Economic

Policy

Alessandro
Fedele

Introduction

Basic Economics
Denitions
Free University of Bozen/Bolzano
Perfect
Competition

Monopoly
Bachelor in Economics and Management
Economic Policy
Lecture 1: Introduction and Allocative E ciency

Alessandro Fedele

2016 March 8th

 Economic
Policy

Alessandro
Fedele Intro - 1
Introduction

Basic Economics
Denitions

Perfect
Competition

Monopoly

Feedback on this course from last year students:

1 Overlapping with Economia Industriale

2 Better explain the exam procedure
3 More mathematical proofs/exercises on the blackboard
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Policy

Alessandro
Fedele Intro - 2
Introduction

Basic Economics
Denitions This is an applied theory course: utility?
Perfect
Competition
What do Bachelor in E&M unibz students choose to do (one
Monopoly
year) after the Bachelor?
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Policy

Alessandro
Fedele Intro - 3
Introduction

Basic Economics
Denitions

Perfect
Competition
Theory is necessary to understand and develop reliable
Monopoly
ideas/opinions in economics
Theory is crucial to be able to succeed in a Master program in
Economics and related topics
Above evidence on studentsstatus after the BA suggests that
applied theory courses are useful
What is the dierence between the job of a university lecturer
and that of a high-school lecturer?
This course is based both on books and my research
This is what I do: http://pro.unibz.it/sta/afedele/
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Alessandro
Fedele General Info - 1
Introduction

Basic Economics
Denitions

Perfect
Competition

Monopoly
This course is divided into four main parts
1. Introduction and Allocative E ciency,
bibliography: lectures notes PLUS Motta,
Competition Policy: Theory and Practice. Cambridge
University Press
2. Competition Policy (or Antitrust Policy): Motta,
Competition Policy: Theory and Practice. Cambridge
University Press, PLUS lectures notes
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Alessandro
Fedele General Info - 2
Introduction

Basic Economics
Denitions

Perfect
Competition
3. Asymmetric information and Microcredit: Macho
Monopoly
Stadler-Perez Castrillo, An Introduction to the
Economics of Information: Incentives and Contracts,
Oxford University Press; Armendriz de
Aghion-Morduch, The Economics of Micronance,
MIT Press (link:
http://www.fgda.org/dati/ContentManager/les/Documenti_micronanza/Economics-of-

Micronance.pdf ), PLUS lectures

notes
4. Macroeconomic Policies and (Un)employment:
lectures notes
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Alessandro
Fedele General Info - 3
Introduction Let us have a look at some past exams:
Basic Economics http://pro.unibz.it/rc/index.asp?LanguageID=EN
Denitions

Perfect You might get a bonus provided that you interact during
Competition
lectures: up to 3 points of the nal mark
Monopoly
Final grade: exam (scheduled on May 18th) + "up to 3 points"
Important: this bonus applies only to the rst exam you enrol
for
Teaching method
1 in each lecture (1h30 on average without break): theory, data,
real-world examples, exercises, discussion; slide of each lecture
uploaded before the lecture
2 "interruption principle": do not hesitate to raise your hand for
any doubt; interactive lectures increase lecturers and students
ability to understand
3 "exclusivity principle": please do not talk while Im speaking
and viceversa; chaotic lectures decrease the overall ability to
understand
How to succeed in the exam? Come to class prepared!
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Alessandro
Fedele Basic Denitions
Introduction

Basic Economics
Denitions

Perfect
Competition

Monopoly

Economics is divided into

1 micro and macroeconomics: investigate the functioning of

economies (positive approach);
2 economic policy: investigates how such a functioning can be
aected in order to overcome problems (normative approach)
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Alessandro
Fedele Normative vs positive theories
Introduction

Basic Economics
Denitions
Positive economic theories seek to explain the observed
Perfect
Competition economic phenomena: subject of microeconomics and
Monopoly macroeconomics courses

Normative economic theories focus on what must be done to

overcome problems: economic policy
Economic policy: interventions into the economy on
the part of public authorities (Government, Central bank)
and on the part of private entities (rms, households) to
reach predetermined goals

Which goals? Most important: allocative e ciency that is

strictly related to the notion of perfect competition
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Alessandro
Fedele Free Market Economy - 1
Introduction

Basic Economics
Denitions

Perfect
Competition
Adam Smith, classical economics (1776): invisible hand of the
Monopoly
(perfectly) competitive market
A market in some particular good or service is a (perfectly)
competitive market if

1 There are many sellers and many buyers

2 All sellers sell an identical product
3 All sellers are price-takers
4 All sellers have a relatively small market share
5 The industry is characterized by freedom of entry and exit
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Alessandro
Fedele Free Market Economy - 2
Introduction

Basic Economics Do competitive markets exist in the real world?

