ECP 3403 MT 1 Review
Factors that limit price discrimination
- iminited information on consumer preferences - possibility of resale - consumer outrage over "unfair prices"
What does a high Lerner index (L ≈ 1) tell you?
A high Lerner index means that the firm is a price-setter and has high market power
What is the connection between the Lerner index and the price elasticity of demand?
A low Lerner index indicates high price elasticity of demand. A high Lerner index indicates low price elasticity of demand.
What does a low Lerner index (L ≈ 0) tell you?
A low Lerner index means that the firm is a price-taker and has low market power
What rule characterizes the optimal quantity choice of a price setting firm?
A price-setting firm will produce q^m where MR(q^m) = MC(q^m)
What rule characterizes the optimal quantity choice of a price taking firm?
A price-taking firm will produce where p = MC
How do the price and quantity choices of a price setting firm differ from those of a price taking firm?
A price-taking firm will supply the quantity such that price equals marginal cost. A price-setting firm will supply the quantity such that marginal revenue equals marginal cost (This leads the firm to produce less and set a higher price than it would as a price taker.)
What is a perfectly competitive industry?
An industry with many small firms, all of them are price takers, homogenous products that have the same characteristics, perfect information and no externalities, free entry into the industry, no artificial barriers to entry
Why would a firm want to discriminate through self selection?
Because they can use it to sort out the high-value consumers from the low-value ones
What does deadweight loss measure, and how is it calculated?
DWL measures the reduction in total surplus as a result of firms choosing to not produce units for which WTP > MC. It's the area under the demand curve, above the line of MC, and to the right of the line of quantity demanded.
What is the difference between a movement along the demand curve and a shift in demand?
Demand curve movement refers to changes in price that affect the quantity demanded. A demand curve shift refers to fundamental changes in the balance of supply and demand that alter the quantity demanded at the same price.
What is the economic meaning of the incentive constraint?
High-end customers need to prefer (or be incentivized) to buy high-end products
How does the pricing rule compare to that used by a standard monopoly? (Note: the takeaway here is that the two rules are very similar. A firm using selection on indicators essentially acts as a monopolist in each market separately. Once we know how to solve monopoly problems, we know how to price using selection on indicators.)
If the firm can set prices using selection by indicators, it should charge lower prices in the market segments with more elastic demand
How do economic outcomes (producer surplus, consumer surplus, quantity) under perfect price discrimination differ relative to the same outcomes under simple monopoly?
If you can perfectly price discriminate, there is zero consumer surplus because each individual pays their exact willingness to pay. It's seemingly efficient because TS is maximized, but it's distributed differently, with the producers taking most if not all of the surplus
What is the connection between elasticity of demand and revenue?
If |E| > 1, then an increase in price leads to a decrease in total revenue. If |E| < 1, then an increase in price leads to an increase in total revenue.
In lecture, we saw that in the long run, a perfectly competitive industry will lead to production at minimum average cost. Explain how long-run firm entry and exit gives rise to this result. What type of efficiency does this represent?
In the long run, as firms enter the market, they will not be able to produce much profit due to the fact that their incumbent competitors are all selling their products for less money than the new firm. That new firm will then be forced to conform to the status quo / low price that the incumbent firms have been selling at, or they will be forced to leave the market due to lack of profit. This would lead to productive efficiency
In what sense is a perfectly competitive industry efficient in the short run, and why?
In the short run, competitive firms set p = MC and produce the quantity which maximizes total surplus (using allocative efficiency)
Teva and Turing are both accused of taking actions which increase the prices of prescription pharmaceuticals. How do these actions affect producer surplus, consumer surplus, and total surplus?
Increase producer surplus, decrease consumer surplus, decrease total surplus due to Dead Weight Loss
Why does market power lead to DWL?
Market power leads firms to set higher prices and produce lower quantities
What is price discrimination through selection on indicators (market segmentation)?
Occurs when a seller divides buyers into groups and charges a different prices to each group
What is price discrimination through self selection?
Occurs when a seller indirectly sorts consumers into groups by offering different deals or packages
Calculating Price Elasticity of Demand (2 Options)
Option 1: (Q2 - Q1) / Q1 / (P2 - P1) / P1 Option 2: (Change in Q / Change in P) / (P1 / Q1)
What is the economic meaning of the participation constraint?
People need to believe that they're better off participating in the market / buying something rather than not participating in the market at all
What are the three main areas of antitrust enforcement?
Price fixing, merger policy, and abuse of dominant position
We identified several examples of firms which deliberately damaged their products (Intel 486SX versus 486DX, IBM LaserPrinter E). How does price discrimination explain this behavior?
Producers want to see if they can sell you a cheaper product, so they can get information from you on what you're willing to buy, leading you to a sort of self-selection
What is the pricing rule for a firm using selection on indicators?
Sellers divides buyers into groups, charges a different price to each group
What is the Lerner Index and how does it measure market power?
The Lerner index measures a firm's market power in terms of its price-cost margin. L measures the fraction of price that is markup.
What is the goal of antitrust policy?
The goal of antitrust policy is to promote effectiveness of competition and mitigate market failures due to market power
What is the margin-elasticity rule for a price setting firm?
The margin-elasticity rule says that if we can measure the price elasticity of demand, we can measure margins, and therefore the extent of market power.
Why would a firm wish to employ market segmentation?
This way, they can effectively target the segments that are most valuable to their business
What is information rent in a self-selection problem?
To induce high-value consumers to select the high-value product, the firm must leave them some consumer surplus, also known as information rent
What is price fixing? (as an area of antitrust enforcement)
an conspiracy by firms to increase prices
What is the economic definition of the inverse demand curve?
answers the question, "what price will induce each quantity demanded?"
What does |E| > 1 mean in terms of demand?
demand is elastic
What does |E| < 1 mean in terms of demand?
demand is inelastic
What does |E| = 1 mean in terms of demand?
demand is unit elastic
What is abuse of dominant position? (as an area of antitrust enforcement)
includes exclusive dealing, predatory pricing, tying arrangements, etc. in which firms attempt to create and exploit market power
What is merger policy? (as an area of antitrust enforcement)
mergers which substantially increase the firm's concentration of their share of the market
Productive Efficiency
output should be produced in the most efficient way possible (firms should minimize costs)
Price Elasticity of Demand
represents the percent change in quantity demanded in response to a given change in price
Allocative Efficiency
resources should be allocated to their most valuable uses (output should be at the right level)
Dynamic Efficiency
resources should be allocative at the right rates to lead the development and improvement of technology over time
How to calculate Consumer Surplus
the area below the demand curve and above the market price
Marginal costs
the derivative cost with respect to output quantity; MC(q) = Cʼ(q) = VC'(q)
What does Consumer Surplus represent?
the difference between what a consumer pays for a good or service and what they are willing to pay for that good or service
Variable costs
the portion of cost which would be zero if output were zero; for example, hourly wages in the factory
Fixed costs
the portion of the cost that does not depend on the output level; for example, the cost of renting a factory
What is the economic definition of the demand curve?
the quantity demanded of a good as a function of the price of the good, holding everything else constant
Producer Surplus
the total revenue that a producer receives from selling their goods minus the marginal cost of production
What is the goal of price discrimination?
to transfer surplus to firms / producers
Average costs
total costs divided by output quantity
Average variable costs
variable cost divided by output quantity
