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on 29 February 2016

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Industrial Economics 1
Industrial economics Focus
No income effect &
Consumer surplus (CS): the total benefit of value the consumers receive beyond what they pay for the good
Welfare Economics
How the allocation of resources affects economic well being
Individual demand
Consumer behavior
The aim of consumer is to maximize his utility under the BUDGET CONSTRAINT
Short Run
Equilibrium P=mc
Normal Profits
Firms is a price taker
large numbers of buyers
Same goods /homogeneous products)
Perfect information
Budget line
Utility line
x(p,m) = max U (x)
s.t. Px=m
is the max utility achievable at given prices and income is called the indirect UTILITY FUNCTION
Both X1* and X2* depends on the
price and income
P: market prices
m: income level of consumers
Determine the combination of X1* and X2* that max the Utility
Sol. optimal bundle X(p,m)
"Consumers demand function"
Slope of the budget line = MRS
(1st derivative of the indifference curve or utility curve)
Solve the problem of consumers with optimization
Lagrangian method (Dem 1)
Quasi-linear utility function

U(x,y)=U(x) + y
s.t. px+y=m

impact of the change in consumers income don't limit the expenditure of the goods
The substitution effect on the other good is small
x depends only on Price
x: good under examination
y: everything else
Lagrangian method (Dem 2)
dU(x)/dx = U'(x) = P
Optimal Condition
Marginal benefit
Value of goods (mc)
marginal benefit (utility) = mc = P
Marginal effects on a P/Q change

CS is a function of the Price
dV(p)/dP= -q(p)
Producers surplus (PS): the total benefit or revenue that producers receive beyond what it costs to produce a good
All the points on the DEMAND curve represents the combination (q,p) such that consumers max their own utility
All the points on the SUPPLY curve represents the combination (q,p) such that firms max their profit
CS is a function of the Quantity
ds(q)/dq= p(q)
cs= u(x)-px

C'(x)= p mc= p
Perfect competitive Market
For consumers
For firms
Cost function C(x)
Profit Maximizing Solution:
the marginal cost = P
In equilibrium demand=supply
Hence the eq. level of output of the x-good is:
U'(x) =C'(x)
marginal willingness to pay for the x-good
marginal cost of production
Gross surplus
PS (x) =Px-C(x)
Total surplus of welfare
W= CS(x) +PS(x)
The competitive equilibrium level of output max the total surplus
Consumer and producer Surplus
How consumers and producers benefit from participating in the market: max benefits (sellers profit & buyers satisfaction)?
Look at the eq
where the market is more efficient
First theorem
Allocation of resources will be ECONOMICAL EFFICIENT but will give an equitable allocation (socially inefficient)
No reallocation possible to make a person better off without making someone else worse off
Is Pareto optimal
Perfect competition equilibrium
Centralized system
(government set the price)
Second theorem
State make transfers of income
Efficient outcome that maximizes total surplus
The perfect competition is a good solution if all of us have the same income
Reallocation of resources for each individual
Whatever the initial endowments are
Ways to redistributed goods
But this taxes lead to bad incentives
Market Power
Public goods
Incomplete information
Market Failures
Firms with market power are PRICE MAKERS
Less output is sold than in the competitive market
is not only in the hand of sellers but also in the hand of buyers
Demand Substitution:
When consumers decide not to switch to alternative products when price rise
Por más de que hayan diferentes alternativasm estas no son buenos substitutos para los consumiores, Como resultado las grandes empresas tiene gran rentabilidad para poder subir el precio por en cima del mc
Consumers can change to other suppliers of the same product
External cost and benefits which occur during economic activities and are not consider by buyers and sellers involved.
This cost affect third parties
Health care, education
if we leave it to the market mechanism it would be a market failure because they will not reach a op. level of output
Car production, alcohol industry
Light houses, fireworks, traffic lights
Nonrival goods:
Nonexclusive goods:
When one person consumes it, the quantity available for others is not reduced
once the good is provided for one person, anyone can use it, and can not be stop from using it
Free rights of property
everyone want to use the product but will wait until someone pay for it and then could use it for free
Once it get public others can duplicate it!
Asymmetric Knowledge
Exists when there is a lack of symmetry or balance between the knowledge of the buyer and the sellers.
Can change supply:
When a doctor say the patient that he needs lot of medicines when in fact not to much is needed.
Situation in which reallocation of goods is not efficient
How to intervene to solve the Market Failures
Ex ante
Regulation: government set rules that company should follow
Ex post (anti trust)
Interventions that government do if the market by its own doesn't work
Monopoly power
How to measure monopoly power?

is max where MC=MR
By the extent (grado) to which price is greater than the MC
Profits and revenues (Dem 3)
The social Cost of monopoly
DWL decreases
when Ed is large
Firms set the price (Price Maker)
One seller-Many buyers
One product (no substitutes)
Barriers to entry
Since the firm is alone he can fix the price according to its purpose
Maximize Profit at the output level

