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Industrial Economics
Robert Akerlof
Lectures 2 and 3
I. Introduction II. Basic Concepts
I. Introduction
1. Module Outline
20 Lectures 4 Tutorials (fortnightly)
Tutorials will begin in weeks 2-3.
Online material
Lecture notes; Handouts; Problem sets/solutions; Essay topics
Textbooks
Cabral, L. (2000) Introduction to Industrial Organization Carlton, D. and J. Perloff (2005) Modern Industrial Organization, 4ed
Assessment
2 Problem sets 1 Essay 1.5 hour final exam 10% (2 5%) 10% 80%
Essay
Due December 10 (first week of break).
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Class participation: highly encouraged! Advice Keep on top of material! Understanding of earlier material necessary for later material. Make sure you understand how to do all of the problem sets. will be key for doing well on the exam. Use the resources available to you: My office hours: Wednesday 2-4pm or by appt., Room S2.103 Amirs office hours: Monday 8-10am, Room S2.94 Come see us sooner rather than later. Your feedback on the course is valued.
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Basic conditions
Demand Production technology R&D technology Advertising technology
Structure
Number of firms Market shares Product differentiation Entry conditions
Conduct
Pricing strategies Production strategies Product choice R&D investment Collusion Entry & exit Advertising
Performance
Market power Profit rates Static efficiency Dynamic efficiency
A few examples of things we will see in this course: 1) What are the determinants of prices? Example: effect of the introduction of generic drugs? 2) Importance of strategic interaction (game theory) Example: effect of Whole Earth Access pricing policy
3) Sources of market power? Why do industries differ in the extent to which firms exhibit market power? Example: cable companies, Facebook, Google
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Policy
Regulation
Public intervention to regulate/correct the behaviour of firms with high potential market power (often monopolists) in industries where technology exhibits strong economies of scale and concentration (e.g. utilities)
Patent policy
Protect intellectual property rights and promote innovation (and the diffusion of welfare gains generated by innovation).
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Outline of Topics
Lectures 2 and 3: Introduction and Basic Concepts Lectures 4 through 8: Market Structure Lectures 9 and 10: Game Theory I Lectures 11 and 12: Game Theory II Lectures 13, 14, and 15: Cartels and Collusion Lecture 16: Product Differentiation Lecture 17: Contestable Markets Lectures 18 and 19: Durable Goods Lecture 20: Transfer Pricing
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Why focus on opportunity cost? This is the notion of cost that firms should base decisions on. Therefore: firms should ignore sunk costs! Two cases: Apple (see handout) Carnegie Opportunity Costs in Practice Example: valuing the costs of owning a 1998 Boeing 737
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User Cost of Capital (UCC) UCC(t) = rV(t)+(V(t)-V(t+1)) = foregone interest + economic depreciation UCC(t) is the opportunity cost: Actual use of V(t) pounds is: purchase capital YieldsV(t+1) Best alternative use of V(t) pounds is: invest with a return of r Yields(1+r)*V(t) Opp. Cost=Difference=(1+r)*V(t)-V(t+1)=UCC(t)
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97
737-700
25,803,980
98
737-700
27,448,430
Cost of owning Boeing 737-700 for 1 year: UCC = interest +depreciation = 5%*($27.4m)+ ($27.4m-$25.8m) = $2.97m
Question for the airline: Will the added revenue from an additional plane exceed $2.97m?
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Average Cost
(pounds per kilowatt)
Tandem-compound design
cross-compound design
Size
(kilowatts)
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Marginal Cost and Average Cost: Marginal cost: how much would it cost to produce an additional unit? MC(q) = C(q) = VC(q) Marginal cost = Derivative of Total cost = Derivative of Variable cost Average cost: AC(q) = AVC(q) + AFC(q)
C (q) VC (q) FC = + q q q
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Economies and diseconomies of scale Economies of Scale AC decreases with q, so MC < AC Most anything digital Constant Costs AC constant with q, so MC = AC Scalable Business Diseconomies of Scale AC increases with q, so MC > AC
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60
50
40
30
20
AC
10
MC
0 0 5 10 15 20 25
Output
60
50
40
AC
30
20
10
0 0 5 10 15 20 25
Output
11
MC
AC
10
-1
Output
Efficient Scale:
Level of output where AC is minimized. Note: at efficient scale, AC=MC. Efficient scale influences firm size in an industry: Suppose there is a firm that is much larger than the efficient scale (high AC). other firms may want to enter the market.
Economies of Scope
Cost savings associated with the joint or simultaneous production of several products
Unit costs are lower than if products are produced separately in stand alone firms
Sources?
Shared use of indivisible inputs
Learning Effects
Costs savings that arise from repetition, practice or experience of ongoing production Todays output affects tomorrows costs. Some sources:
Workers become more adept at jobs Managers learn to schedule production tasks more efficiently Engineers, initially cautious in product design, gain experience and are better able to allow for tolerances in design that decrease costs without compromising quality. Suppliers of materials learn how to produce better and pass on fraction of cost savings.
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On 16 January 1943, Schenectady, a Liberty tanker, split in two while moored in calm water at the outfitting dock at Swan Island, Oregon. A US Coast Guard report described the incident: Without warning and with a report which was heard for at least a mile, the deck and sides of the vessel fractured just aft of the bridge superstructure. The fracture extended almost instantaneously to the turn of the bilge port and starboard. The deck side shell, longitudinal bulkhead and bottom girders fractured. Only the bottom plating held. The vessel jack-knifed and the center portion rose so that no water entered. The bow and stern settled into the silt of the river bottom. The ship was twenty-four hours old. The official Coast Guard report on the Schenectady incident attributed the fracture to welds in critical seams that "were found to be defective.
Peter Thompson, "How Much Did the Liberty Shipbuilders Learn? New Evidence for an Old Case Study. Journal of Political Economy 2001. Photos from http://www.fiu.edu/~thompsop/liberty/photos/liberty_summary.html
John P. Gaines, November 1943. Vessel broke in two off Shumagin Aleutians with the loss of ten lives.
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150
AC per Lot
4.8 4.6 4.4 4.2 4 3.8 0 1 2 3 4 Ln(Lot Number (or Cum. Prod.))