This page intentionally left blank

Industrial Organization

Industrial Organization: Markets and Strategies provides an up-to-date account of modernindustrial organization that blends theory with real-world applications. Written in a clear andaccessible style, it acquaints the reader with the most important models for understandingstrategies chosen by firms with market power and shows how such firms adapt to differentmarket environments. It covers a wide range of topics including recent developments onproduct bundling, branding strategies, restrictions in vertical supply relationships, intellectualproperty protection and two-sided markets, to name just a few. Models are presented in detailand the main results are summarized as lessons. Formal theory is complemented throughoutby real-world cases that show students how it applies to actual organizational settings. Thebook is accompanied by a website containing a number of additional resources for lecturersand students, including exercises, solutions to exercises and slides.

Companion website at www.cambridge.org/belleflamme.

Paul Belleflamme is Professor of Economics at the Universite catholique de Louvain,Belgium. He has published several articles in leading economics journals and teaches coursesin the fields of industrial organization and managerial economics.

Martin Peitz is Professor of Economics at the University of Mannheim, Germany. He haspublished widely in leading economics journals and, with Paul de Bijl, is the author ofRegulation and Entry into Telecommunications Markets (Cambridge University Press, 2003).

IndustrialOrganizationMarkets and Strategies

Paul BelleflammeUniversite catholique de Louvain

Martin PeitzUniversity of Mannheim

CAMBRIDGE UNIVERSITY PRESSCambridge, New York, Melbourne, Madrid, Cape Town, Singapore,So Paulo, Delhi, Dubai, Tokyo

Cambridge University PressThe Edinburgh Building, Cambridge CB2 8RU, UK

First published in print format

ISBN-13 978-0-521-86299-8

ISBN-13 978-0-521-68159-9

ISBN-13 978-0-511-77004-3

Paul Belleflamme and Martin Peitz 2010

2010

Information on this title: www.cambridge.org/9780521862998

This publication is in copyright. Subject to statutory exception and to the provision of relevant collective licensing agreements, no reproduction of any partmay take place without the written permission of Cambridge University Press.

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.

Published in the United States of America by Cambridge University Press, New York

www.cambridge.org

Paperback

eBook (NetLibrary)

Hardback

Contents

List of figures xiiiList of tables xvList of cases xviPreface xix

Part I Getting started 1Introduction to Part I 1

1 What is Markets and Strategies? 31.1 Markets 31.2 Strategies 61.3 Models and material of Markets and Strategies 81.4 Level, scope and organization of the book 9

2 Firms, consumers and the market 132.1 Firms and consumers 13

2.1.1 The firm 142.1.2 Looking inside the black box of a firm 162.1.3 Consumers and rational man 212.1.4 Welfare analysis of market outcomes 24

2.2 Market interaction 262.2.1 The perfectly competitive paradigm 262.2.2 Strategies in a constant environment (monopoly) 262.2.3 Dominant firm model 292.2.4 Imperfect competition 32

2.3 Market definition and market performance 332.3.1 How to define a market? 332.3.2 How to assess market power? 34

Notes for Part I 38References for Part I 39

Part II Market power 41Introduction to Part II 41

3 Static imperfect competition 453.1 Price competition 45

3.1.1 The standard Bertrand model 453.1.2 Price competition with uncertain costs 473.1.3 Price competition with differentiated products 493.1.4 Asymmetric competition with differentiated products 52

vi Contents

3.2 Quantity competition 543.2.1 The linear Cournot model 543.2.2 Implications of Cournot competition 58

3.3 Price versus quantity competition 593.3.1 Limited capacity and price competition 603.3.2 Differentiated products: Cournot versus Bertrand 643.3.3 What is the appropriate modelling choice? 66

3.4 Strategic substitutes and strategic complements 673.5 Estimating market power 70

4 Dynamic aspects of imperfect competition 754.1 Sequential choice: Stackelberg 75

4.1.1 One leader and one follower 764.1.2 One leader and an endogenous number of followers 794.1.3 Commitment 80

4.2 Free entry: endogenous number of firms 814.2.1 Properties of free-entry equilibria 824.2.2 The Cournot model with free entry 834.2.3 Price competition with free entry 854.2.4 Monopolistic competition 87

4.3 Industry concentration and firm turnover 914.3.1 Exogenous versus endogenous sunk costs 914.3.2 Dynamic firm entry and exit 97

Notes for Part II 103References for Part II 104

Part III Sources of market power 107Introduction to Part III 107

5 Product differentiation 1115.1 Views on product differentiation 1125.2 Horizontal product differentiation 113

5.2.1 A simple location model 1135.2.2 The linear Hotelling model 1155.2.3 The quadratic Hotelling model 118

5.3 Vertical product differentiation 1205.3.1 Quality choice 1205.3.2 Natural oligopolies 123

5.4 Empirical analysis of product differentiation 1255.4.1 Probabilistic choice and the logit model 1265.4.2 Empirical analysis of horizontal product differentiation 1295.4.3 Empirical analysis of vertical product differentiation 1305.4.4 Nested logit and other extensions 131

vii Contents

6 Advertising and related marketing strategies 1356.1 Views on advertising 1356.2 Price and non-price strategies in monopoly 139

6.2.1 PriceAdvertising decisions: the DorfmanSteiner model 1396.2.2 A closer look at how advertising affects demand 141

6.3 Some welfare economics of advertising 1426.4 Advertising and competition 144

6.4.1 Informative advertising 1446.4.2 Persuasive advertising 149

7 Consumer inertia 1577.1 Uninformed consumers and search costs 157

7.1.1 Price dispersion 1587.1.2 Consumer search 1637.1.3 Empirical investigation of price dispersion 165

7.2 Switching costs 1677.2.1 Competitive effects of switching costs 1677.2.2 Coupons and endogenous switching costs 1767.2.3 Estimating switching costs 179

7.3 Customer poaching 181

Notes for Part III 188References for Part III 190

Part IV Pricing strategies and market segmentation 193Introduction to Part IV 193

8 Group pricing and personalized pricing 1958.1 Price discrimination 195

8.1.1 Price discrimination: a typology 1958.1.2 Know thy customers 197

8.2 Group and personalized pricing in monopoly 1988.3 Group and personalized pricing in oligopolies 201

8.3.1 Group pricing and localized competition 2018.3.2 Personalized pricing and location decisions 2078.3.3 Geographic price discrimination 208

9 Menu pricing 2179.1 Menu pricing versus group pricing 2179.2 A formal analysis of monopoly menu pricing 219

9.2.1 Quality-dependent prices 2199.2.2 Information goods and damaged goods 2249.2.3 Extension to time- and quantity-dependent prices 226

9.3 Menu pricing under imperfect competition 2279.3.1 Competitive quality-based menu pricing 2289.3.2 Competitive quantity-based menu pricing 234

viii Contents

10 Intertemporal price discrimination 23910.1 Durable good monopoly without commitment 239

10.1.1 Small number of consumers 24010.1.2 Large number of consumers 243

10.2 Durable good monopoly with commitment 24710.2.1 Fixed capacities 24810.2.2 Flexible capacity 25010.2.3 Intertemporal pricing and demand uncertainty 251

10.3 Behaviour-based price discrimination 255

11 Bundling 25911.1 A formal analysis of monopoly bundling 260

11.1.1 Pure bundling as a device to offer a discount 26111.1.2 Mixed bundling 26411.1.3 Extensions 265

11.2 Tying and metering 26911.3 Competitive bundling 272

11.3.1 Bundling as a way to soften price competition 27211.3.2 When bundling intensifies price competition 274

Notes for Part IV 279References for Part IV 280

Part V Product quality and information 283Introduction to Part V 283

12 Asymmetric information, price and advertising signals 28512.1 Asymmetric information problems 285

12.1.1 Hidden information problem 28512.1.2 Hidden action problem 289

12.2 Advertising and price signals 29212.2.1 Advertising signals 29212.2.2 Price signals 29612.2.3 Joint price and advertising signals 303

12.3 Price signalling under imperfect competition 305

13 Marketing tools for experience goods 30913.1 Warranties 309

13.1.1 Warranties as a reliability signal 31013.1.2 Warranties and investment in quality control 312

13.2 Branding 31413.2.1 Intertemporal branding and reputation 31613.2.2 Reputation and competition 31713.2.3 Umbrella branding 320

Notes for Part V 327References for Part V 328

ix Contents

Part VI Theory of competition policy 331Introduction to Part VI 331

14 Cartels and tacit collusion 33514.1 Formation and stability of cartels 336

14.1.1 Simultaneous cartel formation 33714.1.2 Sequential cartel formation 33914.1.3 Network of market-sharing agreements 341

14.2 Sustainability of tacit collusion 34314.2.1 Tacit collusion: the basics 34314.2.2 Optimal punishment of deviating firms 34914.2.3 Collusion and multimarket contact 35314.2.4 Tacit collusion and cyclical demand 35814.2.5 Tacit collusion with unobservable actions 361

14.3 Detecting and fighting collusion 36314.3.1 The difficulty in detecting collusion 36514.3.2 Leniency and whistleblowing programs 367

