Igor Baranov Graduate School of Management St. Petersburg State University Fall 2008

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1 Industrial Organization Igor Baranov Graduate School of Management St. Petersburg State University Fall

2 Introduction WHAT is Industrial Organization Study of How firms behave in markets Whole range of business issues pricing decisions which new products to introduce merger decisions methods for attacking or defending markets Industrial Organization takes a Strategic view of how firms interact 2

3 Industrial Organization In Practice HOW Industrial Organization proceeds in practice Rely on the tools of game theory focuses on strategy and interaction Construct models: abstractions well established tradition in all science Simplification but gain the power of generalization Empirical Analysis Use theory to form testable hypotheses for entry deterring actions examine the impact of advertising 3

4 Motivation for Industrial Organization Study WHY do Industrial Organization? Long-standing concern with market power Sherman Antitrust Act (1890) Section 1: prohibits contracts, combinations and conspiracies in restraint of trade Section 2: makes illegal any attempt to monopolize a market Regulation Economics Theory of Business Strategy 4

5 Structure, Conduct, and Performance The Structure-Conduct-Performance Model Spectrum of markets: pure competition--pure monopoly Closer to monopoly means worse welfare loss IO mission is to identify link from market structure to firm conduct (pricing, advertising, etc) to market outcomes (deadweight loss) 5

6 Chicago and Post-Chicago Frameworks The Chicago School Good as well as bad reasons for monopoly including superior skill and technology Potential entry can discipline even a monopoly Structure is endogenous/causality difficult to determine Post-Chicago Game Theoretic Emphasis Competitive Discipline can Fail Careful econometric testing to determine correct policy in actual cases ADM (collusion) Toys R Us (exclusive dealing) American Airlines (predatory pricing) Merger wave (Maytag and Whirlpool) 6

7 The New Industrial Organization The New Industrial Organization is a blend of features theory in advance of policy recognition of connection between market structure and firms behavior WHAT: The study of imperfect competition and strategic interaction HOW: Build on game theory foundation Derive empirically testable propositions Econometric estimates of relations predicted by theory WHY: Motivated largely by antitrust concerns Also interest in private solutions to inefficient market outcomes 7

8 Basic Microeconomics 8

9 Profitability Accounting profit = sales revenue accounting cost Economic profit = accounting profit less opportunity cost Opportunity cost is value of resource from use in best alternative forgone Economic profit is always less than or equal to accounting profit If positive will cause entry of new firms/investors into market If negative will cause exit of firms/investors from market If zero a normal profit is earned relative to risk no particular incentives for entry or exit of market Normal profit is an opportunity cost of the invested capital Economic profit = Accounting profit less normal profit Superprofit positive economic profit We assume that the goal of the firm is to maximize profit 9

10 Efficiency and Market Performance Contrast two polar cases perfect competition monopoly What is efficiency? no reallocation of the available resources makes one economic agent better off without making some other economic agent worse off 10

11 Perfect Competition Firms and consumers are price-takers Firm can sell as much as it likes at the ruling market price do not need many firms do need the idea that firms believe that their actions will not affect the market price Therefore, marginal revenue equals price To maximize profit a firm of any type must equate marginal revenue with marginal cost So in perfect competition price equals marginal cost 11

12 Perfect competition: an illustration The supply curve moves to the right With With market market demand demand D 2 (a) The Firm (b) With With The market Industry demand demand D 2 and and market market supply supply S 1 Price falls and and market market supply supply S 1 With With market price 1 1 $/unit price P equilibrium C price price is is P 1 C $/unit equilibrium price price is is P 1 the C the firm firm maximizes Entry continues while profits exist and and quantity C and and quantity Now quantity is quantity Now assume is Q assume is is Q that 1 profit C that 1 by by setting MC demand C Existing Long-run firms firms equilibrium maximize is restored demand MR MR (= (= P C ) C ) = MC MC and and at profits price P increases D S to by C and by increasing supply curve S to producing quantity q c c output AC D to to q P 1 P C P 1 Excess Excess profits profits induce induce new new firms firms to to Penter C the the market market D 2 S 2 q c q 1 Quantity Q C Q 1 Q C Quantity 12

13 Monopoly Derivation of the monopolist s marginal revenue Demand: P = A - B.Q Total Revenue: TR = P.Q = A.Q - B.Q 2 Marginal Revenue: MR = dtr/dq MR = A - 2B.Q $/unit A With linear demand the marginal revenue curve is also linear with the same price intercept but twice the slope of the demand curve MR Demand Quantity 13

14 Monopoly and Profit Maximization The monopolist maximizes profit by equating marginal revenue with marginal cost This is a two-stage process $/unit P M AC M Profit Q M MR Q C Stage 1: Choose output where MR = MC This gives output Q Output Output by by the the M monopolist is is Stage less less 2: Identify the market clearing price MC than than the the perfectly This gives price P M competitive output AC output Q C C MR is less than price Price is greater than MC: loss of efficiency Price is greater than average cost Demand Quantity Positive economic profit Long-run equilibrium: no entry 14