Pm: Price that can be charged for Qm

G:Optimal output level Qm
The monopolist price Pm is set by the producer who knows that he can raise the price as high as the consumers are willing to pay and since the demand reflects the buyers willingness to pay, after determining Qm we go up to the demand curve to see the P we can charge to Qm
Positive profit when the Pm > AC
Perfect Competition
Lerner's index
P-MC 1
p Ed
0 < L < 1
Ed= -
dQ P
dP Q
Elasticity of the demand
for a firm:

% change of the Q for
any given % change of P
Revenues= P * Q
dR/dQ= dP/dQ*Q + P(Q)

MR= P'(Q)Q+P(Q)
MR= dP/dQ (Q*p/p) +p
MR= p + p (1/Ed) =MC
multiplico y divido por p
Elastic demand
Inelastic demand
L=1, Ed= 0, 1/Ed = inf
High monopoly power
L=0, Ed= inf, P=MC
Low monopoly power
Price is
Price is
Profit margin or
markup P*-MC
in inelastic
demand is higher
Ability to set price higher than the MC
A firm M. power is determined by the firms Ed
Determinants of the power
Elasticity of market demand
Firm's Ed is determined by:
Number of firms in the market (entry barriers, entry deterrence)

Strategic behavior by incumbent (titular)
New technology
Firm's demand curve = Market demand curve
Entry barriers: economies of scale, high start up cost, suck expenditures for consumers and producers
Goverment restrictions on entry: Natural Monopoly, source of revenues, redistribute rents among citizens, IRPs
Aggressive post entry, raising rivals cost, reducing revenues
(switching costs)
Dead weight loss
dP* dQ
Hasberger's loss (Dem4)
Assumption: MC cte
Represents the extra rent that consumers could obtain from the market in a perfect competition scenario.
Durable Goods
1) Set MR=MC=0 and determine 1st period
consumption (Q1 and P1)

2) Determine second period consumption
and price (Qc and Pc)

Natural Monopoly
Government set the price to max Welfare
Goods that can be used more than once or that once they are bought you don't need to buy them again (Smartphones)
Intemporal price discrimination:
P of perfect competition
Consumers whose willingness to pay is high
With an standard good (monopoly) the demand doesn't change, the equilibrium will be repeated each year.
With durable goods demand decrease over the time
Standard good monopoly
P. Competition
Eq. durable goods monopoly
P2 = Pc
Residual demand
(users that have not yet buy the good)
increase profits decreasing price
Coase conjecture: monopoly firms loses its market power (durability and expectations in prices)
Pacman strategy: monopoly firm bite bite as much as possible the consumers surplus
is a Market that require an expensive infrastructure to deliver goods or services, so is more efficient to allow ONLY ONE firm to produce at a lower cost all the output of an industry.
Are common in markets for ‘essential services’: gas, electricity, telecomunication
Demand is rigid (inelastic)
Large economies of scale
fix cost are high
Economies of scale
Economies of scale (Decreasing ATC)
Multiproduct Setting
1. The cost function is subadditive
2. Economies of scope (Umbrella effect)
Use the same network to produce good 1 and 2
c(q1,q2) < c (q1,0) + c(0,q2)
Stand alone cost
We have natural monopoly if and only if:
3. Average incremental cost decrease
AIC = IC(q1,q2) /q1
IC(q1,q2) =c(q1,q2) - c(0,q2)
Incremental Cost
To determine if there is abuse of the market power we must compare the P with the Stand alone cost or with the IC
What is the best price the government may use?
First best P=MC
Second best P=AC
"Perfect competition Price"
Price bellow AC
Firm incur in a loss
Government transfers money to cover the loss
Profits = 0
No Public transfers
= p(q)q - c(q) = 0
a) Single product setting
b) Multi product setting
Ramsey pricing rule
= =
Pi - C'i
1 +
Scaling down effect:
discount the P set by the firm with the factor
C'i: MC
Set P high when d. Inelastic
Set P low when d. Elastic
**Difference between Lerner Index (Max )and Ramsey Index (Max welfare)
Perfect Competition
Cross subsidization
is strategically used as a anti competitive behaviour
Two goods: one BELONG TO the competitive market the other BELONG TO the monopoly market
incumbent set price above cost in the monopolistic setting and reduce price in the competitive one.

