2 Eco Micro Romania March 2014

Microeconomics
Objectives
Understand the dynamics of the competitive market in order to structure the

right price;
Understand the relationship among firms facing various kind of competition
(pure competition, oligopoly, monopolistic competition, )
Programme structure
Cost analysis (II)
SUPPLY
SUPPLY
Consumer choice, demand curves &

elasticity ratios (I)
MARKET
MARKET
STRUCTURE
STRUCTURE
&
&
COMPETITION
COMPETITION
DEMAND
DEMAND
Pure competition / Monopoly (III)

Imperfect Markets (IV)
Information asymmetry & transaction costs (V)
Prof. Patrick GOUGEON ESCP Europe/ 2014
Demand analysis
DEMAND ANALYSIS
Different perspectives
Consumer choices (utility theory)
Individual Demand
aggregation
Market Demand
Demand to the firm

Demand curve: theoretical background

n goods or services available on the market: i = 1,..n
Prices : p1,..pi,pn
Quantity consumed of each:
x1, ..xi,..xn
Budget: R = pi xi
Objective
Maximise consumer satisfaction: Max U(x1, ..xi,..xn)
under budget constraint: R = R
a change in pi (pi), other prices and budget remaining the same, result in
a change in the quantity purchased of good i (xi)
Individual Demand corresponds to the function that describes the relation between the
price and the quantity of a good purchased by an individual maximising his
satisfaction for a given level of income and other prices being held fix.
Demand Curves
Individual Demand
Reservation price
aggregation
Market Demand
p
q
Market Equilibrium & Surpluses

price
supply
Market Price
Consumer
surplus
At this price
Supply > Demand
Producer
surplus
quantity
Except the marginal consumer , most consumers will pay a price which is lower
than the maximum price they would accept (reservation price).
This is the origin of the consumer surplus
Suppliers would also accept to sell for a lower price.
This is the origin of the producer surplus
About consumption taxes

price
x
Consumers &
suppliers share the
tax burden
p inc. Tax
supply
p1
p bef. Tax
q2
q1
quantity
If consumers have to pay x as tax for each unit, then the demand curve moves down
(for any price p, suppliers receive p-x only)

Illustration
Demand (pre tax):
p = - q + 1000
Supply: p = q + 100
Market price: 550
Taxe: 50/unit
Demand (after tax):
p = - q + 950
Price bef. tax: 525
Price inc. tax: 575
price
Consumers pay 25
more per unit
575 inc. Tax

525 bef. Tax
supply
550
Suppliers receive 25
less per unit
Change in total income for suppliers

- 34375 (-10%!)
50
q2
425
q1
450
quantity

Illustration
Demand (pre tax):
p = - 5q + 3400
Supply: p = q + 100
Market price: 650
Taxe: 50/unit
Demand (after tax):
p = - 5q + 3350
Price bef. tax: 642
Price inc. tax: 692
price
inelastic demand
Consumers pay 42
more per unit
supply
692 inc. Tax

642 bef. Tax
650
Suppliers receive 8
less per unit
Change in total income for suppliers

- -9536 (-2,7%)
q2
542
q1
550
quantity
Demand is inelastic, consumers are less price sensitive, therefore suppliers dont
need to reduce their price much!
Question: what if buyers receive a subsidy?

Elasticity ratios
q
q
Price elasticity: ep = p
p
Market demand
p
p0
p1
<0
Depends on necessity and possible subsitutes

q
q0 q1
Income elasticity: eY=
Cross elasticity: ei/j =

q
q
Y
Y
qi
qi
pj
pj
> 1 ; superior goods

< 1 ; inferior goods
> 0 ; substitutes
< 0 ; complements
Its value has an influence on the

allocation of income growth across
industries and business volatility
A reference to define the relevant

market
COST FUNCTIONS
and related concept
Production function
Production
)
Productionfunction
function::QQ==F(x
F(x11,x,x22,.x
,.xi,.x
i,.xnn)
The level of output Q, depends on the quantity of inputs, (x 1, x2,.xi,.xn),
used in the production process
Types of inputs: Capital, Labour, energy, raw material, components,
Few remarks
Inputs are assumed to be, at least partly, substitutes, so that there exist various
inputs combinations for the same output Q.
If we adopt a short term perspective with reference to a given technology in
place, some inputs are fixed (Capital ) whereas the quantity of other factors
can vary to adjust the output
In the long term the objective is to select the best factor combination
considering all the possible technologies. For a given output Q, considering the
cost of using each factor, there exist an optimal combination (x 1*,..xi*,xn*)
for which the total production cost C(Q) is minimum.
Productivity ratios
Definition:
Definition: ouput/inputs
ouput/inputs
Assuming
Assumingtwo
twofactors
factorsonly:
only:Capital
Capital(K)
(K)and
andLabour
Labour(L)
(L)
Q
Q == F(K,L)
F(K,L)
Factor productivity:
Q/L ; Q/K
Marginal productivity : Q/L ; Q/K )