15 Efficiency and Surplus Can we reallocate resources to make some individuals better off without making others worse off? Need a measure of well-being consumer surplus: difference between the maximum amount a consumer is willing to pay for a unit of a good and the amount actually paid for that unit aggregate consumer surplus is the sum over all units consumed and all consumers producer surplus: difference between the amount a producer receives from the sale of a unit and the amount that unit costs to produce aggregate producer surplus is the sum over all units produced and all producers total surplus = consumer surplus + producer surplus 15

16 Efficiency and surplus: illustration The demand curve measures the willingness to pay for each unit Consumer surplus is the area between the demand curve and the equilibrium price $/unit Competitive Supply The supply curve measures the marginal cost of each unit Producer surplus is the area between the supply curve and the equilibrium price P C Consumer surplus Producer surplus Equilibrium occurs occurs where where supply supply equals equals demand: price price P C C quantity quantity Q C C Demand Aggregate surplus is the sum of consumer surplus and producer surplus The competitive equilibrium is efficient Q C Quantity 16

17 Deadweight loss of Monopoly Assume that the industry is monopolized The monopolist sets MR = MC to give output Q M The market clearing price is P M Consumer surplus is given by this area And producer surplus is given by this area $/unit P M P C Competitive Supply This This is is the the deadweight loss lossof of monopoly The monopolist produces less surplus than the competitive industry. There are mutually beneficial trades that do not take place: between Q M and Q C Q M Q C MR Demand Quantity 17

18 Deadweight loss of Monopoly 2 Why can the monopolist not appropriate the deadweight loss? Increasing output requires a reduction in price this assumes that the same price is charged to everyone. The monopolist creates surplus some goes to consumers some appears as profit The monopolist bases her decisions purely on the surplus she gets, not on consumer surplus The monopolist undersupplies relative to the competitive outcome The primary problem: the monopolist is large relative to the market 18

19 Market Structure and Market Power 19

20 The firm s universe Porter s Five Forces 20

21 Market structures Harder Competition Softer Perfect competition Imperfect competition Monopoly Firms are so small they take price as given and adapt production to maximize profit Monopolistic competition: competiton: Many firms Brand names Oligopoly: Few firms Interdependence Duopoly: Two firms Interdepence Possibilities for lasting superprofit Private monopolies set price to maximize profit 21

22 Introduction Industries have very different structures numbers and size distributions of firms mobile communications, diapers: high concentration newspapers: low concentration How best to measure market structure summary measure concentration curve is possible preference is for a single number concentration ratio or Herfindahl-Hirschman index 22

23 Measure of concentration Compare two different measures of concentration: Firm Rank Market Share Squared Market (%) Share Concentration Index CR 4 = 80 H = 2,

24 Concentration index is affected by, e.g. merger Firm Rank Market Share Squared Market (%) Share 1 Assume that firms and 5 decide 25 to merge The Concentration 5 7 Index changes Market shares change } } 10 } Concentration Index CR 4 = H = 2, ,050 24

25 What is a market? No clear consensus the market for automobiles should we include light trucks; pick-ups SUVs? the market for soft drinks what are the competitors for Coca Cola and Pepsi? With whom do McDonalds and Burger King compete? Presumably define a market by closeness in substitutability of the commodities involved how close is close? how homogeneous do commodities have to be? 25

26 Identifying the relevant market who is the competition? Competitor s products have similar characteristics Ford Focus and VW Golf not Ford Focus and Jeep Grand Cherokee Same occasions for use Coca Cola and Pepsi Cola But not Coca Cola and orange juice Cross elasticities Higher for closer substitutes Sold in the same geographical market Different markets if: sold in different places, transport of the commodity is expensive, and/or travel by consumer is expensive 26

27 Examples of cross elasticities Source: Colander 1998 Why are the two first elasticities different? Why is the last one negative? Are any of these products close substitutes? 27

28 Defining the geographic market 1) Where do consumers live? Identify core area. E.g. register postal code on sales Which competitors are within the geographical area? 2) Survey of residents in the core area regarding shopping habits in- and outside area. Elzinga and Hogarty (1978); well-defined geographic area if: A) Firms in the market draw most (80-90%) of the customers from the market, and B) those who live in the market do most of the purchases from firms in the market 28

29 Market definition Definition is important without consistency concept of a market is meaningless need indication of competitiveness of a market: affected by definition public policy: decisions on mergers can turn on market definition Staples/Office Depot merger rejected on market definition Coca Cola expansion turned on market definition Standard approach has some consistency based upon industrial data substitutability in production not consumption (ease of data collection) 29

