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Frank Cowell: Market Power & Misrepresentation MARKET POWER AND MISREPRESENTATION MICROECONOMICS Principles and Analysis Frank Cowell July 2015 1 Note: the detail in slides marked “ * ” can only be seen if you run the slideshow
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Frank Cowell: Market Power & Misrepresentation Introduction Presentation concerns trading behaviour Context is an exchange economy usual focus is on simple price-taking but we will examine non-competitive behaviour Use a standard modelling framework Endow traders with different degrees of power captured in the trading rules Extend this to a simple model of manipulation and design Begin with a simple analysis of nonlinear prices July 2015 2
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Frank Cowell: Market Power & Misrepresentation Overview Market power Exchange and monopoly Misinformation Market Power and Misrepresentation Nonlinear price systems July 2015 3
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Frank Cowell: Market Power & Misrepresentation The setting Consider an exchange economy Suppose one agent has extended monopoly power Can charge a fee for the right to access good 1 this can only work for goods where resale is difficult otherwise consumers can undermine the fee by bulk-buying and selling on the commodity to others sometimes public utilities fit this paradigm Assume that any other trader acts as a price taker Analyse this within the context of the Edgeworth box July 2015 4
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Frank Cowell: Market Power & Misrepresentation The model Two goods (1,2) and two traders (Alf, Bill) Given resource distribution endowments of two goods are such that Bill owns all good 1 Alf: [R 1 a, R 2 a ] = [0, R 2 a ] Bill: [R 1 b, R 2 b ] = [R 1, R 2 b ] R 2 : = R 2 a + R 2 b Trading outcomes described by allocation vector of consumptions Alf: [x 1 a, x 2 a ] Bill: [x 1 b, x 2 b ] Use good 2 as numéraire price of good 1 is p := p 1 /p 2 Assume materials balance condition satisfied with equality x 1 a + x 1 b = R 1 x 2 a + x 2 b = R 2 permits use of the Edgeworth box diagram July 2015 5
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Frank Cowell: Market Power & Misrepresentation Market power Suppose Bill has the power to set the price p and the entry fee F Then Bill can fix a budget constraint for Alf anywhere in the diagram subject to one important condition this has to do with the trading rules see below Bill’s control over the budget constraint: p fixes the slope; F fixes the position In effect Bill has the power to set a non-linear price system the pair (p, F) examine how this works: July 2015 6
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Frank Cowell: Market Power & Misrepresentation x1x1 a x2x2 b x1x1 b x2x2 a 0a0a The “two-part” tariff The endowment point Price per unit F Fixed charge p [R] July 2015 7 0b0b
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Frank Cowell: Market Power & Misrepresentation x1x1 a x2x2 b x1x1 b x2x2 a 0a0a *Changing the budget constraint Varying F Varying p [R] July 2015 8 0b0b
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Frank Cowell: Market Power & Misrepresentation Key condition Bill nearly has total control over Alf However, one thing remains in Alf’s power: Alf does not have to consume good 1 can just consume his endowment [R 1 a, R 2 a ] This condition effectively constrains Bill’s action Draw Alf’s indifference curve through the endowment point Alf’s reservation indifference curve cannot be forced to trade at an allocation with lower level of utility This is the boundary of Bill’s attainable set Begin with case where Bill considers goods perfect substitutes July 2015 9
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Frank Cowell: Market Power & Misrepresentation Exploitation solution a ’s indifference curves Endowment point b ’s constraint set b ’s indifference curves The solution Entry fee and price F p a’ s reservation indiff curve x1x1 a x2x2 b x1x1 b x2x2 a 0a0a [R] [x a ] July 2015 10 0b0b
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Frank Cowell: Market Power & Misrepresentation Solution works in general case F p Basic model as before b ’s indifference curves Solution as before x1x1 b x1x1 a x2x2 a x2x2 b 0a0a [R] [x a ] July 2015 11 0b0b
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Frank Cowell: Market Power & Misrepresentation Full market power: the result Bill has maximal power in market for good 1 can use a nonlinear pricing scheme sets price ratio and entry fee to market for good 1 Outcome is full exploitation trading partner is forced to reserve indifference curve solution allocation [x a ] is on indifference curve through [R] But it is efficient at [x a ] MRS is is the same for both traders… … so it is on the contract curve Solution applies for general form of Bill’s preferences July 2015 12
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Frank Cowell: Market Power & Misrepresentation Overview Market power Exchange and monopoly Misinformation Market Power and Misrepresentation Power play in the Edgeworth box July 2015 13
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Frank Cowell: Market Power & Misrepresentation Using the idea of market power We’ve characterised market power in a simplified case Bill a had built-in monopolistic advantage also endowed with complete market power Now use this model apply this to a number of trading stories again in a simplified world Address some key questions How related to competitive outcomes? Under what circumstances will we get an efficient outcome? July 2015 14
