Industrial Organization

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1 Industrial Organization Markets and Strategies 2nd edition Paul Belleflamme Université CatholiquedeLouvain Martin Peitz University of Mannheim

2 University Printing House, Cambridge CB2 8BS, United Kingdom Cambridge University Press is part of the University of Cambridge. It furthers the University s mission by disseminating knowledge in the pursuit of education, learning and research at the highest international levels of excellence. Information on this title: Paul Belleflamme and Martin Peitz 2015 This publication is in copyright. Subject to statutory exception and to the provisions of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press. First published 2010 Second edition 2015 Printed in country by printer AcataloguerecordforthispublicationisavailablefromtheBritishLibrary Library of Congress Cataloguing in Publication data ISBN Hardback ISBN Paperback Additional resources for this publication at Cambridge University Press has no responsibility for the persistence or accuracy of URLs for external or third-party internet websites referred to in this publication, and does not guarantee that any content on such websites is, or will remain, accurate or appropriate.

3 List of figures xiii List of tables xv List of cases xvi Preface to the second edition Preface from the first edition xxi xxiii Part I Getting started 1 Introduction to Part I 1 1 What is Markets and Strategies? Markets Strategies Models and material of Markets and Strategies Level, scope and organization of the book 9 2 Firms, consumers and themarket Firms and consumers The firm Looking inside the black box of a firm Consumers and rational man Welfare analysis of market outcomes Market interaction The perfectly competitive paradigm Strategies in a constant environment ( monopoly ) Dominant firm model Imperfect competition Market definition and market performance How to define a market? How to assess market power? 34 References for Part I 39 Part II Market power 41 Introduction to Part II 41 3 Staticimperfect competition Price competition The standard Bertrand model Price competition with uncertain costs Price competition with differentiated products Asymmetric competition with differentiated products Quantity competition 54

4 vi The linear Cournot model Implications of Cournot competition Price vs. quantity competition Limited capacity and price competition Differentiated products: Cournot vs. Bertrand What is the appropriate modelling choice? Strategic substitutes and strategic complements Estimating market power 70 4 Dynamic aspects of imperfect competition Sequential choice: Stackelberg One leader and one follower One leader and an endogenous number of followers Commitment Free entry: endogenous number of firms Properties of free-entry equilibria Welfare properties of the Cournot model with free entry Welfare properties of price competition with free entry Welfare properties of monopolistic competition Industry concentration and firm turnover Exogenous versus endogenous sunk costs Dynamic firm entry and exit 97 References for Part II 104 Part III Sources of market power 107 Introduction to Part III Product differentiation Views on product differentiation Horizontal product differentiation A simple location model The linear Hotelling model The quadratic Hotelling model Vertical product differentiation Quality choice Natural oligopolies Empirical analysis of product differentiation Probabilistic choice and the logit model Empirical analysis of horizontal product differentiation Empirical analysis of vertical product differentiation Nested logit and other extensions Advertising and related marketing strategies Views on advertising Price and non-price strategies in monopoly 142

5 vii Price advertising decisions: Dorfman Steiner model A closer look at how advertising affects demand Some welfare economics of advertising Advertising and competition Informative advertising Persuasive advertising Consumer inertia Uninformed consumers and search costs Price dispersion Consumer search with homogeneous products Empirical investigation of price dispersion Sequential search and differentiated products Switching costs Competitive effects of switching costs Coupons and endogenous switching costs Estimating switching costs 187 References for Part III 192 Part IV Pricing strategies and market segmentation 195 Introduction to Part IV Group pricing and personalized pricing Price discrimination Price discrimination: a typology Know thy customers Group and personalized pricing in monopoly Group and personalized pricing in oligopolies Group pricing and localized competition Personalized pricing and location decisions Geographic price discrimination Menu pricing Menu pricing vs. group pricing A formal analysis of monopoly menu pricing Quality-dependent prices Information goods and damaged goods Extension to time- and quantity-dependent prices Menu pricing under imperfect competition Competitive quality-based menu pricing Competitive quantity-based menu pricing Intertemporal price discrimination Durable-good monopoly without commitment Small number of consumers 244

6 viii Large number of consumers Durable-good monopoly with commitment Fixed capacity Flexible capacity Intertemporal pricing and demand uncertainty Behaviour-based price discrimination Behaviour-based price discrimination by a monopolist Customer poaching Bundling A formal analysis of monopoly bundling Pure bundling as a device to offer a discount Mixed bundling Extensions Tying and metering Competitive bundling Bundling as a way to soften price competition When bundling intensifies price competition 286 References for Part IV 293 Part V Product quality and information 295 Introduction to Part V Asymmetric information, price and advertising signals Asymmetric information problems Hidden information problem Hidden action problem Advertising and price signals Advertising signals Price signals Joint price and advertising signals Price signalling under imperfect competition Marketing tools for experience goods Warranties Warranties as a reliability signal Warranties and investment in quality control Branding Intertemporal branding and reputation Reputation and competition Umbrella branding 335 References for Part V 343 Part VI Theory of competition policy 345 Introduction to Part VI 345

