Mar 28

Joe Bain

Joe Bain Joe Staten Bain, 1912-1991, was an American economist. He spent his whole career as a Professor at the University of California at Berkeley, although he obtained his Doctorate in Harvard under Joseph Schumpeter.

He was a prolific and seminal writer and is considered as father of modern industrial organisation theory, for which he was elected as a Distinguished Fellow of the American Economic Association.

Regarding industrial organisation, Bain took special interest in market structures, developing the Structure, Conduct and Performance paradigm (SCP). His analyses were focused around oligopolies, and on entry and exit barriers. Bain’s analyses are also characterized for being mostly verbal instead of mathematical. From his many written papers and books, we can highlight “Barriers to New Competition”, 1956, and his magnum opus “Industrial Organization”, 1959, as his most influencing works.

Although Bain’s main contribution was to the industrial organisation field, he also contributed greatly to strategic managementand his “Pricing, Distribution and Employment: Economics of an Enterprise System” 1948 and “Price Theory”, 1952, stand out as his most important work regarding this field.

Mar 27

Lope Gallego

Imperfect competition

Imperfect competition or imperfectly competitive markets is one in which some of the rules of perfect competition are not followed. Virtually, all real world markets follow this model, as in practice, all markets have some form of imperfection. When dealing with imperfect competition the equilibrium price can be influenced by the actions of agents. In imperfect competition the price of goods can increase above their marginal cost and thus have customers decrease their level of purchase, and so reach inefficient levels of production. Governments try to avoid these situations and take measures to stop imperfect competition.

The most common forms of imperfect competition include: monopolies, oligopolies, duopolies, monopolistic competition and monopsony.

Roy Harrod was the first economist to develop the theory of imperfect competition and, other authors, such as Edward Chamberlin and Joan Robinson renewed its interest and made major contributions. Nevertheless, it is important to point out that Cournot, in his “Researches into the Mathematical Principles of the Theory of Wealth”, 1838, was the first to model this kind of markets.

Mar 26

Lope Gallego

Perfect competition

Perfect competition or competitive markets -also referred to as pure, or free competition-, expresses the idea of the combination of a wide range of firms, which freely enter or leave the market and which considers prices as information, since each bidder only provides a relative small share of the good to the market and thus do not exert a noticeable influence on it. Therefore, perfect competitors cannot influence the levels of market clearing prices. Also, buyers are numerous and disperse, which also means that they cannot influence prices.

This market model is based on a set of assumptions, each of them representing a necessary but insufficient condition to ensure perfect competition. These assumptions are:

-Homogeneous product: all firms offer the same goods, with the same characteristics and quality as the others, without any variations.

-Large number of agents: there should be a sufficient quantity of buyers and sellers, so that no action from a single agent will affect the market structure or its prices.

-No entry or exit barriers: there has to be free entry and exit of agents in the market. This assumption is of special interest for firms, which must be able to enter or leave the market freely.

-Price flexibility: price adjustments to changes happen as fast as possible. Usually, price changes are assumed instantaneous.

-Free and perfect information: all agents have perfect knowledge of products and their prices, and everything else related to them, as well as free access to this information.

-Perfect factor mobility: all factors should be able to change so adjustments processes can be carried out with the greatest efficiency.

-No government intervention: markets should be left alone as government intervention would only lead to imbalances in perfectly competitive markets.

Perfect competition markets are almost impossible to find in the real word as all markets have some type of imperfection. This is the reason they are mostly considered only theoretically. However, its study helps understand real world markets and their phenomena.

It must be noted that the theory of contestable markets, developed by William J. Baumol in his “Contestable Markets: An Uprising in the Theory of Industry Structure”, 1982, that perfect competition prices and output can be reached with just a few of these assumptions. Furthermore, Bertrand’s duopoly model determines that oligopolistic markets can reach the same prices as in perfect competition as long as oligopolists compete by changing their prices, instead of the quantity offered.