How to avoid or detect this behavior?
Look at the IC
and the stand alone cost
at least price should cover the incremental cost
and should be lower than the standard alone cost
test 1
test 2
Rolling Stones vs.
band x
Extract Consumer Surplus
Price discrimination
"Capturing consumers surplus"
transferring it to producers as
Charge different prices to different consumers for SIMILAR gooods (Pigou 1920)
Example: airplane tickets
First degree:

Charge a

separate price

to each consumer

max or reservation price
Company know characteristics of the consumers (WTP)
Start charging a high price P1 while capturing CS then lowering the price until the CS become zero or until P=Pc
Perfect price discrimination
Difference with P. competition: REVENUES with 1stº the firm is able to extract all CS
Its impractical to charge different P to each individual unless there are
few consumers
Until P=MC
Second degree:

Charge a

different per unit price

for different quantities of the
same good

Example: quantity discount 3X1
Divide consumers into 2 or more groups with

separate demand curves

charge different prices
to each group
Elasticity of demand different for the groups (different WTP)
Third degree:
Example: New York Times

Suppose to have G1 & G2
MC is the same
P1 and P2 prices for each group
Dem 12:
C(Qt): Total Cost , Qt= Q1+Q2

Max Profit for the first group (incremental profit =0)
1st Group of consumers
(In equilibrium)
MR1 = MC
Same for 2nd Group
MR2 = MC
With the Combination of the two conclusions we obtain:
What is the MR?
From the "Lerner index" Dem2
The difference between the standard approach and the 3rdº PD is that each group have DIFFERENT ELASTICITIES
Determining the RELATIVE PRICE:
Example: (inelastic demand) high class tickets
Example 2: (elastic demand) Cinema tickets for students
Is discrimination price
(Focus on CS)
Making a comparison between a
multiple situation PD
a single price situation
Varian (1985)
Vector Prices:
suppose to have a uniform price
and discriminated tariff

MC are constant:
Pi - C is always positive as the firm set P above MC to have positive profits
Discrimination is
if and only if:
Necessary Condition
Sufficient condition
Q must increase (Q effect)
Consumers consume more than in the single price situation
profits due to uniform price LARGER THAN profits due to P discrimination
Increase profits
Increase CS
Fix Q at the single P situation (P effect)
To understand if at the end consumers pay more or less
Average MARK-UP decreases
Company knows consumers' WTP (consumer demand)
Company wants to capture as much CS as possible
Company set variable
P* = MC
and Fixed price
Single consumer
** Kind of 1st Price Discrimination
Two-Part tariff
The more I consume the lower per unit price
Charge mechanism where you pay a
fixed fee
and a
variable fee
T = F* + P*
p: per unit price
Example: Amusement Park
where F(entry) P(usage fee)
Two consumers types
Type A:
Type B:
lower demanders
high demanders
Company knows the demand BUT don't know at which group the consumers belong to
There are people with a high WTP than others
Problem that emerge:
Consumer B can mimic low demanders, switching from Tb to Ta (this decision depends on the final benefit)
Is not a good strategy because high demanders will consume less
Option 1:
Sell only bundle A
Solutions to the switching problem
Option 2:
Sell only bundle B
Sell only to high demanders
because they have more WTP
only B will consume and
A will exit the market
because P is to high with respect to their benefit
The company lost profit related to the higher WTP of consumers B
Option 3: Offering B a contract Qb and a total price Tb presenting a
White triangle area
Incentive high demanders to select the high tariff Tb
also known as
CS of B
B's savings
B's info rent
Benefits of using the
Consumer B indifferent

Ta or Tb
because will obtain the same result (White area)
Is there a better form to increase profits?

Reduce Qa
Increase Tb
Asking high demanders to pay more and low demanders to consume less
Up to which point reduce Qa?
When Extra profits (gain due to B) = loss from low demanders
Separate Equilibria
Quantity Discount: How to reduce Qa ? reducing the variable price
Effects of production and consumption activities not directly reflected in the market
The production of goods generates an EXTRA COST to the rest of the society
Example: Plant dumps waste in the river afeting those downstream
The production of goods generates BENEFITS to the rest of the society
Example: MOBILE SERVICES if many people belongs to the same operator the more users can call at lower price (benefit)
Production produce
Marginal External Cost (MEC) :
increase in cost
imposed on users downstream
Network externalities!
Marginal Social Cost (MSC) :

cost for society for producing one unit of the good (account direct cost of production and negative effect that production generates on society.
the only way to reduce waste is
to recude Q
(as in
fixed proportion production
firms cannot alter the inputs)
Using the Eq. in a competitive market:
Appears a wickness of the P. competition Eq
it actually works as if there were no ecternatilies
From a social point of view, the firm produces too much output
Companies in their decision to produce Q dont consider the impact on the emviroment
From the political point of view, the government need to intervene setting TAX=MEC
when the value of a good depends on the number of other people who use it
Utility depends on the q consumed and on the number N of agents in the market
Direct network externalities
when the utility of an agent of type A depends on the
number of agents belonging to the same group
additional agent
that enter the network generates a
postive externality
(positive feedback) to the existing agents since “
” possibilities are enlarged
Metcalfe’s law
Suppose you want to be in touch with others in a room can be n(n-1)= n^2 -n = n^2 potential connections if n-> infinito
The value of goods characterized by interrelations between people depends on the square of the people using that good
Example: Telephone netwrok
In presence of externalities:
if there are
several different providers
of networks, then it is very advantageous to consumers if they
Social interest
What is the added value if the two companies are
if the value of the network increases through interconnection (due to Metcalfe law), then there should be a way to divide that increase in value so to make all participants better off.
benefits for company 1
depends on the
number of users of company 2
Each network gets equal value from interconnecting (applaying Metcalfe's law)
What happens if one network acquires the other (1 acquires 2)?
Network 1 captures twice as much value by buying out network 2 rather than interconnecting with it.
Indirect network externalities
when the utility of an agent belonging to a group A depends on the
number of agents of the group B
and viceversa
Example: all the so called intermediation market
(Evans & Schamalensee, 2006)
Platforms provide participants with the ability to search over participants on the other side and give the opportunity to consummate matches. Ex: Auction houses, Internet sites
Transaction systems:
This kind refers to any recognized method for payment. Management schemes: Proprietary (American Express) or Associative (VISA). Ex: Payment cards, Bank checks
Advertising-Supported Media:
Platforms create or buy from others contents. Contents attract viewers that attract advertisers. Advertisers are the money side. Ex: Print Media, Yellow Pages.
Ex: Magazines, Free television, Newspaper etc.
Software Platforms:
Platforms allow developers to access to the hardware and provide helpful services to create applications. Users run applications. Ex: Video Games, PC, Mobile Telephone
In all the examples, we have a
(physical or virtual)