Multi Factor Productivity :
Q/(K+L)
Cost Function: a short term perspective

Total cost (TC) = Fixed Costs (F) + Variable Costs (VC)
TC
Average Cost (AC) = TC/Q

Marginal Cost (MC) = C/Q
TCi
AC = MC
Qi
Q*
AC
MC
ACi = TCi/Qi
Q*
Cost Function: a short term perspective

Total cost (TC) = Fixed Costs (F) + Variable Costs (VC)
Proportional ( raw material, energy,.)
Variable Costs (VC):
or
Non proportional (labour, maintenance,..)
Fixed Costs (F): Cost of capital*, other opex

Cost of capital: depreciation + financial cost
Question: which are the determinants of the cost of capital?
About technological flexibility

CM
Price
Margin
Critical
output
Q*
Higher flexibility (green curve),

the probability of an output lower
than the critical level is reduced
Some
Someissues:
issues:
Companies tend to adopt more capital intensive technologies, how does it affects
their flexibility?
Why is a broader client base likely to partly solve the flexibility constraint ?
With reference to flexibility, analyse the strategic advantage provided by
subcontracting
Case study: electricity generation cost

Technology
Number of years of utilisation
size (MW)
Capacity factor
Investment cost per MW (000)
Opex per MWh
Fuel cost per MWh
Discount rate
CCGT
20
830
80%
550000
3.8
31
10%
Assuming one shot capital expenditure year 0

no decommissioning and no carbon cost
Output per year: 830 * 365 * 24 * 80% = 5 816 640 MWh

Variable cost: (31 + 3.8)/MWh = 34.8/MWh
Fixed Cost:
Capital expenditure: (830 000 * 550 000) = 456 500 000
(annuity/20years) = 53 620 319
Total Cost = 53 620 319 + 34.8 * 5 816 640 = 256 568 176
Average Cost = 256 568 176 / 5 816 640 = 44.1 /MWh
Marginal Cost = 34.8
Technology
Number of years of utilisation
size (MW)
Capacity factor
Investment cost per MW (000)
Opex per MWh
Fuel cost per MWh
Discount rate
CCGT
20
830
80%
550000
3.8
31
10%
Case study: electricity cost

Average and marginal cost curves
Assuming one shot capital expenditure year 0

no decommissioning and no carbon cost
44.1
(Min for 80% capacity factor)
Marginal cost: 34.8

(Opex + fuel cost)
The marginal cost is a trigger: as soon as the market price is over the
marginal cost, the plant should start producing......
But to get a profit over a period of time, the average market price
should be above the average cost
Cost Function: long term perspective

Average
AverageCost
Costand
andEconomies
Economiesof
ofScale
Scale
Airline service: alternative technological choices
The long term

average cost curve is
a combination of
short term average
cost curves
The appropriate
technology depends
on the level of output
targeted
The larger the
output, the lower the
average cost
(economies of scale)
The efficient size
corresponds to the
lowest average cost
Average cost
Long Term Average Cost
Low fixed costs
High variable costs
High fixed costs

Low variable costs
Quantity
Efficient size
Cost Function: long run

Economies
Economiesof
ofscale
scalediffer
differfrom:
from:
Economies of scope
Synergies
Gains from exprience
Market Structures
Market structures: classification
Normative approach
Perfect competition versus monopoly
Positive approach
Oligopoly (few firms); monopolistic competition,...
Competition
the regultors view
Market analysis: methodology
Perfect competition vs Monopoly
Issues on competition & market regulation
Market regulation
A place where supply meets demand
price
Demand
Supply
Market
price
quantity
A voting place
A place where information are available for firms
to allocate resources efficiently
A place where inefficiency is sanctioned
Market structures analysis

A basic principle: Profit Maximisation
Profit:
= R(q) - C(q)
Max :
q = Rm - Cm = 0
Rm = Cm
Marginal income = Marginal Cost
= [ P(q) x q ] - C(q)
Demand to the firm
To analyse a particular market

structure we need to specify the
properties of the demand to the firm
Market structures analysis

