1. ECONOMICS FOR BUSINESS (MICROECONOMICS) Lesson 5
Prof. Paolo Buccirossi

2. Table of Contents Auctions Causes of market power Regulatory barriers
Cost advantagases
Network externalities
Innovation and product differentiation

3. Auctions Auction Games Real Scenarios for Auction Games
Auction: a sale in which a good or service is sold to the highest bidder.
In auction games, players called bidders devise bidding strategies without knowing other players’ payoff functions.
A bidder needs to know the rules of the game: the number of units being sold, the format of the bidding, and the value that potential bidders place on the good.
Real Scenarios for Auction Games
Government related games: Government procurement auctions; auctions for electricity and transport markets; auctions to concede portions of the airwaves for radio stations, mobile phones, and wireless internet access.
Market transaction games: goods commonly sold at auction are natural resources such as timber and drilling rights for oil, as well as houses, cars, agricultural produce, horses, antiques, and art.

4. Auctions Elements of Auctions: Number of Units
Auctions can be used to sell one or many units of a good.
Elements of Auctions: Format of Bidding
English auction: Ascending-bid auction process where the good is sold to the last bidder for the highest bid. Common to sell art and antiques.
Dutch auction: Descending-bid auction process where the seller reduces the price until someone accepts the offered price and buys at that price.
Sealed-bid auction: Bidders submit a bid simultaneously without seeing anyone else’s bid and the highest bidder wins. In a first-price auction, the winner pays its own, highest bid. In a second-price auction, the winner pays the amount bid by the second-highest bidder.
Elements of Auctions: Value
Private value: Individual bidders know how much the good is worth to them but not how much other bidders value it.
Common value: The good has the same value to everyone, but no bidder knows exactly what that value is. In a drilling rights auction, bidders know the price of oil but not how much oil can be extracted.

5. Auctions
Bidding Strategies in Private-Value Auctions: Second Price Auction
Second-Price Auction Game Rules: traditional sealed-bid, second-price auction. Each bidder places a different private value on a single, indivisible good.
The amount that you bid affects whether you win, but it does not affect how much you pay if you win, which equals the second-highest bid.
Second-Price Auction Best Strategy
Bidding your highest value is your best strategy (weakly dominates all others).
Suppose that you value a folk art carving at $100. If you bid $100 and win, your CS = nd price. If you bid less than $100, you risk not winning. If you bid more than $100, you risk ending up with a negative CS.
So, bidding $100 leaves you as well off as, or better off than, bidding any other value.

6. Auctions Bidding Strategies in Private-Value Auctions: English Auction
English Auction Game Rules: Ascending-bid auction process where the good is sold to the last bidder for the highest bid. Each bidder has a private value for a single, indivisible good.
The amount that you bid affects whether you win and pay.
English Auction Best Strategy
Your best strategy is to raise the current highest bid as long as your bid is less than the value you place on the good.
Suppose that you value a folk art carving at $100. If you bid an amount b and win, your surplus is $100 – b. Your surplus is positive or zero for b ≤ 100. But, negative if b > 100. So, it is best to raise bids up to $100 and stop there.
If all participants bid up to their value, the winner will pay slightly more than the value of the second-highest bidder. Thus, the outcome is essentially the same as in the sealed-bid, second-price auction.

7. Auctions Bidding Strategies: Dutch and First-Price Sealed Bid Auction
Dutch Rules: Descending-bid auction process where the seller reduces the price until someone accepts the offered price and buys at that price.
Sealed Bid Rules: Bidders submit a bid simultaneously without seeing anyone else’s bid, the highest bidder wins and pays its own bid.
In both games, each bidder has a private value for a single, indivisible good.
The amount that you bid affects whether you win and pay.
Best Strategies and Equivalence of Outcomes
The best strategy for both games is to bid an amount that is equal to or slightly greater than what you expect will be the second-highest bid, given that your value is the highest.
Bidders shave their bids to less than their value to balance the effect of decreasing the probability of winning and increasing CS. The bid depends on the beliefs about the strategies of rivals.
Thus, the expected outcome is the same under each format for private-value auctions: The winner is the person with the highest value, and the winner pays roughly the second-highest value.

8. Auctions The Winner’s Curse Best Strategy to Avoid the Winner’s Curse
The winner’s curse occurs in common-value auctions: the winner’s bid exceeds the common-value item’s value. So, the winner ends up paying too much.
The overbidding occurs when there is uncertainty about the true value of the good, as is in timber land auctions.
Best Strategy to Avoid the Winner’s Curse
Rational bidders shade or reduce their bids below their estimates.
The amount of reduction depends on the number of other bidders, because the more bidders, the more likely that the winning bid is an overestimate.
Bounded Rationality and the Winner’s Curse
Although rational managers should avoid the winner’s curve, there is strong empirical evidence for the winner’s curse (corporate acquisition market).
One explanation is bounded rationality.

9. Regulatory barriers Government Creation of Monopoly Barriers to Entry
Governments grant a license, monopoly rights, or patents
Barriers to Entry
Governments create monopolies either by making it difficult for new firms to obtain a license to operate or by explicitly granting a monopoly right to one firm, thereby excluding other firms.
Firms may induce the Government to erect regulatory barriers to entry; this activity is referred to as rent-seeking
Patents
A patent is an exclusive right granted to the inventor of a new and useful product, process, substance, or design for a specified length of time.

10. Cost conditions Cost Based Monopolies
Two cost structures facilitate the creation of a monopoly:
A firm may have substantially lower costs than potential rivals: cost advantage.
A firm may produce any given output at a lower cost than two or more firms: natural monopoly.
Cost Advantage
A low-cost firm is a monopoly if it sells at a price so low that other potential competitors with higher costs would lose money. No other firm enters the market.
The sources of cost advantage over potential rivals are diverse: superior technology, better way of organizing production, control of an essential facility, or control of a scarce resource.

11. Cost conditions Natural Monopoly Natural Monopoly
One firm can produce the total output of the market at lower cost than two or more firms could:
C(Q) < C(q1) + C(q2) +  + C(qn), where Q = q1 + q2 + … + qn is the sum of the output of any n firms where n ≥ 2 firms (subadditivity of costs)
Economies of scale explain this outcome: a natural monopoly has the same strictly declining average cost curve
When just one firm is the cheapest way to produce any given output level, governments often grant monopoly rights to public utilities of water, gas, electric power, or mail delivery.
Natural Monopoly

12. Networks Externalities
Network Externalities
A good has a network externality if one person’s demand depends on the consumption of a good by others.
If a good has a positive network externality, its value to a consumer grows as the number of units sold increases. A telephone and fax are classical examples.
For a network to succeed, it has to achieve a critical mass of users—enough adopters that others want to join.
A customer can get a direct benefit from a larger network, or an indirect benefit from complementary goods that are offered when a product has a critical mass of users (apps for a smart phone).

13. Networks Externalities
Network Externalities & Monopoly
Because of the need for a critical mass of customers in a market with a positive network externality, we sometimes see only one large firm surviving.
The Windows operating system largely dominates the market—not because it is technically superior to Apple’s operating system or Linux—but because it has a critical mass of users.
But having obtained a monopoly, a firm does not necessarily keep it.

14. Product differentiation
Through advertising and innovation firms can obtain product that consumers perceive to be superior to alternative products
Consumers show a higher willingness to pay for these products so that firms gain market power

15. Market power and social welfare
Market power generates an allocative efficiency
However market power may be the result of
Lower costs
Network externalities
Innovation
Product differentiation
In these cases there might exist a trade-off between allocative efficiency and productive or dynamic efficiency