intermediate between the two groups
of agent.
When we have
several groups of agents
one or more platform
, we say that we face a
two- sided market
Indirect Network externalities
Network externalities : Interconnected network's providers
Characterized by intermediaries
Cross externalities between groups
Business strategy for the platform:
getting both side on board. Only maximizing the number of agent in both side of the market permit to create higher surplus in the market
Pricing issues:
prices are related to: a) relative impact of the positive externality; b) level of price elasticity.
THE MODEL: two side markets
e12: degree of positive externalities that s1 generates on s2
e21: the opposite
P competition
if D(p2) increases (due to a decrease of p2), positive effect also on the market demand 1, raising by e21D(p2)
Benchmark model.
Independent platform
Suppose each market served by one platform
Dem 8
Integrated platform.
Jointly Prices and profits
Only one platform serves all markets
Case I: intermediate level of indirect externalities
The price depend on the different degree of the externalities. The more one side generate positive externalities on one side, the less the side will pay. Example: real state market (if you want to sell an apartment both sides pay)

The curves crosses in point e ( both prices will b positive) both sides pay something
Case II: high externality from 2 to 1 (i.e. e21 > e12)
One side generates much more benefit on the other side than viceversa.
P1 is postive but p2 is negativeso the P will be bellow the MC.
Example: ITunes download for free but you have to pay for songs.
Google, users don't pay, firms pay for Ads
The structure depends on the degree of the externalities . Who pays less is the side that creates more benefits to the other one; who pay more is the side that receives benefits but generates less benefits.
Case III: high externality from 1 to 2 (i.e. e21 < e12)
Increasing the demand of one side, indirectly, increases the demand on the other side
If the cross effects are symmetric (e12 = e21), we obtain:
prices are lower with only one platform: P* < P ind
consumers surplus is higher with only one platform
Profits are higher with only one platform
A simple Model
A simple model (Rohlfs, 1974)
utility function of a consumers of type
: [0, 1]

Fixed P: price to be connected to telecom network
Utility increases if n:[0, 1] increases
Normalized number of users
n:[0, 1]
Per unit benefit: is "per unit" because the TOTAL benefit depends on n
: parameter from 0 to denote the type of consumers
->0 high WTP
->1 low WTP
TOTAL benefit
From the Utility function we can construct the
demand = = q
the consumer indifferent between being connected or not
% of POTENTIAL amount of users WTP the service
is a level of theta such that
Utility goes to 0
(Utility = 0)
In equilibrium:
# potential users = # existing users
A simple model (Rohlfs, 1974)
2 points that crosses Po,
Two equilibria
A: unstable.
B: Stable
The curve (each of its points) represents the
total benefit of consumers
in equilibirum
A: Critical mass
The minimum level of coverage/penetration that a network/technology should reach in order to remain in the market. (Min users needed to have a successful network)
Before A benefit < P consumers do NOT consume
After A benefit >P consumers will continue to consume (never come back to A)
From A to B benefit increase because n increase (benefit > P) consumers continue to consume until they reach B
After B benefit <P consumers consume less (come back to B to be in Eq)
After B also we don't want more users because this could cause congestion
Critical mass
depend on Price
: the lower P the sooner firm achieves A
Relevant concept in high-tech industries: compatible vs. incompatible products
Relevant role of price and its impact on the coverage level
Important factors: switching costs and lock in effect
A new launch emerge the problem related to the adoption of the technology (this is a static model), Reaching the critical mass is a dynamic model
The critical mass strongly depends on price. the faster way to reach the critical mass is to give the technology for free, but at the beginning the cost of developing are high. There is a trade off between covering the investments and spread technology
Switching cost are cost on consumers side. They make demand less sensitive because putting these costs make consumers less willing to switch from a technology to another one the consumers become captive/captured consumers.
The lower is P the sooner firm reach A
Lock-in means that a particular technology or product is dominant, not because its inherent cost is low or performance is good, but because it enjoys the benefits of increasing returns to scale.
Compatible Technoloies: Mac and HP
Market analysis in presence of network externalities
Government optimal decision
is to reach the
social optimal equilibrium
The government should provide the service to the society up to the point in which the costs are equal to the benefit of the society
represents q
W= Gross Surplus - P * Q(P) + P * Q(P)- C(Q) W= Grosss surplus - C(Q)
CS is a function of the Price
dV(P)/dP= -Q(P)
CS is a function of the Quantity
dS(Q)/dQ= P(Q)
cs= U(Q)-PQ
Gross surplus
PS (Q) =PQ-C(Q)
social point of view
, the
optimal coverage
is the
level that maximizes welfare
, given by the sum of consumer net surplus and firm’s profit
Gross surplus is equal to the integral of the demand between 0 and theta(gorro). At the Equilibirum theta(gorro) = n
Gross surplus= Demand
Gross surplus= P (Q)
Dem 6
Best solution: Government has to provide the service to the entire society
= 1
Corner solution
If the function is increasing
a 100% coverage should be reached if
MC < 0,5
Different types of markets: Monopoly & Perfect Competition
Should a private firm choose to cover all the market?
If we have
PERFECT competition
in presence of a market or a good characterized by
, the market will never work,