15 Horizontal mergers 37315.1 Profitability of simple Cournot mergers 374

15.1.1 Mergers between two firms 37415.1.2 Mergers between several firms 37615.1.3 Efficiency-increasing mergers 377

15.2 Welfare analysis of Cournot mergers 38115.2.1 Linear Cournot model with synergies 38215.2.2 General welfare analysis 384

15.3 Beyond simple Cournot mergers 38615.3.1 Successive mergers 38715.3.2 Mergers and entry 38915.3.3 Mergers under price competition 39015.3.4 Coordinated effects 392

15.4 Empirical merger analyses 39515.4.1 Event studies and direct price comparisons 39515.4.2 Merger simulations 395

16 Strategic incumbents and entry 39916.1 Taxonomy of entry-related strategies 400

16.1.1 Entry deterrence 40016.1.2 Entry accommodation 402

16.2 Strategies affecting cost variables 40516.2.1 Investment in capacity as an entry deterrent 40516.2.2 Investment as an entry deterrent reconsidered 41116.2.3 Raising rivals costs 412

16.3 Strategies affecting demand variables 41516.3.1 Brand proliferation 415

x Contents

16.3.2 Bundling and leverage of market power 41716.3.3 Switching costs as an entry deterrent 420

16.4 Limit pricing under incomplete information 42316.5 Entry deterrence and multiple incumbents 427

17 Vertically related markets 43317.1 The double-marginalization problem 433

17.1.1 Linear pricing and double marginalization 43317.1.2 Contractual solutions to the double-marginalization problem 43517.1.3 Double marginalization and retail services 436

17.2 Resale-price maintenance and exclusive territories 43717.2.1 Resale-price maintenance 43717.2.2 Exclusive territories 440

17.3 Exclusive dealing 44317.3.1 Anticompetitive effects of exclusive dealing contracts? The Chicago critique 44517.3.2 Vertical integration and long-term contracts as partial deterrence devices 44617.3.3 Full exclusion and multiple buyers 45017.3.4 Exclusive contracts and investment incentives 452

17.4 Vertical oligopoly and vertical mergers 45417.4.1 Vertical oligopoly 45517.4.2 Exclusionary effects of vertical mergers 45717.4.3 Coordinated effects of vertical mergers 463

Notes for Part VI 466References for Part VI 470

Part VII R&D and intellectual property 475Introduction to Part VII 475

18 Innovation and R&D 47918.1 Market structure and incentives to innovate 480

18.1.1 Monopoly versus perfect competition: the replacement effect 48118.1.2 Incentives to innovate in oligopolies 484

18.2 When innovation affects market structure 48618.2.1 Monopoly threatened by entry: the efficiency effect 48618.2.2 Asymmetric patent races: replacement and efficiency effects 48718.2.3 Socially excessive R&D in a patent race 490

18.3 R&D cooperation and spillovers 49218.3.1 Effects of strategic behaviour 49318.3.2 Effects of R&D cooperation 49718.3.3 Futher analysis of R&D cooperation 499

19 Intellectual property 50519.1 Remedies to the appropriability problem 506

19.1.1 Information and appropriability 50619.1.2 Intellectual property protection 507

xi Contents

19.1.3 Subsidization and secrecy 51219.1.4 Protection of IP in practice 514

19.2 Optimal patent design 51719.2.1 Optimal patent length 51719.2.2 Optimal patent breadth 520

19.3 Patent licensing and pooling 52319.3.1 Licensing to rival firms 52319.3.2 Licensing and cumulative innovations 526

19.4 Intellectual property in the digital economy 53019.4.1 Digital music and end-user piracy 53019.4.2 Economics of open source 533

Notes for Part VII 540References for Part VII 542

Part VIII Networks, standards and systems 545Introduction to Part VIII 545

20 Markets with network goods 54920.1 Network effects 549

20.1.1 Direct and indirect network effects 54920.1.2 Network effects and switching costs 55020.1.3 Empirical evidence on network effects 552

20.2 Markets for a single network good 55420.2.1 Modelling the demand for a network good 55420.2.2 Provision of a network good 563

20.3 Markets for several network goods 56620.3.1 Demand for incompatible network goods 56720.3.2 Oligopoly pricing and standardization 575

21 Strategies for network goods 58121.1 Choosing how to compete 581

21.1.1 A simple analysis of standardization 58221.1.2 A full analysis of standardization 584

21.2 Strategies in standards wars 59121.2.1 Building an installed base for preemption 59121.2.2 Backward compatibility and performance 59621.2.3 Expectations management 599

21.3 Public policy in network markets 60121.3.1 Ex ante interventions 60121.3.2 Ex post interventions 603

Notes for Part VIII 606References for Part VIII 607

xii Contents

Part IX Market intermediation 609Introduction to Part IX 609

22 Markets with intermediated goods 61322.1 Intermediaries as dealers 613

22.1.1 Intermediated versus nonintermediated trade 61422.1.2 Dealer versus pure platform operator 616

22.2 Intermediaries as matchmakers 62222.2.1 Divide-and-conquer strategies 62322.2.2 Sorting by an intermediary in a matching market 625

22.3 Intermediaries as two-sided platforms 62822.3.1 The price structure for intermediation services 62822.3.2 Competing intermediaries 63222.3.3 Implications for antitrust and regulation 639

23 Information and reputation in intermediated product markets 64723.1 Intermediation and information 647

23.1.1 Information overload 64723.1.2 Infomediaries and competition in search markets 65023.1.3 Information and recommendation networks 655

23.2 Intermediation and reputation 66223.2.1 Certifying intermediaries 66223.2.2 Reputation systems 668

Notes for Part IX 674References for Part IX 676

Appendices 679

A Game theory 679A.1 Games in normal form and Nash equilibrium 679A.2 Games in extensive form and subgame perfection 682A.3 Static asymmetric information games and Bayesian Nash equilibrium 684A.4 Dynamic asymmetric information games and perfect Bayesian Nash equilibrium 685

B Competition Policy 689B.1 A brief historical perspective 689B.2 Competition laws 691

B.2.1 Antitrust legislation in the United States 692B.2.2 Competition legislation in the European Union 693

B.3 Competition policy in the EU and in the US 694

Notes for Appendices 697References for Appendices 698

Index 699

Figures

2.1 Consumer surplus page 253.1 Reaction functions and equilibrium in the Bertrand duopoly (with homogeneous

product, and identical and constant marginal costs) 463.2 Residual demand for a Cournot oligopolist 553.3 Cournot duopoly 573.4 Efficient rationing with limited capacities 613.5 Setting p2 > p is not a profitable deviation 633.6 Reaction functions for price vs. quantity competition (when firms produce

substitutable goods) 694.1 Equilibrium number of firms in an endogenous sunk cost industry 954.2 The lower bound of concentration in endogenous vs. exogenous sunk cost industries 965.1 Consumer choice in the linear Hotelling model 1165.2 Profit function in the linear Hotelling model 1175.3 Profit function under vertical differentiation 1215.4 The consumer choice problem on Internet shopbots 1336.1 Demand with informative advertising 1467.1 Period-2 demand in the model with customer poaching 1838.1 Uniform pricing vs. group pricing with two segments 2008.2 Effect of increased segmentation on the division of welfare under monopoly

group pricing 2018.3 Partition of the unit interval 2028.4 Profits of a typical firm at stage 1 2068.5 Firms profits under perfect price discrimination for given locations 2088.6 Pricing policy choices at equilibrium 214

10.1 Optimal intertemporal pricing in the presence of two consumers 24310.2 Concavified profit function 24911.1 Separate selling vs. pure bundling 26111.2 Effect of price reduction under separate selling and pure bundling 26211.3 Consumer surplus under pure bundling vs. separate selling 26311.4 Demand under mixed bundling 26411.5 Separate selling vs. pure bundling with correlated values 26711.6 Bundling an increasing number of goods 26811.7 Bundling in a duopoly 27311.8 Preferences for systems 27512.1 Expected quality under asymmetric information 28712.2 Price distortion to signal high quality 30114.1 Stick-and-carrot strategy in the linear Cournot duopoly 35215.1 Levels of synergies necessary for a Cournot merger to be profitable (p), to enhance

welfare (w) or consumer surplus (c) 38316.1 Best responses in an entry model with capacity commitment 40716.2 The incumbents profit function in an entry model with capacity commitment 40716.3 Possible equilibria in an entry model with capacity commitment 40816.4 Demand in the duopoly model with bundling by firm 1 41817.1 A two-region model with exclusive territories 44117.2 Exclusive dealing contracts as a barrier of entry: the incumbent sellers profit 449

xiv List of figures

18.1 Drastic and nondrastic process innovations 48218.2 Incentives to innovate as a function of market structure 48318.3 Strategic effect of R&D investments 49519.1 Trade-off between dynamic and static efficiency 50920.1 A simple star network 55520.2 Fulfilled expectations demand when consumers value network benefits differently 56020.3 Fulfilled expectations demand when consumers value stand-alone benefits differently 56220.4 Network provision under monopoly and perfect competition 56520.5 Technology adoption with network effects 56920.6 Potential coordination failures in the adoption of incompatible network goods 57020.7 Symmetric bandwagon equilibrium 57421.1 Nash equilibria (NE) in the standardization game 58721.2 Entry deterrence through installed base building (c =0.4) 59322.1 Intermediaries business models: dealer and platform operator 61722.2 Equilibrium trade under dealer and platform intermediation 62123.1 Information overload on an open access platform 64923.2 Information overload and the role of an information gatekeeper 65023.3 Product choice of a single consumer 659A.1 Extensive form of the simplified Stackelberg model 683