7 ix 14 Cartels and tacit collusion Formation and stability of cartels Simultaneous cartel formation Sequential cartel formation Network of market-sharing agreements Sustainability of tacit collusion Tacit collusion: the basics Optimal punishment of deviating firms Collusion and multimarket contact Tacit collusion and cyclical demand Tacit collusion with unobservable actions Detecting and fighting collusion The difficulty in detecting collusion Leniency and whistleblowing programmes Horizontal mergers Profitability of simple Cournot mergers Mergers between two firms Mergers between several firms Efficiency-increasing mergers Welfare analysis of Cournot mergers Linear Cournot model with synergies General welfare analysis Beyond simple Cournot mergers Successive mergers Mergers and entry Mergers under price competition Coordinated effects Empirical merger analyses Event studies and direct price comparisons Merger simulations Strategic incumbents and entry Taxonomy of entry-related strategies Entry deterrence Entry accommodation Strategies affecting cost variables Investment in capacity as an entry deterrent Investment as an entry deterrent reconsidered Raising rivals costs Strategies affecting demand variables Brand proliferation Bundling and leverage of market power Switching costs as an entry deterrent 439

8 x 16.4 Limit pricing under incomplete information Entry deterrence and multiple incumbents Vertically related markets The double-marginalization problem Linear pricing and double marginalization Contractual solutions to the double-marginalization problem Double marginalization and retail services Resale-price maintenance and exclusive territories Resale-price maintenance Exclusive territories Exclusive dealing Anticompetitive effects of exclusive dealing contracts? The Chicago critique Vertical integration and long-term contracts as partial deterrence devices Full exclusion and multiple buyers Vertical foreclosure and secret contracts Exclusive contracts and investment incentives Vertical oligopoly and vertical mergers Vertical oligopoly Exclusionary effects of vertical mergers Coordinated effects of vertical mergers 485 References for Part VI 490 Part VII R&D and intellectual property 495 Introduction to Part VII Innovation and R&D Market structure and incentives to innovate Monopoly versus perfect competition: the replacement effect Incentives to innovate in oligopolies Patent licensing Licensing by an outside innovator Licensing by an inside innovator When innovation affects market structure Monopoly threatened by entry: the efficiency effect Asymmetric patent races: replacement and efficiency effects Socially excessive R&D in a patent race R&D cooperation and spillovers Effects of strategic behaviour Effects of R&D cooperation Further analysis of R&D cooperation Intellectual property Innovation and IP: basics Information and appropriability 532

9 xi Intellectual property rights Alternative incentive mechanisms: rewards and secrecy Protection of IP in practice Protecting innovations Optimal design of IP rights Rewards vs. patents Secrecy vs. patents Cumulative innovations Sequential innovations and holdup Complementary innovations and anticommons Intellectual property in the digital economy End-user piracy Software protection 561 References for Part VII 570 Part VIII Networks, standards and systems 573 Introduction to Part VIII Markets with network goods Network effects Direct and indirect network effects Network effects and switching costs Empirical evidence on network effects Markets for a single network good Modelling the demand for a network good Provision of a network good Markets for several network goods Demand for incompatible network goods Oligopoly pricing and standardization Strategies for network goods Choosing how to compete A simple analysis of standardization A full analysis of standardization Strategies in standards wars Building an installed base for pre-emption Backward compatibility and performance Expectations management Public policy in network markets Ex ante interventions Ex post interventions 634 References for Part VIII 641 Part IX Market intermediation 643 Introduction to Part IX 643

10 xii 22 Markets with intermediated goods Intermediaries as dealers Intermediated vs. non-intermediated trade Dealer vs. pure platform operator Intermediaries as matchmakers Divide-and-conquer strategies Sorting by an intermediary in a matching market Intermediaries as two-sided platforms The price structure for intermediation services Competing intermediaries Implications for antitrust and regulation Information and reputation in intermediated product markets Intermediation and information Information overload Infomediaries and competition in search markets Information and recommendation networks Intermediation and reputation Certifying intermediaries Reputation systems 707 References for Part IX 718 A Game theory 720 A.1 Games in normal form and Nash equilibrium 720 A.2 Games in extensive form and subgame perfection 723 A.3 Static asymmetric-information games and Bayesian Nash equilibrium 725 A.4 Dynamic asymmetric-information games and perfect Bayesian Nash equilibrium 726 B Competition policy 729 B.1 A brief historical perspective 729 B.2 Competition laws 731 B.2.1 Antitrust legislation in the USA 732 B.2.2 Competition legislation in the EU 733 B.3 Competition policy in the EU and in the USA 734 References for Appendices 737 Solutions to end-of-chapter exercises 738 Index 794

Industrial. Organization. Markets and Strategies. 2nd edition. Paul Belleflamme Universite Catholique de Louvain. Martin Peitz University of Mannheim

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