the MC =0, the solution will be different from the optimal social solution, EVEN IF e have positive externalities.
The monopoly wants to maximize profits
Dem 7

provide less
than the
social optimal solution theta(gorro)=1
also with network externalities. If there are not externalities (n: the effect of the number of users disappear) Utility = 1-theta(gorro). The coverage theta(gorro)= 1/2 < 2/3 less than the coverage with Network Externality
The presence of positive externalitites provides a solution closer to the social optimal solution because the monopolistic company will provide more coverage in order to max profits
When MC=0
A general mode: Rochet and Tirole
What matters is the
level of network
externalities among groups
Pc: price that the platform sets for the users
Pm: price set for the merchants
P= Pc+Pm
Q= Dm(Pm) * Dc(Pc)

The quantity is the product between the totl demand on side Dm(Pm) per total demand on the other one Dc(Pc)
A platform maximizes:
Profit = P*Q - C*Q
= (P-C)*Q
=(Pc+Pm-C)* Dm(Pm)*Dc(Pc)
Dem 9
The prices
in two sided markets
depends on
and also on the
elasticity of the demand
Shows the
relevance on externalities
The less elastic demand will pay more, the lower cost perceived in the other side.
Two sided markets
Lerner index
one price
depends on
elasticity of the demand
Shows the
relevance on elasticity
The less elastic the demand curve the higher is the price set by the monopoly.
Application in the two sided theory
ex: american express
ex: Master Card or visa
is a system in which cardholders and merchants are attracted DIRECTLY by the platform
central decision

made by
the card scheme
(american express)
how much to charge cardholders
how much to charge merchants.
1. Platform ask
the price
g + Pb
( fee for having the credit card is a fixed amount)
2. the platform gives the money to the

g - Ps
(discount merchants pay for having the platform is a per unit cost)

card schemes charge less to cardholders and more to merchants
, there will be:
- Decrease the price for card holders
- increase the number of card holders and of card usage
- Fewer merchants willing to accept cards

At first they were competitors now
Visa and Mastercard join
(it is and association of banks).
A card association faces the same problem as a proprietary scheme of
achieving the right balance
cardholder and merchant fees
Card associations
differ from
proprietary schemes
they do not set these fees directly
The members of a card association set the fees: banks and other financial institutions deal directly with
cardholders (issuers)
and with
merchants (acquirers)
The system (VISA) sets a
interchange fee
(a fee paid from the merchants bank - Acquirer to the users bank (issuer). It's an amount of money that is exchange for every transaction.
1. Issuer ask
the price
g + Pb
( monthly fixed fee set by the issuer ) and keeps Pb
2. VISA (system operator) sets a price
(interchange fee a)
between the two banks
3. Issuer pay acquiere
4. Acquirer takes g-a and pays the

g - Ps
(discount on unit base merchants pay, set by the acquirer bank)