Denitions

Perfect
Example: vegetable and fruit sellers in India
Competition

Monopoly
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Alessandro
Fedele Free Market Economy - 3
Introduction

Basic Economics
Denitions

Perfect There are very few examples of competitive markets: why do we

Competition

Monopoly
care about them?
Important result of modern economic theory
First Welfare Theorem: an allocation achieved by a
competitive market economy is Pareto-e cient

Allocation: specic combination of goods in possession of

economic agents
Pareto-e cient allocation: An allocation of goods is said to
be Pareto E cient if we cannot nd a reallocation of those
goods such that we can produce more of something (utility or
output) without producing less of something else
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Alessandro
Fedele Allocative E ciency: a primer
Introduction

Basic Economics
Denitions

Perfect
Competition

Monopoly
More precisely: What do we mean by allocative e ciency?
Suppose someone produces a good. The production cost is 3e
Suppose someone else wants to buy such a good and that the
maximum amount is willing to spend is 4e
Since 4e> 3e there is gain from trade
The dierence 4e> 3e= 1e is the total surplus from trade
A market is said to be allocative e cient if it always enables
trade between buyers and sellers in presence of gains from trade
We need economic policy because...
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Alessandro
Fedele Market Failures
Introduction

Basic Economics
Denitions
...the First Welfare theorem result is not robust for many
Perfect reasons, called market failures, that deviate an actual market
Competition
allocation from an allocative e cient allocation
Monopoly
Market failures are due to

1 Monopolistic and oligopolistic markets: topic of this course

(second part, Antitrust)
2 Asymmetric Information: topic of this course (third part)
3 Involuntary unemployment: topic of this course (fourth part)
4 Public Goods (= non-rival and non-excludable goods)
5 Externalities (= when an agents consumption or production
decision changes the production or consumption possibilities of
other agents): studentsactive participation in class is an
example of positive externality according to the abovementioned
interruption principle
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Alessandro
Fedele Perfect Competition - 1
Introduction

Basic Economics
Denitions

Perfect Let us investigate why a (perfectly) competitive market allocates

Competition
resources e ciently
Monopoly
We rely on a theoretical/mathematical example to compare a
competitive market to a monopolistic market in terms of
allocative e ciency: see also Motta, ch. 2.2
Competitive market: many buyers and many rms ! rms are
price takers; identical good
n = 100 small rms
endowed with the same cost function (=identical rms),
C (q ) = 100q 2 , q quantity produced by each rm
Market demand (= demand of all buyers in the market)
Q = 40 p, p price
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Alessandro
Fedele Perfect Competition - 2
Introduction

Basic Economics
Denitions

Perfect
Competition Marginal cost MC of each rm: how the cost changes when the
Monopoly level of production changes

C (q )
MC = = 200q
q
Supply of each rm: quantity q that maximizes prots given p
Prot : revenue - costs

= pq C (q ) = pq 100q 2

p does not depend on q: each rm cannot aect the market

price, rms are price-taker!
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Alessandro
Fedele Perfect Competition - 3
Introduction

Basic Economics
Denitions

Perfect
Competition Each rm aims at maximizing its prots!
Monopoly To nd the maximum point, if any, of a function, prot in our
example, of one real variable, q in our example, one must
compute the rst derivative and set it equal to zero: First Order
Condition (FOC) (there is also a Second Order Condition, but
here we can forget about it)
FOC:
q = 0,
p 200q = 0
Note that the price is equal to the marginal cost:

p = MC (= 200q )
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Alessandro
Fedele Perfect Competition - 4
Introduction

