MBA Programme 2015/2016

Period 1 Jan/Feb 2016

Prices and Markets

Professor: Amine Ouazad
amine.ouazad@insead.edu
Ext 5476 Office 407D

Assistant: Endora Teo

endora.teo@insead.edu
Ext 5391 Office 548 (open office
space)

Website: http://www.ouazad.com/MBA/

LOGIN: pm (lowercase) PASSWORD: insead2016 (lowercase)

Course Objectives
This course gives you the tools and concepts for managerial decision-making. We will
consider the analysis of demand and supply; how costs of production and demand
analysis lead to optimal pricing decisions, market segmentation, and help you decide
whether to enter or exit a market; how competition between industry participants shapes
prices and output; how collusion between industry players, although illegal, can be
sustained and lead to higher profits. The concepts introduced in this course prepare you
for core and elective courses beyond prices and markets marketing, finance, strategy,
and many others.

Materials
Everything you need is either handed out in class or posted on the web. There is no
required purchase of a textbook.

Course Guide: Firms, Prices, and Markets by Professor Van Zandt is included
in the course pack and downloadable on the webpage. The textbook introduces
the core concepts and presents a number of interesting exercises good
preparation for the assessments.

Reading the Course Guide: Please read this before you read the course guide
Firm, Prices, and Markets. Reading the course guide pinpoints the important
parts of the course guide and the key concepts of each session. The compulsory
readings for the session are given; in some sessions, a simulation game is
played.

Exercises from the Course Guide gives the relevant exercises that prepare for
quizzes and exams.

Readings and Cases: These are newspaper articles, brief reports, or small case
studies. The readings bring elements of context that introduce the class. The
readings are discussed in class.

Slides: The slides are posted on the website and handed out in class. These are
a good way to take notes during the sessions, but they cannot substitute for
class attendance.

Practice Quizzes & Exams: These are past quizzes and exams, useful for
preparation of the two quizzes and exam.

For supplementary reading, you can consult optional textbooks. For students with little
or no previous economics training, a basic textbook, Principles of Economics, 6th edition
by Gregory Mankiw, is recommended. Older editions of these books work fine.
Additional material exercises and reading may be distributed in class or on the
website. Those of you who have already taken a course in microeconomics and want to
reinforce the material in this class or explore additional topics can consult
Microeconomics, (Prentice Hall), by Robert Pyndick and Daniel Rubinfeld, 8th edition.

Help
As many other courses at INSEAD, this course moves fast. Keeping up with the
material, attending classes, and practicing some exercises helps following. Focus and
relaxation are the right way forward. You can always ask for guidance from me or the
tutor.

Tutorial: There is a noncompulsory tutorial on Saturday morning, with schedules

alternating every week between the two sections thats all in the schedule the
MBA office gave you.

Appointments: You can arrange appointments any time by contacting my

assistant. For quick questions, I usually stay 10-15 minutes after class, or you
can easily send me an email.

Mandatory Prereading
The course pack contains a prereading guide. This is made of (i) a maths review and (ii)
some other methodological material. This is different from what the MBA office sent you.
I prefer not to use time in class to cover the maths review and the methodological
material.

Preparing for Class

Very simple: in the course outline part of this syllabus, you will find the readings and
cases for each session. Readings discussed in class are preceded by an arrow
.
Other readings are not compulsory. Some sessions do not have either readings and/or
cases. Read the readings, read the cases.

The document Exercises of the Course Guide contains references to exercises for each
session, which are recommended as preparation before every session. By doing the
exercises you ensure youre ready for the quizzes and the exam.

Grading
Your grade will be based on your work in the course, weighted as follows:
Quiz 1
Quiz 2
Final Exam
Participation in the Simulations

10%
10%
70%
10%

Quiz 1 & 2: Two 45 minute quizzes, primarily intended to provide some feedback on
your progress, will be held sometimes after sessions 7 & 11. You are allowed to bring
one A4 sheet of notes, written on both sides.
Final: A 3-hour closed-book (but 2 A4 cheat sheets allowed) final exam that accounts for
the bulk of the grade. The material covered in the exam consists of the course guide,
solutions to exercises, slides, and in-class material and discussions.
Participation in Market Power Game Simulations: During the period, outside-of-class
simulations of market strategies will be conducted. Instructions for each exercise will be
distributed in class. Typically, groups will be asked to submit their strategies several
times a week on the website. Participation in these simulations is mandatory, and 10%
of the final grade will depend on participation. The success/profit of the strategies will
not be used for grading, since different groups will have different, randomly determined,
competitive advantages in the exercises.
Class Attendance: is mandatory. It is also essential that you be on time for each
session. If you are late for a session, I will mercilessly cold call you. If you miss more
than 3 sessions, you will get a failing grade.
Class participation is not graded nor judged. Spontaneous questions, discussion, mutual
exchange, and respect for other students opinions welcome. Students may also be
called randomly to briefly discuss the starred readings (see course outline at the end of
this syllabus).