of the system operator
(VISA) is:
to maximize the number of transactions by monitoring the # of transactions
balance the payments among banks
in "
a > MC
" will lead to an
acquirers costs
for every card transaction they process. Acquirers will therefore respond to an
increase in Ps
(merchant fees).
For issuers "
is a rebate obtained for providing their services to cardholders (a payment that they receive). Issuers will therefore respond to an
decrease on Pb
(cardholders fees).
No surcharge rule: fees charged to merchants are not passed o by merchants to their consumers
Exception: ticket flight
For any given level of production, the marginal cost of providing it to an additional consumer is zero
Goods that people cannot be excluded from consuming
Efficient level of private good is where marginal benefit = marginal cost
For a public good, the value of each person must be considered and can add demand of all those who value good.
Allocation mechanism: see slides by Prof. Buzzacchi (later on)
Free Riders
There is no way to provide some goods and services without benefiting everyone
Free riders understate the value of a good or service so that they can enjoy its benefit without paying for it
Private Preferences
Government production of a public good is advantageous because the government can assess taxes or fees to pay for it
Is difficult to access the value of this goods because we have the attitudes of
free riding behaviour
Dem 10
Consumer A (low demander) : L
Consumer B (high demander) : H
Optimal non linear tariff: Analytic second P. discrimination OPTION 3
Share of people of tariff A and B
SH'(q): WTP high demanders
SH(q)=gross surplus
SH'(q)= ds(q)/dq=p(q)
Cost function: C(q)
1. incentive compatible
to H
Consumers type L will continue to consume if their
benefit is at least zero
(no negative)
The firm should determine a condition in which
consumer H are indifferent
consuming Qh or QL
2. Participation of L
If firm the wants
L in the market
can charge more than their benefit
otal benefits consumer H can obtain by consuming qH and paying Th
equal or larger
than consuming qL and paying TL
Instead of MAXIMIZING the conditions we use
equality condition
solve for each constraint Th and TL and replace in the REVENUES function
We obtain
1. Distortion on consumer L that depends on the difference of the derivative of gross surplus
2. The white are depends on the variation of Qa = QL
Regulated optimal non linear tariff
Start from the welfare analysis
W= CS + PS
W= GS-P(Q)*Q + P(Q)*Q-C
W(q)=Gross Surplus-C(Q)
Regulated tariff :
the objective function (max profit) change to the
welfare function
government sets the price
Constraint: Profit >=0
We obtain: PH= MC &
1. The price for H remains the same (no distortion)
2. PL above the MC for low demanders
3. PL set by the government is lower (because the scaling down effect)
Similar to Ramsey Price
max W=S(p) + profit
s.t positive profit
Packing two or more products to gain a pricing advantage
example: cable TV and office pack
Conditions necessary for bundling:
Heterogeneous customers (distintos intereses)
Price discrimination is not possible (Same prices)
Demands must be negatively correlated (preference in one good rather than another)
Two different good and many consumers with different WTP (reservation price)
Graph showing the preferences of consumers in terms of WTP and consumption decisions given prices charged
r1 is reservation price of consumer for good 1
r2 is reservation price of consumer for good 2
max amount of price that consumers are willing to pay for buying the good
Consumers fall into four categories based on their reservation price:
Consumers buy the bundle when r1 +r2 >PB
(PB = bundle price)
PB =r1 +r2 or r2 =PB -r1 Region 1: r > PB
Region 2: r < PB
1. Consumers decision when products are sold separately
2. Consumers decision when products are Bundled
effectiveness of bundling
depends upon the
degree of negative correlation

between the two demands
Best when consumers who have high reservation price for Good 1 have a low reservation price for Good 2 and vice versa
Negative correlation
Use of bundling
Mixed Bundling
Practice of selling two or more goods both as a package and individually
Mixed bundling is good strategy when
1. Demands are somewhat negatively correlated
2. Marginal production costs are significant

pure bundling
when products are sold
as a package
Example: Car purchasing you buy the car and also special service
insurance, special wheels
The practice of requiring a customer to purchase one good in order to purchase another
Microsoft for Windows
Xerox machines and the paper
Put in the machine an specific technology to force the use of a specific paper (expensive) produced by them - Antitrust
Differ from bundling
because is NOT a package of services
Allows firm to
meter demand
practice price discrimination
more effectively
New role of the

No longer direct producer of services
Define the rules of the whole sector.
Act as a SUPERVISOR (new governmental body called
Best drive to increase efficiency is to
privatize the company
, HOW?
introduce competition
Legalization Aspects:
1. Competition in the market
, when technology permits the presence of more than one firms
2. Competition for the market
auction mechanism
), when competition in the market is not (legally or technological) feasible but the market is contestable
First is was the NATURAL MONOPOLY when we have only one company with the technology infrastructure
Auction mechanism:
introduce competition ex-ante
for becoming the future monopoly provider, to become in it
companies should compete between them
Strategy to introduce competition
Example: GTT consession
IRA (in the EU)
The price we pay is not decided by the goverment is decided by a public body linked to the
delegated regulatory task to:
Independent regulatory agency
Main purpose
is to
avoid conflicts of interest
and (partially)
state controlled utilities