A basic principle: Profit Maximisation
Total Income
Cost, Profit
Rm
Total Cost
max
Cm
Quantity
Profit
max
Break
even
Quantity
q*
Perfect competition
Definition
Atomicity
Free entry
Transparency
Homogeneity
Factors mobility
Perfect competition
Mecanisms
individual supply
Market
Cost, price
Supply
price
Demand
(N firms)
(marginal cost Cm = P)
Firm
Supply
Average cost
Market price
imposed to all firms
demand function:
P = P, Rm = P
(N+n firms)
Free entry
margin
Long term market price
(price = average cost = Cm)
quantity
P*
QN
QN+n
quantity
= N qN i
Long term market price

equal to the minimum average cost, the lowest that can prevail
The highest possible satisfaction for consumers
No profit !(Return on capital invested is at a normal rate )
qN+ni qNi
Monopoly
Demand to the firm = Market demand
P= - a q + b
R(q) = P x q = - a q2 + b q
Rm
Rm==--22aaqq++bb
price
Cm
P*
Average cost
P max
P
Rm = Cm
q*
P*
P*>>Cm
Cm
Demand: - a q + b
quantity
Rm: - 2 a q + b
P min = Cm
Monopoly
P - Cm
measure of
competition
intensity
Perfect
competition
Antitrust
Competition policy areas
Agreements which restrict competition are prohibited (Article 81 of the Treaty). This is for example the case of price-fixing agreements
and cartels between competitors;
Firms in a dominant position may not abuse of that position (Article 82 of the EC Treaty). This is for example the case for predatory
pricing aiming at eliminating competitors from the market
Mergers
Control of concentration to assess the impact on competition
Liberalisation
"ensuring that competition in the internal market is not distorted"
State aid
State aid that distorts competition in the Common Market is prohibited by the EC Treaty.
The EC Treaty, however, allows exceptions to the ban on state aid where the proposed aid schemes may have a beneficial impact in overall
Union terms. Article 87 of the EC Treaty allows the following forms of aid:
aid having a social character, granted to individual consumers;
aid to make good the damage caused by natural disasters or exceptional occurrences;
aid designed to:
- promote the economic development of underdeveloped areas (regarded as particularly
backward in accordance with Community criteria);
- promote the execution of an important project of common European interest or to remedy a
serious
disturbance in the economy of a Member State;
- facilitate the development of certain activities or areas,
- promote culture and heritage conservation;
International
The EU has established bilateral agreements on competition, particularly with the principal trading partners of the EU, and continues to
develop further bilateral relations. It has also been at the forefront of multilateral co-operation efforts, for example, being among the first
to propose the inclusion of competition policy as a subject for discussion in the World Trade Organisation, and playing a key role in the
International Competition Network.
Source: European commission
Defining the market

A relevant product market comprises all those products and/or services which
are regarded as interchangeable or substitutable by the consumer, by reason of the
products' characteristics, their prices and their intended use.
The relevant geographic market comprises the area in which the undertakings
concerned are involved in the supply and demand of products or services, in which
the conditions of competition are sufficiently homogeneous and which can be
distinguished from neighbouring areas because the conditions of competition are
appreciably different in those areas.
Three elements are considered:
Demand substitution
The question to be answered is whether the parties' customers would switch to readily available substitutes or to suppliers located
elsewhere in response to an hypothetical small (in the range 5%-10%), permanent relative price increase in the products and areas being
considered
Supply substitution
This requires that suppliers be able to switch production to the relevant products and market them in the short term (4) without incurring
significant additional costs or risks in response to small and permanent changes in relative prices
Potential competition
If required, this analysis is only carried out at a subsequent stage, in general once the position of the companies involved in the relevant
market has already been ascertained, and such position is indicative of concerns from a competition point of view.
Source: European commission, Published in the Official Journal: OJ C 372 on 9/12/1997
Imperfect markets
Oligopoly
Oligopoly
Concentration
Concentration measures
measures
Monopoly
Monopoly and
and price
price discrimination
discrimination
Entry
Entry barriers
barriers
Monopolistic
Monopolistic competition
competition
Imperfect markets
Corporate strategy, a main objective: avoid competition
Regulators view
Atomicity
Free entry
Transparency
Homogeneity
Factors mobility
companys view
Concentration
Entry barriers
Information asymmetry
Differentiation
Imperfect markets
Atomicity
Free entry
Transparency
Homogeneity
Factors mobility
Monopoly
Duopoly
OLIGOPOLY
Imperfect markets: measures of concentration