Tables

2.1 Herfindahl indices in the US manufacturing sector page 366.1 Informative advertising in the Yoplait 150 case 1386.2 Advertising for the top 10 US marketers 140

16.1 Payoffs in the brand proliferation game 41716.2 Payoffs in the noncooperative entry deterrence game 42718.1 Expected profits in a patent race 49119.1 Comparative overview of patent and copyright protection in the EU and in the US 51020.1 Consumers utility 56720.2 A typical coordination game 57020.3 Outcomes when opponent plays a bandwagon strategy 57321.1 A simple standardization game 58221.2 Payoffs in standardization game Scenario 1 58621.3 Payoffs in standardization game Scenario 2 59021.4 Installed base and penetration pricing 59323.1 Expected utility according to signal and match 658

Cases

1.1 Alcoas natural monopoly page 62.1 The market for generics 302.2 Using supply-side substitutability to define the relevant market 342.3 How concentration differs across industries and over time 353.1 Bananas and oranges 503.2 Airbus vs. Boeing and the market for wide-bodied aircrafts 513.3 When capacity choices condition pricing decisions in the DVD-by-mail industry 603.4 Digital revolution in the publishing industry 674.1 Entry in small cities in the US 824.2 Socially excessive entry of radio stations in the US 874.3 Endogenous sunk costs for supermarkets in the US 964.4 Entry and exit of hair salons in Sweden 1015.1 Coffee differentiation 1135.2 Product positioning in the VLJ industry: the battle of bathrooms 1235.3 Probabilistic modelling of individual behaviour and Apples iPhone 1265.4 Nested logit in the US car market 1325.5 Nested logit for Internet bookshops: brand matters 1326.1 US 2006 media spending on advertising 1366.2 Yoplait 150 1376.3 Advertising Heinz ketchup 1416.4 Joint advertising campaign to promote private healthcare 1547.1 Does search intensity affect price dispersion? 1667.2 Examples of switching costs 1677.3 Coupons in the ready-to-eat breakfast cereals market 1777.4 Direct econometric methods to estimate switching costs in the market

for mobile telephony 1817.5 Pay-to-switch in the business automation software market 1828.1 Price discrimination in airline fares 1978.2 Data mining 1988.3 International price discrimination in the textbook market 2088.4 International price discrimination in the car market 2108.5 Pricing by supermarkets in the United Kingdom 2159.1 Examples of menu pricing in the information economy 2179.2 Geographical pricing by low cost carriers 2189.3 Damaged goods and fighting brands 2259.4 Empirical studies of price discrimination 2289.5 Add-on pricing 233

10.1 Durable good monopoly and the Microsoft case 24610.2 Planned obsolescence of textbooks 24710.3 Zara and the clothing industry 25411.1 Examples of bundling in the information economy 26011.2 Why does popcorn cost so much at the movies? 27111.3 Triple play 27712.1 Why did prices plunge on the Mumbai second-hand car market after July 2005? 28612.2 Adverse selection in the second-hand car market 28812.3 Selling used products over eBay 289

xvii List of cases

12.4 Quality management systems 29012.5 Empirical examination of advertising as a signal of quality 29512.6 When low quality poses as high quality 29712.7 Price signalling for Bordeaux wines 30213.1 Warranties in the market for new cars 31113.2 The birth of brands in the Indus valley 31413.3 Twin cars and brand names 31513.4 Virtues of the Virgin brand 32113.5 Umbrella branding in the market of oral hygiene products 32514.1 The vitamin cartels 33614.2 The vitamin cartels (2) 34714.3 Multimarket contact in the US airline industry 35314.4 Market-sharing agreements in Europe and the US 35614.5 The vitamin cartels (3) 36414.6 The Joint Executive Committee 36614.7 The vitamin cartels (4) 36714.8 The beer cartel in the Netherlands 36815.1 Mergers and acquisitions in Europe 37415.2 The efficiency defence in the Superior Propane case 38115.3 Potential consolidation in the US airline industry 38715.4 Coordinated effects in the Nestle Perrier merger 39215.5 Merger simulation in mobile telephony in Portugal 39615.6 The proposed merger between the European truck manufacturers Volvo and Scania 39716.1 Kodak vs. Fuji Act I 40416.2 Entry deterrence in hospital procedure markets 41016.3 Regulatory entry deterrence in the professions 41416.4 Entry deterrence in the ready-to-eat cereal industry 41616.5 The European Microsoft case 41916.6 Kodak vs. Fuji Act II 42516.7 Entry deterrence in the airline industry: the threat by Southwest Airlines 42616.8 Kodak vs. Fuji Act III 42917.1 Double marginalization in US cable TV 43517.2 RPM for German books in Germany 44017.3 Exclusive territories in European car dealerships 44117.4 Beer distribution in Chicago 44317.5 Selling spices in Belgium 44517.6 Spontaneous ice cream purchases in Germany 45417.7 Vertical merger in the US shoe industry 45717.8 Vertical integration in cements and ready-mixed industries in the US 46218.1 Microsofts incentives to innovate 48418.2 The race for cleaner cars 49018.3 Antitrust provisions related to R&D cooperation 49918.4 Research joint ventures and collusion 50219.1 Should software be protected by patents or by copyright? 51119.2 The H-Prize 51319.3 Patents in the pharmaceutical sector 51419.4 Patent indicators 51619.5 Arguments against the extension of copyright terms in the US 519

xviii List of cases

19.6 MercExchange vs. eBay: a fatal blow to patent trolls? 52719.7 Why share IP? 53520.1 Network effects: cause or consequence of switching costs? 55120.2 Empirical evidence on network effects in software markets 55220.3 Empirical evidence on network effects in systems markets using the nested

logit approach 55320.4 Heterogeneous adopters for network goods 55820.5 The failure of quadraphonic sound 57220.6 Compatibility, incompatibility and partial compatibility in telephony 57620.7 Trying to build a wall to protect the bricks 57921.1 Standard battle for high-definition DVDs 58321.2 VirginMega wants Apple to open its FairPlay DRM 58321.3 (In)compatibility and excess inertia in the diffusion of PCs and of mobile telephony 58921.4 Commitment in the VCR standards war 59621.5 Making Drupal backward compatible or not? 59721.6 Expectations management in the high-definition DVDs arena 59921.7 Novell sues over cereal box ad campaign 60021.8 EUs inquiries in network markets 60422.1 Dealers and platform operators in the digital economy 61722.2 The no surcharge rule in the credit card industry 62922.3 Pricing access to night clubs 63122.4 Singlehoming environments 63322.5 Multihoming environments 63722.6 Market definition for satellite radio services 64022.7 Exclusive contracting in the videogame industry 64222.8 The Travelport/Worldspan EC case 64422.9 The waterbed effect in mobile telephony 64523.1 Black Friday ads websites 65523.2 Book reviews on Amazon and Barnes & Noble in the US 65623.3 Copurchase links on Amazon.com and the long tail 66123.4 Quality certification by UK tour operators 66523.5 Reputation on Amazon Marketplace 66823.6 Reputation on eBay 672B.1 Virgin/British Airways cases 694

Preface

A large part of economic transactions takes place through markets. On these markets, firmstake decisions in response to prevailing market conditions that affect the well-being of marketparticipants. Such decisions are relevant to the field of Industrial Organization (IO) and theiranalysis lies at the heart of this book. Industrial Organization: Markets and Strategies indeedaims at presenting the role of imperfectly competitive markets for private and social decisions.

Among the numerous decisions taken by firms is the make-or-buy decision, wherebyfirms compare the costs and benefits of manufacturing a product or service against purchasingit. Typically, the firm will prefer the make option over the buy option if the purchase priceis higher than the in-house manufacturing cost or if outside suppliers are unreliable. Naturally,the firm must also have the necessary skills and equipment to meet its own product standards.

There is a clear analogy between this generic dilemma and the decision process thatled us to write this book. As industrial organization teachers since the start of our academiccareers, we have both long relied on existing textbooks to support our courses. Yet, throughthe years, our needs became different from the offers of outside suppliers. That is, the makeoption started to become more tempting than the buy option.

At the end of 2004 we firmly took our decision to make a new textbook.a At thattime (and this still holds today), we could not find on the market any textbook in industrialorganization that suited the type of courses at the advanced undergraduate or master level wewere teaching. We knew that many of our colleagues shared our views. Our objective was thusto produce a new text that would greatly simplify the work of teachers who, thus far, had tocombine material from different books and look for applications to meet their students needs.Naturally, benefits to teachers are meant to spill over to their students. Although we believe informal modelling, we also believe that it is important not to overload students with techniquesand to motivate the analysis with real-world cases. So, we endeavoured to write a book thatblends up-to-date theoretical developments and real-life applications.