IRAs are not part of State Dept or Ministries
IRAs have financial independence, specialized staff and specific tasks (They set prices, define entry conditions, quality standards and access rules)
New role of state
Conduct Regulation
1st Price: Rate of return Regulation
Privatization Reform
Competition Policy
2nd Price: Price cap regulation
1. Regulator define a fix
to the
ROR on investments
In a monoproduct setting:
R: total reveneus
k: capital factor
L: labour factor
w: unit cost of input factors
wL: cost of labour
R-WL = operating profits, net profits or gross margin
(money the company uses to cover investments, can e used to pay shareholders or to internal growth opportunities)
ROR has a
the government say do whatever you want BUT you can not earn more than Rho= 10%
Regulator sets
Total Revenues
of the firm (TR)
p*K : how much money can collect as the return of the investments or total expenditures
VC : variable costs
Hearing process
: when the ex post ROR > Rho regulator reduces prices; ROR < Rho regulator increases prices
Start form Cost
Start form Price
1. Regulator define for a
certain period of time
to the
growth of price(s)
of a
set of goods
(single or weighted average)
In a multiproduct setting:
New price = previous price updated with inflation
inflation rate (retail price index)
(estimated) growth in productivity (reduction that regulator want to pass to consumers)
Previous price on an average of the several goods
2. Regulator sets the
time period
in which the constraint is valid (
regulatory lag
Example: In Italy it lasts (almost) three years

X = 5% -> company have to reduce the cost bellow 5%
RPI= 2%
P=(1+2%-5%)Pt-1=97% of Pt-1
If X>RPI price decreases
(P will be cut down by a certain % discount that regulator impose)
If RPI decreases
Pt decreases
Rate of return regulation
Incentive to over invest
(inefficiently- high VC)
(Averch – Johnson effect)
if Rho >r
No incentive to reduce cost (no productive
cost plus mechanism
if the company invest more - someone else will pay, WHO? Consumers)
Risk of accounting manipulation
No option to gain extra profits
(Rho is fix)
Information demanded method and so high administrative costs
Averch - Jhonson effect: Rho>r
investments assets > investments stock exchange market
with this situation you will decide to over invest in the company
Financial integrity of regulated firm is always guaranteed
Monitoring of profits:
Profitability of the company is fixed
From the financial point of view is riskless
(no matter the amount invested is ALWAYS RECOVERED)
Fixed Return
No incentive to reduce service quality
Price cap
Incentive to reduce costs, especially
quality expenditure
If X is set too high
, regulated firm faces the
risk to go bankrupt
. (Is riskier from the financial point of view)
Risk on cost fluctuations
is completely in charge of the firm
Incentive is related to how long is the regulatory lag
: if it is too short no incentives to cut cost
It induces firms to
reduce their operative costs > X%
(increase in productive efficiency)
Regulated firms freely set their prices.
Thus, regulator delegates to regulated firms to
set every single services’ price
. (given an average level)
Less administrative burdens on regulator almost at first sight
Profitability increases but is unstable
incentive to invest in
cost reducing activities and increase productivity
Higher profitability higher risk
Types of investments
1. Supply side: Machines, land, automation (investments that increase productivity also increase cost)
2. Demand side: RND (research and development), capacity, innovations, new product
(high risk of the investments, the expected return is lower)

Given the
general rule
, the regulated firm is
free to set single prices

with respect
only to the
imposed constraint X on their average level of goods
How firm can set the Single price based on the average price of multiple products?
A regulated multiproduct company subjected to a price cap will set its own (single prices) as following:
In a multiproduct setting:
Vector of prices
vector of quantities
weight for product i

Weighted average prices <= fixed cap
Lagrange L= TT (q(Pi) + M [ Wi*Pi - Pcap ]
Price set by company = Ramsey Price under two conditions
a) wi = qi
b) Miu= 1/(1+ Lambda)
Convergence to Ramsey Prices (2nd Best solution)
Empirical evidence on Price Caps
Mathios and Rogers (1989)
examined AT&T’s long-distance prices and found that most
prices were significantly lower
in states that allowed pricing flexibility
(Price cap)
than in states that used rate-of-return regulation.
Alexander et al. (1996)
examine the evidence on the cost of capital for regulated industries and find that, as expected, firms facing incentive regulation
(Price cap)

higher systematic risk
than firms subject to rate-of-return regulation.
Resende (2000)
finds that incentive regulation
(Price cap)
(including PC) is associated with
greater productive efficiency
than rate-of- return regulation.
PC (Sappington, 2003): Telecommunications Industry US
Incentive to renew some type of equipments (digital commutator, digital transmission) but not to increase aggregate investment
Incentive to increase total factor productivity
Decrease in retail prices
Increase in net profits, evidence for reductions in operative costs
No clear incentive to reduce services’ quality
Energy sector
Incentive regulation increases productivity and service quality in UK electric regional distribution
Quality impact is ambiguous
Incentive regulation increases labour productivity in electric distribution in developing countries
Incentive regulation increases firms’ investments, but only in cost- reducing activities
An Application on Electricity Industry
how incentive regulation in electricity distribution should evolve?
rapid change in generation capacity
massive adoption of renewable resources (non fossil fuels - unstable)
Now is more Bidirectional, consumers become producers of energy (example: google)
Smart grid project:
launch of technological innovation (new investments on innovation
Actual problems
Price caps

