Equipoise REM

Cournot Model
Assume P = 30 Q MC1 = MC2 = 0 Firm 1s reaction curve Q1 = 15 Q2 Firm 2s reaction curve Q2 = 15 Q1 Equlilibrium : Q1 = Q2 =10

Cournot equilibrium

Stackleberg model
One firm sets its output before other firms do Leader Firm 2s reaction curve Q2 =15 Q1 Firm 1s revenue: R1= 30Q1 Q1^2 Q1Q2 And MR1 = R1/Q1 = 15 Q1 Equilibrium : Q1 = 15 , Q2 = 7.5

Competition Versus Collusion: The Prisoners Dilemma

Assume:

FC $20 and VC $0 Firm 1' s demand : Q 12 2 P 1P 2 Firm 2' s demand : Q 12 2 P2 P 1 Nash Equilibrium : P $4 Collusion : P $6

$12 $16

Bertrand Model Heterogeneous Good Case

P1
Firm 2s Reaction Curve
Collusive Equilibrium

$6

$4
Firm 1s Reaction Curve

Nash Equilibrium

$4

$6

P2

Competition Versus Collusion: The Prisoners Dilemma

Possible Pricing Outcomes:

If both charge$6, $16

If P 1 $6 and P 2 $4 then 2 P2Q2 20 (4)12 (2)( 4) 6 20 $20 1 P 1Q1 20 (6)12 (2)( 6) 4 20 $4

Payoff Matrix for Pricing Game

Firm 2 Charge $4 Charge $6

Charge $4

$12, $12

$20, $4

Firm 1 Charge $6

$4, $20

$16, $16

Few Problems

Few more Problems

The Kinked Demand Curve Model

$/Q
Price rise matched Price rise unmatched So long as marginal cost is in the vertical region of the marginal revenue curve, price and output will remain constant.

MC MC
Price cut unmatched

P*

Price cut matched

Q* MR

Quantity

Price Setting by a Dominant Firm

Price D SF
The dominant firms demand curve is the difference between market demand (D) and the supply of the fringe firms (SF).

P1 P* DD P2

MCD

At this price, fringe firms sell QF, so that total sales are QT.

QF QD

QT

MRD

Quantity

First Degree Price Discrimination

Possible where reservation price of each customer can be assessed
E.g. professions like doctor, lawyer, CAs

Implications
No dead weight loss Competitive output level achieved Each unit sold at different price CS mopped-up by the professional

Additional Profit From Perfect First-Degree Price Discrimination

$/Q Pmax Consumer surplus when a single price P* is charged.
With perfect discrimination Each customer pays his reservation price Profits increase

Part of producer surplus when a single price P* is charged.

MC P* PC
Additional profit from perfect price discrimination, i.e., Deadweight loss being converted into monopoly profit.

D = AR

MR
Q* Q** Quantity

In case of first-degree price discrimination, MR coincides with AR, so that MR would have no separate existence.

Second Degree Price Discrimination

Different prices for the same customer for different blocks of quantity Same price within a block Examples: Electricity charges Music, dance lessons Elasticity of demand is different for same individual at different consumption levels

Corresponding figure for 2nd degree discriminating monopoly

$

Consumer Surplus

MC

AC

P2 P3

P1

D=AR

Q1

Q2

Q3

Q MR

Third Degree Price Discrimination

Firm is able to partition consumers into 2 or more groups with distinct demand elasticities
Airline fares: Discount and regular fare Discount coupons by supermarkets Lower rates for kids: Cinema houses, railways Foreign books: hardcover and paperback Export and domestic markets: Dumping? MR1(Q1) = MR2(Q2) = MC(Q1+Q2) High price where demand elasticity is low

Relative prices under Third-degree price discrimination

MC = MR1 = P1(1+1/E1) = MR2 = P2(1+1/E2) => P1/P2 = (1+1/E2)/(1+1/E1) => Pricing: Charge higher price to

group with a lower demand elasticity

Third-Degree Price Discrimination

$/Q P1
How do you get MRT from MR1 and MR2? Through horizontal or vertical addition? It is horizontal addition

P2

MC

D2 = AR2 MRT MR2 D1 = AR1

MR1

Q1

Q2

Qt Quantity

External Benefits
Value MSB
When there are positive externalities (the benefits of repairs to neighbors), marginal social benefits MSB are higher than marginal benefits D. A self-interested home owner invests q1 in repairs. The efficient level of repairs q* is higher. The higher price P1 discourages repair.

D
DWL P1 P* MEB

MC

Is research and development discouraged by positive externalities?

q1

q*

Repair Level

External Costs
Price
When there are negative externalities, the marginal social cost MSC is higher than the marginal cost. The differences is the marginal external cost MEC. The profit maximizing firm produces at q1 while the efficient output level is q*.

MSC MC =MEC

Price

MSCI S = MCI
Aggregate social cost of negative externality

The industry competitive output is Q1 while the efficient level is Q*.

P* P1 P1

MECI MEC D

q* q1

Firm output

Q* Q1

Industry output

The Efficient Level of Emissions

Dollars per unit of Emissions

Why is this more efficient than zero emissions?

MSC

Assume: 1) Competitive market 2) Output and emissions decisions are independent 3) Profit maximizing output chosen

6
At Eo the marginal cost of abating emissions is greater than the marginal social cost.

At E1 the marginal social cost is greater than the marginal cost of abatement. The efficient level of emissions is 12 (E*) where MCA = MSC.