Basic Economics
Denitions

Perfect
Competition

Monopoly Alternative strategy to maximize prots: marginal revenue =

marginal cost
Marginal revenue MR: how revenue changes when the level of
production changes

(pq )
MR = =p
q
p does not depend on q!
MR = MC ) p = 200q: same solution as above!
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Alessandro
Fedele Perfect Competition - 5
Introduction

Basic Economics
Denitions

Perfect
Competition Solving p = 200q by q
Monopoly
p
q= :
200
this is the supply of each rm!
What about market supply?
There are 100 small identical rms: Market supply =
100 (supply of each rm)
p p
Q = 100 )Q=
200 2
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Alessandro
Fedele Perfect Competition - 6
Introduction

Basic Economics
Denitions Equilibrium price and quantity ?
Perfect
Competition
Such that market supply = market demand
Monopoly
Q = p2
Q = 40 p
p
2= 40 p ) pc = 80 3 : this is the market equilibrium price
Market equilibrium quantity is instead

p 40
Qc = c = 40 pc =
2 3
Quantity supplied by each rm at equilibrium:

Qc 2
qc = =
100 15
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Alessandro
Fedele Perfect Competition - 7
Introduction

Basic Economics
Denitions

Perfect
Competition
MC of each rm when it produces the equilibrium quantity,
Monopoly
2 , is equal to the equilibrium price:
qc = 15

2 80
MC = 200 = = pc !
15 3

Result 1 In perfectly competitive markets the actual

quantity produced is such that the marginal cost equals the
price
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Alessandro
Fedele Perfect Competition - 8
Introduction

Basic Economics
Denitions In Figure 2: we depict inverse (= p as a function of Q rather
Perfect than Q as a function of p) demand and supply curves
Competition

Monopoly As we will see shortly, inverse functions are useful to illustrate

why a perfectly competitive market allocates resources e ciently
p = 40 Q (inverse demand)
p = 2Q (inverse supply)
! market equilibrium quantity and price, point
Ec = Qc = 40 80
3 , pc = 3 , are as above!
Proof:
p = 2Q
p = 40 Q
2Q = 40 Q ) Qc = 40
3 : market equilibrium quantity
pc = 2Qc = 40 Qc = 803 : market equilibrium price
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Alessandro
Fedele Monopoly - 1
Introduction A market in some particular good or service is a monopoly
Basic Economics market if a substantial number of buyers versus just one seller
Denitions

Perfect
trade in the good or service
Competition Monopoly market: one rm ! price-maker
Monopoly
Real-world example of (quasi-)monopoly: market for desktop
search engine
Market shares in Europe (May, 2015):
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Alessandro
Fedele Monopoly - 2
Introduction
Suppose the demand function is as above,
Basic Economics
Denitions

Perfect Q = 40 p
Competition

Monopoly
Inverse demand
p (Q ) = 40 Q
The monopolist has the following cost function: C (Q ) = Q 2
Marginal cost MC of the monopolist: how the cost changes
when the level of production changes

C (Q )
MC = = 2Q
Q
Note that the monopolists marginal cost curve coincides with
the inverse market supply curve in perfect competition: this
makes the two dierent market environments comparable in our
theoretical/mathematical example
Yet...
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Alessandro
Fedele Monopoly - 3
Introduction

Basic Economics
Denitions

Perfect
Competition
... the monopolists marginal cost curve is not a supply function,
Monopoly
because it does not derive from a prot maximization strategy of
the rm
More precisely: a supply function takes price as the independent
variable ! rms are price-taker; this is not the case with
monopoly, where the only rm is price-maker

Rather, it simply describes the cost incurred by the monopolist

when producing an additional (small) unit of the good for any
level of production Q
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Alessandro
Fedele Monopoly - 4
Introduction

Basic Economics
Denitions Monopolists prot : revenue - cost
Perfect

= p (Q ) Q Q2
Competition
C (Q ) = (40 Q) Q
Monopoly

Attention! p depends on Q in the monopolists prot function -

p (Q ) = 40 Q - because the monopolist is price-maker
FOC:
Q =0

40Q 2Q 2
= 0 ) 40 4Q = 0
Q
) Qm = 10

Attention! Qm = 10 is a number! It does not depend on p!