Cn:
Cn:Market
Marketshare
shareof
ofthe
then
nlargest
largestsuppliers
suppliers
Herfindahl-Hirschman Index
HHI =
i n
2
P
i1 i
n firms: i = 1,.n
Pi market share of firm
(1/HHI can be understood as the
equivalent number of firms)
HHI 0 Perfect competition

HHI <0.1 unconcentrated
0.1 <HHI<0.18 moderate concentration
HHI > 0.18 high concentration
HHI = 1 Monopoly
In the B2C power sector, six countries have an HHI score of 1.0, indicating the existence
of a monopoly that is not exposed to competition. The average EU27 HHI index of
0.67* in the B2C gas sector reflects the high degree of market concentration and the lack
of effective retail competition in the market. The UK is the most competitive B2B gas
market in terms of its HHI score of 0.10*.
100%
Total
market
share
Lower
concentration
ratio
90% of total population represents

only 30% in terms of market share
30%
90%
Proportion of of firms
(increasing size)
100%

120,0%
120,0%
II
IIII
companies
companies Market
MarketShare
Share Market
MarketShare
Share
AA
25,0%
60,0%
25,0%
60,0%
BB
21,0%
6,0%
21,0%
6,0%
CC
16,0%
6,0%
16,0%
6,0%
DD
15,0%
5,0%
15,0%
5,0%
EE
10,0%
5,0%
10,0%
5,0%
FF
4,0%
5,0%
4,0%
5,0%
GG
3,0%
5,0%
3,0%
5,0%
HH
3,0%
4,0%
3,0%
4,0%
II
2,0%
3,0%
2,0%
3,0%
JJ
1,0%
1,0%
1,0%
1,0%
total
100,0%
100,0%
total
100,0%
100,0%
C4
C4
77,0%
77,0%
77,0%
77,0%
100,0%
100,0%
120,0%
120,0%
80,0%
80,0%
100,0%
100,0%
60,0%
60,0%
80,0%
80,0%
40,0%
40,0%
60,0%
60,0%
20,0%
20,0%
40,0%
40,0%
0,0%
0,0%
1
20,0% 1
20,0%
0,0%
0,0%
2
2
11
3
3
22
4
4
33
5
5
44
6
6
7
7
8
8
55
66
77
9 10 II
9 10
88
99 10
10
Imperfect markets: Oligopoly

Few firms competing
on the market
Lets start from the current position: P, q
Demand to the firm ?

1/ Price increase ?
Competitors would not follow,
demand is elastic
2/ Price reduction ?
Competitors would follow,
demand is inelastic
Demand to the firm
P
q
Rm
Cm
Price stability is
most likely
Rm = Cm

The economic literature proposes many other models based on game theory
Assuming that each participant is a profit maximiser, decisions are made with reference to
anticipations as to the competitors decision
Cournot : having guessed the capacity chosen by the competitor, each firm decide on
its own capacity, the price is then adjusted to clear the market.
(industries where decisions on capacity are most important such as steel, cement,)
Bertrand : taking the price of the competitor as given, each firm decides on price and
adjust its output accordingly
(industries with flexible production structures, inevitably it converges toward p = Cm) )
Since anticipations as to the competitors decision may be wrong, each participant may
have to adjust until an equilibrium is reached
In each case it converges towards a Nash-Equilibrium
Stackelberg : the leader decides which quantity to produce (with consideration of the
reaction of others), then other firms adjust their position
It demonstrates the advantage of being the first mover

OPEC cartel
Nash Equilibrium
II
I
Increase
output
For
Forboth,
both,the
the
decision:
decision:
increase
Dont increase
leads totothe
thebest
best
increaseleads
outcome
outcome
output whatever
whateverthe
the
other
decides
other decides
Increase
output
100; 100
200; 70
Dont
increase
output
70; 200
150; 150
However,
However,
would
wouldthey
they
collude,
both
collude, both
would
wouldachieve
achieve
aabetter
better
outcome
outcome
Imperfect markets:
Monopoly with price discrimination
Objective: capture the consumer surplus resulting from a single price strategy
Three kinds of price discrimination
First-degree (perfect price discrimination)
Each consumer is charged his reservation price
That is the maximum he is ready to pay!
(idealistic)
Second-degree (self selection, non linear

pricing)
The firm is not able to identify the different
groups of customers. Different price-quantity
(or quality) packages are offered, customers are
then expected to self select
Example: insurance contracts, airline,
Third-degree
Different groups of customers are identified
with different price sensibility, the firm offers
the same product for different prices
Imperfect markets
Monopoly behaviour: bundling *
Willingness to pay for software components
Type of consumers
Type A
Type B
Word processor
120
100
Spreadsheet
100
120
Which pricing strategy do you propose ?