Frequently Asked Questions

Should I attend the Saturday tutorials?

Maybe. The Saturday tutorials are meant to help you along the way, if you
encounter difficulties either in the concepts or in the algebra. This is usually
meant for students who have had no prior microeconomics course in their
undergraduate or graduate coursework. The tutorials are not review sessions
and they do not introduce new concepts or materials. Attend if you think that
would help you. Tutorials typically have an attendance of around 20 students for
both sections.
Tutorials are not a place for brain teasers or hypertechnical questions. That
would be disruptive for students who are working on mastering the courses
foundations. If you have such questions, feel free to ask me or the tutor.

What should I do to get ready for the Exam and Quizzes?

Take the exercises of Exercises of the Course Guide, and past quizzes and
exams, and solve them. Pace yourself, a few exercises each week is better than
many exercises just before the exam.
The bottomline is relax. Any MBA student who follows the coursework, attends
the classes, and practices exercises will be ready for the quizzes and the exam.
No surprise there.

Why do I find this course so different from my previous microeconomics

courses?

Certainly because the course is tailored to your professional needs. The material
is arranged in such a way as to make it more practical, oriented towards
managerial decision-making. We care more about practical, deep understanding
of the concepts than about solving exercises.
Moreover, you might not fully remember the course you took more than 5 years
ago. An undergraduate course of Principles of Microeconomics introduces
Principles, and we choose a new angle in this MBA course.

Structure of the Course

Our focus is on the decisions that managers of firms should make.
The topics can be divided along two dimensions:
1. The individual firms decisions.
2. Interaction between firms: Perfect Competition.
3. Interaction between firms: Imperfect competition.
After a simple analysis of a pit market and a quick review of demand and supply in
sessions 1 and 2, in sessions 3 to 8 we consider the decision of a single firm: what
demand the firm faces, what are its costs, and what should be the firms optimal pricing
decision given its demand and costs.
Then in sessions 9 to 16, we consider how firms strategies depend on competitors
products and pricing.
We start with an extreme case where the firms product is a perfect substitute for its
competitors products a firm producing a homogeneous commodity (e.g. one particular
grade of primary aluminum) is in such a case. This case is called perfect competition.
Because the product is a perfect substitute for the products of other firms on the market,
the firm cannot price higher than the market price. Firms are price takers.
In Imperfect competition, in contrast, firms can set their own price. A synonym is to say
that firms have market power. For example, the firm can charge a lower price to sell
more; similarly, the firm can charge a higher price, but then would sell less.
In each case we take the analysis of an individual firms decision in isolation (done in
sessions 3 to 8), i.e., keeping fixed the decisions of other firms, and then we study how
the firms decisions are determined collectively through their interaction. The latter is
called equilibrium.
The real world is one of imperfect competition. However, the perfect competition case is
also very useful to study an extreme case in which firms act as if their decisions had no
effect on prices. In perfect competition, firms observe market prices, cannot affect them,
and assume that they can sell any amount at those prices.
The weekly schedule on the next page shows how sessions correspond to the three
above-mentioned stages of the course: the individual firms decisions; interaction
between firms in perfect competition; interaction between firms in imperfect competition.

Weekly Schedule
Introduction to Markets and their Participants
Sessions 1 & 2

Gains from Trade

Supply, Demand and Markets

Single Firms Decision

Session 3

Consumer Choice and Demand

Session 4

Production and Costs

Session 5

Pricing with Market Power

Session 6

How Pricing Depends on the Demand Curve

Session 7

Explicit Price Discrimination

Session 8

Implicit Price Discrimination

Interacting Firms: Perfect Competition

Session 9

Competitive Supply and Market Price

Session 10

Short-Run Costs and Prices

Session 11

Applications of Perfect Competition

Interacting Firms: Imperfect Competition

Session 12

Static Games and Nash Equilibrium

Session 13

Imperfect Competition: Price and Quantity Wars

Session 14

Strategic Commitment for Entry Deterrence

Session 15

Explicit and Implicit Collusion

Wrap Up
Session 16

Market Power Games Debrief and Wrap Up

Note: Not all topics fit neatly into one session. There will be spillovers. Chapter numbers
in the textbook and in the course do not match. The titles do match.