Accordingly, it is not a supply function but simply the
monopolists supply
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Alessandro
Fedele Monopoly - 5
Introduction

Basic Economics
Denitions

Perfect
Competition
Equilibrium price
Monopoly
pm = 40 10 = 30
Alternative method to maximize prots: marginal revenue =
marginal cost
Marginal revenue MR: how the revenue changes when the level
of production changes

[(40 Q) Q]
MR = = 40 2Q
Q
We let MR = MC and get 40 2Q = 2Q ) Qm = 10
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Alessandro
Fedele Monopoly - 6
Introduction Monopoly
Basic Economics
Denitions Figure 1
Perfect
Competition p
Monopoly
Monopoly Equilibrium in Em : Q=10 and P=30

Monopoly Marginal Cost and Competitve Supply

2Q
40

Em
30 Demand
p=40-Q
20

Marginal revenue
p=40-2Q

10 20 40 Q
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Alessandro
Fedele Monopoly - 7
Introduction

Basic Economics
Denitions Optimal (= that maximizes prots) level of production is such
Perfect that marginal revenue = marginal cost
Competition

Monopoly but under monopoly marginal revenue is less than price:

MR = 40 2Q < p = 40 Q
This is why the equilibrium price is larger than the marginal cost:

pm > MC

Result 2 In monopoly settings the actual quantity

produced is such that the marginal cost is lower than the
price

Recall Result 1: in perfectly competitive markets the actual

quantity produced is such that the marginal cost is equal to the
price ! pc = MC
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Alessandro
Fedele Surplus loss - 1
Introduction

Basic Economics
Denitions

Perfect
Competition

Monopoly
Eect? There is a total surplus (Consumerssurplus +
Producers surplus) loss when moving from perfect competition
towards monopoly: area B + C in Figure 2
Consumerssurplus: area within the demand curve and the
horizontal line denoting price
Producers(or monopolist) surplus: area within the horizontal
line denoting price and the supply curve (or marginal cost curve)
What is B + C?
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Alessandro
Fedele Surplus loss - 2
Introduction
Monopoly versus perfect competition
Basic Economics
Denitions

Perfect Figure 2
Competition

Monopoly p

MonopolyMarginal Cost Surplus loss: area B+C

and Competitve Supply
2Q

B
Em
30 Demand
80/3 Ec
C p=40-Q

Marginal revenue
p=40-2Q

10 40/3 40 Q
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Alessandro
Fedele Surplus loss - 3
Introduction

Basic Economics
Denitions
To understand the notion of total surplus loss:
Perfect
Competition Inverse market demand, p = 40 Q, tells the maximum price
Monopoly
consumers are willing to pay for any quantity Q of the good,
i.e., their evaluation of any quantity of the good
This evaluation is decreasing in the quantity - demand is
downward-sloping! - because marginal utility is decreasing in the
quantity

Under monopoly Qm = 10, hence p = 40 10 = 30: 30 is the

value that consumers assign to quantity Qm = 10
Under perfect competition the equilibrium quantity is higher,
Qc = 40/3, and its evaluation by consumers is
p = 40 40/3 = 80/3
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Alessandro
Fedele Surplus loss - 4
Introduction

Basic Economics
Denitions

Perfect
Competition

Monopoly
Under monopoly the marginal cost of producing the last unit of
the good is MC = 2Qm = 2 10 = 20 lower than the maximum
price, 30, that consumers are willing to pay (see Result 2)

Under perfect competition the marginal cost of producing the

last unit of the good is MC = 2Qc = 80/3 exactly equal to the
maximum price that consumers are willing to pay (see Result 1)
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Alessandro
Fedele Surplus loss - 5
Introduction

Basic Economics
Denitions
It follows that:
Perfect
Competition According to the allocative e ciency principle the production
Monopoly
should be up to Qc because of the existence of gains from trade
between Qm and Qc :
the costs incurred by rms to produce the units of the good
between Qm and Qc are lower than such unitsevaluation by
consumers

Qc is the production level such that "its production cost" is

exactly equal to "its value"
in this respect the production level (hence the resource
allocation) is e cient under perfect competition ! total
surplus is maximum