New Perspectives on Industrial Organization

Victor J. Tremblay Carol HortoiiTremblay New Perspectives on Industrial Organization With Contributions from Behavioral Economics and Game Theory fyj Springer

Contents Part I Introductory and Review Material 1 Introduction 3 1.1 The Origins and Methods of Industrial Organization 4 1.1.1 Early Theoretical Foundations 5 1.1.2 Institutional and Empirical Traditions 6 1.1.3 The Structure-Conduct-Performance Paradigm 7 1.1.4 Competing Paradigms and Public Policy 9 1.1.5 Game Theory and the New Theoretical Industrial Organization 11 1.1.6 New Empirical Industrial Organization 12 1.2 Behavioral Economics and Industrial Organization 13 1.3 Public Policy and Industrial Organization 14 1.4 Economic Theory, Models, and Mathematics 16 1.4.1 Theory, Models, and Reality 16 1.4.2 Modeling and Mathematics 18 1.5 Approach of the Book 20 1.6 Summary 22 2 Demand, Technology, and the Theory of the Firm 25 2.1 The Short Run and the Long Run 26 2.2 Consumer Theory and Demand 27 2.2.1 The Introductory Model of Consumer Choice 27 2.2.2 Market Demand 30 2.2.3 Demand Elasticities 31 2.2.4 Total Revenue, Marginal Revenue, Average Revenue, and Price Elasticity 33 2.2.5 Nonfunctional Demand and Behavioral Economics 35

< Contents 2.3 Technology and Costs 37 2.4 The Theory of the Firm 43 2.4.1 Firm Motives 44 2.4.2 The Boundaries of the Firm 46 2.5 Summary 49 2.6 Review Questions 51 3 Introductory Game Theory and Economic Information 55 3.1 Describing a Game 57 3.2 Static Games of Complete Information 59 3.2.1 Fundamental Types of Static Games 60-3.2.2 Static Game Equilibria 65 3.3 Dynamic Games of Complete and Perfect Information 79 3.3.1 Dynamic Games of Complete and Perfect Information 80 3.4 Repeated Games 87 3.5 Bargaining and Fair Allocations 90 3.6 Games with Incomplete, Asymmetric, and Imperfect Information 93 3.7 Concluding Remarks 95 3.8 Summary 95 3.9 Review Questions 98 4 Behavioral Economics 101 4.1 Why Do We Make Mistakes? 102 4.1.1 Complexity, Information, and Bounded Rationality 102 4.1.2 Of Two Minds: The Dual Systems Approach 103 4.2 Salience 104 4.3 Framing Effects 105 4.3.1 Framing Effects and False Beliefs 106 4.3.2 Anchoring 106 4.3.3 Default Effects 107 4.4 If It Makes You Happy 108 4.4.1 Overconfidence 108 4.4.2 Confirmation Bias 108 4.4.3 Cognitive Dissonance 109 4.5 Choice Under Risk and Uncertainty 109 4.5.1 Reference Dependence 109 4.5.2 Endowment Effects, Loss Aversion, and the Status Quo 110 4.5.3 Uncertainty and Signals of Quality 110

Contents xi 4.6 Time-Inconsistent Preferences Ill 4.6.1 Discounting Ill 4.6.2 Neuroeconomics and Self Control 113 4.6.3 Impulsivity 114 4.6.4 Addiction and Cues 114 4.7 Who Are You? Economics and Identity 115 4.8 Summary 117 4.9 Review Questions 118 Part II Perfect Competition, Monopoly, Product Differentiation, and Market Structure - ' 5 Perfect Competition and Market Imperfections 123 5.1 The Assumptions of Perfect Competition 123 5.2 Firm Behavior in Perfect Competition 124 5.2.1 Firm Demand and Revenue Functions 124 5.2.2 Profit Maximization 127 5.3 Market Equilibrium and Long-Run Supply 129 5.4 Comparative Statics 133 5.5 Efficiency and Welfare 134 5.6 Market Failure and the Limitations of Perfect Competition. 138 5.7 Summary 140 5.8 Review Questions...". 143 6 Monopoly and Monopolistic Competition 145 6.1 Monopoly \ 146 6.1.1 Firm Behavior and Market Equilibrium 147 6.1.2 No Supply Curve in Monopoly 151 6.1.3 Allocative Inefficiency 152 6.1.4 X-inefficiency and Rent-Seeking Behavior 154 6.1.5 Dynamic Considerations: Addiction and Product Durability 155 6.1.6 Social Benefits of Monopoly 156 6.2 Monopolistic Competition 157 6.3 Summary.A 160 6.4 Review Questions 161 7 Product Differentiation. 163 7.1 Types of Product Differentiatioa 165 7.2 Product Differentiation and Firm Demand 166 7.2.1 Multicharacteristic Product Differentiation 166 7.2.2 Horizontal Product Differentiation 166 7.2.3 Vertical Product Differentiation 171