The concretization of our efforts currently lies in your hands. To convince you that thebest option for you is the buy decision, we propose three main reasons for which IndustrialOrganization: Markets and Strategies is your choice.

We have produced a book that is easy to read, while maintaining a high level ofrigour and conciseness. We intend to be exact and clearly state assumptions andresults. As a consequence, you will be able to see easily where a new model starts,what are its assumptions and results, and what are the arguments that lead to thoseresults.

Our book covers a wide range of topics as it includes recent developments in the IOliterature, as well as topical issues (related, e.g., to the digital economy).

Many of the arguments made in IO theory are arguments at the margin; to formalizethem we cannot rely on calculus-free theory. Hence, we present and analyse

a As it took us four years to complete the redaction of this book, we can provide proof that we largelyunderestimated the costs of this make decision. Firms, as analysed in this book, are not subject to such a bias.

xx Preface

simple and hopefully elegant models. We summarize the main results as lessons. Wealso illustrate the relevance of these models by relating them to real-world cases.

The targeted audience of the book is advanced Bachelor or Master students takinga course in industrial organization. The book is also a useful reference for an IO course at thePh.D. level as well as for an advanced course for Business School teaching. In any case, to learneffectively from this book, students need to have a course of intermediate microeconomics orbusiness economics in their academic background. Note that selected chapters of the bookcan also serve as support for courses in business and managerial economics, in managementstrategy, in strategic pricing, in economics of innovation, in the theory of competition policyor in oligopoly theory. It is also possible to focus on topics and cases to outline a course ofindustrial organization in the digital economy.

The specific features of the book help to address a number of learning challengesusually faced by industrial organization students.

Students often struggle to connect theory with practice. The integration ofreal-world cases in the text, showing how theories relate to real applications, greatlyreduces this problem. In addition, this helps students to understand better therelevance of topics.

Students often struggle to understand the working of models. To address this issue,we carefully develop the models we present and we make their assumptions explicit.We want students to see models at work and we make sure that they do not spendtheir time uncovering hidden calculus.

Students may be overwhelmed by a large variety of models and lose track. To avoidor, at least, reduce this risk, we have introduced a large number of lessons that guidethe reader through the book and summarize the main insights of the analysis.

Students may become bored by constructed examples. As a consequence, we drawmany real-world cases from industries that students consider to be important, notablyin consumer goods industries and in the digital economy. This makes students moreinvolved and curious about how to address additional issues that appear in the cases.

Students often have trouble relating different topics with one another. The book iscarefully organized to make sure that students do not close a topic (and forget itsanalysis) when moving to the next one. Each part of the book contains severalchapters covering related topics and starts with a general introduction that gives abirds-eye view of the part material and explains the links between the variouschapters. Multiple cross-references between chapters are made throughout the text.As a result, students should acquire a deeper and more transversal understanding ofthe various issues of industrial organization.

The needs of different types of students may be in conflict. In particular, studentswho want to dig deeper may have problems finding the right material, while thosewho simply want to read the textbook may be distracted by many references in thetext or in footnotes. To solve this dilemma, we minimize the number of footnotesand provide access to the relevant literature through endnotes. Moreover, the

xxi Preface

bibliography is sorted by the parts in which the respective work is cited. Hence, thebook adequately combines access to the scientific literature for those who need it,and uninterrupted reading for those who do not.

A number of supplementary resources accompany the book and help instructorsteach and students learn. Exercises are posted on the textbook website. Solutions to theseexercises are made available to instructors. Additional exercises can be uploaded by otherresearchers. On the website also slides are posted. These come in two different sets (two filesper chapter). The first set provides a quick overview on the different topics. Instructors can usethis set to motivate a particular topic, establish key insights, provide some intuition, and somereality check. The second set presents the most important models in-depth. Each instructorcan make his or her preferred blend from the slides provided by the authors.

Students at Barcelona, Frankfurt, Lie`ge, Louvain, Luxembourg, Manchester,Mannheim and Munich (from the advanced undergraduate to the Ph.D. level) have seenparts of this book at various stages of completion. We thank them for their feedback. Severalpeople colleagues and students dedicated their precious time reading parts of this book andhelped us to make this book a reality with comments and suggestions on previous drafts andexercises for the textbook website. At the risk of forgetting some of them, we want to mentionFrancesca Barigozzi (Bologna), Giuseppe De Feo (Glasgow), Estelle Derclaye (Nottingham),Vincenzo Denicolo (Bologna), Roman Inderst (Frankfurt), Heiko Karle (Brussels), JohannesKoenen (Mannheim), Florian Kopke (Mannheim), Christian Lambertz (Mannheim), MarcoMarinucci (Louvain), Yann Menie`re (Paris), Jeanine Miklos-Thal (Rochester), Volker Nocke(Mannheim), Pierre M. Picard (Luxembourg), Thomas Roende (Copenhagen), Isabel Ruh-mer (Mannheim), Markus Reisinger (Munich), Maarten Pieter Schinkel (Amsterdam), YossiSpiegel (Tel Aviv), Cecilia Vergari (Bologna), Georg von Graevenitz (Munich) and XavierWauthy (Brussels). We should add to this list the various anonymous referees who conscien-tiously reviewed and commented initial drafts of several chapters. We want to thank them all fortheir contributions, support and encouragement. Over the whole period, Chris Harrison fromCambridge University Press was supportive and, perhaps due to our incomplete informationdisclosure about the progress of the book, optimistic that this book project will come to ahappy end. We kept going because we could not disappoint him after all these years. We thankthe team at Cambridge University Press for their dedication to produce this book.

Part IGetting started

Introduction to Part I: Getting started

A large part of economic transactions takes placethrough markets. Markets thus play a central role inthe allocation of goods in the economy. Moreover,the existence and nature of markets affectproduction decisions. Industrial OrganizationMarkets and Strategies is an attempt to present therole of imperfectly competitive markets for privateand social decisions.

The array of issues related to markets andstrategies is extremely large. To convince yourself,log in to the website of any newspaper or magazine,and start a search for these two key words: marketsand strategies. The search engine will provide youwith a long list of articles concerning a huge varietyof sectors, companies and business practices. Asan illustration, here follows a selection of recentarticles that were returned by the InternationalHerald Tribune search engine (www.iht.com) on 1February 2009.1

Pfizer Inc., the worlds largest drugmaker, said Monday itis buying rival Wyeth for $68 billion in a deal that willquickly boost Pfizers revenue and diversification and if itworks as advertised help the company become morenimble.

Only a few years ago, debates about the future of bankingacross the Continent were dominated by talk ofborder-straddling European champions that couldcompete with U.S. giants. But now a differentdevelopment looms: the disintegration of truly Europeanbanking as the financial crisis pressures banks to retrenchand refocus on their home markets.

The shock waves from the global downturn are pushing afragmented and once fast-growing Chinese retail sector toconsolidate as sales slow and profit margins shrink.Global giants like Wal-Mart Stores and Carrefour will

benefit from the consolidation, along with Chinas growingconsumer class, but rapid expansion has caught someretailers overextended as their home markets collapse.

In moves that will help shape the online future of themusic business, Apple said on Tuesday that it wouldremove anticopying restrictions on all of the songs in itspopular iTunes store and allow record companies to set arange of prices for them.

The ancient Chateau dErmenonville and a circuit ofothers around Europe served for more than a dozen yearsas bases for executives from some of the biggest names inoil Exxon Mobil; Royal Dutch Shell; Sasol, of SouthAfrica; and Repsol YPF, of Spain to fix prices of paraffin,the overlooked wax byproduct of crude oil, that is used incandles, paper cups, lip balm and chewing gum. Thescheme drove up prices to consumers in a plot thatprobably touched most households, according to theEuropean commissioner for competition, Neelie Kroes,whose office punished nine oil companies with more thanhalf a billion euros in penalties.

All these stories describe firms takingstrategic decisions (e.g., acquisition of a competitor,repositioning of activities, change in productspecification and pricing) that result from particularmarket conditions (e.g., European banks or Chineseretailers react to adverse demand shocks) and thataffect the well-being of market participants (e.g., theacquisition is likely to improve Pfizers performance,smaller Chinese retailers should suffer from theconsolidation of the sector, European consumerswere hurt by the collusive behavior of paraffinproducers). Such decisions are relevant to the fieldof Industrial Organization and their analysis lies atthe heart of this book.

Before we fully engage in the analysis ofmarkets and strategies, we devote the first part ofthe book to a number of preliminaries. In Chapter 1,we provide a roadmap as well as some instructions

2 Getting started

about how to use the book. In Chapter 2, wepresent the players in a market, namely firms (thatis, sellers) and consumers (that is, buyers). Weelaborate on the hypothesis that firms maximizeprofits and that consumers maximize utility. A largepart of the exposition can be seen as healthwarnings which should be kept in mind whenconsuming the book. We then start the analysis ofmarket interaction and provide some prototypes of

markets, ranging from perfectly competitive tomonopolistic markets. This provides a first glance atfirm strategy in market environments. While this isonly a first look at such markets, it is hopefully usefulmaterial to refresh the knowledge that has beengained in some microeconomics lectures.