almost exclusively
the use of
– operational and capital expenditures.
Need of incentives
focus on outputs
measures of companies’ performance – measures of network reliability,
environmental impact
, customer satisfaction,
ability to meet social obligations
New Incentives Scheme for Innovation & Investment
the Revenue, Innovation, Incentives and Output (RIIO) model adpted by
priority legislation (in Europe) incentive: all the energy produce trough renewable resources will be sold in the system as the first source
Revenue adjustment during period (8 year control P)
1. Price cap (period min of 3 years) NOW regulator set the price for the next 8 years (longer lend, higher
efficiency incentives
, higher revenues, and
output incentives
uncertainty mechanism
(investment innovation is risky) how to avoid the risk? reducing uncertainty
providing extra return if you invest in innovation (aloud recovering all the investment)
Elements outside the price control
innovation stimulus package
(take the extra profits to new innovation —> smart grid) only the investments that stimulate innovation are accepted

Market testing in assessing business plans:
the regulator check the investments and adjust them over the time. Test if the market is able to support the high prices
Transfer of ownership or voting rights in a State-owned enterprise from the state to the private company
The private sector comprises private individuals and economic entities with private shareholders
1961: Fisrt privatization was done in Germany
Global privatization: Dow Jones
1. Monopoly firms where privatize attacking a lot of investors because they know it was profitable
2. Provide a lot of info to the market why? every body may know the status of the company so the company become contestable
3. More Liquidity in the market (a lot of negotiations): speculative, to have market control
When the company is privatize the government divide the company in 100 shares and sell then in the stock market, this increase in demand of shares (1000 investors), but supply stays the same (100 shares) so the price goes up, as the Demand > Supply. consequently the value of the company increases.
Why its important to have a lot of companies in the stock exchange market?
Which kind of firm the government privatize?
Telecoms, transport, finance, agriculture, utilities (gas, electricity)
energy (petrolium)
Empirical Evidences:
The Effect of Privatization
Why have governments embraced privatization?

To reduce national budget deficits and the stock of public debt. The need to cover the public debt (the only way is to sell the companies)
To foster national markets development (increase the growth of the country)
To improve economic efficiency
Megginson and Netter (2001)
what about efficiency?
privatization links to high efficiency but it doesn’t mean lower price
SOEs (state-owned enterprises) are more allocative efficient (best allocation of resources for the society (
p near to MC
state own companies whose set P = MC normal profits, less productive efficient, the cost would be higher
POEs (private-owned enterprises) are more productive efficient (min costs), if they are properly regulated,
Price much higher than the MC
the private company have the incentive to min cost and be more productive efficient (higher Q at lower P)
Privatizations have stimulated the development of institutions that improve market operations
How do countries privatize?
Types of privatization
Privatization through restitution
(of property previously expropriated)
Restitution of a good to the market (not very used)
Privatization through sale of state property
(mostly used)
Direct sales
(assets sales) to an individual, an existing corporation, or to a group of investors.
The government select who would be the owner
Share issue privatization
(SIPs), through a public share offering. T
ake a lot of shares and put them into the market, the market decide the owner
Mass or voucher privatization
(vouchers distributed free or at nominal cost to bid for stakes in SOEs)
Actual Privatization of RUSIA
Privatization through
contracting out production
of public services to private firms

** Golden share: when a the government takes a group of companies and sale them directly to the new owner
**The economist
What’s the impact of ownership on firm value?
Governments are “bad owners”: they typically impose political objectives that destroy firm value
Governments are also “bad regulators” as their interference leads to time-inconsistent regulatory decisions
Partial, not full, privatization boosts economic and financial performance (Gupta, 2005)
Fully privatized firms are typically less valuable than state- controlled firms (Bortolotti and Faccio, 2009) and require a premium to compensate political risk
Why partial ownerships?

Residual state ownership may reassure investors that politicians will not behave so as to reduce the value of partially privatized company
The OECD database
international evaluation that US does
Four indicators for regulation:
the overall indicator including all regulation dimensions
2. BEVI:
barriers to entry
all regulation dimensions except public ownership
separate public ownership because of different investment choices.

Score a based on:
Entry on Barriers, Public Ownership, Market share of dominant players
BEVI the highest is the number of the indicator:
the closed is the system (high entry barriers difficult to entry)
the less liberalized the company
low competition
Empirical assessments:
Significant negative effect of regulation on investment
Privatization (REGPO) has a positive effect on investment if coupled with reduction in barriers to entry, privatization can overcome the reduction in investment due to the change in managerial incentives
REGOL index
Coefficient that correlates the
investments rates
of the countries with the
index of regulation
of the country

the lowest is the index the highest is the investments (viceversa)
In countries where the market is more open, m
ore competitive
less barriers to enter
lower market shares
investments increase
more liberalize
liberalization (open the market, reduce barriers to entry)
have a much huge effect of private Investments
than privatization of companies
The ranking that the study concludes is:
1st. use liberalization
2nd. use privatization
Dem 11
Dem 13
stock exchange index of industrial sectors (New York)
There is a positive correlation between the index and the privatization (the higher is the index the higher is the privatization)
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