Mar 25

Lope Gallego

Market structure

A market is a set of buyers and sellers, commonly referred to as agents, who through their interaction, both real and potential, determine the price of a good, or a set of goods. The concept of a market structure is therefore understood as those characteristics of a market that influence the behaviour and results of the firms working in that market.

The main aspects that determine market structures are: the number of agents in the market, both sellers and buyers; their relative negotiation strength, in terms of ability to set prices; the degree of concentration among them; the degree of differentiation and uniqueness of products; and the ease, or not, of entering and exiting the market. The interaction and differences between these aspects allow for the existence of several market structures, from which we can highlight the following:

–Perfect competition: the efficient market where goods are produced using the most efficient techniques and the least amount of factors. This market is considered to be unrealistic but it is nevertheless of special interest for hypothetical and theoretical reasons.

–Imperfect competition, which includes all situations that differ from perfect competition. Sellers and buyers can influence in the determination of the price of goods, leading to efficiency losses. Imperfect competition includes market structures such as:

–Monopoly: it represents the opposite of perfect competition. This market is composed of a sole seller who will therefore have full power to set prices.

–Oligopoly: in this case, products are offered by a series of firms. However, the number of sellers is not large enough to guarantee perfect competition prices. These markets are usually studied by analysing duopolies, since these are easier to model and the main conclusions can be extrapolated to oligopolies.

–Monopolistic competition: this market is formed by a high number of firms which produce a similar good that can be seen as unique due to differentiation, that will allow prices to be held up higher than marginal costs. In other words, each producer will be considered as a monopoly thanks to differentiation, but the whole market s considered as competitive because the degree of differentiation is not enough to undermine the possibility of substitution effects.

–Monopsony: it’s similar to a monopoly, but in this case there are many firms selling products, but only one buyer, the monopsonist, who will have full power when negotiating prices.

–Oligopsony: similar to oligopolies, but with buyers. Sellers will have to deal with the increased negotiating power of the only few buyers in the market, the oligopsonists.

Mar 24

Lope Gallego

Leonard Savage

Leonard J. Savage

Leonard Jimmie Savage, 1917-1971, was an American mathematician specialised in statistics, and was a Professor at the University of Michigan and Yale University. He also worked in some statistics research institutes at different American universities.

In Savage’s most famous work “Foundations of Statistics” 1954, he introduces several elements on game theory and he elaborates the theory of subjective expected utility, which confronts the relation between the probability for an event and the utility of the event for a certain subject. To this effect, he formulated an axiom that follows coherent behaviours, such as probability and utility consistent with the principle of utility maximisation. Through his work, Savage established the bases for Bayesian statistics and its application to game theory, as well as a criterion used in decision theory known as minimax regret.

Mar 21

Lope Gallego

Daniel Bernoulli

Daniel Bernoulli, 1700-1782, was a Swiss mathematician and physicist. His prolific research and discoveries contributed to a wide range of fields, where we can highlight fluid mechanics, statistics and probability.

Furthermore, his contributions to statistics and probability have a great value in economic science. In his “Exposition of a New Theory on the Measurement of Risk” 1738, Bernoulli made a successful attempt to solve the St. Petersburg paradox, and was therefore able of distinguishing between the expected value and expected utility, and this way setting the base for many risk theories such as risk aversion, risk premium, but especially expected utility theory.

Mar 19

Lope Gallego

John von Neumann

John von Neumann 1903-1957, was a Hungarian-born American mathematician, who made important contributions to numerous fields. Regarding economics, he is well known for his contribution to game theory and for the development, along with Oskar Mogenstern, of expected utility theory.

Von Neumann was one of the earliest creators of the game theory field, thanks to his mathematical abilities. As early as 1928 he developed theorems in this field, but his greatest contribution came as a result of his collaboration with Morgenstern which is reflected in their joint book “Theory of Games and Economic Behavior”, 1944. In this book they formulated the expected utility hypothesis regarding risk aversion, which is analysed using an expected utility function and describes the individual decision-making process. They developed a set of axioms under which the expected utility hypothesis holds, the so called von Neumann–Morgenstern utility theorem.