Once you have worked through these firsttwo chapters, you will be ready to start the realthing.

1What is Markets and Strategies?In this short introductory chapter, we give a broad presentation of the book and indicatehow we think it is best to use it. We start by explaining the title of the book: what do wemean by markets and by strategies, and why do we associate the two terms? We arguethat it is market power and the exercise of it that relate markets and strategies to one another.Next, we outline the approach that we adopt in this book: we believe in formal modelling,which explains that the book is theory-based; yet, we also believe that it is important not tooverload readers with techniques and to motivate the analysis with real-life cases; our aimis thus to blend up-to-date theoretical developments and real-life applications in a rigorousand concise manner. Finally, we describe the level, the scope and the organization of thebook.

1.1 MarketsMarkets allow buyers and sellers to exchange goods and services in return for a monetarypayment. Markets come in a myriad of different varieties. Examples are your local farmersmarkets (local) and the market for passenger jets (global), the market for computer software(product) and software support (service), the market for electricity (homogeneous product)and markets for highly specialized steel (differentiated product). These markets may exist inphysical or virtual space.

We mostly consider markets in which a small number of sellers set price or quantitystrategically, as well as possible other variables, whereas buyers mostly come in large numberso that they non-strategically react to supply conditions. The reverse situation applies tosome procurement markets in which a small number of buyers faces a large number ofsellers. We mainly use examples of markets in which buyers are final consumers; however,the formal investigation relies on certain characteristics of markets that also apply to othermarkets in which buyers are not final consumers but e.g. small retailers, service providers, ormanufacturers.

Market power: what it means

Markets and Strategies, and the industrial organization literature at large, attempts to describethe interaction of firms as sellers, and consumers or other economic agents as buyers. Theoutcome of this interaction is a market allocation (i.e., an allocation of resources throughfree markets). This allocation depends on how the market operates. We want to predict theseresulting allocations (positive analysis) and their efficiency or welfare properties. The latter

4 What is Markets and Strategies?

can be used for normative analysis, e.g., to address the question about whether and how agovernment should intervene.

To address these questions, we have to make assumptions as to how markets operate.Here we may follow the perfectly competitive paradigm according to which both sides of themarket are price-takers and simply post their supplies and demands. This paradigm appears tobe well-suited for those industries in which there are only small entry barriers and many smallfirms compete against each other. In such a market, it can be seen as a good approximationto assume that firms indeed do not have any price-setting power, and that output decisions byan individual firm have a negligible effect on market price and thus on the profit-maximizingdecisions of other firms.a Modern industrial organization literature largely ignores such per-fectly competitive markets and, in this tradition, this book focuses on markets in which firmsdo have market power so that an incremental price increase above marginal costs does not leadto a loss of all (or most) of the demand.

If we are only interested in competition policy issues, neglecting perfectly competitivemarkets is essentially without loss of generality because antitrust authorities deal with concernsof market power and its abuse. If we look at the current landscape of important industries, weobserve that firms such as Microsoft, Boeing, and Porsche clearly do have market power. Forthose firms, a small increase in price does not lead to a loss of all or most of the market share.Even small local retailers may enjoy market power in the sense that small price changes do notlead to drastic changes in demand. The reason is that although there are, e.g., many bakeriesand butchers, they are located at different places and cater to different tastes. Here, productdifferentiation gives rise to market power. Alternatively, firms may offer identical productsor services but consumers may not be perfectly informed. Then firms enjoy market powerdue to consumers being less than perfectly informed (or incurring search costs to obtain thisinformation). Finally, consumers may be locked into long-term contracts or may have becomeaccustomed to a particular product. Then a firm has some market power over these captiveconsumers due to consumer switching costs.b

Market power and its sources are at the core of Markets and Strategies. Because ofmarket power, firms may want to invest in exploring their market environment and findingsuitable instruments to improve their profits. Antitrust authorities may limit the set of actionsthat is available to firms by punishing certain types of behaviour or by interfering ex ante. Forinstance, mergers are only cleared if the antitrust authority does not foresee anticompetitivebehavior as the result of the merger.

While market power appears at first sight to be a static concept, this view is misleading.Firms enjoy market power because other firms do not find it worthwhile to offer identical orsimilar products or services. In particular, fixed costs define a minimum level of output a firmhas to achieve in the industry to make non-negative profits. However, the presence of othermarket characteristics alone may make it unattractive for firms to enter the industry. Moregenerally, in some markets, only one or a small number of firms is viable. At this point, wewant to discuss informally the number of firms in an industry.

a We review the competitive paradigm in some more detail in the next chapter.b We systematically examine these different sources of market power in Part III of the book.

5 1.1 Markets

Natural monopoly and natural oligopoly

Consider a market with few firms and possibly only one firm as seller. If, in the latter case, theprofit-maximizing monopolist makes positive profits and sells above marginal costs or, in amarket with more than one firm, these firms make positive profits and sell above marginal costs,we may wonder whether additional firms may have an incentive to enter so that eventuallyprofits are competed away. Note that post entry, the strategic situation is very different so thatprofits before entry are not a reliable source of information for the entrant firm. Rather, ithas to predict profits that would occur after entry has taken place. It may well come to theconclusion that although current profit levels are high, entry would trigger fierce competitionwhich therefore does not make it worthwhile to enter.

While entry may not be profitable so that there exists a natural monopoly due todemand and supply conditions, an alternative reason for the analysis of a market with a givennumber of firms is the scarcity of available necessary inputs. For instance, mining is limitedto the presence of the natural resource of interest. In other cases, as we now discuss, thegovernment limits the number of firms in the market.

Government-sponsored monopolies and oligopolies

From a competition policy perspective, the role of the government is to avoid the monopoliza-tion of the market. However, it should not be overlooked that the government sometimes doesexactly the opposite, namely that it restricts entry of firms into the market so that the incumbentfirms enjoy market power. The most extreme form are government-sponsored monopolies.

One justification for such monopolies are efficiency considerations based on fixed orsunk costs, or increasing returns more generally. In particular, since additional entry may leadto socially wasteful duplications of certain investments, additional firm entry may be privatelyprofitable but socially undesirable. In such a case, the government may opt for a regulatedmonopoly and explicitly prohibit additional firm entry.

In some instances (e.g., due to resource constraints), it may be socially desirable tolimit the number of firms to, say, three or four. An example can be found in spectrum auctionsfor mobile telephony. Here, the resource constraint is the available spectrum. The goal of theauction, then, is to efficiently distribute the spectrum that is made available.

A second and substantially different reason for granting an albeit temporary monopolyright can be found in investment incentives in new technologies. If innovations were notprotected and could be immediately appropriated by other firms at zero or negligible costs,firms would not have strong incentives to invest in innovations. This is the rationale behindpatent and copyright protection, or, more generally, intellectual property right protection.c

A third reason is the goal to create national champions motivated by the belief thatnational firms lead to higher welfare than foreign ones. Erecting international barriers of entryeffectively limits competition (presuming that the government takes measures that favours thenational firm). While such policies can be frequently observed in the real world, we do notanalyse such policies in this book. We believe that this topic is better addressed in a course oninternational trade.

c See Part VII of the book.

6 What is Markets and Strategies?

Case 1.1 illustrates how a combination of the previous factors allowed Alcoa to enjoya monopoly position in the aluminum market for a long period of time.

Case 1.1 Alcoas natural monopoly2

The processes for extracting aluminum on a large scale were invented at the end of thenineteenth century. Because they were patented, a small number of companies were able todominate the industry right from the start. Among these companies, the most successfulwas Alcoa (shorthand for The Aluminum Company of America). Since the production ofaluminum is capital intensive, it is subject to large economies of scale. This led Alcoa tomanufacture intermediate or final aluminum products so as to develop adequate marketsfor its growing output. The production of aluminum is also intensive in energy (smeltingrequires a lot of electricity) and in raw materials (bauxite). Alcoa quickly understood thecompetitive advantage it could gain by controlling the procurement of these two crucialinputs. As for energy, Alcoa became in 1893 the first customer of the new Niagara FallsPower Company, signing up for hydroelectric power in advance of construction. As for theraw material, Alcoa progressively managed to stake out all the best sources of NorthAmerican bauxite for itself. As a result of these strategies of downstream and upstreamvertical integration (we study these strategies in Chapter 17), Alcoa managed to improveits productivity and increase its scale. These efficiency gains made entry more difficult andprotected its leadership after initial patents had expired. Other factors explain the virtualmonopoly position that Alcoa enjoyed until World War II: public policy, tariff protection,the failure of Alcoas few potential competitors, and the limited checks of antitrust beforeWorld War I (see Appendix B for more on the latter factor).

1.2 StrategiesA large part of modern industrial organization (and most models presented in this book)considers firms as strategic players. What do we mean by this term? This is what we explainin this section.

