent to be a predator
    
    • and for the entrant to resist aggressive behaviour
  • With percentage p, the predation is successful in driving competition out of the market

Question 147

What are other explanations for doing predatory pricing?

Answer 147

• Low-cost signalling:
  
  • Signalling to other firms that your firm has low costs, and that there is no more room for other placers, and that market is not profitable
  • Or, as is in the case with American Tobacco:
    
    • Before acquiring other small firms, the priced predatory, in order to make the firms appear less efficient, and thus acquire them for a bargain
• Reputation for Toughness:
  
  • Aiming to be seen a ‘tough’ by possible entrants, so they do not wish to enter the market, because they know you will be a though competitor
• Growing Markets:
  
  • When capturing a minimum market share early on is essential for long-term survival
  • E.g. platform (xbox, PS etc.)
    
    • Need to get developers to develop for their platform as well

Question 148

What are non-pricing predatory strategies?

Answer 148

• E.g. Microsoft did not charge a price per unit of Windows installed, instead they charged a fixed price for installing Windows, not depending on the units of installation
• Kodak: made their camera files incompatible with other cameras

Question 149

What is the Areeda-Turner test?

Answer 149

Areeda-Turner Test:

• Prices should be regarded as predatory if they fall well below marginal cost
  
  • But, this could also be because the firm wants to move down its learning curve?
• How to distinguish: post-exit price increase
  
  • After the exit of the firm that is driven out, does the prices rise again, or do they remain at the low level?
  • If they rise directly after firm is driven out of market, it might very well be predatory pricing

Question 150

Why should predatory pricing be illegal?

Answer 150

Why should it be illegal?

• US Supreme Court conditions for predatory pricing:
  
  • 1. Price is below costs
  • 2. Pricing below costs is a rational decision (i.e. the firm is likely to recoup its short-run losses)
• Examples where it benefits the consumers:
  
  • When both firms lose the price war episode
  • Network externalities
    
    • It is worth more to have an Apple product when there are a lot having an Apple product

Question 151

What are the assumptions for M&As?

Answer 151

Assumptions:

• N firms
• Same marginal and fixed costs
• Quantity competition (Cournot)

Only talking about Horizontal mergers:

• Two firms the same industry merging

Question 152

What happens when two firms merge?

Answer 152

What happens when firm 1&2 merge?

• Merges normally imply an increase in price and a reduction in costs
• Still has marginal costs c, and fixed costs F
• New equilibrium is N-1 (before it was just N)
  
  • Price increases
  • Quantity decreases
• If product differentiation is not important:
  
  • A merger implies a decrease in consumer welfare
• When N is very large (many firms)
  
  • N is close to N-1
  • Merger is unprofitable
    
    • Before merger, profit was 2*profit with N firms
    • After merger, profit is 1*profit with N-1 firms
      
      • If profit is almost the same before and after, then 1*profit is certainly less than 2*profit

Question 153

What is the result on non-merging firms?

Answer 153

The value of non-merging firms may decrease or increase as the result of a merger, depending on the cost efficiencies generated by the merger

Question 154

What are merger waves?

Answer 154

• Exogenous events:
  
  • Deregulations can cause merger waves to occur
• Endogenous events:
  
  • Let’s say there are 4 firms, and there are only synergies between two of the firms, e.g. 3&4.
  • It can be shows than, to merges for any combination of firms except for 3&4, it will not be profitable
  • However, if firm 3&4 do merge, because they have synergies, the industry now only has 3 firms left.
  • It might now be profitable for other firms, e.g. 1&2 to merge now
  • Example from page 282

Question 155

What is the public policy towards mergers?

Answer 155

Three interested parties:

1. Merging firms
   
   • Expected to gain
2. Non-merging firms
   
   • May gain or lose
3. Consumers:
   
   • Lose

Question 156

What are the two price increase channels for the public policy towards mergers?

Answer 156

1. Unilateral effect:
   
   • A function of the increase in Concentration (Herfindahl (H) index/C4)
   • Sum of the squared market shares
   • As C goes up, the market power, L also goes up
   • Remember: L=Hϵ
2. Collusion effect:
   
   • Also depends on the distribution of market shares
   • When concentration increases and when firms become more symmetric, it is more likely that they will collude (and the price will thus increase)

Question 157

What is the conclusion on public policy on mergers?

Answer 157

The smaller the size of the merging firms, the more likely the total effect of the merger is positive

Question 158

What is the value of R & D in different market structures?

Answer 158

The value of R&D on market structure:

• Monopoly:
  
  • Extra profit of qM·(c-c)
  • From a new innovation, the monopoly get the difference in the costs before and after multiplied by the monopoly quantity
• Perfect competition
  
  • Extra profit of qC·(c-c)
  • In a perfectly competitive market, the firm that reduces costs get a higher return from the innovation, as the firm is able to go from 0 profit, and reduce the price just a tiny bit to capture the whole market.
  • The perfectly competitive quantity is also higher
• Conclusion - Replacement effect:
  
  • The monopoly has a disincentive created by its pre-innovation monopoly profits
  • For the perfectly competitive firm, pre-innovation profits does not exists (equal to 0)
  • This is called the replacement effect
  • Replacement effect states that:
    
    • Generally, it would indicate that firms with more market power (set a higher price cost margin) have a lower incentive to innovative because they have more to lose than firms with little market power (low price cost margin), who have little or nothing to lose from innovation.
    • Market power reduces the incentives to innovate

Question 159

What is the replacement effect of R & D?

