Week 1: An Overview of Welfare & Industrial Economics Francis O'Toole Department of Economics Trinity College Dublin 30 th September 2011

Economics: Fundamentals n Economics: Scarcity and Choice n Scarcity: Wants > Resources (Needs < Resources?) n Choice: Optimising Behaviour, Cost-Benefit Analysis n Incentives and Institutions n Neo-Classical Perspective (self-interested individuals, rational or at least rationally irrational) n Broad (political economy) n Narrow (consumers and producers + some government)

Economic Agents & Models n Consumers (Individuals or Households?) n Firms (Suppliers/Producers) n Government(s) (Ireland, EU?, USA, … ) n Agencies (e.g. Competition Authority, ComReg, CER, Department, … ) n Consumers maximise happiness (utility, satisfaction) subject to income constraint n Firms maximise profit (subject to cost environment) n Government(s) maximise ? n Agencies maximise ? n Economics, Political Economy, Public Choice ≠ Public Finance

Economics: Demand & Consumer Surplus n Individual Consumer Demand n Quantity Demanded = F(P, P sub, P com, Y, Taste, …) n Market Demand =  Individual Demands n Consumer Surplus = Willingness to Pay – Price n Consumer Surplus = “Value” – Price

Economics: Supply n Individual Firm Supply n Quantity Supplied = F(P, P other, w, r, …) n Market Supply =  Individual Supplies n Economic Profits = Revenue – (Economic) Costs n Economic Profits ≠ Accounting Profits n Producer Surplus = Revenue – Total Variable Costs n Long Run: Economic Profits = Producer Surplus

Economics: Societal Welfare n Consumer Surplus + n Producer Surplus = n Societal Welfare n Income Distribution (in “background” at least)

Price Determination & Elasticity n Quantity Demanded = Quantity Supplied n Own-Price Elasticity of Demand (e.g. market power?) n Cross-Price Elasticity of Demand (e.g. substitutes and market definition) n Income Elasticity of Demand n (Own-Price) Elasticity of Supply

Firm’s Costs: Short Run n Short Run: At least one input is fixed n Diminishing Marginal Product/Returns n Total Costs (TC), Average Costs (AC) n Fixed Costs (FC), Average Fixed Costs (AFC) n Variable Costs (VC), Average Variable Costs (AVC) (e.g. predatory pricing) n Marginal Costs (MC): Link to Supply Curve (e.g. predatory pricing)

Firm’s Costs: Long run n Long Run: All inputs are variable (TC = VC) n Shape of Average Cost Curve? Increasing Returns to Scale Decreasing Returns to Scale Constant Returns to Scale

Market Structure n Perfect Competition n Monopoly n Oligopoly, Monopolistic Competition, Imperfect Competition n Contestable Markets n Effective/Workable Competition n Structure  Conduct  Performance (SCP)? n Game Theory n Empirical Industrial Organisation

Perfect Competition: Assumptions n Large number of sellers and buyers n Homogeneous product n Free entry and exit n Full information about demand and supply n Profit Maximisation (MR = MC)

Perfect Competition: Characteristics n Short Run: Profits/Losses possible n Long Run: Entry or Exit until Zero Economic (Excess, Supernormal, Abnormal) Profits n Allocative Efficiency: P (SMB) = MC (SMC) n Productive Efficiency: P = Min AC

Monopoly: Assumptions n One seller, large number of buyers n Homogeneous product (by definition) n Barriers to resource transfers n Full information about demand and supply n Profit Maximisation (MR = MC)

Monopoly: Characteristics n Short Run: Profits/Losses possible n Long Run: Economic Profits (subsidised losses) possible n Allocative Inefficiency: P (SMB) > MC (SMC) n Productive Inefficiency: P > Min AC (generally) n X-Inefficiency? (minimise costs?) n Natural Monopoly (can’t compare with competition) → regulation (narrow sense) n Deadweight Loss: Harberger Triangle n R & D, Profit Motivation

Oligopoly: Assumptions n Few sellers, large number of buyers n Homogeneous or heterogeneous product n Free entry or barriers to entry n Full information about demand and supply (usually) n Aside: Monopolistic Competition = Oligopoly with Heterogeneous + Free Entry

Oligopoly: Characteristics? n Cournot (1838): Quantity Competition n Bertrand (1883): Price Competition n Game Theory n Cournot: Assumptions? Results  n Bertrand: Assumptions  Results? n Repeated Games  ???

Contestable Markets: Assumptions & Outcome n Free entry and exit: No sunk costs n Some price rigidity (e.g. menu costs) or lags relative to entry lag n Perfectly competitive outcome: potential use of hit-and-run strategy (even when n = 1) n Policy Relevance?

Effective/Workable Competition: Assumptions/Characteristics n No “harmful” inhibitions on entry and exit n No “harmful” product differentiation n No “harmful” coordination (e.g. price collusion) n No “harmful” price discrimination n Intrabrand competition, Interbrand competition, potential competition n No Excess (Economic) Profits

Effective/Workable Competition: Assumptions/Characteristics n “To determine whether any industry is workably competitive, therefore, simply have a good graduate student write his dissertation on the industry and render a verdict. It is crucial, of course, that no second graduate be allowed to study the industry.” (Stigler 1956) n Round & Siegfried (1994) Update?