Industrial Organization ( st term)

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1 Industrial Organization ( st term) Oligopoly Theory Dr. S. Farshad Fatemi Graduate School of Management and Economics Sharif University of Technology September 23, / 19 Dr. S. Farshad Fatemi Industrial Organization ( st term)

2 Basic definitions Recall from microeconomics The competitive market Consumer surplus Welfare When consumer surplus in a partial equilibrium analysis is a valid measure of welfare? Compensation Variation Equivalent Variation Ordinanry v Hicksian Demand Function 2 / 19 Dr. S. Farshad Fatemi Industrial Organization ( st term)

3 What is a firm? Firm is a legal entity; but how the size of the firm is determined? The firm as a loophole for the exercise of monopoly power Price discrimination Intermediate price controls The firm as a static synergy The technology (cost structure) and the size of the firm The firm as a lung-run relationship Switching costs Investments The firm as an incomplete contract transcation costs make the contracts incomplete 3 / 19 Dr. S. Farshad Fatemi Industrial Organization ( st term)

4 The Profit maximization hypothesis Do CEOs act in the best interest of shareholders? The principal-agent problem Limits to manegers discretion Yardstick competition Takeovers Supervision Competition Is neoclassical methodolody the best tool to investigate a firm s behavior? Optimizing bahavior Communication and Knowledge Dynamics of organization Group behavior 4 / 19 Dr. S. Farshad Fatemi Industrial Organization ( st term)

5 Industrial Organization ( st term) Oligopoly Theory Dr. S. Farshad Fatemi Graduate School of Management and Economics Sharif University of Technology September 23, / 19 Dr. S. Farshad Fatemi Industrial Organization ( st term)

6 Some key questions How can we measure market power and market structure? How do firms compete? How do price, output, profits depend on the number of firms in the industry? What happens if firms move sequentially? When is merger bad for consumers? And what defines a market anyway?... 6 / 19 Dr. S. Farshad Fatemi Industrial Organization ( st term)

7 Basic concepts of market structure Monopoly: single firm supplying whole market Perfect competition: large no. of competing firms; Each believes that the market price is given, and is not influenced by its own actions (price takers) Oligopoly: Competition among a small no. of firms; Firms are interdependent: actions do affect price, and firms recognize this Consumers are price-takers 7 / 19 Dr. S. Farshad Fatemi Industrial Organization ( st term)

8 Indexes to Measure Market Concentration Suppose there are firms in a given market and the market share of each firm is defined as (it is clear that F s i = 1) s i = q i i i=1 q i (i {1, 2,..., F }) N-Firm Concentration Ratio: The market share of the largest N firms in the industry N F. Ordering the firms so that: CR = N s i i=1 s 1... s N... s F 8 / 19 Dr. S. Farshad Fatemi Industrial Organization ( st term)

9 ...Indexes to Measure Market Concentration The Herfindahl index: The sum of the squares of the market shares of all the firms in the market: HHI = F si 2 i=1 It also can be normalized (range from 0 to 1): HHI = HHI 1 F 1 1 F The Entropy index: The sum of the market shares multiplied by their logarithms: EI = F s i Lns i i=1 9 / 19 Dr. S. Farshad Fatemi Industrial Organization ( st term)

10 Perfect competition Assumptions - Large number of firms, price takers - Free entry and exit (no fixed costs) - Constant marginal cost, c - Homogeneous good - Perfect information Result - Price p = c (also = average cost) - Consumer surplus is maximized 10 / 19 Dr. S. Farshad Fatemi Industrial Organization ( st term)

11 Natural monopoly Situation where it is optimal for there to be only one firm May or may not mean there is only one incumbent Particularly prevalent in network industries, e.g. gas transportation, rail infrastructure, telecoms (local loop) Network may form one part of a vertical structure - Other parts may be competitive: e.g. gas supply - Access to network likely to be an issue 11 / 19 Dr. S. Farshad Fatemi Industrial Organization ( st term)

12 Monopoly pricing Assume - Price setting behaviour - No entry or exit - Homogeneous good - Constant marginal cost c, may have fixed cost F - Perfect information Result p = c 1 1 ɛ where ɛ = price elasticity of demand (as + ve no.) 12 / 19 Dr. S. Farshad Fatemi Industrial Organization ( st term)

13 Oligopoly models Static models: strategies chosen simultaneously - Cournot (1838): firms compete in quantities - Bertrand (1883): firms compete in prices Dynamic models: - Stackelberg leader-follower equilibrium - Initial capacity choices: Kreps and Scheinkman (1983) 13 / 19 Dr. S. Farshad Fatemi Industrial Organization ( st term)

14 Bertrand: static competition in prices Competitive outcome with just two firms! (Bertrand Paradox) The paradox can be resolved by relaxing any of the three assumptions: - Capacity constraint (Edgeworth) - Temporal dimension - Product differentiation 14 / 19 Dr. S. Farshad Fatemi Industrial Organization ( st term)

15 Rationing rules With capacity constraints, prices alone do not determine each firms sales (capacity constraint can be introduced into the model by considering an increasing and convex cost function) Decreasing return to scale softens price competition Ex-ante investment and ex-post price competition Kreps & Scheinkman (1983) show that quantity pre-commitment and Bertrand competition yield Cournot outcomes. 15 / 19 Dr. S. Farshad Fatemi Industrial Organization ( st term)

16 Kreps & Scheinkman (1983) 2-stage game - Stage 1: choose capacity k - Stage 2: compete in prices Cost of capacity is given by a convex function They show that, with surplus-maximising rationing rule, unique equilibrium involves Cournot outputs and price Not robust to changes in rationing rule: can have multiple equilibria and higher outputs Thus, Cournot a reasonable (and least optimistic) reduced form even when firms choose prices, not quantities 16 / 19 Dr. S. Farshad Fatemi Industrial Organization ( st term)

17 Market definition IO models treat the market as given - Market = group of competing, substitutable goods For some products this is (fairly) straightforward - Homogeneous goods, e.g. salt, electricity - Perfect substitutes What is the geographical scope of the market? - Do imports constrain salt prices in a given country? What is the temporal dimension of the market? - Are competitive conditions in electricity supply different at peak times? 17 / 19 Dr. S. Farshad Fatemi Industrial Organization ( st term)

18 Differentiated goods What about products that are differentiated in some way, i.e. imperfect substitutes? Exactly how substitutable must goods be in order to be in the same market? - Is Coca-Cola in the same market as Pepsi Fanta Orange juice Mineral water Tea...? 18 / 19 Dr. S. Farshad Fatemi Industrial Organization ( st term)

19 Market definition Hypothetical monopolist test: - Antitrust market = smallest set of products that a monopolist would have to control in order to be able profitably to raise price above the competitive level by a small amount (5% or 10%)? - Also known as SSNIP test: small but significant and non-transitory increase in price Look at cross-elasticities of demand 19 / 19 Dr. S. Farshad Fatemi Industrial Organization ( st term)

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