xii Contents 7.3 Product Differentiation and Firm Costs 173 7.4 Product Differentiation and the Type of Good 173 7.5 Summary 174 7.6 Review Questions 175 8 Market Structure, Industry Concentration, and Barriers to Entry. 177 8.1 The Delineation of Market Structure 178 8.2 Industry Concentration 179 8.2.1 The Meaning and Measurement of Industry Concentration T. 179 8.2.2 Definition of the Relevant Market 184 8.3 The Extent of Industry Concentration in US Markets 186 8.3.1 Aggregate Concentration 186 8.3.2 Concentration for Selected Industries 187 8.3.3 Changes in Concentration for a Single Industry 188 8.4 The Determinants of Market Structure 191 8.4.1 Gibrat's Law 191 8.4.2 Concentration and Barriers to Entry 193 8.4.3 Sutton's Theory of Sunk Costs and Concentration 199 8.5 Survey and Empirical Evidence 203 8.6 Summary - 206 8.7 Review Questions ". 209 Part III Oligopoly and Market Power 9 Cartels 213 9.1 Cartel Theory 216 9.1.1 Coordination: Output and Price Determination 216 9.1.2 The Fundamental Weakness of a Cartel: The Cartel Dilemma 220 9.1.3 Other Cartel Weaknesses 223 9.2 Strategies That Facilitate Collusion 224 9.2.1 Market Division 224 9.2.2 Most-Favored-Customer Clause 225 9.2.3 Meet-the-Competition Clause 226 9.2.4 Trigger Strategy 227 9.3 Empirical Evidence 229 9.4 Case Studies of Cartels 231 9.4.1 The Steel Industry 231 9.4.2 The OPEC Cartel 232 9.4.3 The International Vitamin Cartel 235 9.5 Summary 237 9.6 Review Questions 238

Contents xiii 10 Quantity and Price Competition in Static Oligopoly Models 241 10.1 Cournot and Bertrand Models with Homogeneous Products 243 10.1.1 The Cournot Model with Two Firms and Symmetric Costs 243 10.1.2 The Cournot Model with Two Firms and Asymmetric Costs 248 10.1.3 The Cournot Model with n Firms and Symmetric Costs 251 10.1.4 The Bertrand Model. -. 254 10.2 Cournot and Bertrand Models with Differentiated Products ::..' 258 10.2.1 The Cournot Model with Multicharacteristic Differentiation 258 10.2.2 The Bertrand Model with Multicharacteristic Differentiation 260 10.2.3 The Bertrand Model with Horizontal and Vertical Differentiation 264 10.3 The Cournot-Bertrand Model 268 10.4 The Choice of Output or Price Competition 272 10.5 Strategic Substitutes and Strategic Complements 275 10.6 Summary : 276 10.7 Review Questions 277 11 Dynamic Monopoly and Oligopoly Models 283 11.1 Two-Period Monopoly arid Duopoly Models 284 11.1.1 The Durable Goods Monopolist 284 11.1.2 The Stackelberg (Dynamic Cournot) Duopoly Model 288 11.1.3 A Dynamic Bertrand Model with Multicharacteristic Differentiation 291 11.1.4 A Dynamic Quantity and Price Game Yields a Cournot Outcome 294 11.1.5 A Dynamic Cournot-Bertrand Model with Multicharacteristic Differentiation 295 11.1.6 Endogenous Timing and Choice of Strategic Variable 296 11.2 Oligopoly Models in Repeated Games 299 11.2.1 Finitely Repeated Duopoly Models 299 11.2.2 Infinitely Repeated Oligopoly Models 300 11.3 Strategic Substitutes, Complements, and Entry Barriers 304 11.4 Summary 307 11.5 Review Questions 308