30 Market definition 2 Government statistical sources (for US: FedStats) The measure of concentration varies across countries Use of production-based statistics has limitations: can put in different industries products that are in the same market The international dimension is important Boeing/McDonnell-Douglas merger relevant market for automobiles, oil, hairdressing Geography is important barrier to entry if the product is expensive to transport but customers can move what is the relevant market for a beach resort or ski-slope? 30

31 Market definition 3 Vertical relations between firms are important most firms make intermediate rather than final goods firm has to make a series of make-or-buy choices upstream and downstream production measures of concentration may assign firms at different stages to the same industry do vertical relations affect underlying structure? firms at different stages may also be assigned to different industries bottlers of soft drinks: low concentration suppliers of soft drinks: high concentration the bottling sector is probably not competitive. In sum: market definition poses real problems existing methods represent a reasonable compromise 31

32 The Role of Policy Government can directly affect market structure by limiting entry license (taxi etc.) airline regulation through the patent system by protecting competition e.g. through the Robinson- Patman Act 32

33 Measuring Market Power/Performance Market structure is often a guide to market performance But this is not a perfect measure can have near competitive prices even with few firms Measure market performance using the Lerner Index LI = P-MC P Perfect competition: LI = 0 since P = MC Monopoly: LI = 1/ inverse of elasticity of demand With more than one but not many firms, the Lerner Index is more complicated: need to average. suppose the goods are homogeneous so all firms sell at the same price 33

34 Lerner Index: Limitations LI has limitations measurement: as with measuring a market meaning: measures outcome but not necessarily performance misspecification: if there are sunk entry costs that need to be covered by positive price-cost margin low price by a high-cost incumbent to protect its market 34

35 Empirical Application: How Bad is Market Power Really? Harberger (1954) exercise: Welfare Loss (WL) is: WL = 1 2 Welfare Loss in relation to sales: WL PQ = 1 2 WL PQ (P MC)(Q C Q) 1 2 (P MC) P This can be expressed as: = D (LI) 2 (Q C Q) Q 35

36 How Bad is Market Power Really? 2 Because most industries are not perfect monopolies, Harberger (1954) calculates WL PQ = 1 2 D(LI) 2 For 73 manufacturing industries assuming D =1. Multiplying the result by each industry s output and summing over all industries he estimates a total welfare loss from monopoly power of about two-tenths of one percent of GDP 36

37 How Bad is Market Power Really? 3 One problem is cost, possibly due to how advertising is treated WL PQ = 1 2 D (P MC) P 2 Under imperfect competition, MC may not be minimized, so P MC may be artificially low. Corrections by Cowling and Mueller (1978) and Aiginger and Pfaffermayr (1997) raise total cost substantially to between 4 and 11 percent of GDP 37

38 Technology and Cost 38

39 The Neoclassical View of the Firm Concentrate upon a neoclassical view of the firm the firm transforms inputs into outputs Inputs Outputs The Firm There is an alternative approach (Coase) What happens inside firms? How are firms structured? What determines size? How are individuals organized/motivated? 39

40 Economies of Scale Sources of economies of scale the 60% rule : capacity related to volume while cost is related to surface area product specialization and the division of labor economies of mass reserves : economize on inventory, maintenance, repair indivisibilities 40

41 Indivisibilities, sunk costs and entry Indivisibilities make scale of entry an important strategic decision: enter large with large-scale indivisibilities: heavy overhead enter small with smaller-scale cheaper equipment: low overhead Some indivisible inputs can be redeployed aircraft Other indivisibilities are highly specialized with little value in other uses market research expenditures Latter are sunk costs: nonrecoverable if production stops Sunk costs affect market structure by affecting entry 41

42 Sunk Costs and Market Structure The greater are sunk costs the more concentrated is market structure An example: Suppose that elasticity of demand = 1 Then total expenditure E = PQ If firms are identical then Q = Nq i Suppose that LI = (P c)/p = A/N a Lerner Index is inversely related to the number of firms Suppose firms operate in only one period: then (P c)q i = K As a result: N e = AE K 1/(1+ ) 42

43 Economies of Scope Sources of economies of scope Shared inputs same equipment for various products shared advertising creating a brand name marketing and R&D expenditures that are generic Cost complementarities producing one good reduces the cost of producing another oil and natural gas oil and benzene computer software and computer support retailing and product promotion 43

44 Determinants of Market Structure Economies of scale and scope affect market structure but cannot be looked at in isolation. They must be considered relative to market size. Should see concentration decline as market size increases Find more extensive range of financial service companies in Wall Street, New York than in Frankfurt

45 Network Externalities Market structure is also affected by the presence of network externalities willingness to pay by a consumer increases as the number of current consumers increase telephones, fax, Internet, Windows software utility from consumption increases when there are more current consumers These markets are likely to contain a small number of firms even if there are limited economies of scale and scope 45

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