Analysing basic monopoly and oligopoly problems decision theory vs. game theory

Game theory is concerned with situations where the players (the decision makers) strategicallyinteract. In contrast, decision theory deals with situations where each decision maker canmake his or her own choices in isolation, i.e., without concern for the actions taken by otherdecision-makers. Abusing terms, one can say that decision theory is a theory of one-persongames, or of games where a single player plays against nature (thus taking uncertainty intoaccount).

The basic monopoly problem can therefore be addressed by using the tools of decisiontheory. Indeed, a monopolist is by definition the only firm to be active in the market; moreover,

7 1.2 Strategies

if the environment is such that no entry is possible and if there is a large number of buyers,whose individual decisions have a negligible impact, the monopolist can make its one-shotdecisions in complete isolation.

Things change as soon as other firms are present in the market, or could be present(i.e., if there is a threat of entry). Then, what these other firms do, or could do, affects the firstfirms profits and it is thus wise for this firm to take this interaction into account in its decisionprocess. That is, if other firms are present on the market, it is important to anticipate theiractions; or, if other firms may enter the market, it is possible to take advance actions so as todiscourage entry or to limit its negative effects. Similarly, if the firm remains the only sellerbut faces a single buyer, the bargaining power of this buyer has to be factored into the decisionprocess. The analysis of such situations (i.e., oligopoly problems, monopolies threatened byentry or bilateral monopolies where a single seller faces a single buyer) belongs to the realmof game theory.

Firms as strategic players and the notion of equilibrium

To analyse markets in which firms interact strategically, we need a solution concept thatprovides predictions as to what will be the market outcome. The basic solution concept we useis the Nash equilibrium. Consider a price-setting duopoly. Here, the profit-maximizing pricechosen by one firm depends on the price set by the other. We call this firm is best-responsebi to the competitors price p j . By definition, in a Nash equilibrium, prices must be mutualbest responses, i.e., pi = bi (pj ), i, j = 1, 2, i = j . Note that this solution is not implied bythe individual rationality assumption. Indeed, it is perfectly rational to set a different price aslong as firm i believes that firm j sets a price different from pj . The Nash equilibrium hasthe additional property that each players belief about the intended play of the other playeris confirmed. Thus, no player has an incentive to deviate given the competitors equilibriumstrategy. We can extend this notion to allow players to mix between different prices. In otherwords they choose a probability distribution of prices. If players can choose mixed strategies,we use the solution concept of mixed-strategy Nash equilibrium.

In richer economic environments, firms choose various actions over time, have privateinformation about their type, make initially a choice that cannot be observed by others, orinteract repeatedly for the foreseeable future. In all these cases, the set of Nash equilibria istypically too large. To obtain sharper predictions, we impose additional restrictions on thesolution concept depending on the problem at hand.

Suppose firms choose actions over time and consider a particular set of strategies thatform a Nash equilibrium. Then this equilibrium is said to be subgame perfect if it induces aNash equilibrium in any subgame (even if this subgame is reached only off the equilibriumpath). For instance, in a price setting oligopoly, one firm may be the first-mover and all otherfirms choose at a second stage. Here, the firm that is the first-mover anticipates the reactionof its competitors to its price change. The restriction to subgame perfect Nash equilibrium isthe standard concept that is used in such applications, but it may nevertheless be criticized insituations where players are not fully forward looking.

In other economic environments, players may be of different types. For instance, ina price-setting duopoly each firm may be a low- or a high-quality firm. If this information isprivate information so that firms only know their own type but not the type of their competitor

8 What is Markets and Strategies?

(while consumers later observe the true quality), beliefs about the other firms type matter. Herewe assume that players know the ex ante quality distribution so that their beliefs are correctfrom an ex ante point of view. The associated equilibrium concept is the one of Bayesian Nashequilibrium: in the price setting duopoly each firm maximizes its profits given its probabilitydistribution over quality types of the competitor.

Private information can also be introduced into environments in which players choosesequentially. For instance a monopolist may sell a product whose quality is only known to thefirm but not to consumers, who become the second player since their beliefs determine theirpurchasing decisions. In this case, the informed player moves first and may use its action tosignal its type. In situations like these, we apply the perfect Bayesian Nash equilibrium concept.Here, uninformed players who choose later can use the observed action of the informed partyto update their beliefs about the type of the firm. In the monopoly context, the firm may, forinstance, choose a very high price to signal the quality of its product. For the reader who is notfamiliar with these concepts, we provide formal definitions of these concepts in Appendix A.In addition, the reader may want to consult a textbook in game theory.3

1.3 Models and material of Markets and StrategiesThis book is theory-based. We are perfectly aware that there is also a great demand fora textbook that covers recent advances in empirical industrial organization. However, wedecided to focus on theory (without ignoring empirical work) for two reasons: first, we find itimportant to start with theory at the advanced undergraduate level as guidance for empiricalwork; second, we find it difficult to provide the empirics at a level which is appropriate foradvanced undergraduates. Concerning our second reason, we hope to be proved wrong soonand would be happy to see our theory-based textbook be complemented by a good textbookon the empirics of industrial organization.

It is our goal to present our book as a collection of topics which are then exploredwith the help of theoretical models. These models are deliberately simple so that we can relyon well-established concepts from game theory, which most of our readers will be familiarwith. In particular, we try to avoid more debatable equilibrium refinement concepts. Most ofour formal analysis relies on functional form specifications, e.g. we often specify the consumerside such that demand is linear. Such functional form assumptions are a mixed blessing: whenhighlighting an economic mechanism, we want to understand the general effects and do notwant our results to rely on the specifics of the demand (and cost) functions. We try to avoidthis criticism by providing a more general intuition for the results, which does not rely onthe particular functional form and hope to be careful enough to address the most importantrobustness issues. Hence, we try to keep the cost of using functional form assumptions lowwhile keeping the technical level of the exposition low. We are, however, aware that some of themodels require somewhat more technical sophistication than others. Particularly demandingmaterial is marked as such.

The main insights of our formal analyses are summarized as lessons. These lessonsare less formal than propositions or theorems but, in our view, better allow the reader to takehome the main message. Lessons are to be seen in the context of the models that are presented.

9 1.4 Level, scope and organization of the book

To better connect to the real world, we provide a number of cases, which relate the generalissue under investigation to a particular industry. Students from business schools should bewarned that these do not, by any means, constitute full-blown case studies, but only sketch afew facts or findings from a particular industry, as illustrated by Case 1.1 above.

Our main text contains few footnotes that present additional remarks or observations.References and the occasional technical remarks are put into endnotes. So, if you are lookingfor detailed references to the scientific literature, do not forget to look at those endnotes;otherwise, we recommend not to interrupt your reading by consulting them. Each chapter (butthis one) ends with a set of review questions and gives a very short guide to the most importantwork on which the exposition is based. Exercises are posted on our website. This allows us tocontinuously update them. They are, however, an integral part of the book. If you master thematerial of the book, you should be able to solve most of them.

1.4 Level, scope and organization of the bookLevel

This book is aimed at advanced undergraduate students who take a course in Industrial Orga-nization, Price Theory, or something similar. We presume that the reader is familiar with basicnotions of calculus. The book can also partly be used for a more specialized course, which,to name a few topics, focuses on competition policy, asymmetric information and industrialorganization, or innovation. This book is also aimed at courses at the Ph.D. level in economicsand management. Here, it may be useful to complement the book with additional material suchas research articles. Also, the book may be useful to practitioners in antitrust and strategy whowant to catch up with some recent ideas.

Scope

Very broadly defined, the scope of the book is the analysis of all markets in which firmsinteract strategically. As illustrated by the numerous real-life situations presented in the book,this analysis spans a very large array of industries belonging to the secondary (manufactureof final goods) and tertiary (services) sectors of the economy, and also to what is sometimescalled the quaternary sector, which consists of all intellectual activities.

Regarding the contents of the book (which we detail below), we want to stress thatwe depart from the majority of previous Industrial Organization (IO) textbooks by giving upthe dichotomy between monopoly and oligopoly. Most books start with monopoly and thenmove to oligopoly (and, often, return to monopoly in between). We find it more appropriateto focus on content issues in the organization of the book. For each issue, we decide whetherseparating monopoly and oligopoly provides additional insights or not. For instance, pricediscrimination is first analysed in a context in which the behaviour of competitors is taken asgiven (monopoly) and then endogenized (oligopoly). Yet, most of the book considers strategicinteraction and can thus be seen, like a large part of current IO theory, as applied oligopolytheory.

10 What is Markets and Strategies?

Organization

Markets and Strategies is organized in nine parts, each part being further divided into two tofour chapters. Each part starts with a general introduction that gives a birds-eye view of thepart material; it is a verbal exposition, usually related to real-life situations, that informallydescribes the salient features of the analysis that follows and explains the organization andthe links between the various chapters. The introduction ends with a summary of what thereader will learn from that part of the book. Each chapter starts with a short introduction thatdescribes its contents. The chapter ends with several review questions and a quick guide to therelevant literature.