Course Outline
Unit I. Introduction to Markets and their Participants
Overview: This course focuses on firms and their transactions with their customers.
Our very first topic (Sessions 1 and 2) looks at a simple model of tradeit is, all at
once, a warm-up, a review, and an introduction to basic concepts that appear
throughout this course.
Sessions 1&2

Gains from trade; Supply, Demand, and Markets

Main concepts:
A Simulated Pit Market, Analysis of trade in which each buyer wants at most one unit
and each seller has at most one unit to sell; gains from trade; producer and consumer
surplus; Pareto efficiency; effect of taxes.
Reading:

In Chicago's Trading Pits, This May Be The Final Generation, New York Times,
August 2000.
Markets in Everything, User-Friendly Data (on the market for drugs in Ireland),
the Economist, July 15, 2011.
Should we care about the Minimum Wage? Forbes, May 13, 2011
Tobacco, from the Lex pages of the Financial Times, June 17, 2010

Unit II. Single Firms Decision: Demand and Costs

Overview: Firms make output and pricing decisions weighing revenue and cost. We
therefore have to understand consumer demand (Session 3)which drives revenue
and firms costs (Session 4).
Session 3

Consumer Choice and Demand

Main concepts:
Estimating demand from price and quantity data; Effects of prices and income on
demand; elasticity of demand; determinants of price elasticity of demand.
Reading:

Who Won the Recession? McDonalds, Slate.

Struggling consumers boost McDonalds, Financial Times, July 22, 2011
Can Kimberly Clark Maintain Its Margins Despite Weaker Pricing? Trefis Market
Analysis, January 7, 2013.

Estimating the Elasticity of Demand for Gasoline (Download data on class

website from http://www.ouazad.com/Courses/MBAPM/Session3/GasolineData.xls).

Session 4

Production and Costs

Main concepts:
Applications of Demand and Supply; Sunk costs and opportunity costs; production
functions and input decisions; short-run versus long-run; long-run fixed costs. Analysis
of cost curves fixed vs variable cost, marginal versus total cost, average cost;
economies and diseconomies of scale.
Reading:

Kaiser makes a bundle by reselling power, Seattle Post, 2000.

Kaiser Aluminums SEC 10-Q Form, November 2000.
Compaq To Abandon Alpha Processor, Move Entire Server Line To Intel Chips,
InformationWeek, June 2001.
Vodafone, Telefonica ink deal to share network infrastructure, Market Watch,
2009.
Vivendis SFR, Bouygues Telecom Discuss Network Sharing in France, the Wall
Street Journal, July 22, 2013.
Long-Run Fixed Costs in the Cellular Industry, 2004.

Unit III. Single Firms Decision: Pricing with Market Power

Overview: We say that a firm has market power if it has some influence over the price of
its product. That is, by producing less the firm can charge more. All firms have some
market power. This unit looks at how an individual firm with market power should choose
output and price by weighing revenue and cost. We first examine the basic pricing and
entry/exit decisions given a fixed demand curve (Session 5). We then see how a shift in
the demand curve affects pricing (Session 6). Elasticity of demand plays an important
role in this analysis.
Session 5

Pricing with Market Power

Main concepts:
Pricing with market power; socially efficient quantity, profit-maximizing quantity;
deadweight loss; marginal conditions for profit maximization in terms of elasticity of
demand; Pricing fallacies.
Reading:

Pricing Software Could Reshape Retail.

How Sears Uses Big Data to Get a Handle on its Pricing, June 14, 2012.
Microsofts Defense: A Tough Sell, but not Impossible, Businessweek 1999.

Session 6

How Pricing Depends on Cost and Demand

Main concepts:
Effects of a shift in the demand curve on pricing. Marginal revenue and elasticity. Effect
of a shift in elasticity on pricing, with constant marginal cost. Effect of an increase in the
volume of demand on pricing, with increasing marginal cost.
Reading:

Airlines hold back on expected fare bonanza, International Herald Tribune, 2001.
McDonalds Behind the Arches, by John F. Love, Excerpt from Chapter 4, The
Owner/Operator.
Study: TV Spots Reduce Consumers' Sensitivity to Price Change

Unit IV. Single Firms Decision: Advanced Pricing

Overview: We revisit the pricing problem of a single firm using more sophisticated
pricing strategies, such as charging different consumers different prices based on
observable characteristics (Session 7) and implicitly differentiating consumers with
hidden characteristics by means of product differentiation and bundling (Session 8).
Session 7

Explicit Market Segmentation

Main concepts:
Perfect price discrimination; informational requirements of perfect price discrimination;
Explicit Price Discrimination, Conditions for Explicit Price Discrimination: Observability
and Non Arbitrage. Equalization of marginal revenues across market segments.
Reading:

The economics of priceline.com, Slate, 2000.