Answer 159

• The monopoly has a disincentive created by its pre-innovation monopoly profits
• For the perfectly competitive firm, pre-innovation profits does not exists (equal to 0)
• This is called the replacement effect
• Replacement effect states that:
  
  • Generally, it would indicate that firms with more market power (set a higher price cost margin) have a lower incentive to innovative because they have more to lose than firms with little market power (low price cost margin), who have little or nothing to lose from innovation.
  • Market power reduces the incentives to innovate

Question 160

How is the dynamic game of R&D?

Answer 160

• Two firms:
  
  • Incumbent (monopolist)
  • Potential competitor (rival)
• Third player:
  
  • R&D lab
  • Has just discovered and patented and innovation
  • Want to sell the innovation (cannot market it)
  • Sells to the firm that pays the most
• Which firm will buy the innovation?
  
  • Monopoly:
    
    • Before buy: receives monopoly profit
    • After buy: receives monopoly profit
      
      • And rival 0 profits
  • Rival:
    
    • Before buy: no profits
    • After buy: duopoly profits
      
      • And monopoly: also duopoly profits
  • Conclusion:
    
    • Monopoly is willing to pay:
      
      • π^M - π^D
    • Rival is willing to pay:
      
      • π^D - 0
    • Monopoly is willing to pay more than rival as long as:
      
      • π^M > 2 · π^D
    • Industry profit definition: total profits under the market structure
      
      • If product are identical and marginal costs are constant:
        
        • Monopoly profits will always be higher than industry (total profit) under duopoly
    • The monopolist often has more to lose from not winning the bid on the patent
    • Efficiency effect:
      
      • That industry structure will move in the direction that total industry profits are higher under monopoly
        
        • The monopoly will thus persist over time

Question 161

What is the effect of probability on R&D?

Answer 161

• Gradual innovation:
  
  • Now with probability p, there is a rival bidding for the patent
  • The monopolist does not know whether a rival will bid, only that it will bid with probability p
    
    • The higher the p, the less the monopoly wants to pay for the innovation
    • The higher the p → the more uncertainty about a rival entering
  • The monopolist is willing to bid up to:
    
    • π^M - ((1 - p) · π^D + pπ^M) = (1 - p)(π^M - π^D)
• Drastic innovation:
• If rival bids and gets innovation, the monopoly will now receive zero profit, and no longer duopoly profit
• Monopoly profit zero: 1-p
• Monopoly initial profit: p
• Monopoly is willing to pay up to:
  
  • π^M - ((1 - p)0 + pπ^M)=(1 - p)π^M
• Rival is willing to pay up to:
  
  • π^M, which is greater than (1 - p)π^M
• Conclusion:
  
  • Monopolist is willing to pay less for a drastic innovation than the rival is
• Conclusion:
• The monopolist have the greatest incentive to invest in a gradual innovation, however, if we add uncertainty and a more drastic innovation, it is likely that the rival is willing to pay more

Question 162

What are the expectations of risk and firm size for R&D?

Answer 162

• Intuition from sport: doesn’t matter to lose by 1 or 2 goals, so better to adapt risky strategy in order to perhaps tie (even though downside is to lose by a lot)
• Two ways to improve with innovation:
  
  • Move up product-quality ladder
  • Move down cost ladder
• Two strategies
  
  • Risky strategy: an innovation that leads to a large jump with a low probability
  • Safe strategy: an innovation that implies a small step up with high probability
• Expectations:
  
  • Markets leader to invest primarily in improvements to their current products (safe strategy) - Gradual innovation
  • Market laggards would primarily invest in the new class of product (risky strategy) - Radical/drastic innovation

Question 163

What is the public policy towards R&D?

Answer 163

• Two areas of public policy:
  
  • Patent protection
  • Interfirm agreements pertaining to R&D
• Trade-off
  
  • Bad: Patents implies monopoly profit
    
    • Higher allocative inefficiencies
  • Good: Higher rate of technical progress
• Two instruments:
  
  • Length of patent
  • Strength of patent
• Conclusion:
  
  • The stronger the patent, the higher the allocative inefficiency
  • Weakening the patent decreases allocative inefficiency
  • Optimal to have a very weak patent system with long patents
  • Trade-off, however:
    
    • Weakening the patent also decreases incentives for innovation

Question 164

What is R & D spillovers and agreements?

Answer 164

• Spillovers:
  
  • $1 of R&D expenditure of firm j, benefits firm i by a value of γ,
    
    • where: 0<γ<1
    • Firm j can freeride on firm i’s R&D
• R&D agreements:
  
  • If firm j and i choose R&D budget together:
    
    • Likely they will choose a very low budget
    • Bad from a social perspective
    • Solves however the free-riding problem