Here is a quick sketch of the book contents (we give a more detailed table of contentsbelow). The book starts with two introductory parts. This part, Part I, helps the reader toget started by describing what the book is about and by defining a number of key concepts.Part II develops the basic models of oligopolistic competition. The goal is to understandhow the nature of the strategic variable, namely price or quantity, and the timing of movesaffect strategic interaction and, thereby, the extent of market power. The reader may alreadybe familiar with some of these models through previous microeconomics or industrial organi-zation courses. However, Part II also includes more advanced material including private costinformation in oligopoly and dynamic firm entry and exit.

The next two parts describe how market power is acquired and exercised. Part IIIlooks at sources of market power: product differentiation, advertising, and consumer inertia.Part IV examines how firms with market power design advanced pricing strategies to captureas much value as possible from their consumers.

The first four parts of the book mainly deal with search goods, i.e., products orservices with features and characteristics that can be easily evaluated before purchase. Incontrast, Part V examines experience goods, i.e., products and services with characteristicsthat can only be ascertained upon consumption because they are difficult to observe in advance.In such markets, consumers have less information than the producers about product quality,and therefore firms have to convince consumers that their products are of high quality. To thisend, firms can use a variety of marketing instruments, which are studied in Part V.

The analysis made up until then is mostly positive in nature. Part VI turns to amore normative analysis by developing the theory of competition policy. It first explores twoways by which the number of firms in the market and thus competition may be reduced:either virtually when a number of firms act as if they were a single one, a behaviour known ascollusion; or actually when horizontal mergers occur, which replace existing direct competitorsby a new, bigger, entity. Next Part VI focuses on monopolization strategies, i.e. strategies by asingle firm that hamper competition. It studies the potential predatory behavior of incumbentfirms facing the threat of entry by other firms on their market. Finally, it analyses verticalarrangements between firms acting at successive stages of the value chain. In this context,vertical mergers are studied.

Parts VII and VIII examine how, in the long run, firms may act to modify a part of theirenvironment that was considered as fixed up to then in the book, namely their technologicalpossibilities. Part VII focuses on firms investments in research and development (R&D),which bring innovation to the market. It also explains what sets investments in R&D apartfrom other investments made by firms or individuals and why institutions such as intellectual

11 1.4 Level, scope and organization of the book

property may be necessary to better align private and social incentives. While Part VII examinesthe early stages of the innovation process (i.e., the creation or invention of new knowledge),Part VIII is more concerned with the later stages, namely the design, adoption and diffusionof technologies. The focus is on so-called network technologies, i.e., technologies, such as soft-ware or communication devices, that become more valuable as they are more widely adopted.This is so because users of these technologies value compatibility, either with the technologiesthat other users adopt or between several pieces of complementary technologies that theyadopt themselves. It follows that the design, adoption and diffusion of such technologies raisedistinct and important issues compared to other types of technologies.

Parts VII and VIII contribute to the understanding of the specificities of what is calledthe information economy, the production and consumption of information. The last part ofthe book, Part IX, sheds additional light on the information economy by considering marketintermediation. In many markets, intermediaries are necessary to make the transactions amongbuyers and sellers possible, or they contribute to add substantial value to these transactions. Itis thus worth having a closer look at the market micro-structure, that is at the way markets areoperated, by studying the strategies of intermediaries and what impacts they have.

The book contains two short appendices. Appendix A presents the basic tools of gametheory that are used throughout the book. Appendix B gives a short description of competitionpolicy, in its historical and legal aspects, thereby complementing Part VI.

Table of contents

Part I Getting startedChapter 1 What is Markets and Strategies?Chapter 2 Firms, consumers and the market

Part II Market powerChapter 3 Static imperfect competitionChapter 4 Dynamic aspects of imperfect competition

Part III Sources of market powerChapter 5 Product differentiationChapter 6 AdvertisingChapter 7 Consumer inertia

Part IV Pricing strategies and market segmentationChapter 8 Group pricing and personalized pricingChapter 9 Menu pricingChapter 10 Intertemporal price discriminationChapter 11 Bundling

Part V Product quality and informationChapter 12 Asymmetric information, price and advertising signalsChapter 13 Marketing tools for experience goods

Part VI Theory of competition policyChapter 14 Cartels and tacit collusion

12 What is Markets and Strategies?

Chapter 15 Horizontal mergersChapter 16 Strategic incumbents and entryChapter 17 Vertically related markets

Part VII R&D and intellectual propertyChapter 18 Innovation and R&DChapter 19 Intellectual property

Part VIII Networks, standards and systemsChapter 20 Markets with network goodsChapter 21 Strategies for network goods

Part IX Market intermediationChapter 22 Markets with intermediated goodsChapter 23 Information and reputation in intermediated product markets

AppendicesA Game theoryB Competition policy

2 Firms, consumers and the marketIn this chapter, we introduce a number of concepts that will prove useful in the rest of thebook. We also clarify the main assumptions underlying the analytical frameworks that wewill use throughout the book. We start by describing the two types of actors who interacton markets, namely the firms and the consumers. How do we represent them? How arethey assumed to behave? How do we measure their well-being? These are the questions weaddress in Section 2.1. We turn next to market interaction itself. In this book the form ofmarket interaction we are interested in is imperfect competition. To delineate the scope ofimperfect competition, it is useful to understand first two extreme market structures whereinteraction among firms is limited or nonexistent. Section 2.2 describes these two marketstructures, namely perfect competition and monopoly. Finally, in Section 2.3, we presentways to define a market and to measure its performance.

2.1 Firms and consumersIn this section, we describe how firms and consumers are usually modelled in the theory ofindustrial organization and throughout this book. In Subsection 2.1.1, we explain that firms areessentially associated to a program of profit maximization and we examine the component ofprofits that is specific to the firm, namely its cost function. Total revenues, the other componentof profits, depend on the consumers preferences (which determine demand) and on the typeof market interaction; these two elements are respectively examined in Subsection 2.1.3 andin Section 2.2.

This simplified representation of the firm proves very useful when considering strat-egic interaction between firms, which is the main concern of this book. However, its mainshortcoming is that it abstracts away all the relationships among the economic agents compos-ing the firm. To assess the scope of the simplified representation of the firm, we look insidethe black box of the firm in Subsection 2.1.2. Acknowledging that the firm may be composedof agents with different information and potentially conflicting objectives, we examine if andhow those objectives can be aligned. We also study the determinants of the firms boundaries:what does the firm decide to make and what does it prefer to buy?

In Subsection 2.1.3, we turn to the description of the consumers. Our focus is on finalconsumers (although we also consider firms as intermediate consumers in some parts of thebook). Final consumers are usually supposed to be rational and price takers. Their decisionsare then aggregated into demand functions. We discuss, however, alternative assumptions ofconsumer behaviour. Finally, in Subsection 2.1.4, we describe the specific assumptions wemake in this book to assess economic allocations in imperfectly competitive markets.

14 Firms, consumers and the market

2.1.1 The firm

We start our description of the firm by defining the various types of costs that enter a firmsprofit function. We then discuss the hypothesis that firms maximize profits.

Opportunity costs

A basic lesson from microeconomics is that what a firm reports as costs are often not economiccosts. This implies that conclusions about economic costs that are derived from reported costdata are questionable. Business people who use different cost concepts for their strategicdecisions are therefore likely to make mistakes in their decision making. This is not to denyother cost concepts their role. In particular, it is often in the interest of a firm to shift costs overtime and space to alter tax payments for the benefit of the firm. However, these cost accountingdata are not helpful for decisions such as how to price a particular product or when to enter aparticular market segment.

There are a number of general observations about the correct concept of economiccosts. Economic costs refer to opportunity costs. This means that historic costs or factor costsare not the relevant costs. For instance, when a firm with scarce capacity of some productionfacility has to decide whether to produce a new product using this scarce capacity, the relevanteconomic costs have to include the profits that could be made from using the required capacityfor its next best alternative use.

Cost functions, economies and diseconomies of scale and scope

In the analysis of markets, we typically take cost functions as the primitives of a firm. However, itis useful at this point to recall that cost functions are derived from a cost minimization problem.The cost function attaches a cost value to each output level, C(q). This represents the minimalcost of the firm given the input prices and the production technology.

We typically assume that a firms cost function is independent of the decision of otherfirms in the market. Note, however, that this is not necessarily the case. In particular, if thefirms active in a particular market segment also compete for resources in the input market(and there are only a few firms in this input market), the output decision of a firm affects inputprices, which not only feeds back into its own cost but also affects the costs of the other firms.

In intermediate microeconomics, the production technology of a firm is analysed.A single-product firm is said to enjoy economies of scale on a certain output range if itbecomes less and less costly to produce on average one unit of output. In other words, averagecosts are decreasing. Conversely, a firm enjoys diseconomies of scale on a certain outputrange if it becomes more and more costly to produce on average one unit of output. In otherwords, average costs are increasing. Scale economies are important in the formation of anindustry: in particular, the presence of scale economies favours a concentrated industry (asdescribed in Case 1.1 above). However, in a short-term analysis any fixed costs are irrelevantand only marginal costs are relevant for firm decision making. Marginal costs may be constant,increasing, decreasing or U-shaped. The simplest formulation is to assume constant marginalcosts of production. We will make this assumption in most of the models that we present in

15 2.1 Firms and consumers

this book. This assumption, together with the presence of fixed costs implies that firms aresubject to economies of scale.