GSK wins battle in parallel drugs case, Financial Times, 2006.

Case:

Will the Roxy Theater Maximize Profits by Eliminating its Student Discount?

Session 8

Implicit Market Segmentation

Main concepts:
Methods for Screening when consumer characteristics cannot be observed; menus and
self-selection; versioning; bundling.
Reading:

New baldness drug is an older product at a premium price, New York Times,

1998.
I got it cheaper than you, Forbes, 1998.
The Saturday Night Stay is Making a Comeback, New York Times, 2008.
Versioning: The Smart Way to Sell Information.

Unit V. Perfect Competition

Overview: As our first look at the interaction between firms, we consider a number of
firms in a market producing very close substitutes. Each firm therefore has very little
market power: If it prices above the going market price of its competitors, demand for its
product collapses, whereas it can sell a large amount at or near the going market price.
It is then a good approximationand a very useful simplificationto study such markets
as if firms had no or did not perceive any market power. Each firm then takes the market
price of its product as given and chooses only how much to produce at this price. This is
the model of perfect competition. After considering long-run equilibrium with entry
(Session 9), we examine short-run costs which take into account that a firm cannot
instantly adjust its production processes in response to changing market conditions
and compare short-run and long-run market adjustments (Session 10). In Session 11,
we look at the threat of entry in markets of perfect competition in two case studies.
Session 9

Competitive Supply and Market Prices

Main concepts:
Competitive Supply and Producer Surplus. Elasticity of Supply. Equilibrium and
Efficiency. Individual and Aggregate Supply curves. Exit and entry.
Reading:
Idea: Differentiation, The Economist, 2009.
Case:

Alusaf Hillside Project, Harvard Business School 9-704-458, Dec. 2003

(For this case please download the data from the website.) To be discussed in
sessions 9 and 10.

Session 10

Short and Long-Run Costs and Prices

Main concepts:
Short-run & Long-run cost curves; exit and entry; short-run versus long-run supply; the
importance of forecasting.
Reading:
Chipmakers signal second dip, Financial Times, October 7 2010.
Shipping Sector Caught in Choppy Waters, Financial Times, November 18,
2012.
Session 11

Applications of Perfect Competition

Main concepts:
Economic profit at the perfectly competitive equilibrium, economic profit in the long run,
pricing of inputs.
Reading:
Building a Cupcake Empire, .Inc, May 24, 2010
The Cupcake Bubble, Slate, 2009.

Growth and Profitability: A Tale of Two Competitive Industries.

The Economist: Of horses' teeth and liberty. The home of unbridled capitalism
has more red tape than you think.

Unit VI. Game Theory and Strategy: Nash Equilibrium

Overview: Perfect competition is an extreme form of interaction between firms the

products of different firms are perfect substitutes and there is a large number of firms.
However, often your firm instead interacts with a small number of competitors and
should think carefully about how to react to other firms actions, how to anticipate other
firms decisions, and how to take into account how other firms will react to your own
decisions. Such thinking is called strategic analysis. The tools economists have
developed for strategic analyses are called game theory. These tools and their
applications are the subject of Units VI and VII. Session 12 considers simple games in
which players do not observe the other players strategies. In session 13, we focus on
how to view the decisions of other players and how to formulate your own decisions.
The session provides applications to pricing, output, and investment decisions when
there are only a few firms in a market and we extend the theory to handle games in
which players have many available actions.
Session 12

Static Games and Nash Equilibrium

Main concepts:
Simultaneous Move Games; Nash Equilibrium; Dominant & Dominated Strategies.
Simulation:

The Guessing Game.

Start of the Market Power Games specific announcements by email.

Reading:

Britain's Bank Run, The Bank that Failed, the Economist, September 2007.
The downfall of Washington Mutual, WaMus Final Days, Kirsten Grind, Puget
Sound Business Journal, September 27,2009
The Heyday of the Auction, The Economist, 1999.

Session 13

Imperfect Competition: Price and Quantity Wars

Main concepts:
Price competition with homogeneous and differentiated products. Quantity competition
with perfect substitutes (Cournot). Imperfect competition with free entry.
Reading:

Encyclopedic Knowledge, Then vs. Now, New York Times, May 2009.
French telecoms mergers face opposition, Financial Times, January 15, 2013.
Saudis Raise Oil Production to Curb Prices, Financial Times, June 2011.