MCA
E0 0 2 4 6 8 10

E* 12 14

16

E1 18 20

22

24

26

Level of Emissions

 Acme, US Electric each emit 40 tons SO2, total of 80 tons. Goal: reduce emissions 25% (to 60 tons/month) Suppose cost of reducing emissions is $100/ton for Acme, $200/ton for US Electric. If regulation requires each firm to reduce 10 tons,
cost to Acme: (10 tons) x ($100/ton) = $1,000 cost to USE: (10 tons) x ($200/ton) = $2,000 total cost of achieving goal = $3,000

Pollution Reduction Limits

 Alternative: issue 60 permits, each allows its bearer one ton of SO2 emissions (so total emissions = 60 tons) give 30 permits to each firm establish market for trading permits Each firm can choose among these options: emit 30 tons of SO2, using all its permits emit < 30 tons, sell unused permits buy additional permits so it can emit > 30 tons

Market-Based Policy #2: Tradable Pollution Permits

Market-Based Policy #2: Tradable Pollution Permits

Suppose market price of permit = $150 One possible equilibrium:

Acme spends $2,000 to cut emissions by 20 tons has 10 unused permits, sells them for $1,500 net cost to Acme: $500
US Electric emissions remain at 40 tons buys 10 permits from Acme for $1,500 net cost to USE: $1,500 Total cost of achieving goal: $2,000

Typology of Goods
Characteristics
Rival Excludable

Nonexcludable
Common Property Resource Public Good

Private Good

Non-rival

Club Good

Efficient Public Good Provision

Benefits (dollars) $7.00 $5.50 D2 $4.00 D $1.50
Efficient output occurs where MC = MB at 2 units of output. MB is $1.50 + $4.00 or $5.50.

When a good is non-rival, the social marginal benefit of consumption (D) , is determined by vertically summing the individual demand curves for the good.

Marginal Cost

Horizontal sum of demand curves

D1 0 1 2 3 4 5 6 7 8 9 10 Output

Common Property Resources

Benefits, Costs ($ per fish)
Without control the number of fish/month is FC where PC = MB (marginal benefit). However, private costs underestimate true cost. The efficient level of fish/month is F* where MSC = MB (D)

Marginal Social Cost

Private Cost

Demand

F*

FC

Fish per Month

Problems

If the market is captured by a first degree discriminating monopolist, the total quantity in the market would be __, while consumer surplus would be ___. Deadweight loss would be ___.

If the market is captured by a second degree monopolist, who charges P1 price for first block of quantity = Q1, and P2 for the block of quantity: Q2 Q1 the consumer surplus would be ___ and deadweight loss would be ___. The second degree monopolists super normal profit would be ___ (>, < or = write the most appropriate option) that of first degree discriminating monopolist, but > _____ (>, <, or = write the most appropriate option) when compared to non-discriminating monopolist charging a uniform price.

There is a vibrant cross-border trade between India and China for Sneezys medicine. How much would Sneezy charge for the medicine in India and China? a. b. c. d. Rs. 10 Rs. 30 Rs. 40 Rs. 50

During a recent visit by the Chinese foreign minister, Sneezy made a deal with him whereby, Sneezy would be the only authorized entity to deal with the cold medicine between India and China. That is, Sneezy would manufacture the drug in India and export to China. No other entity can export/import the drug between India and China. How much would Sneezy charge for the drug in India and China respectively? a. b. c. d. Rs. 30 and Rs. 50 and Rs. 40 and Rs. 60 and Rs. 50 Rs. 50 Rs. 60 Rs. 40

Bundling, Cost-Plus, Transfer Pricing, Two part tariffs

Bundling
Pricing Normal Pricing Bundling

Pure Bundling

Mixed Bundling

Question- Bundling

Mechanics of Cost-Plus Pricing Then determine the markup over cost

The overall objective is to allow the firm to earn its targeted rate of return If the return requires $X of total profit, then the per unit markup will be $X/Q Hence, the price is given by the formula:

X P AVC AFC Q

Mechanics of Cost Plus Pricing

Sum of the last 2 terms in the given formula i.e. AFC + X/Q is called the Gross Profit Margin (GPM) The per unit targeted profit (on investment) = X/Q is called the Net Profit Margin (NPM) Hence, a modified mark-up formula can be written as: Price = (1 + K) AVC
where K (mark-up proportion) = GPM/AVC

Importance & Significance of Transfer Pricing

Transfer price = Price for inter-divisional transaction in a multi-divisional company, which is a major determinant of the overall financial performance of the company Unless the right transfer price is chosen, the company shall end up having less than maximum profit (can be argued intuitively) Assuming a competitive external market exists for sale/purchase of the intermediate good, choice of any transfer price other than the competitive outside price shall lead to lower profit

Fig 1: Transfer Pricing When There is No Outside Market

MC

PA
MCE PE AR MCA

MR

QA = Q E

Quantity

Fig 2: Buying Engines in a Competitive Outside Market

PA

MC MCE AR MCA PE,M MR

PE,M

QE,1 QE,2
= QE

Quantity

Transfer Pricing and Tax

Notation and implication (Continued)
After-tax profit in the downstream country = (1 )(TRD TCD PUQU) After-tax profit in the upstream country = (1 )(PUQU TCU) Total after-tax profit = (1 )(TRD TCD) (1 )(TCU) + ( )(PUQU) Increasing the transfer price (PU) will increase after-tax profit.

Question- Transfer Pricing

Question- cont