If the marginal cost is low, profit maximisation will lead to
propose each component at 100
.But if both components are sold as a bundle, the firm can
propose 220 for it !
See Hal R. VARIAN, Intermediate Microeconomics, 5th edition, Norton, p 444
Imperfect markets: Entry Barriers

Regulatory
Regulatorybarriers
barriers
Brand
Brandand
andreputation
reputation
Scale
Scaleand
andexperience
experience
lock
lockin
inand
andswitching
switchingcost
cost
Upstream
Upstreamand
anddownstream
downstreamcontrol
control
A remark about contestable markets

If there exist high barriers to entry, then existing firms can maintain an abnormal profit (rent).
However, if new entrants could come in with little difficulty, existing firm will behave more
like competitive firms. In this latter case the market is said to be contestable, with a price
not far from what would prevail with pure competition though concentration is high.
Imperfect markets
Atomicity
Free entry
Transparency
Homogeneity
Factors mobility
MONOPOLISTIC
COMPETITION
Imperfect markets: monopolistic competition

Competion and product differenciation
Demand to the firm ?
There is no perfect substitute,
therefore the demand is not
perfectly elastic
price
Average Cost
margin
The short term equilibrium is

similar to a monopoly situation
Entry of new competitors ?
Downwards schift of the demand

curve, leading to zero profit
(for the same price, demand is now
lower)
New entries
quantity
Rm
As compared with perfect competition, the
price is higher (over the minimum long term
average cost)

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Microeconomics

Understand the dynamics of the competitive market in order to structure the

Consumer choice, demand curves &

Pure competition / Monopoly (III)

Prof. Patrick GOUGEON ESCP Europe/ 2014

Demand to the firm

Demand curve: theoretical background

Market Equilibrium & Surpluses

About consumption taxes

Prof. Patrick GOUGEON ESCP Europe/ 2014

About consumption taxes

575 inc. Tax

Change in total income for suppliers

Prof. Patrick GOUGEON ESCP Europe/ 2014

About consumption taxes

692 inc. Tax

Change in total income for suppliers

Question: what if buyers receive a subsidy?

Depends on necessity and possible subsitutes

Income elasticity: eY=

Cross elasticity: ei/j =

> 1 ; superior goods

Its value has an influence on the

A reference to define the relevant

Prof. Patrick GOUGEON ESCP Europe/ 2014

Marginal productivity : Q/L ; Q/K )

Prof. Patrick GOUGEON ESCP Europe/ 2014

Cost Function: a short term perspective

Average Cost (AC) = TC/Q

Cost Function: a short term perspective

Fixed Costs (F): Cost of capital*, other opex

About technological flexibility

Higher flexibility (green curve),

Case study: electricity generation cost

Assuming one shot capital expenditure year 0

Output per year: 830 * 365 * 24 * 80% = 5 816 640 MWh

Prof. Patrick GOUGEON ESCP Europe/ 2014

Case study: electricity cost

Assuming one shot capital expenditure year 0

Marginal cost: 34.8

Cost Function: long term perspective

Prof. Patrick GOUGEON ESCP Europe/ 2014

The long term

High fixed costs

Prof. Patrick GOUGEON ESCP Europe/ 2014

Cost Function: long run

Prof. Patrick GOUGEON ESCP Europe/ 2014

Prof. Patrick GOUGEON ESCP Europe/ 2014

Market structures: classification

Prof. Patrick GOUGEON ESCP Europe/ 2014

Prof. Patrick GOUGEON ESCP Europe/ 2014

Market structures analysis

Prof. Patrick GOUGEON ESCP Europe/ 2014

To analyse a particular market

Market structures analysis

Prof. Patrick GOUGEON ESCP Europe/ 2014

Long term market price

Prof. Patrick GOUGEON ESCP Europe/ 2014

Competition policy areas

Source: European commission

Defining the market

Prof. Patrick GOUGEON ESCP Europe/ 2014