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Frank Cowell: Market Power & Misrepresentation Trading: alternative stories A case with simplified property distribution Bill has all of commodity 1 Alf has all of commodity 2 Review the standard equilibrium concepts the core competitive equilibrium Examine two polar cases 1. Bill has complete market power (can choose point in A’s acceptance set) 2. Alf has complete market power Then consider limited market power Alf can act as a simple monopolist July 2015 15
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Frank Cowell: Market Power & Misrepresentation 0b0b 0a0a x1x1 b x1x1 a x2x2 a x2x2 b [R] p* Trading and competition a ’s indifference curves b ’s indifference curves The contract curve Endowment point Trades acceptable to a & b The core CE and prices [x*] July 2015 16
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Frank Cowell: Market Power & Misrepresentation 0b0b 0a0a x1x1 b x1x1 a x2x2 a x2x2 b [R] [x*] [x a ] Bill has total market power Competitive equilibrium b ’s opportunity set given market power b’ s optimal allocation A nonlinear schedule to implement it July 2015 17
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Frank Cowell: Market Power & Misrepresentation 0b0b 0a0a x1x1 a x2x2 b [x*] [xb] [xb] Alf has total market power a ’s opportunity set given market power a’ s optimal allocation A nonlinear schedule to implement it x1x1 b x2x2 a [R] July 2015 18
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Frank Cowell: Market Power & Misrepresentation Simple monopoly The three stories have a common element characterise three points in the core all stories have efficient outcomes Now a story with less than complete market power Alf can simply set the price Bill acts as price taker Rework the diagram first map out Alf’s attainable allocations then characterise optimum conditional on this restricted-power model July 2015 19
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Frank Cowell: Market Power & Misrepresentation 0b0b 0a0a x1x1 b x1x1 a x2x2 a x2x2 b [R] Alf can set prices b’ s reaction function Endowment a tries out alternative prices a ’s attainable set b ’s preferences July 2015 20
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Frank Cowell: Market Power & Misrepresentation p 0b0b 0a0a x1x1 b x1x1 a x2x2 a x2x2 b [R] ^ ^ Monopoly trading Competitive equilibrium a ’s monopolistic optimum a’ s total market power solution a ’s preferences [x] [x b ] [x*] Efficient allocations (contract curve) MRS and prices at optimum July 2015 21
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Frank Cowell: Market Power & Misrepresentation Summary of market power model Suppose Alf has market power Gets higher utility than in CE Gets higher utility if has total market power than as simple monopolist CE and total market power are efficient Simple monopoly is inefficient price = Alf’s MRS price ≠ Bill’s MRS July 2015 22
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Frank Cowell: Market Power & Misrepresentation Overview Market power Exchange and monopoly Misinformation Market Power and Misrepresentation Applying the simple monopoly model July 2015 23
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Frank Cowell: Market Power & Misrepresentation Misrepresentation The standard exchange model tells a simple story But relies on strong informational assumption each trader has full information about the other’s preferences What happens if we drop this? Use the same model as the market power example take the case where Alf owns good 2 Bill owns good 1 Start from case of perfect information Then suppose that Alf misrepresents preferences Bill continues to reveals full information July 2015 24
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Frank Cowell: Market Power & Misrepresentation 0b0b 0a0a x1x1 b x1x1 a x2x2 a x2x2 b [R] p ^ ^ [x] p* Misrepresentation and distortion a ’s true ICs b ’s true ICs The contract curve Endowment point & core CE allocation and prices a’ s false IC Induced equilibrium with a’ s misrepresentation [x*] July 2015 25
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Frank Cowell: Market Power & Misrepresentation Misrepresentation: outcome The equilibrium has been seen before version with Alf’s misrepresented preferences same that for a simple monopolist Opportunity to masquerade induces a distortion trader with informational advantage forces price in his favour in this case: price ratio = MRS a ≠ MRS b Bilateral trading is manipulable by revealing false preferences Alf secures higher utility for himself What if both can misrepresent? outcome is still likely to be inefficient… July 2015 26
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Frank Cowell: Market Power & Misrepresentation 0b0b 0a0a x1x1 b x1x1 a x2x2 a x2x2 b [R] p ^ p* Misrepresentation and distortion (2) True indifference curves The contract curve & core CE allocation and prices a ’s false ICs Outcome if a misrepresents [x*] ^ [x] b’ s false IC Outcome if both misrepresent ~ [x] July 2015 27
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Frank Cowell: Market Power & Misrepresentation Application Consider a model of international trade Alfaland exports good 2 Billestan exports good 1 Price ratio is terms of trade suppose one country can impose a tariff get inefficient (monopoly) outcome suppose other country retaliates with its own tariff outcome may still be inefficient Same outcomes could arise if each country can misrepresent preferences of its citizens Could design an efficient outcome if use nonlinear prices Alfaland demands payment F for access to market for good 2 or vice versa for Billestan and good 1 July 2015 28
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