Unit VII. Game Theory and Strategy: Entry Deterrence and Collusion
Overview: This unit continues our study of game theory and strategic analysis. We study
games in which players make decisions over time, focusing on how best to use the
commitment entailed in early moves of the game (Session 14): the key conclusion is that
costly decisions in the short-run may entail strategic benefits by preventing the entry of
competitors on your market. When entry cannot be prevented, we consider ways to
sustain cooperation between competitors in repeated games (Session 14).
Session 14

Strategic commitment for Entry Deterrence

Main concepts:
Sequential games. Stackelberg (leader-follower) games. Comparison with simultaneous
move games. How timing matters: The role of externalities and strategic
complementarities.
Reading:

The Unkindest Cuts, The Economist, 2009.

Managing by Commitment, Harvard Business Review, Donald N. Sull.

Session 15

Explicit and Implicit Collusion

Main concepts:
The Nash equilibriums inefficiency. Repeated games and tacit collusion. Trigger
strategies. Tit for tat.
Reading:

Archer Official Taped Talks for FBI, the New York Times, July 11, 1995
$105 Million Lysine Fine Set in Europe, New York Times, June 8, 2000.
Collusion in the stockmarket, The Economist, 1998.

Wrap Up
Session 16

Debrief of Market Power Games and Wrap Up

We review the big picture of the course, provide additional applications, and reveal the
results of the imperfect competition games.

Class Preparation
Reading

Session

Estimating the Elasticity of

Demand for Gasoline
(Download data on class
website)

Session 3

Group
or Indiv.
Group

Deliverables

Will the Roxy Theater

Maximize Profits by
Eliminating its Student
Discount

Session 7

Indiv.

Questions 1, 3 and 4 from the

case. Ignore question 2.
Discussion in class.

New Baldness Drug Is an

Older Product at a Premium
Price

Session 8

Indiv.

Be prepared to answer one

question: Why is Pfizer
charging more money for the
baldness drug?
Discussion in class.

Alusaf Hillside Project

(Download data from
website)

Session 9
Session 10

Group

Construct an industry supply

curve for aluminum using the
data on the class website.
(Instructions and case are in
the coursepack.)

Make two Powerpoint slides.

On one slide answer questions
Q1 and Q2 (Demand function
for gasoline; Price and income
elasticity of demand). On the
second slide, answer questions
Q3-Q5 (demand function for
gasoline with lagged gasoline
consumption; Long-run price
and income elasticities of
demand; Compare the short
and long run elasticities).
Please send the powerpoint file
by email the day before class,
before noon to
carole.guillard@insead.edu.

Make two slides (powerpoint

files). One slide should simply
list the cost components that
you think are the variable costs
in the short run. Use the
information from the case and
not your intuition since it may
not apply to the aluminum
industry. Second slide should
have the supply curve. This is
for Session 9.
Please send the powerpoint file
by email the day before class,
before noon to
carole.guillard@insead.edu.

Be prepared to discuss the big

question should Alusaf build
the plant when aluminum
prices are at $1100 per ton ?
This question will be discussed
in Session 10.
Growth and Profitability: A
Tale of Two Competitive
Industries

Session 11

Indiv.

All questions.
Discussion in class.

Glossary of Synonyms
You will learn new terms as the course progresses. Sometimes two terms have the
same meaning. The greatest confusion often arises when two or more terms are used
for the same concept. This is a list of the most important cases.
1. Gains from trade = surplus.
2. Marginal conditions = first-order conditions = local conditions.
3. Power demand curve = log-linear demand curve
= constant-elasticity demand curve.
4. Efficient = socially efficient (i.e. efficient for both firms and consumers) =
Pareto efficient.
5. Optimal = either socially efficient (for firms and consumers)
or profit-maximizing (for firms), depending on the context.
6. Firms have market power = imperfect competition.
7. Firms are price takers = perfect competition.
Pricing with market power model = monopoly model.
(We use the term monopoly model because it may be familiar to you from
other courses and because it is shorter. However, it inappropriately suggests
that this model is not relevant to firms that interact strategically.)
8. Screening = implicit price discrimination.
9. Implicit market segmentation = implicit price discrimination,
Explicit market segmentation = explicit price discrimination.
10. Equilibrium = either (i) supply = demand, or (ii) Nash equilibrium, or
(iii) backward-induction solution, depending on the context.