A multiproduct firm may be able to lower its average costs of a particular productif it increases its product range (or if it increases the quantity of other products it alreadysells). In this case, we say that the firm enjoys economies of scope. In the opposite case,the firm has diseconomies of scope. Diseconomies of scale and scope can be motivated bytechnological and managerial constraints. In particular, large-scale multi-product productionrequires oversight, which in itself is costly and may in addition lead to behaviour that is notprofit-maximizing from the firms point of view.

Fixed and sunk costs

A firm may not only incur costs that can be attributed to each unit of output but, in addition,may have operation-independent costs. Once in business, a firm often incurs a fixed per periodcost, which is independent of current output levels and only depends on earlier decisions suchas capacity, geographic coverage, and output range. These fixed costs affect the profit level ofthe firm but do not affect, e.g., pricing decisions because the latter are guided by changes at themargin. Observed pricing schemes that apply a fixed markup over total average costs (and thusinclude fixed costs) are not profit-maximizing and will therefore not be considered in this book.

Besides fixed costs, firms from time to time incur initial costs, e.g., when they decide toenter a new geographic market or when they expand their product line. These costs are incurredonce and, often, cannot be fully recovered when reversing the decision. The part of the coststhat cannot be recovered are the sunk costs of the firm. Sunk costs are often exogenous froma firms point of view. For instance, a retailer has to refurbish a retail outlet. Sometimes, thesecosts are determined by the government. For instance, a certain business may require a licensethat has to be purchased from the government and cannot be traded. In other cases, sunk costsare determined by the decisions of firms already active in the market. For instance, incumbentfirms may have acquired a lot of reputation through advertising and other marketing measures.In this case, a firm may have to run an advertising campaign itself to convince consumersto switch to the product. Sunk costs are important to explain the formation of imperfectlycompetitive markets. However, we can abstract them away in the short-run analysis where thenumber of firms is taken as given. Only an analysis with an endogenous number of firms canmake the effects of the level of sunk costs on competition explicit (as we will see in Chapter 4).

The profit-maximization hypothesis

A single-product firm is assumed to make profits (q) which depend on the quantity soldq. Consider for the sake of simplicity a firm with a single given product. Then, its profit arerevenues q P(q), where P() refers to the inverse demand of the firm, decreased by the costsC(q) that the firm incurs. These costs C are the economic costs that the firm incurs. Hence, afirms profit depending on its own quantity is (q) = q P(q) C(q). This formulation ignoresany other variable that may affect profits. In this book, we analyse a number of them, e.g.advertising, R&D efforts, and other efforts that affect inverse demand or costs. In addition, ina market context, we must be aware that the choices of competitors affect profits.

16 Firms, consumers and the market

Firms are assumed to be profit maximizers. This is not to say that profit-maximizingbehaviour is always the best approximation to observed market behaviour, but it providesarguably the natural benchmark for the analysis of firm behaviour. Since we are mostlyconcerned with firms with market power (and thus large firms), we are confident that profit-maximization is often a good behavioural assumption. In particular, if we are interested incompetition policy, profit-maximizing behavior is the undisputed reference point that is usedby antitrust authorities.a

Profit maximization can be seen as the natural objective of the owners of a firm.However, owners may have an objective function that not only contains profits but otherobjectives (or additional constraints). An example would be the owner of a media companywho is not only interested in financial success but also has a particular world (or policy)view that he or she likes to promote. Another example is that the owner is also interestedin market share or total revenue for personal reasons (by the way, this may be the impliedobjective function of a profit-maximizing firm that takes dynamic effects into account). Onemore example is that the owner has non-economic objectives such as to provide employmentin his or her local community or takes particular interest in the well-being of some or all of hisor her customers. While there certainly exist some good real-world examples that documentdeviation from the profit-maximization objective of owners, we still see profit maximizationas the natural starting point of any analysis of industry and therefore maintain the profit-maximization hypothesis throughout the book.

Taking into account that most large companies are not owner-managed, we mustaddress an additional important question: Is profit maximization a reasonable objective functionof firms even if owners have this objective? We now turn to this question. Here our answer willbe less confident.

2.1.2 Looking inside the black box of a firm

In this book, we mostly consider firms as single decision making units that maximize prof-its; this also holds for the industrial organization literature at large. While this is a helpfulabstraction, it may be inappropriate. One reason is that in firms which are not owner-run, topmanagement may have different objectives than the owners of a firm. Top management mayhave non-monetary incentives such as empire building. A good example is merger decisions,which may partly be explained by monetary and non-monetary incentives of top managementto increase the scope of the firm, but which may not be in the interest of owners. Another reasonis that many decisions are not taken by the top management but by middle management. Here,the incentives of the middle manager may be different from those of top management. Themiddle manager may not act in the interest of the whole firm but delegation may still be desir-able for a number of reasons, in particular, because of asymmetric information problems withinthe firm and limited managerial span at the top management. Another reason for the effect offirm organization on firm decisions is dispersed information within a company together withstrategic communication.4

We do not attempt to provide an overview of the theory of the firm, nor to providean account of what determines the boundaries of the firm. We only take a quick look at the

a In a monopoly setting, the profit-maximization hypothesis can be more easily defended if the objective of a theoryis to provide guidance to businesses.

17 2.1 Firms and consumers

relationship between the owner and the manager of a firm, ignoring the firms interaction withother firms in the product market.5 This allows us to obtain some insights as to whether firmsare profit maximizers. Through performance-based pay, the owner can attempt to better alignhis and the managers incentives. In a simple monopoly model, we uncover when interests ofmanagers and owner can be aligned and when not.

A model of manager compensation and the managerowner relationship

We consider a moral-hazard environment, in which shareholders do not observe the action bytop management and have to design a wage contract or compensation scheme that can only bebased on the observed profits.6 The problem is that observed profits not only depend on theunobservable action by top management, but also on some unobservable random component.The owner (e.g., the community of shareholders) is assumed to be risk-neutral and thusmaximizes the expected gross profit of the firm, , minus the payment w to the manager. Theowner observes gross profit . Thus, he can make a wage contract or compensation schemeoffered to the manager dependent upon . Gross profit depends on some unobservable randomevent and the managers effort e [e, e]. For a given random event , higher effort e resultsin higher profits . We can write profits as (e, ).

We analyse the following principalagent relationship. The owner wants to inducethe manager to choose the efficient effort level. However, he can only condition the pay on thecontractible profit level here we ignore the possibility that the manager manipulates profits . The owners objective is to maximize his expected net profit

E[ (e, ) w( (e, ))].The managers utility function is

u(w+ , e).

That is, a manager receives a higher utility if she receives a higher pay w. She also receivesa higher utility if she exerts less effort. In addition, we assume that u is (weakly) concave inw this amounts to income risk aversion; in the special case that u is linear in w the manageris risk-neutral with respect to income. The manager maximizes her expected utility

Eu(w((e, )), e).

The owner offers a wage contract w(). Ex ante, there is a competitive supply of identicalmanagers who have a reservation utility u0. Therefore, choosing their best effort level giventhe proposed contract w must give the hired manager in expected terms at least her reservationutility this is the individual rationality or participation constraint of the manager,

maxe

Eu(w( (e, )), e) u0.

If the owner wants to induce a certain level of effort e from the manager, he must offer acontract that is incentive compatible so that the manager has an incentive to provide thiseffort level:

e = arg maxe

Eu(w((e, )), e).

18 Firms, consumers and the market

As a benchmark, we first consider the situation with full information; this meansthat the owner can perfectly infer the chosen effort level e (either by observing e directly orby observing ). In this case, the owner can effectively choose his desired effort level e byimposing a large penalty in the wage contract for deviation from that level. This implies thatonly the participation constraint is relevant. For a given effort level e, denote random profitsby (e, ). The owners problem is then to maximize expected net payoff with respect tothe wage offered, subject to the participation constraint of the manager:

maxw( )

E [ w( )] s.t. Eu(w(), e) u0.

This becomes a Lagrange problem as the constraint is binding: the owner will make themanager just indifferent between accepting the contract and quitting because all the bargainingpower rests with the owner. Taking the first derivative of this Lagrange problem gives thatwu(w( ), e) is equal to a constant. Since the owner is risk-neutral but the manager is risk-averse, it is optimal for the owner to offer a wage for the manager that is independent of .Therefore, under full information the manager is fully insured.

We compare this full insurance result to the case where the owner only observes .Here, the owner has less control than under full information and he can obtain, at most, fullinformation net profits w(). A full analysis of this model is quite complex. We restrictour analysis to two polar cases, an income risk-neutral manager and an infinitely incomerisk-averse manager.

Consider first an income risk-neutral manager. Recall that this is implied by a utilityfunction that is linear in income. Let us assume that this utility function is additively separablein effort and income. The manager likes income and dislikes effort, which can be provided ata cost z(e) to her. Thus we can write the utility function as u(w, e) = w z(e).