xiv Contents 12 Market Power 311 12.1 The Measurement of Market Power 312 12.1.1 The Lerner Index in a Static Setting 312 12.1.2 The Lerner Index in a Dynamic Setting 315 12.1.3 Other Measures of Market Power and Industry Performance 315 12.2 Estimating Market Power... 318 12.2.1 Estimating Marginal Cost 318 12.2.2 The Price Response to a Change in Costs 319 12.2.3 The New Empirical Industrial Organization Technique." 319 12.2.4 The Stochastic Frontier Method of Estimating Market Power 323 12.2.5 Estimating Game Theoretic Strategies or Behavior 323 12.2.6 Estimating the Overall Efficiency Loss Due to Market Power 324 12.3 Determinants of Market Power 326 12.3.1 Theory 326 12.3.2 Empirical Evidence 328 12.4 Summary 332 12.5 Review Questions."-. 333 Part IV Other Business Strategies 13 Product Design, Multiproduct Production, and Brand Proliferation 343 13.1 Product Design 344 13.1.1 The Choice of a Vertical Characteristic (Quality) 345 13.1.2 The Choice of a Horizontal Characteristic 352 13.1.3 Mass-Market and Niche-Market Product Design 356 13.2 Multiproduct Production 358 13.2.1 Motives for Multiproduct Production 358 13.2.2 Multiproduct Production in Monopoly 362 13.3 Brand Proliferation 367 13.4 Empirical Evidence 371 13.5 Summary 373 13.6 Review Questions 376 14 Price Discrimination and Other Marketing Strategies 379 14.1 Price Discrimination 380 14.1.1 First-Degree or Perfect Price Discrimination 381 14.1.2 Second-Degree or Nonlinear Price Discrimination 384

Contents xv 14.1.3 Third-Degree or Segmented Price Discrimination 386 14.1.4 The Welfare Effect of Price Discrimination 391 14.1.5 Price Discrimination and Strategic Effects 392 14.2 Other Pricing Strategies 392 14.2.1 Intertemporal Pricing Strategies 392 14.2.2 Damaged Goods and Quality-Dependent Pricing 397 14.2.3 Two-Part Tariffs 399 14.2.4 A Theory of Sales or a Mixed Strategy in Price 401 14.2.5 Price Wars and Wars of Attrition 404 14.3 Other Marketing Strategies 406 14.3.1 Marketing with Framing and Anchoring Effects 406 14.3.2 Bundling and Tying Contracts 408 14.3.3 Marketing to Overconfident Consumers 412 14.3.4 Thirty-Day Free Trials and the Endowment Effect 415 14.4 Summary 416 14.5 Review Questions 418 15 Advertising 423 15.1 Theories of Advertising and Product Type 426 15.1.1 Informative Advertising 426 15.1.2 Persuasive Advertising 429 15.1.3 Advertising and Subjective Differentiation 430 15.1.4 Advertising and the Type of Good '.. 433 15.1.5 Implications for Advertising Intensity 434 15.2 Advertising, Demand, and Costs 434 15.2.1 Advertising and Market Demand 435 15.2.2 Advertising and Firm Demand 436 15.2.3 The Cost of Advertising 438 15.3 The Effect of Market Structure on Advertising 439 15.3.1 Advertising and Perfect Competition 439 15.3.2 Advertising and Monopoly 440 15.3.3 Advertising and Imperfect Competition 444 15.3.4 Summary of Implications and Empirical Evidence 455 15.4 The Effect of Advertising on Market Structure 457 15.5 Summary 459 15.6 Review Questions 462 16 Advertising and Welfare 467 16.1 Advertising and Social Responsibility 468 16.2 Advertising and Efficiency 471 16.2.1 Advertising and Efficiency: A Graphical Approach 471 16.2.2 Advertising and Efficiency: A More General Approach Using Calculus 474

xvi Contents 16.2.3 Advertising and Efficiency When Advertising Lowers Consumer Search Costs 476 16.2.4 Advertising and Efficiency: Empirical Evidence 478 16.2.5 Advertising, Strategic Effects, and Cost Efficiency 482 16.3 Summary 483 16.4 Review Questions 484 17 Technological Change, Dynamic Efficiency, and Market Structure 485 17.1 Invention and Technological Change 488 17.1.1 The Economics of Technological Change 488 17.1.2 A Taxonomy of Research, Invention, and Technological Change 492 17.2 Failure of the Market for Ideas 494 17.3 The Effect of Market Structure on Technological Change 498 17.3.1 Monopoly and Technological Change 500 17.3.2 Competition Versus Monopoly 503 17.3.3 Monopoly and a Potential Entrant 506 17.3.4 Oligopoly and the Incentive to Innovate 509 17.4 The Effect of Technological Change on Market Structure 510 17.5 The Empirical Evidence-. 511 17.6 Summary 514 17.7 Review Questions 517 18 Horizontal, Vertical, and Conglomerate Mergers 521 18.1 A Brief History of US Mergers 522 18.2 Main Motives for Merger 524 18.2.1 Market Power 524 18.2.2 Efficiency 525 18.2.3 Other 525 18.3 Horizontal Mergers 526 18.3.1 The Market Power Motive for Mergers 527 18.3.2 Efficiency Motive for Horizontal Mergers 529 18.3.3 The Empirical Evidence 533 18.4 Vertical Integration, Contracts, and Restrictions 536 18.4.1 Efficiency Motive for Vertical Mergers and Restrictions 537 18.4.2 Vertical Relationships and Anticompetitive Effects 548 18.4.3 A Summary of the Empirical Evidence 551

Contents xvii 18.5 Diversification and Conglomerate Mergers 552 18.5.1 Efficiency Motives for Conglomerate Mergers 552 18.5.2 Conglomerate Mergers and Risk Reduction 553 18.5.3 Conglomerate Mergers and Anticompetitive Effects 554 18.5.4 Managerial Motives for Conglomerate Mergers 555 18.5.5 Behavioral Economicsand Conglomerate Mergers 556 18.5.6 Empirical Evidence 557 18.6 Summary 560 18.7 Review Questions '...-..-.:. 562 Part V Economic Performance and Public Policy 19 Efficiency, Equity, and Corporate Responsibility in Imperfect Competition 569 19.1 Efficiency 570 19.1.1 Static Allocative Inefficiency 571 19.1.2 Other Sources of Static Inefficiency 572 19.1.3 Dynamic Inefficiency 574 19.2 Equity and Corporate Responsibility 575 19.2.1 Corporate Social Responsibility 577 19.2.2 Market Power and the Distribution of Income and Wealth 581 19.3 Summary 583 19.4 Review Questions.' 585 20 Antitrust Law and Regulation 587 20.1 An Introduction to Law and Economics 589 20.1.1 The Philosophy of Law 589 20.1.2 Arrow's Impossibility Theorem 591 20.1.3 Legal Systems and the Evolution of the Law 592 20.2 Antitrust Law 595 20.2.1 Antitrust Legislation 596 20.2.2 Enforcement Procedure and Remedies 597 20.2.3 Important Antitrust Cases and Precedents 598 20.3 Regulation and Deregulation 620 20.3.1 The Role of Industry Regulation 621 20.3.2 Natural Monopoly Regulation 624 20.3.3 Economic Deregulation 627 20.4 Social Regulation 630 20.4.1 Pricing and Packaging Behavior 631 20.4.2 Behavioral Economics and Credit Cards 631

xviii Contents 20.4.3 Behavioral Economics and Libertarian Paternalism: Framing and Inertia 632 20.4.4 Behavioral Economics and Asymmetric Paternalism: Selectively Limiting Choices 634 20.5 Social Concerns with Advertising 635 20.5.1 Advertising and Social Responsibility 635 20.5.2 Advertising Bans and Regulations 638 20.6 Summary 639 20.7 Review Questions 643 21 Industry and Firm Studies 647 21.1 Industry Studies 647 21.1.1 The US Brewing Industry 647 21.1.2 The US Cigarette Industry '. 651 21.1.3 The Economics of College Sports 655 21.2 Firm Studies 658 21.2.1 The Schlitz Brewing Company 658 21.2.2 Microsoft 659 21.2.3 General Motors 663 21.3 Term Paper Topics on Industries and Firms. 666 Appendix A: A Review of Mathematics and Econometrics 669 Appendix B: Answers to Review Questions 701 Appendix C 749 References ' 753 Index 785