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Industrial Organization

Igor BaranovGraduate School of ManagementSt. Petersburg State University

Fall 2008

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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

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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

Industrial Organization In Practice

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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

Motivation for Industrial Organization Study

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• 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)

Structure, Conduct, and Performance

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• 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)

Chicago and Post-Chicago Frameworks

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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

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Basic Microeconomics

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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 accountingprofit

– If positive – will cause entry of new firms/investors intomarket

– 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

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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

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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

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Perfect competition: an illustration

$/unit

Quantity

$/unit

Quantity

D1S1

QC

AC

MC

PCPC

(b) The Industry(a) The Firm With market demand D1and market supply S1

equilibrium price is PCand quantity is QC

With market demand D1and market supply S1

equilibrium price is PCand quantity is QC

With market price PCthe firm maximizes

profit by settingMR (= PC) = MC andproducing quantity qc

With market price PCthe firm maximizes

profit by settingMR (= PC) = MC andproducing quantity qc

qc

D2

Now assume thatdemand

increases toD2

Now assume thatdemand

increases toD2

Q1

P1P1

With market demand D2and market supply S1

equilibrium price is P1and quantity is Q1

With market demand D2and market supply S1

equilibrium price is P1and quantity is Q1

q1

Existing firms maximize profits by increasing

output to q1

Existing firms maximize profits by increasing

output to q1

Excess profits inducenew firms to enter

the market

Excess profits inducenew firms to enter

the market

• The supply curve moves to the right

• Price falls

• Entry continues while profits exist

• Long-run equilibrium is restoredat price PC and supply curve S2

S2

Q´C

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Monopoly

• Derivation of the monopolist’s marginal revenue

Demand: P = A - B.Q

Total Revenue: TR = P.Q = A.Q - B.Q2

Marginal Revenue: MR = dTR/dQMR = A - 2B.Q

With linear demand the marginalrevenue curve is also linear with

the same price interceptbut twice the slope of the demand

curve

$/unit

Quantity

Demand

MR

A

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Monopoly and Profit Maximization

• The monopolist maximizes profit by equating marginal revenue with marginal cost

• This is a two-stage process

$/unit

Quantity

DemandMR

AC

MC

Stage 1: Choose output where MR = MCThis gives output QM

QM

Stage 2: Identify the market clearing priceThis gives price PM

PM MR is less than pricePrice is greater than MC: loss ofefficiency

Price is greater than average costACM

Positive economic profitLong-run equilibrium: no entryQC

Output by themonopolist is lessthan the perfectly

competitiveoutput QC

Output by themonopolist is lessthan the perfectly

competitiveoutput QC

Profit

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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

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Quantity

$/unit

Demand

Competitive Supply

PC

QC

The demand curve measures the willingness to pay for each unitConsumer surplus is the area between the demand curve and the equilibrium price

Consumer surplusThe supply curve measures the

marginal cost of each unitProducer surplus is the area between the supply curve and the equilibrium price

Producer surplus

Aggregate surplus is the sum of consumer surplus and producer surplus

Equilibrium occurswhere supply equalsdemand: price PC

quantity QC

Equilibrium occurswhere supply equalsdemand: price PC

quantity QC

Efficiency and surplus: illustration

The competitive equilibrium is efficient

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Deadweight loss of Monopoly

Demand

Competitive Supply

QC

PC

$/unit

MR Quantity

Assume that the industry is monopolizedThe monopolist sets MR = MC to give output QM

The market clearing price is PM

QM

PMConsumer surplus is given by this areaAnd producer surplus is given by this area

The monopolist produces less surplus than the competitive industry. There are mutually beneficial trades that do not take place: between QM and QC

This is the deadweightloss of monopoly

This is the deadweightloss of monopoly

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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

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Market Structure and Market Power

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The firm’s universe – Porter’s Five Forces

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Market structures

Perfectcompetition

Imperfect competitionMonopoly

Firms are so small theytake price as given and adaptproductionto maximizeprofit

Monopolisticcompetiton:•Many firms•Brand names

Monopolisticcompetition:•Many firms•Brand names

Oligopoly:•Few firms•Inter-dependence

Duopoly:•Two firms•Inter-depence

Private monopoliesset price to maximizeprofit

Harder Competition Softer

Possibilities for lasting superprofit

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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

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Measure of concentration• Compare two different measures of concentration:

Firm Rank Market Share Squared Market (%) Share

1 25

2 25

3 25

4 5

5 5

6 5

7 5

8 5

625

625

625

25

2525

2525

CR4 = 80Concentration Index H = 2,000

25

25

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Concentration index is affected by, e.g. merger

Firm Rank Market Share Squared Market(%) Share

1 25

2 25

3 25

4 5

5 5

6 5

7 5

8 5

625

625

625

25

25

25

25

25

CR4 = 80Concentration Index H = 2,000

25

25

25

5} } }10

85

100

2,050

Assume that firms4 and 5 decide

to merge

The ConcentrationIndex changes

Market shareschange

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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?

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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 marketDifferent markets if:

– sold in different places,– transport of the commodity is expensive,– and/or travel by consumer is expensive

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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?

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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, andB) those who live in the market do most of the purchases from firms in the

market

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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)

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• 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?

Market definition 2

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• 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

Market definition 3

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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

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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-MCP

• 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

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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

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Empirical Application: How Bad is Market Power Really?

WL =12

• Welfare Loss in relation to sales:

WLPQ

12

D(LI)2

• Harberger (1954) exercise: Welfare Loss (WL) is:

(P – MC)(QC – Q)

WLPQ

= 12

(P – MC)P

(QC – Q)Q

• This can be expressed as: =

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How Bad is Market Power Really? 2

WLPQ

12D(LI)2

• Because most industries are not perfect monopolies, Harberger (1954) calculates

=

• 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

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How Bad is Market Power Really? 3

WLPQ

12 D

• One problem is cost, possibly due to how advertising is treated

=

• Under imperfect competition, MC may not be minimized, so P – MC may be artificially low.

(P – MC)P

2

• Corrections by Cowling and Mueller (1978) and Aiginger and Pfaffermayr (1997) raise total cost substantially to between 4 and 11 percent of GDP

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Technology and Cost

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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?

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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

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• 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

Indivisibilities, sunk costs and entry

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Sunk Costs and Market Structure

• The greater are sunk costs the more concentrated is market structure

• An example:Suppose that elasticity of demand = 1Then total expenditure E = PQIf firms are identical then Q = NqiSuppose that LI = (P – c)/P = A/Na

Lerner Index is inversely related to the number of firms

Suppose firms operate in only one period: then (P – c)qi = KAs a result:

Ne = AEK

1/(1+)

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• 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

Economies of Scope

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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

2-37

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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