John von Neumann made also another great contribution to decision theory, which is nowadays known as the minimax theorem. This theorem states that each player in a game will try to minimise the maximum payoff possible for the other players, which will in turn maximise his or hers own utility.

Mar 19

Lope Gallego

Oskar Morgenstern

Oskar Morgenstern 1902-1977, was a German born, American economist. He was Professor of Economics first in the University of Vienna and after at Princeton University. His most important contribution to economics was his joint development of expected utility theory , with John von Neumann.

In 1944 Mogenstern and von Neumann published their joint work “Theory of Games and Economic Behavior”. In this book they formulated the expected utility hypothesis towards risk aversion which uses an expected utility function and describes the individual decision-making process. To this end, they developed a set of axioms under which the expected utility hypothesis holds, the so called von Neumann–Morgenstern utility theorem.

Mar 11

Lope Gallego

Critiques to expected utility theory

After John von Neumann and Oskar Morgenstern developed the expected utility theory in their “Theory of Games and Economic Behaviour”, 1944, various different approaches were developed. Although the expected utility function helps us understand the real world, it is important to remember that it is only a simplification of it. Expected utility theory does not completely reflect how agents interact in the real world. Furthermore, agents’ behaviour in the real world seems to systematically break some of the axioms. Let’s see some of the alternative approaches that where formulated after the original expected utility theory came out.

Friedman-Savage perspective:

Milton Friedman along with Leonard J. Savage, developed in their “Utility Analysis of Choices Involving risk”, 1948, their own utility function known as the Friedman-Savage utility function. They argued that a single individual could have different utility functions depending on their initial wealth. The implication of an individual being, at the same time, risk-loving and averse, implies that its utility function has different curvatures as shown in the following figure.

Markowitz’s perspective:

Although the Friedman-Savage perspective somehow explained the flaws in the original expected utility theory axiomatic, the critiques and alternative theories didn’t stop there. Harry Markowitz, who was a student of Milton Friedman, criticized the Friedman-Savage utility function. Markowitz argued in his paper “The Utility of Wealth”, 1952, that the final concavity of their function assumes that individuals with the highest incomes would never gamble. As a prelude to Kahneman and Tversky’s prospect theory, he proposed measuring utility based on a reference level instead of in absolute values. This implied that, to individuals, small gains would provide an increasing utility, while big gains would provide a decreasing utility, as shown in the following figure.

Mar 11

Lope Gallego

Insurance model

Oskar Morgenstern and John von Neumann’s expected utility theory, which analyses individuals’ risk aversion, proves that different individuals have different perspective towards risk. Risk averse individuals have, by definition, a greater preference to avoid risky situations than risk-loving individuals and, to this end, they will be willing to pay an extra amount of money in order to mitigate (or eliminate) the bad consequences of such a risk.

Expected utility theory holds that the demand for insurance can be translated as a demand for certainty. Individuals will prefer to buy insurance in order to assure a certain amount of money (or to have a guarantee of lower losses), instead of its actuarial equivalent uncertain one. The insurance market allows agents to cover themselves against risk. Insurance companies take advantage of risk averse individuals to charge an extra surcharge to pay costs which are not covered by the premium. How individuals perceive insurances depends on their prices, and on the individuals’ preferences and budget constrain. A risk averse individual may be willing to assure against a potential loss, but will pay only up to a certain price for this insurance: if the price exceeds this amount he will not acquire the insurance.

We will use an analytical example for a better understanding:

Imagine an individual with an initial wealth of W₀ who faces the possibility of getting robbed an amount of R. He or she has the option of insuring an amount of K for a risk premium of λK. There are two possible scenarios:

S₁, with a probability of happening p₁: there is indeed a robbery, the individual loses R;
S₂, with a probability of happening p₂: there is no robbery.

We’ll have a budget constraint, in terms of wealth, such as:

The optimum point, given the budget constraint and being MU the marginal utility, is: